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\nof legal and regulatory issues\xe2\x80\x94and organized to permit instructors to tailor the materials to their\nparticular approach. This book engages students by relating law to everyday events with which they\nare already familiar (or with which they are familiarizing themselves in other business courses) and\nby its clear, concise, and readable style. (An earlier business law text by authors Lieberman and\nSiedel was hailed \xe2\x80\x9cthe best written text in a very crowded field.\xe2\x80\x9d)\nThis textbook provides context and essential concepts across the entire range of legal issues with\nwhich managers and business executives must grapple. The text provides the vocabulary and legal\nacumen necessary for businesspeople to talk in an educated way to their customers, employees,\nsuppliers, government officials\xe2\x80\x94and to their own lawyers.\nTraditional publishers often create confusion among customers in the text selection process by\noffering a huge array of publications. Once a text is selected, customers might still have to customize\nthe text to meet their needs. For example, publishers usually offer books that include either case\nsummaries or excerpted cases, but some instructors prefer to combine case summaries with a few\nexcerpted cases so that students can experience reading original material. Likewise, the manner in\nwhich most conventional texts incorporate video is cumbersome because the videos are contained in\na separate library, which makes access more complicating for instructors and students.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n2\n\n\x0cChapter 1\n\nIntroduction to Law and Legal Systems\nLEARNING OBJECTIVES\nAfter reading this chapter, you should be able to do the following:\n1.\n\nDistinguish different philosophies of law\xe2\x80\x94schools of legal thought\xe2\x80\x94and explain their relevance.\n\n2.\n\nIdentify the various aims that a functioning legal system can serve.\n\n3.\n\nExplain how politics and law are related.\n\n4.\n\nIdentify the sources of law and which laws have priority over other laws.\n\n5.\n\nUnderstand some basic differences between the US legal system and other legal systems.\n\nLaw has different meanings as well as different functions. Philosophers have considered issues of\njustice and law for centuries, and several different approaches, or schools of legal thought, have\nemerged. In this chapter, we will look at those different meanings and approaches and will consider\nhow social and political dynamics interact with the ideas that animate the various schools of legal\nthought. We will also look at typical sources of \xe2\x80\x9cpositive law\xe2\x80\x9d in the United States and how some of\nthose sources have priority over others, and we will set out some basic differences between the US\nlegal system and other legal systems.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n3\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.\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\n4\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.\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.\nIn most nation-states (as countries are called in international law), knowing who has power to make and\nenforce the laws is a matter of knowing who has political power; in many places, the people or groups that\nhave 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\nKEY TAKEAWAY\nLaw is the result of political action, and the political landscape is vastly different from nation to nation.\nUnstable or authoritarian governments often fail to serve the principal functions of law.\n\nEXERCISES\n1.\n\nConsider Burma (named Myanmar by its military rulers). What political rights do you have that the\naverage Burmese citizen does not?\n\n2.\n\nWhat is a nongovernment organization, and what does it have to do with government? Do you\ncontribute to (or are you active in) a nongovernment organization? What kind of rights do they\nespouse, what kind of laws do they support, and what kind of laws do they oppose?\n\n[1] Black\xe2\x80\x99s Law Dictionary, 6th ed., s.v. \xe2\x80\x9claw.\xe2\x80\x9d\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n5\n\n\x0c1.2 Schools of Legal Thought\nLEARNING OBJECTIVES\n1.\n\nDistinguish different philosophies of law\xe2\x80\x94schools of legal thought\xe2\x80\x94and explain their relevance.\n\n2.\n\nExplain why natural law relates to the rights that the founders of the US political-legal system found\nimportant.\n\n3.\n\nDescribe legal positivism and explain how it differs from natural law.\n\n4.\n\nDifferentiate critical legal studies and eco-feminist legal perspectives from both natural law and legal\npositivist 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 there are\nothers (see Section 1.2.3 "Other Schools of Legal Thought"), these two are the most influential in how\npeople 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 territory.\nPositivism is a philosophical movement that claims that science provides the only knowledge precise\nenough to be worthwhile. But what are we to make of the social phenomena of laws?\nWe could examine existing statutes\xe2\x80\x94executive orders, regulations, or judicial decisions\xe2\x80\x94in a fairly precise\nway to find out what the law says. For example, we could look at the posted speed limits on most US\nhighways 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 we\ncould look a little deeper and find out how the written law is usually applied. Doing so, we might conclude\nthat sixty-one miles per hour is generally allowed by most state troopers, but that occasionally someone\ngets ticketed for doing fifty-seven miles per hour in fifty-five miles per hour zone. Either approach is\nempirical, even if not rigorously scientific. The first approach, examining in a precise way what the rule\nitself says, is sometimes known as the \xe2\x80\x9cpositivist\xe2\x80\x9d school of legal thought. The second approach\xe2\x80\x94which\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n6\n\n\x0crelies on social context and the actual behavior of the principal actors who enforce the law\xe2\x80\x94is akin to the\n\xe2\x80\x9clegal realist\xe2\x80\x9d school of thought (see Section 1.2.3 "Other Schools of Legal Thought").\nPositivism has its limits and its critics. New Testament readers may recall that King Herod, 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.\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\nnorm 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n7\n\n\x0cDeclaration 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\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.\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.\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\nunjust 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n8\n\n\x0cLegal 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.\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.\nThe 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n9\n\n\x0cThe 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.\nRelated to the CLS School, yet different, is the Eco-feminist 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. Eco-feminists 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. Eco-feminists\nwould say that even with increasing civil and political rights for women (such as the right to vote) and\nwith some nations\xe2\x80\x99 recognizing the rights of children and animals and caring for the environment, the\nlegacy of the past for most nations still confirms the preeminence of \xe2\x80\x9cman\xe2\x80\x9d and his dominance of both\nnature and women.\n\nKEY TAKEAWAY\nEach of the various schools of legal thought has a particular view of what a legal system is or what it\nshould be. The natural-law theorists emphasize the rights and duties of both government and the\ngoverned. Positive law takes as a given that law is simply the command of a sovereign, the political\npower that those governed will obey. Recent writings in the various legal schools of thought emphasize\nlong-standing patterns of domination of the wealthy over others (the CLS School) and of men over\nwomen (eco-feminist legal theory).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n10\n\n\x0cEXERCISES\n1.\n\nVandana Shiva draws a picture of a stream in a forest. She says that in our society the stream is seen\nas unproductive if it is simply there, fulfilling the need for water of women\xe2\x80\x99s families and\ncommunities, until engineers come along and tinker with it, perhaps damming it and using it for\ngenerating hydropower. The same is true of a forest, unless it is replaced with a monoculture\nplantation of a commercial species. A forest may very well be productive\xe2\x80\x94protecting groundwater;\ncreating oxygen; providing fruit, fuel, and craft materials for nearby inhabitants; and creating a habitat\nfor animals that are also a valuable resource. She criticizes the view that if there is no monetary\namount that can 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?\n\n2.\n\nAnatole France said, \xe2\x80\x9cThe law, in its majesty, forbids rich and poor alike from sleeping under bridges.\xe2\x80\x9d\nWhich school of legal thought is represented by this quote?\n\n3.\n\nAdolf Eichmann was a loyal member of the National Socialist Party in the Third Reich and worked hard\nunder Hitler\xe2\x80\x99s government during World War II to round up Jewish people for incarceration\xe2\x80\x94and\neventual extermination\xe2\x80\x94at labor camps like Auschwitz and Buchenwald. After an Israeli \xe2\x80\x9cextraction\nteam\xe2\x80\x9d took him from Argentina to Israel, he was put on trial for \xe2\x80\x9ccrimes against humanity.\xe2\x80\x9d His\ndefense was that he was \xe2\x80\x9cjust following orders.\xe2\x80\x9d Explain why Eichmann was not an adherent of the\nnatural-law school of legal thought.\n\n[1] Cambridge Dictionary of Philosophy, s.v. \xe2\x80\x9cnatural law.\xe2\x80\x9d\n[2] Martin Luther King Jr., \xe2\x80\x9cLetter from Birmingham Jail.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n11\n\n\x0c1.3 Basic Concepts and Categories of US Positive Law\nLEARNING OBJECTIVES\n1.\n\nIn a general way, differentiate contract law from tort law.\n\n2.\n\nConsider the role of law in supporting ethical norms in our society.\n\n3.\n\nUnderstand the differing roles of state law and federal law in the US legal system.\n\n4.\n\nKnow 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 Chapter 8 "Contracts"). Thus it may be wrong to refuse to return a phone call from a friend,\nbut that wrong will not result in a viable lawsuit against you. But if a phone (or the Internet) is used to\nlibel or slander someone, a tort has been committed, and the law may allow the defamed person to be\ncompensated.\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\nprivate 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n12\n\n\x0cwhatever 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 came\ninto being, and a doctrine of stare decisis (pronounced STAR-ay-de-SIGH-sus) became accepted in\nEnglish courts. Stare decisis means, in Latin, \xe2\x80\x9clet the decision stand.\xe2\x80\x9d\nMost judicial decisions that don\xe2\x80\x99t apply legislative acts (known as statutes) will involve one of 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.\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 alreadydecided 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n13\n\n\x0cCourts 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\n\nContracts, including sales, commercial paper, letters of credit, and secured transactions\n\n\xe2\x80\xa2\n\nTorts\n\n\xe2\x80\xa2\n\nProperty, including real property, bailments of personal property (such as when you check your coat\nat a theater or leave your clothes with a dry cleaner), trademarks, copyrights, and the estates of\ndecedents (dead people)\n\n\xe2\x80\xa2\n\nCorporations\n\n\xe2\x80\xa2\n\nPartnerships\n\n\xe2\x80\xa2\n\nDomestic matters, including marriage, divorce, custody, adoption, and visitation\n\n\xe2\x80\xa2\n\nSecurities law\n\n\xe2\x80\xa2\n\nEnvironmental law\n\n\xe2\x80\xa2\n\nAgency law, governing the relationship between principals and their agents.\n\n\xe2\x80\xa2\n\nBanking\n\n\xe2\x80\xa2\n\nInsurance\n\nOver 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n14\n\n\x0cdecision\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(sees Chapter 7 "Introduction to Tort Law").\nSome of the basic differences between civil law and criminal law cases are illustrated in Table 1.1\n"Differences between Civil and Criminal Cases".\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 lose\nby 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\nRegarding 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n15\n\n\x0csued, 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\n\nDrive not more than fifty-five miles per hour where that speed limit is posted.\n\n\xe2\x80\xa2\n\nDo not conspire to fix prices with competitors in the US market.\n\n\xe2\x80\xa2\n\nDo not falsely represent the curative effects of your over-the-counter herbal remedy.\n\n\xe2\x80\xa2\n\nDo not drive your motor vehicle through an intersection while a red traffic signal faces the direction\nyou are coming from.\n\n\xe2\x80\xa2\n\nDo not discriminate against job applicants or employees on the basis of their race, sex, religion, or\nnational origin.\n\n\xe2\x80\xa2\n\nDo 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\nforty 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n16\n\n\x0cquestions 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?)\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 cost is designed to deprive you of property, that is, money, if you\nviolate 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\nKEY TAKEAWAY\nIn most legal systems, like that in the United States, there is a fairly firm distinction between criminal\nlaw (for actions that are offenses against the entire society) and civil law (usually for disputes between\nindividuals or corporations). Basic ethical norms for promise-keeping and not harming others are\nreflected in the civil law of contracts and torts. In the United States, both the states and the federal\ngovernment have roles to play, and sometimes these roles will overlap, as in environmental standards\nset by both states and the federal government.\n\nEXERCISES\n1.\n\nJenna gets a ticket for careless driving after the police come to investigate a car accident she had with\nyou on Hanover Boulevard. Your car is badly damaged through no fault of your own. Is Jenna likely to\nface criminal charges, civil charges, or both?\n\n2.\n\nJenna\xe2\x80\x99s ticket says that she has thirty days in which to respond to the charges against her. The thirty\ndays conforms to a state law that sets this time limit. Is the thirty-day limit procedural law or\nsubstantive law?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n17\n\n\x0c1.4 Sources of Law and Their Priority\nLEARNING OBJECTIVES\n1.\n\nDescribe the different sources of law in the US legal system and the principal institutions that create\nthose laws.\n\n2.\n\nExplain in what way a statute is like a treaty, and vice versa.\n\n3.\n\nExplain why the Constitution is \xe2\x80\x9cprior\xe2\x80\x9d and has priority over the legislative acts of a majority, whether\nin the US Congress or in a state legislature.\n\n4.\n\nDescribe 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.\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).\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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n18\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.\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 interests.\xe2\x80\xa6\n[T]he point here is that privacy, like the other unalienable rights listed first in our Constitution\xe2\x80\xa6is\nunquestionably 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.\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.\nEach 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n19\n\n\x0ca 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.\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.\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 at http://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.\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).\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").\nAgencies propose rules in the Federal Register, published each working day of the year. Rules that are\nformally adopted are published in the Code 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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n20\n\n\x0cLike 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.\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.\nUnited 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n21\n\n\x0cability\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\nStatutes 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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n22\n\n\x0con Tariffs and Trade (GATT) and obligations made later through the World Trade Organization (WTO)\nwould override previous federal or state statutes.\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.\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\nargument invokes utilitarian theory (that the best policy does the greatest good overall for society) and\nDavid Ricardo\xe2\x80\x99s theory of comparative advantage.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n23\n\n\x0ccontract 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.\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\nof action in the courts depends on whether the state courts still recognize and enforce this nowdisappearing cause of action.\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.\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.\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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n24\n\n\x0cperson 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.\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.\nCourts 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\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.\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.\nWhat has the court actually decided, and why? Remember that a court, especially the US Supreme Court,\nis not only deciding one particular case but also setting down guidelines (in its holdings) for federal and\nstate courts that encounter similar issues. Note that court cases often raise a variety of issues or questions\nto be resolved, 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.\nBeyond the decision of the court, it is in looking at the court\xe2\x80\x99s reasoning that you are most likely to\nunderstand what facts have been most significant to the court and what theories (schools of legal thought)\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n25\n\n\x0ceach 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\nKEY TAKEAWAY\nThere are different sources of law in the US legal system. The US Constitution is foundational; US\nstatutory and common law cannot be inconsistent with its provisions. Congress creates statutory law\n(with the signature of the president), and courts will interpret constitutional law and statutory law.\nWhere there is neither constitutional law nor statutory law, the courts function in the realm of\ncommon law. The same is true of law within the fifty states, each of which also has a constitution, or\nfoundational law.\nBoth the federal government and the states have created administrative agencies. An agency only has\nthe power that the legislature gives it. Within the scope of that power, an agency will often create\nregulations (see Chapter 5 "Administrative Law"), which have the same force and effect as statutes.\nTreaties are never negotiated and concluded by states, as the federal government has exclusive\nauthority over relations with other nation-states. A treaty, once ratified by the Senate, has the same\nforce and effect as a statute passed by Congress and signed into law by the president.\nConstitutions, statutes, regulations, treaties, and court decisions can provide a legal basis in the\npositive law. You may believe you have been wronged, but for you to have a right that is enforceable in\ncourt, you must have something in the positive law that you can point to that will support a cause of\naction against your chosen defendant.\n\nEXERCISES\n1.\n\nGive one example of where common law was overridden by the passage of a federal statute.\n\n2.\n\nHow does common law change or evolve without any action on the part of a legislature?\n\n3.\n\nLindsey Paradise is not selected for her sorority of choice at the University of Kansas. She has spent all\nher time rushing that particular sorority, which chooses some of her friends but not her. She is\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n26\n\n\x0cdisappointed and angry and wants to sue the sorority. What are her prospects of recovery in the legal\nsystem? Explain.\n[1] Rulon-Miller v. International Business Machines Corp., 162 Cal. App.3d 241, 255 (1984).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n27\n\n\x0c1.5 Legal and Political Systems of the World\nLEARNING OBJECTIVE\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\n28\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.\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.\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.\n\nKEY TAKEAWAY\nLegal systems vary widely in their aims and in the way they process civil and criminal cases. Commonlaw systems use juries, have one judge, and adhere to precedent. Civil-law systems decide cases\nwithout a jury, often use three judges, and often render shorter opinions without reference to\npreviously decided cases.\n\nEXERCISE\n1.\n\nUse the Internet to identify some of the better-known nations with civil-law systems. Which Asian\nnations came to adopt all or part of civil-law traditions, and why?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n29\n\n\x0c1.6 A Sample Case\nPreliminary Note to Students\nTitle VII of the Civil Rights Act of 1964 is a federal statute that applies to all employers whose workforce\nexceeds fifteen people. The text of Title VII says that\n(a) it shall be an unlawful employment practice for an employer\xe2\x80\x94\n(1) to fail or refuse to hire or to discharge any individual, or otherwise to discriminate against 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.\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.\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.\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.\nThis 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n30\n\n\x0ccarefully. 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\nHarris v. Forklift Systems\n510 U.S. 17 (U.S. Supreme Court 1992)\nJUDGES: O\xe2\x80\x99CONNOR, J., delivered the opinion for a unanimous Court. SCALIA, J., and GINSBURG, J.,\nfiled concurring opinions.\nJUSTICE O\xe2\x80\x99CONNOR delivered the opinion of the Court.\nIn this case we consider the definition of a discriminatorily \xe2\x80\x9cabusive work environment\xe2\x80\x9d (also 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).\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\nasked 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n31\n\n\x0cHarris 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\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).\nWe 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).\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n32\n\n\x0cand 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.\nThis standard, which we reaffirm today, takes a middle path between makings 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 a\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.\nBut Title VII comes into play before the harassing conduct leads to a nervous breakdown. A\ndiscriminatorily abusive work environment, even one that does not seriously affect employees\xe2\x80\x99\npsychological well-being, can and often will detract from employees\xe2\x80\x99 job performance, 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n33\n\n\x0cstatute 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.\nThis is not, and by its nature cannot be, a mathematically precise test. We need not answer today all the\npotential questions it raises, or 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\neffect 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.\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\nWe therefore reverse the judgment of the Court of Appeals, and remand the case for further proceedings\nconsistent with this opinion.\nSo ordered.\n\nNote to Students\nThis was only the second time that the Supreme Court had decided a sexual harassment case. Many\nfeminist legal studies scholars feared that the court would raise the bar and make hostile-workingenvironment claims under Title VII more difficult to win. That did not happen. When the question to be\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n34\n\n\x0cdecided is combined with the court\xe2\x80\x99s decision, we get the holding of the case. Here, the question that the\ncourt poses, plus its answer, yields a holding that \xe2\x80\x9cAn employee need not prove severe psychological\ninjury in order to win a Title VII sexual harassment claim.\xe2\x80\x9d This holding will be true until such time as the\ncourt revisits a similar question and answers it differently. This does happen, but happens rarely.\n\nCASE QUESTIONS\n1.\n\nIs this a criminal case or a civil-law case? How can you tell?\n\n2.\n\nIs the court concerned with making a procedural rule here, or is the court making a statement about the\nsubstantive law?\n\n3.\n\nIs this a case where the court is interpreting the Constitution, a federal statute, a state statute, or the\ncommon law?\n\n4.\n\nIn Harris v. Forklift, what if the trial judge does not personally agree that women should have any rights to\nequal treatment in the workplace? Why shouldn\xe2\x80\x99t that judge dismiss the case even before trial? Or should\nthe judge dismiss the case after giving the female plaintiff her day in court?\n\n5.\n\nWhat was the employer\xe2\x80\x99s argument in this case? Do you agree or disagree with it? What if those who\nlegislated Title VII gave no thought to the question of seriousness of injury at all?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n35\n\n\x0c1.7 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\ninspired 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\nEXERCISES\n1.\n\nWhat is the common law? Where do the courts get the authority to interpret it and to change it?\n\n2.\n\nAfter World War II ended in 1945, there was an international tribunal at Nuremberg that prosecuted\nvarious officials in Germany\xe2\x80\x99s Third Reich who had committed \xe2\x80\x9ccrimes against humanity.\xe2\x80\x9d Many of\nthem claim that they were simply \xe2\x80\x9cfollowing orders\xe2\x80\x9d of Adolf Hitler and his chief lieutenants. What\nlaw, if any, have they violated?\n\n3.\n\nWhat does stare decisis mean, and why is it so basic to common-law legal tradition?\n\n4. In the following situations, which source of law takes priority, and why?\na.\n\nThe state statute conflicts with the common law of that state.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n36\n\n\x0cb.\n\nA federal statute conflicts with the US Constitution.\n\nc.\n\nA common-law decision in one state conflicts with the US Constitution.\n\nd.\n\nA federal statute conflicts with a state constitution.\n\nSELF-TEST QUESTIONS\n1.\n\nThe source of law that is foundational in the US legal system is\n\na.\n\nthe common law\n\nb.\n\nstatutory law\n\nc.\n\nconstitutional law\n\nd.\n\nadministrative law\n\xe2\x80\x9cLaw is the command of a sovereign\xe2\x80\x9d represents what school of legal thought?\n\na.\n\ncivil law\nb.\n\nconstitutional law\n\nc.\n\nnatural law\n\nd.\n\neco-feminist law\n\ne.\n\npositive law\nWhich of the following kinds of law are most often found in state law rather than federal\nlaw?\n\na.\n\ntorts and contracts\nb.\n\nbankruptcy\n\nc.\n\nmaritime law\n\nd.\n\ninternational law\nWhere was natural law discovered?\na.\n\nin nature\n\nb.\n\nin constitutions and statutes\n\nc.\n\nin the exercise of human reason\n\nd.\n\nin the Wall Street Journal\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n37\n\n\x0cWolfe is a state court judge in California. In the case of Riddick v. Clouse, which involves a\ncontract dispute, Wolfe must follow precedent. She establishes a logical relationship between\nthe Riddick case and a case decided by the California Supreme Court, Zhu v. Patel Enterprises,\nInc. She compares the facts of Riddick to the facts in Zhu and to the extent the facts are\nsimilar, applies the same rule to reach her decision. This is\na.\n\ndeductive reasoning\nb.\n\nfaulty reasoning\n\nc.\n\nlinear reasoning\n\nd.\n\nreasoning by analogy\nMoore is a state court judge in Colorado. In the case of Cassidy v. Seawell, also a contract\ndispute, there is no Colorado Supreme Court or court of appeals decision that sets forth a rule\nthat could be applied. However, the California case of Zhu v. Patel Enterprises, Inc. is \xe2\x80\x9cvery\nclose\xe2\x80\x9d on the facts and sets forth a rule of law that could be applied to the Cassidy case. What\nprocess must Moore follow in considering whether to use the Zhu case as precedent?\n\na.\n\nMoore is free to decide the case any way he wants, but he may not look at decisions and\n\nreasons in similar cases from other states.\nb.\n\nMoore must wait for the Colorado legislature and the governor to pass a law that addresses\nthe issues raised in the Cassidy case.\n\nc.\n\nMoore must follow the California case if that is the best precedent.\n\nd.\n\nMoore may follow the California case if he believes that it offers the best reasoning for a\nsimilar case.\n\nSELF-TEST ANSWERS\n1.\n\nc\n\n2.\n\ne\n\n3.\n\na\n\n4.\n\nc\n\n5.\n\nd\n\n6.\n\nd\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n38\n\n\x0cChapter 2\nCorporate Social Responsibility and Business Ethics\nA great society is a society in which [leaders] of business think greatly about their functions.\nAlfred North Whitehead\n\nLEARNING OBJECTIVES\nAfter reading this chapter, you should be able to do the following:\n1.\n\nDefine ethics and explain the importance of good ethics for business people and business\norganizations.\n\n2.\n\nUnderstand the principal philosophies of ethics, including utilitarianism, duty-based ethics, and virtue\nethics.\n\n3.\n\nDistinguish between the ethical merits of various choices by using an ethical decision model.\n\n4.\n\nExplain the difference between shareholder and stakeholder models of ethical corporate governance.\n\n5.\n\nExplain why it is difficult to establish and maintain an ethical corporate culture in a business\norganization.\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\n39\n\n\x0c2.1 What Is Ethics?\nLEARNING OBJECTIVES\n1.\n\nExplain how both individuals and institutions can be viewed as ethical or unethical.\n\n2.\n\nExplain how law and ethics are different, and why a good reputation can be more important than legal\ncompliance.\n\nMost 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.\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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n40\n\n\x0cword 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.\nA word such as good can embrace ethical or moral values but also non-ethical 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.\nThere are three key points here:\n1.\n\nAlthough morals and ethics are not precisely measurable, people generally have similar reactions\nabout what actions or conduct can rightly be called ethical or moral.\n\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\nor company is ethical.\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\n41\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.\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.\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\xe2\x80\xa2\n\nIndividuals and organizations have reputations. (For an individual, moral reputation is most often\ntied to others\xe2\x80\x99 perceptions of his or her character: is the individual honest, diligent, reliable, fair, and\ncaring? The reputation of an organization is built on the goodwill that suppliers, customers, the\ncommunity, and employees feel toward it. Although an organization is not a person in the usual sense,\nthe goodwill that people feel about the organization is based on their perception of its better qualities\nby a variety of stakeholders: customers or clients, suppliers, investors, employees, government\nofficials).\n\n\xe2\x80\xa2\n\nThe goodwill of an organization is to a great extent based on the actions it takes and on whether the\nactions are favorably viewed. (This goodwill is usually specifically counted in the sale of a business as\nan asset that the buyer pays for. While it is difficult to place a monetary value on goodwill, a firm\xe2\x80\x99s\ngood reputation 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\ngroup decision that doing so is immoral. Thus the law provides some important cues as to what society\nregards as right or wrong.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n42\n\n\x0ccontroversies 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 seems lack of moral sensitivity.\nThe 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n43\n\n\x0cThe 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.\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.\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\nKEY TAKEAWAY\nLegal compliance is not the same as acting ethically. Your reputation, individually or corporately,\ndepends on how others regard your actions. Goodwill is hard to measure or quantify, but it is real\nnonetheless and can best be protected by acting ethically.\n\nEXERCISES\n1.\n\nThink of a person who did something morally wrong, at least to your way of thinking. What was it?\nExplain to a friend of yours\xe2\x80\x94or a classmate\xe2\x80\x94why you think it was wrong. Does your friend agree?\nWhy or why not? What is the basic principle that forms the basis for your judgment that it was wrong?\n\n2.\n\nThink of a person who did something morally right, at least to your way of thinking. (This is not a\nmatter of finding something they did well, like efficiently changing a tire, but something good.) What\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n44\n\n\x0cwas it? Explain to a friend of yours\xe2\x80\x94or a classmate\xe2\x80\x94why you think it was right. Does your friend\nagree? Why or why not? What is the basic principle that forms the basis for your judgment that it was\nright?\n3.\n\nThink of an action by a business organization (sole proprietor, partnership, or corporation) that was\nlegal but still strikes you as wrong. What was it? Why do you think it was wrong?\n\n4.\n\nThink of an act by an individual or a corporation that is ethical but not legal. Compare your answer\nwith those of your classmates: were you more likely to find an example from individual action or\ncorporate action? Do you have any thoughts as to why?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n45\n\n\x0c2.2 Major Ethical Perspectives\nLEARNING OBJECTIVES\n1.\n\nDescribe the various major theories about ethics in human decision making.\n\n2.\n\nBegin considering how the major theories about ethics apply to difficult choices in life and business.\n\nThere 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 freemarket 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n46\n\n\x0cThis 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?\nNotice 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.\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, and 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.\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:\n1.\n\nFailing 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.\n\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\n47\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\nor repair known and dangerous defects because it seemed more profitable not to. In 2010, Toyota\nlearned the same lesson.\n4. Underestimating the cost or harm of a certain decision to someone else or some other group of\npeople.\n5.\n\nFavoring short-term benefits, even though the long-term costs are greater.\n\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n48\n\n\x0creversibility: if you make a decision as though you didn\xe2\x80\x99t know what role or position you would have after\nthe 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 duty\nfirst, act rationally, and give moral weight to the inherent equality of all human beings.\nIn considering whether to lie on your resume, reversibility requires you to actively imagine both 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.\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.\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\nand 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n49\n\n\x0cGovernance") 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).\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\nthe social 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.\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\nCalifornia) and nation-states (such as the United States or Germany). Our Constitution can be seen as a\nfundamental social contract.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n50\n\n\x0corganic 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.\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.\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.\nThe relationship between rights and duties\xe2\x80\x94in both law and ethics\xe2\x80\x94calls for some explanations:\n1.\n\nIf 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,\nbut you can\xe2\x80\x99t get away with threatening the president\xe2\x80\x99s life. Even if your criticisms are strong and\ninsistent, you have the right (and our government has the duty to protect your right) to speak freely.\nIn Singapore during the 1990s, even indirect criticisms\xe2\x80\x94mere hints\xe2\x80\x94of the political leadership were\nenough to land you in jail or at least silence you with a libel suit.\n\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\nstate\xe2\x80\x94have been violated. Thus other people have a duty to respect your rights and to not punch you\nin the nose.\n3. Your right in legal terms is only as good as your society\xe2\x80\x99s willingness to provide legal remedies\nthrough the courts and political institutions of society.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n51\n\n\x0cA distinction between basic rights and non-basic 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 in\ncontrast 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\n[1]\n\nAristotle 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.\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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n52\n\n\x0cFrom 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?\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\n[2]\n\nAs 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.\nTo simplify, let\xe2\x80\x99s say that there are ethical and non-ethical 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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n53\n\n\x0cAmong 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.\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.\nNotice 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.\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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n54\n\n\x0cKEY TAKEAWAY\nThroughout history, people have pondered what it means \xe2\x80\x9cto do what is right.\xe2\x80\x9d Some of the main\nanswers have come from the differing perspectives of utilitarian thought; duty-based, or deontological,\nthought; social contract theory; and virtue ethics.\n\nEXERCISES\nXYZ Motor Corporation begins to get customer complaints about two models of its automobiles.\nCustomers have had near-death experiences from sudden acceleration; they would be driving along a\nhighway at normal speed when suddenly the car would begin to accelerate and efforts to stop the\nacceleration by braking fail to work. Drivers could turn off the ignition and come to a safe stop, but XYZ\ndoes not instruct buyers of its cars to do so, nor is this a common reaction among drivers who\nexperience sudden acceleration.\nInternal investigations of half a dozen accidents in US locations come to the conclusion that the\naccidents are not being caused by drivers who mistake the gas pedal for the brake pedal. In fact, there\nappears to be a possible flaw in both models, perhaps in a semiconductor chip, that makes sudden\nacceleration happen. Interference by floor mats and poorly designed gas pedals do not seem to be the\nproblem.\nIt is voluntary to report these incidents to the National Highway Traffic and Safety Administration\n(NHTSA), but the company decides that it will wait awhile and see if there are more complaints.\nRecalling the two models so that local dealers and their mechanics could examine them is also an\noption, but it would be extremely costly. Company executives are aware that quarterly and annual\nprofit-and-loss statements, on which their bonuses depend, could be decisively worse with a recall.\nThey decide that on a cost-benefit basis, it makes more sense to wait until there are more accidents\nand more data. After a hundred or more accidents and nearly fifteen fatalities, the company institutes\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n55\n\n\x0ca selective recall, still not notifying NHTSA, which has its own experts and the authority to order XYZ to\ndo a full recall of all affected models.\nExperts have advised XYZ that standard failure-analysis methodology requires that the company obtain\nabsolutely every XYZ vehicle that has experienced sudden acceleration, using microscopic analysis of all\ncritical components of the electronic system. The company does not wish to take that advice, as it would\nbe\xe2\x80\x94as one top executive put it\xe2\x80\x94\xe2\x80\x9ctoo time-consuming and expensive.\xe2\x80\x9d\n1.\n\nCan XYZ\xe2\x80\x99s approach to this problem be justified under utilitarian theory? If so, how? If not, why not?\n\n2.\n\nWhat would Kant advise XYZ to do? Explain.\n\n3.\n\nWhat would the \xe2\x80\x9cvirtuous\xe2\x80\x9d approach be for XYZ in this situation?\n\n[1] LaRue Tone Hosmer, Moral Leadership in Business (Chicago: Irwin Professional Publishing, 1994), 72.\n[2] James O\xe2\x80\x99Toole and Don Mayer, eds., Good Business: Exercising Effective and Ethical Leadership (London:\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n56\n\n\x0c2.3 An Ethical Decision Model\nLEARNING OBJECTIVE\n1.\n\nUnderstand one model for ethical decision making: a process to arrive at the most ethical option for\nan individual or a business organization, using a virtue ethics approach combined with some elements\nof stakeholder analysis and utilitarianism.\n\nJosephson\xe2\x80\x99s Core Values Model\nOnce you recognize that there is a decision that involves ethical judgment, Michael Josephson 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.\n\nIdentify the stakeholders. That is, who are the potential gainers and losers in the various decisions\nthat might be made here?\n\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.\n\nIf there is no decision that satisfies the greatest number of core values, try to determine which\ndecision delivers the greatest good to the various stakeholders.\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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n57\n\n\x0ctrust. 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.\nRespect: 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.\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.\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.\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.\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.\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.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n58\n\n\x0cThat 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\nthat 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\nKEY TAKEAWAY\nHaving a step-by-step process to analyze difficult moral dilemmas is useful. One such process is offered\nhere, based on the core values of trustworthiness, caring, respect, fairness, responsibility, and\ncitizenship.\n\nEXERCISE\n1.\n\nConsider XYZ in the exercises for Section 2.2.5 "Josephson\xe2\x80\x99s Core Values Analysis and Decision\nProcess" and use the core values decision-making model. What are XYZ\xe2\x80\x99s options when they first\nnotice that two of their models are causing sudden acceleration incidents that put their customers at\nrisk? Who are the stakeholders? What options most clearly meet the criteria for each of the core\nvalues?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n59\n\n\x0c2.4 Corporations and Corporate Governance\nLEARNING OBJECTIVES\n1.\n\nExplain the basic structure of the typical corporation and how the shareholders own the company and\nelect directors to run it.\n\n2.\n\nUnderstand how the shareholder profit-maximization model is different from stakeholder theory.\n\n3.\n\nDiscern and describe the ethical challenges for corporate cultures.\n\n4.\n\nExplain what conscious capitalism is and how it differs from stakeholder theory.\n\nLegal Organization of the Corporation\nFigure 2.1 Corporate Legal Structures\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n60\n\n\x0celect 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 interests; 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\nreplace 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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n61\n\n\x0csame 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\nPresumably, the individuals who are to be responsible are businessmen, which mean individual\nproprietors or corporate executives\xe2\x80\xa6In a free enterprise, private-property system; a corporate executive is\nan 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\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\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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n62\n\n\x0ccharity, 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.\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.\nIn 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\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 non-shareholder interests.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n63\n\n\x0cStakeholder 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.\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\nincorporation 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.\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.\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 that\na 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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n64\n\n\x0cAccording 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\nTable 2.1 The Stakes of Various Stakeholders\n\nManagers\n\nOwnership\n\nThe value of the organization has a direct impact on the wealth of these\nstakeholders.\n\nDirectors who\nown stock\nShareholders\nSalaried\nmanagers\nCreditors\nSuppliers\n\nEconomic\nDependence\n\nStakeholders can be economically dependent without having ownership.\nEach of these stakeholders relies on the corporation in some way for\nfinancial well-being.\n\nEmployees\nLocal\ncommunities\nCommunities\n\nSocial Interests\n\nThese stakeholders are not directly linked to the organization but have\nan interest in making sure the organization acts in a socially responsible\nmanner.\n\nGovernment\nMedia\n\nCorporate Culture and Codes of Ethics\nA corporation is a \xe2\x80\x9cperson\xe2\x80\x9d capable of suing, being sued, and having rights and duties in our 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.\nWhat follows is a series of observations about corporations, ethics, and corporate culture.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n65\n\n\x0cEthical 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\nCEO 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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n66\n\n\x0cThe 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\ncorporate response.\n\n[4]\n\nThe corporate response was consistent with that code, which was lived and\n\nmodeled by the top of the organization.\nIt\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 is 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.\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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n67\n\n\x0cManaging by the Numbers\nIf 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.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n68\n\n\x0cThe 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.\nUltimately, 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\n\nPeople generally choose short-term gains over potential long-term losses.\n\n\xe2\x80\xa2\n\nPeople often justify the harm to others as being minimal or \xe2\x80\x9cnecessary\xe2\x80\x9d to achieve the desired sales\nquota or financial goal.\n\n\xe2\x80\xa2\n\nIn working as a group, we often form an \xe2\x80\x9cus versus them\xe2\x80\x9d mentality. In the Sears case, it is likely 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\n\xe2\x80\xa2\n\nThe long-term losses to Sears are difficult to quantify, while the short-term gains were easy to\nmeasure and (at least for a brief while) quite satisfying financially.\n\n\xe2\x80\xa2\n\nSears\xe2\x80\x99 ongoing rip-offs were possible only because individual consumers lacked the relevant\ninformation about the service being offered. This lack of information is a market failure, since many\nconsumers were demanding more of Sears Auto Center services than they would have (and at a higher\nprice) if relevant information had been available to them earlier. Sears, like other sellers of goods and\nservices, took advantage of a market system, which, in its ideal form, would not permit such\ninformation distortions.\n\n\xe2\x80\xa2\n\nPeople in the organization probably thought that the actions they took were necessary.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n69\n\n\x0cNoting 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.\nThe 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 make 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.\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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n70\n\n\x0c[1] See Robert Jackall, Moral Mazes: The World of Corporate Managers (New York: Oxford University Press, 1988).\n[2] John Schwartz, \xe2\x80\x9cAn Enron Unit Chief Warned, and Was Rebuffed,\xe2\x80\x9d New York Times, February 20, 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: The Johnson &\nJohnson Tylenol Crisis, accessed April 5, 2011.\n[5] Find Law, Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron\nCorp., February 1, 2002, accessed April 5, 2011,http://news.findlaw.com/wsj/docs/enron/sicreport.\n[6] Steven Pearlstein, \xe2\x80\x9cDebating the Enron Effect,\xe2\x80\x9d Washington Post, February 17, 2002.\n[7] Milton Friedman, John Mackey, and T. J. Rodgers, \xe2\x80\x9cRethinking the Social Responsibility of Business,\xe2\x80\x9d\nReason.com, October 2005,http://reason.com/archives/2005/10/01/rethinking-the-social-responsi.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n71\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\nEXERCISES\n1.\n\nConsider again Milton Friedman\xe2\x80\x99s article.\n\na.\n\nWhat does Friedman mean by \xe2\x80\x9cethical custom\xe2\x80\x9d?\n\nb.\n\nIf the laws of the society are limiting the company\xe2\x80\x99s profitability, would the company be within\nits rights to disobey the law?\n\nc.\n\nWhat if the law is \xe2\x80\x9con the books,\xe2\x80\x9d but the company could count on a lack of enforcement from\nstate officials who were overworked and underpaid? Should the company limit its profits?\nSuppose that it could save money by discharging a pollutant into a nearby river, adversely\naffecting fish and, potentially, drinking water supplies for downstream municipalities. In\npolluting against laws that aren\xe2\x80\x99t enforced, is it still acting \xe2\x80\x9cwithin the rules of the game\xe2\x80\x9d?\nWhat if almost all other companies in the industry were saving money by doing similar acts?\nConsider again the Harris v. Forklift case at the end of Chapter 1 "Introduction to Law and\nLegal Systems". The Supreme Court ruled that Ms. Harris was entitled to be heard again by the\nfederal district court, which means that there would be a trial on her claim that Mr. Hardy,\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n72\n\n\x0cowner of Forklift Systems, had created a \xe2\x80\x9chostile working environment\xe2\x80\x9d for Ms. Harris. Apart\nfrom the legal aspects, did he really do anything unethical? How can you tell?\na.\nb.\n\nWhich of his actions, if any, were contrary to utilitarian thinking?\n\nIf Kant were his second-in-command and advising him on ethical matters, would he have\napproved of Mr. Hardy\xe2\x80\x99s behavior? Why or why not?\nConsider the behaviors alleged by Ms. Harris and assume for a moment that they are all true. In\n\nterms of core values, which of these behaviors are not consistent with the core values Josephson\npoints to? Be specific.\nAssume that Forklift Systems is a large public corporation and that the CEO engages in these kinds\nof behaviors. Assume also that the board of directors knows about it. What action should the board\ntake, and why?\nAssume that the year is 1963, prior to the passage of the Civil Rights Act of 1964 and the Title\nVII provisions regarding equal employment opportunity that prohibit discrimination based on\nsex. So, Mr. Hardy\xe2\x80\x99s actions are not illegal, fraudulent, or deceitful. Assume also that he heads\na large public company and that there is a large amount of turnover and unhappiness among\nthe women who work for the company. No one can sue him for being sexist or lecherous, but\nare his actions consistent with maximizing shareholder returns? Should the board be\nconcerned?\nNotice that this question is really a stand-in for any situation faced by a company today regarding\nits CEO where the actions are not illegal but are ethically questionable. What would conscious\ncapitalism tell a CEO or a board to do where some group of its employees are regularly harassed or\ndisadvantaged by top management?\n\nSELF-TEST QUESTIONS\n1.\na.\n\nMilton Friedman would have been most likely to agree to which of the following statements?\nThe purpose of the corporation is to find a path to sustainable corporate profits by paying\n\ncareful attention to key stakeholders.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n73\n\n\x0cb.\n\nThe business of business is business.\n\nc.\n\nThe CEO and the board should have a single-minded focus on delivering maximum value to\nshareholders of the business.\n\nd.\n\nAll is fair in love, war, and business.\nMilton Friedman meant (using the material quoted in this chapter) that companies should\n\na.\n\nFind a path to sustainable profits by looking at the interconnected needs and desires of all\n\nthe stakeholders.\nb.\n\nAlways remember that the business of business is business.\n\nc.\n\nRemind the CEO that he or she has one duty: to maximize shareholder wealth by any means\npossible.\n\nd.\n\nMaximize shareholder wealth by engaging in open competition without fraud or deceit.\nWhat are some key drawbacks to utilitarian thinking at the corporate level?\na.\n\nThe corporation may do a cost-benefit analysis that puts the greatest good of the firm above\n\nall other considerations.\nb.\n\nIt is difficult to predict future consequences; decision makers in for-profit organizations will tend\nto overestimate the upside of certain decisions and underestimate the downside.\n\nc.\n\nShort-term interests will be favored over long-term consequences.\n\nd.\n\nall of the above\n\ne.\n\na and b only\nWhich ethical perspective would allow that under certain circumstances, it might be ethical\nto lie to a liar?\n\na.\n\ndeontology\n\nb.\n\nvirtue ethics\n\nc.\n\nutilitarianism\n\nd.\n\nall of the above\nUnder conscious capitalism,\n\na.\n\nVirtue ethics is ignored.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n74\n\n\x0cb.\n\nShareholders, whether they be traders or long-term investors, are always the first and last\nconsideration for the CEO and the board.\n\nc.\n\nMaximizing profits comes from a focus on higher purposes and harmonizing the interests of\nvarious stakeholders.\n\nd.\n\nKantian duties take precedence over cost-benefit analyses.\n\nSELF-TEST ANSWERS\n1.\n\nc\n\n2.\n\nd\n\n3.\n\nd\n\n4.\n\nc\n\n5.\n\nc\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n75\n\n\x0cChapter 3\nCourts and the Legal Process\nLEARNING OBJECTIVES\nAfter reading this chapter, you should be able to do the following:\n1.\n\nDescribe the two different court systems in the United States, and explain why some cases can be filed\nin either court system.\n\n2.\n\nExplain the importance of subject matter jurisdiction and personal jurisdiction and know the\ndifference between the two.\n\n3.\n\nDescribe the various stages of a civil action: from pleadings, to discovery, to trial, and to appeals.\n\n4.\n\nDescribe 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n76\n\n\x0cstate 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.\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\n77\n\n\x0c3.1 The Relationship between State and Federal Court Systems\nin the United States\nLEARNING OBJECTIVES\n1.\n\nUnderstand the different but complementary roles of state and federal court systems.\n\n2.\n\nExplain why it makes sense for some courts to hear and decide only certain kinds of cases.\n\n3.\n\nDescribe 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\nColumbia, and the federal court system. At the same time, these are not entirely separate; they all have\nseveral points of contact.\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 reiterated 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n78\n\n\x0cAs 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.\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 New\nJersey may sue a citizen of New York over a contract dispute in federal court, but if both were citizens of\nNew Jersey, the plaintiff would be limited to the state courts. The Constitution established diversity\njurisdiction because it was feared that local courts would be hostile toward people from other states and\nthat they would need separate courts. In 2009, nearly a third of all lawsuits filed in federal court were\nbased on diversity of citizenship. In these cases, the federal courts were applying state law, rather than\ntaking federal question jurisdiction, where federal law provided the basis for the lawsuit or where the\nUnited States was a party (as plaintiff or defendant).\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n79\n\n\x0csome 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\nhas original 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\nIn 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n80\n\n\x0csuch 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.\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 was 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").\nMost 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).\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n81\n\n\x0cthe 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\na writ of certiorari remains a possibility.\n\nThe Federal Court System\nDistrict 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\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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n82\n\n\x0cUnited 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\nsubmitted. 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n83\n\n\x0cFederal 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\nKEY TAKEAWAY\nTrial courts and appellate courts have different functions. State trial courts sometimes hear cases with\nfederal law issues, and federal courts sometimes hear cases with state law issues. Within both state\nand federal court systems, it is useful to know the different kinds of courts and what cases they can\ndecide.\n\nEXERCISES\n1.\n\nWhy all of this complexity? Why don\xe2\x80\x99t state courts hear only claims based on state law, and federal\ncourts only federal-law-based claims?\n\n2.\n\nWhy would a plaintiff in Iowa with a case against a New Jersey defendant prefer to have the case\nheard in Iowa?\n\n3.\n\nJames, a New Jersey resident, is sued by Jonah, an Iowa resident. After a trial in which James appears\nand vigorously defends himself, the Iowa state court awards Jonah $136,750 dollars in damages for his\ntort claim. In trying to collect from James in New Jersey, Jonah must have the New Jersey court certify\nthe Iowa judgment. Why, ordinarily, must the New Jersey court do so?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n84\n\n\x0c3.2 The Problem of Jurisdiction\nLEARNING OBJECTIVES\n1.\n\nExplain the concept of subject matter jurisdiction and distinguish it from personal jurisdiction.\n\n2.\n\nUnderstand how and where the US Constitution provides a set of instructions as to what federal\ncourts are empowered by law to do.\n\n3.\n\nKnow which kinds of cases must be heard in federal courts only.\n\n4.\n\nExplain diversity of citizenship jurisdiction and be able to decide whether a case is eligible for diversity\njurisdiction 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.\nThere 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 founders\nin whom power is shared between states and the federal government. This sharing requires a division of\nlabor between the states and the federal government. It is Article III of the US Constitution that spells out\nthe respective spheres of authority (jurisdiction) between state and federal courts.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n85\n\n\x0cTake 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.\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\ngo 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.\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 Law \xe2\x80\x9cof this text.) People have had a need to\nresolve this kind of dispute long before our federal courts were created, and you can tell from Article III\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n86\n\n\x0cthat the founders did not specify that tort or negligence claims should be handled by the federal courts.\nAgain, federal courts are courts of limited jurisdiction, limited to the kinds of cases specified in Article III.\nIf the case before the federal court does not fall within one of those categories, the federal court cannot\nconstitutionally hear the case because it does not have subject matter jurisdiction.\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.\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\ndecide 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\napplicable statute of limitations, it will be too late to re-file in the correct court system. Such cases will be\nroutinely dismissed, regardless of how deserving the plaintiff might be in his quest for justice. (The\nplaintiff\xe2\x80\x99s only remedy at that point would be to sue his lawyer for negligence for failing to mind the clock\nand get to the right court in time!)\n\nExclusive Jurisdiction in Federal Courts\nWith two court systems, a plaintiff (or the plaintiff\xe2\x80\x99s attorney, most likely) must decide whether 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:\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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n87\n\n\x0cBy 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:\n1.\n\nSuits between states. Cases in which two or more states are a party.\n\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,\ncrimes against the law of nations, and crimes relating to the federal government\xe2\x80\x99s authority to\nregulate interstate 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.\n\nPatent, 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,\nprice fixing, 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.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n88\n\n\x0cOther cases specified by federal statute. Any other cases specified by a federal statute where\nCongress declares that federal courts will have exclusive jurisdiction.\n\nConcurrent Jurisdiction\nWhen a plaintiff takes a case to state court, it will be because state courts typically hear that kind 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\n1964), 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. (See Note 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.\n\nA court must always have subject matter jurisdiction and personal jurisdiction over at least one\ndefendant, to hear and decide a case.\n\n2. A state court will have subject matter jurisdiction over any case that is not required to be brought in a\nfederal court.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n89\n\n\x0cSome cases can only be brought in federal court, such as bankruptcy cases, cases involving federal crimes,\npatent cases, and Internal Revenue Service tax court claims. The list of cases for exclusive federal\njurisdiction is fairly short. That means that almost any state court will have subject matter jurisdiction\nover almost any kind of case. If it\xe2\x80\x99s a case based on state law, a state court will always have subject matter\njurisdiction.\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)\nOR\nA 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(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(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.\n4. In diversity cases, the following rules apply.\n(1) Federal civil procedure rules apply to how the case is conducted before and during trial and any\nappeals, but\n(2) State law will be used as the basis for a determination of legal rights and responsibilities.\n(a) This \xe2\x80\x9cchoice of law\xe2\x80\x9d process is interesting but complicated. Basically, each state has its own 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\n90\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(3) Why do some nonresident defendants prefer to be in federal court?\n(a) In the state court, the judge is elected, and the jury may be familiar with or sympathetic to the \xe2\x80\x9clocal\xe2\x80\x9d\nplaintiff.\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(4) If a defendant does not want to be in state court and there is diversity, what is to be done?\n(a) Make a motion for removal to the federal court.\n(b) The federal court will not want to add to its caseload, or docket, but must take the case 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\nfederal 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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n91\n\n\x0cBut 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\n\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.\nIf 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n92\n\n\x0cTable 3.1 Sample Conflict-of-Law Principles\n\nSubstantive Law Issue\n\nLaw to be Applied\n\nLiability for injury caused by tortious conduct\n\nState in which the injury was inflicted\n\nReal property\n\nState where the property is located\n\nPersonal Property: inheritance\n\nDomicile of deceased (not location of property)\n\nContract: validity\n\nState in which contract was made\n\nContract: breach\n\nState in which contract was to be performed*\n\n*Or, in many states, the state with the most significant contacts with the contractual activities\nNote: Choice-of-law clauses in a contract will ordinarily be honored by judges in state and federal\ncourts.\n\nLegal Procedure, Including Due Process and Personal Jurisdiction\nIn this section, we consider how lawsuits are begun and how the court knows that it has both subject\nmatter jurisdiction and personal jurisdiction over at least one of the named defendants.\nThe courts are not the only institutions that can resolve disputes. In Section 3.8 "Alternative 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.\nFirst, 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.)\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.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n93\n\n\x0cThis 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.\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, judges must\ndecide cases. (For example, a legislature need not enact a law, no matter how many people petition it to do\nso.) Fourth, the court must respond in a certain way. The judge must pay attention to the parties\xe2\x80\x99\narguments and his decision must result from their proofs and arguments. Evidence that is not presented\nand legal arguments that are not made cannot be the basis for what the judge decides. Also, judges are\nbound by standards of weighing evidence: the burden of proof in a civil case is generally a \xe2\x80\x9cpreponderance\nof the evidence.\xe2\x80\x9d\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.\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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n94\n\n\x0cidentified as the culprit, perhaps he has an alibi that could be legitimate\xe2\x80\x94the jury must vote to acquit\nrather than convict.\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.\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\nHow a Case Proceeds\nComplaint and Summons\nBeginning a lawsuit is simple and is spelled out in the rules of procedure by which each court 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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n95\n\n\x0cinitial 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.\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\nThe 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n96\n\n\x0chave 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. In Burger 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.\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.\n\nSummary of Rules on Personal Jurisdiction\n1.\n\nOnce a court determines that it has subject matter jurisdiction, it must find at least one defendant\nover which it is \xe2\x80\x9cfair\xe2\x80\x9d (i.e., in accord with due process) to exercise personal jurisdiction.\n\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 states) and sue\ndefendants 2, 3, 4, or 5.\n\n2. The court\xe2\x80\x99s decision in the first lawsuit (against defendant 1) does not determine the liability of the\nnonparticipating defendants.\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 different case 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n97\n\n\x0c3. 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 complaint and a\nsummons on the defendant.\n\n2. There are many ways to do this.\n\xef\x82\xa7\n\nThe process server personally serves a complaint on the defendant.\n\n\xef\x82\xa7\n\nThe process server leaves a copy of the summons and complaint at the residence of the defendant, in\nthe hands of a competent person.\n\n\xef\x82\xa7\n\nThe process server sends the summons and complaint by certified mail, return receipt requested.\n\n\xef\x82\xa7\n\nThe process server, if all other means are not possible, notifies the defendant by publication in a\nnewspaper having a minimum number of readers (as may be specified by law).\n\n4. In addition to successfully serving the defendant with process, a plaintiff must convince the 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.\n1.\n\nConsent. The defendant agrees to the court\xe2\x80\x99s jurisdiction by coming to court, answering the\ncomplaint, 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 for the state\nto say, \xe2\x80\x9cCome back and defend!\xe2\x80\x9d\n4. Service of process within the state will effectively provide personal jurisdiction over the nonresident.\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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n98\n\n\x0cessential 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.\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\nthe 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n99\n\n\x0cInternational 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\nreturning 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\nKEY TAKEAWAY\nThere are two court systems in the United States. It is important to know which system\xe2\x80\x94the state\ncourt system or the federal court system\xe2\x80\x94has the power to hear and decide a particular case. Once\nthat is established, the Constitution compels an inquiry to make sure that no court extends its reach\nunfairly to out-of-state residents. The question of personal jurisdiction is a question of fairness and due\nprocess to nonresidents.\n\nEXERCISES\n1.\n\nThe Constitution specifies that federal courts have exclusive jurisdiction over admiralty claims. Mr.\nand Mrs. Shute have a claim against Carnival Cruise lines for the negligence of the cruise line. Mrs.\nShute sustained injuries as a result of the company\xe2\x80\x99s negligence. Mr. and Mrs. Shute live in the state\nof Washington. Can they bring their claim in state court? Must they bring their claim in federal court?\n\n2.\n\nCongress passed Title VII of the Civil Rights Act of 1964. In Title VII, employers are required not to\ndiscriminate against employees on the basis of race, color, sex, religion, or national origin. In passing\nTitle VII, Congress did not require plaintiffs to file only in federal courts. That is, Congress made no\nstatement in Title VII that federal courts had \xe2\x80\x9cexclusive jurisdiction\xe2\x80\x9d over Title VII claims. Mrs. Harris\nwishes to sue Forklift Systems, Inc. of Nashville, Tennessee, for sexual harassment under Title VII. She\nhas gone through the Equal Employment Opportunity Commission process and has a right-to-sue\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n100\n\n\x0cletter, which is required before a Title VII action can be brought to court. Can she file a complaint that\nwill be heard by a state court?\n3.\n\nMrs. Harris fails to go to the Equal Employment Opportunity Commission to get her right-to-sue letter\nagainst Forklift Systems, Inc. She therefore does not have a viable Title VII cause of action against\nForklift. She does, however, have her rights under Tennessee\xe2\x80\x99s equal employment statute and various\ncourt decisions from Tennessee courts regarding sexual harassment. Forklift is incorporated in\nTennessee and has its principal place of business in Nashville. Mrs. Harris is also a citizen of\nTennessee. Explain why, if she brings her employment discrimination and sexual harassment lawsuit in\na federal court, her lawsuit will be dismissed for lack of subject matter jurisdiction.\n\n4.\n\nSuppose Mr. and Mrs. Robinson find in the original paperwork with Seaway Volkswagen that there is a\ncontractual agreement with a provision that says \xe2\x80\x9call disputes arising between buyer and Seaway\nVolkswagen will be litigated, if at all, in the county courts of Westchester County, New York.\xe2\x80\x9d Will the\nOklahoma court take personal jurisdiction over Seaway Volkswagen, or will it require the Robinsons to\nlitigate their claim in New York?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n101\n\n\x0c3.3 Motions and Discovery\nLEARNING OBJECTIVES\n1.\n\nExplain how a lawsuit can be dismissed prior to any trial.\n\n2.\n\nUnderstand 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\nthe pleadings (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\ncoupled 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n102\n\n\x0cA 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.)\nA third kind of dismissal can take place on a motion for summary judgment. If there is no triable question\nof fact or law, there is no reason to have a trial. For example, the plaintiff sues on a promissory note and,\nat deposition (an oral examination under oath), the defendant admits having made no payment on the\nnote and offers no excuse that would be recognizable as a reason not to pay. There is no reason to have a\ntrial, 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\nbecame 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n103\n\n\x0cverbatim 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.\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\nKEY TAKEAWAY\nMany cases never get to trial. They are disposed of by motions to dismiss or are settled after extensive\ndiscovery makes clear to the parties the strengths and weaknesses of the parties to the dispute.\n\nEXERCISES\n1.\n\nMrs. Robinson (in the Volkswagen Audi case) never establishes residency in Arizona, returns to New\nYork, and files her case in federal district court in New York, alleging diversity jurisdiction. Assume that\nthe defendants do not want to have the case heard in federal court. What motion will they make?\n\n2.\n\nUnder contributory negligence, the negligence of any plaintiff that causes or contributes to the\ninjuries a plaintiff complains of will be grounds for dismissal. Suppose that in discovery, Mr. Ferlito\nin Ferlito v. Johnson & Johnson (Section 3.9 "Cases") admits that he brought the cigarette lighter\ndangerously close to his costume, saying, \xe2\x80\x9cYes, you could definitely say I was being careless; I had a\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n104\n\n\x0cfew drinks under my belt.\xe2\x80\x9d Also, Mrs. Ferlito admits that she never reads product instructions from\nmanufacturers. If the case is brought in a state where contributory negligence is the law, on what\nbasis can Johnson & Johnson have the case dismissed before trial?\n\n3.4 The Pretrial and Trial Phase\nLEARNING OBJECTIVES\n1.\n\nUnderstand how judges can push parties into pretrial settlement.\n\n2.\n\nExplain the meaning and use of directed verdicts.\n\n3.\n\nDistinguish a directed verdict from a judgment n.o.v. (\xe2\x80\x9cnotwithstanding the verdict\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.\nPrior 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n105\n\n\x0cbefore 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.\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\na 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.\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.\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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n106\n\n\x0ckinds 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.\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.\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\nof 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.\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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n107\n\n\x0cFor 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.\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\x9crebuttal\xe2\x80\x9d witnesses.\nWhen all testimony has been introduced, either party may ask the judge for a directed verdict\xe2\x80\x94a verdict\ndecided by the judge without advice from the jury. This motion may be granted if the plaintiff has failed to\nintroduce evidence that is legally sufficient to meet her burden of proof or if the defendant has failed to do\nthe same on issues on which she has the burden of proof. (For example, the plaintiff alleges that the\ndefendant owes him money and introduces a signed promissory note. The defendant cannot show that the\nnote is invalid. The defendant must lose the case unless he can show that the debt has been paid or\notherwise discharged.)\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.\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.\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.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n108\n\n\x0cThese 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.\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\nrequire 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\nPost-trial 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 nonobstante 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.\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.\nRule 50(b) says,\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n109\n\n\x0cverdict.\xe2\x80\xa6 [A] new trial may be prayed for in the alternative. If a verdict was returned the court may allow\nthe 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\nKEY TAKEAWAY\nThe purpose of a trial judge is to ensure justice to all parties to the lawsuit. The judge presides,\ninstructs the jury, and may limit who testifies and what they testify about what. In all of this, the judge\nwill usually commit some errors; occasionally these will be the kinds of errors that seriously\ncompromise a fair trial for both parties. Errors that do seriously compromise a fair trial for both parties\nare prejudicial, as opposed to harmless. The appeals court must decide whether any errors of the trial\ncourt judge are prejudicial or not.\nIf a judge directs a verdict, that ends the case for the party who hasn\xe2\x80\x99t asked for one; if a judge grants\njudgment n.o.v., that will take away a jury verdict that one side has worked very hard to get. Thus a\njudge must be careful not to unduly favor one side or the other, regardless of his or her sympathies.\n\nEXERCISES\n1.\n\nWhat if there was not a doctrine of res judicata? What would the legal system be like?\n\n2.\n\nWhy do you think cross-examination is a \xe2\x80\x9cright,\xe2\x80\x9d as opposed to a \xe2\x80\x9cgood thing\xe2\x80\x9d? What kind of judicial\nsystem would not allow cross-examination of witnesses as a matter of right?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n110\n\n\x0c3.5 Judgment, Appeal, and Execution\nLEARNING OBJECTIVES\n1.\n\nUnderstand the post-trial process\xe2\x80\x94how appellate courts process appeals.\n\n2.\n\nExplain 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\nIf 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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n111\n\n\x0cof 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).\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.\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\nhigher 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n112\n\n\x0cLike 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.\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\nfinal judgment is an injunction, failure to follow its dictates can lead to a contempt citation, with a fine or\njail time imposed.\n\nKEY TAKEAWAY\nThe process of conducting a civil trial has many aspects, starting with pleadings and continuing with\nmotions, discovery, more motions, pretrial conferences, and finally the trial itself. At all stages, the rules\nof civil procedure attempt to give both sides plenty of notice, opportunity to be heard, discovery of\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n113\n\n\x0crelevant information, cross-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 fair trial.\n\nEXERCISES\n1.\n\nMrs. Robinson has a key witness on auto safety that the judge believes is not qualified as an expert. The\njudge examines the witness while the jury is in the jury room and disqualifies him from testifying. The\njury does not get to hear this witness. Her attorney objects. She loses her case. What argument would\nyou expect Mrs. Robinson\xe2\x80\x99s attorney to make in an appeal?\n\n2.\n\nWhy don\xe2\x80\x99t appellate courts need a witness box for witnesses to give testimony under oath?\n3.\n\nA trial judge in Nevada is wondering whether to enforce a surrogate motherhood contract.\nPenelope Barr, of Reno, Nevada, has contracted with Reuben and Tina Goldberg to bear the in\nvitro fertilized egg of Mrs. Goldberg. After carrying the child for nine months, Penelope gives\nbirth, but she is reluctant to give up the child, even though she was paid $20,000 at the start of\nthe contract and will earn an additional $20,000 on handing over the baby to the Goldberg\xe2\x80\x99s.\n(Barr was an especially good candidate for surrogate motherhood: she had borne two perfect\nchildren and at age 28 drinks no wine, does not smoke or use drugs of any kind, practices yoga,\nand maintains a largely vegetarian diet with just enough meat to meet the needs of the fetus\nwithin.)\nThe Goldberg\xe2\x80\x99s have asked the judge for an order compelling Penelope to give up the baby, who\nwas five days old when the lawsuit was filed. The baby is now a month old as the judge looks in\nvain for guidance from any Nevada statute, federal statute, or any prior case in Nevada that\naddressed the issue of surrogate motherhood. He does find several well-reasoned cases, one\nfrom New Jersey, one from Michigan, and one from Oregon. Are any of these \xe2\x80\x9cprecedent\xe2\x80\x9d that\nhe must follow? May he adopt the reasoning of any of these courts, if he should find that\nreasoning persuasive?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n114\n\n\x0c3.6 When Can Someone Bring a Lawsuit?\nLEARNING OBJECTIVES\n1.\n\nExplain the requirements for standing to bring a lawsuit in US courts.\n\n2.\n\nDescribe the process by which a group or class of plaintiffs can be certified to file 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\nexample, 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.\nFor example, suppose you see a sixteen-wheel moving van drives 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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n115\n\n\x0cto 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.\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.\nIf, 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.\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?\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n116\n\n\x0cthe 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 re-litigate the issue if she is dissatisfied with the\noutcome, even though she did not participate at all in the legal proceeding.\n\nKEY TAKEAWAY\nAnyone can file a lawsuit, with or without the help of an attorney, but only those lawsuits where a\nplaintiff has standing will be heard by the courts. Standing has become a complicated question and is\nused by the courts to ensure that civil cases heard are being pursued by those with tangible and\nparticular injuries. Class actions are a way of aggregating claims that are substantially similar and arise\nout of the same facts and circumstances.\n\nEXERCISE\n1.\n\nFuchs Funeral Home is carrying the body of Charles Emmenthaler to its resting place at Forest\nLawn Cemetery. Charles\xe2\x80\x99s wife, Chloe, and their two children, Chucky and Clarice, are following\nthe hearse when the coffin falls on the street, opens, and the body of Charles Emmenthaler falls\nout. The wife and children are shocked and aggrieved and later sue in civil court for damages.\nAssume that this is a viable cause of action based on \xe2\x80\x9cnegligent infliction of emotional distress\xe2\x80\x9d\nin the state of California and that Charles\xe2\x80\x99s brother, sister-in-law, and multiple cousins also were\nin the funeral procession and saw what happened. The brother of Charles, Kingston\nEmmenthaler, also sees his brother\xe2\x80\x99s body on the street, but his wife, their three children, and\nsome of Charles\xe2\x80\x99s other cousins do not.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n117\n\n\x0cCharles was actually emotionally closest to Kingston\xe2\x80\x99s oldest son, Nestor, who was studying abroad\nat the time of the funeral and could not make it back in time. He is as emotionally distraught at his\nuncle\xe2\x80\x99s passing as anyone else in the family and is especially grieved over the description of the\nincident and the grainy video shot by one of the cousins on his cell phone. Who has standing to sue\nFuchs Funeral Home, and who does not?\n\n3.7 Relations with Lawyers\nLEARNING OBJECTIVES\n1.\n\nUnderstand the various ways that lawyers charge for services.\n\n2.\n\nDescribe the contingent fee system in the United States.\n\n3.\n\nKnow the difference between the American rule and the British rule with regard to who pays attorneys\xe2\x80\x99\nfees.\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\nexamples 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.\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.\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.,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n118\n\n\x0cautomobile 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\nAct. 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\nKEY TAKEAWAY\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n119\n\n\x0cLitigation is expensive. Getting a lawyer can be costly, unless you get a lawyer on a contingent fee. Not\nall legal systems allow contingent fees. In many legal systems, the loser pays attorneys\xe2\x80\x99 fees for both\nparties.\n\nEXERCISES\n1.\n\nMrs. Robinson\xe2\x80\x99s attorney estimates that they will recover a million dollars from Volkswagen in the Audi\nlawsuit. She has Mrs. Robinson sign a contract that gives her firm one-third of any recovery after the\nfirm\xe2\x80\x99s expenses are deducted. The judge does in fact award a million dollars, and the defendant pays.\nThe firm\xe2\x80\x99s expenses are $100,000. How much does Mrs. Robinson get?\n\n2.\n\nHarry Potter brings a lawsuit against Draco Malfoy in Chestershire, England, for slander, a form of\ndefamation. Potter alleges that Malfoy insists on calling him a mud blood. Ron Weasley testifies, as does\nNeville Chamberlain. But Harry loses, because the court has no conception of wizardry and cannot make\nsense of the case at all. In dismissing the case, however, who (under English law) will bear the costs of\nthe attorneys who have brought the case for Potter and defended the matter for Malfoy?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n120\n\n\x0c3.8 Alternative Means of Resolving Disputes\nLEARNING OBJECTIVES\n1.\n\nUnderstand how arbitration and mediation are frequently used alternatives to litigation.\n\n2.\n\nDescribe the differences between arbitration and mediation.\n\n3.\n\nExplain 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\nterms 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n121\n\n\x0cthrough 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.\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.\nArbitration is a type of adjudication. The parties use a private decision maker, the arbitrator, and the rules\nof procedure are considerably more relaxed than those that apply in the courtroom. Arbitrators might be\nretired judges, lawyers, or anyone with the kind of specialized knowledge and training that would be\nuseful in making a final, binding decision on the dispute. In a contractual relationship, the parties can\ndecide even before a dispute arises to use arbitration when the time comes. Or parties can decide after a\ndispute arises to use arbitration instead of litigation. In a pre-dispute arbitration agreement (often part of\na larger contract), the parties can spell out the rules of procedure to be used and the method for choosing\nthe arbitrator. For example, they may name the specific person or delegate the responsibility of choosing\nto some neutral person, or they may each designate a person and the two designees may jointly pick a\nthird arbitrator.\nMuch arbitration 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);\nparties 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.\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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n122\n\n\x0cUnder 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\nKEY TAKEAWAY\nLitigation is not the only way to resolve disputes. Informal negotiation between the disputants usually\ncomes first, but both mediation and arbitration are available. Arbitration, though, is final and binding.\nOnce you agree to arbitrate, you will have a final, binding arbitral award that is enforceable through the\ncourts, and courts will almost never allow you to litigate after you have agreed to arbitrate.\n\nEXERCISES\n1.\n\nWhen Mrs. Robinson buys her Audi from Seaway, there is a paragraph in the bill of sale, which both the\ndealer and Mrs. Robinson sign, that says, \xe2\x80\x9cIn the event of any complaint by customer/buyer against\nSeaway regarding the vehicle purchased herein, such complaint shall not be litigated, but may only be\narbitrated under the rules 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 lawsuit in Oklahoma\nagainst Seaway. What result?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n123\n\n\x0c2.\n\nHendrik Koster (Netherlands) contracts with Automark, Inc. (a US company based in Illinois) to supply\nAutomark with a large quantity of valve cap gauges. He does, and Automark fails to pay. Koster thinks\nhe is owed $66,000. There is no agreement to arbitrate or mediate. Can Koster make Automark mediate\nor arbitrate?\n\n3.\n\nSuppose that there is an agreement between Koster and Automark to arbitrate. It says, \xe2\x80\x9cThe parties\nagree to arbitrate any dispute arising under this agreement in accordance with the laws of the\nNetherlands and under the auspices of the International Chamber of Commerce\xe2\x80\x99s arbitration facility.\xe2\x80\x9d\nThe International Chamber of Commerce has arbitration rules and will appoint an arbitrator or arbitral\npanel in the event the parties cannot agree on an arbitrator. The arbitration takes place in Geneva.\nKoster gets an arbitral award for $66,000 plus interest. Automark does not participate in any way. Will a\ncourt in Illinois enforce the arbitral award?\n\n3.9 Cases\nBurger King v. Rudzewicz\nBurger King Corp. v. Rudzewicz\n471 U.S. 462 (U.S. Supreme Court 1985)\n\nSummary\nBurger King Corp. is a Florida corporation with principal offices in Miami. It principally 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\nin 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n124\n\n\x0cRudzewicz 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.\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.\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.\nJustice Brennan delivered the opinion of the court.\nThe Due Process Clause protects an individual\xe2\x80\x99s liberty interest in not being subject to the 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\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n125\n\n\x0cactivities 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\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):\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.\nThis \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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n126\n\n\x0ccommunications 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.\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\nthe 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\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n127\n\n\x0cFlorida. For these reasons it was, at the very least, presumptively reasonable for Rudzewicz to be called to\naccount there for such injuries.\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\naccordingly reversed, and the case is remanded for further proceedings consistent with this opinion.\nIt is so ordered.\n\nCASE QUESTIONS\n1.\n\nWhy did Burger King sue in Florida rather than in Michigan?\n\n2.\n\nIf Florida has a long-arm statute that tells Florida courts that it may exercise personal jurisdiction over\nsomeone like Rudzewicz, why is the court talking about the due process clause?\n\n3.\n\nWhy is this case in federal court rather than in a Florida state court?\n\n4.\n\nIf this case had been filed in state court in Florida, would Rudzewicz be required to come to Florida?\nExplain.\n\nFerlito v. Johnson & Johnson\nFerlito v. Johnson & Johnson Products, Inc.\n771 F. Supp. 196 (U.S. District Ct., Eastern District of Michigan 1991)\nGadola, J.\nPlaintiffs Susan and Frank Ferlito, husband and wife, attended a Halloween party in 1984 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n128\n\n\x0cblackened with Halloween paint. At the party Mr. Ferlito attempted to light his cigarette by using butane\nlighter. 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.\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.\nMOTION FOR JUDGMENT NOTWITHSTANDING THE VERDICT\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.\nThe standard for determining whether to grant a j.n.o.v. is identical to the standard for evaluating a\nmotion for directed verdict:\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\nopinion that reasonable minds could not come to the result reached by the jury, then the motion for\nj.n.o.v. should be granted.\nTo recover in a \xe2\x80\x9cfailure to warn\xe2\x80\x9d product liability action, a plaintiff must prove each of the 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n129\n\n\x0cTo 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\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).\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\nestablish 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.\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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n130\n\n\x0cabsence 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.\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.\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\nclassrooms 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.\n\nORDER\nNOW, THEREFORE, IT IS HEREBY ORDERED that defendant JJP\xe2\x80\x99s motion for judgment\nnotwithstanding the verdict is GRANTED.\nIT IS FURTHER ORDERED that the judgment entered November 2, 1989, is SET ASIDE.\nIT IS FURTHER ORDERED that the clerk will enter a judgment in favor of the defendant JJP.\n\nCASE QUESTIONS\n1.\n\nThe opinion focuses on proximate cause. As we will see in Chapter 7 "Introduction to Tort Law", a\nnegligence case cannot be won unless the plaintiff shows that the defendant has breached a duty and\nthat the defendant\xe2\x80\x99s breach has actually and proximately caused the damage complained of. What,\nexactly, is the alleged breach of duty by the defendant here?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n131\n\n\x0c2.\n\nExplain why Judge Gadola reasoning that JJP had no duty to warn in this case. After this case, would\nthey then have a duty to warn, knowing that someone might use their product in this way?\n\n[1] By \xe2\x80\x9cprima facie case,\xe2\x80\x9d the court means a case in which the plaintiff has presented all the basic elements of the\ncause of action alleged in the complaint. If one or more elements of proof are missing, then the plaintiff has fallen\nshort of establishing a prima facie case, and the case should be dismissed (usually on the basis of a directed\nverdict).\n[2] Note the division of labor here: questions of law are for the judge, while questions of \xe2\x80\x9cfact\xe2\x80\x9d are for the jury.\nHere, \xe2\x80\x9cforeseeability\xe2\x80\x9d is a fact question, while the judge retains authority over questions of law. The division\nbetween questions of fact and questions of law is not an easy one, however.\n\nChapter 4\nConstitutional Law and US Commerce\nLEARNING OBJECTIVES\nAfter reading this chapter, you should be able to do the following:\n1.\n\nExplain the historical importance and basic structure of the US Constitution.\n\n2.\n\nKnow what judicial review is and what it represents in terms of the separation of powers between the\nexecutive, legislative, and judicial branches of government.\n\n3.\n\nLocate the source of congressional power to regulate the economy under the Constitution, and explain\nwhat limitations there are to the reach of congressional power over interstate commerce.\n\n4.\n\nDescribe the different phases of congressional power over commerce, as adjudged by the US Supreme\nCourt over time.\n\n5.\n\nExplain what power the states retain over commerce, and how the Supreme Court may sometimes limit\nthat power.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n132\n\n\x0c6.\n\nDescribe how the Supreme Court, under the supremacy clause of the Constitution, balances state and\nfederal laws that may be wholly or partly in conflict.\n\n7.\n\nExplain 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 of\njudicial review, unique among federal systems globally, through which it can strike down federal or state\nstatutes that it believes violate the Constitution and can even void the president\xe2\x80\x99s executive orders if they\nare contrary to the Constitution\xe2\x80\x99s language. No knowledgeable citizen or businessperson can afford to be\nignorant of its basic provisions.\n\n4.1 Basic Aspects of the US Constitution\nLEARNING OBJECTIVES\n1.\n\nDescribe the American values that are reflected in the US Constitution.\n\n2.\n\nKnow what federalism means, along with separation of powers.\n\n3.\n\nExplain the process of amending the Constitution and why judicial review is particularly 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\ntime\xe2\x80\x94fifty years ago\xe2\x80\x94when \xe2\x80\x9cun-American\xe2\x80\x9d activities were under investigation in Congress and the press;\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n133\n\n\x0cthe 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 if Roe 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\nFederalism\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n134\n\n\x0cThe partnership created in the Constitution between the states and the federal government is\ncalled federalism. The Constitution is a document created by the states in which certain powers 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.\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.\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\nregarding 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n135\n\n\x0cFrom 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. Gore decision 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.\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).\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\nprivacy\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n136\n\n\x0crather 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,\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 do\nexist 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.\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\nKEY TAKEAWAY\n\nThe Constitution gives voice to the idea that people have basic rights and that a civilian president is also\nthe commander in chief of the armed forces. It gives instructions as to how the various branches of\ngovernment must share power and also tries to balance power between the states and the federal\ngovernment. It does not expressly allow for judicial review, but the Supreme Court\xe2\x80\x99s ability to declare\nwhat laws are (or are not) constitutional has given the judicial branch a kind of power not seen in other\nindustrialized democracies.\n\nEXERCISES\n1.\n\nSuppose the Supreme Court declares that Congress and the president cannot authorize the indefinite\ndetention of terrorist suspects without a trial of some sort, whether military or civilian. Suppose also\nthat the people of the United States favor such indefinite detention and that Congress wants to pass a\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n137\n\n\x0claw rebuking the court\xe2\x80\x99s decision. What kind of law would have to be passed, by what institutions, and\nby what voting percentages?\n2.\n\nWhen does a prior decision of the Supreme Court deserve overturning? Name one decision of the\nSupreme Court that you think is no longer \xe2\x80\x9cgood law.\xe2\x80\x9d Does the court have to wait one hundred years\nto overturn its prior case precedents\n\n[1] In Scott v. Sanford (the Dred Scott decision), the court states that Scott should remain a slave, that as a slave he\nis not a citizen of the United States and thus not eligible to bring suit in a federal court, and that as a slave he is\npersonal 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\n4.2 The Commerce Clause\nLEARNING OBJECTIVES\n1.\n\nName the specific clause through which Congress has the power to regulate commerce. What,\nspecifically, does this clause say?\n\n2.\n\nExplain how early decisions of the Supreme Court interpreted the scope of the commerce clause and\nhow that impacted the legislative proposals and programs of Franklin Delano Roosevelt during the\nGreat Depression.\n\n3.\n\nDescribe both the wider use of the commerce clause from World War II through the 1990s and the\nlimitations 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n138\n\n\x0cto make certain laws, then it acts unconstitutionally and its actions may be ruled unconstitutional by the\nSupreme 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 Defense and general Welfare of the United States; but all Duties,\nImposts and Excises shall be uniform throughout the United States;\n[Clause 2] To borrow Money on the credit of the United States;\n[Clause 3] To regulate Commerce with foreign Nations, and among the several States, and\nwith the Indian Tribes;\n[Clause 4] To establish a uniform Rule of Naturalization, and uniform Laws on the subject of\nBankruptcies throughout the United States;\n[Clause 5] To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard 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\nbetween fourteen and sixteen years, who were employees in cotton mill in Charlotte, North Carolina. The\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n139\n\n\x0cfather\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.\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\nIn 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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n140\n\n\x0cappeals; 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\x931970\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.\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\nSubsequent 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).\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n141\n\n\x0cchallenged 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\nschool 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n142\n\n\x0cBrzonkala 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.\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\nopinion \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\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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n143\n\n\x0cagainst 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.\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.\nNotice how similar this reasoning is to the court\xe2\x80\x99s earlier reasoning in Wickard 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\nmarijuana 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\nKEY TAKEAWAY\nThe commerce clause is the basis on which the federal government regulates interstate economic\nactivity. The phrase \xe2\x80\x9cinterstate commerce\xe2\x80\x9d has been subject to differing interpretations by the Supreme\nCourt over the past one hundred years. There are certain matters that are essentially local or intrastate,\nbut the range of federal involvement in local matters is still considerable.\n\nEXERCISES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n144\n\n\x0c1.\n\nWhy would Congress have power under the Civil Rights Act of 1964 to require restaurants and hotels to\nnot discriminate against interstate travelers on the basis of race, color, sex, religion, or national origin?\nSuppose the Holiday Restaurant near I-80 in Des Moines, Iowa, has a sign that says, \xe2\x80\x9cWe reserve the\nright to refuse service to any Muslim or person of Middle Eastern descent.\xe2\x80\x9d Suppose also that the\nrestaurant is very popular 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 happen if the\nowners resisted enforcement by claiming that Title II of the act (relating to \xe2\x80\x9cpublic accommodations\xe2\x80\x9d\nsuch as hotels, motels, and restaurants) was unconstitutional?\n\n2.\n\nIf the Supreme Court were to go back to the days of Hammer v. Dagenhart and rule that only goods and\nservices involving interstate movement could be subject to federal law, what kinds of federal programs\nmight be lacking a sound basis in the commerce clause? \xe2\x80\x9cObama care\xe2\x80\x9d? Medicare? Homeland security?\nSocial Security? What other powers are granted to Congress under the Constitution to legislate for the\ngeneral good of society?\n\n[1] Hipolite Egg Co. v. United States, 220 US 45 (1911).\n[2] Hoke v. United States, 227 US 308 (1913).\n[3] Katzenbach v. McClung, 379 US 294 (1964).\n\n4.3 Dormant Commerce Clause\nLEARNING OBJECTIVES\n1.\n\nUnderstand that when Congress does not exercise its powers under the commerce clause, the Supreme\nCourt may still limit state legislation that discriminates against interstate commerce or places an undue\nburden on interstate commerce.\n\n2.\n\nDistinguish between \xe2\x80\x9cdiscrimination\xe2\x80\x9d dormant-commerce-clause cases and \xe2\x80\x9cundue burden\xe2\x80\x9d dormantcommerce-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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n145\n\n\x0clength. 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 those were never yielded up to the federal government.\nThese 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 the dormant commerce clause.\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.\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.\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\n146\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\nMichigan is facing an intolerable situation with regard to the importation of waste from other states and\nCanada.\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.\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.\nWhy 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n147\n\n\x0cI have teamed up with Senator Stabenow and Congressman Dingell to introduce legislation that would\nstrengthen our ability to stop shipments of waste from Canada.\nWe have protections contained in a 17 year-old international agreement between the U.S. and Canada\ncalled the Agreement Concerning the Trans boundary 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.\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.\nIn 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, and road deterioration resulting from increased vehicular traffic and public health and the\nenvironment.\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\nKEY TAKEAWAY\nWhere Congress does not act pursuant to its commerce clause powers, the states are free to legislate on\nmatters of commerce under their historic police powers. However, the Supreme Court has set limits on\nsuch powers. Specifically, states may not impose undue burdens on interstate commerce and may not\ndiscriminate against articles in interstate commerce.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n148\n\n\x0cEXERCISES\n1.\n\nSuppose that the state of New Jersey wishes to limit the amount of hazardous waste that enters into its\nlandfills. The general assembly in New Jersey passes a law that specifically forbids any hazardous waste\nfrom entering into the state. All landfills are subject to tight regulations that will allow certain kinds of\nhazardous wastes originating in New Jersey to be put in New Jersey landfills but that impose significant\ncriminal fines on landfill operators that accept out-of-state hazardous waste. The Baldessari Brothers\nLandfill in Linden, New Jersey, 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. What is the result?\n\n2.\n\nThe state of Arizona determines through its legislature that trains passing through the state cannot be\nlonger than seventy cars. There is some evidence that in Eastern US states longer trains pose some\nsafety hazards. There is less evidence that long trains are a problem in Western states. Several major\nrailroads find the Arizona legislation costly and burdensome and challenge the legislation after appliedfor permits for longer trains are denied. What kind of dormant commerce clause challenge is this, and\nwhat would it take for the challenge 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\n4.4 Preemption: The Supremacy Clause\nLEARNING OBJECTIVES\n1.\n\nUnderstand the role of the supremacy clause in the balance between state and federal power.\n\n2.\n\nGive examples of cases where state legislation is preempted by federal law and cases where state\nlegislation 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n149\n\n\x0cliability 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\nFermi 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.\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.\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.\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.\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\n150\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, that\nany federal law\xe2\x80\x94evens a regulation of a federal agency\xe2\x80\x94would control over any conflicting state law.\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.\nFederal \xe2\x80\x9coccupation of the field\xe2\x80\x9d occurs, according to the court in Pennsylvania 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.\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\nconclusion 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n151\n\n\x0cCipollone 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\nKEY TAKEAWAY\nIn cases of conflicts between state and federal law, federal law will preempt (or control) state law because\nof the supremacy clause. Preemption can be express or implied. In cases where preemption is implied, the\ncourt usually finds that compliance with both state and federal law is not possible or that a federal\nregulatory scheme is comprehensive (i.e., \xe2\x80\x9coccupies the field\xe2\x80\x9d) and should not be modified by state\nactions.\n\nEXERCISES\n1.\n\nFor many years, the United States engaged in discussions with friendly nations as to the reciprocal use of\nports and harbors. These discussions led to various multilateral agreements between the nations as to the\nconfiguration of oceangoing vessels and how they would be piloted. At the same time, concern over oil\nspills in Puget Sound led 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 imposed many other\nrequirements that went above and beyond agreed-upon requirements in the international agreements\nnegotiated by the federal government. Are the Washington state requirements preempted by federal\nlaw?\n\n2.\n\nThe Federal Arbitration Act of 1925 requires that all contracts for arbitration be treated as any other\ncontract at common law. Suppose that the state of Alabama wishes to protect its citizens from a variety\nof arbitration provisions that they might enter into unknowingly. Thus the legislation provides that all predispute arbitration clauses be in bold print, that they be of twelve-point font or larger, that they be clearly\nplaced within the first two pages of any contract, and that they have a separate signature line where the\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n152\n\n\x0ccustomer, client, or patient acknowledges having read, understood, and signed the arbitration clause in\naddition to any other signatures required on the contract. The legislation does preserve the right of\nconsumers to litigate in the event of a dispute arising with the product or service provider; that is, with\nthis legislation, consumers will not unknowingly waive their right to a trial at common law. Is the Alabama\nlaw preempted by the Federal Arbitration Act?\n\n[1] Cippolone v. Liggett Group, 505 US 504 (1993).\n\n4.5 Business and the Bill of Rights\nLEARNING OBJECTIVES\n1.\n\nUnderstand and describe which articles in the Bill of Rights apply to business activities and how they\napply.\n\n2.\n\nExplain the application of the Fourteenth Amendment\xe2\x80\x94including the due process clause and the equal\nprotection clause\xe2\x80\x94to various rights enumerated in the original Bill of Rights.\n\nWe have already seen the Fourteenth Amendment\xe2\x80\x99s application in Burger King v. Rudzewicz (Section 3.9\n"Cases"). In that case, the court considered whether it was constitutionally correct for a court to assert\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n153\n\n\x0cpersonal 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.\nThe 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.\nHere are some very basic principles to remember:\n1.\n\nThe guarantees of the Bill of Rights apply only to state and federal government action. They do not\nlimit what a company or person in the private sector may do. For example, states may not impose\ncensorship on the media or limit free speech in a way that offends the First Amendment, but your\nboss (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, a\nprivate defense contractor that gets 90 percent of its business from the federal government has been\nheld to be public for purposes of enforcing the constitutional right to free speech (the company had a\nrule barring its employees from speaking out in public against its corporate position). It has even been\nargued that public regulation of private activity is sufficient to convert the private into public activity,\nthus subjecting it to the requirements of due process. But the Supreme Court rejected this extreme\nview in 1974 when it refused to require private power companies, regulated by the state, to give\ncustomers a hearing before cutting off electricity for failure to pay the bill.\n\nSaylor URL: http://www.saylor.org/books\n\n[1]\n\nSaylor.org\n154\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 War,\nthe question of what balance to strike between state sovereignty and federal union has never been\nsimple. In Kimel v. Florida, for example, the Supreme Court found in the words of the Eleventh\nAmendment a basis for declaring that states may not have to obey certain federal statutes.\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.\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.\nPolitical 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n155\n\n\x0cthose 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\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\nThe 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n156\n\n\x0cthat 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\nIn the 1980s, Dow Chemical objected to an over flight 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.)\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\nThe Fifth Amendment has three principal aspects: procedural due process, the takings clause,\nand substantive 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 in Burger King v. Rudzewicz had a\nserious constitutional argument, even though he lost.\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,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n157\n\n\x0cespecially 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?\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.\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\nthat 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n158\n\n\x0cThe 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.\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\nimpositions 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.\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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n159\n\n\x0ccompetent 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 Guarantees\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\nin an Alabama court not too long ago.\n\n[5]\n\nThe 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n160\n\n\x0cchildren 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:\n\xe2\x80\xa2\n\nMinimal scrutiny: economic and social relations. Government actions are usually upheld if there is a\nrational 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n161\n\n\x0csee 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.\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\ndeclared 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\nKEY TAKEAWAY\nThe Bill of Rights, through the Fourteenth Amendment, largely applies to state actions. The Bill of Rights\nhas applied to federal actions from the start. Both the Bill of Rights and the Fourteenth Amendment\napply to business in various ways, but it is important to remember that the rights conferred are rights\nagainst governmental action and not the actions of private enterprise.\n\nEXERCISES\n1.\n\nJohn Hanks works at ProLogis. The company decides to institute a drug-testing policy. John is a good\nand longtime employee but enjoys smoking marijuana on the weekends. The drug testing will involve\nurine samples and, semiannually, a hair sample. It is nearly certain that the drug-testing protocol that\nProLogis proposes will find that Hanks is a marijuana user. The company has made it clear that it will\nhave zero tolerance for any kind of non-prescribed controlled substances. John and several fellow\nemployees wish to go to court to challenge the proposed testing as \xe2\x80\x9can unreasonable search and\nseizure.\xe2\x80\x9d Can he possibly succeed?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n162\n\n\x0c2.\n\nLarry Reed, majority leader in the Senate, is attacked in his reelection campaign by a series of ads\nsponsored by a corporation (Global Defense, Inc.) that does not like his voting record. The corporation is\nupset that Reed would not write a special provision that would favor Global Defense in a defense\nappropriations bill. The ads run constantly on television and radio in the weeks immediately preceding\nElection Day and contain numerous falsehoods. For example, in order to keep the government running\nfinancially, Reed found it 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 the opposing party that\nwanted to privatize all programs for the handicapped. The ad is largely paid for by Global Defense and\ndepicts a handicapped child being helped by the existing program and large letters saying \xe2\x80\x9cDoes Larry\nReed Just Not Care?\xe2\x80\x9d The ad proclaims that it is sponsored by Citizens Who Care for a Better Tomorrow.\nIs this protected speech? Why or why not? Can Reed sue for defamation? Why or why not?\n\n[1] Jackson v. Metropolitan Edison Co., 419 US 345 (1974).\n[2] Buckley v. Valeo, 424 US 1 (1976).\n[3] Kelo v. City of New London, 545 US 469 (2005).\n[4] Cruzan v. Missouri Department of Health, 497 US 261 (1990).\n[5] BMW of North America, Inc. v. Gore, 517 U.S. 559 (1996)\n[6] Plessy v. Ferguson, 163 US 537 (1896).\n[7] United States v. Virginia, 518 US 515 (1996).\n[8] Palmore v. Sidoti, 466 US 429 (1984).\n[9] Atty. Gen. of New York v. Soto-Lopez, 476 US 898 (1986).\n\n4.6 Cases\n\nGriswold v. Connecticut\nGriswold v. Connecticut\n381 U.S. 479 (U.S. Supreme Court 1965)\nA nineteenth-century Connecticut law made the use, possession, or distribution of birth control 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n163\n\n\x0cinformation to a married couple that wished to delay having children for a few years. The directors\nwere fined $100 each.\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\nnot 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.\nPlurality Opinion by Justice William O. Douglass\nWe do not sit as a super legislature to determine the wisdom, need, and propriety of laws that 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[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. Various guarantees create\nzones of privacy. The right of association contained in the penumbra of the First Amendment is one. The\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\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[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. Would we allow the police to search the sacred precincts of marital\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n164\n\n\x0cbedrooms for telltale signs of the use of contraceptives? The very idea is repulsive to the notions of privacy\nsurrounding the marital relationship.\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.\nMr. Justice Stewart, whom Mr. Justice Black joins, is dissenting.\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.\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\npress; 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n165\n\n\x0cThe 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.\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.\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.\n\n1.\n\nCASE QUESTIONS\n\nWhich opinion is the strict constructionist opinion here\xe2\x80\x94Justice Douglas\xe2\x80\x99s or that of Justices Stewart\nand Black?\n\n2.\n\nWhat would have happened if the Supreme Court had allowed the Connecticut Supreme Court decision\nto stand and followed Justice Black\xe2\x80\x99s reasoning? Is it likely that the citizens of Connecticut would have\npersuaded their elected representatives to repeal the law challenged here?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n166\n\n\x0cWickard v. Filburn\nWickard v. Filburn\n317 U.S. 111 (U.S. Supreme Court 1942)\nMr. Justice Jackson delivered the opinion of the Court.\nMr. Filburn for many years past has owned and operated a small farm in Montgomery County, 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.\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\nthe 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.\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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n167\n\n\x0cJUSTICE 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\nAppellee 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.\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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n168\n\n\x0casserted 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.\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\nestablishes 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\xe2\x80\x9cTwins and semis have different characteristics. Twins are more maneuverable, are less sensitive to wind,\nand create fewer splashes and spray. However, they are more likely than semis to jackknife or upset. They\ncan be backed only for a short distance. The negative characteristics are not such that they render the twin\nless safe than semis overall. Semis are more stable, but are more likely to \xe2\x80\x98rear-end\xe2\x80\x99 another vehicle.\xe2\x80\x9d\nIn light of these findings, the District Court applied the standard we enunciated 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\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.\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\n169\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\x98of 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.\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).\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\x9d Bibb v.\nNavajo Freight Lines, Inc., 359 U.S. 520 at (1959).\nBut the incantation of a purpose to promote the public health or safety does not insulate a state 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n170\n\n\x0cState\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.\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\nin Raymond, 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\nA\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n171\n\n\x0cNone 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.\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.\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 Consolidate d\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\nhigher 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]sixty-five foot twin trailer combinations have not been\nshown by experiences in other states to be less safe than 60-foot twin trailer\ncombinations or conventional tractor-semitrailers.\xe2\x80\x9d\nIn sum, although Iowa introduced more evidence on the question of safety than did Wisconsin\nin Raymond, the record as a whole was not more favorable to the State.\n\nB\nConsolidated, meanwhile, demonstrated that Iowa\xe2\x80\x99s law substantially burdens interstate 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n172\n\n\x0cthe 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.\nConsolidated alone incurred about $2 million per year in increased costs.\nIn addition to increasing the costs of the trucking companies (and, indirectly, of the service to\nconsumers), Iowa\xe2\x80\x99s law may aggravate, rather than, ameliorate, the problem of highway 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]\nV\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\nCASE QUESTIONS\n1.\n\nUnder the Constitution, what gives Iowa the right to make rules regarding the size or configuration of\ntrucks upon highways within the state?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n173\n\n\x0c2.\n\nDid Iowa try to exempt trucking lines based in Iowa, or was the statutory rule nondiscriminatory as to\nthe origin of trucks that traveled on Iowa highways?\n\n3.\n\nAre there any federal size or weight standards noted in the case? Is there any kind of truck size or\nweight that could be limited by Iowa law, or must Iowa simply accept federal standards or, if none,\nimpose no standards at all?\n\nHunt v. Washington Apple Advertising Commission\nHunt v. Washington Apple Advertising Commission\n432 U.S. 33 (U.S. Supreme Court 1977)\nMR. CHIEF JUSTICE BURGER delivered the opinion of the Court.\nIn 1973, North Carolina enacted a statute which required, inter alia, all closed containers of 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).\n[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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n174\n\n\x0cvariety 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\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[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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n175\n\n\x0c[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.\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\napple growers and dealers who are already at a competitive disadvantage because of their great distance\nfrom the North Carolina market.\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.\nThird, by prohibiting Washington growers and dealers from marketing apples under their State\xe2\x80\x99s grades,\nthe statute has a leveling effect which 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n176\n\n\x0cthe 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.\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\nsomewhat 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.\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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n177\n\n\x0cthat 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[The court affirmed the lower court\xe2\x80\x99s holding that the North Carolina statute was unconstitutional.]\n\nCASE QUESTIONS\n1.\n\nWas the North Carolina law discriminatory on its face? Was it, possibly, an undue burden on interstate\ncommerce? Why wouldn\xe2\x80\x99t it be?\n\n2.\n\nWhat evidence was there of discriminatory intent behind the North Carolina law? Did that evidence\neven matter? Why or why not?\n\nCitizens United v. Federal Election Commission\nCitizens United v. Federal Election Commission\n588 U.S. ____; 130 S.Ct. 876 (U.S. Supreme Court 2010)\nJustice Kennedy delivered the opinion of the Court.\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.\nIn this case we are asked to reconsider Austin and, in effect, McConnell. It has been noted that\n\xe2\x80\x9cAustin was a significant departure from ancient First Amendment principles,\xe2\x80\x9d Federal Election 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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n178\n\n\x0cI\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. Hillary mentions Senator Clinton by name and\ndepicts interviews with political commentators and other persons, most of them quite critical of Senator\nClinton.\xe2\x80\xa6\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\nBefore 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)\n(A). The Federal Election Commission\xe2\x80\x99s (FEC) regulations further define an electioneering\ncommunication as a communication that is \xe2\x80\x9cpublicly distributed.\xe2\x80\x9d 11 CFR \xc2\xa7100.29(a) (2) (2009). \xe2\x80\x9cIn the\ncase of a candidate for nomination for President\xe2\x80\xa6publicly distributed means\xe2\x80\x9d that the communication\n\xe2\x80\x9c[c]an be received by 50,000 or more persons in a State where a primary election\xe2\x80\xa6is being held within 30\ndays.\xe2\x80\x9d 11 CFR \xc2\xa7100.29(b)(3)(ii). Corporations and unions are barred from using their general treasury\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n179\n\n\x0cfunds for express advocacy or electioneering communications. They may establish, however, a \xe2\x80\x9cseparate\nsegregated fund\xe2\x80\x9d (known as a political action committee, or PAC) for these purposes. 2 U.S.C. \xc2\xa7441b (b)\n(2). The moneys received by the segregated fund are limited to donations from stockholders and\nemployees of the corporation 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 to Hillary and to the three\nads for the movie.\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\nThe 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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n180\n\n\x0cThe 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 law\nbefore 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.\nSection 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.\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\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\x9cBuckley v. Valeo, 424 U.S.\n1 at 19 (1976)\xe2\x80\xa6\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n181\n\n\x0cSpeech 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\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\nGovernment 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\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 anti-distortion 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n182\n\n\x0cWhen 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.\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\nWhen 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 pre-election period is\nnot a permissible remedy. Here Congress has created categorical bans on speech that are asymmetrical to\npreventing quid pro quo-corruption.\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]\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\x9dWRTL, 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. Helvering v. Hallock, 309 U.S. 106 at\n119 (1940).\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\n183\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. Under Austin, 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.\nModern 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n184\n\n\x0cbackground 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. \xc2\xa7431(9) (A)\n(i). Speech would be suppressed in the realm where its necessity is most evident: in the public dialogue\npreceding a real election. Governments are often hostile to speech, but under our law and our tradition it\nseems stranger than fiction for our Government to make this political speech a crime. Yet this is the\nstatute\xe2\x80\x99s purpose and design.\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\x9d McConnell, supra, at 341 (opinion of\nKennedy, J.).\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.\nIt is so ordered.\n\nCASE QUESTIONS\n1.\n\nWhat does the case say about disclosure? Corporations have a right of free speech under the First\nAmendment and may exercise that right through unrestricted contributions of money to political\nparties and candidates. Can the government condition that right by requiring that the parties and\ncandidates disclose to the public the amount and origin of the contribution? What would justify such a\ndisclosure requirement?\n\n2.\n\nAre a corporation\xe2\x80\x99s contributions to political parties and candidates tax deductible as a business\nexpense? Should they be?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n185\n\n\x0c3.\n\nHow is the donation of money equivalent to speech? Is this a strict construction of the Constitution to\nhold that it is?\n\n4.\n\nBased on the Court\xe2\x80\x99s description of the Austin case, what purpose do you think the Austin court was\ntrying to achieve by limiting corporate campaign contributions? Was that purpose consistent (or\ninconsistent) with anything in the Constitution, or is the Constitution essentially silent on this issue?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n186\n\n\x0c4.7 Summary and Exercises\nSummary\nThe U.S. Constitution sets the framework for all other laws of the United States, at both the federal and\nthe state level. It creates a shared balance of power between states and the federal government\n(federalism) and shared power among the branches of government (separation of powers), establishes\nindividual rights against governmental action (Bill of Rights), and provides for federal oversight of\nmatters affecting interstate commerce and commerce with foreign nations. Knowing the contours of the\nUS legal system is not possible without understanding the role of the U.S 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.\n\nEXERCISES\n1.\n\nFor many years, the Supreme Court believed that \xe2\x80\x9ccommercial speech\xe2\x80\x9d was entitled to less\nprotection than other forms of speech. One defining element of commercial speech is that its\ndominant theme is to propose a commercial transaction. This kind of speech is protected by the\nFirst Amendment, but the government is permitted to regulate it more closely than other forms\nof speech. However, the government must make reasonable distinctions, must narrowly tailor\nthe rules restricting commercial speech, and must show that government has a legitimate goal\nthat the law furthers.\n\nEdward Salib owned a Winchell\xe2\x80\x99s Donut House in Mesa, Arizona. To attract customers, he displayed\nlarge signs in store windows. The city ordered him to remove the signs because they violated the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n187\n\n\x0ccity\xe2\x80\x99s sign code, which prohibited 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 rights. What was the result, and\nwhy?\n2.\n\nJennifer is a freshman at her local public high school. Her sister, Jackie, attends a nearby private high\nschool. Neither school allows them to join its respective wrestling team; only boys can wrestle at either\nschool. Does either of them have a winning case based on the equal protection clause of the Fourteenth\nAmendment?\n\n3.\n\nThe employees of the US Treasury Department that work the border crossing between the United\nStates and Mexico learned that they will be subject to routine drug testing. The customs bureau, which\nis a division of the treasury department, announces this policy along with its reasoning: since customs\nagents must routinely search for drugs coming into the United States, it makes sense that border guards\nmust themselves be completely drug-free. Many border guards do not use drugs, have no intention of\nusing drugs, and object to the invasion of their privacy. What is the constitutional basis for their\nobjection?\n\n4.\n\nHappy Time Chevrolet employs Jim Bydalek as a salesman. Bydalek takes part in a Gay Pride March in\nLos Angeles, is interviewed by a local news camera crew, and reports that he is gay and proud of it. His\nemployer is not, and he is fired. Does he have any constitutional causes of action against his employer?\n\n5.\n\nYou begin work at the Happy-Go-Lucky Corporation on Halloween. On your second day at work, you\nwear a political button on your coat, supporting your choice for US senator in the upcoming election.\nYour boss, who is of a different 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?\n\n6.\n\nDavid Lucas paid $975,000 for two residential parcels on the Isle of Palms near Charleston, South\nCarolina. His intention was to build houses on them. Two years later, the South Carolina legislature\npassed a statute that prohibited building beachfront properties. The purpose was to leave the dunes\nsystem in place to mitigate the effects of hurricanes and strong storms. The South Carolina Coastal\nCommission created the rules and regulations with substantial input from the community and from\nexperts and with protection of the dune system primarily in mind. People had been building on the\nshoreline for years, with harmful results to localities and the state treasury. When Lucas applied for\npermits to build two houses near the shoreline, his permits were rejected. He sued, arguing that the\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n188\n\n\x0cSouth Carolina legislation had 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 there been a taking under\nthe Fifth Amendment (as incorporated through the Fourteenth Amendment), and if so, what should the\nstate owe to Lucas? Suppose that Lucas could have made an additional $1 million by building a house on\neach of his parcels. Is he entitled to recover his original purchase price or his potential profits?\n\nSELF-TEST QUESTIONS\n1.\n\nHarvey filed a suit against the state of Colorado, claiming that a Colorado state law violates the\ncommerce clause. The court will agree if the statute\n\na.\n\nplaces an undue burden on interstate commerce\n\nb.\n\npromotes the public health, safety, morals, or general welfare of Colorado\n\nc.\n\nregulates economic activities within the state\xe2\x80\x99s borders\n\nd.\n\na and b\n\ne.\n\nb and c\nThe state legislature in Maine enacts a law that directly conflicts with a federal law. Mapco\nIndustries, located in Portland, Maine, cannot comply with both the state and the federal law.\n\na.\n\nBecause of federalism, the state law will have priority, as long as Maine is using its police\n\npowers.\nb.\n\nBecause there\xe2\x80\x99s a conflict, both laws are invalid; the state and the federal government will have\nto work out a compromise of some sort.\n\nc.\n\nThe federal law preempts the state law.\n\nd.\n\nBoth laws govern concurrently.\nHannah, who lives in Ada, is the owner of Superior Enterprises, Inc. She believes that certain\nactions in the state of Ohio infringe on her federal constitutional rights, especially those found in\nthe Bill of Rights. Most of these rights apply to the states under\n\na.\n\nthe supremacy clause\nb.\n\nthe protection clause\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n189\n\n\x0cc.\n\nthe due process clause of the Fourteenth Amendment\n\nd.\n\nthe Tenth Amendment\nMinnesota enacts a statute that bans all advertising that is in \xe2\x80\x9cbad taste,\xe2\x80\x9d \xe2\x80\x9cvulgar,\xe2\x80\x9d or\n\xe2\x80\x9cindecent.\xe2\x80\x9d In Michigan, Aaron Calloway and his brother, Clarence \xe2\x80\x9cCab\xe2\x80\x9d Calloway, create\nunique beer that they decide to call Old Fart Ale. In their marketing, the brothers have a label in\nwhich an older man in 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 process of belching. He\nis also holding a can of Old Fart Ale. The Minnesota liquor commission orders all Minnesota\nrestaurants, bars, and grocery stores to remove Old Fart Ale from their shelves. The state\nstatute and the commission\xe2\x80\x99s order are likely to be held by a court to be\n\na.\n\na violation of the Tenth Amendment\nb.\n\na violation of the First Amendment\n\nc.\n\na violation of the Calloways\xe2\x80\x99 right to equal protection of the laws\n\nd.\n\na violation of the commerce clause, since only the federal laws can prevent an article of\ncommerce from entering into Minnesota\xe2\x80\x99s market\nRaunch Unlimited, a Virginia partnership, sells smut whenever and wherever it can. Some of its\nmaterial is \xe2\x80\x9cobscene\xe2\x80\x9d (meeting the Supreme Court\xe2\x80\x99s definition under Miller v. California) and\nincludes child pornography. North Carolina has a statute that criminalizes obscenity. What are\npossible results if a store in Raleigh, North Carolina, carries Raunch merchandise?\n\na.\n\nThe partners could be arrested in North Carolina and may well be convicted.\nb.\n\nThe materials in Raleigh may be the basis for a criminal conviction.\n\nc.\n\nThe materials are protected under the First Amendment\xe2\x80\x99s right of free speech.\n\nd.\n\nThe materials are protected under state law.\n\ne.\n\na and b\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n190\n\n\x0cSELF-TEST ANSWERS\n1.\n\na\n\n2.\n\nc\n\n3.\n\nc\n\n4.\n\nb\n\n5.\n\ne\n\nChapter 5\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n191\n\n\x0cAdministrative Law\nLEARNING OBJECTIVES\nAfter reading this chapter, you should be able to do the following:\n1.\n\nUnderstand the purpose served by federal administrative agencies.\n\n2.\n\nKnow the difference between executive branch agencies and independent agencies.\n\n3.\n\nUnderstand the political control of agencies by the president and Congress.\n\n4.\n\nDescribe how agencies make rules and conduct hearings.\n\n5.\n\nDescribe 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\none 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 Powers\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n192\n\n\x0cLEARNING OBJECTIVES\n1.\n\nExplain the reasons why we have federal administrative agencies.\n\n2.\n\nExplain the difference between executive branch agencies and independent agencies.\n\n3.\n\nDescribe the constitutional issue that questions whether administrative agencies could have authority\nto 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 statutes\nby Congress.\nMost 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n193\n\n\x0cterms 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.\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\nfederal equal opportunity employment laws) would empower plaintiffs to go to court and have the law\nstruck down as unconstitutional.\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 to,\nincluding 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 only\nby those who buy or sell those goods and not by third parties or people \xe2\x80\x9cexternal\xe2\x80\x9d to the market\ntransaction. (That is, there are no \xe2\x80\x9cexternalities.\xe2\x80\x9d)\n\n6. All buyers and sellers are utility maximizes; 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 of\nany of the goods being bought and sold in the market.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n194\n\n\x0cIn short, some forms of legislation and regulation are needed to counter a tendency toward consolidation\nof economic power (Chapter 16 "Antitrust Law") and discriminatory attitudes toward certain individuals\nand groups (Chapter 18 "Employment Law") and to insist that people and companies clean up their own\nmesses and not hide information that would empower voluntary choices in the free market.\nBut there are additional reasons to regulate. For example, in economic systems, it is likely for 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.\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.\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, and a military for defense.\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, and grades for this course in business law, and even marriage\npartnership.\nThus 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n195\n\n\x0cunsafe 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.\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\nIndependent 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n196\n\n\x0cremoved 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.\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.\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\nauthority 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n197\n\n\x0ccomplex, 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.\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.\nThe 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?\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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n198\n\n\x0cto 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.\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\nKEY TAKEAWAY\nCongress creates administrative agencies through enabling acts. In these acts, Congress must delegate\nauthority by giving the agency some direction as to what it wants the agency to do. Agencies are usually\ngiven broad powers to investigate, set standards (promulgating regulations), and enforce those\nstandards. Most agencies are executive branch agencies, but some are independent.\n\nEXERCISES\n1.\n\nExplain why Congress needs to delegate rule-making authority to a specialized agency.\n\n2.\n\nExplain why there is any need for interference in the market by means of laws or regulations.\n\n[1] Schechter Poultry Corp. v. United States, 295 US 495 (1935).\n\n5.2 Controlling Administrative Agencies\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n199\n\n\x0cLEARNING OBJECTIVES\n1.\n\nUnderstand how the president controls administrative agencies.\n\n2.\n\nUnderstand how Congress controls administrative agencies.\n\n3.\n\nUnderstand 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 Deep-water 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\nStates"). 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n200\n\n\x0cLegislative Control\nCongress 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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n201\n\n\x0cJudicial 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\nKEY TAKEAWAY\nAdministrative agencies are given unusual powers: to legislate, investigate, and adjudicate. But these\npowers are limited by executive and legislative controls and by judicial review.\n\nEXERCISES\n1.\n\nFind the website of the Consumer Product Safety Commission (CPSC). Identify from that site a product\nthat has been banned by the CPSC for sale in the United States. What reasons were given for its exclusion\nfrom the US market?\n\n2.\n\nWhat has Congress told the CPSC to do in its enabling act? Is this a clear enough mandate to guide the\nagency? What could Congress do if the CPSC does something that may be outside of the scope of its\npowers? What can an affected business do?\n\n5.3 The Administrative Procedure Act\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n202\n\n\x0cLEARNING OBJECTIVES\n1.\n\nUnderstand why the Administrative Procedure Act was needed.\n\n2.\n\nUnderstand how hearings are conducted under the act.\n\n3.\n\nUnderstand how the act affects rulemaking by agencies.\n\nIn 1946, Congress enacted the Administrative Procedure Act (APA). This fundamental statute detailed for\nall federal administrative agencies how they must function when they are deciding cases or issuing\nregulations, the two basic tasks of administration. At the state level, the Model State Administrative\nProcedure Act, issued in 1946 and revised in 1961, has been adopted in twenty-eight states and the District\nof Columbia; three states have adopted the 1981 revision. The other states have statutes that resemble the\nmodel 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\nis 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 examiner.\nThe change in nomenclature was made in 1972 to enhance the prestige of ALJs and more accurately\nreflect their duties. Although not appointed for life as federal judges are, the ALJ must be free of\nassignments inconsistent with the judicial function and is not subject to supervision by anyone in the\nagency who carries on an investigative or prosecutorial function.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n203\n\n\x0cnecessarily 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.\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.\nThe acts creating most of the major federal agencies expressly grant them authority to engage in\nrulemaking. This means, in essence, authority to legislate. The outpouring of federal regulations has been\nimmense. The APA directs agencies about to engage in rulemaking to give notice in\nthe <em class="emphasis">Federal Register</em class="emphasis">of their intent to do so. The Federal\nRegister is published daily, Monday through Friday, in Washington, DC, and contains notice of various\nactions, including announcements of proposed rulemaking and regulations as adopted. The notice must\nspecify the time, place, and nature of the rulemaking and offer a description of the proposed rule or the\nissues involved. Any interested person or organization is entitled to participate by submitting written\n\xe2\x80\x9cdata, views or arguments.\xe2\x80\x9d Agencies are not legally required to air debate over proposed rules, though\nthey often do so.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n204\n\n\x0cAdministrative 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<em class="emphasis">Code of Federal Regulations (CFR)</em class="emphasis">, a multivolume\npaperback series containing all federal rules and regulations keyed to the fifty titles of the US Code (the\ncompilation of all federal statutes enacted by Congress and grouped according to subject).\n\nKEY TAKEAWAY\nAgencies make rules that have the same effect as laws passed by Congress and the president. But such\nrules (regulations) must allow for full participation by interested parties. The Administrative Procedure\nAct (APA) governs both rulemaking and the agency enforcement of regulations, and it provides a process\nfor fair hearings.\n\nEXERCISES\n1.\n\nGo to http://www.regulations.gov/search/Regs/home.html#home. Browse the site. Find a topic that\ninterests you, and then find a proposed regulation. Notice how comments on the proposed rule are\ninvited.\n\n2.\n\nWhy would there be a trial by an administrative agency? Describe the process.\n\n5.4 Administrative Burdens on Business Operations\nLEARNING OBJECTIVES\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n205\n\n\x0c1.\n\nDescribe the paperwork burden imposed by administrative agencies.\n\n2.\n\nExplain why agencies have the power of investigation, and what limits there are to that power.\n\n3.\n\nExplain the need for the Freedom of Information Act and how it works in the US legal system.\n\nThe Paperwork Burden\nThe administrative process is not frictionless. The interplay between government agency and private\nenterprise can burden business operations in a number of ways. Several of these are noted in this section.\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\n$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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n206\n\n\x0cthe 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\nhazards 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n207\n\n\x0cIn 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.\nA 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\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 personal\nprivacy\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.\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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n208\n\n\x0cdisclose it. Most agencies notify a company whose data they are about to disclose. But these practices are\nnot legally required under the FOIA.\n\nKEY TAKEAWAY\nGovernment agencies, in order to do their jobs, collect a great deal of information from businesses. This\ncan range from routine paperwork (often burdensome) to inspections, those with warrants and those\nwithout. Surprise inspections are allowed for closely regulated industries but are subject to Fourth\nAmendment requirements in general. Some information collected by agencies can be accessed using the\nFreedom of Information Act.\n\nEXERCISES\n1.\n\nGive two examples of a closely regulated industry. Explain why some warrantless searches would be\nallowed.\n\n2.\n\nFind out why FOIA requests often take months or years to accomplish.\n\n[1] In re FTC Line of Business Report Litigation, 595 F.2d 685 (D.C. Cir. 1978).\n[2] Marshall v. Barlow\xe2\x80\x99s, Inc., 436 US 307 (1978).\n[3] New York v. Burger, 482 US 691 (1987).\n[4] Dow Chemical Co. v. United States Environmental Protection Agency, 476 US 227 (1986).\n\n5.5 The Scope of Judicial Review\nLEARNING OBJECTIVES\n1.\n\nDescribe the \xe2\x80\x9cexhaustion of remedies\xe2\x80\x9d requirement.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n209\n\n\x0c2.\n\nDetail various strategies for obtaining judicial review of agency rules.\n\n3.\n\nExplain 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\nauthority 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.\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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n210\n\n\x0cNevertheless, 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.\nIn summary, then, an individual or a company may (after exhaustion of administrative remedies)\nchallenge agency action where such action is the following:\n\xe2\x80\xa2\n\nnot in accordance with the agency\xe2\x80\x99s scope of authority\n\n\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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n211\n\n\x0clegitimate, 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?\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\ncontains 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\n[3]\n\nagainst an unlawful search of his home. Subsequent cases have followed this logic to permit suits for\nviolations of other constitutional provisions. This area of the law is in a state of flux, and it is likely to\ncontinue to evolve.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n212\n\n\x0cin 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\nrecover 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.\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\nKEY TAKEAWAY\nAfter exhausting administrative remedies, there are numerous grounds for seeking judicial review of an\nagency\xe2\x80\x99s order or of a final rule. While courts defer to agencies to some degree, an agency must follow\nits own rules, comply with the Administrative Procedure Act, act within the scope of its delegated\nauthority, avoid acting in an arbitrary manner, and make final rules that are supported by substantial\nevidence.\n\nEXERCISES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n213\n\n\x0c1.\n\nWhy would US courts require that someone seeking judicial review of an agency order first exhaust\nadministrative remedies?\n\n2.\n\nOn the Internet, find a case where someone has successfully sued the US government under the Federal\nTort Claims Act. What kind of case was it? Did the government argue sovereign immunity? Does\nsovereign immunity even make sense to you?\n\n[1] Motor Vehicle Manufacturers\xe2\x80\x99 Assn. v. State Farm Mutual Ins., 463 US 29 (1983).\n[2] Dalehite v. United States, 346 US 15 (1953).\n[3] Bivens v. Six Unknown Federal Narcotics Agents, 403 US 388 (1971).\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n214\n\n\x0c436 U.S. 307 (U.S. Supreme Court 1978)\nMR. JUSTICE WHITE delivered the opinion of the Court.\nSection 8(a) of the Occupational Safety and Health Act of 1970 (OSHA or Act) empowers agents 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.\nOn the morning of September 11, 1975, an OSHA inspector entered the customer service area of Barlow\xe2\x80\x99s,\nInc., and 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\nagain 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.\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.\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 asserted permit by\nOSHA.\xe2\x80\xa6The Warrant Clause of the Fourth Amendment protects commercial buildings as well as private\nhomes. To hold otherwise would belie the origin of that Amendment, and the American colonial\nexperience.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n215\n\n\x0cinspected 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[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.\nOn 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[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***\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n216\n\n\x0cThe 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\nAct 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\nCASE QUESTIONS\n1.\n\nState, as briefly and clearly as possible, the argument that Barlow\xe2\x80\x99s is making in this case.\n\n2.\n\nWhy would some industries or businesses be \xe2\x80\x9cclosely regulated\xe2\x80\x9d? What are some of those businesses?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n217\n\n\x0c3.\n\nThe Fourth Amendment speaks of \xe2\x80\x9cpeople\xe2\x80\x9d being secure in their \xe2\x80\x9cpersons, houses, papers, and effects.\xe2\x80\x9d\nWhy would the Fourth Amendment apply to a business, which is not in a \xe2\x80\x9chouse\xe2\x80\x9d?\n\n4.\n\nIf the Fourth Amendment does not distinguish between closely regulated industries and those that are\nnot, why does the court do so?\n\nAmerican Textile Manufacturers Institute v. Donovan\nAmerican Textile Manufacturers Institute v. Donovan\n452 U.S. 490 (1981)\nJUSTICE BRENNAN delivered the opinion of the Court.\nCongress enacted the Occupational Safety and Health Act of 1970 (Act) \xe2\x80\x9cto assure so far as 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.\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\norganizations, 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.\nThe Court of Appeals held that the Act did not require OSHA to compare costs and benefits.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n218\n\n\x0cWe granted certiorari, 449 U.S. 817 (1980), to resolve this important question, which was presented but\nnot decided in last Term\xe2\x80\x99s Industrial 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.\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 reparable dust. Several months later, OSHA published an\nAdvance Notice of Proposed Rulemaking, 39 Fed.Reg. 44769 (1974), requesting comments from\ninterested parties on the NIOSH recommendation and other related matters. Soon thereafter, the Textile\nWorkers Union of America, joined by the North Carolina Public Interest Research Group, petitioned the\nSecretary, urging a more stringent PEL of 100 g/m3.\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/m3 of vertical elutriated lint-free reparable\ncotton dust for all segments of the cotton industry. Ibid. It also suggested an implementation strategy for\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n219\n\n\x0cachieving 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:\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.\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\nplacing 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.\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[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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n220\n\n\x0cthey may accrue are in excess of the estimated costs, and if the lives and social security of people\nare otherwise adversely affected. (emphasis added)\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.\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\nCASE QUESTIONS\n1.\n\nWhat is byssinosis? Why should byssinosis be anything that the textile companies are responsible for,\nethically or legally? If it is well-known that textile workers get cotton dust in their systems and develop\nbrown lung, don\xe2\x80\x99t they nevertheless choose to work there and assume the risk of all injuries?\n\n2.\n\nBy imposing costs on the textile industry, what will be the net effect on US textile manufacturing jobs?\n\n3.\n\nHow is byssinosis a \xe2\x80\x9cnegative externality\xe2\x80\x9d that is not paid for by either the manufacturer or the\nconsumer of textile products? How should the market, to be fair and efficient, adjust for these negative\nexternalities other than by setting a reasonable standard that shares the burden between\nmanufacturers and their employees? Should the entire burden be on the manufacturer?\n\n5.7 Summary and Exercises\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n221\n\n\x0cSummary\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\nEXERCISES\n1.\n\nThe Equal Employment Opportunity Commission seeks data about the racial composition of Terrific\nTextiles\xe2\x80\x99 labor force. Terrific refuses on the grounds that inadvertent disclosure of the numbers might\ncause certain \xe2\x80\x9celements\xe2\x80\x9d to picket its factories. The EEOC takes Terrific to court to get the data. What is\nthe result?\n\n2.\n\nIn order to police the profession, the state legislature has just passed a law permitting the State\nPlumbers\xe2\x80\x99 Association the power to hold hearings to determine whether a particular plumber has\nviolated the plumbing code of ethics, written by the association. Sam, a plumber, objects to the\nconvening of a hearing when he is accused by Roger, a fellow plumber, of acting unethically by soliciting\nbusiness from Roger\xe2\x80\x99s customers. Sam goes to court, seeking to enjoin the association\xe2\x80\x99s disciplinary\ncommittee from holding the hearing. What is the result? How would you argue Sam\xe2\x80\x99s case? The\nassociation\xe2\x80\x99s case?\n\n3.\n\nAssume that the new president of the United States was elected overwhelmingly by pledging in his\ncampaign to \xe2\x80\x9cdo away with bureaucrats who interfere in your lives.\xe2\x80\x9d The day he takes the oath of office\nhe determines to carry out his pledge. Discuss which of the following courses he may lawfully follow: (a)\nFire all incumbent commissioners of federal agencies in order to install new appointees. (b) Demand\nthat all pending regulations being considered by federal agencies be submitted to the White House for\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n222\n\n\x0creview and redrafting, if necessary. (c) Interview potential nominees for agency positions to determine\nwhether their regulatory philosophy is consistent with his.\n4.\n\nDewey owned a mine in Wisconsin. He refused to allow Department of Labor agents into the mine to\nconduct warrantless searches to determine whether previously found safety violations had been\ncorrected. The Federal Mine Safety and Health Amendments Act of 1977 authorize four warrantless\ninspections per year. Is the provision for warrantless inspections by this agency constitutional?\n\n5.\n\n[1]\n\nIn determining the licensing requirements for nuclear reactors, the Nuclear Regulatory Commission\n(NRC) adopted a zero-release assumption: that the permanent storage of certain nuclear waste would\nhave no significant environmental impact and that potential storage leakages should not be a factor\ndiscussed in the appropriate environmental impact statement (EIS) required before permitting\nconstruction of a nuclear power plant. This assumption is based on the NRC\xe2\x80\x99s belief that technology\nwould be developed to isolate the wastes from the environment, and it was clear from the record that\nthe NRC had \xe2\x80\x9cdigested a massive material and disclosed all substantial risks\xe2\x80\x9d and had considered that\nthe zero-release assumption was uncertain. There was a remote possibility of contamination by water\nleakage into the storage facility. An environmental NGO sued, asserting that the NRC had violated the\nregulations governing the EIS by arbitrarily and capriciously ignoring the potential contamination. The\ncourt of appeals agreed, and the power plant appealed. Had the NRC acted arbitrarily and\ncapriciously?\n\n[2]\n\nSELF-TEST QUESTIONS\n1.\n\nMost federal administrative agencies are created by\n\na.\n\nan executive order by the president\n\nb.\n\na Supreme Court decision\n\nc.\n\nthe passage of enabling legislation by Congress, signed by the president\n\nd.\n\na and c\nThe Federal Trade Commission, like most administrative agencies of the federal government, is\npart of\n\na.\n\nthe executive branch of government\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n223\n\n\x0cb.\n\nthe legislative branch of government\n\nc.\n\nthe judicial branch of government\n\nd.\n\nthe administrative branch of government\nIn the Clean Water Act, Congress sets broad guidelines, but it is the Environmental Protection\nAgency that proposes rules to regulate industrial discharges. Where do proposed rules originally\nappear?\n\na.\n\nin the Congressional record\nb.\n\nin the Federal Register\n\nc.\n\nin the Code of Federal Regulations\n\nd.\n\nin the United States code service\nThe legal basis for all administrative law, including regulations of the Federal Trade\nCommission, is found in\n\na.\n\nthe Administrative Procedure Act\nb.\n\nthe US Constitution\n\nc.\n\nthe commerce clause\n\nd.\n\nnone of the above\nThe Federal Trade Commission, like other administrative agencies, has the power to\n\na.\n\nissue proposed rules\nb.\n\nundertake investigations of firms that may have violated FTC regulations\n\nc.\n\nprosecute firms that have violated FTC regulations\n\nd.\n\nnone of the above\n\ne.\n\nall of the above\n\nSELF-TEST ANSWERS\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n224\n\n\x0c1.\n\nc\n\n2.\n\na\n\n3.\n\nb\n\n4.\n\nb\n\n5.\n\ne\n\n[1] Donovan v. Dewey, 452 US 594 (1981).\n[2] Baltimore Gas and Electric Co. v. Natural Resources Defense Council Inc., 462 US 87 (1983).\n\nChapter 6\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n225\n\n\x0cCriminal Law\nLEARNING OBJECTIVES\nAfter reading this chapter, you should be able to do the following:\n1.\n\nExplain how criminal law differs from civil law.\n\n2.\n\nCategorize the various types of crimes and define the most serious felonies.\n\n3.\n\nDiscuss and question the criminal \xe2\x80\x9cintent\xe2\x80\x9d of a corporation.\n\n4.\n\nExplain 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\n6.1 The Nature of Criminal Law\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n226\n\n\x0cCriminal 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.\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.\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\nthat 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\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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n227\n\n\x0cArabia, 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\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!\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\nsociety. 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.\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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n228\n\n\x0ccrime 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.)\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.\n\nKEY TAKEAWAY\nCrimes are usually defined by statute and constitute an offense against society. In each case, there must\nbe both an act and some mens rea (criminal intent).\n\nEXERCISES\n1.\n\nOther than deterring certain kinds of conduct, what purpose does the criminal law serve?\n\n2.\n\nWhy is ignorance of the law no excuse? Why shouldn\xe2\x80\x99t it be an excuse, when criminal laws can be\ncomplicated and sometimes ambiguous?\n\n6.2 Types of Crimes\nLEARNING OBJECTIVES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n229\n\n\x0c1.\n\nCategorize various types of crimes.\n\n2.\n\nName and define the major felonies in criminal law.\n\n3.\n\nExplain how white-collar crime differs from other crimes.\n\n4.\n\nDefine 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\nHomicide 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.\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; intent to inflict great bodily harm\ncan be murder if the result is the death of another person. A killing that takes place while a felony (such as\narmed robbery) is being committed is also murder, whether or not the killer intended any harm. This is\nthe so-called felony murder rule. Examples are the accidental discharge of a gun that kills an innocent\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n230\n\n\x0cbystander or the asphyxiation death of a fireman from smoke resulting from a fire set by an arsonist. The\nfelony murder rule is more significant than it sounds, because it also applies to the accomplices of one\nwho does the killing. Thus the driver of a getaway car stationed a block away from the scene of the robbery\ncan be convicted of murder if a gun accidentally fires during the robbery and someone is killed.\nManslaughter is an act of killing that does not amount to murder. Voluntary manslaughter is an\nintentional killing, but one carried out in the \xe2\x80\x9csudden heat of passion\xe2\x80\x9d as the result of some provocation.\nAn example is a fight that gets out of hand. Involuntary manslaughter entails a lesser degree of\nwillfulness; it usually occurs when someone has taken a reckless action that result in death (e.g., a death\nresulting from a traffic accident in which one driver recklessly runs a red light).\n\nAssault and Battery\nOrdinarily, we would say that a person who has struck another has \xe2\x80\x9cassaulted\xe2\x80\x9d him. Technically, 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\npermission to operate. In the absence of such 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.\nCriminal assault is an attempt to commit a battery or the deliberate placing of another in fear of receiving\nan immediate battery. If you throw a rock at a friend, but he manages to dodge it, you have committed an\nassault. Some states limit an assault to an attempt to commit a battery by one who has a \xe2\x80\x9cpresent ability\xe2\x80\x9d\nto do so. Pointing an unloaded gun and threatening to shoot would not be an assault, nor, of course, could\nit be a battery. The modem tendency, however, is to define an assault as an attempt to commit a battery by\none with an apparent ability to do so.\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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n231\n\n\x0cOffenses 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.\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\nThe 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 away\npersonal property (the peach is part of the land, being connected to the tree). But if he picks up a peach\nlying 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 \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.\nA particular form of larceny is robbery, which is defined as larceny from a person by means of violence or\nintimidation.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n232\n\n\x0cbecause 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.\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\nand 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.\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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n233\n\n\x0cReceiving 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\nForgery\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 collected\nan unlawful fee under color of office. A common example is a salaried building inspector who refuses to\nissue a permit unless the permit tee pays him. Under modern statutes, the crime of extortion has been\nbroadened to include the wrongful collection of money or something else of value by anyone by means of a\nthreat (short of a threat of immediate physical violence, for such a threat would make the demand an act\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n234\n\n\x0cof robbery). This kind of extortion is usually called blackmail. The blackmail threat commonly is to expose\nsome 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\nsneaks 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 house\nfor purposes of collecting insurance was not an act of arson under common law. The statutes today make\nit a felony intentionally to set fire to any building, whether or not it is a dwelling and whether or not the\npurpose 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 cash\nor in the form of any goods, intangibles, or services that the recipient would find valuable. Under common\nlaw, only a public official could be bribed. In most states, bribery charges can result from the bribe of\nanyone performing a public function.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n235\n\n\x0cPerjury\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\nperjurious, 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 out\nin a nonviolent way, usually connected with business. Armed bank robbery is not a white-collar crime, but\nembezzlement 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.\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\nuses 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n236\n\n\x0cinfluence 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 Chapter 16 "Antitrust Law" we consider the fundamentals of antitrust law, which for the most part\naffects the business enterprise civilly. But violations of Section 1 of the Sherman Act, which condemns\nactivities 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 sending into\ninterstate commerce any adulterated or misbranded food, drug, cosmetics, or related device. For example,\nin a 2010 case, Allergen had to pay a criminal fine for marketing Botox as a headache or pain reliever, a\nuse that had not been approved by the Food and Drug Administration. Unlike most criminal statutes,\nwillfulness or deliberate misconduct is not an element of the act. As the United States v. Park case\n(Section 6.7 "Cases") shows, an executive can be held criminally liable even though he may have had no\npersonal 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\nofficers who have responsibility over a project where subcontractors and their employees actually caused\nthe discharge.\n\n[2]\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n237\n\n\x0cViolations 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 payer (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 property;\n(2) misappropriation of computer time; (3) theft of programs; and (4) illegal acquisition of information.\nThe main federal statutory framework for many computer crimes is the Computer Fraud and Abuse Act\n(CFAA; see Table 6.1 "Summary of Provisions of the Computer Fraud and Abuse Act"). Congress only\nprohibited 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\n\nObtaining national security information\n\nSaylor URL: http://www.saylor.org/books\n\nSec. (a)(1)\n\n10 years maximum (20 years second\noffense)\n\nSaylor.org\n238\n\n\x0cTrespassing in a government computer\n\nSec. (a)(3)\n\n1 year (5)\n\nCompromising the confidentiality of a computer\n\nSec. (a)(2)\n\n1 year (10)\n\nAccessing a computer to defraud and obtain\nvalue\n\nSec. (a)4\n\n5 years (10)\n\nIntentional access and reckless damage\n\n(a)(5)(A)(ii) 5 years (20)\n\nTrafficking in passwords\n\n(a)(6)\n\n1 year (10)\n\nKEY TAKEAWAY\nOffenses can be against persons, against property, or against public policy (as when you bribe a public\nofficial, commit perjury, or use public goods such as the mails or the Internet to commit fraud, violate\nantitrust laws, or commit other white-collar crimes).\n\nEXERCISES\n1.\n\nWhich does more serious harm to society: street crimes or white-collar crimes?\n\n2.\n\nWhy are various crimes so difficult to define precisely?\n\n3.\n\nHungry Harold goes by the home of Juanita Martinez. Juanita has just finished baking a cherry pie and\nsets it in the open windowsill to cool. Harold smells the pie from the sidewalk. It is twilight; while still\nlight, the sun has officially set. Harold reaches into the window frame and removes the pie. Technically,\nhas Harold committed burglary? What are the issues here based on the definition of burglary?\n\n4.\n\nWhat is fraud? How is it different from dishonesty? Is being dishonest a criminal offense? If so, have you\nbeen a criminal already today?\n\n[1] United States v. Isaacs, 493 F.2d 1124 (7th Cir. 1974), cert. denied, 417 US 976 (1974).\n[2] U.S. v. Hanousek, 176 F.3d 1116 (9th Cir. 1999).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n239\n\n\x0c6.3 The Nature of a Criminal Act\nLEARNING OBJECTIVES\n1.\n\nUnderstand how it is possible to commit a criminal act without actually doing anything that you think\nmight be criminal.\n\n2.\n\nAnalyze and explain the importance of intention in criminal law and criminal prosecutions.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n240\n\n\x0c3.\n\nExplain how a corporation can be guilty of a crime, even though it is a corporation\xe2\x80\x99s agents that commit\nthe 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\nAshley, 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n241\n\n\x0cLegal 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.\n\nConspiracy\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n242\n\n\x0creasonably 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.\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\ncustomer.\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.\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 or 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\nKEY TAKEAWAY\nAlthough proving the intent to commit a crime (the men\xe2\x80\x99s rea) is essential, the intent can be established\nby inference (circumstantially). Conspirators may not actually commit a crime, for example, but in\npreparing for a criminal act, they may be guilty of the crime of conspiracy. Certain corporate officers, as\nwell, may not be directly committing criminal acts but may be held criminally responsible for acts of their\nagents and contractors.\n\nEXERCISES\n1.\n\nGive an example of how someone can intend to commit a crime but fail to commit one.\n\n2.\n\nDescribe a situation where there is a conspiracy to commit a crime without the crime actually taking\nplace.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n243\n\n\x0c3.\n\nCreate a scenario based on current events where a corporation could be found guilty of committing a\ncrime even though the CEO, the board of directors, and the shareholders have not themselves done a\ncriminal act.\n\n6.4 Responsibility\nLEARNING OBJECTIVES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n244\n\n\x0c1.\n\nExplain why criminal law generally requires that the defendant charged with a crime have criminal\n"intent."\n\n2.\n\nKnow and explain the possible excuses relating to responsibility that are legally recognized by courts,\nincluding 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.\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)\nbut 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n245\n\n\x0cviolating 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.\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\nEntrapment\nOne common technique of criminal investigation is the use of an undercover agent or decoy\xe2\x80\x94the\npoliceman who poses as a buyer of drugs from a street dealer or the elaborate \xe2\x80\x9csting\xe2\x80\x9d operations 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.\nBut a rule against entrapment limits the legal ability of the police to play the role of criminals. The police\nare 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n246\n\n\x0cmay 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.\nIntoxication can be a defense to certain crimes, but the mere fact of drunkenness is not ordinarily\nsufficient.\n\nKEY TAKEAWAY\nIn the United States, some crimes can be committed by not following strict regulatory requirements for\nhealth, safety, or the environment. The law does provide excuses from criminal liability for mistakes of\nfact, entrapment, and lack of capacity.\n\nEXERCISES\n1.\n\nDescribe several situations in which compulsion, consent, or other excuses take away criminal liability.\n\n2.\n\nYour employee is drunk on the job and commits the crime of assault and battery on a customer. He\nclaims lack of capacity as an excuse. Should the courts accept this excuse? Why or why not?\n\n6.5 Procedure\nLEARNING OBJECTIVES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n247\n\n\x0c1.\n\nDescribe the basic steps in pretrial criminal procedure that follow a government\'s determination to arrest\nsomeone for an alleged criminal act.\n\n2.\n\nDescribe the basic elements of trial and post-trial 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.\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\nattendance 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.\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.\nFollowing the preliminary hearing, the prosecutor must either file information (a document stating the\ncrime of which the person being held is accused) or ask the grand jury for an indictment. The grand jury\nconsists of twenty-three people who sit to determine whether there is sufficient evidence to warrant a\nprosecution. It does not sit to determine guilt or innocence. The indictment is the grand jury\xe2\x80\x99s formal\ndeclaration of charges on which the accused will be tried. If indicted, the accused formally becomes a\ndefendant.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n248\n\n\x0cbefore a jury (sometimes referred to as a petit jury). The jury cannot convict unless it finds the defendant\nguilty beyond a reasonable doubt.\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 to\nrecommend to the judge that the sentence be limited. The judge most often, but not always, goes along\nwith the prosecutor\xe2\x80\x99s recommendation.\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\npleaded 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.\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).\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\nKEY TAKEAWAY\nCriminal procedure in US courts is designed to provide a fair process to both criminal defendants and to\nsociety. The grand jury system, prosecutorial discretion, plea bargains, and appeals for lack of a fair trial\nare all part of US criminal procedure.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n249\n\n\x0cEXERCISES\n1.\n\nHarold is charged with the crime of assault with a deadly weapon with intent to kill or inflict serious bodily\ninjury. It is a more serious crime than simple assault. Harold\xe2\x80\x99s attorney wants the prosecutor to give\nHarold a break, but Harold is guilty of at least simple assault and may also have had the intent to kill.\nWhat is Harold\xe2\x80\x99s attorney likely to do?\n\n2.\n\nKumar was driving his car, smoking marijuana, and had an accident with another vehicle. The other driver\nwas slightly injured. When the officer arrived, she detected a strong odor of marijuana in Kumar\xe2\x80\x99s car and\na small amount of marijuana in the glove compartment. The other driver expects to bring a civil action\nagainst Kumar for her injuries after Kumar\xe2\x80\x99s criminal case. What should Kumar plead in the criminal\ncase\xe2\x80\x94careless driving or driving under the influence?\n\n6.6 Constitutional Rights of the Accused\nLEARNING OBJECTIVES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n250\n\n\x0c1.\n\nDescribe the most significant constitutional rights of defendants in US courts, and name the source of\nthese rights.\n\n2.\n\nExplain 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\npolice 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?\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 re-prosecuted for the same crime.\n\nSelf-Incrimination\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n251\n\n\x0cThe 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\nhim 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n252\n\n\x0cCruel 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 is 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.\nThe 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\nKEY TAKEAWAY\nThe US Constitution provides several important protections for criminal defendants, including a\nprohibition on the use of evidence that has been obtained by unconstitutional means. This would\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n253\n\n\x0cinclude evidence seized in violation of the Fourth Amendment and confessions obtained in violation of\nthe Fifth Amendment.\n\nEXERCISES\n1.\n\nDo you think it is useful to have a presumption of innocence in criminal cases? What if there were not\npresumptions of innocence in criminal cases?\n\n2.\n\nDo you think public humiliation, public execution, and unusual punishments would reduce the amount\nof crime? Why do you think so?\n\n3.\n\n\xe2\x80\x9cDue process\xe2\x80\x9d is another phrase for \xe2\x80\x9cfairness.\xe2\x80\x9d Why should the public show fairness toward criminal\ndefendants?\n\n[1] Miranda v. Arizona, 384 US 436 (1966).\n\n6.7 Cases\nFalse Pretenses\nState v. Mills\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n254\n\n\x0c96 Ariz. 377, 396 P.2d 5 (Ariz. 1964)\nLOCKWOOD, VICE CHIEF JUSTICE\nDefendants appeal from a conviction on two counts of obtaining money by false pretenses in 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\nWinifred Mills, his wife, participated in the business generally by answering the telephone, typing, and\nreceiving clients who came to the office.\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.\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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n255\n\n\x0cmisconceive 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.\nDefendants admit that the proposition of law which they assert is a novel one in this jurisdiction.\nRespectable authority in other states persuades us that their contention is without merit. A creditor has a\nright to determine for him whether he wishes to be a secured or an unsecured creditor. In the former case,\nhe has a right to know about the security. If he extends credit in reliance upon security which is falsely\nrepresented 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 intent to defraud.\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 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\nCASE QUESTIONS\n1.\n\nFalse pretense is a crime of obtaining ownership of property of another by making untrue\nrepresentations of fact with intent to defraud. What were the untrue representations of fact made by\nMills?\n\n2.\n\nConcisely state the defendant\xe2\x80\x99s argument as to why Pivowar has not been deprived of any property.\n\n3.\n\nIf Pivowar had presented the notes and Mills had paid, would a crime have been committed?\n\nWhite-Collar Crimes\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n256\n\n\x0cUnited States v. Park\n421 U.S. 658 (1975)\nMR. CHIEF JUSTICE BURGER delivered the opinion of the Court.\nWe granted certiorari to consider whether the jury instructions in the prosecution of a corporate 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).\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\nimprovement 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\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n257\n\n\x0cbehalf 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\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.\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\nOn 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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n258\n\n\x0cindicated 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\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***\nThe question presented by the Government\xe2\x80\x99s petition for certiorari in United 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\na 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\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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n259\n\n\x0c***\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***\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.\nThus 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***\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n260\n\n\x0cThe 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\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\nCASE QUESTIONS\n1.\n\nDid Park have criminal intent to put adulterated food into commerce? If not, how can Park\xe2\x80\x99s conduct be\ncriminalized?\n\n2.\n\nTo get a conviction, what does the prosecutor have to show, other than that Park was the CEO of Acme\nand therefore responsible for what his company did or didn\xe2\x80\x99t do?\n\n6.8 Summary and Exercises\nSummary\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n261\n\n\x0cCriminal 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.\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\ncrime, and a person involved in a conspiracy to commit a felony may find that very little is required to put\nhim into serious trouble.\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 does so.\n\nEXERCISES\n1.\n\nBill is the chief executive of a small computer manufacturing company that desperately needs funds to\ncontinue operating. One day a stranger comes to Bill to induce him to take part in a cocaine smuggling\ndeal that would net Bill millions of dollars. Unbeknownst to Bill, the stranger is an undercover\npoliceman. Bill tells the stranger to go away. The stranger persists, and after five months of arguing and\ncajoling, the stranger wears down Bill\xe2\x80\x99s will to resist. Bill agrees to take delivery of the cocaine and\nhands over a down payment of $10,000 to the undercover agent, who promptly arrests him for\nconspiracy to violate the narcotics laws. What defenses does Bill have?\n\n2.\n\nYou are the manager of a bookstore. A customer becomes irritated at having to stand in line and begins\nto shout at the salesclerk for refusing to wait on him. You come out of your office and ask the customer\nto calm down. He shouts at you. You tell him to leave. He refuses. So you and the salesclerk pick him up\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n262\n\n\x0cand shove him bodily out the door. He calls the police to have you arrested for assault. Should the\npolice arrest you? Assuming that they do, how would you defend yourself in court?\n3.\n\nMarilyn is arrested for arson against a nuclear utility, a crime under both state and federal law. She is\nconvicted in state court and sentenced to five years in jail. Then the federal government decides to\nprosecute her for the same offense. Does she have a double-jeopardy defense against the federal\nprosecution?\n\n4.\n\nTectonics, a US corporation, is bidding on a project in Nigeria, and its employee wins the bid by secretly\ngiving $100,000 to the Nigerian public official that has the most say about which company will be\nawarded the contract. The contract is worth $80 million, and Tectonics expects to make at least $50\nmillion on the project. Has a crime under US law been committed?\n\n5.\n\nSuppose that the CEO of Tectonics, Ted Nelson, is not actually involved in bribery of the Nigerian public\nofficial Adetutu Adeleke. Instead, suppose that the CFO, Jamie Skillset, is very accomplished at\ninsulating both top management and the board of directors from some of the \xe2\x80\x9coperational realities\xe2\x80\x9d\nwithin the company. Skillset knows that Whoopi Goldmine, a Nigerian employee of Tectonics, has made\nthe deal with Adeleke and secured the contract for Tectonics. Is it possible that Nelson, as well as\nSkillset, can be found guilty of a crime?\n\n6.\n\nYou have graduated from college and, after working hard for ten years, have scraped enough money\ntogether to make a down payment on a forty-acre farm within driving distance to the small city where\nyou work in Colorado. In town 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 consignment shop in town. You\nallow her to have a room in your house for a few months until she has enough money to go into\nbusiness. Over the following weeks, however, you realize that old acquaintances from high school are\nstopping by almost daily for short visits. When you bring this up to Hayley, she admits that many old\nfriends are now relying on her for marijuana. She is not a licensed caregiver in Colorado and is clearly\nviolating the law. Out of loyalty, you tell her that she has three weeks to move out, but you do not\nprevent her from continuing sales while she is there. What crime have you committed?\n\n7.\n\nThe Center Art Galleries\xe2\x80\x94Hawaii sells artwork and much of it involves art by the famous surrealist\npainter Salvador Dali. The federal government suspected the center of selling forged Dali artwork and\nobtained search warrants for six locations controlled by the center. The warrants told the executing\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n263\n\n\x0cofficer to seize any items that were \xe2\x80\x9cevidence of violations of federal criminal law.\xe2\x80\x9d The warrants did\nnot describe the specific crime suspected, nor did the warrants limit the seizure of items solely to Dali\nartwork or suspected Dali forgeries. Are these search warrants valid?\n\n[1]\n\nSELF-TEST QUESTIONS\n1.\n\nJared has made several loans to debtors who have declared bankruptcy. These are unsecured\nclaims. Jared \xe2\x80\x9cdoctors\xe2\x80\x9d the documentation to show amounts owed that are higher than the\ndebtors actually owe. Later, Jared is charged with the federal criminal offense of filing false\nclaims. The standard (or \xe2\x80\x9cburden\xe2\x80\x9d) of proof that the US attorney must meet in the prosecution is\n\na.\n\nbeyond all doubt\n\nb.\n\nbeyond a reasonable doubt\n\nc.\n\nclear and convincing evidence\n\nd.\n\na preponderance of the evidence\nJethro, a businessman who resides in Atlanta, creates a disturbance at a local steakhouse and\nis arrested for being drunk and disorderly. Drunk and disorderly is a misdemeanor under Georgia\nlaw. A misdemeanor is a crime punishable by imprisonment for up to\n\na.\n\none year\nb.\n\ntwo years\n\nc.\n\nfive years\n\nd.\n\nnone of the above\nYuan is charged with a crime. To find him guilty, the prosecutor must show\n\na.\n\nactus reus and mens rea\nb.\n\nmens rea only\n\nc.\n\nthe performance of a prohibited act\n\nd.\n\nnone of the above\nKira works for Data Systems Ltd. and may be liable for larceny if she steals\n\na.\n\na competitor\xe2\x80\x99s trade secrets\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n264\n\n\x0cb.\n\ncompany computer time\n\nc.\n\nthe use of Data Systems\xe2\x80\x99 Internet for personal business\n\nd.\n\nany of the above\nCandace is constructing a new office building that is near its completion. She offers Paul $500\nto overlook certain things that are noncompliant with the city\xe2\x80\x99s construction code. Paul accepts\nthe money and overlooks the violations. Later, Candace is charged with the crime of bribery.\nThis occurred when\n\na.\n\nCandace offered the bribe.\nb.\n\nPaul accepted the bribe.\n\nc.\n\nPaul overlooked the violations.\n\nd.\n\nnone of the above\n\nSELF-TEST ANSWERS\n1.\n\nb\n\n2.\n\na\n\n3.\n\na\n\n4.\n\nd\n\n5.\n\na\n\n[1] Center Art Galleries\xe2\x80\x94Hawaii, Inc. v. United States, 875 F.2d 747 (9th Cir. 1989).\n\nChapter 7\nIntroduction to Tort Law\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n265\n\n\x0cLEARNING OBJECTIVES\nAfter reading this chapter, you should be able to do the following:\n1.\n\nKnow why most legal systems have tort law.\n\n2.\n\nIdentify the three kinds of torts.\n\n3.\n\nShow how tort law relates to criminal law and contract law.\n\n4.\n\nUnderstand negligent torts and defenses to claims of negligence.\n\n5.\n\nUnderstand strict liability torts and the reasons for them in the US legal system.\n\nIn 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n266\n\n\x0cLEARNING OBJECTIVES\n1.\n\nExplain why a sound market system requires tort law.\n\n2.\n\nDefine a tort and give two examples.\n\n3.\n\nExplain the moral basis of tort liability.\n\n4.\n\nUnderstand 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 tortis 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.\nLong 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.\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.\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 non-contractual 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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n267\n\n\x0cMany 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\nterms, 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).\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.\nFigure 7.1 Dimensions of Tort Liability\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n268\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.\nThe most obvious standard is willful conduct. If the defendant (often called the tort feasor\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.\nThe 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n269\n\n\x0cthe 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 is\nplaced 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.\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.\nAnother 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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n270\n\n\x0cSince 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.\nIn certain instances, the courts will permit an award of punitive damages. As the word punitive implies,\nthe purpose is to punish the defendant\xe2\x80\x99s actions. Because a punitive award (sometimes called exemplary\ndamages) is at odds with the general purpose of tort law, it is allowable only in aggravated situations. The\nlaw in most states permits recovery of punitive damages only when the defendant has deliberately\ncommitted a wrong with malicious intent or has otherwise done something outrageous.\nPunitive damages are rarely allowed in negligence cases for that reason. But if someone sets out\nintentionally and maliciously to hurt another person, punitive damages may well be appropriate. 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\nKEY TAKEAWAY\nThere are three kinds of torts, and in two of them (negligent torts and strict liability torts), damages are\nusually limited to making the victim whole through an enforceable judgment for money damages. These\ncompensatory damages awarded by a court accomplish only approximate justice for the injuries or\nproperty damage caused by a tortfeasor. Tort laws go a step further toward deterrence, beyond\ncompensation to the plaintiff, in occasionally awarding punitive damages against a defendant. These are\nalmost always in cases where an intentional tort has been committed.\n\nEXERCISES\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n271\n\n\x0c1.\n\nWhy is deterrence needed for intentional torts (where punitive damages are awarded) rather than\nnegligent torts?\n\n2.\n\nWhy are costs imposed on others without their consent problematic for a market economy? What if the\nlaw did not try to re-impose the victim\xe2\x80\x99s costs onto the tortfeasor? What would a totally non-litigious\nsociety be like?\n\n7.2 Intentional Torts\nLEARNING OBJECTIVES\n1.\n\nDistinguish intentional torts from other kinds of torts.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n272\n\n\x0c2.\n\nGive three examples of an intentional tort\xe2\x80\x94one that causes injury to a person, one that causes injury to\nproperty, and one that causes injury to a reputation.\n\nThe analysis of most intentional torts is straightforward and parallels the substantive crimes already\ndiscussed in Chapter 6 "Criminal Law". When physical injury or damage to property is caused, there is\nrarely debate over liability if the plaintiff deliberately undertook to produce the harm. Certain other\nintentional torts are worth noting for their relevance to business.\n\nAssault and Battery\nOne of the most obvious intentional torts is assault and battery. Both criminal law and tort law 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n273\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. (Section 7.5 "Cases") shows, the defendant must be shown to have restrained\nthe plaintiff in order 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\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.\nA 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n274\n\n\x0cpregnant 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.\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.\nIn 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n275\n\n\x0cexample, 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:\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 the\ncontract impossible.\n4. There was injury to the plaintiff.\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.\nTexaco 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n276\n\n\x0cbeen 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.\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.\n\nDefamation\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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n277\n\n\x0cThe 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.\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.\nPublishing 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n278\n\n\x0ccourt. \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.\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\n[4]\n\nstatement] was false or with a reckless disregard of whether it was false or not.\xe2\x80\x9d In subsequent cases, the\ncourt 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n279\n\n\x0cappropriation 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.\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.\n\nPersonal Space\nOne form of intrusion upon a person\xe2\x80\x99s solitude\xe2\x80\x94trespasses\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 Embarrassing Facts\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n280\n\n\x0cCirculations 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\nKEY TAKEAWAY\nThere are many kinds of intentional torts. Some of them involve harm to the physical person or to his or\nher property, reputation or feelings, or economic interests. In each case of intentional tort, the plaintiff\nmust show that the defendant intended harm, but the intent to harm does not need to be directed at a\nparticular person and need not be malicious, as long as the resulting harm is a direct consequence of the\ndefendant\xe2\x80\x99s actions.\n\nEXERCISES\n1.\n\nName two kinds of intentional torts that could result in damage to a business firm\xe2\x80\x99s bottom line.\n\n2.\n\nName two kinds of intentional torts that are based on protection of a person\xe2\x80\x99s property.\n\n3.\n\nWhy are intentional torts more likely to result in a verdict not only for compensatory damages but also\nfor punitive damages?\n\n[1] Roche v. Stern, 675 N.Y.S.2d 133 (1998).\n[2] Katko v. Briney, 183 N.W.2d 657 (Iowa 1971).\n[3] Restatement (Second) of Torts, Section 559 (1965).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n281\n\n\x0c[4] Times v. Sullivan, 376 US 254 (1964).\n\n7.3 Negligence\nLEARNING OBJECTIVES\n1.\n\nUnderstand how the duty of due care relates to negligence.\n\n2.\n\nDistinguish between actual and proximate cause.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n282\n\n\x0c3.\n\nExplain the primary defenses to a claim of negligence.\n\nElements 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.\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.\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 loss.\nEven if a plaintiff can prove each of these aspects, the defendant may be able to show that the law excuses\nthe 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.\nGiven 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n283\n\n\x0cstandard 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.)\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.\nIn 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n284\n\n\x0cDuring the course of the twentieth century, the courts have constantly expanded the notion of\n\xe2\x80\x9cforeseeability,\xe2\x80\x9d so that today many more people are held to be within the zone of injury than 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.\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\nCausation: Actual Cause and Proximate Cause\n\xe2\x80\x9cFor want of a nail, the kingdom was lost,\xe2\x80\x9d as the old saying has it. Virtually any cause of an 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\ncause. Actual 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n285\n\n\x0cconduct, 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 unforeseeable.\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.\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\nexplosives 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n286\n\n\x0cissues 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 phrase res ipsa loquitur,\nmeaning \xe2\x80\x9cthe thing speaks for itself.\xe2\x80\x9d The best evidence is always the most direct evidence: an eyewitness\naccount of the acts in question. But eyewitnesses are often unavailable, and in any event they frequently\ncannot testify directly to the reasonableness of someone\xe2\x80\x99s conduct, which inevitably can only be inferred\nfrom the circumstances.\nIn many cases, therefore, circumstantial evidence (evidence that is indirect) will be the only evidence or\nwill constitute the bulk of the evidence. Circumstantial evidence can often be quite telling: though no one\nsaw anyone leave the building, muddy footprints tracing a path along the sidewalk are fairly conclusive.\nRes ipsa loquitur is a rule of circumstantial evidence that permits the jury to draw an inference of\nnegligence. 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\nprecisely 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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n287\n\n\x0cThere 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, the\nrule encompasses a narrower form than that with which the defendant is charged, because the plaintiff\xe2\x80\x99s\nonly error in such cases is in being less careful of himself than he might have been, whereas the defendant\nis charged with conduct careless toward others. This rule was so manifestly unjust in many cases that\nmost states, either by statute or judicial decision, have changed to some version\nof comparative negligence. Under the rule of comparative negligence, damages are apportioned according\nto the defendant\xe2\x80\x99s degree of culpability. For example, if the plaintiff has sustained a $100,000 injury and\nis 20 percent responsible, the defendant will be liable for $80,000 in damages.\n\nAssumption of Risk\nRisk of injury pervades the modern world, and plaintiffs should not win a lawsuit simply 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.\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).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n288\n\n\x0cThe 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).\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 or force 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\nits 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 responde at superior, meaning that the higher authority must respond to claims brought\nagainst one of its agents. Responde at superior is not limited to the employment relationship but extends\nto a number of other agency relationships as well.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n289\n\n\x0cLegislatures 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\nKEY TAKEAWAY\nThe most common tort claim is based on the negligence of the defendant. In each negligence claim, the\nplaintiff must establish by a preponderance of the evidence that (1) the defendant had a duty of due\ncare, (2) the defendant breached that duty, (3) that the breach of duty both actually and approximately\nhas caused harm to the plaintiff, and (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 case of responde\nat superior, or in the case of someone who loans his automobile to another driver who is negligent and\ncauses injury. There are many excuses (defenses) to claims of negligence, including assumption of risk\nand comparative negligence. In those few jurisdictions where contributory negligence has not been\nmodified to comparative negligence, plaintiffs whose negligence contributes to their own injuries will be\nbarred from any recovery.\n\nEXERCISES\n1.\n\nExplain the difference between comparative negligence and contributory negligence.\n\n2.\n\nHow is actual cause different from probable cause?\n\n3.\n\nWhat is an example of assumption of risk?\n\n4.\n\nHow does res ipsa loquitur help a plaintiff establish a case of negligence?\n\n[1] Tarasoff v. Regents of University of California, 551 P.2d 334 (Calif. 1976).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n290\n\n\x0c[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\nLEARNING OBJECTIVES\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n291\n\n\x0c1.\n\nUnderstand how strict liability torts differ from negligent torts.\n\n2.\n\nUnderstand the historical origins of strict liability under common law.\n\n3.\n\nBe able to apply strict liability concepts to liability for defective products.\n\n4.\n\nDistinguish strict liability from absolute liability, and understand the major defenses to a lawsuit in\nproducts-liability cases.\n\nHistorical Basis of Strict Liability: Animals and Ultra-hazardous Activities\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.\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 ultra-hazardous (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.\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 court invokes 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\nProducts liability is extremely important. Strict liability may also apply as a legal standard for products,\neven those that are not ultra-hazardous. In some national legal systems, strict liability is not available as a\ncause of action to plaintiffs seeking to recover a judgment of products liability against a manufacturer,\nwholesaler, distributor, or retailer. (Some states limit liability to the manufacturer.) But it is available in\nthe United States and initially was created by a California Supreme Court decision in the 1962 case\nof Greenman v. Yuba Power Products, Inc.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n292\n\n\x0cIn Greenman, the plaintiff had used a home power saw and bench, the Shop smith, designed and\nmanufactured by the defendant. He was experienced in using power tools and was injured while using the\napproved lathe attachment to the Shop smith 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\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.\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:\n1.\n\nThe product must be in a defective condition when the defendant sells it.\n\n2. 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 time\nthe injury was sustained.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n293\n\n\x0cSection 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).\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.\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.)\nAnother 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n294\n\n\x0cKEY TAKEAWAY\nCommon-law courts have long held that certain activities are inherently dangerous and that those who\ncause damage to others by engaging in those activities will be held strictly liable. More recently, courts in\nthe United States have applied strict liability to defective products. Strict liability, however, is not\nabsolute liability, as there are many defenses available to defendants in lawsuits based on strict liability,\nsuch as comparative negligence and product abuse.\n\nEXERCISES\n1.\n\nSomeone says, \xe2\x80\x9cStrict liability means that you\xe2\x80\x99re liable for whatever you make, no matter what the\nconsumer does with your product. It\xe2\x80\x99s a crazy system.\xe2\x80\x9d Respond to and refute this statement.\n\n2.\n\nWhat is the essential difference between strict liability torts and negligent torts? Should the US legal\nsystem even allow strict liability torts? What reasons seem persuasive to you?\n\nNext\n[1] Pellman v. McDonald\xe2\x80\x99s Corp., 237 F.2d 512 (S.D.N.Y. 2003).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n295\n\n\x0c7.5 Cases\nIntentional Torts: False Imprisonment\nLester v. Albers Super Markets, Inc.\n94 Ohio App. 313, 114 N.E.2d 529 (Ohio 1952)\nFacts: The plaintiff, carrying a bag of rolls purchased at another store, entered the defendant\xe2\x80\x99s 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***\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\nMany cases are cited in support of the text.\n***\nIn Fenn v. Kroger Grocery & Baking Co., Mo. Sup., 209 S.W. 885, 887, the court said:\nA case was not made out for false arrest. The plaintiff said she was intercepted as she started to leave the\nstore; that Mr. Krause stood where she could not pass him in going out. She does not say that he made any\nattempt to intercept her. She says he escorted her back to the desk, that he asked her to let him see the\nchange.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n296\n\n\x0c\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.\nThe result of the cases is epitomized in 22 Am.Jur. 368, as follows:\nA customer or patron who apparently has not paid for what he has received may be detained for 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***\nFor these reasons, the judgment is reversed and final judgment entered for the defendant-appellant.\n\nCASE QUESTIONS\n1.\n\nThe court begins by saying what false imprisonment is not. What is the legal definition of false\nimprisonment?\n\n2.\n\nWhat kinds of detention are permissible for a store to use in accosting those that may have been\nshoplifting?\n\n3.\n\nJody broke up with Jeremy and refused to talk to him. Jeremy saw Jody get into her car near the\nbusiness school and parked right behind her so she could not move. He then stood next to the driver\xe2\x80\x99s\nwindow for fifteen minutes, begging Jody to talk to him. She kept saying, \xe2\x80\x9cNo, let me leave!\xe2\x80\x9d Has\nJeremy committed the tort of false imprisonment?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n297\n\n\x0cNegligence: Duty of Due Care\nWhitlock v. University of Denver\n744 P.2d 54 (Supreme Court of Colorado1987)\nOn June 19, 1978, at approximately 10:00 p.m., plaintiff Oscar Whitlock suffered a paralyzing 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.\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\nthe 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n298\n\n\x0cthe 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.\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.\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\nUniversity 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.\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:\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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n299\n\n\x0c\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\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:\nThe 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.\nImposition of a duty in all such cases would simply not meet the test of fairness under contemporary\nstandards.\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 purposes of imposition of a duty of care include common carrier/passenger,\ninnkeeper/guest, and 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 recognition of the duty to aid or protect in any relation of\ndependence or of mutual dependence.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n300\n\n\x0c\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\nrelationship 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\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n301\n\n\x0cinhospitable environment, largely inconsistent with the objectives of a modern college\neducation.\xe2\x80\x9d Beach, 726 P.2d at 419.\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. Indeed,\nfraternity and sorority self-governance with minimal supervision appears to have been fostered by the\nUniversity.\n\xe2\x80\xa6\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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n302\n\n\x0cThe 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\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\nB.\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\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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n303\n\n\x0cthe 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\nCASE QUESTIONS\n1.\n\nHow are comparative negligence numbers calculated by the trial court? How can the jury say that the\nuniversity is 72 percent negligent and that Whitlock is 28 percent negligent?\n\n2.\n\nWhy is this not an assumption of risk case?\n\n3.\n\nIs there any evidence that Whitlock was contributory negligent? If not, why would the court engage in\ncomparative negligence calculations?\n\nNegligence: Proximate Cause\nPalsgraf v. Long Island R.R.\n248 N.Y. 339,162 N.E. 99 (N.Y. 1928)\nCARDOZO, Chief Judge\nPlaintiff was standing on a platform of defendant\xe2\x80\x99s railroad after buying a ticket to go to 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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n304\n\n\x0cThe 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\nremoved. 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.\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.\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 truck man 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.\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\n305\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.\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 there\nhas 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***\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\nCASE QUESTIONS\n1.\n\nIs there actual cause in this case? How can you tell?\n\n2.\n\nWhy should Mrs. Palsgraf (or her insurance company) be made to pay for injuries that were caused by\nthe negligence of the Long Island Rail Road?\n\n3.\n\nHow is this accident not foreseeable?\n\nKlein v. Pyrodyne Corporation\nKlein v. Pyrodyne Corporation\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n306\n\n\x0c810 P.2d 917 (Supreme Court of Washington 1991)\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.\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.\nAffirmed.\n\nCASE QUESTIONS\n1.\n\nWhy would certain activities be deemed ultra-hazardous or abnormally dangerous so that strict liability\nis imposed?\n\n2.\n\nIf the activities are known to be abnormally dangerous, did Klein assume the risk?\n\n3.\n\nAssume that the fireworks were negligently manufactured in China. Should Klein\xe2\x80\x99s only remedy be\nagainst the Chinese company, as Pyrodyne argues? Why or why not?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n307\n\n\x0c7.6 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.\nUnlike 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.\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.\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\nEXERCISES\n1.\n\nWhat is the difference in objectives between tort law and criminal law?\n\n2.\n\nA woman fell ill in a store. An employee put the woman in an infirmary but provided no medical care for\nsix hours, and she died. The woman\xe2\x80\x99s family sued the store for wrongful death. What arguments could\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n308\n\n\x0cthe store make that it was not liable? What arguments could the family make? Which seem the stronger\narguments? Why?\n3.\n\nThe signals on a railroad crossing are defective. Although the railroad company was notified of the\nproblem a month earlier, the railroad inspector has failed to come by and repair them. Seeing the all-clear\nsignal, a car drives up and stalls on the tracks as a train rounds the bend. For the past two weeks the car\nhad been stalling, and the driver kept putting off taking the car to the shop for a tune-up. As the train\nrounds the bend, the engineer is distracted by a conductor and does not see the car until it is too late to\nstop. Who is negligent? Who must bear the liability for the damage to the car and to the train?\n\n4.\n\nSuppose in the Katko v. Briney case (Section 7.2 "Intentional Torts") that instead of setting such a device,\nthe defendants had simply let the floor immediately inside the front door rot until it was so weak that\nanybody who came in and took two steps straight ahead would fall through the floor and to the cellar.\nWill the defendant be liable in this case? What if they invited a realtor to appraise the place and did not\nwarn her of the floor? Does it matter whether the injured person is a trespasser or an invitee?\n\n5.\n\nPlaintiff\xe2\x80\x99s husband died in an accident, leaving her with several children and no money except a valid\ninsurance policy by which she was entitled to $5,000. Insurance Company refused to pay, delaying and\nrefusing payment and meanwhile \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. She sued the insurance\ncompany for bad-faith refusal to settle the claim and for the intentional infliction of emotional distress.\nThe lower court dismissed the case. Should the court of appeals allow the matter to proceed to trial?\n\nSELF-TEST QUESTIONS\n1.\n\nCatarina falsely accuses Jeff of stealing from their employer. The statement is defamatory only if\na.\n\na third party hears it\n\nb.\n\nNick suffers severe emotional distress as a result\n\nc.\n\nthe statement is the actual and proximate cause of his distress\n\nd.\n\nthe statement is widely circulated in the local media and on Twitter\nGarrett files a suit against Colossal Media Corporation for defamation. Colossal has said that\nGarrett is a \xe2\x80\x9csleazy, corrupt public official\xe2\x80\x9d (and provided some evidence to back the claim). To win\nhis case, Garrett will have to show that Colossal acted with\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n309\n\n\x0ca.\nb.\n\nmalice\nill will\nc.\n\nmalice aforethought\n\nd.\n\nactual malice\nBig Burger begins a rumor, using social media, that the meat in Burger World is partly composed\nof ground-up worms. The rumor is not true, as Big Burger well knows. Its intent is to get some\ncustomers to shift loyalty from Burger World to Big Burger. Burger World\xe2\x80\x99s best cause of action\nwould be\n\na.\n\ntrespass on the case\nb.\n\nnuisance\n\nc.\n\nproduct disparagement\n\nd.\n\nintentional infliction of emotional distress\nWilfred Phelps, age 65, is driving his Nissan Altima down Main Street when he suffers the first\nseizure of his life. He loses control of his vehicle and runs into three people on the sidewalk.\nWhich statement is true?\n\na.\n\nHe is liable for an intentional tort.\nb.\n\nHe is liable for a negligent tort.\n\nc.\n\nHe is not liable for a negligent tort.\n\nd.\n\nHe is liable under strict liability, because driving a car is abnormally dangerous.\nJonathan carelessly bumps into Amanda, knocking her to the ground. He has committed the tort\nof negligence\n\na.\n\nonly if Amanda is injured\nb.\n\nonly if Amanda is not injured\n\nc.\n\nwhether or not Amanda is injured\n\n1.\n\na\n\n2.\n\nd\n\n3.\n\nc\n\nSELF-TEST ANSWERS\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n310\n\n\x0c4.\n\nc\n\n5.\n\na\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n311\n\n\x0cChapter 8\nContracts\nLEARNING OBJECTIVES\nAfter reading this chapter, you should understand the following:\n1.\n\nWhat role contracts play in society today\n\n2.\n\nWhat a contract is\n\n3.\n\nThe sources of contract law\n\n4.\n\nSome basic contract taxonomy\n\n5.\n\nThe required elements of a contract: mutual assent, consideration, legality, and capacity\n\n6.\n\nThe circumstances when a contract needs to be in writing to be enforceable\n\n7.\n\nThe remedies for breach of contract\n\nThe two fundamental concepts considered the twin cornerstones of business relationships are contract\nand tort. Although both involve the concept of duty, creation of the duty differs in a manner that is\nimportant to business. The parties create contract duties through a bargaining process. The key element\nin the process is control; individuals are in control of a situation because they have the freedom to decide\nwhether to enter into a contractual relationship. Tort duties, in contrast, are obligations the law imposes.\nDespite the obvious difficulty in controlling tort liability, an understanding of tort theory is important\nbecause it is a critical factor in strategic planning and risk management.\n\nNext\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n312\n\n\x0c8.1 General Perspectives on Contracts\nLEARNING OBJECTIVES\n1.\n\nUnderstand the role of contract in society: it moves society from status to contract.\n\n2.\n\nKnow the definition of a contract.\n\n3.\n\nRecognize the sources of contract law: the common law, the UCC, and the Convention on the\nInternational Sale of Goods\xe2\x80\x94a treaty (the CISG).\n\n4.\n\nUnderstand some fundamental contract taxonomy and terminology.\n\nThe Role of Contract in Society\nContract is probably the most familiar legal concept in our society because it is so central to a deeply held\nconviction about the essence of our political, economic, and social life. In common parlance, the term is\nused interchangeably with agreement, bargain, undertaking, or deal; but whatever the word, it embodies\nour notion of freedom to pursue our own lives together with others. Contract is central because it is the\nmeans by which a free society orders what would otherwise be a jostling, frenetic anarchy. So\ncommonplace is the concept of contract\xe2\x80\x94and our freedom to make contracts with each other\xe2\x80\x94that it is\ndifficult to imagine a time when contracts were rare, an age when people\xe2\x80\x99s everyday associations with one\nanother were not freely determined. Yet in historical terms, it was not so long ago that contracts were\nrare, entered into if at all by very few. In \xe2\x80\x9cprimitive\xe2\x80\x9d societies and in the medieval Europe from which our\ninstitutions sprang, the relationships among people were largely fixed; traditions spelled out duties that\neach person owed to family, tribe, or manor. Though he may have oversimplified, Sir Henry Maine, a\nnineteenth-century historian, sketched the development of society in his classic book Ancient Law. As he\nput it:\n(F)rom a condition of society in which all the relations of Persons are summed up in the relations of\nFamily, we seem to have steadily moved towards a phase of social order in which all these relations arise\nfrom the free agreement of Individuals. . . . Thus the status of the Slave has disappeared\xe2\x80\x94it has been\nsuperseded by the contractual relation of the servant to his master. . . . The status of the Female under\nTutelage . . . has also ceased to exist. . . . So too the status of the Son under Power has no true place in the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n313\n\n\x0claw of modern European societies. If any civil obligation binds together the Parent and the child of full\nage, it is one to which only contract gives its legal validity.... If then we employ Status, agreeably with the\nusage of the best writers, to signify these personal conditions [arising from ancient legal privileges of the\nFamily] only, we may say that the movement of the progressive societies has hitherto been a movement\nfrom Status to Contract.\n\n[1]\n\nThis movement was not accidental. It went hand-in-glove with the emerging industrial order; from the\nfifteenth to the nineteenth centuries, as England, especially, evolved into a booming mercantile economy\nwith all that that implies\xe2\x80\x94flourishing trade, growing cities, an expanding monetary system,\ncommercialization of agriculture, mushrooming manufacturing\xe2\x80\x94contract law was created of necessity.\nContract law did not develop, however, according to a conscious, far-seeing plan. It was a response to\nchanging conditions, and the judges who created it frequently resisted, preferring the quieter, imagined\npastoral life of their forefathers. Not until the nineteenth century, in both the United States and England,\ndid a full-fledged law of contracts arise together with modem capitalism.\n\nContract Defined\nAs usual in the law, the legal definition of \xe2\x80\x9ccontract\xe2\x80\x9d is formalistic. The Restatement says: \xe2\x80\x9cA contract is a\npromise or a set of promises for the breach of which the law gives a remedy, or the performance of which\nthe law in some way recognizes as a duty.\xe2\x80\x9d (Restatement (Second) of Contracts, Section 1) Similarly, the\nUniform Commercial Code says: \xe2\x80\x9c\xe2\x80\x98Contract\xe2\x80\x99 means the total legal obligation which results from the\nparties\xe2\x80\x99 agreement as affected by this Act and any other applicable rules of law.\xe2\x80\x9d (Section 1-201(11)) A\nshort-hand definition is: \xe2\x80\x9cA contract is a legally enforceable promise.\xe2\x80\x9d\n\nEconomic View of Contract Law\nIn An Economic Analysis of Law (1973), Judge Richard A. Posner (a former University of Chicago law\nprofessor) suggests that contract law performs three significant economic functions. First, it helps\nmaintain incentives to individuals to exchange goods and services efficiently. Second, it reduces the costs\nof economic transactions because its very existence means that the parties need not go to the trouble of\nnegotiating a variety of rules and terms already spelled out. Third, the law of contracts alerts the parties to\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n314\n\n\x0ctrouble spots that have arisen in the past, thus making it easier to plan the transactions more intelligently\nand avoid potential pitfalls.\n\nSources of Contract Law\nThere are four basic sources of contract law: the Constitution, federal and state statutes, federal and state\ncase law, and administrative law. For our purposes, the most important of these, and the ones that we will\nexamine at some length, are case law and statutes.\n\nCase (Common) Law and the Restatement of Contracts\nBecause contract law was forged in the common-law courtroom, hammered out case by case on the anvil\nof individual judges, it grew in the course of time to formidable proportions. By the early twentieth\ncentury, tens of thousands of contract disputes had been submitted to the courts for resolution, and the\npublished opinions, if collected in one place, would have filled dozens of bookshelves. Clearly this mass of\ncase law was too unwieldy for efficient use. A similar problem had developed in the other leading\nbranches of the common law. Disturbed by the profusion of cases and the resulting uncertainty of the law,\na group of prominent American judges, lawyers, and teachers founded the American law Institute in 1923\nto attempt to clarify, simplify, and improve the law. One of its first projects, and ultimately one of its most\nsuccessful, was the drafting of the Restatement of the Law of Contracts, completed in 1932. A revision\xe2\x80\x94\nthe Restatement (Second) of Contracts\xe2\x80\x94was undertaken in 1946 and finally completed in 1979.\nThe Restatements (others exist in the fields of torts, agency, and conflicts of laws, judgments, property,\nrestitution, security, and trusts) are detailed analyses of the decided cases in the field. These analyses are\nmade with an eye to discerning the various principles that have emerged from the courts, and to the\nmaximum extent possible, the Restatements declare the law as the courts have determined it to be. The\nRestatements, guided by a Reporter (the director of the project) and a staff of legal scholars, go through\nseveral so-called \xe2\x80\x9ctentative\xe2\x80\x9d drafts\xe2\x80\x94sometimes as many as fifteen or twenty\xe2\x80\x94and are screened by various\ncommittees within the American Law Institute before they are eventually published as final documents.\nThe Restatement of Contracts won prompt respect in the courts and has been cited in innumerable cases.\nThe Restatements are not authoritative, in the sense that they are not actual judicial precedents, but they\nare nevertheless weighty interpretive texts, and judges frequently look to them for guidance. They are as\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n315\n\n\x0cclose to \xe2\x80\x9cblack letter\xe2\x80\x9d rules of law as exist anywhere in the American legal system for judge-made\n(common) law.\n\nStatutory Law: The Uniform Commercial Code\nCommon law contract principles govern contracts for real estate and for services, obviously very\nimportant areas of law. But in one area the common law has been superseded by an important statute: the\nUniform Commercial Code (UCC), especially Article 2, which deals with the sale of goods.\n\nA Brief History\nThe UCC is a model law developed by the American law Institute and the National Conference of\nCommissioners on Uniform State Laws; it has been adopted in one form or another in all fifty states, the\nDistrict of Columbia, and the American territories. It is the only \xe2\x80\x9cnational\xe2\x80\x9d law not enacted by Congress.\nBefore the UCC was written, commercial law varied, sometimes greatly, from state to state. This first\nproved a nuisance and then a serious impediment to business as the American economy became\nnationwide during the twentieth century. Although there had been some uniform laws concerned with\ncommercial deals\xe2\x80\x94including the Uniform Sales Act, first published in 1906\xe2\x80\x94few were widely adopted and\nnone nationally. As a result, the law governing sales of goods, negotiable instruments, warehouse receipts,\nsecurities, and other matters crucial to doing business in an industrial, market economy was a crazy quilt\nof untidy provisions that did not mesh well from state to state.\nInitial drafting of the UCC began in 1942 and was ten years in the making, involving the efforts of\nhundreds of practicing lawyers, law teachers, and judges. A final draft, promulgated by the Institute and\nthe Conference, was endorsed by the American Bar Association and published in 1951.\nPennsylvania enacted the code in its entirety in 1953. It was the only state to enact the original version,\nbecause the Law Revision Commission of the New York State legislature began to examine it line by line\nand had serious objections. Three years later, in 1956, a revised code was issued. This version, known as\nthe 1957 Official Text, was enacted in Massachusetts and Kentucky. In 1958, the Conference and the\nInstitute amended the Code further and again reissued it, this time as the 1958 Official Text. Sixteen\nstates, including Pennsylvania, adopted this version.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n316\n\n\x0cBut in so doing, many of these states changed particular provisions. As a consequence, the Uniform\nCommercial Code was no longer so uniform. Responding to this development the American Law Institute\nestablished a permanent editorial board to oversee future revisions of the code. Various subcommittees\nwent to work redrafting, and a 1962 Official Text was eventually published. Twelve more states adopted\nthe code, eleven of them the 1962 text. By 1966, only three states and two territories had failed to enact\nany version: Arizona, Idaho, Louisiana, Guam, and Puerto Rico.\nMeanwhile, non-uniform provisions continued to be enacted in various states, particularly in Article 9, to\nwhich 337 such amendments had been made. In 1971, a redraft of that article was readied and the 1972\nOfficial Text was published. By that time, Louisiana was the only holdout. Two years later, in 1974,\nLouisiana made the UCC a truly national law when it enacted some but not all of the 1972 text\n(significantly, Louisiana has not adopted Article 2). One more major change was made, a revision of\nArticle 8, necessitated by the electronics revolution that led to new ways of transferring investment\nsecurities from seller to purchaser. This change was incorporated in the 1978 Official Text, the version\nthat remains current.\nFrom this brief history, it is clear that the UCC is now a basic law of relevance to every business and\nbusiness lawyer in the United States, even though it is not entirely uniform because different states have\nadopted it at various stages of its evolution\xe2\x80\x94an evolution that continues still.\n\nThe Basic Framework of the UCC\nThe UCC embraces the Jaw of \xe2\x80\x9ccommercial transactions,\xe2\x80\x9d a term of some ambiguity. A 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\nof one single transaction: the 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 \xe2\x80\x9carticles\xe2\x80\x9d:\n\xe2\x80\xa2\n\nSales (Article 2)\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\nLetters of Credit (Article 5)\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n317\n\n\x0c\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\nWe now turn our attention to the sale\xe2\x80\x94the first facet, and the cornerstone, of the commercial transaction.\nSales law is a special type of contract law in that Article 2 applies only to the sale of goods, defined\n(Section 2-105) in part as \xe2\x80\x9call things . . . which are movable at the time of identification to the contract for\nsale other than the money in which the price is to be paid. . . .\xe2\x80\x9d The only contracts and agreements covered\nby Article 2 are those relating to the present or future sale of goods.\nIn certain cases, the courts have difficulty in determining the nature of the object of a sales contract. The\nproblem: How can goods and services are separated in contracts calling for the seller to deliver a\ncombination of goods and services? This difficulty frequently arises in product liability cases in which the\nbuyer sues the seller for breach of one of the UCC warranties. For example, you go to the hairdresser for a\npermanent and the shampoo gives you a severe scalp rash. May you recover damages on the grounds that\neither the hairdresser or the manufacturer breached an implied warranty in the sale of goods?\nWhen the goods used are incidental to the service, the courts are split on whether the plaintiff should win.\nCompare Epstein v. Giannattasio, 197 A.2d 342 (Conn. 1963), in which the court held that no sale of\ngoods had been made because the plaintiff received a treatment in which the cosmetics were only\nincidentally used, with Newark v. Gimbel\xe2\x80\x99s Inc., 258 A.2d 697 (N.J. 1969), in which the court said \xe2\x80\x9c[i]f the\npermanent wave lotion were sold \xe2\x80\xa6 for home consumption . . . unquestionably an implied warranty of\nfitness for that purpose would have been an integral incident of the sale.\xe2\x80\x9d The New Jersey court rejected\nthe defendant\xe2\x80\x99s argument that by actually applying the lotion to the patron\xe2\x80\x99s head the salon lessened the\nliability it otherwise would have had if it had simply sold her the lotion.\nIn two areas, state legislatures have taken the goods vs. services issue out of the courts\xe2\x80\x99 hands and\nresolved the issue through legislation. One area involves restaurant cases, in which typically the plaintiff\ncharges that he became ill because of tainted food. UCC Section 2\xc2\xb7314(1) states that any seller who is\nregularly a merchant of the goods sold impliedly warrants their merchantability in a contract for their\nsale. This section explicitly declares that serving food or drink is a sale, whether they are to be consumed\non or off the premises.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n318\n\n\x0cThe second type of case involves blood transfusions, which can give a patient hepatitis, a serious and\nsometimes fatal disease. Hospitals and blood banks obviously face large potential liability under the UCC\nprovision just referred to on implied warranty of merchantability. Because medical techniques cannot\ndetect the hepatitis virus in any form of blood used, hospitals and blood banks would be in constant\njeopardy, without being able to take effective action to minimize the danger. Most states have enacted\nlegislation specifically providing that blood supplies to be used in transfusions are a service, not goods,\nthus relieving the suppliers and hospitals of an onerous burden.\n\nThree Basic Contract Types: Sources of Law\nWith this brief description of the UCC, it should now be clear that the primary sources of law for the three\nbasic types of contracts are:\n\xe2\x80\xa2\n\nReal estate: common law;\n\n\xe2\x80\xa2\n\nServices: common law;\n\n\xe2\x80\xa2\n\nSale of goods: UCC (as interpreted by the courts).\n\nCommon law and UCC rules are often similar. For example, both require good faith in the performance of\na contract. However, there are two general differences worth noting between the common law of contracts\nand the UCC\xe2\x80\x99s rules governing the sales of goods. First, the UCC is more liberal than the common law in\nupholding the existence of a contract. For example, in a sales contract (covered by the UCC), \xe2\x80\x9copen\xe2\x80\x9d\nterms\xe2\x80\x94that is, those the parties have not agreed upon\xe2\x80\x94do not require a court to rule that no contract was\nmade. However, open terms in a non-sales contract will frequently result in a ruling that there is no\ncontract. Second, although the common law of contracts applies to every person equally, under the UCC\n\xe2\x80\x9cmerchants\xe2\x80\x9d occasionally receive special treatment. By \xe2\x80\x9cmerchants\xe2\x80\x9d the UCC means persons who have\nspecial knowledge or skill who deal in the goods involved in the transaction.\n\nThe Convention on Contracts for the International Sale of Goods\nA Convention on Contracts for the International Sale of Goods (CISG) was approved in 1980 at a\ndiplomatic conference in Vienna. (A convention is a preliminary agreement that serves as the basis for a\nformal treaty.) The Convention has been adopted by several countries, including the United States.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n319\n\n\x0cThe Convention is significant for three reasons. First, the Convention is a uniform law governing the sale\nof goods\xe2\x80\x94in effect, an international Uniform Commercial Code. The major goal of the drafters was to\nproduce a uniform law acceptable to countries with different legal, social and economic systems. Second,\nalthough provisions in the Convention are generally consistent with the UCC, there are significant\ndifferences. For instance, under the Convention, consideration (discussed below) is not required to form a\ncontract and there is no Statute of Frauds (a requirement that some contracts be evidenced by a writing to\nbe enforceable\xe2\x80\x94also discussed below). Finally, the Convention represents the first attempt by the US\nSenate to reform the private law of business through its treaty powers, for the Convention preempts the\nUCC if the parties to a contract elect to use the CISG.\n\nBasic Contract Taxonomy\nContracts are not all cut from the same die. Some are written, some oral; some are explicit, some not.\nBecause contracts can be formed, expressed, and enforced in a variety of ways, taxonomy of contracts has\ndeveloped that is useful in lumping together like legal consequences. In general, contracts are classified\nalong these dimensions: explicitness, mutuality, enforceability, and degree of\ncompletion. Explicitness is concerned with the degree to which the agreement is manifest to those not\nparty to it. Mutuality takes into account whether promises are exchanged by two parties or only\none. Enforceability is the degree to which a given contract is binding. Completion considers whether\nthe contract is yet to be performed or the obligations have been fully discharged by one or both parties.\nWe will examine each of these concepts in turn.\n\nExplicitness\nExpress Contract\nAn express contract is one in which the terms are spelled out directly; the parties to an express contract,\nwhether written or oral, are conscious that they are making an enforceable agreement. For example, an\nagreement to purchase your neighbor\xe2\x80\x99s car for $500 and to take title next Monday is an express contract.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n320\n\n\x0cImplied Contract\nAn implied contract is one that is inferred from the actions of the parties. Although no discussion of terms\ntook place, an implied contract exists if it is clear from the conduct of both parties that they intended there\nbe one. A delicatessen patron who asks for a \xe2\x80\x9cturkey sandwich to go\xe2\x80\x9d has made a contract and is obligated\nto pay when the sandwich is made. By ordering the food, the patron is implicitly agreeing to the price,\nwhether posted or not.\n\nContract Implied in Law: Quasi-contract\nBoth express and implied contracts embody an actual agreement of the parties. A quasi-contract, by\ncontrast, is an obligation said to be \xe2\x80\x98\xe2\x80\x98imposed by law\xe2\x80\x9d in order to avoid unjust enrichment of one person at\nthe expense of another. In fact, a quasi-contract is not a contract at all; it is a fiction that the courts\ncreated to prevent injustice. Suppose, for example, that a carpenter mistakenly believes you have hired\nhim to repair your porch; in fact, it is your neighbor who has hired him. One Saturday morning he arrives\nat your doorstep and begins to work. Rather than stop him, you let him proceed, pleased at the prospect of\nhaving your porch fixed for free (since you have never talked to the carpenter, you figure you need not pay\nhis bill). Although it is true there is no contract, the law implies a contract for the value of the work.\n\nMutuality\nThe garden-variety contract is one in which the parties make mutual promises. Each is both promisor and\npromise; that is, each pledges to do something and each is the recipient of such a pledge. This type of\ncontract is called a bilateral contract. But mutual promises are not necessary to constitute a\ncontract. Unilateral contracts, in which only one party makes a promise, are equally valid but depend\nupon performance of the promise to be binding. If Charles says to Fran, \xe2\x80\x9cI will pay you five dollars if you\nwash my car,\xe2\x80\x9d Charles is contractually bound to pay once Fran washes the car. Fran never makes a\npromise, but by actually performing she makes Charles liable to pay. A common example of a unilateral\ncontract is the offer \xe2\x80\x9c$50 for the return of my lost dog.\xe2\x80\x9d Frances never makes a promise to the offered, but\nif she looks for the dog and finds it, she is entitled to the $50.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n321\n\n\x0cEnforceability\nNot every agreement between two people is a binding contract. An agreement that is lacking one of the\nlegal elements of a contract is said to be void\xe2\x80\x94that is, not a contract at all. An agreement that is illegal\xe2\x80\x94\nfor example, a promise to commit a crime in return for a money payment\xe2\x80\x94is void. Neither party to a void\n\xe2\x80\x9ccontract\xe2\x80\x9d may enforce it.\nBy contrast, a voidable contract is one that is unenforceable by one party but enforceable by the other. For\nexample, a minor (any person under eighteen, in most states) may \xe2\x80\x9cavoid\xe2\x80\x9d a contract with an adult; the\nadult may not enforce the contract against the minor, if the minor refuses to carry out the bargain. But the\nadult has no choice if the minor wishes the contract to be performed. (A contract may be voidable by both\nparties if both are minors.) Ordinarily, the parties to a voidable contract are entitled to be restored to their\noriginal condition. Suppose you agree to buy your seventeen-year-old neighbor\xe2\x80\x99s car. He delivers it to you\nin exchange for your agreement to pay him next week. He has the legal right to terminate the deal and\nrecover the car, in which case you will of course have no obligation to pay him. If you have already paid\nhim, he still may legally demand a return to the status quo ante (previous state of affairs). You must\nreturn the car to him; he must return the cash to you.\nA voidable contract remains a valid contract until it is voided. Thus, a contract with a minor remains in\nforce unless the minor decides he does not wish to be bound by it. When the minor reaches his majority,\nhe may \xe2\x80\x9cratify\xe2\x80\x9d the contract\xe2\x80\x94that is, agree to be bound by it-in which case the contract will no longer be\nvoidable and will thereafter be fully enforceable.\nAn unenforceable contract is one that some rule of law bars a court from enforcing. For example, Tom\nowes Pete money, but Pete has waited too long to collect it and the statute of limitations has run out. The\ncontract for repayment is unenforceable and Pete is out of luck, unless Tom makes a new promise to pay\nor actually pays part of the debt. (However, if Pete is holding collateral as security for the debt, he is\nentitled to keep it; not all rights are extinguished because a contract is unenforceable.)\n\nDegree of Completion\nIn medieval England, contract\xe2\x80\x94defined as set of promises\xe2\x80\x94was not an intuitive concept. The courts gave\nrelief to one who wanted to collect a debt, for in such a case the creditor presumably had already given the\ndebtor something of value and the failure of the debtor to pay up was seen as manifestly unjust. But the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n322\n\n\x0cissue was less clear when neither promise had yet been fulfilled. Suppose John agrees to sell Humphrey a\nquantity of wheat in one month. On the appointed day, Humphrey refuses to take the wheat or to pay. The\nmodem law of contracts holds that a valid contract exists and that Humphrey is required to pay John.\nAn agreement consisting of a set of promises is called an executor contract before either promise is carried\nout. Most executor contracts are enforceable. If one promise or set of terms has been fulfilled\xe2\x80\x94if, for\nexample, John had delivered the wheat to Humphrey\xe2\x80\x94the contract is called partially executed. A contract\nthat has been carried out fully by both parties is called an executed contract.\n\nKEY TAKEAWAYS\nContract is the mechanism by which people in modern society make choices for themselves, as opposed\nto being born or placed into a status as is common in feudal societies. A contract is a legally enforceable\npromise. The law of contract is the common law (for contracts involving real estate and services),\nstatutory law (the Uniform Commercial Code for contract involving the sale or leasing of goods), and\ntreaty law (the Convention on the International Sale of Goods). Contracts may be described based on the\ndegree of their explicitness, mutuality, enforceability, and degree of completion.\n\nEXERCISES\n1.\n\nWhat did Sir Henry Maine mean when he wrote of society\xe2\x80\x99s movement \xe2\x80\x9cfrom status to contract?\n\n2.\n\nAre all promises \xe2\x80\x9ccontracts\xe2\x80\x9d?\n\n3.\n\nWhat is the source of law for contracts involving real estate? For contracts involving the sale of goods?\n\n4.\n\nIn contract taxonomy, what are the degrees of explicitness, mutuality, enforceability, and of\ncompletion?\n\n[1] Sir Henry Maine, Ancient Law (1869), 180\xe2\x80\x9382.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n323\n\n\x0c8.2 Contract Formation\nLEARNING OBJECTIVES\n1.\n\nUnderstand the elements of common-law contracts: mutuality of agreement (offer and acceptance),\nconsideration, legality, and capacity.\n\n2.\n\nLearn when a contract must be in writing\xe2\x80\x94or evidenced by some writing\xe2\x80\x94to be enforceable.\n\nAlthough it has countless wrinkles and nuances, contract law asks two principal questions: did the parties\ncreate a valid, enforceable contract? What remedies are available when one party breaks the contract? The\nanswer to the first question is not always obvious; the range of factors that must be taken into account can\nbe large and their relationship subtle. Since people in business frequently conduct contract negotiations\nwithout the assistance of a lawyer, it is important to attend to the nuances to avoid legal trouble at the\noutset. Whether a valid enforceable contract has been formed depends in turn on whether:\n1.\n\nThe parties reached an agreement (offer and acceptance);\n\n2. Consideration was present (some \xe2\x80\x9cprice was paid for what was received in return);\n3. The agreement was legal;\n4. The parties entered into the contract with capacity to make a contract; and\n5.\n\nThe agreement is in the proper form (something in writing, if required).\n\nThe Agreement: Offer and Acceptance\nThe core of a legal contract is the agreement between the parties. That is not merely a matter of\nconvenience; it is at the heart of our received philosophical and psychological beliefs. As the great student\nof contract law, Samuel Williston, put it:\nIt was a consequence of the emphasis laid on the ego and the individual will that the formation of a\ncontract should seem impossible unless the wills of the parties concurred. Accordingly we find at the end\nof the eighteenth century, and the beginning of the nineteenth century, the prevalent idea that there must\nbe a \xe2\x80\x9cmeeting of the minds\xe2\x80\x9d (a new phrase) in order to form a contract. (1921, p. 365)\nAlthough agreements may take any form, including unspoken conduct between the parties (UCC Section\n2-204(1)), they are usually structured in terms of an offer and an acceptance. Note, however, that not\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n324\n\n\x0cevery agreement, in the broadest sense of the word, need consist of an offer and acceptance, and it is\nentirely possible, therefore, for two persons to reach agreement without forming a contract. For example,\npeople may agree that the weather is pleasant or that it would be preferable to go out for Chinese food\nrather than seeing a foreign film; in neither case has a contract been formed. One of the major functions\nof the law of contracts is to sort out those agreements that are legally binding\xe2\x80\x94those that are contracts\xe2\x80\x94\nfrom those that are not.\nIn interpreting agreements, courts generally apply an objective standard. The Restatement (Second) of\nContracts defines agreement as a \xe2\x80\x9cmanifestation of mutual assent by two or more persons to one\nanother.\xe2\x80\x9d (Section 3) The UCC defines agreement as \xe2\x80\x9cthe bargain of the parties in fact as found in their\nlanguage or by implication from other circumstances including course of dealing or usage of trade or\ncourse of performance.\xe2\x80\x9d (Section 1-201(3)) The critical question is what the parties said or did, not what\nthey thought they said or did.\nThe distinction between objective and subjective standards crops up occasionally when one person claims\nhe spoke in jest. The vice president of a manufacturer of punchboards, used in gambling, testified to the\nWashington State Game Commission that he would pay $100,000 to anyone who found a \xe2\x80\x9ccrooked\nboard.\xe2\x80\x9d Barnes, a bartender, who had purchased two that were crooked some time before, brought one to\nthe company office, and demanded payment. The company refused, claiming that the statement was made\nin jest (the audience before the commission had laughed when the offer was made). The court disagreed,\nholding that it was reasonable to interpret the pledge of $100,000 as a means of promoting punchboards:\n(I)f the jest is not apparent and a reasonable hearer would believe that an offer was being made, then the\nspeaker risks the formation of a contract which was not intended. It is the objective manifestations of the\noffered that count and not secret, unexpressed intentions. If a party\xe2\x80\x99s words or acts, judged by a\nreasonable standard, manifest an intention to agree in regard to the matter in question, that agreement is\nestablished, and it is immaterial what may be the real but unexpressed state of the party\xe2\x80\x99s mind on the\nsubject.\n\n[1]\n\nAn offer is a manifestation of willingness to enter into a bargain such that it would be reasonable for\nanother individual to conclude that assent to the offer would complete the bargain. Offers must be\ncommunicated and must be definite; that is, they must spell out terms to which the offeree can assent.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n325\n\n\x0cTo constitute an agreement, there must be an acceptance of the offer. The offeree must manifest his assent\nto the terms of the offer in a manner invited or required by the offer. Complications arise when an offer is\naccepted indirectly through correspondence. Although offers and revocations of offers are not effective\nuntil received, an acceptance is deemed accepted when sent if the offeree accepts in the manner specified\nby the offeror.\nIf the offeror specifies no particular mode, then acceptance is effective when transmitted as long as the\nofferee uses a reasonable method of acceptance. It is implied that the offeree can use the same means used\nby the offeror or a means of communication customary to the industry. For example, the use of the postal\nservice was so customary that acceptances are considered effective when mailed, regardless of the method\nused to transmit the offer. Indeed, the so-called \xe2\x80\x9cmailbox rule\xe2\x80\x9d (the acceptance is effective upon dispatch)\nhas an ancient lineage, tracing back nearly two hundred years to the English courts.\n\n[2]\n\nConsideration\nConsideration, is the quid pro quo (something given or received for something else) between the\ncontracting parties in the absence of which the law will not enforce the promise or promises made.\nConsider the following three \xe2\x80\x9ccontracts\xe2\x80\x9d:\n1.\n\nBetty offers to give a book to Lou. Lou accepts.\n\n2. Betty offers Lou the book in exchange for Lou\xe2\x80\x99s promise to pay $15. Lou accepts.\n3. Betty offers to give Lou the book if Lou promises to pick it up at Betty\xe2\x80\x99s house. Lou accepts.\nThe question is which, if any, is a binding contract? In American law, only situation 2 is a binding\ncontract, because only that contract contains a set of mutual promises in which each party pledges to give\nup something to the benefit of the other.\nThe question of what constitutes a binding contract has been answered differently throughout history and\nin other cultures. For example, under Roman law, any contract that was reduced to writing was binding,\nwhether or not there was consideration in our sense. Moreover, in later Roman times, certain promises of\ngifts were made binding, whether written or oral; these would not be binding in the United States. And in\nthe Anglo-American tradition, the presence of a seal was once sufficient to make a contract binding\nwithout any other consideration. In most states, the seal is no longer a substitute for consideration,\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n326\n\n\x0calthough in some states it creates a presumption of consideration. The Uniform Commercial Code has\nabolished the seal on contracts for the sale of goods.\nThe existence of consideration is determined by examining whether the person against whom a promise is\nto be enforced (the promisor) received something in return from the person to whom he made the\npromise (the promisee). That may seem a simple enough question. But as with much in the law, the\ncomplicating situations are never very far away. The \xe2\x80\x9csomething\xe2\x80\x9d that is promised or delivered cannot just\nbe anything: a feeling of pride, warmth, amusement, friendship; it must be something known as\na legal detriment\xe2\x80\x94an act, forbearance, or a promise of such from the promisee. The detriment need not be\nan actual detriment; it may in fact be a benefit to the promisee, or at least not a loss. At the same time, the\n\xe2\x80\x9cdetriment\xe2\x80\x9d to the promisee need not confer a tangible benefit on the promisor; the promisee can agree to\nforego something without that something being given to the promisor. Whether consideration is legally\nsufficient has nothing to do with whether it is morally or economically adequate to make the bargain a fair\none. Moreover, legal consideration need not even be certain; it can be a promise contingent on an event\nthat may never happen. Consideration is a legal concept, and it centers on the giving up of a legal right or\nbenefit.\nConsideration has two elements. The first, as just outlined, is whether the promisee has incurred a legal\ndetriment. (Some courts\xe2\x80\x94although a minority\xe2\x80\x94takes the view that a bargained-for legal benefit to the\npromisor is sufficient consideration.) The second is whether the legal detriment was bargained for: did\nthe promisor specifically intend the act, forbearance, or promise in return for his promise? Applying this\ntwo-pronged test to the three examples given at the outset of the chapter, we can easily see why only in the\nsecond is there legally sufficient consideration. In the first, Lou incurred no legal detriment; he made no\npledge to act or to forbear from acting, nor did he in fact act or forbear from acting. In the third example,\nwhat might appear to be such a promise is not really so. Betty made a promise on a condition that Lou\ncome to her house; the intent clearly is to make a gift. Betty was not seeking to induce Lou to come to her\nhouse by promising the book.\nThere is a widely recognized exception to the requirement of consideration. In cases of promissory\nestoppel, the courts will enforce promises without consideration. Simply\nstated, promissory estoppel means that the courts will stop the promisor from claiming that there was no\nconsideration. The doctrine of promissory estoppel is invoked in the interests of justice when three\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n327\n\n\x0cconditions are met: (1) the promise is one that the promisor should reasonably expect to induce the\npromisee to take action or forbear from taking action of a definite and substantial character; (2) the action\nor forbearance is taken; and (3) injustice can be avoided only by enforcing the promise.\nTimko served on the board of trustees of a school. He recommended that the school purchase a building\nfor a substantial sum of money, and to induce the trustees to vote for the purchase, he promised to help\nwith the purchase and to pay at the end of five years the purchase price less the down payment. At the end\nof four years, Timko died. The school sued his estate, which defended on the ground that there was no\nconsideration for the promise. Timko was promised or given nothing in return, and the purchase of the\nbuilding was of no direct benefit to him (which would have made the promise enforceable as a unilateral\ncontract). The court ruled that under the three-pronged promissory estoppel test, Timko\xe2\x80\x99s estate was\nliable.\n\n[3]\n\nIllegality\nIn general, illegal contracts are unenforceable. The courts must grapple with two types of illegalities: (1)\nstatutory violations (e.g., the practice of law by a non-lawyer is forbidden by statute), and (2) violations of\npublic policy not expressly declared unlawful by statute, but so declared by the courts.\n\nCapacity\nA contract is a meeting of minds. If someone lacks mental capacity to understand what he is assenting\nto\xe2\x80\x94or that he is assenting to anything\xe2\x80\x94it is unreasonable to hold him to the consequences of his act.\nThe general rule is that persons younger than eighteen can avoid their contracts. Although the age of\nmajority was lowered in most states during the 1970s to correspond to the Twenty-sixth Amendment\n(ratified in 1971, guaranteeing the right to vote at eighteen), some states still put the age of majority at\ntwenty-one. Legal rights for those fewer than twenty-one remain ambiguous, however. Although eighteenyear-olds may assent to binding contracts, not all creditors and landlords believe it, and they may require\nparents to cosign. For those under twenty-one, there are also legal impediments to holding certain kinds\nof jobs, signing certain kinds of contracts, marrying, leaving home, and drinking alcohol. There is as yet\nno uniform set of rules.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n328\n\n\x0cThe exact day on which the disability of minority vanishes also varies. The old common law rule put it on\nthe day before the twenty-first birthday. Many states have changed this rule so that majority commences\non the day of the eighteenth (or twenty-first) birthday.\nA minor\xe2\x80\x99s contract is voidable, not void. A child wishing to avoid the contract need do nothing positive to\ndisaffirm; the defense of minority to a lawsuit is sufficient. Although the adult cannot enforce the contract,\nthe child can (which is why it is said to be voidable, not void).\nWhen the minor becomes an adult, he has two choices: he may ratify the contract or disaffirm it. She may\nratify explicitly; no further consideration is necessary. She may also do so by implication\xe2\x80\x94for instance, by\ncontinuing to make payments or retaining goods for an unreasonable period of time. (In some states, a\ncourt may ratify the contract before the child becomes an adult. In California, for example, a state statute\npermits a movie producer to seek court approval of a contract with a child actor in order to prevent the\nchild from disaffirming it upon reaching majority and suing for additional wages. As quid pro quo, the\ncourt can order the producer to pay a percentage of the wages into a trust fund that the child\xe2\x80\x99s parents or\nguardians cannot invade.) If the child has not disaffirmed the contract while still a minor, she may do so\nwithin a reasonable time after reaching majority.\nIn most cases of disavowal, the only obligation is to return the goods (if he still has them) or repay the\nconsideration (unless it has been dissipated). However, in two situations, a minor might incur greater\nliability: contracts for necessities and misrepresentation of age.\n\nContract for Necessities\nAt common law, a \xe2\x80\x9cnecessity\xe2\x80\x9d was defined as an essential need of a human being: food, medicine,\nclothing, and shelter. In recent years, however, the courts have expanded the concept, so that in many\nstates today necessities include property and services that will enable the minor to earn a living and to\nprovide for those dependent on him. If the contract is executor, the minor can simply disaffirm. If the\ncontract has been executed, however, the minor must face more onerous consequences. Although he will\nnot be required to perform under the contract, he will be liable under a theory of \xe2\x80\x9cquasi-contract\xe2\x80\x9d for the\nreasonable value of the necessity.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n329\n\n\x0cMisrepresentation of Age\nIn most states, a minor may misrepresent his age and disaffirm in accordance with the general rule,\nbecause that\xe2\x80\x99s what kids do, misrepresent their age. That the adult reasonably believed the minor was also\nan adult is of no consequence in a contract suit. But some states have enacted statutes that make the\nminor liable in certain situations. A Michigan statute, for instance, prohibits a minor from disaffirming if\nhe has signed a \xe2\x80\x9cseparate instrument containing only the statement of age, date of signing and the\nsignature:\xe2\x80\x9d And some states \xe2\x80\x9cestop\xe2\x80\x9d him from claiming to be a minor if he falsely represented himself as\nan adult in making the \xc2\xb7contract. \xe2\x80\x9cEstoppel\xe2\x80\x9d is a refusal by the courts on equitable grounds to listen to an\notherwise valid defense; unless the minor can return the consideration, the contract will be enforced.\nContracts made by an insane or intoxicated person are also said to have been made by a person lacking\ncapacity. In general, such contracts are voidable by the person when capacity is regained (or by the\nperson\xe2\x80\x99s legal representative if capacity is not regained).\n\nForm\nAs a general rule, a contract need not be in writing to be enforceable. An oral agreement to pay a highfashion model $1 million to pose for a photograph is as binding as if the language of the deal were printed\non vellum and signed in the presence of twenty bishops. For centuries, however, a large exception has\ngrown up around the Statute of Frauds, first enacted in England in 1677 under the formal name \xe2\x80\x9cAn Act\nfor the Prevention of Frauds and Perjuries.\xe2\x80\x9d The purpose of the Statute of Frauds is to prevent the fraud\nthat occurs when one party attempts to impose upon another a contract that did not in fact exist. The two\nsections dealing with contracts read as follows:\n[Sect. 4] ...no action shall be brought whereby to charge any executor or administrator upon any special\npromise, to answer damages out of his own estate; (2) or whereby to charge the defendant upon any\nspecial promise to answer for the debt, default or miscarriages of another person; (3) or to charge any\nperson upon any agreement made upon consideration of marriage; (4) or upon any contract or sale of\nlands, tenements or hereditaments, or any interest in or concerning them; (5) or upon any agreement that\nis not to be performed within the space of one year from the making thereof; (6) unless the agreement\nupon which such action shall be brought, or some memorandum or note thereof, shall be in writing, and\nsigned by the party to be charged therewith, or some other person thereunto by him lawfully authorized.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n330\n\n\x0c[Sect. 17] ...no contract for the sale of any goods, wares and merchandizes, for the price of ten pounds\nsterling or upwards, shall be allowed to be good, except the buyer shall accept part of the goods so sold,\nand actually receive the same, or give something in earnest to bind the bargain, or in part of payment, or\nthat some note or memorandum in writing of the said bargain be made and signed by the parties to be\ncharged by such contract, or their agents thereunto lawfully authorized.\nAgain, as may be evident from the title of the act and its language, the general purpose of the law is to\nprovide evidence, in areas of some complexity and importance, that a contract was actually made. To a\nlesser degree, the law serves to caution those about to enter a contract and \xe2\x80\x9cto create a climate in which\nparties often regard their agreements as tentative until there is a signed writing.\xe2\x80\x9d(Restatement (Second)\nof Contracts Chapter 5, statutory note)\nThe Statute of Frauds has been enacted in form similar to the seventeenth century act in most states.\nHowever, in the twentieth century Section 7 was been replaced by a section Uniform Commercial Code.\nThe UCC requires contracts for the sale of goods for $500 or more and for the sale of securities to be in\nwriting.\n\nKEY TAKEAWAYS\nA contract requires mutuality\xe2\x80\x94an offer and an acceptance of the offer; it requires consideration\xe2\x80\x94a\n\xe2\x80\x9cprice\xe2\x80\x9d paid for what is obtained; it requires that the parties to the contract have legal capacity to know\nwhat they are doing; it requires legality. Certain contracts\xe2\x80\x94governed by the statute of frauds\xe2\x80\x94are\nrequired to be evidenced by some writing, signed by the party to be bound. The purpose here is to avoid\nthe fraud that occurs when one person attempts to impose upon another a contract that did not really\nexist.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n331\n\n\x0cEXERCISES\n1.\n\nWhat are the required elements of a contract?\n\n2.\n\nWhen was the Statute of Frauds first enacted, by whom, and why?\n\n3.\n\nBasically, what does the Statute of Frauds require?\n\n[1] Barnes v. Treece, 549 P.2d 1152 (Wash. App. 1976).\n[2] Adams v. Lindsell, 1 Bamewall & Alderson 681 (K.B. 1818).\n[3] Estate of Timko v. Oral Roberts Evangelistic Assn., 215 N.W.2d 750 (Mich. App. 1974).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n332\n\n\x0c8.3 Remedies\nLEARNING OBJECTIVES\n1.\n\nKnow the types of damages: compensatory and punitive.\n\n2.\n\nUnderstand specific performance as a remedy.\n\n3.\n\nUnderstand restitution as a remedy.\n\n4.\n\nRecognize the interplay between contract and tort as a cause of action.\n\nMonetary awards (called \xe2\x80\x9cdamages\xe2\x80\x9d), specific performance, and restitution are the three principle\nremedies.\nIn view of the importance given to the intention of the parties in forming and interpreting contracts, it\nmay seem surprising that the remedy for every breach is not a judicial order that the obligor carry out his\nundertakings. But it is not. Of course, some duties cannot be performed after a breach: time and\ncircumstances will have altered their purpose and rendered many worthless. Still, although there are\nnumerous occasions on which it would be theoretically possible for courts to order the parties to carry out\ntheir contracts, the courts will not do it. In 1897, Justice Oliver Wendell Holmes, Jr., declared in a famous\nline that \xe2\x80\x9cthe duty to keep a contract at common law means a prediction that you must pay damages if you\ndo not keep it.\xe2\x80\x9d By that he meant simply that the common law looks more toward compensating the\npromisee for his loss than toward compelling the promisor to perform\xe2\x80\x94a person always has the power,\nthough not the right, to breach a contract. Indeed, the law of remedies often provides the parties with an\nincentive to break the contract. In short, the promisor has a choice: to perform or pay. The purpose of\ncontract remedies is, for the most part, to compensate the non-breaching party for the losses suffered\xe2\x80\x94to\nput the non-breaching party in the position he, she, or it would have been in had there been no breach.\n\nCompensatory Damages\nOne party has the right to damages (money) when the other party has breached the contract unless, of\ncourse, the contract itself or other circumstances suspend or discharge that\nright. Compensatory damages are the general category of damages awarded to make the non-breaching\nparty whole.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n333\n\n\x0cConsequential Damages\nA basic principle of contract law is that a person injured by breach of contract is not entitled to\ncompensation unless the breaching party, at the time the contract was made, had reason to foresee the\nloss as a probable result of the breach. The leading case, perhaps the most studied case in all the common\nlaw, is Hadley v. Baxendale, decided in England in 1854. Joseph and Jonah Hadley were proprietors of a\nflour mill in Gloucester. In May 1853, the shaft of the milling engine broke, stopping all milling. An\nemployee went to Pickford and Company, a common carrier, and asked that the shaft be sent as quickly as\npossible to a Greenwich foundry that would use the shaft as a model to construct a new one. The carrier\xe2\x80\x99s\nagent promised delivery within two days. But through an error the shaft was shipped by canal rather than\nby rail and did not arrive in Greenwich for seven days. The Hadleys sued Joseph Baxendale, managing\ndirector of Pickford, for the profits they lost because of the delay. In ordering a new trial, the Court of\nExchequer ruled that Baxendale was not liable because he had had no notice that the mill was stopped:\nWhere two parties have made a contract which one of them has broken, the damages which the other\nparty ought to receive in respect of such breach of contract should be such as may fairly and reasonably be\nconsidered either arising naturally, i.e., according to the usual course of things, from such breach of\ncontract itself, or such as may reasonably be supposed to have been in the contemplation of both parties,\nat the time they made the contract, as the probable result of the breach of it.\n\n[1]\n\nThis rule, it has been argued, was a subtle change from the earlier rule that permitted damages for any\nconsequences as long as the breach caused the injury and the plaintiff did not exacerbate it. But the\nchange was evidently rationalized, at least in part, by the observation that in the \xe2\x80\x9cusual course of things,\xe2\x80\x9d\na mill would have on hand a spare shaft, so that its operations would not cease.\n\n[2]\n\nThis sub-set of compensatory damages is called consequential damages\xe2\x80\x94damages that flow as a\nforeseeable consequence of the breach. For example, if you hire a roofer to fix a leak in your roof, and he\ndoes a bad job so that the interior of your house suffers water damage, the roofer is liable not only for the\npoor roofing job, but also for the ruined drapes, damaged flooring and walls, and so on.\n\nNominal Damages\nIf the breach caused no loss, the plaintiff is nevertheless entitled to a minor sum, perhaps one dollar,\ncalled nominal damages. When, for example, a buyer could purchase the same commodity at the same\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n334\n\n\x0cprice as that contracted for, without spending any extra time or money, there can be no real damages in\nthe event of breach.\n\nIncidental Damages\nSuppose City College hires Prof. Blake on a two-year contract, after an extensive search. After one year the\nprofessor quits to take a job elsewhere, in breach of her contract. If City College has to pay $5000 more to\nfind a replacement for year, Blake is liable for that amount\xe2\x80\x94that\xe2\x80\x99s compensatory damages. But what if it\ncosts City College $1200 to search for, bring to campus and interview a replacement? City College can\nclaim that, too, as incidental damages which include additional costs incurred by the non-breaching party\nafter the breach in a reasonable attempt to avoid further loss, even if the attempt is unsuccessful.\n\nPunitive Damages\nPunitive damages are those awarded for the purpose of punishing a defendant in a civil action, in which\ncriminal sanctions may be unavailable. They are not part of the compensation for the loss suffered; they\nare proper in cases in which the defendant has acted willfully and maliciously and are thought to deter\nothers from acting similarly. Since the purpose of contract law is compensation, not punishment, punitive\ndamages have not traditionally been awarded, with one exception: when the breach of contract is also a\ntort for which punitive damages may be recovered. Punitive damages are permitted in the law of torts (in\nmost states) when the behavior is malicious or willful (reckless conduct causing physical harm, deliberate\ndefamation of one\xe2\x80\x99s character, a knowingly unlawful taking of someone\xe2\x80\x99s property), and some kinds of\ncontract breach are also tortuous\xe2\x80\x94for example, when a creditor holding collateral as security under a\ncontract for a loan sells the collateral to a good-faith purchaser for value even though the debtor was not\nin default, he has breached the contract and committed the tort of conversion. Punitive damages may be\nawarded, assuming the behavior was willful and not merely mistaken.\nPunitive damages are not fixed by law. The judge or jury may award at its discretion whatever sum is\nbelieved necessary to redress the wrong or deter like conduct in the future. This means that a richer\nperson may be slapped with much heavier punitive damages than a poorer one in the appropriate case.\nBut the judge in all cases may remit (lower) some or all of a punitive damage award if he or she considers\nit excessive.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n335\n\n\x0cPunitive damage claims have been made in cases dealing with the refusal by insurance companies to\nhonor their contracts. Many of these cases involve disability payments, and among the elements are\ncharges of tortious conduct by the company\xe2\x80\x99s agents or employees. California has been the leader among\nthe state courts in their growing willingness to uphold punitive damage awards despite insurer complaints\nthat the concept of punitive damages is but a device to permit plaintiffs to extort settlements from hapless\ncompanies. Courts have also awarded punitive damages against other types of companies for breach of\ncontract.\n\nSpecific Performance\nSpecific performance is a judicial order to the promisor that he undertake the performance to which he\nobligated himself in a contract. Specific performance is an alternative remedy to damages and may be\nissued at the discretion of the court, subject to a number of exceptions. (When the promisee is seeking\nenforcement of a contractual provision for forbearance\xe2\x80\x94a promise that the promisor will refrain from\ndoing something\xe2\x80\x94an injunction, a judicial order not to act in a specified manner, may be the appropriate\nremedy.) Emily signs a contract to sell Charlotte a gold samovar, a Russian antique of great sentimental\nvalue because it once belonged to Charlotte\xe2\x80\x99s mother. Emily then repudiates the contract while still\nexecutor. A court may properly grant Charlotte an order of specific performance against Emily. Specific\nperformance is an attractive but limited remedy: it is only available for breach of contract to sell a unique\nitem (real estate is always unique).\n\nRestitution\nAs the word implies, restitution is a restoring to one party of what he gave to the other. Therefore, only to\nthe extent that the injured party conferred a benefit on the other party may the injured party be awarded\nrestitution.\nIf the claimant has given the other party a sum of money, there can be no dispute over the amount of the\nrestitution interest. Tom gives Tim $100 to chop his tree into firewood. Tim repudiates. Tom\xe2\x80\x99s restitution\ninterest is $100. But serious difficulties can arise when the benefit conferred was performance. The courts\nhave considerable discretion to award either the cost of hiring someone else to do the work that the\ninjured party performed (generally, the market price of the service) or the value that was added to the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n336\n\n\x0cproperty of the party in breach by virtue of the claimant\xe2\x80\x99s performance. Mellors, a gardener, agrees to\nconstruct ten fences around Lady Chatterley\xe2\x80\x99s flower gardens at the market price of $2,500. After erecting\nthree, Mellors has performed services that would cost $750, market value. Assume that he has increased\nthe value of the Lady\xe2\x80\x99s grounds by $800. If the contract is repudiated, there are two measures of Mellors\xe2\x80\x99s\nrestitution interest: $800, the value by which the property was enhanced; or $750, the amount it would\nhave cost Lady Chatterley to hire someone else to do the work. Which measure to use depends on who\nrepudiated the contract and for what reason.\n\nTort vs. Contract Remedies\nFrequently a contract breach may also amount to tortious conduct. A physician warrants her treatment as\nperfectly safe but performs the operation negligently, scarring the patient for life. The patient could sue\nfor malpractice (tort) or for breach of warranty (contract). The choice involves at least four\nconsiderations:\n1.\n\nStatute of limitations. Most statutes of limitations prescribe longer periods for contract than for tort\nactions.\n\n2. Allowable damages. Punitive damages are more often permitted in tort actions, and certain kinds of\ninjuries are compensable in tort but not in contract suits\xe2\x80\x94for example, pain and suffering.\n3. Expert testimony. In most cases, the use of experts would be the same in either tort or contract suits,\nbut in certain contract cases, the expert witness could be dispensed with, as, for example, in a contract\ncase charging that the physician abandoned the patient.\n4. Insurance coverage. Most policies do not cover intentional torts, so a contract theory that avoids the\nelement of willfulness would provide the plaintiff with a surer chance of recovering money damages.\n\nKEY TAKEAWAYS\nThe purpose of remedies in contract is, usually, to put the non-breaching party in the position he or she\nwould have been in had there been no breach. The remedies are: compensatory damages (money paid to\ncompensate the non-breaching party for the losses caused by the breach), which also include subcategories of incidental and nominal damages; punitive damages (to punish the breaching party) are\nsometimes allowed where the breach is egregious and intentional.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n337\n\n\x0cEXERCISES\n1.\n\nWhat are compensatory damages?\n\n2.\n\nWhen is specific performance an appropriate remedy? Will it be used to require a person to perform a\nservice (such as properly repair a leaky roof)?\n\n3.\n\nWhen is restitution used?\n\n4.\n\nHow could a breach of contract also be a tort, and when is one cause of action chosen over the other?\n\n5.\n\nWhat is the purpose of punitive damages?\n\n[1] Hadley v. Baxendale (1854), 9 Ex. 341, 354, 156 Eng.Rep. 145, 151.\n[2] R. J. Danzig, \xe2\x80\x9cHadley v. Baxendale: A Study in the Industrialization of the Law,\xe2\x80\x9d Journal of Legal Studies 4, no.\n249 (1975): 249.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n338\n\n\x0c8.4 Cases\nObjective Intention\nLucy v. Zehmer\n84 S.E.2d 516 (Va. 1954)\nBuchanan, J.\nThis suit was instituted by W. O. Lucy and J. C. Lucy, complainants, against A. H. Zehmer and Ida S.\nZehmer, his wife, defendants, to have specific performance of a contract by which it was alleged the\nZehmers had sold to W. O. Lucy a tract of land owned by A. H. Zehmer in Dinwiddie county containing\n471.6 acres, more or less, known as the Ferguson farm, for $50,000. J. C. Lucy, the other complainant, is\na brother of W. O. Lucy, to whom W. O. Lucy transferred a half interest in his alleged purchase.\nThe instrument sought to be enforced was written by A. H. Zehmer on December 20, 1952, in these words:\n\xe2\x80\x9cWe hereby agree to sell to W. O. Lucy the Ferguson farm complete for $50,000.00, title satisfactory to\nbuyer,\xe2\x80\x9d and signed by the defendants, A. H. Zehmer and Ida S. Zehmer.\nThe answer of A. H. Zehmer admitted that at the time mentioned W. O. Lucy offered him $50,000 cash\nfor the farm, but that he, Zehmer, considered that the offer was made in jest; that so thinking, and both he\nand Lucy having had several drinks, he wrote out \xe2\x80\x9cthe memorandum\xe2\x80\x9d quoted above and induced his wife\nto sign it; that he did not deliver the memorandum to Lucy, but that Lucy picked it up, read it, put it in his\npocket, attempted to offer Zehmer $5 to bind the bargain, which Zehmer refused to accept, and realizing\nfor the first time that Lucy was serious, Zehmer assured him that he had no intention of selling the farm\nand that the whole matter was a joke. Lucy left the premises insisting that he had purchased the farm.\xe2\x80\xa6\nIn his testimony Zehmer claimed that he \xe2\x80\x9cwas high as a Georgia pine,\xe2\x80\x9d and that the transaction \xe2\x80\x9cwas just a\nbunch of two doggoned drunks bluffing to see who could talk the biggest and say the most.\xe2\x80\x9d That claim is\ninconsistent with his attempt to testify in great detail as to what was said and what was done.\xe2\x80\xa6\nIf it be assumed, contrary to what we think the evidence shows, that Zehmer was jesting about selling his\nfarm to Lucy and that the transaction was intended by him to be a joke, nevertheless the evidence shows\nthat Lucy did not so understand it but considered it to be a serious business transaction and the contract\nto be binding on the Zehmers as well as on himself. The very next day he arranged with his brother to put\nup half the money and take a half interest in the land. The day after that he employed an attorney to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n339\n\n\x0cexamine the title. The next night, Tuesday, he was back at Zehmer\xe2\x80\x99s place and there Zehmer told him for\nthe first time, Lucy said, that he wasn\xe2\x80\x99t going to sell and he told Zehmer, \xe2\x80\x9cYou know you sold that place\nfair and square.\xe2\x80\x9d After receiving the report from his attorney that the title was good he wrote to Zehmer\nthat he was ready to close the deal.\nNot only did Lucy actually believe, but the evidence shows he was warranted in believing, that the contract\nrepresented a serious business transaction and a good faith sale and purchase of the farm.\nIn the field of contracts, as generally elsewhere, \xe2\x80\x9cWe must look to the outward expression of a person as\nmanifesting his intention rather than to his secret and unexpressed intention. The law imputes to a person\nan intention corresponding to the reasonable meaning of his words and acts.\xe2\x80\x9d\nAt no time prior to the execution of the contract had Zehmer indicated to Lucy by word or act that he was\nnot in earnest about selling the farm. They had argued about it and discussed its terms, as Zehmer\nadmitted, for a long time. Lucy testified that if there was any jesting it was about paying $50,000 that\nnight. The contract and the evidence show that he was not expected to pay the money that night. Zehmer\nsaid that after the writing was signed he laid it down on the counter in front of Lucy. Lucy said Zehmer\nhanded it to him. In any event there had been what appeared to be a good faith offer and a good faith\nacceptance, followed by the execution and apparent delivery of a written contract. Both said that Lucy put\nthe writing in his pocket and then offered Zehmer $5 to seal the bargain. Not until then, even under the\ndefendants\xe2\x80\x99 evidence, was anything said or done to indicate that the matter was a joke. Both of the\nZehmers testified that when Zehmer asked his wife to sign he whispered that it was a joke so Lucy\nwouldn\xe2\x80\x99t hear and that it was not intended that he should hear.\nThe mental assent of the parties is not requisite for the formation of a contract. If the words or other acts\nof one of the parties have but one reasonable meaning, his undisclosed intention is immaterial except\nwhen an unreasonable meaning which he attaches to his manifestations is known to the other party.\n\xe2\x80\x9c* * * The law, therefore, judges of an agreement between two persons exclusively from those expressions\nof their intentions which are communicated between them. * * *.\xe2\x80\x9d [Citation]\nAn agreement or mutual assent is of course essential to a valid contract but the law imputes to a person an\nintention corresponding to the reasonable meaning of his words and acts. If his words and acts, judged by\na reasonable standard, manifest an intention to agree, it is immaterial what may be the real but\nunexpressed state of his mind.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n340\n\n\x0cSo a person cannot set up that he was merely jesting when his conduct and words would warrant a\nreasonable person in believing that he intended a real agreement.\nWhether the writing signed by the defendants and now sought to be enforced by the complainants was the\nresult of a serious offer by Lucy and a serious acceptance by the defendants, or was a serious offer by Lucy\nand an acceptance in secret jest by the defendants, in either event it constituted a binding contract of sale\nbetween the parties.\xe2\x80\xa6\nReversed and remanded.\n\nCASE QUESTIONS\n1.\n\nWhat objective evidence was there to support the defendants\xe2\x80\x99 contention that they were just kidding\nwhen they agreed to sell the farm?\n\n2.\n\nSuppose the defendants really did think the whole thing was a kind of joke. Would that make any\ndifference?\n\n3.\n\nAs a matter of public policy, why does the law use an objective standard to determine the seriousness\nof intention, instead of a subjective standard?\n\n4.\n\nIts 85 degrees in July and 5:00 p.m., quitting time. The battery in Mary\xe2\x80\x99s car is out of juice, again. Mary\nsays, \xe2\x80\x9cArrgh! I will sell this stupid car for $50!\xe2\x80\x9d Jason, walking to his car nearby, whips out his checkbook\nand says, \xe2\x80\x9cIt\xe2\x80\x99s a deal. Leave your car here. I\xe2\x80\x99ll give you a ride home and pick up your car after you give\nme the title.\xe2\x80\x9d Do the parties have a contract?\n\nConsideration: Preexisting Obligation\nDenney v. Reppert\n432 S.W.2d 647 (Ky. 1968)\nR. L. Myre, Sr., Special Commissioner.\nThe sole question presented in this case is which of several claimants is entitled to an award for\ninformation leading to the apprehension and conviction of certain bank robbers.\xe2\x80\xa6\nOn June 12th or 13th, 1963, three armed men entered the First State Bank, Eubank, Kentucky, and with a\ndisplay of arms and threats robbed the bank of over $30,000 [about $208,000 in 2010 dollars]. Later in\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n341\n\n\x0cthe day they were apprehended by State Policemen Garret Godby, Johnny Simms and Tilford Reppert,\nplaced under arrest, and the entire loot was recovered. Later all of the prisoners were convicted and\nGarret Godby, Johnny Simms and Tilford Reppert appeared as witnesses at the trial.\nThe First State Bank of Eubank was a member of the Kentucky Bankers Association which provided and\nadvertised a reward of $500.00 for the arrest and conviction of each bank robber. Hence the outstanding\nreward for the three bank robbers was $1,500.00 [about $11,000 in 2010 dollars]. Many became\nclaimants for the reward and the Kentucky State Bankers Association being unable to determine the\nmerits of the claims for the reward asked the circuit court to determine the merits of the various claims\nand to adjudge who was entitled to receive the reward or share in it. All of the claimants were made\ndefendants in the action.\nAt the time of the robbery the claimants Murrell Denney, Joyce Buis, Rebecca McCollum and Jewell\nSnyder were employees of the First State Bank of Eubank and came out of the grueling situation with\ngreat credit and glory. Each one of them deserves approbation and an accolade. They were vigilant in\ndisclosing to the public and the peace officers the details of the crime, and in describing the culprits, and\ngiving all the information that they possessed that would be useful in capturing the robbers. Undoubtedly,\nthey performed a great service. It is in the evidence that the claimant Murrell Denney was conspicuous\nand energetic in his efforts to make known the robbery, to acquaint the officers as to the personal\nappearance of the criminals, and to give other pertinent facts.\nThe first question for determination is whether the employees of the robbed bank are eligible to receive or\nshare in the reward. The great weight of authority answers in the negative. [Citation] states the rule\nthusly:\n\xe2\x80\x98To the general rule that, when a reward is offered to the general public for the performance of some\nspecified act, such reward may be claimed by any person who performs such act, is the exception of\nagents, employees and public officials who are acting within the scope of their employment or official\nduties. * * *.\xe2\x80\x99\xe2\x80\xa6\nAt the time of the robbery the claimants Murrell Denney, Joyce Buis, Rebecca McCollum, and Jewell\nSnyder were employees of the First State Bank of Eubank. They were under duty to protect and conserve\nthe resources and moneys of the bank, and safeguard every interest of the institution furnishing them\nemployment. Each of these employees exhibited great courage, and cool bravery, in a time of stress and\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n342\n\n\x0cdanger. The community and the county have recompensed them in commendation, admiration and high\npraise, and the world looks on them as heroes. But in making known the robbery and assisting in\nacquainting the public and the officers with details of the crime and with identification of the robbers,\nthey performed a duty to the bank and the public, for which they cannot claim a reward.\nThe claims of Corbin Reynolds, Julia Reynolds, Alvie Reynolds and Gene Reynolds also must fail.\nAccording to their statements they gave valuable information to the arresting officers. However, they did\nnot follow the procedure as set forth in the offer of reward in that they never filed a claim with the\nKentucky Bankers Association. It is well established that a claimant of a reward must comply with the\nterms and conditions of the offer of reward. [Citation]\nState Policemen Garret Godby, Johnny Simms and Tilford Reppert made the arrest of the bank robbers\nand captured the stolen money. All participated in the prosecution. At the time of the arrest, it was the\nduty of the state policemen to apprehend the criminals. Under the law they cannot claim or share in the\nreward and they are interposing no claim to it.\nThis leaves the defendant, Tilford Reppert the sole eligible claimant. The record shows that at the time of\nthe arrest he was a deputy sheriff in Rockcastle County, but the arrest and recovery of the stolen money\ntook place in Pulaski County. He was out of his jurisdiction, and was thus under no legal duty to make the\narrest, and is thus eligible to claim and receive the reward. In [Citation] it was said:\n\xe2\x80\x98It is * * * well established that a public officer with the authority of the law to make an arrest may accept\nan offer of reward or compensation for acts or services performed outside of his bailiwick or not within\nthe scope of his official duties. * * *.\xe2\x80\x99\xe2\x80\xa6\nIt is manifest from the record that Tilford Reppert is the only claimant qualified and eligible to receive the\nreward. Therefore, it is the judgment of the circuit court that he is entitled to receive payment of the\n$1,500.00 reward now deposited with the Clerk of this Court.\nThe judgment is affirmed.\n\nCASE QUESTIONS\n1.\n\nWhy did the Bankers Association put the resolution of this matter into the court\xe2\x80\x99s hands?\n\n2.\n\nSeveral claimants came forward for the reward; only one person got it. What was the difference\nbetween the person who got the reward and those who did not?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n343\n\n\x0cConsequential Damages\nEBWS, LLC v. Britly Corp.\n928 A.2d 497 (Vt. 2007)\nReiber, C.J.\nThe Ransom family owns Rock Bottom Farm in Strafford, Vermont, where Earl Ransom owns a dairy\nherd and operates an organic dairy farm. In 2000, the Ransoms decided to build a creamery on-site to\nprocess their milk and formed EBWS, LLC to operate the dairy-processing plant and to market the plant\xe2\x80\x99s\nproducts. In July 2000, Earl Ransom, on behalf of EBWS, met with Britly\xe2\x80\x99s president to discuss building\nthe creamery\xe2\x80\xa6In January 2001, EBWS and Britly entered into a contract requiring Britly to construct a\ncreamery building for EBWS in exchange for $160,318.\xe2\x80\xa6The creamery was substantially completed by\nApril 15, 2001, and EBWS moved in soon afterward. On June 5, 2001, EBWS notified Britly of alleged\ndefects in construction. [EBWS continued to use the creamery pending the necessity to vacate it for three\nweeks when repairs were commenced].\nOn September 12, 2001, EBWS filed suit against Britly for damages resulting from defective design and\nconstruction.\xe2\x80\xa6\nFollowing a three-day trial, the jury found Britly had breached the contract and its express warranty, and\nawarded EBWS: (1) $38,020 in direct damages, and (2) $35,711 in consequential damages.\xe2\x80\xa6\n\xe2\x80\xa6The jury\xe2\x80\x99s award to EBWS included compensation for both direct and consequential damages that\nEBWS claimed it would incur while the facility closed for repairs. Direct damages [i.e., compensatory\ndamages] are for \xe2\x80\x9closses that naturally and usually flow from the breach itself,\xe2\x80\x9d and it is not necessary that\nthe parties actually considered these damages. [Citation]. In comparison, special or consequential\ndamages \xe2\x80\x9cmust pass the tests of causation, certainty and foreseeability, and, in addition, be reasonably\nsupposed to have been in the contemplation of both parties at the time they made the contract.\xe2\x80\x9d\n\xe2\x80\xa6The court ruled that EBWS could not recover for lost profits because it was not a going concern at the\ntime the contract was entered into, and profits were too speculative. The court concluded, however, that\nEBWS could submit evidence of other business losses, including future payment for unused milk and staff\nwages.\xe2\x80\xa6\nAt trial, Huyffer, the CEO of EBWS, testified that during a repairs closure the creamery would be required\nto purchase milk from adjacent Rock Bottom Farm, even though it could not process this milk. She\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n344\n\n\x0cadmitted that such a requirement was self-imposed as there was no written output contract between\nEBWS and the farm to buy milk. In addition, Huyffer testified that EBWS would pay its employees during\nthe closure even though EBWS has no written contract to pay its employees when they are not working.\nThe trial court allowed these elements of damages to be submitted to the jury, and the jury awarded\nEBWS consequential damages for unused milk and staff wages.\nOn appeal, Britly contends that because there is no contractual or legal obligation for EBWS to purchase\nmilk or pay its employees, these are not foreseeable damages. EBWS counters that it is common\nknowledge that cows continue to produce milk, even if the processing plant is not working, and thus it is\nforeseeable that this loss would occur. We conclude that these damages are not the foreseeable result of\nBritly\xe2\x80\x99s breach of the construction contract and reverse the award.\xe2\x80\xa6\n[W]e conclude that\xe2\x80\xa6it is not reasonable to expect Britly to foresee that its failure to perform under the\ncontract would result in this type of damages. While we are sympathetic to EBWS\xe2\x80\x99s contention that the\ncows continue to produce milk, even when the plant is closed down, this fact alone is not enough to\ndemonstrate that buying and dumping milk is a foreseeable result of Britly\xe2\x80\x99s breach of the construction\ncontract. Here, the milk was produced by a separate and distinct entity, Rock Bottom Farm, which sold\nthe milk to EBWS\xe2\x80\xa6\nSimilarly, EBWS maintained no employment agreements with its employees obligating it to pay wages\nduring periods of closure for repairs, dips in market demand, or for any other reason. Any losses EBWS\nmight suffer in the future because it chooses to pay its employees during a plant closure for repairs would\nbe a voluntary expense and not in Britly\xe2\x80\x99s contemplation at the time it entered the construction contract.\nIt is not reasonable to expect Britly to foresee losses incurred as a result of agreements that are informal in\nnature and carry no legal obligation on EBWS to perform. \xe2\x80\x9c[P]arties are not presumed to know the\ncondition of each other\xe2\x80\x99s affairs nor to take into account contracts with a third party that is not\ncommunicated.\xe2\x80\x9d [Citation] While it is true that EBWS may have business reasons to pay its employees\neven without a contractual obligation, for example, to ensure employee loyalty, no evidence was\nintroduced at trial by EBWS to support a sound rationale for such considerations. Under these\ncircumstances, this business decision is beyond the scope of what Britly could have reasonably foreseen as\ndamages for its breach of contract.\xe2\x80\xa6\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n345\n\n\x0cIn addition, the actual costs of the wages and milk are uncertain.\xe2\x80\xa6[T]he the milk and wages here are\nfuture expenses, for which no legal obligation was assumed by EBWS, and which are separate from the\nterms of the parties\xe2\x80\x99 contract. We note that at the time of the construction contract EBWS had not yet\nbegun to operate as a creamery and had no history of buying milk or paying employees. See [Citation]\n(explaining that profits for a new business are uncertain and speculative and not recoverable). Thus, both\nthe cost of the milk and the number and amount of wages of future employees that EBWS might pay in\nthe event of a plant closure for repairs are uncertain.\nAward for consequential damages is reversed.\xe2\x80\xa6\n\nCASE QUESTIONS\n1.\n\nWhy, according to EBWS\xe2\x80\x99s CEO, would EBWS be required to purchase milk from adjacent Rock Bottom\nFarm, even though it could not process this milk?\n\n2.\n\nSurely it is well known in Vermont dairy country that dairy farmers can\xe2\x80\x99t simply stop milking cows when\nno processing plant is available to take the milk\xe2\x80\x94the cows will soon stop producing. Why EBWS was\nthen not entitled to those damages which it will certainly suffer when the creamery is down for repairs?\n\n3.\n\nBritly (the contractor) must have known EBWS had employees that would be idled when the creamery\nshut down for repairs. Why was it not liable for their lost wages?\n\n4.\n\nWhat could EBWS have done at the time of contracting to protect itself against the damages it would\nincur in the event the creamery suffered downtime due to faulty construction\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n346\n\n\x0c8.5 Summary and Exercises\nSummary\nIn this chapter we have seen that two fundamental sources of contract law are the common law as\ndeveloped in the state courts and as summarized in the Restatement (Second) of Contracts, and the\nUniform Commercial Code for the sale of goods.\nSales law is a special type of contract law, governed by Article 2 of the UCC. Article 2 governs the sale of\ngoods only, defined as things movable at the time of identification to the contract for sale. When the goods\nare \xe2\x80\x9csold\xe2\x80\x9d incidental to a service, the courts do not agree on whether Article 2 applies. For two categories\nof goods, legislation specifically answers the question: foodstuffs served by a restaurant are goods; blood\nsupplied for transfusions is not.\nTypes of contracts can be distinguished along these axes: (1) express and implied, including quasicontracts implied by law; (2) bilateral and unilateral; (3) enforceable and unenforceable; and (4)\ncompleted (executed) and uncompleted (executor). To understand contract law, it is necessary to master\nthese distinctions and their nuances.\nIn order to determine whether a valid, enforceable contract exists, the following questions must be\nanswered: (1) Did the parties reach an agreement? (2) Was consideration present? (3) Was the agreement\nlegal? (4) Did the parties have capacity to make a contract? (5) Was the agreement in the proper form?\nRemedies available against someone who breaches a contract include damages, specific performance, and\nrestitution. Frequently the party who is not in breach must choose between tort and contract remedies.\n\nEXERCISES\n1.\n\nOn November 26, Joe wrote to Kate offering to purchase a farm that she owned. Upon receiving the\nletter on November 28, Kate immediately sent Joe a letter of acceptance. However, shortly after mailing\nthe letter, Kate had second thoughts and called Joe to advise him that she was rejecting his offer. The\ncall was made before Joe received the letter of acceptance. Has a contract been formed? Why?\n\n2.\n\nOn a busy day just before April 15, Albert Accountant received a call from a local car dealer. The dealer\nsaid, \xe2\x80\x9cHi, Mr. Accountant. Now, while you have income from doing clients\xe2\x80\x99 taxes, I have an excellent\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n347\n\n\x0coffer for you. You can buy a new Buick Century automobile completely loaded for $36,000. Al, I know\nyou\xe2\x80\x99re busy. If I don\xe2\x80\x99t hear from you by the end of the day, I\xe2\x80\x99ll assume you want the car.\xe2\x80\x9d Albert,\ndistracted, did not respond immediately, and the dealer hung up. Then followed an exhausting day of\nworking with anxiety-ridden tax clients. Albert forgot about the conversation. Two days later a\nstatement arrived from the dealer, with instructions on how Albert should pick up the car at the\ndealership. Is there a contract? Explain.\n3.\n\nBert purchased Ernie\xe2\x80\x99s car. Before selling the car, Ernie had stated to Bert, \xe2\x80\x9cThis car runs well and is\nreliable. Last week I drove the car all the way from Seattle to San Francisco to visit my mother and back\nagain to Seattle.\xe2\x80\x9d In fact, Ernie was not telling the truth: he had driven the car to San Francisco to visit\nhis paramour, not his mother. Upon discovery of the truth, may Bert avoid the contract? Why?\n\n4.\n\nLangstraat was seventeen when he purchased a motorcycle. When applying for insurance, he signed a\n\xe2\x80\x9cNotice of Rejection,\xe2\x80\x9d declining to purchase uninsured motorist coverage. He was involved in an\naccident with an uninsured motorist and sought to disaffirm his rejection of the uninsured motorist\ncoverage on the basis of infancy. May he do so?\n\n5.\n\nRichard promised to have Darlene\xe2\x80\x99s deck awning constructed by July 10. On June 20, Darlene called him\nand asked if he could get the job done by July 3, in time for Independence Day. Richard said he could,\nbut he failed to do so, and Darlene had to rent two canopies at some expense. Darlene claims that\nbecause Richard breached his promise, he is liable for the cost of awning rental. Is she correct\xe2\x80\x94was his\npromise binding? Why?\n\n6.\n\nAfter taking a business law class at State U, Elke entered into a contract to sell her business law book to\na classmate, Matthew, for $45. As part of the same contract, she agreed to prepare a will for Matthew\xe2\x80\x99s\nmother for an additional $110. Elke prepared the will and sent the book to Matthew, but he refused to\npay her. Is she entitled to any payment? Explain.\n\n7.\n\nSara Hohe, a fifteen-year-old junior at Mission Bay High School in San Diego, was injured during a\ncampus hypnotism show sponsored by the PTSA as a fund-raiser for the senior class. Hypnotism shows\nhad been held annually since 1980, and Sara had seen the previous year\xe2\x80\x99s show. She was selected at\nrandom from a group of many volunteers. Her participation in the \xe2\x80\x9cMagic of the Mind Show\xe2\x80\x9d was\nconditioned on signing two release forms. Hohe\xe2\x80\x99s father signed a form entitled \xe2\x80\x9cMission Bay High\nSchool PTSA Presents Dr. Karl Santo.\xe2\x80\x9d Hohe and her father both signed a form titled \xe2\x80\x9cKarl Santo\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n348\n\n\x0cHypnotist,\xe2\x80\x9d releasing Santo and the school district from all liability. During the course of the show, while\napparently hypnotized, Hohe slid from her chair and also fell to the floor about six times and was\ninjured. She, through her father, then sued the school district. The Hohes claimed the release was\ncontrary to public policy; the trial court dismissed the suit on summary judgment. Was the release\ncontrary to public policy? Decide.\n8.\n\nPlaintiff Irma Kozlowski cohabited with Defendant Thaddeus Kozlowski for fifteen years without\nmarriage. She repeatedly asked him specifically about her financial situation should he predecease her,\nand he assured her\xe2\x80\x94she said\xe2\x80\x94that he would arrange to provide for her for the rest of her life. She had\nprovided the necessary household services and emotional support to permit him to successfully pursue\nhis business career; she had performed housekeeping, cleaning, and shopping services and had run the\nhousehold and raised the children, her own as well as his. When they separated and she was \xe2\x80\x9cliterally\nforced out of the house,\xe2\x80\x9d she was sixty-three years old and had no means or wherewithal for survival.\nWhen she sued, he raised the Statute of Frauds\xe2\x80\x99 one-year rule as a defense. Is the defense good?\n\n9.\n\nOwner of an auto repair shop hires Contractor to remodel his shop but does not mention that two days\nafter the scheduled completion date, Owner is to receive five small US Army personnel carrier trucks for\nservice, with a three-week deadline to finish the job and turn the trucks over to the army. The contract\nbetween Owner and the army has a liquidated damages clause calling for $300 a day for every day\ntrucks are not operable after the deadline. Contractor is five days late in finishing the remodel. Can\nOwner claim the $1,500 as damages against Contractor as a consequence of the latter\xe2\x80\x99s tardy\ncompletion of the contract? Explain.\n\n10. Calvin, a promising young basketball and baseball player, signed a multiyear contract with a\nprofessional basketball team after graduating from college. After playing basketball for one year, he\ndecided he would rather play baseball and breached his contract with the basketball team. What\nremedy could the team seek?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n349\n\n\x0cSELF-TEST QUESTIONS\n1.\n\nAn implied contract\n\na.\n\nmust be in writing\n\nb.\n\nis one in which the terms are spelled out\n\nc.\n\nis one inferred from the actions of the parties\n\nd.\n\nis imposed by law to avoid an unjust result\n\ne.\n\nmay be avoided by one party.\nThe Convention on Contracts for the International Sale of Goods is\n\na.\n\nan annual meeting of international commercial purchasing agents.\nb.\n\ncontract law used in overseas US federal territories\n\nc.\n\na customary format or template for drafting contracts\n\nd.\n\na kind of treaty setting out international contract law, to which the United States is a party\n\ne.\n\nthe organization that develops uniform international law.\nConsideration\n\na.\n\ncan consist of a written acknowledgment of some benefit received, even if in fact the benefit is\n\nnot delivered\nb.\n\ncannot be nominal in amount\n\nc.\n\nis a bargained-for act, forbearance, or promise from the promisee\n\nd.\n\nis all of the above\nAn example of valid consideration is a promise\n\na.\n\nby a seventeen-year-old to refrain from drinking alcohol\nb.\n\nto refrain from going to court\n\nc.\n\nto cook dinner if the promisor can get around to it\n\nd.\n\nto repay a friend for the four years of free legal advice he had provided.\nA contract to pay a lobbyist to influence a public official is generally illegal.\n\na.\n\ntrue\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n350\n\n\x0cb.\n\nfalse\n\nSELF-TEST ANSWERS\n1.\n\nc\n\n2.\n\nd\n\n3.\n\nc\n\n4.\n\nb\n\n5.\n\nfalse\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n351\n\n\x0cChapter 9\nConsumer Credit Transactions\nLEARNING OBJECTIVES\nAfter reading this chapter, you should understand the following:\n1.\n\nHow consumers enter into credit transactions and what protections they are afforded when they do\n\n2.\n\nWhat rights consumers have after they have entered into a consumer transaction\n\n3.\n\nWhat debt collection practices third-party collectors may pursue\n\nThis chapter and the three that follow are devoted to debtor-creditor relations. In this chapter, we focus\non the consumer credit transaction. Chapter 10 "Secured Transactions and Suretyship" and Chapter 11\n"Mortgages and Nonconsensual Liens" explore different types of security that a creditor might\nrequire. Chapter 12 "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\n[3]\n\nOr maybe it was $7,300. But 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\nNext\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n352\n\n\x0c[1] Ben Woolsey and Matt Schulz, Credit Card Statistics, Industry Statistics, Debt Statistics, August 24,\n2010, http://www.creditcards.com/credit-card-news/credit-card-industry-facts-personal-debt-statistics-1276.php.\nThis is \xe2\x80\x9ccalculated by dividing the total revolving debt in the U.S. ($852.6 billion as of March 2010 data, as listed in\nthe Federal Reserve\xe2\x80\x99s May 2010 report on consumer credit) by the estimated number of households carrying\ncredit card debt (54 million).\xe2\x80\x9d\n[2] Deborah Fowles, \xe2\x80\x9cYour Monthly Credit Card Minimum Payments May Double,\xe2\x80\x9d About.com Financial\nPlanning,http://financialplan.about.com/od/creditcarddebt/a/CCMinimums.htm.\n[3] Index Credit Cards, Credit Card Debt, February 9, 2010,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, 2007.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n353\n\n\x0c9.1 Entering into a Credit Transaction\nLEARNING OBJECTIVES\n1.\n\nUnderstand what statutes regulate the cost of credit, and the exceptions.\n\n2.\n\nKnow how the cost of credit is expressed in the Truth in Lending Act.\n\n3.\n\nRecognize that there are laws prohibiting discrimination in credit granting.\n\n4.\n\nUnderstand how consumers\xe2\x80\x99 credit records are maintained and may be corrected.\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 9.3 "Cases").\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\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 rates\nvary, depending on whether a first mortgage or a subordinate mortgage is given, or whether the loan\nis 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 the\nstate 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 usury\nlaws 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n354\n\n\x0c\xe2\x80\xa2\n\nLease-purchases on personal property. This is the lease-to-own concept.\n\n\xe2\x80\xa2\n\nCertain financing of mobile homes that have become real property or where financing is insured by\nthe 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\nof 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 to consumer credit\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n355\n\n\x0ctransactions, and it only protects natural-person debtors\xe2\x80\x94it does not protect business organization\ndebtors.\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.\nFigure 9.1 Credit Disclosure Form\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n356\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.\nThe annual percentage rate must be calculated using the total finance charge (including all extra fees).\nSee Figure 9.1 "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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n357\n\n\x0cIn 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 late\npayment penalty.\n\n\xe2\x80\xa2\n\nRequires fair application of payments. Amounts in excess of the minimum payment must be applied\nto the highest interest rate (with some exceptions).\n\n\xe2\x80\xa2\n\nProvides sensible due dates and time to pay.\n\n\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 for\nfilling 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n358\n\n\x0cThe 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\n[2]\n\nunleashed a \xe2\x80\x9cfrenzy of retaliation,\xe2\x80\x9d by re-pricing customer accounts, changing fixed rates to variable\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\nDisclosure 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n359\n\n\x0cwere 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.\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.\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\nassessing 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 9.3\n"Cases" for a case involving the ECOA.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n360\n\n\x0ceducation 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\nAmericans\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.\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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n361\n\n\x0cThe 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).\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.\nUnder 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 9.3 "Cases" for a case involving use of information from a credit report.\n\nKEY TAKEAWAY\nCredit is an important part of the US economy, and there are various laws regulating its availability and\ndisclosure. Usury laws prohibit charging excessive interest rates, though the laws are riddled with\nexceptions. The disclosure of credit costs is regulated by the Truth in Lending Act of 1969, the Consumer\nLeasing Act of 1988, the Fair Credit and Charge Card Disclosure Act of 1989, and the Credit Card\nAccountability, Responsibility, and Disclosure Act of 2009 (these latter three are amendments to the\nTILA). Some states have adopted the Uniform Consumer Credit Code as well. Two major laws prohibit\ninvidious discrimination in the granting of credit: the Equal Credit Opportunity Act of 1974 and the Home\nMortgage Disclosure Act of 1975 (addressing the problem of redlining). The Fair Credit Reporting Act of\n1970 governs the collection and use of consumer credit information held by credit bureaus.\n\nEXERCISES\n1.\n\nThe penalty for usury varies from state to state. What are the two typical penalties?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n362\n\n\x0c2.\n\nWhat has the TILA done to the use of interest as a term to describe how much credit costs, and why?\n\n3.\n\nWhat is redlining?\n\n4.\n\nWhat does the Fair Credit Reporting Act do, in general?\n\n[1] Consumers Union, \xe2\x80\x9cUpcoming Credit Card Protections,\xe2\x80\x9dhttp://www.creditcardreform.org/pdf/dodd-summary509.pdf.\n[2] Liz Pulliam Weston, \xe2\x80\x9cCredit Card Lenders Go on a Rampage,\xe2\x80\x9d MSN Money, November 25, 2009.\n[3] States adopting the Uniform Consumer Credit Code are the following: Colorado, Idaho, Indiana, Iowa, Kansas,\nMaine, Oklahoma, South Carolina, Utah, Wisconsin, Wyoming, and Guam. Cornell University Law School, \xe2\x80\x9cUniform\nLaws.\xe2\x80\x9dhttp://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 The Urban\nInstitute, December 2008,http://www.urban.org/uploadedpdf/1001247_hdma.pdf.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n363\n\n\x0c9.2 Consumer Protection Laws and Debt Collection Practices\nLEARNING OBJECTIVES\n1.\n\nUnderstand that consumers have the right to cancel some purchases made on credit.\n\n2.\n\nKnow how billing mistakes may be corrected.\n\n3.\n\nRecognize that professional debt collectors are governed by some laws restricting 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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n364\n\n\x0cmail or telephone, to emergency repairs and certain other home repairs, or to real estate, insurance, or\nsecurities sales.\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\nBilling Mistakes\nIn 1975, Congress enacted the Fair Credit Billing Act as an amendment to the Consumer Credit Protection\nAct. It was intended to put to an end the phenomenon, by then a standard part of any comedian\xe2\x80\x99s\nrepertoire, of the many ways a computer could insist that you pay a bill, despite errors and despite letters\nyou might have written to complain. The act, which applies only to open-end credit and not to installment\nsales, sets out a procedure that creditors and customers must follow to rectify claimed errors. The\ncustomer has sixty days to notify the creditor of the nature of the error and the amount. Errors can\ninclude charges not incurred or those billed with the wrong description, charges for goods never delivered,\naccounting or arithmetic errors, failure to credit payments or returns, and even charges for which you\nsimply request additional information, including proof of sale. During the time the creditor is replying,\nyou need not pay the questioned item or any finance charge on the disputed amount.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n365\n\n\x0ccreditor 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\nstate 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n366\n\n\x0ccould 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.\nThe 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 for a\nloan 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n367\n\n\x0cvarious 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\nborrower 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.\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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n368\n\n\x0cUnder 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\ndefault 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).\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\nKEY TAKEAWAY\nSeveral laws regulate practices after consumer credit transactions. The FTC provides consumers with a\nthree-day cooling-off period for some in-home sales, during which time the consumer-purchaser may\ncancel the sale. The TILA and some state laws also have some cancellation provisions. Billing errors are\naddressed by the Fair Credit Billing Act, which gives consumers certain rights. Debt collection practices\nsuch as garnishment, wage assignments, and confessions of judgment are regulated (and in some states\nprohibited) by federal and state law. Debt collection practices for third-party debt collectors are\nconstrained by the Fair Debt Collection Practices Act.\n\nEXERCISES\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n369\n\n\x0c1.\n\nUnder what circumstances may a consumer have three days to avoid a contract?\n\n2.\n\nHow does the Fair Credit Billing Act resolve the problem that occurs when a consumer disputes a bill\nand \xe2\x80\x9cargues\xe2\x80\x9d with a computer about it?\n\n3.\n\nWhat is the constitutional problem with garnishment as it was often practiced before 1969?\n\n4.\n\nIf Joe of Joe\xe2\x80\x99s Garage wants to collect on his own the debts he is owed, he is not constrained by the\nFDCPA. What limits are there on his debt collection practices?\n\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 2007: Survey And\nAnalysis, June 2008, 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 Implementing the Telephone\nConsumer Protection Act of 1991,\xe2\x80\x9dhttp://fjallfoss.fcc.gov/edocs_public/attachmatch/FCC-07-232A1.txt. (This\ndocument shows up best with Adobe Acrobat.)\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n370\n\n\x0c9.3 Cases\nUsury\nMatter of Dane\xe2\x80\x99s Estate\n390 N.Y.S.2d 249 (N.Y.A.D. 1976)\nMAHONEY, J.\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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n371\n\n\x0cpresumption 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.\nNext, 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.\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.\nThe order should be affirmed, without costs.\n\nCASE QUESTIONS\n1.\n\nWhat is the consequence to the lender of charging usurious rates in New York?\n\n2.\n\nThe rate charged here was one-half of one percent in excess of the allowable limit. Who made the note,\nthe borrower or the lender? That makes no difference, but should it?\n\n3.\n\nWhat \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.\n214 F.3d 213, C.A.1 (Mass. 2000)\nLynch, J.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n372\n\n\x0cLucas 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[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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n373\n\n\x0cPrice 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\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 cross\ndressers. Second, the Bank says that its employee genuinely could not identify Rosa, which is why she\nasked 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.\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\n\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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n374\n\n\x0cemployer 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.\nIt 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\nWe reverse and remand for further proceedings in accordance with this opinion.\n\nCASE QUESTIONS\n1.\n\nCould the bank have denied Mr. Rosa a loan because he was gay?\n\n2.\n\nIf a woman had applied for loan materials dressed in traditionally masculine attire, could the bank have\ndenied her the materials?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n375\n\n\x0c3.\n\nThe Court offers up at least three possible reasons why Rosa was denied the loan application. What\nwere those possible reasons, and which of them would have been valid reasons to deny him the\napplication?\n\n4.\n\nTo what federal law does the court look in interpreting the application of the ECOA?\n\n5.\n\nWhy did the court rule in Mr. Rosa\xe2\x80\x99s favor when the facts as to why he was denied the loan application\ncould have been interpreted in several different ways?\n\nUses of Credit Reports under the FCRA\nRodgers v. McCullough\n296 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.\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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n376\n\n\x0cjuvenile 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.\nThe dispute in this case centers on whether Ms. McCullough obtained and used Ms. Rodgers\xe2\x80\x99 consumer\nreport for a purpose permitted under the Fair Credit Reporting Act (the \xe2\x80\x9cFCRA\xe2\x80\x9d). Plaintiff contends that\nMs. McCullough, as well as her law firm, Wilkes, McCullough & Wagner, a partnership, and her partners,\nCalvin J. McCullough and John C. Wagner, are liable for the unlawful receipt and use of Ms. Rodgers\xe2\x80\x99\nconsumer report in violation 15 U.S.C. \xc2\xa7\xc2\xa7 1681 o(negligent failure to comply with the FCRA) and 1681n\n(willful failure to comply with the FCRA or obtaining a consumer report under false pretenses). Plaintiff\nhas 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),\nwhether 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[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[A]ny consumer reporting agency may furnish a consumer report under the following circumstances and\nno other\xe2\x80\xa6\n(3) To a person which it has reason to believeSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n377\n\n\x0c(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[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].\nMs. Rodgers does not request summary judgment in her favor on this point, relying on the plain text of\nthe statute, because she was not in arrears on any child support obligation at the time Ms. McCullough did\nnot request the consumer report, nor did she owe Ms. McCullough\xe2\x80\x99s client any debt. She notes that Mr.\nAnthony 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.\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).\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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n378\n\n\x0cThe 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\nof 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\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 cannot 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].\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n379\n\n\x0ccalculating 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.\nDefendants 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).\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.\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 Permissible\nPurpose\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[Discussion of the invasion of privacy claim omitted.]\nConclusion\nFor 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n380\n\n\x0cCASE QUESTIONS\n1.\n\nWhy did the defendant, McCullough, order her secretary to obtain Ms. Rodgers\xe2\x80\x99s credit report? If Ms.\nMcCullough is found liable, why would her law firm partners also be liable?\n\n2.\n\nWhat \xe2\x80\x9cpermissible purpose\xe2\x80\x9d did the defendants contend they had for obtaining the credit report? Why\ndid the court determine that purpose was not permissible?\n\n3.\n\nWhy did the court deny the plaintiff\xe2\x80\x99s motion for summary judgment on the question of whether the\ndefendant \xe2\x80\x9cwillfully\xe2\x80\x9d failed to comply with the act? Is the plaintiff out of luck on that question, or can it\nbe litigated further?\n\n[1] Defendants also admit that Ms. McCullough used the credit report to portray Ms. Rodgers as irresponsible,\nfinancially unstable, and untruthful about her residence and employment history to the Juvenile Court. Defendants\ndo not allege that these constitute permissible purposes under the FCRA.\n\n9.4 Summary and Exercises\nSummary\n\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\nEXERCISES\n1.\n\nCarlene Consumer entered into an agreement with Rent to Buy, Inc., to rent a computer for $20 per\nweek. The agreement also provided that if Carlene chose to rent the computer for fifty consecutive\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n381\n\n\x0cweeks, she would own it. She then asserted that the agreement was not a lease but a sale on credit\nsubject to the Truth in Lending Act, and that Rent to Buy, Inc., violated the act by failing to state the\nannual percentage rate. Is Carlene correct?\n2.\n\nCarlos, a resident of Chicago, was on a road trip to California when he heard a noise under the hood of his\ncar. He took the car to a mechanic for repair. The mechanic overhauled the power steering unit and billed\nCarlos $600, which he charged 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 diagnosed the problem as a\nloose exhaust pipe connection at the manifold. Carlos was billed $300 for this repair, with which he was\nsatisfied. Carlos returned to Chicago and examined his credit card statement. What rights has he as to the\n$600 charge on his card?\n\n3.\n\nKen was the owner of Scrimshaw, a company that manufactured and sold carvings made on fossilized\nivory. He applied for a loan from Bank. Bank found him creditworthy, but seeking additional security for\nrepayment, it required his wife, Linda, to sign a guaranty as well. During a subsequent recession, demand\nfor scrimshaw fell, and Ken\xe2\x80\x99s business went under. Bank filed suit against both Ken and Linda. What\ndefense has Linda?\n\n4.\n\nThe FCRA requires that credit-reporting agencies \xe2\x80\x9cfollow reasonable procedures to assure maximum\npossible accuracy of the information.\xe2\x80\x9d In October of 1989, Renie Guimond became aware of, and notified\nthe credit bureau Trans Union about, inaccuracies in her credit report: that she was married (and it listed\na Social Security number for this nonexistent spouse), that she was also known as Ruth Guimond, and that\nshe had a Saks Fifth Avenue credit card. About a month later, Trans Union responded to Guimond\xe2\x80\x99s letter,\nstating that the erroneous information had been removed. But in March of 1990, Trans Union again\npublished the erroneous information it purportedly had removed. Guimond then requested the source of\nthe erroneous information, to which Trans Union responded that it could not disclose the identity of the\nsource because it did not know its source. The disputed information was eventually removed from\nGuimond\xe2\x80\x99s file in October 1990. When Guimond sued, Trans Union defended that she had no claim\nbecause no credit was denied to her as a result of the inaccuracies in her credit file. The lower court\ndismissed her case; she appealed. To what damages, if any, is Guimond entitled?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n382\n\n\x0c5.\n\nPlaintiff incurred a medical debt of $160. She received two or three telephone calls from\nDefendant, the collection agency; each time she denied any money owing. Subsequently she\nreceived this letter:\nYou have shown that you are unwilling to work out a friendly settlement with us to clear the\nabove debt. Our field investigator has now been instructed to make an investigation in your\nneighborhood and to personally call on your employer.\nThe immediate payment of the full amount, or a personal visit to this office, will spare you this\nembarrassment.\nThe top of the letter notes the creditor\xe2\x80\x99s name and the amount of the alleged debt. The letter was\nsigned by a \xe2\x80\x9ccollection agent.\xe2\x80\x9d The envelope containing that letter presented a return address\nthat included Defendant\xe2\x80\x99s full name: \xe2\x80\x9cCollection Accounts Terminal, Inc.\xe2\x80\x9d What violations of the\nFair Debt Collection Practices Act are here presented?\n\n6.\n\nEric and Sharaveen Rush filed a claim alleging violations of the Fair Credit Reporting Act arising out of an\nallegedly erroneous credit report prepared by a credit bureau from information, in part, from Macy\xe2\x80\x99s, the\ndepartment store. The error causes the Rushes to be denied credit. Macy\xe2\x80\x99s filed a motion to dismiss. Is\nMacy\xe2\x80\x99s liable? Discuss.\n\nSELF-TEST QUESTIONS\n1.\n\nAn example of a loan that is a common exception to usury law is\na.\n\na business loan\n\nb.\n\na mortgage loan\n\nc.\n\nan installment loan\n\nd.\n\nall of the above\nUnder the Fair Credit Reporting Act, an applicant denied credit\n\na.\n\nhas a right to a hearing\nb.\n\nhas the right to be told the name and address of the credit bureau that prepared the credit report\nupon which denial was based\n\nc.\n\nalways must pay a fee for information regarding credit denial\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n383\n\n\x0cd.\n\nnone of the above\nGarnishment of wages\n\na.\n\nis limited by federal law\nb.\n\ninvolves special rules for support cases\n\nc.\n\nis a legal process where a creditor obtains a court order directing the debtor\xe2\x80\x99s employer to pay a\nportion of the debtor\xe2\x80\x99s wages directly to the creditor\n\nd.\n\ninvolves all of the above\nA wage assignment is\n\na.\n\nan example of garnishment\nb.\n\nan example of confession of judgment\n\nc.\n\nan exception to usury law\n\nd.\n\nan agreement that a creditor may take future wages as security for a loan\nThe Truth-in-Truth in Lending Act requires disclosure of\n\na.\n\nthe annual percentage rate\nb.\n\nthe borrower\xe2\x80\x99s race\n\nc.\n\nboth of the above\n\nd.\n\nneither of the above\n\nSELF-TEST ANSWERS\n1.\n\nd\n\n2.\n\nb\n\n3.\n\nd\n\n4.\n\nd\n\n5.\n\na\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n384\n\n\x0cChapter 10\nSecured Transactions and Suretyship\nLEARNING OBJECTIVES\nAfter reading this chapter, you should understand the following:\n1.\n\nThe basic concepts of secured transactions\n\n2.\n\nThe property subject to the security interest\n\n3.\n\nCreation and perfection of the security interest\n\n4.\n\nPriorities for claims on the security interest\n\n5.\n\nRights of creditors on default\n\n6.\n\nThe basic concepts of suretyship\n\n7.\n\nThe relationship between surety and principal\n\n8.\n\nRights among cosureties\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n385\n\n\x0c10.1 Introduction to Secured Transactions\nLEARNING OBJECTIVES\n1.\n\nRecognize, most generally, the two methods by which debtors\xe2\x80\x99 obligations may be secured.\n\n2.\n\nKnow the source of law for personal property security.\n\n3.\n\nUnderstand the meaning of security interest and other terminology necessary to discuss the issues.\n\n4.\n\nKnow what property is subject to the security interest.\n\n5.\n\nUnderstand 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 to\nrepay, 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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n386\n\n\x0cfor 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.\nIn this chapter, we take up security interests in personal property and suretyship. In the next chapter, we\nlook at mortgages and nonconsensual liens.\n\nBasics 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.\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 10.1\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.\nFigure 10.1 The Grasping Hand\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n387\n\n\x0cSource of Law and Definitions\nSource of Law\nArticle 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:\n1.\n\nA transaction, regardless of its form, that creates a security interest in personal property or fixtures by\ncontract;\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n388\n\n\x0cAs 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.\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\nSecurity agreement is \xe2\x80\x9can agreement that creates or provides for a security interest.\xe2\x80\x9d It is the contract that\nsets up the debtor\xe2\x80\x99s duties and the creditor\xe2\x80\x99s rights in event the debtor defaults.\n\n[2]\n\nCollateral \xe2\x80\x9cmeans the property subject to a security interest or agricultural lien.\xe2\x80\x9d\n\n[3]\n\nPurchase-money security interest (PMSI) is the simplest form of security interest. Section 9-103(a) of the\nUCC defines \xe2\x80\x9cpurchase-money collateral\xe2\x80\x9d as \xe2\x80\x9cgoods or software that secures a purchase-money obligation\nwith respect to that collateral.\xe2\x80\x9d A PMSI arises where the debtor gets credit to buy goods and the creditor\ntakes a secured interest in those goods. Suppose you want to buy a big hardbound textbook on credit at\nyour college bookstore. The manager refuses to extend you credit outright but says she will take back a\nPMSI. In other words, she will retain a security interest in the book itself, and if you don\xe2\x80\x99t pay, you\xe2\x80\x99ll have\nto return the book; it will be repossessed. Contrast this situation with a counteroffer you might make:\nbecause she tells you not to mark up the book (in the event that she has to repossess it if you default), you\nwould rather give her some other collateral to hold\xe2\x80\x94for example, your gold college signet ring. Her\nsecurity interest in the ring is not a PMSI but a pledge; a PMSI must be an interest in the particular goods\npurchased. A PMSI would also be created if you borrowed money to buy the book and gave the lender a\nsecurity interest in the book.\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\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n389\n\n\x0cinterest, 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.\nNow we return to definitions.\nDebtor is \xe2\x80\x9ca person (1) having an interest in the collateral other than a security interest or a lien; (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\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.\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,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n390\n\n\x0cBruno 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\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\nBehnfeldt 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\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).\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 mean \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\nSaylor URL: http://www.saylor.org/books\n\n[9]\n\nSaylor.org\n391\n\n\x0cInventory\n\xe2\x80\x9cGoods, other than farm products, held by a person for sale or lease or consisting of raw materials, work\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 good nor in-dispensable paper: accounts and general intangibles.\n\nAccounts\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n392\n\n\x0cThis 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\nsomebody 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 warehouse and is\nentitled to take the chairs and sell them to satisfy the obligation. The warehouse 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n393\n\n\x0cpurchase-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.\n\nDocuments\nThis category includes documents of title\xe2\x80\x94bills of lading and warehouse receipts are examples.\n\nInstruments\nAn \xe2\x80\x9cinstrument\xe2\x80\x9d here is \xe2\x80\x9ca negotiable instrument (checks, drafts, notes, certificates of deposit) 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 endorsement 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 security\ninterest 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:\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n394\n\n\x0c\xe2\x80\xa2\n\nAfter-acquired property. This is property that the debtor acquires after the original deal was set up. It\nallows the secured party to enhance his security as the debtor (obligor) acquires more property\nsubject to collateralization.\n\n\xe2\x80\xa2\n\nSale proceeds. These are proceeds from the disposition of the collateral. Carl Creditor takes a secured\ninterest in Deborah Debtor\xe2\x80\x99s sailboat. She sells the boat and buys a garden tractor. The secured\ninterest 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 and\nfuture 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 future advances\nclause. The agreement gives the creditor a security interest in a $700,000 inventory-picking robot to\nsecure repayment of a loan made to the debtor. The parties contemplate that the debtor will, from\ntime to time, borrow more money, and when the debtor does, the machine will stand as collateral to\nsecure the further indebtedness, without new paperwork.\n\no\n\nExample 2: A debtor signs a security agreement with a bank to buy a car. The security agreement\ncontains a future advances clause. A few years later, the bank sends the debtor a credit card. Two\nyears go by: the car is paid for, but the credit card is in default. The bank seizes the car. \xe2\x80\x9cWhoa!\xe2\x80\x9d says\nthe debtor. \xe2\x80\x9cI paid for the car.\xe2\x80\x9d \xe2\x80\x9cYes,\xe2\x80\x9d says the bank, \xe2\x80\x9cbut it was collateral for all future indebtedness\nyou ran up with us. Check out your loan agreement with us and UCC Section 9-204(c), especially\nComment 5.\xe2\x80\x9d\n\nSee Figure 10.2 "Tangibles and Intangibles as Collateral".\nFigure 10.2 Tangibles and Intangibles as Collateral\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n395\n\n\x0cAttachment 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 10.1 "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\n396\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(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(2) as security for or in total or partial satisfaction of a pre-existing claim; or\n(3) by accepting delivery pursuant to a pre-existing contract for purchase; or\n(4) generally, in return for any consideration sufficient to support a simple contract.\nSuppose Deborah owes Carl $3,000. She cannot repay the sum when due, so she agrees to give 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\nrecord\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 not required in some cases. It is not\nrequired if the debtor makes a pledge of 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n397\n\n\x0cdebtor 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 10.1 "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 the\nworld. It is the secured party\xe2\x80\x99s claim on the collateral.\nThere 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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n398\n\n\x0cA 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\xe2\x80\xa2\n\nThe debtor\xe2\x80\x99s name. Financing statements are indexed under the debtor\xe2\x80\x99s name, so getting that correct\nis 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 property\xe2\x80\x9d\n(such generic references are not acceptable in the security agreement but are OK in the financing\nstatement).\n\n[28]\n\nIf the collateral is real-property-related, covering timber to be cut or fixtures, it must\n\ninclude 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 10.3 "UCC-1 Financing\nStatement" for a typical financing statement. Minor errors or omissions on the form will not make it\nineffective, 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 10.3 UCC-1 Financing Statements\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n399\n\n\x0cDuration of the Financing Statement\nGenerally, the financing statement is effective for five years; a continuation statement may be filed within\nsix months before the five-year expiration date, and it is good for another five years.\n\n[31]\n\nManufactured-\n\nhome filings are good for thirty years. When the debtor\xe2\x80\x99s obligation is satisfied, the secured party files\na termination statement if the collateral was consumer goods; otherwise\xe2\x80\x94upon demand\xe2\x80\x94the secured\nparty sends the debtor a termination statement.\n\n[32]\n\nDebtor 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n400\n\n\x0cFor 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\nTemporary 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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n401\n\n\x0cPerfection 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.\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.\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\nsegregates 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,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n402\n\n\x0cand 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\nis automatic 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\nFigure 10.4 Attachments and Perfection\n\nKEY TAKEAWAY\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n403\n\n\x0cA creditor may be secured\xe2\x80\x94allowed to take the debtor\xe2\x80\x99s property upon debtor\xe2\x80\x99s default\xe2\x80\x94by agreement\nbetween the parties or by operation of law. The law governing agreements for personal property\nsecurity is Article 9 of the UCC. The creditor\xe2\x80\x99s first step is to attach the security interest. This is usually\naccomplished when the debtor, in return for value (a loan or credit) extended from the creditor, puts up\nas collateral some valuable asset in which she has an interest and authenticates (signs) a security\nagreement (the contract) giving the creditor a security interest in collateral and allowing that the\ncreditor may take it if the debtor 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 paper (indispensable\npaper), to intangible assets (like patent rights). Sometimes no security agreement is necessary, mostly if\nthe creditor takes possession of the collateral. After attachment, the prudent creditor will want to\nperfect the security interest to make sure no other creditors claim an interest in the collateral.\nPerfection is most often accomplished by filing a financing statement in the appropriate place to put the\nworld on notice of the creditor\xe2\x80\x99s interest. Perfection can also be achieved by a pledge (possession by the\nsecured creditor) or by \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 (certified securities,\ninstruments, and negotiable documents) but also upon mere attachment to purchase-money security\ninterests in consumer goods.\n\nEXERCISES\n1.\n\nWhy is a creditor ill-advised to be unsecured?\n\n2.\n\nElaine bought a computer for her use as a high school teacher, the school contributing one-third of its\ncost. Elaine was compelled to file for bankruptcy. The computer store claimed it had perfected its\ninterest by mere attachment, and the bankruptcy trustee claimed the computer as an asset of Elaine\xe2\x80\x99s\nbankruptcy estate. Who wins, and why?\n\n3.\n\nWhat is the general rule governing where financing statements should be filed?\n\n4.\n\nIf the purpose of perfection is to alert the world to the creditor\xe2\x80\x99s claim in the collateral, why is\nperfection accomplishable by possession alone in some cases?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n404\n\n\x0c5.\n\nContractor pawned a power tool and got a $200 loan from Pawnbroker. Has there been a perfection of\na security interest?\n\n[1] Uniform Commercial Code, Section 9-109.\n[2] Uniform Commercial Code, Section 9-102(a)(73).\n[3] Uniform Commercial Code; Section 9-102(12).\n[4] Uniform Commercial Code, Section 9-102(a)(28).\n[5] Uniform Commercial Code; Section 9-102 (59).\n[6] Uniform Commercial Code, Section 9-102(a)(71).\n[7] Commercial Brokers, Inc., \xe2\x80\x9cGlossary of Real Estate\nTerms,\xe2\x80\x9dhttp://www.cbire.com/index.cfm/fuseaction/terms.list/letter/C/contentid/32302EC3-81D5-47DFA9CBA32FAE38B22A.\n[8] Uniform Commercial Code; Section 9-102(44).\n[9] Uniform Commercial Code, Section 9-102(a)(48).\n[10] Uniform Commercial Code, Section 9-102(a)(48).\n[11] Uniform Commercial Code, Section 9-102(a)(34).\n[12] Uniform Commercial Code, Section 9-102(a)(33).\n[13] Uniform Commercial Code, Section 9-102(a)(41).\n[14] Uniform Commercial Code, Section 9-102(a)(1).\n[15] Uniform Commercial Code, Section 9-102(a)(2).\n[16] Uniform Commercial Code; Section 9-102(42).\n[17] Uniform Commercial Code; Section 9-102(11).\n[18] Uniform Commercial Code, Section 9-102(a) (47).\n[19] Uniform Commercial Code, Section 9-102(a) (49).\n[20] Uniform Commercial Code, Section 8-102(a) (4) and (a)(18).\n[21] Uniform Commercial Code; Section 9-203(a).\n[22] Uniform Commercial Code; Section 9-203(b) (2).\n[23] Uniform Commercial Code, Section 9-102, Official Comment 9. Here is a free example of a security agreement\nonline: Docstoc, \xe2\x80\x9cFree Business Templates\xe2\x80\x94Sample Open-Ended Security\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n405\n\n\x0cAgreement,\xe2\x80\x9d http://www.docstoc.com/docs/271920/Free-Business-Templates\xe2\x80\x94-Sample-Open-Ended-SecurityAgreement.\n[24] Uniform Commercial Code, Section 9-203(b) (3) (B-D).\n[25] Uniform Commercial Code; Section 9-310(a).\n[26] Uniform Commercial Code, Section 9-502, Official Comment 2.\n[27] Uniform Commercial Code; Section 9-502(a).\n[28] Uniform Commercial Code, Section 9-504.\n[29] Uniform Commercial Code; Section 9-502(b).\n[30] Uniform Commercial Code, Section 9-506; Uniform Commercial Code, Section, 9-502, Comment 3.\n[31] Uniform Commercial Code, Section 9-515.\n[32] Uniform Commercial Code, Section 9-513.\n[33] Uniform Commercial Code, Section 9-316.\n[34] Uniform Commercial Code, Section 9-501.\n[35] Uniform Commercial Code, Section 9-501(a) (2).\n[36] Uniform Commercial Code; Section 9-307(b).\n[37] Uniform Commercial Code, Section 9-303.\n[38] Uniform Commercial Code; Section 9-312(e).\n[39] Uniform Commercial Code; Section 9-312(f) and (g).\n[40] Uniform Commercial Code, Section 9-313.\n[41] Uniform Commercial Code, Section 9-314.\n[42] Uniform Commercial Code, Section 8-106, Official Comment 1.\n\n10.2 Priorities\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n406\n\n\x0cLEARNING OBJECTIVES\n1.\n\nUnderstand the general rule regarding who gets priority among competing secured parties.\n\n2.\n\nKnow the immediate exceptions to the general rule\xe2\x80\x94all involving PMSIs.\n\n3.\n\nUnderstand 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 first with the most.\xe2\x80\x9d The first to do the best job of perfecting wins. The Uniform\nCommercial 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:\n1.\n\nRosemary, without having yet lent money, files a financing statement on February 1 covering certain\ncollateral owned by Susan\xe2\x80\x94Susan\xe2\x80\x99s fur coat. Under UCC Article 9, a filing may be made before the\nsecurity interest attaches. On March 1, Erika files a similar statement, also without having lent any\nmoney. On April 1, Erika loans Susan $1,000, the loan being secured by the fur coat described in the\nstatement she filed on March 1. On May 1, Rosemary also loans Susan $1,000, with the same fur coat\nas security. Who has priority? Rosemary does, since she filed first, even though Erika actually first\nextended the loan, which was perfected when made (because she had already filed). This result is\ndictated by the rule even though Rosemary may have known of Erika\xe2\x80\x99s interest when she subsequently\nmade her loan.\n\n2. Susan cajoles both Rosemary and Erika, each unknown to the other, to loan her $1,000 secured by the\nfur coat, which she already owns and which hangs in her coat closet. Erika gives Susan the money a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n407\n\n\x0cweek after Rosemary, but Rosemary has not perfected and Erika does not either. A week later, they\nfind out they have each made a loan against the same coat. Who has priority? Whoever perfects first:\nthe rule creates a race to the filing office or to Susan\xe2\x80\x99s closet. Whoever can submit the financing\nstatement or actually take possession of the coat first will have priority, and the outcome does not\ndepend on knowledge or lack of knowledge that someone else is claiming a security interest in the\nsame collateral. But what of the rule that in the absence of perfection, whichever security interest first\nattached has priority? This is \xe2\x80\x9cthought to be of merely theoretical interest,\xe2\x80\x9d says the UCC\ncommentary, \xe2\x80\x9csince it is hard to imagine a situation where the case would come into litigation without\n[either party] having perfected his interest.\xe2\x80\x9d And if the debtor filed a petition in bankruptcy, neither\nunperfected security interest could prevail against the bankruptcy trustee.\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\n[2]\n\nIf both parties have perfected, the first to have perfected wins.\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\nsecurity interests (PMSIs), so if the debtor defaults, the creditor repossess the very goods the creditor had\nsold the debtor.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n408\n\n\x0cSuppose 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.\nWhat would happen if this kind of PMSI in non-inventory 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(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\ndebtor 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(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 (afterSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n409\n\n\x0cacquired 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.\nThink 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n410\n\n\x0cbuyer 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.\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\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 inventory\n\nis covered by a security interest, but it\xe2\x80\x99s not OK if he knows \xe2\x80\x9cthat the sale violates a term in an\nagreement with the secured party.\xe2\x80\x9d\n\n[7]\n\nIt would not be conducive to faith in commercial transactions if\n\nbuyers of inventory generally had to worry whether their seller\xe2\x80\x99s creditors were going to repossess the\nthings the buyers had purchased in good faith. For example (based on example 1 to the same\ncomment, UCC 9-320, Official Comment 3), Manufacturer makes appliances and owns\nmanufacturing equipment covered by a perfected security agreement in favor of Lender.\nManufacturer sells the equipment to Dealer, whose business is buying and selling used equipment;\nDealer, in turn, sells the stuff to Buyer, a buyer in the ordinary course. Does Buyer take free of the\nsecurity 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 value,\nfor their own consumer uses, and before the filing of a financing statement covering the goods. This\xe2\x80\x94\nagain\xe2\x80\x94is the rub when a seller of consumer goods perfects by \xe2\x80\x9cmere attachment\xe2\x80\x9d (automatic\nperfection) and the buyer of the goods turns around and sells them. For example, Tom buys a new\nrefrigerator from Sears, which perfects by mere attachment. Tom has cash flow problems and sells the\nfridge to Ned, his neighbor. Ned doesn\xe2\x80\x99t know about Sears\xe2\x80\x99s security interest and pays a reasonable\namount for it. He puts it in his kitchen for home use. Sears cannot repossess the fridge from Ned. If it\nwanted to protect itself fully, Sears would have filed a financing statement; then Ned would be out the\nfridge when the repo men came.\n\n[8]\n\nThe \xe2\x80\x9cvalue\xe2\x80\x9d issue is interestingly presented in the Nicolosi case\n\n(Section 10.5 "Cases").\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n411\n\n\x0c\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 farm\nproducts,\xe2\x80\x9d and the result was that sometimes the buyer had to pay twice: once to the farmer and again\nto the lender whom the farmer didn\xe2\x80\x99t pay. As a result, Congress included in its 1985 Farm Security\nAct, 7 USC 1631, Section 1324, this language: \xe2\x80\x9cA buyer who in the ordinary course of business buys a\nfarm product from a seller engaged in farming operations shall take free of a security interest created\nby the seller, even though the security interest is perfected; and the buyer knows of the existence of\nsuch interest.\xe2\x80\x9d\n\nThere are some other exceptions, beyond our scope here.\n\nLien Creditors\nPersons (including bankruptcy trustees) who become lien creditors before the security interest is\nperfected win out\xe2\x80\x94the unperfected security interest is subordinate to lien creditors. Persons who become\nlien creditors after the security interest is perfected lose (subject to some nuances in situations where the\nlien arises between attachment by the creditor and the filing, and depending upon the type of security\ninterest and the type of collateral).\n\n[9]\n\nMore straightforwardly, perhaps, a lien securing payment or\n\nperformance of an obligation for services or materials furnished with respect to goods by a person in the\nordinary course of business has priority over other security interests (unless a statute provides\notherwise).\n\n[10]\n\nThis is the bailee or \xe2\x80\x9cmaterial man\xe2\x80\x9d (one who supplies materials, as to build a house) with a\n\nlien situation. Garage Mechanic repairs a car in which Owner has previously given a perfected security\ninterest to Bank. Owner doesn\xe2\x80\x99t pay Bank. Bank seeks to repossess the car from Mechanic. It will have to\npay the Mechanic first. And why not? If the car was not running, Bank would have to have it repaired\nanyway.\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\n[11]\n\nthe collateral.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n412\n\n\x0cincluding 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\nthe 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\nKEY TAKEAWAY\nWho among competing creditors gets the collateral if the debtor defaults? The general rule on priorities is\nthat the first to secure most completely wins: if all competitors have perfected, the first to do so wins. If\none has perfected and the others have not, the one who perfects wins. If all have attached, the first to\nattach wins. If none have attached, they\xe2\x80\x99re all unsecured creditors. To this general rule there are a number\nof exceptions. Purchase-money security interests in goods and inventory prevail over previously perfected\nsecured parties in the same goods and inventory (subject to some requirements); fixture financers who file\nproperly have priority over previously perfected mortgagees. Buyers in the ordinary course of business\ntake free of a security interest created by their seller, so long as they don\xe2\x80\x99t know their purchase violates a\nsecurity agreement. Buyers of consumer goods perfected by mere attachment win out over the creditor\nwho declined to file. Buyers in the ordinary course of business of farm products prevail over the farmer\xe2\x80\x99s\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n413\n\n\x0ccreditors (under federal law, not the UCC). Lien creditors who become such before perfection win out;\nthose who become such after perfection usually lose. Bailees in possession and material men have priority\nover previous perfected claimants. Bankruptcy trustees win out over unperfected security interests and\nover perfected ones if they are considered voidable transfers from the debtor to the secured party.\nDeposit accounts perfected by control prevail over previously perfected secured parties in the same\ndeposit accounts.\n\nEXERCISES\n1.\n\nWhat is the general rule regarding priorities for the right to repossess goods encumbered by a security\ninterest when there are competing creditors clamoring for that right?\n\n2.\n\nWhy does it make good sense to allow purchase-money security creditors in (1) inventory, (2) equipment,\nand (3) fixtures priority over creditors who perfected before the PMSI was perfected?\n\n3.\n\nA buyer in the ordinary course of business is usually one buying inventory. Why does it make sense that\nsuch a buyer should take free of a security interest created by his seller?\n\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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n414\n\n\x0c10.3 Rights of Creditor on Default and Disposition after\nRepossession\nLEARNING OBJECTIVES\n1.\n\nUnderstand that the creditor may sue to collect the debt.\n\n2.\n\nRecognize that more commonly the creditor will realize on the collateral\xe2\x80\x94repossess it.\n\n3.\n\nKnow how collateral may be disposed of upon repossession: by sale or by strict foreclosure.\n\nRights of Creditor on Default\nUpon default, the creditor must make an election: to sue, or to repossess.\n\nResort to Judicial Process\nAfter a debtor\xe2\x80\x99s default (e.g., by missing payments on the debt), the creditor could ignore the 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(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(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.\nThis 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n415\n\n\x0cwhose 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 10.5 "Cases".\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\n[2]\n\nexpensive.\xe2\x80\xa6Of course\xe2\x80\xa6all aspects of the disposition must be commercially reasonable.\xe2\x80\x9d Rendering the\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.\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 10.5 "Disposition after Repossession").\nFigure 10.5 Dispositions after Repossession\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n416\n\n\x0cSale\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\nSection 9-620(a). This is known as strict foreclosure. The debtor must consent to letting the creditor take\nthe collateral without a sale in a \xe2\x80\x9crecord authenticated after default,\xe2\x80\x9d or after default the creditor can send\nthe debtor a proposal for the creditor to accept the collateral, and the proposal is effective if not objected\nto within twenty days after it\xe2\x80\x99s sent.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n417\n\n\x0cSection 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 10.5 "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.\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\nKEY TAKEAWAY\nUpon default, the creditor may bring a lawsuit against the debtor to collect a judgment. But the whole\npurpose of secured transactions is to avoid this costly and time-consuming litigation. The more typical\nsituation is that the creditor repossesses 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 may then proceed against\nthe debtor for the deficiency. In consumer cases, the creditor cannot use strict foreclosure if 60 percent of\nthe purchase price has been paid.\n\nEXERCISES\n1.\n\nAlthough a creditor could sue the debtor, get a judgment against it, and collect on the judgment, usually\nthe creditor repossesses the collateral. Why is repossession the preferred method of realizing on the\nsecurity?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n418\n\n\x0c2.\n\nWhy is repossession allowed so long as it can be done without a breach of the peace?\n\n3.\n\nUnder what circumstances is strict foreclosure not allowed?\n\n[1] Here is an example of sophisticated online advertising for a repossession firm: SSR, \xe2\x80\x9cSouthern & Central Coast\nCalifornia Repossession Services,\xe2\x80\x9dhttp://www.simonsrecovery.com/index.htm.\n[2] Uniform Commercial Code, Section 9-609(a) (2), Official Comment 6.\n[3] Uniform Commercial Code, Section 9-611; Uniform Commercial Code, Section 9-610.\n[4] Uniform Commercial Code, 9-620(e); Uniform Commercial Code, Section 9-624.\n[5] Uniform Commercial Code, Section 1-203.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n419\n\n\x0c10.4 Suretyship\nLEARNING OBJECTIVES\n1.\n\nUnderstand what a surety is and why sureties are used in commercial transactions.\n\n2.\n\nKnow how suretyships are created.\n\n3.\n\nRecognize the general duty owed by the surety to the creditor, and the surety\xe2\x80\x99s defenses.\n\n4.\n\nRecognize the principal obligor\xe2\x80\x99s duty to the surety, and the surety\xe2\x80\x99s rights against the surety.\n\n5.\n\nUnderstand 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).\nA surety is one who promises to pay or perform an obligation owed by the principal debtor, and, strictly\nspeaking, the surety is primarily liable on the debt: the creditor can demand payment from the surety\nwhen the debt is due. The creditor is the person to whom the principal debtor (and the surety, strictly\nspeaking) owes an obligation. Very frequently, the creditor requires first that the debtor put up collateral\nto secure indebtedness, and\xe2\x80\x94in addition\xe2\x80\x94that the debtor engages a surety to make extra certain the\ncreditor is paid or performance is made. For example, David Debtor wants Bank to loan his corporation,\nDavid Debtor, Inc., $100,000. Bank says, \xe2\x80\x9cOkay, Mr. Debtor, we\xe2\x80\x99ll loan the corporation money, but we\nwant its computer equipment as security, and we want you personally to guarantee the debt if the\ncorporation can\xe2\x80\x99t pay.\xe2\x80\x9d Sometimes, though, the surety and the principal debtor may have no agreement\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n420\n\n\x0cbetween each other; the surety might have struck a deal with the creditor to act as surety without the\nconsent or knowledge of the principal debtor.\nA guarantor also is one who guarantees an obligation of another, and for practical purposes,\ntherefore, guarantor is usually synonymous with surety\xe2\x80\x94the terms are used pretty much\ninterchangeably. But here\xe2\x80\x99s the technical difference: a surety is usually a party to the original 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.\nFigure 10.6 Defenses of Principal Debtor and Surety\n\nTypes of Suretyship\nWhere there is an interest, public or private, that requires protection from the possibility of a 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n421\n\n\x0cthe 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 defendant\nput up a bond guaranteeing his appearance in court\xe2\x80\x94that\xe2\x80\x99s a type of suretyship where the bail-bonder is\nthe surety\xe2\x80\x94or that a plaintiff put up a bond indemnifying the defendant for the costs of delays caused by\nthe lawsuit\xe2\x80\x94a judicial bond. A bank will take out a bond on its employees in case they steal money from\nthe bank\xe2\x80\x94the bank teller, in this case, is the principal debtor (a fidelity bond). However, as we will see,\nsureties do not anticipate financial loss like insurance companies do: the surety expects, mostly, to be\nrepaid if it has to perform. The principal debtor goes to an insurance company and buys the bond\xe2\x80\x94the\nsuretyship policy. The cost of the premium depends on the surety company, the type of bond applied for,\nand the applicant\xe2\x80\x99s financial history. A sound estimate of premium costs is 1 percent to 4 percent, but if a\nsurety company classifies an applicant as high risk, the premium falls between 5 percent and 20 percent of\nthe bond amount. When the purchaser of real estate agrees to assume the seller\xe2\x80\x99s mortgage (promises to\npay the mortgage debt), the seller then becomes a surety: unless the mortgagee releases the seller (not\nlikely), the seller has to pay if the buyer defaults.\n\nCreation of the Suretyship\nSuretyship can arise only through contract. The general principles of contract law apply to 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\ncontracts that the promise by one person to pay or perform for the debts or defaults of another must be\nevidenced by 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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n422\n\n\x0cCreditors 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 10.5 "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 all\nalong the principal is able to perform.\n\nReimbursement\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n423\n\n\x0cSubrogation\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\nof subrogation 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 ascosureties. A surety who in performing its own obligation\nto the creditor winds up paying more than its proportionate share is entitled to contribution from the\ncosureties.\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, and 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\nthough 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 wants 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n424\n\n\x0cdefense 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\xe2\x80\xa2\n\nRelease of the principal. Whenever a creditor releases the principal, the surety is discharged, unless\nthe surety consents to remain liable or the creditor expressly reserves her rights against the surety.\nThe creditor\xe2\x80\x99s release of the surety, though, does not release the principal debtor because the debtor is\nliable 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 mortgage\nrisks losing the security for the loan and might also inadvertently release a surety, but the failure of\nthe creditor to resort first to collateral is no defense.\n\n\xe2\x80\xa2\n\nStatute of frauds. Suretyship contracts are among those required to be evidenced by some 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 debtor\xe2\x80\x99s\nability 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 of\nconsideration (unless promissory estoppel can be substituted or unless no separate consideration is\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n425\n\n\x0cnecessary because the surety\xe2\x80\x99s and debtor\xe2\x80\x99s obligations arise at the same time), and creditor\xe2\x80\x99s fraud or\nduress on surety. However, fraud by the principal debtor on the surety to induce the suretyship will\nnot release the surety if the creditor extended credit in good faith; if the creditor knows of the fraud\nperpetrated by the debtor on the surety, the surety may avoid liability. See Figure 10.6 "Defenses of\nPrincipal Debtor and Surety".\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\nThe following are defenses of both principal debtor and surety:\n\xe2\x80\xa2\n\nMaterial breach by creditor\n\n\xe2\x80\xa2\n\nLack of mutual assent, failure of consideration\n\n\xe2\x80\xa2\n\nCreditor\xe2\x80\x99s fraud, duress, or misrepresentation of debtor\n\n\xe2\x80\xa2\n\nImpossibility or illegality of performance\n\n\xe2\x80\xa2\n\nMaterial and fraudulent alteration of the contract\n\n\xe2\x80\xa2\n\nStatute of limitations\n\nThe following are defenses of surety only:\n\xe2\x80\xa2\n\nFraud or duress by creditor on surety\n\no\n\nIllegality of suretyship contract\n\no\n\nSurety\xe2\x80\x99s incapacity\n\no\n\nFailure of consideration for surety contract (unless excused)\n\no\n\nStatute of frauds\n\no\n\nActs of creditor or debtor materially affecting surety\xe2\x80\x99s obligations:\n\n\xef\x82\xa7\n\nRefusal by creditor to accept tender of performance\n\n\xef\x82\xa7\n\nRelease of principal debtor without surety\xe2\x80\x99s consent\n\n\xef\x82\xa7\n\nRelease of surety\n\n\xef\x82\xa7\n\nRelease, surrender, destruction, or impairment of collateral\n\n\xef\x82\xa7\n\nExtension of time on principal debtor\xe2\x80\x99s obligation\n\n\xef\x82\xa7\n\nModification of debtor\xe2\x80\x99s duties, place, amount, or manner of debtor\xe2\x80\x99s obligations\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n426\n\n\x0cKEY TAKEAWAY\nCreditors often require not only the security of collateral from the debtor but also that the debtor\nengage a surety. A contract of suretyship is a type of insurance policy, where the surety (insurance\ncompany) promises the creditor that if the principal debtor fails to perform, the surety will undertake\ngood-faith performance instead. A difference between insurance and suretyship, though, is that the\nsurety is entitled to reimbursement by the principal debtor if the surety pays out. The surety is also\nentitled, where appropriate, to exoneration, subrogation, and contribution. The principal debtor and the\nsurety both have some defenses available: some are personal to the debtor, some are joint defenses,\nand some are personal to the surety.\n\nEXERCISES\n1.\n\nWhy isn\xe2\x80\x99t collateral put up by the debtor sufficient security for the creditor\xe2\x80\x94why is a surety often\nrequired?\n\n2.\n\nHow can it be said that sureties do not anticipate financial losses like insurance companies do? What\xe2\x80\x99s\nthe difference, and how does the surety avoid losses?\n\n3.\n\nWhy does the creditor\xe2\x80\x99s failure to perfect a security interest discharge the surety from liability? Why\ndoesn\xe2\x80\x99t failure of the creditor to resort first to perfected collateral discharge the surety?\n\n4.\n\nWhat is the difference between a guarantor and a surety?\n\n[1] American Druggists\xe2\x80\x99 Ins. Co. v. Shoppe, 448 N.W.2d 103, Minn. App. (1989).\n[2] Here is an example of the required notice: Federal Trade Commission, \xe2\x80\x9cFacts for Consumers: The Credit\nPractices 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\n427\n\n\x0c10.5 Cases\nPerfection by Mere Attachment; Priorities\nIn re NICOLOSI\n4 UCC Rep. 111 (Ohio 1966)\n\nPreliminary Statement and Issues\nThis matter is before the court upon a petition by the trustee to sell a diamond ring in his 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.\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.\nNo judicial precedents have been cited in the briefs.\nUnder 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n428\n\n\x0cby 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\nThe difficulty is that the code provisions use terms arising in commercial circles which have different\nsemantically 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.\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.\nAnother problem is implicit, although not covered by the briefs.\nBy the foregoing summary analysis, it is apparent that the diamond ring, when the interest of 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 science question.\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.\nThe 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\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.\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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n429\n\n\x0cOrdered, 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\nCASE QUESTIONS\n1.\n\nWhy didn\xe2\x80\x99t the jewelry store, Rike-Kumler, file a financing statement to protect its security interest in\nthe ring?\n\n2.\n\nHow did the bankruptcy trustee get the ring?\n\n3.\n\nWhat argument did the trustee make as to why he should be able to take the ring as an asset\nbelonging to the estate of the debtor? What did the court determine on this issue?\n\nRepossession and Breach of the Peace\nPantoja-Cahue v. Ford Motor Credit Co.\n872 N.E.2d 1039 (Ill. App. 2007)\nPlaintiff Mario Pantoja-Cahue filed a six-count complaint seeking damages from defendant Ford 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\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\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n430\n\n\x0crepossession 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,\namong 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\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. * * *\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[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).\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\nrepossession is a breach of the peace in violation of section 2A-525(3).\nThere are no Illinois cases analyzing the meaning of the term \xe2\x80\x9cbreach of the peace\xe2\x80\x9d as used in 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n431\n\n\x0cmay, 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\nany use in resolving the issue, is Chrysler Credit Corp. v. Koontz, 277 Ill.App.3d 1078, 214 Ill. Dec. 726,\n661 N.E.2d 1171 (1996).\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\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 sufficient.\xe2\x80\x9d\xe2\x80\xa6\n[The Koontz court] held the circumstances of the repossession did not amount to a breach the peace.\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\ndriveway without entering any gates, doors or other barricades was accomplished without breach of the\npeace).\xe2\x80\xa6\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n432\n\n\x0cAlthough 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\xe2\x80\xa6 [W]e come to essentially the same conclusion: where 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.\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-trespassers 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.\n\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n433\n\n\x0cWe 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 repossession\nmay constitute a breach of the peace.\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\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.\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\nHe 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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n434\n\n\x0cbasis 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.]\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\nCASE QUESTIONS\n1.\n\nUnder what circumstances, if any, would breaking into a locked garage to repossess a car not be\nconsidered a breach of the peace?\n\n2.\n\nThe court did not decide that a breach of the peace had occurred. What would determine that such a\nbreach had occurred?\n\n3.\n\nWhy did the court dismiss the plaintiff\xe2\x80\x99s claim (under UCC Article 2A) that it was unconscionable of\nFord to trick him into signing a lease when he thought he was signing a purchase contract? Would that\nsection of Article 2A make breaking into his garage unconscionable?\n\n4.\n\nWhat alternatives had Ford besides taking the car from the plaintiff\xe2\x80\x99s locked garage?\n\n5.\n\nIf it was determined on remand that a breach of the peace had occurred, what happens to Ford?\n\nDefenses of the Principal Debtor as against Reimbursement to Surety\nFidelity and Deposit Co. of Maryland v. Douglas Asphalt Co.\n338 Fed.Appx. 886, 11th Cir. Ct. (2009)\n\nPer Curium: [1]\nThe Georgia Department of Transportation (\xe2\x80\x9cGDOT\xe2\x80\x9d) contracted with Douglas Asphalt 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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n435\n\n\x0cexecuted 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.\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.\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\nthat 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.\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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n436\n\n\x0cdistrict 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.\nFinding no error, we affirm the judgment of the district court.\n\nCASE QUESTIONS\n1.\n\nWhy were Douglas Asphalt and the Spiveys supposed to pay the sureties nearly $15.5 million?\n\n2.\n\nWhat did the plaintiffs claim the defendant sureties did wrong as relates to how much money they\nspent to cure the default?\n\n3.\n\nWhat is a \xe2\x80\x9ccontest of the default\xe2\x80\x9d?\n\n4.\n\nWhy would the sureties probably not want the principal involved in the project?\n\n[1] Latin for \xe2\x80\x9cby the court.\xe2\x80\x9d A decision of an appeals court as a whole in which no judge is identified as the specific\nauthor.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n437\n\n\x0c10.6 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.\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.\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.\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.\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\nalso 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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n438\n\n\x0cwithout knowledge of the security interest, if the goods are used for personal, family, or household\npurposes.\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.\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.\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\nEXERCISES\n1.\n\nKathy Knittle borrowed $20,000 from Bank to buy inventory to sell in her knit shop and signed a\nsecurity agreement listing as collateral the entire present and future inventory in the shop, including\nproceeds from the sale of inventory. Bank filed no financing statement. A month later, Knittle\nborrowed $5,000 from Creditor, who was aware of Bank\xe2\x80\x99s security interest. Knittle then declared\nbankruptcy. Who has priority, Bank or Creditor?\n\n2.\n\nAssume the same facts as in Exercise 1, except Creditor\xe2\x80\x94again, aware of Bank\xe2\x80\x99s security interest\xe2\x80\x94\nfiled a financing statement to perfect its interest. Who has priority, Bank or Creditor?\n\n3.\n\nHarold and Wilma are married. First Bank has a mortgage on their house, and it covers after-acquired\nproperty. Because Harold has a new job requiring travel to neighboring cities, they purchase a second\ncar for Wilma\xe2\x80\x99s normal household use, financed by Second Bank. They sign a security agreement;\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n439\n\n\x0cSecond Bank files nothing. If they were to default on their house payments, First Bank could repossess\nthe house; could it repossess the car, too?\n4.\na.\n\nKathy Knittle borrowed $20,000 from Bank to buy inventory to sell in her knit shop and signed\na security agreement listing her collateral\xe2\x80\x94present and future\xe2\x80\x94as security for the loan.\nCarlene Customer bought yarn and a tabletop loom from Knittle. Shortly thereafter, Knittle\ndeclared bankruptcy. Can Bank get the loom from Customer?\n\nb.\n\nAssume that the facts are similar to those in Exercise 4a, except that the loom that Knittle sold\nhad been purchased from Larry Loomaker, who had himself given a secured interest in it (and\nthe other looms he manufactured) from Fine Lumber Company (FLC) to finance the purchase\nof the lumber to make the looms. Customer bought the loom from Knittle (unaware of\nLoomaker\xe2\x80\x99s situation); Loomaker failed to pay FLC. Why can FLC repossess the loom from\nCustomer?\n\nc.\n\nWhat recourse does Customer have now?\nCreditor loaned Debtor $30,000 with the provision that the loan was callable by Creditor with\n\nsixty days\xe2\x80\x99 notice to Debtor. Debtor, having been called for repayment, asked for a ninety-day\nextension, which Creditor assented to, provided that Debtor would put up a surety to secure\nrepayment. Surety agreed to serve as surety. When Debtor defaulted, Creditor turned to Surety for\npayment. Surety asserted that Creditor had given no consideration for Surety\xe2\x80\x99s promise, and therefore\nSurety was not bound. Is Surety correct?\n\na.\n\nMrs. Ace said to University Bookstore: \xe2\x80\x9cSell the books to my daughter. I\xe2\x80\x99ll pay for them.\xe2\x80\x9d When\nUniversity Bookstore presented Mrs. 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 defense. Is this a good defense?\nb.\n\nDefendant ran a stop sign and crashed into Plaintiff\xe2\x80\x99s car, causing $8,000 damage. Plaintiff\xe2\x80\x99s\nattorney orally negotiated with Defendant\xe2\x80\x99s insurance company, Goodhands Insurance, to\nsettle the case. Subsequently, Goodhands denied liability and refused to pay, and it raised the\nstatute of frauds as a defense, asserting that any promise by it to pay for its insured\xe2\x80\x99s\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n440\n\n\x0cnegligence would have to be in writing to be enforceable under the statute\xe2\x80\x99s suretyship clause.\nIs Goodhands\xe2\x80\x99s defense valid?\n\na.\n\nFirst Bank has a security interest in equipment owned by Kathy Knittle in her Knit Shop. If Kathy\ndefaults on her loan and First Bank lawfully repossesses, what are the bank\xe2\x80\x99s options? Explain.\nb.\n\nSuppose, instead, that First Bank had a security interest in Kathy\xe2\x80\x99s home knitting machine,\nworth $10,000. She paid $6,200 on the machine and then defaulted. Now what are the bank\xe2\x80\x99s\noptions?\n\nSELF-TEST QUESTIONS\n1.\na.\n\nCreditors may obtain security\nby agreement with the debtor\n\nb.\n\nthrough operation of law\n\nc.\n\nthrough both of the above\n\nd.\n\nthrough neither of the above\nUnder UCC Article 9, when the debtor has pledged collateral to the creditor, what other\ncondition is required for attachment of the security interest?\n\na.\n\nA written security agreement must be authenticated by the debtor.\nb.\n\nThere must be a financing statement filed by or for the creditor.\n\nc.\n\nThe secured party received consideration.\n\nd.\n\nThe debtor must have rights in the collateral.\nTo perfect a security interest, one may\n\na.\n\nfile a financing statement\nb.\n\npledge collateral\n\nc.\n\ntake a purchase-money security interest in consumer goods\n\nd.\n\ndo any of the above\nPerfection benefits the secured party by\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n441\n\n\x0ca.\n\nkeeping the collateral out of the debtor\xe2\x80\x99s reach\nb.\n\npreventing another creditor from getting a secured interest in the collateral\n\nc.\n\nobviating the need to file a financing statement\n\nd.\n\nestablishing who gets priority if the debtor defaults\nCreditor filed a security interest in inventory on June 1, 2012. Creditor\xe2\x80\x99s interest takes\npriority over which of the following?\n\na.\n\na purchaser in the ordinary course of business who bought on June 5\nb.\n\nmechanic\xe2\x80\x99s lien filed on May 10\n\nc.\n\npurchase-money security interest in after-acquired property who filed on May 15\n\nd.\n\njudgment lien creditor who filed the judgment on June 10\n\nSELF-TEST ANSWERS\n1.\n\nc\n\n2.\n\nd\n\n3.\n\nd\n\n4.\n\nd\n\n5.\n\nd\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n442\n\n\x0cChapter 11\nMortgages and Nonconsensual Liens\nLEARNING OBJECTIVES\nAfter reading this chapter, you should understand the following:\n1.\n\nThe basic concepts of mortgages\n\n2.\n\nHow the mortgage is created\n\n3.\n\nPriorities with mortgages as security devices\n\n4.\n\nTermination of the mortgage\n\n5.\n\nOther methods of using real estate as security\n\n6.\n\nNonconsensual liens\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n443\n\n\x0c11.1 Uses, History, and Creation of Mortgages\nLEARNING OBJECTIVES\n1.\n\nUnderstand the terminology used in mortgage transactions, and how mortgages are used as security\ndevices.\n\n2.\n\nKnow a bit about the history of mortgages.\n\n3.\n\nUnderstand how the mortgage is created.\n\nHaving discussed in Chapter 10 "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 11.1 "Security Arrangements").\nFigure 11.1 Security Arrangements\n\nDefinitions\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n444\n\n\x0ctypical 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 10 "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\nShort 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n445\n\n\x0cbecame 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.\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.\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.\nThe law did not rest there. Mortgagees won a measure of relief in the development of the foreclosure. On\ndefault, the mortgagee would seek a court order giving the mortgagor a fixed time\xe2\x80\x94perhaps six months or\na year\xe2\x80\x94within which to pay off the debt; under the court decree, failure meant that the mortgagor was\nforever foreclosed from asserting his right of redemption. This strict foreclosure gave the mortgagee\noutright title at the end of the time period.\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\nin Section 11.2 "Priority, Termination of the Mortgage, and Other Methods of Using Real Estate as\nSecurity".)\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n446\n\n\x0cCreation 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 in Chapter 9 "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\nunexpected 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.\nRed-lining. 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,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n447\n\n\x0cconsistent 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. It is enough here to recall that in a note (really a type of IOU), the mortgagor\npromises to pay a specified principal sum, plus interest, by a certain date or dates. The note is the\nunderlying obligation for which the mortgage serves as security. Without the note, the mortgagee would\nhave an empty document, since the mortgage would secure nothing. Without a mortgage, a note is still\nquite valid, evidencing the debtor\xe2\x80\x99s personal obligation.\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 entire\nprincipal and interest will become due immediately at the lender\xe2\x80\x99s option. Why an acceleration clause?\nWithout it, the lender would be powerless to foreclose the entire mortgage when the mortgagor defaulted\nbut would have to wait until the expiration of the note\xe2\x80\x99s term. Although the acceleration clause is routine,\nit will not be enforced unless the mortgagee acts in an equitable and fair manner. The problem arises\nwhere the mortgagor\xe2\x80\x99s default was the result of some unconscionable conduct of the mortgagee, such as\nrepresenting to the mortgagee that she might take a sixty-day \xe2\x80\x9choliday\xe2\x80\x9d from having to make payments.\nIn Paul H. Cherry v. Chase Manhattan Mortgage Group (Section 11.4 "Cases"), the equitable powers of\nthe court were invoked to prevent acceleration.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n448\n\n\x0cThe 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 in Figure 11.2 "Sample Mortgage Form".\nFigure 11.2 Sample Mortgage Form\n\nKEY TAKEAWAY\nAs a mechanism of security, a mortgage is a promise by the debtor (mortgagor) to repay the creditor\n(mortgagee) for the amount borrowed or credit extended, with real estate put up as security. If the\nmortgagor doesn\xe2\x80\x99t pay as promised, the mortgagee may repossess the real estate. Mortgage law has\nancient roots and brings 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 be reimbursed for\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n449\n\n\x0cany value above that necessary to pay the debt and the expenses of foreclosure. Mortgage law is\nregulated by state and federal statute.\n\nEXERCISES\n1.\n\nWhat role did the right of redemption play in courts of equity changing the substance of a mortgage\nfrom an actual transfer of title to the mortgagee to a mere lien on the property?\n\n2.\n\nWhat abuses did the federal RESPA address?\n\n3.\n\nWhat are the two documents most commonly associated with mortgage transactions?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n450\n\n\x0c11.2 Priority, Termination of the Mortgage, and Other Methods\nof Using Real Estate as Security\nLEARNING OBJECTIVES\n1.\n\nUnderstand why it is important that the mortgagee (creditor) record her interest in the debtor\xe2\x80\x99s real\nestate.\n\n2.\n\nKnow the basic rule of priority\xe2\x80\x94who gets an interest in the property first in case of default\xe2\x80\x94and the\nexceptions to the rule.\n\n3.\n\nRecognize the three ways mortgages can be terminated: payment, assumption, and foreclosure.\n\n4.\n\nBe familiar with other methods (besides mortgages) by which real property can be used as security for\na creditor.\n\nPriorities in Real Property Security\nYou may recall from Chapter 10 "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\nby recording the mortgage. Recording is the act of giving public notice of changes in interests in real\nestate. Recording was created by statute; it did not exist at common law. The typical recording statute\ncalls for a transfer of title or mortgage to be placed in a particular county office, usually the auditor,\nrecorder, or register of deeds.\nA 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n451\n\n\x0cExceptions 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 10 "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.\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.\nCalabash 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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n452\n\n\x0cTermination 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 11.4\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 11.3 "\xe2\x80\x9cSubject to\xe2\x80\x9d Sales versus\nAssumption"). 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n453\n\n\x0cFigure 11.3 \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, by\nwhich the entire principal and interest become due when the property is sold, thus forcing the purchaser\nto get financing at the higher rates. The clause is a device for preventing subsequent purchasers from\nassuming loans with lower-than-market interest rates. Although many state courts at one time refused to\nenforce the due-on-sale clause, Congress reversed this trend when it enacted the Garn\xe2\x80\x93St. Germain\n[1]\n\nDepository Institutions Act in 1982. The act preempts state laws and upholds the validity of due-on-sale\nclauses. When interest rates are low, banks have no interest in enforcing such clauses, and there are ways\nto work around the due-on-sale clause.\n\nForeclosure\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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n454\n\n\x0cby 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 11.4 "Foreclosure").\nThe first type is judicial sale. The mortgagee seeks a court order authorizing the sale to be conducted by a\npublic 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.\nFigure 11.4 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\n455\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 non-judicial means.\nAlpha Imperial Building, LLC v. Schnitzer Family Investment, LLC, Section 11.4 "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 the\nseller over a period of years. Until the final payment, title belongs to the seller. The contract will specify\nthe type of deed to be conveyed at closing, the terms of payment, the buyer\xe2\x80\x99s duty to pay taxes and insure\nthe premises, and the seller\xe2\x80\x99s right to accelerate on default. The buyer\xe2\x80\x99s particular concern in this type of\nsale is whether the seller in fact has title. The buyers can protect themselves by requiring proof of title and\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n456\n\n\x0ctitle insurance when the contract is signed. Moreover, the buyer should record the installment contract to\nprotect against the seller\xe2\x80\x99s attempt to convey title to an innocent third-party purchaser while the contract\nis in effect.\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\nKEY TAKEAWAY\nThe general rule on priority in real property security is that the first creditor to record its interest\nprevails over subsequent creditors. There are some exceptions; the most familiar is that the seller of a\nfixture on a purchase-money security interest has priority over a previously recorded mortgagee. The\nmortgage will terminate by payment, assumption by a new buyer (with a novation releasing the old\nbuyer), and foreclosure. In a judicial-sale foreclosure, a court authorizes the property\xe2\x80\x99s sale; in a\npower-of-sale foreclosure, no court approval is required. In most states, the mortgagor whose\nproperty was foreclosed is given some period of time\xe2\x80\x94six months or a year\xe2\x80\x94to redeem the property;\notherwise, the sale is done, but the debtor may be liable for the deficiency, if any. The deed of trust\navoids any judicial involvement by having the borrower convey the land to a disinterested trustee for\nthe benefit of the lender; the trustee sells it upon default, with the proceeds (after expenses) going to\nthe lender. Another method of real property security is a land contract: title shifts to the buyer only at\nthe end of the term of payments.\n\nEXERCISES\n1.\n\nA debtor borrowed $350,000 to finance the purchase of a house, and the bank recorded its interest on\nJuly 1. On July 15, the debtor bought $10,000 worth of replacement windows from Window Co.;\nWindow Co. recorded its purchase-money security interest that day, and the windows were installed.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n457\n\n\x0cFour years later, the debtor, in hard financial times, declared bankruptcy. As between the bank and\nWindows Co., who will get paid first?\n2.\n\nUnder what interest rate circumstances would banks insist on a due-on-sale clause? Under what\ninterest rate circumstance would banks not object to a new person assuming the mortgage?\n\n3.\n\nWhat is the primary advantage of the deed of trust? What is the primary advantage of the land\ncontract?\n\n4.\n\nA debtor defaulted on her house payments. Under what circumstances might a court not allow the\nbank\xe2\x80\x99s foreclosure on the property?\n\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, California,\nColorado, District of Columbia, Georgia, Hawaii, Idaho, Iowa, Michigan, Minnesota, Mississippi, Missouri, Montana,\nNevada, New Hampshire, North Carolina, Oklahoma, Oregon, Rhode Island, South Dakota, Tennessee, Texas, Utah,\nVirginia, Washington, West Virginia, Wisconsin, and Wyoming.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n458\n\n\x0c11.3 Nonconsensual Lien\nLEARNING OBJECTIVES\n1.\n\nUnderstand the nonconsensual liens issued by courts\xe2\x80\x94attachment liens and judgment liens\xe2\x80\x94and\nhow they are created.\n\n2.\n\nRecognize other types of nonconsensual liens: mechanic\xe2\x80\x99s lien, possessory lien, 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\nMechanic\xe2\x80\x99s Lien\nOverview\nThe most common nonconsensual lien on real estate is the mechanic\xe2\x80\x99s lien. A mechanic\xe2\x80\x99s lien can be\nobtained by one who furnishes labor, services, or materials to improve real estate: this is statutory, and\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n459\n\n\x0cthe 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 11.3.3 "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.\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 11.5 "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.\nFigure 11.5Subcontractors\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n460\n\n\x0cthe 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\nsold 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 11.4 "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. This is\nthe right to continue to keep the goods on which work has been performed or for which materials have\nbeen 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 non-possessory and relate only to work done to improve real\nproperty.\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\n461\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.\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\nKEY TAKEAWAY\nThere are four types of nonconsensual liens: (1) court-decreed liens are attachment liens, which\nprevent a person from disposing of assets pending a lawsuit, and judgment liens, which allow the\nprevailing party in a lawsuit to take property belonging to the debtor to satisfy the judgment; (2)\nmechanics\xe2\x80\x99 liens are authorized 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 personal property allow\none in possession of goods to keep them to satisfy a claim for work done or storage of them; and (4)\ntax liens are enforced by the government to satisfy outstanding tax liabilities and may be assessed\nagainst real or personal property.\n\nEXERCISES\n1.\n\nThe mortgagor\xe2\x80\x99s interests are protected in a judicial foreclosure by a court\xe2\x80\x99s oversight of the process;\nhow is the mortgagor\xe2\x80\x99s interest protected when a deed of trust is used?\n\n2.\n\nWhy is the deed of trust becoming increasingly popular?\n\n3.\n\nWhat is the rationale for the common-law possessory lien?\n\n4.\n\nMike Mechanic repaired Alice Ace\xe2\x80\x99s automobile in his shop, but Alice didn\xe2\x80\x99t have enough money to\npay for the repairs. May Mike have a mechanic\xe2\x80\x99s lien on the car? A possessory lien?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n462\n\n\x0c5.\n\nWhy does federal law exempt unemployment benefits, books and tools of a trade, workers\xe2\x80\x99\ncompensation, minimum amounts of wages and salary, personal effects, furniture, fuel, and other\nsuch items from the sweep of a tax lien?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n463\n\n\x0c11.4 Cases\nDenial of Mortgagee\xe2\x80\x99s Right to Foreclose; Erroneous Filings; Lost Instruments\nPaul H. Cherry v. Chase Manhattan Mortgage Group\n190 F.Supp.2d 1330 (Fed. Dist. Ct. FL 2002)\nBackground\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\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,\n2001, 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\nForeclosure\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],\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n464\n\n\x0cand 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\nMortgage\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 neither possibility nor existence of a third party\ninterest. Although Cherry argues under Biggs v. Smith, 184 So. 106, 107 (1938), that a recorded\nsatisfaction of mortgage is \xe2\x80\x9cprima facie evidence of extinguishment of a mortgage lien,\xe2\x80\x9d Biggs does not\napply this standard to mortgage rights affected by a mistake in the satisfaction.\nTherefore, on these facts, this Court acknowledges that a vacatur is a proper remedy for Chase to 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\nTender\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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n465\n\n\x0cpayments 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.]\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.\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.\nSecond, 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.]\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n466\n\n\x0cpayment 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.\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\nmisunderstanding 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 Chases\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\nReestablishment of the Lost Note and Mortgage\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n467\n\n\x0cThis 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:\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\nCASE QUESTIONS\n1.\n\nWhen Chase figured out that it had issued a Satisfaction of Mortgage erroneously, what did it file to\nrectify the error?\n\n2.\n\nCherry had not made any mortgage payments between the time Chase sent the erroneous\nSatisfaction of Mortgage notice to him and the time of the court\xe2\x80\x99s decision in this case. The court\nlisted five circumstances in which a mortgagee (Chase here) might be denied the right to foreclose on\na delinquent account: which one applied here? The court said Chase had engaged in \xe2\x80\x9can apparent\nobfuscation of the case law before the court\xe2\x80\x9d? What obfuscation did it engage in?\n\n3.\n\nWhat did Cherry do with the mortgage payments after Chase erroneously told him the mortgage was\nsatisfied? What did the court say he should have done with the payments?\n\nMechanic\xe2\x80\x99s Lien Filed against Landlord for Payment of Tenant\xe2\x80\x99s Improvements\nF & D Elec. Contractors, Inc. v. Powder Coaters, Inc.\n567 S.E.2d 842 (S.C. 2002)\nFactual/ Procedural Background\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n468\n\n\x0cCoaters 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.\nThe 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.\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\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.\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 material man\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\nSouth Carolina\xe2\x80\x99s Mechanic\xe2\x80\x99s Lien Statute provides:\nA person to whom a debt is due for labor performed or furnished or for materials furnished and actually\nused in the erection, alteration, or repair of a building\xe2\x80\xa6by virtue of an agreement with, or by consent of,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n469\n\n\x0cthe 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.]\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.\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 material man\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 material\nman, as the Court of Appeals\xe2\x80\x99 opinion indicates. A determination that the required consent must come\nfrom the owner to the material man means the material man 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"\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 material man or\nsub-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 material man. We find the landlord/owner or\nhis agent is free to enter into a lease or agreement with a tenant which allows the tenant to direct the\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n470\n\n\x0cmodifications to the property which have been specifically consented to by the landlord/owner or his\nagent.\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.\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\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\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\nthe 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.\nClearly, if the landlord/owner or his agent gives consent directly to the material man, 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n471\n\n\x0cinstant 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. BG\nHolding 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 pay\nunder 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 any\nwork being performed by them on the site.\n\n\xe2\x80\xa2\n\nThe lease specifically provided that all work on the property was to be approved in writing by BG\nHolding.\n\n\xe2\x80\xa2\n\nDavid Weatherington of F & D testified he was looking to Powder Coaters, not BG Holding, for\npayment.\n\n\xe2\x80\xa2\n\nPowder Coaters acknowledged it was not authorized to bind BG Holding to pay for the modifications.\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 any\nliability\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 be\nnecessary for Powder Coaters to perform their work.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n472\n\n\x0c\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 so\nTaylor 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 testified\nthe following language granted him the authority to perform the electrical up fit, so that he was not\nrequired to submit the plans to BG Holding as required by a provision in the lease: \xe2\x80\x9cLessor shall allow\nLessee to put Office Trailer in Building. All Utilities necessary to handle Lessee\xe2\x80\x99s equipment shall be\npaid for by the Lessee including, but not limited to electricity, water, sewer, and gas.\xe2\x80\x9d (We note that\nBG Holding denies this interpretation, but insists it just requires the 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\nViewing 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.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n473\n\n\x0cConclusion\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 material man express or implied consent acknowledging he may\nbe held liable for the work.\nThe Court of Appeals\xe2\x80\x99 opinion is affirmed as modified.\n\nCASE QUESTIONS\n1.\n\nWhy did the lienor want to go after the landlord instead of the tenant?\n\n2.\n\nDid the landlord here know that there were electrical upgrades needed by the tenant?\n\n3.\n\nWhat kind of knowledge or acceptance did the court determine the landlord-owner needed to have or\ngive before a material man could have a lien on the real estate?\n\n4.\n\nWhat remedy has F & D (the material man) now?\n\nDeeds of Trust; Duties of Trustee\nAlpha Imperial Building, LLC v. Schnitzer Family Investment, LLC, II (SFI).\n2005 WL 715940, (Wash. Ct. App. 2005)\nApplewick, J.\nAlpha Imperial LLC challenges the validity of a non-judicial foreclosure sale on multiple 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n474\n\n\x0cMayur 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[.]\nPioneer 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.\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.\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.\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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n475\n\n\x0cAvenue 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\nAdministration 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\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.\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\n476\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.\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:\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.\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\nBuilding 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n477\n\n\x0c$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.\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.\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 In Steward [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\nin 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\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n478\n\n\x0cpercent 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.\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.\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\nextinguish 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\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n479\n\n\x0c\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.\nAffirmed.\n\nCASE QUESTIONS\n1.\n\nWhy did the plaintiff (Alpha) think the sale should have been set aside because of the location\nproblems?\n\n2.\n\nWhy did the court decide the trustee had no duty to reopen bidding?\n\n3.\n\nWhat is meant by \xe2\x80\x9cchilling bidding\xe2\x80\x9d? What argument did the plaintiff make to support its contention\nthat bidding was chilled?\n\n4.\n\nThe court notes precedent to the effect that a \xe2\x80\x9cgrossly inadequate\xe2\x80\x9d bid price has some definition.\nWhat is the definition? What percentage of the real estate\xe2\x80\x99s value in this case was the winning bid?\n\n5.\n\nA trustee is one who owes a fiduciary duty of the utmost loyalty and good faith to another, the\nbeneficiary. Who was the beneficiary here? What duty is owed to the junior lienholder (Alpha here)\xe2\x80\x94\nany duty?\n\n6.\n\nWhy did the defendants not get the attorneys\xe2\x80\x99 fee award they wanted?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n480\n\n\x0c11.5 Summary and Exercises\nSummary\nA mortgage is a means of securing a debt with real estate. The mortgagor, or borrower, gives the\nmortgage. The lender is the mortgagee, who holds the mortgage. On default, the mortgagee may foreclose\nthe mortgage, convening the security interest into title. In many states, the mortgagor has a statutory\nright of redemption after foreclosure.\nVarious statutes regulate the mortgage business, including the Truth in Lending Act, the Equal Credit\nOpportunity Act, the Real Estate Settlement Procedures Act, and the Home Mortgage Disclosure Act,\nwhich together prescribe a code of fair practices and require various disclosures to be made before the\nmortgage is created.\nThe mortgagor signs both a note and the mortgage at the closing. Without the note, the mortgage would\nsecure nothing. Most notes and mortgages contain an acceleration clause, which calls for the entire\nprincipal and interest to be due, at the mortgagee\xe2\x80\x99s option, if the debtor defaults on any payment.\nIn most states, mortgages must be recorded for the mortgagee to be entitled to priority over third parties\nwho might also claim an interest in the land. The general rule is \xe2\x80\x9cFirst in time, first in right,\xe2\x80\x9d although\nthere are exceptions for fixture filings and nonobligatory future advances. Mortgages are terminated by\nrepayment, novation, or foreclosure, either through judicial sale or under a power-of-sale clause.\nReal estate may also be used as security under a deed of trust, which permits a trustee to sell the land\nautomatically on default, without recourse to a court of law.\nNonconsensual liens are security interests created by law. These include court-decreed liens, such as\nattachment liens and judgment liens. Other liens are mechanic\xe2\x80\x99s liens (for labor, services, or materials\nfurnished in connection with someone\xe2\x80\x99s real property), possessory liens (for artisans working with\nsomeone else\xe2\x80\x99s personal properly), and tax liens.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n481\n\n\x0cEXERCISES\n1.\n\nAble bought a duplex from Carr, who had borrowed from First Bank for its purchase. Able took\ntitle subject to Carr\xe2\x80\x99s mortgage. Able did not make mortgage payments to First Bank; the bank\nforeclosed and sold the property, leaving a deficiency. Which is correct?\n\na.\n\nCarr alone is liable for the deficiency.\n\nb.\n\nAble alone is liable for the deficiency because he assumed the mortgage.\n\nc.\n\nFirst Bank may pursue either Able or Carr.\n\nd.\n\nOnly if Carr fails to pay will Able be liable.\nHarry borrowed $175,000 from Judith, giving her a note for that amount and a mortgage on his\ncondo. Judith did not record the mortgage. After Harry defaulted on his payments, Judith began\nforeclosure proceedings. Harry argued that the mortgage was invalid because Judith had failed to\nrecord it. Judith counter argues that because a mortgage is not an interest in real estate, recording is\nnot necessary. Who is correct? Explain.\nAssume in Exercise 2 that the documents did not contain an acceleration clause and that Harry\nmissed three consecutive payments. Could Judith foreclose? Explain.\nRupert, an automobile mechanic, does carpentry work on weekends. He built a detached garage\nfor Clyde for $20,000. While he was constructing the garage, he agreed to tune up Clyde\xe2\x80\x99s car for an\nadditional $200. When the work was completed, Clyde failed to pay him the $20,200, and Rupert\nclaimed a mechanic\xe2\x80\x99s lien on the garage and car. What problems, if any, might Rupert encounter in\nenforcing his lien? Explain.\nIn Exercise 4, assume that Clyde had borrowed $50,000 from First Bank and had given the bank a\nmortgage on the property two weeks after Rupert commenced work on the garage but several weeks\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n482\n\n\x0cbefore he filed the lien. Assuming that the bank immediately recorded its mortgage and that Rupert\xe2\x80\x99s\nlien is valid, does the mortgage take priority over the lien? Why?\nDefendant purchased a house from Seller and assumed the mortgage indebtedness to Plaintiff. All\nmonthly payments were made on time until March 25, 1948, when no more were made. On October\n8, 1948, Plaintiff sued to foreclose and accelerate the note. In February of 1948, Plaintiff asked to\nobtain a loan elsewhere and pay him off; he offered a discount if she would do so, three times,\nincreasing the amount offered each time. Plaintiff understood that Defendant was getting a loan from\nthe Federal Housing Administration (FHA), but she was confronted with a number of requirements,\nincluding significant property improvements, which\xe2\x80\x94because they were neighbors\xe2\x80\x94Plaintiff knew\nwere ongoing. While the improvements were being made, in June or July, he said to her, \xe2\x80\x9cJust let the\npayments go and we\xe2\x80\x99ll settle everything up at the same time,\xe2\x80\x9d meaning she need not make monthly\npayments until the FHA was consummated, and he\xe2\x80\x99d be paid from the proceeds. But then \xe2\x80\x9che\nchanged his tune\xe2\x80\x9d and sought foreclosure. Should the court order it?\n\nSELF-TEST QUESTIONS\n1.\n\nThe person or institution holding a mortgage is called\n\na.\n\nthe mortgagor\n\nb.\n\nthe mortgagee\n\nc.\n\nthe debtor\n\nd.\n\nnone of the above\nMortgages are regulated by\n\na.\n\nthe Truth in Lending Act\n\nb.\n\nthe Equal Credit Opportunity Act\n\nc.\n\nthe Real Estate Settlement Procedures Act\n\nd.\n\nall of the above\nAt the closing, a mortgagor signs\n\na.\n\nonly a mortgage\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n483\n\n\x0cb.\n\nonly a note\n\nc.\n\neither a note or the mortgage\n\nd.\n\nboth a note and the mortgage\nMortgages are terminated by\n\na.\n\nrepayment\nb.\n\nnovation\n\nc.\n\nforeclosure\n\nd.\n\nany of the above\n\nA lien ordered against a person\xe2\x80\x99s property to prevent its disposal during a lawsuit is called\na.\n\na judgment lien\n\nd.\n\nb.\n\nan attachment lien\n\nc.\n\na possessory lien\n\nnone of the above\n\nSELF-TEST ANSWERS\n1.\n\nb\n\n2.\n\nd\n\n3.\n\nd\n\n4.\n\nd\n\n5.\n\nb\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n484\n\n\x0cChapter 12\nBankruptcy\nLEARNING OBJECTIVES\nAfter reading this chapter, you should understand the following:\n1.\n\nA short history of US bankruptcy law\n\n2.\n\nAn overview of key provisions of the 2005 bankruptcy act\n\n3.\n\nThe basic operation of Chapter 7 bankruptcy\n\n4.\n\nThe basic operation of Chapter 11 bankruptcy\n\n5.\n\nThe basic operation of Chapter 13 bankruptcy\n\n6.\n\nWhat debtor\xe2\x80\x99s relief is available outside of bankruptcy\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n485\n\n\x0c12.1 Introduction to Bankruptcy and Overview of the 2005\nBankruptcy Act\nLEARNING OBJECTIVES\n1.\n\nUnderstand what law governs bankruptcy in the United States.\n\n2.\n\nKnow the key provisions of the law.\n\nThe Purpose of Bankruptcy Law\nBankruptcy law governs the rights of creditors and insolvent debtors who cannot pay their debts. In\nbroadest terms, bankruptcy deals with the seizure of the debtor\xe2\x80\x99s assets and their distribution to the\ndebtor\xe2\x80\x99s various creditors. The term derives from the Renaissance custom of Italian traders, who did their\ntrading from benches in town marketplaces. Creditors literally \xe2\x80\x9cbroke the bench\xe2\x80\x9d of a merchant who failed\nto pay his debts. The term banco rotta (broken bench) thus came to apply to business failures.\nIn the Victorian era, many people in both England and the United States viewed someone who became\nbankrupt as a wicked person. In part, this attitude was prompted by the law itself, which to a greater\ndegree in England and to a lesser degree in the United States treated the insolvent debtor as a sort of\nfelon. Until the second half of the nineteenth century, British insolvents could be imprisoned; jail for\ninsolvent debtors was abolished earlier in the United States. And the entire administration of bankruptcy\nlaw favored the creditor, who could with a mere filing throw the financial affairs of the alleged insolvent\ninto complete disarray.\nToday a different attitude prevails. Bankruptcy is understood as an aspect of financing, a system that\npermits creditors to receive an equitable distribution of the bankrupt person\xe2\x80\x99s assets and promises new\nhope to debtors facing impossible financial burdens. Without such a law, we may reasonably suppose that\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n486\n\n\x0cthe level of economic activity would be far less than it is, for few would be willing to risk being personally\nburdened forever by crushing debt. Bankruptcy gives the honest debtor a fresh start and resolves disputes\namong creditors.\n\nHistory of the Bankruptcy System; Bankruptcy Courts and Judges\nConstitutional Basis\nThe US Constitution prohibits the states from impairing the \xe2\x80\x9cobligation of a contract.\xe2\x80\x9d This means that no\nstate can directly provide a means for discharging a debtor unless the debt has been entirely paid. But the\nConstitution in Article I, Section 8, does give the federal government such a power by providing that\nCongress may enact a uniform bankruptcy law.\n\nBankruptcy Statutes\nCongress passed bankruptcy laws in 1800, 1841, and 1867. These lasted only a few years each. In 1898,\nCongress enacted the Bankruptcy Act, which together with the Chandler Act amendments in 1938, lasted\nuntil 1978. In 1978, Congress passed the Bankruptcy Reform Act, and in 2005, it adopted the current law,\nthe Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). This law is the subject of our\nchapter.\nAt the beginning of the twentieth century, bankruptcies averaged fewer than 20,000 per year. Even in\n1935, at the height of the Great Depression, bankruptcy filings in federal court climbed only to 69,000. At\nthe end of World War II, in 1945, they stood at 13,000. From 1950 on, the statistics show a steep increase.\nDuring the decade before the 1978 changes, bankruptcy filings in court averaged 181,000 a year\xe2\x80\x94reaching\na high of 254,000 in 1975. They soared to over 450,000 filings per year in the 1980s and mostly\nmaintained that pace until just before the 2005 law took effect (see Figure 12.1 "US Bankruptcies, 1980\xe2\x80\x93\n[1]\n\n2009"). The 2005 act\xe2\x80\x94preceded by \xe2\x80\x9cmassive lobbying largely by banks and credit card companies\xe2\x80\x9d \xe2\x80\x94\nwas intended by its promoters to restore personal responsibility and integrity in the bankruptcy system.\nThe law\xe2\x80\x99s critics said it was simply a way for the credit card industry to extract more money from\nconsumers before their debts were wiped away.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n487\n\n\x0cFigure 12.1 US Bankruptcies, 1980\xe2\x80\x932009\n\nBankruptcy Action.com, http://www.bankruptcyaction.com/USbankstats.htm, statistics from\nAdministrative Office of the Courts.\n\nBankruptcy Courts, Judges, and Costs\nEach federal judicial district has a US Bankruptcy Court, whose judges are appointed by US Courts of\nAppeal. Unless both sides agree otherwise, bankruptcy judges are to hear only bankruptcy matters (called\ncore proceedings). Bankruptcy trustees are government lawyers appointed by the US Attorney General.\nThey have administrative responsibilities in overseeing the proceedings.\nThe filing fee for a bankruptcy is about $200, depending upon the type of bankruptcy, and the typical\nlawyer\xe2\x80\x99s fee for uncomplicated cases is about $1,200\xe2\x80\x93$1,400.\n\nOverview of Bankruptcy Provisions\nThe BAPCPA provides for six different kinds of bankruptcy proceedings. Each is covered by its own\nchapter in the act and is usually referred to by its chapter number (see Figure 12.2 "Bankruptcy Options").\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n488\n\n\x0cFigure 12.2 Bankruptcy Options\n\nThe bankruptcy statute (as opposed to case law interpreting it) is usually referred to as the\nbankruptcy code. The types of bankruptcies are as follows:\n\xe2\x80\xa2\n\nChapter 7, Liquidation: applies to all debtors except railroads, insurance companies, most banks and\ncredit unions, and homestead associations.\n\n[2]\n\nA liquidation is a \xe2\x80\x9cstraight\xe2\x80\x9d bankruptcy proceeding. It\n\nentails selling the debtor\xe2\x80\x99s nonexempt assets for cash and distributing the cash to the creditors,\nthereby discharging the insolvent person or business from any further liability for the debt. About 70\npercent of all bankruptcy filings are Chapter 7.\n\xe2\x80\xa2\n\nChapter 9, Adjustment of debts of a municipality: applies to municipalities that are insolvent and\nwant to adjust their debts.\n\n[3]\n\n(The law does not suppose that a town, city, or county will go out of\n\nexistence in the wake of insolvency.)\n\xe2\x80\xa2\n\nChapter 11, Reorganization: applies to anybody who could file Chapter 7, plus railroads. It is the\nmeans by which a financially troubled company can continue to operate while its financial affairs are\nput on a sounder basis. A business might liquidate following reorganization but will probably take on\nnew life after negotiations with creditors on how the old debt is to be paid off. A company may\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n489\n\n\x0cvoluntarily decide to seek Chapter 11 protection in court, or it may be forced involuntarily into a\nChapter 11 proceeding.\n\xe2\x80\xa2\n\nChapter 12, Adjustment of debts of a family farmer or fisherman with regular annual income.\n\n[4]\n\nMany\n\nfamily farmers cannot qualify for reorganization under Chapter 13 because of the low debt ceiling, and\nunder Chapter 11, the proceeding is often complicated and expensive. As a result, Congress created\nChapter 12, which applies only to farmers whose total debts do not exceed $1.5 million.\n\xe2\x80\xa2\n\nChapter 13, Adjustment of debts of an individual with regular income: applies only to individuals (no\ncorporations or partnerships) with debt not exceeding about $1.3 million.\n\n[5]\n\nThis chapter permits an\n\nindividual with regular income to establish a repayment plan, usually either a composition (an\nagreement among creditors, discussed in Section 12.5 "Alternatives to Bankruptcy", \xe2\x80\x9cAlternatives to\nBankruptcy\xe2\x80\x9d) or an extension (a stretch-out of the time for paying the entire debt).\n\xe2\x80\xa2\n\nChapter 15, Ancillary and other cross-border cases: incorporates the United Nations\xe2\x80\x99 Model Law on\nCross-Border Insolvency to promote cooperation among nations involved in cross-border cases and is\nintended to create legal certainty for trade and investment. \xe2\x80\x9cAncillary\xe2\x80\x9d refers to the possibility that a\nUS debtor might have assets or obligations in a foreign country; those non-US aspects of the case are\n\xe2\x80\x9cancillary\xe2\x80\x9d to the US bankruptcy case.\n\nThe BAPCPA includes three chapters that set forth the procedures to be applied to the various\nproceedings. Chapter 1, \xe2\x80\x9cGeneral Provisions,\xe2\x80\x9d establishes who is eligible for relief under the act. Chapter\n3, \xe2\x80\x9cCase Administration,\xe2\x80\x9d spells out the powers of the various officials involved in the bankruptcy\nproceedings and establishes the methods for instituting bankruptcy cases. Chapter 5, \xe2\x80\x9cCreditors, the\nDebtor, and the Estate,\xe2\x80\x9d deals with the debtor\xe2\x80\x99s \xe2\x80\x9cestate\xe2\x80\x9d\xe2\x80\x94his or her assets. It lays down ground rules for\ndetermining which property is to be included in the estate, sets out the powers of the bankruptcy trustee\nto \xe2\x80\x9cavoid\xe2\x80\x9d (invalidate) transactions by which the debtor sought to remove property from the estate, orders\nthe distribution of property to creditors, and sets forth the duties and benefits that accrue to the debtor\nunder the act.\nTo illustrate how these procedural chapters (especially Chapter 3 and Chapter 5) apply, we focus on the\nmost common proceeding: liquidation (Chapter 7). Most of the principles of bankruptcy law discussed in\nconnection with liquidation apply to the other types of proceedings as well. However, some principles\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n490\n\n\x0cvary, and we conclude the chapter by noting special features of two other important proceedings\xe2\x80\x94Chapter\n13 and Chapter 11.\n\nKEY TAKEAWAY\nBankruptcy law\xe2\x80\x99s purpose is to give the honest debtor a fresh start and to resolve disputes among\ncreditors. The most recent amendments to the law were effective in 2005. Bankruptcy law provides\nrelief to six kinds of debtors: (1) Chapter 7, straight bankruptcy\xe2\x80\x94liquidation\xe2\x80\x94applies to most debtors\n(except banks and railroads); (2) Chapter 9 applies to municipalities; (3) Chapter 11 is business\nreorganization; (4) Chapter 12 applies to farmers; (5) Chapter 13 is for wage earners; and (6) Chapter\n15 applies to cross-border bankruptcies. The bankruptcy statutes also have several chapters that cover\nprocedures of bankruptcy proceedings.\n\nEXERCISES\n1.\n\nWhy is bankruptcy law required in a modern capitalistic society?\n\n2.\n\nWho does the bankruptcy trustee represent?\n\n3.\n\nThe three most commonly filed bankruptcies are Chapter 7, 11, and 13. Who gets relief under those\nchapters?\n\n[1] CCH Bankruptcy Reform Act Briefing, \xe2\x80\x9cBankruptcy Abuse Prevention and Consumer Protection Act of 2005,\xe2\x80\x9d\nApril 2005, http://www.cch.com/bankruptcy/bankruptcy_04-21.pdf.\n[2] 11 United States Code, Section 109(b).\n[3] 11 United States Code, Section 109(c).\n[4] 11 United States Code, Section 109(f).\n[5] 11 United States Code, Section 109(e).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n491\n\n\x0c12.2 Case Administration; Creditors\xe2\x80\x99 Claims; Debtors\xe2\x80\x99\nExemptions and Dischargeable Debts; Debtor\xe2\x80\x99s Estate\nLEARNING OBJECTIVES\n1.\n\nUnderstand the basic procedures involved in administering a bankruptcy case.\n\n2.\n\nRecognize the basic elements of creditors\xe2\x80\x99 rights under the bankruptcy code.\n\n3.\n\nUnderstand the fundamentals of what property is included in the debtor\xe2\x80\x99s estate.\n\n4.\n\nIdentify some of the debtor\xe2\x80\x99s exemptions\xe2\x80\x94what property can be kept by the debtor.\n\n5.\n\nKnow some of the debts that cannot be discharged in bankruptcy.\n\n6.\n\nKnow how an estate is liquidated under Chapter 7.\n\nCase Administration (Chapter 3 of the Bankruptcy Code)\nRecall that the purpose of liquidation is to convert the debtor\xe2\x80\x99s assets\xe2\x80\x94except those exempt under the\nlaw\xe2\x80\x94into cash for distribution to the creditors and thereafter to discharge the debtor from further\nliability. With certain exceptions, any person may voluntarily file a petition to liquidate under Chapter 7. A\n\xe2\x80\x9cperson\xe2\x80\x9d is defined as any individual, partnership, or corporation. The exceptions are railroads and\ninsurance companies, banks, savings and loan associations, credit unions, and the like.\nFor a Chapter 7 liquidation proceeding, as for bankruptcy proceedings in general, the various aspects of\ncase administration are covered by the bankruptcy code\xe2\x80\x99s Chapter 3. These include the rules governing\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n492\n\n\x0ccommencement of the proceedings, the effect of the petition in bankruptcy, the first meeting of the\ncreditors, and the duties and powers of trustees.\n\nCommencement\nThe bankruptcy begins with the filing of a petition in bankruptcy with the bankruptcy court.\n\nVoluntary and Involuntary Petitions\nThe individual, partnership, or corporation may file a voluntary petition in bankruptcy; 99 percent of\nbankruptcies are voluntary petitions filed by the debtor. But involuntary bankruptcy is possible, too,\nunder Chapter 7 or Chapter 11. To put anyone into bankruptcy involuntarily, the petitioning creditors\nmust meet three conditions: (1) they must have claims for unsecured debt amounting to at least $13,475;\n(2) three creditors must join in the petition whenever twelve or more creditors have claims against the\nparticular debtor\xe2\x80\x94otherwise, one creditor may file an involuntary petition, as long as his claim is for at\nleast $13,475; (3) there must be no bona fide dispute about the debt owing. If there is a dispute, the debtor\ncan resist the involuntary filing, and if she wins the dispute, the creditors who pushed for the involuntary\npetition have to pay the associated costs. Persons owing less than $13,475, farmers, and charitable\norganizations cannot be forced into bankruptcy.\n\nThe Automatic Stay\nThe petition\xe2\x80\x94voluntary or otherwise\xe2\x80\x94operates as a stay against suits or other actions against the debtor\nto recover claims, enforce judgments, or create liens (but not alimony collection). In other words, once the\npetition is filed, the debtor is freed from worry over other proceedings affecting her finances or property.\nNo more debt collection calls! Anyone with a claim, secured or unsecured, must seek relief in the\nbankruptcy court. This provision in the act can have dramatic consequences. Beset by tens of thousands of\nproducts-liability suits for damages caused by asbestos, UNR Industries and Manville Corporation, the\nnation\xe2\x80\x99s largest asbestos producers, filed (separate) voluntary bankruptcy petitions in 1982; those filings\nautomatically stayed all pending lawsuits.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n493\n\n\x0cFirst Meeting of Creditors\nOnce a petition in bankruptcy is filed, the courts issue an order of relief, which determines that the\ndebtor\xe2\x80\x99s property is subject to bankruptcy court control and creates the stay. The Chapter 7 case may be\ndismissed by the court if, after a notice and hearing, it finds that among other things (e.g., delay,\nnonpayment of required bankruptcy fees), the debts are primarily consumer debts and the debtor could\npay them off\xe2\x80\x94that\xe2\x80\x99s the 2005 act\xe2\x80\x99s famous \xe2\x80\x9cmeans test,\xe2\x80\x9d discussed in Section 12.3 "Chapter 7\nLiquidation".\nAssuming that the order of relief has been properly issued, the creditors must meet within a reasonable\ntime. The debtor is obligated to appear at the meeting and submit to examination under oath. The judge\ndoes not preside and, indeed, is not even entitled to attend the meeting.\nWhen the judge issues an order for relief, an interim trustee is appointed who is authorized initially to\ntake control of the debtor\xe2\x80\x99s assets. The trustee is required to collect the property, liquidate the debtor\xe2\x80\x99s\nestate, and distribute the proceeds to the creditors. The trustee may sue and be sued in the name of the\nestate. Under every chapter except Chapter 7, the court has sole discretion to name the trustee. Under\nChapter 7, the creditors may select their own trustee as long as they do it at the first meeting of creditors\nand follow the procedures laid down in the act.\n\nTrustee\xe2\x80\x99s Powers and Duties\nThe act empowers the trustee to use, sell, or lease the debtor\xe2\x80\x99s property in the ordinary course of business\nor, after notice and a hearing, even if not in the ordinary course of business. In all cases, the trustee must\nprotect any security interests in the property. As long as the court has authorized the debtor\xe2\x80\x99s business to\ncontinue, the trustee may also obtain credit in the ordinary course of business. She may invest money in\nthe estate to yield the maximum, but reasonably safe, return. Subject to the court\xe2\x80\x99s approval, she may\nemploy various professionals, such as attorneys, accountants, and appraisers, and may, with some\nexceptions, assume or reject executor contracts and unexpired leases that the debtor has made. The\ntrustee also has the power to avoid many pre-bankruptcy transactions in order to recover property of the\ndebtor to be included in the liquidation.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n494\n\n\x0cCreditors\xe2\x80\x99 Claims, the Debtor, and the Estate (Chapter 5 of the Bankruptcy Code)\nWe now turn to the major matters covered in Chapter 5 of the bankruptcy act: creditors\xe2\x80\x99 claims, debtors\xe2\x80\x99\nexemptions and discharge, and the property to be included in the estate. We begin with the rules\ngoverning proof of claims by creditors and the priority of their claims.\n\nClaims and Creditors\nA claim is defined as a right to payment, whether or not it is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, un-matured, disputed, undisputed, legal, equitable, secured, or\nunsecured. A creditor is defined as a person or entity with a claim that arose no later than when the court\nissues the order for relief. These are very broad definitions, intended to give the debtor the broadest\npossible relief when finally discharged.\n\nProof of Claims\nBefore the trustee can distribute proceeds of the estate, unsecured creditors must file a proof of claim,\nprima facie evidence that they are owed some amount of money. They must do so within six months after\nthe first date set for the first meeting of creditors. A creditor\xe2\x80\x99s claim is disallowed, even though it is valid,\nif it is not filed in a timely manner. A party in interest, such as the trustee or creditor, may object to a\nproof of claim, in which case the court must determine whether to allow it. In the absence of objection, the\nclaim is \xe2\x80\x9cdeemed allowed.\xe2\x80\x9d The court will not allow some claims. These include unenforceable claims,\nclaims for un-matured interest, claims that may be offset by debts the creditor owes the debtor, and\nunreasonable charges by an insider or an attorney. If it\xe2\x80\x99s a \xe2\x80\x9cno asset\xe2\x80\x9d bankruptcy\xe2\x80\x94most are\xe2\x80\x94creditors are\nin effect told by the court not to waste their time filing proof of claim.\n\nClaims with Priority\nThe bankruptcy act sets out categories of claimants and establishes priorities among them. The law is\ncomplex because it sets up different orders of priorities.\nFirst, secured creditors get their security interests before anyone else is satisfied, because the security\ninterest is not part of the property that the trustee is entitled to bring into the estate. This is why being a\nsecured creditor is important (as discussed in Suretyship \xe2\x80\x9cand Chapter 11 "Mortgages and Nonconsensual\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n495\n\n\x0cLiens"). To the extent that secured creditors have claims in excess of their collateral, they are considered\nunsecured or general creditors and are lumped in with general creditors of the appropriate class.\nSecond, of the six classes of claimants (see Figure 12.3 "Distribution of the Estate"), the first is known as\nthat of \xe2\x80\x9cpriority claims.\xe2\x80\x9d It is subdivided into ten categories ranked in order of priority. The highestpriority class within the general class of priority claims must be paid off in full before the next class can\nshare in a distribution from the estate, and so on. Within each class, members will share pro rata if there\nare not enough assets to satisfy everyone fully. The priority classes, from highest to lowest, are set out in\nthe bankruptcy code (11 USC Section 507) as follows:\n(1) Domestic support obligations (\xe2\x80\x9cDSO\xe2\x80\x9d), which are claims for support due to the spouse, former spouse,\nchild, or child\xe2\x80\x99s representative, and at a lower priority within this class are any claims by a governmental\nunit that has rendered support assistance to the debtor\xe2\x80\x99s family obligations.\n(2) Administrative expenses that are required to administer the bankruptcy case itself. Under former law,\nadministrative expenses had the highest priority, but Congress elevated domestic support obligations\nabove administrative expenses with the passage of the BAPCPA. Actually, though, administrative\nexpenses have a de facto priority over domestic support obligations, because such expenses are deducted\nbefore they are paid to DSO recipients. Since trustees are paid from the bankruptcy estate, the courts have\nallowed de facto top priority for administrative expenses because no trustee is going to administer a\nbankruptcy case for nothing (and no lawyer will work for long without getting paid, either).\n(3) Gap creditors. Claims made by gap creditors in an involuntary bankruptcy petition under Chapter 7 or\nChapter 11 are those that arise between the filing of an involuntary bankruptcy petition and the order for\nrelief issued by the court. These claims are given priority because otherwise creditors would not deal with\nthe debtor, usually a business, when the business has declared bankruptcy but no trustee has been\nappointed and no order of relief issued.\n(4) Employee wages up to $10,950 for each worker, for the 180 days previous to either the bankruptcy\nfiling or when the business ceased operations, whichever is earlier (180-day period).\n(5) Unpaid contributions to employee benefit plans during the 180-day period, but limited by what was\nalready paid by the employer under subsection (4) above plus what was paid on behalf of the employees\nby the bankruptcy estate for any employment benefit plan.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n496\n\n\x0c(6) Any claims for grain from a grain producer or fish from a fisherman for up to $5,400 each against a\nstorage or processing facility.\n(7) Consumer layaway deposits of up to $2,425 each.\n(8) Taxes owing to federal, state, and local governments for income, property, employment and excise\ntaxes. Outside of bankruptcy, taxes usually have a higher priority than this, which is why many times\ncreditors\xe2\x80\x94not tax creditors\xe2\x80\x94file an involuntary bankruptcy petition against the debtor so that they have a\nhigher priority in bankruptcy than they would outside it.\n(9) Allowed claims based on any commitment by the debtor to a federal depository institution to\nmaintain the capital of an insured depository institution.\n(10) Claims for death or personal injury from a motor vehicle or vessel that occurred while the debtor\nwas legally intoxicated.\nThird through sixth (after secured creditors and priority claimants), other claimants are attended to, but\nnot immediately. The bankruptcy code (perhaps somewhat awkwardly) deals with who gets paid when in\nmore than one place. Chapter 5 sets out priority claims as just noted; that order applies to all\nbankruptcies. Chapter 7, dealing with liquidation (as opposed to Chapter 11 and Chapter 13, wherein the\ndebtor pays most of her debt), then lists the order of distribution. Section 726 of 11 United States Code\nprovides: \xe2\x80\x9cDistribution of property of the estate. (1) First, in payment of claims of the kind specified in,\nand in the order specified in section 507\xe2\x80\xa6\xe2\x80\x9d (again, the priority of claims just set out). Following the order\nspecified in the bankruptcy code, our discussion of the order of distribution is taken up in Section 12.3\n"Chapter 7 Liquidation".\n\nDebtor\'s Duties and Exemptions\nThe act imposes certain duties on the debtor, and it exempts some property that the trustee can\naccumulate and distribute from the estate.\n\nDebtor\xe2\x80\x99s Duties\nThe debtor, reasonably enough, is supposed to file a list of creditors, assets, liabilities, and current income\nand a statement of financial affairs. The debtor must cooperate with the trustee and be an \xe2\x80\x9chonest debtor\xe2\x80\x9d\nin general; the failure to abide by these duties is grounds for a denial of discharge.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n497\n\n\x0cThe individual debtor (not including partnerships or corporations) also must show evidence that he or she\nattended an approved nonprofit budget and counseling agency within 180 days before the filing. The\ncounseling may be \xe2\x80\x9can individual or group briefing (including a briefing conducted by telephone or on the\nInternet) that outline[s] the opportunities for available credit counseling and assisted such individual in\nperforming a related budget analysis.\xe2\x80\x9d\n\n[1]\n\nIn Section 111, the 2005 act describes who can perform this\n\ncounseling, and a host of regulations and enforcement mechanisms are instituted, generally applying to\npersons who provide goods or services related to bankruptcy work for consumer debtors whose\nnonexempt assets are less than $150,000, in order to improve the professionalism of attorneys and others\nwho work with debtors in, or contemplating, bankruptcy. A debtor who is incapacitated, disabled, or on\nactive duty in a military zone doesn\xe2\x80\x99t have to go through the counseling.\n\nDebtor\xe2\x80\x99s Exemptions\nThe bankruptcy act exempts certain property of the estate of an individual debtor so that he or she will not\nbe impoverished upon discharge. Exactly what is exempt depends on state law.\nNotwithstanding the Constitution\xe2\x80\x99s mandate that Congress establish \xe2\x80\x9cuniform laws on the subject of\nbankruptcies,\xe2\x80\x9d bankruptcy law is in fact not uniform because the states persuaded Congress to allow nonuniform exemptions. The concept makes sense: what is necessary for a debtor in Maine to live a nonimpoverished post-bankruptcy life might not be the same as what is necessary in southern California. The\nbankruptcy code describes how a person\xe2\x80\x99s residence is determined for claiming state exemptions:\nbasically, where the debtor lived for 730 days immediately before filing or where she lived for 180 days\nimmediately preceding the 730-day period. For example, if the debtor resided in the same state, without\ninterruption, in the two years leading up to the bankruptcy, he can use that state\xe2\x80\x99s exemptions. If not, the\nlocation where he resided for a majority of the half-year preceding the initial two years will be used. The\npoint here is to reduce \xe2\x80\x9cexemption shopping\xe2\x80\x9d\xe2\x80\x94to reduce the incidences in which a person moves to a\ngenerous exemption state only to declare bankruptcy there.\nUnless the state has opted out of the federal exemptions (a majority have), a debtor can choose which\nexemptions to claim.\n\n[2]\n\nThere are also some exemptions not included in the bankruptcy code: veteran\xe2\x80\x99s,\n\nSocial Security, unemployment, and disability benefits are outside the code, and alimony payments are\nalso exempt under federal law. The federal exemptions can be doubled by a married couple filing together.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n498\n\n\x0cHere are the federal exemptions:\n\n[3]\n\nHomestead:\n\xe2\x80\xa2\n\nReal property, including mobile homes and co-ops, or burial plots up to $20,200. Unused portion of\nhomestead, up to $10,125, may be used for other property.\n\nPersonal Property:\n\xe2\x80\xa2\n\nMotor vehicle up to $3,225.\n\n\xe2\x80\xa2\n\nAnimals, crops, clothing, appliances and furnishings, books, household goods, and musical\ninstruments up to $525 per item, and up to $10,775 total.\n\n\xe2\x80\xa2\n\nJewelry up to $1,350.\n\n\xe2\x80\xa2\n\n$1,075 of any property, and unused portion of homestead up to $10,125.\n\n\xe2\x80\xa2\n\nHealth aids.\n\n\xe2\x80\xa2\n\nWrongful death recovery for person you depended upon.\n\n\xe2\x80\xa2\n\nPersonal injury recovery up to $20,200 except for pain and suffering or for pecuniary loss.\n\n\xe2\x80\xa2\n\nLost earnings payments.\n\nPensions:\n\xe2\x80\xa2\n\nTax exempt retirement accounts; IRAs and Roth IRAs up to $1,095,000 per person.\n\nPublic Benefits:\n\xe2\x80\xa2\n\nPublic assistance, Social Security, Veteran\xe2\x80\x99s benefits, Unemployment Compensation.\n\n\xe2\x80\xa2\n\nCrime victim\xe2\x80\x99s compensation.\n\nTools of Trade:\n\xe2\x80\xa2\n\nImplements, books, and tools of trade, up to $2,025.\n\nAlimony and Child Support:\n\xe2\x80\xa2\n\nAlimony and child support needed for support.\n\nInsurance:\n\xe2\x80\xa2\n\nUn-matured life insurance policy except credit insurance.\n\n\xe2\x80\xa2\n\nLife insurance policy with loan value up to $10,775.\n\n\xe2\x80\xa2\n\nDisability, unemployment, or illness benefits.\n\n\xe2\x80\xa2\n\nLife insurance payments for a person you depended on, which you need for support.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n499\n\n\x0cIn the run-up to the 2005 changes in the bankruptcy law, there was concern that some states\xe2\x80\x94especially\n[4]\n\nFlorida \xe2\x80\x94had gone too far in giving debtors\xe2\x80\x99 exemptions. The BAPCPA amended Section 522 to limit the\namount of equity a debtor can exempt, even in a state with unlimited homestead exemptions, in certain\ncircumstances. (Section 522(o) and (p) set out the law\xe2\x80\x99s changes.)\n\nSecured Property\nAs already noted, secured creditors generally have priority, even above the priority claims. That\xe2\x80\x99s why\nbanks and lending institutions almost always secure the debtor\xe2\x80\x99s obligations. But despite the general rule,\nthe debtor can avoid certain types of security interests. Liens that attach to assets that the debtor is\nentitled to claim as exempt can be avoided to the extent the lien impairs the value of the exemption in\nboth Chapter 13 and Chapter 7. To be avoidable, the lien must be a judicial lien (like a judgment or a\ngarnishment), or a non-possessory, non-purchase-money security interest in household goods or tools of\nthe trade.\nTax liens (which are statutory liens, not judicial liens) aren\xe2\x80\x99t avoidable in Chapter 7 even if they impair\nexemptions; tax liens can be avoided in Chapter 13 to the extent the lien is greater than the asset\xe2\x80\x99s value.\n\nDischargeable and Non-dischargeable Debts\nThe whole point of bankruptcy, of course, is for debtors to get relief from the press of debt that they\ncannot reasonably pay.\n\nDischargeable Debts\nOnce discharged, the debtor is no longer legally liable to pay any remaining unpaid debts (except nondischargeable debts) that arose before the court issued the order of relief. The discharge operates to void\nany money judgments already rendered against the debtor and to bar the judgment creditor from seeking\nto recover the judgment.\n\nNon-dischargeable Debts\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n500\n\n\x0cSome debts are not dischargeable in bankruptcy. A bankruptcy discharge varies, depending on the type of\nbankruptcy the debtor files (Chapter 7, 11, 12, or 13). The most common non-dischargeable debts listed in\nSection 523 include the following:\n\xe2\x80\xa2\n\nAll debts not listed in the bankruptcy petition\n\n\xe2\x80\xa2\n\nStudent loans\xe2\x80\x94unless it would be an undue hardship to repay them (see Section 12.6 "Cases", In re\nZygarewicz)\n\n\xe2\x80\xa2\n\nTaxes\xe2\x80\x94federal, state, and municipal\n\n\xe2\x80\xa2\n\nFines for violating the law, including criminal fines and traffic tickets\n\n\xe2\x80\xa2\n\nAlimony and child support, divorce, and other property settlements\n\n\xe2\x80\xa2\n\nDebts for personal injury caused by driving, boating, or operating an aircraft while intoxicated\n\n\xe2\x80\xa2\n\nConsumer debts owed to a single creditor and aggregating more than $550 for luxury goods or\nservices incurred within ninety days before the order of relief\n\n\xe2\x80\xa2\n\nCash advances aggregating more than $825 obtained by an individual debtor within ninety days\nbefore the order for relief\n\n\xe2\x80\xa2\n\nDebts incurred because of fraud or securities law violations\n\n\xe2\x80\xa2\n\nDebts for willful injury to another\xe2\x80\x99s person or his or her property\n\n\xe2\x80\xa2\n\nDebts from embezzlement\n\nThis is not an exhaustive list, and as noted in Section 12.3 "Chapter 7 Liquidation", there are some\ncircumstances in which it is not just certain debts that aren\xe2\x80\x99t dischargeable: sometimes a discharge is\ndenied entirely.\n\nReaffirmation\nA debtor may reaffirm a debt that was discharged. Section 524 of the bankruptcy code provides important\nprotection to the debtor intent on doing so. No reaffirmation is binding unless the reaffirmation was\nmade prior to the granting of the discharge; the reaffirmation agreement must contain a clear and\nconspicuous statement that advises the debtor that the agreement is not required by bankruptcy or nonbankruptcy law and that the agreement may be rescinded by giving notice of rescission to the holder of\nsuch claim at any time prior to discharge or within sixty days after the agreement is filed with the court,\nwhichever is later.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n501\n\n\x0cA written agreement to reaffirm a debt must be filed with the bankruptcy court. The attorney for the\ndebtor must file an affidavit certifying that the agreement represents a fully informed and voluntary\nagreement, that the agreement does not impose an undue hardship on the debtor or a dependent of the\ndebtor, and that the attorney has fully advised the debtor of the legal consequences of the agreement and\nof a default under the agreement. Where the debtor is an individual who was not represented by an\nattorney during the course of negotiating the agreement, the reaffirmation agreement must be approved\nby the court, after disclosures to the debtor, and after the court finds that it is in the best interest of the\ndebtor and does not cause an undue hardship on the debtor or a dependent.\n\nProperty Included in the Estate\nWhen a bankruptcy petition is filed, a debtor\xe2\x80\x99s estate is created consisting of all the debtor\xe2\x80\x99s then-existing\nproperty interests, whether legal or equitable. In addition, the estate includes any bequests, inheritances,\nand certain other distributions of property that the debtor receives within the next 180 days. It also\nincludes property recovered by the trustee under certain powers granted by the law. What is not exempt\nproperty will be distributed to the creditors.\nThe bankruptcy code confers on the trustee certain powers to recover property for the estate that the\ndebtor transferred before bankruptcy.\nOne such power (in Section 544) is to act as a hypothetical lien creditor. This power is best explained by\nan example. Suppose Dennis Debtor purchases equipment on credit from Acme Supply Company. Acme\nfails to perfect its security interest, and a few weeks later Debtor files a bankruptcy petition. By virtue of\nthe section conferring on the trustee the status of a hypothetical lien creditor, the trustee can act as\nthough she had a lien on the equipment, with priority over Acme\xe2\x80\x99s unperfected security interest. Thus the\ntrustee can avoid Acme\xe2\x80\x99s security interest, with the result that Acme would be treated as an unsecured\ncreditor.\nAnother power is to avoid transactions known as voidable preferences\xe2\x80\x94transactions highly favorable to\nparticular creditors.\n\n[5]\n\nA transfer of property is voidable if it was made (1) to a creditor or for his benefit,\n\n(2) on account of a debt owed before the transfer was made, (3) while the debtor was insolvent, (4) on or\nwithin ninety days before the filing of the petition, and (5) to enable a creditor to receive more than he\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n502\n\n\x0cwould have under Chapter 7. If the creditor was an \xe2\x80\x9cinsider\xe2\x80\x9d\xe2\x80\x94one who had a special relationship with the\ndebtor, such as a relative or general partner of the debtor or a corporation that the debtor controls or\nserves in as director or officer\xe2\x80\x94then the trustee may void the transaction if it was made within one year of\nthe filing of the petition, assuming that the debtor was insolvent at the time the transaction was made.\nSome pre-bankruptcy transfers that seem to fall within these provisions do not. The most important\nexceptions are (1) transfers made for new value (the debtor buys a refrigerator for cash one week before\nfiling a petition; this is an exchange for new value and the trustee may not void it); (2) a transfer that\ncreates a purchase-money security interest securing new value if the secured party perfects within ten\ndays after the debtor receives the goods; (3) payment of a debt incurred in the ordinary course of\nbusiness, on ordinary business terms; (4) transfers totaling less than $600 by an individual whose debts\nare primarily consumer debts; (5) transfers totaling less than $5,475 by a debtor whose debts are not\nprimarily consumer debts; and (6) transfers to the extent the transfer was a bona fide domestic support\nobligation.\nA third power of the trustee is to avoid fraudulent transfers made within two years before the date that the\nbankruptcy petition was filed.\n\n[6]\n\nThis provision contemplates various types of fraud. For example, while\n\ninsolvent, the debtor might transfer property to a relative for less than it was worth, intending to recover\nit after discharge. This situation should be distinguished from the voidable preference just discussed, in\nwhich the debtor pays a favored creditor what he actually owes but in so doing cannot then pay other\ncreditors.\n\nKEY TAKEAWAY\nA bankruptcy commences with the filing of a petition of bankruptcy. Creditors file proofs of claim and\nare entitled to certain priorities: domestic support obligations and the costs of administration are first.\nThe debtor has an obligation to file full and truthful schedules and to attend a credit counseling\nsession, if applicable. The debtor has a right to claim exemptions, federal or state, that leave her with\nassets sufficient to make a fresh start: some home equity, an automobile, and clothing and personal\neffects, among others. The honest debtor is discharged of many debts, but some are nondischargeable, among them taxes, debt from illegal behavior (embezzlement, drunk driving), fines,\nstudent loans, and certain consumer debt. A debtor may, after proper counseling, reaffirm debt, but\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n503\n\n\x0conly before filing. The bankruptcy trustee takes over the nonexempt property of the debtor; he may\nact as a hypothetical lien creditor (avoiding unperfected security interests) and avoid preferential and\nfraudulent transfers that unfairly diminish the property of the estate.\n\nEXERCISES\n1.\n\nWhat is the automatic stay, and when does it arise?\n\n2.\n\nWhy are the expenses of claimants administering the bankruptcy given top priority (notwithstanding\nthe nominal top priority of domestic support obligations)?\n\n3.\n\nWhy are debtor\xe2\x80\x99s exemptions not uniform? What sorts of things are exempt from being taken by the\nbankruptcy trustee, and why are such exemptions allowed?\n\n4.\n\nSome debts are non-dischargeable; give three examples. What is the rationale for disallowing some\ndebts from discharge?\n\n5.\n\nHow does the law take care that the debtor is fully informed of the right not to reaffirm debts, and\nwhy is such care taken?\n\n6.\n\nWhat is a hypothetical lien creditor? What is the difference between a preferential transfer and a\nfraudulent one? Why is it relevant to discuss these three things in the same paragraph?\n\n[1] 11 United States Code, Section 109(h).\n[2] These are the states that allow residents to choose either federal or state exemptions (the other states\nmandate the use of state exemptions only): Arkansas, Connecticut, District of Columbia, Hawaii, Kentucky,\nMassachusetts, Michigan, Minnesota, New Hampshire, New Jersey, New Mexico, Pennsylvania, Rhode Island,\nTexas, Vermont, Washington, and Wisconsin.\n[3] 11 United States Code, Section 522.\n[4] The Florida homestead exemption is \xe2\x80\x9c[r]eal or personal property, including mobile or modular home and\ncondominium, to unlimited value. Property cannot exceed: 1/2 acre in a municipality, or 160 acres elsewhere.\xe2\x80\x9d The\n2005 act limits the state homestead exemptions, as noted.\n[5] 11 United States Code, Section 547.\n[6] 11 United States Code, Section 548.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n504\n\n\x0c12.3 Chapter 7 Liquidation\nLEARNING OBJECTIVES\n1.\n\nRecognize the grounds for a Chapter 7 case to be dismissed.\n\n2.\n\nBe familiar with the BAPCPA\xe2\x80\x99s means-testing requirements before Chapter 7 discharge is granted.\n\n3.\n\nKnow under what circumstances a debtor will be denied discharge.\n\n4.\n\nUnderstand the order of distribution of the debtor\xe2\x80\x99s estate under Chapter 7.\n\nTrustee\xe2\x80\x99s Duties under Chapter 7; Grounds for Dismissal: The Means Test\nExcept as noted, the provisions discussed up until now apply to each type of bankruptcy proceeding. The\nfollowing discussion is limited to certain provisions under Chapter 7.\n\nTrustee\xe2\x80\x99s Duties\nIn addition to the duties already noted, the trustee has other duties under Chapter 7. He must sell the\nproperty for money, close up the estate \xe2\x80\x9cas expeditiously as is compatible with the best interests of parties\nin interest,\xe2\x80\x9d investigate the debtor\xe2\x80\x99s financial affairs, examine proofs of claims, reject improper ones,\noppose the discharge of the debtor where doing so is advisable in the trustee\xe2\x80\x99s opinion, furnish a creditor\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n505\n\n\x0cwith information about the estate and his administration (unless the court orders otherwise), file tax\nreports if the business continues to be operated, and make a final report and file it with the court.\n\nConversion\nUnder Section 706 of the bankruptcy code, the debtor may convert a Chapter 7 case to Chapter 11, 12, or\n13 at any time. The court may order a conversion to Chapter 11 at any time upon request of a party in\ninterest and after notice and hearing. And, as discussed next, a case may be converted from Chapter 7 to\nChapter 13 if the debtor agrees, or be dismissed if he does not, in those cases where the debtor makes too\nmuch money to be discharged without it being an \xe2\x80\x9cabuse\xe2\x80\x9d under the 2005 act.\n\nDismissal\nThe court may dismiss a case for three general reasons.\nThe first reason is \xe2\x80\x9cfor cause,\xe2\x80\x9d after notice and a hearing for cause, including (1) unreasonable delay by the\ndebtor that prejudices creditors, (2) nonpayment of any fees required, (3) failure to file required\ndocuments and schedules.\nThe second reason for dismissal (or, with the debtor\xe2\x80\x99s permission, conversion to Chapter 11 or 13) applies\nto debtors whose debt is primarily consumer debt: the court may\xe2\x80\x94after notice and a hearing\xe2\x80\x94dismiss a\ncase if granting relief would be \xe2\x80\x9can abuse of the provisions\xe2\x80\x9d of the bankruptcy code.\nThe third reason for dismissal is really the crux of the 2005 law: under it, the court will find that granting\nrelief under Chapter 7 to a debtor whose debt is primarily consumer debt is \xe2\x80\x9can abuse\xe2\x80\x9d if the debtor makes\ntoo much money. The debtor must pass a means test: If he\xe2\x80\x99s poor enough, he can go Chapter 7. If he is not\npoor enough (or if they are not, in case of a married couple), Chapter 13\xe2\x80\x94making payments to creditors\xe2\x80\x94\nis the way to go. Here is one practitioner\xe2\x80\x99s explanation of the means test:\nTo apply the means test, the courts will look at the debtor\xe2\x80\x99s average income for the 6 months prior to filing\n[not the debtor\xe2\x80\x99s income at the time of filing, when\xe2\x80\x94say\xe2\x80\x94she just lost her job] and compare it to the\nmedian income for that state. For example, the median annual income for a single wage-earner in\nCalifornia is $42,012. If the income is below the median, then Chapter 7 remains open as an option. If the\nincome exceeds the median, the remaining parts of the means test will be applied.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n506\n\n\x0cThe next step in the calculation takes monthly income less reasonable living expenses [\xe2\x80\x9creasonable living\nexpenses\xe2\x80\x9d are strictly calculated based on IRS standards; the figure excludes payments on the debts\nincluded in the bankruptcy], and multiplies that figure times 60. This represents the amount of income\navailable over a 5-year period for repayment of the debt obligations.\nIf the income available for debt repayment over that 5-year period is $10,000 or more, then Chapter 13\nwill be required. In other words, anyone earning above the state median, and with at least $166.67 per\nmonth ($10,000 divided by 60) of available income, will automatically be denied Chapter 7. So for\nexample, if the court determines that you have $200 per month income above living expenses, $200 times\n60 is $12,000. Since $12,000 is above $10,000, you\xe2\x80\x99re stuck with Chapter 13.\nWhat happens if you are above the median income but do NOT have at least $166.67 per month to pay\ntoward your debts? Then the final part of the means test is applied. If the available income is less than\n$100 per month, then Chapter 7 again becomes an option. If the available income is between $100 and\n$166.66, then it is measured against the debt as a percentage, with 25% being the benchmark.\nIn other words, let\xe2\x80\x99s say your income is above the median, your debt is $50,000, and you only have $125\nof available monthly income. We take $125 times 60 months (5 years), which equals $7,500 total. Since\n$7,500 is less than 25% of your $50,000 debt, Chapter 7 is still a possible option for you. If your debt was\nonly $25,000, then your $7,500 of available income would exceed 25% of your debt and you would be\nrequired to file under Chapter 13.\nTo sum up, first figure out whether you are above or below the median income for your state\xe2\x80\x94median\nincome figures are available at http://www.new-bankruptcy-law-info.com. Be sure to account for your\nspouse\xe2\x80\x99s income if you are a two-income family. Next, deduct your average monthly living expenses from\nyour monthly income and multiply by 60. If the result is above $10,000, you\xe2\x80\x99re stuck with Chapter 13. If\nthe result is below $6,000, you may still be able to file Chapter 7. If the result is between $6,000 and\n$10,000, compare it to 25% of your debt. Above 25%, you\xe2\x80\x99re looking at Chapter 13 for sure.\n\n[1]\n\nThe law also requires that attorneys sign the petition (as well as the debtor); the attorney\xe2\x80\x99s signature\ncertifies that the petition is well-grounded in fact and that the attorney has no knowledge after reasonable\ninquiry that the schedules and calculations are incorrect. Attorneys thus have an incentive to err in favor\nof filing Chapter 13 instead of Chapter 7 (perhaps that was part of Congress\xe2\x80\x99s purpose in this section of the\nlaw).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n507\n\n\x0cIf there\xe2\x80\x99s been a dismissal, the debtor and creditors have the same rights and remedies as they had prior\nto the case being commenced\xe2\x80\x94as if the case had never been filed (almost). The debtor can re-file\nimmediately, unless the court orders a 120-day penalty (for failure to appear). In most cases, a debtor can\nfile instantly for a Chapter 13 following a Chapter 7 dismissal.\n\nDistribution of the Estate and Discharge; Denying Discharge\nDistribution of the Estate\nThe estate includes all his or her assets or all their assets (in the case of a married couple) broadly defined.\nFrom the estate, the debtor removes property claimed exempt; the trustee may recapture some assets\nimproperly removed from the estate (preferential and fraudulent transfers), and what\xe2\x80\x99s left is the\ndistributable estate. It is important to note that the vast majority of Chapter 7 bankruptcies are noasset cases\xe2\x80\x9490\xe2\x80\x9395 percent of them, according to one longtime bankruptcy trustee.\n\n[2]\n\nThat means\n\ncreditors get nothing. But in those cases where there are assets, the trustee must distribute the estate to\nthe remaining classes of claimants in this order:\n1.\n\nSecured creditors, paid on their security interests\n\n2. Claims with priority\n3. Unsecured creditors who filed their claims on time\n4. Unsecured creditors who were tardy in filing, if they had no notice of the bankruptcy\n5.\n\nUnsecured creditors who were tardy and had notice, real or constructive\n\n6. Claims by creditors for fines, penalties, and exemplary or punitive damages\n7.\n\nInterest for all creditors at the legal rate\n\n8. The debtor\nFigure 12.3 Distribution of the Estate\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n508\n\n\x0cDischarge\nOnce the estate is distributed, the court will order the debtor discharged (except for non-dischargeable\ndebts) unless one of the following overall exceptions applies for denying discharge (i.e., relief from the\ndebt). This list is not exhaustive:\n1.\n\nThe debtor is not an individual. In a Chapter 7 case, a corporation or partnership does not receive a\nbankruptcy discharge; instead, the entity is dissolved and its assets liquidated. The debts remain\ntheoretically valid but uncollectible until the statute of limitations on them has run. Only an\nindividual can receive a Chapter 7 discharge.\n\n[3]\n\n2. The debtor has concealed or destroyed property with intent to defraud, hinder, or delay within twelve\nmonths preceding filing of the petition.\n3. The debtor has concealed, destroyed, or falsified books and records\n4. The debtor has lied under oath, knowingly given a false account, presented or used a false claim, given\nor received bribes, refused to obey court orders.\n5.\n\nThe debtor has failed to explain satisfactorily any loss of assets.\n\n6. The debtor has declared Chapter 7 or Chapter 11 bankruptcy within eight years, or Chapter 13 within\nsix years (with some exceptions).\n7.\n\nThe debtor failed to participate in \xe2\x80\x9can instructional course concerns personal financial management\xe2\x80\x9d\n(unless that\xe2\x80\x99s excused).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n509\n\n\x0c8. An individual debtor has \xe2\x80\x9cabused\xe2\x80\x9d the bankruptcy process. A preferential transfer is not an \xe2\x80\x9cabuse,\xe2\x80\x9d\nbut it will be set aside. Making too much money to file Chapter 7 is \xe2\x80\x9can abuse\xe2\x80\x9d that will deny\ndischarge.\nA discharge may be revoked if the debtor committed fraud during the bankruptcy proceedings, but the\ntrustee or a creditor must apply for revocation within one year of the discharge.\nHaving the discharge denied does not affect the administration of the bankruptcy case. The trustee can\n(and will) continue to liquidate any nonexempt assets of the debtor and pay the creditors, but the debtor\nstill has to pay the debts left over.\nAs to any consequence of discharge, bankruptcy law prohibits governmental units from discriminating\nagainst a person who has gone through bankruptcy. Debtors are also protected from discrimination by\nprivate employers; for example, a private employer may not fire a debtor because of the bankruptcy.\nCertainly, however, the debtor\xe2\x80\x99s credit rating will be affected by the bankruptcy.\n\nKEY TAKEAWAY\nA Chapter 7 bankruptcy case may be dismissed for cause or because the debtor has abused the system.\nThe debtor is automatically considered to have abused the system if he makes too much money. With\nthe debtor\xe2\x80\x99s permission, the Chapter 7 may be converted to Chapter 11, 12, or 13. The law requires\nthat the debtor pass a means test to qualify for Chapter 7. Assuming the debtor does qualify for\nChapter 7, her nonexempt assets (if there are any) are sold by the trustee and distributed to creditors\naccording to a priority set out in the law. A discharge may be denied, in general because the debtor has\nbehaved dishonestly or\xe2\x80\x94again\xe2\x80\x94has abused the system.\n\nEXERCISES\n1.\n\nWhat is the difference between denial of a discharge for cause and denial for abuse?\n\n2.\n\nWhat is the difference between a dismissal and a denial of discharge?\n\n3.\n\nWhich creditors get satisfied first in a Chapter 7 bankruptcy?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n510\n\n\x0c[1] Charles Phelan, \xe2\x80\x9cThe New Bankruptcy Means Test Explained in Plain\nEnglish,\xe2\x80\x9dBuzzle.com, http://www.buzzle.com/editorials/1-10-2006-85999.asp.\n[2] Eugene Crane, Hearing before the Subcommittee on Commercial and Administrative Law of the Committee on\nthe Judiciary, House of Representatives, One Hundred Tenth Congress, Second Session, Statement to the House\nJudiciary Sub-Committee, September 16, 2008;http://judiciary.house.gov/hearings/printers/110th/44493.PDF.\n[3] 11 United States Code, Section 727(a) (1).\n\n12.4 Chapter 11 and Chapter 13 Bankruptcies\nLEARNING OBJECTIVES\n1.\n\nUnderstand the basic concepts of Chapter 11 bankruptcies.\n\n2.\n\nUnderstand the basic concepts of Chapter 13 bankruptcies.\n\nReorganization: Chapter 11 Bankruptcy\nOverview\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n511\n\n\x0cChapters 11 provides a means by which corporations, partnerships, and other businesses, including sole\nproprietorships, can rehabilitate themselves and continue to operate free from the burden of debts that\nthey cannot pay.\nIt is simple enough to apply for the protection of the court in Chapter 11 proceeding, and for many years,\nlarge financially ailing companies have sought shelter in Chapter 11. Well-known examples include\nGeneral Motors, Texaco, K-Mart, Delta Airlines, and Northwest Airlines. An increasing number of\ncorporations have turned to Chapter 11 even though, by conventional terms, they were solvent. Doing so\nenables them to negotiate with creditors to reduce debt. It also may even permit courts to snuff out\nlawsuits that have not yet been filed. Chapters 3 and 5, discussed in Section 12.2 "Case Administration;\nCreditors\xe2\x80\x99 Claims; Debtors\xe2\x80\x99 Exemptions and Dischargeable Debts; Debtor\xe2\x80\x99s Estate", apply to Chapter 11\nproceedings also. Our discussion, therefore, is limited to special features of Chapter 11.\n\nHow It Works\nEligibility\nAny person eligible for discharge in Chapter 7 proceeding (plus railroads) is eligible for a Chapter 11\nproceeding, except stockbrokers and commodity brokers. Individuals filing Chapter 11 must take credit\ncounseling; businesses do not. A company may voluntarily enter Chapter 11 or may be put there\ninvoluntarily by creditors. Individuals can file Chapter 11 particularly if they have too much debt to qualify\nfor Chapter 13 and make too much money to qualify for Chapter 7; under the 2005 act, individuals must\ncommit future wages to creditors, just as in Chapter 13.\n\n[1]\n\nOperation of Business\nUnless a trustee is appointed, the debtor will retain possession of the business and may continue to\noperate with its own management. The court may appoint a trustee on request of any party in interest\nafter notice and a hearing. The appointment may be made for cause\xe2\x80\x94such as dishonesty, incompetence,\nor gross mismanagement\xe2\x80\x94or if it is otherwise in the best interests of the creditors. Frequently, the same\nincompetent management that got the business into bankruptcy is left running it\xe2\x80\x94that\xe2\x80\x99s a criticism of\nChapter 11.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n512\n\n\x0cCreditors\xe2\x80\x99 Committee\nThe court must appoint a committee of unsecured creditors as soon as practicable after issuing the order\nfor relief. The committee must consist of creditors willing to serve who have the seven largest claims,\nunless the court decides to continue a committee formed before the filing, if the committee was fairly\nchosen and adequately represents the various claims. The committee has several duties, including these:\n(1) to investigate the debtor\xe2\x80\x99s financial affairs, (2) to determine whether to seek appointment of a trustee\nor to let the business continue to operate, and (3) to consult with the debtor or trustee throughout the\ncase.\n\nThe Reorganization Plan\nThe debtor may always file its own plan, whether in a voluntary or involuntary case. If the court leaves the\ndebtor in possession without appointing a trustee, the debtor has the exclusive right to file a\nreorganization plan during the first 120 days. If it does file, it will then have another 60 days to obtain the\ncreditors\xe2\x80\x99 acceptances. Although its exclusivity expires at the end of 180 days, the court may lengthen or\nshorten the period for good cause. At the end of the exclusive period, the creditors\xe2\x80\x99 committee, a single\ncreditor, or a holder of equity in the debtor\xe2\x80\x99s property may file a plan. If the court does appoint a trustee,\nany party in interest may file a plan at any time.\nThe Bankruptcy Reform Act specifies certain features of the plan and permits others to be included.\nAmong other things, the plan must (1) designate classes of claims and ownership interests; (2) specify\nwhich classes or interests are impaired\xe2\x80\x94a claim or ownership interest is impaired if the creditor\xe2\x80\x99s legal,\nequitable, contractual rights are altered under the plan; (3) specify the treatment of any class of claims or\ninterests that is impaired under the plan; (4) provide the same treatment of each claim or interests of a\nparticular class, unless the holder of a particular claim or interest agrees to a less favorable treatment; and\n(5) provide adequate means for carrying out the plan. Basically, what the plan does is provide a process\nfor rehabilitating the company\xe2\x80\x99s faltering business by relieving it from repaying part of its debt and\ninitiating reforms so that the company can try to get back on its feet.\n\nAcceptance of the Plan\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n513\n\n\x0cThe act requires the plan to be accepted by certain proportions of each impaired class of claims and\ninterests. A class of claims accepts the plan if creditors representing at least two-thirds of the dollar\namount of claims and more than one-half the number of allowed claims vote in favor. A class of property\ninterests accepts the plan if creditors representing two-thirds of the dollar amount of the allowed\nownership interests vote in favor. Unimpaired classes of claims and interest are deemed to have accepted\nthe plan; it is unnecessary to solicit their acceptance.\n\nConfirmation of the Plan\nThe final act necessary under Chapter 11 is confirmation by the court. Once the court confirms the plan,\nthe plan is binding on all creditors. The rules governing confirmation are complex, but in essence, they\ninclude the following requirements:\n1.\n\nThe plan must have been proposed in good faith. Companies must also make a good-faith attempt to\nnegotiate modifications in their collective bargaining agreements (labor union contracts).\n\n2. All provisions of the act must have been complied with.\n3. The court must have determined that the reorganized business will be likely to succeed and be\nunlikely to require further financial reorganization in the foreseeable future.\n4. Impaired classes of claims and interests must have accepted the plan, unless the plan treats them in a\n\xe2\x80\x9cfair and equitable\xe2\x80\x9d manner, in which case consent is not required. This is sometimes referred to as\nthe cram-down provision.\n5.\n\nAll members of every class must have received no less value than they would have in Chapter 7\nliquidation.\n\nDischarge, Conversion\nThe debtor gets discharged when all payments under the plan are completed. A Chapter 11 bankruptcy\nmay be converted to Chapter 7, with some restrictions, if it turns out the debtor cannot make the plan\nwork.\n\nAdjustment of Debts of an Individual with Regular Income: Chapter 13\nBankruptcy\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n514\n\n\x0cIn General\nAnyone with a steady income who is having difficulty paying off accumulated debts may seek the\nprotection of a bankruptcy court in Chapter 13 proceeding (often called the wage earner\xe2\x80\x99s plan). Under\nthis chapter, the individual debtor presents a payment plan to creditors, and the court appoints a trustee.\nIf the creditors wind up with more under the plan presented than they would receive in Chapter 7\nproceeding, then the court is likely to approve it. In general, a Chapter 13 repayment plan extends the\ntime to pay the debt and may reduce it so that the debtor need not pay it all. Typically, the debtor will pay\na fixed sum monthly to the trustee, who will distribute it to the creditors. The previously discussed\nprovisions of Chapters 3 and 5 apply also to this chapter; therefore, the discussion that follows focuses on\nsome unique features of Chapter 13.\nPeople seek Chapter 13 discharges instead of Chapter 7 for various reasons: they make too much money to\npass the Chapter 7 means test; they are behind on their mortgage or car payments and want to make them\nup over time and reinstate the original agreement; they have debts that can\xe2\x80\x99t be discharged in Chapter 7;\nthey have nonexempt property they want to keep; they have co-debtors on a personal debt who would be\nliable if the debtor went Chapter 7; they have a real desire to pay their debts but cannot do so without\ngetting the creditors to give them some breathing room. Chapter 7 cases may always be converted to\nChapter 13.\n\nHow It Works\nEligibility\nChapter 13 is voluntary only. Anyone\xe2\x80\x94sole proprietorships included\xe2\x80\x94who has a regular income,\nunsecured debts of less than $336,000, and secured debts of less than $1,010,650 is eligible to seek its\nprotection. The debts must be unpaid and owing at the time the debtor applies for relief. If the person has\nmore debt than that, she will have to file Chapter 11. The debtor must attend a credit-counseling class, as\nin Chapter 7.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n515\n\n\x0cThe Plan\nPlans are typically extensions or compositions\xe2\x80\x94that is, they extend the time to pay what is owing, or they\nare agreements among creditors each to accept something less than the full amount owed (so that all get\nsomething). Under Chapter 13, the stretch-out period is three to five three years. The plan must provide\nfor payments of all future income or a sufficient portion of it to the trustee. Priority creditors are entitled\nto be paid in full, although they may be paid later than required under the original indebtedness. As long\nas the plan is being carried out, the debtor may enjoin any creditors from suing to collect the original debt.\n\nConfirmation\nUnder Section 1325 of the bankruptcy code, the court must approve the plan if it meets certain\nrequirements. These include (1) distribution of property to unsecured creditors whose claims are allowed\nin an amount no less than that which they would have received had the estate been liquidated under\nChapter 7; (2) acceptance by secured creditors, with some exceptions, such as when the debtor surrenders\nthe secured property to the creditor; and (3) proposal of the plan \xe2\x80\x9cin good faith.\xe2\x80\x9d If the trustee or an\nunsecured creditor objects to confirmation, the plan must meet additional tests. For example, a plan will\nbe approved if all of the debtor\xe2\x80\x99s disposable income (as defined in Section 1325) over the commitment\nperiod (three to five years) will be used to make payments under the plan.\n\nDischarge\nOnce a debtor has made all payments called for in the plan, the court will discharge him from all\nremaining debts except certain long-term debts and obligations to pay alimony, maintenance, and\nsupport. Under former law, Chapter 13 was so broad that it permitted the court to discharge the debtor\nfrom many debts considered non-dischargeable under Chapter 7, but 1994 amendments and the 2005 act\nmade Chapter 13 less expansive. Debts dischargeable in Chapter 13, but not in Chapter 7, include debts for\nwillful and malicious injury to property, debts incurred to pay non-dischargeable tax obligations, and\ndebts arising from property settlements in divorce or separation proceedings. (See Section 12.6\n"Cases", In re Ryan, for a discussion of what debts are dischargeable under Chapter 13 as compared with\nChapter 7.)\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n516\n\n\x0cAlthough a Chapter 13 debtor generally receives a discharge only after completing all payments required\nby the court-approved (i.e., \xe2\x80\x9cconfirmed\xe2\x80\x9d) repayment plan, there are some limited circumstances under\nwhich the debtor may request the court to grant a \xe2\x80\x9chardship discharge\xe2\x80\x9d even though the debtor has failed\nto complete plan payments. Such a discharge is available only to a debtor whose failure to complete plan\npayments is due to circumstances beyond the debtor\xe2\x80\x99s control. A Chapter 13 discharge stays on the credit\nrecord for up to ten years.\nA discharge may be denied if the debtor previously went through a bankruptcy too soon before filing\nChapter 13, failed to act in good faith, or\xe2\x80\x94with some exceptions\xe2\x80\x94failed to complete a personal financial\nmanagement course.\n\nKEY TAKEAWAY\nChapter 11\xe2\x80\x94frequently referred to as \xe2\x80\x9ccorporate reorganization\xe2\x80\x9d\xe2\x80\x94is most often used by businesses\nwhose value as a going concern is greater than it would be if liquidated, but, with some exceptions,\nanyone eligible to file Chapter 7 can file Chapter 11. The business owners, or in some cases the trustee\nor creditors, develop a plan to pay the firm\xe2\x80\x99s debts over a three- to five-year period; the plan must be\napproved by creditors and the court. Chapter 13\xe2\x80\x94frequently called the wage-earner\xe2\x80\x99s plan\xe2\x80\x94is a\nsimilar mechanism by which a person can discharge some debt and have longer to pay debts off than\noriginally scheduled. Under Chapter 13, people can get certain relief from creditors that they cannot\nget in Chapter 7.\n\nEXERCISES\n1.\n\nDavid Debtor is a freelance artist with significant debt that he feels a moral obligation to pay. Why is\nChapter 11 his best choice of bankruptcy chapters to file under?\n\n2.\n\nWhat is the practical difference between debts arising from property settlements in divorce or\nseparation proceedings\xe2\x80\x94which can be discharged under Chapter 13\xe2\x80\x94and debts owing for alimony\n(maintenance) and child support\xe2\x80\x94which cannot be discharged under Chapter 13?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n517\n\n\x0c3.\n\nWhy would a person want to go through the long grind of Chapter 13 instead of just declaring straight\nbankruptcy (Chapter 7) and being done with it?\n\n[1] 11 United States Code, Sections 1115, 1123(a) (8), and 1129(a)(15).\n\n12.5 Alternatives to Bankruptcy\nLEARNING OBJECTIVES\n1.\n\nUnderstand that there are non-bankruptcy alternatives for debtors who cannot pay their bills in a timely\nway: assignment for benefit of creditors, compositions, and receiverships.\n\n2.\n\nRecognize the reasons why these alternatives might not work.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n518\n\n\x0cAlternatives to Bankruptcy: Overview\nBankruptcy is a necessary thing in a capitalist economic system. As already noted, without it, few people\nwould be willing to take business risks, and the economy would necessarily operate at a lower level\n(something some people might not think so bad overall). But bankruptcy, however \xe2\x80\x9cenlightened\xe2\x80\x9d society\nmay have become about it since Victorian days, still carries a stigma. Bankruptcy filings are public\ninformation; the lists of people and businesses who declare bankruptcy are regularly published in monthly\nbusiness journals. Bankruptcy is expensive, too, and both debtors and creditors become enmeshed in\nsignificantly complex federal law. For these reasons, among others, both parties frequently determine it is\nin their best interest to find an alternative to bankruptcy. Here we take up briefly three common\nalternatives.\nIn other parts of this book, other non-bankruptcy creditors\xe2\x80\x99 rights are discussed: under the Uniform\nCommercial Code (UCC), creditors have rights to reclaim goods sold and delivered but not paid for; under\nthe UCC, too, creditors have a right to repossess personal property that has been put up as collateral for\nthe debtor\xe2\x80\x99s loan or extension of credit; and mortgagees have the right to repossess real estate without\njudicial assistance in many circumstances. These non-bankruptcy remedies are governed mostly by state\nlaw.\nThe non-bankruptcy alternatives discussed here are governed by state law also.\n\nAssignment for Benefit of Creditors; Compositions; Receivership\nAssignment for Benefit of Creditors\nUnder a common-law assignment for the benefit of creditors, the debtor transfers some or all of his assets\nto a trustee\xe2\x80\x94usually someone appointed by the adjustment bureau of a local credit managers\xe2\x80\x99\nassociation\xe2\x80\x94who sells the assets and apportions the proceeds in some agreed manner, usually pro rata, to\nthe creditors. Of course, not every creditor need agree with such a distribution. Strictly speaking, the\ncommon-law assignment does not discharge the balance of the debt. Many state statutes attempt to\naddress this problem either by prohibiting creditors who accept a partial payment of debt under an\nassignment from claiming the balance or by permitting debtors to demand a release from creditors who\naccept partial payment.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n519\n\n\x0cComposition\nA composition is simply an agreement by creditors to accept less than the full amount of the debt and to\ndischarge the debtor from further liability. As a contract, composition requires consideration; the mutual\nagreement among creditors to accept a pro rata share of the proceeds is held to be sufficient consideration\nto support the discharge. The essential difference between assignment and composition lies in the\ncreditors\xe2\x80\x99 agreement: an assignment implies no agreement among the creditors, whereas a composition\ndoes. Not all creditors of the particular debtor need agree to the composition for it to be valid. A creditor\nwho does not agree to the composition remains free to attempt to collect the full sum owed; in particular,\na creditor not inclined to compose the debt could attach the debtor\xe2\x80\x99s assets while other creditors are\nbargaining over the details of the composition agreement.\nOne advantage of the assignment over the composition is that in the former the debtor\xe2\x80\x99s assets\xe2\x80\x94having\nbeen assigned\xe2\x80\x94are protected from attachment by hungry creditors. Also, the assignment does not require\ncreditors\xe2\x80\x99 consent. However, an advantage to the debtor of the assignment (compared with the\ncomposition) is that in the composition creditors cannot go after the debtor for any deficiency (because\nthey agreed not to).\n\nReceivership\nA creditor may petition the court to appoint a receiver; receivership is a long-established procedure in\nequity whereby the receiver takes over the debtor\xe2\x80\x99s property under instructions from the court. The\nreceiver may liquidate the property, continue to operate the business, or preserve the assets without\noperating the business until the court finally determines how to dispose of the debtor\xe2\x80\x99s property.\nThe difficulty with most of the alternatives to bankruptcy lies in their voluntary character: a creditor who\nrefuses to go along with an agreement to discharge the debtor can usually manage to thwart the debtor\nand her fellow creditors because, at the end of the day, the US Constitution forbids the states from\nimpairing private citizens\xe2\x80\x99 contractual obligations. The only final protection, therefore, is to be found in\nthe federal bankruptcy law.\n\nKEY TAKEAWAY\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n520\n\n\x0cBankruptcy is expensive and frequently convoluted. Non-bankruptcy alternatives include assignment for\nthe benefit of creditors (the debtor\xe2\x80\x99s assets are assigned to a trustee who manages or disposes of them for\ncreditors), compositions (agreements by creditors to accept less than they are owed and to discharge the\ndebtor from further liability), and receivership (a type of court-supervised assignment).\n\nEXERCISES\n1.\n\nWhat is an assignment for benefit of creditors?\n\n2.\n\nWhat is a composition?\n\n3.\n\nWhat is a receivership?\n\n4.\n\nWhy are these alternatives to bankruptcy often unsatisfactory?\n\n12.6 Cases\nDischarge ability of Student Loans under Chapter 7\nIn re Zygarewicz\n423 B.R. 909 (Bkrtcy.E.D.Cal. 2010)\nMCMANUS, BANKRUPTCY JUDGE.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n521\n\n\x0cAngela Zygarewicz, a chapter 7 debtors and the plaintiff in this adversary proceeding, borrowed 16\ngovernment-guaranteed student [sic] loans totaling $81,429. The loans have been assigned to Educational\nCredit Management Corporation (\xe2\x80\x9cECMC\xe2\x80\x9d). By September 2009, the accrual of interest on these student\nloans had caused the debt to balloon to more than $146,000. The debtor asks the court to declare that\nthese student loans were discharged in bankruptcy.\nThe Bankruptcy Code provides financially distressed debtors with a fresh start by discharging most of\ntheir pre-petition debts.\xe2\x80\xa6However, under 11 U.S.C. \xc2\xa7 523(a)(8), there is a presumption that educational\nloans extended by or with the aid of a governmental unit or nonprofit institution are non-dischargeable\nunless the debtor can demonstrate that their repayment would be an undue hardship. See [Citation]. This\nexception to a bankruptcy discharge ensures that student loans, which are typically extended solely on the\nbasis of the student\xe2\x80\x99s future earnings potential, cannot be discharged by recent graduates who then pocket\nall of the future benefits derived from their education. See [Citation].\nThe debtor bears the burden of proving by a preponderance of the evidence that she is entitled to a\ndischarge of the student loan. See [Citation]. That is, the debtor must prove that repayment of student\nloans will cause an undue hardship.\nThe Bankruptcy Code does not define \xe2\x80\x9cthe undue hardship.\xe2\x80\x9d Courts interpreting section 523(a)(8),\nhowever, have concluded that undue hardship [and] is something more than \xe2\x80\x9cgarden-variety hardship.\xe2\x80\x9d\n[Citation.] Only cases involving \xe2\x80\x9creal and substantial\xe2\x80\x9d hardship merit discharges. See [Citation.]\nThe Ninth Circuit has adopted a three-part test to guide courts in their attempts to determine whether a\ndebtor will suffer an undue hardship is required to repay a student loan:\n\xe2\x80\xa2\n\nFirst, the debtor must establish \xe2\x80\x9cthat she cannot maintain, based on current income and expenses, a\n\xe2\x80\x98minimal\xe2\x80\x99 standard of living for herself and her dependents if forced to repay the loans.\xe2\x80\x9d\xe2\x80\xa6\n\n\xe2\x80\xa2\n\nSecond, the debtor must show \xe2\x80\x9cthat additional circumstances exist indicating that this state of affairs\nis likely to persist for a significant portion of the repayment period of the student loans.\xe2\x80\x9d\xe2\x80\xa6\n\n\xe2\x80\xa2\n\nThe third prong requires \xe2\x80\x9cthat the debtor has made good faith efforts to repay the loans.\xe2\x80\xa6\xe2\x80\x9d\n\n(Pena, citing Brunner v. N.Y. State Higher Educ. Servs. Corp., [Citation]).\nDebtor must satisfy all three parts of the Brunner test before her student loans can be discharged. Failure\nto prove any of the three prongs will defeat a debtor\xe2\x80\x99s case.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n522\n\n\x0cWhen this bankruptcy case was filed in September 2005, the debtor was a single woman and had no\ndependents. She is 39 years old.\nSchedule I reported that the debtor was unemployed. The debtor\xe2\x80\x99s responses to the Statement of Financial\nAffairs revealed that she had received $5,500 in income during 2005 prior to the filing of the petition.\nEvidence at trial indicated that after the petition was filed, the debtor found work and earned a total of\n$9,424 in 2005. In 2004 and 2003, she earned $13,994 and $17,339, respectively.\nDespite this modest income, the debtor did not immediately file an adversary proceeding to determine the\ndischarge ability of her student loans. It was almost three years after the entry of her chapter 7 discharge\n\xe2\x80\x98on January 3, 2006 that the debtor reopened her chapter 7 cases in order to pursue this adversary\nproceeding.\xe2\x80\x99\nIn her complaint, the debtor admits that after she received a discharge, she found part-time work with a\nchurch and later took a full-time job as a speech therapist. During 2006, the debtor earned $20,009 and\nin 2007 she earned $37,314. Hence, while it is clear the debtor\xe2\x80\x99s income was very modest in the time\nperiod immediately prior to her bankruptcy petition, her financial situation improved during her\nbankruptcy case.\nThe court cannot conclude based on the evidence of the debtor\xe2\x80\x99s financial circumstances up to the date of\nthe discharge that she was unable to maintain a minimal standard of living if she was required to repay\nher students [sic] loans.\nHowever, in January 2007, the debtor was injured in an automobile accident. Her injuries eventually\nhalted the financial progress she had been making and eventually prevented her from working. She now\nsubsists on social security disability payments.\nThe circumstance creating the debtor\xe2\x80\x99s hardship, the automobile accident, occurred after her chapter 7\npetitions was filed, indeed; approximately one year after her discharge was entered. The debtor is\nmaintaining that this post-petition, post-discharge circumstance warrants a declaration that her student\nloans were discharged effective from the petition date.\nWhen must the circumstances creating a debtor\xe2\x80\x99s hardship arise: before the bankruptcy case is filed; after\nthe case if filed but prior to the entry of a discharge; or at any time, including after the entry of a\ndischarge?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n523\n\n\x0cThe court concludes that the circumstances causing a chapter 7 debtor\xe2\x80\x99s financial hardship must arise\nprior to the entry of the discharge. If the circumstances causing a debtor\xe2\x80\x99s hardship arise after the entry of\na discharge, those circumstances cannot form the basis of a determination that repayment of a student\nloan will be an undue hardship.\xe2\x80\xa6\n[T]here is nothing in the Bankruptcy Code requiring that a complaint under section 523(a) (8) [to\ndischarge student loans] be filed at any particular point in a bankruptcy case, whether it is filed under\nchapter 7 or 13. [Relevant Federal Rules of Bankruptcy Procedure] permits such discharge ability\ncomplaints to be brought at any time, including after the entry of a discharge and the closing of the\nbankruptcy case.\xe2\x80\xa6\nWhile a debtor\xe2\x80\x99s decision to file an action to determine the discharge ability of a student loan is not\ntemporally constrained, this does not mean that a debtor\xe2\x80\x99s financial hardship may arise after a discharge\nhas been entered.\n[The] Coleman [case, cited by debtor] deals with the ripeness of a dispute concerning the discharge ability\nof a student loan. [The Ninth Circuit held that it] is ripe for adjudication at any point during the case. The\nNinth Circuit did not conclude, however, that a debtor could rely upon post-discharge circumstances to\nestablish undue hardship. In fact, the court in Coleman made clear that the debtor could take a snapshot\nof the hardship warranting a discharge of a student loan any time prior to discharge. [Coleman was a\nChapter 13 case.]\nHere, the debtor was injured in an automobile accident on January 17, 2007, almost exactly one year after\nher January 3, 2006 chapter 7 discharges. Because the accident had no causal link to the misfortune\nprompting the debtor to seek bankruptcy relief in the first instance, the accident cannot be relied on to\njustify the discharge of the student loans because repayment would be an undue hardship.\nTo hold otherwise would mean that a bankruptcy discharge is a perpetual license to discharge student\nloans based on events that occur years after the bankruptcy discharge is granted. If a discharged debtor\nsuffers later financial misfortune, that debtor must consider seeking another discharge subject to the\nlimitations imposed by [the sections of the code stipulating how often a person can petition for\nbankruptcy]. In the context of a second case, the debtor could then ask that the student loan be declared\ndischargeable under section 523(a) (8).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n524\n\n\x0cIn this instance, the debtor is now eligible for a discharge in a chapter 13 case. Her chapter 7 petition was\nfiled on September 19, 2005. Section 1328(f) (1) bars a chapter 13 discharge when the debtor has received\na chapter 7 discharge in a case commenced in the prior four years. She would not be eligible for a chapter\n7 discharge until September 19, 2013.\nThis is not to say that post-discharge events are irrelevant. The second and third prongs of the Pena test\nrequire the court to consider whether the circumstances preventing a debtor from repaying a student loan\nare likely to persist, and whether the debtor has made good faith efforts to repay the student loan. Postdischarge events are relevant to these determinations because they require the court to look into the\ndebtor\xe2\x80\x99s financial future.\nUnfortunately for the debtor, it is unnecessary to consider the second and third prongs because she\ncannot satisfy the first prong.\n\nCASE QUESTIONS\n1.\n\nWhat is the rationale for making the bankruptcy discharge of student loans very difficult?\n\n2.\n\nPetitioner argued that she should be able to use a post discharge event (the auto accident) as a basis\nfor establishing that she could not maintain a \xe2\x80\x9cminimal\xe2\x80\x9d standard of living, and thus she should get a\nretroactive discharge of her student loans. What benefit is there to her if she could successfully make\nthe argument, given that she could\xe2\x80\x94as the court noted\xe2\x80\x94file for Chapter 13?\n3.\n\nThe court cites the Coleman case. That was a Chapter 13 proceeding. Here were the facts:\nDebtor had not yet completed her payments under her five-year repayment plan, and no\ndischarge order had yet been entered; one year into the plan, she was laid off work. She had\nbeen trying to repay her student loans for several years, and she claimed she would suffer\nhardship in committing to the five-year repayment plan without any guarantee that her\nstudent loan obligations would be discharged, since she was required to commit all of her\ndisposable income to payments under the plan and would likely be forced to pursue undue\nhardship issue pro se upon completion of the plan.\xe2\x80\x9d In Coleman, the court held that Debtor\ncould, post filing but pre-discharge\xe2\x80\x94one year into the five-year plan\xe2\x80\x94bring up the hardship\nissue.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n525\n\n\x0cNow, in the case here, after the auto accident, the petitioner \xe2\x80\x9csubsists\xe2\x80\x9d on Social Security\ndisability payments, and she has almost $150,000 in debt, yet the court prohibited her from\nclaiming a hardship discharge of student loans. Does this result really make sense? Is the\ncourt\xe2\x80\x99s concern that allowing this post discharge relief would mean \xe2\x80\x9cthat a bankruptcy\ndischarge is a perpetual license to discharge student loans based on events that occur years\nafter the bankruptcy discharge is granted\xe2\x80\x9d well founded? Suppose it is scheduled to take thirty\nyears to pay off student loans; in year 4, the student-borrower, now Debtor, declares Chapter\n7 bankruptcy, student loans not being discharged; in year 6, the person is rendered disabled.\nWhat public policy is offended if the person is allowed to \xe2\x80\x9creopen\xe2\x80\x9d the bankruptcy and use the\npost-bankruptcy event as a basis for claiming a hardship discharge of student loans?\n4.\n\nThe court suggests she file for Chapter 13. What if\xe2\x80\x94because of timing\xe2\x80\x94the petitioner was not eligible\nfor Chapter 13? What would happen then?\n\nChapter 11 Bankruptcy\nIn re Johns-Manville Corp.\n36 B.R. 727 (Bkrtcy. N.Y. 1984)\nLifland, Bankruptcy Judge.\nWhether an industrial enterprise in the United States is highly successful is often gauged by its\n\xe2\x80\x9cmembership\xe2\x80\x9d in what has come to be known as the \xe2\x80\x9cFortune 500\xe2\x80\x9d. Having attained this measure of\nfinancial achievement, Johns-Manville Corp. and its affiliated companies (collectively referred to as\n\xe2\x80\x9cManville\xe2\x80\x9d) were deemed a paradigm of success in corporate America by the financial community. Thus,\nManville\xe2\x80\x99s filing for protection under Chapter 11 of Title 11 of the United States Code (\xe2\x80\x9cthe Code or the\nBankruptcy Code\xe2\x80\x9d) on August 26, 1982 (\xe2\x80\x9cthe filing date\xe2\x80\x9d) was greeted with great surprise and\nconsternation on the part of some of its creditors and other corporations that were being sued along with\nManville for injuries caused by asbestos exposure. As discussed at length herein, Manville submits that\nthe sole factor necessitating its filing is the mammoth problem of uncontrolled proliferation of asbestos\nhealth suits brought against it because of its substantial use for many years of products containing\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n526\n\n\x0casbestos which injured those who came into contact with the dust of this lethal substance. According to\nManville, this current problem of approximately 16,000 lawsuits pending as of the filing date is\ncompounded by the crushing economic burden to be suffered by Manville over the next 20\xe2\x80\x9330 years by\nthe filing of an even more staggering number of suits by those who had been exposed but who will not\nmanifest the asbestos-related diseases until sometime during this future period (\xe2\x80\x9cthe future asbestos\nclaimants\xe2\x80\x9d). Indeed, approximately 6,000 asbestos health claims are estimated to have arisen in only the\nfirst 16 months since the filing date. This burden is further compounded by the insurance industry\xe2\x80\x99s\ngeneral disavowal of liability to Manville on policies written for this very purpose.\nIt is the propriety of the filing by Manville which is the subject of the instant decision. Four separate\nmotions to dismiss the petition pursuant to Section 1112(b) of the Code have been lodged before this\nCourt.\xe2\x80\xa6\nPreliminarily, it must be stated that there is no question that Manville is eligible to be a debtor under the\nCode\xe2\x80\x99s statutory requirements. Moreover, it should also be noted that neither Section 109 nor any other\nprovision relating to voluntary petitions by companies contains any insolvency\nrequirement.\xe2\x80\xa6Accordingly, it is abundantly clear that Manville has met all of the threshold eligibility\nrequirements for filing a voluntary petition under the Code.\xe2\x80\xa6\nA \xe2\x80\x9cprincipal goal\xe2\x80\x9d of the Bankruptcy Code is to provide \xe2\x80\x9copen access\xe2\x80\x9d to the \xe2\x80\x9cbankruptcy process.\xe2\x80\x9d\n[Citation.] The rationale behind this \xe2\x80\x9copen access\xe2\x80\x9d policy is to provide access to bankruptcy relief which is\nas \xe2\x80\x9copen\xe2\x80\x9d as \xe2\x80\x9caccess to the credit economy.\xe2\x80\x9d Thus, Congress intended that \xe2\x80\x9cthere should be no legal\nbarrier to voluntary petitions.\xe2\x80\x9d Another major goal of the Code that of \xe2\x80\x9crehabilitation of debtors,\xe2\x80\x9d requires\nthat relief for debtors must be \xe2\x80\x9ctimely.\xe2\x80\x9d Congress declared that it is essential to both the \xe2\x80\x9copen access\xe2\x80\x9d and\n\xe2\x80\x9crehabilitation\xe2\x80\x9d goals that\n[i]nitiating relief should not be a death knell. The process should encourage resort to it, by debtors and\ncreditors, that cuts short the dissipation of assets and the accumulation of debts. Belated commencement\nof a case may kill an opportunity for reorganization or arrangement.\nAccordingly, the drafters of the Code envisioned that a financially beleaguered debtor with real debt and\nreal creditors should not be required to wait until the economic situation is beyond repair in order to file a\nreorganization petition. The \xe2\x80\x9cCongressional purpose\xe2\x80\x9d in enacting the Code was to encourage resort to the\nbankruptcy process. This philosophy not only comports with the elimination of an insolvency\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n527\n\n\x0crequirement, but also is a corollary of the key aim of Chapter 11 of the Code, that of avoidance of\nliquidation. The drafters of the Code announced this goal, declaring that reorganization is more efficient\nthan liquidation because \xe2\x80\x9cassets that are used for production in the industry for which they were designed\nare more valuable than those same assets sold for scrap.\xe2\x80\x9d [Citation.] Moreover, reorganization also fosters\nthe goals of preservation of jobs in the threatened entity. [Citation.]\nIn the instant case, not only would liquidation be wasteful and inefficient in destroying the utility of\nvaluable assets of the companies as well as jobs, but, more importantly, liquidation would preclude just\ncompensation of some present asbestos victims and all future asbestos claimants. This unassailable reality\nrepresents all the more reason for this Court to adhere to this basic potential liquidation avoidance aim of\nChapter 11 and deny the motions to dismiss. Manville must not be required to wait until its economic\npicture has deteriorated beyond salvation to file for reorganization.\nClearly, none of the justifications for declaring an abuse of the jurisdiction of the bankruptcy court\nannounced by these courts [in various cases cited] are present in the Manville case. In Manville, it is\nundeniable that there has been no sham or hoax perpetrated on the Court in that Manville is a real\nbusiness with real creditors in pressing need of economic reorganization. Indeed, the Asbestos Committee\nhas belied its own contention that Manville has no debt and no real creditors by quantifying a benchmark\nsettlement demand approaching one billion dollars for compensation of approximately 15,500 prepetition asbestos claimants, during the course of negotiations pitched toward achieving a consensual plan.\nThis huge asserted liability does not even take into account the estimated 6,000 new asbestos health\nclaims which have arisen in only the first 16 months since the filing date. The number of post-filing claims\nincreases each day as \xe2\x80\x9cfuture claims back into the present.\xe2\x80\x9d \xe2\x80\xa6\nIn short, Manville\xe2\x80\x99s filing did not in the appropriate sense abuse the jurisdiction of this Court and it is\nindeed, like the debtor in [Citation], a \xe2\x80\x9conce viable business supporting employees and unsecured\ncreditors [that] has more recently been burdened with judgments [and suits] that threaten to put it out of\nexistence.\xe2\x80\x9d Thus, its petition must be sustained.\xe2\x80\xa6\nIn sum, Manville is a financially besieged enterprise in desperate need of reorganization of its crushing\nreal debt, both present and future. The reorganization provisions of the Code were drafted with the aim of\nliquidation avoidance by great access to Chapter 11. Accordingly, Manville\xe2\x80\x99s filing does not abuse the\njurisdictional integrity of this Court, but rather presents the same kinds of reasons that were present in\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n528\n\n\x0c[Citation], for awaiting the determination of Manville\xe2\x80\x99s good faith until it is considered\xe2\x80\xa6as a prerequisite\nto confirmation or as a part of the cadre of motions before me which are scheduled to be heard\nsubsequently.\n[A]ll four of the motions to dismiss the Manville petition are denied in their entirety.\n\nCASE QUESTIONS\n1.\n\nWhat did Manville want to do here, and why?\n\n2.\n\nHow does this case demonstrate the fundamental purpose of Chapter 11 as opposed to Chapter 7\nfilings?\n\n3.\n\nThe historical background here is that Manville knew from at least 1930 that asbestos\xe2\x80\x94used in many\nindustrial applications\xe2\x80\x94was a deadly carcinogen, and it worked diligently for decades to conceal and\nobfuscate the fact. What \xe2\x80\x9cgood faith\xe2\x80\x9d argument was raised by the movants in this case?\n\nChapter 13: What Debts Are Dischargeable?\nIn re Ryan\n389 B.R. 710 9th Cir. BAP, (Idaho, 2008)\nOn July 13, 1995, Ryan was convicted of possession of an unregistered firearm under 26 U.S.C. \xc2\xa7 5861(d)\nin the United States District Court for the District of Alaska. Ryan was sentenced to fifty-seven months in\nprison followed by three years of supervised release. In addition, Ryan was ordered to pay a fine of\n$7,500\xe2\x80\xa6, costs of prosecution in the amount of $83,420, and a special assessment of $50.00. Ryan served\nhis sentence. He also paid the $7,500 fine. The district court, following an appellate mandate, ultimately\neliminated the restitution obligation.\nOn April 25, 2003, Ryan filed a petition for bankruptcy relief under chapter 7 in the District of Idaho. He\nreceived his chapter 7 discharge on August 11, 2003. Shortly thereafter, Ryan filed a case under chapter\n13, listing as his only obligation the amount of unpaid costs of prosecution owed to the United States\n(\xe2\x80\x9cGovernment\xe2\x80\x9d).\xe2\x80\xa6\nRyan completed payments under the plan, and an \xe2\x80\x9cOrder of Discharge\xe2\x80\x9d was entered on October 5, 2006.\nThe chapter 13 trustee\xe2\x80\x99s final report reflected that the Government received $2,774.89 from payments\nmade by Ryan under his plan, but a balance of $77,088.34 on the Government\xe2\x80\x99s costs of prosecution\nclaim remained unpaid. Ryan then renewed his request for determination of discharge ability. The\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n529\n\n\x0cbankruptcy court held that the unpaid portion of the Government\xe2\x80\x99s claim for costs of prosecution was\nexcepted from discharge by \xc2\xa7 1328(a)(3). Ryan appealed.\nSection 1328(a) (3) provides an exception to discharge in chapter 13 for \xe2\x80\x9crestitution, or a criminal fine.\xe2\x80\x9d It\nstates, in pertinent part:\n[A]s soon as practicable after the completion by the debtor of all payments under the plan, the court shall\ngrant the debtor a discharge of all debts provided for by the plan or disallowed under section 502 of this\ntitle except any debt\xe2\x80\xa6\n(3) for restitution, or a criminal fine, included in a sentence on the debtor\xe2\x80\x99s conviction of a crime [.]\n[emphasis added].\nThe essential question, then, is whether these costs of prosecution constitute a \xe2\x80\x9ccriminal fine.\xe2\x80\x9d\nStatutory interpretation begins with a review of the particular language used by Congress in the relevant\nversion of the law. [Citation.]\nThe term \xe2\x80\x9ccriminal fine\xe2\x80\x9d is not defined in [Chapter 13] or anywhere else in the Bankruptcy Code.\nHowever, its use in \xc2\xa7 1328(a)(3) implicates two important policies embedded in the Bankruptcy Code.\nFirst, in light of the objective to provide a fresh start for debtors overburdened by debts that they cannot\npay, exceptions to discharge are interpreted strictly against objecting creditors and in favor of\ndebtors. See, e.g. [Citations]. In chapter 13, this principle is particularly important because Congress\nadopted the liberal \xe2\x80\x9csuper discharge\xe2\x80\x9d provisions of \xc2\xa7 1328 as an incentive to debtors to commit to a plan\nto pay their creditors all of their disposable income over a period of years rather than simply discharging\ntheir debts in a chapter 7 liquidation.\n\xe2\x80\x9c[T]he discharge ability of debts in chapter 13 that are not dischargeable in chapter 7 represents a policy\njudgment that [it] is preferable for debtors to attempt to pay such debts to the best of their abilities over\nthree years rather than for those debtors to have those debts hanging over their heads indefinitely,\nperhaps for the rest of their lives.\xe2\x80\x9d [Citations.]\nA second, countervailing policy consideration is a historic deference, both in the Bankruptcy Code and in\nthe administration of prior bankruptcy law, to accepting criminal sanctions from discharge in bankruptcy.\nApplication of this policy is consistent with a general recognition that, \xe2\x80\x9c[t]he principal purpose of the\nBankruptcy Code is to grant a \xe2\x80\x98fresh start\xe2\x80\x99 to the \xe2\x80\x98honest but unfortunate debtor.\xe2\x80\x99\xe2\x80\x9d [Citation] (emphasis\nadded [in original]).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n530\n\n\x0cThe legislative history is clear that [in its 1994 amendments to the bankruptcy law] Congress intended to\noverrule the result in [of a 1990 Supreme Court case so that]\xe2\x80\xa6\xe2\x80\x9c[N]o debtor with criminal restitution\nobligations will be able to discharge them through any bankruptcy proceeding.\xe2\x80\x9d\xe2\x80\xa6\nThe imposition on a defendant of the costs of a special prosecutor is different from ordering a defendant\nto pay criminal fines. Costs are paid to the entity incurring the costs; criminal fines are generally paid to a\nspecial fund for victims\xe2\x80\x99 compensation and assistance in the U.S. Treasury\xe2\x80\xa6\nTo honor the principle that exceptions to discharge are to be construed narrowly in favor of debtors,\nparticularly in chapter 13, where a broad discharge was provided by Congress as an incentive for debtors\nto opt for relief under that chapter rather than under chapter 7, it is not appropriate to expand the scope\nof the [Chapter 13] exception beyond the terms of the statute. Congress could have adopted an exception\nto discharge in chapter 13 that mirrored [the one in Chapter 7]. It did not do so. In contrast, under [the\n2005] BAPCPA, when Congress wanted to limit the chapter 13 \xe2\x80\x9csuper discharge,\xe2\x80\x9d it incorporated\nexceptions to discharge from [Chapter 7] wholesale.\xe2\x80\xa6\nAs a bottom line matter, Ryan served his time and paid in full the criminal fine that was imposed as part\nof his sentence for conviction of possession of an unregistered firearm. The restitution obligation that was\nincluded as part of his sentence was voided. Ryan paid the Government a total of $6,331.66 to be applied\nto the costs of prosecution awarded as part of his criminal judgment, including $2,774.89 paid under his\nchapter 13 plan, leaving a balance of $77,088.34. We determine that the unpaid balance of the costs of\nprosecution award was covered by Ryan\xe2\x80\x99s chapter 13 discharges.\nBased on the foregoing analysis, we conclude that the exception to discharge included in [Chapter 13] for\n\xe2\x80\x9crestitution, or a criminal fine, included in a sentence on the debtor\xe2\x80\x99s conviction of a crime\xe2\x80\x9d does not cover\ncosts of prosecution included in such a sentence, and we REVERSE.\n\nCASE QUESTIONS\n1.\n\nWhat is the rationale for making some things dischargeable under Chapter 13 that are not\ndischargeable under Chapter 7?\n\n2.\n\nWhat is the difference between \xe2\x80\x9ccriminal restitution\xe2\x80\x9d (which in 1994 Congress said could not get\ndischarged at all) and \xe2\x80\x9cthe costs of prosecution\xe2\x80\x9d?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n531\n\n\x0c3.\n\nWhy did the court decide that Ryan\xe2\x80\x99s obligation to pay \xe2\x80\x9ccosts of prosecution\xe2\x80\x9d was not precluded by\nthe limits on Chapter 13 bankruptcies imposed by Congress?\n\n12.7 Summary and Exercises\nSummary\nThe Constitution gives Congress the power to legislate on bankruptcy. The current law is the Bankruptcy\nAbuse Prevention and Consumer Protection Act of 2005, which provides for six types of proceedings: (1)\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n532\n\n\x0cliquidation, Chapter 7; (2) adjustment of debts of a municipality, Chapter 9; (3) reorganization, Chapter\n11; (4) family farmers with regular income, Chapter 12; (5) individuals with regular income, Chapter 13;\nand (6) cross-border bankruptcies, Chapter 15.\nWith some exceptions, any individual, partnership, or corporation seeking liquidation may file a voluntary\npetition in bankruptcy. An involuntary petition is also possible; creditors petitioning for that must meet\ncertain criteria.\nA petition operates as a stay against the debtor for lawsuits to recover claims or enforce judgments or\nliens. A judge will issue an order of relief and appoint a trustee, who takes over the debtor\xe2\x80\x99s property and\npreserves security interests. To recover monies owed, creditors must file proof of claims. The trustee has\ncertain powers to recover property for the estate that the debtor transferred before bankruptcy. These\ninclude the power to act as a hypothetical lien creditor, to avoid fraudulent transfers and voidable\npreferences.\nThe bankruptcy act sets out categories of claimants and establishes priority among them. After secured\nparties take their security, the priorities are (1) domestic support obligations, (2) administrative expenses,\n(3) gap creditor claims, (4) employees\xe2\x80\x99 wages, salaries, commissions, (5) contributions to employee\nbenefit plans, (6) grain or fish producers\xe2\x80\x99 claims against a storage facility, (7) consumer deposits, (8) taxes\nowed to governments, (9) allowed claims for personal injury or death resulting from debtor\xe2\x80\x99s driving or\noperating a vessel while intoxicated. After these priority claims are paid, the trustee must distribute the\nestate in this order: (a) unsecured creditors who filed timely, (b) unsecured creditors who filed late, (c)\npersons claiming fines and the like, (d) all other creditors, (e) the debtor. Most bankruptcies are no-asset,\nso creditors get nothing.\nUnder Chapter 7\xe2\x80\x99s 2005 amendments, debtors must pass a means test to be eligible for relief; if they make\ntoo much money, they must file Chapter 13.\nCertain property is exempt from the estate of an individual debtor. States may opt out of the federal list of\nexemptions and substitute their own; most have.\nOnce discharged, the debtor is no longer legally liable for most debts. However, some debts are not\ndischargeable, and bad faith by the debtor may preclude discharge. Under some circumstances, a debtor\nmay reaffirm a discharged debt. A Chapter 7 case may be converted to Chapter 11 or 13 voluntarily, or to\nChapter 11 involuntarily.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n533\n\n\x0cChapter 11 provides for reorganization. Any person eligible for discharge in Chapter 7 is eligible for\nChapter 11, except stockbrokers and commodity brokers; those who have too much debt to file Chapter 13\nand surpass the means test for Chapter 7 file Chapter 11. Under Chapter 11, the debtor retains possession\nof the business and may continue to operate it with its own management unless the court appoints a\ntrustee. The court may do so either for cause or if it is in the best interests of the creditors. The court must\nappoint a committee of unsecured creditors, who remain active throughout the proceeding. The debtor\nmay file its own reorganization plan and has the exclusive right to do so within 120 days if it remains in\npossession. The plan must be accepted by certain proportions of each impaired class of claims and\ninterests. It is binding on all creditors, and the debtor is discharged from all debts once the court confirms\nthe plan.\nChapter 13 is for any individual with regular income who has difficulty paying debts; it is voluntary only;\nthe debtor must get credit counseling. The debtor presents a payment plan to creditors, and the court\nappoints a trustee. The plan extends the time to pay and may reduce the size of the debt. If the creditors\nwind up with more in this proceeding than they would have in Chapter 7, the court is likely to approve the\nplan. The court may approve a stretch-out of five years. Some debts not dischargeable under Chapter 7\nmay be under Chapter 13.\nAlternatives to bankruptcy are (1) composition (agreement by creditors to accept less than the face\namount of the debt), (2) assignment for benefit of creditors (transfer of debtor\xe2\x80\x99s property to a trustee, who\nuses it to pay debts), and (3) receivership (a disinterested person is appointed by the court to preserve\nassets and distribute them at the court\xe2\x80\x99s direction). Because these are voluntary procedures, they are\nineffective if all parties do not agree to them.\n\nEXERCISES\n1.\n\nDavid has debts of $18,000 and few assets. Because his debts are less than $25,000, he decides to file\nfor bankruptcy using the state court system rather than the federal system. Briefly describe the\nprocedure he should follow to file for bankruptcy at the state level.\n\n2.\n\nAssume that David in Exercise 1 is irregularly employed and has developed a plan for paying off his\ncreditors. What type of bankruptcy should he use, Chapter 7, 11, or 13? Why?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n534\n\n\x0c3.\n\nAssume that David owns the following unsecured property: a $3,000 oboe, a $1,000 piano, a $2,000\ncar, and a life insurance policy with a cash surrender value of $8,000. How much of this property is\navailable for distribution to his creditors in a bankruptcy? Explain.\n\n4.\n\nIf David owes his ex-wife alimony (maintenance) payments and is obligated to pay $12,000 for an\neducational loan, what effect will his discharge have on these obligations?\n\n5.\n\nAssume that David owns a corporation that he wants to liquidate under Chapter 7. After the corporate\nassets are distributed to creditors, there is still money owing to many of them. What obstacle does\nDavid face in obtaining a discharge for the corporation?\n\n6.\n\nThe famous retired professional football player\xe2\x80\x94with a pension from the NFL\xe2\x80\x94Orenthal James \xe2\x80\x9cO.J.\xe2\x80\x9d\nSimpson was convicted of wrongful death in a celebrated Santa Monica, California, trial in 1997 and\nordered to pay $33.5 million in damages to the families of the deceased. Mr. Simpson sold his\nCalifornia house, moved to Florida, and, from occasional appearances in the press, seemed to be living\na high-style life with a big house, nice cars, and sharp clothing. He has never declared bankruptcy.\nWhy hasn\xe2\x80\x99t he been forced into an involuntary Chapter 7 bankruptcy by his creditors?\n\n7.\na.\n\nA debtor has an automobile worth $5,000. The federal exemption applicable to her is $3,225.\nThe trustee sells the car and gives the debtor the amount of the exemption. The debtor,\nexhausted by the bankruptcy proceedings, takes the $3,225 and spends it on a six-week\nvacation in Baja California. Is this an \xe2\x80\x9cabuse\xe2\x80\x9d of the bankruptcy system?\n\nb.\n\nA debtor has $500 in cash beyond what is exempt in bankruptcy. She takes the cash and buys\nnew tires for her car, which is worth about $2,000. Is this an \xe2\x80\x9cabuse\xe2\x80\x9d of the bankruptcy\nsystem?\n\nSELF-TEST QUESTIONS\n1.\n\nAlternatives to bankruptcy include\n\na.\n\nan assignment\n\nb.\n\na composition\n\nc.\n\nreceivership\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n535\n\n\x0cd.\n\nall of the above\nA composition is\n\na.\n\na procedure where a receiver takes over the debtor\xe2\x80\x99s property\nb.\n\nan agreement by creditors to take less than the face value of their debt\n\nc.\n\nbasically the same as an assignment\n\nd.\n\nnone of these\nThe highest-priority class set out by the 2005 act is for\n\na.\n\nemployees\xe2\x80\x99 wages\nb.\n\nadministrative expenses\n\nc.\n\nproperty settlements arising from divorce\n\nd.\n\ndomestic support obligations\nDarlene Debtor did the following within ninety days of filing for bankruptcy. Which could be\nset aside as a preferential payment?\na.\n\npaid water and electricity bills\n\nb.\n\nmade a gift to the Humane Society\n\nc.\n\nprepaid an installment loan on inventory\n\nd.\n\nborrowed money from a bank secured by a mortgage on business property\nDonald Debtor sold his 1957 Chevrolet to his brother for one-fifth its value sixty days before\nfiling for bankruptcy. The trustee wishes to avoid the transaction on the basis that it was\n\na.\n\na hypothetical lien\nb.\n\na lease disguised as a sale\n\nc.\n\na preferential payment\n\nd.\n\navoidable preference\nAcme Co. filed for bankruptcy with the following debts; which is their correct priority from\nhighest to lowest?\ni. wages of $15,000 owed to employees\nii. unpaid federal taxes\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n536\n\n\x0ciii. balance owed to a creditor who claimed its security with a $5,000 deficiency owing\na.\n\ni, ii, iii\nb.\n\nii, iii, i\n\nc.\n\niii, ii, i\n\nd.\n\ni, iii, ii\n\nSELF-TEST ANSWERS\n1.\n\nd\n\n2.\n\nb\n\n3.\n\nd\n\n4.\n\nc\n\n5.\n\nd\n\n6.\n\na\n\nChapter 13\nIntellectual Property\nLEARNING OBJECTIVES\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n537\n\n\x0cAfter reading this chapter, you should understand the following:\n1.\n\nThe principal kinds of intellectual property\n\n2.\n\nThe difference between patents and trade secrets, and why a company might choose to rely on trade\nsecrets rather than obtain a patent\n\n3.\n\nWhat copyrights are, how to obtain them, and how they differ from trademarks\n\n4.\n\nWhy some \xe2\x80\x9cmarks\xe2\x80\x9d may not be eligible for trademark protection, and how to obtain trademark\nprotection for those that are\n\nFew businesses of any size could operate without being able to protect their rights to a particular type of\nintangible personal property: intellectual property. The major forms of intellectual property are patents,\ncopyrights, and trademarks. Unlike tangible personal property (machines, inventory) or real property\n(land, office buildings), intellectual property is formless. It is the product of the human intellect that is\nembodied in the goods and services a company offers and by which the company is known.\nA patent is a grant from government that gives an inventor the exclusive right to make, use, and sell an\ninvention for a period of twenty years from the date of filing the application for a patent. A copyright is the\nright to exclude others from using or marketing forms of expression. A trademark is the right to prevent\nothers from using a company\xe2\x80\x99s product name, slogan, or identifying design. Other forms of intellectual\nproperty are trade secrets (particular kinds of information of commercial use to a company that created it)\nand right of publicity (the right to exploit a person\xe2\x80\x99s name or image). Note that the property interest\nprotected in each case is not the tangible copy of the invention or writing\xe2\x80\x94not the machine with a\nparticular serial number or the book lying on someone\xe2\x80\x99s shelf\xe2\x80\x94but the invention or words themselves.\nThat is why intellectual property is said to be intangible: it is a right to exclude any others from gaining\neconomic benefit from your own intellectual creation. In this chapter, we examine how Congress, the\ncourts, and the Patent and Trademark Office have worked to protect the major types of intellectual\nproperty.\n\n13.1 Patents\nLEARNING OBJECTIVES\n1.\n\nExplain why Congress would grant exclusive monopolies (patents) for certain periods of time.\n\n2.\n\nDescribe what kinds of things may be patentable and what kinds of things may not be patentable.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n538\n\n\x0c3.\n\nExplain the procedures for obtaining a patent, and how patent rights may be an issue where the\ninvention is created by an employee.\n\n4.\n\nUnderstand who can sue for patent infringement, on what basis, and with what potential remedies.\n\nSource of Authority and Duration\nPatent and copyright law are federal, enacted by Congress under the power given by Article I of the\nConstitution \xe2\x80\x9cto promote the Progress of Science and useful Arts, by securing for limited Times to Authors\nand Inventors the exclusive Right to their respective Writings and Discoveries.\xe2\x80\x9d Under current law, a\npatent gives an inventor exclusive rights to make, use, or sell an invention for twenty years. (If the patent\nis a design patent\xe2\x80\x94protecting the appearance rather than the function of an item\xe2\x80\x94the period is fourteen\nyears.) In return for this limited monopoly, the inventor must fully disclose, in papers filed in the US\nPatent and Trademark Office (PTO), a complete description of the invention.\n\nPatentability\nWhat May Be Patented\nThe patent law says that \xe2\x80\x9cany new and useful process, machine, manufacture, or composition of matter, or\nany new and useful improvement thereof\xe2\x80\x9d may be patented.\n\n[1]\n\nA process is a \xe2\x80\x9cprocess, art or method, and\n[2]\n\nincludes a new use of a known process, machine, manufacture, composition of matter, or material.\xe2\x80\x9d A\nprocess for making rolled steel, for example, qualifies as a patentable process under the statute.\nA machine is a particular apparatus for achieving a certain result or carrying out a distinct process\xe2\x80\x94\nlathes, printing presses, motors, and the cotton gin are all examples of the hundreds of thousands of\nmachines that have received US patents since the first Patent Act in 1790. A manufacture is an article or a\nproduct, such as a television, an automobile, a telephone, or a light bulb. A composition of matter is a new\narrangement of elements so that the resulting compound, such as a metal alloy, is not found in nature. In\nCommissioner of Patents v. Chakrabarty,\n\n[3]\n\nthe Supreme Court said that even living organisms\xe2\x80\x94in\n\nparticular, a new \xe2\x80\x9cgenetically engineered\xe2\x80\x9d bacterium that could \xe2\x80\x9ceat\xe2\x80\x9d oil spills\xe2\x80\x94could be patented.\nThe Chakrabarty decision has spawned innovation: a variety of small biotechnology firms have attracted\nventure capitalists and other investors.\nAccording to the PTO, gene sequences are patentable subject matter, provided they are isolated from their\nnatural state and processed in a way that separates them from other molecules naturally occurring with\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n539\n\n\x0cthem. Gene patenting, always controversial, generated new controversy when the PTO issued a patent to\nHuman Genome Sciences, Inc. for a gene found to serve as a platform from which the AIDS virus can\ninfect cells of the body. Critics faulted the PTO for allowing \xe2\x80\x9cownership\xe2\x80\x9d of a naturally occurring human\ngene and for issuing patents without requiring a showing of the gene\xe2\x80\x99s utility. New guidelines from the\nPTO followed in 2000; these focused on requiring the applicant to make a strong showing on the utility\naspect of patentability and somewhat diminished the rush of biotech patent requests.\nThere are still other categories of patentable subjects. An improvement is an alteration of a process,\nmachine, manufacture, or composition of matter that satisfies one of the tests for patentability given later\nin this section. New, original ornamental designs for articles of manufacture are patentable (e.g., the\nshape of a lamp); works of art are not patentable but are protected under the copyright law. New varieties\nof cultivated or hybridized plants are also patentable, as are genetically modified strains of soybean, corn,\nor other crops.\n\nWhat May Not Be Patented\nMany things can be patented, but not (1) the laws of nature, (2) natural phenomena, and (3) abstract\nideas, including algorithms (step-by-step formulas for accomplishing a specific task).\nOne frequently asked question is whether patents can be issued for computer software. The PTO was\nreluctant to do so at first, based on the notion that computer programs were not \xe2\x80\x9cnovel\xe2\x80\x9d\xe2\x80\x94the software\nprogram either incorporated automation of manual processes or used mathematical equations (which\nwere not patentable). But in 1998, the Supreme Court held in Diamond v. Diehr\n\n[4]\n\nthat patents could be\n\nobtained for a process that incorporated a computer program if the process itself was patentable.\nA business process can also be patentable, as the US Court of Appeals for the Federal Circuit ruled in 1998\nin State Street Bank and Trust v. Signature Financial Group, Inc.\n\n[5]\n\nSignature Financial had a patent for\n\na computerized accounting system that determined share prices through a series of mathematical\ncalculations that would help manage mutual funds. State Street sued to challenge that patent. Signature\nargued that its model and process was protected, and the court of appeals upheld it as a \xe2\x80\x9cpractical\napplication of a mathematical, algorithm, formula, or calculation,\xe2\x80\x9d because it produces a \xe2\x80\x9cuseful, concrete\nand tangible result.\xe2\x80\x9d Since State Street, many other firms have applied for business process patents. For\nexample, Amazon.com obtained a business process patent for its \xe2\x80\x9cone-click\xe2\x80\x9d ordering system, a method of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n540\n\n\x0cprocessing credit-card orders securely. (But see Amazon.com v. Barnesandnoble.com,\n\n[6]\n\nin which the\n\ncourt of appeals rejected Amazon\xe2\x80\x99s challenge to Barnesandnoble.com using its Express Land one-click\nordering system.)\n\nTests for Patentability\nJust because an invention falls within one of the categories of patentable subjects, it is not necessarily\npatentable. The Patent Act and judicial interpretations have established certain tests that must first be\nmet. To approve a patent application, the PTO (as part of the Department of Commerce) will require that\nthe invention, discovery, or process be novel, useful, and nonobvious in light of current technology.\nPerhaps the most significant test of patentability is that of obviousness. The act says that no invention\nmay be patented \xe2\x80\x9cif the differences between the subject matter sought to be patented and the prior art are\nsuch that the subject matter as a whole would have been obvious at the time the invention was made to a\nperson having ordinary skill in the art to which said subject matter pertains.\xe2\x80\x9d This provision of the law has\nproduced innumerable court cases, especially over improvement patents, when those who wish to use an\ninvention on which a patent has been issued have refused to pay royalties on the grounds that the\ninvention was obvious to anyone who looked.\n\nProcedures for Obtaining a Patent\nIn general, the United States (unlike many other countries) grants a patent right to the first person to\ninvent a product or process rather than to the first person to file for a patent on that product or process.\nAs a practical matter, however, someone who invents a product or process but does not file immediately\nshould keep detailed research notes or other evidence that would document the date of invention. An\ninventor who fails to apply for a patent within a year of that date would forfeit the rights granted to an\ninventor who had published details of the invention or offered it for sale. But until the year has passed, the\nPTO may not issue a patent to X if Y has described the invention in a printed publication here or abroad\nor the invention has been in public use or on sale in this country.\nAn inventor cannot obtain a patent automatically; obtaining a patent is an expensive and time-consuming\nprocess, and the inventor will need the services of a patent attorney, a highly specialized practitioner. The\nattorney will help develop the required specification, a description of the invention that gives enough\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n541\n\n\x0cdetail so that one skilled in the art will be able to make and use the invention. After receiving an\napplication, a PTO examiner will search the records and accept or reject the claim. Usually, the attorney\nwill negotiate with the examiner and will rewrite and refine the application until it is accepted. A rejection\nmay be appealed, first to the PTO\xe2\x80\x99s Board of Appeals and then, if that fails, to the federal district court in\nthe District of Columbia or to the US Court of Appeals for the Federal Circuit, the successor court to the\nold US Court of Customs and Patent Appeals.\nOnce a patent application has been filed, the inventor or a company to which she has assigned the\ninvention may put the words \xe2\x80\x9cpatent pending\xe2\x80\x9d on the invention. These words have no legal effect. Anyone\nis free to make the invention as long as the patent has not yet been issued. But they do put others on\nnotice that a patent has been applied for. Once the patent has been granted, infringers may be sued even if\nthe infringed has made the product and offered it for sale before the patent was granted.\nIn today\xe2\x80\x99s global market, obtaining a US patent is important but is not usually sufficient protection. The\ninventor will often need to secure patent protection in other countries as well. Under the Paris Convention\nfor the Protection of Industrial Property (1883), parties in one country can file for patent or trademark\nprotection in any of the other member countries (172 countries as of 2011). The World Trade\nOrganization\xe2\x80\x99s Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) established\nstandards for protecting intellectual property rights (patents, trademarks, and copyrights) and provides\nthat each member nation must have laws that protect intellectual property rights with effective access to\njudicial systems for pursuing civil and criminal penalties for violations of such rights.\n\nPatent Ownership\nThe patent holder is entitled to make and market the invention and to exclude others from doing so.\nBecause the patent is a species of property, it may be transferred. The inventor may assign part or all of\nhis interest in the patent or keep the property interest and license others to manufacture or use the\ninvention in return for payments known as royalties. The license may be exclusive with one licensee, or\nthe inventor may license many to exploit the invention. One important limitation on the inventor\xe2\x80\x99s right\nto the patent interest is the so-called shop right. This is a right created by state courts on equitable\ngrounds giving employers a nonexclusive royalty-free license to use any invention made by an employee\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n542\n\n\x0con company time and with company materials. The shop right comes into play only when a company has\nno express or implied understanding with its employees. Most corporate laboratories have a contractual\nagreement with employees about who owns the invention and what royalties will be paid.\n\nInfringement and Invalidity Suits\nSuits for patent infringement can arise in three ways: (1) the patent holder may seek damages and an\ninjunction against the infringer in federal court, requesting damages for royalties and lost profits as well;\n(2) even before being sued, the accused party may take the patent holder to court under the federal\nDeclaratory Judgment Act, seeking a court declaration that the patent is invalid; (3) the patent holder may\nsue a licensee for royalties claimed to be due, and the licensee may counterclaim that the patent is invalid.\nSuch a suit, if begun in state court, may be removed to federal court.\nIn a federal patent infringement lawsuit, the court may grant the winning party reimbursement for\nattorneys\xe2\x80\x99 fees and costs. If the infringement is adjudged to be intentional, the court can triple the amount\nof damages awarded. Prior to 2006, courts were typically granting permanent injunctions to prevent\nfuture infringement. Citing eBay, Inc. v. Merc Exchange, LLC,\n\n[7]\n\nthe Supreme Court ruled that patent\n\nholders are not automatically entitled to a permanent injunction against infringement during the life of\nthe patent. Courts have the discretion to determine whether justice requires a permanent injunction, and\nthey may conclude that the public interest and equitable principles may be better satisfied with\ncompensatory damages only.\nProving infringement can be a difficult task. Many companies employ engineers to \xe2\x80\x9cdesign around\xe2\x80\x9d a\npatent product\xe2\x80\x94that is, to seek ways to alter the product to such an extent that the substitute product no\nlonger consists of enough of the elements of the invention safeguarded by the patent. However, infringing\nproducts, processes, or machines need not be identical; as the Supreme Court said in Sanitary\nRefrigerator Co. v. Winers,\n\n[8]\n\n\xe2\x80\x9cone device is an infringement of another\xe2\x80\xa6if two devices do the same work\n\nin substantially the same way, and accomplish substantially the same result\xe2\x80\xa6even though they differ in\nname, form, or shape.\xe2\x80\x9d This is known as the doctrine of equivalents. In an infringement suit, the court\nmust choose between these two extremes: legitimate \xe2\x80\x9cdesign around\xe2\x80\x9d and infringement through some\nequivalent product.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n543\n\n\x0cAn infringement suit can often be dangerous because the defendant will almost always assert in its answer\nthat the patent is invalid. The plaintiff patent holder thus runs the risk that his entire patent will be taken\naway from him if the court agrees. In ruling on validity, the court may consider all the tests, such as prior\nart and obviousness, discussed in Section 13.1.2 "Patentability" and rule on these independently of the\nconclusions drawn by the PTO.\n\nPatent Misuse\nAlthough a patent is a monopoly granted to the inventor or his assignee or licensee, the monopoly power\nis legally limited. An owner who misuses the patent may find that he will lose an infringement suit. One\ncommon form of misuse is to tie the patented good to some unpatented one\xe2\x80\x94for example, a patented\nmovie projector that will not be sold unless the buyer agrees to rent films supplied only by the\nmanufacturer of the movie projector, or a copier manufacturer that requires buyers to purchase plain\npaper from it. As we will see in Chapter 16 "Antitrust Law", various provisions of the federal antitrust\nlaws, including, specifically, Section 3 of the Clayton Act, outlaw certain kinds of tying arrangements.\nAnother form of patent misuse is a provision in the licensing agreement prohibiting the manufacturer\nfrom also making competing products. Although the courts have held against several other types of\nmisuse, the general principle is that the owner may not use his patent to restrain trade in unpatented\ngoods.\n\nKEY TAKEAWAY\nMany different \xe2\x80\x9cthings\xe2\x80\x9d are patentable; include gene sequences, business processes, and any other\n\xe2\x80\x9cuseful invention.\xe2\x80\x9d The US Patent and Trademark Office acts on initial applications and may grant a\npatent to an applicant. The patent, which allows a limited-time monopoly, is for twenty years. The\ncategories of patentable things include processes, machines, manufactures, compositions of matter,\nand improvements. Ideas, mental processes, naturally occurring substances, methods of doing\nbusiness, printed matter, and scientific principles cannot be patented. Patent holders may sue for\ninfringement and royalties from an infringer user.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n544\n\n\x0cEXERCISES\n1.\n\nCalera, Inc. discovers a way to capture carbon dioxide emissions at a California power plant and use\nthem to make cement. This is a win for the power company, which needs to reduce its carbon dioxide\nemissions and a win for Calera. Calera decides to patent this invention. What kind of patent would this\nbe? A machine? A composition of matter? A manufacture?\n\n2.\n\nIn your opinion, what is the benefit of allowing companies to isolate genetic material and claim a\npatent? What kind of patent would this be? A machine? A composition of matter? A manufacture?\n\n3.\n\nHow could a \xe2\x80\x9cgarage inventor,\xe2\x80\x9d working on her own, protect a patentable invention while yet\ndemonstrating it to a large company that could bring the invention to market?\n\n[1] 35 United States Code, Section 101.\n[2] 35 United States Code, Section 101.\n[3] Commissioner of Patents v. Chakrabarty, 444 U.S. 1028 (1980).\n[4] Diamond v. Diehr, 450 U.S. 175 (1981).\n[5] State Street Bank and Trust v. Signature Financial Group, Inc., 149 F.3d 1368 (Fed. Cir. 1998).\n[6] Amazon.com v. Barnesandnoble.com, Inc., 239 F.3d 1343 (Fed. Cir. 2001).\n[7] eBay, Inc. v. Merc Exchange, LLC, 546 U.S. 388 (2006).\n[8] Sanitary Refrigerator Co. v. Winers, 280 U.S. 30 (1929).\n\n13.2 Trade Secrets\nLEARNING OBJECTIVES\n1.\n\nDescribe the difference between trade secrets and patents, and explain why a firm might prefer keeping a\ntrade secret rather than obtaining a patent.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n545\n\n\x0c2.\n\nUnderstand the dimensions of corporate espionage and the impact of the federal Economic Espionage\nAct.\n\nDefinition of Trade Secrets\nA patent is an invention publicly disclosed in return for a monopoly. A trade secret is a means to a\nmonopoly that a company hopes to maintain by preventing public disclosure. Why not always take out a\npatent? There are several reasons. The trade secret might be one that is not patentable, such as a customer\nlist or an improvement that does not meet the tests of novelty or non-obviousness. A patent can be\ndesigned around; but if the trade secret is kept, its owner will be the exclusive user of it. Patents are\nexpensive to obtain, and the process is extremely time consuming. Patent protection expires in twenty\nyears, after which anyone is free to use the invention, but a trade secret can be maintained for as long as\nthe secret is kept.\nHowever, a trade secret is valuable only so long as it is kept secret. Once it is publicly revealed, by\nwhatever means, anyone is free to use it. The critical distinction between a patent and a trade secret is\nthis: a patent gives its owner the right to enjoin anyone who infringes it from making use of it, whereas a\ntrade secret gives its \xe2\x80\x9cowner\xe2\x80\x9d the right to sue only the person who improperly took it or revealed it.\nAccording to the Restatement of Torts, Section 757, Comment b, a trade secret may consist of\nany formula, pattern, device or compilation of information which is used in one\xe2\x80\x99s business, and which\ngives him an opportunity to obtain an advantage over competitors who do not know or use it. It may be a\nformula for a chemical compound, a process of manufacturing, treating or preserving materials, a pattern\nfor a machine or other device, or a list of customers\xe2\x80\xa6A trade secret is a process or device for continuous\nuse in the operation of a business. Generally it relates to the production of goods, as, for example, a\nmachine or formula for the production of an article.\nOther types of trade secrets are customer information, pricing data, marketing methods, sources of\nsupply, and secret technical know-how.\n\nElements of Trade Secrets\nTo be entitled to protection, a trade secret must be (1) original and (2) secret.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n546\n\n\x0cOriginality\nThe trade secret must have a certain degree of originality, although not as much as would be necessary to\nsecure a patent. For example, a principle or technique that is common knowledge does not become a\nprotectable trade secret merely because a particular company taught it to one of its employees who now\nwants to leave to work for a competitor.\n\nSecrecy\nSome types of information are obviously secret, like the chemical formula that is jealously guarded\nthrough an elaborate security system within the company. But other kinds of information might not be\nsecret, even though essential to a company\xe2\x80\x99s business. For instance, a list of suppliers that can be devised\neasily by reading through the telephone directory is not secret. Nor is a method secret simply because\nsomeone develops and uses it, if no steps are taken to guard it. A company that circulates a product\ndescription in its catalog may not claim a trade secret in the design of the product if the description\npermits someone to do \xe2\x80\x9creverse engineering.\xe2\x80\x9d A company that hopes to keep its processes and designs\nsecret should affirmatively attempt to do so\xe2\x80\x94for example, by requiring employees to sign a nondisclosure\nagreement covering the corporate trade secrets with which they work. However, a company need not go to\nevery extreme to guard a trade secret.\nTrade-secrets espionage has become a big business. To protect industrial secrets, US corporations spend\nbillions on security arrangements. The line between competitive intelligence gathering and espionage can\nsometimes be difficult to draw. The problem is by no means confined to the United States; companies and\nnations all over the world have become concerned about theft of trade secrets to gain competitive\nadvantage, and foreign governments are widely believed to be involved in espionage and cyber-attacks.\n\nEconomic Espionage Act\nThe Economic Espionage Act (EEA) of 1996 makes the theft or misappropriation of a trade secret a\nfederal crime. The act is aimed at protecting commercial information rather than classified national\ndefense information. Two sorts of activities are criminalized. The first section of the act\n\n[1]\n\ncriminalizes the\n\nmisappropriation of trade secrets (including conspiracy to misappropriate trade secrets and the\nsubsequent acquisition of such misappropriated trade secrets) with the knowledge or intent that the theft\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n547\n\n\x0cwill benefit a foreign power. Penalties for violation are fines of up to US$500,000 per offense and\nimprisonment of up to fifteen years for individuals, and fines of up to US$10 million for organizations.\nThe second section\n\n[2]\n\ncriminalizes the misappropriation of trade secrets related to or included in a\n\nproduct that is produced for or placed in interstate (including international) commerce, with the\nknowledge or intent that the misappropriation will injure the owner of the trade secret. Penalties for\nviolation are imprisonment for up to ten years for individuals (no fines) and fines of up to US$5 million\nfor organizations.\nIn addition to these specific penalties, the fourth section of the EEA\n\n[3]\n\nalso requires criminal forfeiture of\n\n(1) any proceeds of the crime and property derived from proceeds of the crime and (2) any property used,\nor intended to be used, in commission of the crime.\nThe EEA authorizes civil proceedings by the Department of Justice to enjoin violations of the act but does\nnot create a private cause of action. This means that anyone believing they have been victimized must go\nthrough the US attorney general in order to obtain an injunction.\nThe EEA is limited to the United States and has no extraterritorial application unless (1) the offender is a\nUS company or a citizen operating from abroad against a US company or (2) an act in furtherance of the\nespionage takes place in the United States. Other nations lack such legislation, and some may actively\nsupport industrial espionage using both their national intelligence services. The US Office of the National\nCounterintelligence Executive publishes an annual report, mandated by the US Congress, on foreign\neconomic collection and industrial espionage, which outlines these espionage activities of many foreign\nnations.\n\nRight of Employees to Use Trade Secrets\nA perennial source of lawsuits in the trade secrets arena is the employee who is hired away by a\ncompetitor, allegedly taking trade secrets along with him. Companies frequently seek to prevent piracy by\nrequiring employees to sign confidentiality agreements. An agreement not to disclose particular trade\nsecrets learned or developed on the job is generally enforceable. Even without an agreement, an employer\ncan often prevent disclosure under principles of agency law. Sections 395 and 396 of the Restatement\n(Second) of Agency suggest that it is an actionable breach of duty to disclose to third persons information\ngiven confidentially during the course of the agency. However, every person is held to have a right to earn\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n548\n\n\x0ca living. If the rule were strictly applied, a highly skilled person who went to another company might be\nbarred from using his knowledge and skills. The courts do not prohibit people from using elsewhere the\ngeneral knowledge and skills they developed on the job. Only specific trade secrets are protected.\nTo get around this difficulty, some companies require their employees to sign agreements not to compete.\nBut unless the agreements are limited in scope and duration to protect a company against only specific\nmisuse of trade secrets, they are unenforceable.\n\nKEY TAKEAWAY\nTrade secrets, if they can be kept, have indefinite duration and thus greater potential value than patents.\nTrade secrets can be any formula, pattern, device, process, or compilation of information to be used in a\nbusiness. Customer information, pricing data, marketing methods, sources of supply, and technical knowhow could all be trade secrets. State law has protected trade secrets, and federal law has provided\ncriminal sanctions for theft of trade secrets. With the importance of digitized information, methods of\ntheft now include computer hacking; theft of corporate secrets is a burgeoning global business that often\ninvolves cyber-attacks.\n\nEXERCISES\n1.\n\nWu Dang, based in Hong Kong, hacks into the Hewlett-Packard database and \xe2\x80\x9csteals\xe2\x80\x9d plans and\nspecifications for HP\xe2\x80\x99s latest products. The HP server is located in the United States. He sells this\ninformation to a Chinese company in Shanghai. Has he violated the US Economic Espionage Act?\n\n2.\n\nWhat are the advantages of keeping a formula as a trade secret rather than getting patent protection?\n\n[1] Economic Espionage Act, 18 United States Code, Section 1831(a) (1996)\n[2] Economic Espionage Act, 18 United States Code, Section 1832 (1996).\n[3] Economic Espionage Act, 18 United States Code, Section 1834 (1996).\n\n13.3 Copyright\nLEARNING OBJECTIVES\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n549\n\n\x0c1.\n\nDescribe and explain copyrights, how to obtain one, and how they differ from trademarks.\n\n2.\n\nExplain the concept of fair use and describe its limits.\n\nDefinition and Duration\nCopyright is the legal protection given to \xe2\x80\x9cauthors\xe2\x80\x9d for their \xe2\x80\x9cwritings.\xe2\x80\x9d Copyright law is federal; like\npatent law, its source lies in the Constitution. Copyright protects the expression of ideas in some tangible\nform, but it does not protect the ideas themselves. Under the 1976 Copyright Act as amended, a copyright\nin any work created after January 1, 1978, begins when the work is fixed in tangible form\xe2\x80\x94for example,\nwhen a book is written down or a picture is painted\xe2\x80\x94and generally lasts for the life of the author plus 70\nyears after his or her death. This is similar to copyright protection in many countries, but in some\ncountries, the length of copyright protection is the life of the author plus 50 years. For copyrights owned\nby publishing houses, done as works for hire, common copyright expires 95 years from the date of\npublication or 120 years from the date of creation, whichever is first. For works created before 1978, such\nas many of Walt Disney\xe2\x80\x99s movies and cartoons, the US Sonny Bono Copyright Term Extension Act of 1998\nprovided additional protection of up to 95 years from publication date. Thus works created in 1923 by\nDisney would not enter the public domain until 2019 or after, unless the copyright had expired prior to\n1998 or unless the Disney company released the work into the public domain. In general, after expiration\nof the copyright, the work enters the public domain.\nIn 1989, the United States signed the Berne Convention, an international copyright treaty. This law\neliminated the need to place the symbol \xc2\xa9 or the word Copyright or the abbreviation Copr. on the work\nitself. Copyrights can be registered with the US Copyright Office in Washington, DC.\n\nProtected Expression\nThe Copyright Act protects a variety of \xe2\x80\x9cwritings,\xe2\x80\x9d some of which may not seem written at all. These\ninclude literary works (books, newspapers, and magazines), music, drama, choreography, films, art,\nsculpture, and sound recordings. Since copyright covers the expression and not the material or physical\nobject, a book may be copyrighted whether it is on paper, microfilm, tape, or computer disk.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n550\n\n\x0cRights Protected by the Copyright Act\nPreventing Copying\nA copyright gives its holder the right to prevent others from copying his or her work. The copyright holder\nhas the exclusive right to reproduce the work in any medium (paper, film, sound recording), to perform it\n(e.g., in the case of a play), or to display it (a painting or film). A copyright also gives its holder the\nexclusive right to prepare derivative works based on the copyrighted work. Thus a playwright could not\nadapt to the stage a novelist\xe2\x80\x99s book without the latter\xe2\x80\x99s permission.\n\nFair Use\nOne major exception to the exclusivity of copyrights is the fair use doctrine. Section 107 of the Copyright\nAct provides as follows:\nFair use of a copyrighted work, including such use by reproduction in copies or phono records or by any\nother means specified by section 106 of the copyright, for purposes such as criticism, comment, news\nreporting, teaching (including multiple copies for classroom use), scholarship, or research, is not an\ninfringement of copyright. In determining whether the use made of a work in any particular case is a fair\nuse, the factors to be considered shall include\xe2\x80\x93\n(1) the purpose and character of the use, including whether such use is of a commercial nature or is for\nnonprofit educational purposes;\n(2) the nature of the copyrighted work;\n(3) the amount and substantiality of the portion used in relation to the copyrighted work as a whole; and\n(4) the effect of the use upon the potential market for or value of the copyrighted work.\n\n[1]\n\nThese are broad guidelines. Accordingly, any copying could be infringement, and fair use could become a\nquestion of fact on a case-by-case basis. In determining fair use, however, courts have often considered\nthe fourth factor (effect of the use upon the potential market for the copyrighted work) to be the most\nimportant.\nClear examples of fair use would be when book reviewers or writers quote passages from copyrighted\nbooks. Without fair use, most writing would be useless because it could not readily be discussed. But the\ndoctrine of fair use grew more troublesome with the advent of plain-paper copiers and is now even more\ntroublesome with electronic versions of copyrighted materials that are easily copied and distributed. The\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n551\n\n\x0c1976 act took note of the new copier technology, listing \xe2\x80\x9cteaching (including multiple copies for classroom\nuse)\xe2\x80\x9d as one application of fair use. The Copyright Office follows guidelines specifying just how far the\ncopying may go\xe2\x80\x94for example, multiple copies of certain works may be made for classroom use, but copies\nmay not be used to substitute for copyrighted anthologies.\n\nInfringement\nVerbatim use of a copyrighted work is easily provable. The more difficult question arises when the\ncopyrighted work is altered in some way. As in patent law, the standard is one of substantial similarity.\n\nCopy-right ability Standards\nTo be subject to copyright, the writing must be \xe2\x80\x9cfixed\xe2\x80\x9d in some \xe2\x80\x9ctangible medium of expression.\xe2\x80\x9d A\nnovelist who composes a chapter of her next book in her mind and tells it to a friend before putting it on\npaper could not stop the friend from rushing home, writing it down, and selling it (at least the federal\ncopyright law would offer no protection; some states might independently offer a legal remedy, however).\nThe work also must be creative, at least to a minimal degree. Words and phrases, such as names, titles,\nand slogans, are not copyrightable; nor are symbols or designs familiar to the public. But an author who\ncontributes her own creativity\xe2\x80\x94like taking a photograph of nature\xe2\x80\x94may copyright the resulting work,\neven if the basic elements of the composition were not of her making.\nFinally, the work must be \xe2\x80\x9coriginal,\xe2\x80\x9d which means simply that it must have originated with the author.\nThe law does not require that it be novel or unique. This requirement was summarized pithily by Judge\nLearned Hand: \xe2\x80\x9cIf by some magic a man who had never known it were to compose anew Keats\xe2\x80\x99s Ode on a\nGrecian Urn, he would be an author, and, if he copyrighted it, others might not copy that poem, though\nthey might of course copy Keats\xe2\x80\x99s.\xe2\x80\x9d\n\n[2]\n\nSometimes the claim is made that a composer, for example, just\n\nhappened to compose a tune identical or strikingly similar to a copyrighted song; rather than assume the\nunlikely coincidence that Judge Hand hypothesized, the courts will look for evidence that the alleged\ncopier had access to the copyrighted song. If he did\xe2\x80\x94for example, the song was frequently played on the\nair\xe2\x80\x94he cannot defend the copying with the claim that it was unconscious, because the work would not\nthen have been original.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n552\n\n\x0cSection 102 of the Copyright Act excludes copyright protection for any \xe2\x80\x9cidea, procedure, process, system,\nmethod of operation, concept, principle, or discovery, regardless of the form in which it is described,\nexplained, illustrated, or embodied.\xe2\x80\x9d\n\n[3]\n\nEinstein copyrighted books and monographs he wrote on the theory of relativity, but he could not\ncopyright the famous formula E = mc2, nor could he prevent others from writing about the theory. But he\ncould protect the particular way in which his ideas were expressed. In general, facts widely known by the\npublic are not copyrightable, and mathematical calculations are not copyrightable. Compilations of facts\nmay be copyrightable, if the way that they are coordinated or arranged results in a work that shows some\noriginality. For example, compiled information about yachts listed for sale may qualify for copyright\nprotection.\n\n[4]\n\nOne of the most troublesome recent questions concerning expression versus ideas is whether a computer\nprogram may be copyrighted. After some years of uncertainty, the courts have accepted the copy-right\nability of computer programs.\n\n[5]\n\nNow the courts are wrestling with the more difficult question of the scope\n\nof protection: what constitutes an \xe2\x80\x9cidea\xe2\x80\x9d and what constitutes its mere \xe2\x80\x9cexpression\xe2\x80\x9d in a program.\nHow far the copyright law will protect particular software products is a hotly debated topic, sparked by a\nfederal district court\xe2\x80\x99s ruling in 1990 that the \xe2\x80\x9clook and feel\xe2\x80\x9d of Lotus 1-2-3\xe2\x80\x99s menu system is\ncopyrightable and was in fact infringed by Paperback Software\xe2\x80\x99s VP-Planner, a competing\nspreadsheet.\n\n[6]\n\nThe case has led some analysts to \xe2\x80\x9cfear that legal code, rather than software code, is\n\nemerging as the factor that will determine which companies and products will dominate the 1990s.\xe2\x80\x9d\n\n[7]\n\nWho May Obtain a Copyright?\nWith one important exception, only the author may hold the initial copyright, although the author may\nassign it or license any one or more of the rights conveyed by the copyright. This is a simple principle\nwhen the author has written a book or painted a picture. But the law is unclear in the case of a motion\npicture or a sound recording. Is the author the script writer, the producer, the performer, the director, the\nengineer, or someone else? As a practical matter, all parties involved spell out their rights by contract.\nThe exception, which frequently covers the difficulties just enumerated, is for works for hire. Any person\nemployed to write\xe2\x80\x94a journalist or an advertising jingle writer, for example\xe2\x80\x94is not the \xe2\x80\x9cauthor.\xe2\x80\x9d For\npurposes of the statute, the employer is the author and may take out the copyright. When the employee is\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n553\n\n\x0cin fact an \xe2\x80\x9cindependent contractor\xe2\x80\x9d and the work in question involves any one of nine types (book,\nmovies, etc.) spelled out in the Copyright Act, the employer and the creator must spell out their\nentitlement to the copyright in a written agreement.\n\n[8]\n\nObtaining a Copyright\nUntil 1978, a work could not be copyrighted unless it was registered in the Copyright Office or was\npublished and unless each copy of the work carried a copyright notice, consisting of the word Copyright,\nthe abbreviation Copr., or the common symbol \xc2\xa9, together with the date of first publication and the name\nof the copyright owner. Under the 1976 act, copyright became automatic whenever the work was fixed in a\ntangible medium of expression (e.g., words on paper, images on film or videotape, sound on tape or\ncompact disc), even if the work remained unpublished or undistributed. However, to retain copyright\nprotection, the notice had to be affixed once the work was \xe2\x80\x9cpublished\xe2\x80\x9d and copies circulated to the public.\nAfter the United States entered the Berne Convention, an international treaty governing copyrights,\nCongress enacted the Berne Implementation Act, declaring that, effective in 1989, notice, even after\npublication, was no longer required.\nNotice does, however, confer certain benefits. In the absence of notice, a copyright holder loses the right\nto receive statutory damages (an amount stated in the Copyright Act and not required to be proved) if\nsomeone infringes the work. Also, although it is no longer required, an application and two copies of the\nwork (for deposit in the Library of Congress) filed with the Copyright Office, in Washington, DC, will\nenable the copyright holder to file suit should the copyright be infringed. Unlike patent registration, which\nrequires elaborate searching of Patent and Trademark Office (PTO) records, copyright registration does\nnot require a reading of the work to determine whether it is an original creation or an infringement of\nsomeone else\xe2\x80\x99s prior work. But copyright registration does not immunize the holder from an infringement\nsuit. If a second work has been unlawfully copied from an earlier work, the second author\xe2\x80\x99s copyright will\nnot bar the infringed author from collecting damages and obtaining an injunction.\n\nComputer Downloads and the Digital Millennium Copyright Act\nThe ubiquity of the Internet and the availability of personal computers with large capacities have greatly\nimpacted the music business. Sharing of music files took off in the late 1990s with Napster, which lost a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n554\n\n\x0clegal battle on copyright and had to cease doing business. By providing the means by which individuals\ncould copy music that had been purchased, major record labels were losing substantial profits. Grokster, a\nprivately owned software company based in the West Indies, provided peer-to-peer file sharing from 2001\nto 2005 until the US Supreme Court\xe2\x80\x99s decision in MGM Studios, Inc. v. Grokster, Ltd.\n\n[9]\n\nFor computers with the Microsoft operating system, the Court disallowed the peer-to-peer file sharing,\neven though Grokster claimed it did not violate any copyright laws because no files passed through its\ncomputers. (Grokster had assigned certain user computers as \xe2\x80\x9croot super-nodes\xe2\x80\x9d that acted as music hubs\nfor the company and was not directly involved in controlling any specific music-file downloads.)\nGrokster had argued, based on Sony v. Universal Studios,\n\n[10]\n\nthat the sale of its copying equipment (like\n\nthe Betamax videocassette recorders at issue in that case) did not constitute contributory infringement \xe2\x80\x9cif\nthe product is widely used for legitimate, unobjectionable purposes.\xe2\x80\x9d Plaintiffs successfully argued that\nthe Sony safe-harbor concept requires proof that the non-infringing use is the primary use in terms of the\nproduct\xe2\x80\x99s utility.\nThe Digital Millennium Copyright Act (DMCA), passed into law in 1998, implements two 1996 treaties of\nthe World Intellectual Property Organization. It criminalizes production and sale of devices or services\nintended to get around protective measures that control access to copyrighted works. In addition, the\nDMCA heightens the penalties for copyright infringement on the Internet. The DMCA amended Title 17 of\nthe United States Code to extend the reach of copyright, while limiting the liability of the providers of\nonline services for copyright infringement by their users.\n\nKEY TAKEAWAY\nCopyright is the legal protection given to \xe2\x80\x9cauthors\xe2\x80\x9d for their \xe2\x80\x9cwritings.\xe2\x80\x9d It protects ideas in fixed,\ntangible form, not ideas themselves. Copyright protection can extend as long as 120 years from the\ndate of creation or publication. Expression found in literary works, music, drama, film, art, sculpture,\nsound recordings, and the like may be copyrighted. The fair use doctrine limits the exclusivity of\ncopyright in cases where scholars, critics, or teachers use only selected portions of the copyrighted\nmaterial in a way that is unlikely to affect the potential market for or value of the copyrighted work.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n555\n\n\x0cEXERCISES\n1.\n\nExplain how a list could be copyrightable.\n\n2.\n\nAn author wrote a novel, Brunch at Bruno\xe2\x80\x99s, in 1961. She died in 1989, and her heirs now own the\ncopyright. When do the rights of the heirs come to an end? That is, when does Brunch at\nBruno\xe2\x80\x99s enter the public domain?\n\n3.\n\nKeith Bradsher writes a series of articles on China for the New York Times and is paid for doing so.\nSuppose he wants to leave the employ of the Times and be a freelance writer. Can he compile his best\narticles into a book, Changing Times in China, and publish it without the New York Times\xe2\x80\x99 permission?\nDoes it matter that he uses the word Times in his proposed title?\n\n4.\n\nWhat kind of file sharing of music is now entirely legal? Shaunese Collins buys a Yonder Mountain\nString Band CD at a concert at Red Rocks in Morrison, Colorado. With her iMac, she makes a series of\nCDs for her friends. She does this six times. Has she committed six copyright violations?\n\n[1] 17 United States Code, Section 107.\n[2] Sheldon v. Metro-Goldwyn Pictures Corp., 81 F.2d 49 (2d Cir. 1936).\n[3] 17 United States Code, Section 102.\n[4] BUC International Corp. v. International Yacht Council, Ltd., 489 F.3d 1129 (11th Cir. 2007).\n[5] Apple Computer, Inc. v. Franklin Computer Corp., 714 F.2d 1240 (3d Cir. 1983).\n[6] Lotus Development Corp. v. Paperback Software International, 740 F.Supp. 37 (D. Mass. 1990).\n[7] Peter H. Lewis, \xe2\x80\x9cWhen Computing Power Is Generated by the Lawyers,\xe2\x80\x9d New York Times, July 22 1990.\n[8] Community for Creative Non-Violence v. Reid, 109 S.Ct. 2166 (1989).\n[9] MGM Studios, Inc. v. Grokster, Ltd., 545 U.S. 913 (2005).\n[10] Sony v. Universal Studios, 464 U.S. 417 (1984).\n\n13.4 Trademarks\nLEARNING OBJECTIVES\n1.\n\nUnderstand what a trademark is and why it deserves protection.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n556\n\n\x0c2.\n\nKnow why some \xe2\x80\x9cmarks\xe2\x80\x9d may not be eligible for trademark protection, and how to obtain trademark\nprotection for those that are.\n\n3.\n\nExplain what \xe2\x80\x9cblurring\xe2\x80\x9d and \xe2\x80\x9ctarnishment\xe2\x80\x9d are and what remedies are available to the holder of the\nmark.\n\nDefinitions of Trademarks\nA trademark is defined in the federal Lanham Act of 1946 as \xe2\x80\x9cany word, name, symbol, or device or any\ncombination thereof adopted and used by a manufacturer or merchant to identify his goods and\ndistinguish them from goods manufactured or sold by others.\xe2\x80\x9d\n\n[1]\n\nExamples of well-known trademarks are Coca-Cola, Xerox, and Apple. A service mark is used in the sale\nor advertising of services to identify the services of one person and distinguish them from the services of\nothers. Examples of service marks are McDonald\xe2\x80\x99s, BP, and Hilton. A certification mark is used in\nconnection with many products \xe2\x80\x9cto certify regional or other origin, material, mode of manufacture,\nquality, accuracy or other characteristics of such goods or services or that the work or labor on the goods\nor services was performed by members of a union or other organization.\xe2\x80\x9d Examples are the Good\nHousekeeping Seal of Approval and UL (Underwriters Laboratories, Inc., approval mark). Unlike other\nforms of trademark, the owner of the certification mark (e.g., Good Housekeeping, or the Forest\nStewardship Council\xe2\x80\x99s FSC mark) is not the owner of the underlying product.\n\nExtent of Trademark Protection\nKinds of Marks\nTrademarks and other kinds of marks may consist of words and phrases, pictures, symbols, shapes,\nnumerals, letters, slogans, and sounds. Trademarks are a part of our everyday world: the sounds of a radio\nor television network announcing itself (NBC, BBC), the shape of a whiskey bottle (Haig & Haig\xe2\x80\x99s Pinch\nBottle), a series of initials (GE, KPMG, IBM), or an animal\xe2\x80\x99s warning growl (MGM\xe2\x80\x99s lion).\n\nLimitations on Marks\nAlthough trademarks abound, the law limits the subjects that may fall into one of the defined categories.\nNot every word or shape or symbol will be protected in an infringement action. To qualify for protection, a\ntrademark must be used to identify and distinguish. The courts employ a four-part test: (1) Is the mark so\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n557\n\n\x0carbitrary and fanciful that it merits the widest protection? (2) Is it \xe2\x80\x9csuggestive\xe2\x80\x9d enough to warrant\nprotection without proof of secondary meaning? (3) Is it \xe2\x80\x9cdescriptive,\xe2\x80\x9d warranting protection if secondary\nmeaning is proved? (4) Is the mark generic and thus un-protectable?\nThese tests do not have mechanical answers; they call for judgment. Some marks are wholly fanciful,\nclearly identify origin of goods, and distinguish them from others\xe2\x80\x94Kodak, for example. Other marks may\nnot be so arbitrary but may nevertheless be distinctive, either when adopted or as a result of advertising\xe2\x80\x94\nfor example, Crest, as the name of a toothpaste.\nMarks that are merely descriptive of the product are entitled to protection only if it can be shown that the\nmark has acquired secondary meaning. This term reflects a process of identification on the mark in the\npublic mind with the originator of the product. Holiday Inn was initially deemed too descriptive: an inn\nwhere people might go on holiday. But over time, travelers came to identify the source of the Great Sign\nand the name Holiday Inn as the Holiday Inn Corporation in Memphis, and secondary meaning was\ngranted. Holiday Inn could thus protect its mark against other innkeepers, hoteliers, and such; however,\nthe trademark protection for the words Holiday Inn was limited to the corporation\xe2\x80\x99s hotel and motel\nbusiness, and no other.\nCertain words and phrases may not qualify at all for trademark protection. These include generic terms\nlike \xe2\x80\x9cstraw broom\xe2\x80\x9d (for a broom made of straw) and ordinary words like \xe2\x80\x9cfast food.\xe2\x80\x9d In one case, a federal\nappeals court held that the word \xe2\x80\x9cLite\xe2\x80\x9d is generic and cannot be protected by a beer manufacturer to\ndescribe a low-calorie brew.\n\n[2]\n\nDonald Trump\xe2\x80\x99s effort to trademark \xe2\x80\x9cYou\xe2\x80\x99re fired!\xe2\x80\x9d and Paris Hilton\xe2\x80\x99s\n\ndesire to trademark \xe2\x80\x9cThat\xe2\x80\x99s hot!\xe2\x80\x9d were also dismissed as being generic.\nDeceptive words will not be accepted for registration. Thus the US Patent and Trademark Office (PTO)\ndenied registration to the word Vynahyde because it suggested that the plastic material to which it was\napplied came from animal skin. Geographic terms are descriptive words and may not be used as protected\ntrademarks unless they have acquired a secondary meaning, such as Hershey when used for chocolates.\n(Hershey\xe2\x80\x99s chocolates are made in Hershey, Pennsylvania.) A design that reflects a common style cannot\nbe protected in a trademark to exclude other similar designs in the same tradition. Thus the courts have\nruled that a silverware pattern that is a \xe2\x80\x9cfunctional feature\xe2\x80\x9d of the \xe2\x80\x9cbaroque style\xe2\x80\x9d does not qualify for\ntrademark protection. Finally, the Lanham Act denies federal registration to certain marks that fall within\ncategories of words and shapes, including the following: the flag; the name, portrait, or signature of any\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n558\n\n\x0cliving person without consent, or of a deceased US president during the lifetime of his widow; and\nimmoral, deceptive, or scandalous matter (in an earlier era, the phrase \xe2\x80\x9cBubby Trap\xe2\x80\x9d for brassieres was\ndenied registration).\n\nDilution, Tarnishment, and Blurring\nUnder the federal Trademark Dilution Act of 1995, companies with marks that dilute the value of a senior\nmark may be liable for damages. The act provides that owners of marks of significant value have property\nrights that should not be eroded, blurred, tarnished, or diluted in any way by another. But as a plaintiff,\nthe holder of the mark must show (1) that it is a famous mark, (2) that the use of a similar mark is\ncommercial, and (3) that such use causes dilution of the distinctive quality of the mark. Thus a T-shirt\nmaker who promotes a red-and-white shirt bearing the mark Budweiser may be liable to Anheuser-Busch,\nor a pornographic site called Candy land could be liable to Parker Brothers, the board game company.\nInteresting cases have already been brought under this act, including a case brought by Victoria\xe2\x80\x99s Secret\nagainst a small adult store in Kentucky called Victor\xe2\x80\x99s Little Secret. Notice that unlike most prior\ntrademark law, the purpose is not to protect the consumer from confusion as to the source or origin of the\ngoods or services being sold; for example, no one going to the Candy land site would think that Parker\nBrothers was the source.\n\nAcquiring Trademark Rights\nFor the first time in more than forty years, Congress, in 1988, changed the way in which trademarks can\nbe secured. Under the Lanham Act, the fundamental means of obtaining a trademark was through use.\nThe manufacturer or distributor actually must have placed the mark on its product\xe2\x80\x94or on related\ndisplays, labels, shipping containers, advertisements, and the like\xe2\x80\x94and then have begun selling the\nproduct. If the product was sold in interstate commerce, the trademark was entitled to protection under\nthe Lanham Act (or if not, to protection under the common law of the state in which the product was\nsold).\nUnder the Trademark Law Revision Act of 1988, which went into effect in 1989, trademarks can be\nobtained in advance by registering with the PTO an intention to use the mark within six months (the\napplicant can gain extensions of up to thirty more months to put the mark into use). Once obtained, the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n559\n\n\x0ctrademark will be protected for ten years (before the 1988 revision, a federal trademark remained valid\nfor twenty years); if after that time the mark is still being used, the registration can be renewed. Obtaining\na trademark registration lies between obtaining patents and obtaining copyrights in difficulty. The PTO\nwill not routinely register a trademark; it searches its records to ensure that the mark meets several\nstatutory tests and does not infringe another mark. Those who feel that their own marks would be hurt by\nregistration of a proposed mark may file an opposition proceeding with the PTO. Until 1990, the office\nreceived about 77,000 applications each year. With the change in procedure, some experts predicted that\napplications would rise by 30 percent.\nIn many foreign countries, use need not be shown to obtain trademark registration. It is common for\nsome people in these countries to register marks that they expect to be valuable so that they can sell the\nright to use the mark to the company that established the mark\xe2\x80\x99s value. Companies that expect to market\nabroad should register their marks early.\n\nLoss of Rights\nTrademark owners may lose their rights if they abandon the mark, if a patent or copyright expires on\nwhich the mark is based, or if the mark becomes generic. A mark is abandoned if a company goes out of\nbusiness and ceases selling the product. Some marks are based on design patents; when the patent\nexpires, the patent holder will not be allowed to extend the patent\xe2\x80\x99s duration by arguing that the design or\nname linked with the design is a registrable trademark.\nThe most widespread difficulty that a trademark holder faces is the prospect of too much success: if a\ntrademark comes to stand generically for the product itself, it may lose exclusivity in the mark. Famous\nexamples are aspirin, escalator, and cellophane. The threat is a continual one. Trademark holders can\nprotect themselves from their marks\xe2\x80\x99 becoming generic in several ways.\n1.\n\nUse a descriptive term along with the trademark. Look on a jar of Vaseline and you will see that the\nlabel refers to the contents as Vaseline petroleum jelly.\n\n2. Protest generic use of the mark in all publications by writing letters and taking out advertisements.\n3. Always put the words Trademark, Registered Trademark, or the symbol \xc2\xae (meaning \xe2\x80\x9cregistered\xe2\x80\x9d)\nnext to the mark itself, which should be capitalized.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n560\n\n\x0cKEY TAKEAWAY\nTrademark protection is federal, under the Lanham Act. Branding of corporate logos, names, and\nproducts is essential to business success, and understanding trademarks is pivotal to branding. A\n\xe2\x80\x9cmark\xe2\x80\x9d must be distinctive, arbitrary, or fanciful to merit protection: this means that it must not be\ngeneric or descriptive. Marks can be words, symbols, pictures, slogans, sounds, phrases, and even\nshapes. In the United States, rights to marks are obtained by registration and intent to use in\ncommerce and must be renewed every ten years.\n\nEXERCISES\n1.\n\nHow will Google protect its trademark, assuming that people begin using \xe2\x80\x9cGoogle\xe2\x80\x9d as a verb substitute\nfor \xe2\x80\x9cInternet search,\xe2\x80\x9d just like people began using the word \xe2\x80\x9ccellophane\xe2\x80\x9d for all brands of plastic\nwrap?\n\n2.\n\nDo a small amount of web searching and find out what \xe2\x80\x9ctrade dress\xe2\x80\x9d protection is, and how it differs\nfrom trademark protection.\n\n3.\n\nLexisNexis is a brand for a database collection offered by Mead Data Central. Lexus is a high-end\nautomobile. Can Lexus succeed in getting Mead Data Central to stop using \xe2\x80\x9cLexis\xe2\x80\x9d as a mark?\n\n[1] 15 United States Code, Section 1127.\n[2] Miller Brewing Co. v. Falstaff Brewing Corp., 655 F.2d 5 (1st Cir. 1981).\n\n13.5 Cases\nFair Use in Copyright\nElvis Presley Enterprises et al. v. Passport Video et al.\n349 F.3d 622 (9th Circuit Court of Appeals, 2003)\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n561\n\n\x0cTALLMAN, CIRCUIT JUDGE:\nPlaintiffs are a group of companies and individuals holding copyrights in various materials relating to\nElvis Presley. For example, plaintiff SOFA Entertainment, Inc., is the registered owner of several Elvis\nappearances on The Ed Sullivan Show. Plaintiff Promenade Trust owns the copyright to two television\nspecials featuring Elvis: The Elvis 1968 Comeback Special and Elvis Aloha from Hawaii\xe2\x80\xa6Many Plaintiffs\nare in the business of licensing their copyrights. For example, SOFA Entertainment charges $10,000 per\nminute for use of Elvis\xe2\x80\x99 appearances on The Ed Sullivan Show.\nPassport Entertainment and its related entities (collectively \xe2\x80\x9cPassport\xe2\x80\x9d) produced and sold The Definitive\nElvis, a 16-hour video documentary about the life of Elvis Presley. The Definitive Elvis sold for $99 at\nretail. Plaintiffs allege that thousands of copies were sent to retail outlets and other distributors. On its\nbox, The Definitive Elvis describes itself as an all-encompassing, in-depth look at the life and career of a\nman whose popularity is unrivaled in the history of show business and who continues to attract millions\nof new fans each year.\xe2\x80\xa6\nThe Definitive Elvis uses Plaintiffs\xe2\x80\x99 copyrighted materials in a variety of ways. With the video footage, the\ndocumentary often uses shots of Elvis appearing on television while a narrator or interviewee talks over\nthe film. These clips range from only a few seconds in length to portions running as long as 30 seconds. In\nsome instances, the clips are the subject of audio commentary, while in other instances they would more\nproperly be characterized as video \xe2\x80\x9cfiller\xe2\x80\x9d because the commentator is discussing a subject different from\nor more general than Elvis\xe2\x80\x99 performance on a particular television show. But also significant is the\nfrequency with which the copyrighted video footage is used. The Definitive Elvis employs these clips, in\nmany instances, repeatedly. In total, at least 5% to 10% of The Definitive Elvis uses Plaintiffs\xe2\x80\x99 copyrighted\nmaterials.\nUse of the video footage, however, is not limited to brief clips.\xe2\x80\xa6Thirty-five percent of his appearances\non The Ed Sullivan Show is replayed, as well as three minutes from The 1968 Comeback Special.\n***\nPlaintiffs sued Passport for copyright infringement\xe2\x80\xa6Passport, however, asserts that its use of the\ncopyrighted materials was \xe2\x80\x9cfair use\xe2\x80\x9d under 17 U.S.C. \xc2\xa7 107. Plaintiffs moved for a preliminary injunction,\nwhich was granted by the district court after a hearing. The district court found that Passport\xe2\x80\x99s use of\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n562\n\n\x0cPlaintiffs\xe2\x80\x99 copyrighted materials was likely not fair use. The court enjoined Passport from selling or\ndistributing The Definitive Elvis. Passport timely appeals.\n***\nWe first address the purpose and character of Passport\xe2\x80\x99s use of Plaintiffs\xe2\x80\x99 copyrighted materials. Although\nnot controlling, the fact that a new use is commercial as opposed to non-profit weighs against a finding of\nfair use. Harper & Row Publishers, Inc. v. Nation Enters, 471 U.S. 539, 562, 85 L. Ed. 2d 588, 105 S.Ct.\n2218 (1985). And the degree to which the new user exploits the copyright for commercial gain\xe2\x80\x94as\nopposed to incidental use as part of a commercial enterprise\xe2\x80\x94affects the weight we afford commercial\nnature as a factor. More importantly for the first fair-use factor, however, is the \xe2\x80\x9ctransformative\xe2\x80\x9d nature of\nthe new work. Specifically, we ask \xe2\x80\x9cwhether the new work\xe2\x80\xa6merely supersedes the objects of the original\ncreation, or instead adds something new, with a further purpose or different character, altering the first\nwith new expression, meaning, or message.\xe2\x80\xa6\xe2\x80\x9d The more transformative new works, the less significant\nother inquiries, such as commercialism, become.\n***\nThe district court below found that the purpose and character of The Definitive Elvis will likely weigh\nagainst a finding of fair use. We cannot say, based on this record, that the district court abused its\ndiscretion.\nFirst, Passport\xe2\x80\x99s use, while a biography, is clearly commercial in nature. But more significantly, Passport\nseeks to profit directly from the copyrights it uses without a license. One of the most salient selling points\non the box of The Definitive Elvis is that \xe2\x80\x9cEvery Film and Television Appearance is represented.\xe2\x80\x9d Passport\nis not advertising a scholarly critique or historical analysis, but instead seeks to profit at least in part from\nthe inherent entertainment value of Elvis\xe2\x80\x99 appearances on such shows as The Steve Allen Show, The Ed\nSullivan Show, and The 1968 Comeback Special. Passport\xe2\x80\x99s claim that this is scholarly research\ncontaining biographical comments on the life of Elvis is not dispositive of the fair use inquiry.\nSecond, Passport\xe2\x80\x99s use of Plaintiffs\xe2\x80\x99 copyrights is not consistently transformative. True, Passport\xe2\x80\x99s use of\nmany of the television clips is transformative because the clips play for only a few seconds and are used\nfor reference purposes while a narrator talks over them or interviewees explain their context in Elvis\xe2\x80\x99\ncareer. But voice-overs do not necessarily transform a work.\xe2\x80\xa6\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n563\n\n\x0cIt would be impossible to produce a biography of Elvis without showing some of his most famous\ntelevision appearances for reference purposes. But some of the clips are played without much\ninterruption, if any. The purpose of showing these clips likely goes beyond merely making a reference for\na biography, but instead serves the same intrinsic entertainment value that is protected by Plaintiffs\xe2\x80\x99\ncopyrights.\n***\nThe third factor is the amount and substantiality of the portion used in relation to the copyrighted work as\na whole. This factor evaluates both the quantity of the work taken and the quality and importance of the\nportion taken. Regarding the quantity, copying \xe2\x80\x9cmay not be excused merely because it is insubstantial\nwith respect to the infringing work.\xe2\x80\x9d Harper & Row, 471 U.S. at 565 (emphasis in original). But if the\namount used is substantial with respect to the infringing work, it is evidence of the value of the copyrighted work.\nPassport\xe2\x80\x99s uses of clips from television appearances, although in most cases of short duration, were\nrepeated numerous times throughout the tapes. While using a small number of clips to reference an event\nfor biographical purposes seems fair, using a clip over and over will likely no longer serve a biographical\npurpose. Additionally, some of the clips were not short in length. Passport\xe2\x80\x99s use of Elvis\xe2\x80\x99 appearance\non The Steve Allen Show plays for over a minute and many more clips play for more than just a few\nseconds.\nAdditionally, although the clips are relatively short when compared to the entire shows that are\ncopyrighted, they are in many instances the heart of the work. What makes these copyrighted works\nvaluable is Elvis\xe2\x80\x99 appearance on the shows, in many cases singing the most familiar passages of his most\npopular songs. Plaintiffs are in the business of licensing these copyrights. Taking key portions extracts the\nmost valuable part of Plaintiffs\xe2\x80\x99 copyrighted works. With respect to the photographs, the entire picture is\noften used. The music, admittedly, is usually played only for a few seconds.\n***\nThe last, and \xe2\x80\x9cundoubtedly the single most important\xe2\x80\x9d of all the factors, is the effect the use will have on\nthe potential market for and value of the copyrighted works. Harper & Row, 471 U.S. at 566. We must\n\xe2\x80\x9cconsider not only the extent of market harm caused by the particular actions of the alleged infringer, but\nalso whether unrestricted and widespread conduct of the sort engaged in by the defendant\xe2\x80\xa6would result\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n564\n\n\x0cin a substantially adverse impact on the potential market for the original.\xe2\x80\x9d Campbell, 510 U.S. at 590. The\nmore transformative the new work, the less likely the new work\xe2\x80\x99s use of copyrighted materials will affect\nthe market for the materials. Finally, if the purpose of the new work is commercial in nature, \xe2\x80\x9cthe\nlikelihood [of market harm] may be presumed.\xe2\x80\x9d A&M Records, 239 F.3d at 1016 (quoting Sony, 464 U.S.\nat 451).\nThe district court found that Passport\xe2\x80\x99s use of Plaintiffs\xe2\x80\x99 copyrighted materials likely does affect the\nmarket for those materials. This conclusion was not clearly erroneous.\nFirst, Passport\xe2\x80\x99s use is commercial in nature, and thus we can assume market harm. Second, Passport has\nexpressly advertised that The Definitive Elvis contains the television appearances for which Plaintiffs\nnormally charge a licensing fee. If this type of use became wide-spread, it would likely undermine the\nmarket for selling Plaintiffs\xe2\x80\x99 copyrighted material. This conclusion, however, does not apply to the music\nand still photographs. It seems unlikely that someone in the market for these materials would\npurchase The Definitive Elvis instead of a properly licensed product. Third, Passport\xe2\x80\x99s use of the\ntelevision appearances was, in some instances, not transformative, and therefore these uses are likely to\naffect the market because they serve the same purpose as Plaintiffs\xe2\x80\x99 original works.\n***\nWe emphasize that our holding today is not intended to express how we would rule were we examining\nthe case ab initio as district judges. Instead, we confine our review to whether the district court abused its\ndiscretion when it weighed the four statutory fair-use factors together and determined that Plaintiffs\nwould likely succeed on the merits. Although we might view this case as closer than the district court saw\nit, we hold there was no abuse of discretion in the court\xe2\x80\x99s decision to grant Plaintiffs\xe2\x80\x99 requested relief.\nAFFIRMED.\n\nCASE QUESTIONS\n1.\n\nHow would you weigh the four factors in this case? If the trial court had found fair use, would the\nappeals court have overturned its ruling?\n\n2.\n\nWhy do you think that the fourth factor is especially important?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n565\n\n\x0c3.\n\nWhat is the significance of the discussion on \xe2\x80\x9ctransformative\xe2\x80\x9d aspects of the defendant\xe2\x80\x99s product?\n\nTrademark Infringement and Dilution\nPlayboy Enterprises v. Welles\n279 F.3d 796 (9th Circuit Court of Appeals, 2001)\nT. G. NELSON, Circuit Judge:\nTerri Welles was on the cover of Playboy in 1981 and was chosen to be the Playboy Playmate of the Year\nfor 1981. Her use of the title \xe2\x80\x9cPlayboy Playmate of the Year 1981,\xe2\x80\x9d and her use of other trademarked terms\non her website are at issue in this suit. During the relevant time period, Welles\xe2\x80\x99 website offered\ninformation about and free photos of Welles, advertised photos for sale, advertised memberships in her\nphoto club, and promoted her services as a spokesperson. A biographical section described Welles\xe2\x80\x99\nselection as Playmate of the Year in 1981 and her years modeling for PEI. The site included a disclaimer\nthat read as follows: \xe2\x80\x9cThis site is neither endorsed, nor sponsored, nor affiliated with Playboy Enterprises,\nInc. PLAYBOY tm PLAYMATE OF THE YEAR tm AND PLAYMATE OF THE MONTH tm are registered\ntrademarks of Playboy Enterprises, Inc.\xe2\x80\x9d\nWells used (1) the terms \xe2\x80\x9cPlayboy \xe2\x80\x9dand \xe2\x80\x9cPlaymate\xe2\x80\x9d in the meta tags of the website; (2) the phrase\n\xe2\x80\x9cPlaymate of the Year 1981\xe2\x80\x9d on the masthead of the website; (3) the phrases \xe2\x80\x9cPlayboy Playmate of the Year\n1981\xe2\x80\x9d and \xe2\x80\x9cPlaymate of the Year 1981\xe2\x80\x9d on various banner ads, which may be transferred to other websites;\nand (4) the repeated use of the abbreviation \xe2\x80\x9cPMOY \xe2\x80\x9981\xe2\x80\x9d as the watermark on the pages of the website.\nPEI claimed that these uses of its marks constituted trademark infringement, dilution, false designation of\norigin, and unfair competition. The district court granted defendants\xe2\x80\x99 motion for summary judgment. PEI\nappeals the grant of summary judgment on its infringement and dilution claims. We affirm in part and\nreverse in part.\nA. Trademark Infringement\nExcept for the use of PEI\xe2\x80\x99s protected terms in the wallpaper of Welles\xe2\x80\x99 website, we conclude that Welles\xe2\x80\x99\nuses of PEI\xe2\x80\x99s trademarks are permissible, nominative uses. They imply no current sponsorship or\nendorsement by PEI. Instead, they serve to identify Welles as a past PEI \xe2\x80\x9cPlaymate of the Year.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n566\n\n\x0cWe articulated the test for a permissible, nominative use in New Kids On The Block v. New America\nPublishing, Inc. The band, New Kids On The Block, claimed trademark infringement arising from the use\nof their trademarked name by several newspapers. The newspapers had conducted polls asking which\nmember of the band New Kids On The Block was the best and most popular. The papers\xe2\x80\x99 use of the\ntrademarked term did not fall within the traditional fair use doctrine. Unlike a traditional fair use\nscenario, the defendant newspaper was using the trademarked term to describe not its own product, but\nthe plaintiff\xe2\x80\x99s. Thus, the factors used to evaluate fair use were inapplicable. The use was nonetheless\npermissible, we concluded, based on its nominative nature.\nWe adopted the following test for nominative use:\nFirst, the product or service in question must be one not readily identifiable without use of the trademark;\nsecond, only so much of the mark or marks may be used as is reasonably necessary to identify the product\nor service; and third, the user must do nothing that would, in conjunction with the mark, suggest\nsponsorship or endorsement by the trademark holder.\nWe group the uses of PEI\xe2\x80\x99s trademarked terms into three for the purpose of applying the test for\nnominative use.\n1. Headlines and banner advertisements.\n...\nThe district court properly identified Welles\xe2\x80\x99 situation as one which must\xe2\x80\xa6 be accepted. No descriptive\nsubstitute exists for PEI\xe2\x80\x99s trademarks in this context.\xe2\x80\xa6Just as the newspapers in New Kids could only\nidentify the band clearly by using its trademarked name, so can Welles only identify herself clearly by\nusing PEI\xe2\x80\x99s trademarked title.\nThe second part of the nominative use test requires that \xe2\x80\x9conly so much of the mark or marks may be used\nas is reasonably necessary to identify the product or service [.]\xe2\x80\x9d New Kids provided the following\nexamples to explain this element: \xe2\x80\x9c[A] soft drink competitor would be entitled to compare its product to\nCoca-Cola or Coke, but would not be entitled to use Coca-Cola\xe2\x80\x99s distinctive lettering.\xe2\x80\x9d Similarly, in a past\ncase, an auto shop was allowed to use the trademarked term \xe2\x80\x9cVolkswagen\xe2\x80\x9d on a sign describing the cars it\nrepaired, in part because the shop \xe2\x80\x9cdid not use Volkswagen\xe2\x80\x99s distinctive lettering style or color scheme,\nnor did he display the encircled \xe2\x80\x98VW\xe2\x80\x99 emblem.\xe2\x80\x9d Welles\xe2\x80\x99 banner advertisements and headlines satisfy this\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n567\n\n\x0celement because they use only the trademarked words, not the font or symbols associated with the\ntrademarks.\nThe third element requires that the user do \xe2\x80\x9cnothing that would, in conjunction with the mark, suggest\nsponsorship or endorsement by the trademark holder.\xe2\x80\x9d As to this element, we conclude that aside from\nthe wallpaper, which we address separately, Welles does nothing in conjunction with her use of the marks\nto suggest sponsorship or endorsement by PEI. The marks are clearly used to describe the title she\nreceived from PEI in 1981, a title that helps describe who she is. It would be unreasonable to assume that\nthe Chicago Bulls sponsored a website of Michael Jordan\xe2\x80\x99s simply because his name appeared with the\nappellation \xe2\x80\x9cformer Chicago Bull.\xe2\x80\x9d Similarly, in this case, it would be unreasonable to assume that PEI\ncurrently sponsors or endorses someone who describes herself as a \xe2\x80\x9cPlayboy Playmate of the Year in\n1981.\xe2\x80\x9d The designation of the year, in our case, serves the same function as the \xe2\x80\x9cformer\xe2\x80\x9d in our example. It\nshows that any sponsorship or endorsement occurred in the past.\nFor the foregoing reasons, we conclude that Welles\xe2\x80\x99 use of PEI\xe2\x80\x99s marks in her headlines and banner\nadvertisements is a nominative use excepted from the law of trademark infringement.\n2. Meta tags\nWelles includes the terms \xe2\x80\x9cplayboy\xe2\x80\x9d and \xe2\x80\x9cplaymate\xe2\x80\x9d in her Meta tags. Meta tags describe the contents of a\nwebsite using keywords. Some search engines search Meta tags to identify websites relevant to a search.\nThus, when an internet searcher enters \xe2\x80\x9cplayboy\xe2\x80\x9d or \xe2\x80\x9cplaymate\xe2\x80\x9d into a search engine that uses Meta tags,\nthe results will include Welles\xe2\x80\x99 site. Because Welles \xe2\x80\x99Meta tags do not repeat the terms extensively, her site\nwill not be at the top of the list of search results. Applying the three-factor test for nominative use, we\nconclude that the use of the trademarked terms in Welles\xe2\x80\x99 Meta tags is nominative.\nAs we discussed above with regard to the headlines and banner advertisements, Welles has no practical\nway of describing herself without using trademarked terms. In the context of Meta tags, we conclude that\nshe has no practical way of identifying the content of her website without referring to PEI\xe2\x80\x99s trademarks.\n...\nPrecluding their use would have the unwanted effect of hindering the free flow of information on the\ninternet, something which is certainly not a goal of trademark law. Accordingly, the use of trademarked\nterms in the Meta tags meets the first part of the test for nominative use\xe2\x80\xa6We conclude that the Meta tags\nsatisfy the second and third elements of the test as well. The Meta tags use only so much of the marks as\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n568\n\n\x0creasonably necessary and nothing is done in conjunction with them to suggest sponsorship or\nendorsement by the trademark holder. We note that our decision might differ if the Meta tags listed the\ntrademarked term so repeatedly that Welles\xe2\x80\x99 site would regularly appear above PEI\xe2\x80\x99s in searches for one\nof the trademarked terms.\n3. Wallpaper/watermark.\nThe background, or wallpaper, of Welles\xe2\x80\x99 site consists of the repeated abbreviation \xe2\x80\x9cPMOY \xe2\x80\x9981,\xe2\x80\x9d which\nstands for \xe2\x80\x9cPlaymate of the Year 1981.\xe2\x80\x9d Welles\xe2\x80\x99 name or likeness does not appear before or after \xe2\x80\x9cPMOY\n\xe2\x80\x9981.\xe2\x80\x9d The pattern created by the repeated abbreviation appears as the background of the various pages of\nthe website. Accepting, for the purposes of this appeal, that the abbreviation \xe2\x80\x9cPMOY\xe2\x80\x9d is indeed entitled to\nprotection, we conclude that the repeated, stylized use of this abbreviation fails the nominative use test.\nThe repeated depiction of \xe2\x80\x9cPMOY \xe2\x80\x9881\xe2\x80\x9d is not necessary to describe Welles. \xe2\x80\x9cPlayboy Playmate of the Year\n1981\xe2\x80\x9d is quite adequate. Moreover, the term does not even appear to describe Welles\xe2\x80\x94her name or\nlikeness does not appear before or after each \xe2\x80\x9cPMOY \xe2\x80\x9981.\xe2\x80\x9d Because the use of the abbreviation fails the\nfirst prong of the nominative use test, we need not apply the next two prongs of the test.\nBecause the defense of nominative use fails here, and we have already determined that the doctrine of fair\nuse does not apply, we remand to the district court. The court must determine whether trademark law\nprotects the abbreviation \xe2\x80\x9cPMOY,\xe2\x80\x9d as used in the wallpaper.\nB. Trademark Dilution [At this point, the court considers and rejects PEI\xe2\x80\x99s claim for trademark dilution.]\nConclusion\nFor the foregoing reasons, we affirm the district court\xe2\x80\x99s grant of summary judgment as to PEI\xe2\x80\x99s claims for\ntrademark infringement and trademark dilution, with the sole exception of the use of the abbreviation\n\xe2\x80\x9cPMOY.\xe2\x80\x9d We reverse as to the abbreviation and remand for consideration of whether it merits protection\nunder either an infringement or a dilution theory.\n\nCASE QUESTIONS\n1.\n\nDo you agree with the court\xe2\x80\x99s decision that there is no dilution here?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n569\n\n\x0c2.\n\nIf PMOY is not a registered trademark, why does the court discuss it?\n\n3.\n\nWhat does \xe2\x80\x9cnominative use\xe2\x80\x9d mean in the context of this case?\n\n4.\n\nIn business terms, why would PEI even think that it was losing money, or could lose money, based on\nWelles\xe2\x80\x99s use of its identifying marks?\n\n13.6 Summary and Exercises\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n570\n\n\x0cSummary\nThe products of the human mind are at the root of all business, but they are legally protectable only to a\ncertain degree. Inventions that are truly novel may qualify for a twenty-year patent; the inventor may then\nprohibit anyone from using the art (machine, process, manufacture, and the like) or license it on his own\nterms. A business may sue a person who improperly gives away its legitimate trade secrets, but it may not\nprevent others from using the unpatented trade secret once publicly disclosed. Writers or painters,\nsculptors, composers, and other creative artists may generally protect the expression of their ideas for the\nduration of their lives plus seventy years, as long as the ideas are fixed in some tangible medium. That\nmeans that they may prevent others from copying their words (or painting, etc.), but they may not prevent\nanyone from talking about or using their ideas. Finally, one who markets a product or service may protect\nits trademark or service or other mark that is distinctive or has taken on a secondary meaning, but may\nlose it if the mark becomes the generic term for the goods or services.\n\nEXERCISES\n1.\n\nSamuel Morse filed claims in the US Patent Office for his invention of the telegraph and also for the\n\xe2\x80\x9cuse of the motive power of the electric or galvanic current\xe2\x80\xa6however developed, for marking or\nprinting intelligible characters, signs or letters at any distances.\xe2\x80\x9d For which claim, if any, was he\nentitled to a patent? Why?\n\n2.\n\nIn 1957, an inventor dreamed up and constructed a certain new kind of computer. He kept his\ninvention a secret. Two years later, another inventor who conceived the same machine filed a patent\napplication. The first inventor, learning of the patent application, filed for his own patent in 1963. Who\nis entitled to the patent, assuming that the invention was truly novel and not obvious? Why?\n\n3.\n\nA large company discovered that a small company was infringing one of its patents. It wrote the small\ncompany and asked it to stop. The small company denied that it was infringing. Because of personnel\nchanges in the large company, the correspondence file was lost and only rediscovered eight years\nlater. The large company sued. What would be the result? Why?\n\n4.\n\nClifford Witter was a dance instructor at the Arthur Murray Dance Studios in Cleveland. As a condition\nof employment, he signed a contract not to work for a competitor. Subsequently, he was hired by the\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n571\n\n\x0cFred Astaire Dancing Studios, where he taught the method that he had learned at Arthur Murray.\nArthur Murray sued to enforce the non-compete contract. What would be result? What additional\ninformation, if any, would you need to know to decide the case?\n5.\n\nGreenberg worked for Buckingham Wax as its chief chemist, developing chemical formulas for\nproducts by testing other companies\xe2\x80\x99 formulas and modifying them. Brite Products bought\nBuckingham\xe2\x80\x99s goods and resold them under its own name. Greenberg went to work for Brite, where\nhe helped Brite make chemicals substantially similar to the ones it had been buying from Buckingham.\nGreenberg had never made any written or oral commitment to Buckingham restricting his use of the\nchemical formulas he developed. May Buckingham stop Greenberg from working for Brite? May it\nstop him from working on formulas learned while working at Buckingham? Why?\n\nSELF-TEST QUESTIONS\n1.\n\nWhich of the following cannot be protected under patent, copyright, or trademark law?\n\na.\n\na synthesized molecule\n\nb.\n\na one-line book title\n\nc.\n\na one-line advertising jingle\n\nd.\n\na one-word company name\nWhich of the following does not expire by law?\n\na.\n\na closely guarded trade secret not released to the public\nb.\n\na patent granted by the US Patent and Trademark Office\n\nc.\n\na copyright registered in the US Copyright Office\n\nd.\n\na federal trademark registered under the Lanham Act\nA sculptor casts a marble statue of a three-winged bird. To protect against copying, the\nsculptor can obtain which of the following?\n\na.\n\na patent\nb.\n\na trademark\n\nc.\n\na copyright\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n572\n\n\x0cd.\n\nnone of the above\nA stock analyst discovers a new system for increasing the value of a stock portfolio. He may\nprotect against use of his system by other people by securing\n\na.\n\na patent\nb.\n\na copyright\n\nc.\n\na trademark\n\nd.\n\nnone of the above\nA company prints up its customer list for use by its sales staff. The cover page carries a notice\nthat says \xe2\x80\x9cconfidential.\xe2\x80\x9d A rival salesman gets a copy of the list. The company can sue to\nrecover the list because the list is\n\na.\n\npatented\nb.\n\ncopyrighted\n\nc.\n\na trade secret\n\nd.\n\nnone of the above\n\nSELF-TEST ANSWERS\n1.\n\nb\n\n2.\n\na\n\n3.\n\nc\n\n4.\n\nd\n\n5.\n\nc\n\nChapter 14\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n573\n\n\x0cThe Nature and Regulation of Real Estate and the\nEnvironment\nLEARNING OBJECTIVES\nAfter reading this chapter, you should understand the following:\n1.\n\nThe various kinds of interests (or \xe2\x80\x9cestates\xe2\x80\x9d) in real property\n\n2.\n\nThe various rights that come with ownership of real property\n\n3.\n\nWhat easements are, how they are created, and how they function\n\n4.\n\nHow ownership of real property is regulated by tort law, by agreement, and by the public interest\n(through eminent domain)\n\n5.\n\nThe various ways in which environmental laws affect the ownership and use of real property\n\nReal property is an important part of corporate as well as individual wealth. As a consequence, the role of\nthe corporate real estate manager has become critically important within the corporation. The real estate\nmanager must be aware not only of the value of land for purchase and sale but also of proper lease\nnegotiation, tax policies and assessments, zoning and land development, and environmental laws.\nIn this chapter we focus on regulation of land use and the environment (see Figure 14.1 "Chapter\nOverview"). We divide our discussion of the nature of real estate into three major categories: (1) estates;\n(2) rights that are incidental to the possession and ownership of land\xe2\x80\x94for example, the right to air, water,\nand minerals; and (3) easements\xe2\x80\x94the rights in lands of others.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n574\n\n\x0c14.1 Estates\nLEARNING OBJECTIVE\n1.\n\nDistinguish between the various kinds of estates, or interests, in real property that the law recognizes.\n\nIn property law, an estate is an interest in real property, ranging from absolute dominion and control to\nbare possession. Ordinarily when we think of property, we think of only one kind: absolute ownership.\nThe owner of a car has the right to drive it where and when she wants, rebuild it, repaint it, and sell it or\nscrap it. The notion that the owner might lose her property when a particular event happens is foreign to\nour concept of personal property. Not so with real property. You would doubtless think it odd if you were\nsold a used car subject to the condition that you not paint it a different color\xe2\x80\x94and that if you did, you\nwould automatically be stripped of ownership. But land can be sold that way. Land and other real\nproperty can be divided into many categories of interests, as we will see. (Be careful not to confuse the\nvarious types of interests in real property with the forms of ownership, such as joint tenancy. An interest\nin real property that amounts to an estate is a measure of the degree to which a thing is owned; the form\nof ownership deals with the particular person or persons who own it.)\nFigure 14.1 Chapter Overview\n\nThe common law distinguishes estates along two main axes: (1) freeholds versus leaseholds and (2)\npresent versus future interests. A freehold estate is an interest in land that has an uncertain duration. The\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n575\n\n\x0cfreehold can be outright ownership\xe2\x80\x94called the fee simple absolute\xe2\x80\x94or it can be an interest in the land for\nthe life of the possessor; in either case, it is impossible to say exactly how long the estate will last. In the\ncase of one who owns property outright, her estate will last until she sells or transfers it; in the case of a\nlife estate, it will last until the death of the owner or another specified individual. A leasehold estate is one\nwhose termination date is usually known. A one-year lease, for example, will expire precisely at the time\nstated in the lease agreement.\nA present estate is one that is currently owned and enjoyed; a future estate is one that will come into the\nowner\xe2\x80\x99s possession upon the occurrence of a particular event. In this chapter, we consider both present\nand future freehold interests.\n\nPresent Estates (Freeholds)\nFee Simple Absolute\nThe strongest form of ownership is known as the fee simple absolute (or fee simple, or merely fee). This is\nwhat we think of when we say that someone \xe2\x80\x9cowns\xe2\x80\x9d the land. As one court put it, \xe2\x80\x9cThe grant of a fee in\nland conveys to the grantee complete ownership, immediately and forever, with the right of possession\nfrom boundary to boundary and from the center of the earth to the sky, together with all the lawful uses\nthereof.\xe2\x80\x9d\n\n[1]\n\nAlthough the fee simple may be encumbered by a mortgage (you may borrow money against\n\nthe equity in your home) or an easement (you may grant someone the right to walk across your backyard),\nthe underlying control is in the hands of the owner. Though it was once a complex matter in determining\nwhether a person had been given a fee simple interest, today the law presumes that the estate being\ntransferred is a fee simple, unless the conveyance expressly states to the contrary. (In her will, Lady Gaga\ngrants her five-thousand-acre ranch \xe2\x80\x9cto my screen idol, Tilda Swinton.\xe2\x80\x9d On the death of Lady Gaga,\nSwinton takes ownership of the ranch outright in fee simple absolute.)\n\nFee Simple Defeasible\nNot every transfer of real property creates a fee simple absolute. Some transfers may limit the estate. Any\ntransfer specifying that the ownership will terminate upon a particular happening is known as\na fee simple defeasible. Suppose, for example, that Mr. Warbucks conveys a tract of land \xe2\x80\x9cto Miss Florence\nNightingale, for the purpose of operating her hospital and for no other purpose. Conveyance to be good as\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n576\n\n\x0clong as hospital remains on the property.\xe2\x80\x9d This grant of land will remain the property of Miss Nightingale\nand her heirs as long as she and they maintain a hospital. When they stop doing so, the land will\nautomatically revert to Mr. Warbucks or his heirs, without their having to do anything to regain title. Note\nthat the conveyance of land could be perpetual but is not absolute, because it will remain the property of\nMiss Nightingale only so long as she observes the conditions in the grant.\n\nLife Estates\nAn estate measured by the life of a particular person is called a life estate. A conventional life estate is\ncreated privately by the parties themselves. The simplest form is that conveyed by the following words: \xe2\x80\x9cto\nScarlett for life.\xe2\x80\x9d Scarlett becomes a life tenant; as such, she is the owner of the property and may occupy\nit for life or lease it or even sell it, but the new tenant or buyer can acquire only as much as Scarlett has to\ngive, which is ownership for her life (i.e., all she can sell is a life estate in the land, not a fee simple\nabsolute). If Scarlett sells the house and dies a month later, the buyer\xe2\x80\x99s interest would terminate. A life\nestate may be based on the life of someone other than the life tenant: \xe2\x80\x9cto Scarlett for the life of Rhett.\xe2\x80\x9d\nThe life tenant may use the property as though he were the owner in fee simple absolute with this\nexception: he may not act so as to diminish the value of the property that will ultimately go to the\nremainder man\xe2\x80\x94the person who will become owner when the life estate terminates. The life tenant must\npay the life estate for ordinary upkeep of the property, but the remainder man is responsible for\nextraordinary repairs.\nSome life estates are created by operation of law and are known as legal life estates. The most common\nform is a widow\xe2\x80\x99s interest in the real property of her husband. In about one-third of the states, a woman is\nentitled to dower, a right to a percentage (often one-third) of the property of her husband when he dies.\nMost of these states give a widower a similar interest in the property of his deceased wife. Dower is an\nalternative to whatever is bequeathed in the will; the widow has the right to elect the share stated in the\nwill or the share available under dower. To prevent the dower right from upsetting the interests of remote\npurchasers, the right may be waived on sale by having the spouse sign the deed.\n\nFuture Estates\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n577\n\n\x0cTo this point, we have been considering present estates. But people also can have future interests in real\nproperty. Despite the implications of its name, the future interest is owned now but is not available to be\nused or enjoyed now. For the most part, future interests may be bought and sold, just as land held in fee\nsimple absolute may be bought and sold. There are several classes of future interests, but in general there\nare two major types: reversion and remainder.\n\nReversion\nA reversion arises whenever the estate transferred has duration less than that originally owned by the\ntransferor. A typical example of a simple reversion is that which arises when a life estate is conveyed. The\nownership conveyed is only for the life; when the life tenant dies, the ownership interest reverts to the\ngrantor. Suppose the grantor has died in the meantime. Who gets the reversion interest? Since the\nreversion is a class of property that is owned now, it can be inherited, and the grantor\xe2\x80\x99s heirs would take\nthe reversion at the subsequent death of the life tenant.\n\nRemainder\nThe transferor need not keep the reversion interest for himself. He can give that interest to someone else,\nin which case it is known as a remainder interest, because the remainder of the property is being\ntransferred. Suppose the transferor conveys land with these words: \xe2\x80\x9cto Scarlett for life and then to Rhett.\xe2\x80\x9d\nScarlett has a life estate; the remainder goes to Rhett in fee simple absolute. Rhett is said to have a vested\nremainder interest, because on Scarlett\xe2\x80\x99s death, he or his heirs will automatically become owners of the\nproperty. Some remainder interests are contingent\xe2\x80\x94and are therefore known as contingent remainder\ninterests\xe2\x80\x94on the happening of a certain event: \xe2\x80\x9cto my mother for her life, then to my sister if she marries\nHarold before my mother dies.\xe2\x80\x9d The transferor\xe2\x80\x99s sister will become the owner of the property in fee simple\nonly if she marries Harold while her mother is alive; otherwise, the property will revert to the transferor\nor his heirs. The number of permutations of reversions and remainders can become quite complex, far\nmore than we have space to discuss in this text.\n\nKEY TAKEAWAY\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n578\n\n\x0cAn estate is an interest in real property. Estates are of many kinds, but one generic difference is\nbetween ownership estates and possessory estates. Fee simple estates and life estates are ownership\nestates, while leasehold interests are possessory. Among ownership estates, the principal division is\nbetween present estates and future estates. An owner of a future estate has an interest that can be\nbought and sold and that will ripen into present possession at the end of a period of time, at the end of\nthe life of another, or with the happening of some contingent event.\n\nEXERCISES\n1.\n\nJessa owns a house and lot on 9th Avenue. She sells the house to the Hartley family, who wish to have\na conveyance from her that says, \xe2\x80\x9cto Harriet Hartley for life, remainder to her son, Alexander\nSandridge.\xe2\x80\x9d Alexander is married to Chloe, and they have three children, Carmen, Sarah, and Michael.\nWho has a future interest, and who has a present interest? What is the correct legal term for Harriet\xe2\x80\x99s\nestate? Does Alexander, Carmen, Sarah, or Michael have any part of the estate at the time Jessa\nconveys to Harriet using the stated language?\n\n2.\n\nAfter Harriet dies, Alexander wants to sell the property. Alexander and Chloe\xe2\x80\x99s children are all\neighteen years of age or older. Can he convey the property by his signature alone? Who else needs to\nsign?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n579\n\n\x0c14.2 Rights Incident to Possession and Ownership of Real Estate\nLEARNING OBJECTIVE\n1.\n\nUnderstand that property owners have certain rights in the airspace above their land, in the minerals\nbeneath their land, and even in water that adjoins their land.\n\nRights to Airspace\nThe traditional rule was stated by Lord Coke: \xe2\x80\x9cWhoever owns the soil owns up to the sky.\xe2\x80\x9d This traditional\nrule remains valid today, but its application can cause problems. A simple example would be a person who\nbuilds an extension to the upper story of his house so that it hangs out over the edge of his property line\nand thrusts into the airspace of his neighbor. That would clearly be an encroachment on the neighbor\xe2\x80\x99s\nproperty. But is it trespasses when an airplane\xe2\x80\x94or an earth satellite\xe2\x80\x94flies over your backyard? Obviously,\nthe courts must balance the right to travel against landowners\xe2\x80\x99 rights. In U.S. v. Causby,\n\n[1]\n\nthe Court\n\ndetermined that flights over private land may constitute a diminution in the property value if they are so\nlow and so frequent as to be a direct and immediate interference with the enjoyment and use of land.\n\nRights to the Depths\nLord Coke\xe2\x80\x99s dictum applies to the depths as well as the sky. The owner of the surface has the right to the\noil, gas, and minerals below it, although this right can be severed and sold separately. Perplexing\nquestions may arise in the case of oil and gas, which can flow under the surface. Some states say that oil\nand gas can be owned by the owner of the surface land; others say that they are not owned until actually\nextracted\xe2\x80\x94although the property owner may sell the exclusive right to extract them from his land. But\nstates with either rule recognize that oil and gas are capable of being \xe2\x80\x9ccaptured\xe2\x80\x9d by drilling that causes oil\nor gas from under another plot of land to run toward the drilled hole. Since the possibility of capture can\nlead to wasteful drilling practices as everyone nearby rushes to capture the precious commodities, many\nstates have enacted statutes requiring landowners to share the resources.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n580\n\n\x0cRights to Water\nThe right to determine how bodies of water will be used depends on basic property rules. Two different\napproaches to water use in the United States\xe2\x80\x94eastern and western\xe2\x80\x94have developed over time (see Figure\n14.2 "Water Rights"). Eastern states, where water has historically been more plentiful, have adopted the\nso-called riparian rights theory, which itself can take two forms. Riparianrefers to land that includes a\npart of the bed of a waterway or that borders on a public watercourse. A riparian owner is one who owns\nsuch land. What are the rights of upstream and downstream owners of riparian land regarding use of the\nwaters? One approach is the \xe2\x80\x9cnatural flow\xe2\x80\x9d doctrine: Each riparian owner is entitled to have the river or\nother waterway maintained in its natural state. The upstream owner may use the river for drinking water\nor for washing but may not divert it to irrigate his crops or to operate his mill if doing so would materially\nchange the amount of the flow or the quality of the water. Virtually all eastern states today are not so\nrestrictive and rely instead on a \xe2\x80\x9creasonable use\xe2\x80\x9d doctrine, which permits the benefit to be derived from\nuse of the waterway to be weighed against the gravity of the harm. This approach is illustrated in Hoover\nv. Crane, (see Section 14.6.1 "Reasonable Use Doctrine".\n\n[2]\n\nFigure 14.2 Water Rights\n\nIn contrast to riparian rights doctrines, western states have adopted the prior appropriation doctrine. This\nrule looks not to equality of interests but to priority in time: first in time is first in right. The first person\nto use the water for a beneficial purpose has a right superior to latecomers. This rule applies even if the\nfirst user takes all the water for his own needs and even if other users are riparian owners. This rule\ndeveloped in water-scarce states in which development depended on incentives to use rather than hoard\nwater. Today, the prior appropriation doctrine has come under criticism because it gives incentives to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n581\n\n\x0cthose who already have the right to the water to continue to use it profligately, rather than to those who\nmight develop more efficient means of using it.\n\nKEY TAKEAWAY\nProperty owners have certain rights in the airspace above their land. They also have rights in\nsubsurface minerals, which include oil and gas. Those property owners who have bodies of water\nadjacent to their land will also have certain rights to withdraw or impound water for their own use.\nRegarding US water law, the reasonable use doctrine in the eastern states is distinctly different from\nthe prior appropriation doctrine in western states.\n\nEXERCISES\n1.\n\nSteve Hannaford farms in western Nebraska. The farm has passed to succeeding generations of\nHannaford\xe2\x80\x99s, who use water from the North Platte River for irrigation purposes. The headlands of the\nNorth Platte are in Colorado, but use of the water from the North Platte by Nebraskans preceded use\nof the water by settlers in Colorado. What theory of water rights governs Nebraska and Colorado\nresidents? Can the state of Colorado divert and use water in such a way that less of it reaches western\nNebraska and the Hannaford farm? Why or why not?\n\n2.\n\nJamie Stoner decides to put solar panels on the south face of his roof. Jamie lives on a block of oneand two-bedroom bungalows in South Miami, Florida. In 2009, someone purchases the house next\ndoor and within two years decides to add a second and third story. This proposed addition will\nsignificantly decrease the utility of Jamie\xe2\x80\x99s solar array. Does Jamie have any rights that would limit\nwhat his new neighbors can do on their own land?\n\n[1] U.S. v. Causby, 328 U.S. 256 (1946).\n[2] Hoover v. Crane, 362 Mich. 36, 106 N.W.2d 563 (1960).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n582\n\n\x0c14.3 Easements: Rights in the Lands of Others\nLEARNING OBJECTIVES\n1.\n\nExplain the difference between an easement and a license.\n\n2.\n\nDescribe the ways in which easements can be created.\n\nDefinition\nAn easement is an interest in land created by agreement that permits one person to make use of another\xe2\x80\x99s\nestate. This interest can extend to a profit, the taking of something from the other\xe2\x80\x99s land. Though the\ncommon law once distinguished between an easement and profit, today the distinction has faded, and\nprofits are treated as a type of easement. An easement must be distinguished from a mere license, which is\npermission, revocable at the will of the owner, to make use of the owner\xe2\x80\x99s land. An easement is an estate; a\nlicense is personal to the grantee and is not assignable.\nThe two main types of easements are affirmative and negative. An affirmative easement gives a landowner\nthe right to use the land of another (e.g., crossing it or using water from it), while a negative easement, by\ncontrast, prohibits the landowner from using his land in ways that would affect the holder of the\neasement. For example, the builder of a solar home would want to obtain negative easements from\nneighbors barring them from building structures on their land that would block sunlight from falling on\nthe solar home. With the growth of solar energy, some states have begun to provide stronger protection by\nenacting laws that regulate one\xe2\x80\x99s ability to interfere with the enjoyment of sunlight. These laws range from\na relatively weak statute in Colorado, which sets forth rules for obtaining easements, to the much stronger\nstatute in California, which says in effect that the owner of a solar device has a vested right to continue to\nreceive the sunlight.\nAnother important distinction is made between easements appurtenant and easements in gross.\nAn easement appurtenant benefits the owner of adjacent land. The easement is thus appurtenant to the\nholder\xe2\x80\x99s land. The benefited land is called the dominant tenement, and the burdened land\xe2\x80\x94that is, the\nland subject to the easement\xe2\x80\x94is called the servient tenement (see Figure 14.3 "Easement Appurtenant").\nAn easement in gross is granted independent of the easement holder\xe2\x80\x99s ownership or possession of land. It\nis simply an independent right\xe2\x80\x94for example, the right granted to a local delivery service to drive its trucks\nacross a private roadway to gain access to homes at the other end.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n583\n\n\x0cFigure 14.3 Easement Appurtenant\n\nUnless it is explicitly limited to the grantee, an easement appurtenant \xe2\x80\x9cruns with the land.\xe2\x80\x9d That is, when\nthe dominant tenement is sold or otherwise conveyed, the new owner automatically owns the easement. A\ncommercial easement in gross may be transferred\xe2\x80\x94for instance, easements to construct pipelines\ntelegraph and telephone lines, and railroad rights of way. However, most noncommercial easements in\ngross are not transferable, being deemed personal to the original owner of the easement. Rochelle sells\nher friend Mrs. Nanette\xe2\x80\x94who does not own land adjacent to Rochelle\xe2\x80\x94an easement across her country\nfarm to operate skimobiles during the winter. The easement is personal to Mrs. Nanette; she could not sell\nthe easement to anyone else.\n\nCreation\nEasements may be created by express agreement, either in deeds or in wills. The owner of the dominant\ntenement may buy the easement from the owner of the servient tenement or may reserve the easement for\nhim when selling part of his land. But courts will sometimes allow implied easements under certain\ncircumstances. For instance, if the deed refers to an easement that bounds the premises\xe2\x80\x94without\ndescribing it in any detail\xe2\x80\x94a court could conclude that an easement was intended to pass with the sale of\nthe property.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n584\n\n\x0cAn easement can also be implied from prior use. Suppose a seller of land has two lots, with a driveway\nconnecting both lots to the street. The only way to gain access to the street from the back lot is to use the\ndriveway, and the seller has always done so. If the seller now sells the back lot, the buyer can establish an\neasement in the driveway through the front lot if the prior use was (1) apparent at the time of sale, (2)\ncontinuous, and (3) reasonably necessary for the enjoyment of the back lot. The rule of implied easements\nthrough prior use operates only when the ownership of the dominant and servient tenements was\noriginally in the same person.\n\nUse of the Easement\nThe servient owner may use the easement\xe2\x80\x94remember, it is on or under or above his land\xe2\x80\x94as long as his\nuse does not interfere with the rights of the easement owner. Suppose you have an easement to walk along\na path in the woods owned by your neighbor and to swim in a private lake that adjoins the woods. At the\ntime you purchased the easement, your neighbor did not use the lake. Now he proposes to swim in it\nhimself and you protest. You would not have a sound case, because his swimming in the lake would not\ninterfere with your right to do so. But if he proposed to clear the woods and build a mill on it, obliterating\nthe path you took to the lake and polluting the lake with chemical discharges, then you could obtain an\ninjunction to bar him from interfering with your easement.\nThe owner of the dominant tenement is not restricted to using his land as he was at the time he became\nthe owner of the easement. The courts will permit him to develop the land in some \xe2\x80\x9cnormal\xe2\x80\x9d manner. For\nexample, an easement on a private roadway for the benefit of a large estate up in the hills would not be\nlost if the large estate were ultimately subdivided and many new owners wished to use the roadway; the\neasement applies to the entire portion of the original dominant tenement, not merely to the part that\nabuts the easement itself. However, the owner of an easement appurtenant to one tract of land cannot use\nthe easement on another tract of land, even if the two tracts are adjacent.\n\nKEY TAKEAWAY\nAn easement appurtenant runs with the land and benefits the dominant tenement, burdening the\nservient tenement. An easement, generally, has a specific location or description within or over the\nservient tenement. Easements can be created by deed, by will, or by implication.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n585\n\n\x0cEXERCISE\n1.\n\nBeth Delaney owns property next to Kerry Plemmons. The deed to Delaney\xe2\x80\x99s property notes that she\nhas access to a well on the Plemmons property \xe2\x80\x9cto obtain water for household use.\xe2\x80\x9d The well has\nbeen dry for many generations and has not been used by anyone on the Plemmons property or the\nDelaney property for as many generations. The well predated Plemmons\xe2\x80\x99s ownership of the property;\nas the servient tenement, the Plemmons property was burdened by this easement dating back to\n1898. Plemmons hires a company to dig a very deep well near one of his outbuildings to provide water\nfor his horses. The location is one hundred yards from the old well. Does the Delaney property have\nany easement to use water from the new well?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n586\n\n\x0c14.4 Regulation of Land Use\nLEARNING OBJECTIVES\n1.\n\nCompare the various ways in which law limits or restricts the right to use your land in any way that\nyou decide is best for you.\n\n2.\n\nDistinguish between regulation by common law and regulation by public acts such as zoning or\neminent domain.\n\n3.\n\nUnderstand that property owners may restrict the uses of land by voluntary agreement, subject to\nimportant public policy considerations.\n\nLand use regulation falls into three broad categories: (1) restriction on the use of land through tort law,\n(2) private regulation by agreement, and (3) public ownership or regulation through the powers of\neminent domain and zoning.\n\nRegulation of Land Use by Tort Law\nTort law is used to regulate land use in two ways: (1) The owner may become liable for certain activities\ncarried out on the real estate that affect others beyond the real estate. (2) The owner may be liable to\npersons who, upon entering the real estate, are injured.\n\nLandowner\xe2\x80\x99s Activities\nThe two most common torts in this area are nuisance and trespass. A common-law nuisance is an\ninterference with the use and enjoyment of one\xe2\x80\x99s land. Examples of nuisances are excessive noise\n(especially late at night), polluting activities, and emissions of noxious odors. But the activity must\nproduce substantial harm, not fleeting, minor injury, and it must produce those effects on the reasonable\nperson, not on someone who is peculiarly allergic to the complained-of activity. A person who suffered\nmigraine headaches at the sight of croquet being played on a neighbor\xe2\x80\x99s lawn would not likely win a\nnuisance lawsuit. While the meaning of nuisance is difficult to define with any precision, this commonlaw cause of action is a primary means for landowners to obtain damages for invasive environmental\nharms.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n587\n\n\x0cA trespass is the wrongful physical invasion of or entry upon land possessed by another. Loud noise\nblaring out of speakers in the house next door might be a nuisance but could not be a trespass, because\nnoise is not a physical invasion. But spraying pesticides on your gladiolas could constitute a trespass on\nyour neighbor\xe2\x80\x99s property if the pesticide drifts across the boundary.\nNuisance and trespass are complex theories, a full explanation of which would consume far more space\nthan we have. What is important to remember is that these torts are two-edged swords. In some\nsituations, the landowner himself will want to use these theories to sue trespassers or persons creating a\nnuisance, but in other situations, the landowner will be liable under these theories for his own activities.\n\nInjury to Persons Entering the Real Estate\nTraditionally, liability for injury has depended on the status of the person who enters the real estate.\n\nTrespassers\nIf the person is an intruder without permission\xe2\x80\x94a trespasser\xe2\x80\x94the landowner owes him no duty of care\nunless he knows of the intruder\xe2\x80\x99s presence, in which case the owner must exercise reasonable care in his\nactivities and warn of hidden dangers on his land of which he is aware. A known trespasser is someone\nwhom the landowner actually sees on the property or whom he knows frequently intrudes on the\nproperty, as in the case of someone who habitually walks across the land. If a landowner knows that\npeople frequently walk across his property and one day he puts a poisonous chemical on the ground to\neliminate certain insects, he is obligated to warn those who continue to walk on the grounds. Intentional\ninjury to known trespassers is not allowed, even if the trespasser is a criminal intent on robbery, for the\nlaw values human life above property rights.\n\nChildren\nIf the trespasser is a child, a different rule applies in most states. This is the doctrine\nof attractive nuisance. Originally this rule was enunciated to deal with cases in which something on the\nland attracted the child to it, like a swimming pool. In recent years, most courts have dropped the\nrequirement that the child must have been attracted to the danger. Instead, the following elements of\nproof are necessary to make out a case of attractive nuisance (Restatement of Torts, Section 339):\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n588\n\n\x0c1.\n\nThe child must have been injured by a structure or other artificial condition.\n\n2. The possessor of the land (not necessarily the owner) must have known or should have known that\nyoung children would be likely to trespass.\n3. The possessor must have known or should have known that the artificial condition exists and that it\nposed an unreasonable risk of serious injury.\n4. The child must have been too young to appreciate the danger that the artificial condition posed.\n5.\n\nThe risk to the child must have far outweighed the utility of the artificial condition to the possessor.\n\n6. The possessor did not exercise reasonable care in protecting the child or eliminating the danger.\nOld refrigerators, open gravel pits, or mechanisms that a curious child would find inviting are all\nexamples of attractive nuisance. Suppose Farmer Brown keeps an old buggy on his front lawn, accessible\nfrom the street. A five-year-old boy clambers up the buggy one day, falls through a rotted floorboard, and\nbreaks his leg. Is Farmer Brown liable? Probably so. The child was too young to appreciate the danger\nposed by the buggy, a structure. The farmer should have appreciated that young children would be likely\nto come onto the land when they saw the buggy and that they would be likely to climb up onto the buggy.\nMoreover, he should have known, if he did not know in fact, that the buggy, left outside for years without\nbeing tended, would pose an unreasonable risk. The buggy\xe2\x80\x99s utility as a decoration was far overbalanced\nby the risk that it posed to children, and the farmer failed to exercise reasonable care.\n\nLicensees\nA non-trespasser who comes onto the land without being invited, or if invited, comes for purposes\nunconnected with any business conducted on the premises, is known as a licensee. This class of visitors to\nthe land consists of (1) social guests (people you invite to your home for a party); (2) a salesman, not\ninvited by the owner, who wishes to sell something to the owner or occupier of the property; and (3)\npersons visiting a building for a purpose not connected with the business on the land (e.g., students who\nvisit a factory to see how it works). The landowner owes the same duty of care to licensees that he owes to\nknown trespassers. That is, he must warn them against hidden dangers of which he is aware, and he must\nexercise reasonable care in his activities to ensure that they are not injured.\n\nInvitees\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n589\n\n\x0cA final category of persons entering land is that of invitee. This is one who has been invited onto the land,\nusually, though not necessarily, for a business purpose of potential economic benefit to the owner or\noccupier of the premises. This category is confusing because it sounds as though it should include social\nguests (who clearly are invited onto the premises), but traditionally social guests are said to be licensees.\nInvitees include customers of stores, users of athletic and other clubs, customers of repair shops, strollers\nthrough public parks, restaurant and theater patrons, hotel guests, and the like. From the owner\xe2\x80\x99s\nperspective, the major difference between licensees and invitees is that he is liable for injuries resulting to\nthe latter from hidden dangers that he should have been aware of, even if he is not actually aware of the\ndangers. How hidden the dangers are and how broad the owner\xe2\x80\x99s liability is depends on the\ncircumstances, but liability sometimes can be quite broad. Difficult questions arise in lawsuits brought by\ninvitees (or business invitees, as they are sometimes called) when the actions of persons other than the\nlandowner contribute to the injury.\nThe foregoing rules dealing with liability for persons entering the land are the traditional rules at common\nlaw. In recent years, some courts have moved away from the rigidities and sometimes perplexing\ndifferences between trespassers, licensees, and invitees. By court decision, several states have now\nabolished such distinctions and hold the proprietor, owner, or occupier liable for failing to maintain the\npremises in a reasonably safe condition. According to the California Supreme Court,\nA man\xe2\x80\x99s life or limb does not become less worthy of protection by the law nor a loss less worthy of\ncompensation under the law because he has come upon the land of another without permission or with\npermission but without a business purpose. Reasonable people do not ordinarily vary their conduct\ndepending upon such matters, and to focus upon the status of the injured party as a trespasser, licensee,\nor invitee in order to determine the question whether the landowner has a duty of care, is contrary to our\nmodern social mores and humanitarian values. Where the occupier of land is aware of a concealed\ncondition involving in the absence of precautions an unreasonable risk of harm to those coming in contact\nwith it and is aware that a person on the premises is about to come in contact with it, the trier of fact can\nreasonably conclude that a failure to warn or to repair the condition constitutes negligence. Whether or\nnot a guest has a right to expect that his host will remedy dangerous conditions on his account, he should\nreasonably be entitled to rely upon a warning of the dangerous condition so that he, like the host, will be\nin a position to take special precautions when he comes in contact with it.\nSaylor URL: http://www.saylor.org/books\n\n[1]\n\nSaylor.org\n590\n\n\x0cPrivate Regulation of Land Use by Agreement\nA restrictive covenant is an agreement regarding the use of land that \xe2\x80\x9cruns with the land.\xe2\x80\x9d In effect, it is a\ncontractual promise that becomes part of the property and that binds future owners. Violations of\ncovenants can be redressed in court in suits for damages or injunctions but will not result in reversion of\nthe land to the seller.\nUsually, courts construe restrictive covenants narrowly\xe2\x80\x94that is, in a manner most conducive to free use of\nthe land by the ultimate owner (the person against whom enforcement of the covenant is being sought).\nSometimes, even when the meaning of the covenant is clear, the courts will not enforce it. For example,\nwhen the character of a neighborhood changes, the courts may declare the covenant a nullity. Thus a\nrestriction on a one-acre parcel to residential purposes was voided when in the intervening thirty years a\nhost of businesses grew up around it, including a bowling alley, restaurant, poolroom, and sewage\ndisposal plant.\n\n[2]\n\nAn important nullification of restrictive covenants came in 1947 when the US Supreme Court struck down\nas unconstitutional racially restrictive covenants, which barred blacks and other minorities from living on\nland so burdened. The Supreme Court reasoned that when a court enforces such a covenant, it acts in a\ndiscriminatory manner (barring blacks but not whites from living in a home burdened with the covenant)\nand thus violates the Fourteenth Amendment\xe2\x80\x99s guarantee of equal protection of the laws.\n\n[3]\n\nPublic Control of Land Use through Eminent Domain\nThe government may take private property for public purposes. Its power to do so is known as eminent\ndomain. The power of eminent domain is subject to constitutional limitations. Under the Fifth\nAmendment, the property must be put to public use, and the owner is entitled to \xe2\x80\x9cjust compensation\xe2\x80\x9d for\nhis loss. These requirements are sometimes difficult to apply.\n\nPublic Use\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n591\n\n\x0cThe requirement of public use normally means that the property will be useful to the public once the state\nhas taken possession\xe2\x80\x94for example, private property might be condemned to construct a highway.\nAlthough not allowed in most circumstances, the government could even condemn someone\xe2\x80\x99s property in\norder to turn around and sell it to another individual, if a legitimate public purpose could be shown. For\nexample, a state survey in the mid-1960s showed that the government owned 49 percent of Hawaii\xe2\x80\x99s land.\nAnother 47 percent was controlled by seventy-two private landowners. Because this concentration of land\nownership (which dated back to feudal times) resulted in a critical shortage of residential land, the\nHawaiian legislature enacted a law allowing the government to take land from large private estates and\nresell it in smaller parcels to homeowners. In 1984, the US Supreme Court upheld the law, deciding that\nthe land was being taken for a public use because the purpose was \xe2\x80\x9cto attack certain perceived evils of\nconcentrated property ownership.\xe2\x80\x9d\n\n[4]\n\nAlthough the use must be public, the courts will not inquire into the\n\nnecessity of the use or whether other property might have been better suited. It is up to government\nauthorities to determine whether and where to build a road, not the courts.\nThe limits of public use were amply illustrated in the Supreme Court\xe2\x80\x99s 2002 decision of Kelo v. New\nLondon,\n\n[5]\n\nin which Mrs. Kelo\xe2\x80\x99s house was condemned so that the city of New London, in Connecticut,\n\ncould create a marina and industrial park to lease to Pfizer Corporation. The city\xe2\x80\x99s motives were to create\na higher tax base for property taxes. The Court, following precedent in Midkiff and other cases, refused to\ninvalidate the city\xe2\x80\x99s taking on constitutional grounds. Reaction from states was swift; many states passed\nnew laws restricting the bases for state and municipal governments to use powers of eminent domain, and\nmany of these laws also provided additional compensation to property owners whose land was taken.\n\nJust Compensation\nThe owner is ordinarily entitled to the fair market value of land condemned under eminent domain. This\nvalue is determined by calculating the most profitable use of the land at the time of the taking, even\nthough it was being put to a different use. The owner will have a difficult time collecting lost profits; for\ninstance, a grocery store will not usually be entitled to collect for the profits it might have made during the\nnext several years, in part because it can presumably move elsewhere and continue to make profits and in\npart because calculating future profits is inherently speculative.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n592\n\n\x0cTaking\nThe most difficult question in most modern cases is whether the government has in fact \xe2\x80\x9ctaken\xe2\x80\x9d the\nproperty. This is easy to answer when the government acquires title to the property through\ncondemnation proceedings. But more often, a government action is challenged when a law or regulation\ninhibits the use of private land. Suppose a town promulgates a setback ordinance, requiring owners along\ncity sidewalks to build no closer to the sidewalk than twenty feet. If the owner of a small store had only\ntwenty-five feet of land from the sidewalk line, the ordinance would effectively prevent him from housing\nhis enterprise, and the ordinance would be a taking. Challenging such ordinances can sometimes be\ndifficult under traditional tort theories because the government is immune from suit in some of these\ncases. Instead, a theory of inverse condemnation has developed, in which the plaintiff private property\nowner asserts that the government has condemned the property, though not through the traditional\nmechanism of a condemnation proceeding.\n\nPublic Control of Land Use through Zoning\nZoning is a technique by which a city or other municipality regulates the type of activity to be permitted in\ngeographical areas within its boundaries. Though originally limited to residential, commercial, and\nindustrial uses, today\xe2\x80\x99s zoning ordinances are complex sets of regulations. A typical municipality might\nhave the following zones: residential with a host of subcategories (such as for single-family and multiplefamily dwellings), office, commercial, industrial, agricultural, and public lands. Zones may be exclusive, in\nwhich case office buildings would not be permitted in commercial zones, or they may be cumulative, so\nthat a more restricted use would be allowed in a less restrictive zone. Zoning regulations do more than\nspecify the type of use: they often also dictate minimum requirements for parking, open usable space,\nsetbacks, lot sizes, and the like, and maximum requirements for height, length of side lots, and so on.\n\nNonconforming Uses\nWhen a zoning ordinance is enacted, it will almost always affect existing property owners, many of whom\nwill be using their land in ways no longer permitted under the ordinance. To avoid the charge that they\nhave thereby \xe2\x80\x9ctaken\xe2\x80\x9d the property, most ordinances permit previous nonconforming uses to continue,\nthough some ordinances limit the nonconforming uses to a specified time after becoming effective. But\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n593\n\n\x0cthis permission to continue a nonconforming use is narrow; it extends only to the specific use to which the\nproperty was put before the ordinance was enacted. A manufacturer of dresses that suddenly finds itself in\nan area zoned residential may continue to use its sewing machines, but it could not develop a sideline in\nwoodworking.\n\nVariances\nSometimes an owner may desire to use his property in ways not permitted under an existing zoning\nscheme and will ask the zoning board for a variance\xe2\x80\x94authority to carry on a nonconforming use. The\nboard is not free to grant a variance at its whim. The courts apply three general tests to determine the\nvalidity of a variance: (1) The land must be unable to yield a reasonable return on the uses allowed by the\nzoning regulation. (2) The hardship must be unique to the property, not to property generally in the area.\n(3) If granted, the variance must not change the essential character of the neighborhood.\n\nKEY TAKEAWAY\nLand use regulation can mean (1) restrictions on the use of land through tort law, (2) private\nregulation\xe2\x80\x94by agreement, or (3) regulation through powers of eminent domain or zoning.\n\nEXERCISES\n1.\n\nGive one example of the exercise of eminent domain. In order to exercise its power under eminent\ndomain, must the government actually take eventual ownership of the property that is \xe2\x80\x9ctaken\xe2\x80\x9d?\n\n2.\n\nFelix Unger is an adult, trespassing for the first time on Alan Spillborghs\xe2\x80\x99s property. Alan has been\ndigging a deep grave in his backyard for his beloved Saint Bernard, Maximilian, who has just died. Alan\nstops working on the grave when it gets dark, intending to return to the task in the morning. He\nseldom sees trespassers cutting through his backyard. Felix, in the dark, after visiting the local pub,\ndecides to take a shortcut through Alan\xe2\x80\x99s yard and falls into the grave. He breaks his leg. What is the\nstandard of care for Alan toward Felix or other infrequent trespassers? If Alan has no insurance for\nthis accident, would the law make Alan responsible?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n594\n\n\x0c3.\n\nAtlantic Cement owns and operates a cement plant in New York State. Nearby residents are exposed\nto noise, soot, and dust and have experienced lowered property values as a result of Atlantic Cement\xe2\x80\x99s\noperations. Is there a common-law remedy for nearby property owners for losses occasioned by\nAtlantic\xe2\x80\x99s operations? If so, what is it called?\n\n[1] Rowland v. Christian, 443 P.2d 561 (Cal. 1968).\n[2] Norris v. Williams, 54 A.2d 331 (Md. 1947).\n[3] Shelley v. Kraemer, 334 U.S. 1 (1947).\n[4] Hawaii Housing Authority v. Midkiff, 467 U.S. 229 (1984).\n[5] Kelo v. New London, 545 U.S. 469 (2005).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n595\n\n\x0c14.5 Environmental Law\nLEARNING OBJECTIVES\n1.\n\nDescribe the major federal laws that govern business activities that may adversely affect air quality\nand water quality.\n\n2.\n\nDescribe the major federal laws that govern waste disposal and chemical hazards including pesticides.\n\nIn one sense, environmental law is very old. Medieval England had smoke control laws that established\nthe seasons when soft coal could be burned. Nuisance laws give private individuals a limited control over\npolluting activities of adjacent landowners. But a comprehensive set of US laws directed toward general\nprotection of the environment is largely a product of the past quarter-century, with most of the legislative\nactivity stemming from the late 1960s and later, when people began to perceive that the environment was\nsystematically deteriorating from assaults by rapid population growth and greatly increased automobile\ndriving, vast proliferation of factories that generate waste products, and a sharp rise in the production of\ntoxic materials. Two of the most significant developments in environmental law came in 1970, when the\nNational Environmental Policy Act took effect and the Environmental Protection Agency became the first\nof a number of new federal administrative agencies to be established during the decade.\n\nNational Environmental Policy Act\nSigned into law by President Nixon on January 1, 1970, the National Environmental Policy Act (NEPA)\ndeclared that it shall be the policy of the federal government, in cooperation with state and local\ngovernments, \xe2\x80\x9cto create and maintain conditions under which man and nature can exist in productive\nharmony, and fulfill the social, economic, and other requirements of present and future generations of\nAmericans.\xe2\x80\xa6The Congress recognizes that each person should enjoy a healthful environment and that\neach person has a responsibility to contribute to the preservation and enhancement of the\nenvironment.\xe2\x80\x9d\n\n[1]\n\nThe most significant aspect of NEPA is its requirement that federal agencies prepare\nan environmental impact statement in every recommendation or report on proposals for legislation and\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n596\n\n\x0cwhenever undertaking a major federal action that significantly affects environmental quality. The\nstatement must (1) detail the environmental impact of the proposed action, (2) list any unavoidable\nadverse impacts should the action be taken, (3) consider alternatives to the proposed action, (4) compare\nshort-term and long-term consequences, and (5) describe irreversible commitments of resources. Unless\nthe impact statement is prepared, the project can be enjoined from proceeding. Note that NEPA does not\napply to purely private activities but only to those proposed to be carried out in some manner by federal\nagencies.\n\nEnvironmental Protection Agency\nThe Environmental Protection Agency (EPA) has been in the forefront of the news since its creation in\n1970. Charged with monitoring environmental practices of industry, assisting the government and private\nbusiness to halt environmental deterioration, promulgating regulations consistent with federal\nenvironmental policy, and policing industry for violations of the various federal environmental statutes\nand regulations, the EPA has had a pervasive influence on American business. Business Week noted the\nfollowing in 1977: \xe2\x80\x9cCars rolling off Detroit\xe2\x80\x99s assembly line now have antipollution devices as standard\nequipment. The dense black smokestack emissions that used to symbolize industrial prosperity are rare,\nand illegal, sights. Plants that once blithely ran discharge water out of a pipe and into a river must apply\nfor permits that are almost impossible to get unless the plants install expensive water treatment\nequipment. All told, the EPA has made a sizable dent in man-made environmental filth.\xe2\x80\x9d\n\n[2]\n\nThe EPA is especially active in regulating water and air pollution and in overseeing the disposition of toxic\nwastes and chemicals. To these problems we now turn.\n\nWater Pollution\nClean Water Act\nLegislation governing the nation\xe2\x80\x99s waterways goes back a long time. The first federal water pollution\nstatute was the Rivers and Harbors Act of 1899. Congress enacted new laws in 1948, 1956, 1965, 1966, and\n1970. But the centerpiece of water pollution enforcement is the Clean Water Act of 1972 (technically, the\nFederal Water Pollution Control Act Amendments of 1972), as amended in 1977 and by the Water Quality\nAct of 1987. The Clean Water Act is designed to restore and maintain the \xe2\x80\x9cchemical, physical, and\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n597\n\n\x0cbiological integrity of the Nation\xe2\x80\x99s waters.\xe2\x80\x9d\n\n[3]\n\nIt operates on the states, requiring them to designate the\n\nuses of every significant body of water within their borders (e.g., for drinking water, recreation,\ncommercial fishing) and to set water quality standards to reduce pollution to levels appropriate for each\nuse.\nCongress only has power to regulate interstate commerce, and so the Clean Water Act is applicable only to\n\xe2\x80\x9cnavigable waters\xe2\x80\x9d of the United States. This has led to disputes over whether the act can apply, say, to an\nabandoned gravel pit that has no visible connection to navigable waterways, even if the gravel pit provides\nhabitat for migratory birds. In Solid Waste Agency of Northern Cook County v. Army Corps of\nEngineers, the US Supreme Court said no.\n\n[4]\n\nPrivate Industry\nThe Clean Water Act also governs private industry and imposes stringent standards on the discharge of\npollutants into waterways and publicly owned sewage systems. The act created an effluent permit system\nknown as the National Pollutant Discharge Elimination System. To discharge any pollutants into\nnavigable waters from a \xe2\x80\x9cpoint source\xe2\x80\x9d like a pipe, ditch, ship, or container, a company must obtain a\ncertification that it meets specified standards, which are continually being tightened. For example, until\n1983, industry had to use the \xe2\x80\x9cbest practicable technology\xe2\x80\x9d currently available, but after July 1, 1984, it\nhad to use the \xe2\x80\x9cbest available technology\xe2\x80\x9d economically achievable. Companies must limit certain kinds of\n\xe2\x80\x9cconventional pollutants\xe2\x80\x9d (such as suspended solids and acidity) by \xe2\x80\x9cbest conventional control\ntechnology.\xe2\x80\x9d\n\nOther EPA Water Activities\nFederal law governs, and the EPA regulates, a number of other water control measures. Ocean dumping,\nfor example, is the subject of the Marine Protection, Research, and Sanctuaries Act of 1972, which gives\nthe EPA jurisdiction over wastes discharged into the oceans. The Clean Water Act gives the EPA and the\nUS Army Corps of Engineers authority to protect waters, marshlands, and other wetlands against\ndegradation caused by dredging and fill. The EPA also oversees state and local plans for restoring general\nwater quality to acceptable levels in the face of a host of non-point-source pollution. The Clean Water Act\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n598\n\n\x0ccontrols municipal sewage systems, which must ensure that wastewater is chemically treated before being\ndischarged from the sewage system.\nObviously, of critical importance to the nation\xe2\x80\x99s health is the supply of drinking water. To ensure its\ncontinuing purity, Congress enacted the Safe Drinking Water Act of 1974, with amendments passed in\n1986 and 1996. This act aims to protect water at its sources: rivers, lakes, reservoirs, springs, and\ngroundwater wells. (The act does not regulate private wells that serve fewer than twenty-five individuals.)\nThis law has two strategies for combating pollution of drinking water. It establishes national standards for\ndrinking water derived from both surface reservoirs and underground aquifers. It also authorizes the EPA\nto regulate the injection of solid wastes into deep wells (as happens, for instance, by leakage from\nunderground storage tanks).\n\nAir Pollution\nThe centerpiece of the legislative effort to clean the atmosphere is the Clean Air Act of 1970 (amended in\n1975, 1977, and 1990). Under this act, the EPA has set two levels of National Ambient Air Quality\nStandards (NAAQS). The primary standards limit the ambient (i.e., circulating) pollution that affects\nhuman health; secondary standards limit pollution that affects animals, plants, and property. The heart of\nthe Clean Air Act is the requirement that subject to EPA approval, the states implement the standards that\nthe EPA establishes. The setting of these pollutant standards was coupled with directing the states to\ndevelop state implementation plans (SIPs), applicable to appropriate industrial sources in the state, in\norder to achieve these standards. The act was amended in 1977 and 1990 primarily to set new goals\n(dates) for achieving attainment of NAAQS since many areas of the country had failed to meet the\ndeadlines.\nBeyond the NAAQS, the EPA has established several specific standards to control different types of air\npollution. One major type is pollution that mobile sources, mainly automobiles, emit. The EPA requires\nnew cars to be equipped with catalytic converters and to use unleaded gasoline to eliminate the most\nnoxious fumes and to keep them from escaping into the atmosphere. To minimize pollution from\nstationary sources, the EPA also imposes uniform standards on new industrial plants and those that have\nbeen substantially modernized. And to safeguard against emissions from older plants, states must\npromulgate and enforce SIPs.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n599\n\n\x0cThe Clean Air Act is even more solicitous of air quality in certain parts of the nation, such as designated\nwilderness areas and national parks. For these areas, the EPA has set standards to prevent significant\ndeterioration in order to keep the air as pristine and clear as it was centuries ago.\nThe EPA also worries about chemicals so toxic that the tiniest quantities could prove fatal or extremely\nhazardous to health. To control emission of substances like asbestos, beryllium, mercury, vinyl chloride,\nbenzene, and arsenic, the EPA has established or proposed various National Emissions Standards for\nHazardous Air Pollutants.\nConcern over acid rain and other types of air pollution prompted Congress to add almost eight hundred\npages of amendments to the Clean Air Act in 1990. (The original act was fifty pages long.) As a result of\nthese amendments, the act was modernized in a manner that parallels other environmental laws. For\ninstance, the amendments established a permit system that is modeled after the Clean Water Act. And the\namendments provide for felony convictions for willful violations, similar to penalties incorporated into\nother statutes.\nThe amendments include certain defenses for industry. Most important, companies are protected from\nallegations that they are violating the law by showing that they were acting in accordance with a permit. In\naddition to this \xe2\x80\x9cpermit shield,\xe2\x80\x9d the law also contains protection for workers who unintentionally violate\nthe law while following their employers\xe2\x80\x99 instructions.\n\nWaste Disposal\nThough pollution of the air by highly toxic substances like benzene or vinyl chloride may seem a problem\nremoved from that of the ordinary person, we are all in fact polluters. Every year, the United States\ngenerates approximately 230 million tons of \xe2\x80\x9ctrash\xe2\x80\x9d\xe2\x80\x94about 4.6 pounds per person per day. Less than\none-quarter of it is recycled; the rest is incinerated or buried in landfills. But many of the country\xe2\x80\x99s\nlandfills have been closed, either because they were full or because they were contaminating groundwater.\nOnce groundwater is contaminated, it is extremely expensive and difficult to clean it up. In the 1965 Solid\nWaste Disposal Act and the 1970 Resource Recovery Act, Congress sought to regulate the discharge of\ngarbage by encouraging waste management and recycling. Federal grants were available for research and\ntraining, but the major regulatory effort was expected to come from the states and municipalities.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n600\n\n\x0cBut shocking news prompted Congress to get tough in 1976. The plight of homeowners near Love Canal in\nupstate New York became a major national story as the discovery of massive underground leaks of toxic\nchemicals buried during the previous quarter century led to evacuation of hundreds of homes. Next came\nthe revelation that Kepone, an exceedingly toxic pesticide, had been dumped into the James River in\nVirginia, causing a major human health hazard and severe damage to fisheries in the James and\ndownstream in the Chesapeake Bay. The rarely discussed industrial dumping of hazardous wastes now\nbecame an open controversy, and Congress responded in 1976 with the Resource Conservation and\nRecovery Act (RCRA) and the Toxic Substances Control Act (TSCA) and in 1980 with the Comprehensive\nEnvironmental Response, Compensation, and Liability Act (CERCLA).\n\nResource Conservation and Recovery Act\nThe RCRA expresses a \xe2\x80\x9ccradle-to-grave\xe2\x80\x9d philosophy: hazardous wastes must be regulated at every stage.\nThe act gives the EPA power to govern their creation, storage, transport, treatment, and disposal. Any\nperson or company that generates hazardous waste must obtain a permit (known as a \xe2\x80\x9cmanifest\xe2\x80\x9d) either\nto store it on its own site or ship it to an EPA-approved treatment, storage, or disposal facility. No longer\ncan hazardous substances simply be dumped at a convenient landfill. Owners and operators of such sites\nmust show that they can pay for damage growing out of their operations, and even after the sites are\nclosed to further dumping, they must set aside funds to monitor and maintain the sites safely.\nThis philosophy can be severe. In 1986, the Supreme Court ruled that bankruptcy is not a sufficient reason\nfor a company to abandon toxic waste dumps if state regulations reasonably require protection in the\ninterest of public health or safety. The practical effect of the ruling is that trustees of the bankrupt\ncompany must first devote assets to cleaning up a dump site, and only from remaining assets may they\nsatisfy creditors.\n\n[5]\n\nAnother severity is RCRA\xe2\x80\x99s imposition of criminal liability, including fines of up to\n\n$25,000 a day and one-year prison sentences, which can be extended beyond owners to individual\nemployees, as discussed in U.S. v. Johnson & Towers, Inc., et al., (see Section 14.6.2 "Criminal Liability of\nEmployees under RCRA").\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n601\n\n\x0cComprehensive Environmental Response, Compensation, and Liability Act\nThe CERCLA, also known as the Superfund, gives the EPA emergency powers to respond to public health\nor environmental dangers from faulty hazardous waste disposal, currently estimated to occur at more\nthan seventeen thousand sites around the country. The EPA can direct immediate removal of wastes\npresenting imminent danger (e.g., from train wrecks, oil spills, leaking barrels and fires). Injuries can be\nsudden and devastating; in 1979, for example, when a freight train derailed in Florida, ninety thousand\npounds of chlorine gas escaped from a punctured tank car, leaving 8 motorists dead and 183 others\ninjured and forcing 3,500 residents within a 7-mile radius to be evacuated. The EPA may also carry out\n\xe2\x80\x9cplanned removals\xe2\x80\x9d when the danger is substantial, even if immediate removal is not necessary.\nThe EPA prods owners who can be located to voluntarily cleanup sites they have abandoned. But if the\nowners refuse, the EPA and the states will undertake the task, drawing on a federal trust fund financed\nmainly by taxes on the manufacture or import of certain chemicals and petroleum (the balance of the fund\ncomes from general revenues). States must finance 10 percent of the cost of cleaning up private sites and\n50 percent of the cost of cleaning up public facilities. The EPA and the states can then assess unwilling\nowners\xe2\x80\x99 punitive damages up to triple the cleanup costs.\nCleanup requirements are especially controversial when applied to landowners who innocently purchased\ncontaminated property. To deal with this problem, Congress enacted the Superfund Amendment and\nReauthorization Act in 1986, which protects innocent landowners who\xe2\x80\x94at the time of purchase\xe2\x80\x94made an\n\xe2\x80\x9cappropriate inquiry\xe2\x80\x9d into the prior uses of the property. The act also requires companies to publicly\ndisclose information about hazardous chemicals they use. We now turn to other laws regulating chemical\nhazards.\n\nChemical Hazards\nToxic Substances Control Act\nChemical substances that decades ago promised to improve the quality of life have lately shown their\nnegative side\xe2\x80\x94they have serious adverse side effects. For example, asbestos, in use for half a century,\ncauses cancer and asbestosis, a debilitating lung disease, in workers who breathed in fibers decades ago.\nThe result has been crippling disease and death and more than thirty thousand asbestos-related lawsuits\nfiled nationwide. Other substances, such as polychlorinated biphenyls (PCBs) and dioxin, have caused\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n602\n\n\x0csimilar tragedy. Together, the devastating effects of chemicals led to enactment of the TSCA, designed to\ncontrol the manufacture, processing, commercial distribution, use, and disposal of chemicals that pose\nunreasonable health or environmental risks. (The TSCA does not apply to pesticides, tobacco, nuclear\nmaterials, firearms and ammunition, food, food additives, drugs, and cosmetics\xe2\x80\x94all are regulated by\nother federal laws.)\nThe TSCA gives the EPA authority to screen for health and environmental risks by requiring companies to\nnotify the EPA ninety days before manufacturing or importing new chemicals. The EPA may demand that\nthe companies test the substances before marketing them and may regulate them in a number of ways,\nsuch as requiring the manufacturer to label its products, to keep records on its manufacturing and\ndisposal processes, and to document all significant adverse reactions in people exposed to the chemicals.\nThe EPA also has authority to ban certain especially hazardous substances, and it has banned the further\nproduction of PCBs and many uses of asbestos.\nBoth industry groups and consumer groups have attacked the TSCA. Industry groups criticize the act\nbecause the enforcement mechanism requires mountainous paperwork and leads to widespread delay.\nConsumer groups complain because the EPA has been slow to act against numerous chemical substances.\nThe debate continues.\n\nPesticide Regulation\nThe United States is a major user of pesticides, substances that eliminate troublesome insects, rodents,\nfungi, and bacteria, consuming more than a billion pounds a year in the form of thirty-five thousand\nseparate chemicals. As useful as they can be, like many chemical substances, pesticides can have serious\nside effects on humans and plant and animal life. Beginning in the early 1970s, Congress enacted major\namendments to the Federal Insecticide, Fungicide, and Rodenticide Act of 1947 and the Federal Food,\nDrug, and Cosmetic Act (FFDCA) of 1906.\nThese laws direct the EPA to determine whether pesticides properly balance effectiveness against safety. If\nthe pesticide can carry out its intended function without causing unreasonable adverse effects on human\nhealth or the environment, it may remain on the market. Otherwise, the EPA has authority to regulate or\neven ban its distribution and use. To enable the EPA to carry out its functions, the laws require\nmanufacturers to provide a wealth of data about the way individual pesticides work and their side effects.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n603\n\n\x0cThe EPA is required to inspect pesticides to ensure that they conform to their labeled purposes, content,\nand safety, and the agency is empowered to certify pesticides for either general or restricted use. If a\npesticide is restricted, only those persons certified in approved training programs may use it. Likewise,\nunder the Pesticide Amendment to the FFDCA, the EPA must establish specific tolerances for the residue\nof pesticides on feed crops and both raw and processed foods. The Food and Drug Administration (for\nagricultural commodities) and the US Department of Agriculture (for meat, poultry, and fish products)\nenforce these provisions.\n\nOther Types of Environmental Controls\nNoise Regulation\nUnder the Noise Regulation Act of 1972, Congress has attempted to combat a growing menace to US\nworkers, residents, and consumers. People who live close to airports and major highways, workers who\nuse certain kinds of machinery (e.g., air compressors, rock drills, bulldozers), and consumers who use\ncertain products, such as power mowers and air conditioners, often suffer from a variety of ailments. The\nNoise Regulation Act delegates to the EPA power to limit \xe2\x80\x9cnoise emissions\xe2\x80\x9d from these major sources of\nnoise. Under the act, manufacturers may not sell new products that fail to conform to the noise standards\nthe EPA sets, and users are forbidden from dismantling noise control devices installed on these products.\nMoreover, manufacturers must label noisy products properly. Private suits may be filed against violators,\nand the act also permits fines of up to $25,000 per day and a year in jail for those who seek to avoid its\nterms.\n\nRadiation Controls\nThe terrifying effects of a nuclear disaster became frighteningly clear when the Soviet Union\xe2\x80\x99s nuclear\npower plant at Chernobyl exploded in early 1986, discharging vast quantities of radiation into the world\xe2\x80\x99s\nairstream and affecting people thousands of miles away. In the United States, the most notorious nuclear\naccident occurred at the Three Mile Island nuclear utility in Pennsylvania in 1979, crippling the facility for\nyears because of the extreme danger and long life of the radiation. Primary responsibility for overseeing\nnuclear safety rests with the Nuclear Regulatory Commission, but many other agencies and several federal\nlaws (including the Clean Air Act; the Federal Water Pollution Control Act; the Safe Drinking Water Act;\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n604\n\n\x0cthe Uranium Mill Tailings Radiation Control Act; the Marine Protection, Research, and Sanctuaries Act;\nthe Nuclear Waste Policy Act of 1982; the CERCLA; and the Ocean Dumping Act) govern the use of\nnuclear materials and the storage of radioactive wastes (some of which will remain severely dangerous for\nthousands of years). Through many of these laws, the EPA has been assigned the responsibility of setting\nradiation guidelines, assessing new technology, monitoring radiation in the environment, setting limits on\nrelease of radiation from nuclear utilities, developing guidance for use of X-rays in medicine, and helping\nto plan for radiation emergencies.\n\nKEY TAKEAWAY\nLaws limiting the use of one\xe2\x80\x99s property have been around for many years; common-law restraints (e.g.,\nthe law of nuisance) exist as causes of action against those who would use their property to adversely\naffect the life or health of others or the value of their neighbors\xe2\x80\x99 property. Since the 1960s, extensive\nfederal laws governing the environment have been enacted. These include laws governing air, water,\nchemicals, pesticides, solid waste, and nuclear activities. Some laws include criminal penalties for\nnoncompliance.\n\nEXERCISES\n1.\n\nWho is responsible for funding CERCLA? That is, what is the source of funds for cleanups of hazardous\nwaste?\n\n2.\n\nWhy is it necessary to have criminal penalties for noncompliance with environmental laws?\n\n3.\n\nWhat is the role of states in setting standards for clean air and clean water?\n\n4.\n\nWhich federal act sets up a \xe2\x80\x9ccradle-to-grave\xe2\x80\x9d system for handling waste?\n\n5.\n\nWhy are federal environmental laws necessary? Why not let the states exclusively govern in the area\nof environmental protection?\n\n[1] 42 United States Code, Section 4321 et seq.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n605\n\n\x0c[2] \xe2\x80\x9cThe Tricks of the Trade-off,\xe2\x80\x9d Business Week, April 4, 1977, 72.\n[3] 33 United States Code, Section 1251.\n[4] Solid Waste Agency of Northern Cook County v. Army Corps of Engineers, 531 U.S. 159 (2001).\n[5] Midlantic National Bank v. New Jersey, 474 U.S. 494 (1986).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n606\n\n\x0c14.6 Cases\nReasonable Use Doctrine\nHoover v. Crane\n362 Mich. 36, 106 N.W.2d 563 (1960)\nEDWARDS, JUSTICE\nThis appeal represents a controversy between plaintiff cottage and resort owners on an inland Michigan\nlake and defendant, a farmer with a fruit orchard, who was using the lake water for irrigation. The\nchancellor who heard the matter ruled that defendant had a right to reasonable use of lake water. The\ndecree defined such reasonable use in terms which were unsatisfactory to plaintiffs who have appealed.\nThe testimony taken before the chancellor pertained to the situation at Hutchins Lake, in Allegan County,\nduring the summer of 1958. Defendant is a fruit farmer who owns a 180-acre farm abutting on the lake.\nHutchins Lake has an area of 350 acres in a normal season. Seventy-five cottages and several farms,\nincluding defendants, abut on it. Defendant\xe2\x80\x99s frontage is approximately 1/4 mile, or about 10% of the\nfrontage of the lake.\nHutchins Lake is spring fed. It has no inlet but does have an outlet which drains south. Frequently in the\nsummertime the water level falls so that the flow at the outlet ceases.\nAll witnesses agreed that the summer of 1958 was exceedingly dry and plaintiffs\xe2\x80\x99 witnesses testified that\nHutchins Lake\xe2\x80\x99s level was the lowest it had ever been in their memory. Early in August, defendant began\nirrigation of his 50-acre pear orchard by pumping water out of Hutchins Lake. During that month the lake\nlevel fell 6 to 8 inches\xe2\x80\x94the water line receded 50 to 60 feet and cottagers experienced severe difficulties\nwith boating and swimming.\n***\nThe tenor of plaintiffs\xe2\x80\x99 testimony was to attribute the 6- to 8-inch drop in the Hutchins Lake level in that\nsummer to defendant\xe2\x80\x99s irrigation activities. Defendant contended that the decrease was due to natural\ncauses that the irrigation was of great benefit to him and contributed only slightly to plaintiff\xe2\x80\x99s\ndiscomfiture. He suggests to us:\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n607\n\n\x0cOne could fairly say that because plaintiffs couldn\xe2\x80\x99t grapple with the unknown causes that admittedly\noccasioned a greater part of the injury complained of, they chose to grapple mightily with the defendant\nbecause he is known and visible.\nThe circuit judge found it impossible to determine a normal lake level from the testimony, except that the\nnormal summer level of the lake is lower than the level at which the lake ceases to drain into the outlet. He\napparently felt that plaintiffs\xe2\x80\x99 problems were due much more to the abnormal weather conditions of the\nsummer of 1958 than to defendant\xe2\x80\x99s irrigation activities.\nHis opinion concluded:\nAccepting the reasonable use theory advanced by plaintiffs it appears to the court that the most equitable\ndisposition of this case would be to allow defendant to use water from the lake until such time when his\nuse interferes with the normal use of his neighbors. One quarter inch of water from the lake ought not to\ninterfere with the rights and uses of defendant\xe2\x80\x99s neighbors and this quantity of water ought to be\nsufficient in time of need to service 45 acres of pears. A meter at the pump, sealed if need be, ought to be a\nsufficient safeguard. Pumping should not be permitted between the hours of 11 p.m. and 7 a.m. Water\nneed be metered only at such times as there is no drainage into the outlet.\nThe decree in this suit may provide that the case be kept open for the submission of future petitions and\nproofs as the conditions permit or require.\n***\nMichigan has adopted the reasonable-use rule in determining the conflicting rights of riparian owners to\nthe use of lake water.\nIn 1874, Justice COOLEY said:\nIt is therefore not a diminution in the quantity of the water alone, or an alteration in its flow, or either or\nboth of these circumstances combined with injury, that will give a right of action, if in view of all the\ncircumstances, and having regard to equality of right in others, that which has been done and which\ncauses the injury is not unreasonable. In other words, the injury that is incidental to a reasonable\nenjoyment of the common right can demand no redress. Dumont v. Kellogg, 29 Mich 420, 425.\nAnd in People v. Hulbert, the Court said:\nNo statement can be made as to what is such reasonable use which will, without variation or qualification,\napply to the facts of every case. But in determining whether a use is reasonable we must consider what the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n608\n\n\x0cuse is for; its extent, duration, necessity, and its application; the nature and size of the stream, and the\nseveral uses to which it is put; the extent of the injury to the one proprietor and of the benefit to the other;\nand all other facts which may bear upon the reasonableness of the use. Red River Roller Mills v. Wright,\n30 Minn 249, 15 NW 167, and cases cited.\nThe Michigan view is in general accord with 4 Restatement, Torts, \xc2\xa7\xc2\xa7 851\xe2\x80\x93853.\n***\nWe interpret the circuit judge\xe2\x80\x99s decree as affording defendant the total metered equivalent in pumpage of\n1/4 inch of the content of Hutchins Lake to be used in any dry period in between the cessation of flow\nfrom the outlet and the date when such flow recommences. Where the decree also provides for the case to\nbe kept open for future petitions based on changed conditions, it would seem to afford as much protection\nfor plaintiffs as to the future as this record warrants.\nBoth resort use and agricultural use of the lake are entirely legitimate purposes. Neither serves to remove\nwater from the watershed. There is, however, no doubt that the irrigation use does occasion some water\nloss due to increased evaporation and absorption. Indeed, extensive irrigation might constitute a threat to\nthe very existence of the lake in which all riparian owners has a stake; and at some point the use of the\nwater which causes loss must yield to the common good.\nThe question on this appeal is, of course, whether the chancellor\xe2\x80\x99s determination of this point was\nunreasonable as to plaintiffs. On this record, we cannot overrule the circuit judge\xe2\x80\x99s view that most of\nplaintiffs\xe2\x80\x99 1958 plight was due to natural causes. Nor can we say, if this be the only irrigation use intended\nand the only water diversion sought, that use of the amount provided in the decree during the dry season\nis unreasonable in respect to other riparian owners.\nAffirmed.\n\nCASE QUESTIONS\n1.\n\nIf the defendant has caused a diminution in water flow, an alteration of the water flow, and the\nplaintiff is adversely affected, why would the Supreme Court of Michigan not provide some remedy?\n\n2.\n\nIs it possible to define an injury that is \xe2\x80\x9cnot unreasonable\xe2\x80\x9d?\n\n3.\n\nWould the case even have been brought if there had not been a drought?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n609\n\n\x0cCriminal Liability of Employees under RCRA\nU.S. v. Johnson & Towers, Inc., Jack W. Hopkins, and Peter Angel\n741 F.2d 662 (1984)\nSLOVITER, Circuit Judge\nBefore us is the government\xe2\x80\x99s appeal from the dismissal of three counts of an indictment charging\nunlawful disposal of hazardous wastes under the Resource Conservation and Recovery Act. In a question\nof first impression regarding the statutory definition of \xe2\x80\x9cperson,\xe2\x80\x9d the district court concluded that the\nAct\xe2\x80\x99s criminal penalty provision imposing fines and imprisonment could not apply to the individual\ndefendants. We will reverse.\nThe criminal prosecution in this case arose from the disposal of chemicals at a plant owned by Johnson &\nTowers in Mount Laurel, New Jersey. In its operations the company, which repairs and overhauls large\nmotor vehicles, uses degreasers and other industrial chemicals that contain chemicals such as methylene\nchloride and trichloroethylene, classified as \xe2\x80\x9chazardous wastes\xe2\x80\x9d under the Resource Conservation and\nRecovery Act (RCRA), 42 U.S.C. \xc2\xa7\xc2\xa7 6901\xe2\x80\x936987 (1982) and \xe2\x80\x9cpollutants\xe2\x80\x9d under the Clean Water Act, 33\nU.S.C. \xc2\xa7\xc2\xa7 1251\xe2\x80\x931376 (1982). During the period relevant here, the waste chemicals from cleaning\noperations were drained into a holding tank and, when the tank was full, pumped into a trench. The\ntrench flowed from the plant property into Parker\xe2\x80\x99s Creek, a tributary of the Delaware River. Under\nRCRA, generators of such wastes must obtain a permit for disposal from the Environmental Protection\nAgency (E.P.A.). The E.P.A. had neither issued nor received an application for a permit for Johnson &\nTowers\xe2\x80\x99 operations.\nThe indictment named as defendants Johnson & Towers and two of its employees, Jack Hopkins, a\nforeman, and Peter Angel, the service manager in the trucking department. According to the indictment,\nover a three-day period federal agents saw workers pump waste from the tank into the trench, and on the\nthird day observed toxic chemicals flowing into the creek.\nCount 1 of the indictment charged all three defendants with conspiracy under 18 U.S.C. \xc2\xa7 371 (1982).\nCounts 2, 3, and 4 alleged violations under the RCRA criminal provision, 42 U.S.C. \xc2\xa7 6928(d) (1982).\nCount 5 alleged a violation of the criminal provision of the Clean Water Act, 33 U.S.C. \xc2\xa7 1319(c) (1982).\nEach substantive count also charged the individual defendants as aiders and abettors under 18 U.S.C. \xc2\xa7 2\n(1982).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n610\n\n\x0cThe counts under RCRA charged that the defendants \xe2\x80\x9cdid knowingly treat, store, and dispose of, and did\ncause to be treated, stored and disposed of hazardous wastes without having obtained a permit\xe2\x80\xa6in that\nthe defendants discharged, deposited, injected, dumped, spilled, leaked and placed degreasers\xe2\x80\xa6into the\ntrench.\xe2\x80\xa6\xe2\x80\x9d The indictment alleged that both Angel and Hopkins \xe2\x80\x9cmanaged, supervised and directed a\nsubstantial portion of Johnson & Towers\xe2\x80\x99 operations\xe2\x80\xa6including those related to the treatment, storage\nand disposal of the hazardous wastes and pollutants\xe2\x80\x9d and that the chemicals were discharged by \xe2\x80\x9cthe\ndefendants and others at their direction.\xe2\x80\x9d The indictment did not otherwise detail Hopkins\xe2\x80\x99 and Angel\xe2\x80\x99s\nactivities or responsibilities.\nJohnson & Towers pled guilty to the RCRA counts. Hopkins and Angel pled not guilty, and then moved to\ndismiss counts 2, 3, and 4. The court concluded that the RCRA criminal provision applies only to \xe2\x80\x9cowners\nand operators,\xe2\x80\x9d i.e., those obligated under the statute to obtain a permit. Since neither Hopkins nor Angel\nwas an \xe2\x80\x9cowner\xe2\x80\x9d or \xe2\x80\x9coperator,\xe2\x80\x9d the district court granted the motion as to the RCRA charges but held that\nthe individuals could be liable on these three counts under 18 U.S.C. \xc2\xa7 2 for aiding and abetting. The court\ndenied the government\xe2\x80\x99s motion for reconsideration, and the government appealed to this court under 18\nU.S.C. \xc2\xa7 3731 (1982).\n***\nThe single issue in this appeal is whether the individual defendants are subject to prosecution under\nRCRA\xe2\x80\x99s criminal provision, which applies to:\nany person who\xe2\x80\x94\n.\xe2\x80\xa6\n(2) knowingly treats, stores, or disposes of any hazardous waste identified or listed under this subchapter\neither\xe2\x80\x94\n(A) without having obtained a permit under section 6925 of this title\xe2\x80\xa6or\n(B) in knowing violation of any material condition or requirement of such permit.\n42 U.S.C. \xc2\xa7 6928(d) (emphasis added). The permit provision in section 6925, referred to in section\n6928(d), requires \xe2\x80\x9ceach person owning or operating a facility for the treatment, storage, or disposal of\nhazardous waste identified or listed under this subchapter to have a permit\xe2\x80\x9d from the E.P.A.\nThe parties offer contrary interpretations of section 6928(d)(2)(A). Defendants consider it an\nadministrative enforcement mechanism, applying only to those who come within section 6925 and fail to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n611\n\n\x0ccomply; the government reads it as penalizing anyone who handles hazardous waste without a permit or\nin violation of a permit. Neither party has cited another case, nor have we found one, considering the\napplication of this criminal provision to an individual other than an owner or operator.\nAs in any statutory analysis, we are obliged first to look to the language and then, if needed, attempt to\ndivine Congress\xe2\x80\x99 specific intent with respect to the issue.\nFirst, \xe2\x80\x9cperson\xe2\x80\x9d is defined in the statute as \xe2\x80\x9can individual, trust, firm, joint stock company, corporation\n(including a government corporation), partnership, association, State, municipality, commission, political\nsubdivision of a State, or any interstate body.\xe2\x80\x9d 42 U.S.C. \xc2\xa7 6903(15) (1982). Had Congress meant in\nsection 6928(d)(2)(A) to take aim more narrowly, it could have used more narrow language. Since it did\nnot, we attribute to \xe2\x80\x9cany person\xe2\x80\x9d the definition given the term in section 6903(15).\nSecond, under the plain language of the statute the only explicit basis for exoneration is the existence of a\npermit covering the action. Nothing in the language of the statute suggests that we should infer another\nprovision exonerating persons who knowingly treat, store or dispose of hazardous waste but are not\nowners or operators.\nFinally, though the result may appear harsh, it is well established that criminal penalties attached to\nregulatory statutes intended to protect public health, in contrast to statutes based on common law crimes,\nare to be construed to effectuate the regulatory purpose.\n***\nCongress enacted RCRA in 1976 as a \xe2\x80\x9ccradle-to-grave\xe2\x80\x9d regulatory scheme for toxic materials, providing\n\xe2\x80\x9cnationwide protection against the dangers of improper hazardous waste disposal.\xe2\x80\x9d H.R. Rep. No. 1491,\n94th Cong., 2d Sess. 11, reprinted in 1976 U.S. Code Cong. & Ad. News 6238, 6249. RCRA was enacted to\nprovide \xe2\x80\x9ca multifaceted approach toward solving the problems associated with the 3\xe2\x80\x934 billion tons of\ndiscarded materials generated each year, and the problems resulting from the anticipated 8% annual\nincrease in the volume of such waste.\xe2\x80\x9d Id. at 2, 1976 U.S. Code Cong. & Ad. News at 6239. The committee\nreports accompanying legislative consideration of RCRA contain numerous statements evincing the\nCongressional view that improper disposal of toxic materials was a serious national problem.\nThe original statute made knowing disposal (but not treatment or storage) of such waste without a permit\na misdemeanor. Amendments in 1978 and 1980 expanded the criminal provision to cover treatment and\nstorage and made violation of section 6928 a felony. The fact that Congress amended the statute twice to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n612\n\n\x0cbroaden the scope of its substantive provisions and enhance the penalty is a strong indication of Congress\xe2\x80\x99\nincreasing concern about the seriousness of the prohibited conduct.\nWe conclude that in RCRA, no less than in the Food and Drugs Act, Congress endeavored to control\nhazards that, \xe2\x80\x9cin the circumstances of modern industrialism, are largely beyond self-protection.\xe2\x80\x9d United\nStates v. Dotterweich, 320 U.S. at 280. It would undercut the purposes of the legislation to limit the class\nof potential defendants to owners and operators when others also bear responsibility for handling\nregulated materials. The phrase \xe2\x80\x9cwithout having obtained a permit under section 6925\xe2\x80\x9d (emphasis added)\nmerely references the section under which the permit is required and exempts from prosecution under\nsection 6928(d)(2)(A) anyone who has obtained a permit; we conclude that it has no other limiting effect.\nTherefore we reject the district court\xe2\x80\x99s construction limiting the substantive criminal provision by\nconfining \xe2\x80\x9cany person\xe2\x80\x9d in section 6928(d)(2)(A) to owners and operators of facilities that store, treat or\ndispose of hazardous waste, as an unduly narrow view of both the statutory language and the\ncongressional intent.\n\nCASE QUESTIONS\n1.\n\nThe district court (trial court) accepted the individual defendants\xe2\x80\x99 argument. What was that\nargument?\n\n2.\n\nOn what reasoning did the appellate court reject that argument?\n\n3.\n\nIf employees of a company that is violating the RCRA carry out disposal of hazardous substances in\nviolation of the RCRA, they would presumably lose their jobs if they didn\xe2\x80\x99t. What is the moral\njustification for applying criminal penalties to such employees (such as Hopkins and Angel)?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n613\n\n\x0c14.7 Summary and Exercises\nSummary\nAn estate is an interest in real property; it is the degree to which a thing is owned. Freehold estates are\nthose with an uncertain duration; leaseholds are estates due to expire at a definite time. A present estate is\none that is currently owned; a future estate is one that is owned now but not yet available for use.\nPresent estates are (1) the fee simple absolute; (2) the fee simple defeasible, which itself may be divided\ninto three types and (3) the life estate.\nFuture estates are generally of two types: reversion and remainder. A reversion arises whenever a\ntransferred estate will endure for a shorter time than that originally owned by the transferor. A remainder\ninterest arises when the transferor gives the reversion interest to someone else.\nUse of air, earth, and water are the major rights incident to ownership of real property. Traditionally, the\nowner held \xe2\x80\x9cup to the sky\xe2\x80\x9d and \xe2\x80\x9cdown to the depths,\xe2\x80\x9d but these rules have been modified to balance\ncompeting rights in a modern economy. The law governing water rights varies with the states; in general,\nthe eastern states with more plentiful water have adopted either the natural flow doctrine or the\nreasonable use doctrine of riparian rights, giving those who live along a waterway certain rights to use the\nwater. By contrast, western states have tended to apply the prior appropriation doctrine, which holds that\nfirst in time is first in right, even if those downstream are disadvantaged.\nAn easement is an interest in land\xe2\x80\x94created by express agreement, prior use, or necessity\xe2\x80\x94that permits\none person to make use of another\xe2\x80\x99s estate. An affirmative easement gives one person the right to use\nanother\xe2\x80\x99s land; a negative easement prevents the owner from using his land in a way that will affect\nanother person\xe2\x80\x99s land. In understanding easement law, the important distinctions are between easements\nappurtenant and in gross, and between dominant and servient owners.\nThe law not only defines the nature of the property interest but also regulates land use. Tort law regulates\nland use by imposing liability for (1) activities that affect those off the land and (2) injuries caused to\npeople who enter it. The two most important theories relating to the former are nuisance and trespass.\nWith respect to the latter, the common law confusingly distinguishes among trespassers, licensees, and\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n614\n\n\x0cinvitees. Some states are moving away from the perplexing and rigid rules of the past and simply require\nowners to maintain their property in a reasonably safe condition.\nLand use may also be regulated by private agreement through the restrictive covenant, an agreement that\n\xe2\x80\x9cruns with the land\xe2\x80\x9d and that will be binding on any subsequent owner. Land use is also regulated by the\ngovernment\xe2\x80\x99s power under eminent domain to take private land for public purposes (upon payment of\njust compensation), through zoning laws, and through recently enacted environmental statutes, including\nthe National Environmental Policy Act and laws governing air, water, treatment of hazardous wastes, and\nchemicals.\n\nEXERCISES\n1.\n\nDorothy deeded an acre of real estate that she owns to George for the life of Benny and then to Ernie.\nDescribe the property interests of George, Benny, Ernie, and Dorothy.\n\n2.\n\nIn Exercise 1, assume that George moves into a house on the property. During a tornado, the roof is\ndestroyed and a window is smashed. Who is responsible for repairing the roof and window? Why?\n\n3.\n\nDennis likes to spend his weekends in his backyard, shooting his rifle across his neighbor\xe2\x80\x99s yard. If\nDennis never sets foot on his neighbor\xe2\x80\x99s property, and if the bullets strike neither persons nor\nproperty, has he violated the legal rights of the neighbor? Explain.\n\n4.\n\nDennis also drills an oil well in his backyard. He \xe2\x80\x9cslant drills\xe2\x80\x9d the well; that is, the well slants from a\npoint on the surface in his yard to a point four hundred feet beneath the surface of his neighbor\xe2\x80\x99s\nyard. Dennis has slanted the drilling in order to capture his neighbor\xe2\x80\x99s oil. Can he do this legally?\nExplain.\n\n5.\n\nWanda is in charge of acquisitions for her company. Realizing that water is important to company\noperations, Wanda buys a plant site on a river, and the company builds a plant that uses all of the\nriver water. Downstream owners bring suit to stop the company from using any water. What is the\nresult? Why?\n\n6.\n\nSunny decides to build a solar home. Before beginning construction, she wants to establish the legal\nright to prevent her neighbors from constructing buildings that will block the sunlight. She has heard\nthat the law distinguishes between licenses and easements, easements appurtenant and in gross, and\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n615\n\n\x0caffirmative and negative easements. Which of these interests would you recommend for Sunny?\nWhy?\n\nSELF-TEST QUESTIONS\n1.\n\nA freehold estate is defined as an estate\n\na.\n\nwith an uncertain duration\n\nb.\n\ndue to expire at a definite time\n\nc.\n\nowned now but not yet available for use\n\nd.\n\nthat is leased or rented\nA fee simple defeasible is a type of\n\na.\n\npresent estate\nb.\n\nfuture estate\n\nc.\n\nlife estate\n\nd.\n\nleasehold estate\nA reversion is\n\na.\n\na present estate that prevents transfer of land out of the family\nb.\n\na form of life estate\n\nc.\n\na future estate that arises when the estate transferred has a duration less than that originally\nowned by the transferor\n\nd.\n\nidentical to a remainder interest\nAn easement is an interest in land that may be created by\n\na.\n\nexpress agreement\nb.\n\nprior use\n\nc.\n\nnecessity\n\nd.\n\nall of the above\nThe prior appropriation doctrine\n\na.\n\ntends to be applied by eastern states\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n616\n\n\x0cb.\n\nholds that first in time is first in right\n\nc.\n\ngives those that live along a waterway special rights to use the water\n\nd.\n\nall of the above\n\nSELF-TEST ANSWERS\n1.\n\na\n\n2.\n\na\n\n3.\n\nc\n\n4.\n\nd\n\n5.\n\nb\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n617\n\n\x0cChapter 15\nSecurities Regulation\nLEARNING OBJECTIVES\nAfter reading this chapter, you should understand the following:\n1.\n\nThe nature of securities regulation\n\n2.\n\nThe Securities Act of 1933 and the Securities Exchange Act of 1934\n\n3.\n\nLiability under securities laws\n\n4.\n\nWhat insider trading is and why it\xe2\x80\x99s unlawful\n\n5.\n\nCivil and criminal penalties for violations of securities laws\n\nThis chapter examines government regulation of securities and insider trading. Both the registration and\nthe trading of securities are highly regulated by the Securities and Exchange Commission (SEC). A\nviolation of a securities law can lead to severe criminal and civil penalties. But first we examine the\nquestion, Why is there a need for securities regulation?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n618\n\n\x0c15.1 The Nature of Securities Regulation\nLEARNING OBJECTIVES\n1.\n\nRecognize that the definition of security encompasses a broad range of interests.\n\n2.\n\nUnderstand the functions of the Securities and Exchange Commission and the penalties for violations\nof the securities laws.\n\n3.\n\nUnderstand which companies the Securities Exchange Act of 1934 covers.\n\n4.\n\nExplore the purpose of state Blue Sky Laws.\n\n5.\n\nKnow the basic provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act.\n\nWhat we commonly refer to as \xe2\x80\x9csecurities\xe2\x80\x9d are essentially worthless pieces of paper. Their inherent\nvalue lies in the interest in property or an ongoing enterprise that they represent. This disparity between\nthe tangible property\xe2\x80\x94the stock certificate, for example\xe2\x80\x94and the intangible interest it represents gives\nrise to several reasons for regulation. First, there is need for a mechanism to inform the buyer accurately\nwhat it is he is buying. Second, laws are necessary to prevent and provide remedies for deceptive and\nmanipulative acts designed to defraud buyers and sellers. Third, the evolution of stock trading on a\nmassive scale has led to the development of numerous types of specialists and professionals, in dealings\nwith who the public can be at a severe disadvantage, and so the law undertakes to ensure that they do not\ntake unfair advantage of their customers.\nThe Securities Act of 1933 and the Securities Exchange Act of 1934 are two federal statutes that\nare vitally important, having virtually refashioned the law governing corporations during the past half\ncentury. In fact, it is not too much to say that although they deal with securities, they have become the\ngeneral federal law of corporations. This body of federal law has assumed special importance in recent\nyears as the states have engaged in a race to the bottom in attempting to compete with Delaware\xe2\x80\x99s\npermissive corporation law.\n\nWhat Is a Security?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n619\n\n\x0cSecurities law questions are technical and complex and usually require professional counsel. For the nonlawyer, the critical question on which all else turns is whether the particular investment or document is\na security. If it is, anyone attempting any transaction beyond the routine purchase or sale through a\nbroker should consult legal counsel to avoid the various civil and criminal minefields that the law has\nstrewn about.\nThe definition of security, which is set forth in the Securities Act of 1933, is comprehensive, but it does\nnot on its face answer all questions that financiers in a dynamic market can raise. Under Section 2(1) of\nthe act, \xe2\x80\x9csecurity\xe2\x80\x9d includes \xe2\x80\x9cany note, stock, treasury stock, bond, debenture, evidence of indebtedness,\ncertificate of interest or participation in any profit-sharing agreement, collateral-trust certificate,\npreorganization certificate or subscription, transferable share, investment contract, voting-trust\ncertificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral\nrights, or, in general, any interest or instrument commonly known as a \xe2\x80\x98security,\xe2\x80\x99 or any certificate of\ninterest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or\nright to subscribe to or purchase, any of the foregoing.\xe2\x80\x9d\nUnder this definition, an investment may not be a security even though it is so labeled, and it may actually\nbe a security even though it is called something else. For example, does a service contract that obligates\nsomeone who has sold individual rows in an orange orchard to cultivate, harvest, and markets an orange\ncrop involve a security subject to regulation under federal law? Yes, said the Supreme Court in Securities\n& Exchange Commission v. W. J. Howey Co.\n\n[1]\n\nThe Court said the test is whether \xe2\x80\x9cthe person invests his\n\nmoney in a common enterprise and is led to expect profits solely from the efforts of the promoter or a\nthird party.\xe2\x80\x9d Under this test, courts have liberally interpreted \xe2\x80\x9cinvestment contract\xe2\x80\x9d and \xe2\x80\x9ccertificate of\ninterest or participation in any profit-sharing agreement\xe2\x80\x9d to be securities interests in such property as real\nestate condominiums and cooperatives, commodity option contracts, and farm animals.\nThe Supreme Court ruled that notes that are not \xe2\x80\x9cinvestment contracts\xe2\x80\x9d under the Howey test can still be\nconsidered securities if certain factors are present, as discussed in Reves v. Ernst & Young, (see Section\n15.3.1 "What Is a Security?"). These factors include (1) the motivations prompting a reasonable seller and\nbuyer to enter into the transaction, (2) the plan of distribution and whether the instruments are\ncommonly traded for speculation or investment, (3) the reasonable expectations of the investing public,\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n620\n\n\x0cand (4) the presence of other factors that significantly reduce risk so as to render the application of the\nSecurities Act unnecessary.\n\nThe Securities and Exchange Commission\nFunctions\nThe Securities and Exchange Commission (SEC) is over half a century old, having been created by\nCongress in the Securities Exchange Act of 1934. It is an independent regulatory agency, subject to the\nrules of the Administrative Procedure Act (see Chapter 5 "Administrative Law"). The commission is\ncomposed of five members, who have staggered five-year terms. Every June 5, the term of one of the\ncommissioners expires. Although the president cannot remove commissioners during their terms of\noffice, he does have the power to designate the chairman from among the sitting members. The SEC is\nbipartisan: not more than three commissioners may be from the same political party.\nThe SEC\xe2\x80\x99s primary task is to investigate complaints or other possible violations of the law in securities\ntransactions and to bring enforcement proceedings when it believes that violations have occurred. It is\nempowered to conduct information inquiries, interview witnesses, examine brokerage records, and review\ntrading data. If its requests are refused, it can issue subpoenas and seek compliance in federal court. Its\nusual leads come from complaints of investors and the general public, but it has authority to conduct\nsurprise inspections of the books and records of brokers and dealers. Another source of leads is price\nfluctuations that seem to have been caused by manipulation rather than regular market forces.\nAmong the violations the commission searches out are these: (1) unregistered sale of securities subject to\nthe registration requirement of the Securities Act of 1933, (2) fraudulent acts and practices, (3)\nmanipulation of market prices, (4) carrying out of a securities business while insolvent, (5)\nmisappropriation of customers\xe2\x80\x99 funds by brokers and dealers, and (4) other unfair dealings by brokers\nand dealers.\nWhen the commission believes that a violation has occurred, it can take one of three courses. First, it can\nrefer the case to the Justice Department with a recommendation for criminal prosecution in cases of fraud\nor other willful violation of law.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n621\n\n\x0cSecond, the SEC can seek a civil injunction in federal court against further violations. As a result of\namendments to the securities laws in 1990 (the Securities Enforcement Remedies and Penny Stock\nReform Act), the commission can also ask the court to impose civil penalties. The maximum penalty is\n$100,000 for each violation by a natural person and $500,000 for each violation by an entity other than a\nnatural person. Alternatively, the defendant is liable for the gain that resulted from violating securities law\nif the gain exceeds the statutory penalty. The court is also authorized to bar an individual who has\ncommitted securities fraud from serving as an officer or a director of a company registered under the\nsecurities law.\nThird, the SEC can proceed administratively\xe2\x80\x94that is, hold its own hearing, with the usual due process\nrights, before an administrative law judge. If the commissioners by majority vote accept the findings of\nthe administrative law judge after reading briefs and hearing oral argument, they can impose a variety of\nsanctions: suspend or expel members of exchanges; deny, suspend, or revoke the registrations of brokerdealers; censure individuals for misconduct; and bar censured individuals (temporarily or permanently)\nfrom employment with a registered firm. The 1990 securities law amendments allow the SEC to impose\ncivil fines similar to the court-imposed fines described. The amendments also authorize the SEC to order\nindividuals to cease and desist from violating securities law.\n\nFundamental Mission\nThe SEC\xe2\x80\x99s fundamental mission is to ensure adequate disclosure in order to facilitate informed\ninvestment decisions by the public. However, whether a particular security offering is worthwhile or\nworthless is a decision for the public, not for the SEC, which has no legal authority to pass on the merits of\nan offering or to bar the sale of securities if proper disclosures are made.\nOne example of SEC\xe2\x80\x99s regulatory mandate with respect to disclosures involved the 1981 sale of $274\nmillion in limited partnership interests in a company called Petrogene Oil & Gas Associates, New York.\nThe Petrogene offering was designed as a tax shelter. The company\xe2\x80\x99s filing with the SEC stated that the\noffering involved \xe2\x80\x9ca high degree of risk\xe2\x80\x9d and that only those \xe2\x80\x9cwho can afford the complete loss of their\ninvestment\xe2\x80\x9d should contemplate investing. Other disclosures included one member of the controlling\ngroup having spent four months in prison for conspiracy to commit securities fraud; that he and another\nprincipal were the subject of a New Mexico cease and desist order involving allegedly unregistered taxSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n622\n\n\x0csheltered securities; that the general partner, brother-in-law of one of the principals, had no experience in\nthe company\xe2\x80\x99s proposed oil and gas operations (Petrogene planned to extract oil from plants by using\nradio frequencies); that one of the oils to be produced was potentially carcinogenic; and that the\nprincipals \xe2\x80\x9cstand to benefit substantially\xe2\x80\x9d whether or not the company fails and whether or not\npurchasers of shares recovered any of their investment. The prospectus went on to list specific risks.\nDespite this daunting compilation of troublesome details, the SEC permitted the offering because all\ndisclosures were made (Wall Street Journal, December 29, 1981). It is the business of the marketplace,\nnot the SEC, to determine whether the risk is worth taking.\nThe SEC enforces securities laws through two primary federal acts: The Securities Act of 1933 and The\nSecurities Exchange Act of 1934.\n\nSecurities Act of 1933\nGoals\nThe Securities Act of 1933 is the fundamental \xe2\x80\x9ctruth in securities\xe2\x80\x9d law. Its two basic objectives, which are\nwritten in its preamble, are \xe2\x80\x9cto provide full and fair disclosure of the character of securities sold in\ninterstate and foreign commerce and through the mails, and to prevent frauds in the sale thereof.\xe2\x80\x9d\n\nRegistration\nThe primary means for realizing these goals is the requirement of registration. Before securities subject to\nthe act can be offered to the public, the issuer must file a registration statement and prospectus with the\nSEC, laying out in detail relevant and material information about the offering as set forth in various\nschedules to the act. If the SEC approves the registration statement, the issuer must then provide any\nprospective purchaser with the prospectus. Since the SEC does not pass on the fairness of price or other\nterms of the offering, it is unlawful to state or imply in the prospectus that the commission has the power\nto disapprove securities for lack of merit, thereby suggesting that the offering is meritorious.\nThe SEC has prepared special forms for registering different types of issuing companies. All call for a\ndescription of the registrant\xe2\x80\x99s business and properties and of the significant provisions of the security to\nbe offered, facts about how the issuing company is managed, and detailed financial statements certified by\nindependent public accountants.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n623\n\n\x0cOnce filed, the registration and prospectus become public and are open for public inspection. Ordinarily,\nthe effective date of the registration statement is twenty days after filing. Until then, the offering may not\nbe made to the public. Section 2(10) of the act defines prospectus as any \xe2\x80\x9cnotice, circular, advertisement,\nletter, or communication, written or by radio or television, which offers any security for sale or confirms\nthe sale of any security.\xe2\x80\x9d (An exception: brief notes advising the public of the availability of the formal\nprospectus.) The import of this definition is that any communication to the public about the offering of a\nsecurity is unlawful unless it contains the requisite information.\nThe SEC staff examines the registration statement and prospectus, and if they appear to be materially\nincomplete or inaccurate, the commission may suspend or refuse the effectiveness of the registration\nstatement until the deficiencies are corrected. Even after the securities have gone on sale, the agency has\nthe power to issue a stop order that halts trading in the stock.\nSection 5(c) of the act bars any person from making any sale of any security unless it is first registered.\nNevertheless, there are certain classes of exemptions from the registration requirement. Perhaps the most\nimportant of these is Section 4(3), which exempts \xe2\x80\x9ctransactions by any person other than an issuer,\nunderwriter or dealer.\xe2\x80\x9d Section 4(3) also exempts most transactions of dealers. So the net is that trading\nin outstanding securities (the secondary market) is exempt from registration under the Securities Act of\n1933: you need not file a registration statement with the SEC every time you buy or sell securities through\na broker or dealer, for example. Other exemptions include the following: (1) private offerings to a limited\nnumber of persons or institutions who have access to the kind of information registration would disclose\nand who do not propose to redistribute the securities; (2) offerings restricted to the residents of the state\nin which the issuing company is organized and doing business; (3) securities of municipal, state, federal\nand other government instrumentalities, of charitable institutions, of banks, and of carriers subject to the\nInterstate Commerce Act; (4) offerings not in excess of certain specified amounts made in compliance\nwith regulations of the Commission\xe2\x80\xa6: and (5) offerings of \xe2\x80\x9csmall business investment companies\xe2\x80\x9d made\nin accordance with rules and regulations of the Commission.\n\nPenalties\nSection 24 of the Securities Act of 1933 provides for fines not to exceed $10,000 and a prison term not to\nexceed five years, or both, for willful violations of any provisions of the act. This section makes these\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n624\n\n\x0ccriminal penalties specifically applicable to anyone who \xe2\x80\x9cwillfully, in a registration statement filed under\nthis title, makes any untrue statement of a material fact or omits to state any material fact required to be\nstated therein or necessary to make the statements therein not misleading.\xe2\x80\x9d\nSections 11 and 12 provide that anyone injured by false declarations in registration statements,\nprospectuses, or oral communications concerning the sale of the security\xe2\x80\x94as well as anyone injured by\nthe unlawful failure of an issuer to register\xe2\x80\x94may file a civil suit to recover the net consideration paid for\nthe security or for damages if the security has been sold.\nAlthough these civil penalty provisions apply only to false statements in connection with the registration\nstatement, prospectus, or oral communication, the Supreme Court held, in Case v. Borak,\n\n[2]\n\nthat there is\n\nan \xe2\x80\x9cimplied private right of action\xe2\x80\x9d for damages resulting from a violation of SEC rules under the act. The\nCourt\xe2\x80\x99s ruling in Borak opened the courthouse doors to many who had been defrauded but were\npreviously without a practical remedy.\n\nSecurities Exchange Act of 1934\nCompanies Covered\nThe Securities Act of 1933 is limited, as we have just seen, to new securities issues\xe2\x80\x94that is\nthe primary market. The trading that takes place in the secondary market is far more significant, however.\nIn a normal year, trading in outstanding stock totals some twenty times the value of new stock issues.\nTo regulate the secondary market, Congress enacted the Securities Exchange Act of 1934. This law, which\ncreated the SEC, extended the disclosure rationale to securities listed and registered for public trading on\nthe national securities exchanges. Amendments to the act have brought within its ambit every corporation\nwhose equity securities are traded over the counter if the company has at least $10 million in assets and\nfive hundred or more shareholders.\n\nReporting Proxy Solicitation\nAny company seeking listing and registration of its stock for public trading on a national exchange\xe2\x80\x94or\nover the counter, if the company meets the size test\xe2\x80\x94must first submit a registration application to both\nthe exchange and the SEC. The registration statement is akin to that filed by companies under the\nSecurities Act of 1933, although the Securities Exchange Act of 1934 calls for somewhat fewer disclosures.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n625\n\n\x0cThereafter, companies must file annual and certain other periodic reports to update information in the\noriginal filing.\nThe Securities Exchange Act of 1934 also covers proxy solicitation. Whenever management, or a dissident\nminority, seeks votes of holders of registered securities for any corporate purpose, disclosures must be\nmade to the stockholders to permit them to vote yes or no intelligently.\n\nPenalties\nThe logic of the Borak case (discussed in Section 15.1.3 "Securities Act of 1933") also applies to this act, so\nthat private investors may bring suit in federal court for violations of the statute that led to financial\ninjury. Violations of any provision and the making of false statements in any of the required disclosures\nsubject the defendant to a maximum fine of $5 million and a maximum twenty-year prison sentence, but a\ndefendant who can show that he had no knowledge of the particular rule he was convicted of violating\nmay not be imprisoned. The maximum fine for a violation of the act by a person other than a natural\nperson is $25 million. Any issuer omitting to file requisite documents and reports is liable to pay a fine of\n$100 for each day the failure continues.\n\nBlue Sky Laws\nLong before congressional enactment of the securities laws in the 1930s, the states had legislated\nsecurities regulations. Today, every state has enacted a blue sky law, so called because its purpose is to\nprevent \xe2\x80\x9cspeculative schemes which have no more basis than so many feet of \xe2\x80\x98blue sky.\xe2\x80\x99\xe2\x80\x9d\n\n[3]\n\nThe federal\n\nSecurities Act of 1933, discussed in Section 15.1.3 "Securities Act of 1933", specifically preserves the\njurisdiction of states over securities.\nBlue sky laws are divided into three basic types of regulation. The simplest is that which prohibits fraud in\nthe sale of securities. Thus at a minimum, issuers cannot mislead investors about the purpose of the\ninvestment. All blue sky laws have antifraud provisions; some have no other provisions. The second type\ncalls for registration of broker-dealers, and the third type for registration of securities. Some state laws\nparallel the federal laws in intent and form of proceeding, so that they overlap; other blue sky laws\nempower state officials (unlike the SEC) to judge the merits of the offerings, often referred to as\nmerit review laws. As part of a movement toward deregulation, several states have recently modified or\neliminated merit provisions.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n626\n\n\x0cMany of the blue sky laws are inconsistent with each other, making national uniformity difficult. In 1956,\nthe National Conference of Commissioners on Uniform State Laws approved the Uniform Securities Act.\nIt has not been designed to reconcile the conflicting philosophies of state regulation but to take them into\naccount and to make the various forms of regulation as consistent as possible. States adopt various\nportions of the law, depending on their regulatory philosophies. The Uniform Securities Act has antifraud,\nbroker-dealer registration, and securities registration provisions. More recent acts have further increased\nuniformity. These include the National Securities Markets Improvement Act of 1996, which preempted\ndiffering state philosophies with regard to registration of securities and regulation of brokers and\nadvisors, and the Securities Litigation Uniform Standards Act of 1998, which preempted state law\nsecurities fraud claims from being raised in class action lawsuits by investors.\n\nDodd-Frank Wall Street Reform and Consumer Protection Act\nIn 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which is the\nlargest amendment to financial regulation in the United States since the Great Depression. This\namendment was enacted in response to the economic recession of the late 2000s for the following\npurposes: (1) to promote the financial stability of the United States by improving accountability and\ntransparency in the financial system, (2) to end \xe2\x80\x9ctoo big to fail\xe2\x80\x9d institutions, (3) to protect the American\ntaxpayer by ending bailouts, and (4) to protect consumers from abusive financial services practices. The\ninstitutions most affected by the regulatory changes include those involved in monitoring the financial\nsystem, such as the Federal Deposit Insurance Corporation (FDIC) and the SEC. Importantly, the\namendment ended the exemption for investment advisors who previously were not required to register\nwith the SEC because they had fewer than fifteen clients during the previous twelve months and did not\nhold out to the public as investment advisors. This means that in practice, numerous investment advisors,\nas well as hedge funds and private equity firms, are now subject to registration requirements.\n\n[4]\n\nKEY TAKEAWAY\nThe SEC administers securities laws to prevent the fraudulent practices in the sales of securities. The\ndefinition of security is intentionally broad to protect the public from fraudulent investments that\notherwise would escape regulation. The Securities Act of 1933 focuses on the issuance of securities,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n627\n\n\x0cand the Securities Exchange Act of 1934 deals predominantly with trading in issued securities.\nNumerous federal and state securities laws are continuously created to combat securities fraud, with\npenalties becoming increasingly severe.\n\nEXERCISES\n1.\n\nWhat differentiates an ordinary investment from a security? List all the factors.\n\n2.\n\nWhat is the main objective of the SEC?\n\n3.\n\nWhat are the three courses of action that the SEC may take against one who violates a securities law?\n\n4.\n\nWhat is the difference between the Securities Act of 1933 and the Securities Exchange Act of 1934?\n\n5.\n\nWhat do blue sky laws seek to protect?\n\n[1] Securities & Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946).\n[2] Case v. Borak, 377 U.S. 426 (1964).\n[3] Hall v. Geiger-Jones Co., 242 U.S. 539 (1917).\n[4] For more information on the Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub.L. 111-203,\nH.R. 4173), see Thomas, \xe2\x80\x9cMajor Actions,\xe2\x80\x9d Bill Summary & Status 111th Congress (2009\xe2\x80\x932010)\nH.R.4173, http://thomas.loc.gov/cgi-bin/bdquery/z?d111:HR04173:@@@L&summ2=m&#major%20actions.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n628\n\n\x0c15.2 Liability under Securities Law\nLEARNING OBJECTIVES\n1.\n\nUnderstand how the Foreign Corrupt Practices Act prevents American companies from using bribes to\nenter into contracts or gain licenses from foreign governments.\n\n2.\n\nUnderstand the liability for insider trading for corporate insiders, \xe2\x80\x9ctippees,\xe2\x80\x9d and secondary actors\nunder Sections 16(b) and 10(b) of the 1934 Securities Exchange Act.\n\n3.\n\nRecognize how the Sarbanes-Oxley Act has amended the 1934 act to increase corporate regulation,\ntransparency, and penalties.\n\nCorporations may be found liable if they engage in certain unlawful practices, several of which we explore\nin this section.\n\nThe Foreign Corrupt Practices Act\nInvestigations by the Securities and Exchange Commission (SEC) and the Watergate Special Prosecutor in\nthe early 1970s turned up evidence that hundreds of companies had misused corporate funds, mainly by\nbribing foreign officials to induce them to enter into contracts with or grant licenses to US companies.\nBecause revealing the bribes would normally be self-defeating and, in any event, could be expected to stir\nup immense criticism, companies paying bribes routinely hid the payments in various accounts. As a\nresult, one of many statutes enacted in the aftermath of Watergate, the\nForeign Corrupt Practices Act (FCPA) of 1977, was incorporated into the 1934 Securities Exchange Act.\nThe SEC\xe2\x80\x99s legal interest in the matter is not premised on the morality of bribery but rather on the falsity of\nthe financial statements that are being filed.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n629\n\n\x0cCongress\xe2\x80\x99s response to abuses of financial reporting, the FCPA, was much broader than necessary to treat\nthe violations that were uncovered. The FCPA prohibits an issuer (i.e., any US business enterprise), a\nstockholder acting on behalf of an issuer, and \xe2\x80\x9cany officer, director, employee, or agent\xe2\x80\x9d of an issuer from\nusing either the mails or interstate commerce corruptly to offer, pay, or promise to pay anything of value\nto foreign officials, foreign political parties, or candidates if the purpose is to gain business by inducing\nthe foreign official to influence an act of the government to render a decision favorable to the US\ncorporation.\nBut not all payments are illegal. Fewer than 1988 amendments to the FCPA, payments may be made to\nexpedite routine governmental actions, such as obtaining a visa. And payments are allowed if they are\nlawful under the written law of a foreign country. More important than the foreign-bribe provisions, the\nact includes accounting provisions, which broaden considerably the authority of the SEC. These\nprovisions are discussed in SEC v. World-Wide Coin Investments, Ltd.,\n\n[1]\n\nthe first accounting provisions\n\ncase brought to trial.\n\nInsider Trading\nCorporate insiders\xe2\x80\x94directors, officers, or important shareholders\xe2\x80\x94can have a substantial trading\nadvantage if they are privy to important confidential information. Learning bad news (such as financial\nloss or cancellation of key contracts) in advance of all other stockholders will permit the privileged few to\nsell shares before the price falls. Conversely, discovering good news (a major oil find or unexpected\nprofits) in advance gives the insider a decided incentive to purchase shares before the price rises.\nBecause of the unfairness to those who are ignorant of inside information, federal law\nprohibits insider trading. Two provisions of the 1934 Securities Exchange Act are\nparamount: Section 16(b) and 10(b).\n\nRecapture of Short-Swing Profits: Section 16(b)\nThe Securities Exchange Act assumes that any director, officer, or shareholder owning 10 percent or more\nof the stock in a corporation is using inside information if he or any family member makes a profit from\ntrading activities, either buying and selling or selling and buying, during a six-month period. Section 16(b)\npenalizes any such person by permitting the corporation or a shareholder suing on its behalf to recover\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n630\n\n\x0cthe short-swing profits. The law applies to any company with more than $10 million in assets and at least\nfive hundred or more shareholders of any class of stock.\nSuppose that on January 1, Bob (a company officer) purchases one hundred shares of stock in BCT\nBookstore, Inc., for $60 a share. On September 1, he sells them for $100 a share. What is the result? Bob\nis in the clear, because his $4,000 profit was not realized during a six-month period. Now suppose that\nthe price falls, and one month later, on October 1, he repurchases one hundred shares at $30 a share and\nholds them for two years. What is the result? He will be forced to pay back $7,000 in profits even if he had\nno inside information. Why? In August, Bob held one hundred shares of stock, and he did again on\nOctober 1\xe2\x80\x94within a six-month period. His net gain on these transactions was $7,000 ($10,000 realized\non the sale less the $3,000 cost of the purchase).\nAs a consequence of Section 16(b) and certain other provisions, trading in securities by directors, officers,\nand large stockholders presents numerous complexities. For instance, the law requires people in this\nposition to make periodic reports to the SEC about their trades. As a practical matter, directors, officers,\nand large shareholders should not trade in their own company stock in the short run without legal advice.\n\nInsider Trading: Section 10(b) and Rule 10b-5\nSection 10(b) of the Securities Exchange Act of 1934 prohibits any person from using the mails or facilities\nof interstate commerce \xe2\x80\x9cto use or employ, in connection with the purchase or sale of any security\xe2\x80\xa6any\nmanipulative or deceptive device or contrivance in contravention of such rules and regulations as the\nCommission may prescribe as necessary or appropriate in the public interest or for the protection of\ninvestors.\xe2\x80\x9d In 1942, the SEC learned of a company president who misrepresented the company\xe2\x80\x99s financial\ncondition in order to buy shares at a low price from current stockholders. So the commission adopted a\nrule under the authority of Section 10(b). Rule 10b-5, as it was dubbed, has remained unchanged for more\nthan forty years and has spawned thousands of lawsuits and SEC proceedings. It reads as follows:\nIt shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of\ninterstate commerce, or of the mails, or of any facility of any national securities exchange,\n(1) to employ any device, scheme, or artifice to defraud,\n(2) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to\nmake the statements made, in the light of circumstances under which they were made, not misleading, or\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n631\n\n\x0c(3) to engage in any act, practice, or course of business which operates or would operate as a fraud or\ndeceit upon any person, in connection with the purchase or sale of any security.\nRule 10b-5 applies to any person who purchases or sells any security. It is not limited to securities\nregistered under the 1934 Securities Exchange Act. It is not limited to publicly held companies. It applies\nto any security issued by any company, including the smallest closely held company. In substance, it is an\nantifraud rule, enforcement of which seems, on its face, to be limited to action by the SEC. But over the\nyears, the courts have permitted people injured by those who violate the statute to file private damage\nsuits. This sweeping rule has at times been referred to as the \xe2\x80\x9cfederal law of corporations\xe2\x80\x9d or the \xe2\x80\x9ccatch\neverybody\xe2\x80\x9d rule.\nInsider trading ran headlong into Rule 10b-5 beginning in 1964 in a series of cases involving Texas Gulf\nSulphur Company (TGS). On November 12, 1963, the company discovered a rich deposit of copper and\nzinc while drilling for oil near Timmins, Ontario. Keeping the discovery quiet, it proceeded to acquire\nmineral rights in adjacent lands. By April 1964, word began to circulate about TGS\xe2\x80\x99s find.\nNewspapers printed rumors, and the Toronto Stock Exchange experienced a wild speculative spree. On\nApril 12, an executive vice president of TGS issued a press release downplaying the discovery, asserting\nthat the rumors greatly exaggerated the find and stating that more drilling would be necessary before\ncoming to any conclusions. Four days later, on April 16, TGS publicly announced that it had uncovered a\nstrike of 25 million tons of ore. In the months following this announcement, TGS stock doubled in value.\nThe SEC charged several TGS officers and directors with having purchased or told their friends, socalled tippees, to purchase TGS stock from November 12, 1963, through April 16, 1964, on the basis of\nmaterial inside information. The SEC also alleged that the April 12, 1964, press release was deceptive. The\nUS Court of Appeals, in SEC v. Texas Gulf Sulphur Co.,\n\n[2]\n\ndecided that the defendants who purchased the\n\nstock before the public announcement had violated Rule 10b-5. According to the court, \xe2\x80\x9canyone in\npossession of material inside information must either disclose it to the investing public, or, if he is\ndisabled from disclosing to protect a corporate confidence, or he chooses not to do so, must abstain from\ntrading in or recommending the securities concerned while such inside information remains undisclosed.\xe2\x80\x9d\nOn remand, the district court ordered certain defendants to pay $148,000 into an escrow account to be\nused to compensate parties injured by the insider trading.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n632\n\n\x0cThe court of appeals also concluded that the press release violated Rule 10b-5 if \xe2\x80\x9cmisleading to the\nreasonable investor.\xe2\x80\x9d On remand, the district court held that TGS failed to exercise \xe2\x80\x9cdue diligence\xe2\x80\x9d in\nissuing the release. Sixty-nine private damage actions were subsequently filed against TGS by\nshareholders who claimed they sold their stock in reliance on the release. The company settled most of\nthese suits in late 1971 for $2.7 million.\nFollowing the TGS episode, the Supreme Court refined Rule 10b-5 on several fronts. First, in Ernst &\nErnst v. Hochfelder,\n\n[3]\n\nthe Court decided that proof of scienter\xe2\x80\x94defined as \xe2\x80\x9cmental state embracing\n\nintent to deceive, manipulate, or defraud\xe2\x80\x9d\xe2\x80\x94is required in private damage actions under Rule 10b-5. In\nother words, negligence alone will not result in Rule 10b-5 liability. The Court also held that scienter,\nwhich is an intentional act, must be established in SEC injunctive actions.\n\n[4]\n\nThe Supreme Court has placed limitations on the liability of tippees under Rule 10b-5. In 1980, the Court\nreversed the conviction of an employee of a company that printed tender offer and merger prospectuses.\nUsing information obtained at work, the employee had purchased stock in target companies and later sold\nit for a profit when takeover attempts were publicly announced. In Chiarella v. United States, the Court\nheld that the employee was not an insider or a fiduciary and that \xe2\x80\x9ca duty to disclose under Section 10(b)\ndoes not arise from the mere possession of nonpublic market information.\xe2\x80\x9d\n\n[5]\n\nFollowing Chiarella, the\n\nCourt ruled in Dirks v. Securities and Exchange Commission (see Section 15.3.2 "Tippee Liability"), that\ntippees are liable if they had reason to believe that the tipper breached a fiduciary duty in disclosing\nconfidential information and the tipper received a personal benefit from the disclosure.\nThe Supreme Court has also refined Rule 10b-5 as it relates to the duty of a company to\ndisclose material information, as discussed in Basic, Inc. v. Levinson (see Section 15.3.3 "Duty to Disclose\nMaterial Information"). This case is also important in its discussion of the degree of reliance investors\nmust prove to support a Rule 10b-5 action.\nIn 2000, the SEC enacted Rule 10b5-1, which defines trading \xe2\x80\x9con the basis of\xe2\x80\x9d inside information as any\ntime a person trades while aware of material nonpublic information. Therefore, a defendant is not saved\nby arguing that the trade was made independent of knowledge of the nonpublic information. However,\nthe rule also creates an affirmative defense for trades that were planned prior to the person\xe2\x80\x99s receiving\ninside information.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n633\n\n\x0cIn addition to its decisions relating to intent (Ernst & Ernst), tippees (Dirks), materiality (Basic), and\nawareness of nonpublic information (10b5-1), the Supreme Court has considered\nthe misappropriation theory, under which a person who misappropriates information from an employer\nfaces insider trading liability. In a leading misappropriation theory case, the Second Circuit Court of\nAppeals reinstated an indictment against employees who traded on the basis of inside information\nobtained through their work at investment banking firms. The court concluded that the employees\xe2\x80\x99\nviolation of their fiduciary duty to the firms violated securities law.\nmisappropriation theory in United States v. O\xe2\x80\x99Hagan,\n\n[7]\n\n[6]\n\nThe US Supreme Court upheld the\n\nand the SEC adopted the theory as\n\nnew Rule 10b5-2. Under this new rule, the duty of trust or confidence exists when (1) a person agrees to\nmaintain information in confidence; (2) the recipient knows or should have known through history,\npattern, or practice of sharing confidences that the person communicating the information expects\nconfidentiality; and (3) a person received material nonpublic information from his or her spouse, parent,\nchild, or sibling.\nIn 1987, in Carpenter v. United States,\n\n[8]\n\nthe Supreme Court affirmed the conviction of a Wall Street\n\nJournal reporter who leaked advanced information about the contents of his \xe2\x80\x9cHeard on the Street\xe2\x80\x9d\ncolumn. The reporter, who was sentenced to eighteen months in prison, had been convicted on both mail\nand wire fraud and securities law charges for misappropriating information. The Court upheld the mail\nand wire fraud conviction by an 8\xe2\x80\x930 vote and the securities law conviction by a 4\xe2\x80\x934 vote. (In effect, the tie\nvote affirmed the conviction.)\n\n[9]\n\nBeyond these judge-made theories of liability, Congress had been concerned about insider trading, and in\n1984 and 1988, it substantially increased the penalties. A person convicted of insider trading now faces a\nmaximum criminal fine of $1 million and a possible ten-year prison term. A civil penalty of up to three\ntimes the profit made (or loss avoided) by insider trading can also be imposed. This penalty is in addition\nto liability for profits made through insider trading. For example, financier Ivan Boesky, who was\nsentenced in 1987 to a three-year prison term for insider trading, was required to disgorge $50 million of\nprofits and was liable for another $50 million as a civil penalty. In 2003, Martha Stewart was indicted on\ncharges of insider trading but was convicted for obstruction of justice, serving only five months. More\nrecently, in 2009, billionaire founder of the Galleon Group, Raj Rajaratnam, was arrested for insider\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n634\n\n\x0ctrading; he was convicted in May 2011 of all 14 counts of insider trading. For the SEC release on the\nMartha Stewart case, seehttp://www.sec.gov/news/press/2003-69.htm.\nCompanies that knowingly and recklessly fail to prevent insider trading by their employees are subject to\na civil penalty of up to three times the profit gained or loss avoided by insider trading or $1 million,\nwhichever is greater. Corporations are also subject to a criminal fine of up to $2.5 million.\n\nSecondary Actor\nIn Stoneridge Investment Partners v. Scientific-Atlanta,\n\n[10]\n\nthe US Supreme Court held that \xe2\x80\x9caiders and\n\nabettors\xe2\x80\x9d of fraud cannot be held secondarily liable under 10(b) for a private cause of action. This means\nthat secondary actors, such as lawyers and accountants, cannot be held liable unless their conduct\nsatisfies all the elements for 10(b) liability.\nFor an overview of insider trading, go tohttp://www.sec.gov/answers/insider.htm.\n\nSarbanes-Oxley Act\nCongress enacted the Sarbanes-Oxley Act in 2002 in response to major corporate and accounting\nscandals, most notably those involving Enron, Tyco International, Adelphia, and WorldCom. The act\ncreated the Public Company Accounting Oversight Board, which oversees, inspects, and regulates\naccounting firms in their capacity as auditors of public companies. As a result of the act, the SEC may\ninclude civil penalties to a disgorgement fund for the benefit of victims of the violations of the Securities\nAct of 1933 and the Securities Exchange Act of 1934.\n\nKEY TAKEAWAY\nCorrupt practices, misuse of corporate funds, and insider trading unfairly benefit the minority and cost\nthe public billions. Numerous federal laws have been enacted to create liability for these bad actors in\norder to prevent fraudulent trading activities. Both civil and criminal penalties are available to punish\nthose actors who bribe officials or use inside information unlawfully.\n\nEXERCISES\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n635\n\n\x0c1.\n\nWhy is the SEC so concerned with bribery? What does the SEC really aim to prevent through the\nFCPA?\n\n2.\n\nWhat are short-swing profits?\n\n3.\n\nTo whom does Section 16(b) apply?\n\n4.\n\nExplain how Rule 10b-5 has been amended \xe2\x80\x9con the basis of\xe2\x80\x9d insider information.\n\n5.\n\nCan a secondary actor (attorney, accountant) be liable for insider trading? What factors must be\npresent?\n\n[1] SEC v. World-Wide Coin Investments, Ltd., 567 F.Supp. 724 (N.D. Ga. 1983).\n[2] SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968).\n[3] Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976).\n[4] Aaron v. SEC, 446 U.S. 680 (1980).\n[5] Chiarella v. United States, 445 U.S. 222 (1980).\n[6] United States v. Newman, 664 F.2d 12 (2d Cir. 1981).\n[7] United States v. O\xe2\x80\x99Hagan, 521 U.S. 642 (1997).\n[8] Carpenter v. United States, 484 U.S. 19 (1987).\n[9] Carpenter v. United States, 484 U.S. 19 (1987).\n[10] Stoneridge Investment Partners v. Scientific-Atlanta, 552 U.S. 148 (2008).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n636\n\n\x0c15.3 Cases\nWhat Is a Security?\nReves v. Ernst & Young\n494 U.S. 56, 110 S.Ct. 945 (1990)\nJUSTICE MARSHALL delivered the opinion of the Court.\nThis case presents the question whether certain demand notes issued by the Farmer\xe2\x80\x99s Cooperative of\nArkansas and Oklahoma are \xe2\x80\x9csecurities\xe2\x80\x9d within the meaning of \xc2\xa7 3(a)(10) of the Securities and Exchange\nAct of 1934. We conclude that they are.\nThe Co-Op is an agricultural cooperative that, at the same time relevant here, had approximately 23,000\nmembers. In order to raise money to support its general business operations, the Co-Op sold promissory\nnotes payable on demand by the holder. Although the notes were uncollateralized and uninsured, they\npaid a variable rate of interest that was adjusted monthly to keep it higher than the rate paid by local\nfinancial institutions. The Co-Op offered the notes to both members and nonmembers, marketing the\nscheme as an \xe2\x80\x9cInvestment Program.\xe2\x80\x9d Advertisements for the notes, which appeared in each Co-Op\nnewsletter, read in part: \xe2\x80\x9cYOUR CO-OP has more than $11,000,000 in assets to stand behind your\ninvestments. The Investment is not Federal [sic] insured but it is\xe2\x80\xa6Safe\xe2\x80\xa6Secure\xe2\x80\xa6and available when you\nneed it.\xe2\x80\x9d App. 5 (ellipses in original). Despite these assurances, the Co-Op filed for bankruptcy in 1984. At\nthe time of the filing, over 1,600 people held notes worth a total of $10 million.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n637\n\n\x0cAfter the Co-Op filed for bankruptcy, petitioners, a class of holders of the notes, filed suit against Arthur\nYoung & Co., the firm that had audited the Co-Op\xe2\x80\x99s financial statements (and the predecessor to\nrespondent Ernst & Young). Petitioners alleged, inter alia, that Arthur Young had intentionally failed to\nfollow generally accepted accounting principles in its audit, specifically with respect to the valuation of\none of the Co-Op\xe2\x80\x99s major assets, a gasohol plant. Petitioners claimed that Arthur Young violated these\nprinciples in an effort to inflate the assets and net worth of the Co-Op. Petitioners maintained that, had\nArthur Young properly treated the plant in its audits, they would not have purchased demand notes\nbecause the Co-Op\xe2\x80\x99s insolvency would have been apparent. On the basis of these allegations, petitioners\nclaimed that Arthur Young had violated the antifraud provisions of the 1934 Act as well as Arkansas\xe2\x80\x99\nsecurities laws.\nPetitioners prevailed at trial on both their federal and state claims, receiving a $6.1 million judgment.\nArthur Young appealed, claiming that the demand notes were not \xe2\x80\x9csecurities\xe2\x80\x9d under either the 1934 Act or\nArkansas law, and that the statutes\xe2\x80\x99 antifraud provisions therefore did not apply. A panel of the Eighth\nCircuit, agreeing with Arthur Young on both the state and federal issues, reversed. Arthur Young & Co. v.\nReves, 856 F.2d 52 (1988). We granted certiorari to address the federal issue, 490 U.S. 1105, 109 S.Ct.\n3154, 104 L.Ed.2d 1018 (1989), and now reverse the judgment of the Court of Appeals.\n***\nThe fundamental purpose undergirding the Securities Acts is \xe2\x80\x9cto eliminate serious abuses in a largely\nunregulated securities market.\xe2\x80\x9d United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 849, 95 S.Ct.\n2051, 2059, 44 L.Ed.2d 621 (1975). In defining the scope of the market that it wished to regulate, Congress\npainted with a broad brush. It recognized the virtually limitless scope of human ingenuity, especially in\nthe creation of \xe2\x80\x9ccountless and variable schemes devised by those who seek the use of the money of others\non the promise of profits,\xe2\x80\x9d SEC v. W.J. Howey Co., 328 U.S. 293, 299, 66 S.Ct. 1100, 1103, 90 L.Ed. 1244\n(1946), and determined that the best way to achieve its goal of protecting investors was \xe2\x80\x9cto define \xe2\x80\x98the\nterm \xe2\x80\x9csecurity\xe2\x80\x9d in sufficiently broad and general terms so as to include within that definition the many\ntypes of instruments that in our commercial world fall within the ordinary concept of a security.\xe2\x80\x99\xe2\x80\x9d Forman,\nsupra, 421 U.S., at 847-848, 95 S.Ct, at 2058-2059 (quoting H.R.Rep. No. 85, 73d Cong., 1st Sess., 11\n(1933)). Congress therefore did not attempt precisely to cabin the scope of the Securities Acts. Rather, it\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n638\n\n\x0cenacted a definition of \xe2\x80\x9csecurity\xe2\x80\x9d sufficiently broad to encompass virtually any instrument that might be\nsold as an investment.\n***\n[In deciding whether this transaction involves a \xe2\x80\x9csecurity,\xe2\x80\x9d four factors are important.] First, we examine\nthe transaction to assess the motivations that would prompt a reasonable seller and buyer to enter into it.\nIf the seller\xe2\x80\x99s purpose is to raise money for the general use of a business enterprise or to finance\nsubstantial investments and the buyer is interested primarily in the profit the note is expected to generate,\nthe instrument is likely to be a \xe2\x80\x9csecurity.\xe2\x80\x9d If the note is exchanged to facilitate the purchase and sale of a\nminor asset or consumer good, to correct for the seller\xe2\x80\x99s cash-flow difficulties, or to advance some other\ncommercial or consumer purpose, on the other hand, the note is less sensibly described as a \xe2\x80\x9csecurity.\xe2\x80\x9d\nSecond, we examine the \xe2\x80\x9cplan of distribution\xe2\x80\x9d of the instrument to determine whether it is an instrument\nin which there is \xe2\x80\x9ccommon trading for speculation or investment.\xe2\x80\x9d Third, we examine the reasonable\nexpectations of the investing public: The Court will consider instruments to be \xe2\x80\x9csecurities\xe2\x80\x9d on the basis of\nsuch public expectations, even where an economic analysis of the circumstances of the particular\ntransaction might suggest that the instruments are not \xe2\x80\x9csecurities\xe2\x80\x9d as used in that transaction. Finally, we\nexamine whether some factor such as the existence of another regulatory scheme significantly reduces the\nrisk of the instrument, thereby rendering application of the Securities Acts unnecessary.\n***\n[We] have little difficulty in concluding that the notes at issue here are \xe2\x80\x9csecurities.\xe2\x80\x9d\n\nCASE QUESTIONS\n1.\n\nWhat are the four factors the court uses to determine whether or not the transaction involves a\nsecurity?\n\n2.\n\nHow does the definition of security in this case differ from the definition in Securities & Exchange\nCommission v. W. J. Howey?\n\nTippee Liability\nDirks v. Securities and Exchange Commission\n463 U.S. 646 (1983)\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n639\n\n\x0c[A] tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material\nnonpublic information only when the insider has breached his fiduciary duty to the shareholders by\ndisclosing the information to the tippee and the tippee knows or should know that there has been a\nbreach.\n***\nWhether disclosure is a breach of duty therefore depends in large part on the purpose of the disclosure.\nThis standard was identified by the SEC itself in Cady, Roberts: a purpose of the securities laws was to\neliminate \xe2\x80\x9cuse of inside information for personal advantage.\xe2\x80\x9d Thus, the test is whether the insider\npersonally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has\nbeen no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach.\n***\nUnder the inside-trading and tipping rules set forth above, we find that there was no actionable violation\nby Dirks. It is undisputed that Dirks himself was a stranger to Equity Funding, with no preexisting\nfiduciary duty to its shareholders. He took no action, directly, or indirectly, that induced the shareholders\nor officers of Equity Funding to repose trust or confidence in him. There was no expectation by Dirk\xe2\x80\x99s\nsources that he would keep their information in confidence. Nor did Dirks misappropriate or illegally\nobtain the information about Equity Funding. Unless the insiders breached their Cady, Roberts\xe2\x80\x99s duty to\nshareholders in disclosing the nonpublic information to Dirks, he breached no duty when he passed it on\nto investors as well as to the Wall Street Journal.\n***\nIt is clear that neither Secrist nor the other Equity Funding employees violated their Cady, Roberts\xe2\x80\x99s duty\nto the corporation\xe2\x80\x99s shareholders by providing information to Dirks. The tippers received no monetary or\npersonal benefit for revealing Equity Funding\xe2\x80\x99s secrets, nor were their purpose to make a gift of valuable\ninformation to Dirks. As the facts of this case clearly indicate, the tippers were motivated by a desire to\nexpose the fraud. In the absence of a breach of duty to shareholders by the insiders, there was no\nderivative breach by Dirks. Dirks therefore could not have been \xe2\x80\x9ca participant after the fact in [an]\ninsider\xe2\x80\x99s breach of a fiduciary duty.\xe2\x80\x9d Chiarella, 445 U.S., at 230, n. 12.\n***\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n640\n\n\x0cWe conclude that Dirks, in the circumstances of this case, had no duty to abstain from the use of the\ninside information that he obtained. The judgment of the Court of Appeals therefore is reversed.\n\nCASE QUESTIONS\n1.\n\nWhen does a tippee assume a fiduciary duty to shareholders of a corporation?\n\n2.\n\nDid Dirks violate any insider trading laws? Why or why not?\n\n3.\n\nHow does this case refine Rule 10b-5?\n\nDuty to Disclose Material Information\nBasic Inc. v. Levinson\n485 U.S. 224 (1988)\n[In December 1978, Basic Incorporated agreed to merge with Consolidated Engineering. Prior to the\nmerger, Basic made three public statements denying it was involved in merger negotiations. Shareholders\nwho sold their stock after the first of these statements and before the merger was announced sued Basic\nand its directors under Rule 10b-5, claiming that they sold their shares at depressed prices as a result of\nBasic\xe2\x80\x99s misleading statements. The district court decided in favor of Basic on the grounds that Basic\xe2\x80\x99s\nstatements were not material and therefore was not misleading. The court of appeals reversed, and the\nSupreme Court granted certiorari.]\nJUSTICE BLACKMUN.\nWe granted certiorari to resolve the split among the Courts of Appeals as to the standard of materiality\napplicable to preliminary merger discussions, and to determine whether the courts below properly applied\na presumption of reliance in certifying the class, rather than requiring each class member to show direct\nreliance on Basic\xe2\x80\x99s statements.\n***\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n641\n\n\x0cThe Court previously has addressed various positive and common-law requirements for a violation of \xc2\xa7\n10(b) or of Rule 10b-5. The Court also explicitly has defined a standard of materiality under the securities\nlaws, see TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976), concluding in the proxy-solicitation\ncontext that \xe2\x80\x9c[a]n omitted fact is material if there is a substantial likelihood that a reasonable shareholder\nwould consider it important in deciding how to vote.\xe2\x80\x9d\xe2\x80\xa6We now expressly adopt the TSC Industries\nstandard of materiality for the 5 10(b) and Rule 10b-5 context.\nThe application of this materiality standard to preliminary merger discussions is not self-evident. Where\nthe impact of the corporate development on the target\xe2\x80\x99s fortune is certain and clear, the TSC Industries\nmateriality definition admits straight-forward application. Where, on the other hand, the event is\ncontingent or speculative in nature, it is difficult to ascertain whether the \xe2\x80\x9creasonable investor\xe2\x80\x9d would\nhave considered the omitted information significant at the time. Merger negotiations, because of the everpresent possibility that the contemplated transaction will not be effectuated, fall into the latter category.\n***\nEven before this Court\xe2\x80\x99s decision in TSC Industries, the Second Circuit had explained the role of the\nmateriality requirement of Rule 10b-5, with respect to contingent or speculative information or events, in\na manner that gave that term meaning that is independent of the other provisions of the Rule. Under such\ncircumstances, materiality \xe2\x80\x9cwill depend at any given time upon a balancing of both the indicated\nprobability that the event will occur and the anticipated magnitude of the event in light of the totality of\nthe company activity.\xe2\x80\x9d SEC v. Texas Gulf Sulphur Co., 401 F.2d, at 849.\n***\nWhether merger discussions in any particular case are material therefore depends on the facts. Generally,\nin order to assess the probability that the event will occur, a fact finder will need to look to indicia of\ninterest in the transactions at the highest corporate levels. Without attempting to catalog all such possible\nfactors, we note by way of example that board resolutions, instructions to investment bankers, and actual\nnegotiations between principals or their intermediaries may serve as indicia of interest. To assess the\nmagnitude of the transaction to the issuer of the securities allegedly manipulated, a fact finder will need to\nconsider such facts as the size of the two corporate entities and of the potential premiums over market\nvalue. No particular event or factor short of closing the transaction need to be either necessary or\nsufficient by itself to render merger discussions material.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n642\n\n\x0cAs we clarify today, materiality depends on the significance the reasonable investor would place on the\nwithheld or misrepresented information. The fact-specific inquiry we endorse here is consistent with the\napproach a number of courts have taken in assessing the materiality of merger negotiations. Because the\nstandard of materiality we have adopted differs from that used by both courts below, we remand the case\nfor reconsideration of the question whether a grant of summary judgment is appropriate on this record.\nWe turn to the question of reliance and the fraud on-the-market theory. Succinctly put:\nThe fraud on the market theory is based on the hypothesis that, in an open and developed securities\nmarket, the price of a company\xe2\x80\x99s stock is determined by the available information regarding the company\nand its business.\xe2\x80\xa6Misleading statements will therefore defraud purchasers of stock even if the purchasers\ndo not directly rely on the misstatements.\xe2\x80\xa6The causal connection between the defendants\xe2\x80\x99 fraud and the\nplaintiff\xe2\x80\x99s purchase of stock in such a case is no less significant than in a case of direct reliance on\nmisrepresentations. Peil v. Speiser, 806 F.2d 1154, 1160-1161 (CA3 1986).\n***\nWe agree that reliance is an element of a Rule 10b-5 cause of action. Reliance provides the requisite causal\nconnection between a defendant\xe2\x80\x99s misrepresentation and a plaintiff\xe2\x80\x99s misrepresentation and a plaintiff\xe2\x80\x99s\ninjury. There is, however, more than one way to demonstrate the causal connection.\n***\nPresumptions typically serve to assist courts in managing circumstances in which direct proof, for one\nreason or another, is rendered difficult. The courts below accepted a presumption, created by the fraudon-the-market theory and subject to rebuttal by petitioners, that persons who had traded Basic shares had\ndone so in reliance on the integrity of the price set by the market, but because of petitioners\xe2\x80\x99 material\nmisrepresentations that price had been fraudulently depressed. Requiring a plaintiff to show a speculative\nstate of facts, i.e., how he would have acted if omitted material information had been disclosed, or if the\nmisrepresentation had not been made, would place an unnecessarily unrealistic evidentiary burden on the\nRule 10b-5 plaintiff who has traded on an impersonal market.\nArising out of considerations of fairness, public policy, and probability, as well as judicial economy,\npresumptions are also useful devices for allocating the burdens of proof between parties. The presumption\nof reliance employed in this case is consistent with, and, by facilitating Rule 10b-5 litigation, supports, the\ncongressional policy embodied in the 1934 Act\xe2\x80\xa6\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n643\n\n\x0cThe presumption is also supported by common sense and probability. Recent empirical studies have\ntended to confirm Congress\xe2\x80\x99 premise that the market price of shares traded on well-developed markets\nreflects all publicly available information, and, hence, any material misrepresentations. It has been noted\nthat \xe2\x80\x9cit is hard to imagine that there ever is a buyer or seller who does not rely on market integrity. Who\nwould knowingly roll the dice in a crooked crap game?\xe2\x80\x9d Schlanger v. Four-Phase Systems, Inc., 555\nF.Supp. 535, 538 (SDNY 1982)\xe2\x80\xa6An investor who buys or sells stock at the price set by the market does so\nin reliance on the integrity of that price. Because most publicly available information is reflected in\nmarket price, an investor\xe2\x80\x99s reliance on any public material misrepresentations, therefore, may be\npresumed for purposes of a Rule 10b-5 action.\n***\nThe judgment of the Court of Appeals is vacated and the case is remanded to that court for further\nproceedings consistent with this opinion.\n\nCASE QUESTIONS\n1.\n\nHow does the court determine what is or is not material information? How does this differ from its\nprevious rulings?\n\n2.\n\nWhat is the fraud-on-the-market theory?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n644\n\n\x0c15.4 Summary and Exercises\nSummary\nBeyond state corporation laws, federal statutes\xe2\x80\x94most importantly, the Securities Act of 1933 and the\nSecurities Exchange Act of 1934\xe2\x80\x94regulate the issuance and trading of corporate securities. The federal\ndefinition of security is broad, encompassing most investments, even those called by other names.\nThe law does not prohibit risky stock offerings; it bans only those lacking adequate disclosure of risks. The\nprimary means for realizing this goal is the registration requirement: registration statements,\nprospectuses, and proxy solicitations must be filed with the Securities and Exchange Commission (SEC).\nPenalties for violation of securities law include criminal fines and jail terms, and damages may be\nawarded in civil suits by both the SEC and private individuals injured by the violation of SEC rules. A 1977\namendment to the 1934 act is the Foreign Corrupt Practices Act, which prohibits an issuer from paying a\nbribe or making any other payment to foreign officials in order to gain business by inducing the foreign\nofficial to influence his government in favor of the US company. This law requires issuers to keep accurate\nsets of books reflecting the dispositions of their assets and to maintain internal accounting controls to\nensure that transactions comport with management\xe2\x80\x99s authorization.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n645\n\n\x0cThe Securities Exchange Act of 1934 presents special hazards to those trading in public stock on the basis\nof inside information. One provision requires the reimbursement to the company of any profits made\nfrom selling and buying stock during a six-month period by directors, officers, and shareholders owning\n10 percent or more of the company\xe2\x80\x99s stock. Under Rule 10b-5, the SEC and private parties may sue\ninsiders who traded on information not available to the general public, thus gaining an advantage in\neither selling or buying the stock. Insiders include company employees.\nThe Sarbanes-Oxley Act amended the 1934 act, creating more stringent penalties, increasing corporate\nregulation, and requiring greater transparency.\n\nEXERCISES\n1.\n\nAnne operated a clothing store called Anne\xe2\x80\x99s Rags, Inc. She owned all of the stock in the company.\nAfter several years in the clothing business, Anne sold her stock to Louise, who personally managed\nthe business. Is the sale governed by the antifraud provisions of federal securities law? Why?\n\n2.\n\nWhile waiting tables at a campus-area restaurant, you overhear a conversation between two\ncorporate executives who indicate that their company has developed a new product that will\nrevolutionize the computer industry. The product is to be announced in three weeks. If you purchase\nstock in the company before the announcement, will you be liable under federal securities law? Why?\n\n3.\n\nEric was hired as a management consultant by a major corporation to conduct a study, which took him\nthree months to complete. While working on the study, Eric learned that someone working in\nresearch and development for the company had recently made an important discovery. Before the\ndiscovery was announced publicly, Eric purchased stock in the company. Did he violate federal\nsecurities law? Why?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n646\n\n\x0c4.\n\nWhile working for the company, Eric also learned that it was planning a takeover of another\ncorporation. Before announcement of a tender offer, Eric purchased stock in the target company. Did\nhe violate securities law? Why?\n\n5.\n\nThe commercial lending department of First Bank made a substantial loan to Alpha Company after\nobtaining a favorable confidential earnings report from Alpha. Over lunch, Heidi, the loan officer who\nhandled the loan, mentioned the earnings report to a friend who worked in the bank\xe2\x80\x99s trust\ndepartment. The friend proceeded to purchase stock in Alpha for several of the bank\xe2\x80\x99s trusts. Discuss\nthe legal implications.\n\n6.\n\nIn Exercise 5, assume that a week after the loan to Alpha, First Bank financed Beta Company\xe2\x80\x99s\ntakeover of Alpha. During the financing negotiations, Heidi mentioned the Alpha earnings report to\nBeta officials; furthermore, the report was an important factor in Heidi\xe2\x80\x99s decision to finance the\ntakeover. Discuss the legal implications.\n\n7.\n\nIn Exercise 6, assume that after work one day, Heidi told her friend in the trust department that Alpha\nwas Beta\xe2\x80\x99s takeover target. The friend proceeded to purchase additional stock in Alpha for a bank\ntrust he administered. Discuss the legal implications.\n\nSELF-TEST QUESTIONS\n1.\n\nThe issuance of corporate securities is governed by\n\na.\n\nvarious federal statutes\n\nb.\n\nstate law\n\nc.\n\nboth of the above\n\nd.\n\nneither of the above\nThe law that prohibits the payment of a bribe to foreign officials to gain business is called\n\na.\n\nthe Insider Trading Act\nb.\n\nthe blue sky law\n\nc.\n\nthe Foreign Corrupt Practices Act\n\nd.\n\nnone of the above\nThe primary means for banning stock offerings that inadequately disclose risks is\n\na.\n\nthe registration requirement\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n647\n\n\x0cb.\n\nSEC prohibition of risky stock offerings\n\nc.\n\nboth of the above\n\nd.\n\nneither of the above\nTo enforce its prohibition under insider trading, the SEC requires reimbursement to the\ncompany of any profits made from selling and buying stock during any six-month period by\ndirectors owing\na.\n\n60 percent or more of company stock\n\nb.\n\n40 percent or more of company stock\n\nc.\n\n10 percent or more of company stock\n\nd.\n\nnone of the above\nUnder Rule 10b-5, insiders include\n\na.\n\nall company employees\nb.\n\nany person who possesses nonpublic information\n\nc.\n\nall tippees\n\nd.\n\nnone of the above\nThe purpose of the Dodd-Frank Act is to\n\na.\n\npromote financial stability\nb.\n\nend \xe2\x80\x9ctoo big to fail\xe2\x80\x9d\n\nc.\n\nend bailouts\n\nd.\n\nprotect against abusive financial services practices\n\ne.\n\nall of the above\n\nSELF-TEST ANSWERS\n1.\n\nc\n\n2.\n\nc\n\n3.\n\na\n\n4.\n\nd\n\n5.\n\na\n\n6.\n\ne\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n648\n\n\x0cChapter 16\nAntitrust Law\nLEARNING OBJECTIVES\nAfter reading this chapter, you should understand the following:\n1.\n\nThe history and basic framework of antitrust laws on horizontal restraints of trade\n\n2.\n\nThe distinction between vertical restraints of trade and horizontal restraints of trade\n\n3.\n\nThe various exemptions from antitrust law that Congress has created\n\n4.\n\nWhy monopolies pose a threat to competitive markets, and what kinds of monopolies are proscribed by\nthe Sherman Act and the Clayton Act\n\nThis chapter will describe the history and current status of federal laws to safeguard the US market from\nanticompetitive practices, especially those of very large companies that may have a monopoly. Companies\nthat have a monopoly in any market segment have the potential to exercise monopoly power in ways that\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n649\n\n\x0care harmful to consumers and competitors. Economic theory assures us that for the most part,\ncompetition is good: that sound markets will offer buyers lots of choices and good information about\nproducts and services being sold and will present few barriers to entry for buyers and sellers. By\nencouraging more, rather than fewer, competitors in a given segment of the market, US antitrust law\nattempts to preserve consumer choice and to limit barriers to entry, yet it does allow some businesses to\nachieve considerable size and market share on the belief that size can create efficiencies and pass along\nthe benefits to consumers.\n\n16.1 History and Basic Framework of Antitrust Laws in the\nUnited States\nLEARNING OBJECTIVES\n1.\n\nKnow the history and basic framework of antitrust laws in the United States.\n\n2.\n\nUnderstand how US antitrust laws may have international application.\n\n3.\n\nExplain how US antitrust laws are enforced and what kinds of criminal and civil penalties may apply.\n\nIn this chapter, we take up the origins of the federal antitrust laws and the basic rules governing restraints\nof trade.\n\n[1]\n\nWe also look at concentrations of market power: monopoly and acquisitions and\n\nmergers.\n\n[2]\n\nIn, we explore the law of deceptive acts and unfair trade practices, both as administered by the\n\nFederal Trade Commission (FTC) and as regulated at common law.\nFigure 16.1 An Antitrust Schematic\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n650\n\n\x0cThe antitrust laws are aimed at maintaining competition as the driving force of the US economy. The very\nword antitrust implies opposition to the giant trusts that began to develop after the Civil War. Until then,\nthe economy was largely local; manufacturers, distributors, and retailers were generally small. The Civil\nWar demonstrated the utility of large-scale enterprise in meeting the military\xe2\x80\x99s ferocious production\ndemands, and business owners were quick to understand the advantage of size in attracting capital. For\nthe first time, immense fortunes could be made in industry, and adventurous entrepreneurs were quick to\ndo so in an age that lauded the acquisitive spirit.\nThe first great business combinations were the railroads. To avoid ruinous price wars, railroad owners\nmade private agreements, known as \xe2\x80\x9cpools,\xe2\x80\x9d through which they divided markets and offered discounts to\nfavored shippers who agreed to ship goods on certain lines. The pools discriminated against particular\nshippers and certain geographic regions, and public resentment grew.\nFarmers felt the effects first and hardest, and they organized politically to express their opposition. In\ntime, they persuaded many state legislatures to pass laws regulating railroads. In Munn v. Illinois, the\nSupreme Court rejected a constitutional attack on a state law regulating the transportation and\nwarehousing of grain; the court declared that the \xe2\x80\x9cpolice powers\xe2\x80\x9d of the states permit the regulation of\nproperty put to public uses.\n\n[3]\n\nBut over time, many state railroad laws were struck down because they\n\ninterfered with interstate commerce, which only Congress may regulate constitutionally. The consequence\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n651\n\n\x0cwas federal legislation: the Interstate Commerce Act of 1887, establishing the first federal administrative\nagency, the Interstate Commerce Commission.\nIn the meantime, the railroads had discovered that their pools lacked enforcement power. Those who\nnominally agreed to be bound by the pooling arrangement could and often did cheat. The corporate form\nof business enterprise allowed for potentially immense accumulations of capital to be under the control of\na small number of managers; but in the 1870s and 1880s, the corporation was not yet established as the\ndominant legal form of operation. To overcome these disadvantages, clever lawyers for John D.\nRockefeller organized his Standard Oil of Ohio as a common-law trust. Trustees were given corporate\nstock certificates of various companies; by combining numerous corporations into the trust, the trustees\ncould effectively manage and control an entire industry. Within a decade, the Cotton Trust, Lead Trust,\nSugar Trust, and Whiskey Trust, along with oil, telephone, steel, and tobacco trusts, had become, or were\nin the process of becoming, monopolies.\nConsumers howled in protest. The political parties got the message: In 1888, both Republicans and\nDemocrats put an antitrust plank in their platforms. In 1889, the new president, Republican Benjamin\nHarrison, condemned monopolies as \xe2\x80\x9cdangerous conspiracies\xe2\x80\x9d and called for legislation to remedy the\ntendency of monopolies that would \xe2\x80\x9ccrush out\xe2\x80\x9d competition.\nThe result was the Sherman Antitrust Act of 1890, sponsored by Senator John Sherman of Ohio. Its two\nkey sections forbade combinations in restraint of trade and monopolizing. Senator Sherman and other\nsponsors declared that the act had roots in a common-law policy that frowned on monopolies. To an\nextent, it did, but it added something quite important for the future of business and the US economy: the\npower of the federal government to enforce a national policy against monopoly and restraints of trade.\nNevertheless, passage of the Sherman Act did not end the public clamor, because fifteen years passed\nbefore a national administration began to enforce the act, when President Theodore Roosevelt\xe2\x80\x94\xe2\x80\x9dthe\nTrustbuster\xe2\x80\x9d\xe2\x80\x94sent his attorney general after the Northern Securities Corporation, a transportation\nholding company.\nDuring its seven years, the Roosevelt administration initiated fifty-four antitrust suits. The pace picked up\nunder the Taft administration, which in only four years filed ninety antitrust suits. But the pressure for\nfurther reform did not abate, especially when the Supreme Court, in the Standard Oil case of\n1911,\n\n[4]\n\ndeclared that the Sherman Act forbids only \xe2\x80\x9cunreasonable\xe2\x80\x9d restraints of trade. A congressional\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n652\n\n\x0cinvestigation of US Steel Corporation brought to light several practices that had gone unrestrained by the\nSherman Act. It also sparked an important debate, one that has echoes in our own time, about the nature\nof national economic policy: should it enforce competition or regulate business in a partnership kind of\narrangement?\nBig business was firmly on the side of regulation, but Congress opted for the policy followed waveringly to\nthe present: competition enforced by government, not a partnership of government and industry, must be\nthe engine of the economy. Accordingly, in 1914, at the urging of President Woodrow Wilson, Congress\nenacted two more antitrust laws, the Clayton Act and the Federal Trade Commission Act. The Clayton Act\noutlawed price discrimination, exclusive dealing and tying contracts, acquisition of a company\xe2\x80\x99s\ncompetitors, and interlocking directorates. The FTC Act outlawed \xe2\x80\x9cunfair methods\xe2\x80\x9d of competition,\nestablished the FTC as an independent administrative agency, and gave it power to enforce the antitrust\nlaws alongside the Department of Justice.\nThe Sherman, Clayton, and FTC Acts remain the basic texts of antitrust law. Over the years, many states\nhave enacted antitrust laws as well; these laws govern intrastate competition and are largely modeled on\nthe federal laws. The various state antitrust laws are beyond the scope of this textbook.\nTwo additional federal statutes were adopted during the next third of a century as amendments to the\nClayton Act. Enacted in the midst of the Depression in 1936, the Robinson-Patman Act prohibits various\nforms of price discrimination. The Celler-Kefauver Act, strengthening the Clayton Act\xe2\x80\x99s prohibition\nagainst the acquisition of competing companies, was enacted in 1950 in the hopes of stemming what\nseemed to be a tide of corporate mergers and acquisitions. We will examine these laws in turn.\n\nThe Sherman Act\nSection 1 of the Sherman Act declares, \xe2\x80\x9cEvery contract, combination in the form of trust or otherwise, or\nconspiracy, in restraint of trade or commerce among the several states, or with foreign nations, is declared\nto be illegal.\xe2\x80\x9d This is sweeping language. What it embraces seems to depend entirely on the meaning of the\nwords \xe2\x80\x9crestraint of trade or commerce.\xe2\x80\x9d Whatever they might mean, every such restraint is declared\nunlawful. But in fact, as we will see, the proposition cannot be stated quite so categorically, for in 1911 the\nSupreme Court limited the reach of this section to unreasonable restraints of trade.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n653\n\n\x0cWhat does \xe2\x80\x9crestraint of trade\xe2\x80\x9d mean? The Sherman Act\xe2\x80\x99s drafters based the act on a common-law policy\nagainst monopolies and other infringements on competition. But common law regarding restraints of\ntrade had been developed in only rudimentary form, and the words have come to mean whatever the\ncourts say they mean. In short, the antitrust laws, and the Sherman Act in particular, authorize the courts\nto create a federal \xe2\x80\x9ccommon law\xe2\x80\x9d of competition.\nSection 2 of the Sherman Act prohibits monopolization: \xe2\x80\x9cEvery person who shall monopolize, or attempt\nto monopolize, or combine or conspire with any other person or persons, to monopolize any part of the\ntrade or commerce among the several states, or with foreign nations, shall be deemed guilty of a\nmisdemeanor.\xe2\x80\x9d In 1976, Congress upped the ante: violations of the Sherman Act are now felonies. Unlike\nSection 1, Section 2 does not require a combination between two or more people. A single company acting\non its own can be guilty of monopolizing or attempting to monopolize.\n\nThe Clayton Act\nThe Clayton Act was enacted in 1914 to plug what many in Congress saw as loopholes in the Sherman Act.\nPassage of the Clayton Act was closely linked to that of the FTC Act. Unlike the Sherman Act, the Clayton\nAct is not a criminal statute; it merely declares certain defined practices as unlawful and leaves it to the\ngovernment or to private litigants to seek to enjoin those practices. But unlike the FTC Act, the Clayton\nAct does spell out four undesirable practices. Violations of the Sherman Act require an actual adverse\nimpact on competition, whereas violations of the Clayton Act require merely a probable adverse impact.\nThus the enforcement of the Clayton Act involves a prediction that the defendant must rebut in order to\navoid an adverse judgment.\nThe four types of proscribed behavior are these:\n1.\n\nDiscrimination in prices charged different purchasers of the same commodities.\n\n2. Conditioning the sale of one commodity on the purchaser\xe2\x80\x99s refraining from using or dealing in\ncommodities of the seller\xe2\x80\x99s competitors.\n\n[5]\n\n3. Acquiring the stock of a competing corporation.\n\n[6]\n\nBecause the original language did not prohibit\n\nvarious types of acquisitions and mergers that had grown up with modem corporate law and finance,\nCongress amended this section in 1950 (the Celler-Kefauver Act) to extend its prohibition to a wide\nvariety of acquisitions and mergers.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n654\n\n\x0c4. Membership by a single person on more than one corporate board of directors if the companies are or\nwere competitors.\n\n[7]\n\nThe Federal Trade Commission Act\nLike the Clayton Act, the FTC Act is a civil statute, involving no criminal penalties. Unlike the Clayton Act,\nits prohibitions are broadly worded. Its centerpiece is Section 5, which forbids \xe2\x80\x9cunfair methods of\ncompetition in commerce, and unfair or deceptive acts or practices in commerce.\xe2\x80\x9d We examine Section 5\nin .\n\nEnforcement of Antitrust Laws\nGeneral Enforcement\nThere are four different means of enforcing the antitrust laws.\nFirst, the US Department of Justice may bring civil actions to enjoin violations of any section of the\nSherman and Clayton Acts and may institute criminal prosecutions for violations of the Sherman Act.\nBoth civil and criminal actions are filed by the offices of the US attorney in the appropriate federal district,\nunder the direction of the US attorney general. In practice, the Justice Department\xe2\x80\x99s guidance comes\nthrough its Antitrust Division in Washington, headed by an assistant attorney general. With several\nhundred lawyers and dozens of economists and other professionals, the Antitrust Division annually files\nfewer than one hundred civil and criminal actions combined. On average, far more criminal cases are filed\nthan civil cases. In 2006, thirty-four criminal cases and twelve civil cases were filed; in 2007, forty\ncriminal cases and six civil cases; in 2008, fifty-four criminal cases and nineteen civil cases; and in 2009,\nseventy-two criminal cases and nine civil cases.\nThe number of cases can be less important than the complexity and size of a particular case. For\nexample, U.S. v. American Telephone & Telegraph and U.S. v. IBM were both immensely complicated,\ntook years to dispose of, and consumed tens of thousands of hours of staff time and tens of millions of\ndollars in government and defense costs.\nSecond, the FTC hears cases under the Administrative Procedure Act, as described in . The commission\xe2\x80\x99s\ndecisions may be appealed to the US courts of appeals. The FTC may also promulgate \xe2\x80\x9ctrade regulation\nrules,\xe2\x80\x9d which define fair practices in specific industries. The agency has some five hundred lawyers in\nWashington and a dozen field offices, but only about half the lawyers is directly involved in antitrust\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n655\n\n\x0cenforcement. The government\xe2\x80\x99s case against Microsoft was, like the cases against AT&T and IBM, a very\ncomplex case that took a large share of time and resources from both the government and Microsoft.\nThird, in the Antitrust Improvements Act of 1976, Congress authorized state attorneys general to file\nantitrust suits in federal court for damages on behalf of their citizens; such a suit is known as a parens\npatriae claim. Any citizen of the state who might have been injured by the defendant\xe2\x80\x99s actions may opt out\nof the suit and bring his or her own private action. The states have long had the authority to file antitrust\nsuits seeking injunctive relief on behalf of their citizens.\nFourth, private individuals and companies may file suits for damages or injunctions if they have been\ndirectly injured by a violation of the Sherman or Clayton Act. Private individuals or companies may not\nsue under the FTC Act, no matter how unfair or deceptive the behavior complained of; only the FTC may\ndo so. In the 1980s, more than 1,500 private antitrust suits were filed in the federal courts each year,\ncompared with fewer than 100 suits filed by the Department of Justice. More recently, from 2006 to\n2008, private antitrust suits numbered above 1,000 but dropped significantly, to 770, in 2009. The pace\nwas even slower for the first half of 2010. Meanwhile, the Department of Justice filed 40 or fewer criminal\nantitrust cases from 2006 to 2008; that pace has quickened under the Obama administration (72 cases in\n2009).\n\nEnforcement in International Trade\nThe Sherman and Clayton Acts apply when a company\xe2\x80\x99s activities affect US commerce. This means that\nthese laws apply to US companies that agree to fix the price of goods to be shipped abroad and to the acts\nof a US subsidiary of a foreign company. It also means that non\xe2\x80\x93US citizens and business entities can be\nprosecuted for violations of antitrust laws, even if they never set foot in the United States, as long as their\nanticompetitive activities are aimed at the US market. For example, in November of 2010, a federal grand\njury in San Francisco returned an indictment against three former executives in Taiwan. They had\nconspired to fix prices on color display tubes (CDTs), a type of cathode-ray tube used in computer\nmonitors and other specialized applications.\nThe indictment charged Seung-Kyu \xe2\x80\x9cSimon\xe2\x80\x9d Lee, Yeong-Ug \xe2\x80\x9cAlbert\xe2\x80\x9d Yang, and Jae-Sik \xe2\x80\x9cJ. S.\xe2\x80\x9d Kim with\nconspiring with unnamed coconspirators to suppress and eliminate competition by fixing prices, reducing\noutput, and allocating market shares of CDTs to be sold in the United States and elsewhere. Lee, Yang,\nand Kim allegedly participated in the conspiracy during various time periods between at least as early as\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n656\n\n\x0cJanuary 2000 and as late as March 2006. The conspirators met in Taiwan, Korea, Malaysia, China, and\nelsewhere, but not in the United States. They allegedly met for the purpose of exchanging CDT sales,\nproduction, market share, and pricing information for the purpose of implementing, monitoring, and\nenforcing their agreements. Because the intended effects of their actions were to be felt in the United\nStates, the US antitrust laws could apply.\n\nCriminal Sanctions\nUntil 1976, violations of the Sherman Act were misdemeanors. The maximum fine was $50,000 for each\ncount on which the defendant was convicted (only $5,000 until 1955), and the maximum jail sentence was\none year. But in the CDT case just described, each of the three conspirators was charged with violating the\nSherman Act, which carries a maximum penalty of ten years in prison and a $1 million fine for\nindividuals. The maximum fine may be increased to twice the gain derived from the crime or twice the\nloss suffered by the victims if either of those amounts is greater than the statutory maximum fine of $1\nmillion.\n\nForfeitures\nOne provision in the Sherman Act, not much used, permits the government to seize any property in\ntransit in either interstate or foreign commerce if it was the subject of a contract, combination, or\nconspiracy outlawed under Section 1.\n\nInjunctions and Consent Decrees\nThe Justice Department may enforce violations of the Sherman and Clayton Acts by seeking injunctions in\nfederal district court. The injunction can be a complex set of instructions, listing in some detail the\npractices that a defendant is to avoid and even the way in which it will be required to conduct its business\nthereafter. Once an injunction is issued and affirmed on appeal, or the time for appeal has passed, it\nconfers continuing jurisdiction on the court to hear complaints by those who say the defendant is violating\nit. In a few instances, the injunction or a consent decree is in effect the basic \xe2\x80\x9cstatute\xe2\x80\x9d by which an\nindustry operates. A 1956 decree against American Telephone & Telegraph Company (AT&T) kept the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n657\n\n\x0ccompany out of the computer business for a quarter-century, until the government\xe2\x80\x99s monopoly suit\nagainst AT&T was settled and a new decree issued in 1983. The federal courts also have the power to\nbreak up a company convicted of monopolizing or to order divestiture when the violation consists of\nunlawful mergers and acquisitions.\nThe FTC may issue cease and desist orders against practices condemned under Section 5 of the FTC Act\xe2\x80\x94\nwhich includes violations of the Sherman and Clayton Acts\xe2\x80\x94and these orders may be appealed to the\ncourts.\nRather than litigate a case fully, defendants may agree to consent decrees, in which, without admitting\nguilt, they agree not to carry on the activity complained of. Violations of injunctions cease and desist\norders, and consent decrees subject companies to a fine of $10,000 a day for every day the violation\ncontinues. Companies frequently enter into consent decrees\xe2\x80\x94and not just because they wish to avoid the\nexpense and trouble of trial. Section 5 of the Clayton Act says that whenever an antitrust case brought by\nthe federal government under either the Clayton Act or the Sherman Act goes to final judgment, the\njudgment can be used, in a private suit in which the same facts are at issue, as prima facie evidence that\nthe violation was committed. This is a powerful provision, because it means that a private plaintiff need\nprove only that the violation in fact injured him. He need not prove that the defendant committed the acts\nthat amount to antitrust violations. Since this provision makes it relatively easy for private plaintiffs to\nprevail in subsequent suits, defendants in government suits have a strong inducement to enter into\nconsent decrees, because these are not considered judgments. Likewise, a guilty plea in a criminal case\ngives the plaintiff in a later private civil suit prima facie evidence of the defendant\xe2\x80\x99s liability. However, a\nplea of nolo contendere will avoid this result. Section 5 has been the spur for a considerable proportion of\nall private antitrust suits. For example, the government\xe2\x80\x99s price-fixing case against the electric equipment\nindustry that sent certain executives of General Electric to jail in the 1950s led to more than 2,200 private\nsuits.\n\nTreble Damages\nThe crux of the private suit is its unique damage award: any successful plaintiff is entitled to collect three\ntimes the amount of damages actually suffered\xe2\x80\x94treble damages, as they are known\xe2\x80\x94and to be paid the\ncost of his attorneys. These fees can be huge: defendants have had to pay out millions of dollars for\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n658\n\n\x0cattorneys\xe2\x80\x99 fees alone in single cases. The theory of treble damages is that they will serve as an incentive to\nprivate parties to police industry for antitrust violations, thus saving the federal government the immense\nexpense of maintaining an adequate staff for that job.\n\nClass Actions\nOne of the most important developments in antitrust law during the 1970s was the rise of the class action.\nUnder liberalized rules of federal procedure, a single plaintiff may sue on behalf of the entire class of\npeople injured by an antitrust violation. This device makes it possible to bring numerous suits that would\notherwise never have been contemplated. A single individual who has paid one dollar more than he would\nhave been charged in a competitive market obviously will not file suit. But if there are ten million\nconsumers like him, then in a class action he may seek\xe2\x80\x94on behalf of the entire class, of course\xe2\x80\x94$30\nmillion ($10 million trebled), plus attorneys\xe2\x80\x99 fees. Critics charge that the class action is a device that in the\nantitrust field benefits only the lawyers, who have a large incentive to find a few plaintiffs willing to have\ntheir names used in a suit run entirely by the lawyers. Nevertheless, it is true that the class action permits\nantitrust violations to be rooted out that could not otherwise be attacked privately. During the 1970s, suits\nagainst drug companies and the wallboard manufacturing industry were among the many large-scale\nantitrust class actions.\n\nInterpreting the Laws\nVagueness\nThe antitrust laws, and especially Section 1 of the Sherman Act, are exceedingly vague. As Chief Justice\nCharles Evans Hughes once put it, \xe2\x80\x9cThe Sherman Act, as a charter of freedom, has a generality and\nadaptability comparable to that found to be desirable in constitutional provisions.\xe2\x80\x9d\n\n[8]\n\nWithout the\n\nsweeping but vague language, the antitrust laws might quickly have become outdated. As written, they\npermit courts to adapt the law to changing circumstances. But the vagueness can lead to uncertainty and\nuneven applications of the law.\n\nThe \xe2\x80\x9cRule of Reason\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n659\n\n\x0cSection 1 of the Sherman Act says that \xe2\x80\x9cevery\xe2\x80\x9d restraint of trade is illegal. But is a literal interpretation\nreally possible? No, for as Justice Louis Brandeis noted in 1918 in one of the early price-fixing cases,\n\xe2\x80\x9cEvery agreement concerning trade, every regulation of trade restrains. To bind, to restrain, is of their\n[9]\n\nvery essence.\xe2\x80\x9d When a manufacturing company contracts to buy raw materials, trade in those goods is\nrestrained: no one else will have access to them. But to interpret the Sherman Act to include such a\ncontract is an absurdity. Common sense says that \xe2\x80\x9cevery\xe2\x80\x9d cannot really mean every restraint.\nThroughout this century, the courts have been occupied with this question. With the hindsight of\nthousands of cases, the broad outlines of the answer can be confidently stated. Beginning with Standard\nOil Co. of New Jersey v. United States, the Supreme Court has held that only unreasonable restraints of\ntrade are unlawful.\n\n[10]\n\nOften called the rule of reason, the interpretation of Section 1 made in Standard Oil itself has two possible\nmeanings, and they have been confused over the years. The rule of reason could mean that a restraint is\npermissible only if it is ancillary to a legitimate business purpose. The standard example is a covenant not\nto compete. Suppose you decide to purchase a well-regarded bookstore in town. The proprietor is well\nliked and has developed loyal patrons. He says he is going to retire in another state. You realize that if he\nchanged his mind and stayed in town to open another bookstore; your new business would suffer\nconsiderably. So you negotiate as a condition of sale that he agrees not to open another bookstore within\nten miles of the town for the next three years. Since your intent is not to prevent him from going into\nbusiness\xe2\x80\x94as it would be if he had agreed never to open a bookstore anywhere\xe2\x80\x94but merely to protect the\nvalue of your purchase, this restraint of trade is ancillary to your business purpose. The rule of reason\nholds that this is not an unlawful restraint of trade.\nAnother interpretation of the rule of reason is even broader. It holds that agreements that might directly\nimpair competition are not unlawful unless the particular impairment itself is unreasonable. For example,\nseveral retailers of computer software are distraught at a burgeoning price war that will possibly reduce\nprices so low that they will not be able to offer their customers proper service. To avert this \xe2\x80\x9ccutthroat\ncompetition,\xe2\x80\x9d the retailers agree to set a price floor\xe2\x80\x94a floor that, under the circumstances, is reasonable.\nChief Justice Edward White, who wrote the Standard Oil opinion, might have found that such an\nagreement was reasonable because, in view of its purposes, it was not unduly restrictive and did not\nunduly restrain trade.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n660\n\n\x0cBut this latter view is not the law. Almost any business agreement could enhance the market power of one\nor more parties to the agreement, and thus restrain trade. \xe2\x80\x9cThe true test of legality,\xe2\x80\x9d Justice Brandeis\nwrote in 1918 in Chicago Board of Trade, \xe2\x80\x9cis whether the restraint imposed is such as merely regulates\nand perhaps thereby promotes competition or whether it is such as may suppress or even destroy\ncompetition.\xe2\x80\x9d\n\n[11]\n\nSection 1 violation analyzed under the rule of reason will look at several factors,\n\nincluding the purpose of the agreement, the parties\xe2\x80\x99 power to implement the agreement to achieve that\npurpose, and the effect or potential effect of the agreement on competition. If the parties could have used\nless restrictive means to achieve their purpose, the Court would more likely have seen the agreement as\nunreasonable.\n\n[12]\n\n\xe2\x80\x9cPer Se\xe2\x80\x9d Rules\nNot every act or commercial practice needs to be weighed by the rule of reason. Some acts have come to\nbe regarded as intrinsically or necessarily impairing competition, so that no further analysis need be made\nif the plaintiff can prove that the defendant carried them out or attempted or conspired to do so. Pricefixing is an example. Price-fixing is said to be per se illegal under the Sherman Act\xe2\x80\x94that is, unlawful on its\nface. The question in a case alleging price-fixing is not whether the price was reasonable or whether it\nimpaired or enhanced competition, but whether the price in fact was fixed by two sellers in a market\nsegment. Only that question can be at issue.\n\nUnder the Clayton Act\nThe rule of reason and the per se rules apply to the Sherman Act. The Clayton Act has a different\nstandard. It speaks in terms of acts that may tend substantially to lessen competition. The courts must\nconstrue these terms too, and in the sections that follow, we will see how they have done so.\n\nKEY TAKEAWAY\nThe preservation of competition is an important part of public policy in the United States. The various\nantitrust laws were crafted in response to clear abuses by companies that sought to claim easier profits\nby avoiding competition through the exercise of monopoly power, price-fixing, or territorial\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n661\n\n\x0cagreements. The Department of Justice and the Federal Trade Commission have substantial criminal\nand civil penalties to wield in their enforcement of the various antitrust laws.\n\nEXERCISES\n1.\n\nWhy did industries become so much larger after the US Civil War, and how did this lead to abusive\npractices? What role did politics play in creating US laws fostering competition?\n\n2.\n\nGo to the Department of Justice website and see how many antitrust enforcement actions have taken\nplace since 2008.\n\n3.\n\nConsider whether the US government should break up the biggest US banks. Why or why not? If the\nUnited States does so, and other nations have very large government banks, or have very large private\nbanks, can US banks remain competitive?\n\n[1] Sherman Act, Section 1; Clayton Act, Section 3.\n[2] Sherman Act, Section 2; Clayton Act, Section 7.\n[3] Munn v. Illinois, 94 U.S. 113 (1877).\n[4] Standard Oil Co. of New Jersey v. United States, 221 U.S. 1 (1911).\n[5] Clayton Act, Section 3.\n[6] Clayton Act, Section 7.\n[7] Clayton Act, Section 8.\n[8] Appalachian Coals v. United States, 288 U.S. 344, 359 (1933).\n[9] Chicago Board of Trade v. United States, 246 U.S. 231 (1918).\n[10] Standard Oil Co. of New Jersey v. United States, 221 U.S. 1 (1911).\n[11] Chicago Board of Trade v. United States, 246 U.S. 231 (1918).\n[12] Chicago Board of Trade v. United States, 246 U.S. 231 (1918).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n662\n\n\x0c16.2 Horizontal Restraints of Trade\nLEARNING OBJECTIVES\n1.\n\nKnow why competitors are the likely actors in horizontal restraints of trade.\n\n2.\n\nExplain what it means when the Supreme Court declares a certain practice to be a per se violation of\nthe antitrust laws.\n\n3.\n\nDescribe at least three ways in which otherwise competing parties can fix prices.\n\n4.\n\nRecognize why dividing territories is a horizontal restraint of trade.\n\nClassification of antitrust cases and principles is not self-evident because so many cases turn on complex\nfactual circumstances. One convenient way to group the cases is to look to the relationship of those who\nhave agreed or conspired. If the parties are competitors\xe2\x80\x94whether competing manufacturers, wholesalers,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n663\n\n\x0cretailers, or others\xe2\x80\x94there could be a horizontal restraint of trade. If the parties are at different levels of\nthe distribution chain\xe2\x80\x94for example, manufacturer and retailer\xe2\x80\x94their agreement is said to involve\na vertical restraint of trade. These categories are not airtight: a retailer might get competing\nmanufacturers to agree not to supply a competitor of the retailer. This is a vertical restraint with\nhorizontal effects.\n\nPrice-Fixing\nDirect Price-Fixing Agreements\nPrice-fixing agreements are per se violations of Section 1 of the Sherman Act. The per se rule was\n[1]\n\nannounced explicitly in United States v. Trenton Potteries. In that case, twenty individuals and twentythree corporations, makers and distributors of 82 percent of the vitreous pottery bathroom fixtures used\nin the United States, were found guilty of having agreed to establish and adhere to a price schedule. On\nappeal, they did not dispute that they had combined to fix prices. They did argue that the jury should have\nbeen permitted to decide whether what they had done was reasonable. The Supreme Court disagreed,\nholding that any fixing of prices is a clear violation of the Sherman Act.\nTwenty-four years later, the Court underscored this categorical per se rule in Kiefer-Stewart Co. v. Joseph\nE. Seagram & Sons.\n\n[2]\n\nThe defendants were distillers who had agreed to sell liquor only to those\n\nwholesalers who agreed to resell it for no more than a maximum price set by the distillers. The defendants\nargued that setting maximum prices did not violate the Sherman Act because such prices promoted rather\nthan restrained competition. Again, the Supreme Court disagreed: \xe2\x80\x9c[S]uch agreements, no less than those\nto fix minimum prices, cripple the freedom of traders and thereby restrain their ability to sell in\naccordance with their own judgment.\xe2\x80\x9d\nThe per se prohibition against price-fixing is not limited to agreements that directly fix prices. Hundreds\nof schemes that have the effect of controlling prices have been tested in court and found wanting, some\nbecause they were per se restraints of trade, others because their effects were unreasonable\xe2\x80\x94that is,\nbecause they impaired competition\xe2\x80\x94under the circumstances. In the following sections, we examine some\nof these cases briefly.\n\nExchanging Price Information\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n664\n\n\x0cKnowledge of competitors\xe2\x80\x99 prices can be an effective means of controlling prices throughout an industry.\nMembers of a trade association of hardwood manufacturers adopted a voluntary \xe2\x80\x9copen competition\xe2\x80\x9d plan.\nAbout 90 percent of the members adhered to the plan. They accounted for one-third of the production of\nhardwood in the United States. Under the plan, members reported daily on sales and deliveries and\nmonthly on production, inventory, and prices. The association, in turn, sent out price, sales, and\nproduction reports to the participating members. Additionally, members met from time to time to discuss\nthese matters, and they were exhorted to refrain from excessive production in order to keep prices at\nprofitable levels. In American Column and Lumber Company v. United States, the Supreme Court\ncondemned this plan as a per se violation of Section 1 of the Sherman Act.\n\n[3]\n\nNot every exchange of information is necessarily a violation, however. A few years after American Column\nand Lumber, in Maple Flooring Manufacturers\xe2\x80\x99 Association v. United States, the Court refused to find a\nviolation in the practice of an association of twenty-two hardwood-floor manufacturers in circulating a list\nto all members of average costs and freight rates, as well as summaries of sales, prices, and\ninventories.\n\n[4]\n\nThe apparent difference between American Column and Lumber and Maple Flooring was\n\nthat in the latter, the members did not discuss prices at their meetings, and their rules permitted them to\ncharge individually whatever they wished. It is not unlawful, therefore, for members of an industry to\nmeet to discuss common problems or to develop statistical information about the industry through a\ncommon association, as long as the discussions do not border on price or on techniques of controlling\nprices, such as by restricting output. Usually, it takes evidence of collusion to condemn the exchange of\nprices or other data.\n\nControlling Output\nCompetitors also fix prices by controlling an industry\xe2\x80\x99s output. For example, competitors could agree to\nlimit the amount of goods each company makes or by otherwise limiting the amount that comes to\nmarket. This latter technique was condemned in United States v. Socony-Vacuum Oil Co.\n\n[5]\n\nTo prevent oil\n\nprices from dropping, dominant oil companies agreed to and did purchase from independent refiners\nsurplus gasoline that the market was forcing them to sell at distress prices. By buying up this gasoline, the\nlarge companies created a price floor for their own product. This conduct, said the Court, is a per se\nviolation.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n665\n\n\x0cRegulating Competitive Methods\nMany companies may wish to eliminate certain business practices\xe2\x80\x94for example, offering discounts or\npremiums such as trading stamps on purchase of goods\xe2\x80\x94but are afraid or powerless to do so unless their\ncompetitors also stop. The temptation is strong to agree with one\xe2\x80\x99s competitors to jointly end these\npractices; in most instances, doing so is unlawful when the result would be to affect the price at which the\nproduct is sold. But not every agreed-on restraint or standard is necessarily unlawful. Companies might\ndecide that it would serve their customers\xe2\x80\x99 interests as well as their own if the product could be\nstandardized, so that certain names or marks signify a grade or quality of product. When no restriction is\nplaced on what grades are to be sold or at what prices, no restraint of trade has occurred.\nIn National Society of Professional Engineers v. United States, , a canon of ethics of the National Society\nof Professional Engineers prohibited members from making competitive bids. This type of prohibition has\nbeen common in the codes of ethics of all kinds of occupational groups that claim professional status.\nThese groups justify the ban by citing public benefits; though not necessarily price benefits, that flow from\nobservance of the \xe2\x80\x9cethical\xe2\x80\x9d rule.\n\nNon-price Restraints of Trade\nAllocating Territories\nSuppose four ice-cream manufacturers decided one day that their efforts to compete in all four corners of\nthe city were costly and destructive. Why not simply strike a bargain: each will sell ice cream to retail\nshops in only one quadrant of the city. This is not a pricing arrangement; each is free to sell at whatever\nprice it desires. But it is a restraint of trade, for in carving up the territory in which each may sell, they\nmake it impossible for grocery stores to obtain a choice among all four manufacturers. The point becomes\nobvious when the same kind of agreement is put on a national scale: suppose Ford and Toyota agreed that\nFord would not sell its cars in New York and Toyota would not sell Toyotas in California.\nMost cases of territorial allocation are examples of vertical restraints in which manufacturers and\ndistributors strike a bargain. But some cases deal with horizontal allocation of territories. In United States\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n666\n\n\x0cv. Sealy, the defendant company licensed manufacturers to use the Sealy trademark on beds and\n[6]\n\nmattresses and restricted the territories in which the manufacturers could sell. The evidence showed\nthat the licensees, some thirty small bedding manufacturers, actually owned the licensor and were using\nthe arrangement to allocate the territory. It was held to be unlawful per se.\n\nExclusionary Agreements\nWe said earlier that it might be permissible for manufacturers, through a trade association, to establish\ncertain quality standards for the convenience of the public. As long as these standards are not\nexclusionary and do not reflect any control over price, they might not inhibit competition. The UL mark\non electrical and other equipment\xe2\x80\x94a mark to show that the product conforms to specifications of the\nprivate Underwriters Laboratory\xe2\x80\x94is an example. But suppose that certain widget producers establish the\nScientific Safety Council, a membership association whose staff ostensibly assigns quality labels, marked\nSSC, to those manufacturers who meet certain engineering and safety standards. In fact, however, the\nmanufacturers are using the widespread public acceptance of the SSC mark to keep the market to\nthemselves by refusing to let nonmembers join and by refusing to let nonmembers use the SSC mark, even\nif their widgets conform to the announced standards. This subterfuge would be a violation of Section 1 of\nthe Sherman Act.\n\nBoycotts\nAgreements by competitors to boycott (refuse to deal with) those who engage in undesirable practices are\nunlawful. In an early case, a retailers\xe2\x80\x99 trade association circulated a list of wholesale distributors who sold\ndirectly to the public. The intent was to warn member retailers not to buy from those wholesalers.\nAlthough each member was free to act however it wanted, the Court saw in this blacklist a plan to promote\na boycott.\n\n[7]\n\nThis policy remains true even if the objective of the boycott is to prevent unethical or even illegal\nactivities. Members of a garment manufacturers association agreed with a textile manufacturers\nassociation not to use any textiles that had been \xe2\x80\x9cpirated\xe2\x80\x9d from designs made by members of the textile\nassociation. The garment manufacturers also pledged, among other things, not to sell their goods to any\nretailer who did not refrain from using pirated designs. The argument that this was the only way to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n667\n\n\x0cprevent unscrupulous design pirates from operating fell on deaf judicial ears; the Supreme Court held the\npolicy unlawful under Section 5 of the Federal Trade Commission (FTC) Act, the case having been brought\nby the FTC.\n\n[8]\n\nProof of Agreement\nIt is vital for business managers to realize that once an agreement or a conspiracy is shown to have\nexisted, they or their companies can be convicted of violating the law even if neither agreement nor\nconspiracy led to concrete results. Suppose the sales manager of Extremis Widget Company sits down\nover lunch with the sales manager of De Minimis Widget Company and says, \xe2\x80\x9cWhy are we working so\nhard? I have a plan that will let us both relax.\xe2\x80\x9d He explains that their companies can put into operation a\ndata exchange program that will stabilize prices. The other sales manager does not immediately commit\nhimself, but after lunch, he goes to the stationery store and purchases a notebook in which to record the\ninformation he will get from a telephone test of the plan. That action is probably enough to establish a\nconspiracy to fix prices, and the government could file criminal charges at that point. Discussion with\nyour competitors of prices, discounts, production quotas, rebates, bid rigging, trade-in allowances,\ncommission rates, salaries, advertising, and the like is exceedingly dangerous. It can lead to criminal\nconduct and potential jail terms.\n\nProof of Harm\nIt is unnecessary to show that the public is substantially harmed by a restraint of trade as long as the\nplaintiff can show that the restraint injured him. In Klor\xe2\x80\x99s, Inc. v. Broadway-Hale Stores, the plaintiff\nwas a small retail appliance shop in San Francisco.\n\n[9]\n\nNext door to the shop was a competing appliance\n\nstore, one of a chain of stores run by Broadway-Hale. Klor\xe2\x80\x99s alleged that Broadway-Hale, using its\n\xe2\x80\x9cmonopolistic buying power,\xe2\x80\x9d persuaded ten national manufacturers and their distributors, including GE,\nRCA, Admiral, Zenith, and Emerson, to cease selling to Klor\xe2\x80\x99s or to sell at discriminatory prices. The\ndefendants did not dispute the allegations. Instead, they moved for summary judgment on the ground\nthat even if true, the allegations did not give rise to a legal claim because the public could not conceivably\nhave been injured as a result of their concerted refusal to deal. As evidence, they cited the un-contradicted\nfact that within blocks of Klor\xe2\x80\x99s, hundreds of household appliance retailers stood ready to sell the public\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n668\n\n\x0cthe very brands Klor\xe2\x80\x99s was unable to stock as a result of the boycott. The district court granted the motion\nand dismissed Klor\xe2\x80\x99s complaint. The court of appeals affirmed. But the Supreme Court reversed, saying as\nfollows:\nThis combination takes from Klor\xe2\x80\x99s its freedom to buy appliances in an open competitive market and\ndrives it out of business as a dealer in the defendants\xe2\x80\x99 products. It deprives the manufacturers and\ndistributors of their freedom to sell to Klor\xe2\x80\x99s.\xe2\x80\xa6It interferes with the natural flow of interstate commerce.\nIt clearly has, by its \xe2\x80\x9cnature\xe2\x80\x9d and \xe2\x80\x9ccharacter,\xe2\x80\x9d a \xe2\x80\x9cmonopolistic tendency.\xe2\x80\x9d As such it is not to be tolerated\nmerely because the victim is just one merchant whose business is so small that his destruction makes little\ndifference to the economy. Monopoly can surely thrive by the elimination of such small businessmen, one\nat a time, as it can by driving them out in large groups.\nWe have been exploring the Sherman Act as it applies to horizontal restraints of trade\xe2\x80\x94that is, restraints\nof trade between competitors. We now turn our attention to vertical restraints\xe2\x80\x94those that are the result of\nagreements or conspiracies between different levels of the chain of distribution, such as manufacturer and\nwholesaler or wholesaler and retailer.\n\nKEY TAKEAWAY\nCompetitors can engage in horizontal restraints of trade by various means of price-fixing. They can also\nengage in horizontal price restraints of trade by allocating territories or by joint boycotts (refusals to\ndeal). These restraints need not be substantial in order to be actionable as a violation of US antitrust\nlaws.\n\nEXERCISES\n1.\n\nSuppose that BMW of North America tells its dealers that the prestigious M100 cannot be sold for\nmore than $230,000. Explain why this could be a violation of antitrust law.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n669\n\n\x0c2.\n\nSuppose that JPMorgan Chase, the Bank of England, and the Bank of China agree that they will not\ncompete for investment services, and that JPMorgan Chase is given an exclusive right to North and\nSouth America, Bank of England is given access rights to Europe, and Bank of China is given exclusive\nrights to Asia, India, and Australia. Is there a violation of US antitrust law here? If not, why not? If so,\nwhat act does it violate, and how?\n\n3.\n\n\xe2\x80\x9cIt\xe2\x80\x99s a free country.\xe2\x80\x9d Why are agreements by competitors to boycott (to refuse to deal with) certain\nothers considered a problem that needs to be dealt with by law?\n\n[1] United States v. Trenton Potteries, 273 U.S. 392 (1927).\n[2] Kiefer-Stewart Co. v. Joseph E. Seagram & Sons, 340 U.S. 211 (1951).\n[3] American Column and Lumber Company v. United States, 257 U.S. 377 (1921).\n[4] Maple Flooring Manufacturers\xe2\x80\x99 Association v. United States, 268 U.S. 563 (1925).\n[5] United States v. Socony-Vacuum Oil Co., 310 U.S. 150 (1940).\n[6] United States v. Sealy, 388 U.S. 350 (1967).\n[7] Eastern State Lumber Dealers\xe2\x80\x99 Association v. United States, 234 U.S. 600 (1914).\n[8] Fashion Originators\xe2\x80\x99 Guild of America v. Federal Trade Commission, 312 U.S. 457 (1941).\n[9] Klor\xe2\x80\x99s, Inc. v. Broadway-Hale Stores, 359 U.S. 207 (1959).\n\n16.3 Vertical Restraints of Trade\nLEARNING OBJECTIVES\n1.\n\nDistinguish vertical restraints of trade from horizontal restraints of trade.\n\n2.\n\nDescribe exclusive dealing, and explain why exclusive dealing is anticompetitive in any way.\n\n3.\n\nExplain how tying one product\xe2\x80\x99s sale to that of another could be anticompetitive.\n\nWe have been exploring the Sherman Act as it applies to horizontal restraints of trade, restraints that are\ncreated between competitors. We now turn to vertical restraints\xe2\x80\x94those that result from agreements\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n670\n\n\x0cbetween different levels of the chain of distribution, such as manufacturer and wholesaler or wholesaler\nand retailer.\n\nResale Price Maintenance\nIs it permissible for manufacturers to require distributors or retailers to sell products at a set price?\nGenerally, the answer is no, but the strict per se rule against any kind of resale price maintenance has\nbeen somewhat relaxed.\nBut why would a manufacturer want to fix the price at which the retailer sells its goods? There are several\npossibilities. For instance, sustained, long-term sales of many branded appliances and other goods\ndepend on reliable servicing by the retailer. Unless the retailer can get a fair price, it will not provide good\nservice. Anything less than good service will ultimately hurt the brand name and lead to fewer sales.\nAnother possible argument for resale price maintenance is that unless all retailers must abide by a certain\nprice, some goods will not be stocked at all. For instance, the argument runs, bookstores will not stock\nslow-selling books if they cannot be guaranteed a good price on best sellers. Stores free to discount best\nsellers will not have the profit margin to stock other types of books. To guarantee sales of best sellers to\nbookstores carrying many lines of books, it is necessary to put a floor under the price of books. Still\nanother argument is that brand-name goods are inviting targets for loss-leader sales; if one merchant\ndrastically discounts Extremis Widgets, other merchants may not want to carry the line, and the\nmanufacturer may experience unwanted fluctuations in sales.\nNone of these reasons has completely appeased the critics of price-fixing, including the most important\ncritics\xe2\x80\x94the US federal judges. As long ago as 1910, in Dr. Miles Medical Co. v. John D. Park & Sons Co.,\nthe Supreme Court declared vertical price-fixing (what has come to be called resale price maintenance)\nunlawful under the Sherman Act. Dr. Miles Medical Company required wholesalers that bought its\nproprietary medicines to sign an agreement in which they agreed not to sell below a certain price and not\nto sell to retailers who did not have a \xe2\x80\x9cretail agency contract\xe2\x80\x9d with Dr. Miles. The retail agency contract\nsimilarly contained a price floor. Dr. Miles argued that since it was free to make or not make the\nmedicines, it should be free to dictate the prices at which purchasers could sell them. The Court said that\nDr. Miles\xe2\x80\x99s arrangement with more than four hundred jobbers (wholesale distributors) and twenty-five\nthousand retailers was no different than if the wholesalers or retailers agreed among themselves to fix the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n671\n\n\x0cprice. Dr. Miles \xe2\x80\x9chaving sold its product at prices satisfactory to itself, the public is entitled to whatever\nadvantage may be derived from a competition in the subsequent traffic.\xe2\x80\x9d\n\n[1]\n\nIn Dr. Miles, the company\xe2\x80\x99s restrictions impermissibly limited the freedom of choice of other drug\ndistributors and retailers. Society was therefore deprived of various benefits it would have received from\nunrestricted distribution of the drugs. But academics and some judges argue that most vertical price\nrestraints do not limit competition among competitors, and manufacturers retain the power to restrict\noutput, and the power to raise prices. Arguably, vertical price restraints help to ensure economic\nefficiencies and maximize consumer welfare. Some of the same arguments noted in this section\xe2\x80\x94such as\nthe need to ensure good service for retail items\xe2\x80\x94continue to be made in support of a rule of reason.\nThe Supreme Court has not accepted these arguments with regard to minimum prices but has increased\nthe plaintiff\xe2\x80\x99s burden of proof by requiring evidence of an agreement on specific price levels. Where a\ndiscounter is terminated by a manufacturer, it will probably not be told exactly why, and very few\nmanufacturers would be leaving evidence in writing that insists on dealers agreeing to minimum prices.\nMoreover, in State Oil Company v. Khan, the Supreme Court held that \xe2\x80\x9cvertical maximum price fixing,\nlike the majority of commercial arrangements subject to the antitrust laws, should be evaluated under the\nrule of reason.\xe2\x80\x9d\n\n[2]\n\nVertical maximum price-fixing is not legal per se but should be analyzed under a rule of\n\nreason \xe2\x80\x9cto identify the situations in which it amounts to anti-competitive conduct.\xe2\x80\x9d The Khan case is at\nthe end of this chapter, in Section 16.8.2 "Vertical Maximum Price Fixing and the Rule of Reason".\n\nExclusive Dealing and Tying\nWe move now to a non-price vertical form of restraint. Suppose you went to the grocery store intent on\npurchasing a bag of potato chips to satisfy a late-night craving. Imagine your surprise\xe2\x80\x94and indignation\xe2\x80\x94\nif the store manager waved a paper in your face and said, \xe2\x80\x9cI\xe2\x80\x99ll sell you this bag only on the condition that\nyou sign this agreement to buy all of your potato chips in the next five years from me.\xe2\x80\x9d Or if he said, \xe2\x80\x9cI\xe2\x80\x99ll\nsell only if you promise never to buy potato chips from my rival across the street.\xe2\x80\x9d This is\nan exclusive dealing agreement, and if the effect may be to lessen competition substantially, it is unlawful\nunder Section 3 of the Clayton Act. It also may be unlawful under Section 1 of the Sherman Act and\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n672\n\n\x0cSection 5 of the Federal Trade Commission (FTC) Act. Another form of exclusive dealing, known as\na tying contract, is also prohibited under Section 3 of the Clayton Act and under the other statutes. A tying\ncontract results when you are forced to take a certain product in order to get the product you are really\nafter: \xe2\x80\x9cI\xe2\x80\x99ll sell you the potato chips you crave, but only if you purchase five pounds of my Grade B liver.\xe2\x80\x9d\nSection 3 of the Clayton Act declares it unlawful for any person engaged in commerce\nto lease or make a sale or contract for sale of goods, wares, merchandise, machinery, supplies or other\ncommodities, whether patented or unpatented, for use, consumption or resale\xe2\x80\xa6or fix a price charged\ntherefore, or discount from or rebate upon, such price, on the condition\xe2\x80\xa6that the lessee or\npurchaser\xe2\x80\xa6shall not use or deal in the goods, wares, merchandise, machinery, supplies, or\nother commodities of a competitor or competitors of the lessor or seller, where the effect of\nsuch lease, sale, or contract for sale or such condition\xe2\x80\xa6may be to substantially lessen competition or tend\nto erect a monopoly in any line of commerce. (emphasis added)\nUnder Section 3, the potato chip example is not unlawful, for you would not have much of an effect on\ncompetition nor tend to create a monopoly if you signed with your corner grocery. But the Clayton Act has\nserious ramifications for a producer who might wish to require a dealer to sell only its products\xe2\x80\x94such as a\nfast-food franchise that can carry cooking ingredients bought only from the franchisor (Chapter 17 "Unfair\nTrade Practices and the Federal Trade Commission"), an appliance store that can carry only one national\nbrand of refrigerators, or an ice-cream parlor that must buy ice-cream supplies from the supplier of its\nmachinery.\nA situation like the one in the ice-cream example came under review in International Salt Co. v. United\nStates.\n\n[3]\n\nInternational Salt was the largest US producer of salt for industrial uses. It held patents on two\n\nmachines necessary for using salt products; one injected salt into foodstuffs during canning. It leased\nmost of these machines to canners, and the lease required the lessees to purchase from International Salt\nall salt to be used in the machines. The case was decided on summary judgment; the company did not\nhave the chance to prove the reasonableness of its conduct. The Court held that it was not entitled to.\nInternational Salt\xe2\x80\x99s valid patent on the machines did not confer on it the right to restrain trade in\nunpatented salt. Justice Tom Clark said that doing so was a violation of both Section 1 of the Sherman Act\nand Section 3 of the Clayton Act:\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n673\n\n\x0cNot only is price-fixing unreasonable, per se, but also it is unreasonable, per se, to foreclose competitors\nfrom any substantial market. The volume of business affected by these contracts cannot be said to be\ninsignificant or insubstantial, and the tendency of the arrangement to accomplishment of monopoly\nseems obvious. Under the law, agreements are forbidden which \xe2\x80\x9ctend to create a monopoly,\xe2\x80\x9d and it is\nimmaterial that the tendency is a creeping one rather than one that proceeds at full gallop; nor does the\nlaw await arrival at the goal before condemning the direction of the movement.\nIn a case involving the sale of newspaper advertising space (to purchase space in the morning paper, an\nadvertiser would have to take space in the company\xe2\x80\x99s afternoon paper), the government lost because it\ncould not use the narrower standards of Section 3 and could not prove that the defendant had monopoly\npower over the sale of advertising space. (Another afternoon newspaper carried advertisements, and its\nsales did not suffer.) In the course of his opinion, Justice Clark set forth the rule for determining legality\nof tying arrangements under both the Clayton and Sherman Acts:\nWhen the seller enjoys a monopolistic position in the market for the \xe2\x80\x9ctying\xe2\x80\x9d product [i.e., the product that\nthe buyer wants] or if a substantial volume of commerce in the \xe2\x80\x9ctied\xe2\x80\x9d product [i.e., the product that the\nbuyer does not want] is restrained, a tying arrangement violates the narrower standards expressed in\nsection 3 of the Clayton Act because from either factor the requisite potential lessening of competition is\ninferred. And because for even a lawful monopolist it is \xe2\x80\x9cunreasonable per se to foreclose competitors\nfrom any substantial market\xe2\x80\x9d a tying arrangement is banned by section 1 of the Sherman Act wherever\nboth conditions are met.\n\n[4]\n\nThis rule was broadened in 1958 in a Sherman Act case involving the Northern Pacific Railroad Company,\nwhich had received forty million acres of land from Congress in the late nineteenth century in return for\nbuilding a rail line from the Great Lakes to the Pacific. For decades, Northern Pacific leased or sold the\nland on condition that the buyer or lessee use Northern Pacific to ship any crops grown on the land or\ngoods manufactured there. To no avail, the railroad argued that unlike International Salt\xe2\x80\x99s machines, the\nrailroad\xe2\x80\x99s \xe2\x80\x9ctying product\xe2\x80\x9d (its land) was not patented, and that the land users were free to ship on other\nlines if they could find cheaper rates. Wrote Justice Hugo Black,\n[A] tying arrangement may be defined as an agreement by a party to sell one product but only on the\ncondition that the buyer also purchases a different (or tied) product, or at least agrees that he will not\npurchase that product from any other supplier. Where such conditions are successfully exacted\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n674\n\n\x0ccompetition on the merits with respect to the tied product is inevitably curbed\xe2\x80\xa6They deny competitors\nfree access to the market for the tied product, not because the party imposing the tying requirements has a\nbetter product or a lower price but because of his power or leverage in another market. At the same time\nbuyers are forced to forego their free choice between competing products\xe2\x80\xa6They are unreasonable in\nand of them whenever a party has sufficient economic power with respect to the tying\nproduct to appreciably restrain free competition in the market for the tied product and a\n\xe2\x80\x9cnot insubstantial\xe2\x80\x9d amount of interstate commerce is affected. In this case\xe2\x80\xa6the undisputed\nfacts established beyond any genuine question that the defendant possessed substantial economic power\nby virtue of its extensive landholdings which it used as leverage to induce large numbers of purchasers\nand lessees to give it preference.\n\n[5]\n\n(emphasis in original)\n\nTaken together, the tying cases suggest that anyone with certain market power over a commodity or other\nvaluable item (such as a trademark) runs a serious risk of violating the Clayton Act or Sherman Act or\nboth if he insists that the buyer must also take some other product as part of the bargain. Microsoft\nlearned about the perils of \xe2\x80\x9ctying\xe2\x80\x9d in a case brought by the United States, nineteen individual states, and\nthe District of Columbia. The allegation was that Microsoft had tied together various software programs\non its operating system, Microsoft Windows. Windows came prepackaged with Microsoft\xe2\x80\x99s Internet\nExplorer (IE), its Windows Media Player, Outlook Express, and Microsoft Office. The United States\nclaimed that Microsoft had bundled (or \xe2\x80\x9ctied\xe2\x80\x9d) IE to sales of Windows 98, making IE difficult to remove\nfrom Windows 98 by not putting it on the Remove Programs list.\nThe government alleged that Microsoft had designed Windows 98 to work \xe2\x80\x9cunpleasantly\xe2\x80\x9d with Netscape\nNavigator and that this constituted an illegal tying of Windows 98 and IE. Microsoft argued that its web\nbrowser and mail reader were just parts of the operating system, included with other personal computer\noperating systems, and that the integration of the products was technologically justified. The United\nStates Court of Appeals for the District of Columbia Circuit rejected Microsoft\xe2\x80\x99s claim that IE was simply\none facet of its operating system, but the court held that the tie between Windows and IE should be\nanalyzed deferentially under the rule of reason. The case settled before reaching final judicial resolution.\n[6]\n\n(See United States v. Microsoft. )\n\nNon-price Vertical Restraints: Allocating Territory and Customers\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n675\n\n\x0cWith horizontal restraints of trade, we have already seen that it is a per se violation of Section 1 of the\nSherman Act for competitors to allocate customers and territory. But a vertical allocation of customers or\nterritory is only illegal if competition to the markets as a whole is adversely affected. The key here is\ndistinguishing intra-brand competition from inter-brand competition. Suppose that Samsung electronics\nhas relationships with ten different retailers in Gotham City. If Samsung decides to limit its contractual\nrelationships to only six retailers, the market for consumer electronics in Gotham City is still competitive\nin terms of inter-brand competition. Intra-brand competition, however, is now limited. It could be that\nconsumers will pay slightly higher prices for Samsung electronics with only six different retailers selling\nthose products in Gotham City. That is, intra-brand competition is lowered, but inter-brand competition\nremains strong.\nNotice that it is unlikely that the six remaining retailers will raise their prices substantially, since there is\nstill strong inter-brand competition. If the retailer only deals in Samsung electronics, it is unlikely to raise\nprices that much, given the strength of inter-brand competition.\nIf the retailer carries Samsung and other brands, it will also not want to raise prices too much, for then its\ninventory of Samsung electronics will pile up, while its inventory of other electronics products will move\noff the shelves.\nWhy would Samsung want to limit its retail outlets in Gotham City at all? It may be that Samsung has\ndecided that by firming up its dealer network, it can enhance service, offer a wider range of products at\neach of the remaining retailers, ensure improved technical and service support, increase a sense of\ncommitment among the remaining retail outlets, or other good business reasons. Where the retailer deals\nin other electronic consumer brands as well, making sure that well-trained sales and service support is\navailable for Samsung products can promote inter-brand competition in Gotham City. Thus vertical\nallocation of retailers within the territory is not a per se violation of the Sherman Act. It is instead a rule of\nreason violation, or the law will intervene only if Samsung\xe2\x80\x99s activities have an anticompetitive effect on\nthe market as a whole. Notice here that the only likely objections to the new allocation would come from\nthose dealers who were contractually terminated and who are then effectively restricted from selling\nSamsung electronics.\nThere are other potentially legitimate territorial restrictions, and limits on what kind of customer the\nretailer can sell to will prevent a dealer or distributor from selling outside a certain territory or to a certain\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n676\n\n\x0cclass of customers. Samsung may reduce its outlets in Iowa from four to two, and it may also impose\nlimits on those retail outlets from marketing beyond certain areas in and near Iowa.\nSuppose that a Monsanto representative selling various kinds of fertilizers and pesticides was permitted to\nsell only to individual farmers and not to co-ops or retail distributors, or was limited to the state of Iowa.\nThe Supreme Court has held that such vertical territorial or customer searches are not per se violations of\nSection 1 of the Sherman Act, as the situations often increase \xe2\x80\x9cinter-brand competition.\xe2\x80\x9d Thus the rule of\nreason will apply to vertical allocation of customers and territory.\n\nNon-price Vertical Restraints: Exclusive Dealing Agreements\nOften, a distributor or retailer agrees with the manufacturer or supplier not to carry the products of any\nother supplier. This is not in itself (per se) illegal under Section 1 of the Sherman Act or Section 3 of the\nClayton Act. Only if these exclusive dealing contracts have an anticompetitive effect will there be an\nantitrust violation. Ideally, in a competitive market, there are no significant barriers to entry. In the real\nworld, however, various deals are made that can and do restrict entry. Suppose that on his farm in\nGreeley, Colorado, Richard Tucker keeps goats, and he creates a fine, handcrafted goat cheese for the\nmarkets in Denver, Fort Collins, and Boulder, Colorado, and Cheyenne, Wyoming. In these markets, if\nSafeway, Whole Foods, Albertsons, and King Soopers already have suppliers, and the suppliers have\ngained exclusive dealing agreements, Tucker will be effectively barred from the market.\nSuppose that Billy Goat Cheese is a nationally distributed brand of goat cheese and has created exclusive\ndealing arrangements with the four food chains in the four cities. Tucker could sue Billy Goat for violating\nantitrust laws if he finds out about the arrangements. But the courts will not assume a per se violation has\ntaken place. Instead, the courts will look at the number of other distributors available, the portion of the\nmarket foreclosed by the exclusive dealing arrangements, the ease with which new distributors could\nenter the market, the possibility that Tucker could distribute the product himself, and legitimate business\nreasons that led the distributors to accept exclusive dealing contracts from Billy Goat Cheese.\n\nKEY TAKEAWAY\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n677\n\n\x0cVertical restraints of trade can be related to price, can be in the form of tying arrangements, and can\nbe in the form of allocating customers and territories. Vertical restraints can also come in the form of\nexclusive dealing agreements.\n\nEXERCISES\n1.\n\nExplain how a seller with a monopoly in one product and tying the sale of that product to a new\nproduct that has no such monopoly is in any way hurting competition. How \xe2\x80\x9cfree\xe2\x80\x9d is the buyer to\nchoose a product different from the seller\xe2\x80\x99s?\n\n2.\n\nIf your company wants to maintain its image as a high-end product provider, is it legal to create a floor\nfor your product\xe2\x80\x99s prices? If so, under what circumstances?\n\n[1] Dr. Miles Medical Co. v. John D. Park & Sons Co., 220 U.S. 373 (1910).\n[2] State Oil Company v. Khan, 522 U.S. 3 (1997).\n[3] International Salt Co. v. United States, 332 U.S. 392 (1947).\n[4] Times-Picayune Publishing Co. v. United States, 345 U.S. 594 (1953).\n[5] Northern Pacific Railway Co. v. United States, 356 U.S. 1 (1958).\n[6] United States v. Microsoft, 253 F.3d 34 (D.C. Cir. 2001).\n\n16.4 Price Discrimination: The Robinson-Patman Act\nLEARNING OBJECTIVES\n1.\n\nUnderstand why Congress legislated against price-cutting by large companies.\n\n2.\n\nRecognize why price discrimination is not per se illegal.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n678\n\n\x0c3.\n\nIdentify and explain the defenses to a Robinson-Patman price discrimination charge.\n\nIf the relatively simple and straightforward language of the Sherman Act can provide litigants and courts\nwith interpretive headaches, the law against price discrimination\xe2\x80\x94the Robinson-Patman Act\xe2\x80\x94can strike\nthe student with a crippling migraine. Technically, Section 2 of the Clayton Act, the Robinson-Patman\nAct, has been verbally abused almost since its enactment in 1936. It has been called the \xe2\x80\x9cTyphoid Mary of\nAntitrust,\xe2\x80\x9d a \xe2\x80\x9cgrotesque manifestation of the scissors and paste-pot method\xe2\x80\x9d of draftsmanship. Critics\ncarp at more than its language; many have asserted over the years that the act is anticompetitive because\nit prevents many firms from lowering their prices to attract more customers.\nDespite this rhetoric, the Robinson-Patman Act has withstood numerous attempts to modify or repeal it,\nand it can come into play in many everyday situations. Although in recent years the Justice Department\nhas declined to enforce it, leaving government enforcement efforts to the Federal Trade Commission\n(FTC), private plaintiffs are actively seeking treble damages in numerous cases. So whether it makes\neconomic sense or not, the act is a living reality for marketers. This section introduces certain problems\nthat lurk in deciding how to price goods and how to respond to competitors\xe2\x80\x99 prices.\nThe Clayton Act\xe2\x80\x99s original Section 2, enacted in 1914, was aimed at the price-cutting practice of the large\ntrusts, which would reduce the price of products below cost where necessary in a particular location to\nwipe out smaller competitors who could not long sustain such losses. But the original Clayton Act\nexempted from its terms any \xe2\x80\x9cdiscrimination in price\xe2\x80\xa6on account of differences in the quantity of the\ncommodity sold.\xe2\x80\x9d This was a gaping loophole that made it exceedingly difficult to prove a case of price\ndiscrimination.\nNot until the Depression in the 1930s did sufficient cries of alarm over price discrimination force\nCongress to act. The alarm was centered on the practices of large grocery chains. Their immense buying\npower was used as a lever to pry out price discounts from food processors and wholesalers. Unable to\nextract similar price concessions, the small mom-and-pop grocery stores found that they could not offer\nthe retail customer the lower food prices set by the chains. The small shops began to fail. In 1936,\nCongress strengthened Section 2 by enacting the Robinson-Patman Act. Although prompted by concern\nabout how large buyers could use their purchasing power, the act in fact places most of its restrictions on\nthe pricing decisions of sellers.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n679\n\n\x0cThe Statutory Framework\nThe heart of the act is Section 2(a), which reads in pertinent part as follows: \xe2\x80\x9c[I]t shall be unlawful for any\nperson engaged in commerce\xe2\x80\xa6to discriminate in price between different purchasers of commodities of\nlike grade and quality\xe2\x80\xa6where the effect of such discrimination may be substantially to lessen competition\nor tend to create a monopoly in any line of commerce, or to injure, destroy or prevent competition with\nany person who either grants or knowingly receives the benefit of such discrimination, or with customers\nof either of them.\xe2\x80\x9d\nThis section provides certain defenses to a charge of price discrimination. For example, differentials in\nprice are permissible whenever they \xe2\x80\x9cmake only due allowances for differences in the cost of manufacture,\nsale, or delivery resulting from the differing methods or quantities in which such commodities are to such\npurchasers sold or delivered.\xe2\x80\x9d This section also permits sellers to change prices in response to changing\nmarketing conditions or the marketability of the goods\xe2\x80\x94for example, if perishable goods begin to\ndeteriorate, the seller may drop the price in order to move the goods quickly.\nSection 2(b) provides the major defense to price discrimination: any price is lawful if made in good faith\nto meet competition.\n\nDiscrimination by the Seller\nPreliminary Matters\nSimultaneous Sales\nTo be discriminatory, the different prices must have been charged in sales made at the same time or\nreasonably close in time. What constitutes a reasonably close time depends on the industry and the\ncircumstances of the marketplace. The time span for dairy sales would be considerably shorter than that\nfor sales of mainframe computers, given the nature of the product, the frequency of sales, the unit cost,\nand the volatility of the markets.\n\nIdentity of Purchaser\nAnother preliminary issue is the identity of the actual purchaser. A supplier who deals through a dummy\nwholesaler might be charged with price discrimination even though on paper only one sale appears to\nhave been made. Under the \xe2\x80\x9cindirect purchaser\xe2\x80\x9d doctrine, a seller who deals with two or more retail\ncustomers but passes their orders on to a single wholesaler and sells the total quantity to the wholesaler in\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n680\n\n\x0cone transaction can be held to have violated the act. The retailers are treated as indirect purchasers of the\nsupplier.\n\nSales of Commodities\nThe act applies only to sales of commodities. A lease, a rental, or a license to use a product does not\nconstitute a sale; hence price differentials under one of those arrangements cannot be unlawful under\nRobinson-Patman. Likewise, since the act applies only to commodities\xe2\x80\x94tangible things\xe2\x80\x94the courts have\nheld that it does not apply to the sale of intangibles, such as rights to license or use patents, shares in a\nmutual fund, newspaper or television advertising, or title insurance.\n\nGoods of Like Grade and Quality\nOnly those sales involving goods of \xe2\x80\x9clike grade and quality\xe2\x80\x9d can be tested under the act for discriminatory\npricing. What do these terms mean? The leading case is FTC v. Borden Co., in which the Supreme Court\nruled that trademarks and labels do not, for Robinson-Patman purposes, distinguish products that are\notherwise the same.\n\n[1]\n\nGrade and quality must be determined \xe2\x80\x9cby the characteristics of the product itself.\xe2\x80\x9d\n\nWhen the products are physically or chemically identical, they are of like grade and quality, regardless of\nhow imaginative marketing executives attempt to distinguish them. But physical differences that affect\nmarketability can serve to denote products as being of different grade and quality, even if the differences\nare slight and do not affect the seller\xe2\x80\x99s cost in manufacturing or marketing.\n\nCompetitive Injury\nTo violate the Robinson-Patman Act, the seller\xe2\x80\x99s price discrimination must have an anticompetitive effect.\nThe usual Clayton Act standard for measuring injury applies to Robinson-Patman violations\xe2\x80\x94that is, a\nviolation occurs when the effect may be substantially to lessen competition or tend to create a monopoly\nin any line of commerce. But because the Robinson-Patman Act has a more specific test of competitive\ninjury, the general standard is rarely cited.\nThe more specific test measures the impact on particular persons affected. Section 2(a) says that it is\nunlawful to discriminate in price where the effect is \xe2\x80\x9cto injure, destroy, or prevent competition with any\nperson who grants or knowingly receives the benefit of such discrimination or to customers of either of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n681\n\n\x0cthem.\xe2\x80\x9d The effect\xe2\x80\x94injury, destruction, or prevention of competition\xe2\x80\x94is measured against three types of\nthose suffering it: (1) competitors of the seller or supplier (i.e., competitors of the person who \xe2\x80\x9cgrants\xe2\x80\x9d the\nprice discrimination), (2) competitors of the buyer (i.e., competitors of the buyer who \xe2\x80\x9cknowingly receives\nthe benefit\xe2\x80\x9d of the price differential), and (3) customers of either of the two types of competitors. As we\nwill see, the third category presents many difficulties.\nFor purposes of our discussion, assume the following scenario: Ace Brothers Widget Company\nmanufactures the usual sizes and styles of American domestic widgets. It competes primarily with\nNational Widget Corporation, although several smaller companies make widgets in various parts of the\ncountry. Ace Brothers is the largest manufacturer and sells throughout the United States. National sells\nprimarily in the western states. The industry has several forms of distribution. Many retailers buy directly\nfrom Ace and National, but several regional and national wholesalers also operate, including Widget\nJobbers, Ltd. and Widget Pushers, LLC. The retailers in any particular city compete directly against each\nother to sell to the general public. Jobbers and Pushers are in direct competition. Jobbers also sells\ndirectly to the public, so that it is in direct competition with retailers as well as Widget Pushers. As\neveryone knows, widgets are extremely price sensitive, being virtually identical in physical appearance\nand form.\n\nPrimary-Line Injury\nNow consider the situation in California, Oregon, and Wisconsin. The competing manufacturers, Ace\nBrothers and National Widgets, both sell to wholesalers in California and Oregon, but only Ace have a\nsales arm in Wisconsin. Seeing an opportunity, Ace drops its prices to wholesalers in California and\nOregon and raises them in Wisconsin, putting National at a competitive disadvantage. This situation,\nillustrated in Figure 16.2 "Primary-Line Injury", is an example of primary-line injury\xe2\x80\x94the injury is done\ndirectly to a competitor of the company that differentiates its prices. This is price discrimination, and it is\nprohibited under Section 2(a).\n\nFigure 16.2 Primary-Line Injury\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n682\n\n\x0cMost forms of primary-line injury have a geographical basis, but they need not. Suppose National sells\nexclusively to Jobbers in northern California, and Ace Brothers sells both to Jobbers and several other\nwholesalers. If Ace cuts its prices to Jobbers while charging higher prices to the other wholesalers, the\neffect is also primary-line injury to National. Jobbers will obviously want to buy more from Ace at lower\nprices, and National\xe2\x80\x99s reduced business is therefore a direct injury. If Ace intends to drive National out of\nbusiness, this violation of Section 2(a) could also be an attempt to monopolize in violation of Section 2 of\nthe Sherman Act.\n\nSecondary-Line Injury\nNext, we consider injury done to competing buyers. Suppose that Ace Brothers favors Jobbers\xe2\x80\x94or those\nJobbers, a powerful and giant wholesaler induces Ace to act favorably by threatening not to carry Ace\xe2\x80\x99s\nline of widgets otherwise. Although Ace continues to supply both Jobbers and Widget Pushers, it cuts its\nprices to Jobbers. As a result, Jobbers can charge its retail customers lower prices than can Pushers, so\nthat Pusher\xe2\x80\x99s business begins to slack off. This is secondary-line injury at the buyer\xe2\x80\x99s level. Jobbers and\nPushers are in direct competition, and by impairing Pusher\xe2\x80\x99s ability to compete, the requisite injury has\nbeen committed. This situation is illustrated in Figure 16.3 "Secondary-Line Injury".\n\nFigure 16.3Secondary-Line Injury\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n683\n\n\x0cVariations on this secondary-line injury are possible. Assume Ace Brothers sells directly to Fast Widgets, a\nretail shop, and also to Jobbers. Jobbers sell to retail shops that compete with Fast Widgets and also\ndirectly to consumers. The situation is illustrated in Figure 16.4 "Variation on Secondary-Line Injury").\n\nFigure 16.4 Variations on Secondary-Line Injury\n\nIf Ace favors Jobbers by cutting its prices, discriminating against Fast Widgets, the transaction is\nunlawful, even though Jobbers and Fast Widgets do not compete for sales to other retailers. Their\ncompetition for the business of ultimate consumers is sufficient to establish the illegality of the\ndiscrimination. A variation on this situation was at issue in the first important case to test Section 2(a) as\nit affects buyers. Morton Salt sold to both wholesalers and retailers, offering quantity discounts. Its\npricing policy was structured to give large buyers great savings, computed on a yearly total, not on\nshipments made at any one time. Only five retail chains could take advantage of the higher discounts, and\nas a result, these chains could sell salt to grocery shoppers at a price below that at which the chains\xe2\x80\x99 retail\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n684\n\n\x0ccompetitors could buy it from their wholesalers. See Figure 16.5 "Variation: Morton Salt Co." for a\nschematic illustration. In this case, FTC v. Morton Salt Co., the Supreme Court for the first time declared\nthat the impact of the discrimination does not have to be actual; it is enough if there is a \xe2\x80\x9creasonable\npossibility\xe2\x80\x9d of competitive injury.\n\n[2]\n\nFigure 16.5 Variation: Morton Salt Co.\n\nIn order to make out a case of secondary-line injury, it is necessary to show that the buyers purchasing at\ndifferent prices are in fact competitors. Suppose that Ace Brothers sells to Fast Widgets, the retailer, and\nalso to Boron Enterprises, a manufacturer that incorporates widgets in most of its products. Boron does\nnot compete against Fast Widgets, and therefore Ace Brothers may charge different prices to Boron and\nFast without fearing Robinson-Patman repercussions. Figure 16.6 "Variation: Boron-Fast\nSchematic" shows the Boron-Fast schematic.\n\nFigure 16.6 Variation: Boron-Fast Schematic\n\nThird-Line Injury\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n685\n\n\x0cSecond-line injury to buyers does not exhaust the possibilities. Robinson-Patman also works against socalled third-line or tertiary-line injury. At stake here is injury another rung down the chain of distribution.\nAce Brothers sells to Pushers, which processes unfinished widgets in its own factory and sells them in turn\ndirectly to retail customers. Ace also sells to Jobbers, a wholesaler without processing facilities. Jobbers\nsell to retail shops that can process the goods and sell directly to consumers, thus competing with Pushers\nfor the retail business. This distribution chain is shown schematically in Figure 16.7 "Third-Line Injury".\n\nFigure 16.7 Third-Line Injury\n\nIf Ace\xe2\x80\x99s price differs between Pushers and Jobbers so that Jobbers is able to sell at a lower price to the\nultimate consumers than Pushers, a Robinson-Patman violation has occurred.\n\nFourth-Line Injury\nIn a complex economy, the distribution chain can go on and on. So far, we have examined discrimination\non the level of competing supplier-sellers, on the level of competing customers of the supplier-seller, and\non the level of competing customers of customers of the supplier-seller. Does the vigilant spotlight of\nRobinson-Patman penetrate below this level? The Supreme Court has said yes. In Perkins v. Standard Oil\nCo., the Court said that \xe2\x80\x9ccustomer\xe2\x80\x9d in Section 2(a) means any person who distributes the supplier-seller\xe2\x80\x99s\nproduct, regardless of how many intermediaries are involved in getting the product to him.\n\n[3]\n\nSeller\xe2\x80\x99s Defenses\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n686\n\n\x0cPrice discrimination is not per se unlawful. The Robinson-Patman Act allows the seller two general\ndefenses: (1) cost justification and (2) meeting competition. If the seller can demonstrate that sales to one\nparticular buyer are cheaper than sales to others, a price differential is permitted if it is based entirely on\nthe cost differences. For example, if one buyer is willing to have the goods packed in cheaper containers or\nlarger crates that save money that savings can be passed along to the buyer. Similarly, a buyer who takes\nover a warehousing function formerly undertaken by the seller is entitled to have the cost saving reflected\nin the selling price. Suppose the buyer orders its entire requirements for the year from the manufacturer,\na quantity many times greater than that taken by any other customer. This large order permits the\nmanufacturer to make the goods at a considerably reduced unit cost. May the manufacturer pass those\nsavings along to the quantity buyer? It may, as long as it does not pass along the entire savings but only\nthat attributable to the particular buyer, for other buyers add to its total production run and thus\ncontribute to the final unit production cost. The marketing manager should be aware that the courts\nstrictly construe cost-justification claims, and few companies have succeeded with this defense.\n\nMeeting Competition\nLowering a price to meet competition is a complete defense to a charge of price discrimination. Assume\nAce Brothers is selling widgets to retailers in Indiana and Kentucky at $100 per dozen. National Widgets\nsuddenly enters the Kentucky market and, because it has lower manufacturing costs than Ace, sells\nwidgets to the four Kentucky widget retailers at $85 per dozen. Ace may lower its price to that amount in\nKentucky without lowering its Indiana price. However, if National\xe2\x80\x99s price violated the Robinson-Patman\nAct and Ace knew or should have known that it did, Ace may not reduce its price.\nThe defense of meeting competition has certain limitations. For example, the seller may not use this\ndefense as an excuse to charge different customers a price differential over the long run. Moreover, if\nNational\xe2\x80\x99s lower prices result from quantity orders, Ace may reduce its prices only for like quantities. Ace\nmay not reduce its price for lesser quantities if National charges more for smaller orders. And although\nAce may meet National\xe2\x80\x99s price to a given customer, Ace may not legally charge less.\nSection 2(c) prohibits payment of commissions by one party in a transaction to the opposite party (or to\nthe opposite party\xe2\x80\x99s agent) in a sale of goods unless services are actually rendered for them. Suppose the\nbuyer\xe2\x80\x99s broker warehouses the goods. May the seller pass along this cost to the broker in the form of a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n687\n\n\x0crebate? Isn\xe2\x80\x99t that \xe2\x80\x9cservices rendered\xe2\x80\x9d? Although it might seem so, the courts have said no, because they\nrefuse to concede that a buyer\xe2\x80\x99s broker or agent can perform services for the seller. Because Section 2(c) of\nthe Robinson-Patman Act stands on its own, the plaintiff need prove only that a single payment was\nmade. Further proof of competitive impact is unnecessary. Hence Section 2(c) cases are relatively easy to\nwin once the fact of a brokerage commission is uncovered.\n\nAllowances for Merchandising and Other Services\nSections 2(d) and 2(e) of the Robinson-Patman Act prohibit sellers from granting discriminatory\nallowances for merchandising and from performing other services for buyers on a discriminatory basis.\nThese sections are necessary because price alone is far from the only way to offer discounts to favored\nbuyers. Allowances and services covered by these sections include advertising allowances, floor and\nwindow displays, warehousing, return privileges, and special packaging.\n\nKEY TAKEAWAY\nUnder the Robinson-Patman Act, it is illegal to charge different prices to different purchasers if the\nitems are the same and the price discrimination lessens competition. It is legal, however, to charge a\nlower price to a specific buyer if the cost of serving that buyer is lower or if the seller is simply\n\xe2\x80\x9cmeeting competition.\xe2\x80\x9d\n\nEXERCISES\n1.\n\nNikon sells its cameras to retailers at 5 percent less in the state of California than in Nevada or\nArizona. Without knowing more, can you say that this is illegal?\n\n2.\n\nTysons Foods sells its chicken wings to GFS and other very large distributors at a price per wing that is\n10 percent less than it sells to most grocery store chains. The difference is attributable to\ntransportation costs, since GFS and others accept shipments in very large containers, which cost less\nto deliver than smaller containers. Is the price differential legal?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n688\n\n\x0c3.\n\nYour best customer, who has high volume with your company, asks you for a volume discount.\nActually, he demands this, rather than just asking. Under what circumstances, if any, can you grant\nthis request without violating antitrust laws?\n\n[1] FTC v. Borden Co., 383 U.S. 637 (1966).\n[2] FTC v. Morton Salt Co., 334 U.S. 37 (1948).\n[3] Perkins v. Standard Oil Co., 395 U.S. 642 (1969).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n689\n\n\x0c16.5 Exemptions\nLEARNING OBJECTIVE\n1.\n\nKnow and describe the various exemptions from US antitrust law.\n\nRegulated Industries\nCongress has subjected several industries to oversight by specific regulatory agencies. These include\nbanking, securities and commodities exchanges, communications, transportation, and fuel and energy.\nThe question often arises whether companies within those industries are immune to antitrust attack. No\nsimple answer can be given. As a general rule, activities that fall directly within the authority of the\nregulatory agency are immune. The agency is said to have exclusive jurisdiction over the conduct\xe2\x80\x94for\nexample, the rate structure of the national stock exchanges, which are supervised by the Securities and\nExchange Commission. But determining whether a particular case falls within a specific power of an\nagency is still up to the courts, and judges tend to read the antitrust laws broadly and the regulatory laws\nnarrowly when they seem to clash. A doctrine known as primary jurisdiction often dictates that the\nquestion of regulatory propriety must first be submitted to the agency before the courts will rule on an\nantitrust question. If the agency decides the activity complained of is otherwise impermissible, the\nantitrust question becomes moot.\n\nOrganized Labor\nIn the Clayton Act, Congress explicitly exempted labor unions from the antitrust laws in order to permit\nworkers to band together. Section 6 says that \xe2\x80\x9cthe labor of a human being is not a commodity or article of\ncommerce. Nothing contained in the antitrust laws shall be construed to forbid the existence and\noperation of labor\xe2\x80\xa6organizations\xe2\x80\xa6nor shall such organizations or the members thereof, be held or\nconstrued to be illegal combinations or conspiracies in restraint of trade, under the antitrust laws.\xe2\x80\x9d This\nprovision was included to reverse earlier decisions of the courts that had applied the Sherman Act more\nagainst labor than business. Nevertheless, the immunity is not total, and unions have run afoul of the laws\nwhen they have combined with non-labor groups to achieve a purpose unlawful under the antitrust laws.\nThus a union could not bargain with an employer to sell its products above a certain price floor.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n690\n\n\x0cInsurance Companies\nUnder the McCarran-Ferguson Act of 1945, insurance companies are not covered by the antitrust laws to\nthe extent that the states regulate the business of insurance. Whether or not the states adequately regulate\ninsurance and the degree to which the exemption applies are complex questions, and there has been some\npolitical pressure to repeal the insurance exemption.\n\nState Action\nIn 1943, the Supreme Court ruled in Parker v. Brown that when a valid state law regulates a particular\nindustry practice and the industry members are bound to follow that law, then they are exempt from the\nfederal antitrust laws.\n\n[1]\n\nSuch laws include regulation of public power and licensing and regulation of the\n\nprofessions. This exemption for \xe2\x80\x9cstate action\xe2\x80\x9d has proved troublesome and, like the other exemptions, a\ncomplex matter to apply. But it is clear that the state law must require or compel the action and not\nmerely permit it. No state law would be valid if it simply said, \xe2\x80\x9cBakers in the state may jointly establish\ntariffs for the sale of cookies.\xe2\x80\x9d\nThe recent trend of Supreme Court decisions is to construe the exemption as narrowly as possible. A city,\ncounty, or other subordinate unit of a state is not immune under the Parker doctrine. A municipality can\nescape the consequences of antitrust violations\xe2\x80\x94for example, in its operation of utilities\xe2\x80\x94only if it is\ncarrying out express policy of the state. Even then, a state-mandated price-fixing scheme may not survive\na federal antitrust attack. New York law required liquor retailers to charge a certain minimum price, but\nbecause the state itself did not actively supervise the policy it had established, it fell to the Supreme\nCourt\xe2\x80\x99s antitrust axe.\n\nGroup Solicitation of Government\nSuppose representatives of the railroad industry lobby extensively and eventually successfully for state\nlegislation that hampers truckers, the railroads\xe2\x80\x99 deadly enemies. Is this a combination or conspiracy to\nrestrain trade? In Eastern Railroad President\xe2\x80\x99s Conference v. Noerr Motor Freight, Inc., the Supreme\nCourt said no.\n\n[2]\n\nWhat has come to be known as the Noerr doctrine holds that applying the antitrust laws\n\nto such activities would violate First Amendment rights to petition the government. One exception to this\nrule of immunity for soliciting action by the government comes when certain groups seek to harass\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n691\n\n\x0ccompetitors by instituting state or federal proceedings against them if the claims are baseless or known to\nbe false. Nor does the Noerr doctrine apply to horizontal boycotts even if the object is to force the\ngovernment to take action. In FTC v. Superior Court Trial Lawyers Assn., the Supreme Court held that a\ngroup of criminal defense lawyers had clearly violated the Sherman Act when they agreed among\nthemselves to stop handling cases on behalf of indigent defendants to force the local government to raise\nthe lawyers\xe2\x80\x99 fees.\n\n[3]\n\nThe Court rejected their claim that they had a First Amendment right to influence the\n\ngovernment through a boycott to pay a living wage so that indigent defendants could be adequately\nrepresented.\n\nBaseball\nBaseball, the Supreme Court said back in 1923, is not \xe2\x80\x9cin commerce.\xe2\x80\x9d Congress has never seen fit to\noverturn this doctrine. Although some inroads have been made in the way that the leagues and clubs may\nexercise their power, the basic decision stands. Some things are sacred.\n\nKEY TAKEAWAY\nFor various reasons over time, certain industries and organized groups have been exempted from the\noperation of US antitrust laws. These include organized labor, insurance companies, and baseball. In\naddition, First Amendment concerns allow trade groups to solicit both state and federal governments,\nand state law may sometimes provide a \xe2\x80\x9cstate action\xe2\x80\x9d exemption.\n\nEXERCISE\n1.\n\nDo a little Internet research. Find out why Curt Flood brought an antitrust lawsuit against Major\nLeague Baseball and what the Supreme Court did with his case.\n\n[1] Parker v. Brown, 317 U.S. 341 (1943).\n[2] Eastern Railroad President\xe2\x80\x99s Conference v. Noerr Motor Freight, Inc., 365 U.S. 127 (1961).\n[3] FTC v. Superior Court Trial Lawyers Assn., 493 U.S. 411 (1990).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n692\n\n\x0c16.6 Sherman Act, Section 2: Concentrations of Market Power\nLEARNING OBJECTIVES\n1.\n\nUnderstand the ways in which monopoly power can be injurious to competition.\n\n2.\n\nExplain why not all monopolies are illegal under the Sherman Act.\n\n3.\n\nRecognize the importance of defining the relevant market in terms of both geography and product.\n\n4.\n\nDescribe the remedies for Sherman Act Section 2 violations.\n\nIntroduction\nLarge companies, or any company that occupies a large portion of any market segment, can thwart\ncompetition through the exercise of monopoly power. Indeed, monopoly means the lack of\ncompetition, or at least of effective competition. As the Supreme Court has long defined it, monopoly is\n\xe2\x80\x9cthe power to control market prices or exclude competition.\xe2\x80\x9d\n\n[1]\n\nPublic concern about the economic and\n\npolitical power of the large trusts, which tended to become monopolies in the late nineteenth century, led\nto Section 2 of the Sherman Act in 1890 and to Section 7 of the Clayton Act in 1914. These statutes are not\nlimited to the giants of American industry, such as ExxonMobil, Microsoft, Google, or AT&T. A far smaller\ncompany that dominates a relatively small geographic area or that merges with another company in an\narea where few others compete can be in for trouble under Sections 2 or 7. These laws should therefore be\nof concern to all businesses, not just those on the Fortune500 list. In this section, we will consider how\nthe courts have interpreted both the Section 2 prohibition against monopolizing and the Section 7\nprohibition against mergers and acquisitions that tend to lessen competition or to create monopolies.\nSection 2 of the Sherman Act reads as follows: \xe2\x80\x9cEvery person who shall monopolize, or attempt to\nmonopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade\nor commerce among the several states, or with foreign nations, shall be deemed guilty of a [felony].\xe2\x80\x9d\nWe begin the analysis of Section 2 with the basic proposition that a monopoly is not per se unlawful.\nSection 2 itself makes this proposition inescapable: it forbids the act of monopolizing, not the condition or\nattribute of monopoly. Why should that be so? If monopoly power is detrimental to a functioning\ncompetitive market system, why shouldn\xe2\x80\x99t the law ban the very existence of a monopoly?\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n693\n\n\x0cThe answer is that we cannot hope to have \xe2\x80\x9cperfect competition\xe2\x80\x9d but only \xe2\x80\x9cworkable competition.\xe2\x80\x9d Any\nnumber of circumstances might lead to monopolies that we would not want to eliminate. Demand for a\nproduct might be limited to what one company could produce, there thus being no incentive for any\ncompetitor to come into the market. A small town may be able to support only one supermarket,\nnewspaper, or computer outlet. If a company is operating efficiently through economies of scale, we would\nnot want to split it apart and watch the resulting companies fail. An innovator may have a field all to him,\nyet we would not want to penalize the inventor for his very act of invention. Or a company might simply\nbe smarter and more efficient, finally coming to stand alone through the very operation of competitive\npressures. It would be an irony indeed if the law were to condemn a company that was forged in the fires\nof competition itself. As the Supreme Court has said, the Sherman Act was designed to protect\ncompetition, not competitors.\nA company that has had a monopoly position \xe2\x80\x9cthrust upon it\xe2\x80\x9d is perfectly lawful. The law penalizes not the\nmonopolist as such but the competitor who gains his monopoly power through illegitimate means with\nintent to become a monopolist, or who after having become a monopolist acts illegitimately to maintain\nhis power.\nA Section 2 case involves three essential factors:\n1.\n\nWhat is the relevant market for determining dominance? The question of relevant market has two\naspects: a geographic market dimension and a relevant product market dimension. It makes a\nconsiderable difference whether the company is thought to be a competitor in ten states or only one. A\nlarge company in one state may appear tiny matched against competitors operating in many states.\nLikewise, if the product itself has real substitutes, it makes little sense to brand its maker a\nmonopolist. For instance, Coca-Cola is made by only one company, but that does not make the CocaCola Company a monopoly, for its soft drink competes with many in the marketplace.\n\n2. How much monopoly power is too much? What share of the market must a company have to be\nlabeled a monopoly? Is a company with 50 percent of the market a monopoly? 75 percent? 90\npercent?\n3. What constitutes an illegitimate means of gaining or maintaining monopoly power?\nThese factors are often closely intertwined, especially the first two. This makes it difficult to examine each\nseparately, but to the extent possible, we will address each factor in the order given.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n694\n\n\x0cRelevant Markets: Product Market and Geographic Market\nProduct Market\nThe monopolist never exercises power in the abstract. When exercised, monopoly power is used to set\nprices or exclude competition in the market for a particular product or products. Therefore it is essential\nin any Section 2 case to determine what products to include in the relevant market.\nThe Supreme Court looks at \xe2\x80\x9ccross-elasticity of demand\xe2\x80\x9d to determine the relevant market. That is, to\nwhat degree can a substitute be found for the product in question if the producer sets the price too high?\nIf consumers stay with the product as its price rises, moving to a substitute only at a very high price, then\nthe product is probably in a market by itself. If consumers shift to another product with slight rises in\nprice, then the product market is \xe2\x80\x9celastic\xe2\x80\x9d and must include all such substitutes.\n\nGeographic Market\nA company doesn\xe2\x80\x99t have to dominate the world market for a particular product or service in order to be\nheld to be a monopolist. The Sherman Act speaks of \xe2\x80\x9cany part\xe2\x80\x9d of the trade or commerce. The Supreme\nCourt defines this as the \xe2\x80\x9carea of effective competition.\xe2\x80\x9d Ordinarily, the smaller the part the government\ncan point to, the greater its chances of prevailing, since a company usually will have greater control over a\nsingle marketplace than a regional or national market. Because of this, alleged monopolists will usually\nargue for a broad geographic market, while the government tries to narrow it by pointing to such factors\nas transportation costs and the degree to which consumers will shop outside the defined area.\n\nMonopoly Power\nAfter the relevant product and geographic markets are defined, the next question is whether the\ndefendant has sufficient power within them to constitute a monopoly. The usual test is the market share\nthe alleged monopolist enjoys, although no rigid rule or mathematical formula is possible. In United\nStates v. Aluminum Company of America, presented in Section 16.8.3 "Acquiring and Maintaining a\nMonopoly" of this chapter, Judge Learned Hand said that Alcoa\xe2\x80\x99s 90 percent share of the ingot market\nwas enough to constitute a monopoly but that 64 percent would have been doubtful.\n\nSaylor URL: http://www.saylor.org/books\n\n[2]\n\nIn a case against\n\nSaylor.org\n695\n\n\x0cDuPont many years ago, the court looked at a 75 percent market share in cellophane but found that the\nrelevant market (considering the cross-elasticity of demand) was not restricted to cellophane.\n\nMonopolization: Acquiring and Maintaining a Monopoly\nPossessing a monopoly is not per se unlawful. Once a company has been found to have monopoly power\nin a relevant market, the final question is whether it either acquired its monopoly power in an unlawful\nway or has acted unlawfully to maintain it. This additional element of \xe2\x80\x9cdeliberateness\xe2\x80\x9d does not mean that\nthe government must prove that the defendant intended monopolization, in the sense that what\nit desired was the complete exclusion of all competitors. It is enough to show that the monopoly would\nprobably result from its actions, for as Judge Hand put it, \xe2\x80\x9cNo monopolist monopolizes unconscious of\nwhat he is doing.\xe2\x80\x9d\nWhat constitutes proof of unlawful acquisition or maintenance of a monopoly? In general, proof is made\nby showing that the defendant\xe2\x80\x99s acts were aimed at or had the probable effect of excluding competitors\nfrom the market. Violations of Section 1 or other provisions of the antitrust laws are examples. \xe2\x80\x9cPredatory\npricing\xe2\x80\x9d\xe2\x80\x94charging less than cost\xe2\x80\x94can be evidence that the defendant\xe2\x80\x99s purpose was monopolistic, for\nsmall companies cannot compete with large manufacturers capable of sustaining continued losses until\nthe competition folds up and ceases operations.\nIn United States v. Lorain Journal Company, the town of Lorain, Ohio, could support only one\nnewspaper.\n\n[3]\n\nWith a circulation of twenty thousand, the Lorain Journal reached more than 99 percent of\n\nthe town\xe2\x80\x99s families. The Journal had thus lawfully become a monopoly. But when a radio station was set\nup, the paper found itself competing directly for local and national advertising. To retaliate,\nthe Journal refused to accept advertisements unless the advertiser agreed not to advertise on the local\nstation. The Court agreed that this was an unlawful attempt to boycott and hence was a violation of\nSection 2 because the paper was using its monopoly power to exclude a competitor. (Where was the\ninterstate commerce that would bring the activity under federal law? The Court said that the radio station\nwas in interstate commerce because it broadcast national news supported by national advertising.)\nPractices that help a company acquire or maintain its monopoly position need not be unlawful in them. In\nthe Aluminum Company case, Alcoa claimed its monopoly power was the result of superior business skills\nand techniques. These superior skills led it to constantly build plant capacity and expand output at every\nopportunity. But Judge Hand thought otherwise, given that for a quarter of a century other producers\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n696\n\n\x0ccould not break into the market because Alcoa acted at every turn to make it impossible for them to\ncompete, even as Alcoa increased its output by some 800 percent. Judge Hand\xe2\x80\x99s explanation remains the\nclassic exposition.\n\nInnovation as Evidence of Intent to Monopolize\nDuring the 1970s, several monopolization cases seeking huge damages were filed against a number of\nwell-known companies, including Xerox, International Business Machines (IBM), and Eastman Kodak. In\nparticular, IBM was hit with several suits as an outgrowth of the Justice Department\xe2\x80\x99s lawsuit against the\ncomputer maker. (United States v. IBM was filed in 1969 and did not terminate until 1982, when the\ngovernment agreed to drop all charges, a complete victory for the company.) The plaintiffs in many of\nthese suits\xe2\x80\x94SCM Corporation against Xerox, California Computer Products Incorporated against IBM\n(the Calcomp case), Berkey Photo Incorporated against Kodak\xe2\x80\x94charged that the defendants had\nmaintained their alleged monopolies by strategically introducing key product innovations that rendered\ncompetitive products obsolete. For example, hundreds of computer companies manufacture peripheral\nequipment \xe2\x80\x9cplug-compatible\xe2\x80\x9d with IBM computers. Likewise, Berkey manufactured film usable in Kodak\ncameras. When the underlying products are changed\xe2\x80\x94mainframe computers, new types of cameras\xe2\x80\x94the\nexisting manufacturers are left with unusable inventory and face a considerable time lag in designing new\nperipheral equipment. In some of these cases, the plaintiffs managed to obtain sizable treble damage\nawards\xe2\x80\x94SCM won more than $110 million, IBM initially lost one case in the amount of $260 million, and\nBerkey bested Kodak to the tune of $87 million. Had these cases been sustained on appeal, a radical new\ndoctrine would have been imported into the antitrust laws\xe2\x80\x94that innovation for the sake of competing is\nunlawful.\nNone of these cases withstood appellate scrutiny. The Supreme Court has not heard cases in this area, so\nthe law that has emerged is from decisions of the federal courts of appeals. A typical case is ILC\nPeripherals Leasing Corp. v. International Business Machines (the Memorex case).\n\n[4]\n\nMemorex argued\n\nthat among other things, IBM\xe2\x80\x99s tactic of introducing a new generation of computer technology at lower\nprices constituted monopolization. The court disagreed, noting that other companies could \xe2\x80\x9creverse\nengineer\xe2\x80\x9d IBM equipment much more cheaply than IBM could originally design it and that IBM\ncomputers and related products were subject to intense competition to the benefit of plug-compatible\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n697\n\n\x0cequipment users. The actions of IBM undoubtedly hurt Memorex, but they were part and parcel of the\ncompetitive system, the very essence of competition. \xe2\x80\x9cThis kind of conduct by IBM,\xe2\x80\x9d the court said, \xe2\x80\x9cis\nprecisely what the antitrust laws were meant to encourage. Memorex sought to use the antitrust laws to\nmake time stand still and preserve its very profitable position. This court will not assist it and the others\nwho would follow after in this endeavor.\xe2\x80\x9d\nThe various strands of the innovation debate are perhaps best summed up in Berkey Photo, Inc. v.\nEastman Kodak Company, Section 16.8.4 "Innovation and Intent to Monopolize".\n\nAttempts to Monopolize\nSection 2 prohibits not only actual monopolization but also attempts to monopolize. An attempt need not\nsucceed to be unlawful; a defendant who tries to exercise sway over a relevant market can take no legal\ncomfort from failure. In any event, the plaintiff must show a specific intent to monopolize, not merely\nintent to commit the act or acts that constitute the attempt.\n\nRemedies\nSince many of the defendant\xe2\x80\x99s acts that constitute Sherman Act Section 2 monopolizing are also violations\nof Section 1 of the Clayton Act, why should plaintiffs resort to Section 2 at all? What practical difference\ndoes Section 2 make? One answer is that not every act of monopolizing is a violation of another law.\nLeasing and pricing practices that are perfectly lawful for an ordinary competitor may be unlawful only\nbecause of Section 2. But the more important reason is the remedy provided by the Sherman Act:\ndivestiture. In the right case, the courts may order the company broken up.\nIn the Standard Oil decision of 1911, the Supreme Court held that the Standard Oil Company constituted a\nmonopoly and ordered it split apart into separate companies. Several other trusts were similarly dealt\nwith. In many of the early cases, doing so posed no insuperable difficulties, because the companies\nthemselves essentially consisted of separate manufacturing plants knit together by financial controls. But\nnot every company is a loose confederation of potentially separate operating companies.\nThe Alcoa case (Section 16.8.3 "Acquiring and Maintaining a Monopoly") was fraught with difficult\nremedial issues. Judge Hand\xe2\x80\x99s opinion came down in 1945, but the remedial side of the case did not come\nup until 1950. By then the industry had changed radically, with the entrance of Reynolds and Kaiser as\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n698\n\n\x0ceffective competitors, reducing Alcoa\xe2\x80\x99s share of the market to 50 percent. Because any aluminum\nproducer needs considerable resources to succeed and because aluminum production is crucial to national\nsecurity, the later court refused to order the company broken apart. The court ordered Alcoa to take a\nseries of measures that would boost competition in the industry. For example, Alcoa stockholders had to\ndivest themselves of the stock of a closely related Canadian producer in order to remove Alcoa\xe2\x80\x99s control of\nthat company; and the court rendered unenforceable a patent-licensing agreement with Reynolds and\nKaiser that required them to share their inventions with Alcoa, even though neither the Canadian tie nor\nthe patent agreements were in themselves unlawful.\nAlthough the trend has been away from breaking up the monopolist, it is still employed as a potent\nremedy. In perhaps the largest monopolization case ever brought\xe2\x80\x94United States v. American Telephone\n& Telegraph Company\xe2\x80\x94the government sought divestiture of several of AT&T\xe2\x80\x99s constituent companies,\nincluding Western Electric and the various local operating companies. To avoid prolonged litigation,\nAT&T agreed in 1982 to a consent decree that required it to spin off all its operating companies,\ncompanies that had been central to AT&T\xe2\x80\x99s decades-long monopoly.\n\nKEY TAKEAWAY\nAggressive competition is good for consumers and for the market, but if the company has enough\npower to control a market, the benefits to society decrease. Under Section 2 of the Sherman Act, it is\nillegal to monopolize or attempt to monopolize the market. If the company acquires a monopoly in the\nwrong way, using wrongful tactics, it is illegal under Section 2. Courts will look at three questions to see\nif a company has illegally monopolized a market: (1) What is the relevant market? (2) Does the\ncompany control the market? and (3) How did the company acquire or maintain its control?\n\nEXERCISES\n1.\n\nMammoth Company, through three subsidiaries, controls 87 percent of the equipment to operate\ncentral station hazard-detecting devices; these devices are used to prevent burglary and detect fires\nand to provide electronic notification to police and fire departments at a central location. In an\nantitrust lawsuit, Mammoth Company claims that there are other means of protecting against\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n699\n\n\x0cburglary and it therefore does not have monopoly power. Explain how the Justice Department may be\nable to prove its claim that Mammoth Company is operating an illegal monopoly.\n2.\n\nName the sanctions used to enforce Section 2 of the Sherman Act.\n\n3.\n\nLook at any news database or the Department of Justice antitrust website for the past three years and\ndescribe a case involving a challenge to the exercise of a US company\xe2\x80\x99s monopoly power.\n\n[1] United States v. Grinnell Corp., 384 U.S. 563, 571 (1966).\n[2] United States v. Aluminum Co. of America, 148 F.2d 416 (2d Cir. 1945).\n[3] United States v. Lorain Journal Company, 342 U.S. 143 (1951).\n[4] ILC Peripherals Leasing Corp. v. International Business Machines, 458 F.Supp. 423 (N.D. Cal. 1978).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n700\n\n\x0c16.7 Acquisitions and Mergers under Section 7 of the Clayton\nAct\nLEARNING OBJECTIVES\n1.\n\nDistinguish the three kinds of mergers.\n\n2.\n\nDescribe how the courts will define the relevant market in gauging the potential anticompetitive\neffects of mergers and acquisitions.\n\nNeither Section 1 nor Section 2 of the Sherman Act proved particularly useful in barring mergers between\ncompanies or acquisition by one company of another. As originally written, neither did the Clayton Act,\nwhich prohibited only mergers accomplished through the sale of stock, not mergers or acquisitions\ncarried out through acquisition of assets. In 1950, Congress amended the Clayton Act to cover the\nloophole concerning acquisition of assets. It also narrowed the search for relevant market; henceforth, if\ncompetition might be lessened in any line of commerce in any section of the country, the merger is\nunlawful.\nAs amended, the pertinent part of Section 7 of the Clayton Act reads as follows:\n[N]o corporation engaged in commerce shall acquire, directly or indirectly, the whole or any part of the\nstock or other share capital and no corporation subject to the jurisdiction of the Federal Trade\nCommission shall acquire the whole or any part of the assets of another corporation engaged also in\ncommerce, where in any line of commerce in any section of the country, the effect of such acquisition may\nbe substantially to lessen competition, or to tend to create a monopoly.\nNo corporation shall acquire, directly or indirectly, the whole or any part of the stock or other share\ncapital and no corporation subject to the jurisdiction of the Federal Trade Commission shall acquire the\nwhole or any part of the assets of one or more corporations engaged in commerce, where in any line of\ncommerce in any section of the country, the effect of such acquisition, of such stock or assets, or of the use\nof such stock by the voting or granting of proxies or otherwise, may be substantially to lessen competition,\nor to tend to create a monopoly.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n701\n\n\x0cDefinitions\nMergers and Acquisitions\nFor the sake of brevity, we will refer to both mergers and acquisitions as mergers. Mergers are usually\nclassified into three types: horizontal, vertical, and conglomerate.\n\nHorizontal\nA horizontal merger is one between competitors\xe2\x80\x94for example, between two bread manufacturers or two\ngrocery chains competing in the same locale.\n\nVertical\nA vertical merger is that of a supplier and a customer. If the customer acquires the supplier, it is known as\nbackward vertical integration; if the supplier acquires the customer, it is forward vertical integration. For\nexample, a book publisher that buys a paper manufacturer has engaged in backward vertical integration.\nIts purchase of a bookstore chain would be forward vertical integration.\n\nConglomerate Mergers\nConglomerate mergers do not have a standard definition but generally are taken to be mergers between\ncompanies whose businesses are not directly related. Many commentators have subdivided this category\ninto three types. In a \xe2\x80\x9cpure\xe2\x80\x9d conglomerate merger, the businesses are not related, as when a steel\nmanufacturer acquires a movie distributor. In a product-extension merger, the manufacturer of one\nproduct acquires the manufacturer of a related product\xe2\x80\x94for instance, a producer of household cleansers,\nbut not of liquid bleach, acquires a producer of liquid bleach. In a market-extension merger, a company in\none geographic market acquires a company in the same business in a different location. For example,\nsuppose a bakery operating only in San Francisco buys a bakery operating only in Palo Alto. Since they\nhad not completed before the merger, this would not be a horizontal merger.\n\nGeneral Principles\nAs in monopolization cases, a relevant product market and geographic market must first be marked out to\ntest the effect of the merger. But Section 7 of the Clayton Act has a market definition different from that of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n702\n\n\x0cSection 2. Section 7 speaks of \xe2\x80\x9cany line of commerce in any section of the country\xe2\x80\x9d (emphasis added). And\nits test for the effect of the merger is the same as that which we have already seen for exclusive dealing\ncases governed by Section 3: \xe2\x80\x9cmay be substantially to lessen competition or to tend to create a monopoly.\xe2\x80\x9d\nTaken together, this language makes it easier to condemn an unlawful merger than an unlawful\nmonopoly. The relevant product market is any line of commerce, and the courts have taken this language\nto permit the plaintiff to prove the existence of \xe2\x80\x9csubmarkets\xe2\x80\x9d in which the relative effect of the merger is\ngreater. The relevant geographic market is any section of the country, which means that the plaintiff can\nshow the appropriate effect in a city or a particular region and not worry about having to show the effect\nin a national market. Moreover, as we have seen, the effect is one of probability, not actuality. Thus the\nquestion is, Might competition be substantially lessened? Rather than, was competition in fact\nsubstantially lessened? Likewise, the question is, did the merger tend to create a monopoly? rather than,\nDid the merger in fact create a monopoly?\nIn United States v. du Pont, the government charged that du Pont\xe2\x80\x99s \xe2\x80\x9ccommanding position as General\nMotors\xe2\x80\x99 supplier of automotive finishes and fabrics\xe2\x80\x9d was not achieved on competitive merit alone but\nbecause du Pont had acquired a sizable block of GM stock, and the \xe2\x80\x9cconsequent close intercompany\nrelationship led to the insulation of most of the General Motors\xe2\x80\x99 market from free competition,\xe2\x80\x9d in\nviolation of Section 7.\n\n[1]\n\nBetween 1917 and 1919, du Pont took a 23 percent stock interest in GM. The\n\ndistrict court dismissed the complaint, partly on the grounds that at least before the 1950 amendment to\nSection 7, the Clayton Act did not condemn vertical mergers and partly on the grounds that du Pont had\nnot dominated GM\xe2\x80\x99s decision to purchase millions of dollars\xe2\x80\x99 worth of automotive finishes and fabrics.\nThe Supreme Court disagreed with this analysis and sent the case back to trial. The Court specifically held\nthat even though the stock acquisition had occurred some thirty-five years earlier, the government can\nresort to Section 7 whenever it appears that the result of the acquisition will violate the competitive tests\nset forth in the section.\n\nDefining the Market\nIn the seminal Brown Shoe case, the Supreme Court said that the outer boundaries of broad markets \xe2\x80\x9care\ndetermined by the reasonable interchangeability of use or the cross elasticity of demand between the\nproduct itself and substitutes for it\xe2\x80\x9d but that narrower \xe2\x80\x9cwell defined submarkets\xe2\x80\x9d might also be\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n703\n\n\x0cappropriate lines of commerce.\n\n[2]\n\nIn drawing market boundaries, the Court said, courts should\n\nrealistically reflect \xe2\x80\x9c[c]ompetition where, in fact, it exists.\xe2\x80\x9d Among the factors to consider are \xe2\x80\x9cindustry or\npublic recognition of the submarket as a separate economic entity, the product\xe2\x80\x99s peculiar characteristics\nand uses, unique production facilities, distinct customers, distinct prices, sensitivity to price changes and\nspecialized vendors.\xe2\x80\x9d To select the geographic market, courts must consider both \xe2\x80\x9cthe commercial\nrealities\xe2\x80\x9d of the industry and the economic significance of the market.\n\nThe Failing Company Doctrine\nOne defense to a Section 7 case is that one of the merging companies is a failing company. In Citizen\nPublishing Company v. United States, the Supreme Court said that the defense is applicable if two\nconditions are satisfied.\n\n[3]\n\nFirst, a company must be staring bankruptcy in the face; it must have virtually\n\nno chance of being resuscitated without the merger. Second, the acquiring company must be the only\navailable purchaser, and the failing company must have made bona fide efforts to search for another\npurchaser.\n\nBeneficial Effects\nThat a merger might produce beneficial effects is not a defense to a Section 7 case. As the Supreme Court\nsaid in United States v. Philadelphia National Bank, \xe2\x80\x9c[A] merger, the effect of which \xe2\x80\x98may be substantially\nto lessen competition\xe2\x80\x99 is not saved because, on some ultimate reckoning of social or economic debits or\ncredits, it may be deemed beneficial.\xe2\x80\x9d\n\n[4]\n\nAnd in FTC v. Procter & Gamble Co., the Court said, \xe2\x80\x9cPossible\n[5]\n\neconomies cannot be used as a defense to illegality.\xe2\x80\x9d Congress was also aware that some mergers which\nlessen competition may also result in economies but it struck the balance in favor of protecting\ncompetition.\n\nTests of Competitive Effect\nHorizontal Mergers\nThree factors are critical in assessing whether a horizontal merger may substantially lessen competition:\n(1) the market shares of the merging companies, (2) the concentration ratios, and (3) the trends in the\nindustry toward concentration.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n704\n\n\x0cThe first factor is self-evident. A company with 10 percent or even 5 percent of the market is in a different\nposition from one with less than 1 percent. A concentration ratio indicates the number of firms that\nconstitute an industry. An industry with only four firms is obviously much more concentrated than one\nwith ten or seventy firms. Concentration trends indicate the frequency with which firms in the relevant\nmarket have been merging. The first merger in an industry with a low concentration ratio might be\npredicted to have no likely effect on competition, but a merger of two firms in a four-firm industry would\nobviously have a pronounced effect.\nIn the Philadelphia National Bank case, the court announced this test in assessing the legality of a\nhorizontal merger: \xe2\x80\x9c[A] merger which produces a firm controlling an undue percentage share of the\nrelevant market, and results in a significant increase in the concentration of firms in that market is so\ninherently likely to lessen competition substantially that it must be enjoined in the absence of evidence\nclearly showing that the merger is not likely to have such anticompetitive effects.\xe2\x80\x9d In this case, the merger\nled to a 30 percent share of the commercial banking market in a four-county region around Philadelphia\nand an increase in concentration by more than one-third, and the court held that those numbers\namounted to a violation of Section 7. The court also said that \xe2\x80\x9cif concentration is already great, the\nimportance of preventing even slight increases in concentration and so preserving the possibility of\neventual de-concentration is correspondingly great.\xe2\x80\x9d\nThe Hart-Scott-Rodino Antitrust Improvements Act of 1976 requires certain companies to notify the\nJustice Department before actually completing mergers or acquisitions, whether by private negotiation or\nby public tender offer. When one of the companies has sales or assets of $100 million or more and the\nother company $10 million or more, premerger notification must be provided at least thirty days prior to\ncompletion of the deal\xe2\x80\x94or fifteen days in the case of a tender offer of cash for publicly traded shares if the\nresulting merger would give the acquiring company $50 million worth or 15 percent of assets or voting\nsecurities in the acquired company. The rules are complex, but they are designed to give the department\ntime to react to a merger before it has been secretly accomplished and then announced. The 1976 act gives\nthe department the authority to seek an injunction against the completion of any such merger, which of\ncourse greatly simplifies the remedial phase of the case should the courts ultimately hold that the merger\nwould be unlawful. (Note: Section 7 is one of the \xe2\x80\x9ctools\xe2\x80\x9d in the kit of the lawyer who defends companies\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n705\n\n\x0cagainst unwelcomed takeover attempts: if the target company can point to lines of its business in which it\ncompetes with the acquiring company, it can threaten antitrust action in order to block the merger.)\n\nVertical Mergers\nTo prove a Section 7 case involving a vertical merger, the plaintiff must show that the merger forecloses\ncompetition \xe2\x80\x9cin a substantial share of\xe2\x80\x9d a substantial market. But statistical factors alone do not govern in\na vertical merger. To illustrate, we see that in Ford Motor Co. v. United States, the merger between Ford\nand Autolite (a manufacturer of spark plugs) was held unlawful because it eliminated Ford\xe2\x80\x99s potential\nentry into the market as an independent manufacturer of spark plugs and because it foreclosed Ford \xe2\x80\x9cas a\npurchaser of about ten percent of total industry output\xe2\x80\x9d of spark plugs.\n\n[6]\n\nThis decision underscores the\n\nprinciple that a company may serve to enhance competition simply by waiting in the wings as a potential\nentrant to a market. If other companies feel threatened by a company the size of Ford undertaking to\ncompete where it had not done so before, the existing manufacturers will likely keep their prices low so as\nnot to tempt the giant in. Of course, had Ford entered the market on its own by independently\nmanufacturing spark plugs, it might ultimately have caused weak competitors to fold. As the Court said,\n\xe2\x80\x9cHad Ford taken the internal-expansion route, there would have been no illegality; not, however, because\nthe result necessarily would have been commendable, but simply because that course has not been\nproscribed.\xe2\x80\x9d\n\nConglomerate Mergers\nRecall the definition of a conglomerate merger given in Section 16.7.1 "Definitions". None of the three\ntypes listed has a direct impact on competition, so the test for illegality is more difficult to state and apply\nthan for horizontal or vertical mergers. But they are nonetheless within the reach of Section 7. In the late\n1960s and early 1970s, the government filed a number of divestiture suits against conglomerate mergers.\nIt did not win them all, and none reached the Supreme Court; most were settled by consent decree,\nleading in several instances to divestiture either of the acquired company or of another division of the\nacquiring company. Thus International Telephone & Telegraph Company agreed to divest itself of\nCanteen Corporation and either of the following two groups: (1) Avis, Levin & Sons, and Hamilton Life\nInsurance Company; or (2) Hartford Fire Insurance Company. Ling-Temco-Vought agreed to divest itself\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n706\n\n\x0cof either Jones & Laughlin Steel or Braniff Airways and Okonite Corporation. In these and other cases, the\ncourts have looked to specific potential effects, such as raising the barriers to entry into a market and\neliminating potential competition, but they have rejected the more general claim of \xe2\x80\x9cthe rising tide of\neconomic concentration in American industry.\xe2\x80\x9d\n\nEntrenching Oligopoly\nOne way to attack conglomerate mergers is to demonstrate that by taking over a dominant company in an\noligopolistic industry, a large and strong acquiring company will further entrench the oligopoly. In an\noligopolistic industry, just a few major competitors so dominate the industry that competition is quelled.\nIn FTC v. Procter & Gamble Co., the government challenged Procter & Gamble\xe2\x80\x99s (P&G\xe2\x80\x99s) acquisition of\nClorox. P&G was the leading seller of household cleansers, with annual sales of more than $1 billion.\n\n[7]\n\nIn\n\naddition, it was the \xe2\x80\x9cnation\xe2\x80\x99s largest advertiser,\xe2\x80\x9d promoting its products so heavily that it was able to take\nadvantage of substantial advertising discounts from the media. Clorox had more than 48 percent of\nnational sales for liquid bleach in a heavily concentrated industry. Since all liquid bleach is chemically\nidentical, advertising and promotion plays the dominant role in selling the product. Prior to the merger,\nP&G did not make or sell liquid bleach; hence it was a product-extension merger rather than a horizontal\none.\nThe Supreme Court concluded that smaller firms would fear retaliation from P&G if they tried to compete\nin the liquid bleach market and that \xe2\x80\x9ca new entrant would be much more reluctant to face the giant\nProcter than it would have been to face the smaller Clorox.\xe2\x80\x9d Hence \xe2\x80\x9cthe substitution of the powerful\nacquiring firm for the smaller, but already dominant firm may substantially reduce the competitive\nstructure of the industry by raising entry barriers and by dissuading the smaller firms from aggressively\ncompeting.\xe2\x80\x9d The entrenchment theory probably applies only to highly concentrated industries and\ndominant firms, however. Many subsequent cases have come out in favor of the defendants on a variety of\ngrounds\xe2\x80\x94that the merger led simply to a more efficient acquired firm, that the existing competitors were\nstrong and able to compete, or even that the acquiring firm merely gives the acquired company a deep\npocket to better finance its operations.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n707\n\n\x0cEliminating Potential Competition\nThis theory holds that but for the merger, the acquiring company might have competed in the acquired\ncompany\xe2\x80\x99s market. In Procter & Gamble, for example, P&G might have entered the liquid bleach market\nitself and thus given Clorox a run for its money. An additional strong company would then have been in\nthe market. When P&G bought Clorox, however, it foreclosed that possibility. This theory depends on\nproof of some probability that the acquiring company would have entered the market. When the acquired\ncompany is small, however, a Section 7 violation is unlikely; these so-called toehold mergers permit the\nacquiring company to become a competitive force in an industry without necessarily sacrificing any\npreexisting competition.\n\nReciprocity\nMany companies are both heavy buyers and heavy sellers of products. A company may buy from its\ncustomers as well as sell to them. This practice is known in antitrust jargon as reciprocity. Reciprocity is\nthe practice of a seller who uses his volume of purchases from the buyer to induce the buyer to purchase\nfrom him. The clearest example arose in FTC v. Consolidated Foods Corp.\n\n[8]\n\nConsolidated owned\n\nwholesale grocery outlets and retail food stores. It wanted to merge with Gentry, which made dehydrated\nonions and garlic. The Supreme Court agreed that the merger violated Section 7 because of the possibility\nof reciprocity: Consolidated made bulk purchases from several food processors, which were purchasers of\ndehydrated onions and garlic from Gentry and others. Processors who did not buy from Gentry might feel\npressured to do so in order to keep Consolidated as a customer for their food supplies. If so, other onion\nand garlic processors would be foreclosed from competing for sales. A merger that raises the mere\npossibility of reciprocity is not per se unlawful, however. The plaintiff must demonstrate that it was\nprobable the acquiring company would adopt the practice\xe2\x80\x94for example, by conditioning future orders for\nsupplies on the receipt of orders for onions and garlic\xe2\x80\x94and that doing so would have an anticompetitive\neffect given the size of the reciprocating companies and their positions in the market.\n\nJoint Ventures\nSection 7 can also apply to joint ventures, a rule first announced in 1964. Two companies, Hooker and\nAmerican Potash, dominated sales of sodium chlorate in the Southeast, with 90 percent of the market.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n708\n\n\x0cPennsalt Chemicals Corporation produced the rest in the West and sold it in the Southeast through Olin\nMathieson Chemical Corporation. The latter two decided to team up, the better to compete with the\ngiants, and so they formed Penn-Olin, which they jointly owned. The district court dismissed the\ngovernment\xe2\x80\x99s suit, but the Supreme Court reinstated it, saying that a joint venture can serve to blunt\ncompetition, or at least potential competition, between the parent companies. The Court said that the\nlower court must look to a number of factors to determine whether the joint venture was likely to lessen\ncompetition substantially:\nThe number and power of the competitors in the relevant market; the background of their growth; the\npower of the joint ventures; the relationship of their lines of commerce; competition existing between\nthem and the power of each in dealing with the competitors of the other; the setting in which the joint\nventure was created; the reasons and necessities for its existence; the joint venture\xe2\x80\x99s line of commerce and\nthe relationship thereof to that of its parents; the adaptability of its line of commerce to non-competitive\npractices; the potential power of the joint venture in the relevant market; and appraisal of what the\ncompetition in the relevant market would have been if one of the joint ventures had entered it alone\ninstead of through Penn-Olin; the effect, in the event of this occurrence, of the other joint venture\xe2\x80\x99s\npotential competition; and such other factors as might indicate potential risk to competition in the\nrelevant market.\n\n[9]\n\nThese numerous factors illustrate how the entire economic environment surrounding the joint venture\nand mergers in general must be assessed to determine the legalities.\n\nRemedies\nThe Clayton Act provides that the government may seek divestiture when an acquisition or a merger\nviolates the act. Until relatively recently, however, it was unresolved whether a private plaintiff could seek\ndivestiture after proving a Clayton Act violation. In 1990, the Supreme Court unanimously agreed that\ndivestiture is an available remedy in private suits, even in suits filed by a state\xe2\x80\x99s attorney general on behalf\nof consumers.\n\n[10]\n\nThis ruling makes it more likely that anti-merger litigation will increase in the future.\n\nDuring the years of the Reagan administration in the 1980s, the federal government became far less active\nin prosecuting antitrust cases, especially merger cases, than it had been in previous decades. Many giant\nmergers went unchallenged, like the merger between two oil behemoths, Texaco and Getty, resulting in a\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n709\n\n\x0ccompany with nearly $50 billion in assets in 1984. With the arrival of the first Bush administration in\n1989, the talk in Washington antitrust circles was of a renewed interest in antitrust enforcement. The\narrival of the second Bush administration in 2000 brought about an era of less antitrust enforcement than\nhad been undertaken during the Clinton administration. Whether the Obama administration\nreinvigorates antitrust enforcement remains to be seen.\n\nKEY TAKEAWAY\nSection 7 prohibits mergers or acquisitions that might tend to lessen competition in any line of\ncommerce in any section of the country. Mergers and acquisitions are usually classified in one of three\nways: horizontal (between competitors), vertical (between different levels of the distribution chain), or\nconglomerate (between businesses that are not directly related). The latter may be divided into\nproduct-extension and market-expansion mergers. The relevant market test is different than in\nmonopolization cases; in a Section 7 action, relevance of market may be proved.\nIn assessing horizontal mergers, the courts will look to the market shares of emerging companies,\nindustry concentration ratios, and trends toward concentration in the industry. To prove a Section 7\ncase, the plaintiff must show that the merger forecloses competition \xe2\x80\x9cin a substantial share of\xe2\x80\x9d a\nsubstantial market. Conglomerate merger cases are harder to prove and require a showing of specific\npotential effects, such as raising barriers to entry into an industry and thus entrenching monopoly, or\neliminating potential competition. Joint ventures may also be condemned by Section 7. The Hart-ScottRodino Antitrust Improvements Act of 1976 requires certain companies to get premerger notice to the\nJustice Department.\n\nEXERCISES\n1.\n\nSirius Satellite radio and XM satellite radio proposed to merge. Was this a horizontal merger, a vertical\nmerger, or a conglomerate merger? How is the market defined, in terms of both product or service\nand geographic area?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n710\n\n\x0c2.\n\nIn 2010, Live Nation and Ticketmaster proposed to merge. Was this a horizontal merger, a vertical\nmerger, or a conglomerate merger? How should the market be defined, in terms of both product or\nservice and geographic area? Should the US government approve the merger?\n\n[1] United States v. du Pont, 353 U.S. 586 (1957).\n[2] Brown Shoe Co., Inc. v. United States, 370 U.S. 294 (1962).\n[3] Citizen Publishing Company v. United States, 394 U.S. 131 (1969).\n[4] United States v. Philadelphia National Bank, 374 U.S. 321, 371 (1963).\n[5] FTC v. Procter & Gamble Co., 386 U.S. 568, 580 (1967).\n[6] Ford Motor Co. v. United States, 405 U.S. 562 (1972).\n[7] FTC v. Procter & Gamble Co., 386 U.S. 568 (1967).\n[8] FTC v. Consolidated Foods Corp., 380 U.S. 592 (1965).\n[9] United States v. Penn-Olin Chemical Co., 378 U.S. 158 (1964).\n[10] California v. American Stores, 58 U.S.L.W. 4529 (1990).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n711\n\n\x0c16.8 Cases\nHorizontal Restraints of Trade\nNational Society of Professional Engineers v. United States\n435 U.S. 679 (1978)\nMR. JUSTICE STEVENS delivered the opinion of the Court.\nThis is a civil antitrust case brought by the United States to nullify an association\xe2\x80\x99s canon of ethics\nprohibiting competitive bidding by its members. The question is whether the canon may be justified\nunder the Sherman Act, 15 U.S. c. \xc2\xa7 1 et seq. (1976 ed.), because it was adopted by members of a learned\nprofession for the purpose of minimizing the risk that competition would produce inferior engineering\nwork endangering the public safety. The District Court rejected this justification without making any\nfindings on the likelihood that competition would produce the dire consequences foreseen by the\nassociation. The Court of Appeals affirmed. We granted certiorari to decide whether the District Court\nshould have considered the factual basis for the proffered justification before rejecting it. Because we are\nsatisfied that the asserted defense rests on a fundamental misunderstanding of the Rule of Reason\nfrequently applied in antitrust litigation, we affirm.\nEngineering is an important and learned profession. There are over 750,000 graduate engineers in the\nUnited States, of whom about 325,000 are registered as professional engineers. Registration\nrequirements vary from State to State, but usually require the applicant to be a graduate engineer with at\nleast four years of practical experience and to pass a written examination. About half of those who are\nregistered engage in consulting engineering on a fee basis. They perform services in connection with the\nstudy, design, and construction of all types of improvements to real property\xe2\x80\x94bridges, office buildings,\nairports, and factories are examples. Engineering fees, amounting to well over $2 billion each year,\nconstitute about 5% of total construction costs. In any given facility, approximately 50% to 80% of the\ncost of construction is the direct result of work performed by an engineer concerning the systems and\nequipment to be incorporated in the structure.\nThe National Society of Professional Engineers (Society) was organized in 1935 to deal with the\nnontechnical aspects of engineering practice, including the promotion of the professional, social, and\neconomic interests of its members. Its present membership of 69,000 resides throughout the United\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n712\n\n\x0cStates and in some foreign countries. Approximately 12,000 members are consulting engineers who offer\ntheir services to governmental, industrial, and private clients. Some Society members are principals or\nchief executive officers of some of the largest engineering firms in the country.\nThe charges of a consulting engineer may be computed in different ways. He may charge the client a\npercentage of the cost of the project, may charge fixed rates per hour for different types of work, may\nperform an assignment for a specific sum, or he may combine one or more of these approaches.\xe2\x80\xa6This\ncase\xe2\x80\xa6involves a charge that the members of the Society have unlawfully agreed to refuse to negotiate or\neven to discuss the question of fees until after a prospective client has selected the engineer for a\nparticular project. Evidence of this agreement is found in \xc2\xa7 II(c) of the Society\xe2\x80\x99s Code of Ethics, adopted in\nJuly 1964.\nThe District Court found that the Society\xe2\x80\x99s Board of Ethical Review has uniformly interpreted the \xe2\x80\x9cethical\nrules against competitive bidding for engineering services as prohibiting the submission of any form of\nprice information to a prospective customer which would enable that customer to make a price\ncomparison on engineering services.\xe2\x80\x9d If the client requires that such information be provided, then \xc2\xa7 II(c)\nimposes an obligation upon the engineering firm to withdraw from consideration for that job.\n[P]etitioner argues that its attempt to preserve the profession\xe2\x80\x99s traditional method of setting fees for\nengineering services is a reasonable method of forestalling the public harm which might be produced by\nunrestrained competitive bidding. To evaluate this argument it is necessary to identify the contours of the\nRule of Reason and to discuss its application to the kind of justification asserted by petitioner.\n***\nThe test prescribed in Standard Oil is whether the challenged contracts or acts \xe2\x80\x9cwere unreasonably\nrestrictive of competitive conditions.\xe2\x80\x9d Unreasonableness under that test could be based either (I) on the\nnature or character of the contracts, or (2) on surrounding circumstances giving rise to the inference or\npresumption that they were intended to restrain trade and enhance prices. Under either branch of the\ntest, the inquiry is confined to a consideration of impact on competitive conditions.\n***\nPrice is the \xe2\x80\x9ccentral nervous system of the economy,\xe2\x80\x9d United States v. Socony-Vacuum Oil Co., 310 U.S.\n150, 226 n. 59, and an agreement that \xe2\x80\x9cinterfere[s] with the setting of price by free market forces\xe2\x80\x9d is illegal\non its face, United States v. Container Corp., 393 U.S. 333,337. In this case we are presented with an\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n713\n\n\x0cagreement among competitors to refuse to discuss prices with potential customers until after negotiations\nhave resulted in the initial selection of an engineer. While this is not price fixing as such, no elaborate\nindustry analysis is required to demonstrate the anticompetitive character of such an agreement. It\noperates as an absolute ban on competitive bidding, applying with equal force to both complicated and\nsimple projects and to both inexperienced and sophisticated customers. As the District Court found, the\nban \xe2\x80\x9cimpedes the ordinary give and take of the market place,\xe2\x80\x9d and substantially deprives the customer of\n\xe2\x80\x9cthe ability to utilize and compare prices in selecting engineering services.\xe2\x80\x9d On its face, this agreement\nrestrains trade within the meaning of \xc2\xa7 1 of the Sherman Act.\nThe Society\xe2\x80\x99s affirmative defense confirms rather than refutes the anticompetitive purpose and effect of its\nagreement. The Society argues that the restraint is justified because bidding on engineering services is\ninherently imprecise, would lead to deceptively low bids, and would thereby tempt individual engineers to\ndo inferior work with consequent risk to public safety and health. The logic of this argument rests on the\nassumption that the agreement will tend to maintain the price level; if it had no such effect, it would not\nserve its intended purpose. The Society nonetheless invokes the Rule of Reason, arguing that its restraint\non price competition ultimately inures to the public benefit by preventing the production of inferior work\nand by insuring ethical behavior. As the preceding discussion of the Rule of Reason reveals, this Court has\nnever accepted such an argument.\nIt may be, as petitioner argues that competition tends to force prices down and that an inexpensive item\nmay be inferior to one that is more costly. There is some risk, therefore, that competition will cause some\nsuppliers to market a defective product. Similarly, competitive bidding for engineering projects may be\ninherently imprecise and incapable of taking into account all the variables which will be involved in the\nactual performance of the project. Based on these considerations, a purchaser might conclude that his\ninterest in quality\xe2\x80\x94which may embrace the safety of the end product\xe2\x80\x94outweighs the advantages of\nachieving cost savings by pitting one competitor against another. Or an individual vendor might\nindependently refrain from price negotiation until he has satisfied himself that he fully understands the\nscope of his customers\xe2\x80\x99 needs. These decisions might be reasonable; indeed, petitioner has provided\nample documentation for that thesis. But these are not reasons that satisfy the Rule; nor are such\nindividual decisions subject to antitrust attack.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n714\n\n\x0cThe Sherman Act does not require competitive bidding; it prohibits unreasonable restraints on\ncompetition. Petitioner\xe2\x80\x99s ban on competitive bidding prevents all customers from making price\ncomparisons in the initial selection of an engineer, and imposes the Society\xe2\x80\x99s views of the costs and\nbenefits of competition on the entire marketplace. It is this restraint that must be justified under the Rule\nof Reason, and petitioner\xe2\x80\x99s attempt to do so on the basis of the potential threat that competition poses to\nthe public safety and the ethics of its profession is nothing less than a frontal assault on the basic policy of\nthe Sherman Act.\nThe Sherman Act reflects a legislative judgment that ultimately competition will produce not only lower\nprices, but also better goods and services. \xe2\x80\x9cThe heart of our national economic policy long has been faith\nin the value of competition.\xe2\x80\x9d Standard Oil Co. v. FTC, 340 U.S. 231, 248. The assumption that competition\nis the best method of allocating resources in a free market recognizes that all elements of a bargain\xe2\x80\x94\nquality, service, safety, and durability\xe2\x80\x94and not just the immediate cost, are favorably affected by the free\nopportunity to select among alternative offers. Even assuming occasional exceptions to the presumed\nconsequences of competition, the statutory policy precludes inquiry into the question whether\ncompetition is good or bad.\n***\nIn sum, the Rule of Reason does not support a defense based on the assumption that competition itself is\nunreasonable. Such a view of the Rule would create the \xe2\x80\x9csea of doubt\xe2\x80\x9d on which Judge Taft refused to\nembark in Addyston, 85 F. 271 (1898), at 284, and which this Court has firmly avoided ever since.\n***\nThe judgment of the Court of Appeals is affirmed.\n\nCASE QUESTIONS\n1.\n\nWhat kinds of harms are likely if there is unrestrained competitive bidding among engineering firms?\n\n2.\n\nBy what other means (i.e., not including deliberate nondisclosure of price information up to the time\nof contracting) could the National Society of Professional Engineers protect the public from harm?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n715\n\n\x0cVertical Maximum Price Fixing and the Rule of Reason\nState Oil Company v. Barkat U Khan and Khan & Associates\n522 U.S. 3 (1997)\nBarkat U. Khan and his corporation entered into an agreement with State Oil Company to lease and\noperate a gas station and convenience store owned by State Oil. The agreement provided that Khan would\nobtain the station\xe2\x80\x99s gasoline supply from State Oil at a price equal to a suggested retail price set by State\nOil, less a margin of 3.25 cents per gallon. Under the agreement, respondents could charge any amount\nfor gasoline sold to the station\xe2\x80\x99s customers, but if the price charged was higher than State Oil\xe2\x80\x99s suggested\nretail price, the excess was to be rebated to State Oil. Respondents could sell gasoline for less than State\nOil\xe2\x80\x99s suggested retail price, but any such decrease would reduce their 3.25 cents-per-gallon margin.\nAbout a year after respondents began operating the gas station, they fell behind in lease payments. State\nOil then gave notice of its intent to terminate the agreement and commenced a state court proceeding to\nevict respondents. At State Oil\xe2\x80\x99s request, the state court appointed a receiver to operate the gas station.\nThe receiver operated the station for several months without being subject to the price restraints in\nrespondents\xe2\x80\x99 agreement with State Oil. According to respondents, the receiver obtained an overall profit\nmargin in excess of 3.25 cents per gallon by lowering the price of regular-grade gasoline and raising the\nprice of premium grades.\nRespondents sued State Oil in the United States District Court for the Northern District of Illinois,\nalleging in part that State Oil had engaged in price fixing in violation of \xc2\xa7 1 of the Sherman Act by\npreventing respondents from raising or lowering retail gas prices. According to the complaint, but for the\nagreement with State Oil, respondents could have charged different prices based on the grades of\ngasoline, in the same way that the receiver had, thereby achieving increased sales and profits. State Oil\nresponded that the agreement did not actually prevent respondents from setting gasoline prices, and that,\nin substance, respondents did not allege a violation of antitrust laws by their claim that State Oil\xe2\x80\x99s\nsuggested retail price was not optimal.\nThe District Court entered summary judgment for State Oil on this claim, [finding] that [Khan\xe2\x80\x99s\nallegations, if true]\xe2\x80\xa6did not establish the sort of \xe2\x80\x9cmanifestly anticompetitive implications or pernicious\neffect on competition\xe2\x80\x9d that would justify per se prohibition of State Oil\xe2\x80\x99s conduct. The Seventh Circuit\nreversed. The Court of Appeals for the Seventh Circuit reversed the District Court\xe2\x80\x99s grant of summary\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n716\n\n\x0cjudgment for State Oil on the basis of Albrecht v. Herald Co., 390 U.S. 14 (1968). 93 F.3d 1358 (1996). The\ncourt first noted that the agreement between respondents and State Oil did indeed fix maximum gasoline\nprices by making it \xe2\x80\x9cworthless\xe2\x80\x9d for respondents to exceed the suggested retail prices. After reviewing legal\nand economic aspects of price fixing, the court concluded that State Oil\xe2\x80\x99s pricing scheme was a per se\nantitrust violation under Albrecht v. Herald Co., supra. Although the Court of Appeals characterized\nAlbrecht as \xe2\x80\x9cunsound when decided\xe2\x80\x9d and \xe2\x80\x9cinconsistent with later decisions\xe2\x80\x9d of this Court, it felt\nconstrained to follow that decision. The Supreme Court granted certiorari.\nJustice Sandra Day O\xe2\x80\x99Connor\nWe granted certiorari to consider two questions, whether State Oil\xe2\x80\x99s conduct constitutes a per se violation\nof the Sherman Act and whether respondents are entitled to recover damages based on that conduct.\n****\nAlthough the Sherman Act, by its terms, prohibits every agreement \xe2\x80\x9cin restraint of trade,\xe2\x80\x9d this Court has\nlong recognized that Congress intended to outlaw only unreasonable restraints. See, e.g., Arizona v.\nMaricopa County Medical Soc., U.S. Supreme Court (1982). As a consequence, most antitrust claims are\nanalyzed under a \xe2\x80\x9crule of reason,\xe2\x80\x9d according to which the finder of fact must decide whether the\nquestioned practice imposes an unreasonable restraint on competition, taking into account a variety of\nfactors, including specific information about the relevant business, its condition before and after the\nrestraint was imposed, and the restraint\xe2\x80\x99s history, nature, and effect.\nSome types of restraints, however, have such predictable and pernicious anticompetitive effect, and such\nlimited potential for pro-competitive benefit, that they are deemed unlawful per se. Northern Pacific R.\nCo. v. United States, U.S. Supreme Court (1958). Per se treatment is appropriate \xe2\x80\x9conce experience with a\nparticular kind of restraint enables the Court to predict with confidence that the rule of reason will\ncondemn it.\xe2\x80\x9d Maricopa County (1982). Thus, we have expressed reluctance to adopt per se rules with\nregard to \xe2\x80\x9crestraints imposed in the context of business relationships where the economic impact of\ncertain practices is not immediately obvious.\xe2\x80\x9d FTC v. Indiana Federation of Dentists, U.S. Supreme Court\n(1986).\nA review of this Court\xe2\x80\x99s decisions leading up to and beyond Albrecht is relevant to our assessment of the\ncontinuing validity of the per se rule established in Albrecht. Beginning with Dr. Miles Medical Co. v.\nJohn D. Park & Sons Co., U.S. Supreme Court (1911), the Court recognized the illegality of agreements\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n717\n\n\x0cunder which manufacturers or suppliers set the minimum resale prices to be charged by their distributors.\nBy 1940, the Court broadly declared all business combinations \xe2\x80\x9cformed for the purpose and with the effect\nof raising, depressing, fixing, pegging, or stabilizing the price of a commodity in interstate or foreign\ncommerce\xe2\x80\x9d illegal per se. United States v. Socony-Vacuum Oil Co., U.S. Supreme Court (1940).\nAccordingly, the Court condemned an agreement between two affiliated liquor distillers to limit the\nmaximum price charged by retailers in Kiefer-Stewart Co. v. Joseph E. Seagram & Sons, Inc., U.S.\nSupreme Court (1951), noting that agreements to fix maximum prices, \xe2\x80\x9cno less than those to fix minimum\nprices, cripple the freedom of traders and thereby restrain their ability to sell in accordance with their own\njudgment.\xe2\x80\x9d\nIn subsequent cases, the Court\xe2\x80\x99s attention turned to arrangements through which suppliers imposed\nrestrictions on dealers with respect to matters other than resale price. In White Motor Co. v. United\nStates, U.S. Supreme Court (1963), the Court considered the validity of a manufacturer\xe2\x80\x99s assignment of\nexclusive territories to its distributors and dealers. The Court determined that too little was known about\nthe competitive impact of such vertical limitations to warrant treating them as per se unlawful. Four years\nlater, in United States v. Arnold, Schwinn & Co., U.S. Supreme Court (1967), the Court reconsidered the\nstatus of exclusive dealer territories and held that, upon the transfer of title to goods to a distributor, a\nsupplier\xe2\x80\x99s imposition of territorial restrictions on the distributor was \xe2\x80\x9cso obviously destructive of\ncompetition\xe2\x80\x9d as to constitute a per se violation of the Sherman Act. In Schwinn, the Court acknowledged\nthat some vertical restrictions, such as the conferral of territorial rights or franchises, could have procompetitive benefits by allowing smaller enterprises to compete, and that such restrictions might avert\nvertical integration in the distribution process. The Court drew the line, however, at permitting\nmanufacturers to control product marketing once dominion over the goods had passed to dealers.\nAlbrecht, decided [a year after Schwinn], involved a newspaper publisher who had granted exclusive\nterritories to independent carriers subject to their adherence to a maximum price on resale of the\nnewspapers to the public. Influenced by its decisions in Socony-Vacuum, Kiefer-Stewart, and Schwinn,\nthe Court concluded that it was per se unlawful for the publisher to fix the maximum resale price of its\nnewspapers. The Court acknowledged that \xe2\x80\x9cmaximum and minimum price fixing may have different\nconsequences in many situations,\xe2\x80\x9d but nonetheless condemned maximum price fixing for \xe2\x80\x9csubstituting\nthe perhaps erroneous judgment of a seller for the forces of the competitive market.\xe2\x80\x9d\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n718\n\n\x0cNine years later, in Continental T. V., Inc. v. GTE Sylvania, Inc., 433 U.S. 36, 53 L. Ed. 2d 568, 97 S. Ct.\n2549 (1977), the Court overruled Schwinn, thereby rejecting application of a per se rule in the context of\nvertical non-price restrictions. The Court acknowledged the principle of stare decisis, but explained that\nthe need for clarification in the law justified reconsideration of Schwinn:\n\xe2\x80\x9cSince its announcement, Schwinn has been the subject of continuing controversy and confusion, both in\nthe scholarly journals and in the federal courts. The great weight of scholarly opinion has been critical of\nthe decision, and a number of the federal courts confronted with analogous vertical restrictions have\nsought to limit its reach. In our view, the experience of the past 10 years should be brought to bear on this\nsubject of considerable commercial importance.\xe2\x80\x9d\nThe Court then reviewed scholarly works supporting the economic utility of vertical non-price\nrestraints.\xe2\x80\xa6The Court concluded that, because \xe2\x80\x9cdeparture from the rule-of-reason standard must be\nbased upon demonstrable economic effect rather than\xe2\x80\x94as in Schwinn\xe2\x80\x94upon formalistic line drawing,\xe2\x80\x9d\nthe appropriate course would be \xe2\x80\x9cto return to the rule of reason that governed vertical restrictions prior\nto Schwinn.\xe2\x80\x9d Sylvania (1977)\n***\nSubsequent decisions of the Court\xe2\x80\xa6have hinted that the analytical underpinnings of Albrecht were\nsubstantially weakened by Sylvania. We noted in Maricopa County that vertical restraints are generally\nmore defensible than horizontal restraints\xe2\x80\xa6and that decisions such as Sylvania \xe2\x80\x9crecognize the possibility\nthat a vertical restraint imposed by a single manufacturer or wholesaler may stimulate inter-brand\ncompetition even as it reduces intra-brand competition.\xe2\x80\x9d\n[I]n Atlantic Richfield Co. v. USA Petroleum Co. (ARCO), U.S. Supreme Court (1990),\nalthough Albrecht\xe2\x80\x99s continuing validity was not squarely before the Court, some disfavor with that\ndecision was signaled by our statement that we would \xe2\x80\x9cassume, arguendo, that Albrecht correctly held\nthat vertical, maximum price fixing is subject to the per se rule.\xe2\x80\x9d More significantly, we specifically\nacknowledged that vertical maximum price fixing \xe2\x80\x9cmay have procompetitive inter-brand effects,\xe2\x80\x9d and\npointed out that, in the wake of GTE Sylvania, \xe2\x80\x9cthe procompetitive potential of a vertical maximum price\nrestraint is more evident\xe2\x80\xa6than it was when Albrecht was decided, because exclusive territorial\narrangements and other non-price restrictions were unlawful per se in 1968.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n719\n\n\x0cThus, our reconsideration of Albrecht\xe2\x80\x99s continuing validity is informed by several of our decisions, as well\nas a considerable body of scholarship discussing the effects of vertical restraints. Our analysis is also\nguided by our general view that the primary purpose of the antitrust laws is to protect inter-brand\ncompetition. See, e.g., Business Electronics Corp. v. Sharp Electronics Corp., 485 U.S. 717, 726, 99 L. Ed.\n2d 808, 108 S. Ct. 1515 (1988). \xe2\x80\x9cLow prices,\xe2\x80\x9d we have explained, \xe2\x80\x9cbenefit consumers regardless of how\nthose prices are set, and so long as they are above predatory levels, they do not threaten competition.\xe2\x80\x9d\nARCO, supra, at 340. Our interpretation of the Sherman Act also incorporates the notion that\ncondemnation of practices resulting in lower prices to consumers is \xe2\x80\x9cespecially costly\xe2\x80\x9d because \xe2\x80\x9ccutting\nprices in order to increase business often is the very essence of competition.\xe2\x80\x9d\nSo informed, we find it difficult to maintain that vertically-imposed maximum prices could harm\nconsumers or competition to the extent necessary to justify their per se invalidation. As Chief Judge\nPosner wrote for the Court of Appeals in this case:\nAs for maximum resale price fixing, unless the supplier is a monopolist he cannot squeeze his dealers\xe2\x80\x99\nmargins below a competitive level; the attempt to do so would just drive the dealers into the arms of a\ncompeting supplier. A supplier might, however, fix a maximum resale price in order to prevent his dealers\nfrom exploiting a monopoly position.\xe2\x80\xa6Suppose that State Oil, perhaps to encourage\xe2\x80\xa6dealer services\xe2\x80\xa6has\nspaced its dealers sufficiently far apart to limit competition among them (or even given each of them an\nexclusive territory); and suppose further that Union 76 is a sufficiently distinctive and popular brand to\ngive the dealers in it at least a modicum of monopoly power. Then State Oil might want to place a ceiling\non the dealers\xe2\x80\x99 resale prices in order to prevent them from exploiting that monopoly power fully. It would\ndo this not out of disinterested malice, but in its commercial self-interest. The higher the price at which\ngasoline is resold, the smaller the volume sold, and so the lower the profit to the supplier if the higher\nprofit per gallon at the higher price is being snared by the dealer.\xe2\x80\x9d 93 F.3d at 1362.\nWe recognize that the Albrecht decision presented a number of theoretical justifications for a per se rule\nagainst vertical maximum price fixing. But criticism of those premises abounds. The Albrecht decision\nwas grounded in the fear that maximum price fixing by suppliers could interfere with dealer freedom. 390\nU.S. at 152. In response, as one commentator has pointed out, \xe2\x80\x9cthe ban on maximum resale price\nlimitations declared in Albrecht in the name of \xe2\x80\x98dealer freedom\xe2\x80\x99 has actually prompted many suppliers to\nintegrate forward into distribution, thus eliminating the very independent trader for whom Albrecht\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n720\n\n\x0cprofessed solicitude.\xe2\x80\x9d 7 P. Areeda, Antitrust Law, P1635, p. 395 (1989). For example, integration in the\nnewspaper industry since Albrecht has given rise to litigation between independent distributors and\npublishers.\nThe Albrecht Court also expressed the concern that maximum prices may be set too low for dealers to\noffer consumers essential or desired services. 390 U.S. at 152-153. But such conduct, by driving away\ncustomers, would seem likely to harm manufacturers as well as dealers and consumers, making it unlikely\nthat a supplier would set such a price as a matter of business judgment.\xe2\x80\xa6 In addition, Albrecht noted that\nvertical maximum price fixing could effectively channel distribution through large or specially-advantaged\ndealers. 390 U.S. at 153. It is unclear, however, that a supplier would profit from limiting its market by\nexcluding potential dealers. See, e.g., Easterbrook, supra, at 905-908. Further, although vertical\nmaximum price fixing might limit the viability of inefficient dealers, that consequence is not necessarily\nharmful to competition and consumers.\nFinally, Albrecht reflected the Court\xe2\x80\x99s fear that maximum price fixing could be used to disguise\narrangements to fix minimum prices, 390 U.S. at 153, which remain illegal per se. Although we have\nacknowledged the possibility that maximum pricing might mask minimum pricing, see Maricopa County,\n457 U.S. at 348, we believe that such conduct\xe2\x80\x94as with the other concerns articulated in Albrecht\xe2\x80\x94can be\nappropriately recognized and punished under the rule of reason.\xe2\x80\xa6After reconsidering Albrecht\xe2\x80\x99s rationale\nand the substantial criticism the decision has received, however, we conclude that there is insufficient\neconomic justification for per se invalidation of vertical maximum price fixing.\n***\nDespite what Chief Judge Posner aptly described as Albrecht\xe2\x80\x99s \xe2\x80\x9cinfirmities, [and] its increasingly wobbly,\nmoth-eaten foundations,\xe2\x80\x9d there remains the question whether Albrecht deserves continuing respect under\nthe doctrine of stare decisis. The Court of Appeals was correct in applying that principle despite\ndisagreement with Albrecht, for it is this Court\xe2\x80\x99s prerogative alone to overrule one of its precedents.\xe2\x80\xa6We\napproach the reconsideration of decisions of this Court with the utmost caution. Stare decisis reflects \xe2\x80\x9ca\npolicy judgment that \xe2\x80\x98in most matters it is more important that the applicable rule of law be settled than\nthat it be settled right.\xe2\x80\x99\xe2\x80\x9d Agostini v. Felton, U.S. Supreme Court (1997).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n721\n\n\x0cBut \xe2\x80\x9cstare decisis is not an inexorable command.\xe2\x80\x9d Payne v. Tennessee, U.S. Supreme Court (1991). In the\narea of antitrust law, there is a competing interest, well-represented in this Court\xe2\x80\x99s decisions, in\nrecognizing and adapting to changed circumstances and the lessons of accumulated experience.\n\xe2\x80\xa6With the views underlying Albrecht eroded by this Court\xe2\x80\x99s precedent, there is not much of that decision\nto salvage.\xe2\x80\xa6 [W]e find its conceptual foundations gravely weakened. In overruling Albrecht, we of course\ndo not hold that all vertical maximum price fixing is per se lawful. Instead, vertical maximum price fixing,\nlike the majority of commercial arrangements subject to the antitrust laws, should be evaluated under the\nrule of reason.\n\nCASE QUESTIONS\n1.\n\nWhat does Judge Posner of the Seventh Circuit mean when he uses the termmonopsonist? Is he\nreferring to the respondent (Khan and Associates) or to the State Oil Company?\n\n2.\n\nExplain why State Oil Company would want to set a maximum price. What business benefit is it for\nState Oil Company?\n\n3.\n\nThe court clearly states that setting maximum price is no longer a per se violation of the Sherman Act\nand is thus a rule of reason analysis in each case. What about setting minimum prices? Is setting\nminimum prices per se illegal, illegal if it does not pass the rule of reason standard, or entirely legal?\n\nAcquiring and Maintaining a Monopoly\nUnited States v. Aluminum Company of America\n148 F.2d 416 (2d Cir. 1945)\nJUDGE LEARNED HAND\nIt does not follow because \xe2\x80\x9cAlcoa\xe2\x80\x9d had such a monopoly that it \xe2\x80\x9cmonopolized\xe2\x80\x9d the ingot market: it may\nnot have achieved monopoly; monopoly may have been thrust upon it. If it had been a combination of\nexisting smelters which united the whole industry and controlled the production of all aluminum ingot, it\nwould certainly have \xe2\x80\x9cmonopolized\xe2\x80\x9d the market.\xe2\x80\xa6We may start therefore with the premise that to have\ncombined ninety percent of the producers of ingot would have been to \xe2\x80\x9cmonopolize\xe2\x80\x9d the ingot market;\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n722\n\n\x0cand, so far as concerns the public interest, it can make no difference whether an existing competition is\nput an end to, or whether prospective competition is prevented.\xe2\x80\xa6\nNevertheless, it is unquestionably true that from the very outset the courts have at least kept in reserve\nthe possibility that the origin of a monopoly may be critical in determining its legality; and for this they\nhad warrant in some of the congressional debates which accompanied the passage of the Act.\xe2\x80\xa6This notion\nhas usua1ly been expressed by saying that size does not determine guilt; that there must be some\n\xe2\x80\x9cexclusion\xe2\x80\x9d of competitors; that the growth must be something else than \xe2\x80\x9cnatural\xe2\x80\x9d or \xe2\x80\x9cnormal\xe2\x80\x9d; that there\nmust be a \xe2\x80\x9cwrongful intent,\xe2\x80\x9d or some other specific intent; or that some \xe2\x80\x9cunduly\xe2\x80\x9d coercive means must be\nused. At times there has been emphasis upon the use of the active verb, \xe2\x80\x9cmonopolize,\xe2\x80\x9d as the judge noted\nin the case at bar.\nA market may, for example, be so limited that it is impossible to produce at all and meet the cost of\nproduction except by a plant large enough to supply the whole demand. Or there may be changes in taste\nor in cost which drive out all but one purveyor. A single producer may be the survivor out of a group of\nactive competitors, merely by virtue of his superior skill, foresight, and industry. In such cases a strong\nargument can be made that, although the result may expose the public to the evils of monopoly, the Act\ndoes not mean to condemn the resultant of those very forces which it is its prime object to foster: finis\nopus coronal. The successful competitor, having been urged to compete, must not be turned upon when\nhe wins.\n***\n[As] Cardozo, J., in United States v. Swift & Co., 286 U.S. 106, p. 116, 52 S. Ct. 460, 463, 76 L.Ed.\n999,\xe2\x80\xa6said, \xe2\x80\x9cMere size\xe2\x80\xa6is not an offense against the Sherman Act unless magnified to the point at which it\namounts to a monopoly\xe2\x80\xa6but size carries with it an opportunity for abuse that is not to be ignored when\nthe opportunity is proved to have been utilized in the past.\xe2\x80\x9d \xe2\x80\x9cAlcoa\xe2\x80\x99s\xe2\x80\x9d size was \xe2\x80\x9cmagnified\xe2\x80\x9d to make it a\n\xe2\x80\x9cmonopoly\xe2\x80\x9d; indeed, it has never been anything else; and its size not only offered it an \xe2\x80\x9copportunity for\nabuse,\xe2\x80\x9d but it \xe2\x80\x9cutilized\xe2\x80\x9d its size for \xe2\x80\x9cabuse,\xe2\x80\x9d as can easily be shown.\nIt would completely misconstrue \xe2\x80\x9cAlcoa\xe2\x80\x99s\xe2\x80\x9d position in 1940 to hold that it was the passive beneficiary of a\nmonopoly, following upon an involuntary elimination of competitors by automatically\noperative economic forces. Already in 1909, when its last lawful monopoly ended, it sought to strengthen\nits position by unlawful practices, and these concededly continued until 1912. In that year it had two\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n723\n\n\x0cplants in New York, at which it produced less than 42 million pounds of ingot; in 1934 it had five plants\n(the original two, enlarged; one in Tennessee; one in North Carolina; one in Washington), and its\nproduction had risen to about 327 million pounds, an increase of almost eight-fold. Meanwhile not a\npound of ingot had been produced by anyone else in the United States. This increase and this continued\nand undisturbed control did not fall un-designed into \xe2\x80\x9cAlcoa\xe2\x80\x99s\xe2\x80\x9d lap; obviously it could not have done so. It\ncould only have resulted, as it did result, from a persistent determination to maintain the control, with\nwhich it found itself vested in 1912. There were at least one or two abortive attempts to enter the industry,\nbut \xe2\x80\x9cAlcoa\xe2\x80\x9d effectively anticipated and forestalled all competition, and succeeded in holding the field\nalone. True, it stimulated demand and opened new uses for the metal, but not without making sure that it\ncould supply what it had evoked. There is no dispute as to this; \xe2\x80\x9cAlcoa\xe2\x80\x9d avows it as evidence of the skill,\nenergy and initiative with which it has always conducted its business: as a reason why, having won its way\nby fair means, it should be commended, and not dismembered. We need charge it with no moral\nderelictions after 1912; we may assume that all its claims for itself are true. The only question is whether it\nfalls within the exception established in favor of those who do not seek, but cannot avoid, the control of a\nmarket. It seems to us that that question scarcely survives its statement. It was not inevitable that it\nshould always anticipate increases in the demand for ingot and be prepared to supply them. Nothing\ncompelled it to keep doubling and redoubling its capacity before others entered the field. It insists that it\nnever excluded competitors; but we can think of no more effective exclusion than progressively to\nembrace each new opportunity as it opened, and to face every newcomer with new capacity already geared\ninto a great organization, having the advantage of experience, trade connections and the elite of\npersonnel. Only in case we interpret \xe2\x80\x9cexclusion\xe2\x80\x9d as limited to maneuvers not honestly industrial, but\nactuated solely by a desire to prevent competition, can such a course, indefatigably pursued, be deemed\nnot \xe2\x80\x9cexclusionary.\xe2\x80\x9d So to limit it would in our judgment emasculate the Act; would permit just such\nconsolidations as it was designed to prevent.\nWe disregard any question of \xe2\x80\x9cintent.\xe2\x80\x9d Relatively early in the history of the Act\xe2\x80\x941905\xe2\x80\x94Holmes, J., in\nSwift & Co. v. United States, explained this aspect of the Act in a passage often quoted. Although the\nprimary evil was monopoly, the Act also covered preliminary steps, which, if continued, would lead to it.\nThese may do no harm of themselves; but if they are initial moves in a plan or scheme which, carried out,\nwill result in monopoly, they are dangerous and the law will nip them in the bud.\xe2\x80\xa6In order to fall within \xc2\xa7\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n724\n\n\x0c2, the monopolist must have both the power to monopolize, and the intent to monopolize. To read the\npassage as demanding any \xe2\x80\x9cspecific,\xe2\x80\x9d intent, makes nonsense of it, for no monopolist monopolizes\nunconscious of what he is doing. So here, \xe2\x80\x9cAlcoa\xe2\x80\x9d meant to keep, and did keep, that complete and\nexclusive hold upon the ingot market with which it started. That was to \xe2\x80\x9cmonopolize\xe2\x80\x9d that market,\nhowever innocently it otherwise proceeded. So far as the judgment held that it was not within \xc2\xa7 2, it must\nbe reversed.\n\nCASE QUESTIONS\n1.\n\nJudge Learned Hand claims there would be no violation of the Sherman Act in any case where\na company achieves monopoly through \xe2\x80\x9cnatural\xe2\x80\x9d or \xe2\x80\x9cnormal\xe2\x80\x9d operation of the market.\n\na.\n\nWhat language in the Sherman Act requires the plaintiff to show something more than a\ncompany\xe2\x80\x99s monopoly status?\n\nb.\n\nWhat specifics, if any, does Judge Hand provide that indicate that Alcoa not only had market\ndominance but sought to increase its dominance and to exclude competition?\nCan you think of a single producer in a given product or geographic market that has achieved that\n\nstatus because of \xe2\x80\x9cpeer skill, foresight, and industry\xe2\x80\x9d? Is there anything wrong with Alcoa\xe2\x80\x99s selling the\nconcept of aluminum products to an ever-increasing set of customers and then also ensuring that it\nhad the capacity to meet the increasing demand?\nTo stimulate inter-brand competition, would you recommend that Congress change Section 2 so\nthat any company that had over 80 percent of market share would be \xe2\x80\x9cbroken up\xe2\x80\x9d to ensure\ncompetition? Why is this a bad idea? Or why do you think it is a good idea?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n725\n\n\x0cInnovation and Intent to Monopolize\nBerkey Photo, Inc. v. Eastman Kodak Company\n603 F.2d 263 (2d Cir. 1979)\nIRVING R. KAUFMAN, CHIEF JUDGE\nTo millions of Americans, the name Kodak is virtually synonymous with photography.\xe2\x80\xa6It is one of the\ngiants of American enterprise, with international sales of nearly $6 billion in 1977 and pre-tax profits in\nexcess of $1.2 billion.\nThis action, one of the largest and most significant private antitrust suits in history, was brought by\nBerkey Photo, Inc., a far smaller but still prominent participant in the industry. Berkey competes with\nKodak in providing photofinishing services\xe2\x80\x94the conversion of exposed film into finished prints, slides, or\nmovies. Until 1978, Berkey sold cameras as well. It does not manufacture film, but it does purchase Kodak\nfilm for resale to its customers, and it also buys photofinishing equipment and supplies, including color\nprint paper, from Kodak.\nThe two firms thus stand in a complex, multifaceted relationship, for Kodak have been Berkey\xe2\x80\x99s\ncompetitor in some markets and its supplier in others. In this action, Berkey claims that every aspect of\nthe association has been infected by Kodak\xe2\x80\x99s monopoly power in the film, color print paper, and camera\nmarkets, willfully acquired, maintained, and exercised in violation of \xc2\xa7 2 of the Sherman Act, 15 U.S.C. \xc2\xa7\n2.\xe2\x80\xa6Berkey alleges that these violations caused it to lose sales in the camera and photofinishing markets\nand to pay excessive prices to Kodak for film, color print paper, and photofinishing equipment.\n***\n[T]he jury found for Berkey on virtually every point, awarding damages totaling $37,620,130. Judge\nFrankel upheld verdicts aggregating $27,154,700 for lost camera and photofinishing sales and for\nexcessive prices on film and photofinishing equipment.\xe2\x80\xa6Trebled and supplemented by attorneys\xe2\x80\x99 fees and\ncosts pursuant to \xc2\xa7 4 of the Clayton Act, 15 U.S.C. \xc2\xa7 15, Berkey\xe2\x80\x99s judgment reached a grand total of\n$87,091,309.47, with interest, of course, continuing to accrue.\nKodak now appeals this judgment.\nThe principal markets relevant here, each nationwide in scope, are amateur conventional still cameras,\nconventional photographic film, photofinishing services, photofinishing equipment, and color print paper.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n726\n\n\x0cThe \xe2\x80\x9camateur conventional still camera\xe2\x80\x9d market now consists almost entirely of the so-called 110 and 126\ninstant-loading cameras. These are the direct descendants of the popular \xe2\x80\x9cbox\xe2\x80\x9d cameras, the best-known\nof which was Kodak\xe2\x80\x99s so-called \xe2\x80\x9cBrownie.\xe2\x80\x9d Small, simple, and relatively inexpensive, cameras of this type\nare designed for the mass market rather than for the serious photographer.\nKodak has long been the dominant firm in the market thus defined. Between 1954 and 1973 it never\nenjoyed less than 61% of the annual unit sales, nor less than 64% of the dollar volume, and in the peak\nyear of 1964, Kodak cameras accounted for 90% of market revenues. Much of this success is no doubt due\nto the firm\xe2\x80\x99s history of innovation.\nBerkey has been a camera manufacturer since its 1966 acquisition of the Keystone Camera Company, a\nproducer of movie cameras and equipment. In 1968 Berkey began to sell amateur still cameras made by\nother firms, and the following year the Keystone Division commenced manufacturing such cameras itself.\nFrom 1970 to 1977, Berkey accounted for 8.2% of the sales in the camera market in the United States,\nreaching a peak of 10.2% in 1976. In 1978, Berkey sold its camera division and thus abandoned this\nmarket.\n***\nOne must comprehend the fundamental tension\xe2\x80\x94one might almost say the paradox\xe2\x80\x94that is near the\nheart of \xc2\xa7 2\xe2\x80\xa6\nThe conundrum was indicated in characteristically striking prose by Judge Hand, who was not able to\nresolve it. Having stated that Congress \xe2\x80\x9cdid not condone \xe2\x80\x98good trusts\xe2\x80\x99 and condemn \xe2\x80\x98bad\xe2\x80\x99 ones; it forbad\nall,\xe2\x80\x9d he declared with equal force, \xe2\x80\x9cThe successful competitor, having been urged to compete, must not be\nturned upon when he wins.\xe2\x80\x9d\xe2\x80\xa6We must always be mindful lest the Sherman Act be invoked perversely in\nfavor of those who seek protection against the rigors of competition.\n***\nIn sum, although the principles announced by the \xc2\xa7 2 cases often appear to conflict, this much is clear.\nThe mere possession of monopoly power does notipso facto condemns a market participant. But, to avoid\nthe proscriptions of \xc2\xa7 2, the firm must refrain at all times from conduct directed at smothering\ncompetition. This doctrine has two branches. Unlawfully acquired power remains anathema even when\nkept dormant. And it is no less true that a firm with a legitimately achieved monopoly may not wield the\nresulting power to tighten its hold on the market.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n727\n\n\x0c***\nAs Kodak had hoped, the 110 system proved to be a dramatic success. In 1972\xe2\x80\x94the system\xe2\x80\x99s first year\xe2\x80\x94the\ncompany sold 2,984,000 Pocket Instamatics, more than 50% of its sales in the amateur conventional still\ncamera market. The new camera thus accounted in large part for a sharp increase in total market sales,\nfrom 6.2 million units in 1971 to 8.2 million in 1972\xe2\x80\xa6\nBerkey\xe2\x80\x99s Keystone division was a late entrant in the 110 sweepstakes, joining the competition only in late\n1973. Moreover, because of hasty design, the original models suffered from latent defects, and sales that\nyear were a paltry 42,000. With interest in the 126 dwindling, Keystone thus suffered a net decline of\n118,000 unit sales in 1973. The following year, however, it recovered strongly, in large part because\nimprovements in its pocket cameras helped it sell 406,000 units, 7% of all 110s sold that year.\nBerkey contends that the introduction of the 110 system was both an attempt to monopolize and actual\nmonopolization of the camera market.\n***\nIt will be useful at the outset to present the arguments on which Berkey asks us to uphold its verdict:\nKodak, a film and camera monopolist was in a position to set industry standards. Rivals could not\ncompete effectively without offering products similar to Kodak\xe2\x80\x99s. Moreover, Kodak persistently refused to\nmake film available for most formats other than those in which it made cameras. Since cameras are\nworthless without film, this policy effectively prevented other manufacturers from introducing cameras in\nnew formats. Because of its dominant position astride two markets, and by use of its film monopoly to\ndistort the camera market, Kodak forfeited its own right to reap profits from such innovations without\nproviding its rivals with sufficient advance information to enable them to enter the market with copies of\nthe new product on the day of Kodak\xe2\x80\x99s introduction. This is one of several \xe2\x80\x9cpredisclosure\xe2\x80\x9d arguments\nBerkey has advanced in the course of this litigation.\n***\nThrough the 1960s, Kodak followed a checkered pattern of predisclosing innovations to various segments\nof the industry. Its purpose on these occasions evidently was to ensure that the industry would be able to\nmeet consumers\xe2\x80\x99 demand for the complementary goods and services they would need to enjoy the new\nKodak products. But predisclosure would quite obviously also diminish Kodak\xe2\x80\x99s share of the auxiliary\nmarkets. It was therefore, in the words of Walter Fallon, Kodak\xe2\x80\x99s chief executive officer, \xe2\x80\x9ca matter of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n728\n\n\x0cjudgment on each and every occasion\xe2\x80\x9d whether predisclosure would be for or against Kodak\xe2\x80\x99s selfinterest. Kodak decided not to release advance information about the new film and format. The decision\nwas evidently based on the perception of Dr. Louis K. Eilers, Kodak\xe2\x80\x99s chief executive officer at that time\nthat Kodak would gain more from being first on the market for the sale of all goods and services related to\nthe 110 system than it would lose from the inability of other photofinishers to process Kodacolor II.\nJudge Frankel did not decide that Kodak should have disclosed the details of the 110 to other camera\nmanufacturers prior to introduction. Instead, he left the matter to the jury\xe2\x80\xa6We hold that this instruction\nwas in error and that, as a matter of law, Kodak did not have a duty to predisclose information about the\n110 system to competing camera manufacturers.\nAs Judge Frankel indicated, and as Berkey concedes, a firm may normally keep its innovations secret from\nits rivals as long as it wishes, forcing them to catch up on the strength of their own efforts after the new\nproduct is introduced. It is the possibility of success in the marketplace, attributable to superior\nperformance that provides the incentives on which the proper functioning of our competitive economy\nrests\xe2\x80\xa6\nWithholding from others advance knowledge of one\xe2\x80\x99s new products, therefore, ordinarily constitutes valid\ncompetitive conduct. Because, as we have already indicated, a monopolist is permitted, and indeed\nencouraged, by \xc2\xa7 2 to compete aggressively on the merits, any success that it may achieve through \xe2\x80\x9cthe\nprocess of invention and innovation\xe2\x80\x9d is clearly tolerated by the antitrust laws.\n***\nMoreover, enforced predisclosure would cause undesirable consequences beyond merely encouraging the\nsluggishness the Sherman Act was designed to prevent. A significant vice of the theory propounded by\nBerkey lies in the uncertainty of its application. Berkey does not contend, in the colorful phrase of Judge\nFrankel, that \xe2\x80\x9cKodak has to live in a goldfish bowl,\xe2\x80\x9d disclosing every innovation to the world at large.\nHowever predictable in its application, such an extreme rule would be insupportable. Rather, Berkey\npostulates that Kodak had a duty to disclose limited types of information to certain competitors under\nspecific circumstances. But it is difficult to comprehend how a major corporation, accustomed though it is\nto making business decisions with antitrust considerations in mind, could possess the omniscience to\nanticipate all the instances in which a jury might one day in the future retrospectively conclude that\npredisclosure was warranted. And it is equally difficult to discern workable guidelines that a court might\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n729\n\n\x0cset forth to aid the firm\xe2\x80\x99s decision. For example, how detailed must the information conveyed be? And\nhow far must research have progressed before it is \xe2\x80\x9cripe\xe2\x80\x9d for disclosure? These inherent uncertainties\nwould have an inevitable chilling effect on innovation. They go far, we believe, towards explaining why no\ncourt has ever imposed the duty Berkey seeks to create here.\n***\nWe do not perceive, however, how Kodak\xe2\x80\x99s introduction of a new format was rendered an unlawful act of\nmonopolization in the camera market because the firm also manufactured film to fit the cameras. \xe2\x80\x9cThe\n110 system was in substantial part a camera development.\xe2\x80\xa6\xe2\x80\x9d\nClearly, then, the policy considerations militating against predisclosure requirements for monolithic\nmonopolists are equally applicable here. The first firm, even a monopolist, to design a new camera format\nhas a right to the lead time that follows from its success. The mere fact that Kodak manufactured film in\nthe new format as well, so that its customers would not be offered worthless cameras, could not deprive it\nof that reward.\n***\nConclusion We have held that Kodak did not have an obligation, merely because it introduced film and\ncamera in a new format, to make any predisclosure to its camera-making competitors. Nor did the earlier\nuse of its film monopoly to foreclose format innovation by those competitors create of its own force such a\nduty where none had existed before. In awarding Berkey $15,250,000, just $828,000 short of the\nmaximum amount demanded, the jury clearly based its calculation of lost camera profits on Berkey\xe2\x80\x99s\ncentral argument that it had a right to be \xe2\x80\x9cat the starting line when the whistle blew\xe2\x80\x9d for the new system.\nThe verdict, therefore, cannot stand.\n\nCASE QUESTIONS\n1.\n\nConsider patent law. Did Kodak have a legal monopoly on the 110 system (having invented it) for\nseventeen years? Did it have any legal obligation to share the technology with others?\n\n2.\n\nMight it have been better business strategy to give predisclosure to Berkey and others about the\nnecessary changes in film that would come about with the introduction of the 110 camera? How so, or\nwhy not? Is there any way that some sort of predisclosure to Berkey and others would maintain or\nsustain good relations with competitors?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n730\n\n\x0c16.9 Summary and Exercises\nSummary\nFour basic antitrust laws regulate the competitive activities of US business: the Sherman Act, the Clayton\nAct, the Federal Trade Commission Act, and the Robinson-Patman Act. The Sherman Act prohibits\nrestraints of trade and monopolizing. The Clayton Act prohibits a variety of anticompetitive acts,\nincluding mergers and acquisitions that might tend to lessen competition. The Federal Trade Commission\nAct prohibits unfair methods of competition and unfair and deceptive acts or practices in commerce. The\nRobinson-Patman Act prohibits a variety of price discriminations. (This act is actually an amendment to\nthe Clayton Act.) These laws are enforced in four ways: (1) by the US Department of Justice, Antitrust\nDivision; (2) by the Federal Trade Commission; (3) by state attorneys general; and (4) by private litigants.\nThe courts have interpreted Section 1 of the Sherman Act, prohibiting every contract, combination, or\nconspiracy in restraint of trade, by using a rule of reason. Thus reasonable restraints that are ancillary to\nlegitimate business practices are lawful. But some acts are per se unreasonable, such as price-fixing, and\nwill violate Section 1. Section 1 restraints of trade include both horizontal and vertical restraints of trade.\nVertical restraints of trade include resale price maintenance, refusals to deal, and unreasonable territorial\nrestrictions on distributors. Horizontal restraints of trade include price-fixing, exchanging price\ninformation when doing so permits industry members to control prices, controlling output, regulating\ncompetitive methods, allocating territories, exclusionary agreements, and boycotts.\nExclusive dealing contracts and tying contracts whose effects may be to substantially lessen\ncompetition violate Section 3 of the Clayton Act and may also violate both Section 1 of the Sherman Act\nand Section 5 of the Federal Trade Commission Act. Requirements and supply contracts are unlawful if\nthey tie up so much of a commodity that they tend substantially to lessen competition or might tend to do\nso.\nThe Robinson-Patman Act (Section 2 of the Clayton Act) prohibits price discrimination for different\npurchasers of commodities of like grade and quality if the effect may be substantially to (1) lessen\ncompetition or tend to create a monopoly in any line of commerce or (2) impair competition with (a) any\nperson who grants or (b) knowingly receives the benefit of the discrimination, or (c) with customers of\neither of them.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n731\n\n\x0cSome industries and groups are insulated from the direct reach of the antitrust laws. These include\nindustries separately regulated under federal law, organized labor, and insurance companies, activities\nmandated under state law, group solicitation government action, and baseball.\nSection 2 of the Sherman Act prohibits monopolizing or attempting to monopolize any part of interstate\nor foreign trade or commerce. The law does not forbid monopoly as such but only acts or attempts or\nconspiracies to monopolize. The prohibition includes the monopolist who has acquired his monopoly\nthrough illegitimate means.\nThree factors are essential in a Section 2 case: (1) relevant market for determining dominance, (2) the\ndegree of monopoly power, and (3) the particular acts claimed to be illegitimate.\nRelevant market has two dimensions: product market and geographic market. Since many goods have\nclose substitutes, the courts look to the degree to which consumers will shift to other goods or suppliers if\nthe price of the commodity or service in question is priced in a monopolistic way. This test is known as\ncross-elasticity of demand. If the cross-elasticity is high\xe2\x80\x94meaning that consumers will readily shift\xe2\x80\x94then\nthe other goods or services must be included in the product market definition, thus reducing the share of\nthe market that the defendant will be found to have. The geographic market is not the country as a whole,\nbecause Section 2 speaks in terms of \xe2\x80\x9cany part\xe2\x80\x9d of trade or commerce. Usually the government or private\nplaintiff will try to show that the geographic market is small, since that will tend to give the alleged\nmonopolist a larger share of it.\nMarket power in general means the share of the relevant market that the alleged monopolist enjoys. The\nlaw does not lay down fixed percentages, though various decisions seem to suggest that two-thirds of the\nmarket might be too low but three-quarters high enough to constitute monopoly power.\nActs that were aimed at or had the probable effect of excluding competitors from the market are acts of\nmonopolizing. Examples are predatory pricing and boycotts. Despite repeated claims during the 1970s\nand 1980s by smaller competitors, large companies have prevailed in court against the argument that\ninnovation suddenly sprung on the market without notice is per se evidence of intent to monopolize.\nRemedies for Sherman Act Section 2 violations include damages, injunction, and divestiture. These\nremedies are also available in Clayton Act Section 7 cases.\nSection 7 prohibits mergers or acquisitions that might tend to lessen competition in any line of commerce\nin any section of the country. Mergers and acquisitions are usually classified in one of three ways:\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n732\n\n\x0chorizontal (between competitors), vertical (between different levels of the distribution chain), or\nconglomerate (between businesses that are not directly related). The latter may be divided into productextension and market-expansion mergers. The relevant market test is different than in monopolization\ncases; in a Section 7 action, relevance of market may be proved.\nIn assessing horizontal mergers, the courts will look to the market shares of emerging companies,\nindustry concentration ratios, and trends toward concentration in the industry. To prove a Section 7 case,\nthe plaintiff must show that the merger forecloses competition \xe2\x80\x9cin a substantial share of\xe2\x80\x9d a substantial\nmarket. Conglomerate merger cases are harder to prove and require a showing of specific potential\neffects, such as raising barriers to entry into an industry and thus entrenching monopoly, or eliminating\npotential competition. Joint ventures may also be condemned by Section 7. The Hart-Scott-Rodino\nAntitrust Improvements Act of 1976 requires certain companies to get premerger notice to the Justice\nDepartment.\n\nEXERCISES\n1.\n\nTo protect its state\xe2\x80\x99s businesses against ruinous price wars, a state legislature has passed a law\npermitting manufacturers to set a \xe2\x80\x9csuggested resale price\xe2\x80\x9d on all goods that they make and sell direct\nto retailers. Retailers are forbidden to undercut the resale price by more than 10 percent. A retailer\nwho violates the law may be sued by the manufacturer for treble damages: three times the difference\nbetween the suggested resale price and the actual selling price. But out-of-state retailers are bound by\nno such law and are regularly discounting the goods between 35 and 40 percent. As the general\nmanager of a large discount store located within a few miles of a city across the state line, you wish to\noffer the public a price of only 60 percent of the suggested retail price on items covered by the law in\norder to compete with the out-of-state retailers to which your customers have easy access. May you\nlower your price in order to compete? How would you defend yourself if sued by a manufacturer\nwhose goods you discounted in violation of the law?\n\n2.\n\nThe DiForio Motor Car Company is a small manufacturer of automobiles and sells to three distributors\nin the city of Peoria. The largest distributor, Hugh\xe2\x80\x99s Auras, tells DiForio that it is losing money on its\ndealership and will quit selling the cars unless DiForio agrees to give it an exclusive contract. DiForio\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n733\n\n\x0ctells the other distributors, whose contracts were renewed from year to year, that it will no longer sell\nthem cars at the end of the contract year. Smith Autos, one of the other dealers, protests, but DiForio\nrefuses to resupply it. Smith Autos sues DiForio and Hugh\xe2\x80\x99s. What is the result? Why?\n3.\n\nTwenty-five local supermarket chains banded together as Topco Associates Incorporated to sell\ngroceries under a private label. Topco was formed in 1940 to compete with the giant chains, which\nhad the economic clout to sell private-label merchandise unavailable to the smaller chains. Topco\nacted as a purchasing agent for the members. By the late 1960s, Topco\xe2\x80\x99s members were doing a\nbooming business: $1.3 billion in retail sales, with market share ranging from 1.5 percent to 16\npercent in the markets that members served. Topco-brand groceries accounted for no more than 10\npercent of any store\xe2\x80\x99s total merchandise. Under Topco\xe2\x80\x99s rules, members were assigned exclusive\nterritories in which to sell Topco-brand goods. A member chain with stores located in another\nmember\xe2\x80\x99s exclusive territory could not sell Topco-brand goods in those stores. Topco argued that the\nmarket division was necessary to give each chain the economic incentive to advertise and develop\nbrand consciousness and thus to be able to compete more effectively against the large nonmember\nsupermarkets\xe2\x80\x99 private labels. If other stores in the locality could also carry the Topco brand, then it\nwould not be a truly \xe2\x80\x9cprivate\xe2\x80\x9d label and there would be no reason to tout it; it would be like any\nnational brand foodstuff, and Topco members did not have the funds to advertise the brand\nnationally. Which, if any, antitrust laws have Topco violated? Why?\n\n4.\n\nIn 1983, Panda Bears Incorporated, a small manufacturer, began to sell its patented panda bear robot\ndolls (they walk, smile, and eat bamboo shoots) to retail toy shops. The public took an immediate\nfancy to panda bears, and the company found it difficult to meet the demand. Retail shops sold out\neven before their orders arrived. In order to allocate the limited supply fairly while it tooled up to\nincrease production runs, the company announced to its distributors that it would not sell to any\nretailers that did not also purchase its trademarked Panda Bear\xe2\x80\x99s Bambino Bamboo Shoots. It also\nannounced that it would refuse to supply any retailer that sold the robots for less than $59.95. Finally,\nit said that it would refuse to sell to retailers unless they agreed to use the company\xe2\x80\x99s repair services\nexclusively when customers brought bears back to repair malfunctions in their delicate, patented\ncomputerized nervous system. By the following year, with demand still rising, inferior competitive\npanda robots and bamboo shoots began to appear. Some retailers began to lower the Panda Bear\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n734\n\n\x0cprice to meet the competition. The company refused to resupply them. Panda Bears Incorporated also\ndecreed that it would refuse to sell to retailers who carried any other type of bamboo shoot. What\nantitrust violations, if any, has Panda Bear Incorporated committed? What additional information\nmight be useful in helping you to decide?\n5.\n\nElmer has invented a new battery-operated car. The battery, which Elmer has patented, functions for\nfive hundred miles before needing to be recharged. The car, which he has named The Elmer, is a\nsensation when announced, and his factory can barely keep up with the orders. Worried about the\nimpact, all the other car manufacturers ask Elmer for a license to use the battery in their cars. Elmer\nrefuses because he wants the car market all to himself. Banks are eager to lend him the money to\nexpand his production, and within three years he has gained a 5 percent share of the national market\nfor automobiles. During these years, Elmer has kept the price of The Elmer high, to pay for his large\ncosts in tooling up a factory. But then it dawns on him that he can expand his market much more\nrapidly if he drops his price, so he prices the car to yield the smallest profit margin of any car being\nsold in the country. Its retail price is far lower than that of any other domestic car on the market.\nBusiness begins to boom. Within three more years, he has garnered an additional 30 percent of the\nmarket, and he announces at a press conference that he confidently expects to have the market \xe2\x80\x9call to\nmyself\xe2\x80\x9d within the next five years. Fighting for their lives now, the Big Three auto manufacturers\nconsult their lawyers about suing Elmer for monopolizing. Do they have a case? What is Elmer\xe2\x80\x99s\ndefense?\n\n6.\n\nNational Widget Company is the dominant manufacturer of widgets in the United States, with 72\npercent of the market for low-priced widgets and 89 percent of the market for high-priced widgets.\nDozens of companies compete with National in the manufacture and sale of compatible peripheral\nequipment for use with National\xe2\x80\x99s widgets, including countertops, holders, sprockets and gear\nassemblies, instruction booklets, computer software, and several hundred replacements parts.\nRevenues of these peripherals run upwards of $100 million annually. Beginning with the 1981 model\nyear, National Widget sprang a surprise: a completely redesigned widget that made most of the\nperipheral equipment obsolete. Moreover, National set the price for its peripherals below that which\nwould make economic sense for competitors to invest in new plants to tool up for producing\nredesigned peripherals. Five of the largest peripheral-equipment competitors sued National under\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n735\n\n\x0cSection 2 of the Sherman Act. One of these, American Widget Peripherals, Inc., had an additional\ncomplaint: on making inquiries in early 1980, American was assured by National\xe2\x80\x99s general manager\nthat it would not be redesigning any widgets until late 1985 at the earliest. On the basis of that\nstatement, American invested $50 million in a new plant to manufacture the now obsolescent\nperipheral equipment, and as a result, it will probably be forced into bankruptcy. What is the result?\nWhy? How does this differ, if at all, from the Berkey Camera case?\n7.\n\nIn 1959, The Aluminum Company of America (Alcoa) acquired the stock and assets of the\nRome Cable Corporation. Alcoa and Rome both manufactured bare and insulated aluminum\nwire and cable, used for overhead electric power transmission lines. Rome, but not Alcoa,\nmanufactured copper conductor, used for underground transmissions. Insulated aluminum\nwire and cable is quite inferior to copper, but it can be used effectively for overhead\ntransmission, and Alcoa increased its share of annual installations from 6.5 percent in 1950 to\n77.2 percent in 1959. During that time, copper lost out to aluminum for overhead\ntransmission. Aluminum and copper conductor prices do not respond to one another; lower\ncopper conductor prices do not put great pressure on aluminum wire and cable prices. As the\nSupreme Court summarized the facts in United States v. Aluminum Co. of America,\n\n[1]\n\nIn 1958\xe2\x80\x94the year prior to the merger\xe2\x80\x94Alcoa was the leading producer of aluminum\nconductor, with 27.8% of the market; in bare aluminum conductor, it also led the industry with\n32.5%. Alcoa plus Kaiser controlled 50% of the aluminum conductor market and, with its three\nleading competitors, more than 76%. Only nine concerns (including Rome with 1.3%)\naccounted for 95.7% of the output of aluminum conductor, Alcoa was third with 11.6%, and\nRome was eighth with 4.7%. Five companies controlled 65.4% and four smaller ones, including\nRome, added another 22.8%.\nThe Justice Department sued Alcoa-Rome for violation of Section 7 of the Clayton Act. What is\nthe government\xe2\x80\x99s argument? What is the result?\n8.\n\nQuality Graphics has been buying up the stock of companies that manufacture billboards. Quality now\nowns or controls 23 of the 129 companies that make billboards, and its sales account for 3.2 percent\nof the total national market of $72 million. In Texas, Quality has acquired 27 percent of the billboard\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n736\n\n\x0cmarket, and in the Dallas\xe2\x80\x93Ft. Worth area alone, about 25 percent. Billboard advertising accounts for\nonly 0.001 percent of total national advertising sales; the majority goes to newspaper, magazine,\ntelevision, and radio advertising. What claims could the Justice Department assert in a suit against\nQuality? What is Quality\xe2\x80\x99s defense? What is the result?\n9.\n\nThe widget industry consists of six large manufacturers who together account for 62 percent of\noutput, which in 1985 amounted to $2.1 billion in domestic US sales. The remaining 38 percent is\nsupplied by more than forty manufacturers. All six of the large manufacturers and thirty-one of the\nforty small manufacturers belong to the Widget Manufacturers Trade Association (WMTA). An officer\nfrom at least two of the six manufacturers always serves on the WMTA executive committee, which\nconsists of seven members. The full WMTA board of directors consists of one member from each\nmanufacturer. The executive committee meets once a month for dinner at the Widgeters Club; the full\nboard meets semiannually at the Widget Show. The executive committee, which always meets with\nthe association\xe2\x80\x99s lawyer in attendance, discusses a wide range of matters, including industry\nconditions, economic trends, customer relations, technological developments, and the like, but\nscrupulously refrains from discussing price, territories, or output. However, after dinner at the bar,\nfive of the seven members meet for drinks and discuss prices in an informal manner. The chairman of\nthe executive committee concludes the discussion with the following statement: \xe2\x80\x9cIf I had to guess, I\xe2\x80\x99d\nguess that the unit price will increase by 5 percent the first of next month.\xe2\x80\x9d On the first of the month,\nhis prediction is proven to be correct among the five companies whose officers had a drink, and within\na week, most of the other manufacturers likewise increase their prices. At the semiannual meeting of\nthe full board, the WMTA chairman notes that prices have been climbing steadily, and he ventures the\nhope that they will not continue to do so because otherwise they will face stiff competition from the\nwidget industry. However, following the next several meetings of the executive committee, the price\ncontinues to rise as before. The Justice Department gets wind of these discussions and sues the\ncompanies whose officers are members of the board of directors and also sues individually the\nmembers of the executive committee and the chairman of the full board. What laws have they\nviolated, if any, and who has violated them? What remedies or sanctions may the department seek?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n737\n\n\x0cSELF-TEST QUESTIONS\n1.\n\nA company with 95 percent of the market for its product is\n\na.\n\na monopolist\n\nb.\n\nmonopolizing\n\nc.\n\nviolating Section 2 of the Sherman Act\n\nd.\n\nviolating Section 1 of the Sherman Act\nWhich of the following may be evidence of intent to monopolize?\n\na.\n\ninnovative practices\nb.\n\nlarge market share\n\nc.\n\npricing below cost of production\n\nd.\n\nlow profit margins\nA merger that lessens competition in any line of commerce is prohibited by\n\na.\n\nSection 1 of the Sherman Act\nb.\n\nSection 2 of the Sherman Act\n\nc.\n\nSection 7 of the Clayton Act\n\nd.\n\nnone of the above\nWhich of the following statements is true?\n\na.\n\nA horizontal merger is always unlawful.\nb.\n\nA conglomerate merger between companies with unrelated products is always lawful.\n\nc.\n\nA vertical merger violates Section 2 of the Sherman Act.\n\nd.\n\nA horizontal merger that unduly increases the concentration of firms in a particular market is\nalways unlawful.\nA line of commerce is a concept spelled out in\n\na.\n\nSection 7 of the Clayton Act\nb.\n\nSection 2 of the Sherman Act\n\nc.\n\nSection 1 of the Sherman Act\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n738\n\n\x0cd.\n\nnone of the above\n\nSELF-TEST ANSWERS\n1.\n\na\n\n2.\n\nc\n\n3.\n\nc\n\n4.\n\nd\n\n5.\n\nd\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n739\n\n\x0cChapter 17\n\nUnfair Trade Practices and the Federal Trade\nCommission\nLEARNING OBJECTIVES\nAfter reading this chapter, you should understand the following:\n1.\n\nThe general powers of the Federal Trade Commission\n\n2.\n\nThe general principles of law that govern deceptive acts and practices\n\n3.\n\nSeveral categories of deceptive acts and practices, with examples\n\n4.\n\nThe remedies that the Federal Trade Commission has at its disposal to police unfair trade practices\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n740\n\n\x0c17.1 The Federal Trade Commission: Powers and Law Governing\nDeceptive Acts\nLEARNING OBJECTIVES\n1.\n\nDescribe the general powers of the Federal Trade Commission.\n\n2.\n\nDescribe the general principles that guide laws and regulations against unfair and deceptive trade\npractices.\n\nGeneral Powers of the Federal Trade Commission\nCommon law prohibited a variety of trade practices unfair either to competitors or to consumers. These\nincluded passing off one\xe2\x80\x99s products as though they were made by someone else, using a trade name\nconfusingly similar to that of another, stealing trade secrets, and various forms of misrepresentation. In\nthe Federal Trade Commission Act of 1912, Congress for the first time empowered a federal agency to\ninvestigate and deter acts of unfair competition.\nSection 5 of the act gave the Federal Trade Commission (FTC) power to enforce a law that said \xe2\x80\x9cunfair\nmethods of competition in commerce are hereby declared unlawful.\xe2\x80\x9d By \xe2\x80\x9cunfair methods of competition,\xe2\x80\x9d\nCongress originally intended acts that constituted violations of the Sherman and Clayton Antitrust Acts.\nBut from the beginning, the commissioners of the FTC took a broader view of their mandate. Specifically,\nthey were concerned about the problem of false and deceptive advertising and promotional schemes. But\nthe original Section 5 was confining; it seemed to authorize FTC action only when the deceptive\nadvertising injured a competitor of the company. In 1931, the Supreme Court ruled that this was indeed\nthe case: an advertisement that deceived the public was not within the FTC\xe2\x80\x99s jurisdiction unless a\ncompetitor was injured by the misrepresentation also. Congress responded in 1938 with the Wheeler-Lea\nAmendments to the FTC Act. To the words \xe2\x80\x9cunfair methods of competition\xe2\x80\x9d were added these words:\n\xe2\x80\x9cunfair or deceptive acts or practices in commerce.\xe2\x80\x9d Now it became clear that the FTC had a broader role\nto play than as a second agency enforcing the antitrust laws. Henceforth, the FTC would be the guardian\nalso of consumers.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n741\n\n\x0cDeceptive practices that the FTC has prosecuted are also amenable to suit at common law. A tire\nmanufacturer who advertises that his \xe2\x80\x9cspecial tire\xe2\x80\x9d is \xe2\x80\x9cnew\xe2\x80\x9d when it is actually a retread has committed a\ncommon-law misrepresentation, and the buyer could sue for rescission of the contract or for damages. But\nhaving a few buyers sue for misrepresentation does not stop the determined fraudster. Moreover, such\nlawsuits are expensive to bring, and the amount of damages awarded is usually small; thus law actions\nalone cannot adequately address deliberately fraudulent practices.\nThrough Section 5, however, the FTC can seek far-reaching remedies against the sham and the phony; it is\nnot limited to proving damages to individual customers case by case. The FTC can issue cease and desist\norders and has other sanctions to wield as well. So do its counterpart agencies at the state level.\nAs an administrative agency, the FTC has broader powers than those vested in the ordinary prosecutorial\nauthority, such as the Department of Justice. It can initiate administrative proceedings in accordance with\nthe Administrative Procedure Act to enforce the several statutes that it administers. In addition to issuing\ncease and desist orders and getting them enforced in court, the FTC can seek temporary and permanent\ninjunctions, fines, and monetary damages and promulgate trade regulation rules (TRRs). Although the\nFTC\xe2\x80\x99s authority to issue TRRs had long been assumed (and was approved by the US court of appeals in\nWashington in 1973), Congress formalized it in 1975 in the FTC Improvement Act (part of the MagnusonMoss Warranty Act), which gives the FTC explicit authority to prescribe rules defining unfair or deceptive\nacts or practices.\nA TRR is like a statute. It is a detailed statement of procedures and substantive dos and don\xe2\x80\x99ts. Before\npromulgating a TRR, the commission must publish its intention to do so in the Federal Register and must\nhold open hearings on its proposals. Draft versions of a TRR must be published to allow the public to\ncomment. Once issued, the final version is published as part of the Code of Federal Regulations and\nbecomes a permanent part of the law unless modified or repealed by the FTC itself or by Congress\xe2\x80\x94or\noverturned by a court on grounds of arbitrariness, lack of procedural regularity, or the like. A violation of\na TRR is treated exactly like a violation of a federal statute. Once the FTC proves that a defendant violated\na TRR, no further proof is necessary that the defendant\xe2\x80\x99s act was unfair or deceptive. Examples of TRRs\ninclude the Retail Food Store Advertising and Marketing Practices Rule, Games of Chance in the Food\nRetailing and Gasoline Industries Rule, Care Labeling of Textile Wearing Apparel Rule, Mail Order\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n742\n\n\x0cMerchandise Rule, Cooling-Off Period for Door-to-Door Sales Rule, and Use of Negative Option Plans by\nSellers in Commerce.\n\nGeneral Principles of Law Governing Deceptive Acts and Practices\nWith a staff of some sixteen hundred and ten regional offices, the FTC is, at least from time to time, an\nactive regulatory agency. The FTC\xe2\x80\x99s enforcement vigor waxes and wanes with the economic climate.\nCritics have often charged that what the FTC chooses to investigate defies common sense because so many\nof the cases seem to involve trivial, or at least relatively unimportant, offenses: Does the nation really need\na federal agency to guard us against pronouncements by singer Pat Boone on the efficacy of acne\nmedication or to ensure the authenticity of certain crafts sold to tourists in Alaska as \xe2\x80\x9cnative\xe2\x80\x9d? One\nanswer is that through such cases, important principles of law are declared and ratified.\nTo be sure, most readers of this book, unlikely to be gulled by false claims, may see a certain Alice-inWonderland quality to FTC enforcement. But the first principle of FTC action is that it gauges deceptive\nacts and practices as interpreted by the general public, not by the more sophisticated. As a US court of\nappeals once said, the FTC Act was not \xe2\x80\x9cmade for the protection of experts, but for the public\xe2\x80\x94that vast\nmultitude which includes the ignorant, the unthinking, and the credulous.\xe2\x80\x9d The deceptive statement or act\nneed not actually deceive. Before 1983, it was sufficient that the statement had a \xe2\x80\x9ccapacity to deceive.\xe2\x80\x9d\nAccording to a standard adopted in 1983, however, the FTC will take action against deceptive advertising\n\xe2\x80\x9cif there is a representation, omission or practice that is likely to mislead the consumer acting reasonably\nin the circumstances, to the consumer\xe2\x80\x99s detriment.\xe2\x80\x9d Critics of the new standard have charged that it will\nbe harder to prove deception because an advertisement must be \xe2\x80\x9clikely to mislead\xe2\x80\x9d rather than merely\nhave a \xe2\x80\x9ccapacity to deceive.\xe2\x80\x9d The FTC might also be put to the burden of showing that consumers\nreasonably interpreted the ad and that they relied on the ad. Whether the standard will reduce the volume\nof FTC actions against deceptive advertising remains to be seen.\nThe FTC also has the authority to proceed against \xe2\x80\x9cunfair\xe2\x80\xa6acts or practices.\xe2\x80\x9d These need not be deceptive\nbut, instead, of such a character that they offend a common sense of propriety or justice or of an honest\nway of comporting oneself. See Figure 17.1 "Unfair and Deceptive Practices Laws" for a diagram of the\nunfair and deceptive practices discussed in this chapter.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n743\n\n\x0cFigure 17.1 Unfair and Deceptive Practices Laws\n\nKEY TAKEAWAY\nAlthough common law still serves to prohibit certain kinds of trade practices, the FTC has far more\nextensive powers to police unfair and deceptive trade practices. The FTC\xe2\x80\x99s rules, once passed through\nthe processes defined in the Administrative Procedure Act, have the same authority as a federal\nstatute. Trade regulation rules issued by the FTC, if violated, can trigger injunctions, fines, and other\nremedial actions.\n\nEXERCISE\n1.\n\nGo to the FTC website and look at its most recent annual report. Find a description of a loan\nmodification scam, and discuss with another student why a regulatory agency is needed. Ask\nyourselves whether leaving it up to individual consumers to sue the scammers, using common law,\nwould create greater good for society.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n744\n\n\x0c17.2 Deceptive Acts and Practices\nLEARNING OBJECTIVE\n1.\n\nName the categories of deceptive acts and practices that the Federal Trade Commission has found,\nand give examples.\n\nFailure to Disclose Pertinent Facts\nBusinesses are under no general obligation to disclose everything. Advertisers may put a bright face on\ntheir products as long as they do not make a direct material misrepresentation or misstatement. But\nunder certain circumstances, a business may be required to disclose more than it did in order not to be\ninvolved in unfair or deceptive acts and practices. For example, failure to state the cost of a service might\nconstitute deception. Thus a federal court has ruled that it is deceptive for a telephone service to fail to\ndisclose that it cost fifteen dollars per call for customers dialing a special 900 number listed in newspaper\nadvertisements offering jobs.\n\n[1]\n\nLikewise, if a fact not disclosed might have a material bearing on a\n\nconsumer\xe2\x80\x99s decision whether to purchase the product, its omission might be tantamount to deception,\nas J. B. Williams Co. v. FTC (see Section 17.5.1 "False and Misleading Representations"), suggests.\n\nDescriptions of Products\nAlthough certain words are considered mere puffery (greatest, best), other words, which have more\nprecise connotations, can cause trouble if they are misused. One example is the word new. In most cases,\nthe Federal Trade Commission (FTC) has held that if a product is more than six months old, it is not new\nand may not lawfully be advertised as such.\nThe efficacy of products is perhaps their most often advertised aspect. An ad stating that a product will do\nmore than it can is almost always deceptive if the claim is specific. Common examples that the FTC\ncontinues to do battle over are claims that a cream, pill, or other substance will \xe2\x80\x9crejuvenate\xe2\x80\x9d the body;\n\xe2\x80\x9ccure\xe2\x80\x9d baldness, \xe2\x80\x9cpermanently remove\xe2\x80\x9d wrinkles, or \xe2\x80\x9crestore\xe2\x80\x9d the vitality of hair.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n745\n\n\x0cThe composition of goods is another common category of deceptive claims. For example, a product\nadvertised as \xe2\x80\x9cwool\xe2\x80\x9d had better be 100 percent wool; a mixture of wool and synthetic fabrics cannot be\nadvertised as wool. The FTC has lists of dozens of descriptive words with appropriate definitions.\nLabeling of certain products is strictly regulated by specific statutes. Under the Food, Drug, and Cosmetic\nAct, artificial colors and flavors must be disclosed. Other specific federal statutes include the Wool\nProducts Labeling Act, the Textile Fiber Products Identification Act, the Fur Products Labeling Act, and\nthe Flammable Fabrics Act; these acts are enforced by the FTC. In 1966, Congress enacted the Fair\nPackaging and Labeling Act. It governs most consumer products and gives the FTC authority to issue\nregulations for proper labeling of most of them. In particular, the statute is designed to help standardize\nquantity descriptions (\xe2\x80\x9csmall,\xe2\x80\x9d \xe2\x80\x9cmedium,\xe2\x80\x9d and \xe2\x80\x9clarge\xe2\x80\x9d) and enable shoppers to compare the value of\ncompeting goods in the stores.\n\nMisleading Price and Savings Claims\n\xe2\x80\x9cBuy one, get another for half price.\xe2\x80\x9d \xe2\x80\x9cSuggested retail price: $25. Our price: $5.95.\xe2\x80\x9d \xe2\x80\x9cYours for only $95.\nYou save $50.\xe2\x80\x9d Claims such as these assault the eye and ear daily. Unless these ads are strictly true, they\nare violations of Section 5 of the FTC Act. To regulate deceptive price and savings claims, the FTC has\nissued a series of Guides against Deceptive Pricing that set forth certain principles by which the\ncommission will judge the merits of price claims. These guides are not themselves law, but they are\nimportant clues to how the FTC will act when faced with a price claim case and they may even provide\nguidance to state courts hearing claims of deceptive pricing ads.\nIn general, the guides deal with five claims, as follows:\n\xe2\x80\xa2\n\nComparisons of the sale price to a former price. The former price must have been offered for a\nsubstantial period of time in the near past for a seller to be justified in referring to it. A product that\nonce had a price tag of $50, but that never actually sold for more than $40, cannot be hawked at \xe2\x80\x9cthe\nformer price of $50.\xe2\x80\x9d Under the FTC guides, a reduction of at least 10 percent is necessary to make the\nclaim true.\n\n\xe2\x80\xa2\n\nComparable products. \xe2\x80\x9cThis same mattress and box spring would cost you $450 at retail.\xe2\x80\x9d The\nadvertisement is true only if the seller is in fact offering the same merchandise and if the price quoted\nis genuine.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n746\n\n\x0c\xe2\x80\xa2\n\n\xe2\x80\x9cSuggested\xe2\x80\x9d retail price. The same rules apply as those just mentioned. But in the case of a\n\xe2\x80\x9cmanufacturer\xe2\x80\x99s suggested\xe2\x80\x9d price, an additional wrinkle can occur: the manufacturer might help the\nretailer deceive by listing a \xe2\x80\x9csuggested\xe2\x80\x9d price that is in fact considerably greater than the going price\nin the retailer\xe2\x80\x99s trading area. Whether it is the manufacturer who is doing his own selling or the\nretailer who takes advantage of the \xe2\x80\x9clist price\xe2\x80\x9d ticket on the goods, the resulting claim of a bargain is\ndeceptive if the product does not sell for the list price in any market or in the market of the retailer.\n\n\xe2\x80\xa2\n\nBargain based on the purchase of something else. The usual statement in these cases is \xe2\x80\x9cBuy\none, get one free\xe2\x80\x9d (or at some percentage of the usual selling price). Again, the watchwords are literal\naccuracy. If the package of batteries normally sells in the advertiser\xe2\x80\x99s store for ninety-nine cents, and\ntwo packages are now selling for that price, then the advertisement is unexceptionable. But\nadvertisers are often tempted to raise the original selling price or reduce the size or quantity of the\nbargain product; doing so is deceptive.\n\n\xe2\x80\xa2\n\nFalse claims to explain a \xe2\x80\x9csale\xe2\x80\x9d price. \xe2\x80\x9cGiant clearance sale\xe2\x80\x9d or \xe2\x80\x9cgoing out of business\xe2\x80\x9d or\n\xe2\x80\x9climited offer\xe2\x80\x9d are common advertising gimmicks. If true, they are legitimate, but it takes very little to\nmake them deceptive. A \xe2\x80\x9climited offer\xe2\x80\x9d that goes on forever (or a sale price charged beyond the date\non which a sale is said to end) is deceptive. Likewise, false claims that imply the manufacturer is\ncharging the customer a small price are illegitimate. These include claims like \xe2\x80\x9cwholesale price,\xe2\x80\x9d\n\xe2\x80\x9cmanufacturer\xe2\x80\x99s close-outs,\xe2\x80\x9d \xe2\x80\x9cirregulars,\xe2\x80\x9d or \xe2\x80\x9cseconds.\xe2\x80\x9d\n\nBait-and-Switch Advertisements\nA common sales pitch in retail is the bait and switch. The retailer \xe2\x80\x9cbaits\xe2\x80\x9d the prospective customer by\ndangling an alluring offer, but the offer either disappears or is disparaged once the customer arrives.\nSuppose someone sees this advertisement: \xe2\x80\x9cSteinway Grand Piano\xe2\x80\x94only $1,000.\xe2\x80\x9d But when the customer\narrives at the store, he finds that the advertised product has \xe2\x80\x9csold out.\xe2\x80\x9d The retailer then tries to sell the\ndisappointed customer a higher priced product. Or the salesperson may have the product, but she will\ndisparage it\xe2\x80\x94pointing out that it does not really live up to the advertised expectations\xe2\x80\x94and will exhort the\ncustomer to buy the \xe2\x80\x9cbetter,\xe2\x80\x9d more expensive model. These and related tactics are all violations of Section\n5 of the FTC Act. In its Guides Against Bait Advertising, the FTC lists several such unfair practices,\nincluding the following: (1) refusing to demonstrate the advertised product, (2) disparaging the product\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n747\n\n\x0c(e.g., by exhibiting a visibly inferior grade of product next to higher-priced merchandise), (3) failing to\nstock enough of the advertised product to meet anticipated demand (although the advertiser may say\n\xe2\x80\x9csupplies limited,\xe2\x80\x9d if that is the case), (4) stating that delivery of the advertised product will take an\ninordinate amount of time, (5) demonstrating a defective product, and (6) deliberately discouraging the\nwould-be buyer from purchasing the advertised product.\n\nFree Offers\nCareless advertisers will discover that free, perhaps the most powerful word in advertising comes at a\ncost. As just noted, a product is not free if it is conditional on buying another product and the price of the\n\xe2\x80\x9cfree\xe2\x80\x9d product is included in the purchased product (\xe2\x80\x9cBuy one tube and get another tube free\xe2\x80\x9d). Just how\nfar the commission is prepared to take this rule is clear from F.T.C. v. Mary Carter Paint Co.\n\n[2]\n\nIn that\n\ncase, the company offered, from the time it began business, to sell on a two-for-one basis: \xe2\x80\x9cevery second\ncan FREE, gallon or quart.\xe2\x80\x9d The problem was that it had never priced and sold single cans of paint, so the\nFTC assumed that the price of the second can was included in the first, even though Mary Carter claimed\nit had established single-can prices that were comparable to those for paint of comparable quality sold by\ncompeting manufacturers. The Supreme Court sustained the commission\xe2\x80\x99s finding of deception.\n\nProduct Comparisons and Disparagements\nProduct disparagement\xe2\x80\x94saying defamatory things about a competitor\xe2\x80\x99s product\xe2\x80\x94is a common-law tort,\nactionable under state law. It is also actionable under Section 5 of the FTC Act. The FTC brands as\ndisparagement the making of specific untrue statements about a competitor\xe2\x80\x99s product. The agency labels\nan indirect form of disparagement \xe2\x80\x9ccomparative misrepresentation\xe2\x80\x9d\xe2\x80\x94making false claims of superiority\nof one\xe2\x80\x99s own product. Again, the common-law puffing rule would permit the manufacturer of an over-thecounter pain reliever to make the general statement \xe2\x80\x9cOur pill is the best.\xe2\x80\x9d But the claim that a pill \xe2\x80\x9cworks\nthree times as fast as the leading competitor\xe2\x80\x99s\xe2\x80\x9d violates Section 5 if untrue.\nTruth has always been a defense to claims of product disparagement, but even that common-law rule has\nbeen eroded in recent years with the application of the significance doctrine. A statement may be\ntechnically true but insignificant and made in such a way as to be misleading. For example, P. Lorillard\nCo. v. Federal Trade Commission (Section 17.5.2 "Product Comparisons") concerned a comparative study\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n748\n\n\x0cpublished in Reader\xe2\x80\x99s Digest of tar and nicotine in cigarettes. The article suggested that the differences\nwere inconsequential to health, but the company making the cigarette with the smallest amount of tar and\nnicotine touted the fact anyway.\nDuring the 1970s, to help enforce its rules against comparative misrepresentations, the FTC began to\ninsist that advertisers fully document any quantitative claims that their products were superior to others.\nThis meant that the advertiser should have proof of accuracy not only if the commission comes calling; the\nadvertiser should collect the information beforehand. If it does not, the claim will be held presumptively\ndeceptive.\nThe FTC Act and state laws against misleading advertising are not the only statutes aimed at product\ncomparisons. One important more recent federal law is the Trademark Law Revision Act of 1988,\namending the original Lanham Act that protects trademarks as intellectual property (see Chapter 13\n"Intellectual Property"). For many years, the federal courts had ruled that a provision in the Lanham Act\nprohibiting false statements in advertisements was limited to an advertiser\xe2\x80\x99s false statements about its\nown goods or services only. The 1988 amendments overturned that line of court cases, broadening the\nrule to cover false statements about someone else\xe2\x80\x99s goods or services as well. The amendments also\nprohibit false or misleading claims about another company\xe2\x80\x99s commercial activities, such as the nature of\nits warranties. The revised Lanham Act now permits a company injured by a competitor\xe2\x80\x99s false advertising\nto sue directly in federal court.\n\nEndorsements\nHow wonderful to have a superstar (or maybe yesterday\xe2\x80\x99s superstar) appear on television drooling over\nyour product. Presumably, millions of people would buy a throat spray if Lady Gaga swore by it, or a pair\nof jeans if Justin Bieber wore them, or a face cream if Paris Hilton blessed it. In more subtle ways,\nnumerous products are touted every day with one form of testimonial or another: \xe2\x80\x9cThree out of four\ndoctors recommend\xe2\x80\xa6\xe2\x80\x9d or \xe2\x80\x9cDrivers across the country use.\xe2\x80\xa6\xe2\x80\x9d In this area, there are endless opportunities\nfor deception.\nIt is not a deception for a well-known personality to endorse a product without disclosing that she is being\npaid to do so. But the person giving the testimonial must in fact use the product; if she does not, the\nendorsement is deceptive. Suppose an astronaut just returned to Earth is talked into endorsing\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n749\n\n\x0csuspenders (\xe2\x80\x9cThey keep your pants from floating away\xe2\x80\x9d) that he was seen to be wearing on televised shots\nof the orbital mission. If he has customarily worn them, he may properly endorse them. But if he stops\nwearing them for another brand or because he has decided to go back to wearing belts, reruns of the TV\ncommercials must be pulled from the air.\n\nFigure 17.2\n\nConsent Decree: Pat Boone and Cooga Mooga, Inc.\nThat a particular consumer is in fact ecstatic about a product does not save a false statement: it is\ndeceptive to present this glowing testimonial to the public if there are no facts to back up the customer\xe2\x80\x99s\nclaim. The assertion \xe2\x80\x9cI was cured by apricot pits\xe2\x80\x9d to market a cancer remedy would not pass FTC muster.\nNor may an endorser give a testimonial involving subjects known only to experts if the endorser is not\nhimself that kind of expert, as shown in the consent decree negotiated by the FTC with singer Pat Boone\n(Figure 17.2).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n750\n\n\x0cPictorial and Television Advertising\nPictorial representations create special problems because the picture can belie the caption or the\nannouncer\xe2\x80\x99s words. A picture showing an expensive car may be deceptive if the dealer does not stock\nthose cars or if the only readily available cars are different models. The ways of deceiving by creating false\ninferences through pictures are limited only by imagination. White-coated \xe2\x80\x9cdoctors,\xe2\x80\x9d seals of the British\nmonarchy, and plush offices can connote various things about a product, even if the advertisement never\nsays that the man in the white coat is a doctor, that the product is related to the British crown, or that the\ncompany has its operations in the building depicted.\nTelevision demonstrations may also suggest nonexistent properties or qualities in a product. In one case,\nthe commission ordered the manufacturer of a liquid cleaner to cease showing it in use near hot stoves\nand candles, implying falsely that it was nonflammable. A commercial showing a knife cutting through\nnails is deceptive if the nails were precut and different knives were used for the before and after shots.\n\nKEY TAKEAWAY\nA variety of fairly common acts and practices have been held by the FTC to be deceptive (and illegal).\nThese include the failure to disclose pertinent facts, misleading price and savings claims, bait and\nswitch advertisements, careless use of the word \xe2\x80\x9cfree,\xe2\x80\x9d and comparative misrepresentation\xe2\x80\x94making\nmisleading comparisons between your product and the product of another company.\n\nEXERCISES\n1.\n\nLook around this week for an example of a merchant offering something for \xe2\x80\x9cfree.\xe2\x80\x9d Do you think there\nis anything deceptive about the merchant\xe2\x80\x99s offer? If they offer \xe2\x80\x9cfree shipping,\xe2\x80\x9d how do you know that\nthe shipping cost is not hidden in the price? In any case, why do consumers need protection from an\nagency that polices merchant offerings that include the word free?\n\n2.\n\nFind the FTC\xe2\x80\x99s guide against deceptive pricing (http://www.ftc.gov/bcp/guides/decptprc.htm). Can\nyou find any merchants locally that appear to be in violation of the FTC\xe2\x80\x99s rules and principles?\n\n[1] FTC v. Transworld Courier Services, Inc., 59 A&TR Rpt. 174 (N.D. Ga. 1990).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n751\n\n\x0c17.3 Unfair Trade Practices\nLEARNING OBJECTIVES\n1.\n\nExplain how unfair trade practices are different from deceptive trade practices.\n\n2.\n\nName three categories of unfair trade practices, and give examples.\n\nWe turn now to certain practices that not only have deceptive elements but also operate unfairly in ways\nbeyond mere deception. In general, three types of unfair practices will be challenged: (1) failing to\nsubstantiate material representations in advertisements before publishing them or putting them on the\nair, (2) failing to disclose certain material information necessary for consumers to make rational\ncomparisons of price and quality of products, and (3) taking unconscionable advantage of certain\nconsumers or exploiting their weakness. The Federal Trade Commission (FTC) has enjoined many ads of\nthe first type. The second type of unfairness has led the commission to issue a number of trade regulation\nrules (TRRs) setting forth what must be disclosed\xe2\x80\x94for example, octane ratings of gasoline. In this section,\nwe focus briefly on the third type.\n\nContests and Sweepstakes\nIn 1971, the FTC obtained a consent order from Reader\xe2\x80\x99s Digest barring it from promoting a mail-order\nsweepstakes\xe2\x80\x94a sweepstakes in which those responding had a chance to win large monetary or other\nprizes by returning numbered tickets\xe2\x80\x94unless the magazine expressly disclosed how many prizes would be\nawarded and unless all such prizes were in fact awarded. Reader\xe2\x80\x99s Digest had heavily promoted the size\nand number of prizes, but few of the winning tickets were ever returned, and consequently few of the\nprizes were ever actually awarded.\n\n[1]\n\nBeginning in the 1960s, the retail food and gasoline industries began to heavily promote games of chance.\nInvestigations by the FTC and a US House of Representatives small business subcommittee showed that\nthe games were rigged: winners were \xe2\x80\x9cpicked\xe2\x80\x9d early by planting the winning cards early on in the\ndistribution, winning cards were sent to geographic areas most in need of the promotional benefits of\nannouncing winners, not all prizes were awarded before many games terminated, and local retailers could\nspot winning cards and cash them in or give them to favored customers. As a result of these\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n752\n\n\x0cinvestigations, the FTC in 1969 issued its Trade Regulation Rule for Games of Chance in the Food\nRetailing and Gasoline Industries, strictly regulating how the games may operate and be promoted.\nMany marketers use contests, as opposed to sweepstakes, in merchandising their products. In a contest,\nthe consumer must actually do something other than return a ticket, such as fill in a bingo card or come\nup with certain words. It is an unfair practice for the sponsoring company not to abide by its own rules in\ndetermining winners.\n\nDoor-to-Door, Direct Mail and Unsolicited Merchandise\nIn 1974, the FTC promulgated a TRR requiring a three-day cooling-off period within which any door-todoor sales contract can be cancelled. The contract must state the buyer\xe2\x80\x99s right to the cooling-off period.\nFor many years, certain unscrupulous distributors would mail unsolicited merchandise to consumers and\ndemand payment through a series of dunning letters and bills. In 1970, Congress enacted legislation that\ndeclares any unsolicited mailing and subsequent dunning to be an unfair trade practice under Section 5 of\nthe FTC Act. Under this law, if you receive an unsolicited product in the mail, you may treat it as a gift and\nuse it; you are under no obligation to return it or pay for it.\nAnother regulation of mail-order sales is the FTC\xe2\x80\x99s TRR concerning mail-order merchandise. Any directmail merchandiser must deliver the promised goods within thirty days or give the consumer an option to\naccept delayed delivery or a prompt refund of his money or cancellation of the order if it has not been\nprepaid.\n\nNegative-Option Plans\nThe \xe2\x80\x9cnegative option\xe2\x80\x9d was devised in the 1920s by the Book-of-the-Month Club. It is a marketing device\nthrough which the consumer responds to the seller only if she wishes not to receive the product. As used\nby book clubs and other distributors of goods that are sent out periodically, the customer agrees, when\n\xe2\x80\x9cjoining,\xe2\x80\x9d to accept and pay for all items unless she specifically indicates, before they arrive, that she\nwishes to reject them. If she does nothing, she must pay. Difficulties arise when the negative-option notice\narrives late in the mail or when a member quits and continues to receive the monthly notices. Internet\nusers will recognize the negative option in current use as the \xe2\x80\x9copt out\xe2\x80\x9d process, where you are \xe2\x80\x9cin\xe2\x80\x9d unless\nyou notice what\xe2\x80\x99s going on and specifically opt out.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n753\n\n\x0cIn 1974, the FTC issued a TRR governing use of negative-option plans by sellers. The TRR laid down\nspecific notice requirements. Among other things, a subscriber is entitled to ten days in which to notify\nsellers that she has rejected the particular item about to be sent. If a customer has cancelled hers\nmembership, the seller must take back and pay the former member\xe2\x80\x99s mailing expenses for any\nmerchandise mailed after cancellation. The former member may treat any shipments beyond one after\ncancellation as unsolicited merchandise and keep it without having to pay for it or return it.\n\nBreach of Contract\nUnder certain circumstances, a company\xe2\x80\x99s willful breach of contract can constitute an unfair trade\npractice, thus violating section 5 of the FTC Act. In one recent case, a termite and pest exterminating\ncompany signed contracts with its customers guaranteeing \xe2\x80\x9clifetime\xe2\x80\x9d protection against termite damage\nto structures that the company treated. The contract required a customer to renew the service each year\nby paying an unchanging annual fee. Five years after signing these contracts, the company notified\n207,000 customers that it was increasing the annual fee because of inflation. The FTC challenged the fee\nhike on the ground that it was a breach of contract amounting to an unfair trade practice. The FTC\xe2\x80\x99s\ncharges were sustained on appeal. The eleventh circuit approved the FTC\xe2\x80\x99s three-part test for determining\nunfairness: (1) the injury \xe2\x80\x9cmust be substantial,\xe2\x80\x9d (2) \xe2\x80\x9cit must not be outweighed by countervailing benefits\nto consumers,\xe2\x80\x9d and (3) \xe2\x80\x9cit must be an injury that consumers themselves could not reasonably have\navoided.\xe2\x80\x9d In the termite case, all three parts were met: consumers were forced to pay substantially higher\nfees, they received no extra benefits, and they could not have anticipated or prevented the price hike, since\nthe contract specifically precluded them.\n\n[2]\n\nKEY TAKEAWAY\nMarket efficiency is premised on buyers being able to make rational choices about their purchases.\nWhere sellers fail to substantiate material representations or to disclose material information that is\nnecessary for buyers to act rationally, the FTC may find an unfair trade practice. In addition, some\nsellers will take \xe2\x80\x9cunconscionable advantage\xe2\x80\x9d of certain buyers or exploit their weakness. This takes\nplace in various contests and sweepstakes, door-to-door and mail-order selling, and negative-option\nplans. The FTC has issued a number of TRRs to combat some of these unfair practices.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n754\n\n\x0cEXERCISES\n1.\n\nThe FTC receives over ten thousand complaints every year about sweepstakes and prizes. Using the\nInternet or conversations with people you know, name two ways that sweepstakes or contests can be\nunfair to consumers.\n\n2.\n\nAs economic hard times return, many scam artists have approached people in debt or people who are\nin danger of losing their homes. Describe some of the current practices of such people and companies,\nand explain why they are unfair.\n\n3.\n\nWith regard to Exercise 2, discuss and decide whether government serves a useful public function by\nprotecting consumers against such scam artists or whether use of the common law\xe2\x80\x94by the\nindividuals who have been taken advantage of\xe2\x80\x94would create greater good for society.\n\n[1] Reader\xe2\x80\x99s Digest Assoc., 79 F.T.C. 599 (1971).\n[2] Orkin Exterminating Co. v. FTC, 849 F.2d 1354 (11th Cir. 1988), cert. denied, 488 U.S. 1041 (1989).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n755\n\n\x0c17.4 Remedies\nLEARNING OBJECTIVES\n1.\n\nDescribe the various remedies the Federal Trade Commission has used against unfair and deceptive\nacts and practices.\n\n2.\n\nUnderstand that the states also have power to regulate unfair and deceptive trade practices and often\ndo.\n\nThe Federal Trade Commission (FTC) has a host of weapons in its remedial arsenal. It may issue cease\nand desist orders against unfair and deceptive acts and practices and let the punishment fit the crime. For\ninstance, the FTC can order a company to remove or modify a deceptive trade name. It may order\ncompanies to substantiate their advertising. Or if a company fails to disclose facts about a product, the\ncommission may order the company to affirmatively disclose the facts in future advertising. In the J.\nB.Williams case (Section 17.5.2 "Product Comparisons"), the court upheld the commission\xe2\x80\x99s order that the\ncompany tell consumers in future advertising that the condition Geritol is supposed to treat\xe2\x80\x94iron-poor\nblood\xe2\x80\x94is only rarely the cause of symptoms of tiredness that Geritol would help cure.\nThe FTC has often exercised its power to order affirmative disclosures during the past decade, but its\npower to correct advertising deceptions is even broader. In Warner Lambert Co. v. Federal Trade\nCommission, the US court of appeals in Washington, using corrective advertising, approved the\ncommission\xe2\x80\x99s power to order a company to correct in future advertisements its former misleading and\ndeceptive statements regarding Listerine mouthwash should it choose to continue to advertise the\nproduct.\n\n[1]\n\nThe court also approved the FTC\xe2\x80\x99s formula for determining how much the company must\n\nspend: an amount equal to the average annual expenditure on advertising the mouthwash during the ten\nyears preceding the case.\nIn addition to its injunctive powers, the FTC may seek civil penalties of $10,000 for violation of final cease\nand desist orders, and if the violation is a continuing one\xe2\x80\x94an advertising campaign that lasts for weeks or\nmonths\xe2\x80\x94each day is considered a separate violation. The commission may also sue for up to $10,000 per\nviolation, as just described, for violations of its trade regulation rules (TRRs). Under the FTC\nImprovement Act of 1975, the commission is authorized to seek injunctions and collect monetary damages\non behalf of injured consumers in cases involving violations of TRRs. It may also seek restitution for\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n756\n\n\x0cconsumers in cases involving cease and desist orders if the party continuing to commit the unfair or\ndeceptive practice should have known that it would be dishonest or fraudulent to continue doing so. The\nexact reach of this power to seek restitution, which generally had not been available before 1975, remains\nto be tested in the courts. As for private parties, though they have rights under the antitrust statutes, they\nhave no right to sue under Section 5 of the FTC Act.\n\nLittle FTC Acts\nEven when consumers have no direct remedy under federal law for unfair or deceptive acts and practices,\nthey may have recourse under state laws modeled on the FTC Act, known as little FTC acts. All states have\nsome sort of consumer protection act, and these acts are often more liberal than the federal unfair trade\nrules; they permit consumers\xe2\x80\x94and in several states, even aggrieved businesses\xe2\x80\x94to sue when injured by a\nhost of \xe2\x80\x9cimmoral, unethical, oppressive, or unscrupulous\xe2\x80\x9d commercial acts. Often, a successful plaintiff\ncan recover treble damages and attorneys\xe2\x80\x99 fees.\nThe acts are helpful to consumers because common-law fraud is difficult to prove. Its elements are\nrigorous and unyielding: an intentional misrepresentation of material facts, reliance by the recipient,\ncausation, and damages. Many of these elements are omitted from consumer fraud statutes. While most\nstatutes require some aspect of willfulness, some do not. In fact, many states relax or even eliminate the\nelement of reliance, and some states do not even require a showing of causation or injury.\n\nKEY TAKEAWAY\nThe FTC has many weapons to remedy unfair and deceptive trade practices. These include civil\npenalties, cease and desist orders, restitution for consumers, and corrective advertising. States have\nsupplemented common law with their own consumer protection acts, known as little FTC acts.\nRemedies are similar for state statutes, and private parties may bring lawsuits directly.\n\nEXERCISE\n1.\n\nDoan\xe2\x80\x99s Pills are an over-the-counter medicine for low back pain. Using the Internet, find out what\nclaims Doan\xe2\x80\x99s was making and why the FTC thought corrective advertising was necessary.\n\n2.\n\n[1] Warner Lambert Co. v. Federal Trade Commission, 562 F.2d 749 (D.C. Cir. 1977), cert. denied, 435\nU.S. 950 (1978).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n757\n\n\x0c17.5 Cases\nFalse and Misleading Representations\nJ. B. Williams Co. v. FTC\n381 F.2d 884 (6th Cir. 1967)\nCELEBREEZE, CIRCUIT JUDGE\nThe question presented by this appeal is whether Petitioners\xe2\x80\x99 advertising of a product, Geritol, for the\nrelief of iron deficiency anemia, is false and misleading so as to violate Sections 5 and 12 of the Federal\nTrade Commission Act.\nThe J. B. Williams Company, Inc. is a New York corporation engaged in the sale and distribution of two\nproducts known as Geritol liquid and Geritol tablets. Geritol liquid was first marketed in August, 1950;\nGeritol tablets in February, 1952. Geritol is sold throughout the United States and advertisements for\nGeritol have appeared in newspapers and on television in all the States of the United States.\nParkson Advertising Agency, Inc. has been the advertising agency for Williams since 1957. Most of the\nadvertising money for Geritol is spent on television advertising.\xe2\x80\xa6\nThe Commission\xe2\x80\x99s Order requires that not only must the Geritol advertisements be expressly limited to\nthose persons whose symptoms are due to an existing deficiency of one or more of the vitamins contained\nin the preparation, or due to an existing deficiency of iron, but also the Geritol advertisements must\naffirmatively disclose the negative fact that a great majority of persons who experience these symptoms do\nnot experience them because they have a vitamin or iron deficiency; that for the great majority of people\nexperiencing these symptoms, Geritol will be of no benefit. Closely related to this requirement is the\nfurther requirement of the Order that the Geritol advertisements refrain from representing that the\nsymptoms are generally reliable indications of iron deficiency.\n***\nThe main thrust of the Commission\xe2\x80\x99s Order is that the Geritol advertising must affirmatively disclose the\nnegative fact that a great majority of persons who experience these symptoms do not experience them\nbecause there is a vitamin or iron deficiency.\nThe medical evidence on this issue is conflicting and the question is not one which is susceptible to precise\nstatistical analysis.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n758\n\n\x0c***\nWhile the advertising does not make the affirmative representation that the majority of people who are\ntired and rundown are so because of iron deficiency anemia and the product Geritol will be an effective\ncure, there is substantial evidence to support the finding of the Commission that most tired people are not\nso because of iron deficiency anemia, and the failure to disclose this fact is false and misleading because\nthe advertisement creates the impression that the tired feeling is caused by something which Geritol can\ncure.\n***\nHere the advertisements emphasize the fact that if you are often tired and run-down you will feel stronger\nfast by taking Geritol. The Commission, in looking at the overall impression created by the advertisements\non the general public, could reasonably find these advertisements were false and misleading. The finding\nthat the advertisements link common, non-specific symptoms with iron deficiency anemia, and thereby\ncreate a false impression because most people with these symptoms are not suffering from iron deficiency\nanemia, is both reasonable and supported by substantial evidence. The Commission is not bound to the\nliteral meaning of the words, nor must the Commission take a random sample to determine the meaning\nand impact of the advertisements.\nPetitioners argue vigorously that the Commission does not have the legal power to require them to state\nthe negative fact that \xe2\x80\x9cin the great majority of persons who experience such symptoms, these symptoms\nare not caused by a deficiency of one or more of the vitamins contained in the preparation or by iron\ndeficiency or iron deficiency anemia\xe2\x80\x9d; and \xe2\x80\x9cfor such persons the preparation will be of no benefit.\xe2\x80\x9d\nWe believe the evidence is clear that Geritol is of no benefit in the treatment of tiredness except in those\ncases where tiredness has been caused by a deficiency of the ingredients contained in Geritol. The fact that\nthe great majority of people who experience tiredness symptoms do not suffer from any deficiency of the\ningredients in Geritol is a \xe2\x80\x9cmaterial fact\xe2\x80\x9d under the meaning of that term as used in Section 15 of the\nFederal Trade Commission Act and Petitioners\xe2\x80\x99 failure to reveal this fact in this day when the consumer is\ninfluenced by mass advertising utilizing highly developed arts of persuasion, renders it difficult for the\ntypical consumer to know whether the product will in fact meet his needs unless he is told what the\nproduct will or will not do.\xe2\x80\xa6\n***\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n759\n\n\x0cThe Commission forbids the Petitioners\xe2\x80\x99 representation that the presence of iron deficiency anemia can be\nself-diagnosed or can be determined without a medical test. The danger to be remedied here has been\nfully and adequately taken care of in the other requirements of the Order. We can find no Congressional\npolicy against self-medication on a trial and error basis where the consumer is fully informed and the\nproduct is safe as Geritol is conceded to be. In fact, Congressional policy is to encourage such self-help. In\neffect the Commission\xe2\x80\x99s Order l(f) tends to place Geritol in the prescription drug field. We do not consider\nit within the power of the Federal Trade Commission to remove Geritol from the area of proprietary drugs\nand place it in the area of prescription drugs. This requirement of the Order will not be enforced. We also\nfind this Order is not unduly vague and fairly apprises the Petitioners of what is required of them. Petition\ndenied and, except for l (f) of the Commission\xe2\x80\x99s Order, enforcement of the Order will be granted\n\nVideo 49.1\n\nStudents may be interested in a Geritol ad from 1960.\n\nCASE QUESTIONS\n1.\n\nDid the defendant actually make statements that were false? If so, what were they? Or, rather than\nbeing clearly false, were the statements deceptive? If so, how so?\n\n2.\n\nWhether or not you feel that you have \xe2\x80\x9ctired blood\xe2\x80\x9d or \xe2\x80\x9ciron-poor blood,\xe2\x80\x9d you may be amused by a\nGeritol ad from 1960. See Video 49.1. Do the disclaimers at the start of the ad that \xe2\x80\x9cthe majority of\ntired people don\xe2\x80\x99t feel that way because of iron-poor blood\xe2\x80\x9d sound like corrective advertising? Is the\nad still deceptive in some way? If so, how? If not, why not?\n\nProduct Comparisons\nP. Lorillard Co. v. Federal Trade Commission\n186 F.2d 52 (4th Cir. 1950)\nParker, Chief Judge\nThis is a petition to set aside an order of the Federal Trade Commission which directed that the P.\nLorillard Company cease and desist from making certain representations found to be false in the\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n760\n\n\x0cadvertising of its tobacco products. The Commission has filed an answer asking that its order be enforced.\nThe company was ordered to cease and desist \xe2\x80\x9cfrom representing by any means directly or indirectly\xe2\x80\x9d:\nThat Old Gold cigarettes or the smoke therefrom contains less nicotine, or less tars and resins, or is less\nirritating to the throat than the cigarettes or the smoke therefrom of any of the six other leading brands of\ncigarettes.\n***\nLaboratory tests introduced in evidence show that the difference in nicotine, tars and resins of the\ndifferent leading brands of cigarettes is insignificant in amount; and there is abundant testimony of\nmedical experts that such difference as there is could result in no difference in the physiological effect\nupon the smoker. There is expert evidence, also, that the slight difference in the nicotine, tar and resin\ncontent of cigarettes is not constant between different brands, but varies from place to place and from\ntime to time, and that it is a practical impossibility for the manufacturer of cigarettes to determine or to\nremove or substantially reduce such content or to maintain constancy of such content in the finished\ncigarette. This testimony given ample support to the Commission\xe2\x80\x99s findings.\n***\nThe company relies upon the truth of the advertisements complained of, saying that they merely state\nwhat had been truthfully stated in an article in the Reader\xe2\x80\x99s Digest. An examination of the advertisements,\nhowever, shows a perversion of the meaning of the Reader\xe2\x80\x99s Digest article which does little credit to the\ncompany\xe2\x80\x99s advertising department\xe2\x80\x94a perversion which results in the use of the truth in such a way as to\ncause the reader to believe the exact opposite of what was intended by the writer of the article. A\ncomparison of the advertisements with the article makes this very plain. The article, after referring to\nlaboratory tests that had been made on cigarettes of the leading brands, says:\n\xe2\x80\x9cThe laboratory\xe2\x80\x99s general conclusion will be sad news for the advertising copy writers, but good news for\nthe smoker, who need no longer worry as to which cigarette can most effectively nail down his coffin. For\none nail is just about as good as another. Says the laboratory report: \xe2\x80\x98The differences between brands are,\npractically speaking, small, and no single brand is so superior to its competitors as to justify its selection\non the ground that it is less harmful.\xe2\x80\x99 How small the variations are may be seen from the data tabulated\non page 7.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n761\n\n\x0cThe table referred to in the article was inserted for the express purpose of showing the insignificance of\nthe difference in the nicotine and tar content of the smoke from the various brands of cigarettes. It\nappears therefrom that the Old Gold cigarettes examined in the test contained less nicotine, tars and\nresins than the others examined, although the difference, according to the un-contradicted expert\nevidence, was so small as to be entirely insignificant and utterly without meaning so far as effect upon the\nsmoker is concerned. The company proceeded to advertise this difference as though it had received a\ncitation for public service instead of castigation from the Reader\xe2\x80\x99s Digest. In the leading newspapers of the\ncountry and over the radio it advertised that the Reader\xe2\x80\x99s Digest had had experiments conducted and had\nfound that Old Gold cigarettes were lowest in nicotine and lowest in irritating tars and resins, just as\nthough a substantial difference in such content had been found. The following advertisement may be\ntaken as typical:\nOLD GOLDS FOUND LOWEST IN NICOTINE\nOLD GOLDS FOUND LOWEST IN\nTHROAT-IRRITATING TARS AND RESINS\n\xe2\x80\x9cSee Impartial Test by Reader\xe2\x80\x99s Digest July Issue.\xe2\x80\x9d See How Your Brand Compares with Old Gold.\n\xe2\x80\x9cReader\xe2\x80\x99s Digest assigned a scientific testing laboratory to find out about cigarettes. They tested seven\nleading cigarettes and Reader\xe2\x80\x99s Digest published the results.\n\xe2\x80\x9cThe cigarette whose smoke was lowest in nicotine was Old Gold. The cigarette with the least throatirritating tars and resins was Old Gold.\n\xe2\x80\x9cOn both these major counts Old Gold was best among all seven cigarettes tested.\n\xe2\x80\x9cGet July Reader\xe2\x80\x99s Digest. Turn to Page 5. See what this highly respected magazine reports.\n\xe2\x80\x9cYou\xe2\x80\x99ll say, \xe2\x80\x98From now on, my cigarette is Old Gold.\xe2\x80\x99 Light one? Note the mild, interesting flavor. Easier\non the throat? Sure: And more smoking pleasure: Yes, it\xe2\x80\x99s the new Old Gold\xe2\x80\x94finer yet, since \xe2\x80\x98something\nnew has been added\xe2\x80\x99.\xe2\x80\x9d\nThe fault with this advertising was not that it did not print all that the Reader\xe2\x80\x99s Digest article said, but that\nit printed a small part thereof in such a way as to create an entirely false and misleading impression, not\nonly as to what was said in the article, but also as to the quality of the company\xe2\x80\x99s cigarettes. Almost\nanyone reading the advertisements or listening to the radio broadcasts would have gained the very\ndefinite impression that Old Gold cigarettes were less irritating to the throat and less harmful than other\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n762\n\n\x0cleading brands of cigarettes because they contained substantially less nicotine, tars and resins, and that\nthe Reader\xe2\x80\x99s Digest had established this fact in impartial laboratory tests; and few would have troubled to\nlook up the Reader\xe2\x80\x99s Digest to see what it really had said. The truth was exactly the opposite. There was no\nsubstantial difference in Old Gold cigarettes and the other leading brands with respect to their content of\nnicotine, tars and resins and this was what the Reader\xe2\x80\x99s Digest article plainly said. The table who\xe2\x80\x99s\nmeaning the advertisements distorted for the purpose of misleading and deceiving the public was\nintended to prove that there was no practical difference and did prove it when properly understood. To\ntell less than the whole truth is a well-known method of deception; and he who deceives by resorting to\nsuch method cannot excuse the deception by relying upon the truthfulness per se of the partial truth by\nwhich it has been accomplished.\nIn determining whether or not advertising is false or misleading within the meaning of the statute regard\nmust be had, not to fine spun distinctions and arguments that may be made in excuse, but to the effect\nwhich it might reasonably be expected to have upon the general public. \xe2\x80\x9cThe important criterion is the net\nimpression which the advertisement is likely to make upon the general populace.\xe2\x80\x9d As was well said by\nJudge Coxe in Florence Manufacturing Co. v. J. C Dowd & Co., with reference to the law relating to\ntrademarks: \xe2\x80\x9cThe law is not made for the protection of experts, but for the public\xe2\x80\x94that vast multitude\nwhich includes the ignorant, the unthinking and the credulous, who, in making purchases, do not stop to\nanalyze, but are governed by appearances and general impressions.\xe2\x80\x9d\n***\nFor the reasons stated, the petition to set aside the order will be denied and the order will be enforced.\n\nCASE QUESTIONS\n1.\n\nFrom a practical perspective, what (if anything) is wrong with caveat emptor\xe2\x80\x94\xe2\x80\x9dlet the buyer\nbeware\xe2\x80\x9d? The careful consumer could have looked at the Reader\xe2\x80\x99s Digest article; the magazine was\nwidely available in libraries and newsstands.\n\n2.\n\nWhy isn\xe2\x80\x99t this just an example of \xe2\x80\x9cpuffing\xe2\x80\x9d the company\xe2\x80\x99s wares? (Puffing presents opinions rather\nthan facts; statements like \xe2\x80\x9cThis car is a real winner\xe2\x80\x9d and \xe2\x80\x9cYour wife will love this watch\xe2\x80\x9d constitute\npuffing.)\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n763\n\n\x0c17.6 Summary and Exercises\nSummary\nSection 5 of the Federal Trade Commission (FTC) Act gives the FTC the power to enforce a provision\nprohibiting \xe2\x80\x9cunfair methods of competition and unfair or deceptive acts or practices in commerce.\xe2\x80\x9d Under\nthis power, the FTC may bring enforcement proceedings against companies on a case-by-case basis or\nmay promulgate trade regulation rules.\nA deceptive act or practice need not actually deceive as long as it is \xe2\x80\x9clikely to mislead.\xe2\x80\x9d An unfair act or\npractice need not deceive at all but must offend a common sense of propriety or justice or of an honest\nway of acting. Among the proscribed acts or practices are these: failure to disclose pertinent facts, false or\nmisleading description of products, misleading price and savings claims, bait-and-switch advertisements,\nfree-offer claims, false product comparisons and disparagements, and endorsements by those who do not\nuse the product or who have no reasonable basis for making the claims. Among the unfair trade practices\nthat the FTC has sought to deter are certain types of contests and sweepstakes, high-pressure door-todoor and mail-order selling, and certain types of negative-option plans.\nThe FTC has a number of remedial weapons: cease and desist orders tailored to the particular deception\nor unfair act (including affirmative disclosure in advertising and corrections in future advertising), civil\nmonetary penalties, and injunctions, damages, and restitution on behalf of injured consumers. Only the\nFTC may sue to correct violations of Section 5; private parties have no right to sue under Section 5, but\nthey can sue for certain kinds of false advertising under the federal trademark laws.\n\nEXERCISES\n1.\n\nIcebox Ike, a well-known tackle for a professional football team, was recently signed to a multimilliondollar contract to appear in a series of nationally televised advertisements touting the pleasures of\ngoing to the ballet and showing him in the audience watching a ballet. In fact, Icebox has never been\nto a ballet, although he has told his friends that he \xe2\x80\x9ctruly believes\xe2\x80\x9d ballet is a \xe2\x80\x9cwonderful thing.\xe2\x80\x9d The\nFTC opens an investigation to determine whether there are grounds to take legal action against Icebox\nand the ballet company ads. What advice can you give Icebox Ike? What remedies can the FTC seek?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n764\n\n\x0c2.\n\nDoor-to-door salespersons of an encyclopedia company offer a complete set of encyclopedias to\n\xe2\x80\x9cselected\xe2\x80\x9d customers. They tell customers that their only obligation is to pay for a ten-year updating\nservice. In fact, the price of the updating service includes the cost of the encyclopedias. The FTC sues,\ncharging deception under Section 5 of the FTC Act. The encyclopedia company defends itself on the\nground that no one could possibly have been misled because everyone must have understood that no\ncompany could afford to give away a twenty-volume set of books for free. What is the result?\n\n3.\n\nVanessa Cosmetics takes out full-page advertisements in the local newspaper stating that \xe2\x80\x9cthis Sunday\nonly\xe2\x80\x9d the Vanessa Makeup Kit will be \xe2\x80\x9creduced to only $25.\xe2\x80\x9d In fact, the regular price has been $25.50.\nDoes this constitute deceptive advertising? Why?\n\n4.\n\nLilliputian Department Stores advertises a \xe2\x80\x9cspecial\xe2\x80\x9d on an electric carrot slicer, priced \xe2\x80\x9cthis week only\nat $10.\xe2\x80\x9d When customers come to the store, they find the carrot slicer in frayed boxes, and the\nadvertised special is clearly inferior to a higher-grade carrot slicer priced at $25. When customers ask\nabout the difference, the store clerk tells them, \xe2\x80\x9cYou wouldn\xe2\x80\x99t want to buy the cheaper one; it wears\nout much too fast.\xe2\x80\x9d What grounds, if any, exist to charge Lilliputian with violations of the FTC Act?\n\n5.\n\nA toothpaste manufacturer advertises that special tests demonstrate that use of its toothpaste results\nin fewer cavities than \xe2\x80\x9cregular toothpaste.\xe2\x80\x9d In fact, the \xe2\x80\x9cregular\xe2\x80\x9d toothpaste was not marketed but\nwas merely the advertiser\xe2\x80\x99s brand stripped of its fluoride. Various studies over the years have\ndemonstrated, however, that fluoride in toothpaste will reduce the number of cavities a user will get.\nIs this advertisement deceptive under Section 5 of the FTC Act?\n\n6.\n\nMcDonald\xe2\x80\x99s advertises a sweepstakes through a mailing that says prizes are to be reserved for 15,610\n\xe2\x80\x9clucky winners.\xe2\x80\x9d The mailing further states, \xe2\x80\x9cYou may be [a winner] but you will never know if you\ndon\xe2\x80\x99t claim your prize. All prizes not claimed will never be given away, so hurry.\xe2\x80\x9d The mailing does not\ngive the odds of winning. The FTC sues to enjoin the mailing as deceptive. What is the result?\n\nSELF-TEST QUESTIONS\n1.\n\nSection 5 of the Federal Trade Commission Act is enforceable by\n\na.\n\na consumer in federal court\n\nb.\n\na consumer in state court\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n765\n\n\x0cc.\n\nthe FTC in an administrative proceeding\n\nd.\n\nthe FTC suing in federal court\nThe FTC\n\na.\n\nis an independent federal agency\nb.\n\nis an arm of the Justice Department\n\nc.\n\nsupersedes Congress in defining deceptive trade practices\n\nd.\n\nspeaks for the president on consumer matters\nA company falsely stated that its competitor\xe2\x80\x99s product \xe2\x80\x9cwon\xe2\x80\x99t work.\xe2\x80\x9d Which of the following\nstatements is false?\n\na.\n\nThe competitor may sue the company under state law.\nb.\n\nThe competitor may sue the company for violating the FTC Act.\n\nc.\n\nThe competitor may sue the company for violating the Lanham Act.\n\nd.\n\nThe FTC may sue the company for violating the FTC Act.\nThe FTC may order a company that violated Section 5 of the FTC Act by false advertising\n\na.\n\nto go out of business\nb.\n\nto close down the division of the company that paid for false advertising\n\nc.\n\nto issue corrective advertising\n\nd.\n\nto buy back from its customers all the products sold by the advertising\nThe ingredients in a nationally advertised cupcake must be disclosed on the package under\n\na.\n\nstate common law\nb.\n\na trade regulation rule promulgated by the FTC\n\nc.\n\nthe federal Food, Drug, and Cosmetic Act\n\nd.\n\nan executive order of the president\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n766\n\n\x0cSELF-TEST ANSWERS\n1.\n\nc\n\n2.\n\na\n\n3.\n\nb\n\n4.\n\nc\n\n5.\n\nb\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n767\n\n\x0cChapter 18\nEmployment Law\nLEARNING OBJECTIVES\nAfter reading this chapter, you should understand the following:\n1.\n\nHow common-law employment at will is modified by common-law doctrine, federal statutes, and\nstate statutes\n\n2.\n\nVarious kinds of prohibited discrimination under Title VII and examples of each kind\n\n3.\n\nThe various other protections for employees imposed by federal statute, including the Age\nDiscrimination in Employment Act (ADEA) and the Americans with Disabilities Act (ADA)\n\nIn the next chapter, we will examine the laws that govern the relationship between the employer and the\nemployee who belongs, or wants to belong, to a union. Although federal labor law is confined to that\nrelationship, laws dealing with the employment relationship\xe2\x80\x94both state and federal\xe2\x80\x94are far broader than\nthat. Because most employees do not belong to unions, a host of laws dealing with the many faces of\ndiscrimination shapes employers\xe2\x80\x99 power over and duties to their employees. Beyond the issue of\ndiscrimination, the law also governs a number of other issues, such as the extent to which an employer\nmay terminate the relationship itself. We examine these issues later in this chapter.\nEven before statutes governing collective bargaining and various state and federal discrimination laws,\nthe common law set the boundaries for employer-employee relationships. The basic rule that evolved\nprior to the twentieth century was \xe2\x80\x9cemployment at will.\xe2\x80\x9d We will look at employment at will toward the\nend of this chapter. But as we go through the key statutes on employment law and employment\ndiscrimination, bear in mind that these statutes stand as an important set of exceptions to the basic\ncommon-law rule of employment at will. That rule holds that in the absence of a contractual agreement\notherwise, an employee is free to leave employment at any time and for any reason; similarly, an employer\nis free to fire employees at any time and for any reason.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n768\n\n\x0c18.1 Federal Employment Discrimination Laws\nLEARNING OBJECTIVES\n1.\n\nKnow the various federal discrimination laws and how they are applied in various cases.\n\n2.\n\nDistinguish between disparate impact and disparate treatment cases.\n\n3.\n\nUnderstand the concept of affirmative action and its limits in employment law.\n\nAs we look at federal employment discrimination laws, bear in mind that most states also have laws that\nprohibit various kinds of discriminatory practices in employment. Until the 1960s, Congress had intruded\nbut little in the affairs of employers except in union relationships. A company could refuse to hire\nmembers of racial minorities, exclude women from promotions, or pay men more than women for the\nsame work. But with the rise of the civil rights movement in the early 1960s, Congress (and many states)\nbegan to legislate away the employer\xe2\x80\x99s frequently exercised power to discriminate. The most important\nstatutes are Title VII of the Civil Rights Act of 1964, the Equal Pay Act of 1963, the Age Discrimination in\nEmployment Act of 1967, and the Americans with Disabilities Act of 1990.\n\nTitle VII of the Civil Rights Act of 1964\nThe most basic antidiscrimination law in employment is in Title VII of the federal Civil Rights Act of 1964.\nThe key prohibited discrimination is that based on race, but Congress also included sex, religion, national\norigin, and color as prohibited bases for hiring, promotion, layoff, and discharge decisions. To put the\nCivil Rights Act in its proper context, a short history of racial discrimination in the United States follows.\nThe passage of the Civil Rights Act of 1964 was the culmination of a long history that dated back to\nslavery, the founding of the US legal system, the Civil War, and many historical and political\ndevelopments over the ninety-nine years from the end of the Civil War to the passage of the act. The years\nprior to 1964 had seen a remarkable rise of civil disobedience, led by many in the civil rights movement\nbut most prominently by Dr. Martin Luther King Jr. Peaceful civil disobedience was sometimes met with\nviolence, and television cameras were there to record most of it.\nWhile the Civil War had addressed slavery and the secession of Southern states, the Thirteenth,\nFourteenth, and Fifteenth Amendments, ratified just after the war, provided for equal protection under\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n769\n\n\x0cthe law, guaranteed citizenship, and protected the right to vote for African Americans. The amendments\nalso allowed Congress to enforce these provisions by enacting appropriate, specific legislation.\nBut during the Reconstruction Era, many of the Southern states resisted the laws that were passed in\nWashington, DC, to bolster civil rights. To a significant extent, decisions rendered by the US Supreme\nCourt in this era\xe2\x80\x94such as Plessy v. Ferguson, condoning \xe2\x80\x9cseparate but equal\xe2\x80\x9d facilities for different\nraces\xe2\x80\x94restricted the utility of these new federal laws. The states effectively controlled the public\ntreatment of African Americans, and a period of neglect set in that lasted until after World War II. The\nstate laws essentially mandated segregated facilities (restaurants, hotels, schools, water fountains, public\nbathrooms) that were usually inferior for blacks.\nAlong with these Jim Crow laws in the South, the Ku Klux Klan was very strong, and lynching\xe2\x80\x99s (hangings\nwithout any sort of public due process) by the Klan and others were designed to limit the civil and\neconomic rights of the former slaves. The hatred of blacks from that era by many whites in America has\nonly gradually softened since 1964. Even as the civil rights bill was being debated in Congress in 1964,\nsome Young Americans for Freedom in the right wing of the GOP would clandestinely chant \xe2\x80\x9cBe a man,\njoin the Klan\xe2\x80\x9d and sing \xe2\x80\x9cWe will hang Earl Warren from a sour apple tree,\xe2\x80\x9d to the tune of \xe2\x80\x9cBattle Hymn of\nthe Republic,\xe2\x80\x9d in anger over the Chief Justice\xe2\x80\x99s presiding over Brown v. Board of Education, which\nreversed Plessy v. Ferguson.\nBut just a few years earlier, the public service and heroism of many black military units and individuals in\nWorld War II had created a perceptual shift in US society; men of many races who had served together in\nthe war against the Axis powers (fascism in Europe and the Japanese emperor\xe2\x80\x99s rule in the Pacific) began\nto understand their common humanity. Major migrations of blacks from the South to industrial cities of\nthe North also gave impetus to the civil rights movement.\nBills introduced in Congress regarding employment policy brought the issue of civil rights to the attention\nof representatives and senators. In 1945, 1947, and 1949, the House of Representatives voted to abolish\nthe poll tax. The poll tax was a method used in many states to confine voting rights to those who could pay\na tax, and often, blacks could not. The Senate did not go along, but these bills signaled a growing interest\nin protecting civil rights through federal action. The executive branch of government, by presidential\norder, likewise became active by ending discrimination in the nation\xe2\x80\x99s military forces and in federal\nemployment and work done under government contract.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n770\n\n\x0cThe Supreme Court gave impetus to the civil rights movement in its reversal of the \xe2\x80\x9cseparate but equal\xe2\x80\x9d\ndoctrine in the Brown v. Board of Education decision. In its 1954 decision, the Court said, \xe2\x80\x9cTo separate\nblack children from others of similar age and qualifications solely because of their race generates a feeling\nof inferiority as to their status in the community that may affect their hearts and minds in a way never to\nbe undone.\xe2\x80\xa6We conclude that in the field of public education the doctrine of separate but equal has no\nplace. Separate educational facilities are inherently unequal.\xe2\x80\x9d\nThis decision meant that white and black children could not be forced to attend separate public schools.\nBy itself, however, this decision did not create immediate gains, either in public school desegregation or in\nthe desegregation of other public facilities. There were memorable standoffs between federal agents and\nstate officials in Little Rock, Arkansas, for example; the Democratic governor of Arkansas personally\nblocked young black students from entering Little Rock\xe2\x80\x99s Central High School, and it was only President\nEisenhower\xe2\x80\x99s order to have federal marshals accompany the students that forced integration. The year\nwas 1957.\nBut resistance to public school integration was widespread, and other public facilities were not governed\nby the Brown ruling. Restaurants, hotels, and other public facilities were still largely segregated.\nSegregation kept blacks from using public city buses, park facilities, and restrooms on an equal basis with\nwhites. Along with inferior schools, workplace practices throughout the South and also in many Northern\ncities sharply limited African Americans\xe2\x80\x99 ability to advance economically. Civil disobedience began to\ngrow.\nThe bus protests in Montgomery, Alabama, were particularly effective. Planned by civil rights leaders,\nRosa Parks\xe2\x80\x99 refusal to give up her seat to a white person and sit at the back of the public bus led to a\nboycott of the Montgomery bus system by blacks and, later, a boycott of white businesses in Montgomery.\nThere was months of confrontation and some violence; finally, the city agreed to end its long-standing\nrules on segregated seating on buses.\nThere were also protests at lunch counters and other protests on public buses, where groups of Northern\nprotesters\xe2\x80\x94Freedom Riders\xe2\x80\x94sometimes met with violence. In 1962, James Meredith\xe2\x80\x99s attempt to enroll\nas the first African American at the University of Mississippi generated extreme hostility; two people were\nkilled and 375 were injured as the state resisted Meredith\xe2\x80\x99s admission. The murders of civil rights workers\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n771\n\n\x0cMedgar Evers and William L. Moore added to the inflamed sentiments, and whites in Birmingham,\nAlabama, killed four young black girls who were attending Sunday school when their church was bombed.\nThese events were all covered by the nation\xe2\x80\x99s news media, whose photos showed beatings of protesters\nand the use of fire hoses on peaceful protesters. Social tensions were reaching a postwar high by 1964.\nAccording to the government, there were nearly one thousand civil rights demonstrations in 209 cities in\na three-month period beginning May 1963. Representatives and senators could not ignore the impact of\nsocial protest. But the complicated political history of the Civil Rights Act of 1964 also tells us that the\nlegislative result was anything but a foregone conclusion.\n\n[1]\n\nIn Title VII of the Civil Rights Act of 1964, Congress for the first time outlawed discrimination in\nemployment based on race, religion, sex, or national origin:. Title VII declares: \xe2\x80\x9cIt shall be an unlawful\nemployment practice for an employer to fail or refuse to hire or to discharge any individual, or otherwise\nto discriminate 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 Title VII applies to\n(1) employers with fifteen or more employees whose business affects interstate commerce, (2) all\nemployment agencies, (3) labor unions with fifteen or more members, (4) state and local governments\nand their agencies, and (5) most federal government employment.\nIn 1984, the Supreme Court said that Title VII applies to partnerships as well as corporations when ruling\nthat it is illegal to discriminatorily refuse to promote a female lawyer to partnership status in a law firm.\nThis applies, by implication, to other fields, such as accounting.\n\n[2]\n\nThe remedy for unlawful discrimination\n\nis back pay and hiring, reinstatement, or promotion.\nTitle VII established the Equal Employment Opportunity Commission (EEOC) to investigate violations of\nthe act. A victim of discrimination who wishes to file suit must first file a complaint with the EEOC to\npermit that agency to attempt conciliation of the dispute. The EEOC has filed a number of lawsuits to\nprove statistically that a company has systematically discriminated on one of the forbidden bases. The\nEEOC has received perennial criticism for its extreme slowness in filing suits and for failure to handle the\nhuge backlog of complaints with which it has had to wrestle.\nThe courts have come to recognize two major types of Title VII cases:\n1.\n\nCases of disparate treatment\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n772\n\n\x0co\n\nIn this type of lawsuit, the plaintiff asserts that because of race, sex, religion, or national origin, he or\nshe has been treated less favorably than others within the organization. To prevail in a disparate\ntreatment suit, the plaintiff must show that the company intended to discriminate because of one of\nthe factors the law forbids to be considered. Thus in McDonnell Douglas Corp. v. Green, the Supreme\nCourt held that the plaintiff had shown that the company intended to discriminate by refusing to\nrehire him because of his race.\n\n[3]\n\nIn general, there are two types of disparate treatment cases: (1)\n\npattern-and-practice cases, in which the employee asserts that the employer systematically\ndiscriminates on the grounds of race, religion, sex, or national origin; and (2) reprisal or retaliation\ncases, in which the employee must show that the employer discriminated against him or her because\nthat employee asserted his or her Title VII rights.\n2. Cases of disparate impact\no\n\nIn this second type of Title VII case, the employee need not show that the employer intended to\ndiscriminate but only that the effect, or impact, of the employer\xe2\x80\x99s action was discriminatory. Usually,\nthis impact will be upon an entire class of employees. The plaintiff must demonstrate that the reason\nfor the employer\xe2\x80\x99s conduct (such as refusal to promote) was not job related. Disparate impact cases\noften arise out of practices that appear to be neutral or nondiscriminatory on the surface, such as\neducational requirements and tests administered to help the employer choose the most qualified\ncandidate. In the seminal case of Griggs v. Duke Power Co., the Supreme Court held that under Title\nVII, an employer is not free to use any test it pleases; the test must bear a genuine relationship to job\nperformance.\n\n[4]\n\nGriggs stands for the proposition that Title VII \xe2\x80\x9cprohibits employment practices that\n\nhave discriminatory effects as well as those that are intended to discriminate.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n773\n\n\x0cFigure 18.1 A Checklist of Employment Law\n\nDiscrimination Based on Religion\nAn employer who systematically refuses to hire Catholics, Jews, Buddhists, or members of any other\nreligious group engages in unlawful disparate treatment under Title VII. But refusal to deal with someone\nbecause of his or her religion is not the only type of violation under the law. Title VII defines religion as\nincluding religious observances and practices as well as belief and requires the employer to \xe2\x80\x9creasonably\naccommodate to an employee\xe2\x80\x99s or prospective employee\xe2\x80\x99s religious observance or practice\xe2\x80\x9d unless the\nemployer can demonstrate that a reasonable accommodation would work an \xe2\x80\x9cundue hardship on the\nconduct of the employer\xe2\x80\x99s business.\xe2\x80\x9d Thus a company that refused even to consider permitting a devout\nSikh to wear his religiously prescribed turban on the job would violate Title VII.\nBut the company need not make an accommodation that would impose more than a minimal cost. For\nexample, an employee in an airline maintenance department, open twenty-four hours a day, wished to\navoid working on his Sabbath. The employee belonged to a union, and under the collective bargaining\nagreement, a rotation system determined by seniority would have put the worker into a work shift that fell\non his Sabbath. The Supreme Court held that the employer was not required to pay premium wages to\nsomeone whom the seniority system would not require to work on that day and could discharge the\nemployee if he refused the assignment.\nSaylor URL: http://www.saylor.org/books\n\n[5]\n\nSaylor.org\n774\n\n\x0cTitle VII permits religious organizations to give preference in employment to individuals of the same\nreligion. Obviously, a synagogue looking for a spiritual leader would hire a rabbi and not a priest.\n\nSex Discrimination\nA refusal to hire or promote a woman simply because she is female is a clear violation of Title VII. Under\nthe Pregnancy Act of 1978, Congress declared that discrimination because of pregnancy is a form of sex\ndiscrimination. Equal pay for equal or comparable work has also been an issue in sex (or gender)\ndiscrimination. Barbano v. Madison County (see ), presents a straightforward case of sex discrimination.\nIn that case, notice how the plaintiff has the initial burden of proving discriminatory intent and how the\nburden then shifts to the defendant to show a plausible, nondiscriminatory reason for its hiring decision.\nThe late 1970s brought another problem of sex discrimination to the fore: sexual harassment. There is\nmuch fear and ignorance about sexual harassment among both employers and employees. Many men\nthink they cannot compliment a woman on her appearance without risking at least a warning by the\nhuman resources department. Many employers have spent significant time and money trying to train\nemployees about sexual harassment, so as to avoid lawsuits. Put simply, sexual harassment involves\nunwelcome sexual advances, requests for sexual favors, and other verbal or physical conduct of a sexual\nnature.\nThere are two major categories of sexual harassment: (1) quid pro quo and (2) hostile work environment.\nQuid pro quo comes from the Latin phrase \xe2\x80\x9cone thing in return for another.\xe2\x80\x9d If any part of a job is made\nconditional on sexual activity, there is quid pro quo sexual harassment. Here, one person\xe2\x80\x99s power over\nanother is essential; a coworker, for example, is not usually in a position to make sexual demands on\nsomeone at his same level, unless he has special influence with a supervisor who has power to hire, fire,\npromote, or change work assignments. A supervisor, on the other hand, typically has those powers or the\npower to influence those kinds of changes. For example, when the male foreman says to the female line\nworker, \xe2\x80\x9cI can get you off of the night shift if you\xe2\x80\x99ll sleep with me,\xe2\x80\x9d there is quid pro quo sexual\nharassment.\nIn Harris v. Forklift Systems, Inc.\n\n[6]\n\nand in Meritor v. Vinson,\n\n[7]\n\nwe see examples of hostile work\n\nenvironment. Hostile work environment claims are more frequent than quid pro quo claims and so are\nmore worrisome to management. An employee has a valid claim of sexual harassment if sexual talk,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n775\n\n\x0cimagery, or behavior becomes so pervasive that it interferes with the employee\xe2\x80\x99s ability to work to her best\ncapacity. On occasion, courts have found that offensive jokes, if sufficiently frequent and pervasive in the\nworkplace, can create a hostile work environment. Likewise, comments about body parts or public\ndisplays of pornographic pictures can also create a hostile work environment. In short, the plaintiff can be\ndetrimentally offended and hindered in the workplace even if there are no measurable psychological\ninjuries.\nIn the landmark hostile work environment case of Meritor v. Vinson, the Supreme Court held that Title\nVII\xe2\x80\x99s ban on sexual harassment encompasses more than the trading of sexual favors for employment\nbenefits. Unlawful sexual harassment also includes the creation of a hostile or offensive working\nenvironment, subjecting both the offending employee and the company to damage suits even if the victim\nwas in no danger of being fired or of losing a promotion or raise.\nIn recalling Harris v. Forklift Systems (, ), we see that the \xe2\x80\x9creasonable person\xe2\x80\x9d standard is declared by the\ncourt as follows: \xe2\x80\x9cSo long as the environment would reasonably be perceived, and is perceived, as hostile\nor abusive there is no need for it also to be psychologically injurious.\xe2\x80\x9d In Duncan v. General Motors\nCorporation (see), Harris is used as a precedent to deny relief to a woman who was sexually harassed,\nbecause the court believed the conditions were not severe or pervasive enough to unreasonably interfere\nwith her work.\nSex discrimination in terms of wages and benefits is common enough that a number of sizeable class\naction lawsuits have been brought. A class action lawsuit is generally initiated by one or more people who\nbelieve that they, along with a group of other people, have been wronged in similar ways. Class actions for\nsexual harassment have been successful in the past. On June 11, 1998, the EEOC reached a $34 million\nsettlement with Mitsubishi over allegations of widespread sexual harassment at the Normal, Illinois, auto\nplant. The settlement involved about five hundred women who split the $34 million, although only seven\nreceived the maximum $300,000 allowed by law. The others received amounts ranging from $8,000 to\n$225,000.\nClass action lawsuits involve specific plaintiffs (called class plaintiffs or class representatives) who are\nnamed in the class action lawsuit to assert the claims of the unnamed or absent members of the class; thus\nall those with a common complaint need not file their own separate lawsuit. From the point of view of\nplaintiffs who may have lost only a few thousand dollars annually as a result of the discrimination, a class\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n776\n\n\x0caction is advantageous: almost no lawyer would take a complicated civil case that had a potential gain of\nonly a few thousand dollars. But if there are thousands of plaintiffs with very similar claims, the judgment\ncould be well into the millions. Defendants can win the procedural battle by convincing a court that the\nproposed class of plaintiffs does not present common questions of law or of fact.\nIn the Wal-Mart class action case decided by the Supreme Court in 2011, three named plaintiffs (Dukes,\nArana, and Kwapnoski) represented a proposed class of 1.5 million current or former Wal-Mart\nemployees. The plaintiffs\xe2\x80\x99 attorneys asked the trial court in 2001 to certify as a class all women employed\nat any Wal-Mart domestic retail store at any time since December of 1998. As the case progressed through\nthe judicial system, the class grew in size. If the class was certified, and discrimination proven, Wal-Mart\ncould have been liable for over $1 billion in back pay. So Wal-Mart argued that as plaintiffs, the cases of\nthe 1.5 million women did not present common questions of law or of fact\xe2\x80\x94that is, that the claims were\ndifferent enough that the Court should not allow a single class action lawsuit to present such differing\nkinds of claims. Initially, a federal judge disagreed, finding the class sufficiently coherent for purposes of\nfederal civil procedure. The US Court of Appeals for the Ninth Circuit upheld the trial judge on two\noccasions.\nBut the US Supreme Court agreed with Wal-Mart. In the majority opinion, Justice Scalia discussed the\ncommonality condition for class actions.\nQuite obviously, the mere claim by employees of the same company that they have suffered a Title VII\ninjury, or even a disparate impact Title VII injury, gives no cause to believe that all their claims can\nproductively be litigated at once. Their claims must depend upon a common contention\xe2\x80\x94for example, the\nassertion of discriminatory bias on the part of the same supervisor. That common contention, moreover,\nmust be of such a nature that it is capable of class-wide resolution\xe2\x80\x94which means that determination of its\ntruth or falsity will resolve an issue that is central to the validity of each one of the claims in one stroke.\n\n[8]\n\nFinding that there was no common contention, the Supreme Court reversed the lower courts. Many\ncommentators, and four dissenting Justices, believed that the majority opinion has created an\nunnecessarily high hurdle for class action plaintiffs in Title VII cases.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n777\n\n\x0cDiscrimination Based on Race, Color, and National Origin\nTitle VII was primarily enacted to prohibit employment discrimination based on race, color, and national\norigin. Race refers to broad categories such as black, Caucasian, Asian, and Native American. Color simply\nrefers to the color of a person\xe2\x80\x99s skin, and national origin refers to the country of the person\xe2\x80\x99s ancestry.\n\nExceptions to Title VII\nMerit\nEmployers are allowed to select on merit and promote on merit without offending title VII\xe2\x80\x99s requirements.\nMerit decisions are usually based on work, educational experience, and ability tests. All requirements,\nhowever, must be job related. For example, the ability to lift heavy cartons of sixty pounds or more is\nappropriate for certain warehouse jobs but is not appropriate for all office workers. The ability to do\nroutine maintenance (electrical, plumbing, construction) is an appropriate requirement for maintenance\nwork but not for a teaching position. Requiring someone to have a high school degree, as in Griggs vs.\nDuke Power Co., is not appropriate as a qualification for common labor.\n\nSeniority\nEmployers may also maintain seniority systems that reward workers who have been with the company for\na long time. Higher wages, benefits, and choice of working hours or vacation schedules are examples of\nrewards that provide employees with an incentive to stay with the company. If they are not the result of\nintentional discrimination, they are lawful. Where an employer is dealing with a union, it is typical to see\nseniority systems in place.\n\nBona Fide Occupational Qualification (BFOQ)\nFor certain kinds of jobs, employers may impose bona fide occupational qualifications (BFOQs). Under\nthe express terms of Title VII, however, a bona fide (good faith) occupational qualification of race or color\nis never allowed. In the area of religion, as noted earlier, a group of a certain religious faith that is\nsearching for a new spiritual leader can certainly limit its search to those of the same religion. With regard\nto sex (gender), allowing women to be locker-room attendants only in a women\xe2\x80\x99s gym is a valid BFOQ.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n778\n\n\x0cOne important test that the courts employ in evaluating an employer\xe2\x80\x99s BFOQ claims is the \xe2\x80\x9cessence of the\nbusiness\xe2\x80\x9d test.\nIn Diaz v. Pan American World Airways, Inc., the airline maintained a policy of exclusively hiring\nfemales for its flight attendant positions.\n\n[9]\n\nThe essence of the business test was established with the\n\ncourt\xe2\x80\x99s finding that \xe2\x80\x9cdiscrimination based on sex is valid only when the essence of the business operation\nwould be undermined by not hiring members of one sex exclusively.\xe2\x80\x9d Although the court acknowledged\nthat females might be better suited to fulfill the required duties of the position, this was not enough to\nfulfill the essence of the business test:\nThe primary function of an airline is to transport passengers safely from one point to another. While a\npleasant environment, enhanced by the obvious cosmetic effect that female stewardesses provide as well\nas\xe2\x80\xa6their apparent ability to perform the non-mechanical functions of the job in a more effective manner\nthan most men, may all be important, they are tangential to the essence of the business involved. No one\nhas suggested that having male stewards will so seriously affect the operation of an airline as to jeopardize\nor even minimize its ability to provide safe transportation from one place to another.\n\n[10]\n\nThe reason that airlines now use the gender-neutral term flight attendant is a direct result of Title VII. In\nthe 1990s, Hooters had some difficulty convincing the EEOC and certain male plaintiffs that only women\ncould be hired as wait staff in its restaurants. With regard to national origin, directors of movies and\ntheatrical productions would be within their Title VII BFOQ rights to restrict the roles of fictional Asians\nto those actors whose national origin was Asian, but could also permissibly hire Caucasian actors made up\nin \xe2\x80\x9cyellow face.\xe2\x80\x9d\n\nDefenses in Sexual Harassment Cases\nIn the 1977 term, the US Supreme Court issued two decisions that provide an affirmative defense in some\nsexual harassment cases. In Faragher v. City of Boca Raton\nEllerth,\n\n[12]\n\n[11]\n\nand in Burlington Industries, Inc. v.\n\nfemale employees sued for sexual harassment. In each case, they proved that their supervisors\n\nhad engaged in unconsented-to touching as well as verbal sexual harassment. In both cases, the plaintiff\nquit her job and, after going through the EEOC process, got a right-to-sue letter and in fact sued for sexual\nharassment. In Faragher, the employer had never disseminated the policy against sexual harassment to\nits employees. But in the second case, Burlington Industries, the employer had a policy that was made\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n779\n\n\x0cknown to employees. Moreover, a complaints system had been established that was not used by the\nfemale employee.\nBoth opinions rejected the notion of strict or automatic liability for employers when agents (employees)\nengage in sexual harassment. But the employer can have a valid defense to liability if it can prove (1) that\nit exercised reasonable care to prevent and correct any sexual harassment behaviors and (2) that the\nplaintiff employee unreasonably failed to take advantage of any preventive or corrective opportunities\nprovided by the employer or to otherwise avoid harm. As with all affirmative defenses, the employer has\nthe burden of proving this defense.\n\nAffirmative Action\nAffirmative action is mentioned in the statutory language of Title VII, as courts have the power to order\naffirmative action as a remedy for the effects of past discriminatory actions. In addition to court-ordered\naffirmative action, employers may voluntarily use an affirmative action plan to remedy the effects of past\npractices or to achieve diversity within the workforce to reflect the diversity in their community.\nIn Johnson v. Santa Clara County Transportation Agency,\n\n[13]\n\nthe agency had an affirmative action plan.\n\nA woman was promoted from within to the position of dispatcher, even though a male candidate had a\nslightly higher score on a test that was designed to measure aptitude for the job. The man brought a\nlawsuit alleging sex discrimination. The Court found that voluntary affirmative action was not reverse\ndiscrimination in this case, but employers should be careful in hiring and firing and layoff decisions\nversus promotion decisions. It is in the area of promotions that affirmative action is more likely to be\nupheld.\nIn government contracts, President Lyndon Johnson\xe2\x80\x99s Executive Order 11246 prohibits private\ndiscrimination by federal contractors. This is important, because one-third of all US workers are\nemployed by companies that do business with the federal government. Because of this executive order,\nmany companies that do business with the government have adopted voluntary affirmative action\nprograms. In 1995, the Supreme Court limited the extent to which the government could require\ncontractors to establish affirmative action programs. The Court said that such programs are permissible\nonly if they serve a \xe2\x80\x9ccompelling national interest\xe2\x80\x9d and are \xe2\x80\x9cnarrowly tailored\xe2\x80\x9d so that they minimize the\nharm to white males. To make a requirement for contractors, the government must show that the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n780\n\n\x0cprograms are needed to remedy past discrimination, that the programs have time limits, and that\nnondiscriminatory alternatives are not available.\n\n[14]\n\nThe Age Discrimination in Employment Act\nThe Age Discrimination in Employment Act (ADEA) of 1967 (amended in 1978 and again in 1986)\nprohibits discrimination based on age, and recourse to this law has been growing at a faster rate than any\nother federal anti-bias employment law. In particular, the act protects workers over forty years of age and\nprohibits forced retirement in most jobs because of age. Until 1987, federal law had permitted mandatory\nretirement at age seventy, but the 1986 amendments that took effect January 1, 1987, abolished the age\nceiling except for a few jobs, such as firefighters, police officers, tenured university professors, and\nexecutives with annual pensions exceeding $44,000. Like Title VII, the law has a BFOQ exception\xe2\x80\x94for\nexample, employers may set reasonable age limitations on certain high-stress jobs requiring peak physical\ncondition.\nThere are important differences between the ADEA and Title VII, as Gross v. FBL Financial Services,\nInc. () makes clear. It is now more difficult to prove an age discrimination claim than a claim under Title\n\nVII.\n\nDisabilities: Discrimination against the Handicapped\nThe 1990 Americans with Disabilities Act (ADA) prohibits employers from discriminating on the basis of\ndisability. A disabled person is someone with a physical or mental impairment that substantially limits a\nmajor life activity or someone who is regarded as having such impairment. This definition includes people\nwith mental illness, epilepsy, visual impairment, dyslexia, and AIDS. It also covers anyone who has\nrecovered from alcoholism or drug addiction. It specifically does not cover people with sexual disorders,\npyromania, kleptomania, exhibitionism, or compulsive gambling.\nEmployers cannot disqualify an employee or job applicant because of disability as long as he or she can\nperform the essential functions of the job, with reasonable accommodation. Reasonable accommodation\nmight include installing ramps for a wheelchair, establishing more flexible working hours, creating or\nmodifying job assignments, and the like.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n781\n\n\x0cReasonable accommodation means that there is no undue hardship for the employer. The law does not\noffer uniform standards for identifying what may be an undue hardship other than the imposition on the\nemployer of a \xe2\x80\x9csignificant difficulty or expense.\xe2\x80\x9d Cases will differ: the resources and situation of each\nparticular employer relative to the cost or difficulty of providing the accommodation will be considered;\nrelative cost, rather than some definite dollar amount, will be the issue.\nAs with other areas of employment discrimination, job interviewers cannot ask questions about an\napplicant\xe2\x80\x99s disabilities before making a job offer; the interviewer may only ask whether the applicant can\nperform the work. Requirements for a medical exam are a violation of the ADA unless the exam is job\nrelated and required of all applicants for similar jobs. Employers may, however, use drug testing, although\npublic employers are to some extent limited by the Fourth Amendment requirements of reasonableness.\nThe ADA\xe2\x80\x99s definition of disability is very broad. However, the Supreme Court has issued several important\ndecisions that narrow the definition of what constitutes a disability under the act.\nTwo kinds of narrowing decisions stand out: one deals with \xe2\x80\x9ccorrectable conditions,\xe2\x80\x9d and the other deals\nwith repetitive stress injuries. In 1999, the Supreme Court reviewed a case that raised an issue of whether\nsevere nearsightedness (which can be corrected with lenses) qualifies as a disability under the\nADA.\n\n[15]\n\nThe Supreme Court ruled that disability under the ADA will be measured according to how a\n\nperson functions with corrective drugs or devices and not how the person functions without them. In Orr\nv. Wal-Mart Stores, Inc., a federal appellate court held that a pharmacist who suffered from diabetes did\nnot have a cause of action against Wal-Mart under the ADA as long as the condition could be corrected by\ninsulin.\n\n[16]\n\nThe other narrowing decision deals with repetitive stress injuries. For example, carpal tunnel syndrome\xe2\x80\x94\nor any other repetitive stress injury\xe2\x80\x94could constitute a disability under the ADA. By compressing a nerve\nin the wrist through repetitive use, carpal tunnel syndrome causes pain and weakness in the hand. In\n2002, the Supreme Court determined that while an employee with carpal tunnel syndrome could not\nperform all the manual tasks assigned to her, her condition did not constitute a disability under the ADA\nbecause it did not \xe2\x80\x9cextensively limit\xe2\x80\x9d her major life activities. (See.)\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n782\n\n\x0cEqual Pay Act\nThe Equal Pay Act of 1963 protects both men and women from pay discrimination based on sex. The act\ncovers all levels of private sector employees and state and local government employees but not federal\nworkers. The act prohibits disparity in pay for jobs that require equal skill and equal effort. Equal skill\nmeans equal experience, and equal effort means comparable mental and/or physical exertion. The act\nprohibits disparity in pay for jobs that require equal responsibility, such as equal supervision and\naccountability, or similar working conditions.\nIn making their determinations, courts will look at the stated requirements of a job as well as the actual\nrequirements of the job. If two jobs are judged to be equal and similar, the employer cannot pay disparate\nwages to members of different sexes. Along with the EEOC enforcement, employees can also bring private\ncauses of action against an employer for violating this act. There are four criteria that can be used as\ndefenses in justifying differentials in wages: seniority, merit, quantity or quality of product, and any factor\nother than sex. The employer will bear the burden of proving any of these defenses.\nA defense based on merit will require that there is some clearly measurable standard that justifies the\ndifferential. In terms of quantity or quality of product, there may be a commission structure, piecework\nstructure, or quality-control-based payment system that will be permitted. Factors \xe2\x80\x9cother than sex\xe2\x80\x9d do not\ninclude so-called market forces. In Glenn v. General Motors Corp., the US Court of Appeals for the\nEleventh Circuit rejected General Motor\xe2\x80\x99s argument that it was justified in paying three women less than\ntheir male counterparts on the basis of \xe2\x80\x9cthe market force theory\xe2\x80\x9d that women will work for less than a\nman.\n\n[17]\n\nKEY TAKEAWAY\nStarting with employment at will as a common-law doctrine, we see many modifications by statute,\nparticularly after 1960. Title VII of the Civil Rights Act of 1964 is the most significant, for it prohibits\nemployers engaged in interstate commerce from discriminating on the basis of race, color, sex,\nreligion, or national origin.\nSex discrimination, especially sexual harassment, has been a particularly fertile source of litigation.\nThere are many defenses to Title VII claims: the employer may have a merit system or a seniority\nsystem in place, or there may be bona fide occupational qualifications in religion, gender, or national\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n783\n\n\x0corigin. In addition to Title VII, federal statutes limiting employment discrimination are the ADEA, the\nADA, and the Equal Pay Act.\n\nEXERCISES\n1.\n\nGo to the EEOC website. Describe the process by which an employee or ex-employee who wants to\nmake a Title VII claim obtains a right-to-sue letter from the EEOC.\n\n2.\n\nAgain, looking at the EEOC website, find the statistical analysis of Title VII claims brought to the EEOC.\nWhat kind of discrimination is most frequent?\n\n3.\n\nAccording to the EEOC website, what is \xe2\x80\x9cretaliation\xe2\x80\x9d? How frequent are retaliation claims relative to\nother kinds of claims?\n\n4.\n\nGreg Connolly is a member of the Church of God and believes that premarital sex and abortion are\nsinful. He works as a pharmacist for Wal-Mart, and at many times during the week, he is the only\npharmacist available to fill prescriptions. One product sold at his Wal-Mart is the morning-after pill\n(RU 468). Based on his religious beliefs, he tells his employer that he will refuse to fill prescriptions for\nthe morning-after pill. Must Wal-Mart make a reasonable accommodation to his religious beliefs?\n\n[1] See Congress Link, \xe2\x80\x9cMajor Features of the Civil Rights Act of 1964,\xe2\x80\x9d\nathttp://www.congresslink.org/print_basics_histmats_civilrights64text.htm.\n[2] Hishon v. King & Spalding, 467 U.S. 69 (1984).\n[3] McDonnell Douglas Corp. v. Green, 411 U.S. 792 (1973).\n[4] Griggs v. Duke Power Co., 401 U.S. 424 (1971).\n[5] Trans World Airlines v. Hardison, 432 U.S. 63 (1977).\n[6] Harris v. Forklift Systems, Inc., 510 U.S. 17 (1993).\n[7] Meritor v. Vinson, 477 U.S. 57 (1986).\n[8] 564 U.S. ___ (2011).\n[9] Diaz v. Pan American World Airways, Inc., 442 F.2d 385 (5th Cir. 1971).\n[10] Diaz v. Pan American World Airways, Inc., 442 F.2d 385 (5th Cir. 1971).\n[11] Faragher v. City of Boca Raton, 524 U.S. 775 (1998).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n784\n\n\x0c[12] Burlington Industries v. Ellerth, 524 U.S. 742 (1988).\n[13] Johnson v. Santa Clara County Transportation Agency, 480 U.S. 616 (1987).\n[14] Adarand Constructors, Inc. v. Pena, 515 U.S. 200 (1995).\n[15] Sutton v. United Airlines, Inc., 527 U.S. 471 (1999).\n[16] Orr v. Wal-Mart Stores, Inc., 297 F.3d 720 (8th Cir. 2002).\n[17] Glenn v. General Motors Corp., 841 F.2d 1567 (1988).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n785\n\n\x0c18.2 Employment at Will\nLEARNING OBJECTIVES\n1.\n\nUnderstand what is meant by employment at will under common law.\n\n2.\n\nExplain the kinds of common-law (judicially created) exceptions to the employment-at-will doctrine,\nand provide examples.\n\nAt common law, an employee without a contract guaranteeing a job for a specific period was an employee\nat will and could be fired at any time and for any reason, or even for no reason at all. The various federal\nstatutes we have just examined have made inroads on the at-will doctrine. Another federal statute, the\nOccupational Safety and Health Act, prohibits employers from discharging employees who exercise their\nrights under that law.\nThe courts and legislatures in more than forty states have made revolutionary changes in the at-will\ndoctrine. They have done so under three theories: tort, contract, and duty of good faith and fair dealing.\nWe will first consider the tort of wrongful discharge.\nCourts have created a major exception to the employment-at-will rule by allowing the tort of wrongful\ndischarge. Wrongful discharge means firing a worker for a bad reason. What is a bad reason? A bad\nreason can be (1) discharging an employee for refusing to violate a law, (2) discharging an employee for\nexercising a legal right, (3) discharging an employee for performing a legal duty, and (4) discharging an\nemployee in a way that violates public policy.\n\nDischarging an Employee for Refusing to Violate a Law\nSome employers will not want employees to testify truthfully at trial. In one case, a nurse refused a\ndoctor\xe2\x80\x99s order to administer a certain anesthetic when she believed it was wrong for that particular\npatient; the doctor, angry at the nurse for refusing to obey him, then administered the anesthetic himself.\nThe patient soon stopped breathing. The doctor and others could not resuscitate him soon enough, and he\nsuffered permanent brain damage. When the patient\xe2\x80\x99s family sued the hospital, the hospital told the nurse\nshe would be in trouble if she testified. She did testify according to her oath in the court of law (i.e.,\ntruthfully), and after several months of harassment, was finally fired on a pretext. The hospital was held\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n786\n\n\x0cliable for the tort of wrongful discharge. As a general rule, you should not fire an employee for refusing to\nbreak the law.\n\nDischarging an Employee for Exercising a Legal Right\nSuppose Bob Berkowitz files a claim for workers\xe2\x80\x99 compensation for an accident at Pacific Gas & Electric,\nwhere he works and where the accident that injured him took place. He is fired for doing so, because the\nemployer does not want to have its workers\xe2\x80\x99 comp premiums increased. In this case, the right exercised by\nBerkowitz is supported by public policy: he has a legal right to file the claim, and if he can establish that\nhis discharge was caused by his filing the claim, he will prove the tort of wrongful discharge.\n\nDischarging an Employee for Performing a Legal Duty\nCourts have long held that an employee may not be fired for serving on a jury. This is so even though\ncourts do recognize that many employers have difficulty replacing employees called for jury duty. Jury\nduty is an important civic obligation, and employers are not permitted to undermine it.\n\nDischarging an Employee in a Way That Violates Public Policy\nThis is probably the most controversial basis for a tort of wrongful discharge. There is an inherent\nvagueness in the phrase \xe2\x80\x9cbasic social rights, duties, or responsibilities.\xe2\x80\x9d This is similar to the exception in\ncontract law: the courts will not enforce contract provisions that violate public policy. (For the most part,\npublic policy is found in statutes and in cases.) But what constitutes public policy is an important decision\nfor state courts. In Wagenseller v. Scottsdale Memorial Hospital,\n\n[1]\n\nfor example, a nurse who refused to\n\n\xe2\x80\x9cplay along\xe2\x80\x9d with her coworkers on a rafting trip was discharged. The group of coworkers had socialized at\nnight, drinking alcohol; when the partying was near its peak, the plaintiff refused to be part of a group\nthat bared their buttocks to the tune of \xe2\x80\x9cMoon River\xe2\x80\x9d (a composition by Henry Mancini that was popular\nin the 1970s). The court, at great length, considered that \xe2\x80\x9cmooning\xe2\x80\x9d was a misdemeanor under Arizona\nlaw and that therefore her employer could not discharge her for refusing to violate a state law.\nOther courts have gone so far as to include professional oaths and codes as part of public policy. In Rocky\nMountain Hospital and Medical Services v. Diane Mariani, the Colorado Supreme Court reviewed a trial\ncourt decision to refuse relief to a certified public accountant who was discharged when she refused to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n787\n\n\x0cviolate her professional code.\n\n[2]\n\n(Her employer had repeatedly required her to come up with numbers and\n\nresults that did not reflect the true situation, using processes that were not in accord with her training and\nthe code.) The court of appeals had reversed the trial court, and the Supreme Court had to decide if the\nprofessional code of Colorado accountants could be considered to be part of public policy. Given that\naccountants were licensed by the state on behalf of the public, and that the Board of Accountancy had\npublished a code for accounting professionals and required an oath before licensing, the court noted the\nfollowing:\nThe Colorado State Board of Accountancy is established pursuant to section 12-2-103, 5A C.R.S. (1991).\nThe Board has responsibility for making appropriate rules of professional conduct, in order to establish\nand maintain a high standard of integrity in the profession of public accounting. \xc2\xa7 12-2-104, 5A C.R.S.\n(1991). These rules of professional conduct govern every person practicing as a certified public\naccountant. Id. Failure to abide by these rules may result in professional discipline. \xc2\xa7 12-2-123, 5A C.R.S.\n(1991). The rules of professional conduct for accountants have an important public purpose. They ensure\nthe accurate reporting of financial information to the public. They allow the public and the business\ncommunity to rely with confidence on financial reporting. Rule 7.1, 3 C.C.R. 705-1 (1991). In addition, they\nensure that financial information will be reported consistently across many businesses. The legislature\nhas endorsed these goals in section 12-2-101, 5A C.R.S.\nThe court went on to note that the stated purpose of the licensing and registration of certified public\naccountants was to \xe2\x80\x9cprovide for the maintenance of high standards of professional conduct by those so\nlicensed and registered as certified public accountants.\xe2\x80\x9d Further, the specific purpose of Rule 7.1 provided\na clear mandate to support an action for wrongful discharge. Rule 7.1 is entitled \xe2\x80\x9cIntegrity and\nObjectivity\xe2\x80\x9d and states, \xe2\x80\x9cA certificate holder shall not in the performance of professional services\nknowingly misrepresent facts, nor subordinate his judgment to others.\xe2\x80\x9d The fact that Mariani\xe2\x80\x99s employer\nasked her to knowingly misrepresent facts was a sufficient basis in public policy to make her discharge\nwrongful.\n\nContract Modification of Employment at Will\nContract law can modify employment at will. Oral promises made in the hiring process may be\nenforceable even though the promises are not approved by top management. Employee handbooks may\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n788\n\n\x0ccreate implied contracts that specify personnel processes and statements that the employees can be fired\nonly for a \xe2\x80\x9cjust cause\xe2\x80\x9d or only after various warnings, notice, hearing, or other procedures.\n\nGood Faith and Fair Dealing Standard\nA few states, among them Massachusetts and California, have modified the at-will doctrine in a farreaching way by holding that every employer has entered into an implied covenant of good faith and fair\ndealing with its employees. That means, the courts in these states say, that it is \xe2\x80\x9cbad faith\xe2\x80\x9d and therefore\nunlawful to discharge employees to avoid paying commissions or pensions due them. Under this implied\ncovenant of fair dealing, any discharge without good cause\xe2\x80\x94such as incompetence, corruption, or habitual\ntardiness\xe2\x80\x94is actionable. This is not the majority view, as the case in Section 18.4.4 "Disability\nDiscrimination" makes clear.\n\nKEY TAKEAWAY\nAlthough employment at will is still the law, numerous exceptions have been established by judicial\ndecision. Employers can be liable for the tort of wrongful discharge if they discharge an employee for\nrefusing to violate a law, for exercising a legal right or performing a legal duty, or in a way that violates\nbasic public policy.\n\nEXERCISES\n1.\n\nRichard Mudd, an employee of CompuServe, is called for jury duty in Wayne County, Michigan. His\nimmediate supervisor, Harvey Lorie, lets him know that he \xe2\x80\x9cmust\xe2\x80\x9d avoid jury duty at all costs. Mudd\ntells the judge of his circumstances and his need to be at work, but the judge refuses to let Mudd\navoid jury duty. Mudd spends the next two weeks at trial. He sends regular e-mails and texts to Lorie\nduring this time, but on the fourth day gets a text message from Lorie that says, \xe2\x80\x9cDon\xe2\x80\x99t bother to\ncome back.\xe2\x80\x9d When he does return, Lorie tells him he is fired. Does Mudd have a cause of action for\nthe tort of wrongful discharge?\n\n2.\n\nOlga Monge was a schoolteacher in her native Costa Rica. She moved to New Hampshire and attended\ncollege in the evenings to earn US teaching credentials. At night, she worked at the Beebe Rubber\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n789\n\n\x0cCompany after caring for her husband and three children during the day. When she applied for a\nbetter job at the plant, the foreman offered to promote her if she would be \xe2\x80\x9cnice\xe2\x80\x9d and go out on a\ndate with him. She refused, and he assigned her to a lower-wage job, took away her overtime, made\nher clean the washrooms, and generally ridiculed her. She finally collapsed at work, and he fired her.\nDoes Monge have any cause of action?\n\n[1] Wagenseller v. Scottsdale Memorial Hospital, 147 Ariz. 370; 710 P.2d 1025 (1085).\n[2] Rocky Mountain Hospital and Medical Services v. Diane Mariani, 916 P.2d 519 (Colo. 1996).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n790\n\n\x0c18.3 Other Employment-Related Laws\nLEARNING OBJECTIVE\n1.\n\nUnderstand the various federal and state statutes that affect employers in the areas of plant closings,\npensions, workers\xe2\x80\x99 compensation, use of polygraphs, and worker safety.\n\nThe Federal Plant-Closing Act\nA prime source of new jobs across the United States is the opening of new industrial plants\xe2\x80\x94which\naccounted for millions of jobs a year during the 1970s and 1980s. But for every 110 jobs thus created,\nnearly 100 were lost annually in plant closings during that period. In the mid-1980s alone, 2.2 million\nplant jobs were lost each year. As serious as those losses were for the national economy, they were no less\nserious for the individuals who were let go. Surveys in the 1980s showed that large numbers of companies\nprovided little or no notice to employees that their factories were to be shut down and their jobs\neliminated. Nearly a quarter of businesses with more than 100 employees provided no specific notice to\ntheir employees that their particular work site would be closed or that they would suffer mass layoffs.\nMore than half provided two weeks\xe2\x80\x99 notice or less.\nBecause programs to support dislocated workers depend heavily on the giving of advance notice, a\nnational debate on the issue in the late 1980s culminated in 1988 in Congress\xe2\x80\x99s enactment of the Worker\nAdjustment and Retraining Notification (WARN) Act, the formal name of the federal plant-closing act.\nUnder this law, businesses with 100 or more employees must give employees or their local bargaining\nunit, along with the local city or county government, at least sixty days\xe2\x80\x99 notice whenever (1) at least 50\nemployees in a single plant or office facility would lose their jobs or face long-term layoffs or a reduction\nof more than half their working hours as the result of a shutdown and (2) a shutdown would require longterm layoffs of 500 employees or at least a third of the workforce. An employer who violates the act is\nliable to employees for back pay that they would have received during the notice period and may be liable\nto other fines and penalties.\nAn employer is exempted from having to give notice if the closing is caused by business circumstances\nthat were not reasonably foreseeable as of the time the notice would have been required. An employer is\nalso exempted if the business is actively seeking capital or business that if obtained, would avoid or\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n791\n\n\x0cpostpone the shutdown and the employer, in good faith, believes that giving notice would preclude the\nbusiness from obtaining the needed capital or business.\n\nThe Employee Polygraph Protection Act\nStudies calling into question the reliability of various forms of lie detectors have led at least half the states\nand, in 1988, Congress to legislate against their use by private businesses. The Employee Polygraph\nProtection Act forbids private employers from using lie detectors (including such devices as voice stress\nanalyzers) for any reason. Neither employees nor applicants for jobs may be required or even asked to\nsubmit to them. (The act has some exceptions for public employers, defense and intelligence businesses,\nprivate companies in the security business, and manufacturers of controlled substances.)\nUse of polygraphs, machines that record changes in the subject\xe2\x80\x99s blood pressure, pulse, and other\nphysiological phenomena, is strictly limited. They may be used in conjunction with an investigation into\nsuch crimes as theft, embezzlement, and industrial espionage, but in order to require the employee to\nsubmit to polygraph testing, the employer must have \xe2\x80\x9creasonable suspicion\xe2\x80\x9d that the employee is involved\nin the crime, and there must be supporting evidence for the employer to discipline or discharge the\nemployee either on the basis of the polygraph results or on the employee\xe2\x80\x99s refusal to submit to testing.\nThe federal polygraph law does not preempt state laws, so if a state law absolutely bars an employer from\nusing one, the federal law\xe2\x80\x99s limited authorization will be unavailable.\n\nOccupational Safety and Health Act\nIn a heavily industrialized society, workplace safety is a major concern. Hundreds of studies for more than\na century have documented the gruesome toll taken by hazardous working conditions in mines, on\nrailroads, and in factories from tools, machines, treacherous surroundings, and toxic chemicals and other\nsubstances. Studies in the late 1960s showed that more than 14,000 workers were killed and 2.2 million\nwere disabled annually\xe2\x80\x94at a cost of more than $8 billion and a loss of more than 250 million worker days.\nCongress responded in 1970 with the Occupational Safety and Health Act, the primary aim of which is \xe2\x80\x9cto\nassure so far as possible every working man and woman in the Nation safe and healthful working\nconditions.\xe2\x80\x9d\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n792\n\n\x0cThe act imposes on each employer a general duty to furnish a place of employment free from recognized\nhazards likely to cause death or serious physical harm to employees. It also gives the secretary of labor the\npower to establish national health and safety standards. The standard-making power has been delegated\nto the Occupational Safety and Health Administration (OSHA), an agency within the US Department of\nLabor. The agency has the authority to inspect workplaces covered by the act whenever it receives\ncomplaints from employees or reports about fatal or multiple injuries. The agency may assess penalties\nand proceed administratively to enforce its standards. Criminal provisions of the act are enforced by the\nJustice Department.\nDuring its first two decades, OSHA was criticized for not issuing standards very quickly: fewer than thirty\nnational workplace safety standards were issued by 1990. But not all safety enforcement is in the hands of\nthe federal government: although OSHA standards preempt similar state standards, under the act the\nsecretary may permit the states to come up with standards equal to or better than federal standards and\nmay make grants to the states to cover half the costs of enforcement of the state safety standards.\n\nEmployee Retirement Income Security Act\nMore than half the US workforce is covered by private pension plans for retirement. One 1988 estimate\nput the total held in pension funds at more than $1 trillion, costing the federal Treasury nearly $60 billion\nannually in tax write-offs. As the size of the private pension funds increased dramatically in the 1960s,\nCongress began to hear shocking stories of employees defrauded out of pension benefits, deprived of a\nlifetime\xe2\x80\x99s savings through various ruses (e.g., by long vesting provisions and by discharges just before\nretirement). To put an end to such abuses, Congress, in 1974, enacted the Employee Retirement Income\nSecurity Act (ERISA).\nIn general, ERISA governs the vesting of employees\xe2\x80\x99 pension rights and the funding of pension plans.\nWithin five years of beginning employment, employees are entitled to vested interests in retirement\nbenefits contributed on their behalf by individual employers. Multiemployer pension plans must vest their\nemployees\xe2\x80\x99 interests within ten years. A variety of pension plans must be insured through a federal\nagency, the Pension Benefit Guaranty Corporation, to which employers must pay annual premiums. The\ncorporation may assume financial control of underfunded plans and may sue to require employers to\nmake up deficiencies. The act also requires pension funds to disclose financial information to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n793\n\n\x0cbeneficiaries, permits employees to sue for benefits, governs the standards of conduct of fund\nadministrators, and forbids employers from denying employees their rights to pensions. The act largely\npreempts state law governing employee benefits.\n\nFair Labor Standards Act\nIn the midst of the Depression, Congress enacted at President Roosevelt\xe2\x80\x99s urging a national minimum\nwage law, the Fair Labor Standards Act of 1938 (FLSA). The act prohibits most forms of child labor and\nestablished a scale of minimum wages for the regular workweek and a higher scale for overtime. (The\noriginal hourly minimum was twenty-five cents, although the administrator of the Wage and Hour\nDivision of the US Department of Labor, a position created by the act, could raise the minimum rate\nindustry by industry.) The act originally was limited to certain types of work: that which was performed in\ntransporting goods in interstate commerce or in producing goods for shipment in interstate commerce.\nEmployers quickly learned that they could limit the minimum wage by, for example, separating the\ninterstate and intrastate components of their production. Within the next quarter century, the scope of\nthe FLSA was considerably broadened, so that it now covers all workers in businesses that do a particular\ndollar-volume of goods that move in interstate commerce, regardless of whether a particular employee\nactually works in the interstate component of the business. It now covers between 80 and 90 percent of all\npersons privately employed outside of agriculture, and a lesser but substantial percentage of agricultural\nworkers and state and local government employees. Violations of the act are investigated by the\nadministrator of the Wage and Hour Division, who has authority to negotiate back pay on the employee\xe2\x80\x99s\nbehalf. If no settlement is reached, the Labor Department may sue on the employee\xe2\x80\x99s behalf, or the\nemployee, armed with a notice of the administrator\xe2\x80\x99s calculations of back wages due, may sue in federal or\nstate court for back pay. Under the FLSA, a successful employee will receive double the amount of back\nwages due.\n\nWorkers\xe2\x80\x99 Compensation Laws\nSince the beginning of the twentieth century, work-related injuries or illnesses have been covered under\nstate workers\xe2\x80\x99 compensation laws that provide a set amount of weekly compensation for disabilities\ncaused by accidents and illnesses suffered on the job. The compensation plans also pay hospital and\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n794\n\n\x0cmedical expenses necessary to treat workers who are injured by, or become ill from, their work. In\nassuring workers of compensation, the plans eliminate the hazards and uncertainties of lawsuits by\neliminating the need to prove fault. Employers fund the compensation plans by paying into statewide\nplans or purchasing insurance.\n\nOther State Laws\nAlthough it may appear that most employment law is federal, employment discrimination is largely\ngoverned by state law because Congress has so declared it. The Civil Rights Act of 1964 tells federal courts\nto defer to state agencies to enforce antidiscrimination provisions of parallel state statutes with remedies\nsimilar to those of the federal law. Moreover, many states have gone beyond federal law in banning certain\nforms of discrimination. Thus well before enactment of the Americans with Disabilities Act, more than\nforty states prohibited such discrimination in private employment. More than a dozen states ban\nemployment discrimination based on marital status, a category not covered by federal law. Two states\nhave laws that protect those that may be considered \xe2\x80\x9coverweight.\xe2\x80\x9d Two states and more than seventy\ncounties or municipalities ban employment discrimination on the basis of sexual orientation; most large\ncompanies have offices or plants in at least one of these jurisdictions. By contrast, federal law has no\nstatutory law dealing with sexual orientation.\n\nKEY TAKEAWAY\nThere are a number of important federal employment laws collective bargaining or discrimination.\nThese include the federal plant-closing act, the Employee Polygraph Protection Act, the Occupational\nSafety and Health Act, the Employee Retirement Income Security Act, and the Fair Labor Standards Act.\nAt the state level, workers\xe2\x80\x99 compensation laws preempt common-law claims against employers for\nwork-related injuries, and state equal opportunity employment laws provide remedies for certain kinds\nof workplace discrimination that have no parallel at the federal level.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n795\n\n\x0cEXERCISES\n1.\n\nUnited Artists is a corporation doing business in Texas. United Pension Fund is a defined-contribution\nemployee pension benefit plan sponsored by United Artists for employees. Each employee has his or\nher own individual pension account, but plan assets are pooled for investment purposes. The plan is\nadministered by the board of trustees. From 1977 to 1986, seven of the trustees made a series of\nloans to themselves from the plan. These trustees did not (1) require the borrowers to submit a\nwritten application for the loans, (2) assess the prospective borrower\xe2\x80\x99s ability to repay loans, (3)\nspecify a period in which the loans were to be repaid, or (4) call the loans when they remained unpaid.\nThe trustees also charged less than fair-market-value interest for the loans. The secretary of labor\nsued the trustees, alleging that they had breached their fiduciary duty in violation of ERISA. Who\nwon?\n\n2.\n\n[1]\n\nArrow Automotive Industries remanufactures and distributes automobile and truck parts. Its\noperating plants produce identical product lines. The company is planning to open a new facility in\nSanta Maria, California. The employees at the Arrow plant in Hudson, Massachusetts, are represented\nby a union, the United Automobile, Aerospace, and Agricultural Implement Workers of America. The\nHudson plant has a history of unprofitable operations. The union called a strike when the existing\ncollective bargaining agreement expired and a new agreement could not be reached. After several\nmonths, the board of directors of the company voted to close the striking plant. The closing would\ngive Arrow a 24 percent increase in gross profits and free capital and equipment for the new Santa\nMaria plant. In addition, the existing customers of the Hudson plant could be serviced by the\nSpartanburg, South Carolina, plant, which is currently being underutilized. What would have to be\ndone if the plant-closing act applied to the situation?\n\n[2]\n\n[1] Mc Laughlin v. Rowley, 69 F.Supp. 1333 (N.D. Tex. 1988).\n[2] Arrow Automotive Industries, Inc. v. NLRB, 853 F.2d 233 (4th Cir. 1989).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n796\n\n\x0c18.4 Cases\nDisparate Treatment: Burdens of Proof\nBarbano v. Madison County\n922 F.2d 139 (2d Cir. 1990)\n\nFactual Background\nAt the Madison County (New York State) Veterans Service Agency, the position of director became vacant.\nThe County Board of Supervisors created a committee of five men to hold interviews for the position. The\ncommittee interviewed Maureen E. Barbano and four others. When she entered the interview room, she\nheard someone say, \xe2\x80\x9cOh, another woman.\xe2\x80\x9d At the beginning of the interview, Donald Greene said he\nwould not consider \xe2\x80\x9csome woman\xe2\x80\x9d for the position. Greene also asked Barbano some personal questions\nabout her family plans and whether her husband would mind if she transported male veterans. Ms.\nBarbano answered that the questions were irrelevant and discriminatory. However, Greene replied that\nthe questions were relevant because he did not want to hire a woman who would get pregnant and quit.\nAnother committee member, Newbold, agreed that the questions were relevant, and no committee\nmember said the questions were not relevant.\nNone of the interviewers rebuked Greene or objected to the questions, and none of them told Barbano\nthat she need not answer them. Barbano did state that if she decided to have a family she would take no\nmore time off than medically necessary. Greene once again asked whether Barbano\xe2\x80\x99s husband would\nobject to her \xe2\x80\x9crunning around the country with men\xe2\x80\x9d and said he would not want his wife to do it.\nBarbano said she was not his wife. The interview concluded after Barbano asked some questions about\ninsurance.\nAfter interviewing several other candidates, the board hired a man. Barbano sued the county for sex\ndiscrimination in violation of Title VII, and the district court held in her favor. She was awarded $55,000\nin back pay, prejudgment interest, and attorney\xe2\x80\x99s fees. Madison County appealed the judgment of Federal\nDistrict Judge McAvoy; Barbano cross-appealed, asking for additional damages.\nThe court then found that Barbano had established a prima facie case of discrimination under Title VII,\nthus bringing into issue the appellants\xe2\x80\x99 purported reasons for not hiring her. The appellants provided four\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n797\n\n\x0creasons why they chose Wagner over Barbano, which the district court rejected either as unsupported by\nthe record or as a pretext for discrimination in light of Barbano\xe2\x80\x99s interview. The district court then found\nthat because of Barbano\xe2\x80\x99s education and experience in social services, the appellants had failed to prove\nthat absent the discrimination, they still would not have hired Barbano. Accordingly, the court awarded\nBarbano back pay, prejudgment interest, and attorney\xe2\x80\x99s fees. Subsequently, the court denied Barbano\xe2\x80\x99s\nrequest for front pay and a mandatory injunction ordering her appointment as director upon the next\nvacancy. This appeal and cross-appeal followed.\n\nFrom the Opinion of FEINBERG, CIRCUIT JUDGE\nAppellants argue that the district court erred in finding that Greene\xe2\x80\x99s statements during the interview\nshowed that the Board discriminated in making the hiring decision, and that there was no direct evidence\nof discrimination by the Board, making it improper to require that appellants prove that they would not\nhave hired Barbano absent the discrimination. Barbano in turn challenges the adequacy of the relief\nawarded to her by the district court.\n\nA. Discrimination\nAt the outset, we note that Judge McAvoy\xe2\x80\x99s opinion predated Price Waterhouse v. Hopkins, 490 U.S. 228,\n109 S. Ct. 1775, 104 L. Ed. 2d 268 (1990), in which the Supreme Court made clear that a \xe2\x80\x9cpretext\xe2\x80\x9d case\nshould be analyzed differently from a \xe2\x80\x9cmixed motives\xe2\x80\x9d case. Id. 109 S. Ct. at 1788-89. Judge McAvoy, not\nhaving the benefit of the Court\xe2\x80\x99s opinion in Price Waterhouse, did not clearly distinguish between the two\ntypes of cases in analyzing the alleged discrimination. For purposes of this appeal, we do not think it is\ncrucial how the district court categorized the case. Rather, we need only concern ourselves with whether\nthe district court\xe2\x80\x99s findings of fact are supported by the record and whether the district court applied the\nproper legal standards in light of its factual findings.\nWhether the case is one of pretext or mixed motives, the plaintiff bears the burden of persuasion on the\nissue of whether gender played a part in the employment decision. Price Waterhouse v. Hopkins, at 1788.\nAppellants contend that Barbano did not sustain her burden of proving discrimination because the only\nevidence of discrimination involved Greene\xe2\x80\x99s statements during the interview, and Greene was an elected\nofficial over whom the other members of the Board exercised no control. Thus, appellants maintain, since\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n798\n\n\x0cthe hiring decision was made by the 19-member board, evidence of discrimination by one member does\nnot establish that the Board discriminated in making the hiring decision.\nWe agree that discrimination by one individual does not necessarily imply that a collective decisionmaking body of which the individual is a member also discriminated. However, the record before us\nsupports the district court\xe2\x80\x99s finding that the Board discriminated in making the hiring decision.\nFirst, there is little doubt that Greene\xe2\x80\x99s statements during the interview were discriminatory. He said he\nwould not consider \xe2\x80\x9csome woman\xe2\x80\x9d for the position. His questioning Barbano about whether she would get\npregnant and quit was also discriminatory, since it was unrelated to a bona fide occupational\nqualification. King v. Trans World Airlines, 738 F.2d 255, 258 n.2 (8th Cir. 1984). Similarly, Greene\xe2\x80\x99s\nquestions about whether Barbano\xe2\x80\x99s husband would mind if she had to \xe2\x80\x9crun around the country with men,\xe2\x80\x9d\nand that he would not want his wife to do it, were discriminatory, since once again the questions were\nunrelated to bona fide occupational qualifications. Hopkins, at 1786.\nMoreover, the import of Greene\xe2\x80\x99s discriminatory questions was substantial, since apart from one question\nabout her qualifications, none of the interviewers asked Barbano about other areas that allegedly formed\nthe basis for selecting a candidate. Thus, Greene\xe2\x80\x99s questioning constituted virtually the entire interview,\nand so the district court properly found that the interview itself was discriminatory.\nNext, given the discriminatory tenor of the interview, and the acquiescence of the other Committee\nmembers to Greene\xe2\x80\x99s line of questioning, it follows that the judge could find that those present at the\ninterview, and not merely Greene, discriminated against Barbano. Judge McAvoy pointed out that the\nChairman of the Committee, Newbold, thought Greene\xe2\x80\x99s discriminatory questions were relevant.\nSignificantly, Barbano protested that Greene\xe2\x80\x99s questions were discriminatory, but no one agreed with her\nor told her that she need not answer. Indeed, no one even attempted to steer the interview in another\ndirection. This knowing and informed toleration of discriminatory statements by those participating in\nthe interview constitutes evidence of discrimination by all those present. That each member was\nindependently elected to the Board does not mean that the Committee itself was unable to control the\ncourse of the interview. The Committee had a choice of how to conduct the interview, and the court could\nfind that the Committee exercised that choice in a plainly discriminatory fashion.\nThis discrimination directly affected the hiring decision. At the end of the interviewing process, the\ninterviewers evaluated the candidates, and on that basis submitted a recommendation as to which\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n799\n\n\x0ccandidate to hire for the position. \xe2\x80\x9cEvaluation does not occur in a vacuum. By definition, when evaluating\na candidate to fill a vacant position, one compares that candidate against other eligible candidates.\xe2\x80\x9d Berl v.\nCounty of Westchester, 849 F.2d 712, 715 (2d Cir. 1988). Appellants stipulated that Barbano was qualified\nfor the position. Again, because Judge McAvoy could find that the evaluation of Barbano was biased by\ngender discrimination, the judge could also find that the Committee\xe2\x80\x99s recommendation to hire Wagner,\nwhich was the result of a weighing of the relative merits of Barbano, Wagner and the other eligible\ncandidates, was necessarily tainted by discrimination.\nThe Board in turn unanimously accepted the Committee\xe2\x80\x99s recommendation to hire Wagner, and so the\nBoard\xe2\x80\x99s hiring decision was made in reliance upon a discriminatory recommendation. The Supreme Court\nin Hopkins v. Price Waterhouse found that a collective decision-making body can discriminate by relying\nupon discriminatory recommendations, and we are persuaded that the reasoning in that case applies here\nas well.\nIn Hopkins\xe2\x80\x99 case against Price Waterhouse, Ann Hopkins, a candidate for partnership at the accounting\nfirm of Price Waterhouse, alleged that she was refused admission as a partner because of sex\ndiscrimination. Hopkins\xe2\x80\x99s evidence of discrimination consisted largely of evaluations made by various\npartners. Price Waterhouse argued that such evidence did not prove that its internal Policy Board, which\nwas the effective decision-maker as to partnership in that case, had discriminated. The Court rejected that\nargument and found the evidence did establish discrimination:\nHopkins showed that the partnership solicited evaluations from all of the firm\xe2\x80\x99s partners; that it generally\nrelied very heavily on such evaluations in making its decision; that some of the partners\xe2\x80\x99 comments were\nthe product of [discrimination]; and that the firm in no way disclaimed reliance on those particular\ncomments, either in Hopkins\xe2\x80\x99 case or in the past. Certainly, a plausible\xe2\x80\x94and, one might say, inevitable\xe2\x80\x94\nconclusion to draw from this set of circumstances is that the Policy Board in making its decision did in\nfact take into account all of the partners\xe2\x80\x99 comments, including the comments that were motivated by\n[discrimination].\nHopkins, at 1794.\nIn a very significant sense, Barbano presents an even stronger case of discrimination because the only\nrecommendation the Board relied upon here was discriminatory, whereas in Price Waterhouse, not all of\nthe evaluations used in the decision-making process were discriminatory. On the other hand, it is true\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n800\n\n\x0cthat the discriminatory content of some of the evaluations in Price Waterhouse was apparent from\nreading them, whereas here, the recommendation was embodied in a resolution to the Board and a\nreading of the resolution would not reveal that it was tainted by discrimination. Nonetheless, the facts in\nthis case show that the Board was put on notice before making the appointment that the Committee\xe2\x80\x99s\nrecommendation was biased by discrimination.\nBarbano was a member of the public in attendance at the Board meeting in March 1980 when the Board\nvoted to appoint Wagner. Before the Board adopted the resolution appointing Wagner, Barbano objected\nand asked the Board if male applicants were asked the questions she was asked during the interview. At\nthis point, the entire Board membership was alerted to the possibility that the Committee had\ndiscriminated against Barbano during her interview. The Committee members did not answer the\nquestion, except for Newbold, who evaded the issue by stating that he did not ask such questions. The\nBoard\xe2\x80\x99s ability to claim ignorance at this point was even further undermined by the fact that the Chairman\nof the Board, Callahan, was present at many of the interviews, including Barbano\xe2\x80\x99s, in his role as\nChairman of the Board. Callahan did not refute Barbano\xe2\x80\x99s allegations, implying that they were worthy of\ncredence, and none of the Board members even questioned Callahan on the matter.\nIt is clear that those present understood Barbano was alleging that she had been subjected to\ndiscrimination during her interview. John Patane, a member of the Board who had not interviewed\nBarbano, asked Barbano whether she was implying that Madison County was not an equal opportunity\nemployer. Barbano said yes. Patane said the County already had their \xe2\x80\x9ctoken woman.\xe2\x80\x9d Callahan\napologized to Barbano for \xe2\x80\x9cany improper remarks that may have been made,\xe2\x80\x9d but an apology for\ndiscrimination does not constitute an attempt to eliminate the discrimination from the hiring decision.\nEven though the Board was aware of possible improprieties, it made no investigation whatsoever into the\nallegations and did not disclaim any reliance upon the discrimination. In short, the circumstances show\nthe Board was willing to rely on the Committee\xe2\x80\x99s recommendation even if Barbano had been\ndiscriminated against during her interview. On these facts, it was not clearly erroneous for the district\ncourt to conclude that Barbano sustained her burden of proving discrimination by the Board.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n801\n\n\x0cB. The Employer\xe2\x80\x99s Burden\nHaving found that Barbano carried her burden of proving discrimination, the district court then placed\nthe burden on appellants to prove by a preponderance of the evidence that, absent the discrimination,\nthey would not have hired Barbano for the position. Appellants argue that this burden is only placed on an\nemployer if the plaintiff proves discrimination by direct evidence, and since Barbano\xe2\x80\x99s evidence of\ndiscrimination was merely circumstantial, the district court erred by placing the burden of proof on them.\nAppellants, however, misapprehend the nature of Barbano\xe2\x80\x99s proof and thus the governing legal standard.\nThe burden is properly placed on the defendant \xe2\x80\x9conce the plaintiff establishes by direct evidence that an\nillegitimate factor played a motivating or substantial role in an employment decision.\xe2\x80\x9d Grant v. Hazelett\nStrip-Casting Corp., 880 F.2d 1564, 1568 (2d Cir. 1989). Thus, the key inquiry on this aspect of the case is\nwhether the evidence is direct, that is, whether it shows that the impermissible criterion played some part\nin the decision-making process. See Hopkins, at 1791; Grant, 880 F.2d at 1569. If plaintiff provides such\nevidence, the fact-finder must then determine whether the evidence shows that the impermissible\ncriterion played a motivating or substantial part in the hiring decision. Grant, 880 F.2d at 1569.\nAs we found above, the evidence shows that Barbano\xe2\x80\x99s gender was clearly a factor in the hiring decision.\nThat the discrimination played a substantial role in that decision is shown by the importance of the\nrecommendation to the Board. As Rafte testified, the Board utilizes a committee system, and so the Board\n\xe2\x80\x9cusually accepts\xe2\x80\x9d a committee\xe2\x80\x99s recommendation, as it did here when it unanimously voted to appoint\nWagner. Had the Board distanced itself from Barbano\xe2\x80\x99s allegations of discrimination and attempted to\nensure that it was not relying upon illegitimate criteria in adopting the Committee\xe2\x80\x99s recommendation, the\nevidence that discrimination played a substantial role in the Board\xe2\x80\x99s decision would be significantly\nweakened. The Board showed no inclination to take such actions, however, and in adopting the\ndiscriminatory recommendation allowed illegitimate criteria to play a substantial role in the hiring\ndecision.\nThe district court thus properly required appellants to show that the Board would not have hired Barbano\nin the absence of discrimination. \xe2\x80\x9cThe employer has not yet been shown to be a violator, but neither is it\nentitled to the\xe2\x80\xa6presumption of good faith concerning its employment decisions. At this point the\nemployer may be required to convince the fact-finder that, despite the smoke, there is no fire.\xe2\x80\x9d Hopkins,\nat 1798-99 (O\xe2\x80\x99Connor, J., concurring).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n802\n\n\x0cJudge McAvoy noted in his opinion that appellants claimed they chose Wagner over Barbano because he\nwas better qualified in the following areas: (1) interest in veterans\xe2\x80\x99 affairs; (2) experience in the military;\n(3) tactfulness; and (4) experience supervising an office. The judge found that the evidence before him\nsupported only appellants\xe2\x80\x99 first and second reasons for refusing to hire Barbano, but acknowledged that\nthe Committee members \xe2\x80\x9cwere enamored with Wagner\xe2\x80\x99s military record and involvement with veterans\xe2\x80\x99\norganizations.\xe2\x80\x9d However, neither of these is listed as a job requirement in the job description, although\nthe district court found that membership in a veterans\xe2\x80\x99 organization may indicate an interest in veterans\xe2\x80\x99\naffairs. Nonetheless, the district court found that given Barbano\xe2\x80\x99s \xe2\x80\x9ceducation and experience in social\nservices,\xe2\x80\x9d appellants failed to carry their burden of proving by a preponderance of the evidence that,\nabsent discrimination, they would not have hired Barbano.\nThe district court properly held appellants to a preponderance of the evidence standard. Hopkins, 109 S.\nCt. at 1795\xe2\x80\xa6\nAt the time of the hiring decision in 1980, Barbano had been a Social Welfare Examiner for Madison\nCounty for the three previous years. In this position, she determined the eligibility of individuals for\npublic assistance, Medicaid or food stamps, and would then issue or deny the individual\xe2\x80\x99s application\nbased on all federal, state and local regulations pertaining to the program from which the individual was\nseeking assistance. Barbano was thus familiar with the operation of public assistance programs, knew how\nto fill out forms relating to benefits and had become familiar with a number of welfare agencies that could\nbe of use to veterans. Barbano was also working towards an Associate Degree in Human Services at the\ntime. Rafte testified that Barbano\xe2\x80\x99s resume was \xe2\x80\x9cvery impressive.\xe2\x80\x9d Moreover, Barbano, unlike Wagner,\nwas a resident of Madison County, and according to Rafte, a candidate\xe2\x80\x99s residency in the county was\nconsidered to be an advantage. Finally, Barbano had also enlisted in the United States Marine Corps in\n1976, but during recruit training had been given a vaccine that affected her vision. She had received an\nhonorable discharge shortly thereafter.\nWagner had nine years\xe2\x80\x99 experience as an Air Force Personnel Supervisor, maintaining personnel records,\nhad received a high school equivalency diploma and took several extension classes in management. He\nhad been honorably discharged from the Air Force in 1965 with the rank of Staff Sergeant. Wagner was a\nmember of the American Legion, and his application for the position included recommendations from two\nAmerican Legion members. However, for the six years prior to his appointment as Director, Wagner\xe2\x80\x99s sole\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n803\n\n\x0cpaid employment was as a school bus driver and part-time bartender at the American Legion. Wagner\nadmitted that before he was hired he had no knowledge of federal, state and local laws, rules and\nregulations pertaining to veterans\xe2\x80\x99 benefits and services, or knowledge of the forms, methods and\nprocedures used to process veteran benefits claims. Wagner also had not maintained liaison with welfare\nagencies and was unfamiliar with the various welfare agencies that existed in the county.\nTo be sure, both candidates were qualified for the Director\xe2\x80\x99s position, and it is not our job\xe2\x80\x94nor was it the\ndistrict courts\xe2\x80\x94to decide which one was preferable. However, there is nothing to indicate that Judge\nMcAvoy misconceived his function in this phase of the case, which was to decide whether appellants failed\nto prove by a preponderance of the evidence that they would not have hired Barbano even if they had not\ndiscriminated against her. The judge found that defendants had not met that burden. We must decide\nwhether that finding was clearly erroneous, and we cannot say that it was.\n\nCASE QUESTIONS\n1.\n\nMadison County contended that Barbano needed to provide \xe2\x80\x9cdirect evidence\xe2\x80\x9d of discrimination that\nhad played a motivating or substantial part in the decision. What would such evidence look like? Is it\nlikely that most plaintiffs who are discriminated against because of their gender would be able to get\n\xe2\x80\x9cdirect evidence\xe2\x80\x9d that gender was a motivating or substantial factor?\n\n2.\n\nThe \xe2\x80\x9cclearly erroneous\xe2\x80\x9d standard is applied here, as it is in many cases where appellate courts review\ntrial court determinations. State the test, and say why the appellate court believed that the trial\njudge\xe2\x80\x99s ruling was not \xe2\x80\x9cclearly erroneous.\xe2\x80\x9d\n\nTitle VII and Hostile Work Environment\nDuncan v. General Motors Corporation\n300 F.3d 928 (8th Cir. 2002)\nOPINION BY HANSEN, Circuit Judge.\nThe Junior College District of St. Louis (the College) arranged for Diana Duncan to provide in-house\ntechnical training at General Motors Corporation\xe2\x80\x99s (GMC) manufacturing facility in Wentzville, Missouri.\nThroughout her tenure at GMC, Duncan was subjected to unwelcome attention by a GMC employee,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n804\n\n\x0cJames Booth, which culminated in Duncan\xe2\x80\x99s resignation. Duncan subsequently filed this suit under Title\nVII of the Civil Rights Act and the Missouri Human Rights Act, see 42 U.S.C. \xc2\xa7\xc2\xa7 2000e-2000e-17; Mo.\nRev. Stat. \xc2\xa7\xc2\xa7 213.010-213.137,2 alleging that she was sexually harassed and constructively discharged. A\njury found in favor of Duncan and awarded her $4600 in back pay, $700,000 in emotional distress\ndamages on her sexual harassment claim, and $300,000 in emotional distress damages on her\nconstructive discharge claim. GMC appeals from the district court\xe2\x80\x99s denial of its post-trial motion for\njudgment as a matter of law, and the district court\xe2\x80\x99s award of attorneys\xe2\x80\x99 fees attendant to the post-trial\nmotion. We reverse.\n\nI.\nDiana Duncan worked as a technical training clerk in the high-tech area at GMC as part of the College\xe2\x80\x99s\nCenter for Business, Industry, and Labor program from August 1994 until May 1997. Duncan provided inhouse training support to GMC employees.\nDuncan first learned about the College\xe2\x80\x99s position at GMC from Booth, a United Auto Workers Union\ntechnology training coordinator for GMC. Booth frequented the country club where Duncan worked as a\nwaitress and a bartender. Booth asked Duncan if she knew anyone who had computer and typing skills\nand who might be interested in a position at GMC. Duncan expressed interest in the job. Booth brought\nthe pre-employment forms to Duncan at the country club, and he forwarded her completed forms to Jerry\nReese, the manager of operations, manufacturing, and training for the College. Reese arranged to\ninterview Duncan at GMC. Reese, Booth, and Ed Ish, who was Booth\xe2\x80\x99s management counterpart in the\nhigh-tech area of the GMC plant, participated in the interview. Duncan began work at GMC in August\n1994.\nTwo weeks after Duncan began working at GMC, Booth requested an off-site meeting with her at a local\nrestaurant. Booth explained to Duncan that he was in love with a married coworker and that his own\nmarriage was troubled. Booth then propositioned Duncan by asking her if she would have a relationship\nwith him. Duncan rebuffed his advance and left the restaurant. The next day Duncan mentioned the\nincident to the paint department supervisor Joe Rolen, who had no authority over Booth. Duncan did not\nreport Booth\xe2\x80\x99s conduct to either Reese (her supervisor) at the College or Ish (Booth\xe2\x80\x99s management\ncounterpart) at GMC. However, she did confront Booth, and he apologized for his behavior. He made no\nfurther such \xe2\x80\x9cpropositions.\xe2\x80\x9d Duncan stated that Booth\xe2\x80\x99s manner toward her after she declined his advance\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n805\n\n\x0cbecame hostile, and he became more critical of her work. For example, whenever she made a\ntypographical error, he told her that she was incompetent and that he should hire a \xe2\x80\x9cKelly Services\xe2\x80\x9d\nperson to replace her. Duncan admitted that Booth\xe2\x80\x99s criticisms were often directed at other employees as\nwell, including male coworkers.\nDuncan testified to numerous incidents of Booth\xe2\x80\x99s inappropriate behavior. Booth directed Duncan to\ncreate a training document for him on his computer because it was the only computer with the necessary\nsoftware. The screen saver that Booth had selected to use on his computer was a picture of a naked\nwoman. Duncan testified to four or five occasions when Booth would unnecessarily touch her hand when\nshe handed him the telephone. In addition, Booth had a planter in his office that was shaped like a\nslouched man wearing a sombrero. The planter had a hole in the front of the man\xe2\x80\x99s pants that allowed for\na cactus to protrude. The planter was in plain view to anyone entering Booth\xe2\x80\x99s office. Booth also kept a\nchild\xe2\x80\x99s pacifier that was shaped like a penis in his office that he occasionally showed to his coworkers and\nspecifically to Duncan on two occasions.\nIn 1995, Duncan requested a pay increase and told Booth that she would like to be considered for an\nillustrator\xe2\x80\x99s position. Booth said that she would have to prove her artistic ability by drawing his planter.\nDuncan objected, particularly because previous applicants for the position were required to draw\nautomotive parts and not his planter. Ultimately, Duncan learned that she was not qualified for the\nposition because she did not possess a college degree.\nAdditionally in 1995, Booth and a College employee created a \xe2\x80\x9crecruitment\xe2\x80\x9d poster that was posted on a\nbulletin board in the high-tech area. The poster portrayed Duncan as the president and CEO of the Man\nHater\xe2\x80\x99s Club of America. It listed the club\xe2\x80\x99s membership qualifications as: \xe2\x80\x9cMust always be in control of:\n(1) Checking, Savings, all loose change, etc.; (2) (Ugh) Sex; (3) Raising children our way!; (4) Men must\nalways do household chores; (5) Consider T.V. Dinners a gourmet meal.\xe2\x80\x9d\xe2\x80\xa6\nOn May 5, 1997, Booth asked Duncan to type a draft of the beliefs of the \xe2\x80\x9cHe-Men Women Hater\xe2\x80\x99s Club.\xe2\x80\x9d\nThe beliefs included the following:\n\xe2\x80\x94Constitutional Amendment, the 19th, giving women [the] right to vote should be repealed. Real He-Men\nindulge in a lifestyle of cursing, using tools, handling guns, driving trucks, and hunting and of course,\ndrinking beer.\n\xe2\x80\x94Women really do have coodies [sic] and they can spread.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n806\n\n\x0c\xe2\x80\x94Women [are] the cause of 99.9 per cent of stress in men.\n\xe2\x80\x94Sperm has a right to live.\n\xe2\x80\x94All great chiefs of the world are men.\n\xe2\x80\x94Prostitution should be legalized.\nDuncan refused to type the beliefs and resigned two days later.\nDuncan testified that she complained to anyone who would listen to her about Booth\xe2\x80\x99s behavior,\nbeginning with paint department supervisor Joe Rolen after Booth propositioned her in 1994. Duncan\ntestified that between 1994 and 1997 she complained several times to Reese at the College about Booth\xe2\x80\x99s\nbehavior, which would improve at least in the short term after she spoke with Reese.\xe2\x80\xa6\nDuncan filed a charge of sex discrimination with the Equal Employment Opportunity Commission\n(EEOC) on October 30, 1997. The EEOC issued Duncan a right to sue notice on April 17, 1998. Alleging\nsexual harassment and constructive discharge, Duncan filed suit against the College and GMC under both\nTitle VII of the Civil Rights Act and the Missouri Human Rights Act. Duncan settled with the College prior\nto trial. After the jury found in Duncan\xe2\x80\x99s favor on both counts against GMC, GMC filed a post-trial motion\nfor judgment as a matter of law or, alternatively, for a new trial. The district court denied the motion. The\ndistrict court also awarded Duncan attorneys\xe2\x80\x99 fees in conjunction with GMC\xe2\x80\x99s post-trial motion. GMC\nappeals.\n\nII.\nA. Hostile Work Environment\nGMC argues that it was entitled to judgment as a matter of law on Duncan\xe2\x80\x99s hostile work environment\nclaim because she failed to prove a prima facie case. We agree.\xe2\x80\xa6\nIt is undisputed that Duncan satisfies the first two elements of her prima facie case: she is a member of a\nprotected group and Booth\xe2\x80\x99s attention was unwelcome. We also conclude that the harassment was based\non sex\xe2\x80\xa6Although there is some evidence in the record that indicates some of Booth\xe2\x80\x99s behavior, and the\nresulting offensive and disagreeable atmosphere, was directed at both male and female employees, GMC\npoints to ten incidents when Booth\xe2\x80\x99s behavior was directed at Duncan alone. GMC concedes that five of\nthese ten incidents could arguably be based on sex: (1) Booth\xe2\x80\x99s proposition for a \xe2\x80\x9crelationship\xe2\x80\x9d; (2)\nBooth\xe2\x80\x99s touching of Duncan\xe2\x80\x99s hand; (3) Booth\xe2\x80\x99s request that Duncan sketch his planter; (4) the Man\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n807\n\n\x0cHater\xe2\x80\x99s Club poster; and (5) Booth\xe2\x80\x99s request that Duncan type the He-Men Women Haters beliefs. \xe2\x80\x9cA\nplaintiff in this kind of case need not show\xe2\x80\xa6that only women were subjected to harassment, so long as she\nshows that women were the primary target of such harassment.\xe2\x80\x9d We conclude that a jury could reasonably\nfind that Duncan and her gender were the overriding themes of these incidents. The evidence is sufficient\nto support the jury finding that the harassment was based on sex.\nWe agree, however, with GMC\xe2\x80\x99s assertion that the alleged harassment was not so severe or pervasive as to\nalter a term, condition, or privilege of Duncan\xe2\x80\x99s employment\xe2\x80\xa6To clear the high threshold of actionable\nharm, Duncan has to show that \xe2\x80\x9cthe workplace is permeated with discriminatory intimidation, ridicule,\nand insult.\xe2\x80\x9d Harris v. Forklift Systems, Inc., 510 U.S. 17, 21, 126 L. Ed. 2d 295, 114 S. Ct. 367 (1993)\n(internal quotations omitted). \xe2\x80\x9cConduct that is not severe or pervasive enough to create an objectively\nhostile or abusive work environment\xe2\x80\x94an environment that a reasonable person would find hostile or\nabusive\xe2\x80\x94is beyond Title VII\xe2\x80\x99s purview.\xe2\x80\x9d Oncale, 523 U.S. at 81 (internal quotation omitted). Thus, the\nfourth part of a hostile environment claim includes both objective and subjective components: an\nenvironment that a reasonable person would find hostile and one that the victim actually perceived as\nabusive. Harris, 510 U.S. at 21-22. In determining whether the conduct is sufficiently severe or pervasive,\nwe look to the totality of the circumstances, including the \xe2\x80\x9cfrequency of the discriminatory conduct; its\nseverity; whether it is physically threatening or humiliating, or a mere offensive utterance; and whether it\nunreasonably interferes with an employee\xe2\x80\x99s work performance.\xe2\x80\x9d\xe2\x80\xa6These standards are designed to \xe2\x80\x9cfilter\nout complaints attacking the ordinary tribulations of the workplace, such as the sporadic use of abusive\nlanguage, gender-related jokes, and occasional teasing.\xe2\x80\x9d Faragher v. City of Boca Raton, 524 U.S. 775, 788,\n141 L. Ed. 2d 662, 118 S. Ct. 2275 (1998) (internal quotations omitted).\nThe evidence presented at trial illustrates that Duncan was upset and embarrassed by the posting of the\nderogatory poster and was disturbed by Booth\xe2\x80\x99s advances and his boorish behavior; but, as a matter of\nlaw, she has failed to show that these occurrences in the aggregate were so severe and extreme that a\nreasonable person would find that the terms or conditions of Duncan\xe2\x80\x99s employment had been\naltered.\xe2\x80\xa6Numerous cases have rejected hostile work environment claims premised upon facts equally or\nmore egregious than the conduct at issue here. See, e.g., Shepherd v. Comptroller of Pub. Accounts, 168\nF.3d 871, 872, 874 (5th Cir.) (holding that several incidents over a two-year period, including the\ncomment \xe2\x80\x9cyour elbows are the same color as your nipples,\xe2\x80\x9d another comment that plaintiff had big thighs,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n808\n\n\x0crepeated touching of plaintiff\xe2\x80\x99s arm, and attempts to look down the plaintiff\xe2\x80\x99s dress, were insufficient to\nsupport hostile work environment claim), cert. denied, 528 U.S. 963, 145 L. Ed. 2d 308, 120 S. Ct. 395\n(1999); Adusumilli v. City of Chicago, 164 F.3d 353, 357, 361-62 (7th Cir. 1998) (holding conduct\ninsufficient to support hostile environment claim when employee teased plaintiff, made sexual jokes\naimed at her, told her not to wave at police officers \xe2\x80\x9cbecause people would think she was a prostitute,\xe2\x80\x9d\ncommented about low-necked tops, leered at her breasts, and touched her arm, fingers, or buttocks on\nfour occasions), cert. denied, 528 U.S. 988, 145 L. Ed. 2d 367, 120 S. Ct. 450 (1999); Black v. Zaring\nHomes,, Inc., 104 F.3d 822, 823-24, 826 (6th Cir.) (reversing jury verdict and holding behavior merely\noffensive and insufficient to support hostile environment claim when employee reached across plaintiff,\nstating \xe2\x80\x9cnothing I like more in the morning than sticky buns\xe2\x80\x9d while staring at her suggestively; suggested\nto plaintiff that parcel of land be named \xe2\x80\x9cHootersville,\xe2\x80\x9d \xe2\x80\x9cTitusville,\xe2\x80\x9d or \xe2\x80\x9cTwin Peaks\xe2\x80\x9d; and asked \xe2\x80\x9cweren\xe2\x80\x99t\nyou there Saturday night dancing on the tables?\xe2\x80\x9d while discussing property near a biker bar), cert. denied,\n522 U.S. 865, 139 L. Ed. 2d 114, 118 S. Ct. 172 (1997); Weiss v. Coca-Cola Bottling Co., 990 F.2d 333, 337\n(7th Cir. 1993) (holding no sexual harassment when plaintiff\xe2\x80\x99s supervisor asked plaintiff for dates, asked\nabout her personal life, called her a \xe2\x80\x9cdumb blond,\xe2\x80\x9d put his hand on her shoulder several times, placed \xe2\x80\x9cI\nlove you\xe2\x80\x9d signs at her work station, and attempted to kiss her twice at work and once in a bar).\nBooth\xe2\x80\x99s actions were boorish, chauvinistic, and decidedly immature, but we cannot say they created an\nobjectively hostile work environment permeated with sexual harassment. Construing the evidence in the\nlight most favorable to Duncan, she presented evidence of four categories of harassing conduct based on\nher sex: a single request for a relationship, which was not repeated when she rebuffed it, four or five\nisolated incidents of Booth briefly touching her hand, a request to draw a planter, and teasing in the form\nof a poster and beliefs for an imaginary club. It is apparent that these incidents made Duncan\nuncomfortable, but they do not meet the standard necessary for actionable sexual harassment. It is worth\nnoting that Duncan fails to even address this component of her prima facie case in her brief. We conclude\nas a matter of law that she did not show a sexually harassing hostile environment sufficiently severe or\npervasive so as to alter the conditions of her employment, a failure that dooms Duncan\xe2\x80\x99s hostile work\nenvironment claim. See Meritor Sav. Bank, FSB v. Vinson, 477 U.S. 57, 67, 91 L. Ed. 2d 49, 106 S. Ct. 2399\n(1986).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n809\n\n\x0cFor the foregoing reasons, we reverse the district court\xe2\x80\x99s denial of judgment as a matter of law. Because\nGMC should have prevailed on its post-trial motion, the award of attorneys\xe2\x80\x99 fees is likewise vacated.\nRICHARD S. ARNOLD, Circuit Judge, dissenting.\nThe Court concludes that the harassment suffered by Ms. Duncan was not so severe or pervasive as to\nalter a term, condition, or privilege of her employment, and that, therefore, GMC is entitled to judgment\nas a matter of law on her hostile-work environment and constructive-discharge claims. I respectfully\ndisagree.\nMs. Duncan was subjected to a long series of incidents of sexual harassment in her workplace, going far\nbeyond \xe2\x80\x9cgender-related jokes and occasional teasing.\xe2\x80\x9d Faragher v. City of Boca Raton, 524 U.S. 775, 788\n(1988). When the evidence is considered in the light most favorable to her, and she is given the benefit of\nall reasonable inferences, there is \xe2\x80\x9csubstantial evidence to sustain the cause of action.\xe2\x80\x9d Stockmen\xe2\x80\x99s\nLivestock Market, Inc. v. Norwest Bank of Sioux City, 135 F.3d 1236, 1240 (8th Cir. 1998) In Ms. Duncan\xe2\x80\x99s\ncase, a jury reached the conclusion that Mr. Booth\xe2\x80\x99s offensive behavior created a hostile work\nenvironment. I believe this determination was reasonable and supported by ample evidence.\nMs. Duncan was subjected to a sexual advance by her supervisor within days of beginning her job. This\nproposition occurred during work hours and was a direct request for a sexual relationship. The Court\ncharacterizes this incident as a \xe2\x80\x9csingle request,\xe2\x80\x9d (but) [t]his description minimizes the effect of the sexual\nadvance on Ms. Duncan\xe2\x80\x99s working conditions. During the months immediately following this incident,\nMr. Booth became hostile to Ms. Duncan, increased his criticism of her work, and degraded her\nprofessional capabilities in front of her peers. Significantly, there is no suggestion that this hostile\nbehavior occurred before Ms. Duncan refused his request for sex. From this evidence, a jury could easily\ndraw the inference that Mr. Booth changed his attitude about Ms. Duncan\xe2\x80\x99s work because she rejected his\nsexual advance.\nFurther, this sexual overture was not an isolated incident. It was only the beginning of a string of\ndegrading actions that Mr. Booth directed toward Ms. Duncan based on her sex. This inappropriate\nbehavior took many forms, from physical touching to social humiliation to emotional intimidation. For\nexample, Mr. Booth repeatedly touched Ms. Duncan inappropriately on her hand. He publicly singled her\nout before her colleagues as a \xe2\x80\x9cMan Hater\xe2\x80\x9d who \xe2\x80\x9cmust always be in control of\xe2\x80\x9d sex. He required her to\nchoose between drawing a vulgar planter displayed in his office or not being considered for a promotion,\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n810\n\n\x0can unfair choice that would likely intimidate a reasonable person from seeking further career\nadvancement.\nThe Court cites cases in which our sister Circuits have rejected hostile-work environment claims premised\nupon facts that the Court determines to be \xe2\x80\x9cequally or more egregious\xe2\x80\x9d than the conduct at issue here. I do\nnot agree that Ms. Duncan experienced less severe harassment than those plaintiffs. For example, in\nWeiss v. Coca-Cola Bottling Co., 990 F.2d 333 (7th Cir. 1993), the plaintiff did not allege that her work\nduties or evaluations were different because of her sex. This is not the situation Ms. Duncan faced. She\nwas given specific tasks of a sexually charged nature, such as typing up the minutes of the \xe2\x80\x9cHe-Man\nWomen Hater\xe2\x80\x99s Club.\xe2\x80\x9d Performing this \xe2\x80\x9cfunction\xe2\x80\x9d was presented to her as a required duty of her job.\nAlso Ms. Duncan was subjected to allegations that she was professionally \xe2\x80\x9cincompetent because of her\nsex.\xe2\x80\x9d\xe2\x80\xa6She adduced evidence of this factor when she testified that after she rejected his sexual advance,\nMr. Booth became more critical of her work. With the request for her to draw the planter for a promotion,\nMs. Duncan also faced \xe2\x80\x9cconduct that would prevent her from succeeding in the workplace,\xe2\x80\x9d a fact that Ms.\nShepherd could not point to in her case. Additionally, Ms. Duncan was \xe2\x80\x9cpropositioned\xe2\x80\x9d to sleep with her\nemployer\xe2\x80\xa6a claim not made by Ms. Shepherd.\nFinally, we note that in Ms. Duncan\xe2\x80\x99s case the harassing acts were directed specifically at her. The Court\nin Black v. Zaring Homes, 104 F.3d 822, 826 (6th Cir.), cert. denied, 522 U.S. 865, 139 L. Ed. 2d 114, 118\nS. Ct. 172 (1997), stated that the lack of specific comments to the plaintiff supported the conclusion that\nthe defendant\xe2\x80\x99s conduct was not severe enough to create actionable harm. By contrast, in the present case,\na jury could reasonably conclude that Ms. Duncan felt particularly humiliated and degraded by Mr.\nBooth\xe2\x80\x99s behavior because she alone was singled out for this harassment.\nOur own Court\xe2\x80\x99s Title VII jurisprudence suggests that Ms. Duncan experienced enough offensive conduct\nto constitute sexual harassment. For example, in Breeding v. Arthur J. Gallagher and Co. we reversed a\ngrant of summary judgment to an employer, stating that a supervisor who \xe2\x80\x9cfondled his genitals [**25] in\nfront of\xe2\x80\x9d a female employee and \xe2\x80\x9cused lewd and sexually inappropriate language\xe2\x80\x9d could create an\nenvironment severe enough to be actionable under Title VII. 164 F.3d 1151, 1159 (8th Cir. 1999). In Rorie\nv. United Parcel Service, we concluded that a work environment in which \xe2\x80\x9ca supervisor pats a female\nemployee on the back, brushes up against her, and tells her she smells good\xe2\x80\x9d could be found by a jury to\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n811\n\n\x0cbe a hostile work environment. 151 F.3d 757, 762 (8th Cir. 1998). Is it clear that the women in these cases\nsuffered harassment greater than Ms. Duncan? I think not.\nWe have acknowledged that \xe2\x80\x9cthere is no bright line between sexual harassment and merely unpleasant\nconduct, so a jury\xe2\x80\x99s decision must generally stand unless there is trial error.\xe2\x80\x9d Hathaway v. Runyon, 132\nF.3d 1214, 1221 (8th Cir. 1998). We have also ruled that \xe2\x80\x9conce there is evidence of improper conduct and\nsubjective offense, the determination of whether the conduct rose to the level of abuse is largely in the\nhands of the jury.\xe2\x80\x9d Howard v. Burns Bros., Inc., 149 F.3d 835, 840 (8th Cir. 1998). The Court admits that\nMs. Duncan took subjective offense to Mr. Booth\xe2\x80\x99s behavior and characterizes Mr. Booth\xe2\x80\x99s behavior as\n\xe2\x80\x9cboorish, chauvinistic, and decidedly immature.\xe2\x80\x9d Thus, the Court appears to agree that Mr. Booth\xe2\x80\x99s\nbehavior was \xe2\x80\x9cimproper conduct.\xe2\x80\x9d I believe the Court errs in deciding as a matter of law that the jury did\nnot act reasonably in concluding that Ms. Duncan faced severe or pervasive harassment that created a\nhostile work environment.\nTherefore, I dissent from the Court\xe2\x80\x99s conclusion that Ms. Duncan did not present sufficient evidence to\nsurvive judgment as a matter of law on her hostile work-environment and constructive-discharge claims.\n\nCASE QUESTIONS\n1.\n\nWhich opinion is more persuasive to you\xe2\x80\x94the majority opinion or the dissenting opinion?\n\n2.\n\n\xe2\x80\x9cNumerous cases have rejected hostile work environment claims premised upon facts equally or more\negregious than the conduct at issue here.\xe2\x80\x9d By what standard or criteria does the majority opinion\nconclude that Duncan\xe2\x80\x99s experiences were no worse than those mentioned in the other cases?\n\n3.\n\nShould the majority on the appeals court substitute its judgment for that of the jury?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n812\n\n\x0cAge Discrimination: Burden of Persuasion\nGross v. FBL Financial Services, Inc.\n557 U.S. ___ (2009)\nJUSTICE CLARENCE THOMAS delivered the opinion of the court.\n\nI\nPetitioner Jack Gross began working for respondent FBL Financial Group, Inc. (FBL), in 1971. As of 2001,\nGross held the position of claims administration director. But in 2003, when he was 54 years old, Gross\nwas reassigned to the position of claims project coordinator. At that same time, FBL transferred many of\nGross\xe2\x80\x99 job responsibilities to a newly created position\xe2\x80\x94claims administration manager. That position was\ngiven to Lisa Kneeskern, who had previously been supervised by Gross and who was then in her early\nforties. Although Gross (in his new position) and Kneeskern received the same compensation, Gross\nconsidered the reassignment a demotion because of FBL\xe2\x80\x99s reallocation of his former job responsibilities to\nKneeskern.\nIn April 2004, Gross filed suit in District Court, alleging that his reassignment to the position of claims\nproject coordinator violated the ADEA, which makes it unlawful for an employer to take adverse action\nagainst an employee \xe2\x80\x9cbecause of such individual\xe2\x80\x99s age.\xe2\x80\x9d 29 U. S. C. \xc2\xa7623(a). The case proceeded to trial,\nwhere Gross introduced evidence suggesting that his reassignment was based at least in part on his age.\nFBL defended its decision on the grounds that Gross\xe2\x80\x99 reassignment was part of a corporate restructuring\nand that Gross\xe2\x80\x99 new position was better suited to his skills.\nAt the close of trial, and over FBL\xe2\x80\x99s objections, the District Court instructed the jury that it must return a\nverdict for Gross if he proved, by a preponderance of the evidence, that FBL \xe2\x80\x9cdemoted [him] to claims\nproject[t] coordinator\xe2\x80\x9d and that his \xe2\x80\x9cage was a motivating factor\xe2\x80\x9d in FBL\xe2\x80\x99s decision to demote him. The\njury was further instructed that Gross\xe2\x80\x99 age would qualify as a \xe2\x80\x9c\xe2\x80\x98motivating factor,\xe2\x80\x99 if [it] played a part or a\nrole in [FBL]\xe2\x80\x99s decision to demote [him].\xe2\x80\x9d The jury was also instructed regarding FBL\xe2\x80\x99s burden of proof.\nAccording to the District Court, the \xe2\x80\x9cverdict must be for [FBL]\xe2\x80\xa6if it has been proved by the\npreponderance of the evidence that [FBL] would have demoted [Gross] regardless of his age.\xe2\x80\x9d Ibid. The\njury returned a verdict for Gross, awarding him $46,945 in lost compensation. FBL challenged the jury\ninstructions on appeal. The United States Court of Appeals for the Eighth Circuit reversed and remanded\nfor a new trial, holding that the jury had been incorrectly instructed under the standard established in\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n813\n\n\x0cPrice Waterhouse v. Hopkins, 490 U. S. 228 (1989). In Price Waterhouse, this Court addressed the\nproper allocation of the burden of persuasion in cases brought under Title VII of the Civil Rights Act of\n1964, when an employee alleges that he suffered an adverse employment action because of both\npermissible and impermissible considerations\xe2\x80\x94i.e., a \xe2\x80\x9cmixed-motives\xe2\x80\x9d case. 490 U. S., at 232, 244\xe2\x80\x93247\n(plurality opinion). The Price Waterhouse decision was splintered. Four Justices joined a plurality\nopinion, and three Justices dissented. Six Justices ultimately agreed that if a Title VII plaintiff shows that\ndiscrimination was a \xe2\x80\x9cmotivating\xe2\x80\x9d or a \xe2\x80\x9c \xe2\x80\x98substantial\xe2\x80\x99 \xe2\x80\x9c factor in the employer\xe2\x80\x99s action, the burden of\npersuasion should shift to the employer to show that it would have taken the same action regardless of\nthat impermissible consideration. Justice O\xe2\x80\x99Connor further found that to shift the burden of persuasion to\nthe employer, the employee must present \xe2\x80\x9cdirect evidence that an illegitimate criterion was a substantial\nfactor in the [employment] decision.\xe2\x80\x9d\xe2\x80\xa6\nBecause Gross conceded that he had not presented direct evidence of discrimination, the Court of Appeals\nheld that the District Court should not have given the mixed-motives instruction. Ibid. Rather, Gross\nshould have been held to the burden of persuasion applicable to typical, non-mixed-motives claims; the\njury thus should have been instructed only to determine whether Gross had carried his burden of\n\xe2\x80\x9cprov[ing] that age was the determining factor in FBL\xe2\x80\x99s employment action.\xe2\x80\x9d\nWe granted certiorari, 555 U.S. ___ (2008), and now vacate the decision of the Court of Appeals.\n\nII\nThe parties have asked us to decide whether a plaintiff must \xe2\x80\x9cpresent direct evidence of discrimination in\norder to obtain a mixed-motive instruction in a non-Title VII discrimination case.\xe2\x80\x9d Before reaching this\nquestion, however, we must first determine whether the burden of persuasion ever shifts to the party\ndefending an alleged mixed-motives discrimination claim brought under the ADEA. We hold that it does\nnot.\n\nA\nPetitioner relies on this Court\xe2\x80\x99s decisions construing Title VII for his interpretation of the ADEA. Because\nTitle VII is materially different with respect to the relevant burden of persuasion, however, these decisions\ndo not control our construction of the ADEA.\nIn Price Waterhouse, a plurality of the Court and two Justices concurring in the judgment determined\nthat once a \xe2\x80\x9cplaintiff in a Title VII case proves that [the plaintiff\xe2\x80\x99s membership in a protected class] played\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n814\n\n\x0ca motivating part in an employment decision, the defendant may avoid a finding of liability only by\nproving by a preponderance of the evidence that it would have made the same decision even if it had not\ntaken [that factor] into account.\xe2\x80\x9d 490 U. S., at 258; see also id., at 259\xe2\x80\x93260 (opinion of White, J.); id., at\n276 (opinion of O\xe2\x80\x99Connor, J.). But as we explained in Desert Palace, Inc. v. Costa, 539 U. S. 90, 94\xe2\x80\x9395\n(2003), Congress has since amended Title VII by explicitly authorizing discrimination claims in which an\nimproper consideration was \xe2\x80\x9ca motivating factor\xe2\x80\x9d for an adverse employment decision. See 42 U. S. C.\n\xc2\xa72000e\xe2\x80\x932(m) (providing that \xe2\x80\x9can unlawful employment practice is established when the complaining\nparty demonstrates that race, color, religion, sex, or national origin was a motivating factor for any\nemployment practice, even though other factors also motivated the practice\xe2\x80\x9d (emphasis added))\xe2\x80\xa6\nThis Court has never held that this burden-shifting framework applies to ADEA claims. And, we decline to\ndo so now. When conducting statutory interpretation, we \xe2\x80\x9cmust be careful not to apply rules applicable\nunder one statute to a different statute without careful and critical examination.\xe2\x80\x9d Unlike Title VII, the\nADEA\xe2\x80\x99s text does not provide that a plaintiff may establish discrimination by showing that age was simply\na motivating factor. Moreover, Congress neglected to add such a provision to the ADEA when it amended\nTitle VII to add \xc2\xa7\xc2\xa72000e\xe2\x80\x932(m) and 2000e\xe2\x80\x935(g)(2)(B), even though it contemporaneously amended the\nADEA in several ways.\xe2\x80\xa6\nWe cannot ignore Congress\xe2\x80\x99 decision to amend Title VII\xe2\x80\x99s relevant provisions but not make similar\nchanges to the ADEA. When Congress amends one statutory provision but not another, it is presumed to\nhave acted intentionally.\xe2\x80\xa6As a result, the Court\xe2\x80\x99s interpretation of the ADEA is not governed by Title VII\ndecisions such as Desert Palace and Price Waterhouse.\n\nB\nOur inquiry therefore must focus on the text of the ADEA to decide whether it authorizes a mixed-motives\nage discrimination claim. It does not. \xe2\x80\x9cStatutory construction must begin with the language employed by\nCongress and the assumption that the ordinary meaning of that language accurately expresses the\nlegislative purpose.\xe2\x80\x9d\xe2\x80\xa6The ADEA provides, in relevant part, that \xe2\x80\x9c[i]t shall be unlawful for an employer\xe2\x80\xa6to\nfail or refuse to hire or to discharge any individual or otherwise discriminate against any individual with\nrespect to his compensation, terms, conditions, or privileges of employment, because of such individual\xe2\x80\x99s\nage.\xe2\x80\x9d 29 U. S. C. \xc2\xa7623(a)(1) (emphasis added).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n815\n\n\x0cThe words \xe2\x80\x9cbecause of\xe2\x80\x9d mean \xe2\x80\x9cby reason of: on account of.\xe2\x80\x9d Webster\xe2\x80\x99s Third New International Dictionary\n194 (1966); see also Oxford English Dictionary 746 (1933) (defining \xe2\x80\x9cbecause of\xe2\x80\x9d to mean \xe2\x80\x9cBy reason of,\non account of\xe2\x80\x9d (italics in original)); The Random House Dictionary of the English Language 132 (1966)\n(defining \xe2\x80\x9cbecause\xe2\x80\x9d to mean \xe2\x80\x9cby reason; on account\xe2\x80\x9d). Thus, the ordinary meaning of the ADEA\xe2\x80\x99s\nrequirement that an employer took adverse action \xe2\x80\x9cbecause of\xe2\x80\x9d age is that age was the \xe2\x80\x9creason\xe2\x80\x9d that the\nemployer decided to act.\xe2\x80\xa6To establish a disparate-treatment claim under the plain language of the ADEA,\ntherefore, a plaintiff must prove that age was the \xe2\x80\x9cbut-for\xe2\x80\x9d cause of the employer\xe2\x80\x99s adverse decision.\xe2\x80\xa6\nIt follows, then, that under \xc2\xa7623(a)(1), the plaintiff retains the burden of persuasion to establish that age\nwas the \xe2\x80\x9cbut-for\xe2\x80\x9d cause of the employer\xe2\x80\x99s adverse action. Indeed, we have previously held that the burden\nis allocated in this manner in ADEA cases. See Kentucky Retirement Systems v. EEOC, 554 U. S. ____.\nAnd nothing in the statute\xe2\x80\x99s text indicates that Congress has carved out an exception to that rule for a\nsubset of ADEA cases. Where the statutory text is \xe2\x80\x9csilent on the allocation of the burden of persuasion,\xe2\x80\x9d\nwe \xe2\x80\x9cbegin with the ordinary default rule that plaintiffs bear the risk of failing to prove their claims.\n\xe2\x80\x9dSchaffer v. Weast, 546 U. S. 49, 56 (2005)\xe2\x80\xa6\nHence, the burden of persuasion necessary to establish employer liability is the same in alleged mixedmotives cases as in any other ADEA disparate-treatment action. A plaintiff must prove by a\npreponderance of the evidence (which may be direct or circumstantial), that age was the \xe2\x80\x9cbut-for\xe2\x80\x9d cause of\nthe challenged employer decision.\n\nIII\nFinally, we reject petitioner\xe2\x80\x99s contention that our interpretation of the ADEA is controlled by Price\nWaterhouse, which initially established that the burden of persuasion shifted in alleged mixed-motives\nTitle VII claims. In any event, it is far from clear that the Court would have the same approach were it to\nconsider the question today in the first instance.\nWhatever the deficiencies of Price Waterhouse in retrospect, it has become evident in the years since that\ncase was decided that its burden-shifting framework is difficult to apply. For example, in cases tried to a\njury, courts have found it particularly difficult to craft an instruction to explain its burden-shifting\nframework.\xe2\x80\xa6Thus, even if Price Waterhouse was doctrinally sound, the problems associated with its\napplication have eliminated any perceivable benefit to extending its framework to ADEA claims.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n816\n\n\x0cIV\nWe hold that a plaintiff bringing a disparate-treatment claim pursuant to the ADEA must prove, by a\npreponderance of the evidence, that age was the \xe2\x80\x9cbut-for\xe2\x80\x9d cause of the challenged adverse employment\naction. The burden of persuasion does not shift to the employer to show that it would have taken the\naction regardless of age, even when a plaintiff has produced some evidence that age was one motivating\nfactor in that decision. Accordingly, we vacate the judgment of the Court of Appeals and remand the case\nfor further proceedings consistent with this opinion.\nIt is so ordered.\n\nCASE QUESTIONS\n1.\n\nWhat is the practical effect of this decision? Will plaintiffs with age-discrimination cases find it harder\nto win after Gross?\n\n2.\n\nAs Justice Thomas writes about it, does \xe2\x80\x9cbut-for\xe2\x80\x9d cause here mean the \xe2\x80\x9csole cause\xe2\x80\x9d? Must plaintiffs\nnow eliminate any other possible cause in order to prevail in an ADEA lawsuit?\n\n3.\n\nBased on this opinion, if the employer provides a nondiscriminatory reason for the change in the\nemployee\xe2\x80\x99s status (such as \xe2\x80\x9ccorporate restructuring\xe2\x80\x9d or \xe2\x80\x9cbetter alignment of skills\xe2\x80\x9d), does the\nemployer bear any burden of showing that those are not just words but that, for example, the\nrestructuring really does make sense or that the \xe2\x80\x9cskills\xe2\x80\x9d really do line up better in the new\narrangement?\n\n4.\n\nIf the plaintiff was retained at the same salary as before, how could he have a \xe2\x80\x9cdiscrimination\xe2\x80\x9d\ncomplaint, since he still made the same amount of money?\n\n5.\n\nThe case was decided by a 5-4 majority. A dissent was filed by Justice Stevens, and a separate dissent\nby Justice Breyer, joined by Justices Ginsburg and Souter. You can access those\nat http://www.law.cornell.edu/supct/pdf/08-441P.ZD1.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n817\n\n\x0cDisability Discrimination\nToyota v. Williams\n534 U.S. 184 (2000)\n\nFactual Background\nElla Williams\xe2\x80\x99s job at the Toyota manufacturing plant involved using pneumatic tools. When her hands\nand arms began to hurt, she consulted a physician and was diagnosed with carpal tunnel syndrome. The\ndoctor advised her not to work with any pneumatic tools or lift more than twenty pounds. Toyota shifted\nher to a different position in the quality control inspection operations (QCIO) department, where\nemployees typically performed four different tasks. Initially, Williams was given two tasks, but Toyota\nchanged its policy to require all QCIO employees to rotate through all four tasks. When she performed the\n\xe2\x80\x9cshell body audit,\xe2\x80\x9d she had to hold her hands and arms up around shoulder height for several hours at a\ntime.\nShe soon began to experience pain in her neck and shoulders. When she asked permission to do only the\ntwo tasks that she could perform without difficulty, she was refused. According to Toyota, Williams then\nbegan missing work regularly.\nIn 1997, Toyota Motor Manufacturing, Kentucky, Inc. terminated Ella Williams, citing her poor\nattendance record. Subsequently, claiming to be disabled from performing her automobile assembly line\njob by carpal tunnel syndrome and related impairments, Williams sued Toyota for failing to provide her\nwith a reasonable accommodation as required by the Americans with Disabilities Act (ADA) of 1990.\nGranting Toyota summary judgment, the district court held that Williams\xe2\x80\x99s impairment did not qualify as\na disability under the ADA because it had not substantially limited any major life activity and that there\nwas no evidence that Williams had had a record of a substantially limiting impairment. In reversing, the\ncourt of appeals found that the impairments substantially limited Williams in the major life activity of\nperforming manual tasks. Because her ailments prevented her from doing the tasks associated with\ncertain types of manual jobs that require the gripping of tools and repetitive work with hands and arms\nextended at or above shoulder levels for extended periods of time, the appellate court concluded that\nWilliams demonstrated that her manual disability involved a class of manual activities affecting the ability\nto perform tasks at work.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n818\n\n\x0cJUSTICE SANDRA DAY O\xe2\x80\x99CONNOR delivered the unanimous opinion of the court.\nWhen it enacted the ADA in 1990, Congress found that some 43 million Americans have one or more\nphysical or mental disabilities. If Congress intended everyone with a physical impairment that precluded\nthe performance of some isolated, unimportant, or particularly difficult manual task to qualify as\ndisabled, the number of disabled Americans would surely have been much higher. We therefore hold that\nto be substantially limited in performing manual tasks, an individual must have an impairment that\nprevents or severely restricts the individual from doing activities that are of central importance to most\npeople\xe2\x80\x99s daily lives. The impairments impact must also be permanent or long-term.\nWhen addressing the major life activity of performing manual tasks, the central inquiry must be whether\nthe claimant is unable to perform the variety of tasks central to most people\xe2\x80\x99s daily lives, not whether the\nclaimant is unable to perform the tasks associated with her specific job. In this case, repetitive work with\nhands and arms extended at or above shoulder levels for extended periods of time is not an important part\nof most people\xe2\x80\x99s daily lives. The court, therefore, should not have considered respondent\xe2\x80\x99s inability to do\nsuch manual work in or specialized assembly line job as sufficient proof that she was substantially limited\nin performing manual tasks.\nAt the same time, the Court of Appeals appears to have disregarded the very type of evidence that it\nshould have focused upon. It treated as irrelevant \xe2\x80\x9c[t]he fact that [respondent] can\xe2\x80\xa6ten[d] to her personal\nhygiene [and] carr[y]out personal or household chores.\xe2\x80\x9d Yet household chores, bathing, and brushing\none\xe2\x80\x99s teeth are among the types of manual tasks of central importance to people\xe2\x80\x99s daily lives, and should\nhave been part of the assessment of whether respondent was substantially limited in performing manual\ntasks.\nThe District Court noted that at the time respondent sought an accommodation from petitioner, she\nadmitted that she was able to do the manual tasks required by her original two jobs in QCIO. In addition,\naccording to respondent\xe2\x80\x99s deposition testimony, even after her condition worsened, she could still brush\nher teeth, wash her face, bathe, tend her flower garden, fix breakfast, do laundry, and pick up around the\nhouse. The record also indicates that her medical conditions caused her to avoid sweeping, to quit\ndancing, to occasionally seek help dressing, and to reduce how often she plays with her children, gardens,\nand drives long distances. But these changes in her life did not amount to such severe restrictions in the\nactivities that are of central importance to most people\xe2\x80\x99s daily lives that they establish a manual task\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n819\n\n\x0cdisability as a matter of law. On this record, it was therefore inappropriate for the Court of Appeals to\ngrant partial summary judgment to respondent on the issue of whether she was substantially limited in\nperforming manual tasks, and its decision to do so must be reversed.\nAccordingly, we reverse the Court of Appeals\xe2\x80\x99 judgment granting partial summary judgment to\nrespondent and remand the case for further proceedings consistent with this opinion.\n\nCASE QUESTIONS\n1.\n\nWhat is the court\xe2\x80\x99s most important \xe2\x80\x9cfinding of fact\xe2\x80\x9d relative to hands and arms? How does this relate\nto the statutory language that Congress created in the ADA?\n\n2.\n\nThe case is remanded to the lower courts \xe2\x80\x9cfor further proceedings consistent with this opinion.\xe2\x80\x9d In\npractical terms, what does that mean for this case?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n820\n\n\x0c18.5 Summary and Exercises\nSummary\nFor the past forty-eight years, Title VII of the Civil Rights Act of 1964 has prohibited employment\ndiscrimination based on race, religion, sex, or national origin. Any employment decision, including hiring,\npromotion, and discharge, based on one of these factors is unlawful and subjects the employer to an\naward of back pay, promotion, or reinstatement. The Equal Employment Opportunity Commission\n(EEOC) may file suits, as may the employee\xe2\x80\x94after the commission screens the complaint.\nTwo major types of discrimination suits are those for disparate treatment (in which the employer\nintended to discriminate) and disparate impact (in which, regardless of intent, the impact of a particular\nnon-job-related practice has a discriminatory effect). In matters of religion, the employer is bound not\nonly to refrain from discrimination based on an employee\xe2\x80\x99s religious beliefs or preferences but also to\naccommodate the employee\xe2\x80\x99s religious practices to the extent that the accommodation does not impose an\nundue hardship on the business.\nSex discrimination, besides refusal to hire a person solely on the basis of sex, includes discrimination\nbased on pregnancy. Sexual harassment is a form of sex discrimination, and it includes the creation of a\nhostile or offensive working environment. A separate statute, the Equal Pay Act, mandates equal pay for\nmen and women assigned to the same job.\nOne major exception to Title VII permits hiring people of a particular religion, sex, or nationality if that\nfeature is a bona fide occupational qualification. There is no bona fide occupational qualification (BFOQ)\nexception for race, nor is a public stereotype a legitimate basis for a BFOQ.\nAffirmative action plans, permitting or requiring employers to hire on the basis of race to make up for\npast discrimination or to bring up the level of minority workers, have been approved, even though the\nplans may seem to conflict with Title VII. But affirmative action plans have not been permitted to\novercome bona fide seniority or merit systems.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n821\n\n\x0cThe Age Discrimination in Employment Act protects workers over forty from discharge solely on the basis\nof age. Amendments to the law have abolished the age ceiling for retirement, so that most people working\nfor employers covered by the law cannot be forced to retire.\nThe Americans with Disabilities Act of 1990 prohibits discrimination based on disability and applies to\nmost jobs in the private sector.\nAt common law, an employer was free to fire an employee for any reason or for no reason at all. In recent\nyears, the employment-at-will doctrine has been seriously eroded. Many state courts have found against\nemployers on the basis of implied contracts, tortious violation of public policy, or violations of an implied\ncovenant of good faith and fair dealing.\nBeyond antidiscrimination law, several other statutes have an impact on the employment relationship.\nThese include the plant-closing law, the Employee Polygraph Protection Act, the Occupational Safety and\nHealth Act, the Employee Retirement Income Security Act, and the Fair Labor Standards Act.\n\nEXERCISES\n1.\n\nRainbow Airlines, a new air carrier headquartered in Chicago with routes from Rome to Canberra,\nextensively studied the psychology of passengers and determined that more than 93 percent of its\npassengers felt most comfortable with female flight attendants between the ages of twenty-one and\nthirty-four. To increase its profitability, the company issued a policy of hiring only such people for jobs\nin the air but opened all ground jobs to anyone who could otherwise qualify. The policy made no racial\ndistinction, and, in fact, nearly 30 percent of the flight attendants hired were black. What violations of\nfederal law has Rainbow committed, if any?\n\n2.\n\nTex Olafson worked for five years as a messenger for Pressure Sell Advertising Agency, a company\nwithout a unionized workforce. On his fifth anniversary with the company, Tex was called in to the\npresident\xe2\x80\x99s office, was given a 10 percent raise, and was complimented on his diligence. The following\nweek, a new head of the messenger department was hired. He wanted to appoint his nephew to a\nmessenger job but discovered that a company-wide hiring freeze prevented him from adding another\nemployee to the messenger ranks. So he fired Tex and hired his nephew. What remedy, if any, does\nTex have? What additional facts might change the result?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n822\n\n\x0c3.\n\nErnest lost both his legs in combat in Vietnam. He has applied for a job with Excelsior Products in the\ncompany\xe2\x80\x99s quality control lab. The job requires inspectors to randomly check products coming off the\nassembly line for defects. Historically, all inspectors have stood two-hour shifts. Ernest proposes to sit\nin his wheelchair. The company refuses to hire him because it says he will be less efficient. Ernest\xe2\x80\x99s\nprevious employment record shows him to be a diligent, serious worker. Does Ernest have a legal right\nto be hired? What additional facts might you want to know in deciding?\n\n4.\n\nMarlene works for Frenzied Traders, a stockbrokerage with a seat on the New York Stock Exchange.\nFor several years, Marlene has been a floor trader, spending all day in the hurly-burly of stock trading,\nyelling herself hoarse. Each year, she has received a large bonus from the company. She has just told\nthe company that she is pregnant. Citing a company policy, she is told she can no longer engage in\ntrading because it is too tiring for pregnant women. Instead, she may take a backroom job, though the\ncompany cannot guarantee that the floor job will be open after she delivers. Marlene also wants to\ntake six months off after her child is born. The company says it cannot afford to give her that time. It\nhas a policy of granting paid leave to anyone recuperating from a stay in the hospital and unpaid leave\nfor four months thereafter. What legal rights does Marlene have, and what remedies is she entitled\nto?\n\n5.\n\nCharlie Goodfellow works for Yum-burger and has always commanded respect at the local franchise\nfor being the fastest server. One day, he undergoes a profound religious experience, converts to\nSikhism, and changes his name to Sanjay Singh. The tenets of his religion require him to wear a beard\nand a turban. He lets his beard grow, puts on a turban, and his fellow workers tease him. When a\nregional vice president sees that Sanjay is not wearing the prescribed Yum-Burger uniform, he fires\nhim. What rights of Sanjay, if any, has Yum-burger violated? What remedies are available to him?\n\nSELF-TEST QUESTIONS\n1.\n\nAffirmative action in employment\n\na.\n\nis a requirement of Title VII of the Civil Rights Act of 1964\n\nb.\n\nis prohibited by Title VII of the Civil Rights Act of 1964\n\nc.\n\nis a federal statute enacted by Congress\n\nd.\n\ndepends on the circumstances of each case for validity\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n823\n\n\x0cThe Age Discrimination in Employment Act protects\na.\n\nall workers of any age\nb.\n\nall workers up to age seventy\n\nc.\n\nmost workers over forty\n\nd.\n\nno workers over seventy\nFederal laws barring discrimination against the handicapped and disabled\n\na.\n\napply to all disabilities\nb.\n\napply to most disabilities in private employment\n\nc.\n\napply to all disabilities in public employment\n\nd.\n\napply to most disabilities in public employment\nUnder Title VII, a bona fide occupational qualification exception may never apply to cases\ninvolving\n\na.\n\nracial discrimination\nb.\n\nreligious discrimination\n\nc.\n\nsex discrimination\n\nd.\n\nage discrimination\nThe employment-at-will doctrine derives from\n\na.\n\nTitle VII of the Civil Rights Act of 1964\nb.\n\nemployment contracts\n\nc.\n\nthe common law\n\nd.\n\nliberty of contract under the Constitution\n\nSELF-TEST ANSWERS\n1.\n\nd\n\n2.\n\nc\n\n3.\n\nb\n\n4.\n\na\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n824\n\n\x0c5.\n\nc\n\nChapter 19\nLabor-Management Relations\nLEARNING OBJECTIVES\nAfter reading this chapter, you should understand the following:\n1.\n\nHow collective bargaining was resisted for many years in the United States, and how political and\neconomic changes resulted in legalization of labor unions\n\n2.\n\nThe four major federal labor laws in the United States\n\n3.\n\nThe process by which bargaining units are recognized by the National Labor Relations Board\n\n4.\n\nThe various kinds of unfair labor practices that employers might engage in, and those that unions and\ntheir members might engage in\n\nOver half a century, the federal law of labor relations has developed out of four basic statutes into an\nimmense body of cases and precedent regulating the formation and governance of labor unions and the\nrelationships among employers, unions, and union members. Like antitrust law, labor law is a complex\nsubject that has spawned a large class of specialized practitioners. Though specialized, it is a subject that\nno employer of any size can ignore, for labor law has a pervasive influence on how business is conducted\nthroughout the United States. In this chapter, we examine the basic statutory framework and the activities\nthat it regulates.\nIt is important to note at the outset that legal rights for laborers in the United States came about through\nphysical and political struggles. The right of collective bargaining and the right to strike (and\ncorresponding rights for employers, such as the lockout) were hard-won and incremental. The legislation\ndescribed in this chapter began only after many years of labor-management strife, including judicial\nopposition to unions and violent and deadly confrontations between pro-union workers and management.\nIn 1806, the union of Philadelphia Journeymen Cordwainers was convicted of and bankrupted by charges\nof criminal conspiracy after a strike for higher wages, setting a precedent by which the US government\nwould combat unions for years to come. Andrew Jackson became a strikebreaker in 1834 when he sent\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n825\n\n\x0ctroops to the construction sites of the Chesapeake and Ohio Canal. In 1877, a general strike halted the\nmovement of US railroads. In the following days, strike riots spread across the United States. The next\nweek, federal troops were called out to force an end to the nationwide strike. At the Battle of the Viaduct\nin Chicago, federal troops (recently returned from an Indian massacre) killed thirty workers and wounded\nover one hundred. Numerous other violent confrontations marked the post\xe2\x80\x93Civil War period in America,\nincluding the violent rail strikes of 1877, when President Rutherford B. Hayes sent troops to prevent\nobstruction of the mails. President Grover Cleveland used soldiers to break the Pullman strike of 1894.\nNot until the anthracite coal strikes in Pennsylvania in 1902 did the US governments become a mediator\nbetween labor and management rather than an enforcer for industry.\nMany US labor historians see the first phase of the labor movement in terms of the struggles in the private\nsector that led to the labor legislation of the New Deal, described in . The second phase of the movement,\npost\xe2\x80\x93World War II, saw less violent confrontation and more peaceful resolution of labor issues in\ncollective bargaining. Yet right-to-work states in the southern part of the United States and globalization\nweakened the attractiveness of unions in the private sector. Right-to-work states provided a haven for\ncertain kinds of manufacturing operations that wanted no part of bargaining with unions. Globalization\nmeant that companies could (realistically) threaten to relocate outside the United States entirely. Unions\nin the public sector of the United States began to grow stronger relative to unions in the private sector:\ngovernments could not relocate as companies could, and over the last half century, there has been a\ngradual decline in private sector unionism and growth in public sector unionism.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n826\n\n\x0c19.1 A Brief History of Labor Legislation\nLEARNING OBJECTIVES\n1.\n\nUnderstand and explain the rise of labor unions in the United States.\n\n2.\n\nExplain what common-law principles were used by employers and courts to resist legalized collective\nbargaining.\n\n3.\n\nBe able to put US labor law in its historical context.\n\nLabor and the Common Law in the Nineteenth Century\nLabor unions appeared in modern form in the United States in the 1790s in Boston, New York, and\nPhiladelphia. Early in the nineteenth century, employers began to seek injunctions against union\norganizing and other activities. Two doctrines were employed: (1) common-law conspiracy and\n(2) common-law restraint of trade. The first doctrine held that workers who joined together were acting\ncriminally as conspirators, regardless of the means chosen or the objectives sought.\nThe second doctrine\xe2\x80\x94common-law restraint of trade\xe2\x80\x94was also a favorite theory used by the courts to\nenjoin unionizing and other joint employee activities. Workers who banded together to seek better wages\nor working conditions were, according to this theory, engaged in concerted activity that restrained trade in\ntheir labor. This theory made sense in a day in which conventional wisdom held that an employer was\nentitled to buy labor as cheaply as possible\xe2\x80\x94the price would obviously rise if workers were allowed to\nbargain jointly rather than if they were required to offer their services individually on the open market.\n\nLabor under the Antitrust Laws\nThe Sherman Act did nothing to change this basic judicial attitude. A number of cases decided early in the\nact\xe2\x80\x99s history condemned labor activities as violations of the antitrust law. In particular, in the Danbury\nHatters\xe2\x80\x99 case (Loewe v. Lawlor) the Supreme Court held that a \xe2\x80\x9csecondary boycott\xe2\x80\x9d against a\nnonunionized company violated the Sherman Act. The hatters instigated a boycott of retail stores that\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n827\n\n\x0csold hats manufactured by a company whose workers had struck. The union was held liable for treble\ndamages.\n\n[1]\n\nBy 1912, labor had organized widely, and it played a pivotal role in electing Woodrow Wilson and giving\nhim a Democratic Congress, which responded in 1914 with the Clayton Act\xe2\x80\x99s \xe2\x80\x9clabor exemption.\xe2\x80\x9d Section 6\nof the Clayton Act says that labor unions are not \xe2\x80\x9cillegal combinations or conspiracies in restraint of trade,\nunder the antitrust laws.\xe2\x80\x9d Section 20 forbids courts from issuing injunctions in cases involving strikes,\nboycotts, and other concerted union activities (which were declared to be lawful) as long as they arose out\nof disputes between employer and employees over the terms of employment.\nBut even the Clayton Act proved of little lasting value to the unions. In 1921, the Supreme Court again\nstruck out against a secondary boycott that crippled the significance of the Clayton Act provisions. In the\ncase, a machinists\xe2\x80\x99 union staged a boycott against an employer (by whom the members were not\nemployed) in order to pressure the employer into permitting one of its factories to be unionized. The\nCourt ruled that the Clayton Act exemptions applied only in cases involving an employer and its own\nemployees.\n\n[2]\n\nWithout the ability to boycott under those circumstances, and with the threat of antitrust\n\nprosecutions or treble-damage actions, labor would be hard-pressed to unionize many companies. More\nantiunion decisions followed.\n\nMoves toward Modern Labor Legislation\nCollective bargaining appeared on the national scene for the first time in 1918 with the creation of the War\nLabor Conference Board. The National War Labor Board was empowered to mediate or reconcile labor\ndisputes that affected industries essential to the war, but after the war, the board was abolished.\nIn 1926, Congress enacted the Railway Labor Act. This statute imposed a duty on railroads to bargain in\ngood faith with their employees\xe2\x80\x99 elected representatives. The act also established the National Mediation\nBoard to mediate disputes that were not resolved in contract negotiations. The stage was set for more\ncomprehensive national labor laws. These would come with the Great Depression.\n\nThe Norris\xe2\x80\x93La Guardia Act\nThe first labor law of the Great Depression was the Norris\xe2\x80\x93La Guardia Act of 1932. It dealt with the\npropensity of federal courts to issue preliminary injunctions, often ex parte (i.e., after hearing only the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n828\n\n\x0cplaintiff\xe2\x80\x99s argument), against union activities. Even though the permanent injunction might later have\nbeen denied, the effect of the vaguely worded preliminary injunction would have been sufficient to destroy\nthe attempt to unionize. The Norris\xe2\x80\x93La Guardia Act forbids federal courts from temporarily or\npermanently enjoining certain union activities, such as peaceful picketing and strikes. The act is\napplicable is any \xe2\x80\x9clabor dispute,\xe2\x80\x9d defined as embracing \xe2\x80\x9cany controversy concerning terms or conditions\nof employment, or concerning the association or representation of persons in negotiating, fixing,\nmaintaining, changing, or seeking to arrange terms or conditions of employment, regardless of whether or\nnot the disputants stand in the proximate relation of employer and employee.\xe2\x80\x9d This language thus\npermitted the secondary boycott that had been held a violation of the antitrust laws in Duplex Printing\nPress v. Deering. The act also bars the courts from enforcing so-called yellow-dog contracts\xe2\x80\x94agreements\nthat employees made with their employer not to join unions.\n\nThe National Labor Relations Act (the Wagner Act)\nIn 1935, Congress finally enacted a comprehensive labor statute. The National Labor Relations Act\n(NLRA), often called the Wagner Act after its sponsor, Senator Robert F. Wagner, declared in Section 7\nthat workers in interstate commerce \xe2\x80\x9chave the right to self-organization, to form, join or assist labor\norganizations, to bargain collectively through representatives of their own choosing, and to engage in\nconcerted activities for the purpose of collective bargaining or other mutual aid or protection.\xe2\x80\x9d Section 8\nsets out five key unfair labor practices:\n1.\n\nInterference with the rights guaranteed by Section 7\n\n2. Interference with the organization of unions, or dominance by the employer of union administration\n(this section thus outlaws \xe2\x80\x9ccompany unions\xe2\x80\x9d)\n3. Discrimination against employees who belong to unions\n4. Discharging or otherwise discriminating against employees who seek relief under the act\n5.\n\nRefusing to bargain collectively with union representatives\n\nThe procedures for forming a union to represent employees in an appropriate \xe2\x80\x9cbargaining unit\xe2\x80\x9d are set\nout in Section 9. Finally, the Wagner Act established the National Labor Relations Board (NLRB) as an\nindependent federal administrative agency, with power to investigate and remedy unfair labor practices.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n829\n\n\x0cThe Supreme Court upheld the constitutionality of the act in 1937 in a series of five cases. In the\nfirst, NLRB v. Jones & Laughlin Steel Corp., the Court ruled that congressional power under the\nCommerce Clause extends to activities that might affect the flow of interstate commerce, as labor relations\n[3]\n\ncertainly did. Through its elaborate mechanisms for establishing collective bargaining as a basic national\npolicy, the Wagner Act has had a profound effect on interstate commerce during the last half-century.\n\nThe Taft-Hartley Act (Labor-Management Relations Act)\nThe Wagner Act did not attempt to restrict union activities in any way. For a dozen years, opponents of\nunions sought some means of curtailing the breadth of opportunity opened up to unions by the Wagner\nAct. After failing to obtain relief in the Supreme Court, they took their case to Congress and finally\nsucceeded after World War II when, in 1947, Congress, for the first time since 1930, had Republican\nmajorities in both houses. Congress responded to critics of \xe2\x80\x9cbig labor\xe2\x80\x9d with the Taft-Hartley Act, passed\nover President Truman\xe2\x80\x99s veto. Taft-Hartley\xe2\x80\x94known formally as the Labor-Management Relations Act\xe2\x80\x94\ndid not repeal the protections given employees and unions under the NLRA. Instead, it balanced union\npower with a declaration of rights of employers. In particular, Taft-Hartley lists six unfair labor practices\nof unions, including secondary boycotts, strikes aimed at coercing an employer to fire an employee who\nrefuses to join a union, and so-called jurisdictional strikes over which union should be entitled to do a\nspecified jobs at the work site.\nIn addition to these provisions, Taft-Hartley contains several others that balance the rights of unions and\nemployers. For example, the act guarantees both employers and unions the right to present their views on\nunionization and collective bargaining. Like employers, unions became obligated to bargain in good faith.\nThe act outlaws the closed shop (a firm in which a worker must belong to a union), gives federal courts the\npower to enforce collective bargaining agreements, and permits private parties to sue for damages arising\nout of a secondary boycott. The act also created the Federal Mediation and Conciliation Service to cope\nwith strikes that create national emergencies, and it declared strikes by federal employees to be unlawful.\nIt was this provision that President Reagan invoked in 1981 to fire air traffic controllers who walked off\nthe job for higher pay.\n\nThe Landrum-Griffin Act\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n830\n\n\x0cCongressional hearings in the 1950s brought to light union corruption and abuses and led in 1959 to the\nlast of the major federal labor statutes, the Landrum-Griffin Act (Labor-Management Reporting and\nDisclosure Act). It established a series of controls on internal union procedures, including the method of\nelecting union officers and the financial controls necessary to avoid the problems of corruption that had\nbeen encountered. Landrum-Griffin also restricted union picketing under various circumstances,\nnarrowed the loopholes in Taft-Hartley\xe2\x80\x99s prohibitions against secondary boycotts, and banned \xe2\x80\x9chot cargo\xe2\x80\x9d\nagreements (see Section 19.3.6 "Hot Cargo Agreement").\n\nKEY TAKEAWAY\nCommon-law doctrines were used in the early history of the labor movement to enjoin unionizing and\nother joint employee activities. These were deemed to be restraints of trade that violated antitrust\nlaws. In addition, common-law conspiracy charges provided criminal enforcement against joint\nemployee actions and agreements. Politically, the labor movement gained some traction in 1912 and\ngot an antitrust-law exemption in the Clayton Act. But it was not until the Great Depression and the\nNew Deal that the right of collective bargaining was recognized by federal statute in the National Labor\nRelations Act. Subsequent legislation (Taft-Hartley and Landrum-Griffin) added limits to union activities\nand controls over unions in their internal functions.\n\nEXERCISES\n1.\n\nUse the Internet to find stories of government-sponsored violence against union activities in the late\n1900s and early part of the twentieth century. What were some of the most violent confrontations,\nand what caused them? Discuss why business and government were so opposed to collective\nbargaining.\n\n2.\n\nUse the Internet to find out which countries in the world have legal systems that support collective\nbargaining. What do these countries have in common with the United States? Does the People\xe2\x80\x99s\nRepublic of China support collective bargaining?\n\n[1] Loewe v. Lawlor, 208 U.S. 274 (1908).\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n831\n\n\x0c[2] Duplex Printing Press Co. v. Deering, 254 U.S. 443 (1921).\n[3] NLRB v. Jones & Laughlin Steel Corp., 301 U.S. 1 (1937).\n\n19.2 The National Labor Relations Board: Organization and\nFunctions\nLEARNING OBJECTIVE\n1.\n\nExplain the process that leads to recognition of bargaining units by the National Labor Relations\nBoard.\n\nThe National Labor Relations Board (NLRB) consists of five board members, appointed by the president\nand confirmed by the Senate, who serve for five-year, staggered terms. The president designates one of\nthe members as chairman. The president also appoints the general counsel, who is in charge of the board\xe2\x80\x99s\ninvestigatory and prosecutorial functions and who represents the NLRB when it goes (or is taken) to\ncourt. The general counsel also oversees the thirty-three regional offices scattered throughout the country,\neach of which is headed by a regional director.\nThe NLRB serves two primary functions: (1) it investigates allegations of unfair labor practices and\nprovides remedies in appropriate cases, and (2) it decides in contested cases which union should serve as\nthe exclusive bargaining agent for a particular group of employees.\n\nUnfair Labor Practice Cases\nUnfair labor practice cases are fairly common; some twenty-two thousand unfair labor practice claims\nwere filed in 2008. Volume was considerably higher thirty years ago; about forty thousand a year was\ntypical in the early 1980s. A charge of an unfair labor practice must be presented to the board, which has\nno authority to initiate cases on its own. Charges are investigated at the regional level and may result in a\ncomplaint by the regional office. A regional director\xe2\x80\x99s failure to issue a complaint may be appealed to the\ngeneral counsel, whose word is final (there is no possible appeal).\nA substantial number of charges are dismissed or withdrawn each year\xe2\x80\x94sometimes as many as 70\npercent. Once issued, the complaint is handled by an attorney from the regional office. Most cases, usually\naround 80 percent, are settled at this level. If not settled, the case will be tried before an administrative\nlaw judge, who will take evidence and recommend a decision and an order. If no one objects, the decision\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n832\n\n\x0cand order become final as the board\xe2\x80\x99s opinion and order. Any party may appeal the decision to the board\nin Washington. The board acts on written briefs, rarely on oral argument. The board\xe2\x80\x99s order may be\nappealed to the US court of appeals, although its findings of fact are not reviewable \xe2\x80\x9cif supported by\nsubstantial evidence on the record considered as a whole.\xe2\x80\x9d The board may also go to the court of appeals\nto seek enforcement of its orders.\n\nRepresentation Cases\nThe NLRB is empowered to oversee representative elections\xe2\x80\x94that is, elections by employees to determine\nwhether or not to be represented by a union. The board becomes involved if at least 30 percent of the\nmembers of a potential bargaining unit petition it to do so or if an employer petitions on being faced with\na claim by a union that it exclusively represents the employees. The board determines which bargaining\nunit is appropriate and which employees are eligible to vote. A representative of the regional office will\nconduct the election itself, which is by secret ballot. The regional director may hear challenges to the\nelection procedure to determine whether the election was valid.\n\nKEY TAKEAWAY\nThe NLRB has two primary functions: (1) it investigates allegations of unfair labor practices and\nprovides remedies in appropriate cases, and (2) it decides in contested cases which union should serve\nas the exclusive bargaining agent for a particular group of employees.\n\nEXERCISES\n1.\n\nGo to the website for the NLRB. Find out how many unfair labor practice charges are filed each year.\nAlso find out how many \xe2\x80\x9chave merit\xe2\x80\x9d according to the NLRB.\n\n2.\n\nHow many of these unfair labor practice charges that \xe2\x80\x9chave merit\xe2\x80\x9d are settled through the auspices of\nthe NLRB?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n833\n\n\x0c19.3 Labor and Management Rights under the Federal Labor\nLaws\nLEARNING OBJECTIVES\n1.\n\nDescribe and explain the process for the National Labor Relations Board to choose a particular union\nas the exclusive bargaining representative.\n\n2.\n\nDescribe and explain the various duties that employers have in bargaining.\n\n3.\n\nIndicate the ways in which employers may commit unfair labor practice by interfering with union\nactivity.\n\n4.\n\nExplain the union\xe2\x80\x99s right to strike and the difference between an economic strike and a strike over an\nunfair labor practice.\n\n5.\n\nExplain secondary boycotts and hot cargo agreements and why they are controversial.\n\n6.\n\nChoosing the Union as the Exclusive Bargaining Representative\nDetermining the Appropriate Union\nAs long as a union has a valid contract with the employer, no rival union may seek an election to oust it\nexcept within sixty to ninety days before the contract expires. Nor may an election be held if an election\nhas already been held in the bargaining unit during the preceding twelve months.\nWhom does the union represent? In companies of even moderate size, employees work at different tasks\nand have different interests. Must the secretaries, punch press operators, drivers, and clerical help all\nbelong to the same union in a small factory? The National Labor Relations Board (NLRB) has the\nauthority to determine which group of employees will constitute the appropriate bargaining unit. To make\nits determination, the board must look at the history of collective bargaining among similar workers in the\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n834\n\n\x0cindustry; the employees\xe2\x80\x99 duties, wages, skills, and working conditions; the relationship between the\nproposed unit and the structure of the employer\xe2\x80\x99s organization; and the desires of the employees\nthemselves.\nTwo groups must be excluded from any bargaining unit\xe2\x80\x94supervisory employees and independent\ncontractors. Determining whether or not a particular employee is a supervisor is left to the discretion of\nthe board.\n\nInterfering with Employee Communication\nTo conduct an organizing drive, a union must be able to communicate with the employees. But the\nemployer has valid interests in seeing that employees and organizers do not interfere with company\noperations. Several different problems arise from the need to balance these interests.\nOne problem is the protection of the employer\xe2\x80\x99s property rights. May nonemployee union organizers come\nonto the employer\xe2\x80\x99s property to distribute union literature\xe2\x80\x94for example, by standing in the company\xe2\x80\x99s\nparking lots to hand out leaflets when employees go to and from work? May organizers, whether\nemployees or not, picket or hand out literature in private shopping centers in order to reach the public\xe2\x80\x94\nfor example, to protest a company\xe2\x80\x99s policies toward its nonunion employees? The interests of both\nemployees and employers under the NLRB are twofold: (1) the right of the employees (a) to communicate\nwith each other or the public and (b) to hear what union organizers have to say, and (2) the employers\xe2\x80\x99 (a)\nproperty rights and (b) their interest in managing the business efficiently and profitably.\nThe rules that govern in these situations are complex, but in general they appear to provide these answers:\n(1) If the persons doing the soliciting are not employees, the employer may bar them from entering its\nprivate property, even if they are attempting to reach employees\xe2\x80\x94assuming that the employer does not\n[1]\n\ndiscriminate and applies a rule against use of its property equally to everyone. (2) If the solicitors are not\nemployees and they are trying to reach the public, they have no right to enter the employer\xe2\x80\x99s private\nproperty. (3) If the solicitors are employees who are seeking to reach the public, they have the right to\ndistribute on the employer\xe2\x80\x99s property\xe2\x80\x94in a common case, in a shopping center\xe2\x80\x94unless they have a\nconvenient way to reach their audience on public property off the employer\xe2\x80\x99s premises.\n\n[2]\n\n(4) If the\n\nsolicitors are employees seeking to reach employees, the employer is permitted to limit the distribution of\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n835\n\n\x0cliterature or other solicitations to avoid litter or the interruption of work, but it cannot prohibit\nsolicitation on company property altogether.\nIn the leading case of Republic Aviation Corp. v. NLRB, the employer, a nonunion plant, had a standing\nrule against any kind of solicitation on the premises.\n\n[3]\n\nThereafter, certain employees attempted to\n\norganize the plant. The employer fired one employee for soliciting on behalf of the union and three others\nfor wearing union buttons. The Supreme Court upheld the board\xe2\x80\x99s determination that the discharges\nconstituted an unfair labor practice under Section 8(a) of the NLRA. It does not matter, the Court said,\nwhether the employees had other means of communicating with each other or that the employer\xe2\x80\x99s rule\nagainst solicitation may have no effect on the union\xe2\x80\x99s attempt to organize the workers. In other words, the\nemployer\xe2\x80\x99s intent or motive is irrelevant. The only question is whether the employer\xe2\x80\x99s actions might tend\nto interfere with the employees\xe2\x80\x99 exercise of their rights under the NLRB.\n\nRegulating Campaign Statements\nA union election drive is not like a polite conversation over coffee; it is, like political campaigns, full of\ncharges and countercharges. Employers who do not want their employees unionized may warn darkly of\nthe effect of the union on profitability; organizers may exaggerate the company\xe2\x80\x99s financial position. In a\n1982 NLRB case, NLRB v. Midland National Life Ins. Co., the board said it would not set aside an election\nif the parties misrepresented the issues or facts but that it would do so if the statements were made in a\ndeceptive manner\xe2\x80\x94for example, through forged documents.\n\n[4]\n\nThe board also watches for threats and\n\npromises of rewards; for example, the employer might threaten to close the plant if the union succeeds.\nIn NLRB v. Gissel Packing Co., the employer stated his worries throughout the campaign that a union\nwould prompt a strike and forces the plant to close.\n\n[5]\n\nThe board ruled that the employer\xe2\x80\x99s statements\n\nwere an impermissible threat. To the employer\xe2\x80\x99s claim that he was simply exercising his First Amendment\nrights, the Supreme Court held that although employers do enjoy freedom of speech, it is an unfair labor\npractice to threaten consequences that are not rooted in economic realities.\nA union campaign has become an intricate legal duel, heavily dependent on strategic considerations of law\nand public relations. Neither management nor labor can afford to wage a union campaign without\nspecialized advisers who can guide the thrust and parry of the antagonists. Labor usually has such\nadvisers because very few organizational drives are begun without outside organizers who have access to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n836\n\n\x0cunion lawyers. A business person who attempts to fight a union, like a labor organizer or an employee,\nwho attempts to organize one, takes a sizeable risk when acting alone, without competent advice. For\nexample, an employer\xe2\x80\x99s simple statement like \xe2\x80\x9cWe will get the heating fixed\xe2\x80\x9d in response to a seemingly\ninnocent question about the \xe2\x80\x9cdrafty old building\xe2\x80\x9d at a meeting with employees can lead to an NLRB\ndecision to set aside an election if the union loses, because the answer can easily be construed as a\npromise, and under Section 8(c) of the National Labor Relations Act (NLRA), a promise of reward or\nbenefit during an organization campaign is an unfair labor practice by management. Few union election\ncampaigns occur without questions, meetings, and pamphleteering carefully worked out in advance.\nThe results of all the electioneering are worth noting. In the 1980s, some 20 percent of the total US\nworkforce was unionized. As of 2009, the union membership rate was 12.3 percent, and more union\nmembers were public employees than private sector employees. Fairly or unfairly, public employee unions\nwere under attack as of 2010, as their wages generally exceeded the average wages of other categories of\nworkers.\n\nExclusivity\nOnce selected as the bargaining representative for an appropriate group of employees, the union has\nthe exclusive right to bargain. Thereafter, individual employees may not enter into separate contracts with\nthe employer, even if they voted against the particular union or against having a union at all. The principle\nof exclusivity is fundamental to the collective bargaining process. Just how basic it is can be seen\nin Emporium Capwell Co. v. Western Addition Community Organization (Section 19.4.1 "Exclusivity"),\nin which one group of employees protested what they thought were racially discriminatory work\nassignments, barred under the collective bargaining agreement (the contract between the union and the\nemployer). Certain of the employees filed grievances with the union, which looked into the problem more\nslowly than the employees thought necessary. They urged that the union permit them to picket, but the\nunion refused. They picketed anyway, calling for a consumer boycott. The employer warned them to\ndesist, but they continued and were fired. The question was whether they were discharged for engaging in\nconcerted activity protected under Section 7 of the NLRA.\n\nThe Duty to Bargain\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n837\n\n\x0cThe Duty to Bargain in Good Faith\nThe NLRA holds both employer and union to a duty to \xe2\x80\x9cbargain in good faith.\xe2\x80\x9d What these words mean\nhas long been the subject of controversy. Suppose Mr. Mardian, a company\xe2\x80\x99s chief negotiator, announces\nto Mr. Ulasewicz, the company\xe2\x80\x99s chief union negotiator, \xe2\x80\x9cI will sit down and talk with you, but be damned\nif I will agree to a penny more an hour than the people are getting now.\xe2\x80\x9d That is not a refusal to bargain: it\nis a statement of the company\xe2\x80\x99s position, and only Mardian\xe2\x80\x99s actual conduct during the negotiations will\ndetermine whether he was bargaining in good faith. Of course, if he refused to talk to Ulasewicz, he would\nhave been guilty of a failure to bargain in good faith.\nSuppose Mardian has steadily insisted during the bargaining sessions that the company must have\ncomplete control over every aspect of the labor relationship, including the right to hire and fire exactly as\nit saw fit, the right to raise or lower wages whenever it wanted, and the right to determine which employee\nwas to do which job. The Supreme Court has said that an employer is not obligated to accept any\nparticular term in a proposed collective bargaining agreement and that the NLRB may not second-guess\nany agreement eventually reached.\n\n[6]\n\nHowever, the employer must actually engage in bargaining, and a\n\nstubborn insistence on leaving everything entirely to the discretion of management has been construed as\na failure to bargain.\n\n[7]\n\nSuppose Mardian had responded to Ulasewicz\xe2\x80\x99s request for a ten-cent-an-hour raise: \xe2\x80\x9cIf we do that, we\xe2\x80\x99ll\ngo broke.\xe2\x80\x9d Suppose further that Ulasewicz then demanded, on behalf of the union, that Mardian prove his\ncontention but that Mardian refused. Under these circumstances, the Supreme Court has ruled, the NLRB\nis entitled to hold that management has failed to bargain in good faith, for once having raised the issue;\nthe employer must in good faith demonstrate veracity.\n\n[8]\n\nMandatory Subjects of Bargaining\nThe NLRB requires employers and unions to bargain over \xe2\x80\x9cterms and condition of employment.\xe2\x80\x9d Wages,\nhours, and working conditions\xe2\x80\x94whether workers must wear uniforms, when the lunch hour begins, the\ntype of safety equipment on hand\xe2\x80\x94are well-understood terms and conditions of employment. But the\nstatutory phrase is vague, and the cases abound with debates over whether a term insisted on by union or\nmanagement is within the statutory phrase. No simple rule can be stated for determining whether a desire\nof union or management is mandatory or non-mandatory. The cases do suggest that management retains\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n838\n\n\x0cthe right to determine the scope and direction of the enterprise, so that, for example, the decision to invest\nin labor-saving machinery is a non-mandatory subject\xe2\x80\x94meaning that a union could not insist that an\nemployer bargain over it, although the employer may negotiate if it desires. Once a subject is incorporated\nin a collective bargaining agreement, neither side may demand that it be renegotiated during the term of\nthe agreement.\n\nThe Board\xe2\x80\x99s Power to Compel an Agreement\nA mere refusal to agree, without more, is not evidence of bad-faith bargaining. That may seem a difficult\nconclusion to reach in view of what has just been said. Nevertheless, the law is clear that a company may\nrefuse to accede to a union\xe2\x80\x99s demand for any reason other than unwillingness to consider the matter in the\nfirst place. If a union negotiator cannot talk management into accepting his demand, then the union may\ntake other actions\xe2\x80\x94including strikes to try to force management to bow. It follows from this conclusion\nthat the NLRB has no power to compel agreement\xe2\x80\x94even if management is guilty of negotiating in bad\nfaith. The federal labor laws are premised on the fundamental principle that the parties are free to\nbargain.\n\nInterference and Discrimination by the Employer\nUnion Activity on Company Property\nThe employer may not issue a rule flatly prohibiting solicitation or distribution of literature during\n\xe2\x80\x9cworking time\xe2\x80\x9d or \xe2\x80\x9cworking hours\xe2\x80\x9d\xe2\x80\x94a valid rule against solicitation or distribution must permit these\nactivities during employees\xe2\x80\x99 free time, such as on breaks and at meals. A rule that barred solicitation on\nthe plant floor during actual work would be presumptively valid. However, the NLRB has the power to\nenjoin its enforcement if the employer used the rule to stop union soliciting but permitted employees\nduring the forbidden times to solicit for charitable and other causes.\n\n\xe2\x80\x9cRunaway Shop\xe2\x80\x9d\nA business may lawfully decide to move a factory for economic reasons, but it may not do so to discourage\na union or break it apart. The removal of a plant from one location to another is known as a runaway\nshop. An employer\xe2\x80\x99s representative who conceals from union representatives that a move is contemplated\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n839\n\n\x0ccommits an unfair labor practice because the union is deprived of the opportunity to negotiate over an\nimportant part of its members\xe2\x80\x99 working conditions. If a company moves a plant and it is later determined\nthat the move was to interfere with union activity, the board may order the employer to offer affected\nworkers employment at the new site and the cost of transportation.\n\nOther Types of Interference\nSince \xe2\x80\x9cinterference\xe2\x80\x9d is not a precise term but descriptive of a purpose embodied in the law, many activities\nlie within its scope. These include hiring professional strikebreakers to disrupt a strike, showing\nfavoritism toward a particular union to discourage another one, awarding or withholding benefits to\nencourage or discourage unionization, engaging in misrepresentations and other acts during election\ncampaigns, spying on workers, making employment contracts with individual members of a union,\nblacklisting workers, attacking union activists physically or verbally, and disseminating various forms of\nantiunion propaganda.\n\nDiscrimination against Union Members\nUnder Section 8(a) (3) of the NLRA, an employer may not discriminate against employees in hiring or\ntenure to encourage or discourage membership in a labor organization. Thus an employer may not refuse\nto hire a union activist and may not fire an employee who is actively supporting the union or an\norganizational effort if the employee is otherwise performing adequately on the job. Nor may an employer\ndiscriminate among employees seeking reinstatement after a strike or discriminatory layoff or lockout (a\nclosing of the job site to prevent employees from coming to work), hiring only those who were less vocal in\ntheir support of the union.\nThe provision against employer discrimination in hiring prohibits certain types of compulsory unionism.\nFour basic types of compulsory unionism are possible: the closed shop, the union shop, maintenance-ofmembership agreements, and preferential hiring agreements. In addition, a fifth arrangement\xe2\x80\x94the\nagency shop\xe2\x80\x94while not strictly compulsory unionism, has characteristics similar to it. Section 8(a)(3)\nprohibits the closed shop and preferential hiring. But Section 14 permits states to enact more stringent\nstandards and thus to outlaw the union shop, the agency shop, and maintenance of membership as well.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n840\n\n\x0c1.\n\nClosed shop. This type of agreement requires a potential employee to belong to the union before\nbeing hired and to remain a member during employment. It is unlawful, because it would require an\nemployer to discriminate on the basis of membership in deciding whether to hire.\n\n2. Union shop. An employer who enters into a union shop agreement with the union may hire a\nnonunion employee, but all employees who are hired must then become members of the union and\nremain members so long as they work at the job. Because the employer may hire anyone, a union or\nnonunion member, the union shop is lawful unless barred by state law.\n3. Maintenance-of-membership agreements. These agreements require employees who are\nmembers of the union before being hired to remain as members once they are hired unless they take\nadvantage of an \xe2\x80\x9cescape clause\xe2\x80\x9d to resign within a time fixed in the collective bargaining agreement.\nWorkers who were not members of the union before being hired are not required to join once they are\non the job. This type of agreement is lawful unless barred by state law.\n4. Preferential hiring. An employer who accepts a preferential hiring clause agrees to hire only union\nmembers as long as the union can supply him with a sufficient number of qualified workers. These\nclauses are unlawful.\n5.\n\nAgency shop. The agency shop is not true compulsory unionism, for it specifically permits an\nemployee not to belong to the union. However, it does require the employee to pay into the union the\nsame amount required as dues of union members. The legality of an agency shop is determined by\nstate law. If permissible under state law, it is permissible under federal law.\n\nThe Right to Strike\nSection 13 of the NLRA says that \xe2\x80\x9cnothing in this Act, except as specifically provided for herein, shall be\nconstrued so as either to interfere with or impede or diminish in any way the right to strike, or to affect\nthe limitations or qualifications on that right.\xe2\x80\x9d The labor statutes distinguish between two types of strikes:\nthe economic strike and the strike over an unfair labor practice. In the former, employees go on strike to\ntry to force the employer to give in to the workers\xe2\x80\x99 demands. In the latter, the strikers are protesting the\nemployer\xe2\x80\x99s committing an unfair labor practice. The importance of the distinction lies in whether the\nemployees are entitled to regain their jobs after the strike is over. In either type of strike, an employer may\nhire substitute employees during the strike. When it concludes, however, a difference arises. In NLRB v.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n841\n\n\x0cInternational Van Lines, the Supreme Court said that an employer may hire permanent employees to take\nover during an economic strike and need not discharge the substitute employees when it is done.\n\n[9]\n\nThat is\n\nnot true for a strike over an unfair labor practice: an employee who makes an unconditional offer to\nreturn to his job is entitled to it, even though in the meantime the employer may have replaced him.\nThese rules do not apply to unlawful strikes. Not every walkout by workers is permissible. Their collective\nbargaining agreement may contain a no-strike clause barring strikes during the life of the contract. Most\npublic employees\xe2\x80\x94that is, those who work for the government\xe2\x80\x94are prohibited from striking. Sit-down\nstrikes, in which the employees stay on the work site, precluding the employer from using the facility, are\nunlawful. So are wildcat strikes, when a faction within the union walks out without authorization. Also\nunlawful are violent strikes, jurisdictional strikes, secondary strikes and boycotts, and strikes intended to\nforce the employer to sign \xe2\x80\x9chot cargo\xe2\x80\x9d agreements (see Section 19.3.6 "Hot Cargo Agreement").\nTo combat strikes, especially when many employers are involved with a single union trying to bargain for\nbetter conditions throughout an industry, an employer may resort to a lockout. Typically, the union will\ncall a whipsaw strike, striking some of the employers but not all. The whipsaw strike puts pressure on the\nstruck employers because their competitors are still in business. The employers who are not struck may\nlawfully respond by locking out all employees who belong to the multiemployer union. This is known as a\ndefensive lockout. In several cases, the Supreme Court has ruled that an offensive lockout, which occurs\nwhen the employer, anticipating a strike, locks the employees out, is also permissible.\n\nSecondary Boycotts\nSection 8(b)(4), added to the NLRA by the Taft-Hartley Act, prohibits workers from engaging\nin secondary boycotts\xe2\x80\x94strikes, refusals to handle goods, threats, coercion, restraints, and other actions\naimed at forcing any person to refrain from performing services for or handling products of any producer\nother than the employer, or to stop doing business with any other person. Like the Robinson-Patman Act\n(Chapter 16 "Antitrust Law"), this section of the NLRA is extremely difficult to parse and has led to many\nconvoluted interpretations. However, its essence is to prevent workers from picketing employers not\ninvolved in the primary labor dispute.\nSuppose that the Amalgamated Widget Workers of America puts up a picket line around the Ace Widget\nCompany to force the company to recognize the union as the exclusive bargaining agent for Ace\xe2\x80\x99s\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n842\n\n\x0cemployees. The employees themselves do not join in the picketing, but when a delivery truck shows up at\nthe plant gates and discovers the pickets, it turns back because the driver\xe2\x80\x99s policy is never to cross a picket\nline. This activity falls within the literal terms of Section (8) (b) (4): it seeks to prevent the employees of\nAce\xe2\x80\x99s suppliers from doing business with Ace. But in NLRB v. International Rice Milling Co., the Supreme\nCourt declared that this sort of primary activity\xe2\x80\x94aimed directly at the employer involved in the primary\ndispute\xe2\x80\x94is not unlawful.\n\n[10]\n\nSo it is permissible to throw up a picket line to attempt to stop anyone from\n\ndoing business with the employer\xe2\x80\x94whether suppliers, customers, or even the employer\xe2\x80\x99s other employees\n(e.g., those belonging to other unions). That is why a single striking union is so often successful in closing\ndown an entire plant: when the striking union goes out, the other unions \xe2\x80\x9chonor the picket line\xe2\x80\x9d by\nrefusing to cross it and thus stay out of work as well. The employer might have been able to replace the\nstriking workers if they were only a small part of the plant\xe2\x80\x99s labor force, but it becomes nearly impossible\nto replace all the workers within a dozen or more unions.\nSuppose the United Sanders Union strikes the Ace Widget Company. Nonunion sanders refuse to cross\nthe picket line. So Ace sends out its un-sanded widgets to Acme Sanders, a job shop across town, to do the\nsanding job. When the strikers learn what Ace has done, they begin to picket Acme, at which point Acme\xe2\x80\x99s\nsanders honor the picket line and refuse to enter the premises. Acme goes to court to enjoin the pickets\xe2\x80\x94\nan exception to the Norris\xe2\x80\x93La Guardia Act permits the federal courts to enjoin picketing in cases of\nunlawful secondary boycotts. Should the court grant the injunction? It might seem so, but under the socalled ally doctrine, the court will not. Since Acme is joined with Ace to help it finish the work, the courts\ndeem the second employer an ally (or extension) of the first. The second picket line, therefore, is not\nsecondary.\nSuppose that despite the strike, Ace manages to ship its finished product to the Dime Store, which sells a\nvariety of goods, including widgets. The union puts up a picket around the store; the picketers bear signs\nthat urge shoppers to refrain from buying any Ace widgets at the Dime Store. Is this an unlawful\nsecondary boycott? Again, the answer is no. A proviso to Section 8(b)(4) permits publicity aimed at\ntruthfully advising the public that products of a primary employer with whom the union is on strike are\nbeing distributed by a secondary employer.\nNow suppose that the picketers carried signs and orally urged shoppers not to enter the Dime Store at all\nuntil it stopped carrying Ace\xe2\x80\x99s widgets. That would be unlawful: a union may not picket a secondary site to\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n843\n\n\x0cpersuade consumers to refrain from purchasing any of the secondary employer\xe2\x80\x99s products. Likewise, the\nunion may not picket in order to cause the secondary employees (the salesclerks at the Dime Store) to\nrefuse to go to work at the secondary employer. The latter is a classic example of inducing a secondary\nwork stoppage, and it is barred by Section 8(b)(4). However, in DeBartolo Corp. v. Florida Gulf Coast\nBuilding and Construction Trades Council, the Supreme Court opened what may prove to be a significant\nloophole in the prohibition against secondary boycotts.\n\n[11]\n\nInstead of picketing, the union distributed\n\nhandbills at the entrance to a shopping mall, asking customers not to patronize any stores in the mall\nuntil the mall owner, in building new stores, promised to deal only with contractors paying \xe2\x80\x9cfair wages.\xe2\x80\x9d\nThe Court approved the hand-billing, calling it \xe2\x80\x9conly an attempt to persuade customers not to shop in the\nmall,\xe2\x80\x9d distinguishing it from picketing, which the Court said would constitute a secondary boycott.\n\nHot Cargo Agreement\nA union might find it advantageous to include in a collective bargaining agreement a provision under\nwhich the employer agrees to refrain from dealing with certain people or from purchasing their products.\nFor example, suppose the Teamsters Union negotiates a contract with its employers that permit truckers\nto refuse to carry goods to an employer being struck by the Teamsters or any other union. The struck\nemployer is the primary employer; the employer who has agreed to the clause\xe2\x80\x94known as a hot cargo\nclause\xe2\x80\x94is the secondary employer. The Supreme Court upheld these clauses in United Brotherhood of\nCarpenters and Joiners, Local 1976 v. NLRB, but the following year, Congress outlawed them in Section\n8(e), with a partial exemption for the construction industry and a full exemption for garment and apparel\nworkers.\n\n[12]\n\nDiscrimination by Unions\nA union certified as the exclusive bargaining representative in the appropriate bargaining unit is obligated\nto represent employees within that unit, even those who are not members of the union. Various provisions\nof the labor statutes prohibit unions from entering into agreements with employers to discriminate\nagainst nonmembers. The laws also prohibit unions from treating employees unfairly on the basis of race,\ncreed, color, or national origin.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n844\n\n\x0cJurisdictional Disputes\nAce Widget, a peaceful employer, has a distinguished labor history. It did not resist the first union, which\ncame calling in 1936, just after the NLRA was enacted; by 1987, it had twenty-three different unions\nrepresenting 7,200 workers at forty-eight sites throughout the United States. Then, because of\nincreasingly more powerful and efficient machinery, United Widget Workers realized that it was losing\njobs throughout the industry. It decided to attempt to bring within its purview jobs currently performed\nby members of other unions. United Widget Workers asked Ace to assign all sanding work to its members.\nSince sanding work was already being done by members of the United Sanders, Ace management refused.\nUnited Widget Workers decided to go on strike over the issue. Is the strike lawful? Under Section 8(b) (4)\n(D), regulating jurisdictional disputes, it is not. It is an unfair labor practice for a union to strike or engage\nin other concerted actions to pressure an employer to assign or reassign work to one union rather than\nanother.\n\nBankruptcy and the Collective Bargaining Agreement\nAn employer is bound by a collective bargaining agreement to pay the wages of unionized workers\nspecified in the agreement. But obviously, no paper agreement can guarantee wages when an insolvent\ncompany goes out of business. Suppose a company files for reorganization under the bankruptcy laws\n(see Chapter 12 "Bankruptcy"). May it then ignore its contractual obligation to pay wages previously\nbargained for? In the early 1980s, several major companies\xe2\x80\x94for example, Continental Airlines and\nOklahoma-based Wilson Foods Corporation\xe2\x80\x94sought the protection of federal bankruptcy law in part to\ncut union wages. Alarmed, Congress, in 1984, amended the bankruptcy code to require companies to\nattempt to negotiate a modification of their contracts in good faith. In Bankruptcy Code Section 1113,\nCongress set forth several requirements for a debtor to extinguish its obligations under a collective\nbargaining agreement (CBA). Among other requirements, the debtor must make a proposal to the union\nmodifying the CBA based on accurate and complete information, and meet with union leaders and confer\nin good faith after making the proposal and before the bankruptcy judge would rule.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n845\n\n\x0cIf negotiations fail, a bankruptcy judge may approve the modification if it is necessary to allow the debtor\nto reorganize, and if all creditors, the debtor, and affected parties are treated fairly and equitably. If the\nunion rejects the proposal without good cause, and the debtor has met its obligations of fairness and\nconsultation from section 1113, the bankruptcy judge can accept the proposed modification to the CBA. In\n1986, the US court of appeals in Philadelphia ruled that Wheeling-Pittsburgh Steel Corporation could not\nmodify its contract with the United Steelworkers simply because it was financially distressed. The court\npointed to the company\xe2\x80\x99s failure to provide a \xe2\x80\x9csnap-back\xe2\x80\x9d clause in its new agreement. Such a clause\nwould restore wages to the higher levels of the original contract if the company made a comeback faster\nthan anticipated.\n\n[13]\n\nBut in the 2006 case involving Northwest Airlines Chapter 11 reorganization,\n\n[14]\n\nthe\n\ncourt found that Northwest had to reduce labor costs if it were going to successfully reorganize, that it had\nmade an equitable proposal and consulted in good faith with the union, but that the union had rejected\nthe proposed modification without good cause. Section 1113 was satisfied, and Northwest was allowed to\nmodify its CBA with the union.\n\nKEY TAKEAWAY\nThe NLRB determines the appropriate bargaining unit and also supervises union organizing drives. It\nmust balance protecting the employer\xe2\x80\x99s rights, including property rights and the right to manage the\nbusiness efficiently, with the right of employees to communicate with each other. The NLRB will select\na union and give it the exclusive right to bargain and the result will usually be a collective bargaining\nunit. The employer should not interfere with the unionizing process or interfere once the union is in\nplace. The union has the right to strike, subject to certain very important restrictions.\n\nEXERCISES\n1.\n\nSuppose that employees of the Shop Rite chain elect the Allied Food Workers Union as their exclusive\nbargaining agent. Negotiations for an initial collective bargaining agreement begin, but after six\nmonths, no agreement has been reached. The company finds excess damage to merchandise in its\nwarehouse and believes that this was intentional sabotage by dissident employees. The company\nnotifies the union representative that any employees doing such acts will be terminated, and the\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n846\n\n\x0cunion, in turn, notifies the employees. Soon thereafter, a Shop Rite manager notices an employee in\nthe flour section\xe2\x80\x94where he has no right to be\xe2\x80\x94making quick motions with his hands. The manager\nthen finds several bags of flour that have been cut. The employee is fired, whereupon a fellow\nemployee and union member lead more than two dozen employees in an immediate walkout. The\ncompany discharges these employees and refuses to rehire them. The employees file a grievance with\nthe NLRB. Are they entitled to get their jobs back?\n2.\n\n[15]\n\nAmerican Shipbuilding Company has a shipyard in Chicago, Illinois. During winter months, it repairs\nships operating on the Great Lakes, and the workers at the shipyard are represented by several\ndifferent unions. In 1961, the unions notified the company of their intention to seek a modification of\nthe current collective bargaining agreement. On five previous occasions, agreements had been\npreceded by strikes (including illegal strikes) that were called just after ships arrived in the shipyard for\nrepairs. In this way, the unions had greatly increased their leverage in bargaining with the company.\nBecause of this history, the company was anxious about the unions\xe2\x80\x99 strike plans. In August 1961, after\nextended negotiations, the company and the unions reached an impasse. The company then decided\nto lay off most of the workers and sent the following notice: \xe2\x80\x9cBecause of the labor dispute which has\nbeen unresolved since August of 1961, you are laid off until further notice.\xe2\x80\x9d The unions filed unfair\nlabor practice charges with the NLRB. Did the company engage in an unfair labor practice?\n\n[16]\n\n[1] NLRB v. Babcock Wilcox Co., 351 U.S. 105 (1956).\n[2] Hudgens v. NLRB, 424 U.S. 507 (1976).\n[3] Republic Aviation Corp. v. NLRB, 324 U.S. 793 (1945).\n[4] Midland National Life Ins. Co., 263 N.L.R.B. 130 (1982).\n[5] NLRB v. Gissel Packing Co., 395 U.S. 575 (1969).\n[6] NLRB v. American National Insurance Co., 343 U.S. 395 (1962).\n[7] NLRB v. Reed St Prince Manufacturing Co., 205 F.2d 131 (1st Cir. 1953).\n[8] NLRB v. Truitt Manufacturer Co., 351 U.S. 149 (1956).\n[9] NLRB v. International Van Lines, 409 U.S. 48 (1972).\n[10] NLRB v. International Rice Milling Co., 341 U.S. 665 (1951).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n847\n\n\x0c[11] DeBartolo Corp. v. Florida Gulf Coast Building and Construction Trades Council, 485 U.S. 568 (1988).\n[12] United Brotherhood of Carpenters and Joiners, Local 1976 v. NLRB, 357 U.S. 93 (1958).\n[13] Wheeling-Pittsburgh Steel Corp. v. United Steelworkers of America, 791 F.2d 1071 (3d Cir. 1986).\n[14] In re Northwest Airlines Corp., 2006 Bank. LEXIS 1159 (So. District N.Y.).\n[15] NLRB v. Shop Rite Foods, 430 F.2d 786 (5th Cir. 1970).\n[16] American Shipbuilding Company v. NLRB, 380 U.S. 300 (1965).\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n848\n\n\x0c19.4 Case\nExclusivity\nEmporium Capwell Co. v. Western Addition Community Organization\n420 U.S. 50 (1975)\nThe Emporium Capwell Company (Company) operates a department store in San Francisco. At all times\nrelevant to this litigation it was a party to the collective-bargaining agreement negotiated by the San\nFrancisco Retailer\xe2\x80\x99s Council, of which it was a member, and the Department Store Employees Union\n(Union), which represented all stock and marketing area employees of the Company. The agreement, in\nwhich the Union was recognized as the sole collective-bargaining agency for all covered employees,\nprohibited employment discrimination by reason of race, color, creed, national origin, age, or sex, as well\nas union activity. It had a no-strike or lockout clause, and it established grievance and arbitration\nmachinery for processing any claimed violation of the contract, including a violation of the antidiscrimination clause.\nOn April 3, 1968, a group of Company employees covered by the agreement met with the secretarytreasurer of the Union, Walter Johnson, to present a list of grievances including a claim that the Company\nwas discriminating on the basis of race in making assignments and promotions. The Union official agreed\nto certain of the grievances and to investigate the charge of racial discrimination. He appointed an\ninvestigating committee and prepared a report on the employees\xe2\x80\x99 grievances, which he submitted to the\nRetailer\xe2\x80\x99s Council and which the Council in turn referred to the Company. The report described \xe2\x80\x9cthe\npossibility of racial discrimination\xe2\x80\x9d as perhaps the most important issue raised by the employees and\ntermed the situation at the Company as potentially explosive if corrective action were not taken. It offers\nas an example of the problem the Company\xe2\x80\x99s failure to promote a Negro stock employee regarded by other\nemployees as an outstanding candidate but a victim of racial discrimination.\nShortly after receiving the report, the Company\xe2\x80\x99s labor relations director met representatives and agreed\nto \xe2\x80\x9clook into the matter\xe2\x80\x9d of discrimination, and see what needed to be done. Apparently unsatisfied with\nthese representations, the Union held a meeting in September attended by Union officials, Company\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n849\n\n\x0cemployees, and representatives of the California Fair Employment Practices Committee (FEPC) and the\nlocal anti-poverty agency. The secretary-treasurer of the Union announced that the Union had concluded\nthat the Company was discriminating, and that it would process every such grievance through to\narbitration if necessary. Testimony about the Company\xe2\x80\x99s practices was taken and transcribed by a court\nreporter, and the next day the Union notified the Company of its formal charge and demanded that the\nunion-management Adjustment Board be convened \xe2\x80\x9cto hear the entire case.\xe2\x80\x9d\nAt the September meeting some of the Company\xe2\x80\x99s employees had expressed their view that the contract\nprocedures were inadequate to handle a systemic grievance of this sort; they suggested that the Union\ninstead begin picketing the store in protest. Johnson explained that the collective agreement bound the\nUnion to its processes and expressed his view that successful grievant would be helping not only\nthemselves but all others who might be the victims of invidious discrimination as well. The FEPC and\nanti-poverty agency representatives offered the same advice. Nonetheless, when the Adjustment Board\nmeeting convened on October 16, James Joseph Hollins, Torn Hawkins, and two other employees whose\ntestimony the Union had intended to elicit refused to participate in the grievance procedure. Instead,\nHollins read a statement objecting to reliance on correction of individual inequities as an approach to the\nproblem of discrimination at the store and demanding that the president of the Company meet with the\nfour Protestants to work out a broader agreement for dealing with the issue as they saw it. The four\nemployees then walked out of the hearing.\n\xe2\x80\xa6On Saturday, November 2, Hollins, Hawkins, and at least two other employees picketed the store\nthroughout the day and distributed at the entrance handbills urging consumers not to patronize the store.\nJohnson encountered the picketing employees, again urged them to rely on the grievance process, and\nwarned that they might be fired for their activities. The pickets, however, were not dissuaded, and they\ncontinued to press their demand to deal directly with the Company president.\nOn November 7, Hollins and Hawkins were given written warnings that a repetition of the picketing or\npublic statements about the Company could lead to their discharge. When the conduct was repeated the\nfollowing Saturday, the two employees were fired.\n[T]he NLRB Trial Examiner found that the discharged employees had believed in good faith that the\nCompany was discriminating against minority employees, and that they had resorted to concerted activity\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n850\n\n\x0con the basis of that belief. He concluded, however, that their activity was not protected by \xc2\xa7 7 of the Act\nand that their discharges did not, therefore, violate S 8(a) (1).\nThe Board, after oral argument, adopted the findings and conclusions of its Trial Examiner and dismissed\nthe complaint. Among the findings adopted by the Board was that the discharged employees\xe2\x80\x99 course of\nconduct was no mere presentation of a grievance but nothing short of a demand that the [Company]\nbargain with the picketing employees for the entire group of minority employees.\nThe Board concluded that protection of such an attempt to bargain would undermine the statutory system\nof bargaining through an exclusive, elected representative, impede elected unions\xe2\x80\x99 efforts at bettering the\nworking conditions of minority employees, \xe2\x80\x9cand place on the Employer an unreasonable burden of\nattempting to placate self-designated representatives of minority groups while abiding by the terms of a\nvalid bargaining agreement and attempting in good faith to meet whatever demands the bargaining\nrepresentative put forth under that agreement.\xe2\x80\x9d\nOn respondent\xe2\x80\x99s petition for review the Court of Appeals reversed and remanded. The court was of the\nview that concerted activity directed against racial discrimination enjoys a \xe2\x80\x9cunique status\xe2\x80\x9d by virtue of the\nnational labor policy against discrimination.\xe2\x80\xa6The issue, then, is whether such attempts to engage in\nseparate bargaining are protected by 7 of the Act or proscribed by \xc2\xa7 9(a).\nCentral to the policy of fostering collective bargaining, where the employees elect that course, is the\nprinciple of majority rule. If the majority of a unit chooses union representation, the NLRB permits it to\nbargain with its employer to make union membership a condition of employment, thus, imposing its\nchoice upon the minority.\nIn vesting the representatives of the majority with this broad power, Congress did not, of course,\nauthorize a tyranny of the majority over minority interests. First, it confined the exercise of these powers\nto the context of a \xe2\x80\x9cunit appropriate\xe2\x80\x9d for the purposes of collective bargaining, i.e., a group of employees\nwith a sufficient commonality of circumstances to ensure against the submergence of a minority with\ndistinctively different interests in the terms and conditions of their employment. Second, it undertook in\nthe 1959 Landrum-Griffin amendments to assure that minority voices are heard as they are in the\nfunctioning of a democratic institution. Third, we have held, by the very nature of the exclusive bargaining\nrepresentative\xe2\x80\x99s status as representative of all unit employees, Congress implicitly imposed upon it a duty\nfairly and in good faith to represent the interests of minorities within the unit. And the Board has taken\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n851\n\n\x0cthe position that a union\xe2\x80\x99s refusal to process grievances against racial discrimination in violation of that\nduty is an unfair labor practice.\xe2\x80\xa6\n***\nThe decision by a handful of employees to bypass a grievance procedure in favor of attempting to bargain\nwith their employer\xe2\x80\xa6may or may not be predicated upon the actual existence of discrimination. An\nemployer confronted with bargaining demands from each of several minority groups who would not\nnecessarily, or even probably, be able to agree to remain real steps satisfactory to all at once. Competing\nclaims on the employer\xe2\x80\x99s ability to accommodate each group\xe2\x80\x99s demands, e.g., for reassignments and\npromotions to a limited number of positions, could only set one group against the other even if it is not\nthe employer\xe2\x80\x99s intention to divide and overcome them.\xe2\x80\xa6In this instance we do not know precisely what\nform the demands advanced by Hollins, Hawkins, et al, would take, but the nature of the grievance that\nmotivated them indicates that the demands would have included the transfer of some minority employees\nto sales areas in which higher commissions were paid. Yet the collective-bargaining agreement provided\nthat no employee would be transferred from a higher-paying to a lower-paying classification except by\nconsent or in the course of a layoff or reduction in force. The potential for conflict between the minority\nand other employees in this situation is manifest. With each group able to enforce its conflicting\ndemands\xe2\x80\x94the incumbent employees by resort to contractual processes and minority employees by\neconomic coercion\xe2\x80\x94the probability of strife and deadlock is high; the making headway against\ndiscriminatory practices would be minimal.\n***\nAccordingly, we think neither aspect of respondent\xe2\x80\x99s contention in support of a right to short-circuit\norderly, established processes eliminating discrimination in employment is well-founded. The policy of\nindustrial self-determination as expressed in \xc2\xa7 7 does not require fragmentation of the bargaining unit\nalong racial or other lines in order to consist with the national labor policy against discrimination. And in\nthe face of such fragmentation, whatever its effect on discriminatory practices, the bargaining process that\nthe principle of exclusive representation is meant to lubricate could not endure unhampered.\n***\nReversed.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n852\n\n\x0cCASE QUESTIONS\n1.\n\nWhy did the picketers think that the union\xe2\x80\x99s response had been inadequate?\n\n2.\n\nIn becoming members of the union, which had a contract that included an antidiscrimination clause along\nwith a no-strike clause and a no-lockout clause, did the protesting employees waive all right to pursue\ndiscrimination claims in court?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n853\n\n\x0c19.5 Summary and Exercises\nSummary\nFederal labor law is grounded in the National Labor Relations Act, which permits unions to organize and\nprohibits employers from engaging in unfair labor practices. Amendments to the National Labor\nRelations Act (NLRA), such as the Taft-Hartley Act and the Landrum-Griffin Act, declare certain acts of\nunions and employees also to be unfair labor practices.\nThe National Labor Relations Board supervises union elections and decides in contested cases which\nunion should serve as the exclusive bargaining unit, and it also investigates allegations of unfair labor\npractices and provides remedies in appropriate cases.\nOnce elected or certified, the union is the exclusive bargaining unit for the employees it represents.\nBecause the employer is barred from interfering with employee communications when the union is\norganizing for an election, he may not prohibit employees from soliciting fellow employees on company\nproperty but may limit the hours or spaces in which this may be done. The election campaign itself is an\nintricate legal duel; rewards, threats, and misrepresentations that affect the election are unfair labor\npractices.\nThe basic policy of the labor laws is to foster good-faith collective bargaining over wages, hours, and\nworking conditions. The National Labor Relations Board (NLRB) may not compel agreement: it may not\norder the employer or the union to adopt particular provisions, but it may compel a recalcitrant company\nor union to bargain in the first place.\nAmong the unfair labor practices committed by employers are these:\n1.\n\nDiscrimination against workers or prospective workers for belonging to or joining unions. Under\nfederal law, the closed shop and preferential hiring are unlawful. Some states outlaw the union shop,\nthe agency shop, and maintenance-of-membership agreements.\n\n2. Interference with strikes. Employers may hire replacement workers during a strike, but in a strike\nover an unfair labor practice, as opposed to an economic strike, the replacement workers may be\ntemporary only; workers are entitled to their jobs back at the strike\xe2\x80\x99s end.\nAmong the unfair labor practices committed by unions are these:\n1.\n\nSecondary boycotts. Workers may not picket employers not involved in the primary labor dispute.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n854\n\n\x0c2. Hot cargo agreements. An employer\xe2\x80\x99s agreement, under union pressure, to refrain from dealing with\ncertain people or purchasing their products is unlawful.\n3.\n\nEXERCISES\n1.\n\nAfter years of working without a union, employees of Argenta Associates began organizing for a\nrepresentation election. Management did not try to prevent the employees from passing out leaflets\nor making speeches on company property, but the company president did send out a notice to all\nemployees stating that in his opinion, they would be better off without a union. A week before the\nelection, he sent another notice, stating that effective immediately; each employee would be entitled\nto a twenty-five-cents-an-hour raise. The employees voted the union down. The following day, several\nemployees began agitating for another election. This time management threatened to fire anyone\nwho continued talking about an election on the ground that the union had lost and the employees\nwould have to wait a year. The employees\xe2\x80\x99 organizing committee filed an unfair labor practice\ncomplaint with the NLRB. What was the result?\n\n2.\n\nPalooka Industries sat down with Local 308, which represented its telephone operators, to discuss\nrenewal of the collective bargaining agreement. Palooka pressed its case for a no-strike clause in the\nnext contract, but Local 308 refused to discuss it at all. Exasperated, Palooka finally filed an unfair\nlabor practice claim with the NLRB. What was the result?\n\n3.\n\nUnion organizers sought to organize the punch press operators at Dan\xe2\x80\x99s Machine Shop. The shop was\nlocated on a lot surrounded by heavily forested land from which access to employees was impossible.\nThe only practical method of reaching employees on the site was in the company parking lot. When\nthe organizers arrived to distribute handbills, the shop foreman, under instructions from Dan, ordered\nthem to leave. At a hearing before the NLRB, the company said that it was not antiunion but that its\npolicy, which it had always strictly adhered to, forbade nonemployees from being on the property if\nnot on company business. Moreover, company policy barred any activities that would lead to littering.\nThe company noted that the organizers could reach the employees in many other ways\xe2\x80\x94meeting the\nemployees personally in town after hours, calling them at home, writing them letters, or advertising a\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n855\n\n\x0cpublic meeting. The organizers responded that these methods were far less effective means of\nreaching the employees. What was the result? Why?\n\nSELF-TEST QUESTIONS\n1.\n\nWhich of the following is not a subject of mandatory bargaining?\n\na.\n\nrate of pay per hour\n\nb.\n\nlength of the workweek\n\nc.\n\nsafety equipment\n\nd.\n\nnew products to manufacture\nUnder a union shop agreement,\n\na.\n\nan employer may not hire a nonunion member\nb.\n\nan employer must hire a nonunion member\n\nc.\n\nan employee must join the union after being hired\n\nd.\n\nan employee must belong to the union before being hired\nWhich of the following is always unlawful under federal law?\n\na.\n\nunion shop\nb.\n\nagency shop\n\nc.\n\nclosed shop\n\nd.\n\nrunaway shop\nAn employer\xe2\x80\x99s agreement with its union to refrain from dealing with companies being struck\nby other unions is a\n\na.\n\nsecondary boycott agreement\nb.\n\nhot cargo agreement\n\nc.\n\nlockout agreement\n\nd.\n\nmaintenance-of-membership agreement\nStriking employees are entitled to their jobs back when they are engaged in\n\na.\n\neconomic strikes\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n856\n\n\x0cb.\n\njurisdictional strikes\n\nc.\n\nboth economic and jurisdictional strikes\n\nd.\n\nneither economic nor jurisdictional strikes\n\nSELF-TEST ANSWERS\n1.\n\nd\n\n2.\n\nc\n\n3.\n\nc\n\n4.\n\nb\n\n5.\n\na\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n857\n\n\x0cChapter 20\nInternational Law\nLEARNING OBJECTIVES\nAfter reading this chapter, you should understand the following:\n1.\n\nThe concepts of sovereignty, self-determination, failed states, and failing states\n\n2.\n\nThe sources of international law, and examples of treaties, conventions, and customary international\nlaw\n\n3.\n\nHow civil-law disputes between the parties from different nation-states can be resolved through\nnational court systems or arbitration\n\n4.\n\nThe well-recognized bases for national jurisdiction over various parties from different nation-states\n\n5.\n\nThe doctrines of forum non convenient, sovereign immunity, and act of state\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n858\n\n\x0c20.1 Introduction to International Law\nJ. L. Austin, the legal realist, famously defined law as \xe2\x80\x9cthe command of a sovereign.\xe2\x80\x9d He had in mind the\nfact that legal enforcement goes beyond negotiation and goodwill, and may ultimately have to be enforced\nby some agent of the government. For example, if you fail to answer a summons and complaint, a default\njudgment will be entered against you; if you fail to pay the judgment, the sheriff (or US marshal) will\nactually seize assets to pay the judgment, and will come armed with force, if necessary.\nThe force and authority of a government in any given territory is fundamental to sovereignty. Historically,\nthat was understood to mean a nation\xe2\x80\x99s \xe2\x80\x9cright\xe2\x80\x9d to issue its own currency, make and enforce laws within its\nborders without interference from other nations (the \xe2\x80\x9cright of self-determination\xe2\x80\x9d that is noted in the\nCharter of the United Nations), and to defend its territory with military force, if necessary. In a nation at\nrelative peace, sovereignty can be exercised without great difficulty. But many countries are in civil war,\nand others experience \xe2\x80\x9cbreakaway\xe2\x80\x9d areas where force must be used to assert continued sovereignty. In\nsome countries, civil war may lead to the formation of new nation-states, such as in Sudan in 2011.\nIn the United States, there was a Civil War from 1860 to 1864, and even now, there are separatist\nmovements, groups who refuse to recognize the authority of the local, state, or national governments.\nFrom time to time, these groups will declare their independence of the sovereign, raise their own flag,\nrefuse to pay taxes, and resist government authority with arms. In the United States, the federal\ngovernment typically responds to these \xe2\x80\x9cmini-secessionist\xe2\x80\x9d movements with force.\nIn Canada, the province of Quebec has considered separating from Canada, and this came close to reality\nin 1995 on a referendum vote for secession that gained 49.4 percent of the votes. Away from North\nAmerica, claims to exclusive political and legal authority within some geographic area are often the stuff\nof civil and regional wars. Consider Kosovo\xe2\x80\x99s violent secession from Yugoslavia, or Chechnya\xe2\x80\x99s attempted\nsecession from Russia. At stake in all these struggles is the uncontested right to make and enforce laws\nwithin a certain territory. In some nation-states, government control has failed to achieve effective control\nover substantial areas, leaving factions, tribal groups, or armed groups in control. For such nations, the\nphrase \xe2\x80\x9cfailed states\xe2\x80\x9d or \xe2\x80\x9cfailing states\xe2\x80\x9d has sometimes been used. A failing state usually has some\ncombination of lack of control over much of its territory, failure to provide public services, widespread\ncorruption and criminality, and sharp economic decline. Somalia, Chad, and Afghanistan, among others,\nhead the list as of 2011.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n859\n\n\x0cIn a functioning state, the right to make and enforce law is not contested or in doubt. But in the\ninternational arena, there is no sovereign lawgiver and law enforcer. If a criminal burglarizes your house\nand is caught, the legal authorities in your state have little difficulty bringing him to justice. But suppose a\ndictator or military-run government oppresses some of the citizenry, depriving these citizens of the\nchance to speak freely, to carry on a trade or profession, to own property, to be educated, or to have access\nto water and a livable environment, or routinely commits various atrocities against ethnic groups (forced\nlabor, rape, pillage, murder, torture). Who will bring the dictator or government to justice, and before\nwhat tribunal?\nThere is still no forum (court or tribunal) that is universally accepted as a place to try to punish such\npeople. The International Criminal Court has wide support and has prosecuted several individuals for\ncrimes, but the United States has still not agreed to its jurisdiction.\nDuring the 1990s, the United States selectively \xe2\x80\x9cpoliced\xe2\x80\x9d certain conflicts (Kosovo, Haiti, Somalia), but it\ncannot consistently serve over a long period of time as the world\xe2\x80\x99s policeman. The United States has often\nallowed human rights to be violated in many nations without much protest, particularly during the Cold\nWar with the Union of Soviet Socialist Republics (USSR), where alliances with dictatorships and\nnondemocratic regimes were routinely made for strategic reasons.\nStill, international law is no myth. As we shall see, there are enforceable treaties and laws that most\nnations abide by, even as they are free to defect from these treaties. Yet the recent retreat by the United\nStates from pending international agreements (the Kyoto Protocol, the International Criminal Court, and\nothers) may be a sign that multilateralism is on the wane or that other nations and regional groupings (the\nEuropean Union, China) will take a more prominent role in developing binding multilateral agreements\namong nations.\n\nKEY TAKEAWAY\nInternational law is based on the idea of the nation-state that has sovereignty over a population of\ncitizens within a given geographical territory. In theory, at least, this sovereignty means that nationstates should not interfere with legal and political matters within the borders of other nation-states.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n860\n\n\x0cEXERCISES\n1.\n\nUsing news sources, find at least one nation in the world where other nations are officially\ncommenting on or objecting to what goes on within that nation\xe2\x80\x99s borders. Are such objections or\ncomments amounting to an infringement of the other nation\xe2\x80\x99s sovereignty?\n\n2.\n\nUsing news sources, find at least one nation in the world that is engaged in trying to change the\npolitical and legal landscape of another nation. What is it doing, and why? Is this an infringement of\nthe other nation\xe2\x80\x99s sovereignty?\n\n3.\n\nWhat is a failed state? What is a failing state? What is the difference? Is either one a candidate for\ndiplomatic recognition of its sovereignty? Discuss.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n861\n\n\x0c20.2 Sources and Practice of International Law\nLEARNING OBJECTIVES\n1.\n\nExplain what a treaty is and how it differs from a convention.\n\n2.\n\nUnderstand that a treaty can be a voluntary relinquishment of some aspects of sovereignty.\n\n3.\n\nDescribe customary international law, and explain how it is different from treaties as a source of\ninternational law.\n\n4.\n\nDescribe some of the difficulties in enforcing one nation\xe2\x80\x99s judicial judgments in another nation.\n\nIn this section, we shall be looking at a number of different sources of international law. These sources\ninclude treaties and conventions, decisions of courts in various countries (including decisions in your own\nstate and nation), decisions of regional courts (such as the European Court of Justice), the World Trade\nOrganization (WTO), resolutions of the United Nations (UN), and decisions by regional trade\norganizations such as the North American Free Trade Agreement (NAFTA). These sources are different\nfrom most of the cases in your textbook, either because they involve parties from different nations or\nbecause the rule makers or decision makers affect entities beyond their own borders.\nIn brief, the sources of international law include everything that an international tribunal might rely on to\ndecide international disputes. International disputes include arguments between nations, arguments\nbetween individuals or companies from different nations, and disputes between individuals or companies\nand a foreign nation-state. Article 38(1) of the Statute of the International Court of Justice (ICJ) lists four\nsources of international law: treaties and conventions, custom, general principles of law, and judicial\ndecisions and teachings.\nThe ICJ only hears lawsuits between nation-states. Its jurisdiction is not compulsory, meaning that both\nnations in a dispute must agree to have the ICJ hear the dispute.\n\nTreaties and Conventions\nEven after signing a treaty or convention, a nation is always free to go it alone and repudiate all regional\nor international bodies, or refuse to obey the dictates of the United Nations or, more broadly and\nambiguously, \xe2\x80\x9cthe community of nations.\xe2\x80\x9d The United States could repudiate NAFTA, could withdraw\nfrom the UN, and could let the WTO know that it would no longer abide by the post\xe2\x80\x93World War II rules of\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n862\n\n\x0cfree trade embodied in the General Agreement on Tariffs and Trade (GATT). The United States would be\nwithin its rights as a sovereign to do so, since it owes allegiance to no global or international sovereign.\nWhy, however, does it not do so? Why is the United States so involved with the \xe2\x80\x9centangling alliances\xe2\x80\x9d that\nGeorge Washington warned about? Simply put, nations will give away part of their sovereignty if they\nthink it\xe2\x80\x99s in their self-interest to do so. For example, if Latvia joins the European Union (EU), it gives up\nits right to have its own currency but believes it has more to gain.\nA treaty is nothing more than an agreement between two sovereign nations. In international law, a nation\nis usually called a state or nation-state. This can be confusing, since there are fifty US states, none of\nwhich has power to make treaties with other countries. It may be helpful to recall that the thirteen original\nstates under the Articles of Confederation were in fact able to have direct relations with foreign states.\nThus New Jersey (for a few brief years) could have had an ambassador to France or made treaties with\nSpain. Such a decentralized confederation did not last long. Under the present Constitution, states gave\nup their right to deal directly with other countries and vested that power in the federal government.\nThere are many treaties to which the United States is a party. Some of these are conventions, which are\ntreaties on matters of common concern, usually negotiated on a regional or global basis, sponsored by an\ninternational organization, and open to adoption by many nations. For example, as of 2011, there were\n192 parties (nation-states) that had signed on to the Charter of the UN, including the United States,\nUzbekistan, Ukraine, Uganda, United Arab Emirates, United Kingdom of Great Britain and Northern\nIreland, and Uruguay (just to name a few of the nation\xe2\x80\x99s starting with U).\nThe most basic kind of treaty is an agreement between two nation-states on matters of trade and friendly\nrelations. Treaties of friendship, commerce, and navigation (FCN treaties) are fairly common and provide\nfor mutual respect for each nation-state\xe2\x80\x99s citizens in (1) rights of entry, (2) practice of professions, (3)\nright of navigation, (4) acquisition of property, (5) matters of expropriation or nationalization, (6) access\nto courts, and (7) protection of patent rights. Bilateral investment treaties (BITs) are similar but are more\nfocused on commerce and investment. The commercial treaties may deal with a specific product or\nproduct group, investment, tariffs, or taxation.\nNation-states customarily enter not only into FCN treaties and BITs but also into peace treaties or\nweapons limitations treaties, such as the US-Russia Strategic Arms Reduction Talks (START) treaty.\nAgain, treaties are only binding as long as each party continues to recognize their binding effect. In the\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n863\n\n\x0cUnited States, the procedure for ratifying a treaty is that the Senate must approve it by a two-thirds vote\n(politically, an especially difficult number to achieve). Once ratified, a treaty has the same force of law\nwithin the United States as any statute that Congress might pass.\n\nCustom\nCustom between nations is another source of international law. Custom is practice followed by two or\nmore nations in the course of dealing with each other. These practices can be found in diplomatic\ncorrespondence, policy statements, or official government statements. To become custom, a consistent\nand recurring practice must go on over a significant period of time, and nations must recognize that the\npractice or custom is binding and must follow it because of legal obligation and not mere courtesy.\nCustoms may become codified in treaties.\n\nGeneral Principles of Law, or Customary International Law\nEven without treaties, there would be some international law, since not all disputes are confined to the\nterritory of one nation-state. For example, in In re the Bremen, a US company\xe2\x80\x99s disagreement with a\nGerman company was heard in US courts. The US courts had to decide where the dispute would properly\nbe heard. In giving full effect to a forum-selection clause, the US Supreme Court set out a principle that it\nhoped would be honored by courts of other nations\xe2\x80\x94namely, that companies from different states should\nhonor any forum-selection clause in their contract to settle disputes at a specific place or court. (See\nthe Bremen case, Section 20.5.1 "Forum-selection clauses"). If that principle is followed by enough\nnational court systems, it could become a principle of customary international law. As an example,\nconsider that for many years, courts in many nations believed that sovereign immunity was an established\nprinciple of international law.\n\nJudicial Decisions in International Tribunals; Scholarly Teachings\nThe Statute of the International Court of Justice recognizes that international tribunals may also refer to\nthe teachings of preeminent scholars on international law. The ICJ, for example, often referred to the\nscholarly writings of Sir Hersh Lauterpacht in its early decisions. Generally, international tribunals are\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n864\n\n\x0cnot bound by stare decisis (i.e., they may decide each case on its merits). However, courts such as the ICJ\ndo refer to their own past decisions for guidance.\nThere are many international tribunals, including the European Court of Justice, the ICJ, and the\nInternational Criminal Court. Typically, however, disputes between corporations or between individuals\nthat cross national boundaries must be resolved in national court systems or in arbitration. In other\nwords, there is no international civil court, and much complexity in international law derives from the fact\nthat national court systems must often choose from different sources of law, using different legal\ntraditions in order to resolve international disputes. For example, a court in one nation may have some\ndifficulty accepting the judgment of a foreign nation\xe2\x80\x99s court system, as we see in Koster v.\nAutomark (see Section 20.5.2 "Due process in the enforcement of judgments").\n\nDue Process and Recognition of Foreign Judgments\nIssues surrounding recognition of foreign judgments arise when one nation\xe2\x80\x99s courts have questions about\nthe fairness of procedures used in foreign courts to acquire the judgment. Perhaps the defendant was not\nnotified or did not have ample time in which to prepare a defense, or perhaps some measure of damages\nwas assessed that seemed distinctly unfair. If a foreign state makes a judgment against a US company, the\njudgment will not be recognized and enforced in the United States unless the US court believes that the\nforeign judgment provided the US company with due process. But skepticism about a foreign judgment\nworks the other way, as well. For example, if a US court were to assess punitive damages against a Belgian\ncompany, and the successful plaintiff were to ask for enforcement of the US judgment in Belgium, the\nBelgian court would reject that portion of the award based on punitive damages. Compensatory damages\nwould be allowed, but as Belgian law does not recognize punitive damages, it might not recognize that\nportion of the US court\xe2\x80\x99s award.\nConcerns about notice, service of process, and the ability to present certain defenses are evident in Koster\nv. Automark. Many such concerns are eliminated with the use of forum-selection clauses. The classic case\nin US jurisprudence is the Bremen case, which resolves difficult questions of where the case should be\ntried between a US and German company by approving the use of a forum-selection clause indicating that\na court in the United Kingdom would be the only forum that could hear the dispute.\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n865\n\n\x0cPart of what is going on in Bremen is the Supreme Court\xe2\x80\x99s concern that due process should be provided to\nthe US company. What is fair (procedurally) is the dominant question in this case. One clear lesson is that\nissues of fairness regarding personal jurisdiction can be resolved with a forum-selection clause\xe2\x80\x94if both\nparties agree to a forum that would have subject matter jurisdiction, at least minimal fairness is evident,\nbecause both parties have \xe2\x80\x9cconsented\xe2\x80\x9d to have the forum decide the case.\n\nArbitration\nThe idea that a forum-selection clause could, by agreement of the parties, take a dispute out of one\nnational court system and into another court system is just one step removed from the idea that the\nparties can select a fair resolution process that does not directly involve national court systems. In\ninternational arbitration, parties can select, either before or after a dispute arises, an arbitrator or arbitral\npanel that will hear the dispute. As in all arbitration, the parties agree that the arbitrator\xe2\x80\x99s decision will be\nfinal and binding. Arbitration is generally faster, can be less expensive, and is always private, being a\nproceeding not open to media scrutiny.\nTypically, an arbitration clause in the contract will specify the arbitrator or the means of selecting the\narbitrator. For that purpose, there are many organizations that conduct international arbitrations,\nincluding the American Arbitration Association, the International Chamber of Commerce, the\nInternational Centre for Settlement of Investment Disputes, and the United Nations Commission on\nInternational Trade Law. Arbitrators need not be judges or lawyers; they are usually business people,\nlawyers, or judges who are experienced in global commercial transactions. The arbitration clause is thus\nin essence a forum-selection clause and usually includes a choice of law for the arbitrator or arbitral panel\nto follow.\nAn arbitral award is not a judgment. If the losing party refuses to pay the award, the winning party must\npetition a court somewhere to enforce it. Fortunately, almost every country that is engaged in\ninternational commerce has ratified the United Nations Convention on the Recognition and Enforcement\nof Arbitral Awards, sometimes known as the New York Convention. The United States adopted this\nconvention in 1970 and has amended the Federal Arbitration Act accordingly. Anyone who has an arbitral\naward subject to the convention can attach property of the loser located in any country that has signed the\nconvention.\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n866\n\n\x0cKEY TAKEAWAY\nTreaties and conventions, along with customary international law, are the primary sources of what we\ncall international law. Disputes involving parties from different nation-states are resolved in national\n(federal) court systems, and one nation\xe2\x80\x99s recognition and enforcement of another nation\xe2\x80\x99s judicial\norders or judgments will require reciprocal treaties or some review that the order or judgment was\nfairly obtained (that there was due process in the determination of the order or judgment).\n\nEXERCISES\n1.\n\nAt the US Senate website, read about the history of treaties in the United States. What is an\n\xe2\x80\x9cexecutive agreement,\xe2\x80\x9d and why has the use of executive agreements grown so fast since World War\nII?\n\n2.\n\nIs NAFTA a treaty or an executive agreement? What practical difference does it make if it is one rather\nthan the other?\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n867\n\n\x0c20.3 Important Doctrines of Nation-State Judicial Decisions\nLEARNING OBJECTIVES\n1.\n\nDefine and describe the three traditional bases for a nation\xe2\x80\x99s jurisdiction over those individuals and\nentities from other nation-states.\n\n2.\n\nExplain forum non convenient and be able to apply that in a case involving citizens from two different\nnation-states.\n\n3.\n\nDescribe and explain the origins of both sovereign immunity and the act-of-state doctrine, and be able\nto distinguish between the two.\n\nBases for National Jurisdiction under International Law\nA nation-state has jurisdiction to make and enforce laws (1) within its own borders, (2) with respect to its\ncitizens (nationals\xe2\x80\x9d) wherever they might be, and (3) with respect to actions taking place outside the\nterritory but having an objective or direct impact within the territory. In the Restatement (Third) of\nForeign Relations Law, these three jurisdictional bases are known as (1) the territorial principle, (2) the\nnationality principle, and (3) the objective territoriality principle.\nAs we have already seen, many difficult legal issues involve jurisdictional problems. When can a court\nassert authority over a person? (That\xe2\x80\x99s the personal jurisdiction question.) When can a court apply its own\nlaw rather than the law of another state? When is it obligated to respect the legal decisions of other states?\nAll these problems have been noted in the context of US domestic law, with its state-federal system; the\nresolution of similar problems on a global scale are only slightly more complicated.\nThe territorial principle is fairly simple. Anything that happens within a nation\xe2\x80\x99s borders is subject to its\nlaws. A German company that makes direct investment in a plant in Spartanburg, South Carolina, is\nsubject to South Carolina law and US law as well.\nNationality jurisdiction often raises problems. The citizens of a nation-state are subject to its laws while\nwithin the nation and beyond. The United States has passed several laws that govern the conduct of US\nnationals abroad. United States companies may not, for example, bribe public officials of foreign countries\n\nSaylor URL: http://www.saylor.org/books\n\nSaylor.org\n868\n\n\x0cin order to get contracts (Foreign Corrupt Practices Act of 1976). Title VII of the Civil Rights Act also\napplies extraterritorially\xe2\x80\x94where a US citizen is employed abroad by a US company.\nFor example, suppose Jennifer Stanley (a US citizen) is discriminated against on the basis of gender by\nAramco (a US-based company) in Saudi Arabia, and she seeks to sue under Title VII of the Civil rights Act\nof 1964. The extraterritorial reach of US law seems odd, especially if Saudi Arabian law or custom conflicts\nwith US law. Indeed, in EEOC v. Arabian American Oil Co., the Supreme Court was hesitant to say that\nUS law would \xe2\x80\x9creach\xe2\x80\x9d across the globe to dictate proper corporate conduct.\n\n[1]\n\nLater that year, Congress\n\nmade it clear by amending Title VII so that its rules would in fact reach that far, at least where US citizens\nwere the parties to a dispute. But if Saudi Arabian law directly conflicted with US law, principles of\ncustomary international law would require that territorial jurisdiction would trump nationality\njurisdiction.\nNote that where the US laws conflict with local or host country laws, we have potential conflict in the\nextraterritorial application of US law to activities in a foreign land. See, for example, Kern v.\nDynalectron.\n\n[2]\n\nIn Kern, a Baptist pilot (US citizen) wanted to work for a company that provided\n\nemergency services to those Muslims who were on a pilgrimage to Mecca. The job required helicopter\npilots to occasionally land to provide emergency services. However, Saudi law required that all who set\nfoot in Mecca must be Muslim. Saudi law provided for death to violators. Kern (wanting the job) tried to\nconvert but couldn\xe2\x80\x99t give up his Baptist roots. He sued Dynalectron (a US company) for discrimination\nunder Title VII, claiming that he was denied the job because of his religion. Dynalectron did not deny that\nthey had discriminated on the basis of his religion but argued that because of the Saudi law, they had no\nviable choice. Kern lost on the Title VII claim (his religion was a bona fide occupational qualification). The\ncourt understood that US law would apply extraterritorially because of his nationality and the US\nnationality of his employer.\nThe principle of objective territoriality is fairly simple: acts taking place within the borders of one nation\ncan have a direct and foreseeable impact in another nation. International law recognizes that nationstates act appropriately when they make and enforce law against actors whose conduct has such direct\neffects. A lawsu
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