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Preface
Our goal is to provide students with a textbook that is up to date and comprehensive in its coverage
of legal and regulatory issues—and organized to permit instructors to tailor the materials to their
particular approach. This book engages students by relating law to everyday events with which they
are already familiar (or with which they are familiarizing themselves in other business courses) and
by its clear, concise, and readable style. (An earlier business law text by authors Lieberman and
Siedel was hailed “the best written text in a very crowded field.”)
This textbook provides context and essential concepts across the entire range of legal issues with
which managers and business executives must grapple. The text provides the vocabulary and legal
acumen necessary for businesspeople to talk in an educated way to their customers, employees,
suppliers, government officials—and to their own lawyers.
Traditional publishers often create confusion among customers in the text selection process by
offering a huge array of publications. Once a text is selected, customers might still have to customize
the text to meet their needs. For example, publishers usually offer books that include either case
summaries or excerpted cases, but some instructors prefer to combine case summaries with a few
excerpted cases so that students can experience reading original material. Likewise, the manner in
which most conventional texts incorporate video is cumbersome because the videos are contained in
a separate library, which makes access more complicating for instructors and students.

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Chapter 1

Introduction to Law and Legal Systems
LEARNING OBJECTIVES
After reading this chapter, you should be able to do the following:
1.

Distinguish different philosophies of law—schools of legal thought—and explain their relevance.

2.

Identify the various aims that a functioning legal system can serve.

3.

Explain how politics and law are related.

4.

Identify the sources of law and which laws have priority over other laws.

5.

Understand some basic differences between the US legal system and other legal systems.

Law has different meanings as well as different functions. Philosophers have considered issues of
justice and law for centuries, and several different approaches, or schools of legal thought, have
emerged. In this chapter, we will look at those different meanings and approaches and will consider
how social and political dynamics interact with the ideas that animate the various schools of legal
thought. We will also look at typical sources of “positive law” in the United States and how some of
those sources have priority over others, and we will set out some basic differences between the US
legal system and other legal systems.

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1.1 What Is Law?
Law is a word that means different things at different times. Black’s Law Dictionary says that law is “a
body of rules of action or conduct prescribed by controlling authority, and having binding legal force. That
which must be obeyed and followed by citizens subject to sanctions or legal consequence is a law.”

[1]

Functions of the Law
In a nation, the law can serve to (1) keep the peace, (2) maintain the status quo, (3) preserve individual
rights, (4) protect minorities against majorities, (5) promote social justice, and (6) provide for orderly
social change. Some legal systems serve these purposes better than others. Although a nation ruled by an
authoritarian government may keep the peace and maintain the status quo, it may also oppress minorities
or political opponents (e.g., Burma, Zimbabwe, or Iraq under Saddam Hussein). Under colonialism,
European nations often imposed peace in countries whose borders were somewhat arbitrarily created by
those same European nations. Over several centuries prior to the twentieth century, empires were built by
Spain, Portugal, Britain, Holland, France, Germany, Belgium, and Italy. With regard to the functions of
the law, the empire may have kept the peace—largely with force—but it changed the status quo and
seldom promoted the native peoples’ rights or social justice within the colonized nation.
In nations that were former colonies of European nations, various ethnic and tribal factions have
frequently made it difficult for a single, united government to rule effectively. In Rwanda, for example,
power struggles between Hutus and Tutsis resulted in genocide of the Tutsi minority. (Genocide is the
deliberate and systematic killing or displacement of one group of people by another group. In 1948, the
international community formally condemned the crime of genocide.) In nations of the former Soviet
Union, the withdrawal of a central power created power vacuums that were exploited by ethnic leaders.
When Yugoslavia broke up, the different ethnic groups—Croats, Bosnians, and Serbians—fought bitterly
for home turf rather than share power. In Iraq and Afghanistan, the effective blending of different groups
of families, tribes, sects, and ethnic groups into a national governing body that shares power remains to be
seen.

Law and Politics
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In the United States, legislators, judges, administrative agencies, governors, and presidents make law,
with substantial input from corporations, lobbyists, and a diverse group of nongovernment organizations
(NGOs) such as the American Petroleum Institute, the Sierra Club, and the National Rifle Association. In
the fifty states, judges are often appointed by governors or elected by the people. The process of electing
state judges has become more and more politicized in the past fifteen years, with growing campaign
contributions from those who would seek to seat judges with similar political leanings.
In the federal system, judges are appointed by an elected official (the president) and confirmed by other
elected officials (the Senate). If the president is from one party and the other party holds a majority of
Senate seats, political conflicts may come up during the judges’ confirmation processes. Such a division
has been fairly frequent over the past fifty years.
In most nation-states (as countries are called in international law), knowing who has power to make
and enforce the laws is a matter of knowing who has political power; in many places, the people or groups
that have military power can also command political power to make and enforce the laws. Revolutions are
difficult and contentious, but each year there are revolts against existing political-legal authority; an
aspiration for democratic rule, or greater “rights” for citizens, is a recurring theme in politics and law.

KEY TAKEAWAY
Law is the result of political action, and the political landscape is vastly different from nation to nation.
Unstable or authoritarian governments often fail to serve the principal functions of law.

EXERCISES
1.

Consider Burma (named Myanmar by its military rulers). What political rights do you have that the
average Burmese citizen does not?

2.

What is a nongovernment organization, and what does it have to do with government? Do you
contribute to (or are you active in) a nongovernment organization? What kind of rights do they
espouse, what kind of laws do they support, and what kind of laws do they oppose?

[1] Black’s Law Dictionary, 6th ed., s.v. “law.”
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1.2 Schools of Legal Thought
LEARNING OBJECTIVES
1.

Distinguish different philosophies of law—schools of legal thought—and explain their relevance.

2.

Explain why natural law relates to the rights that the founders of the US political-legal system found
important.

3.

Describe legal positivism and explain how it differs from natural law.

4.

Differentiate critical legal studies and ecofeminist legal perspectives from both natural law and legal
positivist perspectives.

There are different schools (or philosophies) concerning what law is all about. Philosophy of law is also
called jurisprudence, and the two main schools are legal positivism and natural law. Although
there are others (see Section 1.2.3 "Other Schools of Legal Thought"), these two are the most influential in
how people think about the law.

Legal Positivism: Law as Sovereign Command
As legal philosopher John Austin concisely put it, “Law is the command of a sovereign.” Law is only law,
in other words, if it comes from a recognized authority and can be enforced by that authority,
or sovereign—such as a king, a president, or a dictator—who has power within a defined area or
territory. Positivism is a philosophical movement that claims that science provides the only knowledge
precise enough to be worthwhile. But what are we to make of the social phenomena of laws?
We could examine existing statutes—executive orders, regulations, or judicial decisions—in a fairly
precise way to find out what the law says. For example, we could look at the posted speed limits on most
US highways and conclude that the “correct” or “right” speed is no more than fifty-five miles per hour. Or
we could look a little deeper and find out how the written law is usually applied. Doing so, we might
conclude that sixty-one miles per hour is generally allowed by most state troopers, but that occasionally
someone gets ticketed for doing fifty-seven miles per hour in a fifty-five miles per hour zone. Either
approach is empirical, even if not rigorously scientific. The first approach, examining in a precise way
what the rule itself says, is sometimes known as the “positivist” school of legal thought. The second

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approach—which relies on social context and the actual behavior of the principal actors who enforce the
law—is akin to the “legal realist” school of thought (see Section 1.2.3 "Other Schools of Legal Thought").
Positivism has its limits and its critics. New Testament readers may recall that King Herod, fearing the
birth of a Messiah, issued a decree that all male children below a certain age be killed. Because it was the
command of a sovereign, the decree was carried out (or, in legal jargon, the decree was “executed”).
Suppose a group seizes power in a particular place and commands that women cannot attend school and
can only be treated medically by women, even if their condition is life-threatening and women doctors are
few and far between. Suppose also that this command is carried out, just because it is the law and is
enforced with a vengeance. People who live there will undoubtedly question the wisdom, justice, or
goodness of such a law, but it is law nonetheless and is generally carried out. To avoid the law’s impact, a
citizen would have to flee the country entirely. During the Taliban rule in Afghanistan, from which this
example is drawn, many did flee.
The positive-law school of legal thought would recognize the lawmaker’s command as legitimate;
questions about the law’s morality or immorality would not be important. In contrast, the natural-law
school of legal thought would refuse to recognize the legitimacy of laws that did not conform to natural,
universal, or divine law. If a lawmaker issued a command that was in violation of natural law, a citizen
would be morally justified in demonstrating civil disobedience. For example, in refusing to give up her
seat to a white person, Rosa Parks believed that she was refusing to obey an unjust law.

Natural Law
The natural-law school of thought emphasizes that law should be based on a universal moral order.
Natural law was “discovered” by humans through the use of reason and by choosing between that which is
good and that which is evil. Here is the definition of natural law according to the Cambridge Dictionary of
Philosophy: “Natural law, also called the law of nature in moral and political philosophy, is an objective
norm or set of objective norms governing human behavior, similar to the positive laws of a human ruler,
but binding on all people alike and usually understood as involving a superhuman legislator.”

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Both the US Constitution and the United Nations (UN) Charter have an affinity for the natural-law
outlook, as it emphasizes certain objective norms and rights of individuals and nations. The US
Declaration of Independence embodies a natural-law philosophy. The following short extract should
provide some sense of the deep beliefs in natural law held by those who signed the document.

The Unanimous Declaration of the Thirteen United States of America
July 4, 1776
When in the Course of human events, it becomes necessary for one people to dissolve the political bands
which have connected them with another, and to assume among the powers of the earth, the separate and
equal station to which the Laws of Nature and of Nature’s God entitle them, a decent respect to the
opinions of mankind requires that they should declare the causes which impel them to the separation.
We hold these truths to be self-evident, that all men are created equal, that they are endowed by their
Creator with certain unalienable Rights, that among these are Life, Liberty and the Pursuit of Happiness.
That to secure these rights, Governments are instituted among Men, deriving their just powers from the
consent of the governed.…
The natural-law school has been very influential in American legal thinking. The idea that certain rights,
for example, are “unalienable” (as expressed in the Declaration of Independence and in the writings of
John Locke) is consistent with this view of the law. Individuals may have “God-given” or “natural” rights
that government cannot legitimately take away. Government only by consent of the governed is a natural
outgrowth of this view.
Civil disobedience—in the tradition of Henry Thoreau, Mahatma Gandhi, or Martin Luther King Jr.—
becomes a matter of morality over “unnatural” law. For example, in his “Letter from Birmingham Jail,”
Martin Luther King Jr. claims that obeying an unjust law is not moral and that deliberately disobeying an
unjust law is in fact a moral act that expresses “the highest respect for law”: “An individual who breaks a
law that conscience tells him is unjust, and who willingly accepts the penalty of imprisonment in order to
arouse the conscience of the community over its injustice, is in reality expressing the highest respect for

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law.…One who breaks an unjust law must do so openly, lovingly, and with a willingness to accept the
penalty.”

[2]

Legal positivists, on the other hand, would say that we cannot know with real confidence what “natural”
law or “universal” law is. In studying law, we can most effectively learn by just looking at what the written
law says, or by examining how it has been applied. In response, natural-law thinkers would argue that if
we care about justice, every law and every legal system must be held accountable to some higher standard,
however hard that may be to define.
It is easier to know what the law “is” than what the law “should be.” Equal employment laws, for example,
have specific statutes, rules, and decisions about racial discrimination. There are always difficult issues of
interpretation and decision, which is why courts will resolve differing views. But how can we know the
more fundamental “ought” or “should” of human equality? For example, how do we know that “all men
are created equal” (from the Declaration of Independence)? Setting aside for the moment questions about
the equality of women, or that of slaves, who were not counted as men with equal rights at the time of the
declaration—can the statement be empirically proven, or is it simply a matter of a priori knowledge? (A
priori means “existing in the mind prior to and independent of experience.”) Or is the statement about
equality a matter of faith or belief, not really provable either scientifically or rationally? The dialogue
between natural-law theorists and more empirically oriented theories of “what law is” will raise similar
questions. In this book, we will focus mostly on the law as it is, but not without also raising questions
about what it could or should be.

Other Schools of Legal Thought
The historical school of law believes that societies should base their legal decisions today on the examples
of the past. Precedent would be more important than moral arguments.
The legal realist school flourished in the 1920s and 1930s as a reaction to the historical school. Legal
realists pointed out that because life and society are constantly changing, certain laws and doctrines have
to be altered or modernized in order to remain current. The social context of law was more important to
legal realists than the formal application of precedent to current or future legal disputes. Rather than

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suppose that judges inevitably acted objectively in applying an existing rule to a set of facts, legal realists
observed that judges had their own beliefs, operated in a social context, and would give legal decisions
based on their beliefs and their own social context.
The legal realist view influenced the emergence of the critical legal studies (CLS) school of thought. The
“Crits” believe that the social order (and the law) is dominated by those with power, wealth, and influence.
Some Crits are clearly influenced by the economist Karl Marx and also by distributive justice theory
(see Chapter 2 "Corporate Social Responsibility and Business Ethics"). The CLS school believes the
wealthy have historically oppressed or exploited those with less wealth and have maintained social control
through law. In so doing, the wealthy have perpetuated an unjust distribution of both rights and goods in
society. Law is politics and is thus not neutral or value-free. The CLS movement would use the law to
overturn the hierarchical structures of domination in the modern society.
Related to the CLS school, yet different, is the ecofeminist school of legal thought. This school
emphasizes—and would modify—the long-standing domination of men over both women and the rest of
the natural world. Ecofeminists would say that the same social mentality that leads to exploitation of
women is at the root of man’s exploitation and degradation of the natural environment. They would say
that male ownership of land has led to a “dominator culture,” in which man is not so much a steward of
the existing environment or those “subordinate” to him but is charged with making all that he controls
economically “productive.” Wives, children, land, and animals are valued as economic resources, and legal
systems (until the nineteenth century) largely conferred rights only to men with land. Ecofeminists would
say that even with increasing civil and political rights for women (such as the right to vote) and with some
nations’ recognizing the rights of children and animals and caring for the environment, the legacy of the
past for most nations still confirms the preeminence of “man” and his dominance of both nature and
women.

KEY TAKEAWAY
Each of the various schools of legal thought has a particular view of what a legal system is or what it should be.
The natural-law theorists emphasize the rights and duties of both government and the governed. Positive law
takes as a given that law is simply the command of a sovereign, the political power that those governed will

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obey. Recent writings in the various legal schools of thought emphasize long-standing patterns of domination
of the wealthy over others (the CLS school) and of men over women (ecofeminist legal theory).

EXERCISES
1.

Vandana Shiva draws a picture of a stream in a forest. She says that in our society the stream is seen as
unproductive if it is simply there, fulfilling the need for water of women’s families and communities, until
engineers come along and tinker with it, perhaps damming it and using it for generating hydropower. The
same is true of a forest, unless it is replaced with a monoculture plantation of a commercial species. A
forest may very well be productive—protecting groundwater; creating oxygen; providing fruit, fuel, and
craft materials for nearby inhabitants; and creating a habitat for animals that are also a valuable resource.
She criticizes the view that if there is no monetary amount that can contribute to gross domestic product,
neither the forest nor the river can be seen as a productive resource. Which school of legal thought does
her criticism reflect?

2.

Anatole France said, “The law, in its majesty, forbids rich and poor alike from sleeping under bridges.”
Which school of legal thought is represented by this quote?

3.

Adolf Eichmann was a loyal member of the National Socialist Party in the Third Reich and worked hard
under Hitler’s government during World War II to round up Jewish people for incarceration—and
eventual extermination—at labor camps like Auschwitz and Buchenwald. After an Israeli “extraction
team” took him from Argentina to Israel, he was put on trial for “crimes against humanity.” His defense
was that he was “just following orders.” Explain why Eichmann was not an adherent of the natural-law
school of legal thought.

[1] Cambridge Dictionary of Philosophy, s.v. “natural law.”
[2] Martin Luther King Jr., “Letter from Birmingham Jail.”

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1.3 Basic Concepts and Categories of US Positive Law
LEARNING OBJECTIVES
1.

In a general way, differentiate contract law from tort law.

2.

Consider the role of law in supporting ethical norms in our society.

3.

Understand the differing roles of state law and federal law in the US legal system.

4.

Know the difference between criminal cases and civil cases.

Most of what we discuss in this book is positive law—US positive law in particular. We will also consider
the laws and legal systems of other nations. But first, it will be useful to cover some basic concepts and
distinctions.

Law: The Moral Minimums in a Democratic Society
The law does not correct (or claim to correct) every wrong that occurs in society. At a minimum, it aims to
curb the worst kind of wrongs, the kinds of wrongs that violate what might be called the “moral
minimums” that a community demands of its members. These include not only violations of criminal law
(see Chapter 6 "Criminal Law") but also torts (see Chapter 7 "Introduction to Tort Law") and broken
promises (see Chapter 8 "Introduction to Contract Law"). Thus it may be wrong to refuse to return a
phone call from a friend, but that wrong will not result in a viable lawsuit against you. But if a phone (or
the Internet) is used to libel or slander someone, a tort has been committed, and the law may allow the
defamed person to be compensated.
There is a strong association between what we generally think of as ethical behavior and what the laws
require and provide. For example, contract law upholds society’s sense that promises—in general—should
be kept. Promise-breaking is seen as unethical. The law provides remedies for broken promises (in breach
of contract cases) but not for all broken promises; some excuses are accepted when it would be reasonable
to do so. For tort law, harming others is considered unethical. If people are not restrained by law from
harming one another, orderly society would be undone, leading to anarchy. Tort law provides for
compensation when serious injuries or harms occur. As for property law issues, we generally believe that
private ownership of property is socially useful and generally desirable, and it is generally protected (with

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some exceptions) by laws. You can’t throw a party at my house without my permission, but my right to do
whatever I want on my own property may be limited by law; I can’t, without the public’s permission,
operate an incinerator on my property and burn heavy metals, as toxic ash may be deposited throughout
the neighborhood.

The Common Law: Property, Torts, and Contracts
Even before legislatures met to make rules for society, disputes happened and judges decided them. In
England, judges began writing down the facts of a case and the reasons for their decision. They often
resorted to deciding cases on the basis of prior written decisions. In relying on those prior decisions, the
judge would reason that since a current case was pretty much like a prior case, it ought to be decided the
same way. This is essentially reasoning by analogy. Thus the use of precedent in common-law cases
came into being, and a doctrine of stare decisis (pronounced STAR-ay-de-SIGH-sus) became accepted
in English courts. Stare decisis means, in Latin, “let the decision stand.”
Most judicial decisions that don’t apply legislative acts (known as statutes) will involve one of three areas
of law—property, contract, or tort. Property law deals with the rights and duties of those who can legally
own land (real property), how that ownership can be legally confirmed and protected, how property can
be bought and sold, what the rights of tenants (renters) are, and what the various kinds of “estates” in
land are (e.g., fee simple, life estate, future interest, easements, or rights of way). Contract law deals with
what kinds of promises courts should enforce. For example, should courts enforce a contract where one of
the parties was intoxicated, underage, or insane? Should courts enforce a contract where one of the
parties seemed to have an unfair advantage? What kind of contracts would have to be in writing to be
enforced by courts? Tort law deals with the types of cases that involve some kind of harm and or injury
between the plaintiff and the defendant when no contract exists. Thus if you are libeled or a competitor
lies about your product, your remedy would be in tort, not contract.
The thirteen original colonies had been using English common law for many years, and they continued to
do 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

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today a judicial opinion that refers to a seventeenth- or eighteenth-century English common-law case is
quite rare.
Courts in one state may look to common-law decisions from the courts of other states where the reasoning
in a similar case is persuasive. This will happen in “cases of first impression,” a fact pattern or situation
that the courts in one state have never seen before. But if the supreme court in a particular state has
already ruled on a certain kind of case, lower courts in that state will always follow the rule set forth by
their highest court.

State Courts and the Domain of State Law
In the early years of our nation, federal courts were not as active or important as state courts. States had
jurisdiction (the power to make and enforce laws) over the most important aspects of business life. The
power of state law has historically included governing the following kinds of issues and claims:
•

Contracts, including sales, commercial paper, letters of credit, and secured transactions

•

Torts

•

Property, including real property, bailments of personal property (such as when you check your
coat at a theater or leave your clothes with a dry cleaner), trademarks, copyrights, and the estates
of decedents (dead people)

•

Corporations

•

Partnerships

•

Domestic matters, including marriage, divorce, custody, adoption, and visitation

•

Securities law

•

Environmental law

•

Agency law, governing the relationship between principals and their agents.

•

Banking

•

Insurance

Over the past eighty years, however, federal law has become increasingly important in many of these
areas, including banking, securities, and environmental law.

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Civil versus Criminal Cases
Most of the cases we will look at in this textbook are civil cases. Criminal cases are certainly of interest to
business, especially as companies may break criminal laws. A criminal case involves a governmental
decision—whether state or federal—to prosecute someone (named as a defendant) for violating society’s
laws. The law establishes a moral minimum and does so especially in the area of criminal laws; if you
break a criminal law, you can lose your freedom (in jail) or your life (if you are convicted of a capital
offense). In a civil action, you would not be sent to prison; in the worst case, you can lose property
(usually money or other assets), such as when Ford Motor Company lost a personal injury case and the
judge awarded $295 million to the plaintiffs or when Pennzoil won a $10.54 billion verdict against Texaco
(see Chapter 7 "Introduction to Tort Law").
Some of the basic differences between civil law and criminal law cases are illustrated in Table 1.1
"Differences between Civil and Criminal Cases".
Table 1.1 Differences between Civil and Criminal Cases

Civil Cases

Criminal Cases

Parties

Plaintiff brings case; defendant must answer or lose
by default

Prosecutor brings case; defendant may
remain silent

Proof

Preponderance of evidence

Beyond a reasonable doubt

Reason

To settle disputes peacefully, usually between
private parties

To maintain order in society
To punish the most blameworthy
To deter serious wrongdoing

Remedies Money damages (legal remedy)

Fines, jail, and forfeitures

Injunctions (equitable remedy)
Specific performance (equity)

Regarding plaintiffs and prosecutors, you can often tell a civil case from a criminal case by looking at the
caption of a case going to trial. If the government appears first in the caption of the case (e.g., U.S. v.
Lieberman, it is likely that the United States is prosecuting on behalf of the people. The same is true of
cases prosecuted by state district attorneys (e.g., State v. Seidel). But this is not a foolproof formula.

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Governments will also bring civil actions to collect debts from or settle disputes with individuals,
corporations, or other governments. Thus U.S. v. Mayer might be a collection action for unpaid taxes,
or U.S. v. Canada might be a boundary dispute in the International Court of Justice. Governments can be
sued, as well; people occasionally sue their state or federal government, but they can only get a trial if the
government waives its sovereign immunity and allows such suits. Warner v. U.S., for example, could be a
claim for a tax refund wrongfully withheld or for damage caused to the Warner residence by a sonic boom
from a US Air Force jet flying overhead.

Substance versus Procedure
Many rules and regulations in law are substantive, and others are procedural. We are used to seeing laws
as substantive; that is, there is some rule of conduct or behavior that is called for or some action that is
proscribed (prohibited). The substantive rules tell us how to act with one another and with the
government. For example, all of the following are substantive rules of law and provide a kind of command
or direction to citizens:
•

Drive not more than fifty-five miles per hour where that speed limit is posted.

•

Do not conspire to fix prices with competitors in the US market.

•

Do not falsely represent the curative effects of your over-the-counter herbal remedy.

•

Do not drive your motor vehicle through an intersection while a red traffic signal faces the
direction you are coming from.

•

Do not discriminate against job applicants or employees on the basis of their race, sex, religion, or
national origin.

•

Do not discharge certain pollutants into the river without first getting a discharge permit.

In contrast, procedural laws are the rules of courts and administrative agencies. They tell us how to
proceed if there is a substantive-law problem. For example, if you drive fifty-three miles per hour in a
forty mile-per-hour zone on Main Street on a Saturday night and get a ticket, you have broken a
substantive rule of law (the posted speed limit). Just how and what gets decided in court is a matter of
procedural law. Is the police officer’s word final, or do you get your say before a judge? If so, who goes
first, you or the officer? Do you have the right to be represented by legal counsel? Does the hearing or trial

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have to take place within a certain time period? A week? A month? How long can the state take to bring its
case? What kinds of evidence will be relevant? Radar? (Does it matter what kind of training the officer has
had on the radar device? Whether the radar device had been tested adequately?) The officer’s personal
observation? (What kind of training has he had, how is he qualified to judge the speed of a car, and other
questions arise.) What if you unwisely bragged to a friend at a party recently that you went a hundred
miles an hour on Main Street five years ago at half past three on a Tuesday morning? (If the prosecutor
knows of this and the “friend” is willing to testify, is it relevant to the charge of fifty-three in a forty-mileper-hour zone?)
In the United States, all state procedural laws must be fair, since the due process clause of the Fourteenth
Amendment directs that no state shall deprive any citizen of “life, liberty, or property,” without due
process of law. (The $200 fine plus court costs is designed to deprive you of property, that is, money, if
you violate the speed limit.) Federal laws must also be fair, because the Fifth Amendment to the US
Constitution has the exact same due process language as the Fourteenth Amendment. This suggests that
some laws are more powerful or important than others, which is true. The next section looks at various
types of positive law and their relative importance.

KEY TAKEAWAY
In most legal systems, like that in the United States, there is a fairly firm distinction between criminal law (for
actions that are offenses against the entire society) and civil law (usually for disputes between individuals or
corporations). Basic ethical norms for promise-keeping and not harming others are reflected in the civil law of
contracts and torts. In the United States, both the states and the federal government have roles to play, and
sometimes these roles will overlap, as in environmental standards set by both states and the federal
government.

EXERCISES
1. Jenna gets a ticket for careless driving after the police come to investigate a car accident she had with you
on Hanover Boulevard. Your car is badly damaged through no fault of your own. Is Jenna likely to face
criminal charges, civil charges, or both?

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2. Jenna’s ticket says that she has thirty days in which to respond to the charges against her. The thirty days
conforms to a state law that sets this time limit. Is the thirty-day limit procedural law or substantive law?

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1.4 Sources of Law and Their Priority
LEARNING OBJECTIVES
1.

Describe the different sources of law in the US legal system and the principal institutions that create
those laws.

2.

Explain in what way a statute is like a treaty, and vice versa.

3.

Explain why the Constitution is “prior” and has priority over the legislative acts of a majority, whether
in the US Congress or in a state legislature.

4.

Describe the origins of the common-law system and what common law means.

Sources of Law
In the United States today, there are numerous sources of law. The main ones are (1) constitutions—both
state and federal, (2) statutes and agency regulations, and (3) judicial decisions. In addition, chief
executives (the president and the various governors) can issue executive orders that have the effect of law.
In international legal systems, sources of law include treaties (agreements between states or countries)
and what is known as customary international law (usually consisting of judicial decisions from national
court systems where parties from two or more nations are in a dispute).
As you might expect, these laws sometimes conflict: a state law may conflict with a federal law, or a
federal law might be contrary to an international obligation. One nation’s law may provide one
substantive rule, while another nation’s law may provide a different, somewhat contrary rule to apply. Not
all laws, in other words, are created equal. To understand which laws have priority, it is essential to
understand the relationships between the various kinds of law.

Constitutions
Constitutions are the foundation for a state or nation’s other laws, providing the country’s legislative,
executive, and judicial framework. Among the nations of the world, the United States has the oldest
constitution still in use. It is difficult to amend, which is why there have only been seventeen amendments

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following the first ten in 1789; two-thirds of the House and Senate must pass amendments, and threefourths of the states must approve them.
The nation’s states also have constitutions. Along with providing for legislative, executive, and judicial
functions, state constitutions prescribe various rights of citizens. These rights may be different from, and
in addition to, rights granted by the US Constitution. Like statutes and judicial decisions, a constitution’s
specific provisions can provide people with a “cause of action” on which to base a lawsuit (see Section
1.4.3 "Causes of Action, Precedent, and " on “causes of action”). For example, California’s constitution
provides that the citizens of that state have a right of privacy. This has been used to assert claims against
businesses that invade an employee’s right of privacy. In the case of Virginia Rulon-Miller, her employer,
International Business Machines (IBM), told her to stop dating a former colleague who went to work for a
competitor. When she refused, IBM terminated her, and a jury fined the company for $300,000 in
damages. As the California court noted, “While an employee sacrifices some privacy rights when he enters
the workplace, the employee’s privacy expectations must be balanced against the employer’s
interests.…[T]he point here is that privacy, like the other unalienable rights listed first in our
Constitution…is unquestionably a fundamental interest of our society.”

[1]

Statutes and Treaties in Congress
In Washington, DC, the federal legislature is known as Congress and has both a House of Representatives
and a Senate. The House is composed of representatives elected every two years from various districts in
each state. These districts are established by Congress according to population as determined every ten
years by the census, a process required by the Constitution. Each state has at least one district; the most
populous state (California) has fifty-two districts. In the Senate, there are two senators from each state,
regardless of the state’s population. Thus Delaware has two senators and California has two senators, even
though California has far more people. Effectively, less than 20 percent of the nation’s population can
send fifty senators to Washington.
Many consider this to be antidemocratic. The House of Representatives, on the other hand, is directly
proportioned by population, though no state can have less than one representative.

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Each Congressional legislative body has committees for various purposes. In these committees, proposed
bills are discussed, hearings are sometimes held, and bills are either reported out (brought to the floor for
a vote) or killed in committee. If a bill is reported out, it may be passed by majority vote. Because of the
procedural differences between the House and the Senate, bills that have the same language when
proposed in both houses are apt to be different after approval by each body. A conference committee will
then be held to try to match the two versions. If the two versions differ widely enough, reconciliation of
the two differing versions into one acceptable to both chambers (House and Senate) is more difficult.
If the House and Senate can agree on identical language, the reconciled bill will be sent to the president
for signature or veto. The Constitution prescribes that the president will have veto power over any
legislation. But the two bodies can override a presidential veto with a two-thirds vote in each chamber.
In the case of treaties, the Constitution specifies that only the Senate must ratify them. When the Senate
ratifies a treaty, it becomes part of federal law, with the same weight and effect as a statute passed by the
entire Congress. The statutes of Congress are collected in codified form in the US Code. The code is
available online at http://uscode.house.gov.

Delegating Legislative Powers: Rules by Administrative Agencies
Congress has found it necessary and useful to create government agencies to administer various laws
(see Chapter 5 "Administrative Law"). The Constitution does not expressly provide for administrative
agencies, but the US Supreme Court has upheld the delegation of power to create federal agencies.
Examples of administrative agencies would include the Occupational Safety and Health Administration
(OSHA), the Environmental Protection Agency (EPA), and the Federal Trade Commission (FTC).
It is important to note that Congress does not have unlimited authority to delegate its lawmaking powers
to an agency. It must delegate its authority with some guidelines for the agency and cannot altogether
avoid its constitutional responsibilities (see Chapter 5 "Administrative Law").

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Agencies propose rules in the Federal Register, published each working day of the year. Rules that are
formally adopted are published in the Code of Federal Regulations, or CFR, available online
athttp://www.access.gpo.gov/nara/cfr/cfr-table-search.html.

State Statutes and Agencies: Other Codified Law
Statutes are passed by legislatures and provide general rules for society. States have legislatures
(sometimes called assemblies), which are usually made up of both a senate and a house of representatives.
Like the federal government, state legislatures will agree on the provisions of a bill, which is then sent to
the governor (acting like the president for that state) for signature. Like the president, governors often
have a veto power. The process of creating and amending, or changing, laws is filled with political
negotiation and compromise.
On a more local level, counties and municipal corporations or townships may be authorized under a
state’s constitution to create or adopt ordinances. Examples of ordinances include local building codes,
zoning laws, and misdemeanors or infractions such as skateboarding or jaywalking. Most of the more
unusual laws that are in the news from time to time are local ordinances. For example, in Logan County,
Colorado, it is illegal to kiss a sleeping woman; in Indianapolis, Indiana, and Eureka, Nebraska, it is a
crime to kiss if you have a mustache. But reportedly, some states still have odd laws here and there.
Kentucky law proclaims that every person in the state must take a bath at least once a year, and failure to
do so is illegal.

Judicial Decisions: The Common Law
Common law consists of decisions by courts (judicial decisions) that do not involve interpretation of
statutes, regulations, treaties, or the Constitution. Courts make such interpretations, but many cases are
decided where there is no statutory or other codified law or regulation to be interpreted. For example, a
state court deciding what kinds of witnesses are required for a valid will in the absence of a rule (from a
statute) is making common law.
United States law comes primarily from the tradition of English common law. By the time England’s
American colonies revolted in 1776, English common-law traditions were well established in the colonial

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courts. English common law was a system that gave written judicial decisions the force of law throughout
the country. Thus if an English court delivered an opinion as to what constituted the common-law crime
of burglary, other courts would stick to that decision, so that a common body of law developed throughout
the country. Common law is essentially shorthand for the notion that a common body of law, based on
past written decisions, is desirable and necessary.
In England and in the laws of the original thirteen states, common-law decisions defined crimes such as
arson, burglary, homicide, and robbery. As time went on, US state legislatures either adopted or modified
common-law definitions of most crimes by putting them in the form of codes or statutes. This legislative
ability—to modify or change common law into judicial law—points to an important phenomenon: the
priority of statutory law over common law. As we will see in the next section, constitutional law will have
priority over statutory law.

Priority of Laws
The Constitution as Preemptive Force in US Law
The US Constitution takes precedence over all statutes and judicial decisions that are inconsistent. For
example, 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’s obligation under the
First Amendment to protect free speech. Or if the Michigan courts were to allow a professor to bring a
lawsuit against a student who had said something about him that was derogatory but not defamatory, the
state’s judicial system would not be acting according to the First Amendment. (As we will see in Chapter 7
"Introduction to Tort Law", free speech has its limits; defamation was a cause of action at the time the
First Amendment was added to the Constitution, and it has been understood that the free speech rights in
the First Amendment did not negate existing common law.)

Statutes and Cases
Statutes 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,
and not pay overtime work at a higher rate. But various statutes changed that. For example, the federal

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Fair Labor Standards Act (1938) forbid the use of oppressive child labor and established a minimum pay
wage and overtime pay rules.

Treaties as Statutes: The “Last in Time” Rule
A treaty or convention is considered of equal standing to a statute. Thus when Congress ratified the North
American Free Trade Agreement (NAFTA), any judicial decisions or previous statutes that were
inconsistent—such as quotas or limitations on imports from Mexico that were opposite to NAFTA
commitments—would no longer be valid. Similarly, US treaty obligations under the General Agreement
on Tariffs and Trade (GATT) and obligations made later through the World Trade Organization (WTO)
would override previous federal or state statutes.
One 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
in 1988 spelled out certain protections for dolphins in the Eastern Tropical Pacific, and the United States
began refusing to allow the importation of tuna that were caught using “dolphin-unfriendly” methods
(such as purse seining). This was challenged at a GATT dispute panel in Switzerland, and the United
States lost. The discussion continued at the WTO under its dispute resolution process. In short, US
environmental statutes can be ruled contrary to US treaty obligations.
Under most treaties, the United States can withdraw, or take back, any voluntary limitation on its
sovereignty; participation in treaties is entirely elective. That is, the United States may “unbind” itself
whenever it chooses. But for practical purposes, some limitations on sovereignty may be good for the
nation. The argument goes something like this: if free trade in general helps the United States, then it
makes some sense to be part of a system that promotes free trade; and despite some temporary setbacks,
the WTO decision process will (it is hoped) provide far more benefits than losses in the long run. This
argument invokes utilitarian theory (that the best policy does the greatest good overall for society) and
David Ricardo’s theory of comparative advantage.
Ultimately, whether the United States remains a supporter of free trade and continues to participate as a
leader in the WTO will depend upon citizens electing leaders who support the process. Had Ross Perot

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been elected in 1992, for example, NAFTA would have been politically (and legally) dead during his term
of office.

Causes of Action, Precedent, and Stare Decisis
No matter how wrong someone’s actions may seem to you, the only wrongs you can right in a court are
those that can be tied to one or more causes of action. Positive law is full of cases, treaties, statutes,
regulations, and constitutional provisions that can be made into a cause of action. If you have an
agreement with Harold Hill that he will purchase seventy-six trombones from you and he fails to pay for
them after you deliver, you will probably feel wronged, but a court will only act favorably on your
complaint if you can show that his behavior gives you a cause of action based on some part of your state’s
contract law. This case would give you a cause of action under the law of most states; unless Harold Hill
had some legal excuse recognized by the applicable state’s contract law—such as his legal incompetence,
his being less than eighteen years of age, his being drunk at the time the agreement was made, or his claim
that the instruments were trumpets rather than trombones or that they were delivered too late to be of use
to him—you could expect to recover some compensation for his breaching of your agreement with him.
An old saying in the law is that the law does not deal in trifles, or unimportant issues (in Latin, de minimis
non curat lex). Not every wrong you may suffer in life will be a cause to bring a court action. If you are
stood up for a Saturday night date and feel embarrassed or humiliated, you cannot recover anything in a
court of law in the United States, as there is no cause of action (no basis in the positive law) that you can
use in your complaint. If you are engaged to be married and your spouse-to-be bolts from the wedding
ceremony, there are some states that do provide a legal basis on which to bring a lawsuit. “Breach of
promise to marry” is recognized in several states, but most states have abolished this cause of action,
either by judicial decision or by legislation. Whether a runaway bride or groom gives rise to a valid cause
of action in the courts depends on whether the state courts still recognize and enforce this nowdisappearing cause of action.
Your cause of action is thus based on existing laws, including decided cases. How closely your case “fits”
with a prior decided case raises the question of precedent.

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As noted earlier in this chapter, the English common-law tradition placed great emphasis on precedent
and what is called stare decisis. A court considering one case would feel obliged to decide that case in a
way similar to previously decided cases. Written decisions of the most important cases had been spread
throughout England (the common “realm”), and judges hoped to establish a somewhat predictable,
consistent group of decisions.
The English legislature (Parliament) was not in the practice of establishing detailed statutes on crimes,
torts, contracts, or property. Thus definitions and rules were left primarily to the courts. By their nature,
courts could only decide one case at a time, but in doing so they would articulate holdings, or general
rules, that would apply to later cases.
Suppose that one court had to decide whether an employer could fire an employee for no reason at all.
Suppose that there were no statutes that applied to the facts: there was no contract between the employer
and the employee, but the employee had worked for the employer for many years, and now a younger
person was replacing him. The court, with no past guidelines, would have to decide whether the employee
had stated a “cause of action” against the employer. If the court decided that the case was not legally
actionable, it would dismiss the action. Future courts would then treat similar cases in a similar way. In
the process, the court might make a holding that employers could fire employees for any reason or for no
reason. This rule could be applied in the future should similar cases come up.
But suppose that an employer fired an employee for not committing perjury (lying on the witness stand in
a court proceeding); the employer wanted the employee to cover up the company's criminal or unethical
act. Suppose that, as in earlier cases, there were no applicable statutes and no contract of employment.
Courts relying on a holding or precedent that “employers may fire employees for any reason or no reason”
might rule against an employee seeking compensation for being fired for telling the truth on the witness
stand. Or it might make an exception to the general rule, such as, “Employers may generally discharge
employees for any reason or for no reason without incurring legal liability; however, employers will incur
legal liability for firing an employee who refuses to lie on behalf of the employer in a court proceeding.”
In each case (the general rule and its exception), the common-law tradition calls for the court to explain
the reasons for its ruling. In the case of the general rule, “freedom of choice” might be the major reason.

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In the case of the perjury exception, the efficiency of the judicial system and the requirements of
citizenship might be used as reasons. Because the court’s “reasons” will be persuasive to some and not to
others, there is inevitably a degree of subjectivity to judicial opinions. That is, reasonable people will
disagree as to the persuasiveness of the reasoning a court may offer for its decision.
Written judicial opinions are thus a good playing field for developing critical thinking skills by identifying
the issue in a case and examining the reasons for the court’s previous decision(s), or holding.
What has the court actually decided, and why? Remember that a court, especially the US Supreme Court,
is not only deciding one particular case but also setting down guidelines (in its holdings) for federal and
state courts that encounter similar issues. Note that court cases often raise a variety of issues or questions
to be resolved, and judges (and attorneys) will differ as to what the real issue in a case is. A holding is the
court’s complete answer to an issue that is critical to deciding the case and thus gives guidance to the
meaning of the case as a precedent for future cases.
Beyond the decision of the court, it is in looking at the court’s reasoning that you are most likely to
understand what facts have been most significant to the court and what theories (schools of legal thought)
each trial or appellate judge believes in. Because judges do not always agree on first principles (i.e., they
subscribe to different schools of legal thought), there are many divided opinions in appellate opinions and
in each US Supreme Court term.

KEY TAKEAWAY
There are different sources of law in the US legal system. The US Constitution is foundational; US statutory
and common law cannot be inconsistent with its provisions. Congress creates statutory law (with the signature
of the president), and courts will interpret constitutional law and statutory law. Where there is neither
constitutional law nor statutory law, the courts function in the realm of common law. The same is true of law
within the fifty states, each of which also has a constitution, or foundational law.
Both the federal government and the states have created administrative agencies. An agency only has the
power that the legislature gives it. Within the scope of that power, an agency will often create regulations
(see Chapter 5 "Administrative Law"), which have the same force and effect as statutes. Treaties are never
negotiated and concluded by states, as the federal government has exclusive authority over relations with

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other nation-states. A treaty, once ratified by the Senate, has the same force and effect as a statute passed by
Congress and signed into law by the president.
Constitutions, statutes, regulations, treaties, and court decisions can provide a legal basis in the positive law.
You may believe you have been wronged, but for you to have a right that is enforceable in court, you must
have something in the positive law that you can point to that will support a cause of action against your
chosen defendant.

EXERCISES
1.

Give one example of where common law was overridden by the passage of a federal statute.

2.

How does common law change or evolve without any action on the part of a legislature?

3.

Lindsey Paradise is not selected for her sorority of choice at the University of Kansas. She has spent all her
time rushing that particular sorority, which chooses some of her friends but not her. She is disappointed
and angry and wants to sue the sorority. What are her prospects of recovery in the legal system? Explain.

[1] Rulon-Miller v. International Business Machines Corp., 162 Cal. App.3d 241, 255 (1984).

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1.5 Legal and Political Systems of the World
LEARNING OBJECTIVE
1.

Describe how the common-law system differs from the civil-law system.

Other legal and political systems are very different from the US system, which came from English
common-law traditions and the framers of the US Constitution. Our legal and political traditions are
different both in what kinds of laws we make and honor and in how disputes are resolved in court.

Comparing Common-Law Systems with Other Legal Systems
The common-law tradition is unique to England, the United States, and former colonies of the British
Empire. Although there are differences among common-law systems (e.g., most nations do not permit
their judiciaries to declare legislative acts unconstitutional; some nations use the jury less frequently), all
of them recognize the use of precedent in judicial cases, and none of them relies on the comprehensive,
legislative codes that are prevalent in civil-law systems.

Civil-Law Systems
The main alternative to the common-law legal system was developed in Europe and is based in Roman
and Napoleonic law. A civil-law or code-law system is one where all the legal rules are in one or more
comprehensive legislative enactments. During Napoleon’s reign, a comprehensive book of laws—a code—
was developed for all of France. The code covered criminal law, criminal procedure, noncriminal law and
procedure, and commercial law. The rules of the code are still used today in France and in other
continental European legal systems. The code is used to resolve particular cases, usually by judges without
a jury. Moreover, the judges are not required to follow the decisions of other courts in similar cases. As
George Cameron of the University of Michigan has noted, “The law is in the code, not in the cases.” He
goes on to note, “Where several cases all have interpreted a provision in a particular way, the French
courts may feel bound to reach the same result in future cases, under the doctrine of jurisprudence
constante. The major agency for growth and change, however, is the legislature, not the courts.”

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Civil-law systems are used throughout Europe as well as in Central and South America. Some nations in
Asia and Africa have also adopted codes based on European civil law. Germany, Holland, Spain, France,
and Portugal all had colonies outside of Europe, and many of these colonies adopted the legal practices
that were imposed on them by colonial rule, much like the original thirteen states of the United States,
which adopted English common-law practices.
One source of possible confusion at this point is that we have already referred to US civil law in contrast to
criminal law. But the European civil law covers both civil and criminal law.
There are also legal systems that differ significantly from the common-law and civil-law systems. The
communist and socialist legal systems that remain (e.g., in Cuba and North Korea) operate on very
different assumptions than those of either English common law or European civil law. Islamic and other
religion-based systems of law bring different values and assumptions to social and commercial relations.

KEY TAKEAWAY
Legal systems vary widely in their aims and in the way they process civil and criminal cases. Common-law
systems use juries, have one judge, and adhere to precedent. Civil-law systems decide cases without a jury,
often use three judges, and often render shorter opinions without reference to previously decided cases.

EXERCISE
1.

Use the Internet to identify some of the better-known nations with civil-law systems. Which Asian nations
came to adopt all or part of civil-law traditions, and why?

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1.6 A Sample Case
Preliminary Note to Students
Title VII of the Civil Rights Act of 1964 is a federal statute that applies to all employers whose workforce
exceeds fifteen people. The text of Title VII says that
(a) it shall be an unlawful employment practice for an employer—
(1) to fail or refuse to hire or to discharge any individual, or otherwise to discriminate against any
individual with respect to his compensation, terms, conditions, or privileges of employment, because of
such individual’s race, color, religion, sex, or natural origin.
At common law—where judges decide cases without reference to statutory guidance—employers were
generally free to hire and fire on any basis they might choose, and employees were generally free to work
for an employer or quit an employer on any basis they might choose (unless the employer and the
employee had a contract). This rule has been called “employment at will.” State and federal statutes that
prohibit discrimination on any basis (such as the prohibitions on discrimination because of race, color,
religion, sex, or national origin in Title VII) are essentially legislative exceptions to the common-law
employment-at-will rule.
In the 1970s, many female employees began to claim a certain kind of sex discrimination: sexual
harassment. Some women were being asked to give sexual favors in exchange for continued employment
or promotion (quid pro quo sexual harassment) or found themselves in a working environment that put
their chances for continued employment or promotion at risk. This form of sexual discrimination came to
be called “hostile working environment” sexual harassment.
Notice that the statute itself says nothing about sexual harassment but speaks only in broad terms about
discrimination “because of” sex (and four other factors). Having set the broad policy, Congress left it to
employees, employers, and the courts to fashion more specific rules through the process of civil litigation.
This is a case from our federal court system, which has a trial or hearing in the federal district court, an
appeal to the Sixth Circuit Court of Appeals, and a final appeal to the US Supreme Court. Teresa Harris,

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having lost at both the district court and the Sixth Circuit Court of Appeals, here has petitioned for a writ
of certiorari (asking the court to issue an order to bring the case to the Supreme Court), a petition that is
granted less than one out of every fifty times. The Supreme Court, in other words, chooses its cases
carefully. Here, the court wanted to resolve a difference of opinion among the various circuit courts of
appeal as to whether or not a plaintiff in a hostile-working-environment claim could recover damages
without showing “severe psychological injury.”
Harris v. Forklift Systems
510 U.S. 17 (U.S. Supreme Court 1992)
JUDGES: O’CONNOR, J., delivered the opinion for a unanimous Court. SCALIA, J., and GINSBURG, J.,
filed concurring opinions.
JUSTICE O’CONNOR delivered the opinion of the Court.
In this case we consider the definition of a discriminatorily “abusive work environment” (also known as a
“hostile work environment”) under Title VII of the Civil Rights Act of 1964, 78 Stat. 253, as amended, 42
U.S.C. § 2000e et seq. (1988 ed., Supp. III).
I
Teresa Harris worked as a manager at Forklift Systems, Inc., an equipment rental company, from April
1985 until October 1987. Charles Hardy was Forklift’s president.
The Magistrate found that, throughout Harris’ time at Forklift, Hardy often insulted her because of her
gender and often made her the target of unwanted sexual innuendoes. Hardy told Harris on several
occasions, in the presence of other employees, “You’re a woman, what do you know” and “We need a man
as the rental manager”; at least once, he told her she was “a dumbass woman.” Again in front of others, he
suggested that the two of them “go to the Holiday Inn to negotiate [Harris’s] raise.” Hardy occasionally
asked Harris and other female employees to get coins from his front pants pocket. He threw objects on the
ground in front of Harris and other women, and asked them to pick the objects up. He made sexual
innuendoes about Harris’ and other women’s clothing.

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In mid-August 1987, Harris complained to Hardy about his conduct. Hardy said he was surprised that
Harris was offended, claimed he was only joking, and apologized. He also promised he would stop, and
based on this assurance Harris stayed on the job. But in early September, Hardy began anew: While
Harris was arranging a deal with one of Forklift’s customers, he asked her, again in front of other
employees, “What did you do, promise the guy…some [sex] Saturday night?” On October 1, Harris
collected her paycheck and quit.
Harris then sued Forklift, claiming that Hardy’s conduct had created an abusive work environment for her
because of her gender. The United States District Court for the Middle District of Tennessee, adopting the
report and recommendation of the Magistrate, found this to be “a close case,” but held that Hardy’s
conduct did not create an abusive environment. The court found that some of Hardy’s comments
“offended [Harris], and would offend the reasonable woman,” but that they were not “so severe as to be
expected to seriously affect [Harris’s] psychological well-being. A reasonable woman manager under like
circumstances would have been offended by Hardy, but his conduct would not have risen to the level of
interfering with that person’s work performance.
“Neither do I believe that [Harris] was subjectively so offended that she suffered injury.…Although Hardy
may at times have genuinely offended [Harris], I do not believe that he created a working environment so
poisoned as to be intimidating or abusive to [Harris].”
In focusing on the employee’s psychological well-being, the District Court was following Circuit precedent.
See Rabidue v. Osceola Refining Co., 805 F.2d 611, 620 (CA6 1986), cert. denied, 481 U.S. 1041, 95 L. Ed.
2d 823, 107 S. Ct. 1983 (1987). The United States Court of Appeals for the Sixth Circuit affirmed in a brief
unpublished decision…reported at 976 F.2d 733 (1992).
We granted certiorari, 507 U.S. 959 (1993), to resolve a conflict among the Circuits on whether conduct,
to be actionable as “abusive work environment” harassment (no quid pro quo harassment issue is present
here), must “seriously affect [an employee’s] psychological well-being” or lead the plaintiff to “suffer
injury.” Compare Rabidue (requiring serious effect on psychological well-being); Vance v. Southern Bell
Telephone & Telegraph Co., 863 F.2d 1503, 1510 (CA11 1989) (same); and Downes v. FAA, 775 F.2d 288,

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292 (CA Fed. 1985) (same), with Ellison v. Brady, 924 F.2d 872, 877–878 (CA9 1991) (rejecting such a
requirement).
II
Title VII of the Civil Rights Act of 1964 makes it “an unlawful employment practice for an employer…to
discriminate against any individual with respect to his compensation, terms, conditions, or privileges of
employment, because of such individual’s race, color, religion, sex, or national origin.” 42 U.S.C. § 2000e2(a)(1). As we made clear in Meritor Savings Bank, FSB v. Vinson, 477 U.S. 57 (1986), this language “is
not limited to ‘economic’ or ‘tangible’ discrimination. The phrase ‘terms, conditions, or privileges of
employment’ evinces a congressional intent ‘to strike at the entire spectrum of disparate treatment of men
and women’ in employment,” which includes requiring people to work in a discriminatorily hostile or
abusive environment. Id., at 64, quoting Los Angeles Dept. of Water and Power v. Manhart, 435 U.S. 702,
707, n.13, 55 L. Ed. 2d 657, 98 S. Ct. 1370 (1978). When the workplace is permeated with “discriminatory
intimidation, ridicule, and insult,” 477 U.S. at 65, that is “sufficiently severe or pervasive to alter the
conditions of the victim’s employment and create an abusive working environment,” Title VII is violated.
This standard, which we reaffirm today, takes a middle path between making actionable any conduct that
is merely offensive and requiring the conduct to cause a tangible psychological injury. As we pointed out
in Meritor, “mere utterance of an…epithet which engenders offensive feelings in an employee,” does not
sufficiently affect the conditions of employment to implicate Title VII. Conduct that is not severe or
pervasive enough to create an objectively hostile or abusive work environment—an environment that a
reasonable person would find hostile or abusive—is beyond Title VII’s purview. Likewise, if the victim
does not subjectively perceive the environment to be abusive, the conduct has not actually altered the
conditions of the victim’s employment, and there is no Title VII violation.
But Title VII comes into play before the harassing conduct leads to a nervous breakdown. A
discriminatorily abusive work environment, even one that does not seriously affect employees’
psychological well-being, can and often will detract from employees’ job performance, discourage
employees from remaining on the job, or keep them from advancing in their careers. Moreover, even
without regard to these tangible effects, the very fact that the discriminatory conduct was so severe or

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pervasive that it created a work environment abusive to employees because of their race, gender, religion,
or national origin offends Title VII’s broad rule of workplace equality. The appalling conduct alleged in
Meritor, and the reference in that case to environments “‘so heavily polluted with discrimination as to
destroy completely the emotional and psychological stability of minority group workers,’” Id., at 66,
quoting Rogers v. EEOC, 454 F.2d 234, 238 (CA5 1971), cert. denied, 406 U.S. 957,32 L. Ed. 2d 343, 92 S.
Ct. 2058 (1972), merely present some especially egregious examples of harassment. They do not mark the
boundary of what is actionable.
We therefore believe the District Court erred in relying on whether the conduct “seriously affected
plaintiff’s psychological well-being” or led her to “suffer injury.” Such an inquiry may needlessly focus the
fact finder’s attention on concrete psychological harm, an element Title VII does not require. Certainly
Title VII bars conduct that would seriously affect a reasonable person’s psychological well-being, but the
statute is not limited to such conduct. So long as the environment would reasonably be perceived, and is
perceived, as hostile or abusive, Meritor, supra, at 67, there is no need for it also to be psychologically
injurious.
This is not, and by its nature cannot be, a mathematically precise test. We need not answer today all the
potential questions it raises, nor specifically address the Equal Employment Opportunity Commission’s
new regulations on this subject, see 58 Fed. Reg. 51266 (1993) (proposed 29 CFR §§ 1609.1, 1609.2); see
also 29 CFR § 1604.11 (1993). But we can say that whether an environment is “hostile” or “abusive” can be
determined only by looking at all the circumstances. These may include the frequency of the
discriminatory conduct; its severity; whether it is physically threatening or humiliating, or a mere
offensive utterance; and whether it unreasonably interferes with an employee’s work performance. The
effect on the employee’s psychological well-being is, of course, relevant to determining whether the
plaintiff actually found the environment abusive. But while psychological harm, like any other relevant
factor, may be taken into account, no single factor is required.
III
Forklift, while conceding that a requirement that the conduct seriously affect psychological well-being is
unfounded, argues that the District Court nonetheless correctly applied the Meritor standard. We

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disagree. Though the District Court did conclude that the work environment was not “intimidating or
abusive to [Harris],” it did so only after finding that the conduct was not “so severe as to be expected to
seriously affect plaintiff’s psychological well-being,” and that Harris was not “subjectively so offended that
she suffered injury,” ibid. The District Court’s application of these incorrect standards may well have
influenced its ultimate conclusion, especially given that the court found this to be a “close case.”
We therefore reverse the judgment of the Court of Appeals, and remand the case for further proceedings
consistent with this opinion.
So ordered.

Note to Students
This was only the second time that the Supreme Court had decided a sexual harassment case. Many
feminist 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
decided is combined with the court’s decision, we get the holding of the case. Here, the question that the
court poses, plus its answer, yields a holding that “An employee need not prove severe psychological
injury in order to win a Title VII sexual harassment claim.” This holding will be true until such time as the
court revisits a similar question and answers it differently. This does happen, but happens rarely.

CASE QUESTIONS
1.

Is this a criminal case or a civil-law case? How can you tell?

2.

Is the court concerned with making a procedural rule here, or is the court making a statement about the
substantive law?

3.

Is this a case where the court is interpreting the Constitution, a federal statute, a state statute, or the
common law?

4.

In Harris v. Forklift, what if the trial judge does not personally agree that women should have any rights to
equal treatment in the workplace? Why shouldn’t that judge dismiss the case even before trial? Or should
the judge dismiss the case after giving the female plaintiff her day in court?

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5.

What was the employer’s argument in this case? Do you agree or disagree with it? What if those who
legislated Title VII gave no thought to the question of seriousness of injury at all?

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1.7 Summary and Exercises
Summary
There are differing conceptions of what law is and of what law should be. Laws and legal systems differ
worldwide. The legal system in the United States is founded on the US Constitution, which is itself
inspired by natural-law theory and the idea that people have rights that cannot be taken by government
but only protected by government. The various functions of the law are done well or poorly depending on
which nation-state you look at. Some do very well in terms of keeping order, while others do a better job
of allowing civil and political freedoms. Social and political movements within each nation greatly affect
the nature and quality of the legal system within that nation.
This chapter has familiarized you with a few of the basic schools of legal thought, such as natural law,
positive law, legal realism, and critical legal studies. It has also given you a brief background in common
law, including contracts, torts, and criminal law. The differences between civil and criminal cases,
substance and procedure, and the various sources of law have also been reviewed. Each source has a
different level of authority, starting with constitutions, which are primary and will negate any lower-court
laws that are not consistent with its principles and provisions. The basic differences between the common
law and civil law (continental, or European) systems of law are also discussed.

EXERCISES
1.

What is the common law? Where do the courts get the authority to interpret it and to change it?

2.

After World War II ended in 1945, there was an international tribunal at Nuremberg that prosecuted
various officials in Germany’s Third Reich who had committed “crimes against humanity.” Many of
them claim that they were simply “following orders” of Adolf Hitler and his chief lieutenants. What
law, if any, have they violated?

3.

What does stare decisis mean, and why is it so basic to common-law legal tradition?

4.

In the following situations, which source of law takes priority, and why?
a.

The state statute conflicts with the common law of that state.

b.

A federal statute conflicts with the US Constitution.

c.

A common-law decision in one state conflicts with the US Constitution.

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d.

A federal statute conflicts with a state constitution.

SELF-TEST QUESTIONS
1.

The source of law that is foundational in the US legal system is

a.

the common law

b.

statutory law

c.

constitutional law

d.

administrative law
“Law is the command of a sovereign” represents what school of legal thought?

a.

civil law

b.

constitutional law

c.

natural law

d.

ecofeminist law

e.

positive law

3.

Which of the following kinds of law are most often found in state law rather than federal law?

a.

torts and contracts

b.

bankruptcy

c.

maritime law

d.

international law
Where was natural law discovered?

a.

in nature

b.

in constitutions and statutes

c.

in the exercise of human reason

d.

in the Wall Street Journal
Wolfe is a state court judge in California. In the case of Riddick v. Clouse, which involves a
contract dispute, Wolfe must follow precedent. She establishes a logical relationship between the
Riddick case and a case decided by the California Supreme Court, Zhu v. Patel Enterprises, Inc. She
compares the facts of Riddick to the facts in Zhu and to the extent the facts are similar, applies the
same rule to reach her decision. This is

a.

deductive reasoning

b.

faulty reasoning

c.

linear reasoning

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d.

reasoning by analogy
Moore is a state court judge in Colorado. In the case of Cassidy v. Seawell, also a contract
dispute, there is no Colorado Supreme Court or court of appeals decision that sets forth a rule that
could be applied. However, the California case of Zhu v. Patel Enterprises, Inc. is “very close” on the
facts and sets forth a rule of law that could be applied to the Cassidy case. What process must Moore
follow in considering whether to use the Zhu case as precedent?

a.

Moore is free to decide the case any way he wants, but he may not look at decisions and reasons in
similar cases from other states.

b.

Moore must wait for the Colorado legislature and the governor to pass a law that addresses the issues
raised in the Cassidy case.

c.

Moore must follow the California case if that is the best precedent.

d.

Moore may follow the California case if he believes that it offers the best reasoning for a similar case.

SELF-TEST ANSWERS
1.

c

2.

e

3.

a

4.

c

5.

d

6.

d

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Chapter 2

Corporate Social Responsibility and Business Ethics
A great society is a society in which [leaders] of business think greatly about their functions.
-Alfred North Whitehead

LEARNING OBJECTIVES
After reading this chapter, you should be able to do the following:
1.

Define ethics and explain the importance of good ethics for business people and business organizations.

2.

Understand the principal philosophies of ethics, including utilitarianism, duty-based ethics, and virtue
ethics.

3.

Distinguish between the ethical merits of various choices by using an ethical decision model.

4.

Explain the difference between shareholder and stakeholder models of ethical corporate governance.

5.

Explain why it is difficult to establish and maintain an ethical corporate culture in a business
organization.

Few subjects are more contentious or important as the role of business in society, particularly,
whether corporations have social responsibilities that are distinct from maximizing shareholder
value. While the phrase “business ethics” is not oxymoronic (i.e., a contradiction in terms), there is
plenty of evidence that businesspeople and firms seek to look out primarily for themselves. However,
business organizations ignore the ethical and social expectations of consumers, employees, the
media, nongovernment organizations (NGOs), government officials, and socially responsible
investors at their peril. Legal compliance alone no longer serves the long-term interests of many
companies, who find that sustainable profitability requires thinking about people and the planet as
well as profits.
This chapter has a fairly modest aim: to introduce potential businesspeople to the differences
between legal compliance and ethical excellence by reviewing some of the philosophical perspectives
that apply to business, businesspeople, and the role of business organizations in society.

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2.1 What Is Ethics?
LEARNING OBJECTIVES
1.

Explain how both individuals and institutions can be viewed as ethical or unethical.

2.

Explain how law and ethics are different, and why a good reputation can be more important than
legal compliance.

Most of those who write about ethics do not make a clear distinction between ethics and morality.
The question of what is “right” or “morally correct” or “ethically correct” or “morally desirable” in
any situation is variously phrased, but all of the words and phrases are after the same thing: what act
is “better” in a moral or ethical sense than some other act? People sometimes speak of morality as
something personal but view ethics as having wider social implications. Others see morality as the
subject of a field of study, that field being ethics. Ethics would be morality as applied to any number
of subjects, including journalistic ethics, business ethics, or the ethics of professionals such as
doctors, attorneys, and accountants. We will venture a definition of ethics, but for our purposes,
ethics and morality will be used as equivalent terms.

People often speak about the ethics or morality of individuals and also about the morality or ethics of
corporations and nations. There are clearly differences in the kind of moral responsibility that we can
fairly ascribe to corporations and nations; we tend to see individuals as having a soul, or at least a
conscience, but there is no general agreement that nations or corporations have either. Still, our
ordinary use of language does point to something significant: if we say that some nations are “evil”
and others are “corrupt,” then we make moral judgments about the quality of actions undertaken by
the governments or people of that nation. For example, if North Korea is characterized by the US
president as part of an “axis of evil,” or if we conclude that WorldCom or Enron acted “unethically” in
certain respects, then we are making judgments that their collective actions are morally deficient.
In talking about morality, we often use the word good; but that word can be confusing. If we say that
Microsoft is a “good company,” we may be making a statement about the investment potential of
Microsoft stock, or their preeminence in the market, or their ability to win lawsuits or appeals or to
influence administrative agencies. Less likely, though possibly, we may be making a statement about

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the civic virtue and corporate social responsibility of Microsoft. In the first set of judgments, we use
the word good but mean something other than ethical or moral; only in the second instance are we
using the word good in its ethical or moral sense.
A word such as good can embrace ethical or moral values but also nonethical values. If I like Daniel
and try to convince you what a “good guy” he is, you may ask all sorts of questions: Is he goodlooking? Well-off? Fun to be with? Humorous? Athletic? Smart? I could answer all of those questions
with a yes, yet you would still not know any of his moral qualities. But if I said that he was honest,
caring, forthright, and diligent, volunteered in local soup kitchens, or tithed to the church, many
people would see Daniel as having certain ethical or moral qualities. If I said that he keeps the
Golden Rule as well as anyone I know, you could conclude that he is an ethical person. But if I said
that he is “always in control” or “always at the top of his game,” you would probably not make
inferences or assumptions about his character or ethics.
There are three key points here:
1.

Although morals and ethics are not precisely measurable, people generally have similar reactions
about what actions or conduct can rightly be called ethical or moral.

2. As humans, we need and value ethical people and want to be around them.
3. Saying that someone or some organization is law-abiding does not mean the same as saying a
person or company is ethical.

Here is a cautionary note: for individuals, it is far from easy to recognize an ethical problem, have a
clear and usable decision-making process to deal it, and then have the moral courage to do what’s
right. All of that is even more difficult within a business organization, where corporate employees
vary in their motivations, loyalties, commitments, and character. There is no universally accepted
way for developing an organization where employees feel valued, respected, and free to openly
disagree; where the actions of top management are crystal clear; and where all the employees feel
loyal and accountable to one another.

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Before talking about how ethics relates to law, we can conclude that ethics is the study of morality—
“right” and “wrong”—in the context of everyday life, organizational behaviors, and even how society
operates and is governed.

How Do Law and Ethics Differ?
There is a difference between legal compliance and moral excellence. Few would choose a professional
service, health care or otherwise, because the provider had a record of perfect legal compliance, or always
following the letter of the law. There are many professional ethics codes, primarily because people realize
that law prescribes only a minimum of morality and does not provide purpose or goals that can mean
excellent service to customers, clients, or patients.
Business ethicists have talked for years about the intersection of law and ethics. Simply put, what is legal
is not necessarily ethical. Conversely, what is ethical is not necessarily legal. There are lots of legal
maneuvers that are not all that ethical; the well-used phrase “legal loophole” suggests as much.
Here are two propositions about business and ethics. Consider whether they strike you as true or whether
you would need to know more in order to make a judgment.
•

Individuals and organizations have reputations. (For an individual, moral reputation is most
often tied to others’ perceptions of his or her character: is the individual honest, diligent, reliable,
fair, and caring? The reputation of an organization is built on the goodwill that suppliers,
customers, the community, and employees feel toward it. Although an organization is not a
person in the usual sense, the goodwill that people feel about the organization is based on their
perception of its better qualities by a variety of stakeholders: customers or clients, suppliers,
investors, employees, government officials).

•

The goodwill of an organization is to a great extent based on the actions it takes and on whether
the actions are favorably viewed. (This goodwill is usually specifically counted in the sale of a
business as an asset that the buyer pays for. While it is difficult to place a monetary value on
goodwill, a firm’s good reputation will generally call for a higher evaluation in the final accounting
before the sale. Legal troubles or a reputation for having legal troubles will only lessen the price

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for a business and will even lessen the value of the company’s stock as bad legal news comes to the
public’s attention.)
Another reason to think about ethics in connection with law is that the laws themselves are meant to
express some moral view. If there are legal prohibitions against cheating the Medicare program, it is
because people (legislators or their agents) have collectively decided that cheating Medicare is wrong. If
there are legal prohibitions against assisting someone to commit suicide, it is because there has been a
group decision that doing so is immoral. Thus the law provides some important cues as to what society
regards as right or wrong.
Finally, important policy issues that face society are often resolved through law, but it is important to
understand the moral perspectives that underlie public debate—as, for example, in the continuing
controversies over stem-cell research, medical use of marijuana, and abortion. Some ethical perspectives
focus on rights, some on social utility, some on virtue or character, and some on social justice. People
consciously (or, more often, unconsciously) adopt one or more of these perspectives, and even if they
completely agree on the facts with an opponent, they will not change their views. Fundamentally, the
difference comes down to incompatible moral perspectives, a clash of basic values. These are hot-button
issues because society is divided, not so much over facts, but over basic values. Understanding the varied
moral perspectives and values in public policy debates is a clarifying benefit in following or participating
in these important discussions.

Why Should an Individual or a Business Entity Be Ethical?
The usual answer is that good ethics is good business. In the long run, businesses that pay attention to
ethics as well as law do better; they are viewed more favorably by customers. But this is a difficult claim to
measure scientifically, because “the long run” is an indistinct period of time and because there are as yet
no generally accepted criteria by which ethical excellence can be measured. In addition, life is still lived in
the short run, and there are many occasions when something short of perfect conduct is a lot more
profitable.

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Some years ago, Royal Dutch/Shell (one of the world’s largest companies) found that it was in deep
trouble with the public for its apparent carelessness with the environment and human rights. Consumers
were boycotting and investors were getting frightened, so the company took a long, hard look at its ethic
of short-term profit maximization. Since then, changes have been made. The CEO told one group of
business ethicists that the uproar had taken them by surprise; they thought they had done everything
right, but it seemed there was a “ghost in the machine.” That ghost was consumers, NGOs, and the media,
all of whom objected to the company’s seeming lack of moral sensitivity.
The market does respond to unethical behavior. In Section 2.4 "Corporations and Corporate Governance",
you will read about the Sears Auto Centers case. The loss of goodwill toward Sears Auto Centers was real,
even though the total amount of money lost cannot be clearly accounted for. Years later, there are people
who will not go near a Sears Auto Center; the customers who lost trust in the company will never return,
and many of their children may avoid Sears Auto Centers as well.
The Arthur Andersen story is even more dramatic. A major accounting firm, Andersen worked closely
with Enron in hiding its various losses through creative accounting measures. Suspiciously, Andersen’s
Houston office also did some shredding around the clock, appearing to cover up what it was doing for
Enron. A criminal case based on this shredding resulted in a conviction, later overturned by the Supreme
Court. But it was too late. Even before the conviction, many clients had found other accounting firms that
were not under suspicion, and the Supreme Court’s reversal came too late to save the company. Even
without the conviction, Andersen would have lost significant market share.
The irony of Andersen as a poster child for overly aggressive accounting practices is that the man who
founded the firm built it on integrity and straightforward practices. “Think straight, talk straight” was the
company’s motto. Andersen established the company’s reputation for integrity over a hundred years ago
by refusing to play numbers games for a potentially lucrative client.
Maximizing profits while being legally compliant is not a very inspiring goal for a business. People in an
organization need some quality or excellence to strive for. By focusing on pushing the edge of what is
legal, by looking for loopholes in the law that would help create short-term financial gain, companies have

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often learned that in the long term they are not actually satisfying the market, the shareholders, the
suppliers, or the community generally.

KEY TAKEAWAY
Legal compliance is not the same as acting ethically. Your reputation, individually or corporately, depends on
how others regard your actions. Goodwill is hard to measure or quantify, but it is real nonetheless and can
best be protected by acting ethically.

EXERCISES
1.

Think of a person who did something morally wrong, at least to your way of thinking. What was it? Explain
to a friend of yours—or a classmate—why you think it was wrong. Does your friend agree? Why or why
not? What is the basic principle that forms the basis for your judgment that it was wrong?

2.

Think of a person who did something morally right, at least to your way of thinking. (This is not a matter
of finding something they did well, like efficiently changing a tire, but something good.) What was it?
Explain to a friend of yours—or a classmate—why you think it was right. Does your friend agree? Why or
why not? What is the basic principle that forms the basis for your judgment that it was right?

3.

Think of an action by a business organization (sole proprietor, partnership, or corporation) that was legal
but still strikes you as wrong. What was it? Why do you think it was wrong?

4.

Think of an act by an individual or a corporation that is ethical but not legal. Compare your answer with
those of your classmates: were you more likely to find an example from individual action or corporate
action? Do you have any thoughts as to why?

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2.2 Major Ethical Perspectives
LEARNING OBJECTIVES
1.

Describe the various major theories about ethics in human decision making.

2.

Begin considering how the major theories about ethics apply to difficult choices in life and business.

There are several well-respected ways of looking at ethical issues. Some of them have been around for
centuries. It is important to know that many who think a lot about business and ethics have deeply held
beliefs about which perspective is best. Others would recommend considering ethical problems from a
variety of different perspectives. Here, we take a brief look at (1) utilitarianism, (2) deontology, (3) social
justice and social contract theory, and (4) virtue theory. We are leaving out some important perspectives,
such as general theories of justice and “rights” and feminist thought about ethics and patriarchy.

Utilitarianism
Utilitarianism is a prominent perspective on ethics, one that is well aligned with economics and the
free-market outlook that has come to dominate much current thinking about business, management, and
economics. Jeremy Bentham is often considered the founder of utilitarianism, though John Stuart Mill
(who wrote On Liberty and Utilitarianism) and others promoted it as a guide to what is good.
Utilitarianism emphasizes not rules but results. An action (or set of actions) is generally deemed good or
right if it maximizes happiness or pleasure throughout society. Originally intended as a guide for
legislators charged with seeking the greatest good for society, the utilitarian outlook may also be practiced
individually and by corporations.
Bentham believed that the most promising way to obtain agreement on the best policies for a society
would be to look at the various policies a legislature could pass and compare the good and bad
consequences of each. The right course of action from an ethical point of view would be to choose the
policy that would produce the greatest amount of utility, or usefulness. In brief, the utilitarian principle
holds that an action is right if and only if the sum of utilities produced by that action is greater than the
sum of utilities from any other possible act.

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This statement describes “act utilitarianism”—which action among various options will deliver the
greatest good to society? “Rule utilitarianism” is a slightly different version; it asks, what rule or principle,
if followed regularly, will create the greatest good?
Notice that the emphasis is on finding the best possible results and that the assumption is that we can
measure the utilities involved. (This turns out to be more difficult that you might think.) Notice also that
“the sum total of utilities” clearly implies that in doing utilitarian analysis, we cannot be satisfied if an act
or set of acts provides the greatest utility to us as individuals or to a particular corporation; the test is,
instead, whether it provides the greatest utility to society as a whole. Notice that the theory does not tell us
what kinds of utilities may be better than others or how much better a good today is compared with a
good a year from today.
Whatever its difficulties, utilitarian thinking is alive and well in US law and business. It is found in such
diverse places as cost-benefit analysis in administrative and regulatory rules and calculations,
environmental impact studies, the majority vote, product comparisons for consumer information,
marketing studies, tax laws, and strategic planning. In management, people will often employ a form of
utility reasoning by projecting costs and benefits for plan X versus plan Y. But the issue in most of these
cost-benefit analyses is usually (1) put exclusively in terms of money and (2) directed to the benefit of the
person or organization doing the analysis and not to the benefit of society as a whole.
An individual or a company that consistently uses the test “What’s the greatest good for me or the
company?” is not following the utilitarian test of the greatest good overall. Another common failing is to
see only one or two options that seem reasonable. The following are some frequent mistakes that people
make in applying what they think are utilitarian principles in justifying their chosen course of action:
1.

Failing to come up with lots of options that seem reasonable and then choosing the one that has
the greatest benefit for the greatest number. Often, a decision maker seizes on one or two
alternatives without thinking carefully about other courses of action. If the alternative does more
good than harm, the decision maker assumes it’s ethically okay.

2. Assuming that the greatest good for you or your company is in fact the greatest good for all—that
is, looking at situations subjectively or with your own interests primarily in mind.

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3. Underestimating the costs of a certain decision to you or your company. The now-classic Ford
Pinto case demonstrates how Ford Motor Company executives drastically underestimated the
legal costs of not correcting a feature on their Pinto models that they knew could cause death or
injury. General Motors was often taken to task by juries that came to understand that the
company would not recall or repair known and dangerous defects because it seemed more
profitable not to. In 2010, Toyota learned the same lesson.
4. Underestimating the cost or harm of a certain decision to someone else or some other group of
people.
5.

Favoring short-term benefits, even though the long-term costs are greater.

6. Assuming that all values can be reduced to money. In comparing the risks to human health or
safety against, say, the risks of job or profit losses, cost-benefit analyses will often try to compare
apples to oranges and put arbitrary numerical values on human health and safety.

Rules and Duty: Deontology
In contrast to the utilitarian perspective, the deontological view presented in the writings of Immanuel
Kant purports that having a moral intent and following the right rules is a better path to ethical conduct
than achieving the right results. A deontologist like Kant is likely to believe that ethical action arises from
doing one’s duty and that duties are defined by rational thought. Duties, according to Kant, are not
specific to particular kinds of human beings but are owed universally to all human beings. Kant therefore
uses “universalizing“ as a form of rational thought that assumes the inherent equality of all human beings.
It considers all humans as equal, not in the physical, social, or economic sense, but equal before God,
whether they are male, female, Pygmy, Eskimoan, Islamic, Christian, gay, straight, healthy, sick, young, or
old.
For Kantian thinkers, this basic principle of equality means that we should be able to universalize any
particular law or action to determine whether it is ethical. For example, if you were to consider
misrepresenting yourself on a resume for a particular job you really wanted and you were convinced that
doing so would get you that job, you might be very tempted to do so. (What harm would it be? you might
ask yourself. When I have the job, I can prove that I was perfect for it, and no one is hurt, while both the

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employer and I are clearly better off as a result!) Kantian ethicists would answer that your chosen course
of action should be a universal one—a course of action that would be good for all persons at all times.
There are two requirements for a rule of action to be universal: consistency and reversibility. Consider
reversibility: if you make a decision as though you didn’t know what role or position you would have after
the decision, you would more likely make an impartial one—you would more likely choose a course of
action that would be most fair to all concerned, not just you. Again, deontology requires that we put
duty first, act rationally, and give moral weight to the inherent equality of all human beings.
In considering whether to lie on your resume, reversibility requires you to actively imagine both that you
were the employer in this situation and that you were another well-qualified applicant who lost the job
because someone else padded his resume with false accomplishments. If the consequences of such an
exercise of the imagination are not appealing to you, your action is probably not ethical.
The second requirement for an action to be universal is the search for consistency. This is more abstract.
A deontologist would say that since you know you are telling a lie, you must be willing to say that lying, as
a general, universal phenomenon, is acceptable. But if everyone lied, then there would be no point to
lying, since no one would believe anyone. It is only because honesty works well for society as a whole and
is generally practiced that lying even becomes possible! That is, lying cannot be universalized, for it
depends on the preexistence of honesty.
Similar demonstrations can be made for actions such as polluting, breaking promises, and committing
most crimes, including rape, murder, and theft. But these are the easy cases for Kantian thinkers. In the
gray areas of life as it is lived, the consistency test is often difficult to apply. If breaking a promise would
save a life, then Kantian thought becomes difficult to apply. If some amount of pollution can allow
employment and the harm is minimal or distant, Kantian thinking is not all that helpful. Finally, we
should note that the well-known Golden Rule, “Do unto others as you would have them do unto you,”
emphasizes the easier of the two universalizing requirements: practicing reversibility (“How would I like it
if someone did this to me?”).

Social Justice Theory and Social Contract Theory

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Social justice theorists worry about “distributive justice”—that is, what is the fair way to distribute goods
among a group of people? Marxist thought emphasizes that members of society should be given goods to
according to their needs. But this redistribution would require a governing power to decide who gets what
and when. Capitalist thought takes a different approach, rejecting any giving that is not voluntary. Certain
economists, such as the late Milton Friedman (see the sidebar in Section 2.4 "Corporations and Corporate
Governance") also reject the notion that a corporation has a duty to give to unmet needs in society,
believing that the government should play that role. Even the most dedicated free-market capitalist will
often admit the need for some government and some forms of welfare—Social Security, Medicare,
assistance to flood-stricken areas, help for AIDs patients—along with some public goods (such as defense,
education, highways, parks, and support of key industries affecting national security).
People who do not see the need for public goods (including laws, court systems, and the government
goods and services just cited) often question why there needs to be a government at all. One response
might be, “Without government, there would be no corporations.” Thomas Hobbes believed that people in
a “state of nature” would rationally choose to have some form of government. He called this
the social contract, where people give up certain rights to government in exchange for security and
common benefits. In your own lives and in this course, you will see an ongoing balancing act between
human desires for freedom and human desires for order; it is an ancient tension. Some commentators
also see a kind of social contract between corporations and society; in exchange for perpetual duration
and limited liability, the corporation has some corresponding duties toward society. Also, if a corporation
is legally a “person,” as the Supreme Court reaffirmed in 2010, then some would argue that if this
corporate person commits three felonies, it should be locked up for life and its corporate charter revoked!
Modern social contract theorists, such as Thomas Donaldson and Thomas Dunfee (Ties that Bind, 1999),
observe that various communities, not just nations, make rules for the common good. Your college or
school is a community, and there are communities within the school (fraternities, sororities, the folks
behind the counter at the circulation desk, the people who work together at the university radio station,
the sports teams, the faculty, the students generally, the gay and lesbian alliance) that have rules, norms,
or standards that people can buy into or not. If not, they can exit from that community, just as we are free
(though not without cost) to reject US citizenship and take up residence in another country.

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Donaldson and Dunfee’s integrative social contracts theory stresses the importance of studying the rules
of smaller communities along with the larger social contracts made in states (such as Colorado or
California) and nation-states (such as the United States or Germany). Our Constitution can be seen as a
fundamental social contract.
It is important to realize that a social contract can be changed by the participants in a community, just as
the US Constitution can be amended. Social contract theory is thus dynamic—it allows for structural and
organic changes. Ideally, the social contract struck by citizens and the government allows for certain
fundamental rights such as those we enjoy in the United States, but it need not. People can give up
freedom-oriented rights (such as the right of free speech or the right to be free of unreasonable searches
and seizures) to secure order (freedom from fear, freedom from terrorism). For example, many citizens in
Russia now miss the days when the Kremlin was all powerful; there was less crime and more equality and
predictability to life in the Soviet Union, even if there was less freedom.
Thus the rights that people have—in positive law—come from whatever social contract exists in the
society. This view differs from that of the deontologists and that of the natural-law thinkers such as
Gandhi, Jesus, or Martin Luther King Jr., who believed that rights come from God or, in less religious
terms, from some transcendent moral order.
Another important movement in ethics and society is the communitarian outlook. Communitarians
emphasize that rights carry with them corresponding duties; that is, there cannot be a right without a
duty. Interested students may wish to explore the work of Amitai Etzioni. Etzioni was a founder of the
Communitarian Network, which is a group of individuals who have come together to bolster the moral,
social, and political environment. It claims to be nonsectarian, nonpartisan, and international in scope.
The relationship between rights and duties—in both law and ethics—calls for some explanations:
1.

If you have a right of free expression, the government has a duty to respect that right but can put
reasonable limits on it. For example, you can legally say whatever you want about the US
president, but you can’t get away with threatening the president’s life. Even if your criticisms are
strong and insistent, you have the right (and our government has the duty to protect your right) to

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speak freely. In Singapore during the 1990s, even indirect criticisms—mere hints—of the political
leadership were enough to land you in jail or at least silence you with a libel suit.
2. Rights and duties exist not only between people and their governments but also between
individuals. Your right to be free from physical assault is protected by the law in most states, and
when someone walks up to you and punches you in the nose, your rights—as set forth in the
positive law of your state—have been violated. Thus other people have a duty to respect your
rights and to not punch you in the nose.
3. Your right in legal terms is only as good as your society’s willingness to provide legal remedies
through the courts and political institutions of society.
A distinction between basic rights and nonbasic rights may also be important. Basic rights may include
such fundamental elements as food, water, shelter, and physical safety. Another distinction is between
positive rights (the right to bear arms, the right to vote, the right of privacy) and negative rights (the right
to be free from unreasonable searches and seizures, the right to be free of cruel or unusual punishments).
Yet another is between economic or social rights (adequate food, work, and environment) and political or
civic rights (the right to vote, the right to equal protection of the laws, the right to due process).

Aristotle and Virtue Theory
Virtue theory, or virtue ethics, has received increasing attention over the past twenty years, particularly
in contrast to utilitarian and deontological approaches to ethics. Virtue theory emphasizes the value of
virtuous qualities rather than formal rules or useful results. Aristotle is often recognized as the first
philosopher to advocate the ethical value of certain qualities, or virtues, in a person’s character. As LaRue
Hosmer has noted, Aristotle saw the goal of human existence as the active, rational search for excellence,
and excellence requires the personal virtues of honesty, truthfulness, courage, temperance, generosity,
and high-mindedness. This pursuit is also termed “knowledge of the good” in Greek philosophy.

[1]

Aristotle believed that all activity was aimed at some goal or perceived good and that there must be some
ranking that we do among those goals or goods. Happiness may be our ultimate goal, but what does that
mean, exactly? Aristotle rejected wealth, pleasure, and fame and embraced reason as the distinguishing
feature of humans, as opposed to other species. And since a human is a reasoning animal, happiness must

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be associated with reason. Thus happiness is living according to the active (rather than passive) use of
reason. The use of reason leads to excellence, and so happiness can be defined as the active, rational
pursuit of personal excellence, or virtue.
Aristotle named fourteen virtues: (1) courage, particularly in battle; (2) temperance, or moderation in
eating and drinking; (3) liberality, or spending money well; (4) magnificence, or living well; (5) pride, or
taking pleasure in accomplishments and stature; (6) high-mindedness, or concern with the noble rather
than the petty; (7) unnamed virtue, which is halfway between ambition and total lack of effort; (8)
gentleness, or concern for others; (9) truthfulness; (10) wit, or pleasure in group discussions; (11)
friendliness, or pleasure in personal conduct; (12) modesty, or pleasure in personal conduct; (13)
righteous indignation, or getting angry at the right things and in the right amounts; and (14) justice.
From a modern perspective, some of these virtues seem old-fashioned or even odd. Magnificence, for
example, is not something we commonly speak of. Three issues emerge: (1) How do we know what a virtue
is these days? (2) How useful is a list of agreed-upon virtues anyway? (3) What do virtues have to do with
companies, particularly large ones where various groups and individuals may have little or no contact
with other parts of the organization?
As to the third question, whether corporations can “have” virtues or values is a matter of lively debate. A
corporation is obviously not the same as an individual. But there seems to be growing agreement that
organizations do differ in their practices and that these practices are value driven. If all a company cares
about is the bottom line, other values will diminish or disappear. Quite a few books have been written in
the past twenty years that emphasize the need for businesses to define their values in order to be
competitive in today’s global economy.

[2]

As to the first two questions regarding virtues, a look at Michael Josephson’s core values may prove
helpful.

Josephson’s Core Values Analysis and Decision Process

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Michael Josephson, a noted American ethicist, believes that a current set of core values has been
identified and that the values can be meaningfully applied to a variety of personal and corporate
decisions.
To simplify, let’s say that there are ethical and nonethical qualities among people in the United States.
When you ask people what kinds of qualities they admire in others or in themselves, they may say wealth,
power, fitness, sense of humor, good looks, intelligence, musical ability, or some other quality. They may
also value honesty, caring, fairness, courage, perseverance, diligence, trustworthiness, or integrity. The
qualities on the second list have something in common—they are distinctively ethical characteristics. That
is, they are commonly seen as moral or ethical qualities, unlike the qualities on the first list. You can be,
like the Athenian Alcibiades, brilliant but unprincipled, or, like some political leaders today, powerful but
dishonest, or wealthy but uncaring. You can, in short, have a number of admirable qualities (brilliance,
power, wealth) that are not per se virtuous. Just because Harold is rich or good-looking or has a good
sense of humor does not mean that he is ethical. But if Harold is honest and caring (whether he is rich or
poor, humorous or humorless), people are likely to see him as ethical.
Among the virtues, are any especially important? Studies from the Josephson Institute of Ethics in
Marina del Rey, California, have identified six core values in our society, values that almost everyone
agrees are important to them. When asked what values people hold dear, what values they wish to be
known by, and what values they wish others would exhibit in their actions, six values consistently turn up:
(1) trustworthiness, (2) respect, (3) responsibility, (4) fairness, (5) caring, and (6) citizenship.
Note that these values are distinctly ethical. While many of us may value wealth, good looks, and
intelligence, having wealth, good looks, and intelligence does not automatically make us virtuous in our
character and habits. But being more trustworthy (by being honest and by keeping promises) does make
us more virtuous, as does staying true to the other five core values.
Notice also that these six core values share something in common with other ethical values that are less
universally agreed upon. Many values taught in the family or in places of worship are not generally agreed
on, practiced, or admired by all. Some families and individuals believe strongly in the virtue of saving
money or in abstaining from alcohol or sex prior to marriage. Others clearly do not, or at least don’t act on

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their beliefs. Moreover, it is possible to have and practice core ethical values even if you take on heavy
debt, knock down several drinks a night, or have frequent premarital sex. Some would dispute this, saying
that you can’t really lead a virtuous life if you get into debt, drink heavily, or engage in premarital sex. But
the point here is that since people do disagree in these areas, the ethical traits of thrift, temperance, and
sexual abstinence do not have the unanimity of approval that the six core values do.
The importance of an individual’s having these consistent qualities of character is well known. Often we
remember the last bad thing a person did far more than any or all previous good acts. For example, Eliot
Spitzer and Bill Clinton are more readily remembered by people for their last, worst acts than for any good
they accomplished as public servants. As for a company, its good reputation also has an incalculable value
that when lost takes a great deal of time and work to recover. Shell, Nike, and other companies have
discovered that there is a market for morality, however difficult to measure, and that not paying attention
to business ethics often comes at a serious price. In the past fifteen years, the career of ethics and
compliance officer has emerged, partly as a result of criminal proceedings against companies but also
because major companies have found that reputations cannot be recovered retroactively but must be
pursued proactively. For individuals, Aristotle emphasized the practice of virtue to the point where virtue
becomes a habit. Companies are gradually learning the same lesson.

KEY TAKEAWAY
Throughout history, people have pondered what it means “to do what is right.” Some of the main answers
have come from the differing perspectives of utilitarian thought; duty-based, or deontological, thought; social
contract theory; and virtue ethics.

EXERCISES
XYZ Motor Corporation begins to get customer complaints about two models of its automobiles. Customers
have had near-death experiences from sudden acceleration; they would be driving along a highway at normal
speed when suddenly the car would begin to accelerate, and efforts to stop the acceleration by braking fail to
work. Drivers could turn off the ignition and come to a safe stop, but XYZ does not instruct buyers of its cars to
do so, nor is this a common reaction among drivers who experience sudden acceleration.

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Internal investigations of half a dozen accidents in US locations come to the conclusion that the accidents are
not being caused by drivers who mistake the gas pedal for the brake pedal. In fact, there appears to be a
possible flaw in both models, perhaps in a semiconductor chip, that makes sudden acceleration happen.
Interference by floor mats and poorly designed gas pedals do not seem to be the problem.
It is voluntary to report these incidents to the National Highway Traffic and Safety Administration (NHTSA), but
the company decides that it will wait awhile and see if there are more complaints. Recalling the two models so
that local dealers and their mechanics could examine them is also an option, but it would be extremely costly.
Company executives are aware that quarterly and annual profit-and-loss statements, on which their bonuses
depend, could be decisively worse with a recall. They decide that on a cost-benefit basis, it makes more sense
to wait until there are more accidents and more data. After a hundred or more accidents and nearly fifteen
fatalities, the company institutes a selective recall, still not notifying NHTSA, which has its own experts and the
authority to order XYZ to do a full recall of all affected models.
Experts have advised XYZ that standard failure-analysis methodology requires that the company obtain
absolutely every XYZ vehicle that has experienced sudden acceleration, using microscopic analysis of all critical
components of the electronic system. The company does not wish to take that advice, as it would be—as one
top executive put it—“too time-consuming and expensive.”
1.

Can XYZ’s approach to this problem be justified under utilitarian theory? If so, how? If not, why not?

2.

What would Kant advise XYZ to do? Explain.

3.

What would the “virtuous” approach be for XYZ in this situation?

[1] LaRue Tone Hosmer, Moral Leadership in Business (Chicago: Irwin Professional Publishing, 1994), 72.
[2] James O’Toole and Don Mayer, eds., Good Business: Exercising Effective and Ethical Leadership (London:
Routledge, 2010).

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2.3 An Ethical Decision Model
LEARNING OBJECTIVE
1.

Understand one model for ethical decision making: a process to arrive at the most ethical option for
an individual or a business organization, using a virtue ethics approach combined with some elements
of stakeholder analysis and utilitarianism.

Josephson’s Core Values Model
Once you recognize that there is a decision that involves ethical judgment, Michael Josephson would first
have you ask as many questions as are necessary to get a full background on the relevant facts. Then,
assuming you have all the needed information, the decision process is as follows:
1.

Identify the stakeholders. That is, who are the potential gainers and losers in the various decisions
that might be made here?

2. Identify several likely or reasonable decisions that could be made.
3. Consider which stakeholders gain or lose with each decision.
4. Determine which decision satisfies the greatest number of core values.
5.

If there is no decision that satisfies the greatest number of core values, try to determine which
decision delivers the greatest good to the various stakeholders.

It is often helpful to identify who (or what group) is the most important stakeholder, and why. In Milton
Friedman’s view, it will always be the shareholders. In the view of John Mackey, the CEO of Whole Foods
Market, the long-term viability and profitability of the organization may require that customers come
first, or, at times, some other stakeholder group (see “Conscious Capitalism” in Section 2.4 "Corporations
and Corporate Governance").

The Core Values
Here are the core values and their subcomponents as developed by the Josephson Institute of Ethics.

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Trustworthiness: Be honest—tell the truth, the whole truth, and nothing but the truth; be sincere,
forthright; don’t deceive, mislead, or be tricky with the truth; don’t cheat or steal, and don’t betray a
trust. Demonstrate integrity—stand up for what you believe, walk the walk as well as talking the talk; be
what you seem to be; show commitment and courage. Be loyal—stand by your family, friends, co-workers,
community, and nation; be discreet with information that comes into your hands; don’t spread rumors or
engage in harmful gossip; don’t violate your principles just to win friendship or approval; don’t ask a
friend to do something that is wrong. Keep promises—keep your word, honor your commitments, and pay
your debts; return what you borrow.
Respect: Judge people on their merits, not their appearance; be courteous, polite, appreciative, and
accepting of differences; respect others’ right to make decisions about their own lives; don’t abuse,
demean, mistreat anyone; don’t use, manipulate, exploit, or take advantage of others.
Responsibility: Be accountable—think about the consequences on yourself and others likely to be
affected before you act; be reliable; perform your duties; take responsibility for the consequences of your
choices; set a good example and don’t make excuses or take credit for other people’s work. Pursue
excellence: Do your best, don’t quit easily, persevere, be diligent, make all you do worthy of pride.
Exercise self-restraint—be disciplined, know the difference between what you have a right to do and what
is right to do.
Fairness: Treat all people fairly, be open-minded; listen; consider opposing viewpoints; be consistent;
use only appropriate considerations; don’t let personal feelings improperly interfere with decisions; don’t
take unfair advantage of mistakes; don’t take more than your fair share.
Caring: Show you care about others through kindness, caring, sharing, compassion, and empathy; treat
others the way you want to be treated; don’t be selfish, mean, cruel, or insensitive to others’ feelings.
Citizenship: Play by the rules, obey laws; do your share, respect authority, stay informed, vote, protect
your neighbors, pay your taxes; be charitable, help your community; protect the environment, conserve
resources.

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When individuals and organizations confront ethical problems, the core values decision model offered by
Josephson generally works well (1) to clarify the gains and losses of the various stakeholders, which then
raises ethical awareness on the part of the decision maker and (2) to provide a fairly reliable guide as to
what the most ethical decision would be. In nine out of ten cases, step 5 in the decision process is not
needed.
That said, it does not follow that students (or managers) would necessarily act in accord with the results of
the core values decision process. There are many psychological pressures and organizational constraints
that place limits on people both individually and in organizations. These pressures and constraints tend to
compromise ideal or the most ethical solutions for individuals and for organizations. For a business, one
essential problem is that ethics can cost the organization money or resources, at least in the short term.
Doing the most ethical thing will often appear to be something that fails to maximize profits in the short
term or that may seem pointless because if you or your organization acts ethically, others will not, and
society will be no better off, anyway.

KEY TAKEAWAY
Having a step-by-step process to analyze difficult moral dilemmas is useful. One such process is offered here,
based on the core values of trustworthiness, caring, respect, fairness, responsibility, and citizenship.

EXERCISE
1.

Consider XYZ in the exercises for Section 2.2.5 "Josephson’s Core Values Analysis and Decision
Process" and use the core values decision-making model. What are XYZ’s options when they first notice
that two of their models are causing sudden acceleration incidents that put their customers at risk? Who
are the stakeholders? What options most clearly meet the criteria for each of the core values?

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2.4 Corporations and Corporate Governance
LEARNING OBJECTIVES
1.

Explain the basic structure of the typical corporation and how the shareholders own the company
and elect directors to run it.

2.

Understand how the shareholder profit-maximization model is different from stakeholder theory.

3.

Discern and describe the ethical challenges for corporate cultures.

4.

Explain what conscious capitalism is and how it differs from stakeholder theory.

Legal Organization of the Corporation
Figure 2.1 Corporate Legal Structure

Figure 2.1 "Corporate Legal Structure", though somewhat oversimplified, shows the basic legal structure
of a corporation under Delaware law and the laws of most other states in the United States. Shareholders
elect directors, who then hire officers to manage the company. From this structure, some very basic
realities follow. Because the directors of a corporation do not meet that often, it’s possible for the officers
hired (top management, or the “C-suite”) to be selective of what the board knows about, and directors are
not always ready and able to provide the oversight that the shareholders would like. Nor does the law

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require officers to be shareholders, so that officers’ motivations may not align with the best interests of the
company. This is the “agency problem” often discussed in corporate governance: how to get officers and
other top management to align their own interests with those of the shareholders. For example, a CEO
might trade insider information to the detriment of the company’s shareholders. Even board members are
susceptible to misalignment of interests; for example, board members might resist hostile takeover bids
because they would likely lose their perks (short for perquisites) as directors, even though the tender offer
would benefit stockholders. Among other attempted realignments, the use of stock options was an
attempt to make managers more attentive to the value of company stock, but the law of unintended
consequences was in full force; managers tweaked and managed earnings in the bubble of the 1990s bull
market, and “managing by numbers” became an epidemic in corporations organized under US corporate
law. The rights of shareholders can be bolstered by changes in state and federal law, and there have been
some attempts to do that since the late 1990s. But as owners, shareholders have the ultimate power to
replace nonperforming or underperforming directors, which usually results in changes at the C-suite level
as well.

Shareholders and Stakeholders
There are two main views about what the corporation’s duties are. The first view—maximizing profits—is
the prevailing view among business managers and in business schools. This view largely follows the idea
of Milton Friedman that the duty of a manager is to maximize return on investment to the owners. In
essence, managers’ legally prescribed duties are those that make their employment possible. In terms of
the legal organization of the corporation, the shareholders elect directors who hire managers, who have
legally prescribed duties toward both directors and shareholders. Those legally prescribed duties are a
reflection of the fact that managers are managing other people’s money and have a moral duty to act as a
responsible agent for the owners. In law, this is called the manager’s fiduciary duty. Directors have the
same duties toward shareholders. Friedman emphasized the primacy of this duty in his writings about
corporations and social responsibility.

Maximizing Profits: Milton Friedman

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Economist Milton Friedman is often quoted as having said that the only moral duty a corporation has is to
make the most possible money, or to maximize profits, for its stockholders. Friedman’s beliefs are noted
at length (see sidebar on Friedman’s article from the New York Times), but he asserted in a now-famous
1970 article that in a free society, “there is one and only one social responsibility of business: to use its
resources and engage in activities designed to increase its profits as long as it stays within the rules of the
game, which is to say, engages in open and free competition without deception and fraud.” What follows is
a major portion of what Friedman had to say in 1970.

“The Social Responsibility of Business Is to Increase Its Profits”
Milton Friedman, New York Times Magazine, September 13, 1970
What does it mean to say that “business” has responsibilities? Only people can have responsibilities. A
corporation is an artificial person and in this sense may have artificial responsibilities, but “business” as a
whole cannot be said to have responsibilities, even in this vague sense.…
Presumably, the individuals who are to be responsible are businessmen, which means individual
proprietors or corporate executives.…In a free enterprise, private-property system, a corporate executive
is an employee of the owners of the business. He has direct responsibility to his employers. That
responsibility is to conduct the business in accordance with their desires, which generally will be to make
as much money as possible while conforming to the basic rules of the society, both those embodied in law
and those embodied in ethical custom.…
…[T]he manager is that agent of the individuals who own the corporation or establish the eleemosynary
institution, and his primary responsibility is to them…
Of course, the corporate executive is also a person in his own right. As a person, he may have other
responsibilities that he recognizes or assumes voluntarily—to his family, his conscience, his feeling of
charity, his church, his clubs, his city, his country. He may feel impelled by these responsibilities to devote
part of his income to causes he regards as worthy, to refuse to work for particular corporations, even to
leave his job…But in these respects he is acting as a principal, not an agent; he is spending his own money

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or time or energy, not the money of his employers or the time or energy he has contracted to devote to
their purposes. If these are “social responsibilities,” they are the social responsibilities of individuals, not
of business.
What does it mean to say that the corporate executive has a “social responsibility” in his capacity as
businessman? If this statement is not pure rhetoric, it must mean that he has to act in some way that is
not in the interest of his employers. For example, that he is to refrain from increasing the price of the
product in order to contribute to the social objective of preventing inflation, even though a price increase
would be in the best interests of the corporation. Or that he is to make expenditures on reducing pollution
beyond the amount that is in the best interests of the corporation or that is required by law in order to
contribute to the social objective of improving the environment. Or that, at the expense of corporate
profits, he is to hire “hardcore” unemployed instead of better qualified available workmen to contribute to
the social objective of reducing poverty.
In each of these cases, the corporate executive would be spending someone else’s money for a general
social interest. Insofar as his actions…reduce returns to stockholders, he is spending their money. Insofar
as his actions raise the price to customers, he is spending the customers’ money. Insofar as his actions
lower the wages of some employees, he is spending their money.
This process raises political questions on two levels: principle and consequences. On the level of political
principle, the imposition of taxes and the expenditure of tax proceeds are governmental functions. We
have established elaborate constitutional, parliamentary, and judicial provisions to control these
functions, to assure that taxes are imposed so far as possible in accordance with the preferences and
desires of the public.…
Others have challenged the notion that corporate managers have no real duties except toward the owners
(shareholders). By changing two letters in shareholder, stakeholder theorists widened the range of people
and institutions that a corporation should pay moral consideration to. Thus they contend that a
corporation, through its management, has a set of responsibilities toward nonshareholder interests.

Stakeholder Theory
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Stakeholders of a corporation include its employees, suppliers, customers, and the community.
Stakeholder is a deliberate play on the word shareholder, to emphasize that corporations have obligations
that extend beyond the bottom-line aim of maximizing profits. A stakeholder is anyone who most would
agree is significantly affected (positively or negatively) by the decision of another moral agent.
There is one vital fact about corporations: the corporation is a creation of the law. Without law (and
government), corporations would not have existence. The key concept for corporations is the legal fact of
limited liability. The benefit of limited liability for shareholders of a corporation meant that larger pools of
capital could be aggregated for larger enterprises; shareholders could only lose their investments should
the venture fail in any way, and there would be no personal liability and thus no potential loss of personal
assets other than the value of the corporate stock. Before New Jersey and Delaware competed to make
incorporation as easy as possible and beneficial to the incorporators and founders, those who wanted the
benefits of incorporation had to go to legislatures—usually among the states—to show a public purpose
that the company would serve.
In the late 1800s, New Jersey and Delaware changed their laws to make incorporating relatively easy.
These two states allowed incorporation “for any legal purpose,” rather than requiring some public
purpose. Thus it is government (and its laws) that makes limited liability happen through the corporate
form. That is, only through the consent of the state and armed with the charter granted by the state can a
corporation’s shareholders have limited liability. This is a right granted by the state, a right granted for
good and practical reasons for encouraging capital and innovation. But with this right comes a related
duty, not clearly stated at law, but assumed when a charter is granted by the state: that the corporate form
of doing business is legal because the government feels that it socially useful to do so.
Implicitly, then, there is a social contract between governments and corporations: as long as corporations
are considered socially useful, they can exist. But do they have explicit social responsibilities? Milton
Friedman’s position suggests that having gone along with legal duties, the corporation can ignore any
other social obligations. But there are others (such as advocates of stakeholder theory) who would say
that a corporation’s social responsibilities go beyond just staying within the law and go beyond the

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corporation’s shareholders to include a number of other important stakeholders, those whose lives can be
affected by corporate decisions.
According to stakeholder theorists, corporations (and other business organizations) must pay attention
not only to the bottom line but also to their overall effect on the community. Public perception of a
company’s unfairness, uncaring, disrespect, or lack of trustworthiness often leads to long-term failure,
whatever the short-term successes or profits may be. A socially responsible corporation is likely to
consider the impact of its decisions on a wide range of stakeholders, not just shareholders. As Table 2.1
"The Stakes of Various Stakeholders" indicates, stakeholders have very different kinds of interests
(“stakes”) in the actions of a corporation.
Table 2.1 The Stakes of Various Stakeholders

Managers

Ownership

The value of the organization has a direct impact on the wealth of these
stakeholders.

Directors who
own stock
Shareholders
Salaried
managers
Creditors
Suppliers

Economic
Dependence

Stakeholders can be economically dependent without having ownership.
Each of these stakeholders relies on the corporation in some way for
financial well-being.

Employees
Local
communities
Communities

Social Interests

These stakeholders are not directly linked to the organization but have
an interest in making sure the organization acts in a socially responsible
manner.

Government
Media

Corporate Culture and Codes of Ethics
A corporation is a “person” capable of suing, being sued, and having rights and duties in our legal system.
(It is a legal or juridical person, not a natural person, according to our Supreme Court.) Moreover, many
corporations have distinct cultures and beliefs that are lived and breathed by its members. Often, the

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culture of a corporation is the best defense against individuals within that firm who may be tempted to
break the law or commit serious ethical misdeeds.
What follows is a series of observations about corporations, ethics, and corporate culture.

Ethical Leadership Is Top-Down
People in an organization tend to watch closely what the top managers do and say. Regardless of
managers’ talk about ethics, employees quickly learn what speech or actions are in fact rewarded. If the
CEO is firm about acting ethically, others in the organization will take their cues from him or her. People
at the top tend to set the target, the climate, the beliefs, and the expectations that fuel behavior.

Accountability Is Often Weak
Clever managers can learn to shift blame to others, take credit for others’ work, and move on before
“funny numbers” or other earnings management tricks come to light.

[1]

Again, we see that the manager is

often an agent for himself or herself and will often act more in his or her self-interest than for the
corporate interest.

Killing the Messenger
Where organizations no longer function, inevitably some employees are unhappy. If they call attention to
problems that are being covered up by coworkers or supervisors, they bring bad news. Managers like to
hear good news and discourage bad news. Intentionally or not, those who told on others, or blew the
whistle, have rocked the boat and become unpopular with those whose defalcations they report on and
with the managers who don’t really want to hear the bad news. In many organizations, “killing the
messenger” solves the problem. Consider James Alexander at Enron Corporation, who was deliberately
shut out after bringing problems to CEO Ken Lay’s attention.

[2]

When Sherron Watkins sent Ken Lay a

letter warning him about Enron’s accounting practices, CFO Andrew Fastow tried to fire her.

[3]

Ethics Codes

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Without strong leadership and a willingness to listen to bad news as well as good news, managers do not
have the feedback necessary to keep the organization healthy. Ethics codes have been put in place—partly
in response to federal sentencing guidelines and partly to encourage feedback loops to top management.
The best ethics codes are aspirational, or having an ideal to be pursued, not legalistic or compliance
driven. The Johnson & Johnson ethics code predated the Tylenol scare and the company’s oft-celebrated
corporate response.

[4]

The corporate response was consistent with that code, which was lived and

modeled by the top of the organization.
It’s often noted that a code of ethics is only as important as top management is willing to make it. If the
code is just a document that goes into a drawer or onto a shelf, it will not effectively encourage good
conduct within the corporation. The same is true of any kind of training that the company undertakes,
whether it be in racial sensitivity or sexual harassment. If the message is not continuously reinforced, or
(worse yet) if the message is undermined by management’s actions, the real message to employees is that
violations of the ethics code will not be taken seriously, or that efforts to stop racial discrimination or
sexual harassment are merely token efforts, and that the important things are profits and performance.
The ethics code at Enron seems to have been one of those “3-P” codes that wind up sitting on shelves—
“Print, Post, and Pray.” Worse, the Enron board twice suspended the code in 1999 to allow outside
partnerships to be led by a top Enron executive who stood to gain financially from them.

[5]

Ethics Hotlines and Federal Sentencing Guidelines
The federal sentencing guidelines were enacted in 1991. The original idea behind these guidelines was for
Congress to correct the lenient treatment often given to white-collar, or corporate, criminals. The
guidelines require judges to consider “aggravating and mitigating” factors in determining sentences and
fines. (While corporations cannot go to jail, its officers and managers certainly can, and the corporation
itself can be fined. Many companies will claim that it is one bad apple that has caused the problem; the
guidelines invite these companies to show that they are in fact tending their orchard well. They can show
this by providing evidence that they have (1) a viable, active code of ethics; (2) a way for employees to
report violations of law or the ethics code; and (3) an ethics ombudsman, or someone who oversees the
code.

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In short, if a company can show that it has an ongoing process to root out wrongdoing at all levels of the
company, the judge is allowed to consider this as a major mitigating factor in the fines the company will
pay. Most Fortune 500 companies have ethics hotlines and processes in place to find legal and ethical
problems within the company.

Managing by the Numbers
If you manage by the numbers, there is a temptation to lie about those numbers, based on the need to get
stock price ever higher. At Enron, “15 percent a year or better earnings growth” was the mantra. Jeffrey
Pfeffer, professor of organizational behavior at Stanford University, observes how the belief that “stock
price is all that matters” has been hardwired into the corporate psyche. It dictates not only how people
judge the worth of their company but also how they feel about themselves and the work that they are
doing. And, over time, it has clouded judgments about what is acceptable corporate behavior.

[6]

Managing by Numbers: The Sears Auto Center Story
If winning is the most important thing in your life, then you must be prepared to do anything to win.
—Michael Josephson
Most people want to be winners or associate with winners. As humans, our desire to associate with those
who have status provides plenty of incentive to glorify winners and ignore losers. But if an individual, a
team, or a company does whatever it takes to win, then all other values are thrown out in the goal to win
at all costs. The desire of some people within Sears & Roebuck Company’s auto repair division to win by
gaining higher profits resulted in the situation portrayed here.
Sears Roebuck & Company has been a fixture in American retailing throughout the twentieth century. At
one time, people in rural America could order virtually anything (including a house) from Sears. Not
without some accuracy, the company billed itself as “the place where Americans shop.” But in 1992, Sears
was charged by California authorities with gross and deliberate fraud in many of its auto centers.

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The authorities were alerted by a 50 percent increase in consumer complaints over a three-year period.
New Jersey’s division of consumer affairs also investigated Sears Auto Centers and found that all six
visited by investigators had recommended unnecessary repairs. California’s department of consumer
affairs found that Sears had systematically overcharged by an average of $223 for repairs and routinely
billed for work that was not done. Sears Auto Centers were the largest providers of auto repair services in
the state.
The scam was a variant on the old bait-and-switch routine. Customers received coupons in the mail
inviting them to take advantage of hefty discounts on brake jobs. When customers came in to redeem
their coupons, sales staffers would convince them to authorize additional repairs. As a management tool,
Sears had also established quotas for each of their sales representatives to meet.
Ultimately, California got Sears to settle a large number of lawsuits against it by threatening to revoke
Sears’ auto repair license. Sears agreed to distribute $50 coupons to nearly a million customers
nationwide who had obtained certain services between August 1, 1990, and January 31, 1992. Sears also
agreed to pay $3.5 million to cover the costs of various government investigations and to contribute $1.5
million annually to conduct auto mechanic training programs. It also agreed to abandon its repair service
quotas. The entire settlement cost Sears $30 million. Sears Auto Center sales also dropped about 15 to 20
percent after news of the scandal broke.
Note that in boosting sales by performing unnecessary services, Sears suffered very bad publicity. Losses
were incalculable. The short-term gains were easy to measure; long-term consequences seldom are. The
case illustrates a number of important lessons:
•

People generally choose short-term gains over potential long-term losses.

•

People often justify the harm to others as being minimal or “necessary” to achieve the desired
sales quota or financial goal.

•

In working as a group, we often form an “us versus them” mentality. In the Sears case, it is likely
that Sears “insiders” looked at customers as “outsiders,” effectively treating them (in Kantian
terms) as means rather than ends in themselves. In short, outsiders were used for the benefit of
insiders.

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•

The long-term losses to Sears are difficult to quantify, while the short-term gains were easy to
measure and (at least for a brief while) quite satisfying financially.

•

Sears’ ongoing rip-offs were possible only because individual consumers lacked the relevant
information about the service being offered. This lack of information is a market failure, since
many consumers were demanding more of Sears Auto Center services than they would have (and
at a higher price) if relevant information had been available to them earlier. Sears, like other
sellers of goods and services, took advantage of a market system, which, in its ideal form, would
not permit such information distortions.

•

People in the organization probably thought that the actions they took were necessary.

Noting this last point, we can assume that these key people were motivated by maximizing profits and had
lost sight of other goals for the organization.
The emphasis on doing whatever is necessary to win is entirely understandable, but it is not ethical. The
temptation will always exist—for individuals, companies, and nations—to dominate or to win and to write
the history of their actions in a way that justifies or overlooks the harm that has been done. In a way, this
fits with the notion that “might makes right,” or that power is the ultimate measure of right and wrong.

Conscious Capitalism
One effort to integrate the two viewpoints of stakeholder theory and shareholder primacy is the conscious
capitalism movement. Companies that practice conscious capitalism embrace the idea that profit and
prosperity can and must go hand in hand with social justice and environmental stewardship. They operate
with a holistic or systems view. This means that they understand that all stakeholders are connected and
interdependent. They reject false trade-offs between stakeholder interests and strive for creative ways to
achieve win-win-win outcomes for all.

[7]

The “conscious business” has a purpose that goes beyond maximizing profits. It is designed to maximize
profits but is focused more on its higher purpose and does not fixate solely on the bottom line. To do so, it
focuses on delivering value to all its stakeholders, harmonizing as best it can the interests of consumers,
partners, investors, the community, and the environment. This requires that company managers take a

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“servant leadership” role, serving as stewards to the company’s deeper purpose and to the company’s
stakeholders.
Conscious business leaders serve as such stewards, focusing on fulfilling the company’s purpose,
delivering value to its stakeholders, and facilitating a harmony of interests, rather than on personal gain
and self-aggrandizement. Why is this refocusing needed? Within the standard profit-maximizing model,
corporations have long had to deal with the “agency problem.” Actions by top-level managers—acting on
behalf of the company—should align with the shareholders, but in a culture all about winning and money,
managers sometimes act in ways that are self-aggrandizing and that do not serve the interests of
shareholders. Laws exist to limit such self-aggrandizing, but the remedies are often too little and too late
and often catch only the most egregious overreaching. Having a culture of servant leadership is a much
better way to see that a company’s top management works to ensure a harmony of interests.

[1] See Robert Jackall, Moral Mazes: The World of Corporate Managers (New York: Oxford University Press, 1988).
[2] John Schwartz, “An Enron Unit Chief Warned, and Was Rebuffed,” New York Times, February 20, 2002.
[3] Warren Bennis, “A Corporate Fear of Too Much Truth,” New York Times, February 17, 2002.
[4] University of Oklahoma Department of Defense Joint Course in Communication, Case Study: The Johnson &
Johnson Tylenol Crisis, accessed April 5, 2011.
[5] FindLaw, Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron Corp.,
February 1, 2002, accessed April 5, 2011,http://news.findlaw.com/wsj/docs/enron/sicreport.
[6] Steven Pearlstein, “Debating the Enron Effect,” Washington Post, February 17, 2002.
[7] Milton Friedman, John Mackey, and T. J. Rodgers, “Rethinking the Social Responsibility of Business,”
Reason.com, October 2005,http://reason.com/archives/2005/10/01/rethinking-the-social-responsi.

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2.5 Summary and Exercises
Summary
Doing good business requires attention to ethics as well as law. Understanding the long-standing
perspectives on ethics—utilitarianism, deontology, social contract, and virtue ethics—is helpful in sorting
out the ethical issues that face us as individuals and businesses. Each business needs to create or maintain
a culture of ethical excellence, where there is ongoing dialogue not only about the best technical practices
but also about the company’s ethical challenges and practices. A firm that has purpose and passion
beyond profitability is best poised to meet the needs of diverse stakeholders and can best position itself
for long-term, sustainable success for shareholders and other stakeholders as well.

EXERCISES
1.

Consider again Milton Friedman’s article.

a.

What does Friedman mean by “ethical custom”?

b.

If the laws of the society are limiting the company’s profitability, would the company be within its
rights to disobey the law?

c.

What if the law is “on the books,” but the company could count on a lack of enforcement from state
officials who were overworked and underpaid? Should the company limit its profits? Suppose that it
could save money by discharging a pollutant into a nearby river, adversely affecting fish and,
potentially, drinking water supplies for downstream municipalities. In polluting against laws that
aren’t enforced, is it still acting “within the rules of the game”? What if almost all other companies in
the industry were saving money by doing similar acts?
Consider again the Harris v. Forklift case at the end of Chapter 1 "Introduction to Law and Legal
Systems". The Supreme Court ruled that Ms. Harris was entitled to be heard again by the federal
district court, which means that there would be a trial on her claim that Mr. Hardy, owner of Forklift
Systems, had created a “hostile working environment” for Ms. Harris. Apart from the legal aspects,
did he really do anything unethical? How can you tell?
a.

Which of his actions, if any, were contrary to utilitarian thinking?

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b.

If Kant were his second-in-command and advising him on ethical matters, would he have approved of
Mr. Hardy’s behavior? Why or why not?
Consider the behaviors alleged by Ms. Harris and assume for a moment that they are all true. In
terms of core values, which of these behaviors are not consistent with the core values Josephson
points to? Be specific.
Assume that Forklift Systems is a large public corporation and that the CEO engages in these
kinds of behaviors. Assume also that the board of directors knows about it. What action should the
board take, and why?
Assume that the year is 1963, prior to the passage of the Civil Rights Act of 1964 and the Title VII
provisions regarding equal employment opportunity that prohibit discrimination based on sex. So,
Mr. Hardy’s actions are not illegal, fraudulent, or deceitful. Assume also that he heads a large public
company and that there is a large amount of turnover and unhappiness among the women who work
for the company. No one can sue him for being sexist or lecherous, but are his actions consistent with
maximizing shareholder returns? Should the board be concerned?
Notice that this question is really a stand-in for any situation faced by a company today regarding its
CEO where the actions are not illegal but are ethically questionable. What would conscious capitalism
tell a CEO or a board to do where some group of its employees are regularly harassed or
disadvantaged by top management?

SELF-TEST QUESTIONS
1.

Milton Friedman would have been most likely to agree to which of the following statements?
a.

The purpose of the corporation is to find a path to sustainable corporate profits by paying careful

attention to key stakeholders.
b.

The business of business is business.

c.

The CEO and the board should have a single-minded focus on delivering maximum value to

shareholders of the business.
d.

All is fair in love, war, and business.
Milton Friedman meant (using the material quoted in this chapter) that companies should

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a.

Find a path to sustainable profits by looking at the interconnected needs and desires of all the
stakeholders.

b.

Always remember that the business of business is business.

c.

Remind the CEO that he or she has one duty: to maximize shareholder wealth by any means possible.

d.

Maximize shareholder wealth by engaging in open competition without fraud or deceit.
What are some key drawbacks to utilitarian thinking at the corporate level?

a.

The corporation may do a cost-benefit analysis that puts the greatest good of the firm above all other
considerations.

b.

It is difficult to predict future consequences; decision makers in for-profit organizations will tend to
overestimate the upside of certain decisions and underestimate the downside.

c.

Short-term interests will be favored over long-term consequences.

d.

all of the above

e.

a and b only
Which ethical perspective would allow that under certain circumstances, it might be ethical to lie

to a liar?
a.

deontology

b.

virtue ethics

c.

utilitarianism

d.

all of the above
Under conscious capitalism,

a.

Virtue ethics is ignored.

b.

Shareholders, whether they be traders or long-term investors, are always the first and last
consideration for the CEO and the board.

c.

Maximizing profits comes from a focus on higher purposes and harmonizing the interests of various
stakeholders.

d.

Kantian duties take precedence over cost-benefit analyses.

SELF-TEST ANSWERS
1.

c

2.

d

3.

d

4.

c

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5.

c

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Chapter 3

Courts and the Legal Process
LEARNING OBJECTIVES
After reading this chapter, you should be able to do the following:
1.

Describe the two different court systems in the United States, and explain why some cases can
be filed in either court system.

2.

Explain the importance of subject matter jurisdiction and personal jurisdiction and know the
difference between the two.

3.

Describe the various stages of a civil action: from pleadings, to discovery, to trial, and to appeals.

4.

Describe two alternatives to litigation: mediation and arbitration.

In the United States, law and government are interdependent. The Constitution establishes the basic
framework of government and imposes certain limitations on the powers of government. In turn, the
various branches of government are intimately involved in making, enforcing, and interpreting the law.
Today, much of the law comes from Congress and the state legislatures. But it is in the courts that
legislation is interpreted and prior case law is interpreted and applied.
As we go through this chapter, consider the case of Harry and Kay Robinson. In which court should the
Robinsons file their action? Can the Oklahoma court hear the case and make a judgment that will be
enforceable against all of the defendants? Which law will the court use to come to a decision? Will it use
New York law, Oklahoma law, federal law, or German law?

Robinson v. Audi
Harry and Kay Robinson purchased a new Audi automobile from Seaway Volkswagen, Inc. (Seaway), in
Massena, New York, in 1976. The following year the Robinson family, who resided in New York, left that
state for a new home in Arizona. As they passed through Oklahoma, another car struck their Audi in the
rear, causing a fire that severely burned Kay Robinson and her two children. Later on, the Robinsons
brought a products-liability action in the District Court for Creek County, Oklahoma, claiming that their

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injuries resulted from the defective design and placement of the Audi’s gas tank and fuel system. They
sued numerous defendants, including the automobile’s manufacturer, Audi NSU Auto Union
Aktiengesellschaft (Audi); its importer, Volkswagen of America, Inc. (Volkswagen); its regional
distributor, World-Wide Volkswagen Corp. (World-Wide); and its retail dealer, Seaway.
Should the Robinsons bring their action in state court or in federal court? Over which of the defendants
will the court have personal jurisdiction?

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3.1 The Relationship between State and Federal Court Systems
in the United States
LEARNING OBJECTIVES
1.

Understand the different but complementary roles of state and federal court systems.

2.

Explain why it makes sense for some courts to hear and decide only certain kinds of cases.

3.

Describe the difference between a trial court and an appellate court.

Although it is sometimes said that there are two separate court systems, the reality is more complex.
There are, in fact, fifty-two court systems: those of the fifty states, the local court system in the District of
Columbia, and the federal court system. At the same time, these are not entirely separate; they all have
several points of contact.
State and local courts must honor both federal law and the laws of the other states. First, state courts must
honor federal law where state laws are in conflict with federal laws (under the supremacy clause of the
Constitution; see Chapter 4 "Constitutional Law and US Commerce"). Second, claims arising under
federal statutes can often be tried in the state courts, where the Constitution or Congress has not explicitly
required that only federal courts can hear that kind of claim. Third, under the full faith and credit clause,
each state court is obligated to respect the final judgments of courts in other states. Thus a contract
dispute resolved by an Arkansas court cannot be relitigated in North Dakota when the plaintiff wants to
collect on the Arkansas judgment in North Dakota. Fourth, state courts often must consider the laws of
other states in deciding cases involving issues where two states have an interest, such as when drivers
from two different states collide in a third state. Under these circumstances, state judges will consult their
own state’s case decisions involving conflicts of laws and sometimes decide that they must apply another
state’s laws to decide the case (see Table 3.1 "Sample Conflict-of-Law Principles").
As state courts are concerned with federal law, so federal courts are often concerned with state law and
with what happens in state courts. Federal courts will consider state-law-based claims when a case
involves claims using both state and federal law. Claims based on federal laws will permit the federal court
to take jurisdiction over the whole case, including any state issues raised. In those cases, the federal court
is said to exercise “pendent jurisdiction” over the state claims. Also, the Supreme Court will occasionally

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take appeals from a state supreme court where state law raises an important issue of federal law to be
decided. For example, a convict on death row may claim that the state’s chosen method of execution using
the injection of drugs is unusually painful and involves “cruel and unusual punishment,” raising an Eighth
Amendment issue.
There is also a broad category of cases heard in federal courts that concern only state legal issues—
namely, cases that arise between citizens of different states. The federal courts are permitted to hear these
cases under their so-called diversity of citizenship jurisdiction (or diversity jurisdiction). A citizen of
New Jersey may sue a citizen of New York over a contract dispute in federal court, but if both were
citizens of New Jersey, the plaintiff would be limited to the state courts. The Constitution established
diversity jurisdiction because it was feared that local courts would be hostile toward people from other
states and that they would need separate courts. In 2009, nearly a third of all lawsuits filed in federal
court were based on diversity of citizenship. In these cases, the federal courts were applying state law,
rather than taking federal question jurisdiction, where federal law provided the basis for the lawsuit
or where the United States was a party (as plaintiff or defendant).
Why are there so many diversity cases in federal courts? Defense lawyers believe that there is sometimes a
“home-court advantage” for an in-state plaintiff who brings a lawsuit against a nonresident in his local
state court. The defense attorney is entitled to ask for removal to a federal court where there is diversity.
This fits with the original reason for diversity jurisdiction in the Constitution—the concern that judges in
one state court would favor the in-state plaintiff rather than a nonresident defendant. Another reason
there are so many diversity cases is that plaintiffs’ attorneys know that removal is common and that it will
move the case along faster by filing in federal court to begin with. Some plaintiffs’ attorneys also find
advantages in pursuing a lawsuit in federal court. Federal court procedures are often more efficient than
state court procedures, so that federal dockets are often less crowded. This means a case will get to trial
faster, and many lawyers enjoy the higher status that comes in practicing before the federal bench. In
some federal districts, judgments for plaintiffs may be higher, on average, than in the local state court. In
short, not only law but also legal strategy factor into the popularity of diversity cases in federal courts.

State Court Systems
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The vast majority of civil lawsuits in the United States are filed in state courts. Two aspects of civil
lawsuits are common to all state courts: trials and appeals. A court exercising a trial function
has original jurisdiction—that is, jurisdiction to determine the facts of the case and apply the law to
them. A court that hears appeals from the trial court is said to have appellate jurisdiction—it must
accept the facts as determined by the trial court and limit its review to the lower court’s theory of the
applicable law.

Limited Jurisdiction Courts
In most large urban states and many smaller states, there are four and sometimes five levels of courts. The
lowest level is that of the limited jurisdiction courts. These are usually county or municipal courts with
original jurisdiction to hear minor criminal cases (petty assaults, traffic offenses, and breach of peace,
among others) and civil cases involving monetary amounts up to a fixed ceiling (no more than $10,000 in
most 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.
One familiar limited jurisdiction court is the small claims court, with jurisdiction to hear civil cases
involving claims for amounts ranging between $1,000 and $5,000 in about half the states and for
considerably less in the other states ($500 to $1,000). The advantage of the small claims court is that its
procedures are informal, it is often located in a neighborhood outside the business district, it is usually
open after business hours, and it is speedy. Lawyers are not necessary to present the case and in some
states are not allowed to appear in court.

General Jurisdiction Courts
All other civil and criminal cases are heard in the general trial courts, or courts of general jurisdiction.
These go by a variety of names: superior, circuit, district, or common pleas court (New York calls its
general trial court the supreme court). These are the courts in which people seek redress for incidents
such as automobile accidents and injuries, or breaches of contract. These state courts also prosecute those
accused of murder, rape, robbery, and other serious crimes. The fact finder in these general jurisdiction
courts is not a judge, as in the lower courts, but a jury of citizens.

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Although courts of general jurisdiction can hear all types of cases, in most states more than half involve
family matters (divorce, child custody disputes, and the like). A third were commercial cases, and slightly
over 10 percent were devoted to car accident cases and other torts (as discussed in Chapter 7
"Introduction to Tort Law").
Most states have specialized courts that hear only a certain type of case, such as landlord-tenant disputes
or probate of wills. Decisions by judges in specialized courts are usually final, although any party
dissatisfied with the outcome may be able to get a new trial in a court of general jurisdiction. Because
there has been one trial already, this is known as a trial de novo. It is not an appeal, since the case
essentially starts over.

Appellate Courts
The losing party in a general jurisdiction court can almost always appeal to either one or two higher
courts. These intermediate appellate courts—usually called courts of appeal—have been established in
forty states. They do not retry the evidence, but rather determine whether the trial was conducted in a
procedurally correct manner and whether the appropriate law was applied. For example, the appellant
(the losing party who appeals) might complain that the judge wrongly instructed the jury on the meaning
of the law, or improperly allowed testimony of a particular witness, or misconstrued the law in question.
The appellee (who won in the lower court) will ask that the appellant be denied—usually this means that
the appellee wants the lower-court judgment affirmed. The appellate court has quite a few choices: it can
affirm, modify, reverse, or reverse and remand the lower court (return the case to the lower court for
retrial).
The last type of appeal within the state courts system is to the highest court, the state supreme court,
which is composed of a single panel of between five and nine judges and is usually located in the state
capital. (The intermediate appellate courts are usually composed of panels of three judges and are situated
in various locations around the state.) In a few states, the highest court goes by a different name: in New
York, it is known as the court of appeals. In certain cases, appellants to the highest court in a state have
the right to have their appeals heard, but more often the supreme court selects the cases it wishes to hear.
For most litigants, the ruling of the state supreme court is final. In a relatively small class of cases—those

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in which federal constitutional claims are made—appeal to the US Supreme Court to issue
a writ of certiorari remains a possibility.

The Federal Court System
District Courts
The federal judicial system is uniform throughout the United States and consists of three levels. At the
first level are the federal district courts, which are the trial courts in the federal system. Every state has
one or more federal districts; the less populous states have one, and the more populous states (California,
Texas, and New York) have four. The federal court with the heaviest commercial docket is the US District
Court for the Southern District of New York (Manhattan). There are forty-four district judges and fifteen
magistrates in this district. The district judges throughout the United States commonly preside over all
federal trials, both criminal and civil.

Courts of Appeal
Cases from the district courts can then be appealed to the circuit courts of appeal, of which there are
thirteen (Figure 3.1 "The Federal Judicial Circuits"). Each circuit oversees the work of the district courts in
several states. For example, the US Court of Appeals for the Second Circuit hears appeals from district
courts in New York, Connecticut, and Vermont. The US Court of Appeals for the Ninth Circuit hears
appeals from district courts in California, Oregon, Nevada, Montana, Washington, Idaho, Arizona, Alaska,
Hawaii, and Guam. The US Court of Appeals for the District of Columbia Circuit hears appeals from the
district court in Washington, DC, as well as from numerous federal administrative agencies (see Chapter 5
"Administrative Law"). The US Court of Appeals for the Federal Circuit, also located in Washington, hears
appeals in patent and customs cases. Appeals are usually heard by three-judge panels, but sometimes
there will be a rehearing at the court of appeals level, in which case all judges sit to hear the case “en
banc.”
There are also several specialized courts in the federal judicial system. These include the US Tax Court,
the Court of Customs and Patent Appeals, and the Court of Claims.

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United States Supreme Court
Overseeing all federal courts is the US Supreme Court, in Washington, DC. It consists of nine justices—the
chief justice and eight associate justices. (This number is not constitutionally required; Congress can
establish any number. It has been set at nine since after the Civil War.) The Supreme Court has selective
control over most of its docket. By law, the cases it hears represent only a tiny fraction of the cases that are
submitted. In 2008, the Supreme Court had numerous petitions (over 7,000, not including thousands of
petitions from prisoners) but heard arguments in only 87 cases. The Supreme Court does not sit in panels.
All the justices hear and consider each case together, unless a justice has a conflict of interest and must
withdraw from hearing the case.
Figure 3.1 The Federal Judicial Circuits

Federal judges—including Supreme Court justices—are nominated by the president and must be
confirmed by the Senate. Unlike state judges, who are usually elected and preside for a fixed term of years,
federal judges sit for life unless they voluntarily retire or are impeached.

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KEY TAKEAWAY
Trial courts and appellate courts have different functions. State trial courts sometimes hear cases with federal
law issues, and federal courts sometimes hear cases with state law issues. Within both state and federal court
systems, it is useful to know the different kinds of courts and what cases they can decide.

EXERCISES
1.

Why all of this complexity? Why don’t state courts hear only claims based on state law, and federal courts
only federal-law-based claims?

2.

Why would a plaintiff in Iowa with a case against a New Jersey defendant prefer to have the case heard in
Iowa?

3.

James, a New Jersey resident, is sued by Jonah, an Iowa resident. After a trial in which James appears and
vigorously defends himself, the Iowa state court awards Jonah $136,750 dollars in damages for his tort
claim. In trying to collect from James in New Jersey, Jonah must have the New Jersey court certify the
Iowa judgment. Why, ordinarily, must the New Jersey court do so?

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3.2 The Problem of Jurisdiction
LEARNING OBJECTIVES
1.

Explain the concept of subject matter jurisdiction and distinguish it from personal jurisdiction.

2.

Understand how and where the US Constitution provides a set of instructions as to what federal courts
are empowered by law to do.

3.

Know which kinds of cases must be heard in federal courts only.

4.

Explain diversity of citizenship jurisdiction and be able to decide whether a case is eligible for diversity
jurisdiction in the federal courts.

Jurisdiction is an essential concept in understanding courts and the legal system. Jurisdiction is a
combination of two Latin words: juris (law) and diction(to speak). Which court has the power “to speak
the law” is the basic question of jurisdiction.
There are two questions about jurisdiction in each case that must be answered before a judge will hear a
case: the question of subject matter jurisdiction and the question of personal jurisdiction. We will
consider the question of subject matter jurisdiction first, because judges do; if they determine, on the
basis of the initial documents in the case (the “pleadings”), that they have no power to hear and decide
that kind of case, they will dismiss it.

The Federal-State Balance: Federalism
State courts have their origins in colonial era courts. After the American Revolution, state courts
functioned (with some differences) much like they did in colonial times. The big difference after 1789 was
that state courts coexisted with federal courts. Federalism was the system devised by the nation’s
founders in which power is shared between states and the federal government. This sharing requires a
division of labor between the states and the federal government. It is Article III of the US Constitution
that spells out the respective spheres of authority (jurisdiction) between state and federal courts.
Take a close look at Article III of the Constitution. (You can find a printable copy of the Constitution
at http://www.findlaw.com.) Article III makes clear that federal courts are courts of limited power or
jurisdiction. Notice that the only kinds of cases federal courts are authorized to deal with have strong

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federal connections. For example, federal courts have jurisdiction when a federal law is being used by the
plaintiff or prosecutor (a “federal question” case) or the case arises “in admiralty” (meaning that the
problem arose not on land but on sea, beyond the territorial jurisdiction of any state, or in navigable
waters within the United States). Implied in this list is the clear notion that states would continue to have
their own laws, interpreted by their own courts, and that federal courts were needed only where the issues
raised by the parties had a clear federal connection. The exception to this is diversity jurisdiction,
discussed later.
The Constitution was constructed with the idea that state courts would continue to deal with basic kinds
of claims such as tort, contract, or property claims. Since states sanction marriages and divorce, state
courts would deal with “domestic” (family) issues. Since states deal with birth and death records, it stands
to reason that paternity suits, probate disputes, and the like usually wind up in state courts. You wouldn’t
go to the federal building or courthouse to get a marriage license, ask for a divorce, or probate a will: these
matters have traditionally been dealt with by the states (and the thirteen original colonies before them).
Matters that historically get raised and settled in state court under state law include not only domestic and
probate matters but also law relating to corporations, partnerships, agency, contracts, property, torts, and
commercial dealings generally. You cannot get married or divorced in federal court, because federal
courts have no jurisdiction over matters that are historically (and are still) exclusively within the domain
of state law.
In terms of subject matter jurisdiction, then, state courts will typically deal with the kinds of disputes just
cited. Thus if you are Michigan resident and have an auto accident in Toledo with an Ohio resident and
you each blame each other for the accident, the state courts would ordinarily resolve the matter if the
dispute cannot otherwise be settled. Why state courts? Because when you blame one another and allege
that it’s the other person’s fault, you have the beginnings of a tort case, with negligence as a primary
element of the claim, and state courts have routinely dealt with this kind of claim, from British colonial
times through Independence and to the present. (See also Chapter 7 "Introduction to Tort Law"of this
text.) People have had a need to resolve this kind of dispute long before our federal courts were created,
and you can tell from Article III that the founders did not specify that tort or negligence claims should be
handled by the federal courts. Again, federal courts are courts of limited jurisdiction, limited to the kinds

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of cases specified in Article III. If the case before the federal court does not fall within one of those
categories, the federal court cannot constitutionally hear the case because it does not have subject matter
jurisdiction.
Always remember: a court must have subject matter jurisdiction to hear and decide a case. Without it, a
court cannot address the merits of the controversy or even take the next jurisdictional step of figuring out
which of the defendants can be sued in that court. The question of which defendants are appropriately
before the court is a question of personal jurisdiction.
Because there are two court systems, it is important for a plaintiff to file in the right court to begin with.
The right court is the one that has subject matter jurisdiction over the case—that is, the power to hear and
decide the kind of case that is filed. Not only is it a waste of time to file in the wrong court system and be
dismissed, but if the dismissal comes after the filing period imposed by the
applicable statute of limitations, it will be too late to refile in the correct court system. Such cases will
be routinely dismissed, regardless of how deserving the plaintiff might be in his quest for justice. (The
plaintiff’s only remedy at that point would be to sue his lawyer for negligence for failing to mind the clock
and get to the right court in time!)

Exclusive Jurisdiction in Federal Courts
With two court systems, a plaintiff (or the plaintiff’s attorney, most likely) must decide whether to file a
case in the state court system or the federal court system. Federal courts have exclusive jurisdiction over
certain kinds of cases. The reason for this comes directly from the Constitution. Article III of the US
Constitution provides the following:
The judicial Power shall extend to all Cases, in Law and Equity, arising under this Constitution, the Laws
of the United States, and Treaties made, or which shall be made, under their Authority; to all Cases
affecting Ambassadors, other public Ministers and Consuls; to all Cases of admiralty and maritime
Jurisdiction; to Controversies to which the United States shall be a Party; to Controversies between two or
more States; between a State and Citizens of another State; between Citizens of different States; between

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Citizens of the same State claiming Lands under Grants of different States, and between a State, or the
Citizens thereof, and foreign States, Citizens or Subjects.
By excluding diversity cases, we can assemble a list of the kinds of cases that can only be heard in federal
courts. The list looks like this:
1.

Suits between states. Cases in which two or more states are a party.

2. Cases involving ambassadors and other high-ranking public figures. Cases arising between
foreign ambassadors and other high-ranking public officials.
3. Federal crimes. Crimes defined by or mentioned in the US Constitution or those defined or
punished by federal statute. Such crimes include treason against the United States, piracy,
counterfeiting, crimes against the law of nations, and crimes relating to the federal government’s
authority to regulate interstate commerce. However, most crimes are state matters.
4. Bankruptcy. The statutory procedure, usually triggered by insolvency, by which a person is
relieved of most debts and undergoes a judicially supervised reorganization or liquidation for the
benefit of the person’s creditors.
5.

Patent, copyright, and trademark cases
a.

Patent. The exclusive right to make, use, or sell an invention for a specified period (usually
seventeen years), granted by the federal government to the inventor if the device or process is
novel, useful, and nonobvious.

b. Copyright. The body of law relating to a property right in an original work of authorship
(such as a literary, musical, artistic, photographic, or film work) fixed in any tangible medium
of expression, giving the holder the exclusive right to reproduce, adapt, distribute, perform,
and display the work.
c.

Trademark. A word, phrase, logo, or other graphic symbol used by a manufacturer or seller to
distinguish its product or products from those of others.

6. Admiralty. The system of laws that has grown out of the practice of admiralty courts: courts that
exercise jurisdiction over all maritime contracts, torts, injuries, and offenses.

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7.

Antitrust. Federal laws designed to protect trade and commerce from restraining monopolies,
price fixing, and price discrimination.

8. Securities and banking regulation. The body of law protecting the public by regulating the
registration, offering, and trading of securities and the regulation of banking practices.
9. Other cases specified by federal statute. Any other cases specified by a federal statute where
Congress declares that federal courts will have exclusive jurisdiction.

Concurrent Jurisdiction
When a plaintiff takes a case to state court, it will be because state courts typically hear that kind of case
(i.e., there is subject matter jurisdiction). If the plaintiff’s main cause of action comes from a certain
state’s constitution, statutes, or court decisions, the state courts have subject matter jurisdiction over the
case. If the plaintiff’s main cause of action is based on federal law (e.g., Title VII of the Civil Rights Act of
1964), the federal courts have subject matter jurisdiction over the case. But federal courts will also have
subject matter jurisdiction over certain cases that have only a state-based cause of action; those cases are
ones in which the plaintiff(s) and the defendant(s) are from different states and the amount in
controversy is more than $75,000. State courts can have subject matter jurisdiction over certain cases that
have only a federal-based cause of action. The Supreme Court has now made clear that state courts
have concurrent jurisdiction of any federal cause of action unless Congress has given exclusive
jurisdiction to federal courts.
In short, a case with a federal question can be often be heard in either state or federal court, and a case
that has parties with a diversity of citizenship can be heard in state courts or in federal courts where the
tests of complete diversity and amount in controversy are met. (See Note 3.18 "Summary of Rules on
Subject Matter Jurisdiction".)
Whether a case will be heard in a state court or moved to a federal court will depend on the parties. If a
plaintiff files a case in state trial court where concurrent jurisdiction applies, a defendant may (or may
not) ask that the case be removed to federal district court.

Summary of Rules on Subject Matter Jurisdiction
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1.

A court must always have subject matter jurisdiction, and personal jurisdiction over at least one
defendant, to hear and decide a case.

2. A state court will have subject matter jurisdiction over any case that is not required to be brought
in a federal court.
Some cases can only be brought in federal court, such as bankruptcy cases, cases involving federal
crimes, patent cases, and Internal Revenue Service tax court claims. The list of cases for exclusive
federal jurisdiction is fairly short. That means that almost any state court will have subject matter
jurisdiction over almost any kind of case. If it’s a case based on state law, a state court will always
have subject matter jurisdiction.
3. A federal court will have subject matter jurisdiction over any case that is either based on a federal
law (statute, case, or US Constitution)
OR
A federal court will have subject matter jurisdiction over any case based on state law where the
parties are (1) from different states and (2) the amount in controversy is at least $75,000.
(1) The different states requirement means that no plaintiff can have permanent residence in a
state where any defendant has permanent residence—there must be complete diversity of
citizenship as between all plaintiffs and defendants.
(2) The amount in controversy requirement means that a good-faith estimate of the amount the
plaintiff may recover is at least $75,000.
NOTE: For purposes of permanent residence, a corporation is considered a resident where it is
incorporated AND where it has a principal place of business.
4. In diversity cases, the following rules apply.
(1) Federal civil procedure rules apply to how the case is conducted before and during trial and
any appeals, but
(2) State law will be used as the basis for a determination of legal rights and responsibilities.

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(a) This “choice of law” process is interesting but complicated. Basically, each state has its own set
of judicial decisions that resolve conflict of laws. For example, just because A sues B in a Texas
court, the Texas court will not necessarily apply Texas law. Anna and Bobby collide and suffer
serious physical injuries while driving their cars in Roswell, New Mexico. Both live in Austin, and
Bobby files a lawsuit in Austin. The court there could hear it (having subject matter jurisdiction
and personal jurisdiction over Bobby) but would apply New Mexico law, which governs motor
vehicle laws and accidents in New Mexico. Why would the Texas judge do that?
(b) The Texas judge knows that which state’s law is chosen to apply to the case can make a
decisive difference in the case, as different states have different substantive law standards. For
example, in a breach of contract case, one state’s version of the Uniform Commercial Code may be
different from another’s, and which one the court decides to apply is often exceedingly good for
one side and dismal for the other. In Anna v. Bobby, if Texas has one kind of comparative
negligence statute and New Mexico has a different kind of comparative negligence statute, who
wins or loses, or how much is awarded, could well depend on which law applies. Because both
were under the jurisdiction of New Mexico’s laws at the time, it makes sense to apply New Mexico
law.
(3) Why do some nonresident defendants prefer to be in federal court?
(a) In the state court, the judge is elected, and the jury may be familiar with or sympathetic to the
“local” plaintiff.
(b) The federal court provides a more neutral forum, with an appointed, life-tenured judge and a
wider pool of potential jurors (drawn from a wider geographical area).
(4) If a defendant does not want to be in state court and there is diversity, what is to be done?
(a) Make a motion for removal to the federal court.
(b) The federal court will not want to add to its caseload, or docket, but must take the case unless
there is not complete diversity of citizenship or the amount in controversy is less than $75,000.

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To better understand subject matter jurisdiction in action, let’s take an example. Wile E. Coyote wants a
federal judge to hear his products-liability action against Acme, Inc., even though the action is based on
state law. Mr. Coyote’s attorney wants to “make a federal case” out of it, thinking that the jurors in the
federal district court’s jury pool will understand the case better and be more likely to deliver a “high value”
verdict for Mr. Coyote. Mr. Coyote resides in Arizona, and Acme is incorporated in the state of Delaware
and has its principal place of business in Chicago, Illinois. The federal court in Arizona can hear and
decide Mr. Coyote’s case (i.e., it has subject matter jurisdiction over the case) because of diversity of
citizenship. If Mr. Coyote was injured by one of Acme’s defective products while chasing a roadrunner in
Arizona, the federal district court judge would hear his action—using federal procedural law—and decide
the case based on the substantive law of Arizona on product liability.
But now change the facts only slightly: Acme is incorporated in Delaware but has its principal place of
business in Phoenix, Arizona. Unless Mr. Coyote has a federal law he is using as a basis for his claims
against Acme, his attempt to get a federal court to hear and decide the case will fail. It will fail because
there is not complete diversity of citizenship between the plaintiff and the defendant.

Robinson v. Audi
Now consider Mr. and Mrs. Robinson and their products-liability claim against Seaway Volkswagen and
the other three defendants. There is no federal products-liability law that could be used as a cause of
action. They are most likely suing the defendants using products-liability law based on common-law
negligence or common-law strict liability law, as found in state court cases. They were not yet Arizona
residents at the time of the accident, and their accident does not establish them as Oklahoma residents,
either. They bought the vehicle in New York from a New York–based retailer. None of the other
defendants is from Oklahoma.
They file in an Oklahoma state court, but how will they (their attorney or the court) know if the state court
has subject matter jurisdiction? Unless the case is required to be in a federal court (i.e., unless the federal
courts have exclusive jurisdiction over this kind of case), any state court system will have subject matter
jurisdiction, including Oklahoma’s state court system. But if their claim is for a significant amount of
money, they cannot file in small claims court, probate court, or any court in Oklahoma that does not have

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statutory jurisdiction over their claim. They will need to file in a court of general jurisdiction. In short,
even filing in the right court system (state versus federal), the plaintiff must be careful to find the court
that has subject matter jurisdiction.
If they wish to go to federal court, can they? There is no federal question presented here (the claim is
based on state common law), and the United States is not a party, so the only basis for federal court
jurisdiction would be diversity jurisdiction. If enough time has elapsed since the accident and they have
established themselves as Arizona residents, they could sue in federal court in Oklahoma (or elsewhere),
but only if none of the defendants—the retailer, the regional Volkswagen company, Volkswagen of North
America, or Audi (in Germany) are incorporated in or have a principal place of business in Arizona. The
federal judge would decide the case using federal civil procedure but would have to make the appropriate
choice of state law. In this case, the choice of conflicting laws would most likely be Oklahoma, where the
accident happened, or New York, where the defective product was sold.
Table 3.1 Sample Conflict-of-Law Principles

Substantive Law Issue

Law to be Applied

Liability for injury caused by tortious conduct

State in which the injury was inflicted

Real property

State where the property is located

Personal Property: inheritance

Domicile of deceased (not location of property)

Contract: validity

State in which contract was made

Contract: breach

State in which contract was to be performed*

*Or, in many states, the state with the most significant contacts with the contractual activities
Note: Choice-of-law clauses in a contract will ordinarily be honored by judges in state and federal
courts.

Legal Procedure, Including Due Process and Personal Jurisdiction
In this section, we consider how lawsuits are begun and how the court knows that it has both subject
matter jurisdiction and personal jurisdiction over at least one of the named defendants.
The courts are not the only institutions that can resolve disputes. In Section 3.8 "Alternative Means of
Resolving Disputes", we will discuss other dispute-resolution forums, such as arbitration and mediation.

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For now, let us consider how courts make decisions in civil disputes. Judicial decision making in the
context of litigation (civil lawsuits) is a distinctive form of dispute resolution.
First, to get the attention of a court, the plaintiff must make a claim based on existing laws. Second, courts
do not reach out for cases. Cases are brought to them, usually when an attorney files a case with the right
court in the right way, following the various laws that govern all civil procedures in a state or in the federal
system. (Most US states’ procedural laws are similar to the federal procedural code.)
Once at the court, the case will proceed through various motions (motions to dismiss for lack of
jurisdiction, for example, or insufficient service of process), the proofs (submission of evidence), and the
arguments (debate about the meaning of the evidence and the law) of contesting parties.
This is at the heart of the adversary system, in which those who oppose each other may attack the other’s
case through proofs and cross-examination. Every person in the United States who wishes to take a case
to court is entitled to hire a lawyer. The lawyer works for his client, not the court, and serves him as an
advocate, or supporter. The client’s goal is to persuade the court of the accuracy and justness of his
position. The lawyer’s duty is to shape the evidence and the argument—the line of reasoning about the
evidence—to advance his client’s cause and persuade the court of its rightness. The lawyer for the
opposing party will be doing the same thing, of course, for her client. The judge (or, if one is sitting, the
jury) must sort out the facts and reach a decision from this cross-fire of evidence and argument.
The method of adjudication—the act of making an order or judgment—has several important features.
First, it focuses the conflicting issues. Other, secondary concerns are minimized or excluded altogether.
Relevance is a key concept in any trial. The judge is required to decide the questions presented at the trial,
not to talk about related matters. Second, adjudication requires that the judge’s decision be reasoned, and
that is why judges write opinions explaining their decisions (an opinion may be omitted when the verdict
comes from a jury). Third, the judge’s decision must not only be reasoned but also be responsive to the
case presented: the judge is not free to say that the case is unimportant and that he therefore will ignore it.
Unlike other branches of government that are free to ignore problems pressing upon them,
judges mustdecide cases. (For example, a legislature need not enact a law, no matter how many people
petition it to do so.) Fourth, the court must respond in a certain way. The judge must pay attention to the

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parties’ arguments and his decision must result from their proofs and arguments. Evidence that is not
presented and legal arguments that are not made cannot be the basis for what the judge decides. Also,
judges are bound by standards of weighing evidence: the burden of proof in a civil case is generally a
“preponderance of the evidence.”
In all cases, the plaintiff—the party making a claim and initiating the lawsuit (in a criminal case the
plaintiff is the prosecution)—has the burden of proving his case. If he fails to prove it, the defendant—the
party being sued or prosecuted—will win.
Criminal prosecutions carry the most rigorous burden of proof: the government must prove its case
against the defendant beyond a reasonable doubt. That is, even if it seems very likely that the defendant
committed the crime, as long as there remains some reasonable doubt—perhaps he was not clearly
identified as the culprit, perhaps he has an alibi that could be legitimate—the jury must vote to acquit
rather than convict.
By contrast, the burden of proof in ordinary civil cases—those dealing with contracts, personal injuries,
and most of the cases in this book—is a preponderance of the evidence, which means that the plaintiff’s
evidence must outweigh whatever evidence the defendant can muster that casts doubts on the plaintiff’s
claim. This is not merely a matter of counting the number of witnesses or of the length of time that they
talk: the judge in a trial without a jury (a bench trial), or the jury where one is impaneled, must apply the
preponderance of evidence test by determining which side has the greater weight of credible, relevant
evidence.
Adjudication and the adversary system imply certain other characteristics of courts. Judges must be
impartial; those with a personal interest in a matter must refuse to hear it. The ruling of a court, after all
appeals are exhausted, is final. This principle is known as res judicata (Latin for “the thing is decided”),
and it means that the same parties may not take up the same dispute in another court at another time.
Finally, a court must proceed according to a public set of formal procedural rules; a judge cannot make up
the rules as he goes along. To these rules we now turn.

How a Case Proceeds
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Complaint and Summons
Beginning a lawsuit is simple and is spelled out in the rules of procedure by which each court system
operates. In the federal system, the plaintiff begins a lawsuit by filing a complaint—a document clearly
explaining the grounds for suit—with the clerk of the court. The court’s agent (usually a sheriff, for state
trial courts, or a US deputy marshal, in federal district courts) will then serve the defendant with the
complaint and a summons. The summons is a court document stating the name of the plaintiff and his
attorney and directing the defendant to respond to the complaint within a fixed time period.
The timing of the filing can be important. Almost every possible legal complaint is governed by a federal
or state statute of limitations, which requires a lawsuit to be filed within a certain period of time. For
example, in many states a lawsuit for injuries resulting from an automobile accident must be filed within
two years of the accident or the plaintiff forfeits his right to proceed. As noted earlier, making a correct
initial filing in a court that has subject matter jurisdiction is critical to avoiding statute of limitations
problems.

Jurisdiction and Venue
The place of filing is equally important, and there are two issues regarding location. The first is subject
matter jurisdiction, as already noted. A claim for breach of contract, in which the amount at stake is $1
million, cannot be brought in a local county court with jurisdiction to hear cases involving sums of up to
only $1,000. Likewise, a claim for copyright violation cannot be brought in a state superior court, since
federal courts have exclusive jurisdiction over copyright cases.
The second consideration is venue—the proper geographic location of the court. For example, every
county in a state might have a superior court, but the plaintiff is not free to pick any county. Again, a
statute will spell out to which court the plaintiff must go (e.g., the county in which the plaintiff resides or
the county in which the defendant resides or maintains an office).

Service of Process and Personal Jurisdiction

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The defendant must be “served”—that is, must receive notice that he has been sued. Service can be done
by physically presenting the defendant with a copy of the summons and complaint. But sometimes the
defendant is difficult to find (or deliberately avoids the marshal or other process server). The rules spell
out a variety of ways by which individuals and corporations can be served. These include using US Postal
Service certified mail or serving someone already designated to receive service of process. A corporation
or partnership, for example, is often required by state law to designate a “registered agent” for purposes of
getting public notices or receiving a summons and complaint.
One of the most troublesome problems is service on an out-of-state defendant. The personal jurisdiction
of a state court over persons is clear for those defendants found within the state. If the plaintiff claims that
an out-of-state defendant injured him in some way, must the plaintiff go to the defendant’s home state to
serve him? Unless the defendant had some significant contact with the plaintiff’s state, the plaintiff may
indeed have to. For instance, suppose a traveler from Maine stopped at a roadside diner in Montana and
ordered a slice of homemade pie that was tainted and caused him to be sick. The traveler may not simply
return home and mail the diner a notice that he is suing it in a Maine court. But if out-of-state defendants
have some contact with the plaintiff’s state of residence, there might be grounds to bring them within the
jurisdiction of the plaintiff’s state courts. In Burger King v. Rudzewicz, Section 3.9 "Cases", the federal
court in Florida had to consider whether it was constitutionally permissible to exercise personal
jurisdiction over a Michigan franchisee.
Again, recall that even if a court has subject matter jurisdiction, it must also have personal jurisdiction
over each defendant against whom an enforceable judgment can be made. Often this is not a problem; you
might be suing a person who lives in your state or regularly does business in your state. Or a nonresident
may answer your complaint without objecting to the court’s “in personam” (personal) jurisdiction. But
many defendants who do not reside in the state where the lawsuit is filed would rather not be put to the
inconvenience of contesting a lawsuit in a distant forum. Fairness—and the due process clause of the
Fourteenth Amendment—dictates that nonresidents should not be required to defend lawsuits far from
their home base, especially where there is little or no contact or connection between the nonresident and
the state where a lawsuit is brought.

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Summary of Rules on Personal Jurisdiction
1.

Once a court determines that it has subject matter jurisdiction, it must find at least one defendant
over which it is “fair” (i.e., in accord with due process) to exercise personal jurisdiction.

2. If a plaintiff sues five defendants and the court has personal jurisdiction over just one, the case
can be heard, but the court cannot make a judgment against the other four.
1.

But if the plaintiff loses against defendant 1, he can go elsewhere (to another state or
states) and sue defendants 2, 3, 4, or 5.

2. The court’s decision in the first lawsuit (against defendant 1) does not determine the
liability of the nonparticipating defendants.
This involves the principle of res judicata, which means that you can’t bring the same action
against the same person (or entity) twice. It’s like the civil side of double jeopardy. Res means
“thing,” and judicata means “adjudicated.” Thus the “thing” has been “adjudicated” and should
not be judged again. But, as to nonparticipating parties, it is not over. If you have a different case
against the same defendant—one that arises out of a completely different situation—that case is
not barred by res judicata.
3. Service of process is a necessary (but not sufficient) condition for getting personal jurisdiction
over a particular defendant (see rule 4).
1.

In order to get a judgment in a civil action, the plaintiff must serve a copy of the
complaint and a summons on the defendant.

2. There are many ways to do this.
•

The process server personally serves a complaint on the defendant.

•

The process server leaves a copy of the summons and complaint at the residence of
the defendant, in the hands of a competent person.

•

The process server sends the summons and complaint by certified mail, return
receipt requested.

•

The process server, if all other means are not possible, notifies the defendant by
publication in a newspaper having a minimum number of readers (as may be
specified by law).

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4. In addition to successfully serving the defendant with process, a plaintiff must convince the court
that exercising personal jurisdiction over the defendant is consistent with due process and any
statutes in that state that prescribe the jurisdictional reach of that state (the so-called long-arm
statutes). The Supreme Court has long recognized various bases for judging whether such process
is fair.
1.

Consent. The defendant agrees to the court’s jurisdiction by coming to court, answering
the complaint, and having the matter litigated there.

2. Domicile. The defendant is a permanent resident of that state.
3. Event. The defendant did something in that state, related to the lawsuit, that makes it fair
for the state to say, “Come back and defend!”
4. Service of process within the state will effectively provide personal jurisdiction over the
nonresident.
Again, let’s consider Mrs. Robinson and her children in the Audi accident. She could file a lawsuit
anywhere in the country. She could file a lawsuit in Arizona after she establishes residency there. But
while the Arizona court would have subject matter jurisdiction over any products-liability claim (or any
claim that was not required to be heard in a federal court), the Arizona court would face an issue of “in
personam jurisdiction,” or personal jurisdiction: under the due process clause of the Fourteenth
Amendment, each state must extend due process to citizens of all of the other states. Because fairness is
essential to due process, the court must consider whether it is fair to require an out-of-state defendant to
appear and defend against a lawsuit that could result in a judgment against that defendant.
Almost every state in the United States has a statute regarding personal jurisdiction, instructing judges
when 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
the Fourteenth Amendment, which binds the states with its proviso to guarantee the due process rights of
the citizens of every state in the union. The “minimum contacts” test in Burger King v.
Rudzewicz (Section 3.9 "Cases") tries to make the fairness mandate of the due process clause more
specific. So do other tests articulated in the case (such as “does not offend traditional notions of fair play
and substantial justice”). These tests are posed by the Supreme Court and heeded by all lower courts in

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order to honor the provisions of the Fourteenth Amendment’s due process guarantees. These tests are in
addition to any state long-arm statute’s instructions to courts regarding the assertion of personal
jurisdiction over nonresidents.

Choice of Law and Choice of Forum Clauses
In a series of cases, the Supreme Court has made clear that it will honor contractual choices of parties in a
lawsuit. Suppose the parties to a contract wind up in court arguing over the application of the contract’s
terms. If the parties are from two different states, the judge may have difficulty determining which law to
apply (see Table 3.1 "Sample Conflict-of-Law Principles"). But if the contract says that a particular state’s
law will be applied if there is a dispute, then ordinarily the judge will apply that state’s law as a rule of
decision in the case. For example, Kumar Patel (a Missouri resident) opens a brokerage account with
Goldman, Sachs and Co., and the contractual agreement calls for “any disputes arising under this
agreement” to be determined “according to the laws of the state of New York.” When Kumar claims in a
Missouri court that his broker is “churning” his account, and, on the other hand, Goldman, Sachs claims
that Kumar has failed to meet his margin call and owes $38,568.25 (plus interest and attorney’s fees), the
judge in Missouri will apply New York law based on the contract between Kumar and Goldman, Sachs.
Ordinarily, a choice-of-law clause will be accompanied by a choice-of-forum clause. In a choice-of-forum
clause, the parties in the contract specify which court they will go to in the event of a dispute arising under
the terms of contract. For example, Harold (a resident of Virginia) rents a car from Alamo at the Denver
International Airport. He does not look at the fine print on the contract. He also waives all collision and
other insurance that Alamo offers at the time of his rental. While driving back from Telluride Bluegrass
Festival, he has an accident in Idaho Springs, Colorado. His rented Nissan Altima is badly damaged. On
returning to Virginia, he would like to settle up with Alamo, but his insurance company and Alamo cannot
come to terms. He realizes, however, that he has agreed to hear the dispute with Alamo in a specific court
in San Antonio, Texas. In the absence of fraud or bad faith, any court in the United States is likely to
uphold the choice-of-form clause and require Harold (or his insurance company) to litigate in San
Antonio, Texas.

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KEY TAKEAWAY
There are two court systems in the United States. It is important to know which system—the state court
system or the federal court system—has the power to hear and decide a particular case. Once that is
established, the Constitution compels an inquiry to make sure that no court extends its reach unfairly to outof-state residents. The question of personal jurisdiction is a question of fairness and due process to
nonresidents.

EXERCISES
1.

The Constitution specifies that federal courts have exclusive jurisdiction over admiralty claims. Mr. and
Mrs. Shute have a claim against Carnival Cruise lines for the negligence of the cruise line. Mrs. Shute
sustained injuries as a result of the company’s negligence. Mr. and Mrs. Shute live in the state of
Washington. Can they bring their claim in state court? Must they bring their claim in federal court?

2.

Congress passed Title VII of the Civil Rights Act of 1964. In Title VII, employers are required not to
discriminate against employees on the basis of race, color, sex, religion, or national origin. In passing Title
VII, Congress did not require plaintiffs to file only in federal courts. That is, Congress made no statement
in Title VII that federal courts had “exclusive jurisdiction” over Title VII claims. Mrs. Harris wishes to sue
Forklift Systems, Inc. of Nashville, Tennessee, for sexual harassment under Title VII. She has gone through
the Equal Employment Opportunity Commission process and has a right-to-sue letter, which is required
before a Title VII action can be brought to court. Can she file a complaint that will be heard by a state
court?

3.

Mrs. Harris fails to go to the Equal Employment Opportunity Commission to get her right-to-sue letter
against Forklift Systems, Inc. She therefore does not have a viable Title VII cause of action against Forklift.
She does, however, have her rights under Tennessee’s equal employment statute and various court
decisions from Tennessee courts regarding sexual harassment. Forklift is incorporated in Tennessee and
has its principal place of business in Nashville. Mrs. Harris is also a citizen of Tennessee. Explain why, if she
brings her employment discrimination and sexual harassment lawsuit in a federal court, her lawsuit will
be dismissed for lack of subject matter jurisdiction.

4.

Suppose Mr. and Mrs. Robinson find in the original paperwork with Seaway Volkswagen that there is a
contractual agreement with a provision that says “all disputes arising between buyer and Seaway
Volkswagen will be litigated, if at all, in the county courts of Westchester County, New York.” Will the

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Oklahoma court take personal jurisdiction over Seaway Volkswagen, or will it require the Robinsons to
litigate their claim in New York?

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3.3 Motions and Discovery
LEARNING OBJECTIVES
1.

Explain how a lawsuit can be dismissed prior to any trial.

2.

Understand the basic principles and practices of discovery before a trial.

The early phases of a civil action are characterized by many different kinds of motions and a complex
process of mutual fact-finding between the parties that is known as discovery. A lawsuit will start with
the pleadings (complaint and answer in every case, and in some cases a counterclaim by the defendant
against the plaintiff and the plaintiff’s reply to the defendant’s counterclaim). After the pleadings, the
parties may make various motions, which are requests to the judge. Motions in the early stages of a
lawsuit usually aim to dismiss the lawsuit, to have it moved to another venue, or to compel the other party
to act in certain ways during the discovery process.

Initial Pleadings, and Motions to Dismiss
The first papers filed in a lawsuit are called the pleadings. These include the plaintiff’s complaint and then
(usually after thirty or more days) the answer or response from the defendant. The answer may be
coupled with a counterclaim against the plaintiff. (In effect, the defendant becomes the plaintiff for the
claims she has against the original plaintiff.) The plaintiff may reply to any counterclaim by the defendant.
State and federal rules of civil procedure require that the complaint must state the nature of the plaintiff’s
claim, the jurisdiction of the court, and the nature of the relief that is being asked for (usually an award of
money, but sometimes an injunction, or a declaration of legal rights). In an answer, the defendant will
often deny all the allegations of the complaint or will admit to certain of its allegations and deny others.
A complaint and subsequent pleadings are usually quite general and give little detail. Cases can be decided
on the pleadings alone in the following situations: (1) If the defendant fails to answer the complaint, the
court can enter a default judgment, awarding the plaintiff what he seeks. (2) The defendant can move to
dismiss the complaint on the grounds that the plaintiff failed to “state a claim on which relief can be
granted,” or on the basis that there is no subject matter jurisdiction for the court chosen by the plaintiff,
or on the basis that there is no personal jurisdiction over the defendant. The defendant is saying, in effect,

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that even if all the plaintiff’s allegations are true, they do not amount to a legal claim that can be heard by
the 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
dismiss the complaint without any further proceedings. (This type of dismissal is occasionally still called a
demurrer.)
A third kind of dismissal can take place on a motion for summary judgment. If there is no triable
question of fact or law, there is no reason to have a trial. For example, the plaintiff sues on a promissory
note and, at deposition (an oral examination under oath), the defendant admits having made no payment
on the note and offers no excuse that would be recognizable as a reason not to pay. There is no reason to
have a trial, and the court should grant summary judgment.

Discovery
If there is a factual dispute, the case will usually involve some degree of discovery, where each party tries
to get as much information out of the other party as the rules allow. Until the 1940s, when discovery
became part of civil procedure rules, a lawsuit was frequently a game in which each party hid as much
information as possible and tried to surprise the other party in court.
Beginning with a change in the Federal Rules of Civil Procedure adopted by the Supreme Court in 1938
and subsequently followed by many of the states, the parties are entitled to learn the facts of the case
before trial. The basic idea is to help the parties determine what the evidence might be, who the potential
witnesses are, and what specific issues are relevant. Discovery can proceed by several methods. A party
may serve an interrogatory on his adversary—a written request for answers to specific questions. Or a
party may depose the other party or a witness. A deposition is a live question-and-answer session at which
the witness answers questions put to him by one of the parties’ lawyers. His answers are recorded
verbatim and may be used at trial. Each party is also entitled to inspect books, documents, records, and
other physical items in the possession of the other. This is a broad right, as it is not limited to just
evidence that is admissible at trial. Discovery of physical evidence means that a plaintiff may inspect a
company’s accounts, customer lists, assets, profit-and-loss statements, balance sheets, engineering and
quality-control reports, sales reports, and virtually any other document.

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The lawyers, not the court, run the discovery process. For example, one party simply makes a written
demand, stating the time at which the deposition will take place or the type of documents it wishes to
inspect and make copies of. A party unreasonably resisting discovery methods (whether depositions,
written interrogatories, or requests for documents) can be challenged, however, and judges are often
brought into the process to push reluctant parties to make more disclosure or to protect a party from
irrelevant or unreasonable discovery requests. For example, the party receiving the discovery request can
apply to the court for a protective order if it can show that the demand is for privileged material (e.g., a
party’s lawyers’ records are not open for inspection) or that the demand was made to harass the opponent.
In complex cases between companies, the discovery of documents can run into tens of millions of pages
and can take years. Depositions can consume days or even weeks of an executive’s time.

KEY TAKEAWAY
Many cases never get to trial. They are disposed of by motions to dismiss or are settled after extensive
discovery makes clear to the parties the strengths and weaknesses of the parties to the dispute.

EXERCISES
1.

Mrs. Robinson (in the Volkswagen Audi case) never establishes residency in Arizona, returns to New York,
and files her case in federal district court in New York, alleging diversity jurisdiction. Assume that the
defendants do not want to have the case heard in federal court. What motion will they make?

2.

Under contributory negligence, the negligence of any plaintiff that causes or contributes to the injuries a
plaintiff complains of will be grounds for dismissal. Suppose that in discovery, Mr. Ferlito in Ferlito v.
Johnson & Johnson (Section 3.9 "Cases") admits that he brought the cigarette lighter dangerously close to
his costume, saying, “Yes, you could definitely say I was being careless; I had a few drinks under my belt.”
Also, Mrs. Ferlito admits that she never reads product instructions from manufacturers. If the case is
brought in a state where contributory negligence is the law, on what basis can Johnson & Johnson have
the case dismissed before trial?

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3.4 The Pretrial and Trial Phase
LEARNING OBJECTIVES
1.

Understand how judges can push parties into pretrial settlement.

2.

Explain the meaning and use of directed verdicts.

3.

Distinguish a directed verdict from a judgment n.o.v. (“notwithstanding the verdict”).

After considerable discovery, one of the parties may believe that there is no triable issue of law or fact for
the court to consider and may file a motion with the court for summary judgment. Unless it is very clear,
the judge will deny a summary judgment motion, because that ends the case at the trial level; it is a “final
order” in the case that tells the plaintiff “no” and leaves no room to bring another lawsuit against the
defendant for that particular set of facts (res judicata). If the plaintiff successfully appeals a summary
judgment motion, the case will come back to the trial court.
Prior to the trial, the judge may also convene the parties in an effort to investigate the possibilities of
settlement. Usually, the judge will explore the strengths and weaknesses of each party’s case with the
attorneys. The parties may decide that it is more prudent or efficient to settle than to risk going to trial.

Pretrial Conference
At various times during the discovery process, depending on the nature and complexity of the case, the
court may hold a pretrial conference to clarify the issues and establish a timetable. The court may also
hold a settlement conference to see if the parties can work out their differences and avoid trial altogether.
Once discovery is complete, the case moves on to trial if it has not been settled. Most cases are settled
before this stage; perhaps 85 percent of all civil cases end before trial, and more than 90 percent of
criminal prosecutions end with a guilty plea.

Trial
At trial, the first order of business is to select a jury. (In a civil case of any consequence, either party can
request one, based on the Sixth Amendment to the US Constitution.) The judge and sometimes the
lawyers are permitted to question the jurors to be sure that they are unbiased. This questioning is known

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as the voir dire (pronounced vwahr-DEER). This is an important process, and a great deal of thought goes
into selecting the jury, especially in high-profile cases. A jury panel can be as few as six persons, or as
many as twelve, with alternates selected and sitting in court in case one of the jurors is unable to continue.
In a long trial, having alternates is essential; even in shorter trials, most courts will have at least two
alternate jurors.
In both criminal and civil trials, each side has opportunities to challenge potential jurors for cause. For
example, in the Robinsons’ case against Audi, the attorneys representing Audi will want to know if any
prospective jurors have ever owned an Audi, what their experience has been, and if they had a similar
problem (or worse) with their Audi that was not resolved to their satisfaction. If so, the defense attorney
could well believe that such a juror has a potential for a bias against her client. In that case, she could use
a challenge for cause, explaining to the judge the basis for her challenge. The judge, at her discretion,
could either accept the for-cause reason or reject it.
Even if an attorney cannot articulate a for-cause reason acceptable to the judge, he may use one of several
peremptory challenges that most states (and the federal system) allow. A trial attorney with many years of
experience may have a sixth sense about a potential juror and, in consultation with the client, may decide
to use a peremptory challenge to avoid having that juror on the panel.
After the jury is sworn and seated, the plaintiff’s lawyer makes an opening statement, laying out the
nature of the plaintiff’s claim, the facts of the case as the plaintiff sees them, and the evidence that the
lawyer will present. The defendant’s lawyer may also make an opening statement or may reserve his right
to do so at the end of the plaintiff’s case.
The plaintiff’s lawyer then calls witnesses and presents the physical evidence that is relevant to her proof.
The direct testimony at trial is usually far from a smooth narration. The rules of evidence (that govern the
kinds of testimony and documents that may be introduced at trial) and the question-and-answer format
tend to make the presentation of evidence choppy and difficult to follow.
Anyone who has watched an actual televised trial or a television melodrama featuring a trial scene will
appreciate the nature of the trial itself: witnesses are asked questions about a number of issues that may

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or may not be related, the opposing lawyer will frequently object to the question or the form in which it is
asked, and the jury may be sent from the room while the lawyers argue at the bench before the judge.
After direct testimony of each witness is over, the opposing lawyer may conduct cross-examination. This
is a crucial constitutional right; in criminal cases it is preserved in the Constitution’s Sixth Amendment
(the right to confront one’s accusers in open court). The formal rules of direct testimony are then relaxed,
and the cross-examiner may probe the witness more informally, asking questions that may not seem
immediately relevant. This is when the opposing attorney may become harsh, casting doubt on a witness’s
credibility, trying to trip her up and show that the answers she gave are false or not to be trusted. This use
of cross-examination, along with the requirement that the witness must respond to questions that are at
all relevant to the questions raised by the case, distinguishes common-law courts from those of
authoritarian regimes around the world.
Following cross-examination, the plaintiff’s lawyer may then question the witness again: this is called
redirect examination and is used to demonstrate that the witness’s original answers were accurate and to
show 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
cross-examination or redirect.
During the trial, the judge’s chief responsibility is to see that the trial is fair to both sides. One big piece of
that responsibility is to rule on the admissibility of evidence. A judge may rule that a particular question is
out of order—that is, not relevant or appropriate—or that a given document is irrelevant. Where the
attorney is convinced that a particular witness, a particular question, or a particular document (or part
thereof) is critical to her case, she may preserve an objection to the court’s ruling by saying “exception,” in
which case the court stenographer will note the exception; on appeal, the attorney may cite any number of
exceptions as adding up to the lack of a fair trial for her client and may request a court of appeals to order
a retrial.
For the most part, courts of appeal will not reverse and remand for a new trial unless the trial court
judge’s errors are “prejudicial,” or “an abuse of discretion.” In short, neither party is entitled to a perfect

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trial, but only to a fair trial, one in which the trial judge has made only “harmless errors” and not
prejudicial ones.
At the end of the plaintiff’s case, the defendant presents his case, following the same procedure just
outlined. The plaintiff is then entitled to present rebuttal witnesses, if necessary, to deny or argue with the
evidence the defendant has introduced. The defendant in turn may present “surrebuttal” witnesses.
When all testimony has been introduced, either party may ask the judge for a directed verdict—a
verdict decided by the judge without advice from the jury. This motion may be granted if the plaintiff has
failed to introduce evidence that is legally sufficient to meet her burden of proof or if the defendant has
failed to do the same on issues on which she has the burden of proof. (For example, the plaintiff alleges
that the defendant owes him money and introduces a signed promissory note. The defendant cannot show
that the note is invalid. The defendant must lose the case unless he can show that the debt has been paid
or otherwise discharged.)
The defendant can move for a directed verdict at the close of the plaintiff’s case, but the judge will usually
wait to hear the entire case until deciding whether to do so. Directed verdicts are not usually granted,
since it is the jury’s job to determine the facts in dispute.
If the judge refuses to grant a directed verdict, each lawyer will then present a closing argument to the
jury (or, if there is no jury, to the judge alone). The closing argument is used to tie up the loose ends, as
the attorney tries to bring together various seemingly unrelated facts into a story that will make sense to
the jury.
After closing arguments, the judge will instruct the jury. The purpose of jury instruction is to explain to
the jurors the meaning of the law as it relates to the issues they are considering and to tell the jurors what
facts they must determine if they are to give a verdict for one party or the other. Each lawyer will have
prepared a set of written instructions that she hopes the judge will give to the jury. These will be tailored
to advance her client’s case. Many a verdict has been overturned on appeal because a trial judge has
wrongly instructed the jury. The judge will carefully determine which instructions to give and often will
use a set of pattern instructions provided by the state bar association or the supreme court of the state.

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These pattern jury instructions are often safer because they are patterned after language that appellate
courts have used previously, and appellate courts are less likely to find reversible error in the instructions.
After all instructions are given, the jury will retire to a private room and discuss the case and the answers
requested by the judge for as long as it takes to reach a unanimous verdict. Some minor cases do not
require a unanimous verdict. If the jury cannot reach a decision, this is called a hung jury, and the case
will have to be retried. When a jury does reach a verdict, it delivers it in court with both parties and their
lawyers present. The jury is then discharged, and control over the case returns to the judge. (If there is no
jury, the judge will usually announce in a written opinion his findings of fact and how the law applies to
those facts. Juries just announce their verdicts and do not state their reasons for reaching them.)

Posttrial Motions
The losing party is allowed to ask the judge for a new trial or for a judgment notwithstanding the verdict
(often called a judgment n.o.v., from the Latinnon obstante veredicto). A judge who decides that a
directed verdict is appropriate will usually wait to see what the jury’s verdict is. If it is favorable to the
party the judge thinks should win, she can rely on that verdict. If the verdict is for the other party, he can
grant the motion for judgment n.o.v. This is a safer way to proceed because if the judge is reversed on
appeal, a new trial is not necessary. The jury’s verdict always can be restored, whereas without a jury
verdict (as happens when a directed verdict is granted before the case goes to the jury), the entire case
must be presented to a new jury. Ferlito v. Johnson & Johnson (Section 3.9 "Cases") illustrates the
judgment n.o.v. process in a case where the judge allowed the case to go to a jury that was overly
sympathetic to the plaintiffs.
Rule 50(b) of the Federal Rules of Civil Procedure provides the authorization for federal judges making a
judgment contrary to the judgment of the jury. Most states have a similar rule.
Rule 50(b) says,
Whenever a motion for a directed verdict made at the close of all the evidence is denied or for any reason
is not granted, the court is deemed to have submitted the action to the jury subject to a later
determination of the legal questions raised by the motion. Not later than 10 days after entry of judgment,

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a party who has moved for a directed verdict may move to have the verdict and any judgment entered
thereon set aside and to have judgment entered in accordance with the party’s motion for a directed
verdict.…[A] new trial may be prayed for in the alternative. If a verdict was returned the court may allow
the judgment to stand or may reopen the judgment and either order a new trial or direct the entry of
judgment as if the requested verdict had been directed.

KEY TAKEAWAY
The purpose of a trial judge is to ensure justice to all parties to the lawsuit. The judge presides, instructs the
jury, and may limit who testifies and what they testify about what. In all of this, the judge will usually commit
some errors; occasionally these will be the kinds of errors that seriously compromise a fair trial for both
parties. Errors that do seriously compromise a fair trial for both parties are prejudicial, as opposed to
harmless. The appeals court must decide whether any errors of the trial court judge are prejudicial or not.
If a judge directs a verdict, that ends the case for the party who hasn’t asked for one; if a judge grants
judgment n.o.v., that will take away a jury verdict that one side has worked very hard to get. Thus a judge
must be careful not to unduly favor one side or the other, regardless of his or her sympathies.

EXERCISES
1.

What if there was not a doctrine of res judicata? What would the legal system be like?

2.

Why do you think cross-examination is a “right,” as opposed to a “good thing”? What kind of judicial
system would not allow cross-examination of witnesses as a matter of right?

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3.5 Judgment, Appeal, and Execution
LEARNING OBJECTIVES
1.

Understand the posttrial process—how appellate courts process appeals.

2.

Explain how a court’s judgment is translated into relief for the winning party.

Judgment or Order
At the end of a trial, the judge will enter an order that makes findings of fact (often with the help of a jury)
and conclusions of law. The judge will also make a judgment as to what relief or remedy should be given.
Often it is an award of money damages to one of the parties. The losing party may ask for a new trial at
this point or within a short period of time following. Once the trial judge denies any such request, the
judgment—in the form of the court’s order—is final.

Appeal
If the loser’s motion for a new trial or a judgment n.o.v. is denied, the losing party may appeal but must
ordinarily post a bond sufficient to ensure that there are funds to pay the amount awarded to the winning
party. In an appeal, the appellant aims to show that there was some prejudicial error committed by the
trial judge. There will be errors, of course, but the errors must be significant (i.e., not harmless). The basic
idea is for an appellate court to ensure that a reasonably fair trial was provided to both sides. Enforcement
of the court’s judgment—an award of money, an injunction—is usually stayed (postponed) until the
appellate court has ruled. As noted earlier, the party making the appeal is called the appellant, and the
party defending the judgment is the appellee (or in some courts, the petitioner and the respondent).
During the trial, the losing party may have objected to certain procedural decisions by the judge. In
compiling a record on appeal, the appellant needs to show the appellate court some examples of mistakes
made by the judge—for example, having erroneously admitted evidence, having failed to admit proper
evidence that should have been admitted, or having wrongly instructed the jury. The appellate court must
determine if those mistakes were serious enough to amount to prejudicial error.

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Appellate and trial procedures are different. The appellate court does not hear witnesses or accept
evidence. It reviews the record of the case—the transcript of the witnesses’ testimony and the documents
received into evidence at trial—to try to find a legal error on a specific request of one or both of the
parties. The parties’ lawyers prepare briefs (written statements containing the facts in the case), the
procedural steps taken, and the argument or discussion of the meaning of the law and how it applies to
the facts. After reading the briefs on appeal, the appellate court may dispose of the appeal without
argument, issuing a written opinion that may be very short or many pages. Often, though, the appellate
court will hear oral argument. (This can be months, or even more than a year after the briefs are filed.)
Each lawyer is given a short period of time, usually no more than thirty minutes, to present his client’s
case. The lawyer rarely gets a chance for an extended statement because he is usually interrupted by
questions from the judges. Through this exchange between judges and lawyers, specific legal positions can
be tested and their limits explored.
Depending on what it decides, the appellate court will affirm the lower court’s
judgment, modify it, reverse it, or remand it to the lower court for retrial or other action directed by the
higher court. The appellate court itself does not take specific action in the case; it sits only to rule on
contested issues of law. The lower court must issue the final judgment in the case. As we have already
seen, there is the possibility of appealing from an intermediate appellate court to the state supreme court
in twenty-nine states and to the US Supreme Court from a ruling from a federal circuit court of appeal. In
cases raising constitutional issues, there is also the possibility of appeal to the Supreme Court from the
state courts.
Like trial judges, appellate judges must follow previous decisions, or precedent. But not every previous
case is a precedent for every court. Lower courts must respect appellate court decisions, and courts in one
state are not bound by decisions of courts in other states. State courts are not bound by decisions of
federal courts, except on points of federal law that come from federal courts within the state or from a
federal circuit in which the state court sits. A state supreme court is not bound by case law in any other
state. But a supreme court in one state with a type of case it has not previously dealt with may find
persuasive reasoning in decisions of other state supreme courts.

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Federal district courts are bound by the decisions of the court of appeals in their circuit, but decisions by
one circuit court are not precedents for courts in other circuits. Federal courts are also bound by decisions
of the state supreme courts within their geographic territory in diversity jurisdiction cases. All courts are
bound by decisions of the US Supreme Court, except the Supreme Court itself, which seldom reverses
itself but on occasion has overturned its own precedents.
Not everything a court says in an opinion is a precedent. Strictly speaking, only the exact holding is
binding on the lower courts. A holding is the theory of the law that applies to the particular circumstances
presented in a case. The courts may sometimes declare what they believe to be the law with regard to
points that are not central to the case being decided. These declarations are called dicta (the
singular, dictum), and the lower courts do not have to give them the same weight as holdings.

Judgment and Order
When a party has no more possible appeals, it usually pays up voluntarily. If not voluntarily, then the
losing party’s assets can be seized or its wages or other income garnished to satisfy the judgment. If the
final judgment is an injunction, failure to follow its dictates can lead to a contempt citation, with a fine or
jail time imposed.

KEY TAKEAWAY
The process of conducting a civil trial has many aspects, starting with pleadings and continuing with motions,
discovery, more motions, pretrial conferences, and finally the trial itself. At all stages, the rules of civil
procedure attempt to give both sides plenty of notice, opportunity to be heard, discovery of relevant
information, cross-examination, and the preservation of procedural objections for purposes of appeal. All of
these rules and procedures are intended to provide each side with a fair trial.

EXERCISES
1.

Mrs. Robinson has a key witness on auto safety that the judge believes is not qualified as an expert. The
judge examines the witness while the jury is in the jury room and disqualifies him from testifying. The jury
does not get to hear this witness. Her attorney objects. She loses her case. What argument would you
expect Mrs. Robinson’s attorney to make in an appeal?

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2.

Why don’t appellate courts need a witness box for witnesses to give testimony under oath?

3.

A trial judge in Nevada is wondering whether to enforce a surrogate motherhood contract. Penelope Barr,
of Reno, Nevada, has contracted with Reuben and Tina Goldberg to bear the in vitro fertilized egg of Mrs.
Goldberg. After carrying the child for nine months, Penelope gives birth, but she is reluctant to give up the
child, even though she was paid $20,000 at the start of the contract and will earn an additional $20,000
on handing over the baby to the Goldbergs. (Barr was an especially good candidate for surrogate
motherhood: she had borne two perfect children and at age 28 drinks no wine, does not smoke or use
drugs of any kind, practices yoga, and maintains a largely vegetarian diet with just enough meat to meet
the needs of the fetus within.)
The Goldbergs have asked the judge for an order compelling Penelope to give up the baby, who was five
days old when the lawsuit was filed. The baby is now a month old as the judge looks in vain for guidance
from any Nevada statute, federal statute, or any prior case in Nevada that addressed the issue of
surrogate motherhood. He does find several well-reasoned cases, one from New Jersey, one from
Michigan, and one from Oregon. Are any of these “precedent” that he must follow? May he adopt the
reasoning of any of these courts, if he should find that reasoning persuasive?

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3.6 When Can Someone Bring a Lawsuit?
LEARNING OBJECTIVES
1.

Explain the requirements for standing to bring a lawsuit in US courts.

2.

Describe the process by which a group or class of plaintiffs can be certified to file a class action case.

Almost anyone can bring a lawsuit, assuming they have the filing fee and the help of an attorney. But the
court may not hear it, for a number of reasons. There may be no case or controversy, there may be no law
to support the plaintiff’s claim, it may be in the wrong court, too much time might have lapsed (a statute
of limitations problem), or the plaintiff may not have standing.

Case or Controversy: Standing to Sue
Article III of the US Constitution provides limits to federal judicial power. For some cases, the Supreme
Court has decided that it has no power to adjudicate because there is no “case or controversy.” For
example, perhaps the case has settled or the “real parties in interest” are not before the court. In such a
case, a court might dismiss the case on the grounds that the plaintiff does not have “standing” to sue.
For example, suppose you see a sixteen-wheel moving van drive across your neighbor’s flower bed,
destroying her beloved roses. You have enjoyed seeing her roses every summer, for years. She is forlorn
and tells you that she is not going to raise roses there anymore. She also tells you that she has decided not
to sue, because she has made the decision to never deal with lawyers if at all possible. Incensed, you
decide to sue on her behalf. But you will not have standing to sue because your person or property was not
directly injured by the moving van. Standing means that only the person whose interests are directly
affected has the legal right to sue.
The standing doctrine is easy to understand in straightforward cases such as this but is often a fairly
complicated matter. For example, can fifteen or more state attorneys general bring a lawsuit for a
declaratory judgment that the health care legislation passed in 2010 is unconstitutional? What particular
injury have they (or the states) suffered? Are they the best set of plaintiffs to raise this issue? Time—and
the Supreme Court—will tell.

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Class Actions
Most lawsuits concern a dispute between two people or between a person and a company or other
organization. But it can happen that someone injures more than one person at the same time. A driver
who runs a red light may hit another car carrying one person or many people. If several people are injured
in the same accident, they each have the right to sue the driver for the damage that he caused them. Could
they sue as a group? Usually not, because the damages would probably not be the same for each person,
and different facts would have to be proved at the trial. Plus, the driver of the car that was struck might
have been partially to blame, so the defendant’s liability toward him might be different from his liability
toward the passengers.
If, however, the potential plaintiffs were all injured in the same way and their injuries were identical, a
single lawsuit might be a far more efficient way of determining liability and deciding financial
responsibility than many individual lawsuits.
How could such a suit be brought? All the injured parties could hire the same lawyer, and she could
present a common case. But with a group numbering more than a handful of people, it could become
overwhelmingly complicated. So how could, say, a million stockholders who believed they were cheated by
a corporation ever get together to sue?
Because of these types of situations, there is a legal procedure that permits one person or a small group of
people to serve as representatives for all others. This is the class action. The class action is provided for in
the Federal Rules of Civil Procedure (Rule 23) and in the separate codes of civil procedure in the states.
These rules differ among themselves and are often complex, but in general anyone can file a class action in
an appropriate case, subject to approval of the court. Once the class is “certified,” or judged to be a legally
adequate group with common injuries, the lawyers for the named plaintiffs become, in effect, lawyers for
the entire class.
Usually a person who doesn’t want to be in the class can decide to leave. If she does, she will not be
included in an eventual judgment or settlement. But a potential plaintiff who is included in the class

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cannot, after a final judgment is awarded, seek to relitigate the issue if she is dissatisfied with the
outcome, even though she did not participate at all in the legal proceeding.

KEY TAKEAWAY
Anyone can file a lawsuit, with or without the help of an attorney, but only those lawsuits where a plaintiff has
standing will be heard by the courts. Standing has become a complicated question and is used by the courts to
ensure that civil cases heard are being pursued by those with tangible and particular injuries. Class actions are
a way of aggregating claims that are substantially similar and arise out of the same facts and circumstances.

EXERCISE
1.

Fuchs Funeral Home is carrying the body of Charles Emmenthaler to its resting place at Forest Lawn
Cemetery. Charles’s wife, Chloe, and their two children, Chucky and Clarice, are following the hearse
when the coffin falls on the street, opens, and the body of Charles Emmenthaler falls out. The wife and
children are shocked and aggrieved and later sue in civil court for damages. Assume that this is a viable
cause of action based on “negligent infliction of emotional distress” in the state of California and that
Charles’s brother, sister-in-law, and multiple cousins also were in the funeral procession and saw what
happened. The brother of Charles, Kingston Emmenthaler, also sees his brother’s body on the street, but
his wife, their three children, and some of Charles’s other cousins do not.
Charles was actually emotionally closest to Kingston’s oldest son, Nestor, who was studying abroad at the
time of the funeral and could not make it back in time. He is as emotionally distraught at his uncle’s
passing as anyone else in the family and is especially grieved over the description of the incident and the
grainy video shot by one of the cousins on his cell phone. Who has standing to sue Fuchs Funeral Home,
and who does not?

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3.7 Relations with Lawyers
LEARNING OBJECTIVES
1.

Understand the various ways that lawyers charge for services.

2.

Describe the contingent fee system in the United States.

3.

Know the difference between the American rule and the British rule with regard to who pays
attorneys’ fees.

Legal Fees
Lawyers charge for their services in one of three different ways: flat rate, hourly rate, and contingent fee.
A flat rate is used usually when the work is relatively routine and the lawyer knows in advance
approximately how long it will take her to do the job. Drawing a will or doing a real estate closing are
examples of legal work that is often paid a flat rate. The rate itself may be based on a percentage of the
worth of the matter—say, 1 percent of a home’s selling price.
Lawyers generally charge by the hour for courtroom time and for ongoing representation in commercial
matters. Virtually every sizable law firm bills its clients by hourly rates, which in large cities can range
from $300 for an associate’s time to $500 and more for a senior partner’s time.
A contingent fee is one that is paid only if the lawyer wins—that is, it is contingent, or depends upon, the
success of the case. This type of fee arrangement is used most often in personal injury cases (e.g.,
automobile accidents, products liability, and professional malpractice). Although used quite often, the
contingent fee is controversial. Trial lawyers justify it by pointing to the high cost of preparing for such
lawsuits. A typical automobile accident case can cost at least ten thousand dollars to prepare, and a
complicated products-liability case can cost tens of thousands of dollars. Few people have that kind of
money or would be willing to spend it on the chance that they might win a lawsuit. Corporate and
professional defendants complain that the contingent fee gives lawyers a license to go big game hunting,
or to file suits against those with deep pockets in the hopes of forcing them to settle.

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Trial lawyers respond that the contingent fee arrangement forces them to screen cases and weed out cases
that are weak, because it is not worth their time to spend the hundreds of hours necessary on such cases if
their chances of winning are slim or nonexistent.

Costs
In England and in many other countries, the losing party must pay the legal expenses of the winning
party, including attorneys’ fees. That is not the general rule in this country. Here, each party must pay
most of its own costs, including (and especially) the fees of lawyers. (Certain relatively minor costs, such
as filing fees for various documents required in court, are chargeable to the losing side, if the judge
decides it.) This type of fee structure is known as the American rule (in contrast to the British rule).
There are two types of exceptions to the American rule. By statute, Congress and the state legislatures
have provided that the winning party in particular classes of cases may recover its full legal costs from the
loser—for example, the federal antitrust laws so provide and so does the federal Equal Access to Justice
Act. The other exception applies to litigants who either initiate lawsuits in bad faith, with no expectation
of winning, or who defend them in bad faith, in order to cause the plaintiff great expense. Under these
circumstances, a court has the discretion to award attorneys’ fees to the winner. But this rule is not
infinitely flexible, and courts do not have complete freedom to award attorneys’ fees in any amount, but
only "reasonable" attorney's fees.

KEY TAKEAWAY
Litigation is expensive. Getting a lawyer can be costly, unless you get a lawyer on a contingent fee. Not all legal
systems allow contingent fees. In many legal systems, the loser pays attorneys’ fees for both parties.

EXERCISES
1.

Mrs. Robinson’s attorney estimates that they will recover a million dollars from Volkswagen in the Audi
lawsuit. She has Mrs. Robinson sign a contract that gives her firm one-third of any recovery after the
firm’s expenses are deducted. The judge does in fact award a million dollars, and the defendant pays. The
firm’s expenses are $100,000. How much does Mrs. Robinson get?

2.

Harry Potter brings a lawsuit against Draco Malfoy in Chestershire, England, for slander, a form of
defamation. Potter alleges that Malfoy insists on calling him a mudblood. Ron Weasley testifies, as does

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Neville Chamberlain. But Harry loses, because the court has no conception of wizardry and cannot make
sense of the case at all. In dismissing the case, however, who (under English law) will bear the costs of the
attorneys who have brought the case for Potter and defended the matter for Malfoy?

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3.8 Alternative Means of Resolving Disputes
LEARNING OBJECTIVES
1.

Understand how arbitration and mediation are frequently used alternatives to litigation.

2.

Describe the differences between arbitration and mediation.

3.

Explain why arbitration is final and binding.

Disputes do not have to be settled in court. No law requires parties who have a legal dispute to seek
judicial resolution if they can resolve their disagreement privately or through some other public forum. In
fact, the threat of a lawsuit can frequently motivate parties toward private negotiation. Filing a lawsuit
may convince one party that the other party is serious. Or the parties may decide that they will come to
terms privately rather than wait the three or four years it can frequently take for a case to move up on the
court calendar.

Arbitration
Beginning around 1980, a movement toward alternative dispute resolution began to gain force throughout
the United States. Bar associations, other private groups, and the courts themselves wanted to find
quicker and cheaper ways for litigants and potential litigants to settle certain types of quarrels than
through the courts. As a result, neighborhood justice centers or dispute resolution centers have sprung up
in communities. These are where people can come for help in settling disputes, of both civil and criminal
nature, that should not consume the time and money of the parties or courts in lengthy proceedings.
These alternative forums use a variety of methods, including arbitration, mediation, and conciliation, to
bring about agreement or at least closure of the dispute. These methods are not all alike, and their
differences are worth noting.
Arbitration is a type of adjudication. The parties use a private decision maker, the arbitrator, and the rules
of procedure are considerably more relaxed than those that apply in the courtroom. Arbitrators might be
retired judges, lawyers, or anyone with the kind of specialized knowledge and training that would be
useful in making a final, binding decision on the dispute. In a contractual relationship, the parties can
decide even before a dispute arises to use arbitration when the time comes. Or parties can decide after a
dispute arises to use arbitration instead of litigation. In a predispute arbitration agreement (often part of a
larger contract), the parties can spell out the rules of procedure to be used and the method for choosing

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the arbitrator. For example, they may name the specific person or delegate the responsibility of choosing
to some neutral person, or they may each designate a person and the two designees may jointly pick a
third arbitrator.
Many arbitrations take place under the auspices of the American Arbitration Association, a private
organization headquartered in New York, with regional offices in many other cities. The association uses
published sets of rules for various types of arbitration (e.g., labor arbitration or commercial arbitration);
parties who provide in contracts for arbitration through the association are agreeing to be bound by the
association’s rules. Similarly, the National Association of Securities Dealers provides arbitration services
for disputes between clients and brokerage firms. International commercial arbitration often takes place
through the auspices of the International Chamber of Commerce. A multilateral agreement known as the
Convention on the Recognition and Enforcement of Arbitral Awards provides that agreements to
arbitrate—and arbitral awards—will be enforced across national boundaries.
Arbitration has two advantages over litigation. First, it is usually much quicker, because the arbitrator
does not have a backlog of cases and because the procedures are simpler. Second, in complex cases, the
quality of the decision may be higher, because the parties can select an arbitrator with specialized
knowledge.
Under both federal and state law, arbitration is favored, and a decision rendered by an arbitrator is
binding by law and may be enforced by the courts. The arbitrator’s decision is final and binding, with very
few exceptions (such as fraud or manifest disregard of the law by the arbitrator or panel of arbitrators).
Saying that arbitration is favored means that if you have agreed to arbitration, you can’t go to court if the
other party wants you to arbitrate. Under the Federal Arbitration Act, the other party can go to court and
get a stay against your litigation and also get an order compelling you to go to arbitration.

Mediation
Unlike adjudication, mediation gives the neutral party no power to impose a decision. The mediator is a
go-between who attempts to help the parties negotiate a solution. The mediator will communicate the
parties’ positions to each other, will facilitate the finding of common ground, and will suggest outcomes.
But the parties have complete control: they may ignore the recommendations of the mediator entirely,
settle in their own way, find another mediator, agree to binding arbitration, go to court, or forget the
whole thing!

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KEY TAKEAWAY
Litigation is not the only way to resolve disputes. Informal negotiation between the disputants usually comes
first, but both mediation and arbitration are available. Arbitration, though, is final and binding. Once you agree
to arbitrate, you will have a final, binding arbitral award that is enforceable through the courts, and courts will
almost never allow you to litigate after you have agreed to arbitrate.

EXERCISES
1.

When Mrs. Robinson buys her Audi from Seaway, there is a paragraph in the bill of sale, which both the
dealer and Mrs. Robinson sign, that says, “In the event of any complaint by customer/buyer against
Seaway regarding the vehicle purchased herein, such complaint shall not be litigated, but may only be
arbitrated under the rules of the American Arbitration Association and in accordance with New York law.”
Mrs. Robinson did not see the provision, doesn’t like it, and wants to bring a lawsuit in Oklahoma against
Seaway. What result?

2.

Hendrik Koster (Netherlands) contracts with Automark, Inc. (a US company based in Illinois) to supply
Automark with a large quantity of valve cap gauges. He does, and Automark fails to pay. Koster thinks he
is owed $66,000. There is no agreement to arbitrate or mediate. Can Koster make Automark mediate or
arbitrate?

3.

Suppose that there is an agreement between Koster and Automark to arbitrate. It says, “The parties agree
to arbitrate any dispute arising under this agreement in accordance with the laws of the Netherlands and
under the auspices of the International Chamber of Commerce’s arbitration facility.” The International
Chamber of Commerce has arbitration rules and will appoint an arbitrator or arbitral panel in the event
the parties cannot agree on an arbitrator. The arbitration takes place in Geneva. Koster gets an arbitral
award for $66,000 plus interest. Automark does not participate in any way. Will a court in Illinois enforce
the arbitral award?

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3.9 Cases
Burger King v. Rudzewicz
Burger King Corp. v. Rudzewicz
471 U.S. 462 (U.S. Supreme Court 1985)

Summary
Burger King Corp. is a Florida corporation with principal offices in Miami. It principally conducts
restaurant business through franchisees. The franchisees are licensed to use Burger King’s trademarks
and service marks in standardized restaurant facilities. Rudzewicz is a Michigan resident who, with a
partner (MacShara) operated a Burger King franchise in Drayton Plains, Michigan. Negotiations for
setting up the franchise occurred in 1978 largely between Rudzewicz, his partner, and a regional office of
Burger King in Birmingham, Michigan, although some deals and concessions were made by Burger King
in Florida. A preliminary agreement was signed in February of 1979. Rudzewicz and MacShara assumed
operation of an existing facility in Drayton Plains and MacShara attended prescribed management
courses in Miami during the four months following Feb. 1979.
Rudzewicz and MacShara bought $165,000 worth of restaurant equipment from Burger King’s Davmor
Industries division in Miami. But before the final agreements were signed, the parties began to disagree
over site-development fees, building design, computation of monthly rent, and whether Rudzewicz and
MacShara could assign their liabilities to a corporation they had formed. Negotiations took place between
Rudzewicz, MacShara, and the Birmingham regional office; but Rudzewicz and MacShara learned that the
regional office had limited decision-making power and turned directly to Miami headquarters for their
concerns. The final agreement was signed by June 1979 and provided that the franchise relationship was
governed by Florida law, and called for payment of all required fees and forwarding of all relevant notices
to Miami headquarters.
The Drayton Plains restaurant did fairly well at first, but a recession in late 1979 caused the franchisees to
fall far behind in their monthly payments to Miami. Notice of default was sent from Miami to Rudzewicz,

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who nevertheless continued to operate the restaurant as a Burger King franchise. Burger King sued in
federal district court for the southern district of Florida. Rudzewicz contested the court’s personal
jurisdiction over him, since he had never been to Florida.
The federal court looked to Florida’s long arm statute and held that it did have personal jurisdiction over
the non-resident franchisees, and awarded Burger King a quarter of a million dollars in contract damages
and enjoined the franchisees from further operation of the Drayton Plains facility. Franchisees appealed
to the 11th Circuit Court of Appeals and won a reversal based on lack of personal jurisdiction. Burger King
petitioned the Supreme Ct. for a writ of certiorari.
Justice Brennan delivered the opinion of the court.
The Due Process Clause protects an individual’s liberty interest in not being subject to the binding
judgments of a forum with which he has established no meaningful “contacts, ties, or relations.”
International Shoe Co. v. Washington. By requiring that individuals have “fair warning that a particular
activity may subject [them] to the jurisdiction of a foreign sovereign,” the Due Process Clause “gives a
degree of predictability to the legal system that allows potential defendants to structure their primary
conduct with some minimum assurance as to where that conduct will and will not render them liable to
suit.”…
Where a forum seeks to assert specific jurisdiction over an out-of-state defendant who has not consented
to suit there, this “fair warning” requirement is satisfied if the defendant has “purposefully directed” his
activities at residents of the forum, and the litigation results from alleged injuries that “arise out of or
relate to” those activities, Thus “[t]he forum State does not exceed its powers under the Due Process
Clause if it asserts personal jurisdiction over a corporation that delivers its products into the stream of
commerce with the expectation that they will be purchased by consumers in the forum State” and those
products subsequently injure forum consumers. Similarly, a publisher who distributes magazines in a
distant State may fairly be held accountable in that forum for damages resulting there from an allegedly
defamatory story.…

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…[T]he constitutional touchstone remains whether the defendant purposefully established “minimum
contacts” in the forum State.…In defining when it is that a potential defendant should “reasonably
anticipate” out-of-state litigation, the Court frequently has drawn from the reasoning of Hanson v.
Denckla, 357 U.S. 235, 253 (1958):
The unilateral activity of those who claim some relationship with a nonresident defendant cannot satisfy
the requirement of contact with the forum State. The application of that rule will vary with the quality and
nature of the defendant’s activity, but it is essential in each case that there be some act by which the
defendant purposefully avails itself of the privilege of conducting activities within the forum State, thus
invoking the benefits and protections of its laws.
This “purposeful availment” requirement ensures that a defendant will not be haled into a jurisdiction
solely as a result of “random,” “fortuitous,” or “attenuated” contacts, or of the “unilateral activity of
another party or a third person,” [Citations] Jurisdiction is proper, however, where the contacts
proximately result from actions by the defendant himself that create a “substantial connection” with the
forum State. [Citations] Thus where the defendant “deliberately” has engaged in significant activities
within a State, or has created “continuing obligations” between himself and residents of the forum, he
manifestly has availed himself of the privilege of conducting business there, and because his activities are
shielded by “the benefits and protections” of the forum’s laws it is presumptively not unreasonable to
require him to submit to the burdens of litigation in that forum as well.
Jurisdiction in these circumstances may not be avoided merely because the defendant did not physically
enter the forum State. Although territorial presence frequently will enhance a potential defendant’s
affiliation with a State and reinforce the reasonable foreseeability of suit there, it is an inescapable fact of
modern commercial life that a substantial amount of business is transacted solely by mail and wire
communications across state lines, thus obviating the need for physical presence within a State in which
business is conducted. So long as a commercial actor’s efforts are “purposefully directed” toward residents
of another State, we have consistently rejected the notion that an absence of physical contacts can defeat
personal jurisdiction there.

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Once it has been decided that a defendant purposefully established minimum contacts within the forum
State, these contacts may be considered in light of other factors to determine whether the assertion of
personal jurisdiction would comport with “fair play and substantial justice.” International Shoe Co. v.
Washington, 326 U.S., at 320. Thus courts in “appropriate case[s]” may evaluate “the burden on the
defendant,” “the forum State’s interest in adjudicating the dispute,” “the plaintiff’s interest in obtaining
convenient and effective relief,” “the interstate judicial system’s interest in obtaining the most efficient
resolution of controversies,” and the “shared interest of the several States in furthering fundamental
substantive social policies.” These considerations sometimes serve to establish the reasonableness of
jurisdiction upon a lesser showing of minimum contacts than would otherwise be required. [Citations]
Applying these principles to the case at hand, we believe there is substantial record evidence supporting
the District Court’s conclusion that the assertion of personal jurisdiction over Rudzewicz in Florida for the
alleged breach of his franchise agreement did not offend due process.…
In this case, no physical ties to Florida can be attributed to Rudzewicz other than MacShara’s brief
training course in Miami. Rudzewicz did not maintain offices in Florida and, for all that appears from the
record, has never even visited there. Yet this franchise dispute grew directly out of “a contract which had a
substantial connection with that State.” Eschewing the option of operating an independent local
enterprise, Rudzewicz deliberately “reach[ed] out beyond” Michigan and negotiated with a Florida
corporation for the purchase of a long-term franchise and the manifold benefits that would derive from
affiliation with a nationwide organization. Upon approval, he entered into a carefully structured 20-year
relationship that envisioned continuing and wide-reaching contacts with Burger King in Florida. In light
of Rudzewicz’ voluntary acceptance of the long-term and exacting regulation of his business from Burger
King’s Miami headquarters, the “quality and nature” of his relationship to the company in Florida can in
no sense be viewed as “random,” “fortuitous,” or “attenuated.” Rudzewicz’ refusal to make the
contractually required payments in Miami, and his continued use of Burger King’s trademarks and
confidential business information after his termination, caused foreseeable injuries to the corporation in
Florida. For these reasons it was, at the very least, presumptively reasonable for Rudzewicz to be called to
account there for such injuries.

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…Because Rudzewicz established a substantial and continuing relationship with Burger King’s Miami
headquarters, received fair notice from the contract documents and the course of dealing that he might be
subject to suit in Florida, and has failed to demonstrate how jurisdiction in that forum would otherwise be
fundamentally unfair, we conclude that the District Court’s exercise of jurisdiction pursuant to Fla. Stat.
48.193(1)(g) (Supp. 1984) did not offend due process. The judgment of the Court of Appeals is accordingly
reversed, and the case is remanded for further proceedings consistent with this opinion.
It is so ordered.

CASE QUESTIONS
1.

Why did Burger King sue in Florida rather than in Michigan?

2.

If Florida has a long-arm statute that tells Florida courts that it may exercise personal jurisdiction over
someone like Rudzewicz, why is the court talking about the due process clause?

3.

Why is this case in federal court rather than in a Florida state court?

4.

If this case had been filed in state court in Florida, would Rudzewicz be required to come to Florida?
Explain.

Ferlito v. Johnson & Johnson
Ferlito v. Johnson & Johnson Products, Inc.
771 F. Supp. 196 (U.S. District Ct., Eastern District of Michigan 1991)
Gadola, J.
Plaintiffs Susan and Frank Ferlito, husband and wife, attended a Halloween party in 1984 dressed as
Mary (Mrs. Ferlito) and her little lamb (Mr. Ferlito). Mrs. Ferlito had constructed a lamb costume for her
husband by gluing cotton batting manufactured by defendant Johnson & Johnson Products (“JJP”) to a
suit of long underwear. She had also used defendant’s product to fashion a headpiece, complete with ears.
The costume covered Mr. Ferlito from his head to his ankles, except for his face and hands, which were
blackened with Halloween paint. At the party Mr. Ferlito attempted to light his cigarette by using a butane
lighter. The flame passed close to his left arm, and the cotton batting on his left sleeve ignited. Plaintiffs

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sued defendant for injuries they suffered from burns which covered approximately one-third of Mr.
Ferlito’s body.
Following a jury verdict entered for plaintiffs November 2, 1989, the Honorable Ralph M. Freeman
entered a judgment for plaintiff Frank Ferlito in the amount of $555,000 and for plaintiff Susan Ferlito in
the amount of $ 70,000. Judgment was entered November 7, 1989. Subsequently, on November 16, 1989,
defendant JJP filed a timely motion for judgment notwithstanding the verdict pursuant to Fed.R.Civ.P.
50(b) or, in the alternative, for new trial. Plaintiffs filed their response to defendant’s motion December
18, 1989; and defendant filed a reply January 4, 1990. Before reaching a decision on this motion, Judge
Freeman died. The case was reassigned to this court April 12, 1990.
MOTION FOR JUDGMENT NOTWITHSTANDING THE VERDICT
Defendant JJP filed two motions for a directed verdict, the first on October 27, 1989, at the close of
plaintiffs’ proofs, and the second on October 30, 1989, at the close of defendant’s proofs. Judge Freeman
denied both motions without prejudice. Judgment for plaintiffs was entered November 7, 1989; and
defendant’s instant motion, filed November 16, 1989, was filed in a timely manner.
The standard for determining whether to grant a j.n.o.v. is identical to the standard for evaluating a
motion for directed verdict:
In determining whether the evidence is sufficient, the trial court may neither weigh the evidence, pass on
the credibility of witnesses nor substitute its judgment for that of the jury. Rather, the evidence must be
viewed in the light most favorable to the party against whom the motion is made, drawing from that
evidence all reasonable inferences in his favor. If after reviewing the evidence…the trial court is of the
opinion that reasonable minds could not come to the result reached by the jury, then the motion for
j.n.o.v. should be granted.
To recover in a “failure to warn” product liability action, a plaintiff must prove each of the following four
elements of negligence: (1) that the defendant owed a duty to the plaintiff, (2) that the defendant violated
that duty, (3) that the defendant’s breach of that duty was a proximate cause of the damages suffered by
the plaintiff, and (4) that the plaintiff suffered damages.

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To establish a prima facie case that a manufacturer’s breach of its duty to warn was a proximate cause of
an injury sustained, a plaintiff must present evidence that the product would have been used differently
had the proffered warnings been given.

[1]

[Citations omitted] In the absence of evidence that a warning

would have prevented the harm complained of by altering the plaintiff’s conduct, the failure to warn
cannot be deemed a proximate cause of the plaintiff’s injury as a matter of law. [In accordance with
procedure in a diversity of citizenship case, such as this one, the court cites Michigan case law as the basis
for its legal interpretation.]
…
A manufacturer has a duty “to warn the purchasers or users of its product about dangers associated with
intended use.” Conversely, a manufacturer has no duty to warn of a danger arising from an unforeseeable
misuse of its product. [Citation] Thus, whether a manufacturer has a duty to warn depends on whether
the use of the product and the injury sustained by it are foreseeable. Gootee v. Colt Industries Inc., 712
F.2d 1057, 1065 (6th Cir. 1983); Owens v. Allis-Chalmers Corp., 414 Mich. 413, 425, 326 N.W.2d 372
(1982). Whether a plaintiff’s use of a product is foreseeable is a legal question to be resolved by the court.
Trotter, supra. Whether the resulting injury is foreseeable is a question of fact for the jury.

[2]

Thomas v.

International Harvester Co., 57 Mich. App. 79, 225 N.W.2d 175 (1974).
In the instant action no reasonable jury could find that JJP’s failure to warn of the flammability of cotton
batting was a proximate cause of plaintiffs’ injuries because plaintiffs failed to offer any evidence to
establish that a flammability warning on JJP’s cotton batting would have dissuaded them from using the
product in the manner that they did.
Plaintiffs repeatedly stated in their response brief that plaintiff Susan Ferlito testified that “she would
never again use cotton batting to make a costume…However, a review of the trial transcript reveals that
plaintiff Susan Ferlito never testified that she would never again use cotton batting to make a costume.
More importantly, the transcript contains no statement by plaintiff Susan Ferlito that a flammability
warning on defendant JJP’s product would have dissuaded her from using the cotton batting to construct
the costume in the first place. At oral argument counsel for plaintiffs conceded that there was no
testimony during the trial that either plaintiff Susan Ferlito or her husband, plaintiff Frank J. Ferlito,

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would have acted any different if there had been a flammability warning on the product’s package. The
absence of such testimony is fatal to plaintiffs’ case; for without it, plaintiffs have failed to prove
proximate cause, one of the essential elements of their negligence claim.
In addition, both plaintiffs testified that they knew that cotton batting burns when it is exposed to flame.
Susan Ferlito testified that she knew at the time she purchased the cotton batting that it would burn if
exposed to an open flame. Frank Ferlito testified that he knew at the time he appeared at the Halloween
party that cotton batting would burn if exposed to an open flame. His additional testimony that he would
not have intentionally put a flame to the cotton batting shows that he recognized the risk of injury of
which he claims JJP should have warned. Because both plaintiffs were already aware of the danger, a
warning by JJP would have been superfluous. Therefore, a reasonable jury could not have found that
JJP’s failure to provide a warning was a proximate cause of plaintiffs’ injuries.
The evidence in this case clearly demonstrated that neither the use to which plaintiffs put JJP’s product
nor the injuries arising from that use were foreseeable. Susan Ferlito testified that the idea for the
costume was hers alone. As described on the product’s package, its intended uses are for cleansing,
applying medications, and infant care. Plaintiffs’ showing that the product may be used on occasion in
classrooms for decorative purposes failed to demonstrate the foreseeability of an adult male encapsulating
himself from head to toe in cotton batting and then lighting up a cigarette.
ORDER
NOW, THEREFORE, IT IS HEREBY ORDERED that defendant JJP’s motion for judgment
notwithstanding the verdict is GRANTED.
IT IS FURTHER ORDERED that the judgment entered November 2, 1989, is SET ASIDE.
IT IS FURTHER ORDERED that the clerk will enter a judgment in favor of the defendant JJP.

CASE QUESTIONS

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1.

The opinion focuses on proximate cause. As we will see in Chapter 7 "Introduction to Tort Law", a
negligence case cannot be won unless the plaintiff shows that the defendant has breached a duty and
that the defendant’s breach has actually and proximately caused the damage complained of. What,
exactly, is the alleged breach of duty by the defendant here?

2.

Explain why Judge Gadola reasoning that JJP had no duty to warn in this case. After this case, would they
then have a duty to warn, knowing that someone might use their product in this way?

[1] By “prima facie case,” the court means a case in which the plaintiff has presented all the basic elements of the
cause of action alleged in the complaint. If one or more elements of proof are missing, then the plaintiff has fallen
short of establishing a prima facie case, and the case should be dismissed (usually on the basis of a directed
verdict).
[2] Note the division of labor here: questions of law are for the judge, while questions of “fact” are for the jury.
Here, “foreseeability” is a fact question, while the judge retains authority over questions of law. The division
between questions of fact and questions of law is not an easy one, however.

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Chapter 4

Constitutional Law and US Commerce
LEARNING OBJECTIVES
After reading this chapter, you should be able to do the following:
1.

Explain the historical importance and basic structure of the US Constitution.

2.

Know what judicial review is and what it represents in terms of the separation of powers
between the executive, legislative, and judicial branches of government.

3.

Locate the source of congressional power to regulate the economy under the Constitution, and
explain what limitations there are to the reach of congressional power over interstate
commerce.

4.

Describe the different phases of congressional power over commerce, as adjudged by the US
Supreme Court over time.

5.

Explain what power the states retain over commerce, and how the Supreme Court may
sometimes limit that power.

6.

Describe how the Supreme Court, under the supremacy clause of the Constitution, balances state
and federal laws that may be wholly or partly in conflict.

7.

Explain how the Bill of Rights relates to business activities in the United States.

The US Constitution is the foundation for all of US law. Business and commerce are directly affected
by the words, meanings, and interpretations of the Constitution. Because it speaks in general terms,
its provisions raise all kinds of issues for scholars, lawyers, judges, politicians, and commentators.
For example, arguments still rage over the nature and meaning of “federalism,” the concept that
there is shared governance between the states and the federal government. The US Supreme Court is
the ultimate arbiter of those disputes, and as such it has a unique role in the legal system. It has
assumed the power of judicial review, unique among federal systems globally, through which it can
strike down federal or state statutes that it believes violate the Constitution and can even void the
president’s executive orders if they are contrary to the Constitution’s language. No knowledgeable
citizen or businessperson can afford to be ignorant of its basic provisions.

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4.1 Basic Aspects of the US Constitution
LEARNING OBJECTIVES
1.

Describe the American values that are reflected in the US Constitution.

2.

Know what federalism means, along with separation of powers.

3.

Explain the process of amending the Constitution and why judicial review is particularly significant.

The Constitution as Reflecting American Values
In the US, the one document to which all public officials and military personnel pledge their unswerving
allegiance is the Constitution. If you serve, you are asked to “support and defend” the Constitution
“against all enemies, foreign and domestic.” The oath usually includes a statement that you swear that this
oath is taken freely, honestly, and without “any purpose of evasion.” This loyalty oath may be related to a
time—fifty years ago—when “un-American” activities were under investigation in Congress and the press;
the fear of communism (as antithetical to American values and principles) was paramount. As you look at
the Constitution and how it affects the legal environment of business, please consider what basic values it
may impart to us and what makes it uniquely American and worth defending “against all enemies, foreign
and domestic.”
In Article I, the Constitution places the legislature first and prescribes the ways in which representatives
are elected to public office. Article I balances influence in the federal legislature between large states and
small states by creating a Senate in which the smaller states (by population) as well as the larger states
have two votes. In Article II, the Constitution sets forth the powers and responsibilities of the branch—the
presidency—and makes it clear that the president should be the commander in chief of the armed forces.
Article II also gives states rather than individuals (through the Electoral College) a clear role in the
election process. Article III creates the federal judiciary, and the Bill of Rights, adopted in 1791, makes
clear that individual rights must be preserved against activities of the federal government. In general, the
idea of rights is particularly strong.

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The Constitution itself speaks of rights in fairly general terms, and the judicial interpretation of various
rights has been in flux. The “right” of a person to own another person was notably affirmed by the
Supreme Court in the Dred Scottdecision in 1857.

[1]

The “right” of a child to freely contract for long,

tedious hours of work was upheld by the court in Hammer v. Dagenhart in 1918. Both decisions were
later repudiated, just as the decision that a woman has a “right” to an abortion in the first trimester of
pregnancy could later be repudiated if Roe v. Wade is overturned by the Supreme Court.

[2]

General Structure of the Constitution
Look at the Constitution. Notice that there are seven articles, starting with Article I (legislative powers),
Article II (executive branch), and Article III (judiciary). Notice that there is no separate article for
administrative agencies. The Constitution also declares that it is “the supreme Law of the Land” (Article
VI). Following Article VII are the ten amendments adopted in 1791 that are referred to as the Bill of
Rights. Notice also that in 1868, a new amendment, the Fourteenth, was adopted, requiring states to
provide “due process” and “equal protection of the laws” to citizens of the United States.

Federalism
The partnership created in the Constitution between the states and the federal government is
called federalism. The Constitution is a document created by the states in which certain powers are
delegated to the national government, and other powers are reserved to the states. This is made explicit in
the Tenth Amendment.

Separation of Powers and Judicial Review
Because the Founding Fathers wanted to ensure that no single branch of the government, especially the
executive branch, would be ascendant over the others, they created various checks and balances to ensure
that each of the three principal branches had ways to limit or modify the power of the others. This is
known as the separation of powers. Thus the president retains veto power, but the House of
Representatives is entrusted with the power to initiate spending bills.

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Power sharing was evident in the basic design of Congress, the federal legislative branch. The basic power
imbalance was between the large states (with greater population) and the smaller ones (such as
Delaware). The smaller ones feared a loss of sovereignty if they could be outvoted by the larger ones, so
the federal legislature was constructed to guarantee two Senate seats for every state, no matter how small.
The Senate was also given great responsibility in ratifying treaties and judicial nominations. The net effect
of this today is that senators from a very small number of states can block treaties and other important
legislation. The power of small states is also magnified by the Senate’s cloture rule, which currently
requires sixty out of one hundred senators to vote to bring a bill to the floor for an up-or-down vote.
Because the Constitution often speaks in general terms (with broad phrases such as “due process” and
“equal protection”), reasonable people have disagreed as to how those terms apply in specific cases. The
United States is unique among industrialized democracies in having a Supreme Court that reserves for
itself that exclusive power to interpret what the Constitution means. The famous case of Marbury v.
Madison began that tradition in 1803, when the Supreme Court had marginal importance in the new
republic. The decision in Bush v. Gore, decided in December of 2000, illustrates the power of the court to
shape our destiny as a nation. In that case, the court overturned a ruling by the Florida Supreme Court
regarding the way to proceed on a recount of the Florida vote for the presidency. The court’s ruling was
purportedly based on the “equal protection of the laws” provision in the Fourteenth Amendment.
From Marbury to the present day, the Supreme Court has articulated the view that the US Constitution
sets the framework for all other US laws, whether statutory or judicially created. Thus any statute (or
portion thereof) or legal ruling (judicial or administrative) in conflict with the Constitution is not
enforceable. And as the Bush v. Gore decision indicates, the states are not entirely free to do what they
might choose; their own sovereignty is limited by their union with the other states in a federal sovereign.
If the Supreme Court makes a “bad decision” as to what the Constitution means, it is not easily
overturned. Either the court must change its mind (which it seldom does) or two-thirds of Congress and
three-fourths of the states must make an amendment (Article V).
Because the Supreme Court has this power of judicial review, there have been many arguments about how
it should be exercised and what kind of “philosophy” a Supreme Court justice should have. President

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Richard Nixon often said that a Supreme Court justice should “strictly construe” the Constitution and not
add to its language. Finding law in the Constitution was “judicial activism” rather than “judicial restraint.”
The general philosophy behind the call for “strict constructionist” justices is that legislatures make laws in
accord with the wishes of the majority, and so unelected judges should not make law according to their
own views and values. Nixon had in mind the 1960s Warren court, which “found” rights in the
Constitution that were not specifically mentioned—the right of privacy, for example. In later years, critics
of the Rehnquist court would charge that it “found” rights that were not specifically mentioned, such as
the right of states to be free from federal antidiscrimination laws. See, for example, Kimel v. Florida
Board of Regents, or the Citizens United v. Federal Election Commission case (Section 4.6.5), which held
that corporations are “persons” with “free speech rights” that include spending unlimited amounts of
money in campaign donations and political advocacy.

[3]

Because Roe v. Wade has been so controversial, this chapter includes a seminal case on “the right of
privacy,” Griswold v. Connecticut, Section 4.6.1. Was the court was correct in recognizing a “right of
privacy” in Griswold? This may not seem like a “business case,” but consider: the manufacture and
distribution of birth control devices is a highly profitable (and legal) business in every US state. Moreover,
Griswold illustrates another important and much-debated concept in US constitutional law: substantive
due process (see Section 4.5.3 "Fifth Amendment"). The problem of judicial review and its proper scope is
brought into sharp focus in the abortion controversy. Abortion became a lucrative service business
after Roe v. Wade was decided in 1973. That has gradually changed, with state laws that have limited
rather than overruled Roe v. Wade and with persistent antiabortion protests, killings of abortion doctors,
and efforts to publicize the human nature of the fetuses being aborted. The key here is to understand that
there is no explicit mention in the Constitution of any right of privacy. As Justice Harry Blackmun argued
in his majority opinion in Roe v. Wade,
The Constitution does not explicitly mention any right of privacy. In a line of decisions, however, the
Court has recognized that a right of personal privacy or a guarantee of certain areas or zones of privacy,
does exist under the Constitution.…[T]hey also make it clear that the right has some extension to activities
relating to marriage…procreation…contraception…family relationships…and child rearing and

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education.…The right of privacy…is broad enough to encompass a woman’s decision whether or not to
terminate her pregnancy.
In short, justices interpreting the Constitution wield quiet yet enormous power through judicial review. In
deciding that the right of privacy applied to a woman’s decision to abort in the first trimester, the
Supreme Court did not act on the basis of a popular mandate or clear and unequivocal language in the
Constitution, and it made illegal any state or federal legislative or executive action contrary to its
interpretation. Only a constitutional amendment or the court’s repudiation of Roe v. Wade as a precedent
could change that interpretation.

KEY TAKEAWAY
The Constitution gives voice to the idea that people have basic rights and that a civilian president is also the
commander in chief of the armed forces. It gives instructions as to how the various branches of government
must share power and also tries to balance power between the states and the federal government. It does not
expressly allow for judicial review, but the Supreme Court’s ability to declare what laws are (or are not)
constitutional has given the judicial branch a kind of power not seen in other industrialized democracies.

EXERCISES
1.

Suppose the Supreme Court declares that Congress and the president cannot authorize the indefinite
detention of terrorist suspects without a trial of some sort, whether military or civilian. Suppose also that
the people of the United States favor such indefinite detention and that Congress wants to pass a law
rebuking the court’s decision. What kind of law would have to be passed, by what institutions, and by
what voting percentages?

2.

When does a prior decision of the Supreme Court deserve overturning? Name one decision of the
Supreme Court that you think is no longer “good law.” Does the court have to wait one hundred years to
overturn its prior case precedents?

[1] In Scott v. Sanford (the Dred Scott decision), the court states that Scott should remain a slave, that as a slave he
is 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
personal property and thus has never been free.

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[2] Roe v. Wade, 410 US 113 (1973).
[3] Kimel v. Florida Board of Regents, 528 US 62 (2000).

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4.2 The Commerce Clause
LEARNING OBJECTIVES
1.

Name the specific clause through which Congress has the power to regulate commerce. What,
specifically, does this clause say?

2.

Explain how early decisions of the Supreme Court interpreted the scope of the commerce clause and
how that impacted the legislative proposals and programs of Franklin Delano Roosevelt during the
Great Depression.

3.

Describe both the wider use of the commerce clause from World War II through the 1990s and the
limitations the Supreme Court imposed in Lopezand other cases.

First, turn to Article I, Section 8. The commerce clause gives Congress the exclusive power to make
laws relating to foreign trade and commerce and to commerce among the various states. Most of the
federally created legal environment springs from this one clause: if Congress is not authorized in the
Constitution to make certain laws, then it acts unconstitutionally and its actions may be ruled
unconstitutional by the Supreme Court. Lately, the Supreme Court has not been shy about ruling acts of
Congress unconstitutional.
Here are the first five parts of Article I, Section 8, which sets forth the powers of the federal legislature.
The commerce clause is in boldface. It is short, but most federal legislation affecting business depends on
this very clause:

Section 8
[Clause 1] The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises, to pay the
Debts and provide for the common Defence and general Welfare of the United States; but all Duties,
Imposts and Excises shall be uniform throughout the United States;
[Clause 2] To borrow Money on the credit of the United States;
[Clause 3] To regulate Commerce with foreign Nations, and among the several States, and
with the Indian Tribes;

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[Clause 4] To establish a uniform Rule of Naturalization, and uniform Laws on the subject of
Bankruptcies throughout the United States;
[Clause 5] To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights
and Measures;

Early Commerce Clause Cases
For many years, the Supreme Court was very strict in applying the commerce clause: Congress could only
use it to legislate aspects of the movement of goods from one state to another. Anything else was deemed
local rather than national. For example, In Hammer v. Dagenhart, decided in 1918, a 1916 federal statute
had barred transportation in interstate commerce of goods produced in mines or factories employing
children under fourteen or employing children fourteen and above for more than eight hours a day. A
complaint was filed in the US District Court for the Western District of North Carolina by a father in his
own behalf and on behalf of his two minor sons, one under the age of fourteen years and the other
between fourteen and sixteen years, who were employees in a cotton mill in Charlotte, North Carolina.
The father’s lawsuit asked the court to enjoin (block) the enforcement of the act of Congress intended to
prevent interstate commerce in the products of child labor.
The Supreme Court saw the issue as whether Congress had the power under the commerce clause to
control interstate shipment of goods made by children under the age of fourteen. The court found that
Congress did not. The court cited several cases that had considered what interstate commerce could be
constitutionally regulated by Congress. In Hipolite Egg Co. v. United States, the Supreme Court had
sustained the power of Congress to pass the Pure Food and Drug Act, which prohibited the introduction
into the states by means of interstate commerce impure foods and drugs.

[1]

In Hoke v. United States, the

Supreme Court had sustained the constitutionality of the so-called White Slave Traffic Act of 1910,
whereby the transportation of a woman in interstate commerce for the purpose of prostitution was
forbidden. In that case, the court said that Congress had the power to protect the channels of interstate
commerce: “If the facility of interstate transportation can be taken away from the demoralization of
lotteries, the debasement of obscene literature, the contagion of diseased cattle or persons, the impurity of

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food and drugs, the like facility can be taken away from the systematic enticement to, and the enslavement
in prostitution and debauchery of women, and, more insistently, of girls.”

[2]

In each of those instances, the Supreme Court said, “[T]he use of interstate transportation was necessary
to the accomplishment of harmful results.” In other words, although the power over interstate
transportation was to regulate, that could only be accomplished by prohibiting the use of the facilities of
interstate commerce to effect the evil intended. But in Hammer v. Dagenhart, that essential element was
lacking. The law passed by Congress aimed to standardize among all the states the ages at which children
could be employed in mining and manufacturing, while the goods themselves are harmless. Once the
labor is done and the articles have left the factory, the “labor of their production is over, and the mere fact
that they were intended for interstate commerce transportation does not make their production subject to
federal control under the commerce power.”
In short, the early use of the commerce clause was limited to the movement of physical goods between
states. Just because something might enter the channels of interstate commerce later on does not make it
a fit subject for national regulation. The production of articles intended for interstate commerce is a
matter of local regulation. The court therefore upheld the result from the district and circuit court of
appeals; the application of the federal law was enjoined. Goods produced by children under the age of
fourteen could be shipped anywhere in the United States without violating the federal law.

From the New Deal to the New Frontier and the Great Society:1930s–1970
During the global depression of the 1930s, the US economy saw jobless rates of a third of all workers, and
President Roosevelt’s New Deal program required more active federal legislation. Included in the New
Deal program was the recognition of a “right” to form labor unions without undue interference from
employers. Congress created the National Labor Relations Board (NLRB) in 1935 to investigate and to
enjoin employer practices that violated this right.
In 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
the Jones & Laughlin Steel Corporation with discriminating against employees who were union members.

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The company’s position was that the law authorizing the NLRB was unconstitutional, exceeding
Congress’s powers. The court held that the act was narrowly constructed so as to regulate industrial
activities that had the potential to restrict interstate commerce. The earlier decisions under the commerce
clause to the effect that labor relations had only an indirect effect on commerce were effectively reversed.
Since the ability of employees to engage in collective bargaining (one activity protected by the act) is “an
essential condition of industrial peace,” the national government was justified in penalizing corporations
engaging in interstate commerce that “refuse to confer and negotiate” with their workers. This was,
however, a close decision, and the switch of one justice made this ruling possible. Without this switch, the
New Deal agenda would have been effectively derailed.

The Substantial Effects Doctrine: World War II to the 1990s
Subsequent to NLRB v. Jones & Laughlin Steel Corporation, Congress and the courts generally accepted
that even modest impacts on interstate commerce were “reachable” by federal legislation. For example,
the case of Wickard v. Filburn, from 1942, represents a fairly long reach for Congress in regulating what
appear to be very local economic decisions (Section 4.6.2).
Wickard established that “substantial effects” in interstate commerce could be very local indeed! But
commerce clause challenges to federal legislation continued. In the 1960s, the Civil Rights Act of 1964 was
challenged on the ground that Congress lacked the power under the commerce clause to regulate what
was otherwise fairly local conduct. For example, Title II of the act prohibited racial discrimination in
public accommodations (such as hotels, motels, and restaurants), leading to the famous case
of Katzenbach v. McClung(1964).
Ollie McClung’s barbeque place in Birmingham, Alabama, allowed “colored” people to buy takeout at the
back of the restaurant but not to sit down with “white” folks inside. The US attorney sought a court order
to require Ollie to serve all races and colors, but Ollie resisted on commerce clause grounds: the federal
government had no business regulating a purely local establishment. Indeed, Ollie did not advertise
nationally, or even regionally, and had customers only from the local area. But the court found that some
42 percent of the supplies for Ollie’s restaurant had moved in the channels of interstate commerce. This
was enough to sustain federal regulation based on the commerce clause.

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For nearly thirty years following, it was widely assumed that Congress could almost always find some
interstate commerce connection for any law it might pass. It thus came as something of a shock in 1995
when the Rehnquist court decided U.S. v. Lopez. Lopez had been convicted under a federal law that
prohibited possession of firearms within 1,000 feet of a school. The law was part of a twenty-year trend
(roughly 1970 to 1990) for senators and congressmen to pass laws that were tough on crime. Lopez’s
lawyer admitted that Lopez had had a gun within 1,000 feet of a San Antonio school yard but challenged
the law itself, arguing that Congress exceeded its authority under the commerce clause in passing this
legislation. The US government’s Solicitor General argued on behalf of the Department of Justice to the
Supreme Court that Congress was within its constitutional rights under the commerce clause because
education of the future workforce was the foundation for a sound economy and because guns at or near
school yards detracted from students’ education. The court rejected this analysis, noting that with the
government’s analysis, an interstate commerce connection could be conjured from almost anything.
Lopez went free because the law itself was unconstitutional, according to the court.
Congress made no attempt to pass similar legislation after the case was decided. But in passing
subsequent legislation, Congress was often careful to make a record as to why it believed it was addressing
a problem that related to interstate commerce. In 1994, Congress passed the Violence Against Women Act
(VAWA), having held hearings to establish why violence against women on a local level would impair
interstate commerce. In 1994, while enrolled at Virginia Polytechnic Institute (Virginia Tech), Christy
Brzonkala alleged that Antonio Morrison and James Crawford, both students and varsity football players
at Virginia Tech, had raped her. In 1995, Brzonkala filed a complaint against Morrison and Crawford
under Virginia Tech’s sexual assault policy. After a hearing, Morrison was found guilty of sexual assault
and sentenced to immediate suspension for two semesters. Crawford was not punished. A second hearing
again found Morrison guilty. After an appeal through the university’s administrative system, Morrison’s
punishment was set aside, as it was found to be “excessive.” Ultimately, Brzonkala dropped out of the
university. Brzonkala then sued Morrison, Crawford, and Virginia Tech in federal district court, alleging
that Morrison’s and Crawford’s attack violated 42 USC Section 13981, part of the VAWA), which provides
a federal civil remedy for the victims of gender-motivated violence. Morrison and Crawford moved to
dismiss Brzonkala’s suit on the ground that Section 13981’s civil remedy was unconstitutional. In

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dismissing the complaint, the district court found that that Congress lacked authority to enact Section
13981 under either the commerce clause or the Fourteenth Amendment, which Congress had explicitly
identified as the sources of federal authority for the VAWA. Ultimately, the court of appeals affirmed, as
did the Supreme Court.
The Supreme Court held that Congress lacked the authority to enact a statute under the commerce clause
or the Fourteenth Amendment because the statute did not regulate an activity that substantially affected
interstate commerce nor did it redress harm caused by the state. Chief Justice William H. Rehnquist
wrote for the court that “under our federal system that remedy must be provided by the Commonwealth of
Virginia, and not by the United States.” Dissenting, Justice Stephen G. Breyer argued that the majority
opinion “illustrates the difficulty of finding a workable judicial Commerce Clause touchstone.” Justice
David H. Souter, dissenting, noted that VAWA contained a “mountain of data assembled by
Congress…showing the effects of violence against women on interstate commerce.”
The absence of a workable judicial commerce clause touchstone remains. In 1996, California voters
passed the Compassionate Use Act, legalizing marijuana for medical use. California’s law conflicted with
the federal Controlled Substances Act (CSA), which banned possession of marijuana. After the Drug
Enforcement Administration (DEA) seized doctor-prescribed marijuana from a patient’s home, a group of
medical marijuana users sued the DEA and US Attorney General John Ashcroft in federal district court.
The medical marijuana users argued that the CSA—which Congress passed using its constitutional power
to regulate interstate commerce—exceeded Congress’s commerce clause power. The district court ruled
against the group, but the Ninth Circuit Court of Appeals reversed and ruled the CSA unconstitutional
because it applied to medical marijuana use solely within one state. In doing so, the Ninth Circuit relied
on U.S. v. Lopez (1995) and U.S. v. Morrison (2000) to say that using medical marijuana did not
“substantially affect” interstate commerce and therefore could not be regulated by Congress.
But by a 6–3 majority, the Supreme Court held that the commerce clause gave Congress authority to
prohibit the local cultivation and use of marijuana, despite state law to the contrary. Justice John Paul
Stevens argued that the court’s precedents established Congress’s commerce clause power to regulate
purely local activities that are part of a “class of activities” with a substantial effect on interstate

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commerce. The majority argued that Congress could ban local marijuana use because it was part of such a
class of activities: the national marijuana market. Local use affected supply and demand in the national
marijuana market, making the regulation of intrastate use “essential” to regulating the drug’s national
market.
Notice how similar this reasoning is to the court’s earlier reasoning in Wickard v. Filburn (Section 4.6.2).
In contrast, the court’s conservative wing was adamant that federal power had been exceeded. Justice
Clarence Thomas’s dissent in Gonzalez v. Raich stated that Raich’s local cultivation and consumption of
marijuana was not “Commerce…among the several States.” Representing the “originalist” view that the
Constitution should mostly mean what the Founders meant it to mean, he also said that in the early days
of the republic, it would have been unthinkable that Congress could prohibit the local cultivation,
possession, and consumption of marijuana.

KEY TAKEAWAY
The commerce clause is the basis on which the federal government regulates interstate economic activity. The
phrase “interstate commerce” has been subject to differing interpretations by the Supreme Court over the
past one hundred years. There are certain matters that are essentially local or intrastate, but the range of
federal involvement in local matters is still considerable.

EXERCISES
1.

Why would Congress have power under the Civil Rights Act of 1964 to require restaurants and hotels to
not discriminate against interstate travelers on the basis of race, color, sex, religion, or national origin?
Suppose the Holiday Restaurant near I-80 in Des Moines, Iowa, has a sign that says, “We reserve the right
to refuse service to any Muslim or person of Middle Eastern descent.” Suppose also that the restaurant is
very popular locally and that only 40 percent of its patrons are travelers on I-80. Are the owners of the
Holiday Restaurant in violation of the Civil Rights Act of 1964? What would happen if the owners resisted
enforcement by claiming that Title II of the act (relating to “public accommodations” such as hotels,
motels, and restaurants) was unconstitutional?

2.

If the Supreme Court were to go back to the days of Hammer v. Dagenhart and rule that only goods and
services involving interstate movement could be subject to federal law, what kinds of federal programs

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might be lacking a sound basis in the commerce clause? “Obamacare”? Medicare? Homeland security?
Social Security? What other powers are granted to Congress under the Constitution to legislate for the
general good of society?

[1] Hipolite Egg Co. v. United States, 220 US 45 (1911).
[2] Hoke v. United States, 227 US 308 (1913).
[3] Katzenbach v. McClung, 379 US 294 (1964).

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4.3 Dormant Commerce Clause
LEARNING OBJECTIVES
1.

Understand that when Congress does not exercise its powers under the commerce clause, the
Supreme Court may still limit state legislation that discriminates against interstate commerce or
places an undue burden on interstate commerce.

2.

Distinguish between “discrimination” dormant-commerce-clause cases and “undue burden”
dormant-commerce-clause cases.

Congress has the power to legislate under the commerce clause and often does legislate. For example,
Congress might say that trucks moving on interstate highways must not be more than seventy feet in
length. But if Congress does not exercise its powers and regulate in certain areas (such as the size and
length of trucks on interstate highways), states may make their own rules. States may do so under the socalled historic police powers of states that were never yielded up to the federal government.
These police powers can be broadly exercised by states for purposes of health, education, welfare, safety,
morals, and the environment. But the Supreme Court has reserved for itself the power to determine when
state action is excessive, even when Congress has not used the commerce clause to regulate. This power is
claimed to exist in the dormant commerce clause.
There are two ways that a state may violate the dormant commerce clause. If a state passes a law that is an
“undue burden” on interstate commerce or that “discriminates” against interstate commerce, it will be
struck down. Kassel v. Consolidated Freightways, in Section 4.7 "Summary and Exercises", is an example
of a case where Iowa imposed an undue burden on interstate commerce by prohibiting double trailers on
its highways.

[1]

Iowa’s prohibition was judicially declared void when the Supreme Court judged it to be an

undue burden.
Discrimination cases such as Hunt v. Washington Apple Advertising Commission (Section 4.6 "Cases")
pose a different standard. The court has been fairly inflexible here: if one state discriminates in its
treatment of any article of commerce based on its state of origin, the court will strike down the law. For
example, in Oregon Waste Systems v. Department of Environmental Quality,the state wanted to place a

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slightly higher charge on waste coming from out of state.

[2]

The state’s reasoning was that in-state

residents had already contributed to roads and other infrastructure and that tipping fees at waste facilities
should reflect the prior contributions of in-state companies and residents. Out-of-state waste handlers
who wanted to use Oregon landfills objected and won their dormant commerce clause claim that Oregon’s
law discriminated “on its face” against interstate commerce. Under the Supreme Court’s rulings, anything
that moves in channels of interstate commerce is “commerce,” even if someone is paying to get rid of
something instead of buying something.
Thus the states are bound by Supreme Court decisions under the dormant commerce clause to do nothing
that differentiates between articles of commerce that originate from within the state from those that
originate elsewhere. If Michigan were to let counties decide for themselves whether to take garbage from
outside of the county or not, this could also be a discrimination based on a place of origin outside the
state. (Suppose, for instance, each county were to decide not to take waste from outside the county; then
all Michigan counties would effectively be excluding waste from outside of Michigan, which is
discriminatory.)

[3]

The Supreme Court probably would uphold any solid waste requirements that did not differentiate on the
basis of origin. If, for example, all waste had to be inspected for specific hazards, then the law would apply
equally to in-state and out-of-state garbage. Because this is the dormant commerce clause, Congress could
still act (i.e., it could use its broad commerce clause powers) to say that states are free to keep out-of-state
waste from coming into their own borders. But Congress has declined to do so. What follows is a
statement from one of the US senators from Michigan, Carl Levin, in 2003, regarding the significant
amounts of waste that were coming into Michigan from Toronto, Canada.

Dealing with Unwelcome Waste
Senator Carl Levin, January 2003
Michigan is facing an intolerable situation with regard to the importation of waste from other states and
Canada.

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Canada is the largest source of waste imports to Michigan. Approximately 65 truckloads of waste come in
to Michigan per day from Toronto alone, and an estimated 110–130 trucks come in from Canada each day.
This problem isn’t going to get any better. Ontario’s waste shipments are growing as the Toronto area
signs new contracts for waste disposal here and closes its two remaining landfills. At the beginning of
1999, the Toronto area was generating about 2.8 million tons of waste annually, about 700,000 tons of
which were shipped to Michigan. By early this year, barring unforeseen developments, the entire 2.8
million tons will be shipped to Michigan for disposal.
Why can’t Canada dispose of its trash in Canada? They say that after 20 years of searching they have not
been able to find a suitable Ontario site for Toronto’s garbage. Ontario has about 345,000 square miles
compared to Michigan’s 57,000 square miles. With six times the land mass, that argument is laughable.
The Michigan Department of Environmental Quality estimates that, for every five years of disposal of
Canadian waste at the current usage volume, Michigan is losing a full year of landfill capacity. The
environmental impacts on landfills, including groundwater contamination, noise pollution and foul odors,
are exacerbated by the significant increase in the use of our landfills from sources outside of Michigan.
I have teamed up with Senator Stabenow and Congressman Dingell to introduce legislation that would
strengthen our ability to stop shipments of waste from Canada.
We have protections contained in a 17 year-old international agreement between the U.S. and Canada
called the Agreement Concerning the Transboundary Movement of Hazardous Waste. The U.S. and
Canada entered into this agreement in 1986 to allow the shipment of hazardous waste across the
U.S./Canadian border for treatment, storage or disposal. In 1992, the two countries decided to add
municipal solid waste to the agreement. To protect both countries, the agreement requires notification of
shipments to the importing country and it also provides that the importing country may withdraw consent
for shipments. Both reasons are evidence that these shipments were intended to be limited. However, the
agreement’s provisions have not been enforced by the United States.
Canada could not export waste to Michigan without the 1986 agreement, but the U.S. has not
implemented the provisions that are designed to protect the people of Michigan. Although those of us that

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introduced this legislation believe that the Environmental Protection Agency has the authority to enforce
this agreement, they have not done so. Our bill would require the EPA [Environmental Protection Agency]
to enforce the agreement.
In order to protect the health and welfare of the citizens of Michigan and our environment, we must
consider the impact of the importation of trash on state and local recycling efforts, landfill capacity, air
emissions, road deterioration resulting from increased vehicular traffic and public health and the
environment.
Our bill would require the EPA to consider these factors in determining whether to accept imports of trash
from Canada. It is my strong view that such a review should lead the EPA to say “no” to the status quo of
trash imports.

KEY TAKEAWAY
Where Congress does not act pursuant to its commerce clause powers, the states are free to legislate on
matters of commerce under their historic police powers. However, the Supreme Court has set limits on such
powers. Specifically, states may not impose undue burdens on interstate commerce and may not discriminate
against articles in interstate commerce.

EXERCISES
1.

Suppose that the state of New Jersey wishes to limit the amount of hazardous waste that enters into its
landfills. The general assembly in New Jersey passes a law that specifically forbids any hazardous waste
from entering into the state. All landfills are subject to tight regulations that will allow certain kinds of
hazardous wastes originating in New Jersey to be put in New Jersey landfills but that impose significant
criminal fines on landfill operators that accept out-of-state hazardous waste. The Baldessari Brothers
Landfill in Linden, New Jersey, is fined for taking hazardous waste from a New York State transporter and
appeals that ruling on the basis that New Jersey’s law is unconstitutional. What is the result?

2.

The state of Arizona determines through its legislature that trains passing through the state cannot be
longer than seventy cars. There is some evidence that in Eastern US states longer trains pose some safety
hazards. There is less evidence that long trains are a problem in Western states. Several major railroads

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find the Arizona legislation costly and burdensome and challenge the legislation after applied-for permits
for longer trains are denied. What kind of dormant commerce clause challenge is this, and what would it
take for the challenge to be successful?

[1] Kassell v. Consolidated Freightways, 450 US 662 (1981).
[2] Oregon Waste Systems v. Department of Environmental Quality, 511 US 93 (1994).
[3] Fort Gratiot Sanitary Landfill v. Michigan Dep’t of Natural Resources, 504 US 353 (1992).

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4.4 Preemption: The Supremacy Clause
LEARNING OBJECTIVES
1.

Understand the role of the supremacy clause in the balance between state and federal power.

2.

Give examples of cases where state legislation is preempted by federal law and cases where state
legislation is not preempted by federal law.

When Congress does use its power under the commerce clause, it can expressly state that it wishes to have
exclusive regulatory authority. For example, when Congress determined in the 1950s to promote nuclear
power (“atoms for peace”), it set up the Nuclear Regulatory Commission and provided a limitation of
liability for nuclear power plants in case of a nuclear accident. The states were expressly told to stay out of
the business of regulating nuclear power or the movement of nuclear materials. Thus Rochester,
Minnesota, or Berkeley, California, could declare itself a nuclear-free zone, but the federal government
would have preempted such legislation. If Michigan wished to set safety standards at Detroit Edison’s
Fermi II nuclear reactor that were more stringent than the federal Nuclear Regulatory Commission’s
standards, Michigan’s standards would be preempted and thus be void.
Even where Congress does not expressly preempt state action, such action may be impliedly pre-empted.
States cannot constitutionally pass laws that interfere with the accomplishment of the purposes of the
federal law. Suppose, for example, that Congress passes a comprehensive law that sets standards for
foreign vessels to enter the navigable waters and ports of the United States. If a state creates a law that
sets standards that conflict with the federal law or sets standards so burdensome that they interfere with
federal law, the doctrine of preemption will (in accordance with the supremacy clause) void the state
law or whatever parts of it are inconsistent with federal law.
But Congress can allow what might appear to be inconsistencies; the existence of federal statutory
standards does not always mean that local and state standards cannot be more stringent. If California
wants cleaner air or water than other states, it can set stricter standards—nothing in the Clean Water Act
or Clean Air Act forbids the state from setting stricter pollution standards. As the auto industry well
knows, California has set stricter standards for auto emissions. Since the 1980s, most automakers have

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made both a federal car and a California car, because federal Clean Air Act emissions restrictions do not
preempt more rigorous state standards.
Large industries and companies actually prefer regulation at the national level. It is easier for a large
company or industry association to lobby in Washington, DC, than to lobby in fifty different states.
Accordingly, industry often asks Congress to put preemptive language into its statutes. The tobacco
industry is a case in point.
The cigarette warning legislation of the 1960s (where the federal government required warning labels on
cigarette packages) effectively preempted state negligence claims based on failure to warn. When the
family of a lifetime smoker who had died sued in New Jersey court, one cause of action was the company’s
failure to warn of the dangers of its product. The Supreme Court reversed the jury’s award based on the
federal preemption of failure to warn claims under state law.

[1]

The Supremacy Clause
Article VI
This Constitution, and the Laws of the United States which shall be made in Pursuance thereof; and all
Treaties made, or which shall be made, under the Authority of the United States, shall be the supreme
Law of the Land; and the Judges in every State shall be bound thereby, any Thing in the Constitution or
Laws of any State to the Contrary notwithstanding.
The preemption doctrine derives from the supremacy clause of the Constitution, which states that the
“Constitution and the Laws of the United States…shall be the supreme Law of the Land…any Thing in the
Constitutions or Laws of any State to the Contrary notwithstanding.” This means of course, that
any federal law—even a regulation of a federal agency—would control over any conflicting state law.
Preemption can be either express or implied. When Congress chooses to expressly preempt state law, the
only question for courts becomes determining whether the challenged state law is one that the federal law
is intended to preempt. Implied preemption presents more difficult issues. The court has to look beyond
the express language of federal statutes to determine whether Congress has “occupied the field” in which

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the state is attempting to regulate, or whether a state law directly conflicts with federal law, or whether
enforcement of the state law might frustrate federal purposes.
Federal “occupation of the field” occurs, according to the court in Pennsylvania v. Nelson (1956), when
there is “no room” left for state regulation. Courts are to look to the pervasiveness of the federal scheme of
regulation, the federal interest at stake, and the danger of frustration of federal goals in making the
determination as to whether a challenged state law can stand.
In Silkwood v. Kerr-McGee (1984), the court, voting 5–4, found that a $10 million punitive damages
award (in a case litigated by famed attorney Gerry Spence) against a nuclear power plant was not
impliedly preempted by federal law. Even though the court had recently held that state regulation of the
safety aspects of a federally licensed nuclear power plant was preempted, the court drew a different
conclusion with respect to Congress’s desire to displace state tort law—even though the tort actions might
be premised on a violation of federal safety regulations.
Cipollone v. Liggett Group (1993) was a closely watched case concerning the extent of an express
preemption provision in two cigarette labeling laws of the 1960s. The case was a wrongful death action
brought against tobacco companies on behalf of Rose Cipollone, a lung cancer victim who had started
smoking cigarette in the 1940s. The court considered the preemptive effect on state law of a provision that
stated, “No requirement based on smoking and health shall be imposed under state law with respect to
the advertising and promotion of cigarettes.” The court concluded that several types of state tort actions
were preempted by the provision but allowed other types to go forward.

KEY TAKEAWAY
In cases of conflicts between state and federal law, federal law will preempt (or control) state law because of
the supremacy clause. Preemption can be express or implied. In cases where preemption is implied, the court
usually finds that compliance with both state and federal law is not possible or that a federal regulatory
scheme is comprehensive (i.e., “occupies the field”) and should not be modified by state actions.

EXERCISES

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1.

For many years, the United States engaged in discussions with friendly nations as to the reciprocal use of
ports and harbors. These discussions led to various multilateral agreements between the nations as to the
configuration of oceangoing vessels and how they would be piloted. At the same time, concern over oil
spills in Puget Sound led the state of Washington to impose fairly strict standards on oil tankers and
requirements for the training of oil tanker pilots. In addition, Washington’s state law imposed many other
requirements that went above and beyond agreed-upon requirements in the international agreements
negotiated by the federal government. Are the Washington state requirements preempted by federal
law?

2.

The Federal Arbitration Act of 1925 requires that all contracts for arbitration be treated as any other
contract at common law. Suppose that the state of Alabama wishes to protect its citizens from a variety of
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 placed within the first two pages of any contract, and that they have a separate signature line
where the customer, client, or patient acknowledges having read, understood, and signed the arbitration
clause in addition to any other signatures required on the contract. The legislation does preserve the right
of consumers to litigate in the event of a dispute arising with the product or service provider; that is, with
this legislation, consumers will not unknowingly waive their right to a trial at common law. Is the Alabama
law preempted by the Federal Arbitration Act?

[1] Cippolone v. Liggett Group, 505 US 504 (1993).

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4.5 Business and the Bill of Rights
LEARNING OBJECTIVES
1.

Understand and describe which articles in the Bill of Rights apply to business activities and how they
apply.

2.

Explain the application of the Fourteenth Amendment—including the due process clause and the
equal protection clause—to various rights enumerated in the original Bill of Rights.

We have already seen the Fourteenth Amendment’s application in Burger King v. Rudzewicz (Section 3.9
"Cases"). In that case, the court considered whether it was constitutionally correct for a court to assert
personal jurisdiction over a nonresident. The states cannot constitutionally award a judgment against a
nonresident if doing so would offend traditional notions of fair play and substantial justice. Even if the
state’s long-arm statute would seem to allow such a judgment, other states should not give it full faith and
credit (see Article V of the Constitution). In short, a state’s long-arm statute cannot confer personal
jurisdiction that the state cannot constitutionally claim.
The Bill of Rights (the first ten amendments to the Constitution) was originally meant to apply to federal
actions only. During the twentieth century, the court began to apply selected rights to state action as well.
So, for example, federal agents were prohibited from using evidence seized in violation of the Fourth
Amendment, but state agents were not, until Mapp v. Ohio (1960), when the court applied the guarantees
(rights) of the Fourth Amendment to state action as well. In this and in similar cases, the Fourteenth
Amendment’s due process clause was the basis for the court’s action. The due process clause commanded
that states provide due process in cases affecting the life, liberty, or property of US citizens, and the court
saw in this command certain “fundamental guarantees” that states would have to observe. Over the years,
most of the important guarantees in the Bill of Rights came to apply to state as well as federal action. The
court refers to this process as selective incorporation.
Here are some very basic principles to remember:
1.

The guarantees of the Bill of Rights apply only to state and federal government action. They do
not limit what a company or person in the private sector may do. For example, states may not

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impose censorship on the media or limit free speech in a way that offends the First Amendment,
but your boss (in the private sector) may order you not to talk to the media.
2. In some cases, a private company may be regarded as participating in “state action.” For example,
a private defense contractor that gets 90 percent of its business from the federal government has
been held to be public for purposes of enforcing the constitutional right to free speech (the
company had a rule barring its employees from speaking out in public against its corporate
position). It has even been argued that public regulation of private activity is sufficient to convert
the private into public activity, thus subjecting it to the requirements of due process. But the
Supreme Court rejected this extreme view in 1974 when it refused to require private power
companies, regulated by the state, to give customers a hearing before cutting off electricity for
failure to pay the bill.

[1]

3. States have rights, too. While “states rights” was a battle cry of Southern states before the Civil
War, the question of what balance to strike between state sovereignty and federal union has never
been simple. In Kimel v. Florida, for example, the Supreme Court found in the words of the
Eleventh Amendment a basis for declaring that states may not have to obey certain federal
statutes.

First Amendment
In part, the First Amendment states that “Congress shall make no law…abridging the freedom of speech,
or of the press.” The Founding Fathers believed that democracy would work best if people (and the press)
could talk or write freely, without governmental interference. But the First Amendment was also not
intended to be as absolute as it sounded. Oliver Wendell Holmes’s famous dictum that the law does not
permit you to shout “Fire!” in a crowded theater has seldom been answered, “But why not?” And no one in
1789 thought that defamation laws (torts for slander and libel) had been made unconstitutional.
Moreover, because the apparent purpose of the First Amendment was to make sure that the nation had a
continuing, vigorous debate over matters political, political speech has been given the highest level of
protection over such other forms of speech as (1) “commercial speech,” (2) speech that can and should be
limited by reasonable “time, place, and manner” restrictions, or (3) obscene speech.

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Because of its higher level of protection, political speech can be false, malicious, mean-spirited, or even a
pack of lies. A public official in the United States must be prepared to withstand all kinds of false
accusations and cannot succeed in an action for defamation unless the defendant has acted with “malice”
and “reckless disregard” of the truth. Public figures, such as CEOs of the largest US banks, must also be
prepared to withstand accusations that are false. In any defamation action, truth is a defense, but a
defamation action brought by a public figure or public official must prove that the defendant not only has
his facts wrong but also lies to the public in a malicious way with reckless disregard of the truth.
Celebrities such as Lindsay Lohan and Jon Stewart have the same burden to go forward with a defamation
action. It is for this reason that the National Enquirer writes exclusively about public figures, public
officials, and celebrities; it is possible to say many things that aren’t completely true and still have the
protection of the First Amendment.
Political speech is so highly protected that the court has recognized the right of people to support political
candidates through campaign contributions and thus promote the particular viewpoints and speech of
those candidates. Fearing the influence of money on politics, Congress has from time to time placed
limitations on corporate contributions to political campaigns. But the Supreme Court has had mixed
reactions over time. Initially, the court recognized the First Amendment right of a corporation to donate
money, subject to certain limits.

[2]

In another case, Austin v. Michigan Chamber of Commerce (1990), the

Michigan Campaign Finance Act prohibited corporations from using treasury money for independent
expenditures to support or oppose candidates in elections for state offices. But a corporation could make
such expenditures if it set up an independent fund designated solely for political purposes. The law was
passed on the assumption that “the unique legal and economic characteristics of corporations necessitate
some regulation of their political expenditures to avoid corruption or the appearance of corruption.”
The Michigan Chamber of Commerce wanted to support a candidate for Michigan’s House of
Representatives by using general funds to sponsor a newspaper advertisement and argued that as a
nonprofit organization, it was not really like a business firm. The court disagreed and upheld the Michigan
law. Justice Marshall found that the chamber was akin to a business group, given its activities, linkages
with community business leaders, and high percentage of members (over 75 percent) that were business
corporations. Furthermore, Justice Marshall found that the statute was narrowly crafted and

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implemented to achieve the important goal of maintaining integrity in the political process. But as you
will see in Citizens United v. Federal Election Commission (Section 4.6 "Cases"), Austin was overruled;
corporations are recognized as “persons” with First Amendment political speech rights that cannot be
impaired by Congress or the states without some compelling governmental interest with restrictions on
those rights that are “narrowly tailored.”

Fourth Amendment
The Fourth Amendment says, “all persons shall be secure in their persons, houses, papers, and effects
from unreasonable searches and seizures, and no warrants shall issue, but upon probable cause, before a
magistrate and upon Oath, specifically describing the persons to be searched and places to be seized.”
The court has read the Fourth Amendment to prohibit only those government searches or seizures that
are “unreasonable.” Because of this, businesses that are in an industry that is “closely regulated” can be
searched more frequently and can be searched without a warrant. In one case, an auto parts dealer at a
junkyard was charged with receiving stolen auto parts. Part of his defense was to claim that the search
that found incriminating evidence was unconstitutional. But the court found the search reasonable,
because the dealer was in a “closely regulated industry.”
In the 1980s, Dow Chemical objected to an overflight by the US Environmental Protection Agency (EPA).
The EPA had rented an airplane to fly over the Midland, Michigan, Dow plant, using an aerial mapping
camera to photograph various pipes, ponds, and machinery that were not covered by a roof. Because the
court’s precedents allowed governmental intrusions into “open fields,” the EPA search was ruled
constitutional. Because the literal language of the Fourth Amendment protected “persons, houses, papers,
and effects,” anything searched by the government in “open fields” was reasonable. (The court’s opinion
suggested that if Dow had really wanted privacy from governmental intrusion, it could have covered the
pipes and machinery that were otherwise outside and in open fields.)
Note again that constitutional guarantees like the Fourth Amendment apply to governmental action. Your
employer or any private enterprise is not bound by constitutional limits. For example, if drug testing of all
employees every week is done by government agency, the employees may have a cause of action to object

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based on the Fourth Amendment. However, if a private employer begins the same kind of routine drug
testing, employees have no constitutional arguments to make; they can simply leave that employer, or
they may pursue whatever statutory or common-law remedies are available.

Fifth Amendment
The Fifth Amendment states, “No person shall be…deprived of life, liberty, or property, without due
process of law; nor shall private property be taken for public use, without just compensation.”
The Fifth Amendment has three principal aspects: procedural due process, the takings clause,
and substantive due process. In terms of procedural due process, the amendment prevents
government from arbitrarily taking the life of a criminal defendant. In civil lawsuits, it is also
constitutionally essential that the proceedings be fair. This is why, for example, the defendant in Burger
King v. Rudzewicz had a serious constitutional argument, even though he lost.
The takings clause of the Fifth Amendment ensures that the government does not take private property
without just compensation. In the international setting, governments that take private property engage in
what is called expropriation. The standard under customary international law is that when governments
do that, they must provide prompt, adequate, and effective compensation. This does not always happen,
especially where foreign owners’ property is being expropriated. The guarantees of the Fifth Amendment
(incorporated against state action by the Fourteenth Amendment) are available to property owners where
state, county, or municipal government uses the power of eminent domain to take private property for
public purposes. Just what is a public purpose is a matter of some debate. For example, if a city were to
condemn economically viable businesses or neighborhoods to construct a baseball stadium with public
money to entice a private enterprise (the baseball team) to stay, is a public purpose being served?
In Kelo v. City of New London, Mrs. Kelo and other residents fought the city of New London, in its
attempt to use powers of eminent domain to create an industrial park and recreation area that would have
Pfizer & Co. as a principal tenant.

[3]

The city argued that increasing its tax base was a sufficient public

purpose. In a very close decision, the Supreme Court determined that New London’s actions did not
violate the takings clause. However, political reactions in various states resulted in a great deal of new

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state legislation that would limit the scope of public purpose in eminent domain takings and provide
additional compensation to property owners in many cases.
In addition to the takings clause and aspects of procedural due process, the Fifth Amendment is also the
source of what is called substantive due process. During the first third of the twentieth century, the
Supreme Court often nullified state and federal laws using substantive due process. In 1905, for example,
inLochner v. New York, the Supreme Court voided a New York statute that limited the number of hours
that bakers could work in a single week. New York had passed the law to protect the health of employees,
but the court found that this law interfered with the basic constitutional right of private parties to freely
contract with one another. Over the next thirty years, dozens of state and federal laws were struck down
that aimed to improve working conditions, secure social welfare, or establish the rights of unions.
However, in 1934, during the Great Depression, the court reversed itself and began upholding the kinds of
laws it had struck down earlier.
Since then, the court has employed a two-tiered analysis of substantive due process claims. Under the first
tier, legislation on economic matters, employment relations, and other business affairs is subject to
minimal judicial scrutiny. This means that a law will be overturned only if it serves no rational
government purpose. Under the second tier, legislation concerning fundamental liberties is subject to
“heightened judicial scrutiny,” meaning that a law will be invalidated unless it is “narrowly tailored to
serve a significant government purpose.”
The Supreme Court has identified two distinct categories of fundamental liberties. The first category
includes most of the liberties expressly enumerated in the Bill of Rights. Through a process known as
selective incorporation, the court has interpreted the due process clause of the Fourteenth Amendment to
bar states from denying their residents the most important freedoms guaranteed in the first ten
amendments to the federal Constitution. Only the Third Amendment right (against involuntary
quartering of soldiers) and the Fifth Amendment right to be indicted by a grand jury have not been made
applicable to the states. Because these rights are still not applicable to state governments, the Supreme
Court is often said to have “selectively incorporated” the Bill of Rights into the due process clause of the
Fourteenth Amendment.

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The second category of fundamental liberties includes those liberties that are not expressly stated in the
Bill of Rights but that can be seen as essential to the concepts of freedom and equality in a democratic
society. These unstated liberties come from Supreme Court precedents, common law, moral philosophy,
and deeply rooted traditions of US legal history. The Supreme Court has stressed that he
word liberty cannot be defined by a definitive list of rights; rather, it must be viewed as a rational
continuum of freedom through which every aspect of human behavior is protected from arbitrary
impositions and random restraints. In this regard, as the Supreme Court has observed, the due process
clause protects abstract liberty interests, including the right to personal autonomy, bodily integrity, selfdignity, and self-determination.
These liberty interests often are grouped to form a general right to privacy, which was first recognized
in Griswold v. Connecticut (Section 4.6.1), where the Supreme Court struck down a state statute
forbidding married adults from using, possessing, or distributing contraceptives on the ground that the
law violated the sanctity of the marital relationship. According to Justice Douglas’s plurality opinion, this
penumbra of privacy, though not expressly mentioned in the Bill of Rights, must be protected to establish
a buffer zone or breathing space for those freedoms that are constitutionally enumerated.
But substantive due process has seen fairly limited use since the 1930s. During the 1990s, the Supreme
Court was asked to recognize a general right to die under the doctrine of substantive due process.
Although the court stopped short of establishing such a far-reaching right, certain patients may exercise a
constitutional liberty to hasten their deaths under a narrow set of circumstances. In Cruzan v. Missouri
Department of Health, the Supreme Court ruled that the due process clause guarantees the right of
competent adults to make advanced directives for the withdrawal of life-sustaining measures should they
become incapacitated by a disability that leaves them in a persistent vegetative state.

[4]

Once it has been

established by clear and convincing evidence that a mentally incompetent and persistently vegetative
patient made such a prior directive, a spouse, parent, or other appropriate guardian may seek to terminate
any form of artificial hydration or nutrition.

Fourteenth Amendment: Due Process and Equal Protection Guarantees

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The Fourteenth Amendment (1868) requires that states treat citizens of other states with due process.
This can be either an issue of procedural due process (as in Section 3.9 "Cases", Burger King v.
Rudzewicz) or an issue of substantive due process. For substantive due process, consider what happened
in an Alabama court not too long ago.

[5]

The plaintiff, Dr. Ira Gore, bought a new BMW for $40,000 from a dealer in Alabama. He later discovered
that the vehicle’s exterior had been slightly damaged in transit from Europe and had therefore been
repainted by the North American distributor prior to his purchase. The vehicle was, by best estimates,
worth about 10 percent less than he paid for it. The distributor, BMW of North America, had routinely
sold slightly damaged cars as brand new if the damage could be fixed for less than 3 percent of the cost of
the car. In the trial, Dr. Gore sought $4,000 in compensatory damages and also punitive damages. The
Alabama trial jury considered that BMW was engaging in a fraudulent practice and wanted to punish the
defendant for a number of frauds it estimated at somewhere around a thousand nationwide. The jury
awarded not only the $4,000 in compensatory damages but also $4 million in punitive damages, which
was later reduced to $2 million by the Alabama Supreme Court. On appeal to the US Supreme Court, the
court found that punitive damages may not be “grossly excessive.” If they are, then they violate
substantive due process. Whatever damages a state awards must be limited to what is reasonably
necessary to vindicate the state’s legitimate interest in punishment and deterrence.
“Equal protection of the laws” is a phrase that originates in the Fourteenth Amendment, adopted in 1868.
The amendment provides that no state shall “deny to any person within its jurisdiction the equal
protection of the laws.” This is the equal protection clause. It means that, generally speaking,
governments must treat people equally. Unfair classifications among people or corporations will not be
permitted. A well-known example of unfair classification would be race discrimination: requiring white
children and black children to attend different public schools or requiring “separate but equal” public
services, such as water fountains or restrooms. Yet despite the clear intent of the 1868 amendment,
“separate but equal” was the law of the land until Brown v. Board of Education (1954).

[6]

Governments make classifications every day, so not all classifications can be illegal under the equal
protection clause. People with more income generally pay a greater percentage of their income in taxes.

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People with proper medical training are licensed to become doctors; people without that training cannot
be licensed and commit a criminal offense if they do practice medicine. To know what classifications are
permissible under the Fourteenth Amendment, we need to know what is being classified. The court has
created three classifications, and the outcome of any equal protection case can usually be predicted by
knowing how the court is likely to classify the case:
•

Minimal scrutiny: economic and social relations. Government actions are usually upheld if there
is a rational basis for them.

•

Intermediate scrutiny: gender. Government classifications are sometimes upheld.

•

Strict scrutiny: race, ethnicity, and fundamental rights. Classifications based on any of these are
almost never upheld.

Under minimal scrutiny for economic and social regulation, laws that regulate economic or social issues
are presumed valid and will be upheld if they are rationally related to legitimate goals of government. So,
for example, if the city of New Orleans limits the number of street vendors to some rational number (more
than one but fewer than the total number that could possibly fit on the sidewalks), the local ordinance
would not be overturned as a violation of equal protection.
Under intermediate scrutiny, the city of New Orleans might limit the number of street vendors who are
men. For example, suppose that the city council decreed that all street vendors must be women, thinking
that would attract even more tourism. A classification like this, based on sex, will have to meet a sterner
test than a classification resulting from economic or social regulation. A law like this would have to
substantially relate to important government objectives. Increasingly, courts have nullified government
sex classifications as societal concern with gender equality has grown. (See Shannon Faulkner’s case
against The Citadel, an all-male state school.)

[7]

Suppose, however, that the city of New Orleans decided that no one of Middle Eastern heritage could
drive a taxicab or be a street vendor. That kind of classification would be examined with strict scrutiny to
see if there was any compelling justification for it. As noted, classifications such as this one are almost
never upheld. The law would be upheld only if it were necessary to promote a compelling state interest.
Very few laws that have a racial or ethnic classification meet that test.

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The strict scrutiny test will be applied to classifications involving racial and ethnic criteria as well as
classifications that interfere with a fundamental right. In Palmore v. Sidoti, the state refused to award
[8]

custody to the mother because her new spouse was racially different from the child. This practice was
declared unconstitutional because the state had made a racial classification; this was presumptively
invalid, and the government could not show a compelling need to enforce such a classification through its
law. An example of government action interfering with a fundamental right will also receive strict
scrutiny. When New York State gave an employment preference to veterans who had been state residents
at the time of entering the military, the court declared that veterans who were new to the state were less
likely to get jobs and that therefore the statute interfered with the right to travel, which was deemed a
fundamental right.

[9]

KEY TAKEAWAY
The Bill of Rights, through the Fourteenth Amendment, largely applies to state actions. The Bill of Rights has
applied to federal actions from the start. Both the Bill of Rights and the Fourteenth Amendment apply to
business in various ways, but it is important to remember that the rights conferred are rights against
governmental action and not the actions of private enterprise.

EXERCISES
1.

John Hanks works at ProLogis. The company decides to institute a drug-testing policy. John is a good and
longtime employee but enjoys smoking marijuana on the weekends. The drug testing will involve urine
samples and, semiannually, a hair sample. It is nearly certain that the drug-testing protocol that ProLogis
proposes will find that Hanks is a marijuana user. The company has made it clear that it will have zero
tolerance for any kind of nonprescribed controlled substances. John and several fellow employees wish to
go to court to challenge the proposed testing as “an unreasonable search and seizure.” Can he possibly
succeed?

2.

Larry Reed, majority leader in the Senate, is attacked in his reelection campaign by a series of ads
sponsored by a corporation (Global Defense, Inc.) that does not like his voting record. The corporation is
upset that Reed would not write a special provision that would favor Global Defense in a defense
appropriations bill. The ads run constantly on television and radio in the weeks immediately preceding
election day and contain numerous falsehoods. For example, in order to keep the government running

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financially, Reed found it necessary to vote for a bill that included a last-minute rider that defunded a
small government program for the handicapped, sponsored by someone in the opposing party that
wanted to privatize all programs for the handicapped. The ad is largely paid for by Global Defense and
depicts a handicapped child being helped by the existing program and large letters saying “Does Larry
Reed Just Not Care?” The ad proclaims that it is sponsored by Citizens Who Care for a Better Tomorrow. Is
this protected speech? Why or why not? Can Reed sue for defamation? Why or why not?

[1] Jackson v. Metropolitan Edison Co., 419 US 345 (1974).
[2] Buckley v. Valeo, 424 US 1 (1976).
[3] Kelo v. City of New London, 545 US 469 (2005).
[4] Cruzan v. Missouri Department of Health, 497 US 261 (1990).
[5] BMW of North America, Inc. v. Gore, 517 U.S. 559 (1996)
[6] Plessy v. Ferguson, 163 US 537 (1896).
[7] United States v. Virginia, 518 US 515 (1996).
[8] Palmore v. Sidoti, 466 US 429 (1984).
[9] Atty. Gen. of New York v. Soto-Lopez, 476 US 898 (1986).

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4.6 Cases
Griswold v. Connecticut
Griswold v. Connecticut
381 U.S. 479 (U.S. Supreme Court 1965)
A nineteenth-century Connecticut law made the use, possession, or distribution of birth control devices
illegal. The law also prohibited anyone from giving information about such devices. The executive
director and medical director of a planned parenthood association were found guilty of giving out such
information to a married couple that wished to delay having children for a few years. The directors
were fined $100 each.
They appealed throughout the Connecticut state court system, arguing that the state law violated
(infringed) a basic or fundamental right of privacy of a married couple: to live together and have sex
together without the restraining power of the state to tell them they may legally have intercourse but
not if they use condoms or other birth control devices. At each level (trial court, court of appeals, and
Connecticut Supreme Court), the Connecticut courts upheld the constitutionality of the convictions.
Plurality Opinion by Justice William O. Douglass
We do not sit as a super legislature to determine the wisdom, need, and propriety of laws that touch
economic problems, business affairs, or social conditions. The [Connecticut] law, however, operates
directly on intimate relation of husband and wife and their physician’s role in one aspect of that relation.
[Previous] cases suggest that specific guarantees in the Bill of Rights have penumbras, formed by
emanations from those guarantees that help give them life and substance.…Various guarantees create
zones of privacy. The right of association contained in the penumbra of the First Amendment is one.…The
Third Amendment in its prohibition against the quartering of soldiers “in any house” in time of peace
without the consent of the owner is another facet of that privacy. The Fourth Amendment explicitly
affirms the “right of the people to be secure in their persons, houses, papers and effects, against
unreasonable searches and seizures.” The Fifth Amendment in its Self-Incrimination Clause enables the

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citizen to create a zone of privacy which the government may not force him to surrender to his detriment.
The Ninth Amendment provides: “The enumeration in the Constitution, of certain rights, shall not be
construed to deny or disparage others retained by the people.”
The Fourth and Fifth Amendments were described…as protection against all governmental invasions “of
the sanctity of a man’s home and the privacies of life.” We recently referred in Mapp v. Ohio…to the
Fourth Amendment as creating a “right to privacy, no less important than any other right carefully and
particularly reserved to the people.”
[The law in question here], in forbidding the use of contraceptives rather than regulating their
manufacture or sale, seeks to achieve its goals by having a maximum destructive impact on [the marital]
relationship. Such a law cannot stand.…Would we allow the police to search the sacred precincts of
marital bedrooms for telltale signs of the use of contraceptives? The very idea is repulsive to the notions of
privacy surrounding the marital relationship.
We deal with a right of privacy older than the Bill of Rights—older than our political parties, older than
our school system. Marriage is a coming together for better or for worse, hopefully enduring, and intimate
to the degree of being sacred. It is an association that promotes a way of life, not causes; a harmony in
living, not political faiths; a bilateral loyalty, not commercial or social projects. Yet it is an association for
as noble a purpose as any involved in our prior decisions.
Mr. Justice Stewart, whom Mr. Justice Black joins, dissenting.
Since 1879 Connecticut has had on its books a law which forbids the use of contraceptives by anyone. I
think this is an uncommonly silly law. As a practical matter, the law is obviously unenforceable, except in
the oblique context of the present case. As a philosophical matter, I believe the use of contraceptives in the
relationship of marriage should be left to personal and private choice, based upon each individual’s moral,
ethical, and religious beliefs. As a matter of social policy, I think professional counsel about methods of
birth control should be available to all, so that each individual’s choice can be meaningfully made. But we
are not asked in this case to say whether we think this law is unwise, or even asinine. We are asked to hold
that it violates the United States Constitution. And that I cannot do.

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In the course of its opinion the Court refers to no less than six Amendments to the Constitution: the First,
the Third, the Fourth, the Fifth, the Ninth, and the Fourteenth. But the Court does not say which of these
Amendments, if any, it thinks is infringed by this Connecticut law.
…
As to the First, Third, Fourth, and Fifth Amendments, I can find nothing in any of them to invalidate this
Connecticut law, even assuming that all those Amendments are fully applicable against the States. It has
not even been argued that this is a law “respecting an establishment of religion, or prohibiting the free
exercise thereof.” And surely, unless the solemn process of constitutional adjudication is to descend to the
level of a play on words, there is not involved here any abridgment of “the freedom of speech, or of the
press; or the right of the people peaceably to assemble, and to petition the Government for a redress of
grievances.” No soldier has been quartered in any house. There has been no search, and no seizure.
Nobody has been compelled to be a witness against himself.
The Court also quotes the Ninth Amendment, and my Brother Goldberg’s concurring opinion relies
heavily upon it. But to say that the Ninth Amendment has anything to do with this case is to turn
somersaults with history. The Ninth Amendment, like its companion the Tenth, which this Court held
“states but a truism that all is retained which has not been surrendered,” United States v. Darby, 312 U.S.
100, 124, was framed by James Madison and adopted by the States simply to make clear that the adoption
of the Bill of Rights did not alter the plan that the Federal Government was to be a government of express
and limited powers, and that all rights and powers not delegated to it were retained by the people and the
individual States. Until today no member of this Court has ever suggested that the Ninth Amendment
meant anything else, and the idea that a federal court could ever use the Ninth Amendment to annul a law
passed by the elected representatives of the people of the State of Connecticut would have caused James
Madison no little wonder.
What provision of the Constitution, then, does make this state law invalid? The Court says it is the right of
privacy “created by several fundamental constitutional guarantees.” With all deference, I can find no such
general right of privacy in the Bill of Rights, in any other part of the Constitution, or in any case ever
before decided by this Court.

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At the oral argument in this case we were told that the Connecticut law does not “conform to current
community standards.” But it is not the function of this Court to decide cases on the basis of community
standards. We are here to decide cases “agreeably to the Constitution and laws of the United States.” It is
the essence of judicial duty to subordinate our own personal views, our own ideas of what legislation is
wise and what is not. If, as I should surely hope, the law before us does not reflect the standards of the
people of Connecticut, the people of Connecticut can freely exercise their true Ninth and Tenth
Amendment rights to persuade their elected representatives to repeal it. That is the constitutional way to
take this law off the books.

CASE QUESTIONS
1.

Which opinion is the strict constructionist opinion here—Justice Douglas’s or that of Justices Stewart
and Black?

2.

What would have happened if the Supreme Court had allowed the Connecticut Supreme Court
decision to stand and followed Justice Black’s reasoning? Is it likely that the citizens of Connecticut
would have persuaded their elected representatives to repeal the law challenged here?

Wickard v. Filburn
Wickard v. Filburn
317 U.S. 111 (U.S. Supreme Court 1942)
Mr. Justice Jackson delivered the opinion of the Court.
Mr. Filburn for many years past has owned and operated a small farm in Montgomery County, Ohio,
maintaining a herd of dairy cattle, selling milk, raising poultry, and selling poultry and eggs. It has been
his practice to raise a small acreage of winter wheat, sown in the Fall and harvested in the following July;
to sell a portion of the crop; to feed part to poultry and livestock on the farm, some of which is sold; to use
some in making flour for home consumption; and to keep the rest for the following seeding.
His 1941 wheat acreage allotment was 11.1 acres and a normal yield of 20.1 bushels of wheat an acre. He
sowed, however, 23 acres, and harvested from his 11.9 acres of excess acreage 239 bushels, which under

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the terms of the Act as amended on May 26, 1941, constituted farm marketing excess, subject to a penalty
of 49 cents a bushel, or $117.11 in all.
The general scheme of the Agricultural Adjustment Act of 1938 as related to wheat is to control the
volume moving in interstate and foreign commerce in order to avoid surpluses and shortages and the
consequent abnormally low or high wheat prices and obstructions to commerce. [T]he Secretary of
Agriculture is directed to ascertain and proclaim each year a national acreage allotment for the next crop
of wheat, which is then apportioned to the states and their counties, and is eventually broken up into
allotments for individual farms.
It is urged that under the Commerce Clause of the Constitution, Article I, § 8, clause 3, Congress does not
possess the power it has in this instance sought to exercise. The question would merit little consideration
since our decision in United States v. Darby, 312 U.S. 100, sustaining the federal power to regulate
production of goods for commerce, except for the fact that this Act extends federal regulation to
production not intended in any part for commerce but wholly for consumption on the farm.

Kassel v. Consolidated Freightways Corp.
Kassel v. Consolidated Freightways Corp.
450 U.S. 662 (U.S. Supreme Court 1981)
JUSTICE POWELL announced the judgment of the Court and delivered an opinion, in which JUSTICE
WHITE, JUSTICE BLACKMUN, and JUSTICE STEVENS joined.
The question is whether an Iowa statute that prohibits the use of certain large trucks within the State
unconstitutionally burdens interstate commerce.

I
Appellee Consolidated Freightways Corporation of Delaware (Consolidated) is one of the largest common
carriers in the country: it offers service in 48 States under a certificate of public convenience and necessity
issued by the Interstate Commerce Commission. Among other routes, Consolidated carries commodities

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through Iowa on Interstate 80, the principal east-west route linking New York, Chicago, and the west
coast, and on Interstate 35, a major north-south route.
Consolidated 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 “semi,” is 55 feet in length overall. Such trucks have
long been used on the Nation’s highways. Consolidated also uses a two-axle tractor pulling a single-axle
trailer which, in turn, pulls a single-axle dolly and a second single-axle trailer. This combination, known
as a double, or twin, is 65 feet long overall. Many trucking companies, including Consolidated,
increasingly prefer to use doubles to ship certain kinds of commodities. Doubles have larger capacities,
and the trailers can be detached and routed separately if necessary. Consolidated would like to use 65-foot
doubles on many of its trips through Iowa.
The State of Iowa, however, by statute, restricts the length of vehicles that may use its highways. Unlike all
other States in the West and Midwest, Iowa generally prohibits the use of 65-foot doubles within its
borders.
…
Because of Iowa’s statutory scheme, Consolidated cannot use its 65-foot doubles to move commodities
through the State. Instead, the company must do one of four things: (i) use 55-foot singles; (ii) use 60-foot
doubles; (iii) detach the trailers of a 65-foot double and shuttle each through the State separately; or (iv)
divert 65-foot doubles around Iowa. Dissatisfied with these options, Consolidated filed this suit in the
District Court averring that Iowa’s statutory scheme unconstitutionally burdens interstate commerce.
Iowa defended the law as a reasonable safety measure enacted pursuant to its police power. The State
asserted that 65-foot doubles are more dangerous than 55-foot singles and, in any event, that the law
promotes safety and reduces road wear within the State by diverting much truck traffic to other states.
In a 14-day trial, both sides adduced evidence on safety and on the burden on interstate commerce
imposed by Iowa’s law. On the question of safety, the District Court found that the “evidence clearly
establishes that the twin is as safe as the semi.” 475 F.Supp. 544, 549 (SD Iowa 1979). For that reason,
“there is no valid safety reason for barring twins from Iowa’s highways because of their

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configuration.…The evidence convincingly, if not overwhelmingly, establishes that the 65-foot twin is as
safe as, if not safer than, the 60-foot twin and the 55-foot semi.…”
“Twins and semis have different characteristics. Twins are more maneuverable, are less sensitive to wind,
and create less splash and spray. However, they are more likely than semis to jackknife or upset. They can
be backed only for a short distance. The negative characteristics are not such that they render the twin less
safe than semis overall. Semis are more stable, but are more likely to ‘rear-end’ another vehicle.”
In light of these findings, the District Court applied the standard we enunciated in Raymond Motor
Transportation, Inc. v. Rice, 434 U.S. 429 (1978), and concluded that the state law impermissibly
burdened interstate commerce: “[T]he balance here must be struck in favor of the federal interests.
The total effect of the law as a safety measure in reducing accidents and casualties is so slight and
problematical that it does not outweigh the national interest in keeping interstate commerce free from
interferences that seriously impede it.”
The Court of Appeals for the Eighth Circuit affirmed. 612 F.2d 1064 (1979). It accepted the District Court’s
finding that 65-foot doubles were as safe as 55-foot singles. Id. at 1069. Thus, the only apparent safety
benefit to Iowa was that resulting from forcing large trucks to detour around the State, thereby reducing
overall truck traffic on Iowa’s highways. The Court of Appeals noted that this was not a constitutionally
permissible interest. It also commented that the several statutory exemptions identified above, such as
those applicable to border cities and the shipment of livestock, suggested that the law, in effect, benefited
Iowa residents at the expense of interstate traffic. Id. at 1070-1071. The combination of these exemptions
weakened the presumption of validity normally accorded a state safety regulation. For these reasons, the
Court of Appeals agreed with the District Court that the Iowa statute unconstitutionally burdened
interstate commerce.
Iowa appealed, and we noted probable jurisdiction. 446 U.S. 950 (1980). We now affirm.

II
It is unnecessary to review in detail the evolution of the principles of Commerce Clause adjudication. The
Clause is both a “prolific ‘ of national power and an equally prolific source of conflict with legislation of the

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state[s].” H. P. Hood & Sons, Inc. v. Du Mond, 336 U.S. 525, 336 U.S. 534 (1949). The Clause permits
Congress to legislate when it perceives that the national welfare is not furthered by the independent
actions of the States. It is now well established, also, that the Clause itself is “a limitation upon state power
even without congressional implementation.” Hunt v. Washington Apple Advertising Comm’n, 432 U.S.
333 at 350 (1977). The Clause requires that some aspects of trade generally must remain free from
interference by the States. When a State ventures excessively into the regulation of these aspects of
commerce, it “trespasses upon national interests,” Great A&P Tea Co. v. Cottrell, 424 U.S. 366, 424 U.S.
373 (1976), and the courts will hold the state regulation invalid under the Clause alone.
The Commerce Clause does not, of course, invalidate all state restrictions on commerce. It has long been
recognized that, “in the absence of conflicting legislation by Congress, there is a residuum of power in the
state to make laws governing matters of local concern which nevertheless in some measure affect
interstate commerce or even, to some extent, regulate it.” Southern Pacific Co. v. Arizona, 325 U.S. 761
(1945).
The extent of permissible state regulation is not always easy to measure. It may be said with confidence,
however, that a State’s power to regulate commerce is never greater than in matters traditionally of local
concern. Washington Apple Advertising Comm’n, supra at 432 U.S. 350. For example, regulations that
touch upon safety—especially highway safety—are those that “the Court has been most reluctant to
invalidate.” Raymond, supra at 434 U.S. 443 (and other cases cited). Indeed, “if safety justifications are
not illusory, the Court will not second-guess legislative judgment about their importance in comparison
with related burdens on interstate commerce.” Raymond, supra at 434 U.S. at 449. Those who would
challenge such bona fide safety regulations must overcome a “strong presumption of validity.” Bibb v.
Navajo Freight Lines, Inc., 359 U.S. 520 at (1959).
But the incantation of a purpose to promote the public health or safety does not insulate a state law from
Commerce Clause attack. Regulations designed for that salutary purpose nevertheless may further the
purpose so marginally, and interfere with commerce so substantially, as to be invalid under the
Commerce Clause. In the Court’s recent unanimous decision in Raymond we declined to “accept the
State’s contention that the inquiry under the Commerce Clause is ended without a weighing of the

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asserted safety purpose against the degree of interference with interstate commerce.” This “weighing” by a
court requires—and indeed the constitutionality of the state regulation depends on—“a sensitive
consideration of the weight and nature of the state regulatory concern in light of the extent of the burden
imposed on the course of interstate commerce.” Id. at 434 U.S. at 441; accord, Pike v. Bruce Church, Inc.,
397 U.S. 137 at 142 (1970);Bibb, supra, at 359 U.S. at 525-530.

III
Applying these general principles, we conclude that the Iowa truck length limitations unconstitutionally
burden interstate commerce.
In Raymond Motor Transportation, Inc. v. Rice, the Court held that a Wisconsin statute that precluded
the use of 65-foot doubles violated the Commerce Clause. This case is Raymond revisited. Here, as
in Raymond, the State failed to present any persuasive evidence that 65-foot doubles are less safe than 55foot singles. Moreover, Iowa’s law is now out of step with the laws of all other Midwestern and Western
States. Iowa thus substantially burdens the interstate flow of goods by truck. In the absence of
congressional action to set uniform standards, some burdens associated with state safety regulations must
be tolerated. But where, as here, the State’s safety interest has been found to be illusory, and its
regulations impair significantly the federal interest in efficient and safe interstate transportation, the state
law cannot be harmonized with the Commerce Clause.

A
Iowa made a more serious effort to support the safety rationale of its law than did Wisconsin in Raymond,
but its effort was no more persuasive. As noted above, the District Court found that the “evidence clearly
establishes that the twin is as safe as the semi.” The record supports this finding. The trial focused on a
comparison of the performance of the two kinds of trucks in various safety categories. The evidence
showed, and the District Court found, that the 65-foot double was at least the equal of the 55-foot single in
the ability to brake, turn, and maneuver. The double, because of its axle placement, produces less splash
and spray in wet weather. And, because of its articulation in the middle, the double is less susceptible to
dangerous “off-tracking,” and to wind.

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None of these findings is seriously disputed by Iowa. Indeed, the State points to only three ways in which
the 55-foot single is even arguably superior: singles take less time to be passed and to clear intersections;
they may back up for longer distances; and they are somewhat less likely to jackknife.
The first two of these characteristics are of limited relevance on modern interstate highways. As the
District Court found, the negligible difference in the time required to pass, and to cross intersections, is
insignificant on 4-lane divided highways, because passing does not require crossing into oncoming traffic
lanes, Raymond, 434 U.S. at 444, and interstates have few, if any, intersections. The concern over backing
capability also is insignificant, because it seldom is necessary to back up on an interstate. In any event, no
evidence suggested any difference in backing capability between the 60-foot doubles that Iowa permits
and the 65-foot doubles that it bans. Similarly, although doubles tend to jackknife somewhat more than
singles, 65-foot doubles actually are less likely to jackknife than 60-foot doubles.
Statistical studies supported the view that 65-foot doubles are at least as safe overall as 55-foot singles and
60-foot doubles. One such study, which the District Court credited, reviewed Consolidated’s comparative
accident experience in 1978 with its own singles and doubles. Each kind of truck was driven 56 million
miles on identical routes. The singles were involved in 100 accidents resulting in 27 injuries and one
fatality. The 65-foot doubles were involved in 106 accidents resulting in 17 injuries and one fatality. Iowa’s
expert statistician admitted that this study provided “moderately strong evidence” that singles have a
higher injury rate than doubles. Another study, prepared by the Iowa Department of Transportation at the
request of the state legislature, concluded that “[s]ixty-five foot twin trailer combinations have not been
shown by experiences in other states to be less safe than 60-foot twin trailer
combinations or conventional tractor-semitrailers.”
In sum, although Iowa introduced more evidence on the question of safety than did Wisconsin
in Raymond, the record as a whole was not more favorable to the State.

B
Consolidated, meanwhile, demonstrated that Iowa’s law substantially burdens interstate commerce.
Trucking companies that wish to continue to use 65-foot doubles must route them around Iowa or detach

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the trailers of the doubles and ship them through separately. Alternatively, trucking companies must use
the smaller 55-foot singles or 65-foot doubles permitted under Iowa law. Each of these options engenders
inefficiency and added expense. The record shows that Iowa’s law added about $12.6 million each year to
the costs of trucking companies.
Consolidated alone incurred about $2 million per year in increased costs.
In addition to increasing the costs of the trucking companies (and, indirectly, of the service to
consumers), Iowa’s 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
same quantity of goods through Iowa or the same number of larger trucks must drive longer distances to
bypass Iowa. In either case, as the District Court noted, the restriction requires more highway miles to be
driven to transport the same quantity of goods. Other things being equal, accidents are proportional to
distance traveled. Thus, if 65-foot doubles are as safe as 55-foot singles, Iowa’s law tends to increase the
number of accidents and to shift the incidence of them from Iowa to other States.

[IV. Omitted]
V
In sum, the statutory exemptions, their history, and the arguments Iowa has advanced in support of its
law in this litigation all suggest that the deference traditionally accorded a State’s safety judgment is not
warranted. See Raymond, supra at 434 U.S. at 444-447. The controlling factors thus are the findings of
the District Court, accepted by the Court of Appeals, with respect to the relative safety of the types of
trucks at issue, and the substantiality of the burden on interstate commerce.
Because Iowa has imposed this burden without any significant countervailing safety interest, its statute
violates the Commerce Clause. The judgment of the Court of Appeals is affirmed.
It is so ordered.

CASE QUESTIONS
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1.

Under the Constitution, what gives Iowa the right to make rules regarding the size or configuration of
trucks upon highways within the state?

2.

Did Iowa try to exempt trucking lines based in Iowa, or was the statutory rule nondiscriminatory as to
the origin of trucks that traveled on Iowa highways?

3.

Are there any federal size or weight standards noted in the case? Is there any kind of truck size or
weight that could be limited by Iowa law, or must Iowa simply accept federal standards or, if none,
impose no standards at all?

Hunt v. Washington Apple Advertising Commission
Hunt v. Washington Apple Advertising Commission
432 U.S. 33 (U.S. Supreme Court 1977)
MR. CHIEF JUSTICE BURGER delivered the opinion of the Court.
In 1973, North Carolina enacted a statute which required, inter alia, all closed containers of apples sold,
offered for sale, or shipped into the State to bear “no grade other than the applicable U.S. grade or
standard.”…Washington State is the Nation’s largest producer of apples, its crops accounting for
approximately 30% of all apples grown domestically and nearly half of all apples shipped in closed
containers in interstate commerce. [Because] of the importance of the apple industry to the State, its
legislature has undertaken to protect and enhance the reputation of Washington apples by establishing a
stringent, mandatory inspection program [that] requires all apples shipped in interstate commerce to be
tested under strict quality standards and graded accordingly. In all cases, the Washington State grades
[are] the equivalent of, or superior to, the comparable grades and standards adopted by the [U.S. Dept. of]
Agriculture (USDA).
[In] 1972, the North Carolina Board of Agriculture adopted an administrative regulation, unique in the 50
States, which in effect required all closed containers of apples shipped into or sold in the State to display
either the applicable USDA grade or a notice indicating no classification. State grades were expressly
prohibited. In addition to its obvious consequence—prohibiting the display of Washington State apple
grades on containers of apples shipped into North Carolina—the regulation presented the Washington

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apple industry with a marketing problem of potentially nationwide significance. Washington apple
growers annually ship in commerce approximately 40 million closed containers of apples, nearly 500,000
of which eventually find their way into North Carolina, stamped with the applicable Washington State
variety and grade. [Compliance] with North Carolina’s unique regulation would have required
Washington growers to obliterate the printed labels on containers shipped to North Carolina, thus giving
their product a damaged appearance. Alternatively, they could have changed their marketing practices to
accommodate the needs of the North Carolina market, i.e., repack apples to be shipped to North Carolina
in containers bearing only the USDA grade, and/or store the estimated portion of the harvest destined for
that market in such special containers. As a last resort, they could discontinue the use of the preprinted
containers entirely. None of these costly and less efficient options was very attractive to the industry.
Moreover, in the event a number of other States followed North Carolina’s lead, the resultant inability to
display the Washington grades could force the Washington growers to abandon the State’s expensive
inspection and grading system which their customers had come to know and rely on over the 60-odd
years of its existence.…
Unsuccessful in its attempts to secure administrative relief [with North Carolina], the Commission
instituted this action challenging the constitutionality of the statute. [The] District Court found that the
North Carolina statute, while neutral on its face, actually discriminated against Washington State growers
and dealers in favor of their local counterparts [and] concluded that this discrimination [was] not justified
by the asserted local interest—the elimination of deception and confusion from the marketplace—arguably
furthered by the [statute].
…
[North Carolina] maintains that [the] burdens on the interstate sale of Washington apples were far
outweighed by the local benefits flowing from what they contend was a valid exercise of North Carolina’s
[police powers]. Prior to the statute’s enactment,…apples from 13 different States were shipped into North
Carolina for sale. Seven of those States, including [Washington], had their own grading systems which,
while differing in their standards, used similar descriptive labels (e.g., fancy, extra fancy, etc.). This
multiplicity of inconsistent state grades [posed] dangers of deception and confusion not only in the North

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Carolina market, but in the Nation as a whole. The North Carolina statute, appellants claim, was enacted
to eliminate this source of deception and confusion. [Moreover], it is contended that North Carolina
sought to accomplish this goal of uniformity in an evenhanded manner as evidenced by the fact that its
statute applies to all apples sold in closed containers in the State without regard to their point of origin.
[As] the appellants properly point out, not every exercise of state authority imposing some burden on the
free flow of commerce is invalid, [especially] when the State acts to protect its citizenry in matters
pertaining to the sale of foodstuffs. By the same token, however, a finding that state legislation furthers
matters of legitimate local concern, even in the health and consumer protection areas, does not end the
inquiry. Rather, when such state legislation comes into conflict with the Commerce Clause’s overriding
requirement of a national “common market,” we are confronted with the task of effecting an
accommodation of the competing national and local interests. We turn to that task.
As the District Court correctly found, the challenged statute has the practical effect of not only burdening
interstate sales of Washington apples, but also discriminating against them. This discrimination takes
various forms. The first, and most obvious, is the statute’s consequence of raising the costs of doing
business in the North Carolina market for Washington apple growers and dealers, while leaving those of
their North Carolina counterparts unaffected. [This] disparate effect results from the fact that North
Carolina apple producers, unlike their Washington competitors, were not forced to alter their marketing
practices in order to comply with the statute. They were still free to market their wares under the USDA
grade or none at all as they had done prior to the statute’s enactment. Obviously, the increased costs
imposed by the statute would tend to shield the local apple industry from the competition of Washington
apple growers and dealers who are already at a competitive disadvantage because of their great distance
from the North Carolina market.
Second, the statute has the effect of stripping away from the Washington apple industry the competitive
and economic advantages it has earned for itself through its expensive inspection and grading system. The
record demonstrates that the Washington apple-grading system has gained nationwide acceptance in the
apple trade. [The record] contains numerous affidavits [stating a] preference [for] apples graded under
the Washington, as opposed to the USDA, system because of the former’s greater consistency, its

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emphasis on color, and its supporting mandatory inspections. Once again, the statute had no similar
impact on the North Carolina apple industry and thus operated to its benefit.
Third, by prohibiting Washington growers and dealers from marketing apples under their State’s grades,
the statute has a leveling effect which insidiously operates to the advantage of local apple producers.
[With] free market forces at work, Washington sellers would normally enjoy a distinct market advantage
vis-à-vis local producers in those categories where the Washington grade is superior. However, because of
the statute’s operation, Washington apples which would otherwise qualify for and be sold under the
superior Washington grades will now have to be marketed under their inferior USDA counterparts. Such
“downgrading” 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
embargo against those Washington apples in the superior grades as Washington dealers withhold them
from the North Carolina market. At best, it will deprive Washington sellers of the market premium that
such apples would otherwise command.
Despite the statute’s facial neutrality, the Commission suggests that its discriminatory impact on
interstate commerce was not an unintended by-product, and there are some indications in the record to
that effect. The most glaring is the response of the North Carolina Agriculture Commissioner to the
Commission’s request for an exemption following the statute’s passage in which he indicated that before
he could support such an exemption, he would “want to have the sentiment from our apple
producers since they were mainly responsible for this legislation being passed.” [Moreover], we find it
somewhat suspect that North Carolina singled out only closed containers of apples, the very means by
which apples are transported in commerce, to effectuate the statute’s ostensible consumer protection
purpose when apples are not generally sold at retail in their shipping containers. However, we need not
ascribe an economic protection motive to the North Carolina Legislature to resolve this case; we conclude
that the challenged statute cannot stand insofar as it prohibits the display of Washington State grades
even if enacted for the declared purpose of protecting consumers from deception and fraud in the
marketplace.
…

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Finally, we note that any potential for confusion and deception created by the Washington grades was not
of the type that led to the statute’s enactment. Since Washington grades are in all cases equal or superior
to their USDA counterparts, they could only “deceive” or “confuse” a consumer to his benefit, hardly a
harmful result.
In addition, it appears that nondiscriminatory alternatives to the outright ban of Washington State grades
are readily available. For example, North Carolina could effectuate its goal by permitting out-of-state
growers to utilize state grades only if they also marked their shipments with the applicable USDA label. In
that case, the USDA grade would serve as a benchmark against which the consumer could evaluate the
quality of the various state grades.…
[The court affirmed the lower court’s holding that the North Carolina statute was unconstitutional.]

CASE QUESTIONS
1.

Was the North Carolina law discriminatory on its face? Was it, possibly, an undue burden on interstate
commerce? Why wouldn’t it be?

2.

What evidence was there of discriminatory intent behind the North Carolina law? Did that evidence
even matter? Why or why not?

Citizens United v. Federal Election Commission
Citizens United v. Federal Election Commission
588 U.S. ____; 130 S.Ct. 876 (U.S. Supreme Court 2010)
Justice Kennedy delivered the opinion of the Court.
Federal law prohibits corporations and unions from using their general treasury funds to make
independent expenditures for speech defined as an “electioneering communication” or for speech
expressly advocating the election or defeat of a candidate. 2 U.S.C. §441b. Limits on electioneering
communications were upheld in McConnell v. Federal Election Comm’n, 540 U.S. 93, 203–209 (2003).
The holding of McConnell rested to a large extent on an earlier case, Austin v. Michigan Chamber of

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Commerce, 494 U.S. 652 (1990).Austin had held that political speech may be banned based on the
speaker’s corporate identity.
In this case we are asked to reconsider Austin and, in effect, McConnell. It has been noted that
“Austin was a significant departure from ancient First Amendment principles,” Federal Election Comm’n
v. Wisconsin Right to Life, Inc., 551 U.S. 449, 490 (2007) (WRTL) (Scalia, J., concurring in part and
concurring in judgment). We agree with that conclusion and hold that stare decisis does not compel the
continued acceptance of Austin. The Government may regulate corporate political speech through
disclaimer and disclosure requirements, but it may not suppress that speech altogether. We turn to the
case now before us.

I
A
Citizens United is a nonprofit corporation. It has an annual budget of about $12 million. Most of its funds
are from donations by individuals; but, in addition, it accepts a small portion of its funds from for-profit
corporations.
In January 2008, Citizens United released a film entitled Hillary: The Movie. We refer to the film
as Hillary. It is a 90-minute documentary about then-Senator Hillary Clinton, who was a candidate in the
Democratic Party’s 2008 Presidential primary elections. Hillary mentions Senator Clinton by name and
depicts interviews with political commentators and other persons, most of them quite critical of Senator
Clinton.…
In December 2007, a cable company offered, for a payment of $1.2 million, to make Hillary available on a
video-on-demand channel called “Elections ’08.”…Citizens 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
ad includes a short (and, in our view, pejorative) statement about Senator Clinton, followed by the name
of the movie and the movie’s Website address. Citizens United desired to promote the video-on-demand
offering by running advertisements on broadcast and cable television.

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B
Before the Bipartisan Campaign Reform Act of 2002 (BCRA), federal law prohibited—and still does
prohibit—corporations and unions from using general treasury funds to make direct contributions to
candidates or independent expenditures that expressly advocate the election or defeat of a candidate,
through any form of media, in connection with certain qualified federal elections.…BCRA §203 amended
§441b to prohibit any “electioneering communication” as well. An electioneering communication is
defined as “any broadcast, cable, or satellite communication” that “refers to a clearly identified candidate
for Federal office” and is made within 30 days of a primary or 60 days of a general election. §434(f)(3)(A).
The Federal Election Commission’s (FEC) regulations further define an electioneering communication as
a communication that is “publicly distributed.” 11 CFR §100.29(a)(2) (2009). “In the case of a candidate
for nomination for President…publicly distributed means” that the communication “[c]an be received by
50,000 or more persons in a State where a primary election…is being held within 30 days.” 11 CFR
§100.29(b)(3)(ii). Corporations and unions are barred from using their general treasury funds for express
advocacy or electioneering communications. They may establish, however, a “separate segregated fund”
(known as a political action committee, or PAC) for these purposes. 2 U.S.C. §441b(b)(2). The moneys
received by the segregated fund are limited to donations from stockholders and employees of the
corporation or, in the case of unions, members of the union. Ibid.

C
Citizens United wanted to make Hillary available through video-on-demand within 30 days of the 2008
primary elections. It feared, however, that both the film and the ads would be covered by §441b’s ban on
corporate-funded independent expenditures, thus subjecting the corporation to civil and criminal
penalties under §437g. In December 2007, Citizens United sought declaratory and injunctive relief against
the FEC. It argued that (1) §441b is unconstitutional as applied to Hillary; and (2) BCRA’s disclaimer and
disclosure requirements, BCRA §§201 and 311, are unconstitutional as applied to Hillary and to the three
ads for the movie.
The District Court denied Citizens United’s motion for a preliminary injunction, and then granted the
FEC’s motion for summary judgment.

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…
The court held that §441b was facially constitutional under McConnell, and that §441b was constitutional
as applied to Hillary because it was “susceptible of no other interpretation than to inform the electorate
that Senator Clinton is unfit for office, that the United States would be a dangerous place in a President
Hillary Clinton world, and that viewers should vote against her.” 530 F. Supp. 2d, at 279. The court also
rejected Citizens United’s challenge to BCRA’s disclaimer and disclosure requirements. It noted that “the
Supreme Court has written approvingly of disclosure provisions triggered by political speech even though
the speech itself was constitutionally protected under the First Amendment.” Id. at 281.

II
[Omitted: the court considers whether it is possible to reject the BCRA without declaring certain
provisions unconstitutional. The court concludes it cannot find a basis to reject the BCRA that does not
involve constitutional issues.]

III
The First Amendment provides that “Congress shall make no law…abridging the freedom of speech.”
Laws enacted to control or suppress speech may operate at different points in the speech process.…The
law before us is an outright ban, backed by criminal sanctions. Section 441b makes it a felony for all
corporations—including nonprofit advocacy corporations—either to expressly advocate the election or
defeat of candidates or to broadcast electioneering communications within 30 days of a primary election
and 60 days of a general election. Thus, the following acts would all be felonies under §441b: The Sierra
Club runs an ad, within the crucial phase of 60 days before the general election, that exhorts the public to
disapprove of a Congressman who favors logging in national forests; the National Rifle Association
publishes a book urging the public to vote for the challenger because the incumbent U.S. Senator supports
a handgun ban; and the American Civil Liberties Union creates a Web site telling the public to vote for a
Presidential candidate in light of that candidate’s defense of free speech. These prohibitions are classic
examples of censorship.

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Section 441b is a ban on corporate speech notwithstanding the fact that a PAC created by a corporation
can still speak. PACs are burdensome alternatives; they are expensive to administer and subject to
extensive regulations. For example, every PAC must appoint a treasurer, forward donations to the
treasurer promptly, keep detailed records of the identities of the persons making donations, preserve
receipts for three years, and file an organization statement and report changes to this information within
10 days.
And that is just the beginning. PACs must file detailed monthly reports with the FEC, which are due at
different times depending on the type of election that is about to occur.…
PACs have to comply with these regulations just to speak. This might explain why fewer than 2,000 of the
millions of corporations in this country have PACs. PACs, furthermore, must exist before they can speak.
Given the onerous restrictions, a corporation may not be able to establish a PAC in time to make its views
known regarding candidates and issues in a current campaign.
Section 441b’s prohibition on corporate independent expenditures is thus a ban on speech. As a
“restriction on the amount of money a person or group can spend on political communication during a
campaign,” that statute “necessarily reduces the quantity of expression by restricting the number of issues
discussed, the depth of their exploration, and the size of the audience reached.” Buckley v. Valeo, 424 U.S.
1 at 19 (1976).…
Speech is an essential mechanism of democracy, for it is the means to hold officials accountable to the
people. See Buckley, supra, at 14–15 (“In a republic where the people are sovereign, the ability of the
citizenry to make informed choices among candidates for office is essential.”) The right of citizens to
inquire, 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 “‘has its fullest and most urgent
application’ to speech uttered during a campaign for political office.”
For these reasons, political speech must prevail against laws that would suppress it, whether by design or
inadvertence. Laws that burden political speech are “subject to strict scrutiny,” which requires the

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Government to prove that the restriction “furthers a compelling interest and is narrowly tailored to
achieve that interest.”
…
The Court has recognized that First Amendment protection extends to corporations. This protection has
been extended by explicit holdings to the context of political speech. Under the rationale of these
precedents, political speech does not lose First Amendment protection “simply because its source is a
corporation.” Bellotti, supra, at 784. The Court has thus rejected the argument that political speech of
corporations or other associations should be treated differently under the First Amendment simply
because such associations are not “natural persons.”
The purpose and effect of this law is to prevent corporations, including small and nonprofit corporations,
from presenting both facts and opinions to the public. This makes Austin’s antidistortion rationale all the
more an aberration. “[T]he First Amendment protects the right of corporations to petition legislative and
administrative bodies.” Bellotti, 435 U.S., at 792, n. 31.…
Even if §441b’s expenditure ban were constitutional, wealthy corporations could still lobby elected
officials, although smaller corporations may not have the resources to do so. And wealthy individuals and
unincorporated associations can spend unlimited amounts on independent expenditures. See, e.g., WRTL,
551 U.S., at 503–504 (opinion of Scalia, J.) (“In the 2004 election cycle, a mere 24 individuals contributed
an astounding total of $142 million to [26 U.S.C. §527 organizations]”). Yet certain disfavored
associations of citizens—those that have taken on the corporate form—are penalized for engaging in the
same political speech.
When Government seeks to use its full power, including the criminal law, to command where a person
may get his or her information or what distrusted source he or she may not hear, it uses censorship to
control thought. This is unlawful. The First Amendment confirms the freedom to think for ourselves.
What we have said also shows the invalidity of other arguments made by the Government. For the most
part relinquishing the anti-distortion rationale, the Government falls back on the argument that corporate
political speech can be banned in order to prevent corruption or its appearance.…

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When Congress finds that a problem exists, we must give that finding due deference; but Congress may
not choose an unconstitutional remedy. If elected officials succumb to improper influences from
independent expenditures; if they surrender their best judgment; and if they put expediency before
principle, then surely there is cause for concern. We must give weight to attempts by Congress to seek to
dispel either the appearance or the reality of these influences. The remedies enacted by law, however,
must comply with the First Amendment; and, it is our law and our tradition that more speech, not less, is
the governing rule. An outright ban on corporate political speech during the critical preelection period is
not a permissible remedy. Here Congress has created categorical bans on speech that are asymmetrical to
preventing quid pro quo corruption.
Our precedent is to be respected unless the most convincing of reasons demonstrates that adherence to it
puts us on a course that is sure error. “Beyond workability, the relevant factors in deciding whether to
adhere to the principle of stare decisis include the antiquity of the precedent, the reliance interests at
stake, and of course whether the decision was well reasoned.” [citing prior cases]
These considerations counsel in favor of rejecting Austin, which itself contravened this Court’s earlier
precedents in Buckley and Bellotti. “This Court has not hesitated to overrule decisions offensive to the
First Amendment.” WRTL, 551 U.S., at 500 (opinion of Scalia, J.). “[S]tare decisis is a principle of policy
and not a mechanical formula of adherence to the latest decision.”Helvering v. Hallock, 309 U.S. 106 at
119 (1940).
Austin is undermined by experience since its announcement. Political speech is so ingrained in our
culture that speakers find ways to circumvent campaign finance laws. See, e.g., McConnell, 540 U.S., at
176–177 (“Given BCRA’s tighter restrictions on the raising and spending of soft money, the incentives…to
exploit [26 U.S.C. §527] organizations will only increase”). Our Nation’s speech dynamic is changing, and
informative voices should not have to circumvent onerous restrictions to exercise their First Amendment
rights. Speakers have become adept at presenting citizens with sound bites, talking points, and scripted
messages that dominate the 24-hour news cycle. Corporations, like individuals, do not have monolithic
views. On certain topics corporations may possess valuable expertise, leaving them the best equipped to
point out errors or fallacies in speech of all sorts, including the speech of candidates and elected officials.

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Rapid changes in technology—and the creative dynamic inherent in the concept of free expression—
counsel against upholding a law that restricts political speech in certain media or by certain speakers.
Today, 30-second television ads may be the most effective way to convey a political message. Soon,
however, it may be that Internet sources, such as blogs and social networking Web sites, will provide
citizens with significant information about political candidates and issues. Yet, §441b would seem to ban a
blog post expressly advocating the election or defeat of a candidate if that blog were created with
corporate funds. The First Amendment does not permit Congress to make these categorical distinctions
based on the corporate identity of the speaker and the content of the political speech.
Due consideration leads to this conclusion: Austin should be and now is overruled. We return to the
principle established in Buckley and Bellotti that the Government may not suppress political speech on
the basis of the speaker’s corporate identity. No sufficient governmental interest justifies limits on the
political speech of nonprofit or for-profit corporations.

[IV. Omitted]
V
When word concerning the plot of the movie Mr. Smith Goes to Washington reached the circles of
Government, some officials sought, by persuasion, to discourage its distribution. See Smoodin,
“Compulsory” Viewing for Every Citizen: Mr. Smith and the Rhetoric of Reception, 35 Cinema Journal 3,
19, and n. 52 (Winter 1996) (citing Mr. Smith Riles Washington, Time, Oct. 30, 1939, p. 49); Nugent,
Capra’s Capitol Offense, N. Y. Times, Oct. 29, 1939, p. X5. Under Austin, though, officials could have done
more than discourage its distribution—they could have banned the film. After all, it, like Hillary, was
speech funded by a corporation that was critical of Members of Congress. Mr. Smith Goes to
Washington may be fiction and caricature; but fiction and caricature can be a powerful force.
Modern day movies, television comedies, or skits on YouTube.com might portray public officials or public
policies in unflattering ways. Yet if a covered transmission during the blackout period creates the
background for candidate endorsement or opposition, a felony occurs solely because a corporation, other
than an exempt media corporation, has made the “purchase, payment, distribution, loan, advance,

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deposit, or gift of money or anything of value” in order to engage in political speech. 2 U.S.C.
§431(9)(A)(i). Speech would be suppressed in the realm where its necessity is most evident: in the public
dialogue preceding a real election. Governments are often hostile to speech, but under our law and our
tradition it seems stranger than fiction for our Government to make this political speech a crime. Yet this
is the statute’s purpose and design.
Some members of the public might consider Hillary to be insightful and instructive; some might find it to
be neither high art nor a fair discussion on how to set the Nation’s course; still others simply might
suspend judgment on these points but decide to think more about issues and candidates. Those choices
and assessments, however, are not for the Government to make. “The First Amendment underwrites the
freedom to experiment and to create in the realm of thought and speech. Citizens must be free to use new
forms, and new forums, for the expression of ideas. The civic discourse belongs to the people, and the
Government may not prescribe the means used to conduct it.” McConnell,supra, at 341 (opinion of
Kennedy, J.).
The judgment of the District Court is reversed with respect to the constitutionality of 2 U.S.C. §441b’s
restrictions on corporate independent expenditures. The case is remanded for further proceedings
consistent with this opinion.
It is so ordered.

CASE QUESTIONS
1.

What does the case say about disclosure? Corporations have a right of free speech under the First
Amendment and may exercise that right through unrestricted contributions of money to political parties
and candidates. Can the government condition that right by requiring that the parties and candidates
disclose to the public the amount and origin of the contribution? What would justify such a disclosure
requirement?

2.

Are a corporation’s contributions to political parties and candidates tax deductible as a business expense?
Should they be?

3.

How is the donation of money equivalent to speech? Is this a strict construction of the Constitution to
hold that it is?

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4.

Based on the Court’s description of the Austin case, what purpose do you think the Austin court was
trying to achieve by limiting corporate campaign contributions? Was that purpose consistent (or
inconsistent) with anything in the Constitution, or is the Constitution essentially silent on this issue?

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4.7 Summary and Exercises
Summary
The US. Constitution sets the framework for all other laws of the United States, at both the federal and the
state level. It creates a shared balance of power between states and the federal government (federalism)
and shared power among the branches of government (separation of powers), establishes individual rights
against governmental action (Bill of Rights), and provides for federal oversight of matters affecting
interstate commerce and commerce with foreign nations. Knowing the contours of the US legal system is
not possible without understanding the role of the US Constitution.
The Constitution is difficult to amend. Thus when the Supreme Court uses its power of judicial review to
determine that a law is unconstitutional, it actually shapes what the Constitution means. New meanings
that emerge must do so by the process of amendment or by the passage of time and new appointments to
the court. Because justices serve for life, the court changes its philosophical outlook slowly.
The Bill of Rights is an especially important piece of the Constitutional framework. It provides legal
causes of action for infringements of individual rights by government, state or federal. Through the due
process clause of the Fifth Amendment and the Fourteenth Amendment, both procedural and (to some
extent) substantive due process rights are given to individuals.

EXERCISES
1.

For many years, the Supreme Court believed that “commercial speech” was entitled to less
protection than other forms of speech. One defining element of commercial speech is that its
dominant theme is to propose a commercial transaction. This kind of speech is protected by the First
Amendment, but the government is permitted to regulate it more closely than other forms of speech.
However, the government must make reasonable distinctions, must narrowly tailor the rules
restricting commercial speech, and must show that government has a legitimate goal that the law
furthers.

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Edward Salib owned a Winchell’s Donut House in Mesa, Arizona. To attract customers, he displayed
large signs in store windows. The city ordered him to remove the signs because they violated the
city’s sign code, which prohibited covering more than 30 percent of a store’s windows with signs.
Salib sued, claiming that the sign code violated his First Amendment rights. What was the result, and
why?
2.

Jennifer is a freshman at her local public high school. Her sister, Jackie, attends a nearby private high
school. Neither school allows them to join its respective wrestling team; only boys can wrestle at
either school. Do either of them have a winning case based on the equal protection clause of the
Fourteenth Amendment?

3.

The employees of the US Treasury Department that work the border crossing between the United
States and Mexico learned that they will be subject to routine drug testing. The customs bureau,
which is a division of the treasury department, announces this policy along with its reasoning: since
customs agents must routinely search for drugs coming into the United States, it makes sense that
border guards must themselves be completely drug-free. Many border guards do not use drugs, have
no intention of using drugs, and object to the invasion of their privacy. What is the constitutional
basis for their objection?

4.

Happy Time Chevrolet employs Jim Bydalek as a salesman. Bydalek takes part in a Gay Pride March in
Los Angeles, is interviewed by a local news camera crew, and reports that he is gay and proud of it.
His employer is not, and he is fired. Does he have any constitutional causes of action against his
employer?

5.

You begin work at the Happy-Go-Lucky Corporation on Halloween. On your second day at work, you
wear a political button on your coat, supporting your choice for US senator in the upcoming election.
Your boss, who is of a different political persuasion, looks at the button and says, “Take that stupid
button off or you’re fired.” Has your boss violated your constitutional rights?

6.

David Lucas paid $975,000 for two residential parcels on the Isle of Palms near Charleston, South
Carolina. His intention was to build houses on them. Two years later, the South Carolina legislature
passed a statute that prohibited building beachfront properties. The purpose was to leave the dunes
system in place to mitigate the effects of hurricanes and strong storms. The South Carolina Coastal
Commission created the rules and regulations with substantial input from the community and from

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experts and with protection of the dune system primarily in mind. People had been building on the
shoreline for years, with harmful results to localities and the state treasury. When Lucas applied for
permits to build two houses near the shoreline, his permits were rejected. He sued, arguing that the
South Carolina legislation had effectively “taken” his property. At trial, South Carolina conceded that
because of the legislation, Lucas’s property was effectively worth zero. Has there been a taking under
the Fifth Amendment (as incorporated through the Fourteenth Amendment), and if so, what should
the state owe to Lucas? Suppose that Lucas could have made an additional $1 million by building a
house on each of his parcels. Is he entitled to recover his original purchase price or his potential
profits?

SELF-TEST QUESTIONS
1.

Harvey filed a suit against the state of Colorado, claiming that a Colorado state law violates the
commerce clause. The court will agree if the statute
a.

places an undue burden on interstate commerce

b.

promotes the public health, safety, morals, or general welfare of Colorado

c.

regulates economic activities within the state’s borders

d.

a and b

e.

b and c

The state legislature in Maine enacts a law that directly conflicts with a federal law. Mapco
Industries, located in Portland, Maine, cannot comply with both the state and the federal law.
a. Because of federalism, the state law will have priority, as long as Maine is using its police
powers.
b. Because there’s a conflict, both laws are invalid; the state and the federal government will
have to work out a compromise of some sort.
c. The federal law preempts the state law.
d. Both laws govern concurrently.
Hannah, who lives in Ada, is the owner of Superior Enterprises, Inc. She believes that certain
actions in the state of Ohio infringe on her federal constitutional rights, especially those found in
the Bill of Rights. Most of these rights apply to the states under
a. the supremacy clause

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b. the protection clause
c. the due process clause of the Fourteenth Amendment
d. the Tenth Amendment
Minnesota enacts a statute that bans all advertising that is in “bad taste,” “vulgar,” or
“indecent.” In Michigan, Aaron Calloway and his brother, Clarence “Cab” Calloway, create unique
beer that they decide to call Old Fart Ale. In their marketing, the brothers have a label in which an
older man in a dirty T-shirt is sitting in easy chair, looking disheveled and having a three-day
growth of stubble on his chin. It appears that the man is in the process of belching. He is also
holding a can of Old Fart Ale. The Minnesota liquor commission orders all Minnesota restaurants,
bars, and grocery stores to remove Old Fart Ale from their shelves. The state statute and the
commission’s order are likely to be held by a court to be
a. a violation of the Tenth Amendment
b. a violation of the First Amendment
c. a violation of the Calloways’ right to equal protection of the laws
d. a violation of the commerce clause, since only the federal laws can prevent an article of
commerce from entering into Minnesota’s market
Raunch Unlimited, a Virginia partnership, sells smut whenever and wherever it can. Some of its
material is “obscene” (meeting the Supreme Court’s definition under Miller v. California) and
includes child pornography. North Carolina has a statute that criminalizes obscenity. What are
possible results if a store in Raleigh, North Carolina, carries Raunch merchandise?
a. The partners could be arrested in North Carolina and may well be convicted.
b. The materials in Raleigh may be the basis for a criminal conviction.
c. The materials are protected under the First Amendment’s right of free speech.
d. The materials are protected under state law.
e. a and b

SELF-TEST ANSWERS
1.

a

2.

c

3.

c

4.

b

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5.

e

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Chapter 5

Administrative Law
LEARNING OBJECTIVES
After reading this chapter, you should be able to do the following:
1.

Understand the purpose served by federal administrative agencies.

2.

Know the difference between executive branch agencies and independent agencies.

3.

Understand the political control of agencies by the president and Congress.

4.

Describe how agencies make rules and conduct hearings.

5.

Describe how courts can be used to challenge administrative rulings.

From the 1930s on, administrative agencies, law, and procedures have virtually remade our
government and much of private life. Every day, business must deal with rules and decisions of state
and federal administrative agencies. Informally, such rules are often called regulations, and they
differ (only in their source) from laws passed by Congress and signed into law by the president. The
rules created by agencies are voluminous: thousands of new regulations pour forth each year. The
overarching question of whether there is too much regulation—or the wrong kind of regulation—of
our economic activities is an important one but well beyond the scope of this chapter, in which we
offer an overview of the purpose of administrative agencies, their structure, and their impact on
business.

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5.1 Administrative Agencies: Their Structure and Powers
LEARNING OBJECTIVES
1.

Explain the reasons why we have federal administrative agencies.

2.

Explain the difference between executive branch agencies and independent agencies.

3.

Describe the constitutional issue that questions whether administrative agencies could have authority
to make enforceable rules that affect business.

Why Have Administrative Agencies?
The US Constitution mentions only three branches of government: legislative, executive, and judicial
(Articles I, II, and III). There is no mention of agencies in the Constitution, even though federal agencies
are sometimes referred to as “the fourth branch of government.” The Supreme Court has recognized the
legitimacy of federal administrative agencies to make rules that have the same binding effect as
statutes by Congress.
Most commentators note that having agencies with rule-making power is a practical necessity: (1)
Congress does not have the expertise or continuity to develop specialized knowledge in various areas (e.g.,
communications, the environment, aviation). (2) Because of this, it makes sense for Congress to set forth
broad statutory guidance to an agency and delegate authority to the agency to propose rules that further
the statutory purposes. (3) As long as Congress makes this delegating guidance sufficiently clear, it is not
delegating improperly. If Congress’s guidelines are too vague or undefined, it is (in essence) giving away
its constitutional power to some other group, and this it cannot do.

Why Regulate the Economy at All?
The market often does not work properly, as economists often note. Monopolies, for example, happen in
the natural course of human events but are not always desirable. To fix this, well-conceived and
objectively enforced competition law (what is called antitrust law in the United States) is needed.
Negative externalities must be “fixed,” as well. For example, as we see in tort law (Chapter 7 "Introduction
to Tort Law"), people and business organizations often do things that impose costs (damages) on others,

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and the legal system will try—through the award of compensatory damages—to make fair adjustments. In
terms of the ideal conditions for a free market, think of tort law as the legal system’s attempt to
compensate for negative externalities: those costs imposed on people who have not voluntarily consented
to bear those costs.
In terms of freedoms to enter or leave the market, the US constitutional guarantees of equal protection
can prevent local, state, and federal governments from imposing discriminatory rules for commerce that
would keep minorities, women, and gay people from full participation in business. For example, if the
small town of Xenophobia, Colorado, passed a law that required all business owners and their employees
to be Christian, heterosexual, and married, the equal protection clause (as well as numerous state and
federal equal opportunity employment laws) would empower plaintiffs to go to court and have the law
struck down as unconstitutional.
Knowing that information is power, we will see many laws administered by regulatory agencies that seek
to level the playing field of economic competition by requiring disclosure of the most pertinent
information for consumers (consumer protection laws), investors (securities laws), and citizens (e.g., the
toxics release inventory laws in environmental law).

Ideal Conditions for a Free Market
1.

There are many buyers and many sellers, and none of them has a substantial share of the market.

2. All buyers and sellers in the market are free to enter the market or leave it.
3. All buyers and all sellers have full and perfect knowledge of what other buyers and sellers are up to,
including knowledge of prices, quantity, and quality of all goods being bought or sold.
4. The goods being sold in the market are similar enough to each other that participants do not have
strong preferences as to which seller or buyer they deal with.
5.

The costs and benefits of making or using the goods that are exchanged in the market are borne only
by those who buy or sell those goods and not by third parties or people “external” to the market
transaction. (That is, there are no “externalities.”)

6. All buyers and sellers are utility maximizers; each participant in the market tries to get as much as
possible for as little as possible.

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7.

There are no parties, institutions, or governmental units regulating the price, quantity, or quality of
any of the goods being bought and sold in the market.

In short, some forms of legislation and regulation are needed to counter a tendency toward consolidation
of economic power and discriminatory attitudes toward certain individuals and groups (Chapter 30
"Employment Law") and to insist that people and companies clean up their own messes and not hide
information that would empower voluntary choices in the free market.
But there are additional reasons to regulate. For example, in economic systems, it is likely for natural
monopolies to occur. These are where one firm can most efficiently supply all of the good or service.
Having duplicate (or triplicate) systems for supplying electricity, for example, would be inefficient, so
most states have a public utilities commission to determine both price and quality of service. This is direct
regulation.
Sometimes destructive competition can result if there is no regulation. Banking and insurance are good
examples of this. Without government regulation of banks (setting standards and methods), open and
fierce competition would result in widespread bank failures. That would erode public confidence in banks
and business generally. The current situation (circa 2011) of six major banks that are “too big to fail” is,
however, an example of destructive noncompetition.
Other market imperfections can yield a demand for regulation. For example, there is a need to regulate
frequencies for public broadcast on radio, television, and other wireless transmissions (for police, fire,
national defense, etc.). Many economists would also list an adequate supply of public goods as something
that must be created by government. On its own, for example, the market would not provide public goods
such as education, a highway system, lighthouses, a military for defense.
True laissez-faire capitalism—a market free from any regulation—would not try to deal with market
imperfections and would also allow people to freely choose products, services, and other arrangements
that historically have been deemed socially unacceptable. These would include making enforceable
contracts for the sale and purchase of persons (slavery), sexual services, “street drugs” such as heroin or

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crack cocaine, votes for public office, grades for this course in business law, and even marriage
partnership.
Thus the free market in actual terms—and not in theory—consists of commerce legally constrained by
what is economically desirable and by what is socially desirable as well. Public policy objectives in the
social arena include ensuring equal opportunity in employment, protecting employees from unhealthy or
unsafe work environments, preserving environmental quality and resources, and protecting consumers
from unsafe products. Sometimes these objectives are met by giving individuals statutory rights that can
be used in bringing a complaint (e.g., Title VII of the Civil Rights Act of 1964, for employment
discrimination), and sometimes they are met by creating agencies with the right to investigate and
monitor and enforce statutory law and regulations created to enforce such law (e.g., the Environmental
Protection Agency, for bringing a lawsuit against a polluting company).

History of Federal Agencies
Through the commerce clause in the US Constitution, Congress has the power to regulate trade between
the states and with foreign nations. The earliest federal agency therefore dealt with trucking and railroads,
to literally set the rules of the road for interstate commerce. The first federal agency, the Interstate
Commerce Commission (ICC), was created in 1887. Congress delegated to the ICC the power to enforce
federal laws against railroad rate discrimination and other unfair pricing practices. By the early part of
this century, the ICC gained the power to fix rates. From the 1970s through 1995, however, Congress
passed deregulatory measures, and the ICC was formally abolished in 1995, with its powers transferred to
the Surface Transportation Board.
Beginning with the Federal Trade Commission (FTC) in 1914, Congress has created numerous other
agencies, many of them familiar actors in American government. Today more than eighty-five federal
agencies have jurisdiction to regulate some form of private activity. Most were created since 1930, and
more than a third since 1960. A similar growth has occurred at the state level. Most states now have
dozens of regulatory agencies, many of them overlapping in function with the federal bodies.

Classification of Agencies
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Independent agencies are different from federal executive departments and other executive agencies by
their structural and functional characteristics. Most executive departments have a single director,
administrator, or secretary appointed by the president of the United States. Independent agencies almost
always have a commission or board consisting of five to seven members who share power over the agency.
The president appoints the commissioners or board subject to Senate confirmation, but they often serve
with staggered terms and often for longer terms than a usual four-year presidential term. They cannot be
removed except for “good cause.” This means that most presidents will not get to appoint all the
commissioners of a given independent agency. Most independent agencies have a statutory requirement
of bipartisan membership on the commission, so the president cannot simply fill vacancies with members
of his own political party.
In addition to the ICC and the FTC, the major independent agencies are the Federal Communications
Commission (1934), Securities and Exchange Commission (1934), National Labor Relations Board (1935),
and Environmental Protection Agency (1970). See Note 5.4 "Ideal Conditions for a Free Market" in the
sidebar.
By contrast, members of executive branch agencies serve at the pleasure of the president and are therefore
far more amenable to political control. One consequence of this distinction is that the rules that
independent agencies promulgate may not be reviewed by the president or his staff—only Congress may
directly overrule them—whereas the White House or officials in the various cabinet departments may
oversee the work of the agencies contained within them (unless specifically denied the power by
Congress).

Powers of Agencies
Agencies have a variety of powers. Many of the original statutes that created them, like the Federal
Communications Act, gave them licensing power. No party can enter into the productive activity covered
by the act without prior license from the agency—for example, no utility can start up a nuclear power
plant unless first approved by the Nuclear Regulatory Commission. In recent years, the move toward
deregulation of the economy has led to diminution of some licensing power. Many agencies also have the
authority to set the rates charged by companies subject to the agency’s jurisdiction. Finally, the agencies

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can regulate business practices. The FTC has general jurisdiction over all business in interstate commerce
to monitor and root out “unfair acts” and “deceptive practices.” The Securities and Exchange Commission
(SEC) oversees the issuance of corporate securities and other investments and monitors the practices of
the stock exchanges.
Unlike courts, administrative agencies are charged with the responsibility of carrying out a specific
assignment or reaching a goal or set of goals. They are not to remain neutral on the various issues of the
day; they must act. They have been given legislative powers because in a society growing ever more
complex, Congress does not know how to legislate with the kind of detail that is necessary, nor would it
have the time to approach all the sectors of society even if it tried. Precisely because they are to do what
general legislative bodies cannot do, agencies are specialized bodies. Through years of experience in
dealing with similar problems they accumulate a body of knowledge that they can apply to accomplish
their statutory duties.
All administrative agencies have two different sorts of personnel. The heads, whether a single
administrator or a collegial body of commissioners, are political appointees and serve for relatively
limited terms. Below them is a more or less permanent staff—the bureaucracy. Much policy making
occurs at the staff level, because these employees are in essential control of gathering facts and presenting
data and argument to the commissioners, who wield the ultimate power of the agencies.

The Constitution and Agencies
Congress can establish an agency through legislation. When Congress gives powers to an agency, the
legislation is known as an enabling act. The concept that Congress can delegate power to an agency is
known as the delegation doctrine. Usually, the agency will have all three kinds of power: executive,
legislative, and judicial. (That is, the agency can set the rules that business must comply with, can
investigate and prosecute those businesses, and can hold administrative hearings for violations of those
rules. They are, in effect, rule maker, prosecutor, and judge.) Because agencies have all three types of
governmental powers, important constitutional questions were asked when Congress first created them.
The most important question was whether Congress was giving away its legislative power. Was the

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separation of powers violated if agencies had power to make rules that were equivalent to legislative
statutes?
In 1935, in Schechter Poultry Corp. v. United States, the Supreme Court overturned the National
Industrial Recovery Act on the ground that the congressional delegation of power was too broad.

[1]

Under

the law, industry trade groups were granted the authority to devise a code of fair competition for the
entire industry, and these codes became law if approved by the president. No administrative body was
created to scrutinize the arguments for a particular code, to develop evidence, or to test one version of a
code against another. Thus it was unconstitutional for the Congress to transfer all of its legislative powers
to an agency. In later decisions, it was made clear that Congress could delegate some of its legislative
powers, but only if the delegation of authority was not overly broad.
Still, some congressional enabling acts are very broad, such as the enabling legislation for the
Occupational Safety and Health Administration (OSHA), which is given the authority to make rules to
provide for safe and healthful working conditions in US workplaces. Such a broad initiative power gives
OSHA considerable discretion. But, as noted in Section 5.2 "Controlling Administrative Agencies", there
are both executive and judicial controls over administrative agency activities, as well as ongoing control by
Congress through funding and the continuing oversight of agencies, both in hearings and through
subsequent statutory amendments.

KEY TAKEAWAY
Congress creates administrative agencies through enabling acts. In these acts, Congress must delegate
authority by giving the agency some direction as to what it wants the agency to do. Agencies are usually given
broad powers to investigate, set standards (promulgating regulations), and enforce those standards. Most
agencies are executive branch agencies, but some are independent.

EXERCISES
1.

Explain why Congress needs to delegate rule-making authority to a specialized agency.

2.

Explain why there is any need for interference in the market by means of laws or regulations.

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[1] Schechter Poultry Corp. v. United States, 295 US 495 (1935).

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5.2 Controlling Administrative Agencies
LEARNING OBJECTIVES
1.

Understand how the president controls administrative agencies.

2.

Understand how Congress controls administrative agencies.

3.

Understand how the courts can control administrative agencies.

During the course of the past seventy years, a substantial debate has been conducted, often in shrill terms,
about the legitimacy of administrative lawmaking. One criticism is that agencies are “captured” by the
industry they are directed to regulate. Another is that they overregulate, stifling individual initiative and
the ability to compete. During the 1960s and 1970s, a massive outpouring of federal law created many new
agencies and greatly strengthened the hands of existing ones. In the late 1970s during the Carter
administration, Congress began to deregulate American society, and deregulation increased under the
Reagan 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
remains to be seen whether the Deepwater Horizon oil blowout of 2010 will lead to more environmental
regulations or a rethinking on how to make agencies more effective regulators.
Administrative agencies are the focal point of controversy because they are policy-making bodies,
incorporating facets of legislative, executive, and judicial power in a hybrid form that fits uneasily at best
in the framework of American government (see Figure 5.1 "Major Administrative Agencies of the United
States"). They are necessarily at the center of tugging and hauling by the legislature, the executive branch,
and the judiciary, each of which has different means of exercising political control over them. In early
1990, for example, the Bush administration approved a Food and Drug Administration regulation that
limited disease-prevention claims by food packagers, reversing a position by the Reagan administration in
1987 permitting such claims.
Figure 5.1 Major Administrative Agencies of the United States

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Legislative Control
Congress 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.
Another approach to controlling agencies is to reduce or threaten to reduce their appropriations. By
retaining ultimate control of the purse strings, Congress can exercise considerable informal control over
regulatory policy.

Executive Control
The president (or a governor, for state agencies) can exercise considerable control over agencies that are
part of his cabinet departments and that are not statutorily defined as independent. Federal agencies,
moreover, are subject to the fiscal scrutiny of the Office of Management and Budget (OMB), subject to the
direct control of the president. Agencies are not permitted to go directly to Congress for increases in

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budget; these requests must be submitted through the OMB, giving the president indirect leverage over
the continuation of administrators’ programs and policies.

Judicial Review of Agency Actions
Administrative agencies are creatures of law and like everyone else must obey the law. The courts have
jurisdiction to hear claims that the agencies have overstepped their legal authority or have acted in some
unlawful manner.
Courts are unlikely to overturn administrative actions, believing in general that the agencies are better
situated to judge their own jurisdiction and are experts in rulemaking for those matters delegated to them
by Congress. Some agency activities are not reviewable, for a number of reasons. However, after a
business (or some other interested party) has exhausted all administrative remedies, it may seek judicial
review of a final agency decision. The reviewing court is often asked to strike down or modify agency
actions on several possible bases (see Section 5.5.2 "Strategies for Obtaining Judicial Review" on
“Strategies for Obtaining Judicial Review”).

KEY TAKEAWAY
Administrative agencies are given unusual powers: to legislate, investigate, and adjudicate. But these powers
are limited by executive and legislative controls and by judicial review.

EXERCISES
1.

Find the website of the Consumer Product Safety Commission (CPSC). Identify from that site a product
that has been banned by the CPSC for sale in the United States. What reasons were given for its exclusion
from the US market?

2.

What has Congress told the CPSC to do in its enabling act? Is this a clear enough mandate to guide the
agency? What could Congress do if the CPSC does something that may be outside of the scope of its
powers? What can an affected business do?

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5.3 The Administrative Procedure Act
LEARNING OBJECTIVES
1.

Understand why the Administrative Procedure Act was needed.

2.

Understand how hearings are conducted under the act.

3.

Understand how the act affects rulemaking by agencies.

In 1946, Congress enacted the Administrative Procedure Act (APA). This fundamental statute
detailed for all federal administrative agencies how they must function when they are deciding cases or
issuing regulations, the two basic tasks of administration. At the state level, the Model State
Administrative Procedure Act, issued in 1946 and revised in 1961, has been adopted in twenty-eight states
and the District of Columbia; three states have adopted the 1981 revision. The other states have statutes
that resemble the model state act to some degree.

Trial-Type Hearings
Deciding cases is a major task of many agencies. For example, the Federal Trade Commission (FTC) is
empowered to charge a company with having violated the Federal Trade Commission Act. Perhaps a seller
is accused of making deceptive claims in its advertising. Proceeding in a manner similar to a court, staff
counsel will prepare a case against the company, which can defend itself through its lawyers. The case is
tried before an administrative law judge (ALJ), formerly known as an administrative hearing
examiner. The change in nomenclature was made in 1972 to enhance the prestige of ALJs and more
accurately reflect their duties. Although not appointed for life as federal judges are, the ALJ must be free
of assignments inconsistent with the judicial function and is not subject to supervision by anyone in the
agency who carries on an investigative or prosecutorial function.
The accused parties are entitled to receive notice of the issues to be raised, to present evidence, to argue,
to cross-examine, and to appear with their lawyers. Ex parte (eks PAR-tay) communications—contacts
between the ALJ and outsiders or one party when both parties are not present—are prohibited. However,
the usual burden-of-proof standard followed in a civil proceeding in court does not apply: the ALJ is not
bound to decide in favor of that party producing the more persuasive evidence. The rule in most

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administrative proceedings is “substantial evidence,” evidence that is not flimsy or weak, but is not
necessarily overwhelming evidence, either. The ALJ in most cases will write an opinion. That opinion is
not the decision of the agency, which can be made only by the commissioners or agency head. In effect,
the ALJ’s opinion is appealed to the commission itself.
Certain 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
spot by skilled inspectors. Certain licenses can be administered through tests without a hearing (a test for
a driver’s license), and some decisions can be made by election of those affected (labor union elections).

Rulemaking
Trial-type hearings generally impose on particular parties liabilities based on past or present facts.
Because these cases will serve as precedents, they are a partial guide to future conduct by others. But they
do not directly apply to nonparties, who may argue in a subsequent case that their conduct does not fit
within the holding announced in the case. Agencies can affect future conduct far more directly by
announcing rules that apply to all who come within the agency’s jurisdiction.
The acts creating most of the major federal agencies expressly grant them authority to engage in
rulemaking. This means, in essence, authority to legislate. The outpouring of federal regulations has been
immense. The APA directs agencies about to engage in rulemaking to give notice in the
Federal Register of their intent to do so. The Federal Register is published daily, Monday through
Friday, in Washington, DC, and contains notice of various actions, including announcements of proposed
rulemaking and regulations as adopted. The notice must specify the time, place, and nature of the
rulemaking and offer a description of the proposed rule or the issues involved. Any interested person or
organization is entitled to participate by submitting written “data, views or arguments.” Agencies are not
legally required to air debate over proposed rules, though they often do so.
The procedure just described is known as “informal” rulemaking. A different procedure is required for
“formal” rulemaking, defined as those instances in which the enabling legislation directs an agency to

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make rules “on the record after opportunity for an agency hearing.” When engaging in formal rulemaking,
agencies must hold an adversary hearing.
Administrative regulations are not legally binding unless they are published. Agencies must publish in
the Federal Register the text of final regulations, which ordinarily do not become effective until thirty
days later. Every year the annual output of regulations is collected and reprinted in the
Code of Federal Regulations (CFR), a multivolume paperback series containing all federal rules and
regulations keyed to the fifty titles of the US Code (the compilation of all federal statutes enacted by
Congress and grouped according to subject).

KEY TAKEAWAY
Agencies make rules that have the same effect as laws passed by Congress and the president. But such rules
(regulations) must allow for full participation by interested parties. The Administrative Procedure Act (APA)
governs both rulemaking and the agency enforcement of regulations, and it provides a process for fair
hearings.

EXERCISES
1.

Go to http://www.regulations.gov/search/Regs/home.html#home. Browse the site. Find a topic that
interests you, and then find a proposed regulation. Notice how comments on the proposed rule are
invited.

2.

Why would there be a trial by an administrative agency? Describe the process.

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5.4 Administrative Burdens on Business Operations
LEARNING OBJECTIVES
1.

Describe the paperwork burden imposed by administrative agencies.

2.

Explain why agencies have the power of investigation, and what limits there are to that power.

3.

Explain the need for the Freedom of Information Act and how it works in the US legal system.

The Paperwork Burden
The administrative process is not frictionless. The interplay between government agency and private
enterprise can burden business operations in a number of ways. Several of these are noted in this section.
Deciding whether and how to act are not decisions that government agencies reach out of the blue. They
rely heavily on information garnered from business itself. Dozens of federal agencies require corporations
to keep hundreds of types of records and to file numerous periodic reports. The Commission on Federal
Paperwork, established during the Ford administration to consider ways of reducing the paperwork
burden, estimated in its final report in 1977 that the total annual cost of federal paperwork amounted to
$50 billion and that the 10,000 largest business enterprises spent $10 billion annually on paperwork
alone. The paperwork involved in licensing a single nuclear power plant, the commission said, costs
upward of $15 million.
Not surprisingly, therefore, businesses have sought ways of avoiding requests for data. Since the 1940s,
the Federal Trade Commission (FTC) has collected economic data on corporate performance from
individual companies for statistical purposes. As long as each company engages in a single line of
business, data are comparable. When the era of conglomerates began in the 1970s, with widely divergent
types of businesses brought together under the roof of a single corporate parent, the data became useless
for purposes of examining the competitive behavior of different industries. So the FTC ordered dozens of
large companies to break out their economic information according to each line of business that they
carried on. The companies resisted, but the US Court of Appeals for the District of Columbia Circuit,
where much of the litigation over federal administrative action is decided, directed the companies to

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comply with the commission’s order, holding that the Federal Trade Commission Act clearly permits the
agency to collect information for investigatory purposes.

[1]

In 1980, responding to cries that businesses, individuals, and state and local governments were being
swamped by federal demands for paperwork, Congress enacted the Paperwork Reduction Act. It gives
power to the federal Office of Management and Budget (OMB) to develop uniform policies for
coordinating the gathering, storage, and transmission of all the millions of reports flowing in each year to
the scores of federal departments and agencies requesting information. These reports include tax and
Medicare forms, financial loan and job applications, questionnaires of all sorts, compliance reports, and
tax and business records. The OMB was given the power also to determine whether new kinds of
information are needed. In effect, any agency that wants to collect new information from outside must
obtain the OMB’s approval.

Inspections
No one likes surprise inspections. A section of the Occupational Safety and Health Act of 1970 empowers
agents of the Occupational Safety and Health Administration (OSHA) to search work areas for safety
hazards and for violations of OSHA regulations. The act does not specify whether inspectors are required
to obtain search warrants, required under the Fourth Amendment in criminal cases. For many years, the
government insisted that surprise inspections are not unreasonable and that the time required to obtain a
warrant would defeat the surprise element. The Supreme Court finally ruled squarely on the issue in 1978.
In Marshall v. Barlow’s, Inc., the court held that no less than private individuals, businesses are entitled
to refuse police demands to search the premises unless a court has issued a search warrant.

[2]

But where a certain type of business is closely regulated, surprise inspections are the norm, and no
warrant is required. For example, businesses with liquor licenses that might sell to minors are subject to
both overt and covert inspections (e.g., an undercover officer may “search” a liquor store by sending an
underage patron to the store). Or a junkyard that specializes in automobiles and automobile parts may
also be subject to surprise inspections, on the rationale that junkyards are highly likely to be active in the
resale of stolen autos or stolen auto parts.

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It is also possible for inspections to take place without a search warrant and without the permission of the
business. For example, the Environmental Protection Agency (EPA) wished to inspect parts of the Dow
Chemical facility in Midland, Michigan, without the benefit of warrant. When they were refused, agents of
the EPA obtained a fairly advanced aerial mapping camera and rented an airplane to fly over the Dow
facility. Dow went to court for a restraining order against the EPA and a request to have the EPA turn over
all photographs taken. But the Supreme Court ruled that the areas photographed were “open fields” and
not subject to the protections of the Fourth Amendment.

[4]

Access to Business Information in Government Files
In 1966, Congress enacted the Freedom of Information Act (FOIA), opening up to the citizenry many of
the files of the government. (The act was amended in 1974 and again in 1976 to overcome a tendency of
many agencies to stall or refuse access to their files.) Under the FOIA, any person has a legally enforceable
right of access to all government documents, with nine specific exceptions, such as classified military
intelligence, medical files, and trade secrets and commercial or financial information if “obtained from a
person and privileged or confidential.” Without the trade-secret and financial-information exemptions,
business competitors could, merely by requesting it, obtain highly sensitive competitive information
sitting in government files.
A federal agency is required under the FOIA to respond to a document request within ten days. But in
practice, months or even years may pass before the government actually responds to an FOIA request.
Requesters must also pay the cost of locating and copying the records. Moreover, not all documents are
available for public inspection. Along with the trade-secret and financial-information exemptions, the
FOIA specifically exempts the following:
•

records required by executive order of the president to be kept secret in the interest of national
defense or public policy

•

records related solely to the internal personnel rules and practice of an agency

•

records exempted from disclosure by another statute

•

interagency memos or decisions reflecting the deliberative process

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•

personnel files and other files that if disclosed, would constitute an unwarranted invasion of
personal privacy

•

information compiled for law enforcement purposes

•

geological information concerning wells

Note that the government may provide such information but is not required to provide such information;
it retains discretion to provide information or not.
Regulated companies are often required to submit confidential information to the government. For these
companies, submitting such information presents a danger under the FOIA of disclosure to competitors.
To protect information from disclosure, the company is well advised to mark each document as privileged
and confidential so that government officials reviewing it for a FOIA request will not automatically
disclose it. Most agencies notify a company whose data they are about to disclose. But these practices are
not legally required under the FOIA.

KEY TAKEAWAY
Government agencies, in order to do their jobs, collect a great deal of information from businesses. This can
range from routine paperwork (often burdensome) to inspections, those with warrants and those without.
Surprise inspections are allowed for closely regulated industries but are subject to Fourth Amendment
requirements in general. Some information collected by agencies can be accessed using the Freedom of
Information Act.

EXERCISES
1.

Give two examples of a closely regulated industry. Explain why some warrantless searches would be
allowed.

2.

Find out why FOIA requests often take months or years to accomplish.

[1] In re FTC Line of Business Report Litigation, 595 F.2d 685 (D.C. Cir. 1978).
[2] Marshall v. Barlow’s, Inc., 436 US 307 (1978).
[3] New York v. Burger, 482 US 691 (1987).

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[4] Dow Chemical Co. v. United States Environmental Protection Agency, 476 US 227 (1986).

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5.5 The Scope of Judicial Review
LEARNING OBJECTIVES
1.

Describe the “exhaustion of remedies” requirement.

2.

Detail various strategies for obtaining judicial review of agency rules.

3.

Explain under what circumstances it is possible to sue the government.

Neither an administrative agency’s adjudication nor its issuance of a regulation is necessarily final. Most
federal agency decisions are appealable to the federal circuit courts. To get to court, the appellant must
overcome numerous complex hurdles. He or she must have standing—that is, be in some sense directly
affected by the decision or regulation. The case must be ripe for review; administrative remedies such as
further appeal within the agency must have been exhausted.

Exhaustion of Administrative Remedies
Before you can complain to court about an agency’s action, you must first try to get the agency to
reconsider its action. Generally, you must have asked for a hearing at the hearing examiner level, there
must have been a decision reached that was unfavorable to you, and you must have appealed the decision
to the full board. The full board must rule against you, and only then will you be heard by a court. The
broadest exception to this exhaustion of administrative remedies requirement is if the agency had
no authority to issue the rule or regulation in the first place, if exhaustion of remedies would be
impractical or futile, or if great harm would happen should the rule or regulation continue to apply. Also,
if the agency is not acting in good faith, the courts will hear an appeal without exhaustion.

Strategies for Obtaining Judicial Review
Once these obstacles are cleared, the court may look at one of a series of claims. The appellant might
assert that the agency’s action was ultra vires (UL-truh VI-reez)—beyond the scope of its authority as set
down in the statute. This attack is rarely successful. A somewhat more successful claim is that the agency
did not abide by its own procedures or those imposed upon it by the Administrative Procedure Act.

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In formal rulemaking, the appellant also might insist that the agency lacked substantial evidence for the
determination that it made. If there is virtually no evidence to support the agency’s findings, the court
may reverse. But findings of fact are not often overturned by the courts.
Likewise, there has long been a presumption that when an agency issues a regulation, it has the authority
to do so: those opposing the regulation must bear a heavy burden in court to upset it. This is not a
surprising rule, for otherwise courts, not administrators, would be the authors of regulations.
Nevertheless, regulations cannot exceed the scope of the authority conferred by Congress on the agency.
In an important 1981 case before the Supreme Court, the issue was whether the secretary of labor, acting
through the Occupational Health and Safety Administration (OSHA), could lawfully issue a standard
limiting exposure to cotton dust in the workplace without first undertaking a cost-benefit analysis. A
dozen cotton textile manufacturers and the American Textile Manufacturers Institute, representing 175
companies, asserted that the cotton dust standard was unlawful because it did not rationally relate the
benefits to be derived from the standard to the costs that the standard would impose. See Section 5.6
"Cases", American Textile Manufacturers Institute v. Donovan.
In summary, then, an individual or a company may (after exhaustion of administrative remedies)
challenge agency action where such action is the following:
•

not in accordance with the agency’s scope of authority

•

not in accordance with the US Constitution or the Administrative Procedure Act

•

not in accordance with the substantial evidence test

•

unwarranted by the facts

•

arbitrary, capricious, an abuse of discretion, or otherwise not in accord with the law

Section 706 of the Administrative Procedure Act sets out those standards. While it is difficult to show that
an agency’s action is arbitrary and capricious, there are cases that have so held. For example, after the
Reagan administration set aside a Carter administration rule from the National Highway Traffic and
Safety Administration on passive restraints in automobiles, State Farm and other insurance companies
challenged the reversal as arbitrary and capricious. Examining the record, the Supreme Court found that
the agency had failed to state enough reasons for its reversal and required the agency to review the record

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and the rule and provide adequate reasons for its reversal. State Farm and other insurance companies
thus gained a legal benefit by keeping an agency rule that placed costs on automakers for increased
passenger safety and potentially reducing the number of injury claims from those it had insured.

[1]

Suing the Government
In the modern administrative state, the range of government activity is immense, and administrative
agencies frequently get in the way of business enterprise. Often, bureaucratic involvement is wholly
legitimate, compelled by law; sometimes, however, agencies or government officials may overstep their
bounds, in a fit of zeal or spite. What recourse does the private individual or company have?
Mainly for historical reasons, it has always been more difficult to sue the government than to sue private
individuals or corporations. For one thing, the government has long had recourse to the doctrine of
sovereign immunity as a shield against lawsuits. Yet in 1976, Congress amended the Administrative
Procedure Act to waive any federal claim to sovereign immunity in cases of injunctive or other
nonmonetary relief. Earlier, in 1946, in the Federal Tort Claims Act, Congress had waived sovereign
immunity of the federal government for most tort claims for money damages, although the act contains
several exceptions for specific agencies (e.g., one cannot sue for injuries resulting from fiscal operations of
the Treasury Department or for injuries stemming from activities of the military in wartime). The act also
contains a major exception for claims “based upon [an official’s] exercise or performance or the failure to
exercise or perform a discretionary function or duty.” This exception prevents suits against parole boards
for paroling dangerous criminals who then kill or maim in the course of another crime and suits against
officials whose decision to ship explosive materials by public carrier leads to mass deaths and injuries
following an explosion en route.

[2]

In recent years, the Supreme Court has been stripping away the traditional immunity enjoyed by many
government officials against personal suits. Some government employees—judges, prosecutors,
legislators, and the president, for example—have absolute immunity against suit for official actions. But
many public administrators and government employees have at best a qualified immunity. Under a
provision of the Civil Rights Act of 1871 (so-called Section 1983 actions), state officials can be sued in
federal court for money damages whenever “under color of any state law” they deprive anyone of his

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rights under the Constitution or federal law. In Bivens v. Six Unknown Federal Narcotics Agents, the
Supreme Court held that federal agents may be sued for violating the plaintiff’s Fourth Amendment rights
[3]

against an unlawful search of his home. Subsequent cases have followed this logic to permit suits for
violations of other constitutional provisions. This area of the law is in a state of flux, and it is likely to
continue to evolve.
Sometimes damage is done to an individual or business because the government has given out erroneous
information. For example, suppose that Charles, a bewildered, disabled navy employee, is receiving a
federal disability annuity. Under the regulations, he would lose his pension if he took a job that paid him
in each of two succeeding years more than 80 percent of what he earned in his old navy job. A few years
later, Congress changed the law, making him ineligible if he earned more than 80 percent in anyone year.
For many years, Charles earned considerably less than the ceiling amount. But then one year he got the
opportunity to make some extra money. Not wishing to lose his pension, he called an employee relations
specialist in the US Navy and asked how much he could earn and still keep his pension. The specialist
gave him erroneous information over the telephone and then sent him an out-of-date form that said
Charles could safely take on the extra work. Unfortunately, as it turned out, Charles did exceed the salary
limit, and so the government cut off his pension during the time he earned too much. Charles sues to
recover his lost pension. He argues that he relied to his detriment on false information supplied by the
navy and that in fairness the government should be estopped from denying his claim.
Unfortunately for Charles, he will lose his case. In Office of Personnel Management v. Richmond, the
Supreme Court reasoned that it would be unconstitutional to permit recovery.

[4]

The appropriations

clause of Article I says that federal money can be paid out only through an appropriation made by law.
The law prevented this particular payment to be made. If the court were to make an exception, it would
permit executive officials in effect to make binding payments, even though unauthorized, simply by
misrepresenting the facts. The harsh reality, therefore, is that mistakes of the government are generally
held against the individual, not the government, unless the law specifically provides for recompense (as,
for example, in the Federal Tort Claims Act just discussed).

KEY TAKEAWAY
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After exhausting administrative remedies, there are numerous grounds for seeking judicial review of an
agency’s order or of a final rule. While courts defer to agencies to some degree, an agency must follow its own
rules, comply with the Administrative Procedure Act, act within the scope of its delegated authority, avoid
acting in an arbitrary manner, and make final rules that are supported by substantial evidence.

EXERCISES
1.

Why would US courts require that someone seeking judicial review of an agency order first exhaust
administrative remedies?

2.

On the Internet, find a case where someone has successfully sued the US government under the Federal
Tort Claims Act. What kind of case was it? Did the government argue sovereign immunity? Does sovereign
immunity even make sense to you?

[1] Motor Vehicle Manufacturers’ Assn. v. State Farm Mutual Ins., 463 US 29 (1983).
[2] Dalehite v. United States, 346 US 15 (1953).
[3] Bivens v. Six Unknown Federal Narcotics Agents, 403 US 388 (1971).
[4] Office of Personnel Management v. Richmond, 110 S. Ct. 2465 (1990).

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5.6 Cases
Marshall v. Barlow’s, Inc.
Marshall v. Barlow’s, Inc.
436 U.S. 307 (U.S. Supreme Court 1978)
MR. JUSTICE WHITE delivered the opinion of the Court.
Section 8(a) of the Occupational Safety and Health Act of 1970 (OSHA or Act) empowers agents of the
Secretary of Labor (Secretary) to search the work area of any employment facility within the Act’s
jurisdiction. The purpose of the search is to inspect for safety hazards and violations of OSHA regulations.
No search warrant or other process is expressly required under the Act.
On the morning of September 11, 1975, an OSHA inspector entered the customer service area of Barlow’s,
Inc., an electrical and plumbing installation business located in Pocatello, Idaho. The president and
general manager, Ferrol G. “Bill” Barlow, was on hand; and the OSHA inspector, after showing his
credentials, informed Mr. Barlow that he wished to conduct a search of the working areas of the business.
Mr. Barlow inquired whether any complaint had been received about his company. The inspector
answered no, but that Barlow’s, Inc., had simply turned up in the agency’s selection process. The inspector
again asked to enter the nonpublic area of the business; Mr. Barlow’s response was to inquire whether the
inspector had a search warrant.
The inspector had none. Thereupon, Mr. Barlow refused the inspector admission to the employee area of
his business. He said he was relying on his rights as guaranteed by the Fourth Amendment of the United
States Constitution.
Three months later, the Secretary petitioned the United States District Court for the District of Idaho to
issue an order compelling Mr. Barlow to admit the inspector. The requested order was issued on
December 30, 1975, and was presented to Mr. Barlow on January 5, 1976. Mr. Barlow again refused
admission, and he sought his own injunctive relief against the warrantless searches assertedly permitted
by OSHA.…The Warrant Clause of the Fourth Amendment protects commercial buildings as well as

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private homes. To hold otherwise would belie the origin of that Amendment, and the American colonial
experience.
An important forerunner of the first 10 Amendments to the United States Constitution, the Virginia Bill of
Rights, specifically opposed “general warrants, whereby an officer or messenger may be commanded to
search suspected places without evidence of a fact committed.” The general warrant was a recurring point
of contention in the Colonies immediately preceding the Revolution. The particular offensiveness it
engendered was acutely felt by the merchants and businessmen whose premises and products were
inspected for compliance with the several parliamentary revenue measures that most irritated the
colonists.…
***
This Court has already held that warrantless searches are generally unreasonable, and that this rule
applies to commercial premises as well as homes. In Camara v. Municipal Court, we held:
[E]xcept in certain carefully defined classes of cases, a search of private property without proper consent
is ‘unreasonable’ unless it has been authorized by a valid search warrant.
On the same day, we also ruled: As we explained in Camara, a search of private houses is presumptively
unreasonable if conducted without a warrant. The businessman, like the occupant of a residence, has a
constitutional right to go about his business free from unreasonable official entries upon his private
commercial property. The businessman, too, has that right placed in jeopardy if the decision to enter and
inspect for violation of regulatory laws can be made and enforced by the inspector in the field without
official authority evidenced by a warrant. These same cases also held that the Fourth Amendment
prohibition against unreasonable searches protects against warrantless intrusions during civil as well as
criminal investigations. The reason is found in the “basic purpose of this Amendment…[which] is to
safeguard the privacy and security of individuals against arbitrary invasions by governmental officials.” If
the government intrudes on a person’s property, the privacy interest suffers whether the government’s
motivation is to investigate violations of criminal laws or breaches of other statutory or regulatory
standards.…

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[A]n exception from the search warrant requirement has been recognized for “pervasively regulated
business[es],” United States v. Biswell, 406 U.S. 311, 316 (1972), and for “closely regulated” industries
“long subject to close supervision and inspection,” Colonnade Catering Corp. v. United States, 397 U.S.
72, 74, 77 (1970). These cases are indeed exceptions, but they represent responses to relatively unique
circumstances. Certain industries have such a history of government oversight that no reasonable
expectation of privacy could exist for a proprietor over the stock of such an enterprise. Liquor
(Colonnade) and firearms (Biswell) are industries of this type when an entrepreneur embarks upon such a
business, he has voluntarily chosen to subject himself to a full arsenal of governmental regulation.
***
The clear import of our cases is that the closely regulated industry of the type involved
in Colonnade and Biswell is the exception. The Secretary would make it the rule. Invoking the WalshHealey Act of 1936, 41 U.S.C. § 35 et seq., the Secretary attempts to support a conclusion that all
businesses involved in interstate commerce have long been subjected to close supervision of employee
safety and health conditions. But…it is quite unconvincing to argue that the imposition of minimum
wages and maximum hours on employers who contracted with the Government under the Walsh-Healey
Act prepared the entirety of American interstate commerce for regulation of working conditions to the
minutest detail. Nor can any but the most fictional sense of voluntary consent to later searches be found in
the single fact that one conducts a business affecting interstate commerce. Under current practice and
law, few businesses can be conducted without having some effect on interstate commerce.
***
The critical fact in this case is that entry over Mr. Barlow’s objection is being sought by a Government
agent. Employees are not being prohibited from reporting OSHA violations. What they observe in their
daily functions is undoubtedly beyond the employer’s reasonable expectation of privacy. The Government
inspector, however, is not an employee. Without a warrant he stands in no better position than a member
of the public. What is observable by the public is observable, without a warrant, by the Government
inspector as well. The owner of a business has not, by the necessary utilization of employees in his
operation, thrown open the areas where employees alone are permitted to the warrantless scrutiny of

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Government agents. That an employee is free to report, and the Government is free to use, any evidence of
noncompliance with OSHA that the employee observes furnishes no justification for federal agents to
enter a place of business from which the public is restricted and to conduct their own warrantless search.
***
[The District Court judgment is affirmed.]

CASE QUESTIONS
1.

State, as briefly and clearly as possible, the argument that Barlow’s is making in this case.

2.

Why would some industries or businesses be “closely regulated”? What are some of those businesses?

3.

The Fourth Amendment speaks of “people” being secure in their “persons, houses, papers, and effects.”
Why would the Fourth Amendment apply to a business, which is not in a “house”?

4.

If the Fourth Amendment does not distinguish between closely regulated industries and those that are
not, why does the court do so?

American Textile Manufacturers Institute v. Donovan
American Textile Manufacturers Institute v. Donovan
452 U.S. 490 (1981)
JUSTICE BRENNAN delivered the opinion of the Court.
Congress enacted the Occupational Safety and Health Act of 1970 (Act) “to assure so far as possible every
working man and woman in the Nation safe and healthful working conditions.…“The Act authorizes the
Secretary of Labor to establish, after notice and opportunity to comment, mandatory nationwide
standards governing health and safety in the workplace. In 1978, the Secretary, acting through the
Occupational Safety and Health Administration (OSHA), promulgated a standard limiting occupational
exposure to cotton dust, an airborne particle byproduct of the preparation and manufacture of cotton
products, exposure to which produces a “constellation of respiratory effects” known as “byssinosis.” This
disease was one of the expressly recognized health hazards that led to passage of the Act.

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Petitioners in these consolidated cases representing the interests of the cotton industry, challenged the
validity of the “Cotton Dust Standard” in the Court of Appeals for the District of Columbia Circuit
pursuant to § 6 (f) of the Act, 29 U.S.C. § 655 (f). They contend in this Court, as they did below, that the
Act requires OSHA to demonstrate that its Standard reflects a reasonable relationship between the costs
and benefits associated with the Standard. Respondents, the Secretary of Labor and two labor
organizations, counter that Congress balanced the costs and benefits in the Act itself, and that the Act
should therefore be construed not to require OSHA to do so. They interpret the Act as mandating that
OSHA enact the most protective standard possible to eliminate a significant risk of material health
impairment, subject to the constraints of economic and technological feasibility.
The Court of Appeals held that the Act did not require OSHA to compare costs and benefits.
We granted certiorari, 449 U.S. 817 (1980), to resolve this important question, which was presented but
not decided in last Term’s Industrial Union Dept. v. American Petroleum Institute, 448 U.S. 607 (1980),
and to decide other issues related to the Cotton Dust Standard.
***
Not until the early 1960’s was byssinosis recognized in the United States as a distinct occupational hazard
associated with cotton mills. In 1966, the American Conference of Governmental Industrial Hygienists
(ACGIH), a private organization, recommended that exposure to total cotton dust be limited to a
“threshold limit value” of 1,000 micrograms per cubic meter of air (1,000 g/m3.) averaged over an 8-hour
workday. See 43 Fed. Reg. 27351, col. 1 (1978). The United States Government first regulated exposure to
cotton dust in 1968, when the Secretary of Labor, pursuant to the Walsh-Healey Act, 41 U.S.C. 35 (e),
promulgated airborne contaminant threshold limit values, applicable to public contractors, that included
the 1,000 g/m3 limit for total cotton dust. 34 Fed. Reg. 7953 (1969). Following passage of the Act in 1970,
the 1,000 g/m3. standard was adopted as an “established Federal standard” under 6 (a) of the Act, 84 Stat.
1593, 29 U.S.C. 655 (a), a provision designed to guarantee immediate protection of workers for the period
between enactment of the statute and promulgation of permanent standards.

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That same year, the Director of the National Institute for Occupational Safety and Health (NIOSH),
pursuant to the Act, 29 U.S.C. §§ 669(a)(3), 671 (d)(2), submitted to the Secretary of Labor a
recommendation for a cotton dust standard with a permissible exposure limit (PEL) that “should be set at
the lowest level feasible, but in no case at an environmental concentration as high as 0.2 mg lint-free
cotton dust/cu m,” or 200 g/m3. of lint-free respirable dust. Several months later, OSHA published an
Advance Notice of Proposed Rulemaking, 39 Fed.Reg. 44769 (1974), requesting comments from
interested parties on the NIOSH recommendation and other related matters. Soon thereafter, the Textile
Worker’s Union of America, joined by the North Carolina Public Interest Research Group, petitioned the
Secretary, urging a more stringent PEL of 100 g/m3.
On December 28, 1976, OSHA published a proposal to replace the existing federal standard on cotton dust
with a new permanent standard, pursuant to § 6(b)(5) of the Act, 29 U.S.C. § 655(b)(5). 41 Fed.Reg.
56498. The proposed standard contained a PEL of 200 g/m3 of vertical elutriated lint-free respirable
cotton dust for all segments of the cotton industry. Ibid. It also suggested an implementation strategy for
achieving the PEL that relied on respirators for the short term and engineering controls for the long-term.
OSHA invited interested parties to submit written comments within a 90-day period.
***
The starting point of our analysis is the language of the statute itself. Section 6(b)(5) of the Act, 29 U.S.C.
§ 655(b)(5) (emphasis added), provides:
The Secretary, in promulgating standards dealing with toxic materials or harmful physical agents under
this subsection, shall set the standard which most adequately assures, to the extent feasible, on the
basis of the best available evidence, that no employee will suffer material impairment of health or
functional capacity even if such employee has regular exposure to the hazard dealt with by such standard
for the period of his working life. Although their interpretations differ, all parties agree that the phrase “to
the extent feasible” contains the critical language in § 6(b)(5) for purposes of these cases.
The plain meaning of the word “feasible” supports respondents’ interpretation of the statute. According to
Webster’s Third New International Dictionary of the English Language 831 (1976), “feasible” means

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“capable of being done, executed, or effected.” In accord, the Oxford English Dictionary 116 (1933)
(“Capable of being done, accomplished or carried out”); Funk & Wagnalls New “Standard” Dictionary of
the English Language 903 (1957) (“That may be done, performed or effected”). Thus, § 6(b)(5) directs the
Secretary to issue the standard that “most adequately assures…that no employee will suffer material
impairment of health,” limited only by the extent to which this is “capable of being done.” In effect then,
as the Court of Appeals held, Congress itself defined the basic relationship between costs and benefits, by
placing the “benefit” of worker health above all other considerations save those making attainment of this
“benefit” unachievable. Any standard based on a balancing of costs and benefits by the Secretary that
strikes a different balance than that struck by Congress would be inconsistent with the command set forth
in § 6(b)(5). Thus, cost-benefit analysis by OSHA is not required by the statute because feasibility analysis
is.
When Congress has intended that an agency engage in cost-benefit analysis, it has clearly indicated such
intent on the face of the statute. One early example is the Flood Control Act of 1936, 33 U.S.C. § 701:
[T]he Federal Government should improve or participate in the improvement of navigable waters or their
tributaries, including watersheds thereof, for flood control purposes if the benefits to whomsoever
they may accrue are in excess of the estimated costs, and if the lives and social security of people
are otherwise adversely affected. (emphasis added)
A more recent example is the Outer Continental Shelf Lands Act Amendments of 1978, providing that
offshore drilling operations shall use the best available and safest technologies which the Secretary
determines to be economically feasible, wherever failure of equipment would have a significant effect on
safety, health, or the environment, except where the Secretary determines that theincremental benefits
are clearly insufficient to justify the incremental costs of using such technologies.
These and other statutes demonstrate that Congress uses specific language when intending that an agency
engage in cost-benefit analysis. Certainly in light of its ordinary meaning, the word “feasible” cannot be
construed to articulate such congressional intent. We therefore reject the argument that Congress
required cost-benefit analysis in § 6(b)(5).

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CASE QUESTIONS
1.

What is byssinosis? Why should byssinosis be anything that the textile companies are responsible for,
ethically or legally? If it is well-known that textile workers get cotton dust in their systems and develop
brown lung, don’t they nevertheless choose to work there and assume the risk of all injuries?

2.

By imposing costs on the textile industry, what will be the net effect on US textile manufacturing jobs?

3.

How is byssinosis a “negative externality” that is not paid for by either the manufacturer or the consumer
of textile products? How should the market, to be fair and efficient, adjust for these negative
externalities other than by setting a reasonable standard that shares the burden between manufacturers
and their employees? Should all the burden be on the manufacturer?

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5.7 Summary and Exercises
Summary
Administrative rules and regulations constitute the largest body of laws that directly affect business.
These regulations are issued by dozens of federal and state agencies that regulate virtually every aspect of
modern business life, including the natural environment, corporate finance, transportation,
telecommunications, energy, labor relations, and trade practices. The administrative agencies derive their
power to promulgate regulations from statutes passed by Congress or state legislatures.
The agencies have a variety of powers. They can license companies to carry on certain activities or prohibit
them from doing so, lay down codes of conduct, set rates that companies may charge for their services,
and supervise various aspects of business.

EXERCISES
1.

The Equal Employment Opportunity Commission seeks data about the racial composition of Terrific
Textiles’ labor force. Terrific refuses on the grounds that inadvertent disclosure of the numbers might
cause certain “elements” to picket its factories. The EEOC takes Terrific to court to get the data. What is
the result?

2.

In order to police the profession, the state legislature has just passed a law permitting the State Plumbers’
Association the power to hold hearings to determine whether a particular plumber has violated the
plumbing code of ethics, written by the association. Sam, a plumber, objects to the convening of a hearing
when he is accused by Roger, a fellow plumber, of acting unethically by soliciting business from Roger’s
customers. Sam goes to court, seeking to enjoin the association’s disciplinary committee from holding the
hearing. What is the result? How would you argue Sam’s case? The association’s case?

3.

Assume that the new president of the United States was elected overwhelmingly by pledging in his
campaign to “do away with bureaucrats who interfere in your lives.” The day he takes the oath of office
he determines to carry out his pledge. Discuss which of the following courses he may lawfully follow: (a)
Fire all incumbent commissioners of federal agencies in order to install new appointees. (b) Demand that
all pending regulations being considered by federal agencies be submitted to the White House for review

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and redrafting, if necessary. (c) Interview potential nominees for agency positions to determine whether
their regulatory philosophy is consistent with his.
4.

Dewey owned a mine in Wisconsin. He refused to allow Department of Labor agents into the mine to
conduct warrantless searches to determine whether previously found safety violations had been
corrected. The Federal Mine Safety and Health Amendments Act of 1977 authorizes four warrantless
inspections per year. Is the provision for warrantless inspections by this agency constitutional?

5.

[1]

In determining the licensing requirements for nuclear reactors, the Nuclear Regulatory Commission (NRC)
adopted a zero-release assumption: that the permanent storage of certain nuclear waste would have no
significant environmental impact and that potential storage leakages should not be a factor discussed in
the appropriate environmental impact statement (EIS) required before permitting construction of a
nuclear power plant. This assumption is based on the NRC’s belief that technology would be developed to
isolate the wastes from the environment, and it was clear from the record that the NRC had “digested a
massive material and disclosed all substantial risks” and had considered that the zero-release assumption
was uncertain. There was a remote possibility of contamination by water leakage into the storage facility.
An environmental NGO sued, asserting that the NRC had violated the regulations governing the EIS by
arbitrarily and capriciously ignoring the potential contamination. The court of appeals agreed, and the
power plant appealed. Had the NRC acted arbitrarily and capriciously?

[2]

SELF-TEST QUESTIONS
1.

Most federal administrative agencies are created by
a.

an executive order by the president

b.

a Supreme Court decision

c.

the passage of enabling legislation by Congress, signed by the president

d.

a and c
The Federal Trade Commission, like most administrative

agencies of the federal government, is part of
a.

the executive branch of government

b.

the legislative branch of government

c.

the judicial branch of government

d.

the administrative branch of government

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In the Clean Water Act, Congress sets broad guidelines, but it
is the Environmental Protection Agency that proposes rules to regulate industrial discharges.
Where do proposed rules originally appear?
a.

in the Congressional record

b.

in the Federal Register

c.

in the Code of Federal Regulations

d.

in the United States code service
The legal basis for all administrative law, including regulations

of the Federal Trade Commission, is found in
a.

the Administrative Procedure Act

b.

the US Constitution

c.

the commerce clause

d.

none of the above
The Federal Trade Commission, like other administrative

agencies, has the power to
a.

issue proposed rules

b.

undertake investigations of firms that may have violated FTC regulations

c.

prosecute firms that have violated FTC regulations

d.

none of the above

e.

all of the above

SELF-TEST ANSWERS
1.

c

2.

a

3.

b

4.

b

5.

e

[1] Donovan v. Dewey, 452 US 594 (1981).
[2] Baltimore Gas and Electric Co. v. Natural Resources Defense Council Inc., 462 US 87 (1983).

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Chapter 6

Criminal Law
LEARNING OBJECTIVES
After reading this chapter, you should be able to do the following:
1.

Explain how criminal law differs from civil law.

2.

Categorize the various types of crimes and define the most serious felonies.

3.

Discuss and question the criminal “intent” of a corporation.

4.

Explain basic criminal procedure and the rights of criminal defendants.

At times, unethical behavior by businesspeople can be extreme enough that society will respond by
criminalizing certain kinds of activities. Ponzi schemes, arson, various kinds of fraud, embezzlement,
racketeering, foreign corrupt practices, tax evasion, and insider trading are just a few. A corporation
can face large fines, and corporate managers can face both fines and jail sentences for violating
criminal laws. This chapter aims to explain how criminal law differs from civil law, to discuss various
types of crimes, and to relate the basic principles of criminal procedure.

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6.1 The Nature of Criminal Law
Criminal law is the most ancient branch of the law. Many wise observers have tried to define and explain
it, but the explanations often include many complex and subtle distinctions. A traditional criminal law
course would include a lot of discussions on criminal intent, the nature of criminal versus civil
responsibility, and the constitutional rights accorded the accused. But in this chapter, we will consider
only the most basic aspects of intent, responsibility, and constitutional rights.
Unlike civil actions, where plaintiffs seek compensation or other remedies for themselves, crimes involve
“the state” (the federal government, a state government, or some subunit of state government). This is
because crimes involve some “harm to society” and not just harm to certain individuals. But “harm to
society” is not always evident in the act itself. For example, two friends of yours at a party argue, take the
argument outside, and blows are struck; one has a bloody nose and immediately goes home. The crimes of
assault and battery have been committed, even though no one else knows about the fight and the friends
later make up. By contrast, suppose a major corporation publicly announces that it is closing operations in
your community and moving operations to Southeast Asia. There is plenty of harm to society as the plant
closes down and no new jobs take the place of the company’s jobs. Although the effects on society are
greater in the second example, only the first example is a crime.
Crimes are generally defined by legislatures, in statutes; the statutes describe in general terms the nature
of the conduct they wish to criminalize. For government punishment to be fair, citizens must have clear
notice of what is criminally prohibited. Ex post facto laws—laws created “after the fact” to punish an act
that was legal at the time—are expressly prohibited by the US Constitution. Overly vague statutes can also
be struck down by courts under a constitutional doctrine known as “void for vagueness.”
What is considered a crime will also vary from society to society and from time to time. For example,
while cocaine use was legal in the United States at one time, it is now a controlled substance, and
unauthorized use is now a crime. Medical marijuana was not legal fifty years ago when its use began to
become widespread, and in some states its use or possession was a felony. Now, some states make it legal
to use or possess it under some circumstances. In the United States, you can criticize and make jokes

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about the president of the United States without committing a crime, but in many countries it is a serious
criminal act to criticize a public official.
Attitudes about appropriate punishment for crimes will also vary considerably from nation to nation.
Uganda has decreed long prison sentences for homosexuals and death to repeat offenders. In Saudi
Arabia, the government has proposed to deliberately paralyze a criminal defendant who criminally
assaulted someone and unintentionally caused the victim’s paralysis. Limits on punishment are set in the
United States through the Constitution’s prohibition on “cruel or unusual punishments.”
It is often said that ignorance of the law is no excuse. But there are far too many criminal laws for anyone
to know them all. Also, because most people do not actually read statutes, the question of “criminal
intent” comes up right away: if you don’t know that the legislature has made driving without a seat belt
fastened a misdemeanor, you cannot have intended to harm society. You might even argue that there is no
harm to anyone but yourself!
The usual answer to this is that the phrase “ignorance of the law is no excuse” means that society (through
its elected representatives) gets to decide what is harmful to society, not you. Still, you may ask, “Isn’t it
my choice whether to take the risk of failing to wear a seat belt? Isn’t this a victimless crime? Where is the
harm to society?” A policymaker or social scientist may answer that your injuries, statistically, are
generally going to be far greater if you don’t wear one and that your choice may actually impose costs on
society. For example, you might not have enough insurance, so that a public hospital will have to take care
of your head injuries, injuries that would likely have been avoided by your use of a seat belt.
But, as just noted, it is hard to know the meaning of some criminal laws. Teenagers hanging around the
sidewalks on Main Street were sometimes arrested for “loitering.” The constitutional void-for-vagueness
doctrine has led the courts to overturn statutes that are not clear. For example, “vagrancy” was long held
to be a crime, but US courts began some forty years ago to overturn vagrancy and “suspicious person”
statutes on the grounds that they are too vague for people to know what they are being asked not to do.
This requirement that criminal statutes not be vague does not mean that the law always defines crimes in
ways that can be easily and clearly understood. Many statutes use terminology developed by the common-

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law courts. For example, a California statute defines murder as “the unlawful killing of a human being,
with malice aforethought.” If no history backed up these words, they would be unconstitutionally vague.
But there is a rich history of judicial decisions that provides meaning for much of the arcane language like
“malice aforethought” strewn about in the statute books.
Because a crime is an act that the legislature has defined as socially harmful, the parties involved cannot
agree among themselves to forget a particular incident, such as a barroom brawl, if the authorities decide
to prosecute. This is one of the critical distinctions between criminal and civil law. An assault is both a
crime and a tort. The person who was assaulted may choose to forgive his assailant and not to sue him for
damages. But he cannot stop the prosecutor from bringing an indictment against the assailant. (However,
because of crowded dockets, a victim that declines to press charges may cause a busy prosecutor to choose
to not to bring an indictment.)
A crime consists of an act defined as criminal—an actus reus—and the requisite “criminal intent.”
Someone who has a burning desire to kill a rival in business or romance and who may actually intend to
murder but does not act on his desire has not committed a crime. He may have a “guilty mind”—the
translation of the Latin phrase mens rea—but he is guilty of no crime. A person who is forced to commit a
crime at gunpoint is not guilty of a crime, because although there was an act defined as criminal—an actus
reus—there was no criminal intent.

KEY TAKEAWAY
Crimes are usually defined by statute and constitute an offense against society. In each case, there must be
both an act and some mens rea (criminal intent).

EXERCISES
1.

Other than deterring certain kinds of conduct, what purpose does the criminal law serve?

2.

Why is ignorance of the law no excuse? Why shouldn’t it be an excuse, when criminal laws can be
complicated and sometimes ambiguous?

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6.2 Types of Crimes
LEARNING OBJECTIVES
1.

Categorize various types of crimes.

2.

Name and define the major felonies in criminal law.

3.

Explain how white-collar crime differs from other crimes.

4.

Define a variety of white-collar crimes.

Most classifications of crime turn on the seriousness of the act. In general, seriousness is defined by the
nature or duration of the punishment set out in the statute. A felony is a crime punishable (usually) by
imprisonment of more than one year or by death. (Crimes punishable by death are sometimes known as
capital crimes; they are increasingly rare in the United States.) The major felonies include murder, rape,
kidnapping, armed robbery, embezzlement, insider trading, fraud, and racketeering. All other crimes are
usually known as misdemeanors, petty offenses, or infractions. Another way of viewing crimes is by the
type of social harm the statute is intended to prevent or deter, such as offenses against the person,
offenses against property, and white-collar crime.

Offenses against the Person
Homicide
Homicide is the killing of one person by another. Not every killing is criminal. When the law permits one
person to kill another—for example, a soldier killing an enemy on the battlefield during war, or a killing in
self-defense—the death is considered the result of justifiable homicide. An excusable homicide, by
contrast, is one in which death results from an accident in which the killer is not at fault.
All other homicides are criminal. The most severely punished form is murder, defined as homicide
committed with “malice aforethought.” This is a term with a very long history. Boiled down to its
essentials, it means that the defendant had the intent to kill. A killing need not be premeditated for any
long period of time; the premeditation might be quite sudden, as in a bar fight that escalates in that
moment when one of the fighters reaches for a knife with the intent to kill.

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Sometimes a homicide can be murder even if there is no intent to kill; an intent to inflict great bodily
harm can be murder if the result is the death of another person. A killing that takes place while a felony
(such as armed robbery) is being committed is also murder, whether or not the killer intended any harm.
This is the so-called felony murder rule. Examples are the accidental discharge of a gun that kills an
innocent bystander or the asphyxiation death of a fireman from smoke resulting from a fire set by an
arsonist. The felony murder rule is more significant than it sounds, because it also applies to the
accomplices of one who does the killing. Thus the driver of a getaway car stationed a block away from the
scene of the robbery can be convicted of murder if a gun accidentally fires during the robbery and
someone is killed. Manslaughter is an act of killing that does not amount to murder. Voluntary
manslaughter is an intentional killing, but one carried out in the “sudden heat of passion” as the result of
some provocation. An example is a fight that gets out of hand. Involuntary manslaughter entails a lesser
degree of willfulness; it usually occurs when someone has taken a reckless action that results in death
(e.g., a death resulting from a traffic accident in which one driver recklessly runs a red light).

Assault and Battery
Ordinarily, we would say that a person who has struck another has “assaulted” him. Technically, that is
a battery—the unlawful application of force to another person. The force need not be violent. Indeed, a
man who kisses a woman is guilty of a battery if he does it against her will. The other person may consent
to the force. That is one reason why surgeons require patients to sign consent forms, giving the doctor
permission to operate. In the absence of such a consent, an operation is a battery. That is also why football
players are not constantly being charged with battery. Those who agree to play football agree to submit to
the rules of the game, which of course include the right to tackle. But the consent does not apply to all acts
of physical force: a hockey player who hits an opponent over the head with his stick can be prosecuted for
the crime of battery.
Criminal assault is an attempt to commit a battery or the deliberate placing of another in fear of
receiving an immediate battery. If you throw a rock at a friend, but he manages to dodge it, you have
committed an assault. Some states limit an assault to an attempt to commit a battery by one who has a
“present ability” to do so. Pointing an unloaded gun and threatening to shoot would not be an assault, nor,

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of course, could it be a battery. The modem tendency, however, is to define an assault as an attempt to
commit a battery by one with an apparentability to do so.
Assault and battery may be excused. For example, a bar owner (or her agent, the bouncer) may use
reasonable force to remove an unruly patron. If the use of force is excessive, the bouncer can be found
guilty of assault and battery, and a civil action could arise against the bar owner as well.

Offenses against Property
Theft: Larceny, Robbery, Embezzlement, False Pretenses
The concept of theft is familiar enough. Less familiar is the way the law has treated various aspects of the
act of stealing. Criminal law distinguishes among many different crimes that are popularly known as theft.
Many technical words have entered the language—burglary, larceny, robbery—but are often used
inaccurately. Brief definitions of the more common terms are discussed here.
The basic crime of stealing personal property is larceny. By its old common-law definition, still in use
today, larceny is the wrongful “taking and carrying away of the personal property of another with intent to
steal the same.”
The separate elements of this offense have given rise to all kinds of difficult cases. Take the theft of fruit,
for example, with regard to the essential element of “personal property.” If a man walking through an
orchard plucks a peach from a tree and eats it, he is not guilty of larceny because he has not taken away
personal property (the peach is part of the land, being connected to the tree). But if he picks up a peach
lying on the ground, he is guilty of larceny. Or consider the element of “taking” or “carrying away.”
Sneaking into a movie theater without paying is not an act of larceny (though in most states it is a criminal
act). Taking electricity by tapping into the power lines of an electric utility was something that baffled
judges late in the nineteenth century because it was not clear whether electricity is a “something” that can
be taken. Modern statutes have tended to make clear that electricity can be the object of larceny. Or
consider the element of an “intent to steal the same.” If you borrow your friend’s BMW without his
permission in order to go to the grocery store, intending to return it within a few minutes and then do

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return it, you have not committed larceny. But if you meet another friend at the store who convinces you
to take a long joyride with the car and you return hours later, you may have committed larceny.
A particular form of larceny is robbery, which is defined as larceny from a person by means of violence
or intimidation.
Larceny involves the taking of property from the possession of another. Suppose that a person legitimately
comes to possess the property of another and wrongfully appropriates it—for example, an automobile
mechanic entrusted with your car refuses to return it, or a bank teller who is entitled to temporary
possession of cash in his drawer takes it home with him. The common law had trouble with such cases
because the thief in these cases already had possession; his crime was in assuming ownership. Today,
such wrongful conversion, known as embezzlement, has been made a statutory offense in all states.
Statutes against larceny and embezzlement did not cover all the gaps in the law. A conceptual problem
arises in the case of one who is tricked into giving up his title to property. In larceny and embezzlement,
the thief gains possession or ownership without any consent of the owner or custodian of the property.
Suppose, however, that an automobile dealer agrees to take his customer’s present car as a trade-in. The
customer says that he has full title to the car. In fact, the customer is still paying off an installment loan
and the finance company has an interest in the old car. If the finance company repossesses the car, the
customer—who got a new car at a discount because of his false representation—cannot be said to have
taken the new car by larceny or embezzlement. Nevertheless, he tricked the dealer into selling, and the
dealer will have lost the value of the repossessed car. Obviously, the customer is guilty of a criminal act;
the statutes outlawing it refer to this trickery as the crime of false pretenses, defined as obtaining
ownership of the property of another by making untrue representations of fact with intent to defraud.
A number of problems have arisen in the judicial interpretation of false-pretense statutes. One concerns
whether the taking is permanent or only temporary. The case of State v. Mills (Section 6.7 "Cases") shows
the subtle questions that can be presented and the dangers inherent in committing “a little fraud.”
In the Mills case, the claim was that a mortgage instrument dealing with one parcel of land was used
instead for another. This is a false representation of fact. Suppose, by contrast, that a person

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misrepresents his state of mind: “I will pay you back tomorrow,” he says, knowing full well that he does
not intend to. Can such a misrepresentation amount to false pretenses punishable as a criminal offense?
In most jurisdictions it cannot. A false-pretense violation relates to a past event or existing fact, not to a
statement of intention. If it were otherwise, anyone failing to pay a debt might find himself facing criminal
prosecution, and business would be less prone to take risks.
The problem of proving intent is especially difficult when a person has availed himself of the services of
another without paying. A common example is someone leaving a restaurant without paying for the meal.
In most states, this is specifically defined in the statutes as theft of services.

Receiving Stolen Property
One who engages in receiving stolen property with knowledge that it is stolen is guilty of a felony or
misdemeanor, depending on the value of the property. The receipt need not be personal; if the property is
delivered to a place under the control of the receiver, then he is deemed to have received it. “Knowledge”
is construed broadly: not merely actual knowledge, but (correct) belief and suspicion (strong enough not
to investigate for fear that the property will turn out to have been stolen) are sufficient for conviction.

Forgery
Forgery is false writing of a document of legal significance (or apparent legal significance!) with intent to
defraud. It includes the making up of a false document or the alteration of an existing one. The writing
need not be done by hand but can be by any means—typing, printing, and so forth. Documents commonly
the subject of forgery are negotiable instruments (checks, money orders, and the like), deeds, receipts,
contracts, and bills of lading. The forged instrument must itself be false, not merely contain a falsehood. If
you fake your neighbor’s signature on one of his checks made out to cash, you have committed forgery.
But if you sign a check of your own that is made out to cash, knowing that there is no money in your
checking account, the instrument is not forged, though the act may be criminal if done with the intent to
defraud.
The mere making of a forged instrument is unlawful. So is the “uttering” (or presentation) of such an
instrument, whether or not the one uttering it actually forged it. The usual example of a false signature is

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by no means the only way to commit forgery. If done with intent to defraud, the backdating of a
document, the modification of a corporate name, or the filling in of lines left blank on a form can all
constitute forgery.

Extortion
Under common law, extortion could only be committed by a government official, who corruptly
collected an unlawful fee under color of office. A common example is a salaried building inspector who
refuses to issue a permit unless the permittee pays him. Under modern statutes, the crime of extortion has
been broadened to include the wrongful collection of money or something else of value by anyone by
means of a threat (short of a threat of immediate physical violence, for such a threat would make the
demand an act of robbery). This kind of extortion is usually called blackmail. The blackmail threat
commonly is to expose some fact of the victim’s private life or to make a false accusation about him.

Offenses against Habitation and Other Offenses
Burglary
Burglary is not a crime against property. It is defined as “the breaking and entering of the dwelling of
another in the nighttime with intent to commit a felony.” The intent to steal is not an issue: a man who
sneaks into a woman’s home intent on raping her has committed a burglary, even if he does not carry out
the act. The student doing critical thinking will no doubt notice that the definition provides plenty of room
for argument. What is “breaking”? (The courts do not require actual destruction; the mere opening of a
closed door, even if unlocked, is enough.) What is entry? When does night begin? What kind of intent?
Whose dwelling? Can a landlord burglarize the dwelling of his tenant? (Yes.) Can a person burglarize his
own home? (No.)

Arson
Under common law, arson was the malicious burning of the dwelling of another. Burning one’s own
house for purposes of collecting insurance was not an act of arson under common law. The statutes today

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make it a felony intentionally to set fire to any building, whether or not it is a dwelling and whether or not
the purpose is to collect insurance.

Bribery
Bribery is a corrupt payment (or receipt of such a payment) for official action. The payment can be in
cash or in the form of any goods, intangibles, or services that the recipient would find valuable. Under
common law, only a public official could be bribed. In most states, bribery charges can result from the
bribe of anyone performing a public function.
Bribing a public official in government procurement (contracting) can result in serious criminal charges.
Bribing a public official in a foreign country to win a contract can result in charges under the Foreign
Corrupt Practices Act.

Perjury
Perjury is the crime of giving a false oath, either orally or in writing, in a judicial or other official
proceeding (lies made in proceedings other than courts are sometimes termed “false swearing”). To be
perjurious, the oath must have been made corruptly—that is, with knowledge that it was false or without
sincere belief that it was true. An innocent mistake is not perjury. A statement, though true, is perjury if
the maker of it believes it to be false. Statements such as “I don’t remember” or “to the best of my
knowledge” are not sufficient to protect a person who is lying from conviction for perjury. To support a
charge of perjury, however, the false statement must be “material,” meaning that the statement is relevant
to whatever the court is trying to find out.

White-Collar Crime
White-collar crime, as distinguished from “street crime,” refers generally to fraud-related acts carried
out in a nonviolent way, usually connected with business. Armed bank robbery is not a white-collar crime,
but embezzlement by a teller or bank officer is. Many white-collar crimes are included within the statutory
definitions of embezzlement and false pretenses. Most are violations of state law. Depending on how they
are carried out, many of these same crimes are also violations of federal law.

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Any act of fraud in which the United States postal system is used or which involves interstate phone calls
or Internet connections is a violation of federal law. Likewise, many different acts around the buying and
selling of securities can run afoul of federal securities laws. Other white-collar crimes include tax fraud;
price fixing; violations of food, drug, and environmental laws; corporate bribery of foreign companies;
and—the newest form—computer fraud. Some of these are discussed here; others are covered in later
chapters.

Mail and Wire Fraud
Federal law prohibits the use of the mails or any interstate electronic communications medium for the
purpose of furthering a “scheme or artifice to defraud.” The statute is broad, and it is relatively easy for
prosecutors to prove a violation. The law also bans attempts to defraud, so the prosecutor need not show
that the scheme worked or that anyone suffered any losses. “Fraud” is broadly construed: anyone who
uses the mails or telephone to defraud anyone else of virtually anything, not just of money, can be
convicted under the law. In one case, a state governor was convicted of mail fraud when he took bribes to
influence the setting of racing dates. The court’s theory was that he defrauded the citizenry of its right to
his “honest and faithful services” as governor.

[1]

Violations of the Food and Drug Act
The federal Food, Drug, and Cosmetic Act prohibits any person or corporation from sending into
interstate commerce any adulterated or misbranded food, drug, cosmetics, or related device. For example,
in a 2010 case, Allergen had to pay a criminal fine for marketing Botox as a headache or pain reliever, a
use that had not been approved by the Food and Drug Administration. Unlike most criminal statutes,
willfulness or deliberate misconduct is not an element of the act. As the United States v. Park case
(Section 6.7 "Cases") shows, an executive can be held criminally liable even though he may have had no
personal knowledge of the violation.

Environmental Crimes
Many federal environmental statutes have criminal provisions. These include the Federal Water Pollution
Control Act (commonly called the Clean Water Act); the Rivers and Harbors Act of 1899 (the Refuse Act);

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the Clean Air Act; the Federal Insecticide, Fungicide, and Rodenticide Act (FIFRA); the Toxic Substances
Control Act (TSCA); and the Resource Conservation and Recovery Act (RCRA). Under the Clean Water
Act, for example, wrongful discharge of pollutants into navigable waters carries a fine ranging from
$2,500 to $25,000 per day and imprisonment for up to one year. “Responsible corporate officers” are
specifically included as potential defendants in criminal prosecutions under the act. They can include
officers who have responsibility over a project where subcontractors and their employees actually caused
the discharge.

[2]

Violations of the Foreign Corrupt Practices Act
As a byproduct of Watergate, federal officials at the Securities and Exchange Commission and the Internal
Revenue Service uncovered many instances of bribes paid by major corporations to officials of foreign
governments to win contracts with those governments. Congress responded in 1977 with the Foreign
Corrupt Practices Act, which imposed a stringent requirement that the disposition of assets be accurately
and fairly accounted for in a company’s books and records. The act also made illegal the payment of bribes
to foreign officials or to anyone who will transmit the money to a foreign official to assist the payor (the
one offering and delivering the money) in getting business.

Violations of the Racketeering Influenced and Corrupt Organizations Act
In 1970 Congress enacted the Racketeering Influenced and Corrupt Organizations Act (RICO), aimed at
ending organized crime’s infiltration into legitimate business. The act tells courts to construe its language
broadly “to effectuate its remedial purpose,” and many who are not part of organized crime have been
successfully prosecuted under the act. It bans a “pattern of racketeering,” defined as the commission of at
least two acts within ten years of any of a variety of already-existing crimes, including mail, wire, and
securities fraud. The act thus makes many types of fraud subject to severe penalties.

Computer Crime
Computer crime generally falls into four categories: (1) theft of money, financial instruments, or
property; (2) misappropriation of computer time; (3) theft of programs; and (4) illegal acquisition of
information. The main federal statutory framework for many computer crimes is the Computer Fraud and

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Abuse Act (CFAA; see Table 6.1 "Summary of Provisions of the Computer Fraud and Abuse Act").
Congress only prohibited computer fraud and abuse where there was a federal interest, as where
computers of the government were involved or where the crime was interstate in nature.
Table 6.1 Summary of Provisions of the Computer Fraud and Abuse Act

Obtaining national security information

Sec. (a)(1)

10 years maximum (20 years second offense)

Trespassing in a government computer

Sec. (a)(3)

1 year (5)

Compromising the confidentiality of a computer

Sec. (a)(2)

1 year (10)

Accessing a computer to defraud and obtain value Sec. (a)4

5 years (10)

Intentional access and reckless damage

(a)(5)(A)(ii) 5 years (20)

Trafficking in passwords

(a)(6)

1 year (10)

KEY TAKEAWAY
Offenses can be against persons, against property, or against public policy (as when you bribe a public official,
commit perjury, use public goods such as the mails or the Internet to commit fraud, or commit other whitecollar crimes).

EXERCISES
1.

Which does more serious harm to society: street crimes or white-collar crimes?

2.

Why are various crimes so difficult to define precisely?

3.

Hungry Harold goes by the home of Juanita Martinez. Juanita has just finished baking a cherry pie and sets
it in the open windowsill to cool. Harold smells the pie from the sidewalk. It is twilight; while still light, the
sun has officially set. Harold reaches into the window frame and removes the pie. Technically, has Harold
committed burglary? What are the issues here based on the definition of burglary?

4.

What is fraud? How is it different from dishonesty? Is being dishonest a criminal offense? If so, have you
been a criminal already today?

[1] United States v. Isaacs, 493 F.2d 1124 (7th Cir. 1974), cert. denied, 417 US 976 (1974).
[2] U.S. v. Hanousek, 176 F.3d 1116 (9th Cir. 1999).

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6.3 The Nature of a Criminal Act
LEARNING OBJECTIVES
1.

Understand how it is possible to commit a criminal act without actually doing anything that you think
might be criminal.

2.

Analyze and explain the importance of intention in criminal law and criminal prosecutions.

3.

Explain how a corporation can be guilty of a crime, even though it is a corporation’s agents that
commit the crime.

To be guilty of a crime, you must have acted. Mental desire or intent to do so is insufficient. But what
constitutes an act? This question becomes important when someone begins to commit a crime, or does so
in association with others, or intends to do one thing but winds up doing something else.

Attempt
It is not necessary to commit the intended crime to be found guilty of a criminal offense. An attempt to
commit the crime is punishable as well, though usually not as severely. For example, Brett points a gun at
Ashley, intending to shoot her dead. He pulls the trigger but his aim is off, and he misses her heart by four
feet. He is guilty of an attempt to murder. Suppose, however, that earlier in the day, when he was
preparing to shoot Ashley, Brett had been overheard in his apartment muttering to himself of his
intention, and that a neighbor called the police. When they arrived, he was just snapping his gun into his
shoulder holster.
At that point, courts in most states would not consider him guilty of an attempt because he had not passed
beyond the stage of preparation. After having buttoned his jacket he might have reconsidered and put the
gun away. Determining when the accused has passed beyond mere preparation and taken an actual step
toward perpetrating the crime is often difficult and is usually for the jury to decide.

Impossibility
What if a defendant is accused of attempting a crime that is factually impossible? For example, suppose
that men believed they were raping a drunken, unconscious woman, and were later accused of attempted

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rape, but defended on the grounds of factual impossibility because the woman was actually dead at the
time sexual intercourse took place? Or suppose that a husband intended to poison his wife with
strychnine in her coffee, but put sugar in the coffee instead? The “mens rea” or criminal intent was there,
but the act itself was not criminal (rape requires a live victim, and murder by poisoning requires the use of
poison). States are divided on this, but thirty-seven states have ruled out factual impossibility as a defense
to the crime of attempt.
Legal impossibility is different, and is usually acknowledged as a valid defense. If the defendant completes
all of his intended acts, but those acts do not fulfill all the required elements of a crime, there could be a
successful “impossibility” defense. If Barney (who has poor sight), shoots at a tree stump, thinking it is his
neighbor, Ralph, intending to kill him, has he committed an attempt? Many courts would hold that he has
not. But the distinction between factual impossibility and legal impossibility is not always clear, and the
trend seems to be to punish the intended attempt.

Conspiracy
Under both federal and state laws, it is a separate offense to work with others toward the commission of a
crime. When two or more people combine to carry out an unlawful purpose, they are engaged in a
conspiracy. The law of conspiracy is quite broad, especially when it is used by prosecutors in connection
with white-collar crimes. Many people can be swept up in the net of conspiracy, because it is unnecessary
to show that the actions they took were sufficient to constitute either the crime or an attempt. Usually, the
prosecution needs to show only (1) an agreement and (2) a single overt act in furtherance of the
conspiracy. Thus if three people agree to rob a bank, and if one of them goes to a store to purchase a gun
to be used in the holdup, the three can be convicted of conspiracy to commit robbery. Even the purchase
of an automobile to be used as the getaway car could support a conspiracy conviction.
The act of any one of the conspirators is imputed to the other members of the conspiracy. It does not
matter, for instance, that only one of the bank robbers fired the gun that killed a guard. All can be
convicted of murder. That is so even if one of the conspirators was stationed as a lookout several blocks
away and even if he specifically told the others that his agreement to cooperate would end “just as soon as
there is shooting.”

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Agency and Corporations
A person can be guilty of a crime if he acts through another. Again, the usual reason for “imputing” the
guilt of the actor to another is that both were engaged in a conspiracy. But imputation of guilt is not
limited to a conspiracy. The agent may be innocent even though he participates. A corporate officer
directs a junior employee to take a certain bag and deliver it to the officer’s home. The employee
reasonably believes that the officer is entitled to the bag. Unbeknownst to the employee, the bag contains
money that belongs to the company, and the officer wishes to keep it. This is not a conspiracy. The
employee is not guilty of larceny, but the officer is, because the agent’s act is imputed to him.
Since intent is a necessary component of crime, an agent’s intent cannot be imputed to his principal if the
principal did not share the intent. The company president tells her sales manager, “Go make sure our
biggest customer renews his contract for next year”—by which she meant, “Don’t ignore our biggest
customer.” Standing before the customer’s purchasing agent, the sales manager threatens to tell the
purchasing agent’s boss that the purchasing agent has been cheating on his expense account, unless he
signs a new contract. The sales manager could be convicted of blackmail, but the company president could
not.
Can a corporation be guilty of a crime? For many types of crimes, the guilt of individual employees may be
imputed to the corporation. Thus the antitrust statutes explicitly state that the corporation may be
convicted and fined for violations by employees. This is so even though the shareholders are the ones who
ultimately must pay the price—and who may have had nothing to do with the crime nor the power to stop
it. The law of corporate criminal responsibility has been changing in recent years. The tendency is to hold
the corporation liable under criminal law if the act has been directed by a responsible officer or group
within the corporation (the president or board of directors).

KEY TAKEAWAY
Although proving the intent to commit a crime (the mens rea) is essential, the intent can be established by
inference (circumstantially). Conspirators may not actually commit a crime, for example, but in preparing for a
criminal act, they may be guilty of the crime of conspiracy. Certain corporate officers, as well, may not be

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directly committing criminal acts but may be held criminally responsible for acts of their agents and
contractors.

EXERCISES
1.

Give an example of how someone can intend to commit a crime but fail to commit one.

2.

Describe a situation where there is a conspiracy to commit a crime without the crime actually taking
place.

3.

Create a scenario based on current events where a corporation could be found guilty of committing a
crime even though the CEO, the board of directors, and the shareholders have not themselves done a
criminal act.

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6.4 Responsibility
LEARNING OBJECTIVES
1.

Explain why criminal law generally requires that the defendant charged with a crime have criminal
"intent."

2.

Know and explain the possible excuses relating to responsibility that are legally recognized by courts,
including lack of capacity.

In General
The mens rea requirement depends on the nature of the crime and all the circumstances surrounding the
act. In general, though, the requirement means that the accused must in some way have intended the
criminal consequences of his act. Suppose, for example, that Charlie gives Gabrielle a poison capsule to
swallow. That is the act. If Gabrielle dies, is Charlie guilty of murder? The answer depends on what his
state of mind was. Obviously, if he gave it to her intending to kill her, the act was murder.
What if he gave it to her knowing that the capsule was poison but believing that it would only make her
mildly ill? The act is still murder, because we are all liable for the consequences of any intentional act that
may cause harm to others. But suppose that Gabrielle had asked Harry for aspirin, and he handed her two
pills that he reasonably believed to be aspirin (they came from the aspirin bottle and looked like aspirin)
but that turned out to be poison, the act would not be murder, because he had neither intent nor a state of
knowledge from which intent could be inferred.
Not every criminal law requires criminal intent as an ingredient of the crime. Many regulatory codes
dealing with the public health and safety impose strict requirements. Failure to adhere to such
requirements is a violation, whether or not the violator had mens rea. The United States v.
Park case, Section 6.7 "Cases", a decision of the US Supreme Court, shows the different considerations
involved in mens rea.

Excuses That Limit or Overcome Responsibility
Mistake of Fact and Mistake of Law
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Ordinarily, ignorance of the law is not an excuse. If you believe that it is permissible to turn right on a red
light but the city ordinance prohibits it, your belief, even if reasonable, does not excuse your violation of
the law. Under certain circumstances, however, ignorance of law will be excused. If a statute imposes
criminal penalties for an action taken without a license, and if the government official responsible for
issuing the license formally tells you that you do not need one (though in fact you do), a conviction for
violating the statute cannot stand. In rare cases, a lawyer’s advice, contrary to the statute, will be held to
excuse the client, but usually the client is responsible for his attorney’s mistakes. Otherwise, as it is said,
the lawyer would be superior to the law.
Ignorance or mistake of fact more frequently will serve as an excuse. If you take a coat from a restaurant,
believing it to be yours, you cannot be convicted of larceny if it is not. Your honest mistake of fact negates
the requisite intent. In general, the rule is that a mistaken belief of fact will excuse criminal responsibility
if (1) the belief is honestly held, (2) it is reasonable to hold it, and (3) the act would not have been criminal
if the facts were as the accused supposed them to have been.

Entrapment
One common technique of criminal investigation is the use of an undercover agent or decoy—the
policeman who poses as a buyer of drugs from a street dealer or the elaborate “sting” operations in which
ostensibly stolen goods are “sold” to underworld “fences.” Sometimes these methods are the only way by
which certain kinds of crime can be rooted out and convictions secured.
But a rule against entrapment limits the legal ability of the police to play the role of criminals. The police
are permitted to use such techniques to detect criminal activity; they are not permitted to do so to
instigate crime. The distinction is usually made between a person who intends to commit a crime and one
who does not. If the police provide the former with an opportunity to commit a criminal act—the sale of
drugs to an undercover agent, for example—there is no defense of entrapment. But if the police knock on
the door of one not known to be a drug user and persist in a demand that he purchase drugs from them,
finally overcoming his will to resist, a conviction for purchase and possession of drugs can be overturned
on the ground of entrapment.

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Other Excuses
A number of other circumstances can limit or excuse criminal liability. These include compulsion (a gun
pointed at one’s head by a masked man who apparently is unafraid to use the weapon and who demands
that you help him rob a store), honest consent of the “victim” (the quarterback who is tackled), adherence
to the requirements of legitimate public authority lawfully exercised (a policeman directs a towing
company to remove a car parked in a tow-away zone), the proper exercise of domestic authority (a parent
may spank a child, within limits), and defense of self, others, property, and habitation. Each of these
excuses is a complex subject in itself.

Lack of Capacity
A further defense to criminal prosecution is the lack of mental capacity to commit the crime. Infants and
children are considered incapable of committing a crime; under common law any child under the age of
seven could not be prosecuted for any act. That age of incapacity varies from state to state and is now
usually defined by statutes. Likewise, insanity or mental disease or defect can be a complete defense.
Intoxication can be a defense to certain crimes, but the mere fact of drunkenness is not ordinarily
sufficient.

KEY TAKEAWAY
In the United States, some crimes can be committed by not following strict regulatory requirements for
health, safety, or the environment. The law does provide excuses from criminal liability for mistakes of fact,
entrapment, and lack of capacity.

EXERCISES
1.

Describe several situations in which compulsion, consent, or other excuses take away criminal liability.

2.

Your employee is drunk on the job and commits the crime of assault and battery on a customer. He claims
lack of capacity as an excuse. Should the courts accept this excuse? Why or why not?

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6.5 Procedure
LEARNING OBJECTIVES
1.

Describe the basic steps in pretrial criminal procedure that follow a government's determination to arrest
someone for an alleged criminal act.

2.

Describe the basic elements of trial and posttrial criminal procedure.

The procedure for criminal prosecutions is complex. Procedures will vary from state to state. A criminal
case begins with an arrest if the defendant is caught in the act or fleeing from the scene; if the defendant is
not caught, a warrant for the defendant’s arrest will issue. The warrant is issued by a judge or a magistrate
upon receiving a complaint detailing the charge of a specific crime against the accused. It is not enough
for a police officer to go before a judge and say, “I’d like you to arrest Bonnie because I think she’s just
murdered Clyde.” She must supply enough information to satisfy the magistrate that there is probable
cause (reasonable grounds) to believe that the accused committed the crime. The warrant will be issued to
any officer or agency that has power to arrest the accused with warrant in hand.
The accused will be brought before the magistrate for a preliminary hearing. The purpose of the hearing is
to determine whether there is sufficient reason to hold the accused for trial. If so, the accused can be sent
to jail or be permitted to make bail. Bail is a sum of money paid to the court to secure the defendant’s
attendance at trial. If he fails to appear, he forfeits the money. Constitutionally, bail can be withheld only
if there is reason to believe that the accused will flee the jurisdiction.
Once the arrest is made, the case is in the hands of the prosecutor. In the fifty states, prosecution is a
function of the district attorney’s office. These offices are usually organized on a county-by-county basis.
In the federal system, criminal prosecution is handled by the office of the US attorney, one of whom is
appointed for every federal district.
Following the preliminary hearing, the prosecutor must either file aninformation (a document stating the
crime of which the person being held is accused) or ask the grand jury for an indictment. The grand jury
consists of twenty-three people who sit to determine whether there is sufficient evidence to warrant a
prosecution. It does not sit to determine guilt or innocence. The indictment is the grand jury’s formal

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declaration of charges on which the accused will be tried. If indicted, the accused formally becomes a
defendant.
The defendant will then be arraigned, that is, brought before a judge to answer the accusation in the
indictment. The defendant may plead guilty or not guilty. If he pleads not guilty, the case will be tried
before a jury (sometimes referred to as a petit jury). The jury cannot convict unless it finds the defendant
guiltybeyond a reasonable doubt.
The defendant might have pleaded guilty to the offense or to a lesser charge (often referred to as a “lesser
included offense”—simple larceny, for example, is a lesser included offense of robbery because the
defendant may not have used violence but nevertheless stole from the victim). Such a plea is usually
arranged through plea bargaining with the prosecution. In return for the plea, the prosecutor promises to
recommend to the judge that the sentence be limited. The judge most often, but not always, goes along
with the prosecutor’s recommendation.
The defendant is also permitted to file a plea of nolo contendere (no contest) in prosecutions for certain
crimes. In so doing, he neither affirms nor denies his guilt. He may be sentenced as though he had
pleaded guilty, although usually a nolo plea is the result of a plea bargain. Why plead nolo? In some
offenses, such as violations of the antitrust laws, the statutes provide that private plaintiffs may use a
conviction or a guilty plea as proof that the defendant violated the law. This enables a plaintiff to prove
liability without putting on witnesses or evidence and reduces the civil trial to a hearing about the
damages to plaintiff. The nolo plea permits the defendant to avoid this, so that any plaintiff will have to
not only prove damages but also establish civil liability.
Following a guilty plea or a verdict of guilt, the judge will impose a sentence after presentencing reports
are written by various court officials (often, probation officers). Permissible sentences are spelled out in
statutes, though these frequently give the judge a range within which to work (e.g., twenty years to life).
The judge may sentence the defendant to imprisonment, a fine, or both, or may decide to suspend
sentence (i.e., the defendant will not have to serve the sentence as long as he stays out of trouble).

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Sentencing usually comes before appeal. As in civil cases, the defendant, now convicted, has the right to
take at least one appeal to higher courts, where issues of procedure and constitutional rights may be
argued.

KEY TAKEAWAY
Criminal procedure in US courts is designed to provide a fair process to both criminal defendants and to
society. The grand jury system, prosecutorial discretion, plea bargains, and appeals for lack of a fair trial are all
part of US criminal procedure.

EXERCISES
1.

Harold is charged with the crime of assault with a deadly weapon with intent to kill or inflict serious bodily
injury. It is a more serious crime than simple assault. Harold’s attorney wants the prosecutor to give
Harold a break, but Harold is guilty of at least simple assault and may also have had the intent to kill.
What is Harold’s attorney likely to do?

2.

Kumar was driving his car, smoking marijuana, and had an accident with another vehicle. The other driver
was slightly injured. When the officer arrived, she detected a strong odor of marijuana in Kumar’s car and
a small amount of marijuana in the glove compartment. The other driver expects to bring a civil action
against Kumar for her injuries after Kumar’s criminal case. What should Kumar plead in the criminal
case—careless driving or driving under the influence?

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6.6 Constitutional Rights of the Accused
LEARNING OBJECTIVES
1.

Describe the most significant constitutional rights of defendants in US courts, and name the source of
these rights.

2.

Explain the Exclusionary rule and the reason for its existence.

Search and Seizure
The rights of those accused of a crime are spelled out in four of the ten constitutional amendments that
make up the Bill of Rights (Amendments Four, Five, Six, and Eight). For the most part, these
amendments have been held to apply to both the federal and the state governments. The Fourth
Amendment says in part that “the right of the people to be secure in their persons, houses, papers, and
effects, against unreasonable searches and seizures, shall not be violated.” Although there are numerous
and tricky exceptions to the general rule, ordinarily the police may not break into a person’s house or
confiscate his papers or arrest him unless they have a warrant to do so. This means, for instance, that a
policeman cannot simply stop you on a street corner and ask to see what is in your pockets (a power the
police enjoy in many other countries), nor can your home be raided without probable cause to believe that
you have committed a crime. What if the police do search or seize unreasonably?
The courts have devised a remedy for the use at trial of the fruits of an unlawful search or seizure.
Evidence that is unconstitutionally seized is excluded from the trial. This is the so-called exclusionary
rule, first made applicable in federal cases in 1914 and brought home to the states in 1961.
The exclusionary ruleis highly controversial, and there are numerous exceptions to it. But it remains
generally true that the prosecutor may not use evidence willfully taken by the police in violation of
constitutional rights generally, and most often in the violation of Fourth Amendment rights. (The fruits of
a coerced confession are also excluded.)

Double Jeopardy
The Fifth Amendment prohibits the government from prosecuting a person twice for the same offense.
The amendment says that no person shall be “subject for the same offence to be twice put in jeopardy of

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life or limb.” If a defendant is acquitted, the government may not appeal. If a defendant is convicted and
his conviction is upheld on appeal, he may not thereafter be reprosecuted for the same crime.

Self-Incrimination
The Fifth Amendment is also the source of a person’s right against self-incrimination (no person “shall be
compelled in any criminal case to be a witness against himself”). The debate over the limits of this right
has given rise to an immense literature. In broadest outline, the right against self-incrimination means
that the prosecutor may not call a defendant to the witness stand during trial and may not comment to the
jury on the defendant’s failure to take the stand. Moreover, a defendant’s confession must be excluded
from evidence if it was not voluntarily made (e.g., if the police beat the person into giving a confession).
In Miranda v. Arizona, the Supreme Court ruled that no confession is admissible if the police have not
first advised a suspect of his constitutional rights, including the right to have a lawyer present to advise
him during the questioning.

[1]

These so-called Miranda warnings have prompted scores of follow-up cases

that have made this branch of jurisprudence especially complex.

Speedy Trial
The Sixth Amendment tells the government that it must try defendants speedily. How long a delay is too
long depends on the circumstances in each case. In 1975, Congress enacted the Speedy Trial Act to give
priority to criminal cases in federal courts. It requires all criminal prosecutions to go to trial within
seventy-five days (though the law lists many permissible reasons for delay).

Cross-Examination
The Sixth Amendment also says that the defendant shall have the right to confront witnesses against him.
No testimony is permitted to be shown to the jury unless the person making it is present and subject to
cross-examination by the defendant’s counsel.

Assistance of Counsel
The Sixth Amendment guarantees criminal defendants the right to have the assistance of defense counsel.
During the eighteenth century and before, the British courts frequently refused to permit defendants to

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have lawyers in the courtroom during trial. The right to counsel is much broader in this country, as the
result of Supreme Court decisions that require the state to pay for a lawyer for indigent defendants in
most criminal cases.

Cruel and Unusual Punishment
Punishment under the common law was frequently horrifying. Death was a common punishment for
relatively minor crimes. In many places throughout the world, punishments still persist that seem cruel
and unusual, such as the practice of stoning someone to death. The guillotine, famously in use during and
after the French Revolution, is no longer used, nor are defendants put in stocks for public display and
humiliation. In pre-Revolutionary America, an unlucky defendant who found himself convicted could face
brutal torture before death.
The Eighth Amendment banned these actions with the words that “cruel and unusual punishments [shall
not be] inflicted.” Virtually all such punishments either never were enacted or have been eliminated from
the statute books in the United States. Nevertheless, the Eighth Amendment has become a source of
controversy, first with the Supreme Court’s ruling in 1976 that the death penalty, as haphazardly applied
in the various states, amounted to cruel and unusual punishment. Later Supreme Court opinions have
made it easier for states to administer the death penalty. As of 2010, there were 3,300 defendants on
death row in the United States. Of course, no corporation is on death row, and no corporation’s charter
has ever been revoked by a US state, even though some corporations have repeatedly been indicted and
convicted of criminal offenses.

Presumption of Innocence
The most important constitutional right in the US criminal justice system is the presumption of
innocence. The Supreme Court has repeatedly cautioned lower courts in the United States that juries must
be properly instructed that the defendant is innocent until proven guilty. This is the origin of the “beyond
all reasonable doubt” standard of proof and is an instruction given to juries in each criminal case. The
Fifth Amendment notes the right of “due process” in federal proceedings, and the Fourteenth Amendment
requires that each state provide “due process” to defendants.

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KEY TAKEAWAY
The US Constitution provides several important protections for criminal defendants, including a prohibition on
the use of evidence that has been obtained by unconstitutional means. This would include evidence seized in
violation of the Fourth Amendment and confessions obtained in violation of the Fifth Amendment.

EXERCISES
1.

Do you think it is useful to have a presumption of innocence in criminal cases? What if there were not a
presumption of innocence in criminal cases?

2.

Do you think public humiliation, public execution, and unusual punishments would reduce the amount of
crime? Why do you think so?

3.

“Due process” is another phrase for “fairness.” Why should the public show fairness toward criminal
defendants?

[1] Miranda v. Arizona, 384 US 436 (1966).

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6.7 Cases
False Pretenses
State v. Mills
96 Ariz. 377, 396 P.2d 5 (Ariz. 1964)
LOCKWOOD, VICE CHIEF JUSTICE
Defendants appeal from a conviction on two counts of obtaining money by false pretenses in violation of
AR.S. §§ 13-661.A3. and 13-663.A1. The material facts, viewed “…in the light most favorable to sustaining
the conviction,” are as follows: Defendant William Mills was a builder and owned approximately 150
homes in Tucson in December, 1960. Mills conducted his business in his home. In 1960 defendant
Winifred Mills, his wife, participated in the business generally by answering the telephone, typing, and
receiving clients who came to the office.
In December 1960, Mills showed the complainant, Nathan Pivowar, a house at 1155 Knox Drive and
another at 1210 Easy Street, and asked Pivowar if he would loan money on the Knox Drive house. Pivowar
did not indicate at that time whether he would agree to such a transaction. Later in the same month
Nathan Pivowar told the defendants that he and his brother, Joe Pivowar, would loan $5,000 and $4,000
on the two houses. Three or four days later Mrs. Mills, at Pivowar’s request, showed him these homes
again.
Mills had prepared two typed mortgages for Pivowar. Pivowar objected to the wording, so in Mills’ office
Mrs. Mills retyped the mortgages under Pivowar’s dictation. After the mortgages had been recorded on
December 31, 1960, Pivowar gave Mills a bank check for $5,791.87, some cash, and a second mortgage
formerly obtained from Mills in the approximate sum of $3,000. In exchange Mills gave Pivowar two
personal notes in the sums of $5,250.00 and $4,200.00 and the two mortgages as security for the loan.
Although the due date for Mills’ personal notes passed without payment being made, the complainant did
not present the notes for payment, did not demand that they be paid, and did not sue upon them. In 1962
the complainant learned that the mortgages which he had taken as security in the transaction were not

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first mortgages on the Knox Drive and Easy Street properties. These mortgages actually covered two
vacant lots on which there were outstanding senior mortgages. On learning this, Pivowar signed a
complaint charging the defendants with the crime of theft by false pretenses.
On appeal defendants contend that the trial court erred in denying their motion to dismiss the
information. They urge that a permanent taking of property must be proved in order to establish the
crime of theft. Since the complainant had the right to sue on the defendants’ notes, the defendants assert
that complainant cannot be said to have been deprived of his property permanently. Defendants
misconceive the elements of the crime of theft by false pretenses. Stated in a different form, their
argument is that although the complainant has parted with his cash, a bank check, and a second
mortgage, the defendants intend to repay the loan.
Defendants admit that the proposition of law which they assert is a novel one in this jurisdiction.
Respectable authority in other states persuades us that their contention is without merit. A creditor has a
right to determine for himself whether he wishes to be a secured or an unsecured creditor. In the former
case, he has a right to know about the security. If he extends credit in reliance upon security which is
falsely represented to be adequate, he has been defrauded even if the debtor intends to repay the debt. His
position is now that of an unsecured creditor. At the very least, an unreasonable risk of loss has been
forced upon him by reason of the deceit. This risk which he did not intend to assume has been imposed
upon him by the intentional act of the debtor, and such action constitutes an intent to defraud.
***
The cases cited by defendants in support of their contention are distinguishable from the instant case in
that they involved theft by larceny. Since the crime of larceny is designed to protect a person’s possessory
interest in property whereas the crime of false pretenses protects one’s title interest, the requirement of a
permanent deprivation is appropriate to the former. Accordingly, we hold that an intent to repay a loan
obtained on the basis of a false representation of the security for the loan is no defense.
***
Affirmed in part, reversed in part, and remanded for resentencing.

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CASE QUESTIONS
1.

False pretenses is a crime of obtaining ownership of property of another by making untrue
representations of fact with intent to defraud. What were the untrue representations of fact made by
Mills?

2.

Concisely state the defendant’s argument as to why Pivowar has not been deprived of any property.

3.

If Pivowar had presented the notes and Mills had paid, would a crime have been committed?

White-Collar Crimes
United States v. Park
421 U.S. 658 (1975)
MR. CHIEF JUSTICE BURGER delivered the opinion of the Court.
We granted certiorari to consider whether the jury instructions in the prosecution of a corporate officer
under § 301 (k) of the Federal Food, Drug, and Cosmetic Act, 52 Stat. 1042, as amended, 21 U.S.C. § 331
(k), were appropriate under United States v. Dotterweich, 320 U.S. 277 (1943). Acme Markets, Inc., is a
national retail food chain with approximately 36,000 employees, 874 retail outlets, 12 general
warehouses, and four special warehouses. Its headquarters, including the office of the president,
respondent Park, who is chief executive officer of the corporation, are located in Philadelphia,
Pennsylvania. In a five-count information filed in the United States District Court for the District of
Maryland, the Government charged Acme and respondent with violations of the Federal Food, Drug, and
Cosmetic Act. Each count of the information alleged that the defendants had received food that had been
shipped in interstate commerce and that, while the food was being held for sale in Acme’s Baltimore
warehouse following shipment in interstate commerce, they caused it to be held in a building accessible to
rodents and to be exposed to contamination by rodents. These acts were alleged to have resulted in the
food’s being adulterated within the meaning of 21 U.S.C. §§ 342 (a)(3) and (4), in violation of 21 U.S.C. §
331 (k).

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Acme pleaded guilty to each count of the information. Respondent pleaded not guilty. The evidence at
trial demonstrated that in April 1970 the Food and Drug Administration (FDA) advised respondent by
letter of insanitary conditions in Acme’s Philadelphia warehouse. In 1971 the FDA found that similar
conditions existed in the firm’s Baltimore warehouse. An FDA consumer safety officer testified concerning
evidence of rodent infestation and other insanitary conditions discovered during a 12-day inspection of
the Baltimore warehouse in November and December 1971. He also related that a second inspection of the
warehouse had been conducted in March 1972. On that occasion the inspectors found that there had been
improvement in the sanitary conditions, but that “there was still evidence of rodent activity in the building
and in the warehouses and we found some rodent-contaminated lots of food items.”
The Government also presented testimony by the Chief of Compliance of the FDA’s Baltimore office, who
informed respondent by letter of the conditions at the Baltimore warehouse after the first inspection.
There was testimony by Acme’s Baltimore division vice president, who had responded to the letter on
behalf of Acme and respondent and who described the steps taken to remedy the insanitary conditions
discovered by both inspections. The Government’s final witness, Acme’s vice president for legal affairs
and assistant secretary, identified respondent as the president and chief executive officer of the company
and read a bylaw prescribing the duties of the chief executive officer. He testified that respondent
functioned by delegating “normal operating duties” including sanitation, but that he retained “certain
things, which are the big, broad, principles of the operation of the company and had “the responsibility of
seeing that they all work together.”
At the close of the Government’s case in chief, respondent moved for a judgment of acquittal on the
ground that “the evidence in chief has shown that Mr. Park is not personally concerned in this Food and
Drug violation.” The trial judge denied the motion, stating that United States v. Dotterweich, 320 U.S. 277
(1943), was controlling.
Respondent was the only defense witness. He testified that, although all of Acme’s employees were in a
sense under his general direction, the company had an “organizational structure for responsibilities for
certain functions” according to which different phases of its operation were “assigned to individuals who,
in turn, have staff and departments under them.” He identified those individuals responsible for

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sanitation, and related that upon receipt of the January 1972 FDA letter, he had conferred with the vice
president for legal affairs, who informed him that the Baltimore division vice president “was investigating
the situation immediately and would be taking corrective action and would be preparing a summary of the
corrective action to reply to the letter.” Respondent stated that he did not “believe there was anything [he]
could have done more constructively than what [he] found was being done.”
On cross-examination, respondent conceded that providing sanitary conditions for food offered for sale to
the public was something that he was “responsible for in the entire operation of the company” and he
stated that it was one of many phases of the company that he assigned to “dependable subordinates.”
Respondent was asked about and, over the objections of his counsel, admitted receiving, the April 1970
letter addressed to him from the FDA regarding insanitary conditions at Acme’s Philadelphia warehouse.
He acknowledged that, with the exception of the division vice president, the same individuals had
responsibility for sanitation in both Baltimore and Philadelphia. Finally, in response to questions
concerning the Philadelphia and Baltimore incidents, respondent admitted that the Baltimore problem
indicated the system for handling sanitation “wasn’t working perfectly” and that as Acme’s chief executive
officer he was “responsible for any result which occurs in our company.”
At the close of the evidence, respondent’s renewed motion for a judgment of acquittal was denied. The
relevant portion of the trial judge’s instructions to the jury challenged by respondent is set out in the
margin. Respondent’s counsel objected to the instructions on the ground that they failed fairly to reflect
our decision in United States v. Dotterweich supra, and to define “‘responsible relationship.’” The trial
judge overruled the objection. The jury found respondent guilty on all counts of the information, and he
was subsequently sentenced to pay a fine of $50 on each count. The Court of Appeals reversed the
conviction and remanded for a new trial.
***
The question presented by the Government’s petition for certiorari in United States v. Dotterweich, and
the focus of this Court’s opinion, was whether the manager of a corporation, as well as the corporation
itself, may be prosecuted under the Federal Food, Drug, and Cosmetic Act of 1938 for the introduction of
misbranded and adulterated articles into interstate commerce. In Dotterweich, a jury had disagreed as to

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the corporation, a jobber purchasing drugs from manufacturers and shipping them in interstate
commerce under its own label, but had convicted Dotterweich, the corporation’s president and general
manager. The Court of Appeals reversed the conviction on the ground that only the drug dealer, whether
corporation or individual, was subject to the criminal provisions of the Act, and that where the dealer was
a corporation, an individual connected therewith might be held personally only if he was operating the
corporation as his ‘alter ego.’
In reversing the judgment of the Court of Appeals and reinstating Dotterweich’s conviction, this Court
looked to the purposes of the Act and noted that they “touch phases of the lives and health of people
which, in the circumstances of modern industrialism, are largely beyond self-protection. It observed that
the Act is of “a now familiar type” which “dispenses with the conventional requirement for criminal
conduct-awareness of some wrongdoing: In the interest of the larger good it puts the burden of acting at
hazard upon a person otherwise innocent but standing in responsible relation to a public danger. Central
to the Court’s conclusion that individuals other than proprietors are subject to the criminal provisions of
the Act was the reality that the only way in which a corporation can act is through the individuals, who act
on its behalf.
***
The Court recognized that, because the Act dispenses with the need to prove “consciousness of
wrongdoing,” it may result in hardship even as applied to those who share “responsibility in the business
process resulting in” a violation.…The rule that corporate employees who have “a responsible share in the
furtherance of the transaction which the statute outlaws” are subject to the criminal provisions of the Act
was not formulated in a vacuum. Cf. Morissette v. United States, 342 U.S. 246, 258 (1952). Cases under
the Federal Food and Drugs Act of 1906 reflected the view both that knowledge or intent were not
required to be proved in prosecutions under its criminal provisions, and that responsible corporate agents
could be subjected to the liability thereby imposed.
***

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The rationale of the interpretation given the Act in Dotterweich…has been confirmed in our subsequent
cases. Thus, the Court has reaffirmed the proposition that the public interest in the purity of its food is so
great as to warrant the imposition of the highest standard of care on distributors.
Thus Dotterweich and the cases which have followed reveal that in providing sanctions which reach and
touch the individuals who execute the corporate mission—and this is by no means necessarily confined to
a single corporate agent or employee—the Act imposes not only a positive duty to seek out and remedy
violations when they occur but also, and primarily, a duty to implement measures that will insure that
violations will not occur. The requirements of foresight and vigilance imposed on responsible corporate
agents are beyond question demanding, and perhaps onerous, but they are no more stringent than the
public has a right to expect of those who voluntarily assume positions of authority in business enterprises
whose services and products affect the health and well-being of the public that supports them.
***
Reading the entire charge satisfies us that the jury’s attention was adequately focused on the issue of
respondent’s authority with respect to the conditions that formed the basis of the alleged violations.
Viewed as a whole, the charge did not permit the jury to find guilt solely on the basis of respondent’s
position in the corporation; rather, it fairly advised the jury that to find guilt it must find respondent “had
a responsible relation to the situation,” and “by virtue of his position…had…authority and responsibility”
to deal with the situation.
The situation referred to could only be “food…held in unsanitary conditions in a warehouse with the result
that it consisted, in part, of filth or…may have been contaminated with filth.”
Our conclusion that the Court of Appeals erred in its reading of the jury charge suggests as well our
disagreement with that court concerning the admissibility of evidence demonstrating that respondent was
advised by the FDA in 1970 of insanitary conditions in Acme’s Philadelphia warehouse. We are satisfied
that the Act imposes the highest standard of care and permits conviction of responsible corporate officials
who, in light of this standard of care, have the power to prevent or correct violations of its provisions.
***

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Reversed.

CASE QUESTIONS
1.

Did Park have criminal intent to put adulterated food into commerce? If not, how can Park’s conduct
be criminalized?

2.

To get a conviction, what does the prosecutor have to show, other than that Park was the CEO of
Acme and therefore responsible for what his company did or didn’t do?

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6.8 Summary and Exercises
Summary
Criminal law is that branch of law governing offenses against society. Most criminal law requires a specific
intent to commit the prohibited act (although a very few economic acts, made criminal by modern
legislation, dispense with the requirement of intent). In this way, criminal law differs from much of civil
law—for example, from the tort of negligence, in which carelessness, rather than intent, can result in
liability.
Major crimes are known as felonies. Minor crimes are known as misdemeanors. Most people have a
general notion about familiar crimes, such as murder and theft. But conventional knowledge does not
suffice for understanding technical distinctions among related crimes, such as larceny, robbery, and false
pretenses. These distinctions can be important because an individual can be found guilty not merely for
committing one of the acts defined in the criminal law but also for attempting or conspiring to commit
such an act. It is usually easier to convict someone of attempt or conspiracy than to convict for the main
crime, and a person involved in a conspiracy to commit a felony may find that very little is required to put
him into serious trouble.
Of major concern to the business executive is white-collar crime, which encompasses a host of offenses,
including bribery, embezzlement, fraud, restraints of trade, and computer crime. Anyone accused of crime
should know that they always have the right to consult with a lawyer and should always do so.

EXERCISES
1.

Bill is the chief executive of a small computer manufacturing company that desperately needs funds to
continue operating. One day a stranger comes to Bill to induce him to take part in a cocaine smuggling
deal that would net Bill millions of dollars. Unbeknownst to Bill, the stranger is an undercover policeman.
Bill tells the stranger to go away. The stranger persists, and after five months of arguing and cajoling, the
stranger wears down Bill’s will to resist. Bill agrees to take delivery of the cocaine and hands over a down

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payment of $10,000 to the undercover agent, who promptly arrests him for conspiracy to violate the
narcotics laws. What defenses does Bill have?
2.

You are the manager of a bookstore. A customer becomes irritated at having to stand in line and begins to
shout at the salesclerk for refusing to wait on him. You come out of your office and ask the customer to
calm down. He shouts at you. You tell him to leave. He refuses. So you and the salesclerk pick him up and
shove him bodily out the door. He calls the police to have you arrested for assault. Should the police
arrest you? Assuming that they do, how would you defend yourself in court?

3.

Marilyn is arrested for arson against a nuclear utility, a crime under both state and federal law. She is
convicted in state court and sentenced to five years in jail. Then the federal government decides to
prosecute her for the same offense. Does she have a double-jeopardy defense against the federal
prosecution?

4.

Tectonics, a US corporation, is bidding on a project in Nigeria, and its employee wins the bid by secretly
giving $100,000 to the Nigerian public official that has the most say about which company will be
awarded the contract. The contract is worth $80 million, and Tectonics expects to make at least $50
million on the project. Has a crime under US law been committed?

5.

Suppose that the CEO of Tectonics, Ted Nelson, is not actually involved in bribery of the Nigerian public
official Adetutu Adeleke. Instead, suppose that the CFO, Jamie Skillset, is very accomplished at insulating
both top management and the board of directors from some of the “operational realities” within the
company. Skillset knows that Whoopi Goldmine, a Nigerian employee of Tectonics, has made the deal
with Adeleke and secured the contract for Tectonics. Is it possible that Nelson, as well as Skillset, can be
found guilty of a crime?

6.

You have graduated from college and, after working hard for ten years, have scraped enough money
together to make a down payment on a forty-acre farm within driving distance to the small city where
you work in Colorado. In town at lunch one day, you run into an old friend from high school, Hayley Mills,
who tells you that she is saving her money to start a high-end consignment shop in town. You allow her to
have a room in your house for a few months until she has enough money to go into business. Over the
following weeks, however, you realize that old acquaintances from high school are stopping by almost
daily for short visits. When you bring this up to Hayley, she admits that many old friends are now relying
on her for marijuana. She is not a licensed caregiver in Colorado and is clearly violating the law. Out of

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loyalty, you tell her that she has three weeks to move out, but you do not prevent her from continuing
sales while she is there. What crime have you committed?
7.

The Center Art Galleries—Hawaii sells artwork, and much of it involves art by the famous surrealist
painter Salvador Dali. The federal government suspected the center of selling forged Dali artwork and
obtained search warrants for six locations controlled by the center. The warrants told the executing
officer to seize any items that were “evidence of violations of federal criminal law.” The warrants did not
describe the specific crime suspected, nor did the warrants limit the seizure of items solely to Dali artwork
or suspected Dali forgeries. Are these search warrants valid?

[1]

SELF-TEST QUESTIONS
1.

Jared has made several loans to debtors who have declared bankruptcy. These are unsecured
claims. Jared “doctors” the documentation to show amounts owed that are higher than the
debtors actually owe. Later, Jared is charged with the federal criminal offense of filing false claims.
The standard (or “burden”) of proof that the US attorney must meet in the prosecution is

a.

beyond all doubt

b.

beyond a reasonable doubt

c.

clear and convincing evidence

d.

a preponderance of the evidence
Jethro, a businessman who resides in Atlanta, creates a disturbance at a local steakhouse and is
arrested for being drunk and disorderly. Drunk and disorderly is a misdemeanor under Georgia
law. A misdemeanor is a crime punishable by imprisonment for up to

a.

one year

b.

two years

c.

five years

d.

none of the above
Yuan is charged with a crime. To find him guilty, the prosecutor must show

a.

actus reus and mens rea

b.

mens rea only

c.

the performance of a prohibited act

d.

none of the above

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Kira works for Data Systems Ltd. and may be liable for larceny if she steals
a.

a competitor’s trade secrets

b.

company computer time

c.

the use of Data Systems’ Internet for personal business

d.

any of the above
Candace is constructing a new office building that is near its completion. She offers Paul $500 to
overlook certain things that are noncompliant with the city’s construction code. Paul accepts the
money and overlooks the violations. Later, Candace is charged with the crime of bribery. This
occurred when

a.

Candace offered the bribe.

b.

Paul accepted the bribe.

c.

Paul overlooked the violations.

d.

none of the above

SELF-TEST ANSWERS
1.

b

2.

a

3.

a

4.

d

5.

a

[1] Center Art Galleries—Hawaii, Inc. v. United States, 875 F.2d 747 (9th Cir. 1989).

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Chapter 7

Introduction to Tort Law
LEARNING OBJECTIVES
After reading this chapter, you should be able to do the following:
1.

Know why most legal systems have tort law.

2.

Identify the three kinds of torts.

3.

Show how tort law relates to criminal law and contract law.

4.

Understand negligent torts and defenses to claims of negligence.

5.

Understand strict liability torts and the reasons for them in the US legal system.

In civil litigation, contract and tort claims are by far the most numerous. The law attempts to adjust
for harms done by awarding damages to a successful plaintiff who demonstrates that the defendant
was the cause of the plaintiff’s losses. Torts can be intentional torts, negligent torts, or strict liability
torts. Employers must be aware that in many circumstances, their employees may create liability in
tort. This chapter explains the different kind of torts, as well as available defenses to tort claims.

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7.1 Purpose of Tort Laws
LEARNING OBJECTIVES
1.

Explain why a sound market system requires tort law.

2.

Define a tort and give two examples.

3.

Explain the moral basis of tort liability.

4.

Understand the purposes of damage awards in tort.

Definition of Tort
The term tort is the French equivalent of the English word wrong. The word tortis also derived from the
Latin word tortum, which means twisted or crooked or wrong, in contrast to the word rectum, which
means straight (rectitude uses that Latin root). Thus conduct that is twisted or crooked and not straight is
a tort. The term was introduced into the English law by the Norman jurists.
Long ago, tort was used in everyday speech; today it is left to the legal system. A judge will instruct a jury
that a tort is usually defined as a wrong for which the law will provide a remedy, most often in the form of
money damages. The law does not remedy all “wrongs.” The preceding definition of tort does not reveal
the underlying principles that divide wrongs in the legal sphere from those in the moral sphere. Hurting
someone’s feelings may be more devastating than saying something untrue about him behind his back; yet
the law will not provide a remedy for saying something cruel to someone directly, while it may provide a
remedy for "defaming" someone, orally or in writing, to others.
Although the word is no longer in general use, tort suits are the stuff of everyday headlines. More and
more people injured by exposure to a variety of risks now seek redress (some sort of remedy through the
courts). Headlines boast of multimillion-dollar jury awards against doctors who bungled operations,
against newspapers that libeled subjects of stories, and against oil companies that devastate entire
ecosystems. All are examples of tort suits.
The law of torts developed almost entirely in the common-law courts; that is, statutes passed by
legislatures were not the source of law that plaintiffs usually relied on. Usually, plaintiffs would rely on the
common law (judicial decisions). Through thousands of cases, the courts have fashioned a series of rules

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that govern the conduct of individuals in their noncontractual dealings with each other. Through
contracts, individuals can craft their own rights and responsibilities toward each other. In the absence of
contracts, tort law holds individuals legally accountable for the consequences of their actions. Those who
suffer losses at the hands of others can be compensated.
Many acts (like homicide) are both criminal and tortious. But torts and crimes are different, and the
difference is worth noting. A crime is an act against the people as a whole. Society punishes the murderer;
it does not usually compensate the family of the victim. Tort law, on the other hand, views the death as a
private wrong for which damages are owed. In a civil case, the tort victim or his family, not the state,
brings the action. The judgment against a defendant in a civil tort suit is usually expressed in monetary
terms, not in terms of prison times or fines, and is the legal system’s way of trying to make up for the
victim’s loss.

Kinds of Torts
There are three kinds of torts: intentional torts, negligent torts, and strict liability torts. Intentional torts
arise from intentional acts, whereas unintentional torts often result from carelessness (e.g., when a
surgical team fails to remove a clamp from a patient’s abdomen when the operation is finished). Both
intentional torts and negligent torts imply some fault on the part of the defendant. In strict liability torts,
by contrast, there may be no fault at all, but tort law will sometimes require a defendant to make up for
the victim’s losses even where the defendant was not careless and did not intend to do harm.

Dimensions of Tort Liability
There is a clear moral basis for recovery through the legal system where the defendant has been careless
(negligent) or has intentionally caused harm. Using the concepts that we are free and autonomous beings
with basic rights, we can see that when others interfere with either our freedom or our autonomy, we will
usually react negatively. As the old saying goes, “Your right to swing your arm ends at the tip of my nose.”
The law takes this even one step further: under intentional tort law, if you frighten someone by swinging
your arms toward the tip of her nose, you may have committed the tort of assault, even if there is no actual
touching (battery).

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Under a capitalistic market system, rational economic rules also call for no negative externalities. That is,
actions of individuals, either alone or in concert with others, should not negatively impact third parties.
The law will try to compensate third parties who are harmed by your actions, even as it knows that a
money judgment cannot actually mend a badly injured victim.
Figure 7.1 Dimensions of Tort Liability

Dimensions of Tort: Fault
Tort principles can be viewed along different dimensions. One is the fault dimension. Like criminal law,
tort law requires a wrongful act by a defendant for the plaintiff to recover. Unlike criminal law, however,
there need not be a specific intent. Since tort law focuses on injury to the plaintiff, it is less concerned than
criminal law about the reasons for the defendant’s actions. An innocent act or a relatively innocent one
may still provide the basis for liability. Nevertheless, tort law—except for strict liability—relies on
standards of fault, or blameworthiness.
The most obvious standard is willful conduct. If the defendant (often called the tortfeasor—i.e., the one
committing the tort) intentionally injures another, there is little argument about tort liability. Thus all

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crimes resulting in injury to a person or property (murder, assault, arson, etc.) are also torts, and the
plaintiff may bring a separate lawsuit to recover damages for injuries to his person, family, or property.
Most tort suits do not rely on intentional fault. They are based, rather, on negligent conduct that in the
circumstances is careless or poses unreasonable risks of causing damage. Most automobile accident and
medical malpractice suits are examples of negligence suits.
The fault dimension is a continuum. At one end is the deliberate desire to do injury. The middle ground is
occupied by careless conduct. At the other end is conduct that most would consider entirely blameless, in
the moral sense. The defendant may have observed all possible precautions and yet still be held liable.
This is called strict liability. An example is that incurred by the manufacturer of a defective product that is
placed on the market despite all possible precautions, including quality-control inspection. In many
states, if the product causes injury, the manufacturer will be held liable.

Dimensions of Tort: Nature of Injury
Tort liability varies by the type of injury caused. The most obvious type is physical harm to the person
(assault, battery, infliction of emotional distress, negligent exposure to toxic pollutants, wrongful death)
or property (trespass, nuisance, arson, interference with contract). Mental suffering can be redressed if it
is a result of physical injury (e.g., shock and depression following an automobile accident). A few states
now permit recovery for mental distress alone (a mother’s shock at seeing her son injured by a car while
both were crossing the street). Other protected interests include a person’s reputation (injured by
defamatory statements or writings), privacy (injured by those who divulge secrets of his personal life), and
economic interests (misrepresentation to secure an economic advantage, certain forms of unfair
competition).

Dimensions of Tort: Excuses
A third element in the law of torts is the excuse for committing an apparent wrong. The law does not
condemn every act that ultimately results in injury.

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One common rule of exculpation is assumption of risk. A baseball fan who sits along the third base line
close to the infield assumes the risk that a line drive foul ball may fly toward him and strike him. He will
not be permitted to complain in court that the batter should have been more careful or that management
should have either warned him or put up a protective barrier.
Another excuse is negligence of the plaintiff. If two drivers are careless and hit each other on the highway,
some states will refuse to permit either to recover from the other. Still another excuse is consent: two
boxers in the ring consent to being struck with fists (but not to being bitten on the ear).

Damages
Since the purpose of tort law is to compensate the victim for harm actually done, damages are usually
measured by the extent of the injury. Expressed in money terms, these include replacement of property
destroyed, compensation for lost wages, reimbursement for medical expenses, and dollars that are
supposed to approximate the pain that is suffered. Damages for these injuries are called
compensatory damages.
In certain instances, the courts will permit an award of punitive damages. As the word punitive implies,
the purpose is to punish the defendant’s actions. Because a punitive award (sometimes called exemplary
damages) is at odds with the general purpose of tort law, it is allowable only in aggravated situations. The
law in most states permits recovery of punitive damages only when the defendant has deliberately
committed a wrong with malicious intent or has otherwise done something outrageous.
Punitive damages are rarely allowed in negligence cases for that reason. But if someone sets out
intentionally and maliciously to hurt another person, punitive damages may well be appropriate. Punitive
damages are intended not only to punish the wrongdoer, by exacting an additional and sometimes heavy
payment (the exact amount is left to the discretion of jury and judge), but also to deter others from similar
conduct. The punitive damage award has been subject to heavy criticism in recent years in cases in which
it has been awarded against manufacturers. One fear is that huge damage awards on behalf of a multitude
of victims could swiftly bankrupt the defendant. Unlike compensatory damages, punitive damages are
taxable.

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KEY TAKEAWAY
There are three kinds of torts, and in two of them (negligent torts and strict liability torts), damages are
usually limited to making the victim whole through an enforceable judgment for money damages. These
compensatory damages awarded by a court accomplish only approximate justice for the injuries or property
damage caused by a tortfeasor. Tort laws go a step further toward deterrence, beyond compensation to the
plaintiff, in occasionally awarding punitive damages against a defendant. These are almost always in cases
where an intentional tort has been committed.

EXERCISES
1.

Why is deterrence needed for intentional torts (where punitive damages are awarded) rather than
negligent torts?

2.

Why are costs imposed on others without their consent problematic for a market economy? What if the
law did not try to reimpose the victim’s costs onto the tortfeasor? What would a totally nonlitigious
society be like?

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7.2 Intentional Torts
LEARNING OBJECTIVES
1.

Distinguish intentional torts from other kinds of torts.

2.

Give three examples of an intentional tort—one that causes injury to a person, one that causes injury
to property, and one that causes injury to a reputation.

The analysis of most intentional torts is straightforward and parallels the substantive crimes already
discussed in Chapter 6 "Criminal Law". When physical injury or damage to property is caused, there is
rarely debate over liability if the plaintiff deliberately undertook to produce the harm. Certain other
intentional torts are worth noting for their relevance to business.

Assault and Battery
One of the most obvious intentional torts is assault and battery. Both criminal law and tort law serve to
restrain individuals from using physical force on others. Assault is (1) the threat of immediate harm or
offense of contact or (2) any act that would arouse reasonable apprehension of imminent harm. Battery is
unauthorized and harmful or offensive physical contact with another person that causes injury.
Often an assault results in battery, but not always. In Western Union Telegraph Co. v. Hill, for example,
the defendant did not touch the plaintiff’s wife, but the case presented an issue of possible assault even
without an actual battery; the defendant employee attempted to kiss a customer across the countertop,
couldn't quite reach her, but nonetheless created actionable fear (or, as the court put it, “apprehension”)
on the part of the plaintiff's wife. It is also possible to have a battery without an assault. For example, if
someone hits you on the back of the head with an iron skillet and you didn’t see it coming, there is a
battery but no assault. Likewise, if Andrea passes out from drinking too much at the fraternity party and a
stranger (Andre) kisses her on the lips while she is passed out, she would not be aware of any threat of
offensive contact and would have no apprehension of any harm. Thus there has been no tort of assault,
but she could allege the tort of battery. (The question of what damages, if any, would be an interesting
argument.)

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Under the doctrine of transferred intent, if Draco aims his wand at Harry but Harry ducks just in time and
the impact is felt by Hermione instead, English law (and American law) would transfer Draco’s intent
from the target to the actual victim of the act. Thus Hermione could sue Draco for battery for any damages
she had suffered.

False Imprisonment
The tort of false imprisonment originally implied a locking up, as in a prison, but today it can occur if a
person is restrained in a room or a car or even if his or her movements are restricted while walking down
the street. People have a right to be free to go as they please, and anyone who without cause deprives
another of personal freedom has committed a tort. Damages are allowed for time lost, discomfort and
resulting ill health, mental suffering, humiliation, loss of reputation or business, and expenses such as
attorneys’ fees incurred as a result of the restraint (such as a false arrest). But as the case of Lester v.
Albers Super Markets, Inc. (Section 7.5 "Cases") shows, the defendant must be shown to have restrained
the plaintiff in order for damages to be allowed.

Intentional Infliction of Emotional Distress
Until recently, the common-law rule was that there could be no recovery for acts, even though
intentionally undertaken, that caused purely mental or emotional distress. For a case to go to the jury, the
courts required that the mental distress result from some physical injury. In recent years, many courts
have overthrown the older rule and now recognize the so-called new tort. In an employment context,
however, it is rare to find a case where a plaintiff is able to recover. The most difficult hurdle is proving
that the conduct was “extreme” or “outrageous.”
In an early California case, bill collectors came to the debtor’s home repeatedly and threatened the
debtor’s pregnant wife. Among other things, they claimed that the wife would have to deliver her child in
prison. The wife miscarried and had emotional and physical complications. The court found that the
behavior of the collection company’s two agents was sufficiently outrageous to prove the tort of
intentional infliction of emotional distress. In Roche v. Stern (New York), the famous cable television talk
show host Howard Stern had tastelessly discussed the remains of Deborah Roche, a topless dancer and

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cable access television host.

[1]

The remains had been brought to Stern’s show by a close friend of Roche,

Chaunce Hayden, and a number of crude comments by Stern and Hayden about the remains were
videotaped and broadcast on a national cable television station. Roche’s sister and brother sued Howard
Stern and Infinity broadcasting and were able to get past the defendant’s motion to dismiss to have a jury
consider their claim.
A plaintiff’s burden in these cases is to show that the mental distress is severe. Many states require that
this distress must result in physical symptoms such as nausea, headaches, ulcers, or, as in the case of the
pregnant wife, a miscarriage. Other states have not required physical symptoms, finding that shame,
embarrassment, fear, and anger constitute severe mental distress.

Trespass and Nuisance
Trespass is intentionally going on land that belongs to someone else or putting something on someone
else’s property and refusing to remove it. This part of tort law shows how strongly the law values the rights
of property owners. The right to enjoy your property without interference from others is also found in
common law of nuisance. There are limits to property owners’ rights, however. In Katko v. Briney, for
example, the plaintiff was injured by a spring gun while trespassing on the defendant’s property.

[2]

The

defendant had set up No Trespassing signs after ten years of trespassing and housebreaking events, with
the loss of some household items. Windows had been broken, and there was “messing up of the property
in general.” The defendants had boarded up the windows and doors in order to stop the intrusions and
finally had set up a shotgun trap in the north bedroom of the house. One defendant had cleaned and oiled
his 20-gauge shotgun and taken it to the old house where it was secured to an iron bed with the barrel
pointed at the bedroom door. “It was rigged with wire from the doorknob to the gun’s trigger so would fire
when the door was opened.” The angle of the shotgun was adjusted to hit an intruder in the legs. The
spring could not be seen from the outside, and no warning of its presence was posted.
The plaintiff, Katko, had been hunting in the area for several years and considered the property
abandoned. He knew it had long been uninhabited. He and a friend had been to the house and found
several old bottles and fruit jars that they took and added to their collection of antiques. When they made
a second trip to the property, they entered by removing a board from a porch window. When the plaintiff

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opened the north bedroom door, the shotgun went off and struck him in the right leg above the ankle
bone. Much of his leg was blown away. While Katko knew he had no right to break and enter the house
with intent to steal bottles and fruit jars, the court held that a property owner could not protect an
unoccupied boarded-up farmhouse by using a spring gun capable of inflicting death or serious injury.
In Katko, there is an intentional tort. But what if someone trespassing is injured by the negligence of the
landowner? States have differing rules about trespass and negligence. In some states, a trespasser is only
protected against the gross negligence of the landowner. In other states, trespassers may be owed the duty
of due care on the part of the landowner. The burglar who falls into a drained swimming pool, for
example, may have a case against the homeowner unless the courts or legislature of that state have made
it clear that trespassers are owed the limited duty to avoid gross negligence. Or a very small child may
wander off his own property and fall into a gravel pit on a nearby property and suffer death or serious
injury; if the pit should (in the exercise of due care) have been filled in or some barrier erected around it,
then there was negligence. But if the state law holds that the duty to trespassers is only to avoid gross
negligence, the child’s family would lose, unless the state law makes an exception for very young
trespassers. In general, guests, licensees, and invitees are owed a duty of due care; a trespasser may not be
owed such a duty, but states have different rules on this.

Intentional Interference with Contractual Relations
Tortious interference with a contract can be established by proving four elements:
1.

There was a contract between the plaintiff and a third party.

2. The defendant knew of the contract.
3. The defendant improperly induced the third party to breach the contract or made performance of
the contract impossible.
4. There was injury to the plaintiff.
In a famous case of contract interference, Texaco was sued by Pennzoil for interfering with an agreement
that Pennzoil had with Getty Oil. After complicated negotiations between Pennzoil and Getty, a takeover
share price was struck, a memorandum of understanding was signed, and a press release announced the

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agreement in principle between Pennzoil and Getty. Texaco’s lawyers, however, believed that Getty oil was
“still in play,” and before the lawyers for Pennzoil and Getty could complete the paperwork for their
agreement, Texaco announced it was offering Getty shareholders an additional $12.50 per share over
what Pennzoil had offered.
Texaco later increased its offer to $228 per share, and the Getty board of directors soon began dealing
with Texaco instead of Pennzoil. Pennzoil decided to sue in Texas state court for tortious interference with
a contract. After a long trial, the jury returned an enormous verdict against Texaco: $7.53 billion in actual
damages and $3 billion in punitive damages. The verdict was so large that it would have bankrupted
Texaco. Appeals from the verdict centered on an obscure rule of the Securities and Exchange Commission
(SEC), Rule 10(b)-13, and Texaco’s argument was based on that rule and the fact that the contract had not
been completed. If there was no contract, Texaco could not have legally interfered with one. After the SEC
filed a brief that supported Texaco’s interpretation of the law, Texaco agreed to pay $3 billion to Pennzoil
to dismiss its claim of tortious interference with a contract.

Malicious Prosecution
Malicious prosecution is the tort of causing someone to be prosecuted for a criminal act, knowing that
there was no probable cause to believe that the plaintiff committed the crime. The plaintiff must show that
the defendant acted with malice or with some purpose other than bringing the guilty to justice. A mere
complaint to the authorities is insufficient to establish the tort, but any official proceeding will support the
claim—for example, a warrant for the plaintiff’s arrest. The criminal proceeding must terminate in the
plaintiff’s favor in order for his suit to be sustained.
A majority of US courts, though by no means all, permit a suit for wrongful civil proceedings. Civil
litigation is usually costly and burdensome, and one who forces another to defend himself against baseless
accusations should not be permitted to saddle the one he sues with the costs of defense. However,
because, as a matter of public policy, litigation is favored as the means by which legal rights can be
vindicated—indeed, the Supreme Court has even ruled that individuals have a constitutional right to
litigate—the plaintiff must meet a heavy burden in proving his case. The mere dismissal of the original
lawsuit against the plaintiff is not sufficient proof that the suit was unwarranted. The plaintiff in a suit for

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wrongful civil proceedings must show that the defendant (who was the plaintiff in the original suit) filed
the action for an improper purpose and had no reasonable belief that his cause was legally or factually
well grounded.

Defamation
Defamation is injury to a person’s good name or reputation. In general, if the harm is done through the
spoken word—one person to another, by telephone, by radio, or on television—it is called slander. If the
defamatory statement is published in written form, it is called libel.
The Restatement (Second) of Torts defines a defamatory communication as one that “so tends to harm the
reputation of another as to lower him in the estimation of the community or to deter third persons from
associating or dealing with him.”

[3]

A statement is not defamatory unless it is false. Truth is an absolute defense to a charge of libel or slander.
Moreover, the statement must be “published”—that is, communicated to a third person. You cannot be
libeled by one who sends you a letter full of false accusations and scurrilous statements about you unless a
third person opens it first (your roommate, perhaps). Any living person is capable of being defamed, but
the dead are not. Corporations, partnerships, and other forms of associations can also be defamed, if the
statements tend to injure their ability to do business or to garner contributions.
The statement must have reference to a particular person, but he or she need not be identified by name. A
statement that “the company president is a crook” is defamatory, as is a statement that “the major
network weathermen are imposters.” The company president and the network weathermen could show
that the words were aimed at them. But statements about large groups will not support an action for
defamation (e.g., “all doctors are butchers” is not defamatory of any particular doctor).
The law of defamation is largely built on strict liability. That a person did not intend to defame is
ordinarily no excuse; a typographical error that converts a true statement into a false one in a newspaper,
magazine, or corporate brochure can be sufficient to make out a case of libel. Even the exercise of due care
is usually no excuse if the statement is in fact communicated. Repeating a libel is itself a libel; a libel
cannot be justified by showing that you were quoting someone else. Though a plaintiff may be able to

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prove that a statement was defamatory, he is not necessarily entitled to an award of damages. That is
because the law contains a number of privileges that excuse the defamation.
Publishing false information about another business’s product constitutes the tort of slander of quality, or
trade libel. In some states, this is known as the tort of product disparagement. It may be difficult to
establish damages, however. A plaintiff must prove that actual damages proximately resulted from the
slander of quality and must show the extent of the economic harm as well.

Absolute Privilege
Statements made during the course of judicial proceedings are absolutely privileged, meaning that they
cannot serve as the basis for a defamation suit. Accurate accounts of judicial or other proceedings are
absolutely privileged; a newspaper, for example, may pass on the slanderous comments of a judge in
court. “Judicial” is broadly construed to include most proceedings of administrative bodies of the
government. The Constitution exempts members of Congress from suits for libel or slander for any
statements made in connection with legislative business. The courts have constructed a similar privilege
for many executive branch officials.

Qualified Privilege
Absolute privileges pertain to those in the public sector. A narrower privilege exists for private citizens. In
general, a statement that would otherwise be actionable is held to be justified if made in a reasonable
manner and for a reasonable purpose. Thus you may warn a friend to beware of dealing with a third
person, and if you had reason to believe that what you said was true, you are privileged to issue the
warning, even though false. Likewise, an employee may warn an employer about the conduct or character
of a fellow or prospective employee, and a parent may complain to a school board about the competence
or conduct of a child’s teacher. There is a line to be drawn, however, and a defendant with nothing but an
idle interest in the matter (an “officious intermeddler”) must take the risk that his information is wrong.
In 1964, the Supreme Court handed down its historic decision in New York Times v. Sullivan, holding
that under the First Amendment a libel judgment brought by a public official against a newspaper cannot
stand unless the plaintiff has shown “actual malice,” which in turn was defined as “knowledge that [the

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[4]

statement] was false or with a reckless disregard of whether it was false or not.” In subsequent cases, the
court extended the constitutional doctrine further, applying it not merely to government officials but
to public figures, people who voluntarily place themselves in the public eye or who involuntarily find
themselves the objects of public scrutiny. Whether a private person is or is not a public figure is a difficult
question that has so far eluded rigorous definition and has been answered only from case to case. A CEO
of a private corporation ordinarily will be considered a private figure unless he puts himself in the public
eye—for example, by starring in the company’s television commercials.

Invasion of Privacy
The right of privacy—the right “to be let alone”—did not receive judicial recognition until the twentieth
century, and its legal formulation is still evolving. In fact there is no single right of privacy. Courts and
commentators have discerned at least four different types of interests: (1) the right to control the
appropriation of your name and picture for commercial purposes, (2) the right to be free of intrusion on
your “personal space” or seclusion, (3) freedom from public disclosure of embarrassing and intimate facts
of your personal life, and (4) the right not to be presented in a “false light.”

Appropriation of Name or Likeness
The earliest privacy interest recognized by the courts was appropriation of name or likeness: someone else
placing your photograph on a billboard or cereal box as a model or using your name as endorsing a
product or in the product name. A New York statute makes it a misdemeanor to use the name, portrait, or
picture of any person for advertising purposes or for the purposes of trade (business) without first
obtaining written consent. The law also permits the aggrieved person to sue and to recover damages for
unauthorized profits and also to have the court enjoin (judicially block) any further unauthorized use of
the plaintiff’s name, likeness, or image. This is particularly useful to celebrities.
Because the publishing and advertising industries are concentrated heavily in New York, the statute plays
an important part in advertising decisions made throughout the country. Deciding what “commercial” or
“trade” purposes are is not always easy. Thus a newsmagazine may use a baseball player’s picture on its

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cover without first obtaining written permission, but a chocolate manufacturer could not put the player’s
picture on a candy wrapper without consent.

Personal Space
One form of intrusion upon a person’s solitude—trespass—has long been actionable under common law.
Physical invasion of home or other property is not a new tort. But in recent years, the notion of intrusion
has been broadened considerably. Now, taking photos of someone else with your cell phone in a locker
room could constitute invasion of the right to privacy. Reading someone else’s mail or e-mail could also
constitute an invasion of the right to privacy. Photographing someone on a city street is not tortious, but
subsequent use of the photograph could be. Whether the invasion is in a public or private space, the
amount of damages will depend on how the image or information is disclosed to others.

Public Disclosure of Embarassing Facts
Circulation of false statements that do injury to a person are actionable under the laws of defamation.
What about true statements that might be every bit as damaging—for example, disclosure of someone’s
income tax return, revealing how much he earned? The general rule is that if the facts are truly private
and of no “legitimate” concern to the public, then their disclosure is a violation of the right to privacy. But
a person who is in the public eye cannot claim the same protection.

False Light
A final type of privacy invasion is that which paints a false picture in a publication. Though false, it might
not be libelous, since the publication need contain nothing injurious to reputation. Indeed, the publication
might even glorify the plaintiff, making him seem more heroic than he actually is. Subject to the First
Amendment requirement that the plaintiff must show intent or extreme recklessness, statements that put
a person in a false light, like a fictionalized biography, are actionable.

KEY TAKEAWAY
There are many kinds of intentional torts. Some of them involve harm to the physical person or to his or her
property, reputation or feelings, or economic interests. In each case of intentional tort, the plaintiff must show

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that the defendant intended harm, but the intent to harm does not need to be directed at a particular person
and need not be malicious, as long as the resulting harm is a direct consequence of the defendant’s actions.

EXERCISES
1.

Name two kinds of intentional torts that could result in damage to a business firm’s bottom line.

2.

Name two kinds of intentional torts that are based on protection of a person’s property.

3.

Why are intentional torts more likely to result in a verdict not only for compensatory damages but also for
punitive damages?

[1] Roche v. Stern, 675 N.Y.S.2d 133 (1998).
[2] Katko v. Briney, 183 N.W.2d 657 (Iowa 1971).
[3] Restatement (Second) of Torts, Section 559 (1965).
[4] Times v. Sullivan, 376 US 254 (1964).

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7.3 Negligence
LEARNING OBJECTIVES
1.

Understand how the duty of due care relates to negligence.

2.

Distinguish between actual and proximate cause.

3.

Explain the primary defenses to a claim of negligence.

Elements of Negligence
Physical harm need not be intentionally caused. A pedestrian knocked over by an automobile does not
hurt less because the driver intended no wrong but was merely careless. The law imposes a duty of care on
all of us in our everyday lives. Accidents caused by negligence are actionable.
Determining negligence is not always easy. If a driver runs a red light, we can say that he is negligent
because a driver must always be careful to ascertain whether the light is red and be able to stop if it is.
Suppose that the driver was carrying a badly injured person to a nearby hospital and that after slowing
down at an intersection, went through a red light, blowing his horn, whereupon a driver to his right,
seeing him, drove into the intersection anyway and crashed into him. Must one always stop at a red light?
Is proof that the light was red always proof of negligence? Usually, but not always: negligence is an
abstract concept that must always be applied to concrete and often widely varying sets of circumstances.
Whether someone was or was not negligent is almost always a question of fact for a jury to decide. Rarely
is it a legal question that a judge can settle.
The tort of negligence has four elements: (1) a duty of due care that the defendant had, (2)
the breach of the duty of due care, (3) connection between cause and injury, and (4) actual damage or loss.
Even if a plaintiff can prove each of these aspects, the defendant may be able to show that the law excuses
the conduct that is the basis for the tort claim. We examine each of these factors below.

Standard of Care
Not every unintentional act that causes injury is negligent. If you brake to a stop when you see a child dart
out in front of your car, and if the noise from your tires gives someone in a nearby house a heart attack,
you have not acted negligently toward the person in the house. The purpose of the negligence standard is

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to protect others against the risk of injury that foreseeably would ensue from unreasonably dangerous
conduct.
Given the infinite variety of human circumstances and conduct, no general statement of a reasonable
standard of care is possible. Nevertheless, the law has tried to encapsulate it in the form of the famous
standard of “the reasonable man.” This fictitious person “of ordinary prudence” is the model that juries
are instructed to compare defendants with in assessing whether those defendants have acted negligently.
Analysis of this mythical personage has baffled several generations of commentators. How much
knowledge must he have of events in the community, of technology, of cause and effect? With what
physical attributes, courage, or wisdom is this nonexistent person supposedly endowed? If the defendant
is a person with specialized knowledge, like a doctor or an automobile designer, must the jury also treat
the “reasonable man” as having this knowledge, even though the average person in the community will
not? (Answer: in most cases, yes.)
Despite the many difficulties, the concept of the reasonable man is one on which most negligence cases
ultimately turn. If a defendant has acted “unreasonably under the circumstances” and his conduct posed
an unreasonable risk of injury, then he is liable for injury caused by his conduct. Perhaps in most
instances, it is not difficult to divine what the reasonable man would do. The reasonable man stops for
traffic lights and always drives at reasonable speeds, does not throw baseballs through windows, performs
surgical operations according to the average standards of the medical profession, ensures that the floors of
his grocery store are kept free of fluids that would cause a patron to slip and fall, takes proper precautions
to avoid spillage of oil from his supertanker, and so on. The "reasonable man" standard imposes hindsight
on the decisions and actions of people in society; the circumstances of life are such that courts may
sometimes impose a standard of due care that many people might not find reasonable.

Duty of Care and Its Breach
The law does not impose on us a duty to care for every person. If the rule were otherwise, we would all, in
this interdependent world, be our brothers’ keepers, constantly unsure whether any action we took might
subject us to liability for its effect on someone else. The law copes with this difficulty by limiting the
number of people toward whom we owe a duty to be careful.

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In general, the law imposes no obligation to act in a situation to which we are strangers. We may pass the
drowning child without risking a lawsuit. But if we do act, then the law requires us to act carefully. The
law of negligence requires us to behave with due regard for the foreseeable consequences of our actions in
order to avoid unreasonable risks of injury.
During the course of the twentieth century, the courts have constantly expanded the notion of
“foreseeability,” so that today many more people are held to be within the zone of injury than was once the
case. For example, it was once believed that a manufacturer or supplier owed a duty of care only to
immediate purchasers, not to others who might use the product or to whom the product might be resold.
This limitation was known as the rule of privity. And users who were not immediate purchasers were said
not to be in privity with a supplier or manufacturer. In 1916, Judge Benjamin N. Cardozo, then on the
New York Court of Appeals, penned an opinion in a celebrated case that exploded the theory of privity,
though it would take half a century before the last state—Mississippi in 1966—would fall in line.
Determining a duty of care can be a vexing problem. Physicians, for example, are bound by principles of
medical ethics to respect the confidences of their patients. Suppose a patient tells a psychiatrist that he
intends to kill his girlfriend. Does the physician then have a higher legal duty to warn prospective victim?
The California Supreme Court has said yes.

[1]

Establishing a breach of the duty of due care where the defendant has violated a statute or municipal
ordinance is eased considerably with the doctrine of negligence per se, a doctrine common to all US state
courts. If a legislative body sets a minimum standard of care for particular kinds of acts to protect a
certain set of people from harm and a violation of that standard causes harm to someone in that set, the
defendant is negligent per se. If Harvey is driving sixty-five miles per hour in a fifty-five-mile-per-hour
zone when he crashes into Haley’s car and the police accident report establishes that or he otherwise
admits to going ten miles per hour over the speed limit, Haley does not have to prove that Harvey has
breached a duty of due care. She will only have to prove that the speeding was an actual and proximate
cause of the collision and will also have to prove the extent of the resulting damages to her.

Causation: Actual Cause and Proximate Cause

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“For want of a nail, the kingdom was lost,” as the old saying has it. Virtually any cause of an injury can be
traced to some preceding cause. The problem for the law is to know when to draw the line between causes
that are immediate and causes too remote for liability reasonably to be assigned to them. In tort theory,
there are two kinds of causes that a plaintiff must prove: actual cause and proximate
cause. Actual cause (causation in fact) can be found if the connection between the defendant’s act and the
plaintiff’s injuries passes the “but for” test: if an injury would not have occurred “but for” the defendant’s
conduct, then the defendant is the cause of the injury. Still, this is not enough causation to create liability.
The injuries to the plaintiff must also be foreseeable, or not “too remote,” for the defendant’s act to create
liability. This is proximate cause: a cause that is not too remote or unforseeable.
Suppose that the person who was injured was not one whom a reasonable person could have expected to
be harmed. Such a situation was presented in one of the most famous US tort cases, Palsgraf v. Long
Island Railroad (Section 7.5 "Cases"), which was decided by Judge Benjamin Cardozo. Although Judge
Cardozo persuaded four of his seven brethren to side with his position, the closeness of the case
demonstrates the difficulty that unforeseeable consequences and unforeseeable plaintiffs present.

Damages
For a plaintiff to win a tort case, she must allege and prove that she was injured. The fear that she might
be injured in the future is not a sufficient basis for a suit. This rule has proved troublesome in medical
malpractice and industrial disease cases. A doctor’s negligent act or a company’s negligent exposure of a
worker to some form of contamination might not become manifest in the body for years. In the meantime,
the tort statute of limitations might have run out, barring the victim from suing at all. An increasing
number of courts have eased the plaintiff’s predicament by ruling that the statute of limitations does not
begin to run until the victim discovers that she has been injured or contracted a disease.
The law allows an exception to the general rule that damages must be shown when the plaintiff stands in
danger of immediate injury from a hazardous activity. If you discover your neighbor experimenting with
explosives in his basement, you could bring suit to enjoin him from further experimentation, even though
he has not yet blown up his house—and yours.

Problems of Proof
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The plaintiff in a tort suit, as in any other, has the burden of proving his allegations.
He must show that the defendant took the actions complained of as negligent, demonstrate the
circumstances that make the actions negligent, and prove the occurrence and extent of injury. Factual
issues are for the jury to resolve. Since it is frequently difficult to make out the requisite proof, the law
allows certain presumptions and rules of evidence that ease the plaintiff’s task, on the ground that without
them substantial injustice would be done. One important rule goes by the Latin phrase res ipsa loquitur,
meaning “the thing speaks for itself.” The best evidence is always the most direct evidence: an eyewitness
account of the acts in question. But eyewitnesses are often unavailable, and in any event they frequently
cannot testify directly to the reasonableness of someone’s conduct, which inevitably can only be inferred
from the circumstances.
In many cases, therefore, circumstantial evidence (evidence that is indirect) will be the only evidence or
will constitute the bulk of the evidence. Circumstantial evidence can often be quite telling: though no one
saw anyone leave the building, muddy footprints tracing a path along the sidewalk are fairly conclusive.
Res ipsa loquitur is a rule of circumstantial evidence that permits the jury to draw an inference of
negligence. A common statement of the rule is the following: “There must be reasonable evidence of
negligence but where the thing is shown to be under the management of the defendant or his servants,
and the accident is such as in the ordinary course of things does not happen if those who have the
management use proper care, it affords reasonable evidence, in the absence of explanation by the
defendants, that the accident arose from want of care.”

[2]

If a barrel of flour rolls out of a factory window and hits someone, or a soda bottle explodes, or an airplane
crashes, courts in every state permit juries to conclude, in the absence of contrary explanations by the
defendants, that there was negligence. The plaintiff is not put to the impossible task of explaining
precisely how the accident occurred. A defendant can always offer evidence that he acted reasonably—for
example, that the flour barrel was securely fastened and that a bolt of lightning, for which he was not
responsible, broke its bands, causing it to roll out the window. But testimony by the factory employees
that they secured the barrel, in the absence of any further explanation, will not usually serve to rebut the
inference. That the defendant was negligent does not conclude the inquiry or automatically entitle the

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plaintiff to a judgment. Tort law provides the defendant with several excuses, some of which are discussed
briefly in the next section.

Excuses
There are more excuses (defenses) than are listed here, but contributory negligence or comparative
negligence, assumption of risk, and act of God are among the principal defenses that will completely or
partially excuse the negligence of the defendant.

Contributory and Comparative Negligence
Under an old common-law rule, it was a complete defense to show that the plaintiff in a negligence suit
was himself negligent. Even if the plaintiff was only mildly negligent, most of the fault being chargeable to
the defendant, the court would dismiss the suit if the plaintiff’s conduct contributed to his injury. In a few
states today, this rule of contributory negligence is still in effect. Although referred to as negligence, the
rule encompasses a narrower form than that with which the defendant is charged, because the plaintiff’s
only error in such cases is in being less careful of himself than he might have been, whereas the defendant
is charged with conduct careless toward others. This rule was so manifestly unjust in many cases that
most states, either by statute or judicial decision, have changed to some version
of comparative negligence. Under the rule of comparative negligence, damages are apportioned according
to the defendant’s degree of culpability. For example, if the plaintiff has sustained a $100,000 injury and
is 20 percent responsible, the defendant will be liable for $80,000 in damages.

Assumption of Risk
Risk of injury pervades the modern world, and plaintiffs should not win a lawsuit simply because they
took a risk and lost. The law provides, therefore, that when a person knowingly takes a risk, he or she
must suffer the consequences.
The assumption of risk doctrine comes up in three ways. The plaintiff may have formally agreed with the
defendant before entering a risky situation that he will relieve the defendant of liability should injury
occur. (“You can borrow my car if you agree not to sue me if the brakes fail, because they’re worn and I
haven’t had a chance to replace them.”) Or the plaintiff may have entered into a relationship with the

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defendant knowing that the defendant is not in a position to protect him from known risks (the fan who is
hit by a line drive in a ballpark). Or the plaintiff may act in the face of a risky situation known in advance
to have been created by the defendant’s negligence (failure to leave, while there was an opportunity to do
so, such as getting into an automobile when the driver is known to be drunk).
The difficulty in many cases is to determine the dividing line between subjectivity and objectivity. If the
plaintiff had no actual knowledge of the risk, he cannot be held to have assumed it. On the other hand, it is
easy to claim that you did not appreciate the danger, and the courts will apply an objective standard of
community knowledge (a “but you should have known” test) in many situations. When the plaintiff has no
real alternative, however, assumption of risk fails as a defense (e.g., a landlord who negligently fails to
light the exit to the street cannot claim that his tenants assumed the risk of using it).
At the turn of the century, courts applied assumption of risk in industrial cases to bar relief to workers
injured on the job. They were said to assume the risk of dangerous conditions or equipment. This rule has
been abolished by workers’ compensation statutes in most states.

Act of God
Technically, the rule that no one is responsible for an “act of God,” or force majeure as it is sometimes
called, is not an excuse but a defense premised on a lack of causation. If a force of nature caused the harm,
then the defendant was not negligent in the first place. A marina, obligated to look after boats moored at
its dock, is not liable if a sudden and fierce storm against which no precaution was possible destroys
someone’s vessel. However, if it is foreseeable that harm will flow from a negligent condition triggered by
a natural event, then there is liability. For example, a work crew failed to remove residue explosive gas
from an oil barge. Lightning hit the barge, exploded the gas, and injured several workmen. The plaintiff
recovered damages against the company because the negligence consisted in the failure to guard against
any one of a number of chance occurrences that could ignite the gas.

[3]

Vicarious Liability
Liability for negligent acts does not always end with the one who was negligent. Under certain
circumstances, the liability is imputed to others. For example, an employer is responsible for the

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negligence of his employees if they were acting in the scope of employment. This rule of vicarious liability
is often calledrespondeat superior, meaning that the higher authority must respond to claims brought
against one of its agents. Respondeat superior is not limited to the employment relationship but extends
to a number of other agency relationships as well.
Legislatures in many states have enacted laws that make people vicariously liable for acts of certain people
with whom they have a relationship, though not necessarily one of agency. It is common, for example, for
the 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
to one who, in an intoxicated state, later causes injury to others. In these situations, although the injurious
act of the drinker stemmed from negligence, the one whom the law holds vicariously liable (the bartender)
is not himself necessarily negligent—the law is holding him strictly liable, and to this concept we now
turn.

KEY TAKEAWAY
The most common tort claim is based on the negligence of the defendant. In each negligence claim, the
plaintiff must establish by a preponderance of the evidence that (1) the defendant had a duty of due care, (2)
the defendant breached that duty, (3) that the breach of duty both actually and approximately has caused
harm to the plaintiff, and (4) that the harm is measurable in money damages.
It is also possible for the negligence of one person to be imputed to another, as in the case of respondeat
superior, or in the case of someone who loans his automobile to another driver who is negligent and causes
injury. There are many excuses (defenses) to claims of negligence, including assumption of risk and
comparative negligence. In those few jurisdictions where contributory negligence has not been modified to
comparative negligence, plaintiffs whose negligence contributes to their own injuries will be barred from any
recovery.

EXERCISES
1.

Explain the difference between comparative negligence and contributory negligence.

2.

How is actual cause different from probable cause?

3.

What is an example of assumption of risk?

4.

How does res ipsa loquitur help a plaintiff establish a case of negligence?

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[1] Tarasoff v. Regents of University of California, 551 P.2d 334 (Calif. 1976).
[2] Scott v. London & St. Katherine Docks Co., 3 H. & C. 596, 159 Eng.Rep. 665 (Q.B. 1865).
[3] Johnson v. Kosmos Portland Cement Co., 64 F.2d 193 (6th Cir. 1933).

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7.4 Strict Liability
LEARNING OBJECTIVES
1.

Understand how strict liability torts differ from negligent torts.

2.

Understand the historical origins of strict liability under common law.

3.

Be able to apply strict liability concepts to liability for defective products.

4.

Distinguish strict liability from absolute liability, and understand the major defenses to a lawsuit in
products-liability cases.

Historical Basis of Strict Liability: Animals and Ultrahazardous Activities
To this point, we have considered principles of liability that in some sense depend upon the “fault” of the
tortfeasor. This fault is not synonymous with moral blame.
Aside from acts intended to harm, the fault lies in a failure to live up to a standard of reasonableness or
due care. But this is not the only basis for tort liability. Innocent mistakes can be a sufficient basis. As we
have already seen, someone who unknowingly trespasses on another’s property is liable for the damage
that he does, even if he has a reasonable belief that the land is his. And it has long been held that someone
who engages in ultrahazardous (or sometimes, abnormally dangerous) activities is liable for damage that
he causes, even though he has taken every possible precaution to avoid harm to someone else.
Likewise, the owner of animals that escape from their pastures or homes and damage neighboring
property may be liable, even if the reason for their escape was beyond the power of the owner to stop (e.g.,
a fire started by lightning that burns open a barn door). In such cases, the courts invoke the principle of
strict liability, or, as it is sometimes called, liability without fault. The reason for the rule is explained
in Klein v. Pyrodyne Corporation (Section 7.5 "Cases").

Strict Liability for Products
Because of the importance of products liability, this text devotes an entire chapter to it (Chapter 17
"Products Liability"). Strict liability may also apply as a legal standard for products, even those that are
not ultrahazardous. In some national legal systems, strict liability is not available as a cause of action to
plaintiffs seeking to recover a judgment of products liability against a manufacturer, wholesaler,

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distributor, or retailer. (Some states limit liability to the manufacturer.) But it is available in the United
States and initially was created by a California Supreme Court decision in the 1962 case of Greenman v.
Yuba Power Products, Inc.
In Greenman, the plaintiff had used a home power saw and bench, the Shopsmith, designed and
manufactured by the defendant. He was experienced in using power tools and was injured while using the
approved lathe attachment to the Shopsmith to fashion a wooden chalice. The case was decided on the
premise that Greenman had done nothing wrong in using the machine but that the machine had a defect
that was “latent” (not easily discoverable by the consumer). Rather than decide the case based on
warranties, or requiring that Greenman prove how the defendant had been negligent, Justice Traynor
found for the plaintiff based on the overall social utility of strict liability in cases of defective products.
According to his decision, the purpose of such liability is to ensure that the “cost of injuries resulting from
defective products is borne by the manufacturers…rather than by the injured persons who are powerless
to protect themselves.”
Today, the majority of US states recognize strict liability for defective products, although some states limit
strict liability actions to damages for personal injuries rather than property damage. Injured plaintiffs
have to prove the product caused the harm but do not have to prove exactly how the manufacturer was
careless. Purchasers of the product, as well as injured guests, bystanders, and others with no direct
relationship with the product, may sue for damages caused by the product.
The Restatement of the Law of Torts, Section 402(a), was originally issued in 1964. It is a widely accepted
statement of the liabilities of sellers of goods for defective products. The Restatement specifies six
requirements, all of which must be met for a plaintiff to recover using strict liability for a product that the
plaintiff claims is defective:
1.

The product must be in a defective condition when the defendant sells it.

2. The defendant must normally be engaged in the business of selling or otherwise distributing the
product.
3. The product must be unreasonably dangerous to the user or consumer because of its defective
condition.

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4. The plaintiff must incur physical harm to self or to property by using or consuming the product.
5.

The defective condition must be the proximate cause of the injury or damage.

6. The goods must not have been substantially changed from the time the product was sold to the
time the injury was sustained.
Section 402(a) also explicitly makes clear that a defendant can be held liable even though the defendant
has exercised “all possible care.” Thus in a strict liability case, the plaintiff does not need to show “fault”
(or negligence).
For defendants, who can include manufacturers, distributors, processors, assemblers, packagers, bottlers,
retailers, and wholesalers, there are a number of defenses that are available, including assumption of risk,
product misuse and comparative negligence, commonly known dangers, and the knowledgeable-user
defense. We have already seen assumption of risk and comparative negligence in terms of negligence
actions; the application of these is similar in products-liability actions.
Under product misuse, a plaintiff who uses a product in an unexpected and unusual way will not recover
for injuries caused by such misuse. For example, suppose that someone uses a rotary lawn mower to trim
a hedge and that after twenty minutes of such use loses control because of its weight and suffers serious
cuts to his abdomen after dropping it. Here, there would be a defense of product misuse, as well as
contributory negligence. Consider the urban (or Internet) legend of Mervin Gratz, who supposedly put his
Winnebago on autopilot to go back and make coffee in the kitchen, then recovered millions after his
Winnebago turned over and he suffered serious injuries. There are multiple defenses to this alleged
action; these would include the defenses of contributory negligence, comparative negligence, and product
misuse. (There was never any such case, and certainly no such recovery; it is not known who started this
legend, or why.)
Another defense against strict liability as a cause of action is the knowledgeable user defense. If the
parents of obese teenagers bring a lawsuit against McDonald’s, claiming that its fast-food products are
defective and that McDonald’s should have warned customers of the adverse health effects of eating its
products, a defense based on the knowledgeable user is available. In one case, the court found that the
high levels of cholesterol, fat, salt, and sugar in McDonald’s food is well known to users. The court stated,

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“If consumers know (or reasonably should know) the potential ill health effects of eating at McDonald’s,
they cannot blame McDonald’s if they, nonetheless, choose to satiate their appetite with a surfeit of
supersized McDonald’s products.”

[1]

KEY TAKEAWAY
Common-law courts have long held that certain activities are inherently dangerous and that those who cause
damage to others by engaging in those activities will be held strictly liable. More recently, courts in the United
States have applied strict liability to defective products. Strict liability, however, is not absolute liability, as
there are many defenses available to defendants in lawsuits based on strict liability, such as comparative
negligence and product abuse.

EXERCISES
1.

Someone says, “Strict liability means that you’re liable for whatever you make, no matter what the
consumer does with your product. It’s a crazy system.” Respond to and refute this statement.

2.

What is the essential difference between strict liability torts and negligent torts? Should the US legal
system even allow strict liability torts? What reasons seem persuasive to you?

[1] Pellman v. McDonald’s Corp., 237 F.2d 512 (S.D.N.Y. 2003).

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7.5 Cases
Intentional Torts: False Imprisonment
Lester v. Albers Super Markets, Inc.
94 Ohio App. 313, 114 N.E.2d 529 (Ohio 1952)
Facts: The plaintiff, carrying a bag of rolls purchased at another store, entered the defendant’s grocery
store to buy some canned fruit. Seeing her bus outside, she stepped out of line and put the can on the
counter. The store manager intercepted her and repeatedly demanded that she submit the bag to be
searched. Finally she acquiesced; he looked inside and said she could go. She testified that several people
witnessed the scene, which lasted about fifteen minutes, and that she was humiliated. The jury awarded
her $800. She also testified that no one laid a hand on her or made a move to restrain her from leaving by
any one of numerous exits.
***
MATTHEWS, JUDGE.
As we view the record, it raises the fundamental question of what is imprisonment. Before any need for a
determination of illegality arises there must be proof of imprisonment. In 35 Corpus Juris Secundum
(C.J.S.), False Imprisonment, § II, pages 512–13, it is said: “Submission to the mere verbal direction of
another, unaccompanied by force or by threats of any character, cannot constitute a false imprisonment,
and there is no false imprisonment where an employer interviewing an employee declines to terminate the
interview if no force or threat of force is used and false imprisonment may not be predicated on a person’s
unfounded belief that he was restrained.”
Many cases are cited in support of the text.
***
In Fenn v. Kroger Grocery & Baking Co., Mo. Sup., 209 S.W. 885, 887, the court said:

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A case was not made out for false arrest. The plaintiff said she was intercepted as she started to leave the
store; that Mr. Krause stood where she could not pass him in going out. She does not say that he made any
attempt to intercept her. She says he escorted her back to the desk, that he asked her to let him see the
change.
…She does not say that she went unwillingly…Evidence is wholly lacking to show that she was detained by
force or threats. It was probably a disagreeable experience, a humiliating one to her, but she came out
victorious and was allowed to go when she desired with the assurance of Mr. Krause that it was all right.
The demurrer to the evidence on both counts was properly sustained.
The result of the cases is epitomized in 22 Am.Jur. 368, as follows:
A customer or patron who apparently has not paid for what he has received may be detained for a
reasonable time to investigate the circumstances, but upon payment of the demand, he has the
unqualified right to leave the premises without restraint, so far as the proprietor is concerned, and it is
false imprisonment for a private individual to detain one for an unreasonable time, or under unreasonable
circumstances, for the purpose of investigating a dispute over the payment of a bill alleged to be owed by
the person detained for cash services.
***
For these reasons, the judgment is reversed and final judgment entered for the defendant-appellant.

CASE QUESTIONS
1.

The court begins by saying what false imprisonment is not. What is the legal definition of false
imprisonment?

2.

What kinds of detention are permissible for a store to use in accosting those that may have been
shoplifting?

3.

Jody broke up with Jeremy and refused to talk to him. Jeremy saw Jody get into her car near the business
school and parked right behind her so she could not move. He then stood next to the driver’s window for
fifteen minutes, begging Jody to talk to him. She kept saying, “No, let me leave!” Has Jeremy committed
the tort of false imprisonment?

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Negligence: Duty of Due Care
Whitlock v. University of Denver
744 P.2d 54 (Supreme Court of Colorado1987)
On June 19, 1978, at approximately 10:00 p.m., plaintiff Oscar Whitlock suffered a paralyzing injury while
attempting to complete a one-and-three-quarters front flip on a trampoline. The injury rendered him a
quadriplegic. The trampoline was owned by the Beta Theta Pi fraternity (the Beta house) and was situated
on the front yard of the fraternity premises, located on the University campus. At the time of his injury,
Whitlock was twenty years old, attended the University of Denver, and was a member of the Beta house,
where he held the office of acting house manager. The property on which the Beta house was located was
leased to the local chapter house association of the Beta Theta Pi fraternity by the defendant University of
Denver.
Whitlock had extensive experience jumping on trampolines. He began using trampolines in junior high
school and continued to do so during his brief tenure as a cadet at the United States Military Academy at
West Point, where he learned to execute the one-and-three-quarters front flip. Whitlock testified that he
utilized the trampoline at West Point every other day for a period of two months. He began jumping on
the trampoline owned by the Beta house in September of 1977. Whitlock recounted that in the fall and
spring prior to the date of his injury, he jumped on the trampoline almost daily. He testified further that
prior to the date of his injury, he had successfully executed the one-and-three-quarters front flip between
seventy-five and one hundred times.
During the evening of June 18 and early morning of June 19, 1978, Whitlock attended a party at the Beta
house, where he drank beer, vodka and scotch until 2:00 a.m. Whitlock then retired and did not awaken
until 2:00 p.m. on June 19. He testified that he jumped on the trampoline between 2:00 p.m. and 4:00
p.m., and again at 7:00 p.m. At 10:00 p.m., the time of the injury, there again was a party in progress at
the Beta house, and Whitlock was using the trampoline with only the illumination from the windows of
the fraternity house, the outside light above the front door of the house, and two street lights in the area.
As Whitlock attempted to perform the one-and-three-quarters front flip, he landed on the back of his
head, causing his neck to break.

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Whitlock brought suit against the manufacturer and seller of the trampoline, the University, the Beta
Theta Pi fraternity and its local chapter, and certain individuals in their capacities as representatives of
the Beta Theta Pi organizations. Whitlock reached settlements with all of the named defendants except
the University, so only the negligence action against the University proceeded to trial. The jury returned a
verdict in favor of Whitlock, assessing his total damages at $ 7,300,000. The jury attributed twenty-eight
percent of causal negligence to the conduct of Whitlock and seventy-two percent of causal negligence to
the conduct of the University. The trial court accordingly reduced the amount of the award against the
University to $ 5,256,000.
The University moved for judgment notwithstanding the verdict, or, in the alternative, a new trial. The
trial court granted the motion for judgment notwithstanding the verdict, holding that as a matter of law,
no reasonable jury could have found that the University was more negligent than Whitlock, and that the
jury’s monetary award was the result of sympathy, passion or prejudice.
A panel of the court of appeals reversed…by a divided vote. Whitlock v. University of Denver, 712 P.2d
1072 (Colo. App. 1985). The court of appeals held that the University owed Whitlock a duty of due care to
remove the trampoline from the fraternity premises or to supervise its use.…The case was remanded to
the trial court with orders to reinstate the verdict and damages as determined by the jury. The University
then petitioned for certiorari review, and we granted that petition.

II.
A negligence claim must fail if based on circumstances for which the law imposes no duty of care upon the
defendant for the benefit of the plaintiff. [Citations] Therefore, if Whitlock’s judgment against the
University is to be upheld, it must first be determined that the University owed a duty of care to take
reasonable measures to protect him against the injury that he sustained.
Whether a particular defendant owes a legal duty to a particular plaintiff is a question of law. [Citations]
“The court determines, as a matter of law, the existence and scope of the duty—that is, whether the
plaintiff’s interest that has been infringed by the conduct of the defendant is entitled to legal protection.”
[Citations] In Smith v. City & County of Denver, 726 P.2d 1125 (Colo. 1986), we set forth several factors to
be considered in determining the existence of duty in a particular case:

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Whether the law should impose a duty requires consideration of many factors including, for example, the
risk involved, the foreseeability and likelihood of injury as weighed against the social utility of the actor’s
conduct, the magnitude of the burden of guarding against injury or harm, and the consequences of placing
the burden upon the actor.
…A court’s conclusion that a duty does or does not exist is “an expression of the sum total of those
considerations of policy which lead the law to say that the plaintiff is [or is not] entitled to protection.”
…
We believe that the fact that the University is charged with negligent failure to act rather than negligent
affirmative action is a critical factor that strongly militates against imposition of a duty on the University
under the facts of this case. In determining whether a defendant owes a duty to a particular plaintiff, the
law has long recognized a distinction between action and a failure to act—“that is to say, between active
misconduct working positive injury to others [misfeasance] and passive inaction or a failure to take steps
to protect them from harm [nonfeasance].” W. Keeton, § 56, at 373. Liability for nonfeasance was slow to
receive recognition in the law. “The reason for the distinction may be said to lie in the fact that by
‘misfeasance’ the defendant has created a new risk of harm to the plaintiff, while by ‘nonfeasance’ he has
at least made his situation no worse, and has merely failed to benefit him by interfering in his
affairs.” Id. TheRestatement (Second) of Torts § 314 (1965) summarizes the law on this point as follows:
The fact that an actor realizes or should realize that action on his part is necessary for another’s aid or
protection does not of itself impose upon him a duty to take such action.
Imposition of a duty in all such cases would simply not meet the test of fairness under contemporary
standards.
In nonfeasance cases the existence of a duty has been recognized only during the last century in situations
involving a limited group of special relationships between parties. Such special relationships are
predicated on “some definite relation between the parties, of such a character that social policy justifies
the imposition of a duty to act.” W. Keeton, § 56, at 374. Special relationships that have been recognized
by various courts for the purpose of imposition of a duty of care include common carrier/passenger,

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innkeeper/guest, possessor of land/invited entrant, employer/employee, parent/child, and
hospital/patient. See Restatement (Second) of Torts § 314 A (1965); 3 Harper and James, § 18.6, at 722–
23. The authors of the Restatement (Second) of Torts § 314 A, comment b (1965), state that “the law
appears…to be working slowly toward a recognition of the duty to aid or protect in any relation of
dependence or of mutual dependence.”
…

III.
The present case involves the alleged negligent failure to act, rather than negligent action. The plaintiff
does not complain of any affirmative action taken by the University, but asserts instead that the
University owed to Whitlock the duty to assure that the fraternity’s trampoline was used only under
supervised conditions comparable to those in a gymnasium class, or in the alternative to cause the
trampoline to be removed from the front lawn of the Beta house.…If such a duty is to be recognized, it
must be grounded on a special relationship between the University and Whitlock. According to the
evidence, there are only two possible sources of a special relationship out of which such a duty could arise
in this case: the status of Whitlock as a student at the University, and the lease between the University and
the fraternity of which Whitlock was a member. We first consider the adequacy of the student-university
relationship as a possible basis for imposing a duty on the University to control or prohibit the use of the
trampoline, and then examine the provisions of the lease for that same purpose.

A.
The student-university relationship has been scrutinized in several jurisdictions, and it is generally agreed
that a university is not an insurer of its students’ safety. [Citations] The relationship between a university
and its students has experienced important change over the years. At one time, college administrators and
faculties stood in loco parentis to their students, which created a special relationship “that imposed a duty
on the college to exercise control over student conduct and, reciprocally, gave the students certain rights
of protection by the college.” Bradshaw, 612 F.2d at 139. However, in modern times there has evolved a
gradual reapportionment of responsibilities from the universities to the students, and a corresponding
departure from the in loco parentis relationship. Id. at 139–40. Today, colleges and universities are

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regarded as educational institutions rather than custodial ones. Beach, 726 P.2d at 419 (contrasting
colleges and universities with elementary and high schools).
…
…By imposing a duty on the University in this case, the University would be encouraged to exercise more
control over private student recreational choices, thereby effectively taking away much of the
responsibility recently recognized in students for making their own decisions with respect to private
entertainment and personal safety. Such an allocation of responsibility would “produce a repressive and
inhospitable environment, largely inconsistent with the objectives of a modern college
education.” Beach, 726 P.2d at 419.
The evidence demonstrates that only in limited instances has the University attempted to impose
regulations or restraints on the private recreational pursuits of its students, and the students have not
looked to the University to assure the safety of their recreational choices. Nothing in the University’s
student handbook, which contains certain regulations concerning student conduct, reflects an effort by
the University to control the risk-taking decisions of its students in their private recreation.…Indeed,
fraternity and sorority self-governance with minimal supervision appears to have been fostered by the
University.
…
Aside from advising the Beta house on one occasion to put the trampoline up when not in use, there is no
evidence that the University officials attempted to assert control over trampoline use by the fraternity
members. We conclude from this record that the University’s very limited actions concerning safety of
student recreation did not give Whitlock or the other members of campus fraternities or sororities any
reason to depend upon the University for evaluation of the safety of trampoline use.…Therefore, we
conclude that the student-university relationship is not a special relationship of the type giving rise to a
duty of the University to take reasonable measures to protect the members of fraternities and sororities
from risks of engaging in extra-curricular trampoline jumping.

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The plaintiff asserts, however, that we should recognize a duty of the University to take affirmative action
to protect fraternity members because of the foreseeability of the injury, the extent of the risks involved in
trampoline use, the seriousness of potential injuries, and the University’s superior knowledge concerning
these matters. The argument in essence is that a duty should spring from the University’s natural interest
in the welfare and safety of its students, its superior knowledge of the nature and degree of risk involved
in trampoline use, and its knowledge of the use of trampolines on the University campus. The evidence
amply supports a conclusion that trampoline use involves risks of serious injuries and that the potential
for an injury such as that experienced by Whitlock was foreseeable. It shows further that prior injuries
resulting from trampoline accidents had been reported to campus security and to the student clinic, and
that University administrators were aware of the number and severity of trampoline injuries nationwide.
The record, however, also establishes through Whitlock’s own testimony that he was aware of the risk of
an accident and injury of the very nature that he experienced.…
We conclude that the relationship between the University and Whitlock was not one of dependence with
respect to the activities at issue here, and provides no basis for the recognition of a duty of the University
to take measures for protection of Whitlock against the injury that he suffered.

B.
We next examine the lease between the University and the fraternity to determine whether a special
relationship between the University and Whitlock can be predicated on that document. The lease was
executed in 1929, extends for a ninety-nine year term, and gives the fraternity the option to extend the
term for another ninety-nine years. The premises are to be occupied and used by the fraternity “as a
fraternity house, clubhouse, dormitory and boarding house, and generally for religious, educational, social
and fraternal purposes.” Such occupation is to be “under control of the tenant.” (emphasis added) The
annual rental at all times relevant to this case appears from the record to be one dollar. The University has
the obligation to maintain the grounds and make necessary repairs to the building, and the fraternity is to
bear the cost of such maintenance and repair.
…

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We conclude that the lease, and the University’s actions pursuant to its rights under the lease, provide no
basis of dependence by the fraternity members upon which a special relationship can be found to exist
between the University and the fraternity members that would give rise to a duty upon the University to
take affirmative action to assure that recreational equipment such as a trampoline is not used under
unsafe conditions.

IV.
Considering all of the factors presented, we are persuaded that under the facts of this case the University
of Denver had no duty to Whitlock to eliminate the private use of trampolines on its campus or to
supervise that use. There exists no special relationship between the parties that justifies placing a duty
upon the University to protect Whitlock from the well-known dangers of using a trampoline. Here, a
conclusion that a special relationship existed between Whitlock and the University sufficient to warrant
the imposition of liability for nonfeasance would directly contravene the competing social policy of
fostering an educational environment of student autonomy and independence.
We reverse the judgment of the court of appeals and return this case to that court with directions to
remand it to the trial court for dismissal of Whitlock’s complaint against the University.

CASE QUESTIONS
1.

How are comparative negligence numbers calculated by the trial court? How can the jury say that the
university is 72 percent negligent and that Whitlock is 28 percent negligent?

2.

Why is this not an assumption of risk case?

3.

Is there any evidence that Whitlock was contributorily negligent? If not, why would the court engage in
comparative negligence calculations?

Negligence: Proximate Cause
Palsgraf v. Long Island R.R.
248 N.Y. 339,162 N.E. 99 (N.Y. 1928)
CARDOZO, Chief Judge

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Plaintiff was standing on a platform of defendant’s railroad after buying a ticket to go to Rockaway Beach.
A train stopped at the station, bound for another place. Two men ran forward to catch it. One of the men
reached the platform of the car without mishap, though the train was already moving. The other man,
carrying a package, jumped aboard the car, but seemed unsteady as if about to fall. A guard on the car,
who had held the door open, reached forward to help him in, and another guard on the platform pushed
him from behind. In this act, the package was dislodged, and fell upon the rails. It was a package of small
size, about fifteen inches long, and was covered by a newspaper. In fact it contained fireworks, but there
was nothing in its appearance to give notice of its contents. The fireworks when they fell exploded. The
shock of· the explosion threw down some scales at the other end of the platform many feet away. The
scales struck the plaintiff, causing injuries for which she sues.
The conduct of the defendant’s guard, if a wrong in its relation to the holder of the package, was not a
wrong in its relation to the plaintiff, standing far away. Relatively to her it was not negligence at all.
Nothing in the situation gave notice that the falling package had in it the potency of peril to persons thus
removed. Negligence is not actionable unless it involves the invasion of a legally protected interest, the
violation of a right. “Proof of negligence in the air, so to speak, will not do.…If no hazard was apparent to
the eye of ordinary vigilance, an act innocent and harmless, at least to outward seeming, with reference to
her, did not take to itself the quality of a tort because it happened to be a wrong, though apparently not
one involving the risk of bodily insecurity, with reference to someone else.…The plaintiff sues in her own
right for a wrong personal to her, and not as the vicarious beneficiary of a breach of duty to another.
A different conclusion will involve us, and swiftly too, in a maze of contradictions. A guard stumbles over
a package which has been left upon a platform.
It seems to be a bundle of newspapers. It turns out to be a can of dynamite. To the eye of ordinary
vigilance, the bundle is abandoned waste, which may be kicked or trod on with impunity. Is a passenger at
the other end of the platform protected by the law against the unsuspected hazard concealed beneath the
waste? If not, is the result to be any different, so far as the distant passenger is concerned, when the guard
stumbles over a valise which a truckman or a porter has left upon the walk?…The orbit of the danger as
disclosed to the eye of reasonable vigilance would be the orbit of the duty. One who jostles one’s neighbor
in a crowd does not invade the rights of others standing at the outer fringe when the unintended contact

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casts a bomb upon the ground. The wrongdoer as to them is the man who carries the bomb, not the one
who explodes it without suspicion of the danger. Life will have to be made over, and human nature
transformed, before prevision so extravagant can be accepted as the norm of conduct, the customary
standard to which behavior must conform.
The argument for the plaintiff is built upon the shifting meanings of such words as “wrong” and
“wrongful” and shares their instability. For what the plaintiff must show is a “wrong” to herself; i.e., a
violation of her own right, and not merely a “wrong” to someone else, nor conduct “wrongful” because
unsocial, but not a “wrong” to anyone. We are told that one who drives at reckless speed through a
crowded city street is guilty of a negligent act and therefore of a wrongful one, irrespective of the
consequences.
Negligent the act is, and wrongful in the sense that it is unsocial, but wrongful and unsocial in relation to
other travelers, only because the eye of vigilance perceives the risk of damage. If the same act were to be
committed on a speedway or a race course, it would lose its wrongful quality. The risk reasonably to be
perceived defines the duty to be obeyed, and risk imports relation; it is risk to another or to others within
the range of apprehension. This does not mean, of course, that one who launches a destructive force is
always relieved of liability, if the force, though known to be destructive, pursues an unexpected
path.…Some acts, such as shooting are so imminently dangerous to anyone who may come within reach of
the missile however unexpectedly, as to impose a duty of prevision not far from that of an insurer. Even
today, and much oftener in earlier stages of the law, one acts sometimes at one’s peril.…These cases aside,
wrong-is defined in terms of the natural or probable, at least when unintentional.…Negligence, like risk, is
thus a term of relation.
Negligence in the abstract, apart from things related, is surely not a tort, if indeed it is understandable at
all.…One who seeks redress at law does not make out a cause of action by showing without more that
there has been damage to his person. If the harm was not willful, he must show that the act as to him had
possibilities of danger so many and apparent as to entitle him to be protected against the doing of it
though the harm was unintended.
***

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The judgment of the Appellate Division and that of the Trial Term should be reversed, and the complaint
dismissed, with costs in all courts.

CASE QUESTIONS
1.

Is there actual cause in this case? How can you tell?

2.

Why should Mrs. Palsgraf (or her insurance company) be made to pay for injuries that were caused by the
negligence of the Long Island Rail Road?

3.

How is this accident not foreseeable?

Klein v. Pyrodyne Corporation
Klein v. Pyrodyne Corporation
810 P.2d 917 (Supreme Court of Washington 1991)
Pyrodyne Corporation (Pyrodyne) is a licensed fireworks display company that contracted to display
fireworks at the Western Washington State Fairgrounds in Puyallup, Washington, on July 4,1987. During
the fireworks display, one of the mortar launchers discharged a rocket on a horizontal trajectory parallel
to the earth. The rocket exploded near a crowd of onlookers, including Danny Klein. Klein’s clothing was
set on fire, and he suffered facial burns and serious injury to his eyes. Klein sued Pyrodyne for strict
liability to recover for his injuries. Pyrodyne asserted that the Chinese manufacturer of the fireworks was
negligent in producing the rocket and therefore Pyrodyne should not be held liable. The trial court applied
the doctrine of strict liability and held in favor of Klein. Pyrodyne appealed.
Section 519 of the Restatement (Second) of Torts provides that any party carrying on an “abnormally
dangerous activity” is strictly liable for ensuing damages. The public display of fireworks fits this
definition. The court stated: “Any time a person ignites rockets with the intention of sending them aloft to
explode in the presence of large crowds of people, a high risk of serious personal injury or property
damage is created. That risk arises because of the possibility that a rocket will malfunction or be
misdirected.” Pyrodyne argued that its liability was cut off by the Chinese manufacturer’s negligence. The
court rejected this argument, stating, “Even if negligence may properly be regarded as an intervening
cause, it cannot function to relieve Pyrodyne from strict liability.”

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The Washington Supreme Court held that the public display of fireworks is an abnormally dangerous
activity that warrants the imposition of strict liability.
Affirmed.

CASE QUESTIONS
1.

Why would certain activities be deemed ultrahazardous or abnormally dangerous so that strict liability is
imposed?

2.

If the activities are known to be abnormally dangerous, did Klein assume the risk?

3.

Assume that the fireworks were negligently manufactured in China. Should Klein’s only remedy be against
the Chinese company, as Pyrodyne argues? Why or why not?

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7.6 Summary and Exercises
Summary
The principles of tort law pervade modern society because they spell out the duties of care that we owe
each other in our private lives. Tort law has had a significant impact on business because modern
technology poses significant dangers and the modern market is so efficient at distributing goods to a wide
class of consumers.
Unlike criminal law, tort law does not require the tortfeasor to have a specific intent to commit the act for
which he or she will be held liable to pay damages. Negligence—that is, carelessness—is a major factor in
tort liability. In some instances, especially in cases involving injuries caused by products, a no-fault
standard called strict liability is applied.
What constitutes a legal injury depends very much on the circumstances. A person can assume a risk or
consent to the particular action, thus relieving the person doing the injury from tort liability. To be liable,
the tortfeasor must be the proximate cause of the injury, not a remote cause. On the other hand, certain
people are held to answer for the torts of another—for example, an employer is usually liable for the torts
of his employees, and a bartender might be liable for injuries caused by someone to whom he sold too
many drinks. Two types of statutes—workers’ compensation and no-fault automobile insurance—have
eliminated tort liability for certain kinds of accidents and replaced it with an immediate insurance
payment plan.
Among the torts of particular importance to the business community are wrongful death and personal
injury caused by products or acts of employees, misrepresentation, defamation, and interference with
contractual relations.

EXERCISES
1.

What is the difference in objectives between tort law and criminal law?

2.

A woman fell ill in a store. An employee put the woman in an infirmary but provided no medical care for
six hours, and she died. The woman’s family sued the store for wrongful death. What arguments could

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the store make that it was not liable? What arguments could the family make? Which seem the stronger
arguments? Why?
3.

The signals on a railroad crossing are defective. Although the railroad company was notified of the
problem a month earlier, the railroad inspector has failed to come by and repair them. Seeing the all-clear
signal, a car drives up and stalls on the tracks as a train rounds the bend. For the past two weeks the car
had been stalling, and the driver kept putting off taking the car to the shop for a tune-up. As the train
rounds the bend, the engineer is distracted by a conductor and does not see the car until it is too late to
stop. Who is negligent? Who must bear the liability for the damage to the car and to the train?

4.

Suppose in the Katko v. Briney case (Section 7.2 "Intentional Torts") that instead of setting such a device,
the defendants had simply let the floor immediately inside the front door rot until it was so weak that
anybody who came in and took two steps straight ahead would fall through the floor and to the cellar.
Will the defendant be liable in this case? What if they invited a realtor to appraise the place and did not
warn her of the floor? Does it matter whether the injured person is a trespasser or an invitee?

5.

Plaintiff’s husband died in an accident, leaving her with several children and no money except a valid
insurance policy by which she was entitled to $5,000. Insurance Company refused to pay, delaying and
refusing payment and meanwhile “inviting” Plaintiff to accept less than $5,000, hinting that it had a
defense. Plaintiff was reduced to accepting housing and charity from relatives. She sued the insurance
company for bad-faith refusal to settle the claim and for the intentional infliction of emotional distress.
The lower court dismissed the case. Should the court of appeals allow the matter to proceed to trial?

SELF-TEST QUESTIONS
1.

Catarina falsely accuses Jeff of stealing from their employer. The statement is defamatory only if
a.

a third party hears it

b.

Nick suffers severe emotional distress as a result

c.

the statement is the actual and proximate cause of his distress

d.

the statement is widely circulated in the local media and on Twitter
Garrett files a suit against Colossal Media Corporation for defamation. Colossal has said that

Garrett is a “sleazy, corrupt public official” (and provided some evidence to back the claim). To
win his case, Garrett will have to show that Colossal acted with

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a. malice
b. ill will
c. malice aforethought
d. actual malice
Big Burger begins a rumor, using social media, that the meat in Burger World is partly composed
of ground-up worms. The rumor is not true, as Big Burger well knows. Its intent is to get some
customers to shift loyalty from Burger World to Big Burger. Burger World’s best cause of action
would be
a.

trespass on the case

b.

nuisance

c.

product disparagement

d.

intentional infliction of emotional distress
Wilfred Phelps, age 65, is driving his Nissan Altima down Main Street when he suffers the first
seizure of his life. He loses control of his vehicle and runs into three people on the sidewalk.
Which statement is true?

a.

He is liable for an intentional tort.

b.

He is liable for a negligent tort.

c.

He is not liable for a negligent tort.

d.

He is liable under strict liability, because driving a car is abnormally dangerous.
Jonathan carelessly bumps into Amanda, knocking her to the ground. He has committed the tort
of negligence

a.

only if Amanda is injured

b.

only if Amanda is not injured

c.

whether or not Amanda is injured

SELF-TEST ANSWERS
1.

a

2.

d

3.

c

4.

c

5.

a

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Chapter 8

Introduction to Contract Law
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

Why and how contract law has developed

2.

What a contract is

3.

What topics will be discussed in the contracts chapter of this book

4.

What the sources of contract law are

5.

How contracts are classified (basic taxonomy)

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8.1 General Perspectives on Contracts
LEARNING OBJECTIVES
1.

Explain contract law’s cultural roots: how it has evolved as capitalism has evolved.

2.

Understand that contracts serve essential economic purposes.

3.

Define contract.

4.

Understand the basic issues in contract law.

The Role of Contracts in Modern Society
Contract is probably the most familiar legal concept in our society because it is so central to the essence of
our political, economic, and social life. In common parlance, contract is used interchangeably
with agreement, bargain, undertaking, or deal. Whatever the word, the concept it embodies is our notion
of freedom to pursue our own lives together with others. Contract is central because it is the means by
which a free society orders what would otherwise be a jostling, frenetic anarchy.
So commonplace is the concept of contract—and our freedom to make contracts with each other—that it is
difficult to imagine a time when contracts were rare, when people’s everyday associations with one
another were not freely determined. Yet in historical terms, it was not so long ago that contracts were
rare, entered into if at all by very few: that affairs should be ordered based on mutual assent was mostly
unknown. In primitive societies and in feudal Europe, relationships among people were largely fixed;
traditions spelled out duties that each person owed to family, tribe, or manor. People were born into an
ascribed position—a status (not unlike the caste system still existing in India)—and social mobility was
limited. Sir Henry Maine, a nineteenth-century British historian, wrote that “the movement of the
progressive societies has…been a movement from status to contract.”

[1]

This movement was not

accidental—it developed with the emerging industrial order. From the fifteenth to the nineteenth century,
England evolved into a booming mercantile economy, with flourishing trade, growing cities, an expanding
monetary system, the commercialization of agriculture, and mushrooming manufacturing. With this
evolution, contract law was created of necessity.
Contract law did not develop according to a conscious plan, however. It was a response to changing
conditions, and the judges who created it frequently resisted, preferring the imagined quieter pastoral life

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of their forefathers. Not until the nineteenth century, in both the United States and England, did a fullfledged law of contracts arise together with, and help create, modern capitalism.
Modern capitalism, indeed, would not be possible without contract law. So it is that in planned
economies, like those of the former Soviet Union and precapitalistic China, the contract did not determine
the nature of an economic transaction. That transaction was first set forth by the state’s planning
authorities; only thereafter were the predetermined provisions set down in a written contract. Modern
capitalism has demanded new contract regimes in Russia and China; the latter adopted its Revised
Contract Law in 1999.
Contract law may be viewed economically as well as culturally. In An Economic Analysis of Law, Judge
Richard A. Posner (a former University of Chicago law professor) suggests that contract law performs
three significant economic functions. First, it helps maintain incentives for individuals to exchange goods
and services efficiently. Second, it reduces the costs of economic transactions because its very existence
means that the parties need not go to the trouble of negotiating a variety of rules and terms already
spelled out. Third, the law of contracts alerts the parties to troubles that have arisen in the past, thus
making it easier to plan the transactions more intelligently and avoid potential pitfalls.

[2]

The Definition of Contract
As usual in the law, the legal definition of contract is formalistic. The Restatement (Second) of Contracts
(Section 1) says, “A contract is a promise or a set of promises for the breach of which the law gives a
remedy, or the performance of which the law in some way recognizes as a duty.” Similarly, the Uniform
Commercial Code says, “‘Contract’ means the total legal obligation which results from the parties’
agreement as affected by this Act and any other applicable rules of law.”

[3]

As operational definitions,

these two are circular; in effect, a contract is defined as an agreement that the law will hold the parties to.
Most simply, a contract is a legally enforceable promise. This implies that not every promise or agreement
creates a binding contract; if every promise did, the simple definition set out in the preceding sentence
would read, “A contract is a promise.” But—again—a contract is not simply a promise: it is a legally
enforceable promise. The law takes into account the way in which contracts are made, by whom they are

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made, and for what purposes they are made. For example, in many states, a wager is unenforceable, even
though both parties “shake” on the bet. We will explore these issues in the chapters to come.

Overview of the Contracts Chapter
Although contract law has many wrinkles and nuances, it consists of four principal inquiries, each of
which will be taken up in subsequent chapters:
1.

Did the parties create a valid contract? Four elements are necessary for a valid contract:
a.

Mutual assent (i.e., offer and acceptance), Chapter 9 "The Agreement"

b. Real assent (no duress, undue influence, misrepresentation, mistake, or
incapacity), Chapter 10 "Real Assent"
c.

Consideration, Chapter 11 "Consideration"

d. Legality, Chapter 12 "Legality"
2. What does the contract mean, and is it in the proper form to carry out this meaning? Sometimes
contracts need to be in writing (or evidenced by some writing), or they can’t be enforced.
Sometimes it isn’t clear what the contract means, and a court has to figure that out. These
problems are taken up inChapter 13 "Form and Meaning".
3. Do persons other than the contracting parties have rights or duties under the contract? Can the
right to receive a benefit from the contract be assigned, and can the duties be delegated so that a
new person is responsible? Can persons not a party to the contract sue to enforce its terms? These
questions are addressed in Chapter 14 "Third-Party Rights".
4. How do contractual duties terminate, and what remedies are available if a party has breached the
contract? These issues are taken up in Chapter 15 "Discharge of Obligations" and Chapter 16
"Remedies".
Together, the answers to these four basic inquiries determine the rights and obligations of contracting
parties.

KEY TAKEAWAY
Contract law developed when the strictures of feudalism dissipated, when a person’s position in society came
to be determined by personal choice (by mutual agreement) and not by status (by how a person was born).

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Capitalism and contract law have developed together, because having choices in society means that people
decide and agree to do things with and to each other, and those agreements bind the parties; the agreements
must be enforceable.

EXERCISES
1.

Why is contract law necessary in a society where a person’s status is not predetermined by birth?

2.

Contract law serves some economic functions. What are they?

[1] Sir Henry Maine, Ancient Law (1869), 180–82.
[2] Richard A. Posner, Economic Analysis of Law (New York: Aspen, 1973).
[3] Uniform Commercial Code, Section 1-201(11).

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8.2 Sources of Contract Law
LEARNING OBJECTIVES
1.

Understand that contract law comes from two sources: judges (cases) and legislation.

2.

Know what the Restatement of Contracts is.

3.

Recognize the Convention on Contracts for the International Sale of Goods.

The most important sources of contract law are state case law and state statutes (though there are also
many federal statutes governing how contracts are made by and with the federal government).

Case Law
Law made by judges is called case law. Because contract law was made up in the common-law courtroom
by individual judges as they applied rules to resolve disputes before them, it grew over time to formidable
proportions. By the early twentieth century, tens of thousands of contract disputes had been submitted to
the courts for resolution, and the published opinions, if collected in one place, would have filled dozens of
bookshelves. Clearly this mass of material was too unwieldy for efficient use. A similar problem also had
developed in the other leading branches of the common law.
Disturbed by the profusion of cases and the resulting uncertainty of the law, a group of prominent
American judges, lawyers, and law teachers founded the American Law Institute (ALI) in 1923 to attempt
to clarify, simplify, and improve the law. One of the ALI’s first projects, and ultimately one of its most
successful, was the drafting of the Restatement of the Law of Contracts, completed in 1932. A revision—
the Restatement (Second) of Contracts—was undertaken in 1964 and completed in 1979. Hereafter,
references to “the Restatement” pertain to the Restatement (Second) of Contracts.
The Restatements—others exist in the fields of torts, agency, conflicts of laws, judgments, property,
restitution, security, and trusts—are detailed analyses of the decided cases in each field. These analyses
are made with an eye to discerning the various principles that have emerged from the courts, and to the
maximum extent possible, the Restatements declare the law as the courts have determined it to be. The
Restatements, guided by a reporter (the director of the project) and a staff of legal scholars, go through

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several so-called tentative drafts—sometimes as many as fifteen or twenty—and are screened by various
committees within the ALI before they are eventually published as final documents.
The Restatement (Second) of Contracts won prompt respect in the courts and has been cited in
innumerable cases. The Restatements are not authoritative, in the sense that they are not actual judicial
precedents; but they are nevertheless weighty interpretive texts, and judges frequently look to them for
guidance. They are as close to “black letter” rules of law as exist anywhere in the American common-law
legal system.
Common law, case law (the terms are synonymous), governs contracts for the sale of real estate and
services. “Services” refer to acts or deeds (like plumbing, drafting documents, driving a car) as opposed to
the sale of property.

Statutory Law: The Uniform Commercial Code
Common-law contract principles govern contracts for real estate and services. Because of the historical
development of the English legal system, contracts for the sale of goods came to be governed by a different
body of legal rules. In its modern American manifestation, that body of rules is an important statute: the
Uniform Commercial Code (UCC), especially Article 2, which deals with the sale of goods.

History of the UCC
A bit of history is in order. Before the UCC was written, commercial law varied, sometimes greatly, from
state to state. This first proved a nuisance and then a serious impediment to business as the American
economy became nationwide during the twentieth century. Although there had been some uniform laws
concerned with commercial deals—including the Uniform Sales Act, first published in 1906—few were
widely adopted and none nationally. As a result, the law governing sales of goods, negotiable instruments,
warehouse receipts, securities, and other matters crucial to doing business in an industrial market
economy was a crazy quilt of untidy provisions that did not mesh well from state to state.
The UCC is a model law developed by the ALI and the National Conference of Commissioners on Uniform
State Laws; it has been adopted in one form or another by the legislatures in all fifty states, the District of

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Columbia, and the American territories. It is a “national” law not enacted by Congress—it is not federal
law but uniform state law.
Initial drafting of the UCC began in 1942 and was ten years in the making, involving the efforts of
hundreds of practicing lawyers, law teachers, and judges. A final draft, promulgated by the ALI, was
endorsed by the American Bar Association and published in 1951. Various revisions followed in different
states, threatening the uniformity of the UCC. The ALI responded by creating a permanent editorial board
to oversee future revisions. In one or another of its various revisions, the UCC has been adopted in whole
or in part in all American jurisdictions. The UCC is now a basic law of relevance to every business and
business lawyer in the United States, even though it is not entirely uniform because different states have
adopted it at various stages of its evolution—an evolution that continues still.

Organization of the UCC
The UCC consists of nine major substantive articles; each deals with separate though related subjects. The
articles are as follows:
•

Article 1: General Provisions

•

Article 2: Sales

•

Article 2A: Leases

•

Article 3: Commercial Paper

•

Article 4: Bank Deposits and Collections

•

Article 4A: Funds Transfers

•

Article 5: Letters of Credit

•

Article 6: Bulk Transfers

•

Article 7: Warehouse Receipts, Bills of Lading, and Other Documents of Title

•

Article 8: Investment Securities

•

Article 9: Secured Transactions

Article 2 deals only with the sale of goods, which the UCC defines as “all things…which are movable at the
time of identification to the contract for sale other than the money in which the price is to be paid.”

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The

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only contracts and agreements covered by Article 2 are those relating to the present or future sale of
goods.
Article 2 is divided in turn into six major parts: (1) Form, Formation, and Readjustment of Contract; (2)
General Obligation and Construction of Contract; (3) Title, Creditors, and Good Faith Purchasers; (4)
Performance; (5) Breach, Repudiation, and Excuse; and (6) Remedies.
Figure 8.1 Sources of Law

International Sales Law
The Convention on Contracts for the International Sale of Goods
A Convention on Contracts for the International Sale of Goods (CISG)was approved in 1980 at a
diplomatic conference in Vienna. (A convention is a preliminary agreement that serves as the basis for a
formal treaty.) The CISG has been adopted by more than forty countries, including the United States.
The CISG is significant for three reasons. First, it is a uniform law governing the sale of goods—in effect,
an international Uniform Commercial Code. The major goal of the drafters was to produce a uniform law
acceptable to countries with different legal, social, and economic systems. Second, although provisions in
the CISG are generally consistent with the UCC, there are significant differences. For instance, under the
CISG, consideration (discussed in Chapter 11 "Consideration") is not required to form a contract, and
there is no Statute of Frauds (a requirement that certain contracts be evidenced by a writing). Third, the
CISG represents the first attempt by the US Senate to reform the private law of business through its treaty
powers, for the CISG preempts the UCC. The CISG is not mandatory: parties to an international contract
for the sale of goods may choose to have their agreement governed by different law, perhaps the UCC, or

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perhaps, say, Japanese contract law. The CISG does not apply to contracts for the sale of (1) ships or
aircraft, (2) electricity, or (3) goods bought for personal, family, or household use, nor does it apply (4)
where the party furnishing the goods does so only incidentally to the labor or services part of the contract.

KEY TAKEAWAY
Judges have made contract law over several centuries by deciding cases that create, extend, or change the
developing rules affecting contract formation, performance, and enforcement. The rules from the cases have
been abstracted and organized in the Restatements of Contracts. To facilitate interstate commerce, contract
law for many commercial transactions—especially the sale of goods—not traditionally within the purview of
judges has been developed by legal scholars and presented for the states to adopt as the Uniform Commercial
Code. There is an analogous Convention on Contracts for the International Sale of Goods, to which the United
States is a party.

EXERCISES
1.

How do judges make contract law?

2.

What is the Restatement of the Law of Contracts, and why was it necessary?

3.

Why was the Uniform Commercial Code developed, and by whom?

4.

Who adopts the UCC as governing law?

5.

What is the Convention on Contracts for the International Sale of Goods?

[1] Uniform Commercial Code, Section 2-105.

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8.3 Basic Taxonomy of Contracts
LEARNING OBJECTIVES
1.

Understand that contracts are classified according to the criteria of explicitness, mutuality,
enforceability, and degree of completion and that some noncontract promises are nevertheless
enforceable under the doctrine of promissory estoppel.

2.

Keep your eyes (and ears) alert to the use of suffixes (word endings) in legal terminology that express
relationships between parties.

Some contracts are written, some oral; some are explicit, some not. Because contracts can be formed,
expressed, and enforced in a variety of ways, a taxonomy of contracts has developed that is useful in
grouping together like legal consequences. In general, contracts are classified along four different
dimensions: explicitness, mutuality, enforceability, and degree of completion. Explicitness is the degree to
which the agreement is manifest to those not party to it. Mutuality takes into account whether promises
are given by two parties or only one. Enforceability is the degree to which a given contract is binding.
Completion considers whether the contract is yet to be performed or whether the obligations have been
fully discharged by one or both parties. We will examine each of these concepts in turn.

Explicitness
Express Contract
An express contract is one in which the terms are spelled out directly. The parties to an express contract,
whether it is written or oral, are conscious that they are making an enforceable agreement. For example,
an agreement to purchase your neighbor’s car for $5,500 and to take title next Monday is an express
contract.

Implied Contract (Implied in Fact)
An implied contract is one that is inferred from the actions of the parties. When parties have not
discussed terms, an implied contract exists if it is clear from the conduct of both parties that they intended
there be one. A delicatessen patron who asks for a turkey sandwich to go has made a contract and is

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obligated to pay when the sandwich is made. By ordering the food, the patron is implicitly agreeing to the
price, whether posted or not.
The distinction between express and implied contracts has received a degree of notoriety in the so-called
palimony cases, in which one member of an unmarried couple seeks a division of property after a longstanding live-together relationship has broken up. When a married couple divorces, their legal marriage
contract is dissolved, and financial rights and obligations are spelled out in a huge body of domestic
relations statutes and judicial decisions. No such laws exist for unmarried couples. However, about onethird of the states recognize common-law marriage, under which two people are deemed to be married if
they live together with the intent to be married, regardless of their failure to have obtained a license or
gone through a ceremony. Although there is no actual contract of marriage (no license), their behavior
implies that the parties intended to be treated as if they were married.

Quasi-Contract
A quasi-contract (implied in law) is—unlike both express and implied contracts, which embody an actual
agreement of the parties—an obligation said to be “imposed by law” in order to avoid unjust enrichment of
one person at the expense of another. A quasi-contract is not a contract at all; it is a fiction that the courts
created to prevent injustice. Suppose, for example, that the local lumberyard mistakenly delivers a load of
lumber to your house, where you are repairing your deck. It was a neighbor on the next block who ordered
the lumber, but you are happy to accept the load for free; since you never talked to the lumberyard, you
figure you need not pay the bill. Although it is true there is no contract, the law implies a contract for the
value of the material: of course you will have to pay for what you got and took. The existence of this
implied contract does not depend on the intention of the parties.

Mutuality
Bilateral Contract
The typical contract is one in which the parties make mutual promises. Each is both promisor and
promisee; that is, each pledges to do something, and each is the recipient of such a pledge. This type of
contract is called a bilateral contract.

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Unilateral Contract
Mutual promises are not necessary to constitute a contract. Unilateral contracts, in which one party
performs an act in exchange for the other party’s promise, are equally valid. An offer of a reward—for
catching a criminal or for returning a lost cat—is an example of a unilateral contract: there is an offer on
one side, and the other side accepts by taking the action requested.
Figure 8.2 Bilateral and Unilateral Contracts

Enforceability
Void
Not every agreement between two people is a binding contract. An agreement that is lacking one of the
legal elements of a contract is said to be avoid contract—that is, not a contract at all. An agreement that is
illegal—for example, a promise to commit a crime in return for a money payment—is void. Neither party
to a void “contract” may enforce it.

Voidable
By contrast, a voidable contract is one that may become unenforceable by one party but can be enforced
by the other. For example, a minor (any person under eighteen, in most states) may “avoid” a contract
with an adult; the adult may not enforce the contract against the minor if the minor refuses to carry out
the bargain. But the adult has no choice if the minor wishes the contract to be performed. (A contract may
be voidable by both parties if both are minors.)

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Ordinarily, the parties to a voidable contract are entitled to be restored to their original condition.
Suppose you agree to buy your seventeen-year-old neighbor’s car. He delivers it to you in exchange for
your agreement to pay him next week. He has the legal right to terminate the deal and recover the car, in
which case you will of course have no obligation to pay him. If you have already paid him, he still may
legally demand a return to the status quo ante (previous state of affairs). You must return the car to him;
he must return the cash to you.
A voidable contract remains a valid contract until it is voided. Thus a contract with a minor remains in
force unless the minor decides he or she does not wish to be bound by it. When the minor reaches
majority, he or she may “ratify” the contract—that is, agree to be bound by it—in which case the contract
will no longer be voidable and will thereafter be fully enforceable.

Unenforceable
An unenforceable contract is one that some rule of law bars a court from enforcing. For example, Tom
owes Pete money, but Pete has waited too long to collect it and the statute of limitations has run out. The
contract for repayment is unenforceable and Pete is out of luck, unless Tom makes a new promise to pay
or actually pays part of the debt. (However, if Pete is holding collateral as security for the debt, he is
entitled to keep it; not all rights are extinguished because a contract is unenforceable.) A debt becomes
unenforceable, too, when the debtor declares bankruptcy.
A bit more on enforceability is in order. A promise or what seems to be a promise is usually enforceable
only if it is otherwise embedded in the elements necessary to make that promise a contract. Those
elements are mutual assent, real assent, consideration, capacity, and legality. Sometimes, though, people
say things that seem like promises, and on which another person relies. In the early twentieth century,
courts began, in some circumstances, to recognize that insisting on the existence of the traditional
elements of contract to determine whether a promise is enforceable could work an injustice where there
has been reliance. Thus developed the equitable doctrine of promissory estoppel, which has become an
important adjunct to contract law. The Restatement (Section 90) puts it this way: “A promise which the
promisor should reasonably expect to induce action or forbearance on the party of the promisee or a third

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person and which does induce such action or forbearance is binding if injustice can be avoided only by
enforcement of the promise. The remedy granted for breach may be limited as justice requires.”
To be “estopped” means to be prohibited from denying now the validity of a promise you made before.
The doctrine has an interesting background. In 1937, High Trees House Ltd. (a British corporation) leased
a block of London apartments from Central London Properties. As World War II approached, vacancy
rates soared because people left the city. In 1940 the parties agreed to reduce the rent rates by half, but no
term was set for how long the reduction would last. By mid-1945, as the war was ending, occupancy was
again full, and Central London sued for the full rental rates from June on. The English court, under Judge
Alfred Thompson Denning (1899–1999), had no difficulty finding that High Trees owed the full amount
once full occupancy was again achieved, but Judge Denning went on. In an aside (called a dicta—a
statement “by the way”—that is, not necessary as part of the decision), he mused about what would have
happened if in 1945 Central London had sued for the full-occupancy rate back to 1940. Technically, the
1940 amendment to the 1937 contract was not binding on Central London—it lacked consideration—and
Central London could have reached back to demand full-rate payment. But Judge Denning said that High
Trees would certainly have relied on Central London’s promise that a reduced-rate rent would be
acceptable, and that would have been enough to bind it, to prevent it from acting inconsistently with the
promise. He wrote, “The courts have not gone so far as to give a cause of action in damages for the breach
of such a promise, but they have refused to allow the party making it to act inconsistently with it.”

[1]

In the years since, though, courts have gone so far as to give a cause of action in damages for various
noncontract promises. Contract protects agreements; promissory estoppel protects reliance, and that’s a
significant difference. The law of contracts continues to evolve.

Degree of Completion
An agreement consisting of a set of promises is called an executory contract before any promises are
carried out. Most executory contracts are enforceable. If John makes an agreement to deliver wheat to
Humphrey and does so, the contract is called a partially executed contract: one side has performed, the
other has not. When John pays for the wheat, the contract is fully performed. A contract that has been
carried out fully by both parties is called an executed contract.

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Terminology: Suffixes Expressing Relationships
Although not really part of the taxonomy of contracts (i.e., the orderly classification of the subject), an
aspect of contractual—indeed, legal—terminology should be highlighted here. Suffixes (the end syllables
of words) in the English language are used to express relationships between parties in legal terminology.
Here are examples:
•

Offeror. One who makes an offer.

•

Offeree. One to whom an offer is made.

•

Promisor. One who makes a promise.

•

Promisee. One to whom a promise is made.

•

Obligor. One who makes and has an obligation.

•

Obligee. One to whom an obligation is made.

•

Transferor. One who makes a transfer.

•

Transferee. One to whom a transfer is made.

KEY TAKEAWAY
Contracts are described and thus defined on the basis of four criteria: explicitness (express, implied, or quasicontracts), mutuality (bilateral or unilateral), enforceability (void, voidable, unenforceable), and degree of
completion (executory, partially executed, executed). Legal terminology in English often describes
relationships between parties by the use of suffixes, to which the eye and ear must pay attention.

EXERCISES
1.

Able writes to Baker: “I will mow your lawn for $20.” If Baker accepts, is this an express or implied
contract?

2.

Able telephones Baker: “I will mow your lawn for $20.” Is this an express or implied contract?

3.

What is the difference between a void contract and a voidable one?

4.

Carr staples this poster to a utility pole: “$50 reward for the return of my dog, Argon.” Describe this in
contractual terms regarding explicitness, mutuality, enforceability, and degree of completion.

5.

Is a voidable contract always unenforceable?

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6.

Contractor bids on a highway construction job, incorporating Guardrail Company’s bid into its overall bid
to the state. Contractor cannot accept Guardrail’s offer until it gets the nod from the state. Contractor
gets the nod from the state, but before it can accept Guardrail’s offer, the latter revokes it. Usually a
person can revoke an offer any time before it is accepted. Can Guardrail revoke its offer in this case?

[1] Central London Property Trust Ltd. v. High Trees House Ltd. (1947) KB 130.

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8.4 Cases
Explicitness: Implied Contract
Roger’s Backhoe Service, Inc. v. Nichols
681 N.W.2d 647 (Iowa 2004)
Carter, J.
Defendant, Jeffrey S. Nichols, is a funeral director in Muscatine.…In early 1998 Nichols decided to build a
crematorium on the tract of land on which his funeral home was located. In working with the Small
Business Administration, he was required to provide drawings and specifications and obtain estimates for
the project. Nichols hired an architect who prepared plans and submitted them to the City of Muscatine
for approval. These plans provided that the surface water from the parking lot would drain onto the
adjacent street and alley and ultimately enter city storm sewers. These plans were approved by the city.
Nichols contracted with Roger’s [Backhoe Service, Inc.] for the demolition of the foundation of a building
that had been razed to provide room for the crematorium and removal of the concrete driveway and
sidewalk adjacent to that foundation. Roger’s completed that work and was paid in full.
After construction began, city officials came to the jobsite and informed Roger’s that the proposed
drainage of surface water onto the street and alley was unsatisfactory. The city required that an effort be
made to drain the surface water into a subterranean creek, which served as part of the city’s storm sewer
system. City officials indicated that this subterranean sewer system was about fourteen feet below the
surface of the ground.…Roger’s conveyed the city’s mandate to Nichols when he visited the jobsite that
same day.
It was Nichols’ testimony at trial that, upon receiving this information, he advised…Roger’s that he was
refusing permission to engage in the exploratory excavation that the city required. Nevertheless, it
appears without dispute that for the next three days Roger’s did engage in digging down to the
subterranean sewer system, which was located approximately twenty feet below the surface. When the
underground creek was located, city officials examined the brick walls in which it was encased and

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determined that it was not feasible to penetrate those walls in order to connect the surface water drainage
with the underground creek. As a result of that conclusion, the city reversed its position and once again
gave permission to drain the surface water onto the adjacent street and alley.
[T]he invoices at issue in this litigation relate to charges that Roger’s submitted to Nichols for the three
days of excavation necessary to locate the underground sewer system and the cost for labor and materials
necessary to refill the excavation with compactable materials and attain compaction by means of a
tamping process.…The district court found that the charges submitted on the…invoices were fair and
reasonable and that they had been performed for Nichols’ benefit and with his tacit approval.…
The court of appeals…concluded that a necessary element in establishing an implied-in-fact contract is
that the services performed be beneficial to the alleged obligor. It concluded that Roger’s had failed to
show that its services benefited Nichols.…
In describing the elements of an action on an implied contract, the court of appeals stated in [Citation],
that the party seeking recovery must show:
(1) the services were carried out under such circumstances as to give the recipient reason to understand:
(a) they were performed for him and not some other person, and
(b) they were not rendered gratuitously, but with the expectation of compensation from the recipient; and
(2) the services were beneficial to the recipient.
In applying the italicized language in [Citation] to the present controversy, it was the conclusion of the
court of appeals that Roger’s’ services conferred no benefit on Nichols. We disagree. There was substantial
evidence in the record to support a finding that, unless and until an effort was made to locate the
subterranean sewer system, the city refused to allow the project to proceed. Consequently, it was
necessary to the successful completion of the project that the effort be made. The fact that examination of
the brick wall surrounding the underground creek indicated that it was unfeasible to use that source of
drainage does not alter the fact that the project was stalemated until drainage into the underground creek

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was fully explored and rejected. The district court properly concluded that Roger’s’ services conferred a
benefit on Nichols.…
Decision of court of appeals vacated; district court judgment affirmed.

CASE QUESTIONS
1.

What facts must be established by a plaintiff to show the existence of an implied contract?

2.

What argument did Nichols make as to why there was no implied contract here?

3.

How would the facts have to be changed to make an express contract?

Mutuality of Contract: Unilateral Contract
SouthTrust Bank v. Williams
775 So.2d 184 (Ala. 2000)
Cook, J.
SouthTrust Bank (“SouthTrust”) appeals from an order denying its motion to compel arbitration of an
action against it by checking-account customers Mark Williams and Bessie Daniels. We reverse and
remand.
Daniels and Williams began their relationship with SouthTrust in 1981 and 1995, respectively, by
executing checking-account “signature cards.” The signature card each customer signed contained a
“change-in-terms” clause. Specifically, when Daniels signed her signature card, she “agree[d] to be subject
to the Rules and Regulations as may now or hereafter be adopted by the Bank.” (Emphasis
added.)…[Later,] SouthTrust added paragraph 33 to the regulations:…
ARBITRATION OF DISPUTES. You and we agree that the transactions in your account involve
‘commerce’ under the Federal Arbitration Act (‘FAA’). ANY CONTROVERSY OR CLAIM BETWEEN YOU
AND US…WILL BE SETTLED BY BINDING ARBITRATION UNDER THE FAA.…
This action…challenges SouthTrust’s procedures for paying overdrafts, and alleges that SouthTrust
engages in a “uniform practice of paying the largest check(s) before paying multiple smaller checks…[in
order] to generate increased service charges for [SouthTrust] at the expense of [its customers].”

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SouthTrust filed a “motion to stay [the] lawsuit and to compel arbitration.” It based its motion on
paragraph 33 of the regulations. [T]he trial court…entered an order denying SouthTrust’s motion to
compel arbitration. SouthTrust appeals.…
Williams and Daniels contend that SouthTrust’s amendment to the regulations, adding paragraph 33, was
ineffective because, they say, they did not expressly assent to the amendment. In other words, they object
to submitting their claims to arbitration because, they say, when they opened their accounts, neither the
regulations nor any other relevant document contained an arbitration provision. They argue that “mere
failure to object to the addition of a material term cannot be construed as an acceptance of it.”…They
contend that SouthTrust could not unilaterally insert an arbitration clause in the regulations and make it
binding on depositors like them.
SouthTrust, however, referring to its change-of-terms clause insists that it “notified” Daniels and Williams
of the amendment in January 1997 by enclosing in each customer’s “account statement” a complete copy
of the regulations, as amended. Although it is undisputed that Daniels and Williams never affirmatively
assented to these amended regulations, SouthTrust contends that their assent was evidenced by their
failure to close their accounts after they received notice of the amendments.…Thus, the disposition of this
case turns on the legal effect of Williams and Daniels’s continued use of the accounts after the regulations
were amended.
Williams and Daniels argue that “[i]n the context of contracts between merchants [under the UCC], a
written confirmation of an acceptance may modify the contract unless it adds a material term, and
arbitration clauses are material terms.”…
Williams and Daniels concede—as they must—…that Article 2 governs “transactions in goods,” and,
consequently, that it is not applicable to the transactions in this case. Nevertheless, they argue:
It would be astonishing if a Court were to consider the addition of an arbitration clause a material
alteration to a contract between merchants, who by definition are sophisticated in the trade to which the
contract applies, but not hold that the addition of an arbitration clause is a material alteration pursuant to
a change-of-terms clause in a contract between one sophisticated party, a bank, and an entire class of less
sophisticated parties, its depositors.…

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In response, SouthTrust states that “because of the ‘at-will’ nature of the relationship, banks by necessity
must contractually reserve the right to amend their deposit agreements from time to time.” In so stating,
SouthTrust has precisely identified the fundamental difference between the transactions here and those
transactions governed by [Article 2].
Contracts for the purchase and sale of goods are essentially bilateral and executory in nature. See
[Citation] “An agreement whereby one party promises to sell and the other promises to buy a thing at a
later time…is a bilateral promise of sale or contract to sell”.…“[A] unilateral contract results from an
exchange of a promise for an act; a bilateral contract results from an exchange of promises.”…Thus, “in a
unilateral contract, there is no bargaining process or exchange of promises by parties as in a bilateral
contract.” [Citation] “[O]nly one party makes an offer (or promise) which invites performance by another,
and performance constitutes both acceptance of that offer and consideration.” Because “a ‘unilateral
contract’ is one in which no promisor receives promise as consideration for his promise,” only one party is
bound.…The difference is not one of semantics but of substance; it determines the rights and
responsibilities of the parties, including the time and the conditions under which a cause of action accrues
for a breach of the contract.
This case involves at-will, commercial relationships, based upon a series of unilateral transactions. Thus,
it is more analogous to cases involving insurance policies, such as [Citations]. The common thread
running through those cases was the amendment by one of the parties to a business relationship of a
document underlying that relationship—without the express assent of the other party—to require the
arbitration of disputes arising after the amendment.…
The parties in [the cited cases], like Williams and Daniels in this case, took no action that could be
considered inconsistent with an assent to the arbitration provision. In each case, they continued the
business relationship after the interposition of the arbitration provision. In doing so, they implicitly
assented to the addition of the arbitration provision.…
Reversed and remanded.

CASE QUESTIONS
1.

Why did the plaintiffs think they should not be bound by the arbitration clause?

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2.

The court said this case involved a unilateral contract. What makes it that, as opposed to a bilateral
contract?

3.

What should the plaintiffs have done if they didn’t like the arbitration requirement?

Unilateral Contract and At-Will Employment
Woolley v. Hoffmann-La Roche, Inc.
491 A.2d 1257 (N.J. 1985)
Wilntz, C. J.
Plaintiff, Richard Woolley, was hired by defendant, Hoffmann-La Roche, Inc., in October 1969, as an
Engineering Section Head in defendant’s Central Engineering Department at Nutley. There was no
written employment contract between plaintiff and defendant. Plaintiff began work in mid-November
1969. Sometime in December, plaintiff received and read the personnel manual on which his claims are
based.
[The company’s personnel manual had eight pages;] five of the eight pages are devoted to “termination.”
In addition to setting forth the purpose and policy of the termination section, it defines “the types of
termination” as “layoff,” “discharge due to performance,” “discharge, disciplinary,” “retirement” and
“resignation.” As one might expect, layoff is a termination caused by lack of work, retirement a
termination caused by age, resignation a termination on the initiative of the employee, and discharge due
to performance and discharge, disciplinary, are both terminations for cause. There is no category set forth
for discharge without cause. The termination section includes “Guidelines for discharge due to
performance,” consisting of a fairly detailed procedure to be used before an employee may be fired for
cause. Preceding these definitions of the five categories of termination is a section on “Policy,” the first
sentence of which provides: “It is the policy of Hoffmann-La Roche to retain to the extent consistent with
company requirements, the services of all employees who perform their duties efficiently and effectively.”
In 1976, plaintiff was promoted, and in January 1977 he was promoted again, this latter time to Group
Leader for the Civil Engineering, the Piping Design, the Plant Layout, and the Standards and Systems
Sections. In March 1978, plaintiff was directed to write a report to his supervisors about piping problems

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in one of defendant’s buildings in Nutley. This report was written and submitted to plaintiff’s immediate
supervisor on April 5, 1978. On May 3, 1978, stating that the General Manager of defendant’s Corporate
Engineering Department had lost confidence in him, plaintiff’s supervisors requested his resignation.
Following this, by letter dated May 22, 1978, plaintiff was formally asked for his resignation, to be
effective July 15, 1978.
Plaintiff refused to resign. Two weeks later defendant again requested plaintiff’s resignation, and told him
he would be fired if he did not resign. Plaintiff again declined, and he was fired in July.
Plaintiff filed a complaint alleging breach of contract.…The gist of plaintiff’s breach of contract claim is
that the express and implied promises in defendant’s employment manual created a contract under which
he could not be fired at will, but rather only for cause, and then only after the procedures outlined in the
manual were followed. Plaintiff contends that he was not dismissed for good cause, and that his firing was
a breach of contract.
Defendant’s motion for summary judgment was granted by the trial court, which held that the
employment manual was not contractually binding on defendant, thus allowing defendant to terminate
plaintiff’s employment at will. The Appellate Division affirmed. We granted certification.
The employer’s contention here is that the distribution of the manual was simply an expression of the
company’s “philosophy” and therefore free of any possible contractual consequences. The former
employee claims it could reasonably be read as an explicit statement of company policies intended to be
followed by the company in the same manner as if they were expressed in an agreement signed by both
employer and employees.…
This Court has long recognized the capacity of the common law to develop and adapt to current
needs.…The interests of employees, employers, and the public lead to the conclusion that the common law
of New Jersey should limit the right of an employer to fire an employee at will.
In order for an offer in the form of a promise to become enforceable, it must be accepted. Acceptance will
depend on what the promisor bargained for: he may have bargained for a return promise that, if given,
would result in a bilateral contract, both promises becoming enforceable. Or he may have bargained for

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some action or nonaction that, if given or withheld, would render his promise enforceable as a unilateral
contract. In most of the cases involving an employer’s personnel policy manual, the document is prepared
without any negotiations and is voluntarily distributed to the workforce by the employer. It seeks no
return promise from the employees. It is reasonable to interpret it as seeking continued work from the
employees, who, in most cases, are free to quit since they are almost always employees at will, not simply
in the sense that the employer can fire them without cause, but in the sense that they can quit without
breaching any obligation. Thus analyzed, the manual is an offer that seeks the formation of a unilateral
contract—the employees’ bargained-for action needed to make the offer binding being their continued
work when they have no obligation to continue.
The unilateral contract analysis is perfectly adequate for that employee who was aware of the manual and
who continued to work intending that continuation to be the action in exchange for the employer’s
promise; it is even more helpful in support of that conclusion if, but for the employer’s policy manual, the
employee would have quit. See generally M. Petit, “Modern Unilateral Contracts,” 63 Boston Univ. Law
Rev. 551 (1983) (judicial use of unilateral contract analysis in employment cases is widespread).
…All that this opinion requires of an employer is that it be fair. It would be unfair to allow an employer to
distribute a policy manual that makes the workforce believe that certain promises have been made and
then to allow the employer to renege on those promises. What is sought here is basic honesty: if the
employer, for whatever reason, does not want the manual to be capable of being construed by the court as
a binding contract, there are simple ways to attain that goal. All that need be done is the inclusion in a
very prominent position of an appropriate statement that there is no promise of any kind by the employer
contained in the manual; that regardless of what the manual says or provides, the employer promises
nothing and remains free to change wages and all other working conditions without having to consult
anyone and without anyone’s agreement; and that the employer continues to have the absolute power to
fire anyone with or without good cause.
Reversed and remanded for trial.

CASE QUESTIONS
1.

What did Woolley do to show his acceptance of the terms of employment offered to him?

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2.

In part of the case not included here, the court notes that Mr. Woolley died “before oral arguments on
this case.” How can there be any damages if the plaintiff has died? Who now has any case to pursue?

3.

The court here is changing the law of employment in New Jersey. It is making case law, and the rule here
articulated governs similar future cases in New Jersey. Why did the court make this change? Why is it
relevant that the court says it would be easy for an employer to avoid this problem?

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8.5 Summary and Exercises
Summary
Contract law developed as the status-centered organization of feudal society faded and people began to
make choices about how they might order their lives. In the capitalistic system, people make choices about
how to interact with others, and—necessarily—those choices expressed as promises must be binding and
enforceable.
The two fundamental sources of contract law are (1) the common law as developed in the state courts and
as summarized in the Restatement (Second) of Contracts and (2) the Uniform Commercial Code for the
sale of goods. In general, the UCC is more liberal than the common law in upholding the existence of a
contract.
Types of contracts can be distinguished by four criteria: (1) express and implied, including quasi-contracts
implied by law; (2) bilateral and unilateral; (3) enforceable and unenforceable; and (4) completed
(executed) and uncompleted (executory). To understand contract law, it is necessary to master these
distinctions and their nuances.

EXERCISES
1.
a.

Mr. and Mrs. Smith, an elderly couple, had no relatives. When Mrs. Smith became ill, the Smiths
asked a friend, Henrietta, to help with various housekeeping chores, including cleaning and
cooking. Although the Smiths never promised to pay her, Henrietta performed the chores for
eighteen months. Henrietta now claims that she is entitled to the reasonable value of the services
performed. Is she correct? Explain.

b.

Assume instead that the Smiths asked Mrs. Smith’s sister, Caroline, who lived nearby, to help with
the housekeeping. After eighteen months, Caroline claims she is entitled to the reasonable value
of the services performed. Is she correct? Explain.

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A letter from Bridge Builders Inc. to the Allied Steel Company stated, “We offer to purchase 10,000 tons of
No. 4 steel pipe at today’s quoted price for delivery two months from today. Your acceptance must be
received in five days.” Does Bridge Builders intend to create a bilateral or a unilateral contract? Why?
Roscoe’s barber persuaded him to try a new hair cream called Sansfree, which the barber applied to
Roscoe’s hair and scalp. The next morning Roscoe had a very unpleasant rash along his hairline. Upon
investigation he discovered that the rash was due to an improper chemical compound in Sansfree. If
Roscoe filed a breach of contract action against the barber, would the case be governed by the Uniform
Commercial Code or common law? Explain.
Rachel entered into a contract to purchase a 2004 Dodge from Hanna, who lived in the neighboring
apartment. When a dispute arose over the terms of the contract, Hanna argued that, because neither she
nor Rachel was a merchant, the dispute should be decided under general principles of common law.
Rachel, on the other hand, argued that Hanna was legally considered to be a merchant because she sold
the car for profit and that, consequently, the sale was governed by the Uniform Commercial Code. Who is
correct? Explain.
Lee and Michelle decided to cohabit. When they set up house, Michelle gave up her career, and Lee
promised to share his earnings with her on a fifty-fifty basis. Several years later they ended their
relationship, and when Lee failed to turn over half of his earnings, Michelle filed suit on the basis of Lee’s
promise. What kind of contract would Michelle allege that Lee had breached? Explain.
Harry and Wilma were divorced in 2008, and Harry was ordered in the divorce decree to pay his ex-wife
$10,000. In 2009 and 2010 Harry was hospitalized, incurring $3,000 in bills. He and Wilma discussed the
matter, and Wilma agreed to pay the bill with her own money, even though Harry still owed her $5,000
from the divorce decree. When Harry died in late 2010, Wilma made a claim against his estate for $8,000
(the $3,000 in medical bills and the $5,000 from the decree), but the estate was only willing to pay the
$5,000 from the decree, claiming she had paid the hospital bill voluntarily and had no contract for
repayment. Is the estate correct? Explain.
Louie, an adult, entered into a contract to sell a case of scotch whiskey to Leroy, a minor. Is the contract
void or voidable? Explain.

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James Mann owned a manufacturing plant that assembled cell phones. A CPA audit determined
that several phones were missing. Theft by one or more of the workers was suspected.
Accordingly, under Mann’s instructions, the following sign was placed in the employees’ cafeteria:
Reward. We are missing phones. I want all employees to watch for thievery. A reward of $500 will
be paid for information given by any employee that leads to the apprehension of employee
thieves.
—James Mann
Waldo, a plant employee, read the notice and immediately called Mann, stating, “I accept your
offer. I promise to watch other employees and provide you with the requested information.” Has
a contract been formed? Explain.
Almost every day Sally took a break at lunch and went to the International News Stand—a magazine
store—to browse the newspapers and magazines and chat with the owner, Conrad. Often she bought a
magazine. One day she went there, browsed a bit, and took a magazine off the rack. Conrad was busy with
three customers. Sally waved the magazine at Conrad and left the store with it. What kind of a contract, if
any, was created?
Joan called Devon Sand & Gravel and ordered two “boxes” (dump-truck loads) of gravel to be spread on
her rural driveway by the “shoot and run” method: the tailgate is partially opened, the dump-truck bed is
lifted, and the truck moves down the driveway spreading gravel as it goes. The driver mistakenly graveled
the driveway of Joan’s neighbor, Watson, instead of Joan’s. Is Devon entitled to payment by Watson?
Explain.

SELF-TEST QUESTIONS
1.

An implied contract

a.

must be in writing

b.

is one in which the terms are spelled out

c.

is one inferred from the actions of the parties

d.

is imposed by law to avoid an unjust result

e.

may be avoided by one party
The Convention on Contracts for the International Sale of Goods is

a.

an annual meeting of international commercial purchasing agents.

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b.

contract law used in overseas US federal territories

c.

a customary format or template for drafting contracts

d.

a kind of treaty setting out international contract law, to which the United States is a party

e.

the organization that develops uniform international law
An unenforceable contract is

a.

void, not a contract at all

b.

one that a court will not enforce for either side because of a rule of law

c.

unenforceable by one party but enforceable by the other

d.

one that has been performed by one party but not the other

e.

too indefinite to be valid
Betty Baker found a bicycle apparently abandoned near her house. She took it home and spent
$150 repairing and painting it, after which Carl appeared and proved his ownership of it. Under
what theory is Betty able to get reimbursed for her expenditures?

a.

express contract

b.

implied contract

c.

apparent or quasi-contract

d.

executory contract

e.

none: she will not get reimbursed
Alice discusses with her neighbor Bob her plan to hire Woodsman to cut three trees on her side
of their property line, mentioning that she can get a good deal because Woodsman is now
between jobs. Bob says, “Oh, don’t do that. My brother is going to cut some trees on my side, and
he can do yours too for free.” Alice agrees. But Bob’s brother is preoccupied and never does the
job. Three weeks later Alice discovers Woodsman’s rates have risen prohibitively. Under what
theory does Alice have a cause of action against Bob?

a.

express contract

b.

promissory estoppel

c.

quasi-contract

d.

implied contract

e.

none: she has no cause of action against Bob

SELF-TEST ANSWERS
1.

c

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2.

d

3.

c

4.

c

5.

b

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Chapter 9

The Agreement
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

What a contract offer is, and what proposals are not offers

2.

How an offer is communicated

3.

How definite the offer needs to be

4.

How long an offer is good for

5.

How an offer is accepted, who can accept it, and when acceptance is effective

In this chapter, we begin the first of the four broad inquiries of contract law mentioned in Chapter 8
"Introduction to Contract Law": Did the parties create a valid contract? The answer is not always
obvious; the range of factors that must be taken into account can be large, and their relationships
subtle. Since businesspeople frequently conduct contract negotiations without the assistance of a
lawyer, it is important to attend to the nuances in order to avoid legal trouble at the outset. Whether
a contract has been formed depends in turn on whether
1.

the parties reached an agreement (the focus of this chapter);

2. consideration was present;
3. the agreement was legal; and
4. the parties entered into the contract of their own free will, with knowledge of the facts, and with
the capacity to make a contract.

Factors 2, 3, and 4 are the subjects of subsequent chapters.

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9.1 The Agreement in General
LEARNING OBJECTIVES
1.

Recognize that not all agreements or promises are contracts.

2.

Understand that whether a contract exists is based on an objective analysis of the parties’ interaction,
not on a subjective one.

The Significance of Agreement
The core of a legal contract is the agreement between the parties. This is not a necessary ingredient; in
Communist nations, contracts were (or are, in the few remaining Communist countries) routinely
negotiated between parties who had the terms imposed on them. But in the West, and especially in the
United States, agreement is of the essence. That is not merely a matter of convenience; it is at the heart of
our philosophical and psychological beliefs. As the great student of contract law Samuel Williston put it,
“It was a consequence of the emphasis laid on the ego and the individual will that the formation of a
contract should seem impossible unless the wills of the parties concurred. Accordingly we find at the end
of the eighteenth century, and the beginning of the nineteenth century, the prevalent idea that there must
be a “meeting of the minds” (a new phrase) in order to form a contract.”

[1]

Although agreements may take any form, including unspoken conduct between the parties, they are
[2]

usually structured in terms of an offer and an acceptance. These two components will be the focus of our
discussion. Note, however, that not every agreement, in the broadest sense of the word, need consist of an
offer and an acceptance, and that it is entirely possible, therefore, for two persons to reach agreement
without forming a contract. For example, people may agree that the weather is pleasant or that it would be
preferable to go out for Chinese food rather than to see a foreign film; in neither case has a contract been
formed. One of the major functions of the law of contracts is to sort out those agreements that are legally
binding—those that are contracts—from those that are not.

The Objective Test
In interpreting agreements, courts generally apply an objective standard(outwardly, as an observer would
interpret; not subjectively). The Restatement (Second) of Contracts defines agreement as a

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“manifestation of mutual assent by two or more persons to one another.”

[3]

The Uniform Commercial

Code defines agreement as “the bargain of the parties in fact as found in their language or by implication
from other circumstances including course of dealing or usage of trade or course of performance.”

[4]

The

critical question is what the parties said or did, not what they thought they said or did, or not what
impression they thought they were making.
The distinction between objective and subjective standards crops up occasionally when one person claims
he spoke in jest. The vice president of a company that manufactured punchboards, used in gambling,
testified to the Washington State Game Commission that he would pay $100,000 to anyone who found a
“crooked board.” Barnes, a bartender, who had purchased two boards that were crooked some time
before, brought one to the company office and demanded payment. The company refused, claiming that
the statement was made in jest (the audience at the commission hearing had laughed when the offer was
made). The court disagreed, holding that it was reasonable to interpret the pledge of $100,000 as a means
of promoting punchboards:
[I]f the jest is not apparent and a reasonable hearer would believe that an offer was being made, then the
speaker risks the formation of a contract which was not intended. It is the objective manifestations of the
offeror that count and not secret, unexpressed intentions. If a party’s words or acts, judged by a
reasonable standard, manifest an intention to agree in regard to the matter in question, that agreement is
established, and it is immaterial what may be the real but unexpressed state of the party’s mind on the
subject.

[5]

Lucy v. Zehmer (Section 9.4.1 "Objective Intention" at the end of the chapter) illustrates that a party’s real
state of mind must be expressed to the other party, rather than in an aside to one’s spouse.

KEY TAKEAWAY
Fundamentally, a contract is a legally binding “meeting of the minds” between the parties. It is not the
unexpressed intention in the minds of the parties that determines whether there was “a meeting.” The test is
objective: how would a reasonable person interpret the interaction?

EXERCISES

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1.

For the purposes of determining whether a party had a contractual intention, why do courts employ an
objective rather than a subjective test?

2.

What is the relationship between “the emphasis laid on the ego and the individual will” in modern times
(Williston) and the concept of the contractual agreement?

[1] Samuel Williston, “Freedom of Contract,” Cornell Law Quarterly 6 (1921), 365.
[2] Uniform Commercial Code, Section 2-204(1).
[3] Uniform Commercial Code, Section 3.
[4] Uniform Commercial Code, Section 1-201(3).
[5] Barnes v. Treece, 549 P.2d 1152 (Wash. App. 1976).

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9.2 The Offer
LEARNING OBJECTIVES
1.

Know the definition of offer.

2.

Recognize that some proposals are not offers.

3.

Understand the three essentials of an offer: intent, communication, and definiteness.

4.

Know when an offer expires and can no longer be accepted.

Offer and acceptance may seem to be straightforward concepts, as they are when two people meet face-toface. But in a commercial society, the ways of making offers and accepting them are nearly infinite. A
retail store advertises its merchandise in the newspaper. A seller makes his offer by mail or over the
Internet. A telephone caller states that his offer will stand for ten days. An offer leaves open a crucial term.
An auctioneer seeks bids. An offeror gives the offeree a choice. All these situations can raise tricky
questions, as can corresponding situations involving acceptances.

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

[1]

Two key elements are implicit in that definition: the offer must be communicated, and it must be

definite. Before considering these requirements, we examine the threshold question of whether an offer
was intended. Let us look at proposals that may look like, but are not, offers.

Proposals That Are Not Offers
Advertisements
Most advertisements, price quotations, and invitations to bid are not construed as offers. A notice in the
newspaper that a bicycle is on sale for $800 is normally intended only as an invitation to the public to
come to the store to make a purchase. Similarly, a statement that a seller can “quote” a unit price to a
prospective purchaser is not, by itself, of sufficient definiteness to constitute an offer; quantity, time of
delivery, and other important factors are missing from such a statement. Frequently, in order to avoid
construction of a statement about price and quantity as an offer, a seller or buyer may say, “Make me an

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offer.” Such a statement obviously suggests that no offer has yet been made. This principle usually applies
to invitations for bids (e.g., from contractors on a building project). Many forms used by sales
representatives as contracts indicate that by signing, the customer is making an offer to be accepted by the
home office and is not accepting an offer made by the sales representative.
Although advertisements, price quotations, and the like are generally not offers, the facts in each case are
important. Under the proper circumstances, an advertised statement can be construed as an offer, as
shown in the well-known Lefkowitz case (Section 9.4.2 "Advertisements as Offers" at the end of the
chapter), in which the offended customer acted as his own lawyer and pursued an appeal to the Minnesota
Supreme Court against a Minneapolis department store that took back its advertised offer.
Despite the common-law rule that advertisements are normally to be considered invitations rather than
offers, legislation and government regulations may offer redress. For many years, retail food stores have
been subject to a rule, promulgated by the Federal Trade Commission (FTC), that goods advertised as
“specials” must be available and must be sold at the price advertised. It is unlawful for a retail chain not to
have an advertised item in each of its stores and in sufficient quantity, unless the advertisement
specifically states how much is stocked and which branch stores do not carry it. Many states have enacted
consumer protection statutes that parallel the FTC rule.

Invitations to Bid
Invitations to bid are also not generally construed as offers. An auctioneer does not make offers but
solicits offers from the crowd: “May I have an offer?—$500? $450? $450! I have an offer for $450. Do I
hear $475? May I have an offer?”

Communication
A contract is an agreement in which each party assents to the terms of the other party. Without mutual
assent there cannot be a contract, and this implies that the assent each person gives must be with
reference to that of the other. If Toni places several alternative offers on the table, only one of which can
be accepted, and invites Sandy to choose, no contract is formed if Sandy says merely, “I accept your
terms.” Sandy must specify which offer she is assenting to.

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From this general proposition, it follows that no contract can be legally binding unless an offer is in fact
communicated to the offeree. If you write an e-mail to a friend with an offer to sell your car for a certain
sum and then get distracted and forget to send it, no offer has been made. If your friend coincidentally emails you the following day and says that she wants to buy your car and names the same sum, no contract
has been made. Her e-mail to you is not an acceptance, since she did not know of your offer; it is, instead,
an offer or an invitation to make an offer. Nor would there have been a contract if you had sent your
communication and the two e-mails crossed in cyberspace. Both e-mails would be offers, and for a valid
contract to be formed, it would still be necessary for one of you to accept the other’s offer. An offer is not
effective until it is received by the offeree (and that’s also true of a revocation of the offer, and a rejection
of the offer by the offeree).
The requirement that an offer be communicated does not mean that every term must be communicated.
You call up your friend and offer to sell him your car. You tell him the price and start to tell him that you
will throw in the snow tires but will not pay for a new inspection, and that you expect to keep the car
another three weeks. Impatiently, he cuts you off and says, “Never mind about all that; I’ll accept your
offer on whatever terms you want.” You and he have a contract.
These principles apply to unknown offers of reward. An offer of a reward constitutes a unilateral contract
that can be made binding only by performing the task for which the reward is offered. Suppose that
Bonnie posts on a tree a sign offering a reward for returning her missing dog. If you saw the sign, found
the dog, and returned it, you would have fulfilled the essentials of the offer. But if you chanced upon the
dog, read the tag around its neck, and returned it without ever having been aware that a reward was
offered, then you have not responded to the offer, even if you acted in the hope that the owner would
reward you. There is no contractual obligation.
In many states, a different result follows from an offer of a reward by a governmental entity. Commonly,
local ordinances provide that a standing reward of, say, $1,000 will be paid to anyone providing
information that leads to the arrest and conviction of arsonists. To collect the reward, it is not necessary
for a person who does furnish local authorities with such information to know that a reward ordinance
exists. In contract terms, the standing reward is viewed as a means of setting a climate in which people
will be encouraged to act in certain ways in the expectation that they will earn unknown rewards. It is also

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possible to view the claim to a reward as noncontractual; the right to receive it is guaranteed, instead, by
the local ordinance.
Although a completed act called for by an unknown private offer does not give rise to a contract, partial
performance usually does. Suppose Apex Bakery posts a notice offering a one-week bonus to all bakers
who work at least six months in the kitchen. Charlene works two months before discovering the notice on
the bulletin board. Her original ignorance of the offer will not defeat her claim to the bonus if she
continues working, for the offer serves as an inducement to complete the performance called for.

Definiteness
The common law reasonably requires that an offer spell out the essential proposed terms with
sufficient definiteness—certainty of terms that enables a court to order enforcement or measure damages
in the event of a breach. As it has often been put, “The law does not make contracts for the parties; it
merely enforces the duties which they have undertaken” (Simpson, 1965, p. 19). Thus a supposed promise
to sell “such coal as the promisor may wish to sell” is not an enforceable term because the seller, the coal
company, undertakes no duty to sell anything unless it wishes to do so. Essential terms certainly include
price and the work to be done. But not every omission is fatal; for example, as long as a missing term can
be fixed by referring to some external standard—such as “no later than the first frost”—the offer is
sufficiently definite.
In major business transactions involving extensive negotiations, the parties often sign a preliminary
“agreement in principle” before a detailed contract is drafted. These preliminary agreements may be
definite enough to create contract liability even though they lack many of the terms found in a typical
contract. For example, in a famous 1985 case, a Texas jury concluded that an agreement made “in
principle” between the Pennzoil Company and the Getty Oil Company and not entirely finished was
binding and that Texaco had unlawfully interfered with their contract. As a result, Texaco was held liable
for over $10 billion, which was settled for $3 billion after Texaco went into bankruptcy.
Offers that state alternatives are definitive if each alternative is definite. David offers Sheila the
opportunity to buy one of two automobiles at a fixed price, with delivery in two months and the choice of
vehicle left to David. Sheila accepts. The contract is valid. If one of the cars is destroyed in the interval

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before delivery, David is obligated to deliver the other car. Sometimes, however, what appears to be an
offer in the alternative may be something else. Charles makes a deal to sell his business to Bernie. As part
of the bargain, Charles agrees not to compete with Bernie for the next two years, and if he does, to pay
$25,000. Whether this is an alternative contract depends on the circumstances and intentions of the
parties. If it is, then Charles is free to compete as long as he pays Bernie $25,000. On the other hand, the
intention might have been to prevent Charles from competing in any event; hence a court could order
payment of the $25,000 as damages for a breach and still order Charles to refrain from competition until
the expiration of the two-year period.

The UCC Approach
The Uniform Commercial Code (UCC) is generally more liberal in its approach to definiteness than is the
common law—at least as the common law was interpreted in the heyday of classical contract doctrine.
Section 2-204(3) states the rule: “Even though one or more terms are left open, a contract for sale does
not fail for indefiniteness if the parties have intended to make a contract and there is a reasonably certain
basis for giving an appropriate remedy.”
The drafters of the UCC sought to give validity to as many contracts as possible and grounded that validity
on the intention of the parties rather than on formalistic requirements. As the official comment to Section
2-204(3) notes, “If the parties intend to enter into a binding agreement, this subsection recognizes that
agreement as valid in law, despite missing terms, if there is any reasonably certain basis for granting a
remedy.…Commercial standards on the point of ‘indefiniteness’ are intended to be applied.” Other
sections of the UCC spell out rules for filling in such open provisions as price, performance, and
remedies.

[2]

One of these sections, Section 2-306(1), provides that a contract term under which a buyer agrees to
purchase the seller’s entire output of goods (an “outputs contract”) or a seller agrees to meet all the
buyer’s requirements (a “requirements” or “needs” contract) means output or requirements that occur in
good faith. A party to such a contract cannot offer or demand a quantity that is “unreasonably
disproportionate” to a stated estimate or past quantities.

Duration of Offer
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An offer need not be accepted on the spot. Because there are numerous ways of conveying an offer and
numerous contingencies that may be part of the offer’s subject matter, the offeror might find it necessary
to give the offeree considerable time to accept or reject the offer. By the same token, an offer cannot
remain open forever, so that once given, it never lapses and cannot be terminated. The law recognizes
seven ways by which the offer can expire (besides acceptance, of course): revocation, rejection by the
offeree, counteroffer, acceptance with counteroffer, lapse of time, death or insanity of a person or
destruction of an essential term, and illegality. We will examine each of these in turn.

Revocation
People are free to make contracts and, in general, to revoke them.

Revocability
The general rule, both in common law and under the UCC, is that the offeror may revoke his or her offer
at any time before acceptance, even if the offer states that it will remain open for a specified period of
time. Neil offers Arlene his car for $5,000 and promises to keep the offer open for ten days. Two days
later, Neil calls Arlene to revoke the offer. The offer is terminated, and Arlene’s acceptance thereafter,
though within the ten days, is ineffective. But if Neil had sent hisrevocation (the taking back of an offer
before it is accepted) by mail, and if Arlene, before she received it, had telephoned her acceptance, there
would be a contract, since revocation is effective only when the offeree actually receives it. There is an
exception to this rule for offers made to the public through newspaper or like advertisements. The offeror
may revoke a public offering by notifying the public by the same means used to communicate the offer. If
no better means of notification is reasonably available, the offer is terminated even if a particular offeree
had no actual notice.
Revocation may be communicated indirectly. If Arlene had learned from a friend that Neil had sold his car
to someone else during the ten-day period, she would have had sufficient notice. Any attempt to accept
Neil’s offer would have been futile.

Irrevocable Offers

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Not every type of offer is revocable. One type of offer that cannot be revoked is the option contract (the
promisor explicitly agrees for consideration to limit his right to revoke). Arlene tells Neil that she cannot
make up her mind in ten days but that she will pay him $25 to hold the offer open for thirty days. Neil
agrees. Arlene has an option to buy the car for $5,000; if Neil should sell it to someone else during the
thirty days, he will have breached the contract with Arlene. Note that the transactions involving Neil and
Arlene consist of two different contracts. One is the promise of a thirty-day option for the promise of $25.
It is this contract that makes the option binding and is independent of the original offer to sell the car for
$5,000. The offer can be accepted and made part of an independent contract during the option period.
Partial performance of a unilateral contract creates an option. Although the option is not stated explicitly,
it is recognized by law in the interests of justice. Otherwise, an offeror could induce the offeree to go to
expense and trouble without ever being liable to fulfill his or her part of the bargain. Before the offeree
begins to carry out the contract, the offeror is free to revoke the offer. But once performance begins, the
law implies an option, allowing the offeree to complete performance according to the terms of the offer. If,
after a reasonable time, the offeree does not fulfill the terms of the offer, then it may be revoked.

Revocability under the UCC
The UCC changes the common-law rule for offers by merchants. Under Section 2-205, a firm offer (a
written and signed promise by a merchant to hold an offer to buy or sell goods for some period of time) is
irrevocable. That is, an option is created, but no consideration is required. The offer must remain open for
the time period stated or, if no time period is given, for a reasonable period of time, which may not exceed
three months.

Irrevocability by Law
By law, certain types of offers may not be revoked (statutory irrevocability), despite the absence of
language to that effect in the offer itself. One major category of such offers is that of the contractor
submitting a bid to a public agency. The general rule is that once the period of bidding opens, a bidder on
a public contract may not withdraw his or her bid unless the contracting authority consents. The
contractor who purports to withdraw is awarded the contract based on the original bid and may be sued
for damages for nonperformance.

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Rejection by the Offeree
Rejection (a manifestation of refusal to agree to the terms of an offer) of the offer is effective when the
offeror receives it. A subsequent change of mind by the offeree cannot revive the offer. Donna calls Chuck
to reject Chuck’s offer to sell his lawn mower. Chuck is then free to sell it to someone else. If Donna
changes her mind and calls Chuck back to accept after all, there still is no contract, even if Chuck has
made no further effort to sell the lawn mower. Having rejected the original offer, Donna, by her second
call, is not accepting but making an offer to buy. Suppose Donna had written Chuck to reject, but on
changing her mind, decided to call to accept before the rejection letter arrived. In that case, the offer
would have been accepted.

Counteroffer
A counteroffer, a response that varies the terms of an offer, is a rejection. Jones offers Smith a small
parcel of land for $10,000 and says the offer will remain open for one month. Smith responds ten days
later, saying he will pay $5,000. Jones’s original offer has thereby been rejected. If Jones now declines
Smith’s counteroffer, may Smith bind Jones to his original offer by agreeing to pay the full $10,000? He
may not, because once an original offer is rejected, all the terms lapse. However, an inquiry by Smith as to
whether Jones would consider taking less is not a counteroffer and would not terminate the offer.

Acceptance with Counteroffer
This is not really an acceptance at all but is a counteroffer: an acceptance that changes the terms of the
offer is a counteroffer and terminates the offer. The common law imposes a mirror image rule: the
acceptance must match the offer in all its particulars or the offer is rejected. However, if an acceptance
that requests a change or an addition to the offer does not require the offeror’s assent, then the acceptance
is valid. The broker at Friendly Real Estate offers you a house for $320,000. You accept but include in
your acceptance “the vacant lot next door.” Your acceptance is a counteroffer, which serves to terminate
the original offer. If, instead, you had said, “It’s a deal, but I’d prefer it with the vacant lot next door,” then
there is a contract because you are not demanding that the broker abide by your request. If you had said,
“It’s a deal, and I’d also like the vacant lot next door,” you have a contract, because the request for the lot
is a separate offer, not a counteroffer rejecting the original proposal.

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The UCC and Counteroffers
The UCC is more liberal than the common law in allowing contracts to be formed despite counteroffers
and in incorporating the counteroffers into the contracts. This UCC provision is necessary because the use
of routine forms for contracts is very common, and if the rule were otherwise, much valuable time would
be wasted by drafting clauses tailored to the precise wording of the routine printed forms. A buyer and a
seller send out documents accompanying or incorporating their offers and acceptances, and the
provisions in each document rarely correspond precisely. Indeed, it is often the case that one side’s form
contains terms favorable to it but inconsistent with terms on the other side’s form. Section 2-207 of the
UCC attempts to resolve this “battle of the forms” by providing that additional terms or conditions in an
acceptance operate as such unless the acceptance is conditioned on the offeror’s consent to the new or
different terms. The new terms are construed as offers but are automatically incorporated in any contract
between merchants for the sale of goods unless “(a) the offer expressly limits acceptance to the terms of
the offer; (b) [the terms] materially alter it; or (c) notification of objection to them has already been given
or is given within a reasonable time after notice of them is received.”
An example of terms that become part of the contract without being expressly agreed to are clauses
providing for interest payments on overdue bills. Examples of terms that would materially alter the
contract and hence need express approval are clauses that negate the standard warranties that sellers give
buyers on their merchandise.
Frequently, parties use contract provisions to prevent the automatic introduction of new terms. A typical
seller’s provision is as follows:
Amendments
Any modification of this document by the Buyer, and all additional or different terms included in Buyer’s
purchase order or any other document responding to this offer, are hereby objected to. BY ORDERING
THE GOODS HERE FOR SHIPMENT, BUYER AGREES TO ALL THE TERMS AND CONDITIONS
CONTAINED ON BOTH SIDES OF THIS DOCUMENT.

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Section 2-207 of the UCC, liberalizing the mirror image rule, is pervasive, covering all sorts of contracts,
from those between industrial manufacturers to those between friends.

Lapse of Time
Offers are not open-ended; they lapse after some period of time. An offer may contain its own specific
time limitation—for example, “until close of business today.”
In the absence of an expressly stated time limit, the common-law rule is that the offer expires at the end of
a “reasonable” time. Such a period is a factual question in each case and depends on the particular
circumstances, including the nature of the service or property being contracted for, the manner in which
the offer is made, and the means by which the acceptance is expected to be made. Whenever the contract
involves a speculative transaction—the sale of securities or land, for instance—the time period will depend
on the nature of the security and the risk involved. In general, the greater the risk to the seller, the shorter
the period of time. Karen offers to sell Gary a block of oil stocks that are fluctuating rapidly hour by hour.
Gary receives the offer an hour before the market closes; he accepts by fax two hours after the market has
opened the next morning and after learning that the stock has jumped up significantly. The time period
has lapsed if Gary was accepting a fixed price that Karen set, but it may still be open if the price is market
price at time of delivery. (Under Section 41 of the Restatement, an offer made by mail is “seasonably
accepted if an acceptance is mailed at any time before midnight on the day on which the offer is
received.”)
For unilateral contracts, both the common law and the UCC require the offeree to notify the offeror that
he has begun to perform the terms of the contract. Without notification, the offeror may, after a
reasonable time, treat the offer as having lapsed.

Death or Insanity of the Offeror
The death or insanity of the offeror prior to acceptance terminates the offer; the offer is said to die with
the offeror. (Notice, however, that the death of a party to a contract does not necessarily terminate the
contract: the estate of a deceased person may be liable on a contract made by the person before death.)

Destruction of Subject Matter Essential to the Offer
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Destruction of something essential to the contract also terminates the offer. You offer to sell your car, but
the car is destroyed in an accident before your offer is accepted; the offer is terminated.

Postoffer Illegality
A statute making unlawful the object of the contract will terminate the offer if the statute takes effect after
the offer was made. Thus an offer to sell a quantity of herbal weight-loss supplements will terminate if the
Food and Drug Administration outlaws the sale of such supplements.

KEY TAKEAWAY
An offer is a manifestation of willingness to enter into a contract, effective when received. It must be
communicated to the offeree, be made intentionally (according to an objective standard), and be definite
enough to determine a remedy in case of breach. An offer terminates in one of seven ways: revocation before
acceptance (except for option contracts, firm offers under the UCC, statutory irrevocability, and unilateral
offers where an offeree has commenced performance); rejection; counteroffer; acceptance with counteroffer;
lapse of time (as stipulated or after a reasonable time); death or insanity of the offeror before acceptance or
destruction of subject matter essential to the offer; and postoffer illegality.

EXERCISES
1.

Why is it said an offer is a “manifestation” of willingness to enter into a contract? How could willingness
be “manifested”?

2.

Which kind of standard is used to determine whether a person has made an offer—subjective or
objective?

3.

If Sandra posts a written notice offering “to the kitchen staff at Coldwater Bay (Alaska) transportation to
Seattle at the end of the fishing season,” and if David, one of the maintenance workers, says to her, “I
accept your offer of transportation to Seattle,” is there a contract?

4.

What are the seven ways an offer can terminate?

[1] Restatement (Second) of Contracts, Section 24.
[2] Chiefly, Uniform Commercial Code, Sections 2-305 through 2-310.

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9.3 The Acceptance
LEARNING OBJECTIVES
1.

Define acceptance.

2.

Understand who may accept an offer.

3.

Know when the acceptance is effective.

4.

Recognize when silence is acceptance.

General Definition of Acceptance
To result in a legally binding contract, an offer must be accepted by the offeree. Just as the law helps
define and shape an offer and its duration, so the law governs the nature and manner of acceptance. The
Restatement defines acceptance of an offer as “a manifestation of assent to the terms thereof made by the
[1]

offeree in a manner invited or required by the offer.” The assent may be either by the making of a mutual
promise or by performance or partial performance. If there is doubt about whether the offer requests a
return promise or a return act, the Restatement, Section 32, provides that the offeree may accept with
either a promise or performance. The Uniform Commercial Code (UCC) also adopts this view; under
Section 2-206(1)(a), “an offer to make a contract shall be construed as inviting acceptance in any manner
and by any medium reasonable in the circumstances” unless the offer unambiguously requires a certain
mode of acceptance.

Who May Accept?
The identity of the offeree is usually clear, even if the name is unknown. The person to whom a promise is
made is ordinarily the person whom the offeror contemplates will make a return promise or perform the
act requested. But this is not invariably so. A promise can be made to one person who is not expected to
do anything in return. The consideration necessary to weld the offer and acceptance into a legal contract
can be given by a third party. Under the common law, whoever is invited to furnish consideration to the
offeror is the offeree, and only an offeree may accept an offer. A common example is sale to a minor.
George promises to sell his automobile to Bartley, age seventeen, if Bartley’s father will promise to pay
$3,500 to George. Bartley is the promisee (the person to whom the promise is made) but not the offeree;
Bartley cannot legally accept George’s offer. Only Bartley’s father, who is called on to pay for the car, can

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accept, by making the promise requested. And notice what might seem obvious: a promise to perform as
requested in the offer is itself a binding acceptance.

When Is Acceptance Effective?
As noted previously, an offer, a revocation of the offer, and a rejection of the offer are not effective until
received. The same rule does not always apply to the acceptance.

Instantaneous Communication
Of course, in many instances the moment of acceptance is not in question: in face-to-face deals or
transactions negotiated by telephone, the parties extend an offer and accept it instantaneously during the
course of the conversation. But problems can arise in contracts negotiated through correspondence.

Stipulations as to Acceptance
One common situation arises when the offeror stipulates the mode of acceptance (e.g., return mail, fax, or
carrier pigeon). If the offeree uses the stipulated mode, then the acceptance is deemed effective when sent.
Even though the offeror has no knowledge of the acceptance at that moment, the contract has been
formed. Moreover, according to the Restatement, Section 60, if the offeror says that the offer can be
accepted only by the specified mode, that mode must be used. (It is said that “the offeror is the master of
the offer.”)
If the offeror specifies no particular mode, then acceptance is effective when transmitted, as long as the
offeree uses a reasonable method of acceptance. It is implied that the offeree can use the same means used
by the offeror or a means of communication customary to the industry.

The “Mailbox Rule”
The use of the postal service is customary, so acceptances are considered effective when mailed,
regardless of the method used to transmit the offer. Indeed, the so-called mailbox rule has a lineage
tracing back more than one hundred years to the English courts.

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The mailbox rule may seem to create particular difficulties for people in business, since the acceptance is
effective even though the offeror is unaware of the acceptance, and even if the letter is lost and never
arrives. But the solution is the same as the rationale for the rule. In contracts negotiated through
correspondence, there will always be a burden on one of the parties. If the rule were that the acceptance is
not effective until received by the offeror, then the offeree would be on tenterhooks, rather than the other
way around, as is the case with the present rule. As between the two, it seems fairer to place the burden on
the offeror, since he or she alone has the power to fix the moment of effectiveness. All the offeror need do
is specify in the offer that acceptance is not effective until received.
In all other cases—that is, when the offeror fails to specify the mode of acceptance and the offeree uses a
mode that is not reasonable—acceptance is deemed effective only when received.

Acceptance “Outruns” Rejection
When the offeree sends a rejection first and then later transmits a superseding acceptance, the “effective
when received” rule also applies. Suppose a seller offers a buyer two cords of firewood and says the offer
will remain open for a week. On the third day, the buyer writes the seller, rejecting the offer. The following
evening, the buyer rethinks his firewood needs, and on the morning of the fifth day, he sends an e-mail
accepting the seller’s terms. The previously mailed letter arrives the following day. Since the letter had not
yet been received, the offer had not been rejected. For there to be a valid contract, the e-mailed acceptance
must arrive before the mailed rejection. If the e-mail were hung up in cyberspace, although through no
fault of the buyer, so that the letter arrived first, the seller would be correct in assuming the offer was
terminated—even if the e-mail arrived a minute later. In short, where “the acceptance outruns the
rejection” the acceptance is effective. See Figure 9.1.
Figure 9.1

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When Is Communication Effective?

Electronic Communications
Electronic communications have, of course, become increasingly common. Many contracts are negotiated
by e-mail, accepted and “signed” electronically. Generally speaking, this does not change the rules. The
Uniform Electronic Transactions Act (UETA) was promulgated (i.e., disseminated for states to adopt) in
1999. It is one of a number of uniform acts, like the Uniform Commercial Code. As of June 2010, fortyseven states and the US Virgin Islands had adopted the statute. The introduction to the act provides that
“the purpose of the UETA is to remove barriers to electronic commerce by validating and effectuating
electronic records and signatures.”
a.

[3]

In general, the UETA provides the following:

A record or signature may not be denied legal effect or enforceability solely because it is in
electronic form.

b. A contract may not be denied legal effect or enforceability solely because an electronic record was
used in its formation.
c.

If a law requires a record to be in writing, an electronic record satisfies the law.

d. If a law requires a signature, an electronic signature satisfies the law.
The UETA, though, doesn’t address all the problems with electronic contracting. Clicking on a computer
screen may constitute a valid acceptance of a contractual offer, but only if the offer is clearly
communicated. In Specht v. Netscape Communications Corp., customers who had downloaded a free
online computer program complained that it effectively invaded their privacy by inserting into their

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machines “cookies”; they wanted to sue, but the defendant said they were bound to arbitration.

[4]

They

had clicked on the Download button, but hidden below it were the licensing terms, including the
arbitration clause. The federal court of appeals held that there was no valid acceptance. The court said,
“We agree with the district court that a reasonably prudent Internet user in circumstances such as these
would not have known or learned of the existence of the license terms before responding to defendants’
invitation to download the free software, and that defendants therefore did not provide reasonable notice
of the license terms. In consequence, the plaintiffs’ bare act of downloading the software did not
unambiguously manifest assent to the arbitration provision contained in the license terms.”
If a faxed document is sent but for some reason not received or not noticed, the emerging law is that the
mailbox rule does not apply. A court would examine the circumstances with care to determine the reason
for the nonreceipt or for the offeror’s failure to notice its receipt. A person has to have fair notice that his
or her offer has been accepted, and modern communication makes the old-fashioned mailbox rule—that
acceptance is effective upon dispatch—problematic.

[5]

Silence as Acceptance
General Rule: Silence Is Not Acceptance
Ordinarily, for there to be a contract, the offeree must make some positive manifestation of assent to the
offeror’s terms. The offeror cannot usually word his offer in such a way that the offeree’s failure to
respond can be construed as an acceptance.

Exceptions
The Restatement, Section 69, gives three situations, however, in which silence can operate as an
acceptance. The first occurs when the offeree avails himself of services proffered by the offeror, even
though he could have rejected them and had reason to know that the offeror offered them expecting
compensation. The second situation occurs when the offer states that the offeree may accept without
responding and the offeree, remaining silent, intends to accept. The third situation is that of previous
dealings, in which only if the offeree intends not to accept is it reasonable to expect him to say so.

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As an example of the first type of acceptance by silence, assume that a carpenter happens by your house
and sees a collapsing porch. He spots you in the front yard and points out the deterioration. “I’m a
professional carpenter,” he says, “and between jobs. I can fix that porch for you. Somebody ought to.” You
say nothing. He goes to work. There is an implied contract, with the work to be done for the carpenter’s
usual fee.
To illustrate the second situation, suppose that a friend has left her car in your garage. The friend sends
you a letter in which she offers you the car for $4,000 and adds, “If I don’t hear from you, I will assume
that you have accepted my offer.” If you make no reply, with the intention of accepting the offer, a
contract has been formed.
The third situation is illustrated by Section 9.4.3 "Silence as Acceptance", a well-known decision made by
Justice Oliver Wendell Holmes Jr. when he was sitting on the Supreme Court of Massachusetts.

KEY TAKEAWAY
Without an acceptance of an offer, no contract exists, and once an acceptance is made, a contract is formed. If
the offeror stipulates how the offer should be accepted, so be it. If there is no stipulation, any reasonable
means of communication is good. Offers and revocations are usually effective upon receipt, while an
acceptance is effective on dispatch. The advent of electronic contracting has caused some modification of the
rules: courts are likely to investigate the facts surrounding the exchange of offer and acceptance more
carefully than previously. But the nuances arising because of the mailbox rule and acceptance by silence still
require close attention to the facts.

EXERCISES
1.

Rudy puts this poster, with a photo of his dog, on utility poles around his neighborhood: “$50 reward for
the return of my lost dog.” Carlene doesn’t see the poster, but she finds the dog and, after looking at the
tag on its collar, returns the dog to Rudy. As she leaves his house, her eye falls on one of the posters, but
Rudy declines to pay her anything. Why is Rudy correct that Carlene has no legal right to the reward?

2.

How has the UCC changed the common law’s mirror image rule, and why?

3.

When is an offer generally said to be effective? A rejection of an offer? A counteroffer?

4.

How have modern electronic communications affected the law of offer and acceptance?

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5.

When is silence considered an acceptance?

[1] Restatement (Second) of Contracts, Section 24.
[2] Adams v. Lindsell, 1 Barnewall & Alderson 681 (K.B. 1818).
[3] The National Conference of Commissioners on Uniform State Laws, Uniform Electronic Transactions Act
(1999) (Denver: National Conference of Commissioners on Uniform State Laws, 1999), accessed March 29,
2011,http://www.law.upenn.edu/bll/archives/ulc/fnact99/1990s/ueta99.pdf.
[4] Specht v. Netscape Communications Corp., 306 F.3d 17 (2d Cir. 2002).
[5] See, for example, Clow Water Systems Co. v. National Labor Relations Board, 92 F.3d 441 (6th Cir. 1996).

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9.4 Cases
Objective Intention
Lucy v. Zehmer
84 S.E.2d 516 (Va. 1954)
Buchanan, J.
This suit was instituted by W. O. Lucy and J. C. Lucy, complainants, against A. H. Zehmer and Ida S.
Zehmer, his wife, defendants, to have specific performance of a contract by which it was alleged the
Zehmers had sold to W. O. Lucy a tract of land owned by A. H. Zehmer in Dinwiddie county containing
471.6 acres, more or less, known as the Ferguson farm, for $50,000. J. C. Lucy, the other complainant, is
a brother of W. O. Lucy, to whom W. O. Lucy transferred a half interest in his alleged purchase.
The instrument sought to be enforced was written by A. H. Zehmer on December 20, 1952, in these words:
“We hereby agree to sell to W. O. Lucy the Ferguson farm complete for $50,000.00, title satisfactory to
buyer,” and signed by the defendants, A. H. Zehmer and Ida S. Zehmer.
The answer of A. H. Zehmer admitted that at the time mentioned W. O. Lucy offered him $50,000 cash
for the farm, but that he, Zehmer, considered that the offer was made in jest; that so thinking, and both he
and Lucy having had several drinks, he wrote out “the memorandum” quoted above and induced his wife
to sign it; that he did not deliver the memorandum to Lucy, but that Lucy picked it up, read it, put it in his
pocket, attempted to offer Zehmer $5 to bind the bargain, which Zehmer refused to accept, and realizing
for the first time that Lucy was serious, Zehmer assured him that he had no intention of selling the farm
and that the whole matter was a joke. Lucy left the premises insisting that he had purchased the farm.…
In his testimony Zehmer claimed that he “was high as a Georgia pine,” and that the transaction “was just a
bunch of two doggoned drunks bluffing to see who could talk the biggest and say the most.” That claim is
inconsistent with his attempt to testify in great detail as to what was said and what was done.…
If it be assumed, contrary to what we think the evidence shows, that Zehmer was jesting about selling his
farm to Lucy and that the transaction was intended by him to be a joke, nevertheless the evidence shows

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that Lucy did not so understand it but considered it to be a serious business transaction and the contract
to be binding on the Zehmers as well as on himself. The very next day he arranged with his brother to put
up half the money and take a half interest in the land. The day after that he employed an attorney to
examine the title. The next night, Tuesday, he was back at Zehmer’s place and there Zehmer told him for
the first time, Lucy said, that he wasn’t going to sell and he told Zehmer, “You know you sold that place
fair and square.” After receiving the report from his attorney that the title was good he wrote to Zehmer
that he was ready to close the deal.
Not only did Lucy actually believe, but the evidence shows he was warranted in believing, that the contract
represented a serious business transaction and a good faith sale and purchase of the farm.
In the field of contracts, as generally elsewhere, “We must look to the outward expression of a person as
manifesting his intention rather than to his secret and unexpressed intention. The law imputes to a person
an intention corresponding to the reasonable meaning of his words and acts.”
At no time prior to the execution of the contract had Zehmer indicated to Lucy by word or act that he was
not in earnest about selling the farm. They had argued about it and discussed its terms, as Zehmer
admitted, for a long time. Lucy testified that if there was any jesting it was about paying $50,000 that
night. The contract and the evidence show that he was not expected to pay the money that night. Zehmer
said that after the writing was signed he laid it down on the counter in front of Lucy. Lucy said Zehmer
handed it to him. In any event there had been what appeared to be a good faith offer and a good faith
acceptance, followed by the execution and apparent delivery of a written contract. Both said that Lucy put
the writing in his pocket and then offered Zehmer $5 to seal the bargain. Not until then, even under the
defendants’ evidence, was anything said or done to indicate that the matter was a joke. Both of the
Zehmers testified that when Zehmer asked his wife to sign he whispered that it was a joke so Lucy
wouldn’t hear and that it was not intended that he should hear.
The mental assent of the parties is not requisite for the formation of a contract. If the words or other acts
of one of the parties have but one reasonable meaning, his undisclosed intention is immaterial except
when an unreasonable meaning which he attaches to his manifestations is known to the other party.

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“* * * The law, therefore, judges of an agreement between two persons exclusively from those expressions
of their intentions which are communicated between them. * * *.” [Citation]
An agreement or mutual assent is of course essential to a valid contract but the law imputes to a person an
intention corresponding to the reasonable meaning of his words and acts. If his words and acts, judged by
a reasonable standard, manifest an intention to agree, it is immaterial what may be the real but
unexpressed state of his mind.
So a person cannot set up that he was merely jesting when his conduct and words would warrant a
reasonable person in believing that he intended a real agreement.
Whether the writing signed by the defendants and now sought to be enforced by the complainants was the
result of a serious offer by Lucy and a serious acceptance by the defendants, or was a serious offer by Lucy
and an acceptance in secret jest by the defendants, in either event it constituted a binding contract of sale
between the parties.…
Reversed and remanded.

CASE QUESTIONS
1.

What objective evidence was there to support the defendants’ contention that they were just kidding
when they agreed to sell the farm?

2.

Suppose the defendants really did think the whole thing was a kind of joke. Would that make any
difference?

3.

As a matter of public policy, why does the law use an objective standard to determine the seriousness of
intention, instead of a subjective standard?

4.

It’s 85 degrees in July and 5:00 p.m., quitting time. The battery in Mary’s car is out of juice, again. Mary
says, “Arrgh! I will sell this stupid car for $50!” Jason, walking to his car nearby, whips out his checkbook
and says, “It’s a deal. Leave your car here. I’ll give you a ride home and pick up your car after you give me
the title.” Do the parties have a contract?

Advertisements as Offers
Lefkowitz v. Great Minneapolis Surplus Store

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86 N.W.2d 689 (Minn. 1957)
Murphy, Justice.
This is an appeal from an order of the Municipal Court of Minneapolis denying the motion of the
defendant for amended findings of fact, or, in the alternative, for a new trial. The order for judgment
awarded the plaintiff the sum of $138.50 as damages for breach of contract.
This case grows out of the alleged refusal of the defendant to sell to the plaintiff a certain fur piece which it
had offered for sale in a newspaper advertisement. It appears from the record that on April 6, 1956, the
defendant published the following advertisement in a Minneapolis newspaper:
Saturday 9 A.M. Sharp
3 Brand New Fur Coats Worth to $100.00
First Come
First Served
$1 Each
[The $100 coat would be worth about $800 in 2010 dollars.] On April 13, the defendant again published
an advertisement in the same newspaper as follows:
Saturday 9 A.M.
2 Brand New Pastel Mink 3-Skin Scarfs
Selling for. $89.50
Out they go Saturday. Each…$1.00
1 Black Lapin Stole Beautiful, worth $139.50…$1.00
First Come First Served

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The record supports the findings of the court that on each of the Saturdays following the publication of the
above-described ads the plaintiff was the first to present himself at the appropriate counter in the
defendant’s store and on each occasion demanded the coat and the stole so advertised and indicated his
readiness to pay the sale price of $1. On both occasions, the defendant refused to sell the merchandise to
the plaintiff, stating on the first occasion that by a “house rule” the offer was intended for women only and
sales would not be made to men, and on the second visit that plaintiff knew defendant’s house rules.
The trial court properly disallowed plaintiff’s claim for the value of the fur coats since the value of these
articles was speculative and uncertain. The only evidence of value was the advertisement itself to the effect
that the coats were “Worth to $100.00,” how much less being speculative especially in view of the price for
which they were offered for sale. With reference to the offer of the defendant on April 13, 1956, to sell the
“1 Black Lapin Stole * * * worth $139.50 * * *” the trial court held that the value of this article was
established and granted judgment in favor of the plaintiff for that amount less the $1 quoted purchase
price.
1.

The defendant contends that a newspaper advertisement offering items of merchandise for sale at a
named price is a “unilateral offer” which may be withdrawn without notice. He relies upon authorities
which hold that, where an advertiser publishes in a newspaper that he has a certain quantity or
quality of goods which he wants to dispose of at certain prices and on certain terms, such
advertisements are not offers which become contracts as soon as any person to whose notice they may
come signifies his acceptance by notifying the other that he will take a certain quantity of them. Such
advertisements have been construed as an invitation for an offer of sale on the terms stated, which
offer, when received, may be accepted or rejected and which therefore does not become a contract of
sale until accepted by the seller; and until a contract has been so made, the seller may modify or
revoke such prices or terms. [Citations]

…On the facts before us we are concerned with whether the advertisement constituted an offer, and, if so,
whether the plaintiff’s conduct constituted an acceptance.

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There are numerous authorities which hold that a particular advertisement in a newspaper or circular
letter relating to a sale of articles may be construed by the court as constituting an offer, acceptance of
which would complete a contract. [Citations]
The test of whether a binding obligation may originate in advertisements addressed to the general public
is “whether the facts show that some performance was promised in positive terms in return for something
requested.” 1 Williston, Contracts (Rev. ed.) s 27.
The authorities above cited emphasize that, where the offer is clear, definite, and explicit, and leaves
nothing open for negotiation, it constitutes an offer, acceptance of which will complete the contract.…
Whether in any individual instance a newspaper advertisement is an offer rather than an invitation to
make an offer depends on the legal intention of the parties and the surrounding circumstances. [Citations]
We are of the view on the facts before us that the offer by the defendant of the sale of the Lapin fur was
clear, definite, and explicit, and left nothing open for negotiation. The plaintiff having successfully
managed to be the first one to appear at the seller’s place of business to be served, as requested by the
advertisement, and having offered the stated purchase price of the article, he was entitled to performance
on the part of the defendant. We think the trial court was correct in holding that there was in the conduct
of the parties a sufficient mutuality of obligation to constitute a contract of sale.
2. The defendant contends that the offer was modified by a “house rule” to the effect that only women
were qualified to receive the bargains advertised. The advertisement contained no such restriction.
This objection may be disposed of briefly by stating that, while an advertiser has the right at any time
before acceptance to modify his offer, he does not have the right, after acceptance, to impose new or
arbitrary conditions not contained in the published offer. [Citations]
Affirmed.

CASE QUESTIONS
1.

If the normal rule is that display advertisements in newspapers and the like are not offers, but rather
invitations to make an offer, why was this different? Why did the court hold that this was an offer?

2.

What is the rationale for the rule that a display ad is usually not an offer?

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3.

If a newspaper display advertisement reads, “This offer is good for two weeks,” is it still only an invitation
to make an offer, or is it an offer?

4.

Is a listing by a private seller for the sale of a trailer on Craigslist or in the weekly classified advertisements
an offer or an invitation to make an offer?

Silence as Acceptance
Hobbs v.Massasoit Whip Co.
33 N.E. 495 (Mass. 1893)
Holmes, J.
This is an action for the price of eel skins sent by the plaintiff to the defendant, and kept by the defendant
some months, until they were destroyed. It must be taken that the plaintiff received no notice that the
defendant declined to accept the skins. The case comes before us on exceptions to an instruction to the
jury that, whether there was any prior contract or not, if skins are sent to the defendant, and it sees fit,
whether it has agreed to take them or not, to lie back, and to say nothing, having reason to suppose that
the man who has sent them believes that it is taking them, since it says nothing about it, then, if it fails to
notify, the jury would be warranted in finding for the plaintiff.
Standing alone, and unexplained, this proposition might seem to imply that one stranger may impose a
duty upon another, and make him a purchaser, in spite of himself, by sending goods to him, unless he will
take the trouble, and bear the expense, of notifying the sender that he will not buy. The case was argued
for the defendant on that interpretation. But, in view of the evidence, we do not understand that to have
been the meaning of the judge and we do not think that the jury can have understood that to have been his
meaning. The plaintiff was not a stranger to the defendant, even if there was no contract between them.
He had sent eel skins in the same way four or five times before, and they had been accepted and paid for.
On the defendant’s testimony, it was fair to assume that if it had admitted the eel skins to be over 22
inches in length, and fit for its business, as the plaintiff testified and the jury found that they were, it
would have accepted them; that this was understood by the plaintiff; and, indeed, that there was a
standing offer to him for such skins.

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In such a condition of things, the plaintiff was warranted in sending the defendant skins conforming to
the requirements, and even if the offer was not such that the contract was made as soon as skins
corresponding to its terms were sent, sending them did impose on the defendant a duty to act about them;
and silence on its part, coupled with a retention of the skins for an unreasonable time, might be found by
the jury to warrant the plaintiff in assuming that they were accepted, and thus to amount to an
acceptance. [Citations] The proposition stands on the general principle that conduct which imports
acceptance or assent is acceptance or assent, in the view of the law, whatever may have been the actual
state of mind of the party—a principle sometimes lost sight of in the cases. [Citations]
Exceptions overruled.

CASE QUESTIONS
1.

What is an eel, and why would anybody make a whip out of its skin?

2.

Why did the court here deny the defendant’s assertion that it never accepted the plaintiff’s offer?

3.

If it reasonably seems that silence is acceptance, does it make any difference what the offeree really
intended?

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9.5 Summary and Exercises
Summary
Whether a legally valid contract was formed depends on a number of factors, including whether the
parties reached agreement, whether consideration was present, and whether the agreement was legal.
Agreement may seem like an intuitive concept, but intuition is not a sufficient guide to the existence of
agreement in legal terms. The most common way of examining an agreement for legal sufficiency is by
determining whether a valid offer and acceptance were made.
An offer is a manifestation of willingness to enter into a bargain such that it would be reasonable for
another individual to conclude that assent to the offer would complete the bargain. Offers must be
communicated and must be definite; that is, they must spell out terms to which the offeree can assent.
An important aspect of the offer is its duration. An offer can expire in any one of several ways: (1)
rejection, (2) counteroffer, (3) acceptance with counteroffer, (4) lapse of time, (5) death or insanity of the
offeror or destruction of an essential term, (6) illegality, and (7) revocation. No understanding of
agreement is complete without a mastery of these conditions.
To constitute an agreement, an offer must be accepted.
The offeree must manifest his assent to the terms of the offer in a manner invited or required by the offer.
Complications arise when an offer is accepted indirectly through correspondence. Although offers and
revocations of offers are not effective until received, an acceptance is deemed accepted when sent if the
offeree accepts in the manner specified by the offeror. But the nuances that arise because of the mailbox
rule and acceptance by silence require close attention to the circumstances of each agreement.

EXERCISES
1.

Sarah’s student apartment was unfurnished. She perused Doug’s List, an online classified ad service (for
nonmerchants), and saw this advertisement: “Moving. For sale: a very nice brown leather couch, almost
new, $600.” There was an accompanying photo and contact information. Sarah e-mailed the contact,
saying she wanted to buy the couch. Does Sarah have a contract with the seller? Explain.

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2.

Seller called Buyer on the telephone and offered to sell his used stereo. Buyer agreed to buy it without
asking the price. The next day Buyer changed her mind and attempted to back out of the agreement. Do
the parties have a contract? Explain.

3.

On August 1, Ernie wrote to Elsie offering to sell Elsie his car for $7,600, and he promised to hold the offer
open for ten days. On August 4 Ernie changed his mind; he sent Elsie a letter revoking the offer. On
August 5 Elsie e-mailed Ernie, accepting the offer. Ernie’s letter of revocation arrived on August 6. Is there
a contract? Explain.

4.

On August 1 Grover visited a local electronics shop to purchase a new television. He saw one he liked but
wasn’t sure if he could afford the $750. The store owner agreed to write up and sign an offer stating that
it would be held open for ten days, which he did. On August 2 the owner changed his mind and sent
Grover an e-mail revoking the offer, which Grover received immediately. On August 3 Grover sent a reply
e-mail accepting the original offer. Is there a contract? Explain.
5.

Acme Corporation sent the following letter, here set out in its entirety:
January 2, 2012
Acme Corporation
We hereby offer you 100 Acme golden widgets, size 6. This offer will be good for 10 days.
[Signed] Roberta Acme
Owner, Acme Corporation
Is this offer irrevocable for the time stated? Explain.

6.

On November 26, Joe wrote to Kate offering to purchase a farm that she owned. Upon receiving the letter
on November 28, Kate immediately sent Joe a letter of acceptance. However, shortly after mailing the
letter, Kate had second thoughts and called Joe to advise him that she was rejecting his offer. The call was
made before Joe received the letter of acceptance. Has a contract been formed? Why?

7.

On a busy day just before April 15, Albert Accountant received a call from a local car dealer. The dealer
said, “Hi, Mr. Accountant. Now, while you have income from doing clients’ taxes, I have an excellent offer
for you. You can buy a new Buick Century automobile completely loaded for $36,000. Al, I know you’re
busy. If I don’t hear from you by the end of the day, I’ll assume you want the car.” Albert, distracted, did

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not respond immediately, and the dealer hung up. Then followed an exhausting day of working with
anxiety-ridden tax clients. Albert forgot about the conversation. Two days later a statement arrived from
the dealer, with instructions on how Albert should pick up the car at the dealership. Is there a contract?
Explain.
8.

Mr. and Mrs. Mitchell, the owners of a small secondhand store, attended an auction where they bought a
used safe for $50. The safe, part of the Sumstad estate, had a locked compartment inside, a fact the
auctioneer mentioned. After they bought the safe, the Mitchells had a locksmith open the interior
compartment; it contained $32,000 in cash. The locksmith called the police, who impounded the safe, and
a lawsuit ensued between the Mitchells and the Sumstad estate to determine the ownership of the cash.
Who should get it, and why?

9.

Ivan Mestrovic, an internationally renowned artist, and his wife lived for years in a house in Indiana. Ivan
died in 1982. His widow remained in the house for some years; upon her death the contents of the house
were willed to her children. When the Wilkens bought the house from the estate, it was very cluttered. A
bank representative (the executor of the estate) said, “You can clean it yourself and keep whatever items
you want, or we—as executor of Mrs. Mestrovic’s estate—will hire a rubbish removal service to dispose
of it.” The Wilkens opted to clean it up themselves, and amid the mess, behind sofas and in odd closets,
were six apparently valuable paintings by Mestrovic. The estate claimed them; the Wilkens claimed them.
Who gets the paintings, and why?

10. David Kidd’s dog bit Mikaila Sherrod. On June 14, 2010, the Kidds offered to settle for $32,000. On July 12
the Sherrods sued the Kidds. On July 20 the Kidds bumped their offer up to $34,000. The suit was subject
to mandatory arbitration, which proceeded on April 28, 2011. On May 5 the arbitrator awarded the
Sherrods $25,000. On May 9 the Sherrods wrote to the Kidds and purported to accept their last offer of
$34,000, made the year before. The Sherrods’ attorney moved to enforce that purported $34,000
“settlement agreement.” The court concluded that the offer was properly accepted because it had not
been withdrawn and entered judgment against the Kidds for $34,000. The Kidds appealed. What result
should obtain on appeal, and why?

[1]

SELF-TEST QUESTIONS
1.

In interpreting agreements for the purpose of establishing whether a valid contract exists, courts
generally apply

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a.

subjective standards

b.

objective standards

c.

either a subjective or an objective standard

d.

none of the above
A valid offer must be

a.

written

b.

written and intended

c.

communicated by letter

d.

communicated and definite
An offer

a.

must specify time, place, and manner of acceptance

b.

must be accepted immediately to be valid

c.

need not be accepted immediately

d.

can only be accepted by the same means it was made
An offer generally

a.

is rejected by a counteroffer

b.

can be revoked if the offeror changes his or her mind

c.

can lapse after a reasonable period of time

d.

involves all of the above
An acceptance is generally considered effective

a.

when a letter is received by the offeror

b.

when a letter is mailed

c.

when the offeree is silent

d.

only when the acceptance is transmitted in writing

SELF-TEST ANSWERS
1.

b

2.

d

3.

c

4.

d

5.

b

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[1] Sherrod ex rel. Cantone v. Kidd, 155 P.3d 976 (Wash. Ct. App., 2007).

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Chapter 10

Real Assent
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

Contracts require “a meeting of the minds” between competent parties, and if there is no such
“meeting,” the agreement is usually voidable.

2.

Parties must enter the contract voluntarily, without duress or undue influence.

3.

Misrepresentation or fraud, when proven, vitiates a contract.

4.

A mistake may make a contract voidable.

5.

Parties to a contract must have capacity—that is, not labor under infancy, intoxication, or insanity.

We turn to the second of the four requirements for a valid contract. In addition to manifestation of
assent, a party’s assent must be real; he or she must consent to the contract freely, with adequate
knowledge, and must have capacity. The requirement of real assent raises the following major
questions:
1.

Did the parties enter into the contract of their own free will, or was one forced to agree under
duress or undue influence?

2. Did the parties enter into the contract with full knowledge of the facts, or was one or both led to
the agreement through fraud or mistake?
3. Did both parties have the capacity to make a contract?

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10.1 Duress and Undue Influence
LEARNING OBJECTIVES
1.

Recognize that if a person makes an agreement under duress (being forced to enter a contract against
his or her will), the agreement is void.

2.

Understand what undue influence is and what the typical circumstances are when it arises to make a
contract voidable.

Duress
When a person is forced to do something against his or her will, that person is said to have been the victim
of duress—compulsion. There are two types of duress: physical duress and duress by improper threat. A
contract induced by physical violence is void.

Physical Duress
If a person is forced into entering a contract on threat of physical bodily harm, he or she is the victim
of physical duress. It is defined by the Restatement (Second) of Contracts in Section 174: “If conduct that
appears to be a manifestation of assent by a party who does not intend to engage in that conduct is
physically compelled by duress, the conduct is not effective as a manifestation of assent.”
Comment (a) to Section 174 provides in part, “This Section involves an application of that principle to
those relatively rare situations in which actual physical force has been used to compel a party to appear
to assent to a contract.…The essence of this type of duress is that a party is compelled by physical force to
do an act that he has no intention of doing. He is, it is sometimes said, ‘a mere mechanical instrument.’
The result is that there is no contract at all, or a ‘void contract’ as distinguished from a voidable one”
(emphasis added).
The Restatement is undoubtedly correct that there are “relatively rare situations in which actual physical
force” is used to compel assent to a contract. Extortion is a crime.

Duress by Threat

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The second kind of duress is duress by threat; it is more common than physical duress. Here the
perpetrator threatens the victim, who feels there is no reasonable alternative but to assent to the contract.
It renders the contract voidable. This rule contains a number of elements.
First, the threat must be improper. Second, there must be no reasonable alternative. If, for example, a
supplier threatens to hold up shipment of necessary goods unless the buyer agrees to pay more than the
contract price, this would not be duress if the buyer could purchase identical supplies from someone else.
Third, the test for inducement is subjective. It does not matter that the person threatened is unusually
timid or that a reasonable person would not have felt threatened. The question is whether the threat in
fact induced assent by the victim. Such facts as the victim’s belief that the threatener had the ability to
carry out the threat and the length of time between the threat and assent are relevant in determining
whether the threat did prompt the assent.
There are many types of improper threats that might induce a party to enter into a contract: threats to
commit a crime or a tort (e.g., bodily harm or taking of property), to instigate criminal prosecution, to
instigate civil proceedings when a threat is made in bad faith, to breach a “duty of good faith and fair
dealing under a contract with the recipient,” or to disclose embarrassing details about a person’s private
life.
Jack buys a car from a local used-car salesman, Mr. Olson, and the next day realizes he bought a lemon.
He threatens to break windows in Olson’s showroom if Olson does not buy the car back for $2,150, the
purchase price. Mr. Olson agrees. The agreement is voidable, even though the underlying deal is fair, if
Olson feels he has no reasonable alternative and is frightened into agreeing. Suppose Jack knows that
Olson has been tampering with his cars’ odometers, a federal offense, and threatens to have Olson
prosecuted if he will not repurchase the car. Even though Olson may be guilty, this threat makes the
repurchase contract voidable, because it is a misuse for personal ends of a power (to go to the police)
given each of us for other purposes. If these threats failed, suppose Jack then tells Olson, “I’m going to
haul you into court and sue your pants off.” If Jack means he will sue for his purchase price, this is not an
improper threat, because everyone has the right to use the courts to gain what they think is rightfully
theirs. But if Jack meant that he would fabricate damages done him by a (falsely) claimed odometer

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manipulation, that would be an improper threat. Although Olson could defend against the suit, his
reputation would suffer in the meantime from his being accused of odometer tampering.
A threat to breach a contract that induces the victim to sign a new contract could be improper. Suppose
that as part of the original purchase price, Olson agrees to make all necessary repairs and replace all failed
parts for the first ninety days. At the end of one month, the transmission dies, and Jack demands a
replacement. Olson refuses to repair the car unless Jack signs a contract agreeing to buy his next car from
Olson. Whether this threat is improper depends on whether Jack has a reasonable alternative; if a
replacement transmission is readily available and Jack has the funds to pay for it, he might have an
alternative in suing Olson in small claims court for the cost. But if Jack needs the car immediately and he
is impecunious, then the threat would be improper and the contract voidable. A threat to breach a
contract is not necessarily improper, however. It depends on whether the new contract is fair and
equitable because of unanticipated circumstances. If, for example, Olson discovers that he must purchase
a replacement transmission at three times the anticipated cost, his threat to hold up work unless Jack
agrees to pay for it might be reasonable.

Undue Influence
The Restatement of Contracts (Second) characterizes undue influence as “unfair persuasion.”

[1]

It is a

milder form of duress than physical harm or threats. The unfairness does not lie in any
misrepresentation; rather, it occurs when the victim is under the domination of the persuader or is one
who, in view of the relationship between them, is warranted in believing that the persuader will act in a
manner detrimental to the victim’s welfare if the victim fails to assent. It is the improper use of trust or
power to deprive a person of free will and substitute instead another’s objective. Usually the fact pattern
involves the victim being isolated from receiving advice except from the persuader. Falling within this rule
are situations where, for example, a child takes advantage of an infirm parent, a doctor takes advantage of
an ill patient, or a lawyer takes advantage of an unknowledgeable client. If there has been undue
influence, the contract is voidable by the party who has been unfairly persuaded. Whether the relationship
is one of domination and the persuasion is unfair is a factual question. The answer hinges on a host of
variables, including “the unfairness of the resulting bargain, the unavailability of independent advice, and
the susceptibility of the person persuaded.”

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[2]

See Section 10.5.1 "Undue Influence",Hodge v. Shea.

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KEY TAKEAWAY
A contract induced by physical duress—threat of bodily harm—is void; a contract induced by improper
threats—another type of duress—is voidable. Voidable also are contracts induced by undue influence, where
a weak will is overborne by a stronger one.

EXERCISES
1.

What are the two types of duress?

2.

What are the elements necessary to support a claim of undue influence?

[1] Restatement (Second) of Contracts, Section 177.
[2] Restatement (Second) of Contracts, Section 177(b).

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10.2 Misrepresentation
LEARNING OBJECTIVES
1.

Understand the two types of misrepresentation: fraudulent and nonfraudulent.

2.

Distinguish between fraudulent misrepresentation in the execution and fraudulent misrepresentation
in the inducement.

3.

Know the elements necessary to prove fraudulent and nonfraudulent misrepresentation.

4.

Recognize the remedies for misrepresentation.

General Description
The two types of misrepresentation are fraudulent and nonfraudulent. Within the former are fraud in the
execution and fraud in the inducement. Within the latter are negligent misrepresentation and innocent
misrepresentation.
Misrepresentation is a statement of fact that is not consistent with the truth. If misrepresentation is
intentional, it is fraudulent misrepresentation; if it is not intentional, it is nonfraudulent
misrepresentation, which can be either negligent or innocent.
In further taxonomy, courts distinguish between fraud in the execution and fraud in the
inducement. Fraud in the execution is defined by the Restatement as follows: “If a misrepresentation as to
the character or essential terms of a proposed contract induces conduct that appears to be a manifestation
of assent by one who neither knows nor has reasonable opportunity to know of the character or essential
terms of the proposed contract, his conduct is not effective as a manifestation of assent.”

[1]

For example,

Alphonse and Gaston decide to sign a written contract incorporating terms to which they have agreed. It is
properly drawn up, and Gaston reads it and approves it. Before he can sign it, however, Alphonse
shrewdly substitutes a different version to which Gaston has not agreed. Gaston signs the substitute
version. There is no contract. There has been fraud in the execution.
Fraud in the inducement is more common. It involves some misrepresentation about the subject of the
contract that induces assent. Alphonse tells Gaston that the car Gaston is buying from Alphonse has just
been overhauled—which pleases Gaston—but it has not been. This renders the contract voidable.

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Fraudulent Misrepresentation
Necessary to proving fraudulent misrepresentation (usually just “fraud,” though technically “fraud” is the
crime and “fraudulent misrepresentation” is the civil wrong) is a misstatement of fact that is intentionally
made and justifiably relied upon.

Misstatement of Fact
Again, generally, any statement not in accord with the facts (a fact is something amenable to testing as
true) is a misrepresentation. Falsity does not depend on intent. A typist’s unnoticed error in a letter
(inadvertently omitting the word “not,” for example, or transposing numbers) can amount to a
misrepresentation on which the recipient may rely (it is not fraudulent misrepresentation). A half-truth
can amount to a misrepresentation, as, for example, when the seller of a hotel says that the income is from
both permanent and transient guests but fails to disclose that the bulk of the income is from single-night
stopovers by seamen using the hotel as a brothel.

[2]

Concealment
Another type of misrepresentation is concealment. It is an act that is equivalent to a statement that the
facts are to the contrary and that serves to prevent the other party from learning the true statement of
affairs; it is hiding the truth. A common example is painting over defects in a building—by concealing the
defects, the owner is misrepresenting the condition of the property. The act of concealment need not be
direct; it may consist of sidetracking the other party from gaining necessary knowledge by, for example,
convincing a third person who has knowledge of the defect not to speak. Concealment is always a
misrepresentation.

Nondisclosure
A more passive type of concealment is nondisclosure. Although generally the law imposes no obligation
on anyone to speak out, nondisclosure of a fact can operate as a misrepresentation under certain
circumstances. This occurs, for example, whenever the other party has erroneous information, or, as Reed
v. King (Section 10.5.2 "Misrepresentation by Concealment") shows, where the nondisclosure amounts to

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a failure to act in good faith, or where the party who conceals knows or should know that the other side
cannot, with reasonable diligence, discover the truth.
In a remarkable 1991 case out of New York, a New York City stockbroker bought an old house upstate
(basically anyplace north of New York City) in the village of Nyack, north of New York City, and then
wanted out of the deal when he discovered—the defendant seller had not told him—that it was “haunted.”
The court summarized the facts: “Plaintiff, to his horror, discovered that the house he had recently
contracted to purchase was widely reputed to be possessed by poltergeists [ghosts], reportedly seen by
defendant seller and members of her family on numerous occasions over the last nine years. Plaintiff
promptly commenced this action seeking rescission of the contract of sale. Supreme Court reluctantly
dismissed the complaint, holding that plaintiff has no remedy at law in this jurisdiction.”
The high court of New York ruled he could rescind the contract because the house was “haunted as a
matter of law”: the defendant had promoted it as such on village tours and in Reader’s Digest. She had
concealed it, and no reasonable buyer’s inspection would have revealed the “fact.” The dissent basically
hooted, saying, “The existence of a poltergeist is no more binding upon the defendants than it is upon this
court.”

[3]

Statement Made False by Subsequent Events
If a statement of fact is made false by later events, it must be disclosed as false. For example, in idle
chatter one day, Alphonse tells Gaston that he owns thirty acres of land. In fact, Alphonse owns only
twenty-seven, but he decided to exaggerate a little. He meant no harm by it, since the conversation had no
import. A year later, Gaston offers to buy the “thirty acres” from Alphonse, who does not correct the
impression that Gaston has. The failure to speak is a nondisclosure—presumably intentional, in this
situation—that would allow Gaston to rescind a contract induced by his belief that he was purchasing
thirty acres.

Statements of Opinion

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An opinion, of course, is not a fact; neither is sales puffery. For example, the statements “In my opinion
this apple is very tasty” and “These apples are the best in the county” are not facts; they are not expected
to be taken as true. Reliance on opinion is hazardous and generally not considered justifiable.
If Jack asks what condition the car is in that he wishes to buy, Mr. Olson’s response of “Great!” is not
ordinarily a misrepresentation. As the Restatement puts it: “The propensity of sellers and buyers to
exaggerate the advantages to the other party of the bargains they promise is well recognized, and to some
extent their assertions must be discounted.”

[4]

Vague statements of quality, such as that a product is

“good,” ought to suggest nothing other than that such is the personal judgment of the opinion holder.
Despite this general rule, there are certain exceptions that justify reliance on opinions and effectively
make them into facts. Merely because someone is less astute than the one with whom she is bargaining
does not give rise to a claim of justifiable reliance on an unwarranted opinion. But if the person is
inexperienced and susceptible or gullible to blandishments, the contract can be voided, as illustrated
in Vokes v. Arthur Murray, Inc. in Section 10.5.3 "Misrepresentation by Assertions of Opinion".

Misstatement of Law
Incorrect assertions of law usually do not give rise to any relief, but sometimes they do. An assertion that
“the city has repealed the sales tax” or that a court has cleared title to a parcel of land is a statement of
fact; if such assertions are false, they are governed by the same rules that govern misrepresentations of
fact generally. An assertion of the legal consequences of a given set of facts is generally an opinion on
which the recipient relies at his or her peril, especially if both parties know or assume the same facts.
Thus, if there is a lien on a house, the seller’s statement that “the courts will throw it out, you won’t be
bothered by it” is an opinion. A statement that “you can build a five-unit apartment on this property” is
not actionable because, at common law, people are supposed to know what the local and state laws are,
and nobody should rely on a layperson’s statement about the law. However, if the statement of law is
made by a lawyer or real estate broker, or some other person on whom a layperson may justifiably rely,
then it may be taken as a fact and, if untrue, as the basis for a claim of misrepresentation. (Assertions
about foreign laws are generally held to be statements of fact, not opinion.)

Assertions of Intention
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Usually, assertions of intention are not considered facts. The law allows considerable leeway in the
honesty of assertions of intention. The Restatement talks in terms of “a misrepresentation of
intention…consistent with reasonable standards of fair dealing.”

[5]

The right to misstate intentions is

useful chiefly in the acquisition of land; the cases permit buyers to misrepresent the purpose of the
acquisition so as not to arouse the suspicion of the seller that the land is worth considerably more than his
asking price. To be a misrepresentation that will permit rescission, an assertion of intention must be false
at the time made; that is, the person asserting an intention must not then have intended it. That later he
or she does not carry out the stated intention is not proof that there was no intention at the time asserted.
Moreover, to render a contract voidable, the false assertion of intention must be harmful in some way to
other interests of the recipient. Thus, in the common example, the buyer of land tells the seller that he
intends to build a residence on the lot, but he actually intends to put up a factory and has lied because he
knows that otherwise the seller will not part with it because her own home is on an adjacent lot. The
contract is voidable by the seller. So a developer says, as regards the picturesque old barn on the property,
“I’ll sure try to save it,” but after he buys the land he realizes it would be very expensive (and in the way),
so he does not try to save it. No misrepresentation.

Intentionally Made Misrepresentation
The second element necessary to prove fraud is that the misrepresentation was intentionally made. A
misrepresentation is intentionally made “if the maker intends his assertion to induce a party to manifest
his assent and the maker (a) knows or believes that the assertion is not in accord with the facts, or (b)
does not have the confidence that he states or implies in the truth of the assertion, or (c) knows that he
does not have the basis that he states or implies for the assertion.”

[6]

The question of intent often has practical consequences in terms of the remedy available to the plaintiff. If
the misrepresentation is fraudulent, the plaintiff may, as an alternative to avoiding the contract, recover
damages. Some of this is discussed in Section 10.2.4 "Remedies" and more fully in Chapter 16 "Remedies",
where we see that some states would force the plaintiff to elect one of these two remedies, whereas other
states would allow the plaintiff to pursue both remedies (although only one type of recovery would
eventually be allowed). If the misrepresentation is not intentional, then the common law allowed the
plaintiff only the remedy of rescission. But the Uniform Commercial Code (UCC), Section 2-721, allows

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both remedies in contracts for the sale of goods, whether the misrepresentation is fraudulent or not, and
does not require election of remedies.

Reliance
The final element necessary to prove fraud is reliance by the victim. He or she must show that the
misrepresentation induced assent—that is, he or she relied on it. The reliance need not be solely on the
false assertion; the defendant cannot win the case by demonstrating that the plaintiff would have assented
to the contract even without the misrepresentation. It is sufficient to avoid the contract if the plaintiff
weighed the assertion as one of the important factors leading him to make the contract, and he believed it
to be true. The person who asserts reliance to avoid a contract must have acted in good faith and
reasonably in relying on the false assertion. Thus if the victim failed to read documents given him that
truly stated the facts, he cannot later complain that he relied on a contrary statement, as, for example,
when the purchaser of a car dealership was told the inventory consisted of new cars, but the supporting
papers, receipt of which he acknowledged, clearly stated how many miles each car had been driven. If Mr.
Olson tells Jack that the car Jack is interested in is “a recognized classic,” and if Jack doesn’t care a whit
about that but buys the car because he likes its tail fins, he will have no case against Mr. Olson when he
finds out the car is not a classic: it didn’t matter to him, and he didn’t rely on it.
Ordinarily, the person relying on a statement need not verify it independently. However, if verification is
relatively easy, or if the statement is one that concerns matters peculiarly within the person’s purview, he
or she may not be held to have justifiably relied on the other party’s false assertion. Moreover, usually the
rule of reliance applies to statements about past events or existing facts, not about the occurrence of
events in the future.

Nonfraudulent Misrepresentation
Nonfraudulent misrepresentation may also be grounds for some relief. There are two types: negligent
misrepresentation and innocent misrepresentation.

Negligent Misrepresentation

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Where representation is caused by carelessness, it isnegligent misrepresentation. To prove it, a plaintiff
must show a negligent misstatement of fact that is material and justifiably relied upon.

Negligent
As an element of misrepresentation, “negligent” here means the party who makes the representation was
careless. A potential buyer of rural real estate asks the broker if the neighborhood is quiet. The broker
assures her it is. In fact, the neighbors down the road have a whole kennel of hunting hounds that bark a
lot. The broker didn’t know that; she just assumed the neighborhood was quiet. That is negligence: failure
to use appropriate care.

Misstatement of Fact
Whether a thing is a fact may be subject to the same general analysis used in discussing fraudulent
misrepresentation. (A person could negligently conceal a fact, or negligently give an opinion, as in legal
malpractice.)

Materiality
A material misrepresentation is one that “would be likely to induce a reasonable person to manifest his
assent” or that “the maker knows…would be likely to induce the recipient to do so.”

[7]

An honestly

mistaken statement that the house for sale was built in 1922 rather than 1923 would not be the basis for
avoiding the contract because it is not material unless the seller knew that the buyer had sentimental or
other reasons for purchasing a house built in 1922.
We did not mention materiality as an element of fraud; if the misrepresentation is fraudulent, the victim
can avoid the contract, no matter the significance of the misrepresentation. So although materiality is not
technically required for fraudulent misrepresentation, it is usually a crucial factor in determining whether
the plaintiff did rely. Obviously, the more immaterial the false assertion, the less likely it is that the victim
relied on it to his detriment. This is especially the case when the defendant knows that he does not have
the basis that he states for an assertion but believes that the particular point is unimportant and therefore
immaterial. And of course it is usually not worth the plaintiff’s while to sue over an immaterial fraudulent
misrepresentation. Consequently, for practical purposes, materiality is an important consideration in

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most cases. Reed v. King (Section 10.5.2 "Misrepresentation by Concealment") discusses materiality (as
well as nondisclosure).

Justifiable Reliance
The issues here for negligent misrepresentation are the same as those set out for fraudulent
misrepresentation.
Negligent misrepresentation implies culpability and is usually treated the same as fraudulent
misrepresentation; if the representation is not fraudulent, however, it cannot be the basis for rescission
unless it is also material.

Innocent Misrepresentation
The elements necessary to prove innocent misrepresentation are, reasonably enough, based on what we’ve
looked at so far, as follows: an innocent misstatement of fact that is material and justifiably relied upon.
It is not necessary here to go over the elements in detail. The issues are the same as previously discussed,
except now the misrepresentation is innocent. The plaintiffs purchased the defendants’ eighteen-acre
parcel on the defendants’ representation that the land came with certain water rights for irrigation, which
they believed was true. It was not true. The plaintiffs were entitled to rescission on the basis of innocent
misrepresentation.

[8]

Remedies
Remedies will be taken up in Chapter 16 "Remedies", but it is worth noting the difference between
remedies for fraudulent misrepresentation and remedies for nonfraudulent misrepresentation.
Fraudulent misrepresentation has traditionally given the victim the right to rescind the contract promptly
(return the parties to the before-contract status)or affirm it and bring an action for damages caused by the
[9]

fraud, but not both. The UCC (Section 2-721) has rejected the “election of remedies” doctrine; it allows
cumulative damages, such that the victim can both return the goods and sue for damages. And this is the
modern trend for fraudulent misrepresentation: victims may first seek damages, and if that does not make

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them whole, they may seek rescission.

[10]

In egregious cases of fraud where the defendant has undertaken

a pattern of such deceit, the rare civil remedy of punitive damages may be awarded against the defendant.
One further note: the burden of proof for fraudulent misrepresentation is that it must be proved not just
“by a preponderance of the evidence,” as in the typical civil case, but rather “by clear, cogent, and
convincing evidence”; the fact finder must believe the claim of fraud is very probably true.

[11]

KEY TAKEAWAY
Misrepresentation may be of two types: fraudulent (in the execution or in the inducement) and nonfraudulent
(negligent or innocent). Each type has different elements that must be proved, but in general there must be a
misstatement of fact by some means that is intentionally made (for fraud), material (for nonfraudulent), and
justifiably relied upon.

EXERCISES
1.

Distinguish between fraudulent misrepresentation and nonfraudulent misrepresentation, between fraud
in the execution and fraud in the inducement, and between negligent and innocent misrepresentation.

2.

List the elements that must be shown to prove the four different types of misrepresentation noted in
Exercise 1.

3.

What is the difference between the traditional common-law approach to remedies for fraud and the
UCC’s approach?

[1] Restatement (Second) of Contracts, Section 163.
[2] Ikeda v. Curtis, 261 P.2d 684 (Wash. 1951).
[3] Stambovsky v. Ackley, 169 A.D.2d 254 (N.Y. 1991).
[4] Restatement (Second) of Contracts, Section 168(d).
[5] Restatement (Second) of Contracts, Section 171(1).
[6] Restatement (Second) of Contracts, Section 162(1).
[7] Restatement (Second) of Contracts, Section 162(2).
[8] Lesher v. Strid, 996 P.2d 988 (Or. Ct. App. 2000).
[9] Merritt v. Craig, 753 A.2d 2 (Md. Ct. App. 2000).
[10] Ehrman v. Mann, 979 So.2d 1011 (Fla. Ct. App. 2008).

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[11] Kirkham v. Smith, 23 P.3d 10 (Wash. Ct. App. 2001).

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10.3 Mistake
LEARNING OBJECTIVES
1.

Recognize under what circumstances a person may be relieved of a unilateral mistake.

2.

Recognize when a mutual mistake will be grounds for relief, and the types of mutual mistakes.

In discussing fraud, we have considered the ways in which trickery by the other party makes a contract
void or voidable. We now examine the ways in which the parties might “trick” themselves by making
assumptions that lead them mistakenly to believe that they have agreed to something they have not. A
mistake is “a belief about a fact that is not in accord with the truth.”

[1]

Mistake by One Party
Unilateral Mistake
Where one party makes a mistake, it is a unilateral mistake. The rule: ordinarily, a contract is not voidable
because one party has made a mistake about the subject matter (e.g., the truck is not powerful enough to
haul the trailer; the dress doesn’t fit).

Exceptions
If one side knows or should know that the other has made a mistake, he or she may not take advantage of
it. A person who makes the mistake of not reading a written document will usually get no relief, nor will
relief be afforded to one whose mistake is caused by negligence (a contractor forgets to add in the cost of
insulation) unless the negligent party would suffer unconscionable hardship if the mistake were not
corrected. Courts will allow the correction of drafting errors in a contract (“reformation”) in order to make
the contract reflect the parties’ intention.

[2]

Mutual Mistake
In the case of mutual mistake—both parties are wrong about the subject of the contract—relief may be
granted.

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The Restatement sets out three requirements for successfully arguing mutual mistake.

[3]

The party

seeking to avoid the contract must prove that
1.

the mistake relates to a “basic assumption on which the contract was made,”

2. the mistake has a material effect on the agreed exchange of performances,
3. the party seeking relief does not bear the risk of the mistake.
Basic assumption is probably clear enough. In the famous “cow case,” the defendant sold the plaintiff a
cow—Rose of Abalone—believed by both to be barren and thus of less value than a fertile cow (a promising
young dairy cow in 2010 might sell for $1,800).

[4]

Just before the plaintiff was to take Rose from the

defendant’s barn, the defendant discovered she was “large with calf”; he refused to go on with the
contract. The court held this was a mutual mistake of fact—“a barren cow is substantially a different
creature than a breeding one”—and ruled for the defendant. That she was infertile was “a basic
assumption,” but—for example—that hay would be readily available to feed her inexpensively was not, and
had hay been expensive, that would not have vitiated the contract.

Material Effect on the Agreed-to Exchange of Performance
“Material effect on the agreed-to exchange of performance” means that because of the mutual mistake,
there is a significant difference between the value the parties thought they were exchanging compared
with what they would exchange if the contract were performed, given the standing facts. Again, in the cow
case, had the seller been required to go through with the deal, he would have given up a great deal more
than he anticipated, and the buyer would have received an unagreed-to windfall.

Party Seeking Relief Does Not Bear the Risk of the Mistake
Assume a weekend browser sees a painting sitting on the floor of an antique shop. The owner says, “That
old thing? You can have it for $100.” The browser takes it home, dusts it off, and hangs it on the wall. A
year later a visitor, an expert in art history, recognizes the hanging as a famous lost El Greco worth $1
million. The story is headlined; the antique dealer is chagrined and claims the contract for sale should be
voided because both parties mistakenly thought they were dickering over an “old, worthless” painting. The
contract is valid. The owner is said to bear the risk of mistake because he contracted with conscious

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awareness of his ignorance: he knew he didn’t know what the painting’s possible value might be, but he
didn’t feel it worthwhile to have it appraised. He gambled it wasn’t worth much, and lost.

KEY TAKEAWAY
A mistake may be unilateral, in which case no relief will be granted unless the other side knows of the mistake
and takes advantage of it. A mistake may be mutual, in which case relief may be granted if it is about a basic
assumption on which the contract was made, if the mistake has a material effect on the agreed-to exchange,
and if the person adversely affected did not bear the risk of the mistake.

EXERCISES
1.

Why is relief usually not granted for unilateral mistakes? When is relief granted for them?

2.

If there is a mutual mistake, what does the party seeking relief have to show to avoid the contract?

[1] Restatement (Second) of Contracts, Section 151.
[2] Sikora v. Vanderploeg, 212 S.W.3d 277 (Tenn. Ct. App. 2006).
[3] Restatement (Second) of Contracts, Section 152.
[4] Sherwood v. Walker, 33 N.W. 919 (1887).

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10.4 Capacity
LEARNING OBJECTIVES
1.

Understand that infants may avoid their contracts, with limitations.

2.

Understand that insane or intoxicated people may avoid their contracts, with limitations.

3.

Understand the extent to which contracts made by mentally ill persons are voidable, void, or
effectively enforceable.

4.

Recognize that contracts made by intoxicated persons may be voidable.

A contract is a meeting of minds. If someone lacks mental capacity to understand what he is assenting
to—or that he is assenting to anything—it is unreasonable to hold him to the consequences of his act. At
common law there are various classes of people who are presumed to lack the requisite capacity. These
include infants (minors), the mentally ill, and the intoxicated.

Minors (or “Infants”)
The General Rule
The general rule is this: minors (or more legalistically “infants”) are in most states persons younger than
seventeen years old; they can avoid their contracts, up to and within a reasonable time after reaching
majority, subject to some exceptions and limitations. The rationale here is that infants do not stand on an
equal footing with adults, and it is unfair to require them to abide by contracts made when they have
immature judgment.
The words minor and infant are mostly synonymous, but not exactly, necessarily. In a state where the
legal age to drink alcohol is twenty-one, a twenty-year-old would be a minor, but not an infant, because
infancy is under eighteen. A seventeen-year-old may avoid contracts (usually), but an eighteen-year-old,
while legally bound to his contracts, cannot legally drink alcohol. Strictly speaking, the better term for one
who may avoid his contracts is infant, even though, of course, in normal speaking we think of an infant as
a baby.
The age of majority (when a person is no longer an infant or a minor) was lowered in all states except
Mississippi during the 1970s (to correspond to the Twenty-Sixth Amendment, ratified in 1971,

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guaranteeing the right to vote at eighteen) from twenty-one to either eighteen or nineteen. Legal rights for
those under twenty-one remain ambiguous, however. Although eighteen-year-olds may assent to binding
contracts, not all creditors and landlords believe it, and they may require parents to cosign. For those
under twenty-one, there are also legal impediments to holding certain kinds of jobs, signing certain kinds
of contracts, marrying, leaving home, and drinking alcohol. There is as yet no uniform set of rules.
The exact day on which the disability of minority vanishes also varies. The old common-law rule put it on
the day before the twenty-first birthday. Many states have changed this rule so that majority commences
on the day of the eighteenth birthday.
An infant’s contract is voidable, not void. An infant wishing to avoid the contract need do nothing positive
to disaffirm. The defense of infancy to a lawsuit is sufficient; although the adult cannot enforce the
contract, the infant can (which is why it is said to be voidable, not void).

Exceptions and Complications
There are exceptions and complications here. We call out six of them.

Necessities
First, as an exception to the general rule, infants are generally liable for the reasonable cost of necessities
(for the reason that denying them the right to contract for necessities would harm them, not protect
them). At common law, a necessity was defined as food, medicine, clothing, or shelter. In recent years,
however, the courts have expanded the concept, so that in many states today, necessities include property
and services that will enable the infant to earn a living and to provide for those dependent on him. If the
contract is executory, the infant can simply disaffirm. If the contract has been executed, however, the
infant must face more onerous consequences. Although he will not be required to perform under the
contract, he will be liable under a theory of “quasi-contract” for the reasonable value of the necessity.
In Gastonia Personnel Corp. v. Rogers, an emancipated infant, nineteen years old (before the age of
minority was reduced), needed employment; he contracted with a personnel company to find him a job,
for which it would charge him a fee.

[1]

The company did find him a job, and when he attempted to

disaffirm his liability for payment on the grounds of infancy, the North Carolina court ruled against him,

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holding that the concepts of necessities “should be enlarged to include such…services as are reasonable
and necessary to enable the infant to earn the money required to provide the necessities of life for
himself” and his dependents.

Nonvoidable Contracts
Second, state statutes variously prohibit disaffirmation for such contracts as insurance, education or
medical care, bonding agreements, stocks, or bank accounts. In addition, an infant will lose her power to
avoid the contract if the rights of third parties intervene. Roberta, an infant, sells a car to Oswald; Oswald,
in turn, shortly thereafter sells it to Byers, who knows nothing of Roberta. May Roberta—still an infant—
recover it from Byers? No: the rights of the third party have intervened. To allow the infant seller recovery
in this situation would undermine faith in commercial transactions.

Misrepresentation of Age
A third exception involves misrepresentation of age. Certainly, that the adult reasonably believed the
infant was an adult is of no consequence in a contract suit. In many states, an infant may misrepresent his
age and disaffirm in accordance with the general rule. But it depends. If an infant affirmatively lies about
his age, the trend is to deny disaffirmation. A Michigan statute, for instance, prohibits an infant from
disaffirming if he has signed a “separate instrument containing only the statement of age, date of signing
and the signature.” And some states estop him from claiming to be an infant even if he less expressly
falsely represented himself as an adult. Estoppel is a refusal by the courts on equitable grounds to allow a
person to escape liability on an otherwise valid defense; unless the infant can return the consideration, the
contract will be enforced. It is a question of fact how far a nonexpress (an implied) misrepresentation will
be allowed to go before it is considered so clearly misleading as to range into the prohibited area. Some
states hold the infant liable for damages for the tort of misrepresentation, but others do not. As William
Prosser, the noted torts scholar, said of cases paying no attention to an infant’s lying about his age, “The
effect of the decisions refusing to recognize tort liability for misrepresentation is to create a privileged
class of liars who are a great trouble to the business world.”

[2]

Ratification

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Fourth, when the infant becomes an adult, she has two choices: she may ratify the contract or disaffirm it.
She may ratify explicitly; no further consideration is necessary. She may also do so by implication—for
instance, by continuing to make payments or retaining goods for an unreasonable period of time. If the
child has not disaffirmed the contract while still an infant, she may do so within a reasonable time after
reaching majority; what is a “reasonable time” depends on the circumstances.

Duty to Return Consideration Received
Fifth, in most cases of disavowal, the infant’s only obligation is to return the goods (if he still has them) or
repay the consideration (unless it has been dissipated); he does not have to account for what he wasted,
consumed, or damaged during the contract. But since the age of majority has been lowered to eighteen or
nineteen, when most young people have graduated from high school, some courts require, if appropriate
to avoid injustice to the adult, that the infant account for what he got. (In Dodson v. Shrader, the supreme
court of Tennessee held that an infant would—if the contract was fair—have to pay for the pickup truck he
bought and wrecked.)

[3]

Tort Connected with a Contract
Sixth, the general rule is that infants are liable for their torts (e.g., assault, trespass, nuisance, negligence)
unless the tort suit is only an indirect method of enforcing a contract. Henry, age seventeen, holds himself
out to be a competent mechanic. He is paid $500 to overhaul Baker’s engine, but he does a careless job
and the engine is seriously damaged. He offers to return the $500 but disaffirms any further contractual
liability. Can Baker sue him for his negligence, a tort? No, because such a suit would be to enforce the
contract.

Persons Who Are Mentally Ill or Intoxicated
Mentally Ill Persons
The general rule is that a contract made by person who is mentally ill is voidable by the person when she
regains her sanity, or, as appropriate, by a guardian. If, though, a guardian has been legally appointed for
a person who is mentally ill, any contract made by the mentally ill person is void, but may nevertheless be

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ratified by the ward (the incompetent person who is under a guardianship) upon regaining sanity or by
the guardian.

[4]

However, if the contract was for a necessity, the other party may have a valid claim against the estate of
the one who is mentally ill in order to prevent unjust enrichment. In other cases, whether a court will
enforce a contract made with a person who is mentally ill depends on the circumstances. Only if the
mental illness impairs the competence of the person in the particular transaction can the contract be
avoided; the test is whether the person understood the nature of the business at hand. Upon avoidance,
the mentally ill person must return any property in her possession. And if the contract was fair and the
other party had no knowledge of the mental illness, the court has the power to order other relief.

Intoxicated Persons
If a person is so drunk that he has no awareness of his acts, and if the other person knows this, there is no
contract. The intoxicated person is obligated to refund the consideration to the other party unless he
dissipated it during his drunkenness. If the other person is unaware of his intoxicated state, however, an
offer or acceptance of fair terms manifesting assent is binding.
If a person is only partially inebriated and has some understanding of his actions, “avoidance depends on
a showing that the other party induced the drunkenness or that the consideration was inadequate or that
the transaction departed from the normal pattern of similar transactions; if the particular transaction is
one which a reasonably competent person might have made, it cannot be avoided even though entirely
executory.”

[5]

A person who was intoxicated at the time he made the contract may nevertheless

subsequently ratify it. Thus where Mervin Hyland, several times involuntarily committed for alcoholism,
executed a promissory note in an alcoholic stupor but later, while sober, paid the interest on the past-due
note, he was denied the defense of intoxication; the court said he had ratified his contract.

[6]

In any event,

intoxicated is a disfavored defense on public policy grounds.

KEY TAKEAWAY
Infants may generally disaffirm their contracts up to majority and within a reasonable time afterward, but the
rule is subject to some exceptions and complications: necessities, contracts made nonvoidable by statute,

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misrepresentation of age, extent of duty to return consideration, ratification, and a tort connected with the
contract are among these exceptions.
Contracts made by insane or intoxicated people are voidable when the person regains competency. A contract
made by a person under guardianship is void, but the estate will be liable for necessities. A contract made
while insane or intoxicated may be ratified.

EXERCISES
1.

Ivar, an infant, bought a used car—not a necessity—for $9,500. Seller took advantage of Ivar’s infancy:
the car was really worth only $5,500. Can Ivar keep the car but disclaim liability for the $4,000 difference?

2.

If Ivar bought the car and it was a necessity, could he disclaim liability for the $4,000?

3.

Alice Ace found her adult son’s Christmas stocking; Mrs. Ace herself had made it fifty years before. It was
considerably deteriorated. Isabel, sixteen, handy with knitting, agreed to reknit it for $100, which Mrs.
Ace paid in advance. Isabel, regrettably, lost the stocking. She returned the $100 to Mrs. Ace, who was
very upset. May Mrs. Ace now sue Isabel for the loss of the stocking (conversion) and emotional distress?

4.

Why is voluntary intoxication a disfavored defense?

[1] Gastonia Personnel Corp. v. Rogers, 172 S.E.2d 19 (N.C. 1970).
[2] William L. Prosser, Handbook of the Law of Torts, 4th ed. (St. Paul, MN: West, 1971), 999.
[3] Dodson v. Shrader, 824 S.W.2d 545 (Tenn. 1992).
[4] Restatement (Second) of Contracts, Section 13.
[5] Restatement (Second) of Contracts, Section 16(b).
[6] First State Bank of Sinai v. Hyland, 399 N.W.2d 894 (S.D. 1987).

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10.5 Cases
Undue Influence
Hodge v. Shea
168 S.E.2d 82 (S.C. 1969)
Brailsford, J.
In this equitable action the circuit court decreed specific performance of a contract for the sale of land,
and the defendant has appealed. The plaintiff is a physician, and the contract was prepared and executed
in his medical office on August 19, 1965. The defendant had been plaintiff’s patient for a number of years.
On the contract date, he was seventy-five years of age, was an inebriate of long standing, and was afflicted
by grievous chronic illnesses, including arteriosclerosis, cirrhosis of the liver, neuritises, arthritis of the
spine and hip and varicose veins of the legs. These afflictions and others required constant medication
and frequent medical attention, and rendered him infirm of body and mind, although not to the point of
incompetency to contract.
During the period immediately before and after August 19, 1965, George A. Shea, the defendant, was
suffering a great deal of pain in his back and hip and was having difficulty in voiding. He was attended
professionally by the plaintiff, Dr. Joseph Hodge, either at the Shea home, at the doctor’s office or in the
hospital at least once each day from August 9 through August 26, 1965, except for August 17. The contract
was signed during the morning of August 19. One of Dr. Hodge’s frequent house calls was made on the
afternoon of that day, and Mr. Shea was admitted to the hospital on August 21, where he remained until
August 25.
Mr. Shea was separated from his wife and lived alone. He was dependent upon Dr. Hodge for house calls,
which were needed from time to time. His relationship with his physician, who sometimes visited him as a
friend and occasionally performed non-professional services for him, was closer than ordinarily arises
from that of patient and physician.…

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“Where a physician regularly treats a chronically ill person over a period of two years, a confidential
relationship is established, raising a presumption that financial dealings between them are fraudulent.”
[Citation]
A 125 acre tract of land near Mr. Shea’s home, adjacent to land which was being developed as residential
property, was one of his most valuable and readily salable assets. In 1962, the developer of this contiguous
land had expressed to Mr. Shea an interest in it at $1000.00 per acre. A firm offer of this amount was
made in November, 1964, and was refused by Mr. Shea on the advice of his son-in-law that the property
was worth at least $1500.00 per acre. Negotiations between the developer and Mr. Ransdell commenced
at that time and were in progress when Mr. Shea, at the instance of Dr. Hodge and without consulting Mr.
Ransdell or anyone else, signed the contract of August 19, 1965. Under this contract Dr. Hodge claims the
right to purchase twenty choice acres of the 125 acre tract for a consideration calculated by the circuit
court to be the equivalent of $361.72 per acre. The market value of the land on the contract date has been
fixed by an unappealed finding of the master at $1200.00 per acre.…
The consideration was expressed in the contract between Dr. Hodge and Mr. Shea as follows:
The purchase price being (Cadillac Coupe DeVille 6600) & $4000.00 Dollars, on the following terms: Dr.
Joseph Hodge to give to Mr. George Shea a new $6600 coupe DeVille Cadillac which is to be registered in
name of Mr. George A. Shea at absolutely no cost to him. In return, Mr. Shea will give to Dr. Joe Hodge
his 1964 Cadillac coupe DeVille and shall transfer title of this vehicle to Dr. Hodge. Further, Dr. Joseph
Hodge will pay to Mr. George A. Shea the balance of $4000.00 for the 20 acres of land described above
subject to survey, title check, less taxes on purchase of vehicle.
Dr. Hodge was fully aware of Mr. Shea’s financial troubles, the liens on his property and his son-in-law’s
efforts in his behalf. He was also aware of his patient’s predilection for new Cadillacs. Although he was not
obligated to do so until the property was cleared of liens, which was not accomplished until the following
June, Dr. Hodge hastened to purchase a 1965 Cadillac Coupe DeVille and delivered it to Mr. Shea on the
day after his discharge from the hospital on August 25, 1965. If he acted in haste in an effort to fortify
what he must have realized was a dubious contract, he has so far succeeded.…

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The case at hand is attended by gross inadequacy of consideration, serious impairment of the grantor’s
mentality from age, intemperance and disease, and a confidential relationship between the grantee and
grantor. Has the strong presumption of vitiating unfairness arising from this combination of
circumstances been overcome by the evidence? We must conclude that it has not. The record is devoid of
any evidence suggesting a reason, compatible with fairness, for Mr. Shea’s assent to so disadvantageous a
bargain. Disadvantageous not only because of the gross disparity between consideration and value, but
because of the possibility that the sale would impede the important negotiations in which Mr. Ransdell
was engaged. Unless his memory failed him, Mr. Shea knew that his son-in-law expected to sell the 125
acre tract for about $1500.00 per acre as an important step toward raising sufficient funds to satisfy the
tax and judgment liens against the Shea property. These circumstances furnish strong evidence that Mr.
Shea’s assent to the contract, without so much as notice to Mr. Ransdell, was not the product of a
deliberate Exercise of an informed judgment.…
Finally, on this phase of the case, it would be naive not to recognize that the 1965 Cadillac was used to
entice a highly susceptible old man into a hard trade. Mr. Shea was fatuously fond of new Cadillacs, but
was apparently incapable of taking care of one. His own 1964 model (he had also had a 1963 model) had
been badly abused. According to Dr. Hodge, it ‘smelled like a toilet. * * * had several fenders bumped,
bullet holes in the top and the car was just filthy * * *. It was a rather foul car.’…Knowing the condition of
Mr. Shea’s car, his financial predicament and the activities of his son-in-law in his behalf, Dr. Hodge used
the new automobile as a means of influencing Mr. Shea to agree to sell. The means was calculated to
becloud Mr. Shea’s judgment, and, under the circumstances, its use was unfair.…
Reversed and remanded.

CASE QUESTIONS
1.

Why is it relevant that Mr. Shea was separated from his wife and lived alone?

2.

Why is it relevant that it was his doctor who convinced him to sell the real estate?

3.

Why did the doctor offer the old man a Cadillac as part of the deal?

4.

Generally speaking, if you agree to sell your real estate for less than its real value, that’s just a unilateral
mistake and the courts will grant no relief. What’s different here?

Misrepresentation by Concealment
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Reed v. King
193 Cal. Rptr. 130 (Calif. Ct. App. 1983)
Blease, J.
In the sale of a house, must the seller disclose it was the site of a multiple murder? Dorris Reed purchased
a house from Robert King. Neither King nor his real estate agents (the other named defendants) told Reed
that a woman and her four children were murdered there ten years earlier. However, it seems “truth will
come to light; murder cannot be hid long.” (Shakespeare, Merchant of Venice, Act II, Scene II.) Reed
learned of the gruesome episode from a neighbor after the sale. She sues seeking rescission and damages.
King and the real estate agent defendants successfully demurred to her first amended complaint for
failure to state a cause of action. Reed appeals the ensuing judgment of dismissal. We will reverse the
judgment.

Facts
We take all issuable facts pled in Reed’s complaint as true. King and his real estate agent knew about the
murders and knew the event materially affected the market value of the house when they listed it for sale.
They represented to Reed the premises were in good condition and fit for an “elderly lady” living alone.
They did not disclose the fact of the murders. At some point King asked a neighbor not to inform Reed of
that event. Nonetheless, after Reed moved in neighbors informed her no one was interested in purchasing
the house because of the stigma. Reed paid $76,000, but the house is only worth $65,000 because of its
past.…

Discussion
Does Reed’s pleading state a cause of action? Concealed within this question is the nettlesome problem of
the duty of disclosure of blemishes on real property which are not physical defects or legal impairments to
use.
Numerous cases have found non-disclosure of physical defects and legal impediments to use of real
property are material. [Citation] However, to our knowledge, no prior real estate sale case has faced an

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issue of non-disclosure of the kind presented here. Should this variety of ill-repute be required to be
disclosed? Is this a circumstance where “non-disclosure of the fact amounts to a failure to act in good faith
and in accordance with reasonable standards of fair dealing [?]” (Rest.2d Contracts, § 161, subd. (b).)
The paramount argument against an affirmative conclusion is it permits the camel’s nose of unrestrained
irrationality admission to the tent. If such an “irrational” consideration is permitted as a basis of
rescission the stability of all conveyances will be seriously undermined. Any fact that might disquiet the
enjoyment of some segment of the buying public may be seized upon by a disgruntled purchaser to void a
bargain. In our view, keeping this genie in the bottle is not as difficult a task as these arguments assume.
We do not view a decision allowing Reed to survive a demurrer in these unusual circumstances as
endorsing the materiality of facts predicating peripheral, insubstantial, or fancied harms.
The murder of innocents is highly unusual in its potential for so disturbing buyers they may be unable to
reside in a home where it has occurred. This fact may foreseeably deprive a buyer of the intended use of
the purchase. Murder is not such a common occurrence that buyers should be charged with anticipating
and discovering this disquieting possibility. Accordingly, the fact is not one for which a duty of inquiry
and discovery can sensibly be imposed upon the buyer.
Reed alleges the fact of the murders has a quantifiable effect on the market value of the premises. We
cannot say this allegation is inherently wrong and, in the pleading posture of the case, we assume it to be
true. If information known or accessible only to the seller has a significant and measureable effect on
market value and, as is alleged here, the seller is aware of this effect, we see no principled basis for making
the duty to disclose turn upon the character of the information. Physical usefulness is not and never has
been the sole criterion of valuation. Stamp collections and gold speculation would be insane activities if
utilitarian considerations were the sole measure of value.
Reputation and history can have a significant effect on the value of realty. “George Washington slept here”
is worth something, however physically inconsequential that consideration may be. Ill-repute or “bad will”
conversely may depress the value of property. Failure to disclose such a negative fact where it will have a
forseeably depressing effect on income expected to be generated by a business is tortuous. [Citation] Some
cases have held that unreasonablefears of the potential buying public that a gas or oil pipeline may

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rupture may depress the market value of land and entitle the owner to incremental compensation in
eminent domain.
Whether Reed will be able to prove her allegation the decade-old multiple murder has a significant effect
on market value we cannot determine. If she is able to do so by competent evidence she is entitled to a
favorable ruling on the issues of materiality and duty to disclose. Her demonstration of objective tangible
harm would still the concern that permitting her to go forward will open the floodgates to rescission on
subjective and idiosyncratic grounds.…
The judgment is reversed.

CASE QUESTIONS
1.

Why is it relevant that the plaintiff was “an elderly lady living alone”?

2.

How did Mrs. Reed find out about the gruesome fact here?

3.

Why did the defendants conceal the facts?

4.

What is the concern about opening “floodgates to rescission on subjective and idiosyncratic grounds”?

5.

Why did George Washington sleep in so many places during the Revolutionary War?

6.

Did Mrs. Reed get to rescind her contract and get out of the house as a result of this case?

Misrepresentation by Assertions of Opinion
Vokes v. Arthur Murray, Inc.
212 S.2d. 906 (Fla. 1968)
Pierce, J.
This is an appeal by Audrey E. Vokes, plaintiff below, from a final order dismissing with prejudice, for
failure to state a cause of action, her fourth amended complaint, hereinafter referred to as plaintiff’s
complaint.
Defendant Arthur Murray, Inc., a corporation, authorizes the operation throughout the nation of dancing
schools under the name of “Arthur Murray School of Dancing” through local franchised operators, one of
whom was defendant J. P. Davenport whose dancing establishment was in Clearwater.

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Plaintiff Mrs. Audrey E. Vokes, a widow of 51 years and without family, had a yen to be “an accomplished
dancer” with the hopes of finding “new interest in life.” So, on February 10, 1961, a dubious fate, with the
assist of a motivated acquaintance, procured her to attend a “dance party” at Davenport’s “School of
Dancing” where she whiled away the pleasant hours, sometimes in a private room, absorbing his
accomplished sales technique, during which her grace and poise were elaborated upon and her rosy future
as “an excellent dancer” was painted for her in vivid and glowing colors. As an incident to this interlude,
he sold her eight 1/2-hour dance lessons to be utilized within one calendar month therefrom, for the sum
of $14.50 cash in hand paid, obviously a baited “come-on.”
Thus she embarked upon an almost endless pursuit of the terpsichorean art during which, over a period of
less than sixteen months, she was sold fourteen “dance courses” totaling in the aggregate 2302 hours of
dancing lessons for a total cash outlay of $31,090.45 [about $220,000 in 2010 dollars] all at Davenport’s
dance emporium. All of these fourteen courses were evidenced by execution of a written “Enrollment
Agreement-Arthur Murray’s School of Dancing” with the addendum in heavy black print, “No one will be
informed that you are taking dancing lessons. Your relations with us are held in strict confidence”, setting
forth the number of “dancing lessons” and the “lessons in rhythm sessions” currently sold to her from
time to time, and always of course accompanied by payment of cash of the realm.
These dance lesson contracts and the monetary consideration therefore of over $31,000 were procured
from her by means and methods of Davenport and his associates which went beyond the unsavory, yet
legally permissible, perimeter of “sales puffing” and intruded well into the forbidden area of undue
influence, the suggestion of falsehood, the suppression of truth, and the free Exercise of rational
judgment, if what plaintiff alleged in her complaint was true. From the time of her first contact with the
dancing school in February, 1961, she was influenced unwittingly by a constant and continuous barrage of
flattery, false praise, excessive compliments, and panegyric encomiums, to such extent that it would be
not only inequitable, but unconscionable, for a Court exercising inherent chancery power to allow such
contracts to stand.
She was incessantly subjected to overreaching blandishment and cajolery. She was assured she had “grace
and poise”; that she was “rapidly improving and developing in her dancing skill”; that the additional
lessons would “make her a beautiful dancer, capable of dancing with the most accomplished dancers”;

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that she was “rapidly progressing in the development of her dancing skill and gracefulness”, etc., etc. She
was given “dance aptitude tests” for the ostensible purpose of “determining” the number of remaining
hours of instructions needed by her from time to time.
At one point she was sold 545 additional hours of dancing lessons to be entitled to an award of the
“Bronze Medal” signifying that she had reached “the Bronze Standard”, a supposed designation of dance
achievement by students of Arthur Murray, Inc.…At another point, while she still had over 1,000 unused
hours of instruction she was induced to buy 151 additional hours at a cost of $2,049.00 to be eligible for a
“Student Trip to Trinidad”, at her own expense as she later learned.…
Finally, sandwiched in between other lesser sales promotions, she was influenced to buy an additional 481
hours of instruction at a cost of $6,523.81 in order to “be classified as a Gold Bar Member, the ultimate
achievement of the dancing studio.”
All the foregoing sales promotions, illustrative of the entire fourteen separate contracts, were procured by
defendant Davenport and Arthur Murray, Inc., by false representations to her that she was improving in
her dancing ability, that she had excellent potential, that she was responding to instructions in dancing
grace, and that they were developing her into a beautiful dancer, whereas in truth and in fact she did not
develop in her dancing ability, she had no “dance aptitude,” and in fact had difficulty in “hearing that
musical beat.” The complaint alleged that such representations to her “were in fact false and known by the
defendant to be false and contrary to the plaintiff’s true ability, the truth of plaintiff’s ability being fully
known to the defendants, but withheld from the plaintiff for the sole and specific intent to deceive and
defraud the plaintiff and to induce her in the purchasing of additional hours of dance lessons.” It was
averred that the lessons were sold to her “in total disregard to the true physical, rhythm, and mental
ability of the plaintiff.” In other words, while she first exulted that she was entering the “spring of her life”,
she finally was awakened to the fact there was “spring” neither in her life nor in her feet.
The complaint prayed that the Court decree the dance contracts to be null and void and to be cancelled,
that an accounting be had, and judgment entered against, the defendants “for that portion of the
$31,090.45 not charged against specific hours of instruction given to the plaintiff.” The Court held the
complaint not to state a cause of action and dismissed it with prejudice. We disagree and reverse.

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It is true that “generally a misrepresentation, to be actionable, must be one of fact rather than of opinion.”
[Citations] But this rule has significant qualifications, applicable here. It does not apply where there is a
fiduciary relationship between the parties, or where there has been some artifice or trick employed by the
representor, or where the parties do not in general deal at “arm’s length” as we understand the phrase, or
where the representee does not have equal opportunity to become apprised of the truth or falsity of the
fact represented. [Citation] As stated by Judge Allen of this Court in [Citation]:
“* * * A statement of a party having * * * superior knowledge may be regarded as a statement of fact
although it would be considered as opinion if the parties were dealing on equal terms.”…
In [Citation] it was said that “* * * what is plainly injurious to good faith ought to be considered as a fraud
sufficient to impeach a contract.”… [Reversed.]

CASE QUESTIONS
1.

What was the motivation of the “motivated acquaintance” in this case?

2.

Why is it relevant that Mrs. Vokes was a “widow of 51 years and without family”?

3.

How did the defendant J. P. Davenport entice her into spending a lot of money on dance lessons?

4.

What was the defendants’ defense as to why they should not be liable for misrepresentation, and why
was that defense not good?

5.

Would you say the court here is rather condescending to Mrs. Vokes, all things considered?

Mutual Mistake
Konic International Corporation v. Spokane Computer Services, Inc.,
708 P.2d 932 (Idaho 1985)
The magistrate found the following facts. David Young, an employee of Spokane Computer, was instructed
by his employer to investigate the possibility of purchasing a surge protector, a device which protects
computers from damaging surges of electrical current. Young’s investigation turned up several units
priced from $50 to $200, none of which, however, were appropriate for his employer’s needs. Young then
contacted Konic. After discussing Spokane Computer’s needs with a Konic engineer, Young was referred
to one of Konic’s salesmen. Later, after deciding on a certain unit, Young inquired as to the price of the

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selected item. The salesman responded, “fifty-six twenty.” The salesman meant $5,620. Young in turn
thought $56.20.
The salesman for Konic asked about Young’s authority to order the equipment and was told that Young
would have to get approval from one of his superiors. Young in turn prepared a purchase order for $56.20
and had it approved by the appropriate authority. Young telephoned the order and purchase order
number to Konic who then shipped the equipment to Spokane Computer. However, because of internal
processing procedures of both parties the discrepancy in prices was not discovered immediately. Spokane
Computer received the surge protector and installed it in its office. The receipt and installation of the
equipment occurred while the president of Spokane Computer was on vacation. Although the president’s
father, who was also chairman of the board of Spokane Computer, knew of the installation, he only
inquired as to what the item was and who had ordered it. The president came back from vacation the day
after the surge protector had been installed and placed in operation and was told of the purchase. He
immediately ordered that power to the equipment be turned off because he realized that the equipment
contained parts which alone were worth more than $56 in value. Although the president then told Young
to verify the price of the surge protector, Young failed to do so. Two weeks later, when Spokane Computer
was processing its purchase order and Konic’s invoice, the discrepancy between the amount on the invoice
and the amount on the purchase order was discovered. The president of Spokane Computer then
contacted Konic, told Konic that Young had no authority to order such equipment, that Spokane
Computer did not want the equipment, and that Konic should remove it. Konic responded that Spokane
Computer now owned the equipment and if the equipment was not paid for, Konic would sue for the
price. Spokane Computer refused to pay and this litigation ensued.
Basically what is involved here is a failure of communication between the parties. A similar failure to
communicate arose over 100 years ago in the celebrated case of Raffles v. Wichelhaus, [Citation] which
has become better known as the case of the good ship “Peerless.” In Peerless, the parties agreed on a sale
of cotton which was to be delivered from Bombay by the ship “Peerless.” In fact, there were two ships
named “Peerless” and each party, in agreeing to the sale, was referring to a different ship. Because the
sailing time of the two ships was materially different, neither party was willing to agree to shipment by the
“other” Peerless. The court ruled that, because each party had a different ship in mind at the time of the

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contract, there was in fact no binding contract. ThePeerless rule later was incorporated into section 71 of
the Restatement of Contracts and has now evolved into section 20 of Restatement (Second) of Contracts
(1981). Section 20 states in part:
(1) There is no manifestation of mutual assent to an exchange if the parties attach materially different
meanings to their manifestations and
(a) neither knows or has reason to know the meaning attached by the other.
Comment (c) to Section 20 further explains that “even though the parties manifest mutual assent to the
same words of agreement, there may be no contract because of a material difference of understanding as
to the terms of the exchange.” Another authority, Williston, discussing situations where a mistake will
prevent formation of a contract, agrees that “where a phrase of contract…is reasonably capable of different
interpretations…there is no contract.” [Citation]
In the present case, both parties attributed different meanings to the same term, “fifty-six twenty.” Thus,
there was no meeting of the minds of the parties. With a hundred fold difference in the two prices,
obviously price was a material term. Because the “fifty-six twenty” designation was a material term
expressed in an ambiguous form to which two meanings were obviously applied, we conclude that no
contract between the parties was ever formed. Accordingly, we do not reach the issue of whether Young
had authority to order the equipment.
[Affirmed.]

CASE QUESTIONS
1.

Why is it reasonable to say that no contract was made in this case?

2.

A discrepancy in price of one hundred times is, of course, enormous. How could such an egregious
mistake have occurred by both parties? In terms of running a sensible business, how could this kind of
mistake be avoided before it resulted in expensive litigation?

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10.6 Summary and Exercises
Summary
No agreement is enforceable if the parties did not enter into it (1) of their own free will, (2) with adequate
knowledge of the terms, and (3) with the mental capacity to appreciate the relationship.
Contracts coerced through duress will void a contract if actually induced through physical harm and will
make the contract voidable if entered under the compulsion of many types of threats. The threat must be
improper and leave no reasonable alternative, but the test is subjective—that is, what did the person
threatened actually fear, not what a more reasonable person might have feared.
Misrepresentations may render an agreement void or voidable. Among the factors to be considered are
whether the misrepresentation was deliberate and material; whether the promisee relied on the
misrepresentation in good faith; whether the representation was of fact, opinion, or intention; and
whether the parties had a special relationship.
Similarly, mistaken beliefs, not induced by misrepresentations, may suffice to avoid the bargain. Some
mistakes on one side only make a contract voidable. More often, mutual mistakes of facts will show that
there was no meeting of the minds.
Those who lack capacity are often entitled to avoid contract liability. Although it is possible to state the
general rule, many exceptions exist—for example, in contracts for necessities, infants will be liable for the
reasonable value of the goods purchased.

EXERCISES
1.

Eulrich, an auto body mechanic who had never operated a business, entered into a Snap-On Tools
franchise agreement. For $22,000 invested from his savings and the promise of another $22,000 from the
sale of inventory, he was provided a truck full of tools. His job was to drive around his territory and sell
them. The agreement allowed termination by either party; if Eulrich terminated, he was entitled to resell
to Snap-On any new tools he had remaining. When he complained that his territory was not profitable,
his supervisors told him to work it harder, that anybody could make money with Snap-On’s marketing

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system. (In fact, the evidence was the system made money for the supervisors and little for dealers;
dealers quickly failed and were replaced by new recruits.) Within several months Eulrich was out of
money and desperate. He tried to “check in” his truck to get money to pay his household bills and
uninsured medical bills for his wife; the supervisors put him off for weeks. On the check-in day, the
exhausted Eulrich’s supervisors berated him for being a bad businessman, told him no check would be
forthcoming until all the returned inventory was sold, and presented him with a number of papers to sign,
including a “Termination Agreement” whereby he agreed to waive any claims against Snap-On; he was
not aware that was what he had signed. He sued to rescind the contract and for damages. The defendants
held up the waiver as a defense. Under what theory might Eulrich recover?
2.

[1]

Chauncey, a college student, worked part-time in a restaurant. After he had worked for several months,
the owner of the restaurant discovered that Chauncey had stolen $2,000 from the cash register. The
owner called Chauncey’s parents and told them that if they did not sign a note for $2,000, he would
initiate criminal proceedings against Chauncey. The parents signed and delivered the note to the owner
but later refused to pay. May the owner collect on the note? Why?

3.

A restaurant advertised a steak dinner that included a “juicy, great-tasting steak, a fresh crisp salad, and a
warm roll.” After reading the ad, Clarence visited the restaurant and ordered the steak dinner. The steak
was dry, the lettuce in the salad was old and limp with brown edges, and the roll was partly frozen. May
Clarence recover from the restaurant on the basis of misrepresentation? Why?

4.

Bert purchased Ernie’s car. Before selling the car, Ernie had stated to Bert, “This car runs well and is
reliable. Last week I drove the car all the way from Seattle to San Francisco to visit my mother and back
again to Seattle.” In fact, Ernie was not telling the truth: he had driven the car to San Francisco to visit his
paramour, not his mother. Upon discovery of the truth, may Bert avoid the contract? Why?

5.

Randolph enrolled in a business law class and purchased a new business law textbook from the local
bookstore. He dropped the class during the first week and sold the book to his friend Scott. Before
making the sale, Randolph told Scott that he had purchased the book new and had owned it for one
week. Unknown to either Randolph or Scott, the book was in fact a used one. Scott later discovered some
underlining in the middle of the book and attempted to avoid the contract. Randolph refused to refund
the purchase price, claiming that he had not intentionally deceived his friend. May Scott avoid the
contract? Why?

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6.

Langstraat was seventeen when he purchased a motorcycle. When applying for insurance, he signed a
“Notice of Rejection,” declining to purchase uninsured motorist coverage. He was involved in an accident
with an uninsured motorist and sought to disaffirm his rejection of the uninsured motorist coverage on
the basis of infancy. May he do so?

7.

Waters was attracted to Midwest Supply by its advertisements for doing federal income taxes. The ads
stated “guaranteed accurate tax preparation.” Waters inquired about amending past returns to obtain
refunds. Midwest induced him to apply for and receive improper refunds. When Waters was audited, he
was required to pay more taxes, and the IRS put tax liens on his wages and bank accounts. In fact,
Midwest hired people with no knowledge about taxes at all; if a customer inquired about employees’
qualifications, Midwest’s manual told the employees to say, “Midwest has been preparing taxes for
twenty years.” The manual also instructed office managers never to refer to any employee as a
“specialist” or “tax expert,” but never to correct any news reporters or commentators if they referred to
employees as such. What cause of action has Waters, and for what remedies?
8.

Mutschler Grain Company (later Jamestown Farmers Elevator) agreed to sell General Mills 30,000
bushels of barley at $1.22 per bushel. A dispute arose: Mutschler said that transportation was to
be by truck but that General Mills never ordered any trucks to pick up the grain; General Mills said
the grain was to be shipped by rail (railcars were in short supply). Nine months later, after
Mutschler had delivered only about one-tenth the contracted amount, the price of barley was
over $3.00 per bushel. Mutschler defaulted on, and then repudiated, the contract. Fred Mutschler
then received this telephone call from General Mills: “We’re General Mills, and if you don’t deliver
this grain to us, why we’ll have a battery of lawyers in there tomorrow morning to visit you, and
then we are going to the North Dakota Public Service (Commission); we’re going to the
Minneapolis Grain Exchange and we’re going to the people in Montana and there will be no more
Mutschler Grain Company. We’re going to take your license.”
Mutchsler then shipped 22,000 bushels of barley at the $1.22 rate and sued General Mills for the
difference between that price and the market price of over $3.00. Summary judgment issued for
General Mills. Upon what basis might Mutschler Grain appeal?

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9.

Duke decided to sell his car. The car’s muffler had a large hole in it, and as a result, the car made a loud
noise. Before showing the car to potential buyers, Duke patched the hole with muffler tape to quiet it.
Perry bought the car after test-driving it. He later discovered the faulty muffler and sought to avoid the
contract, claiming fraud. Duke argued that he had not committed fraud because Perry had not asked
about the muffler and Duke had made no representation of fact concerning it. Is Duke correct? Decide
and explain.

10. At the end of the term at college, Jose, talking in the library with his friend Leanne, said, “I’ll sell you my
business law notes for $25.” Leanne agreed and paid him the money. Jose then realized he’d made a
mistake in that he had offered his notes when he meant to offer his book. Leanne didn’t want the book;
she had a book. She wanted the notes. Would Leanne have a cause of action against Jose if he refused to
deliver the notes? Decide and explain.

SELF-TEST QUESTIONS
1.

2.

3.

Misrepresentation that does not go to the core of a contract is
a.

fraud in the execution

b.

fraud in the inducement

c.

undue influence

d.

an example of mistake

In order for a misrepresentation to make a contract voidable,
a.

it must have been intentional

b.

the party seeking to void must have relied on the misrepresentation

c.

it must always be material

d.

none of the above is required

A mistake by one party will not invalidate a contract unless
a.

the other party knew of the mistake

b.

the party making the mistake did not read the contract closely

c.

the parties to the contract had never done business before

d.

the party is mistaken about the law

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Upon reaching the age of majority, a person who entered into a contract to purchase goods
while a minor may
a.

ratify the contract and keep the goods without paying for them

b.

disaffirm the contract and keep the goods without paying for them

c.

avoid paying for the goods by keeping them without ratifying or disaffirming the contract

d.

none of these

Seller does not disclose to Buyer that the foundation of a house is infested with termites. Upon
purchasing the house and remodeling part of the basement, Buyer discovers the termites. Has
Buyer a cause of action against Seller?
a.

yes

b.

no

SELF-TEST ANSWERS
1.

a

2.

d

3.

a

4.

e

5.

b

[1] Eulrich v. Snap-On Tools Corp., 853 P.2d 1350 (Or. Ct. App. 1993).

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Chapter 11

Consideration
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

What “consideration” is in contract law, what it is not, and what purposes it serves

2.

How the sufficiency of consideration is determined

3.

In what common situations an understanding of consideration is important

4.

What promises are enforceable without consideration

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11.1 General Perspectives on Consideration
LEARNING OBJECTIVES
1.

Understand what “consideration” is in contract law.

2.

Recognize what purposes the doctrine serves.

3.

Understand how the law determines whether consideration exists.

4.

Know the elements of consideration.

The Purpose of Consideration
This chapter continues our inquiry into whether the parties created a valid contract. In Chapter 9 "The
Agreement", we saw that the first requisite of a valid contract is an agreement: offer and acceptance. In
this chapter, we assume that agreement has been reached and concentrate on one of its crucial aspects:
the existence of consideration. Which of the following, if any, is a contract?
a.

Betty offers to give a book to Lou. Lou accepts.

b. Betty offers Lou the book in exchange for Lou’s promise to pay twenty-five dollars. Lou accepts.
c.

Betty offers to give Lou the book if Lou promises to pick it up at Betty’s house. Lou agrees.

In American law, only the second situation is a binding contract, because only that contract
contains consideration, a set of mutual promises in which each party agrees to give up something to the
benefit of the other. This chapter will explore the meaning and rationale of that statement.
The question of what constitutes a binding contract has been answered differently throughout history and
in other cultures. For example, under Roman law, a contract without consideration was binding if certain
formal requirements were met. And in the Anglo-American tradition, the presence of a seal—the wax
impression affixed to a document—was once sufficient to make a contract binding without any other
consideration. The seal is no longer a substitute for consideration, although in some states it creates a
presumption of consideration; in forty-nine states, the Uniform Commercial Code (UCC) has abolished
the seal on contracts for the sale of goods. (Louisiana has not adopted UCC Article 2.)
Whatever its original historical purposes, and however apparently arcane, the doctrine of consideration
serves some still-useful purposes. It provides objective evidence for asserting that a contract exists; it

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distinguishes between enforceable and unenforceable bargains; and it is a check against rash,
unconsidered action, against thoughtless promise making.

[1]

A Definition of Consideration
Consideration is said to exist when the promisor receives some benefit for his promise and the promisee
gives up something in return; it is the bargained-for price you pay for what you get. That may seem simple
enough. But as with much in the law, the complicating situations are never very far away. The
“something” that is promised or delivered cannot be just anything, such as a feeling of pride, warmth,
amusement, or friendship; it must be something known as alegal detriment—an act, forbearance, or a
promise of such from the promisee. The detriment need not be an actual detriment; it may in fact be a
benefit to the promisee, or at least not a loss. The detriment to one side is usually alegal benefit to the
other, but the detriment to the promisee need not confer a tangible benefit on the promisor; the promisee
can agree to forego something without that something being given to the promisor. Whether
consideration is legally sufficient has nothing to do with whether it is morally or economically adequate to
make the bargain a fair one. Moreover, legal consideration need not even be certain; it can be a promise
contingent on an event that may never happen. Consideration is a legal concept, and it centers on the
giving up of a legal right or benefit.
Consideration has two elements. The first, as just outlined, is whether the promisee has incurred a legal
detriment—given up something, paid some “price,” though it may be, for example, the promise to do
something, like paint a house. (Some courts—although a minority—take the view that a bargained-for
legal benefit to the promisor is sufficient consideration.) The second element is whether the legal
detriment was bargained for: did the promisor specifically intend the act, forbearance, or promise in
return for his promise? Applying this two-pronged test to the three examples given at the outset of the
chapter, we can easily see why only in the second is there legally sufficient consideration. In the first, Lou
incurred no legal detriment; he made no pledge to act or to forbear from acting, nor did he in fact act or
forbear from acting. In the third example, what might appear to be such a promise is not really so. Betty
made a promise on a condition that Lou comes to her house; the intent clearly is to make a gift.

KEY TAKEAWAY
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Consideration is—with some exceptions—a required element of a contract. It is the bargained-for giving up of
something of legal value for something in return. It serves the purposes of making formal the intention to
contract and reducing rash promise making.

EXERCISES
1.

Alice promises to give her neighbor a blueberry bush; the neighbor says, “Thank you!” Subsequently, Alice
changes her mind. Is she bound by her promise?

2.

Why, notwithstanding its relative antiquity, does consideration still serve some useful purposes?

3.

Identify the exchange of consideration in this example: A to B, “I will pay you $800 if you paint my
garage.” B to A, “Okay, I’ll paint your garage for $800.”

[1] Lon L. Fuller, “Consideration and Form,” Columbia Law Review 41 (1941): 799.

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11.2 Legal Sufficiency
LEARNING OBJECTIVES
1.

Know in general what “legal sufficiency” means when examining consideration.

2.

Recognize how the concept operates in such common situations as threat of litigation, and accord
and satisfaction.

3.

Understand why illusory promises are unenforceable, and how courts deal with needs, outputs, and
exclusive dealings contracts.

The Concept of Legal Sufficiency
As suggested in Section 11.1 "General Perspectives on Consideration", what is required in contract is the
exchange of a legal detriment and a legal benefit; if that happens, the consideration is said to
have legal sufficiency.

Actual versus Legal Detriment
Suppose Phil offers George $500 if George will quit smoking for one year. Is Phil’s promise binding?
Because George is presumably benefiting by making and sticking to the agreement—surely his health will
improve if he gives up smoking—how can his act be considered a legal detriment? The answer is that there
is forbearance on George’s part: George is legally entitled to smoke, and by contracting not to, he suffers a
loss of his legal right to do so. This is a legal detriment; consideration does not require an actual
detriment.

Adequacy of Consideration
Scrooge offers to buy Caspar’s motorcycle, worth $700, for $10 and a shiny new fountain pen (worth $5).
Caspar agrees. Is this agreement supported by adequate consideration? Yes, because both have agreed to
give up something that is theirs: Scrooge, the cash and the pen; Caspar, the motorcycle. Courts are not
generally concerned with the economic adequacy of the consideration but instead with whether it is
present. As Judge Richard A. Posner puts it, “To ask whether there is consideration is simply to inquire
whether the situation is one of exchange and a bargain has been struck. To go further and ask whether the
consideration is adequate would require the court to do what…it is less well equipped to do than the

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parties—decide whether the price (and other essential terms) specified in the contract are
reasonable.”

[1]

In short, “courts do not inquire into the adequacy of consideration.”

Of course, normally, parties to contracts will not make such a one-sided deal as Scrooge and Caspar’s. But
there is a common class of contracts in which nominal consideration—usually one dollar—is recited in
printed forms. Usually these are option contracts, in which “in consideration of one dollar in hand paid
and receipt of which is hereby acknowledged” one party agrees to hold open the right of the other to make
a purchase on agreed terms. The courts will enforce these contracts if the dollar is intended “to support a
short-time option proposing an exchange on fair terms.”

[2]

If, however, the option is for an unreasonably

long period of time and the underlying bargain is unfair (the Restatement gives as an example a ten-year
option permitting the optionee to take phosphate rock from a widow’s land at a per-ton payment of only
one-fourth the prevailing rate), then the courts are unlikely to hold that the nominal consideration makes
the option irrevocable.
Because the consideration on such option contracts is nominal, its recital in the written instrument is
usually a mere formality, and it is frequently never paid; in effect, the recital of nominal consideration is
false. Nevertheless, the courts will enforce the contract—precisely because the recital has become a
formality and nobody objects to the charade. Moreover, it would be easy enough to upset an option based
on nominal consideration by falsifying oral testimony that the dollar was never paid or received. In a
contest between oral testimonies where the incentive to lie is strong and there is a written document
clearly incorporating the parties’ agreement, the courts prefer the latter. However, asSection 11.4.1
"Consideration for an Option", Board of Control of Eastern Michigan University v. Burgess,
demonstrates, the state courts are not uniform on this point, and it is a safe practice always to deliver the
consideration, no matter how nominal.

Applications of the Legal Sufficiency Doctrine
This section discusses several common circumstances where the issue of whether the consideration
proffered (offered up) is adequate.

Threat of Litigation: Covenant Not to Sue

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Because every person has the legal right to file suit if he or she feels aggrieved, a promise to refrain from
going to court is sufficient consideration to support a promise of payment or performance. In Dedeaux v.
Young, Dedeaux purchased property and promised to make certain payments to Young, the broker.

[3]

But

Dedeaux thereafter failed to make these payments, and Young threatened suit; had he filed papers in
court, the transfer of title could have been blocked. To keep Young from suing, Dedeaux promised to pay a
5 percent commission if Young would stay out of court. Dedeaux later resisted paying on the ground that
he had never made such a promise and that even if he had, it did not amount to a contract because there
was no consideration from Young. The court disagreed, holding that the evidence supported Young’s
contention that Dedeaux had indeed made such a promise and upholding Young’s claim for the
commission because “a request to forbear to exercise a legal right has been generally accepted as sufficient
consideration to support a contract.” If Young had had no grounds to sue—for example, if he had
threatened to sue a stranger, or if it could be shown that Dedeaux had no obligation to him originally—
then there would have been no consideration because Young would not have been giving up a legal right.
A promise to forebear suing in return for settlement of a dispute is called
a covenant not to sue (covenant is another word for agreement).

Accord and Satisfaction Generally
Frequently, the parties to a contract will dispute the meaning of its terms and conditions, especially the
amount of money actually due. When the dispute is genuine (and not the unjustified attempt of one party
to avoid paying a sum clearly due), it can be settled by the parties’ agreement on a fixed sum as the
amount due. This second agreement, which substitutes for the disputed first agreement, is called an
accord, and when the payment or other term is discharged, the completed second contract is known as
anaccord and satisfaction. A suit brought for an alleged breach of the original contract could be defended
by citing the later accord and satisfaction.
An accord is a contract and must therefore be supported by consideration. Suppose Jan owes Andy
$7,000, due November 1. On November 1, Jan pays only $3,500 in exchange for Andy’s promise to release
Jan from the remainder of the debt. Has Andy (the promisor) made a binding promise? He has not,
because there is no consideration for the accord. Jan has incurred no detriment; she has received
something (release of the obligation to pay the remaining $3,500), but she has given up nothing. But if

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Jan and Andy had agreed that Jan would pay the $3,500 on October 25, then there would be
consideration; Jan would have incurred a legal detriment by obligating herself to make a payment earlier
than the original contract required her to. If Jan had paid the $3,500 on November 11 and had given Andy
something else agreed to—a pen, a keg of beer, a peppercorn—the required detriment would also be
present.
Let’s take a look at some examples of the accord and satisfaction principle. The dispute that gives rise to
the parties’ agreement to settle by an accord and satisfaction may come up in several typical ways: where
there is an unliquidated debt; a disputed debt; an “in-full-payment check” for less than what the creditor
claims is due; unforeseen difficulties that give rise to a contract modification, or a novation; or a
composition among creditors. But no obligation ever arises—and no real legal dispute can arise—where a
person promises a benefit if someone will do that which he has a preexisting obligation to, or where a
person promises a benefit to someone not to do that which the promisee is already disallowed from doing,
or where one makes an illusory promise.

Settling an Unliquidated Debt
An unliquidated debt is one that is uncertain in amount. Such debts frequently occur when people consult
professionals in whose offices precise fees are rarely discussed, or where one party agrees, expressly or by
implication, to pay the customary or reasonable fees of the other without fixing the exact amount. It is
certain that a debt is owed, but it is not certain how much. (Aliquidated debt, on the other hand, is one
that is fixed in amount, certain. A debt can be liquidated by being written down in unambiguous terms—
“IOU $100”—or by being mathematically ascertainable—$1 per pound of ice ordered and 60 pounds
delivered; hence the liquidated debt is $60.)
Here is how the matter plays out: Assume a patient goes to the hospital for a gallbladder operation. The
cost of the operation has not been discussed beforehand in detail, although the cost in the metropolitan
area is normally around $8,000. After the operation, the patient and the surgeon agree on a bill of
$6,000. The patient pays the bill; a month later the surgeon sues for another $2,000. Who wins? The
patient: he has forgone his right to challenge the reasonableness of the fee by agreeing to a fixed amount
payable at a certain time. The agreement liquidating the debt is an accord and is enforceable. If, however,

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the patient and the surgeon had agreed on an $8,000 fee before the operation, and if the patient
arbitrarily refused to pay this liquidated debt unless the surgeon agreed to cut her fee in half, then the
surgeon would be entitled to recover the other half in a lawsuit, because the patient would have given no
consideration—given up nothing, “suffered no detriment”—for the surgeon’s subsequent agreement to cut
the fee.

Settling a Disputed Debt
A disputed debt arises where the parties did agree on (liquidated) the price or fee but subsequently get
into a dispute about its fairness, and then settle. When this dispute is settled, the parties have given
consideration to an agreement to accept a fixed sum as payment for the amount due. Assume that in the
gallbladder case the patient agrees in advance to pay $8,000. Eight months after the operation and as a
result of nausea and vomiting spells, the patient undergoes a second operation; the surgeons discover a
surgical sponge embedded in the patient’s intestine. The patient refuses to pay the full sum of the original
surgeon’s bill; they settle on $6,000, which the patient pays. This is a binding agreement because
subsequent facts arose to make legitimate the patient’s quarrel over his obligation to pay the full bill. As
long as the dispute is based in fact and is not trumped up, as long as the promisee is acting in good faith,
then consideration is present when a disputed debt is settled.

The “In-Full-Payment” Check Situation
To discharge his liquidated debt for $8,000 to the surgeon, the patient sends a check for $6,000 marked
“payment in full.” The surgeon cashes it. There is no dispute. May the surgeon sue for the remaining
$2,000? This may appear to be an accord: by cashing the check, the surgeon seems to be agreeing with
the patient to accept the $6,000 in full payment. But consideration is lacking. Because the surgeon is
owed more than the face amount of the check, she causes the patient no legal detriment by accepting the
check. If the rule were otherwise, debtors could easily tempt hard-pressed creditors to accept less than the
amount owed by presenting immediate cash. The key to the enforceability of a “payment in full” legend is
the character of the debt. If unliquidated, or if there is a dispute, then “payment in full” can serve as
accord and satisfaction when written on a check that is accepted for payment by a creditor. But if the debt
is liquidated and undisputed, there is no consideration when the check is for a lesser amount. (However, it

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is arguable that if the check is considered to be an agreement modifying a sales contract, no consideration
is necessary under Uniform Commercial Code (UCC) Section 2-209.)

Unforeseen Difficulties
An unforeseen difficulty arising after a contract is made may be resolved by an accord and satisfaction,
too. Difficulties that no one could foresee can sometimes serve as catalyst for a further promise that may
appear to be without consideration but that the courts will enforce nevertheless. Suppose Peter contracts
to build Jerry a house for $390,000. While excavating, Peter unexpectedly discovers quicksand, the
removal of which will cost an additional $10,000. To ensure that Peter does not delay, Jerry promises to
pay Peter $10,000 more than originally agreed. But when the house is completed, Jerry reneges on his
promise. Is Jerry liable? Logically perhaps not: Peter has incurred no legal detriment in exchange for the
$10,000; he had already contracted to build the house. But most courts would allow Peter to recover on
the theory that the original contract was terminated, or modified, either by mutual agreement or by an
implied condition that the original contract would be discharged if unforeseen difficulties developed. In
short, the courts will enforce the parties’ own mutual recognition that the unforeseen conditions had
made the old contract unfair. The parties either have modified their original contract (which requires
consideration at common law) or have given up their original contract and made a new one (called
a novation).
It is a question of fact whether the new circumstance is new and difficult enough to make a preexisting
obligation into an unforeseen difficulty. Obviously, if Peter encounters only a small pocket of quicksand—
say two gallons’ worth—he would have to deal with it as part of his already-agreed-to job. If he encounters
as much quicksand as would fill an Olympic-sized swimming pool, that’s clearly unforeseen, and he
should get extra to deal with it. Someplace between the two quantities of quicksand there is enough of the
stuff so that Peter’s duty to remove it is outside the original agreement and new consideration would be
needed in exchange for its removal.

Creditors’ Composition
A creditors’ composition may give rise to debt settlement by an accord and satisfaction. It is an agreement
whereby two or more creditors of a debtor consent to the debtor’s paying them pro rata shares of the debt

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due in full satisfaction of their claims. A composition agreement can be critically important to a business
in trouble; through it, the business might manage to stave off bankruptcy. Even though the share accepted
is less than the full amount due and is payable after the due date so that consideration appears to be
lacking, courts routinely enforce these agreements. The promise of each creditor to accept a lesser share
than that owed in return for getting something is taken as consideration to support the promises of the
others. A debtor has $3,000 on hand. He owes $3,000 each to A, B, and C. A, B, and C agree to accept
$1,000 each and discharge the debtor. Each creditor has given up $2,000 but in return has at least
received something, the $1,000. Without the composition, one might have received the entire amount
owed her, but the others would have received nothing.

Preexisting Duty
Not amenable to settlement by an accord and satisfaction is the situation where a party has
a preexisting duty and he or she is offered a benefit to discharge it. When the only consideration offered
the promisor is an act or promise to act to carry out a preexisting duty, there is no valid contract.
As Denney v. Reppert(Section 11.4.2 "Consideration: Preexisting Obligation") makes clear, the promisee
suffers no legal detriment in promising to undertake that which he is already obligated to do. Where a
person is promised a benefit not to do that which he is already disallowed from doing, there is no
consideration. David is sixteen years old; his uncle promises him $50 if he will refrain from smoking. The
promise is not enforceable: legally, David already must refrain from smoking, so he has promised to give
up nothing to which he had a legal right. As noted previously, the difficulty arises where it is unclear
whether a person has a preexisting obligation or whether such unforeseen difficulties have arisen as to
warrant the recognition that the parties have modified the contract or entered into a novation. What if
Peter insists on additional payment for him to remove one wheelbarrow full of quicksand from the
excavation? Surely that’s not enough “unforeseen difficulty.” How much quicksand is enough?

Illusory Promises
Not every promise is a pledge to do something. Sometimes it is anillusory promise, where the terms of the
contract really bind the promisor to give up nothing, to suffer no detriment. For example, Lydia offers to
pay Juliette $10 for mowing Lydia’s lawn. Juliette promises to mow the lawn if she feels like it. May

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Juliette enforce the contract? No, because Juliette has incurred no legal detriment; her promise is illusory,
since by doing nothing she still falls within the literal wording of her promise. The doctrine that such
bargains are unenforceable is sometimes referred to as the rule of mutuality of obligation: if one party to a
contract has not made a binding obligation, neither is the other party bound. Thus if A contracts to hire B
for a year at $6,000 a month, reserving the right to dismiss B at any time (an “option to cancel” clause),
and B agrees to work for a year, A has not really promised anything; A is not bound to the agreement, and
neither is B.
The illusory promise presents a special problem in agreements for exclusive dealing, outputs, and needs
contracts.

Exclusive Dealing Agreement
In an exclusive dealing agreement, one party (the franchisor) promises to deal solely with the other party
(the franchisee)—for example, a franchisor-designer agrees to sell all of her specially designed clothes to a
particular department store (the franchisee). In return, the store promises to pay a certain percentage of
the sales price to the designer. On closer inspection, it may appear that the store’s promise is illusory: it
pays the designer only if it manages to sell dresses, but it may sell none. The franchisor-designer may
therefore attempt to back out of the deal by arguing that because the franchisee is not obligated to do
anything, there was no consideration for her promise to deal exclusively with the store.
Courts, however, have upheld exclusive dealing contracts on the theory that the franchisee has an
obligation to use reasonable efforts to promote and sell the product or services. This obligation may be
spelled out in the contract or implied by its terms. In the classic statement of this concept, Judge
Benjamin N. Cardozo, then on the New York Court of Appeals, in upholding such a contract, declared:
It is true that [the franchisee] does not promise in so many words that he will use reasonable efforts to
place the defendant’s endorsements and market her designs. We think, however, that such a promise is
fairly to be implied. The law has outgrown its primitive stage of formalism when the precise word was the
sovereign talisman, and every slip was fatal. It takes a broader view today. A promise may be lacking, and
yet the whole writing may be “instinct with an obligation,” imperfectly expressed.…His promise to pay the

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defendant one-half of the profits and revenues resulting from the exclusive agency and to render accounts
monthly was a promise to use reasonable efforts to bring profits and revenues into existence.

[4]

The UCC follows the same rule. In the absence of language specifically delineating the seller’s or buyer’s
duties, an exclusive dealing contract under Section 2-306(2) imposes “an obligation by the seller to use
best efforts to supply the goods and by the buyer to use best efforts to promote their sale.”

Outputs Contracts and Needs Contracts
A similar issue arises with outputs contracts and needs contracts. In anoutputs contract, the seller—say a
coal company—agrees to sell its entire yearly output of coal to an electric utility. Has it really agreed to
produce and sell any coal at all? What if the coal-mine owner decides to shut down production to take a
year’s vacation—is that a violation of the agreement? Yes. The law imposes upon the seller here a duty to
produce and sell a reasonable amount. Similarly, if the electric utility contracted to buy all its
requirements of coal from the coal company—a needs contract—could it decide to stop operation entirely
and take no coal? No, it is required to take a reasonable amount.

KEY TAKEAWAY
Courts do not inquire into the adequacy of consideration, but (with some exceptions) do require the promisor
to incur a legal detriment (the surrender of any legal right he or she possesses—to give up something) in order
to receive the bargained-for benefit. The surrender of the right to sue is a legal detriment, and the issue arises
in analyzing various kinds of dispute settlement agreements (accord and satisfaction): the obligation to pay
the full amount claimed by a creditor on a liquidated debt, an unliquidated debt, and a disputed debt. Where
unforeseen difficulties arise, an obligor will be entitled to additional compensation (consideration) to resolve
them either because the contract is modified or because the parties have entered into a novation, but no
additional consideration is owing to one who performs a preexisting obligation or forbears from performing
that which he or she is under a legal duty not to perform. If a promisor gives an illusory promise, he or she
gives no consideration and no contract is formed; but exclusive dealing agreements, needs contracts, and
outputs contracts are not treated as illusory.

EXERCISES
1.

What is meant by “legally sufficient” consideration?

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2.

Why do courts usually not “inquire into the adequacy of consideration”?

3.

How can it be said there is consideration in the following instances: (a) settlement of an unliquidated
debt? (b) settlement of a disputed debt? (c) a person agreeing to do more than originally contracted for
because of unforeseen difficulties? (d) a creditor agreeing with other creditors for each of them to accept
less than they are owed from the debtor?

4.

Why is there no consideration where a person demands extra compensation for that which she is already
obligated to do, or for forbearing to do that which she already is forbidden from doing?

5.

What is the difference between a contract modification and a novation?

6.

How do courts resolve the problem that a needs or outputs contract apparently imposes no detriment—
no requirement to pass any consideration to the other side—on the promisor?

[1] Richard A. Posner, Economic Analysis of Law (New York: Aspen, 1973), 46.
[2] Restatement (Second) of Contracts, Section 87(b).
[3] Dedeaux v. Young, 170 So.2d 561 (1965).
[4] Otis F. Wood v. Lucy, Lady Duff-Gordon, 118 N.E. 214 (1917).

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11.3 Promises Enforceable without Consideration
LEARNING OBJECTIVE
1.

Understand the exceptions to the requirement of consideration.

For a variety of policy reasons, courts will enforce certain types of promises even though consideration
may be absent. Some of these are governed by the Uniform Commercial Code (UCC); others are part of
the established common law.

Promises Enforceable without Consideration at Common Law
Past Consideration
Ordinarily, past consideration is not sufficient to support a promise. By past consideration, the courts
mean an act that could have served as consideration if it had been bargained for at the time but that was
not the subject of a bargain. For example, Mrs. Ace’s dog Fluffy escapes from her mistress’s condo at dusk.
Robert finds Fluffy, sees Mrs. Ace, who is herself out looking for her pet, and gives Fluffy to her. She says,
“Oh, thank you for finding my dear dog. Come by my place tomorrow morning and I’ll give you fifty
dollars as a reward.” The next day Robert stops by Mrs. Ace’s condo, but she says, “Well, I don’t know.
Fluffy soiled the carpet again last night. I think maybe a twenty-dollar reward would be plenty.” Robert
cannot collect the fifty dollars. Even though Mrs. Ace might have a moral obligation to pay him and honor
her promise, there was no consideration for it. Robert incurred no legal detriment; his contribution—
finding the dog—was paid out before her promise, and his past consideration is invalid to support a
contract. There was no bargained-for exchange.
However, a valid consideration, given in the past to support a promise, can be the basis for another, later
contract under certain circumstances. These occur when a person’s duty to act for one reason or another
has become no longer binding. If the person then makes a new promise based on the unfulfilled past duty,
the new promise is binding without further consideration. Three types of cases follow.

Promise Revived after Statute of Limitations Has Passed

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A statute of limitations is a law requiring a lawsuit to be filed within a specified period of years. For
example, in many states a contract claim must be sued on within six years; if the plaintiff waits longer
than that, the claim will be dismissed, regardless of its merits. When the time period set forth in the
statute of limitations has lapsed, the statute is said to have “run.” If a debtor renews a promise to pay or
acknowledges a debt after the running of a statute of limitations, then under the common law the promise
is binding, although there is no consideration in the usual sense. In many states, this promise or
acknowledgment must be in writing and signed by the debtor. Also, in many states, the courts will imply a
promise or acknowledgment if the debtor makes a partial payment after the statute has run.

Voidable Duties
Some promises that might otherwise serve as consideration are voidable by the promisor, for a variety of
reasons, including infancy, fraud, duress, or mistake. But a voidable contract does not automatically
become void, and if the promisor has not avoided the contract but instead thereafter renews his promise,
it is binding. For example, Mr. Melvin sells his bicycle to Seth, age thirteen. Seth promises to pay Mr.
Melvin one hundred dollars. Seth may repudiate the contract, but he does not. When he turns eighteen, he
renews his promise to pay the one hundred dollars. This promise is binding. (However, a promise made
up to the time he turned eighteen would not be binding, since he would still have been a minor.)

Promissory Estoppel
We examined the meaning of this forbidding phrase in Chapter 8 "Introduction to Contract Law" (recall
the English High Trees case). It represents another type of promise that the courts will enforce without
consideration. Simply stated,promissory estoppel means that the courts will stop the promisor from
claiming that there was no consideration. The doctrine of promissory estoppel is invoked in the interests
of justice when three conditions are met: (1) the promise is one that the promisor should reasonably
expect to induce the promisee to take action or forbear from taking action of a definite and substantial
character; (2) the action or forbearance is taken; and (3) injustice can be avoided only by enforcing the
promise. (The complete phraseology is “promissory estoppel with detrimental reliance.”)
Timko served on the board of trustees of a school. He recommended that the school purchase a building
for a substantial sum of money, and to induce the trustees to vote for the purchase, he promised to help

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with the purchase and to pay at the end of five years the purchase price less the down payment. At the end
of four years, Timko died. The school sued his estate, which defended on the ground that there was no
consideration for the promise. Timko was promised or given nothing in return, and the purchase of the
building was of no direct benefit to him (which would have made the promise enforceable as a unilateral
contract). The court ruled that under the three-pronged promissory estoppel test, Timko’s estate was
liable.

[1]

Cases involving pledges of charitable contributions have long been troublesome to courts. Recognizing the
necessity to charitable institutions of such pledges, the courts have also been mindful that a mere pledge
of money to the general funds of a hospital, university, or similar institution does not usually induce
substantial action but is, rather, simply a promise without consideration. When the pledge does prompt a
charitable institution to act, promissory estoppel is available as a remedy. In about one-quarter of the
states, another doctrine is available for cases involving simple pledges: the “mutual promises” theory,
whereby the pledges of many individuals are taken as consideration for each other and are binding against
each promisor. This theory was not available to the plaintiff in Timko because his was the only promise.

Moral Obligation
The Restatement allows, under some circumstances, the enforcement of past-consideration contracts. It
provides as follows in Section 86, “Promise for Benefit Received”:
A promise made in recognition of a benefit previously received by the promisor from the promisee is
binding to the extent necessary to prevent injustice.
A promise is not binding under Subsection (1)
if the promisee conferred the benefit as a gift or for other reasons the promisor has not been unjustly
enriched; or
to the extent that its value is disproportionate to the benefit.

Promises Enforceable without Consideration by Statute

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We have touched on several common-law exceptions to the consideration requirement. Some also are
provided by statute.

Under the UCC
The UCC permits one party to discharge, without consideration, a claim or right arising out of an alleged
breach of contract by the other party. This is accomplished by delivering to the other party a signed
written waiver orrenunciation.

[2]

This provision applies to any contract governed by the UCC and is not

limited to the sales provisions of Article 2.
The UCC also permits a party to discharge the other side without consideration when there is no breach,
and it permits parties to modify their Article 2 contract without consideration.

[3]

The official comments to

the UCC section add the following: “However, modifications made thereunder must meet the test of good
faith imposed by this Act. The effective use of bad faith to escape performance on the original contract
terms is barred, and the extortion of a “modification” without legitimate commercial reason is ineffective
as a violation of the duty of good faith.”
Seller agrees to deliver a ton of coal within seven days. Buyer needs the coal sooner and asks Seller to
deliver within four days. Seller agrees. This promise is binding even though Seller received no additional
consideration beyond the purchase price for the additional duty agreed to (the duty to get the coal to
Buyer sooner than originally agreed). The UCC allows a merchant’s firm offer, signed, in writing, to bind
the merchant to keep the offer to buy or sell open without consideration.

[4]

This is the UCC’s equivalent of

a common-law option, which, as you recall, does require consideration.
Section 1-207 of the UCC allows a party a reservation of rights while performing a contract. This section
raises a difficult question when a debtor issues an in-full-payment check in payment of a disputed debt. As
noted earlier in this chapter, because under the common law the creditor’s acceptance of an in-fullpayment check in payment of a disputed debt constitutes an accord and satisfaction, the creditor cannot
collect an amount beyond the check. But what if the creditor, in cashing the check, reserves the right
(under Section 1-207) to sue for an amount beyond what the debtor is offering? The courts are split on the
issue: regarding the sale of goods governed by the UCC, some courts allow the creditor to sue for the
unpaid debt notwithstanding the check being marked “paid in full,” and others do not.

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Bankruptcy
Bankruptcy is, of course, federal statutory law. The rule here regarding a promise to pay after the
obligation is discharged is similar to that governing statutes of limitations. Traditionally, a promise to
repay debts after a bankruptcy court has discharged them makes the debtor liable once again. This
traditional rule gives rise to potential abuse; after undergoing the rigors of bankruptcy, a debtor could be
badgered by creditors into reaffirmation, putting him in a worse position than before, since he must wait
six years before being allowed to avail himself of bankruptcy again.
The federal Bankruptcy Act includes certain procedural protections to ensure that the debtor knowingly
enters into a reaffirmation of his debt. Among its provisions, the law requires the debtor to have
reaffirmed the debt before the debtor is discharged in bankruptcy; he then has sixty days to rescind his
reaffirmation. If the bankrupt party is an individual, the law also requires that a court hearing be held at
which the consequences of his reaffirmation must be explained, and reaffirmation of certain consumer
debts is subject to court approval if the debtor is not represented by an attorney.

International Contracts
Contracts governed by the Convention on Contracts for the International Sale of Goods (as mentioned
in Chapter 8 "Introduction to Contract Law") do not require consideration to be binding.

KEY TAKEAWAY
There are some exceptions to the consideration requirement. At common law, past consideration doesn’t
count, but no consideration is necessary in these cases: where a promise barred by the statute of limitations is
revived, where a voidable duty is reaffirmed, where there has been detrimental reliance on a promise (i.e.,
promissory estoppel), or where a court simply finds the promisor has a moral obligation to keep the promise.
Under statutory law, the UCC has several exceptions to the consideration requirement. No consideration is
needed to revive a debt discharged in bankruptcy, and none is called for under the Convention on Contracts
for the International Sale of Goods.

EXERCISES
1.

Melba began work for Acme Company in 1975 as a filing clerk. Thirty years later she had risen to be
comptroller. At a thirty-year celebration party, her boss, Mr. Holder, said, “Melba, I hope you work here

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for a long time, and you can retire at any time, but if you decide to retire, on account of your years of
good service, the company will pay you a monthly pension of $2,000.” Melba continued to work for
another two years, then retired. The company paid the pension for three years and then, in an economic
downturn, stopped. When Melba sued, the company claimed it was not obligated to her because the
pension was of past consideration. What will be the result?
2.

What theories are used to enforce charitable subscriptions?

3.

What are the elements necessary for the application of the doctrine of promissory estoppel?

4.

Under what circumstances does the Restatement employ moral obligation as a basis for enforcing an
otherwise unenforceable contract?

5.

Promises unenforceable because barred by bankruptcy or by the running of the statute of limitations can
be revived without further consideration. What do the two circumstances have in common?

6.

Under the UCC, when is no consideration required where it would be in equivalent situations at common
law?

[1] Estate of Timko v. Oral Roberts Evangelistic Assn., 215 N.W.2d 750 (Mich. App. 1974).
[2] Uniform Commercial Code, Section 1-107.
[3] Uniform Commercial Code, Sections 2-209(4) and 2-209(1).
[4] Uniform Commercial Code, Section 2-205.

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11.4 Cases
Consideration for an Option
Board of Control of Eastern Michigan University v. Burgess
206 N.W.2d 256 (Mich. 1973)
Burns, J.
On February 15, 1966, defendant signed a document which purported to grant to plaintiff a 60-day option
to purchase defendant’s home. That document, which was drafted by plaintiff’s agent, acknowledged
receipt by defendant of “One and no/100 ($1.00) Dollar and other valuable consideration.” Plaintiff
concedes that neither the one dollar nor any other consideration was ever paid or even tendered to
defendant. On April 14, 1966, plaintiff delivered to defendant written notice of its intention to exercise the
option. On the closing date defendant rejected plaintiff’s tender of the purchase price. Thereupon, plaintiff
commenced this action for specific performance.
At trial defendant claimed that the purported option was void for want of consideration, that any
underlying offer by defendant had been revoked prior to acceptance by plaintiff, and that the agreed
purchase price was the product of fraud and mutual mistake. The trial judge concluded that no fraud was
involved, and that any mutual mistake was not material. He also held that defendant’s acknowledgment of
receipt of consideration bars any subsequent contention to the contrary. Accordingly, the trial judge
entered judgment for plaintiff.
Options for the purchase of land, if based on valid consideration, are contracts which may be specifically
enforced. [Citations] Conversely, that which purports to be an option, but which is not based on valid
consideration, is not a contract and will not be enforced. [Citations] One dollar is valid consideration for
an option to purchase land, provided the dollar is paid or at least tendered. [Citations] In the instant case
defendant received no consideration for the purported option of February 15, 1966.

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A written acknowledgment of receipt of consideration merely creates a rebuttable presumption that
consideration has, in fact, passed. Neither the parol evidence rule nor the doctrine of estoppel bars the
presentation of evidence to contradict any such acknowledgment. [Citation]
It is our opinion that the document signed by defendant on February 15, 1966, is not an enforceable
option, and that defendant is not barred from so asserting.
The trial court premised its holding to the contrary on Lawrence v. McCalmont…(1844). That case is
significantly distinguishable from the instant case. Mr. Justice Story held that ‘(t)he guarantor
acknowledged the receipt of one dollar, and is now estopped to deny it.’ However, in reliance upon the
guaranty substantial credit had been extended to the guarantor’s sons. The guarantor had received
everything she bargained for, save one dollar. In the instant case defendant claims that she never received
any of the consideration promised her.
That which purports to be an option for the purchase of land, but which is not based on valid
consideration, is a simple offer to sell the same land. [Citation] An option is a contract collateral to an
offer to sell whereby the offer is made irrevocable for a specified period. [Citation] Ordinarily, an offer is
revocable at the will of the offeror. Accordingly, a failure of consideration affects only the collateral
contract to keep the offer open, not the underlying offer.
A simple offer may be revoked for any reason or for no reason by the offeror at any time prior to its
acceptance by the offeree. [Citation] Thus, the question in this case becomes, ‘Did defendant effectively
revoke her offer to sell before plaintiff accepted that offer?’…
Defendant testified that within hours of signing the purported option she telephoned plaintiff’s agent and
informed him that she would not abide by the option unless the purchase price was increased. Defendant
also testified that when plaintiff’s agent delivered to her on April 14, 1966, plaintiff’s notice of its intention
to exercise the purported option, she told him that ‘the option was off’.
Plaintiff’s agent testified that defendant did not communicate to him any dissatisfaction until sometime in
July, 1966.

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If defendant is telling the truth, she effectively revoked her offer several weeks before plaintiff accepted
that offer, and no contract of sale was created. If plaintiff’s agent is telling the truth, defendant’s offer was
still open when plaintiff accepted that offer, and an enforceable contract was created. The trial judge
thought it unnecessary to resolve this particular dispute. In light of our holding the dispute must be
resolved.
An appellate court cannot assess the credibility of witnesses. We have neither seen nor heard them testify.
[Citation] Accordingly, we remand this case to the trial court for additional findings of fact based on the
record already before the court.…
Reversed and remanded for proceedings consistent with this opinion. Costs to defendant.

CASE QUESTIONS
1.

Why did the lower court decide the option given by the defendant was valid?

2.

Why did the appeals court find the option invalid?

3.

The case was remanded. On retrial, how could the plaintiff (the university) still win?

4.

It was not disputed that the defendant signed the purported option. Is it right that she should get out of it
merely because she didn’t really get the $1.00?

Consideration: Preexisting Obligation
Denney v. Reppert
432 S.W.2d 647 (Ky. 1968)
R. L. Myre, Sr., Special Commissioner.
The sole question presented in this case is which of several claimants is entitled to an award for
information leading to the apprehension and conviction of certain bank robbers.…
On June 12th or 13th, 1963, three armed men entered the First State Bank, Eubank, Kentucky, and with a
display of arms and threats robbed the bank of over $30,000 [about $208,000 in 2010 dollars]. Later in
the day they were apprehended by State Policemen Garret Godby, Johnny Simms and Tilford Reppert,

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placed under arrest, and the entire loot was recovered. Later all of the prisoners were convicted and
Garret Godby, Johnny Simms and Tilford Reppert appeared as witnesses at the trial.
The First State Bank of Eubank was a member of the Kentucky Bankers Association which provided and
advertised a reward of $500.00 for the arrest and conviction of each bank robber. Hence the outstanding
reward for the three bank robbers was $1,500.00 [about $11,000 in 2010 dollars]. Many became
claimants for the reward and the Kentucky State Bankers Association being unable to determine the
merits of the claims for the reward asked the circuit court to determine the merits of the various claims
and to adjudge who was entitled to receive the reward or share in it. All of the claimants were made
defendants in the action.
At the time of the robbery the claimants Murrell Denney, Joyce Buis, Rebecca McCollum and Jewell
Snyder were employees of the First State Bank of Eubank and came out of the grueling situation with
great credit and glory. Each one of them deserves approbation and an accolade. They were vigilant in
disclosing to the public and the peace officers the details of the crime, and in describing the culprits, and
giving all the information that they possessed that would be useful in capturing the robbers. Undoubtedly,
they performed a great service. It is in the evidence that the claimant Murrell Denney was conspicuous
and energetic in his efforts to make known the robbery, to acquaint the officers as to the personal
appearance of the criminals, and to give other pertinent facts.
The first question for determination is whether the employees of the robbed bank are eligible to receive or
share in the reward. The great weight of authority answers in the negative. [Citation] states the rule
thusly:
‘To the general rule that, when a reward is offered to the general public for the performance of some
specified act, such reward may be claimed by any person who performs such act, is the exception of
agents, employees and public officials who are acting within the scope of their employment or official
duties. * * *.’…
At the time of the robbery the claimants Murrell Denney, Joyce Buis, Rebecca McCollum, and Jewell
Snyder were employees of the First State Bank of Eubank. They were under duty to protect and conserve
the resources and moneys of the bank, and safeguard every interest of the institution furnishing them

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employment. Each of these employees exhibited great courage, and cool bravery, in a time of stress and
danger. The community and the county have recompensed them in commendation, admiration and high
praise, and the world looks on them as heroes. But in making known the robbery and assisting in
acquainting the public and the officers with details of the crime and with identification of the robbers,
they performed a duty to the bank and the public, for which they cannot claim a reward.
The claims of Corbin Reynolds, Julia Reynolds, Alvie Reynolds and Gene Reynolds also must fail.
According to their statements they gave valuable information to the arresting officers. However, they did
not follow the procedure as set forth in the offer of reward in that they never filed a claim with the
Kentucky Bankers Association. It is well established that a claimant of a reward must comply with the
terms and conditions of the offer of reward. [Citation]
State Policemen Garret Godby, Johnny Simms and Tilford Reppert made the arrest of the bank robbers
and captured the stolen money. All participated in the prosecution. At the time of the arrest, it was the
duty of the state policemen to apprehend the criminals. Under the law they cannot claim or share in the
reward and they are interposing no claim to it.
This leaves the defendant, Tilford Reppert the sole eligible claimant. The record shows that at the time of
the arrest he was a deputy sheriff in Rockcastle County, but the arrest and recovery of the stolen money
took place in Pulaski County. He was out of his jurisdiction, and was thus under no legal duty to make the
arrest, and is thus eligible to claim and receive the reward. In [Citation] it was said:
‘It is * * * well established that a public officer with the authority of the law to make an arrest may accept
an offer of reward or compensation for acts or services performed outside of his bailiwick or not within
the scope of his official duties. * * *.’…
It is manifest from the record that Tilford Reppert is the only claimant qualified and eligible to receive the
reward. Therefore, it is the judgment of the circuit court that he is entitled to receive payment of the
$1,500.00 reward now deposited with the Clerk of this Court.
The judgment is affirmed.

CASE QUESTIONS
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1.

Why did the Bankers Association put the resolution of this matter into the court’s hands?

2.

Several claimants came forward for the reward; only one person got it. What was the difference between
the person who got the reward and those who did not?

Consideration: Required for Contract Modification
Gross v. Diehl Specialties International, Inc.
776 S.W.2d 879 (Missouri Ct. App. 1989)
Smith, J.
Plaintiff appeals from a jury verdict and resultant judgment for defendant in a breach of employment
contract case.…
Plaintiff was employed under a fifteen year employment contract originally executed in 1977 between
plaintiff and defendant. Defendant, at that time called Dairy Specialties, Inc., was a company in the
business of formulating ingredients to produce non-dairy products for use by customers allergic to cow’s
milk. Plaintiff successfully formulated [Vitamite]…for that usage.
Thereafter, on August 24, 1977, plaintiff and defendant corporation entered into an employment contract
employing plaintiff as general manager of defendant for fifteen years. Compensation was established at
$14,400 annually plus cost of living increases. In addition, when 10% of defendant’s gross profits
exceeded the annual salary, plaintiff would receive an additional amount of compensation equal to the
difference between his compensation and 10% of the gross profits for such year. On top of that plaintiff
was to receive a royalty for the use of each of his inventions and formulae of 1% of the selling price of all of
the products produced by defendant using one or more of plaintiff’s inventions or formulae during the
term of the agreement. That amount was increased to 2% of the selling price following the term of the
agreement. The contract further provided that during the term of the agreement the inventions and
formulae would be owned equally by plaintiff and defendant and that following the term of the agreement
the ownership would revert to plaintiff. During the term of the agreement defendant had exclusive rights
to use of the inventions and formulae and after the term of agreement a non-exclusive right of use.

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At the time of the execution of the contract, sales had risen from virtually nothing in 1976 to $750,000
annually from sales of Vitamite and a chocolate flavored product formulated by plaintiff called Chocolite.
[Dairy’s owner] was in declining health and in 1982 desired to sell his company. At that time yearly sales
were $7,500,000. [Owner] sold the company to the Diehl family enterprises for 3 million dollars.
Prior to sale Diehl insisted that a new contract between plaintiff and defendant be executed or Diehl
would substantially reduce the amount to be paid for [the company]. A new contract was executed August
24, 1982. It reduced the expressed term of the contract to 10 years, which provided the same expiration
date as the prior contract. It maintained the same base salary of $14,400 effective September 1982,
thereby eliminating any cost of living increases incurred since the original contract. The 10% of gross
profit provision remained the same. The new contract provided that plaintiff’s inventions and formula
were exclusively owned by defendant during the term of the contract and after its termination. The 1%
royalty during the term of the agreement remained the same, but no royalties were provided for after the
term of the agreement. No other changes were made in the agreement. Plaintiff received no compensation
for executing the new contract. He was not a party to the sale of the company by [Owner] and received
nothing tangible from that sale.
After the sale plaintiff was given the title and responsibilities of president of defendant with additional
duties but no additional compensation. In 1983 and 1984 the business of the company declined severely
and in October 1984, plaintiff’s employment with defendant was terminated by defendant. This suit
followed.…
We turn now to the court’s holding that the 1982 agreement was the operative contract. Plaintiff contends
this holding is erroneous because there existed no consideration for the 1982 agreement. We agree. A
modification of a contract constitutes the making of a new contract and such new contract must be
supported by consideration. [Citation] Where a contract has not been fully performed at the time of the
new agreement, the substitution of a new provision, resulting in a modification of the obligations
on both sides, for a provision in the old contract still unperformed is sufficient consideration for the new
contract. While consideration may consist of either a detriment to the promisee or a benefit to the
promisor, a promise to carry out an already existing contractual duty does not constitute consideration.
[Citation]

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Under the 1982 contract defendant assumed no detriment it did not already have. The term of the
contract expired on the same date under both contracts. Defendant undertook no greater obligations than
it already had. Plaintiff on the other hand received less than he had under the original contract. His base
pay was reduced back to its amount in 1977 despite the provision in the 1977 contract for cost of living
adjustments. He lost his equal ownership in his formulae during the term of the agreement and his
exclusive ownership after the termination of the agreement. He lost all royalties after termination of the
agreement and the right to use and license the formulae subject to defendant’s right to non-exclusive use
upon payment of royalties. In exchange for nothing, defendant acquired exclusive ownership of the
formulae during and after the agreement, eliminated royalties after the agreement terminated, turned its
non-exclusive use after termination into exclusive use and control, and achieved a reduction in plaintiff’s
base salary. Defendant did no more than promise to carry out an already existing contractual duty. There
was no consideration for the 1982 agreement.
Defendant asserts that consideration flowed to plaintiff because the purchase of defendant by the Diehls
might not have occurred without the agreement and the purchase provided plaintiff with continued
employment and a financially viable employer. There is no evidence to support this contention. Plaintiff
had continued employment with the same employer under the 1977 agreement. Nothing in the 1982
agreement provided for any additional financial protection to plaintiff. The essence of defendant’s
position is that [the owner] received more from his sale of the company because of the new agreement
than he would have without it. We have difficulty converting [the owner’s] windfall into a benefit to
plaintiff.
[Remanded to determine how much plaintiff should receive.]

CASE QUESTIONS
1.

Why did the court determine that Plaintiff’s postemployment benefits should revert to those in his
original contract instead being limited to those in the modified contract?

2.

What argument did Defendant make as to why the terms of the modified contract should be valid?

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11.5 Summary and Exercises
Summary
Most agreements—including contract modification at common law (but not under the Uniform
Commercial Code [UCC])—are not binding contracts in the absence of what the law terms
“consideration.” Consideration is usually defined as a “legal detriment”—an act, forbearance, or a
promise. The act can be the payment of money, the delivery of a service, or the transfer of title to property.
Consideration is a legal concept in that it centers on the giving up of a legal right or benefit.
An understanding of consideration is important in many commonplace situations, including those in
which (1) a debtor and a creditor enter into an accord that is later disputed, (2) a duty is preexisting, (3) a
promise is illusory, and (4) creditors agree to a composition.
Some promises are enforceable without consideration. These include certain promises under the UCC and
other circumstances, including (1) contracts barred by the statute of limitations, (2) promises by a
bankrupt to repay debts, and (3) situations in which justice will be served by invoking the doctrine of
promissory estoppel. Determining whether an agreement should be upheld despite the lack of
consideration, technically defined, calls for a diligent assessment of the factual circumstances.

EXERCISES
1.

Hornbuckle purchased equipment from Continental Gin (CG) for $6,300. However, after some of the
equipment proved defective, Hornbuckle sent CG a check for $4,000 marked “by endorsement this check
is accepted in full payment,” and CG endorsed and deposited the check. May CG force Hornbuckle to pay
the remaining $2,300? Why?

2.

Joseph Hoffman alleged that Red Owl Stores promised him that it would build a store building in Chilton,
Wisconsin, and stock it with merchandise for Hoffman to operate in return for Hoffman’s investment of
$18,000. The size, cost, design, and layout of the store building was not discussed, nor were the terms of
the lease as to rent, maintenance, and purchase options. Nevertheless, in reliance on Red Owl’s promise,
the Hoffmans sold their bakery and grocery store business, purchased the building site in Chilton, and
rented a residence there for the family. The deal was never consummated: a dispute arose, Red Owl did

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not build the store, and it denied liability to Hoffman on the basis that its promise to him was too
indefinite with respect to all details for a contract to have resulted. Is Hoffman entitled to some relief? On
what theory?
3.

Raquel contracted to deliver one hundred widgets to Sam on December 15, for which he would pay
$4,000. On November 25, Sam called her and asked if she could deliver the widgets on December 5.
Raquel said she could, and she promised delivery on that day. Is her promise binding? Why?

4.

Richard promised to have Darlene’s deck awning constructed by July 10. On June 20, Darlene called him
and asked if he could get the job done by July 3, in time for Independence Day. Richard said he could, but
he failed to do so, and Darlene had to rent two canopies at some expense. Darlene claims that because
Richard breached his promise, he is liable for the cost of awning rental. Is she correct—was his promise
binding? Why?

5.

Seller agreed to deliver gasoline to Buyer at $3.15 per gallon over a period of one year. By the sixth
month, gasoline had increased in price over a dollar a gallon. Although Seller had gasoline available for
sale, he told Buyer the price would have to increase by that much or he would be unable to deliver. Buyer
agreed to the increase, but when billed, refused to pay the additional amount. Is Buyer bound by the
promise? Explain.

6.

Montbanks’s son, Charles, was seeking an account executive position with Dobbs, Smith & Fogarty, Inc., a
large brokerage firm. Charles was independent and wished no interference by his well-known father. The
firm, after several weeks’ deliberation, decided to hire Charles. They made him an offer on April 12, 2010,
and Charles accepted. Montbanks, unaware that his son had been hired and concerned that he might not
be, mailed a letter to Dobbs on April 13 in which he promised to give the brokerage firm $150,000 in
commission business if the firm would hire his son. The letter was received by Dobbs, and the firm wishes
to enforce it against Montbanks. May Dobbs enforce the promise? Why?

7.

In 1869, William E. Story promised his nephew, William E. Story II (then sixteen years old), $5,000 (about
$120,000 in today’s money) if “Willie” would abstain from drinking alcohol, smoking, swearing, and
playing cards or billiards for money until the nephew reached twenty-one years of age. All of these were
legally permissible activities for the teenager at that time in New York State. Willie accepted his uncle’s
promise and did refrain from the prohibited acts until he turned twenty-one. When the young man asked
for the money, his uncle wrote to him that he would honor the promise but would rather wait until Willie

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was older before delivering the money, interest added on. Willie agreed. Subsequently, Willie assigned
the right to receive the money to one Hamer (Willie wanted the money sooner), and Story I died without
making any payment. The estate, administered by Franklin Sidway, refused to pay, asserting there was no
binding contract due to lack of consideration: the boy suffered no “detriment,” and the uncle got no
benefit. The trial court agreed with the estate, and the plaintiff appealed. Should the court on appeal
affirm or reverse? Explain.
8.

Harold Pearsall and Joe Alexander were friends for over twenty-five years. About twice a week, they
bought what they called a package: a half-pint of vodka, orange juice, two cups, and two lottery tickets.
They went to Alexander’s house to watch TV, drink screwdrivers, and scratch the lottery tickets. The two
had been sharing tickets and screwdrivers since the Washington, DC, lottery began. On the evening in
issue, Pearsall bought the package and asked Alexander, “Are you in on it?” Alexander said yes. Pearsall
asked for his half of the purchase price, but Alexander had no money. A few hours later, Alexander,
having come by some funds of his own, bought another package. He handed one ticket to Pearsall, and
they both scratched the tickets; Alexander’s was a $20,000 winner. When Pearsall asked for his share,
Alexander refused to give him anything. Are the necessary elements of offer, acceptance, and
consideration present here so as to support Pearsall’s assertion the parties had a contract?

9.

Defendant, Lee Taylor, had assaulted his wife, who took refuge in the house of Plaintiff, Harrington. The
next day, Taylor gained access to the house and began another assault upon his wife. Mrs. Taylor knocked
him down with an axe and was on the point of cutting his head open or decapitating him while he was
lying on the floor when Plaintiff intervened and caught the axe as it was descending. The blow intended
for Defendant fell upon Harrington’s hand, mutilating it badly, but saving Defendant’s life. Subsequently,
Defendant orally promised to pay Plaintiff her damages but, after paying a small sum, failed to pay
anything more. Is Harrington entitled to enforce Taylor’s entire promise?

10. White Sands Forest Products (Defendant) purchased logging equipment from Clark Corporation (Plaintiff)
under an installment contract that gave Plaintiff the right to repossess and resell the equipment if
Defendant defaulted on the contract. Defendant did default and agreed to deliver the equipment to
Plaintiff if Plaintiff would then discharge Defendant from further obligation. Plaintiff accepted delivery
and resold the equipment, but the sale left a deficiency (there was still money owing by Defendant).

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Plaintiff then sued for the deficiency, and Defendant set up as a defense the accord and satisfaction. Is
the defense good?

SELF-TEST QUESTIONS
1.

Consideration

a.

can consist of a written acknowledgment of some benefit received, even if in fact the benefit is
not delivered

b.

cannot be nominal in amount

c.

is a bargained-for act, forbearance, or promise from the promisee

d.

is all of the above
An example of valid consideration is a promise

a.

by a seventeen-year-old to refrain from drinking alcohol

b.

to refrain from going to court

c.

to cook dinner if the promisor can get around to it

d.

to repay a friend for the four years of free legal advice he had provided
An unliquidated debt is a debt

a.

one is not able to pay

b.

not yet paid

c.

of uncertain amount

d.

that is unenforceable debt
The rule that if one party to a contract has not made a binding obligation, the other party is not
bound is called

a.

revocation

b.

mutuality of obligation

c.

accord and satisfaction

d.

estoppel
Examples of promises enforceable without consideration include

a.

an agreement modifying a sales contract

b.

a promise to pay a debt after the statute of limitations has run

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c.

a debtor’s promise to repay a debt that has been discharged in bankruptcy

d.

all of the above

SELF-TEST ANSWERS
1.

c

2.

b

3.

c

4.

b

5.

d

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Chapter 12

Legality
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

The types of contracts (bargains) that are deemed illegal

2.

How courts deal with disputes concerning illegal contracts

3.

Under what circumstances courts will enforce otherwise illegal contracts

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12.1 General Perspectives on Illegality
LEARNING OBJECTIVES
1.

Understand why courts refuse to enforce illegal agreements.

2.

Recognize the rationale behind exceptions to the rule.

We have discussed the requirements of mutual assent, real assent, and consideration. We now turn to the
fourth of the five requirements for a valid contract: the legality of the underlying bargain. The basic rule is
that courts will not enforce an illegal bargain. (The term illegal bargain is better than illegal
contract because a contract is by definition a legal agreement, but the latter terminology prevails in
common usage.) Why should this be? Why should the courts refuse to honor contracts made privately by
people who presumably know what they are doing—for example, a wager on the World Series or a
championship fight? Two reasons are usually given. One is that refusal to enforce helps discourage
unlawful behavior; the other is that honoring such contracts would demean the judiciary. Are these
reasons valid? Yes and no, in the opinion of one contracts scholar:
[D]enying relief to parties who have engaged in an illegal transaction…helps to effectuate the public policy
involved by discouraging the conduct that is disapproved. Mere denial of contractual and quasicontractual remedy [however] rarely has a substantial effect in discouraging illegal conduct. A man who is
hired to perform a murder is not in the least deterred by the fact that the courts are not open to him to
collect his fee. Such a man has other methods of enforcement, and they are in fact more effective than
legal process. The same is true in varying degrees where less heinous forms of illegal conduct are involved.
Even in the matter of usury it was found that mere denial of enforcement was of little value in the effort to
eliminate the loan shark. And restraints of trade were not curbed to an appreciable extent until contracts
in restraint of trade were made criminal.
In most instances, then, the protection of the good name of the judicial institution must provide the
principal reason for the denial of a remedy to one who has trafficked in the forbidden. This is, moreover, a
very good reason. The first duty of an institution is to preserve itself, and if the courts to any appreciable
extent busied themselves with “justice among thieves,” the community…would be shocked and the courts
[1]

would be brought into disrepute.

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Strictly enforced, the rule prohibiting courts from ordering the parties to honor illegal contracts is harsh.
It means that a promisee who has already performed under the contract can neither obtain performance
of the act for which he bargained nor recover the money he paid or the value of the performance he made.
The court will simply leave the parties where it finds them, meaning that one of the parties will have
received an uncompensated benefit.
Not surprisingly, the severity of the rule against enforcement has led courts to seek ways to moderate its
impact, chiefly by modifying it according to the principle of restitution. In general, restitution requires
that one who has conferred a benefit or suffered a loss should not unfairly be denied compensation.
Pursuing this notion, the courts have created several exceptions to the general rule. Thus a party who is
excusably ignorant that his promise violates public policy and a party who is not equally in the wrong may
recover. Likewise, when a party “would otherwise suffer a forfeiture that is disproportionate in relation to
[2]

the contravention of public policy involved,” restitution will be allowed. Other exceptions exist when the
party seeking restitution withdraws from the transaction contemplated in the contract before the illegal
purpose has been carried out and when “allowing the claim would put an end to a continuing situation
that is contrary to the public interest.”

[3]

An example of the latter situation occurs when two bettors place

money in the hands of a stakeholder. If the wager is unlawful, the loser of the bet has the right to recover
his money from the stakeholder before it is paid out to the winner.
Though by and large courts enforce contracts without considering the worth or merits of the bargain they
incorporate, freedom of contract can conflict with other public policies. Tensions arise between the desire
to let people pursue their own ends and the belief that certain kinds of conduct should not be encouraged.
Thus a patient may agree to be treated by an herbalist, but state laws prohibit medical care except by
licensed physicians. Law and public policies against usury, gambling, obstructing justice, bribery, corrupt
influence, perjury, restraint of trade, impairment of domestic relations, and fraud all significantly affect
the authority and willingness of courts to enforce contracts.
In this chapter, we will consider two types of illegality: (1) that which results from a bargain that violates a
statute and (2) that which the courts deem contrary to public policy, even though not expressly set forth in
statutes.

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KEY TAKEAWAY
Courts refuse to enforce illegal bargains notwithstanding the basic concept of freedom to contract because
they do not wish to reward illegal behavior or sully themselves with adjudication of that which is forbidden to
undertake. However, fairness sometimes compels courts to make exceptions.

EXERCISES
1.

Why is illegal contract a contradiction in terms?

2.

Why do courts refuse to enforce contracts (or bargains) made by competent adults if the contracts harm
no third party but are illegal?

[1] Harold C. Havighurst, review of Corbin on Contracts, by Arthur L. Corbin, Yale Law Journal 61 (1952): 1143,
1144–45.
[2] Restatement (Second) of Contracts, Section 197(b).
[3] Restatement (Second) of Contracts, Section 197(b).

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12.2 Agreements in Violation of Statute
LEARNING OBJECTIVES
1.

Understand that various types of bargains may be made illegal by statute, including gambling, some
service-for-fee agreements involving unlicensed practitioners, and usury.

2.

Recognize that while gambling contracts are often illegal, some agreements that might appear to
involve gambling are not.

Overview
Any bargain that violates the criminal law—including statutes that govern extortion, robbery,
embezzlement, forgery, some gambling, licensing, and consumer credit transactions—is illegal. Thus
determining whether contracts are lawful may seem to be an easy enough task. Clearly, whenever the
statute itself explicitly forbids the making of the contract or the performance agreed upon, the bargain
(such as a contract to sell drugs) is unlawful. But when the statute does not expressly prohibit the making
of the contract, courts examine a number of factors, as discussed in Section 12.5.1 "Extension of Statutory
Illegality Based on Public Policy" involving the apparently innocent sale of a jewelry manufacturing firm
whose real business was making marijuana-smoking paraphernalia.

Types of Bargains Made Illegal by Statute
Gambling Contracts
All states have regulations affecting gambling (wagering) contracts because gambling tends to be an
antiutilitarian activity most attractive to those who can least afford it, because gambling tends to reinforce
fatalistic mind-sets fundamentally incompatible with capitalism and democracy, because gambling can be
addictive, and because gambling inevitably attracts criminal elements lured by readily available money.
With the spread of antitax enthusiasms over the last thirty-some years, however, some kinds of gambling
have been legalized and regulated, including state-sponsored lotteries. Gambling is betting on an outcome
of an event over which the bettors have no control where the purpose is to play with the risk.
But because the outcome is contingent on events that lie outside the power of the parties to control does
not transform a bargain into a wager. For example, if a gardener agrees to care for the grounds of a

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septuagenarian for life in return for an advance payment of $10,000, the uncertainty of the date of the
landowner’s death does not make the deal a wager. The parties have struck a bargain that accurately
assesses, to the satisfaction of each, the risks of the contingency in question. Likewise, the fact that an
agreement is phrased in the form of a wager does not make it one. Thus a father says to his daughter, “I’ll
bet you can’t get an A in organic chemistry. If you do, I’ll give you $50.” This is a unilateral contract, the
consideration to the father being the daughter’s achieving a good grade, a matter over which she has
complete control.
Despite the general rule against enforcing wagers, there are exceptions, most statutory but some rooted in
the common law. The common law permits the sale or purchase of securities: Sally invests $6,000 in
stock in Acme Company, hoping the stock will increase in value, though she has no control over the firm’s
management. It is not called gambling; it is considered respectable risk taking in the capitalist system, or
“entrepreneurialism.” (It really is gambling, though, similar to horse-race gambling.) But because there
are speculative elements to some agreements, they are subject to state and federal regulation.
Insurance contracts are also speculative, but unless one party has no insurable interest (a concern for the
person or thing insured) in the insured, the contract is not a wager. Thus if you took out a life insurance
contract on the life of someone whose name you picked out of the phone book, the agreement would be
void because you and the insurance company would have been gambling on a contingent event. (You bet
that the person would die within the term of the policy, the insurance company that she would not.) If,
however, you insure your spouse, your business partner, or your home, the contingency does not make the
policy a wagering agreement because you will have suffered a direct loss should it occur, and the
agreement, while compensating for a possible loss, does not create a new risk just for the “game.”

Sunday Contracts
At common law, contracts entered into on Sundays, as well as other commercial activities, were valid and
enforceable. But a separate, religious tradition that traces to the Second Commandment frowned on work
performed on “the Lord’s Day.” In 1781 a New Haven city ordinance banning Sunday work was printed on
blue paper, and since that time such laws have been known as blue laws. The first statewide blue law was
enacted in the United States in 1788; it prohibited travel, work, sports and amusements, and the carrying

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on of any business or occupation on Sundays. The only exceptions in most states throughout most of the
nineteenth century were mutual promises to marry and contracts of necessity or charity. As the Puritan
fervor wore off, and citizens were, more and more, importuned to consider themselves “consumers” in a
capitalistic economic system, the laws have faded in importance and are mostly repealed, moribund, or
unenforced. Washington State, up until 2008, completely prohibited hard alcohol sales on Sunday, and all
liquor stores were closed, but subsequently the state—desperate for tax revenue—relaxed the prohibition.

Usury
A usury statute is one that sets the maximum allowable interest that may be charged on a loan; usury is
charging illegal interest rates. Formerly, such statutes were a matter of real importance because the
penalty levied on the lender—ranging from forfeiture of the interest, or of both the principal and the
interest, or of some part of the principal—was significant. But usury laws, like Sunday contract laws, have
been relaxed to accommodate an ever-more-frenzied consumer society. There are a number of
transactions to which the laws do not apply, varying by state: small consumer loans, pawn shop loans,
payday loans, and corporate loans. In Marquette v. First Omaha Service Corp., the Supreme Court ruled
that a national bank could charge the highest interest rate allowed in its home state to customers living
anywhere in the United States, including states with restrictive interest caps.

[1]

Thus it was that in 1980

Citibank moved its credit card headquarters from cosmopolitan New York City to the somewhat less
cosmopolitan Sioux Falls, South Dakota. South Dakota had recently abolished its usury laws, and so, as
far as credit-card interest rates, the sky was the limit. That appealed to Citibank and a number of other
financial institutions, and to the state: it became a major player in the US financial industry, garnering
many jobs.

[2]

Licensing Statutes
To practice most professions and carry on the trade of an increasing number of occupations, states require
that providers of services possess licenses—hairdressers, doctors, plumbers, real estate brokers, and egg
inspectors are among those on a long list. As sometimes happens, though, a person may contract for the
services of one who is unlicensed either because he is unqualified and carrying on his business without a
license or because for technical reasons (e.g., forgetting to mail in the license renewal application) he does

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not possess a license at the moment. Robin calls Paul, a plumber, to install the pipes for her new kitchen.
Paul, who has no license, puts in all the pipes and asks to be paid. Having discovered that Paul is
unlicensed, Robin refuses to pay. May Paul collect?
To answer the question, a three-step analysis is necessary. First, is a license required? Some occupations
may be performed without a license (e.g., lawn mowing). Others may be performed with or without
certain credentials, the difference lying in what the professional may tell the public. (For instance, an
accountant need not be a certified public accountant to carry on most accounting functions.) Let us
assume that the state requires everyone who does any sort of plumbing for pay to have a valid license.
The second step is to determine whether the licensing statute explicitly bars recovery by someone who has
performed work while unlicensed. Some do; many others contain no specific provision on the point.
Statutes that do bar recovery must of course govern the courts when they are presented with the question.
If the statute is silent, courts must, in the third step of the analysis, distinguish between “regulatory” and
“revenue” licenses. A regulatory license is intended to protect the public health, safety, and welfare. To
obtain these licenses, the practitioner of the art must generally demonstrate his or her abilities by taking
some sort of examination, like the bar exam for lawyers or the medical boards for doctors. A plumber’s or
electrician’s licensing requirement might fall into this category. A revenue license generally requires no
such examination and is imposed for the sake of raising revenue and to ensure that practitioners register
their address so they can be found if a disgruntled client wants to serve them legal papers for a lawsuit.
Some revenue licenses, in addition to requiring registration, require practitioners to demonstrate that
they have insurance. A license to deliver milk, open to anyone who applies and pays the fee, would be an
example of a revenue license. (In some states, plumbing licenses are for revenue purposes only.)
Generally speaking, failure to hold a regulatory license bars recovery, but the absence of a revenue or
registration license does not—the person may obtain the license and then move to recover. See Section
12.5.2 "Unlicensed Practitioner Cannot Collect Fee" for an example of a situation in which the state statute
demands practitioners be licensed.

KEY TAKEAWAY

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Gambling, interest rates, and Sunday contracts are among the types of contracts that have, variously, been
subject to legislative illegality. Laws may require certain persons to have licenses in order to practice a trade
or profession. Whether an unlicensed person is barred from recovering a fee for service depends on the
language of the statute and the purpose of the requirement: if it is a mere revenue-raising or registration
statute, recovery will often be allowed. If the practitioner is required to prove competency, no recovery is
possible for an unlicensed person.

EXERCISES
1.

List the typical kinds of contracts made illegal by statute.

2.

Why are some practitioners completely prohibited from collecting a fee for service if they don’t have a
license, and others allowed to collect the fee after they get the license?

3.

If no competency test is required, why do some statutes require the practitioner to be licensed?

[1] Marquette v. First Omaha Service Corp., 439 US 299 (1978).
[2] See Thomas M. Reardon, “T. M. Reardon’s first-hand account of Citibank’s move to South
Dakota,” NorthWestern Financial Review, September 15, 2004, accessed March 1,
2011, http://www.highbeam.com/doc/1P3-708279811.html. Mr. Reardon was a member of the South Dakota
Bankers’ Association.

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12.3 Bargains Made Illegal by Common Law
LEARNING OBJECTIVE
1.

Understand what contracts or bargains have been declared illegal by courts.

Overview
Public policy is expressed by courts as well as legislatures. In determining whether to enforce a contract
where there is no legislative dictate, courts must ordinarily balance the interests at stake. To strike the
proper balance, courts must weigh the parties’ expectations, the forfeitures that would result from denial
of enforcement, and the public interest favoring enforcement against these factors: the strength of the
policy, whether denying enforcement will further the policy, the seriousness and deliberateness of the
violation, and how direct the connection is between the misconduct and the contractual term to be
enforced.

[1]

Types of Bargains Made Illegal by Common Law
Common-Law Restraint of Trade
One of the oldest public policies evolved by courts is the common-law prohibition against restraint of
trade. From the early days of industrialism, the courts took a dim view of ostensible competitors who
agreed among themselves to fix prices or not to sell in each other’s territories. Since 1890, with the
enactment of the Sherman Act, the law of restraint of trade has been absorbed by federal and state
antitrust statutes. But the common-law prohibition still exists. Though today it is concerned almost
exclusively with promises not to compete in sales of businesses and employment contracts, it can arise in
other settings. For example, George’s promise to Arthur never to sell the parcel of land that Arthur is
selling to him is void because it unreasonably restrains trade in the land.
The general rule is one of reason: not every restraint of trade is unlawful; only unreasonable ones are. As
the Restatement puts it, “Every promise that relates to business dealings or to a professional or other
gainful occupation operates as a restraint in the sense that it restricts the promisor’s future activity. Such
a promise is not, however, unenforceable, unless the restraint that it imposes is unreasonably detrimental
to the smooth operation of a freely competitive private economy.”

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An agreement that restrains trade

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will be construed as unreasonable unless it is ancillary to a legitimate business interest and is no greater
than necessary to protect the legitimate interest. Restraint-of-trade cases usually arise in two settings: (1)
the sale of a business and an attendant agreement not to compete with the purchasers and (2) an
employee’s agreement not to compete with the employer should the employee leave for any reason.

Sale of a Business
A first common area where a restraint-of-trade issue may arise is with the sale of a business. Regina sells
her lingerie store to Victoria and promises not to establish a competing store in town for one year. Since
Victoria is purchasing Regina’s goodwill (the fact that customers are used to shopping at her store), as
well as her building and inventory, there is clearly a property interest to be protected. And the
geographical limitation (“in town”) is reasonable if that is where the store does business. But if Regina had
agreed not to engage in any business in town, or to wait ten years before opening up a new store, or not to
open up a new store anywhere within one hundred miles of town, she could avoid the noncompetition
terms of the contract because the restraint in each case (nature, duration, and geographic area of
restraint) would have been broader than necessary to protect Victoria’s interest. Whether the courts will
uphold an agreement not to compete depends on all the circumstances of the particular case, as the
Connecticut barber in Section 12.5.3 "Unconscionability"discovered.

Employment Noncompete Agreements
A second common restraint-of-trade issue arises with regard tononcompete agreements in employment
contracts. As a condition of employment by the research division of a market research firm, Bruce, a
product analyst, is required to sign an agreement in which he promises, for a period of one year after
leaving the company, not to “engage, directly or indirectly, in any business competing with the company
and located within fifty miles of the company’s main offices.” The principal reason recited in the
agreement for this covenant not to compete is that by virtue of the employment, Bruce will come to learn a
variety of internal secrets, including client lists, trade or business secrets, reports, confidential business
discussions, ongoing research, publications, computer programs, and related papers. Is this agreement a
lawful restraint of trade?

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Here both the property interest of the employer and the extent of the restraint are issues. Certainly an
employer has an important competitive interest in seeing that company information not walk out the door
with former employees. Nevertheless, a promise by an employee not to compete with his or her former
employer is scrutinized carefully by the courts, and an injunction (an order directing a person to stop
doing what he or she should not do) will be issued cautiously, partly because the prospective employee is
usually confronted with a contract of adhesion (take it or leave it) and is in a weak bargaining position
compared to the employer, and partly because an injunction might cause the employee’s unemployment.
Many courts are not enthusiastic about employment noncompete agreements. The California Business
and Professions Code provides that “every contract by which anyone is restrained from engaging in a
lawful profession, trade, or business of any kind is to that extent void.”

[3]

As a result of the statute, and to

promote entrepreneurial robustness, California courts typically interpret the statute broadly and refuse to
enforce noncompete agreements. Other states are less stingy, and employers have attempted to avoid the
strictures of no-enforcement state rulings by providing that their employment contracts will be
interpreted according to the law of a state where noncompetes are favorably viewed.
If a covenant not to compete is ruled unlawful, the courts can pursue one of three courses by way of
remedy. A court can refuse to enforce the entire covenant, freeing the employee to compete thenceforth.
The court could delete from the agreement only that part that is unreasonable and enforce the remainder
(the “blue pencil” rule). In some states, the courts have moved away from this rule and have actually taken
to rewriting the objectionable clause themselves. Since the parties intended that there be some form of
restriction on competition, a reasonable modification would achieve a more just result.

[4]

Unconscionable Contracts
Courts may refuse to enforce unconscionable contracts, those that are very one-sided, unfair, the product
of unequal bargaining power, or oppressive; a court may find the contract divisible and enforce only the
parts that are not unconscionable.
The common-law rule is reflected in Section 208 of the Restatement: “If a contract or term thereof is
unconscionable at the time the contract is made a court may refuse to enforce the contract, or may enforce

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the remainder of the contract without the unconscionable term, or may so limit the application of any
unconscionable term as to avoid any unconscionable result.”
And the Uniform Commercial Code (UCC) (again, of course, a statute, not common law) provides a
similar rule in Section 2-302(1): “If the court as a matter of law finds the contract or any clause of the
contract to have been unconscionable at the time it was made the court may refuse to enforce the contract,
or it may enforce the remainder of the contract without the unconscionable clause, or it may so limit the
application of any unconscionable clause as to avoid any unconscionable result.”
Unconscionable is not defined in the Restatement or the UCC, but cases have given gloss to the meaning,
as in Section 12.5.3 "Unconscionability", Williams v. Walker-Thomas Furniture Co., a well-known early
interpretation of the section by the DC Court of Appeals.
Unconscionability may arise procedurally or substantively. A term is procedurally unconscionable if it is
imposed upon the “weaker” party because of fine or inconspicuous print, unexpected placement in the
contract, lack of opportunity to read the term, lack of education or sophistication that precludes
understanding, or lack of equality of bargaining power. Substantive unconscionability arises where the
affected terms are oppressive and harsh, where the term deprives a party of any real remedy for breach.
Most often—but not always—courts find unconscionable contracts in the context of consumer transactions
rather than commercial transactions. In the latter case, the assumption is that the parties tend to be
sophisticated businesspeople able to look out for their own contract interests.

Exculpatory Clauses
The courts have long held that public policy disfavors attempts to contract out of tort
liability. Exculpatory clauses that exempt one party from tort liability to the other for harm caused
intentionally or recklessly are unenforceable without exception. A contract provision that exempts a party
from tort liability for negligence is unenforceable under two general circumstances: (1) when it “exempts
an employer from liability to an employee for injury in the course of his employment” or (2) when it
exempts one charged with a duty of public service and who is receiving compensation from liability to one
to whom the duty is owed.

[5]

Contract terms with offensive exculpatory clauses may be considered

somewhat akin to unconscionability.

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Put shortly, exculpatory clauses are OK if they are reasonable. Put not so shortly, exculpatory clauses will
generally be held valid if (1) the agreement does not involve a business generally thought suitable for
public regulation (a twenty-kilometer bicycle race, for example, is probably not one thought generally
suitable for public regulation, whereas a bus line is); (2) the party seeking exculpation is not performing a
business of great importance to the public or of practical necessity for some members of the public; (3) the
party does not purport to be performing the service to just anybody who comes along (unlike the bus
line); (4) the parties are dealing at arms’ length, able to bargain about the contract; (5) the person or
property of the purchaser is not placed under control of the seller, subject to his or his agent’s
carelessness; or (6) the clause is conspicuous and clear.

[6]

Obstructing the Administration of Justice or Violating a Public Duty
It is well established under common law that contracts that would interfere with the administration of
justice or that call upon a public official to violate a public duty are void and unenforceable. Examples of
such contracts are numerous: to conceal or compound a crime, to pay for the testimony of a witness in
court contingent on the court’s ruling, to suppress evidence by paying a witness to leave the state, or to
destroy documents. Thus, in an unedifying case in Arkansas, a gambler sued a circuit court judge to
recover $1,675 allegedly paid to the judge as protection money, and the Arkansas Supreme Court affirmed
the dismissal of the suit, holding, “The law will not aid either party to the alleged illegal and void
contract…‘but will leave them where it finds them, if they have been equally cognizant of the
illegality.’”

[7]

Also in this category are bribes, agreements to obstruct or delay justice (jury tampering,

abuse of the legal process), and the like.

Family Relations
Another broad area in which public policy intrudes on private contractual arrangements is that of
undertakings between couples, either prior to or during marriage. Marriage is quintessentially a
relationship defined by law, and individuals have limited ability to change its scope through legally
enforceable contracts. Moreover, marriage is an institution that public policy favors, and agreements that
unreasonably restrain marriage are void. Thus a father’s promise to pay his twenty-one-year-old daughter
$100,000 if she refrains from marrying for ten years would be unenforceable. However, a promise in

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apostnuptial (after marriage) agreement that if the husband predeceases the wife, he will provide his wife
with a fixed income for as long as she remains unmarried is valid because the offer of support is related to
the need. (Upon remarriage, the need would presumably be less pressing.) Property settlements before,
during, or upon the breakup of a marriage are generally enforceable, since property is not considered to
be an essential incident of marriage. But agreements in the form of property arrangements that tend to be
detrimental to marriage are void—for example, a prenuptial (premarital) contract in which the wife-to-be
agrees on demand of the husband-to-be to leave the marriage and renounce any claims upon the
husband-to-be at any time in the future in return for which he will pay her $100,000. Separation
agreements are not considered detrimental to marriage as long as they are entered after or in
contemplation of immediate separation; but a separation agreement must be “fair” under the
circumstances, and judges may review them upon challenge. Similarly, child custody agreements are not
left to the whim of the parents but must be consistent with the best interest of the child, and the courts
retain the power to examine this question.
The types of contracts or bargains that might be found illegal are innumerable, limited only by the
ingenuity of those who seek to overreach.

KEY TAKEAWAY
Courts will not enforce contracts that are, broadly speaking, contrary to public policy. These include some
noncompete agreements, exculpatory clauses, unconscionable bargains, contracts to obstruct the public
process or justice, and contracts interfering with family relations.

EXERCISES
1.

Why are employment noncompete agreements viewed less favorably than sale-of-business noncompete
agreements?

2.

Can a person by contract exculpate herself from liability for gross negligence? For ordinary negligence?

3.

A parking lot agreement says the parking lot is “not responsible for loss of contents or damage to the
vehicle.” Is that acceptable? Explain.

4.

A valet parking lot agreement—where the car owner gives the keys to the attendant who parks the car—
has the same language as that for the lot in Exercise 3. Is that acceptable? Explain.

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[1] Restatement (Second) of Contracts, Section 178.
[2] Restatement (Second) of Contracts, Section 186(a).
[3] California Business and Professions Code, Section 16600.
[4] Raimondo v. Van Vlerah, 325 N.E.2d 544 (Ohio 1975).
[5] Restatement (Second) of Contracts, Section 195.
[6] Henrioulle v. Marin Ventures, Inc., 573 P.2d 465 (Calif. 1978).
[7] Womack v. Maner, 301 S.W.2d 438 (Ark. 1957).

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12.4 Effect of Illegality and Exceptions
LEARNING OBJECTIVES
1.

Recognize that courts will not enforce illegal bargains.

2.

Know that there are exceptions to that rule.

Effect of Illegality
The general rule is this: courts will not enforce illegal bargains. The parties are left where the court found
them, and no relief is granted: it’s a hands-off policy. The illegal agreement is void, and that a wrongdoer
has benefited to the other’s detriment does not matter.
For example, suppose a specialty contractor, statutorily required to have a license, constructs a waterslide
for Plaintiff, when the contractor knew or should have known he was unlicensed. Plaintiff discovers the
impropriety and refuses to pay the contractor $80,000 remaining on the deal. The contractor will not get
paid.

[1]

In another example, a man held himself out to be an architect in a jurisdiction requiring that

architects pass a test to be licensed. He was paid $80,000 to design a house costing $900,000. The
project was late and over budget, and the building violated relevant easement building-code rules. The
unlicensed architect was not allowed to keep his fee.

[2]

Exceptions
As always in the law, there are exceptions. Of relevance here are situations where a court might permit
one party to recover: party withdrawing before performance, party protected by statute, party not equally
at fault, excusable ignorance, and partial illegality.

Party Withdrawing before Performance
Samantha and Carlene agree to bet on a soccer game and deliver their money to the stakeholder.
Subsequently, but before the payout, Carlene decides she wants out; she can get her money from the
stakeholder. Ralph hires Jacob for $5,000 to arrange a bribe of a juror. Ralph has a change of heart; he
can get his money from Jacob.

Party Protected by Statute
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An airline pilot, forbidden by federal law from working overtime, nevertheless does so; she would be
entitled to payment for the overtime worked. Securities laws forbid the sale or purchase of unregistered
offerings—such a contract is illegal; the statute allows the purchaser rescission (return of the money paid).
An attorney (apparently unwittingly) charged his client beyond what the statute allowed for procuring for
the client a government pension; the pensioner could get the excess from the attorney.

Party Not Equally at Fault
One party induces another to make an illegal contract by undue influence, fraud, or duress; the victim can
recover the consideration conveyed to the miscreant if possible.

Excusable Ignorance
A woman agrees to marry a man not knowing that he is already married; bigamy is illegal, the marriage is
void, and she may sue him for damages. A laborer is hired to move sealed crates, which contain
marijuana; it is illegal to ship, sell, or use marijuana, but the laborer is allowed payment for his services.

Partial Illegality
A six-page employment contract contains two paragraphs of an illegal noncompete agreement. The illegal
part is thrown out, but the legal parts are enforceable.

KEY TAKEAWAY
There are a number of exceptions to the general rule that courts give no relief to either party to an illegal
contract. The rule may be relaxed in cases where justice would be better served than by following the stricture
of hands off.

EXERCISES
1.

When, in general, will a court allow a party relief from an illegal contract (or bargain)?

2.

A and B engage in a game of high-stakes poker under circumstances making the game illegal in the
jurisdiction. A owes B $5,000 when A loses. When A does not pay, B sues. Does B get the money? What if
A had paid B the $5,000 and then sued to get it back?

[1] Pacific Custom Pools, Inc. v. Turner Construction, 94 Cal. Rptr. 2d 756 (Calif. 2000).

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[2] Ransburg v. Haase, 586 N.E. 2d 1295 (Ill. Ct. App. 1992).

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12.5 Cases
Extension of Statutory Illegality Based on Public Policy
Bovard v. American Horse Enterprises
247 Cal. Rptr. 340 (Calif. 1988)
[Bovard sued Ralph and American Horse Enterprises (a corporation) to recover on promissory notes that
were signed when Ralph purchased the corporation, ostensibly a jewelry-making business. The trial court
dismissed Bovard’s complaint.]
Puglia, J.
The court found that the corporation predominantly produced paraphernalia used to smoke marijuana
[roach clips and bongs] and was not engaged significantly in jewelry production, and that Bovard had
recovered the corporate machinery through self-help [i.e., he had repossessed it]. The parties do not
challenge these findings. The court acknowledged that the manufacture of drug paraphernalia was not
itself illegal in 1978 when Bovard and Ralph contracted for the sale of American Horse Enterprises, Inc.
However, the court concluded a public policy against the manufacture of drug paraphernalia was implicit
in the statute making the possession, use and transfer of marijuana unlawful. The trial court held the
consideration for the contract was contrary to the policy of express law, and the contract was therefore
illegal and void. Finally, the court found the parties were in pari delicto [equally at fault] and thus with
respect to their contractual dispute should be left as the court found them.
The trial court concluded the consideration for the contract was contrary to the policy of the law as
expressed in the statute prohibiting the possession, use and transfer of marijuana. Whether a contract is
contrary to public policy is a question of law to be determined from the circumstances of the particular
case. Here, the critical facts are not in dispute. Whenever a court becomes aware that a contract is illegal,
it has a duty to refrain from entertaining an action to enforce the contract. Furthermore the court will not
permit the parties to maintain an action to settle or compromise a claim based on an illegal contract.…

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[There are several] factors to consider in analyzing whether a contract violates public policy: “Before
labeling a contract as being contrary to public policy, courts must carefully inquire into the nature of the
conduct, the extent of public harm which may be involved, and the moral quality of the conduct of the
parties in light of the prevailing standards of the community [Citations]”
These factors are more comprehensively set out in the Restatement Second of Contracts section 178:
(1) A promise or other term of an agreement is unenforceable on grounds of public policy if legislation
provides that it is unenforceable or the interest in its enforcement is clearly outweighed in the
circumstances by a public policy against the enforcement of such terms.
(2) In weighing the interest in the enforcement of a term, account is taken of
(a) the parties’ justified expectations,
(b) any forfeiture that would result if enforcement were denied, and
(c) any special public interest in the enforcement of the particular term.
(3) In weighing a public policy against enforcement of a term, account is taken of
(a) the strength of that policy as manifested by legislation or judicial decisions,
(b) the likelihood that a refusal to enforce the term will further that policy,
(c) the seriousness of any misconduct involved and the extent to which it was deliberate, and
(d) the directness of the connection between that misconduct and the term.
Applying the Restatement test to the present circumstances, we conclude the interest in enforcing this
contract is very tenuous. Neither party was reasonably justified in expecting the government would not
eventually act to geld American Horse Enterprises, a business harnessed to the production of
paraphernalia used to facilitate the use of an illegal drug. Moreover, although voidance of the contract
imposed a forfeiture on Bovard, he did recover the corporate machinery, the only assets of the business
which could be used for lawful purposes, i.e., to manufacture jewelry. Thus, the forfeiture was

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significantly mitigated if not negligible. Finally, there is no special public interest in the enforcement of
this contract, only the general interest in preventing a party to a contract from avoiding a debt.
On the other hand, the Restatement factors favoring a public policy against enforcement of this contract
are very strong. As we have explained, the public policy against manufacturing paraphernalia to facilitate
the use of marijuana is strongly implied in the statutory prohibition against the possession, use, etc., of
marijuana, a prohibition which dates back at least to 1929.…Obviously, refusal to enforce the instant
contract will further that public policy not only in the present circumstances but by serving notice on
manufacturers of drug paraphernalia that they may not resort to the judicial system to protect or advance
their business interests. Moreover, it is immaterial that the business conducted by American Horse
Enterprises was not expressly prohibited by law when Bovard and Ralph made their agreement since both
parties knew that the corporation’s products would be used primarily for purposes which were expressly
illegal. We conclude the trial court correctly declared the contract contrary to the policy of express law and
therefore illegal and void.

CASE QUESTIONS
1.

Why did the court think it was significant that Bovard had repossessed the jewelry-making equipment?

2.

What did Bovard want in this case?

3.

If it was not illegal to make bongs and roach clips, why did the court determine that this contract should
not be enforced?

Unlicensed Practitioner Cannot Collect Fee
Venturi & Company v. Pacific Malibu Development Corp.
172 Cal.App.4th 1417 (Calif. Ct. App. 2009)
Rubin, J.
In June 2003, plaintiff Venturi & Company LLC and defendant Pacific Malibu Development Corp. entered
into a contract involving development of a high-end resort on undeveloped property on the Bahamian
island of Little Exuma. Under the contract, plaintiff agreed to serve as a financial advisor and find

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financing for the Little Exuma project.…[P]laintiff was entitled to some payment under the contract even
if plaintiff did not secure financing for the project [called a success fee].
After signing the contract, plaintiff contacted more than 60 potential sources of financing for the
project.…[I]n the end, defendants did not receive financing from any source that plaintiff had identified.
Defendants terminated the contract in January 2005. Two months earlier, however, defendants had
signed a [financing agreement] with the Talisker Group. Plaintiff was not involved in defendants’
negotiations with the Talisker Group.…Nevertheless, plaintiff claimed the contract’s provision for a
success fee entitled plaintiff to compensation following the [agreement]. When defendants refused to pay
plaintiff’s fee, plaintiff sued defendants for the fee and for the reasonable value of plaintiff’s services.
Defendants moved for summary judgment. They argued plaintiff had provided the services of a real estate
broker by soliciting financing for the Little Exuma project yet did not have a broker’s license. Thus,
defendants asserted…the Business and Professions Code barred plaintiff from receiving any compensation
as an unlicensed broker.…Plaintiff opposed summary judgment. It argued that one of its managing
principals, Jane Venturi, had a real estate sales license and was employed by a real estate broker (whom
plaintiff did not identify) when defendants had signed their term sheet with the Talisker Group, the
document that triggered plaintiff’s right to a fee.
The court entered summary judgment for defendants. The court found plaintiff had acted as a real estate
broker when working on the Little Exuma project. The court pointed, however, to plaintiff’s lack of
evidence that Jane Venturi’s unnamed broker had employed or authorized her to work on the
project.…[Summary judgment was issued in favor of defendants, denying plaintiff any recovery.] This
appeal followed.
The court correctly ruled plaintiff could not receive compensation for providing real estate broker services
to defendants because plaintiff was not a licensed broker. (Section 11136 [broker’s license required to
collect compensation for broker services].) But decisions such as Lindenstadt [Citation] establish that the
court erred in denying plaintiff compensation to the extent plaintiff’s services were not those of a real
estate broker. In Lindenstadt, the parties entered into 25 to 30 written agreements in which the plaintiff
promised to help the defendant find businesses for possible acquisition. After the plaintiff found a number

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of such businesses, the defendant refused to compensate the plaintiff. The defendant cited the plaintiff’s
performance of broker’s services without a license as justifying its refusal to pay. On appeal, the appellate
court rejected the defendant’s sweeping contention that the plaintiff’s unlicensed services
for somebusiness opportunities meant the plaintiff could not receive compensation forany business
opportunity. Rather, the appellate court directed the trial court to examine individually each business
opportunity to determine whether the plaintiff acted as an unlicensed broker for that transaction or
instead provided only services for which it did not need a broker’s license.
Likewise here, the contract called for plaintiff to provide a range of services, some apparently requiring a
broker’s license, others seemingly not. Moreover, and more to the point, plaintiff denied having been
involved in arranging, let alone negotiating, defendants’ placement of Securities with the Talisker Group
for which plaintiff claimed a “success fee” under the contract’s provision awarding it a fee even if it had no
role in procuring the financing. Thus, triable issues existed involving the extent to which plaintiff provided
either unlicensed broker services or, alternatively, non-broker services for which it did not need a license.
(Accord: [Citation] [severability allowed partial enforcement of personal manager employment contract
when license required for some, but not all, services rendered under the contract].)
[T]he contract here…envisioned plaintiff directing its efforts toward many potential sources of financing.
As to some of those sources, plaintiff may have crossed the line into performing broker services. But for
other sources, plaintiff may have provided only financial and marketing advice for which it did not need a
broker’s license. (See, e.g. [Citation] [statute barring unlicensed contractor from receiving fees for some
services did not prohibit recovery for work not within scope of licensing statute].) And finally, as to the
Talisker Group, plaintiff may have provided even less assistance than financial and marketing advice,
given that plaintiff denied involvement with the group. Whether plaintiff crossed the line into providing
broker services is thus a triable issue of fact that we cannot resolve on summary judgment.
…Plaintiff…did not have a broker’s license, and therefore was not entitled to compensation for broker’s
services. Plaintiff contends it was properly licensed because one of its managers, Jane Venturi, obtained a
real estate sales license in February 2004. Thus, she, and plaintiff claims by extension itself, were licensed
when defendants purportedly breached the contract by refusing to pay plaintiff months later for the
Talisker Group placement. Jane Venturi’s sales license was not, however, sufficient; only a licensed broker

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may provide broker services. A sales license does not permit its holder to represent another unless the
salesperson acts under a broker’s authority.
The judgment for defendants is vacated, and the trial court is directed to enter a new order denying
defendants’ motion for summary judgment.…

CASE QUESTIONS
1.

Why did the plaintiff think it should be entitled to full recovery under the contract, including for services
rendered as a real estate broker? Why did the court deny that?

2.

Even if the plaintiff were not a real estate broker, why would that mean it could not recover for real
estate services provided to the defendant?

3.

The appeals court remanded the case; what did it suggest the plaintiff should recover on retrial?

Unconscionability
Williams v. Walker-Thomas Furniture Co.
350 F.2d 445 (D.C. Ct. App. 1965)
Wright, J.
Appellee, Walker-Thomas Furniture Company, operates a retail furniture store in the District of
Columbia. During the period from 1957 to 1962 each appellant in these cases purchased a number of
household items from Walker-Thomas, for which payment was to be made in installments. The terms of
each purchase were contained in a printed form contract which set forth the value of the purchased item
and purported to lease the item to appellant for a stipulated monthly rent payment. The contract then
provided, in substance, that title would remain in Walker-Thomas until the total of all the monthly
payments made equaled the stated value of the item, at which time appellants could take title. In the event
of a default in the payment of any monthly installment, Walker-Thomas could repossess the item.
The contract further provided that ‘the amount of each periodical installment payment to be made by
(purchaser) to the Company under this present lease shall be inclusive of and not in addition to the
amount of each installment payment to be made by (purchaser) under such prior leases, bills or accounts;
and all payments now and hereafter made by (purchaser) shall be credited pro rata on all outstanding

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leases, bills and accounts due the Company by (purchaser) at the time each such payment is made.’ The
effect of this rather obscure provision was to keep a balance due on every item purchased until the balance
due on all items, whenever purchased, was liquidated. As a result, the debt incurred at the time of
purchase of each item was secured by the right to repossess all the items previously purchased by the
same purchaser, and each new item purchased automatically became subject to a security interest arising
out of the previous dealings.
On May 12, 1962, appellant Thorne purchased an item described as a daveno, three tables, and two lamps,
having total stated value of $391.11 [about $2,800 in 2011 dollars]. Shortly thereafter, he defaulted on his
monthly payments and appellee sought to replevy [repossess] all the items purchased since the first
transaction in 1958. Similarly, on April 17, 1962, appellant Williams bought a stereo set of stated value of
$514.95 [about $3,600 in 2011 dollars]. She too defaulted shortly thereafter, and appellee sought to
replevy all the items purchased since December, 1957. The Court of General Sessions granted judgment
for appellee. The District of Columbia Court of Appeals affirmed, and we granted appellants’ motion for
leave to appeal to this court.
Appellants’ principal contention, rejected by both the trial and the appellate courts below, is that these
contracts, or at least some of them, are unconscionable and, hence, not enforceable. [In its opinion the
lower court said:]
The record reveals that prior to the last purchase appellant had reduced the balance in her account to
$164. The last purchase, a stereo set, raised the balance due to $678. Significantly, at the time of this and
the preceding purchases, appellee was aware of appellant’s financial position. The reverse side of the
stereo contract listed the name of appellant’s social worker and her $218 monthly stipend from the
government. Nevertheless, with full knowledge that appellant had to feed, clothe and support both herself
and seven children on this amount, appellee sold her a $514 stereo set.
We cannot condemn too strongly appellee’s conduct. It raises serious questions of sharp practice and
irresponsible business dealings. A review of the legislation in the District of Columbia affecting retail sales
and the pertinent decisions of the highest court in this jurisdiction disclose, however, no ground upon
which this court can declare the contracts in question contrary to public policy. We note that were the

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Maryland Retail Installment Sales Act…or its equivalent, in force in the District of Columbia, we could
grant appellant appropriate relief. We think Congress should consider corrective legislation to protect the
public from such exploitive contracts as were utilized in the case at bar.
We do not agree that the court lacked the power to refuse enforcement to contracts found to be
unconscionable. In other jurisdictions, it has been held as a matter of common law that unconscionable
contracts are not enforceable. While no decision of this court so holding has been found, the notion that
an unconscionable bargain should not be given full enforcement is by no means novel.…
Since we have never adopted or rejected such a rule, the question here presented is actually one of first
impression.…[W]e hold that where the element of unconscionability is present at the time a contract is
made, the contract should not be enforced.
Unconscionability has generally been recognized to include an absence of meaningful choice on the part of
one of the parties together with contract terms which are unreasonably favorable to the other party.
Whether a meaningful choice is present in a particular case can only be determined by consideration of all
the circumstances surrounding the transaction. In many cases the meaningfulness of the choice is negated
by a gross inequality of bargaining power. The manner in which the contract was entered is also relevant
to this consideration. Did each party to the contract, considering his obvious education or lack of it, have a
reasonable opportunity to understand the terms of the contract, or were the important terms hidden in a
maze of fine print and minimized by deceptive sales practices? Ordinarily, one who signs an agreement
without full knowledge of its terms might be held to assume the risk that he has entered a one-sided
bargain. But when a party of little bargaining power, and hence little real choice, signs a commercially
unreasonable contract with little or no knowledge of its terms, it is hardly likely that his consent, or even
an objective manifestation of his consent, was ever given to all the terms. In such a case the usual rule that
the terms of the agreement are not to be questioned should be abandoned and the court should consider
whether the terms of the contract are so unfair that enforcement should be withheld.…
In determining reasonableness or fairness, the primary concern must be with the terms of the contract
considered in light of the circumstances existing when the contract was made. The test is not simple, nor
can it be mechanically applied. The terms are to be considered ‘in the light of the general commercial

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background and the commercial needs of the particular trade or case.’ Corbin suggests the test as being
whether the terms are ‘so extreme as to appear unconscionable according to the mores and business
practices of the time and place.’ We think this formulation correctly states the test to be applied in those
cases where no meaningful choice was exercised upon entering the contract. So ordered.
Danaher, J. (dissenting):
[The lower] court…made no finding that there had actually been sharp practice. Rather the appellant
seems to have known precisely where she stood.
There are many aspects of public policy here involved. What is a luxury to some may seem an outright
necessity to others. Is public oversight to be required of the expenditures of relief funds? A washing
machine, e.g., in the hands of a relief client might become a fruitful source of income. Many relief clients
may well need credit, and certain business establishments will take long chances on the sale of items,
expecting their pricing policies will afford a degree of protection commensurate with the risk. Perhaps a
remedy when necessary will be found within the provisions of the D.C. “Loan Shark” law, [Citation].
I mention such matters only to emphasize the desirability of a cautious approach to any such problem,
particularly since the law for so long has allowed parties such great latitude in making their own contracts.
I dare say there must annually be thousands upon thousands of installment credit transactions in this
jurisdiction, and one can only speculate as to the effect the decision in these cases will have.

CASE QUESTIONS
1.

Did the court here say that cross-collateral contracts are necessarily unconscionable?

2.

Why is it relevant that the plaintiff had seven children and was on welfare?

3.

Why did the defendant have a cross-collateral clause in the contract? What would happen if no such
clauses were allowed?

4.

What are the elements of unconscionability that the court articulates?

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12.6 Summary and Exercises
Summary
In general, illegal contracts are unenforceable. The courts must grapple with two types of illegalities: (1)
statutory violations and (2) violations of public policy not expressly declared unlawful by statute. The
former include gambling contracts, contracts with unlicensed professionals, and Sunday contracts.
Contracts that violate public policy include many types of covenants not to compete. No general rule for
determining their legality can be given, except to say that the more rigid their restrictions against working
or competing, the less likely they will withstand judicial scrutiny. Other types of agreements that may
violate public policy and hence are unenforceable include provisions that waive tort liability and contracts
that interfere with family relationships.
The exceptions to the rule that illegal agreements will not be enforced and that courts leave the parties
where they are generally involve situations where the hands-off approach would lead to an unfair result:
where the parties are not equally at fault, where one is excusably ignorant or withdraws before
performance, or where one is protected by a statute. A court may sometimes divide a contract, enforcing
the legal part and not the illegal part.

EXERCISES
1.

Henrioulle was an unemployed widower with two children who received public assistance from the Marin
County (California) Department of Social Services. There was a shortage of housing for low-income
residents in Marin County. He entered into a lease agreement on a printed form by which the landlord
disclaimed any liability for any injury sustained by the tenants anywhere on the property. Henrioulle
fractured his wrist when he tripped on a rock on the common stairs in the apartment building. The
landlord had been having a hard time keeping the area clean. Is the disclaimer valid? Explain.

2.

Albert Bennett, an amateur cyclist, entered a bicycle race sponsored by the United States Cycling
Federation. He signed a release exculpating the federation for liability: “I further understand that
serious accidents occasionally occur during bicycle racing and that participants in bicycle racing
occasionally sustain mortal or serious personal injuries, and/or property damage, as a consequence
thereof. Knowing the risks of bicycle racing, nevertheless I hereby agree to assume those risks and to

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release and hold harmless all the persons or entities mentioned above who (through negligence or
carelessness) might otherwise be liable to me (or my heirs or assigns) for damages.”
During the race, Bennett was hit by an automobile that had been allowed on the otherwise
blocked-off street by agents of the defendant. Bennett sued; the trial court dismissed the case on
summary judgment. Bennett appealed. What was the decision on appeal?
3.

Ramses owned an industrial supply business. He contracted to sell the business to Tut. Clause VI of
their Agreement of Sale provided as follows: “In further consideration for the purchase, Ramses
agrees that he shall not compete, either directly or indirectly, in the same business as is conducted by
the corporation in its established territory.”
Two months after the sale, Ramses opened a competing business across the street from the
business now owned by Tut, who brought suit, asking the court to close Ramses’s business on the
basis of Clause VI. What should the court decide? Why?

4.

After taking a business law class at State U, Elke entered into a contract to sell her business law book to a
classmate, Matthew, for $45. As part of the same contract, she agreed to prepare a will for Matthew’s
mother for an additional $110. Elke prepared the will and sent the book to Matthew, but he refused to
pay her. Is she entitled to any payment? Explain.

5.

Elmo, a door-to-door salesman, entered into a contract to sell the Wilson family $320 worth of household
products on credit. The Wilsons later learned that Elmo had failed to purchase a city license to make
door-to-door sales and refused to pay him. May Elmo collect from the Wilsons? Why?

6.

Gardner purchased from Singer a sewing machine ($700) and three vacuums (about $250 each), one after
the other, on Singer’s “1 to 36 month plan.” Gardner defaulted after paying a total of $400 on account,
and Singer sued to repossess all the purchases. Gardner defended by claiming the purchase plan was
unconscionable and pointed to the Williams case (Section 12.5.3 "Unconscionability") as controlling law
(that cross-collateral contracts are unconscionable). The trial court ruled for Gardner; Singer appealed.
What was the result on appeal?

7.

Blubaugh leased a large farm combine from John Deere Leasing by signing an agreement printed on very
lightweight paper. The back side of the form was “written in such fine, light print as to be nearly
illegible.…The court was required to use a magnifying glass.” And the wording was “unreasonably

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complex,” but it contained terms much in John Deere’s favor. When Blubaugh defaulted, John Deere
repossessed the combine, sold it for more than he had paid, and sued him for additional sums in
accordance with the default clauses on the back side of the lease. Blubaugh defended by asserting the
clauses were unconscionable. Is this a case of procedural, substantive, or no unconscionability? Decide.
8.

Sara Hohe, a fifteen-year-old junior at Mission Bay High School in San Diego, was injured during a campus
hypnotism show sponsored by the PTSA as a fund-raiser for the senior class. Hypnotism shows had been
held annually since 1980, and Sara had seen the previous year’s show. She was selected at random from a
group of many volunteers. Her participation in the “Magic of the Mind Show” was conditioned on signing
two release forms. Hohe’s father signed a form entitled “Mission Bay High School PTSA Presents Dr. Karl
Santo.” Hohe and her father both signed a form titled “Karl Santo Hypnotist,” releasing Santo and the
school district from all liability. During the course of the show, while apparently hypnotized, Hohe slid
from her chair and also fell to the floor about six times and was injured. She, through her father, then
sued the school district. The Hohes claimed the release was contrary to public policy; the trial court
dismissed the suit on summary judgment. Was the release contrary to public policy? Decide.

9.

In 1963 the Southern Railway Company was disturbed by an order issued by the Interstate Commerce
Commission, a federal agency, which would adversely affect the firm’s profit by some $13 million [about
$90 million in 2011 dollars]. Southern hired a lawyer, Robert Troutman, who was a friend of President
John F. Kennedy, to lobby the president that the latter might convince the attorney general, Robert
Kennedy, to back Southern’s position in a lawsuit against the ICC. It worked; Southern won. Southern then
refused to pay Troutman’s bill in the amount of $200,000 [about $14 million in 2011 dollars] and moved
for summary judgment dismissing Troutman’s claim, asserting—among other things—that contracts
whereby one person is hired to use his influence with a public official are illegal bargains. Should
summary judgment issue? Decide.

10. Buyer, representing himself to be experienced in timber negotiations, contracted to buy the timber on
Seller’s land. The first $11,500 would go to Buyer, the next $2,000 would go to Seller, and the rest would
be divided fifty-fifty after costs of removal of the timber. Buyer said the timber would be worth $18,000–
$20,000. When Seller discovered the timber was in fact worth more than $50,000, he sued, claiming the
contract was unconscionable. How should the court rule?

SELF-TEST QUESTIONS
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1.

Gambling contracts are

a.

always unenforceable

b.

enforceable if written

c.

in effect enforceable in certain situations involving the sale of securities

d.

always enforceable when made with insurance companies
In State X, plumbers must purchase a license but do not have to pass an examination. This is an
example of

a.

a regulatory license

b.

a revenue license

c.

both a and b

d.

neither a nor b
A contract to pay a lobbyist to influence a public official is generally illegal.

a.

true

b.

false

2.

Exculpatory clauses are sometimes enforceable when they relieve someone from liability for

a.

an intentional act

b.

recklessness

c.

negligence

d.

all of the above
An employee’s promise not to compete with the employer after leaving the company

a.

is never enforceable because it restrains trade

b.

is always enforceable if in writing

c.

is always enforceable

d.

is enforceable if related to the employer’s property interests

SELF-TEST ANSWERS
1.

c

2.

b

3.

b

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4.

c

5.

d

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Chapter 13

Form and Meaning
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

What kinds of contracts must be evidenced by some writing under the Statute of Frauds, what
the exceptions to the requirements are, and what satisfies a writing requirement

2.

What effect prior or contemporaneous “side” agreements have on a written contract

3.

How a contract is to be interpreted if its meaning is disputed

In four chapters, we have focused on the question of whether the parties created a valid contract and
have examined the requirements of (1) agreement (offer and acceptance), (2) real consent (free will,
knowledge, and capacity), (3) consideration, and (4) legality. Assuming that these requirements have
been met, we now turn to the form and meaning of the contract itself. Does the contract have to be in
a written form, and—if there is a dispute—what does the contract mean?

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13.1 The Statute of Frauds
LEARNING OBJECTIVES
1.

Know which contracts are required to be evidenced by some writing to be enforceable.

2.

Understand the exceptions to that requirement.

3.

Recognize what the writing requirement means.

4.

Understand the effect of noncompliance with the Statute of Frauds.

Overview of the Statute of Frauds
The general rule is this: a contract need not be in writing to be enforceable. An oral agreement to pay a
high-fashion model $2 million to pose for photographs is as binding as if the language of the deal were
printed on vellum and signed in the presence of twenty bishops. For three centuries, however, a large
exception grew up around the Statute of Frauds, first enacted in England in 1677 under the formal name
“An Act for the Prevention of Frauds and Perjuries.” TheStatute of Frauds requires that some contracts be
evidenced by a writing, signed by the party to be bound. The English statute’s two sections dealing with
contracts read as follows:
[Sect. 4]…no action shall be brought
1.

whereby to charge any executor or administrator upon any special promise, to answer damages out of
his own estate;

2. or whereby to charge the defendant upon any special promise to answer for the debt, default or
miscarriages of another person;
3. or to charge any person upon any agreement made upon consideration of marriage;
4. or upon any contract or sale of lands, tenements or hereditaments, or any interest in or concerning
them;
5.

or upon any agreement that is not to be performed within the space of one year from the making
thereof;

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unless the agreement upon which such action shall be brought, or some memorandum or note thereof,
shall be in writing, and signed by the party to be charged therewith, or some other person thereunto by
him lawfully authorized.
[Sect. 17]…no contract for the sale of any goods, wares and merchandizes, for the price of ten pounds
sterling or upwards, shall be allowed to be good, except the buyer shall accept part of the goods so sold,
and actually receive the same, or give something in earnest to bind the bargain or in part of payment, or
that some note or memorandum in writing of the said bargain be made and signed by the parties to be
charged by such contract, or their agents thereunto lawfully authorized.
As may be evident from the title of the act and its language, the general purpose of the law is to provide
evidence, in areas of some complexity and importance, that a contract was actually made. To a lesser
degree, the law serves to caution those about to enter a contract and “to create a climate in which parties
often regard their agreements as tentative until there is a signed writing.”

[1]

Notice, of course, that this is

a statute; it is a legislative intrusion into the common law of contracts. The name of the act is somewhat
unfortunate: insofar as it deals with fraud at all, it does not deal with fraud as we normally think of it. It
tries to avoid the fraud that occurs when one person attempts to impose on another a contract that never
was agreed to.
The Statute of Frauds has been enacted in form similar to the seventeenth-century act in every state but
Maryland and New Mexico, where judicial decisions have given it legal effect, and Louisiana. With minor
exceptions in Minnesota, Wisconsin, North Carolina, and Pennsylvania, the laws all embrace the same
categories of contracts that are required to be in writing. Early in the twentieth century, Section 17 was
replaced by a section of the Uniform Sales Act, and this in turn has now been replaced by provisions in the
Uniform Commercial Code (UCC).
Figure 13.1 Contracts Required to Be in Writing

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However ancient, the Statute of Frauds is alive and well in the United States. Today it is used as a
technical defense in many contract actions, often with unfair results: it can be used by a person to wriggle
out of an otherwise perfectly fine oral contract (it is said then to be used “as a sword instead of a shield”).
Consequently, courts interpret the law strictly and over the years have enunciated a host of exceptions—
making what appears to be simple quite complex. Indeed, after more than half a century of serious
scholarly criticism, the British Parliament repealed most of the statute in 1954. As early as 1885, a British
judge noted that “in the vast majority of cases [the statute’s] operation is simply to enable a man to break
a promise with impunity because he did not write it down with sufficient formality.” A proponent of the
repeal said on the floor of the House of Commons that “future students of law will, I hope, have their
labours lightened by the passage of this measure.” In the United States, students have no such reprieve
from the Statute of Frauds, to which we now turn for examination.

Types of Contracts Required in Writing and the Exceptions
Promises to Pay the Debt of Another
The rule: a promise to pay the debt of another person must be evidenced by some writing if it is a
“collateral promise of suretyship (or ‘guaranty’).” A collateral promise is one secondary or ancillary to
some other promise. Asurety or guarantor (the terms are essentially synonymous) is one who promises to
perform upon the default of another. Consider this:
A and B agree to pay C.

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Here, both A and B are making a direct promise to pay C. Although A is listed first, both are promising to
pay C. Now consider this:
B agrees to pay C if A does not.
Here it is clear that there must be another agreement somewhere for A to pay C, but that is not contained
in this promise. Rather, B is making an agreement with C that is collateral—on the side—to the promise A
is making to C. Sometimes the other agreement somewhere for A to pay C is actually in the same
document as B’s promise to pay C if A does not. That does not make B’s promise a direct promise as
opposed to a collateral one.
Suppose Lydia wishes to purchase on credit a coat at Miss Juliette’s Fine Furs. Juliette thinks Lydia’s
creditworthiness is somewhat shaky. So Lydia’s friend Jessica promises Miss Juliette’s that if the store
will extend Lydia credit, Jessica will pay whatever balance is due should Lydia default. Jessica is a surety
for Lydia, and the agreement is subject to the Statute of Frauds; an oral promise will not be
enforceable.

[2]

Suppose Jessica very much wants Lydia to have the coat, so she calls the store and says,

“Send Lydia the fur, and I will pay for it.” This agreement does not create a suretyship, because Jessica is
primarily liable: she is making a direct promise to pay. To fall within the Statute of Frauds, the surety
must back the debt of another person to a third-party promisee (also known as the obligee of the principal
debtor). The “debt,” incidentally, need not be a money obligation; it can be any contractual duty. If Lydia
had promised to work as a cashier on Saturdays at Miss Juliette’s in return for the coat, Jessica could
become surety to that obligation by agreeing to work in Lydia’s place if she failed to show up. Such a
promise would need to be in writing to be enforceable.
The exception: the main purpose doctrine. The main purpose doctrine is a major exception to the surety
provision of the Statute of Frauds. It holds that if the promisor’s principal reason for acting as surety is to
secure her own economic advantage, then the agreement is not bound by the Statute of Frauds writing
requirement. Suppose, in the previous example, that Jessica is really the one who wants the fur coat but
cannot, for reasons of prudence, let it be known that she has bought one. So she proposes that Lydia “buy”
it for her and that she will guarantee Lydia’s payments. Since the main purpose of Jessica’s promise is to
advance her own interests, an oral agreement is binding. Normally, the main purpose rule comes into play

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when the surety desires a financial advantage to herself that cannot occur unless she provides some
security. For example, the board chairman of a small company, who also owns all the voting stock, might
guarantee a printer that if his company defaulted in paying the bill for desperately needed catalogs, he
would personally pay the bill. If his main purpose in giving the guarantee was to get the catalogues printed
in order to stave off bankruptcy, and thus to preserve his own interest in the company, he would be bound
by an oral agreement.

[3]

The same principle can be used to bind other creditors to oral agreements, as the

bank discovered in Section 13.4.1 "The Statute of Frauds’ Main Purpose Doctrine" (Wilson Floors).

Agreements of Executor or Administrator
The rule: the promise by an executor or administrator of an estate to answer personally for the debt or
other duty of the deceased is analogous to the surety provision—it must be evidenced by some writing if it
is to be enforced over an objection by the would-be obligor. For an agreement to be covered by the statute,
there must have been an obligation before the decedent’s death. Thus if the executor arranges for a
funeral and guarantees payment should the estate fail to pay the fee, an oral contract is binding, because
there was no preexisting obligation. If, however, the decedent has made his own arrangements and signed
a note obligating his estate to pay, the executor’s promise to guarantee payment would be binding only if
written.
The exception: the main purpose exception to the surety provision applies to this section of the Statute
of Frauds as well as to the “promises to pay the debts of another” section, noted earlier.

The Marriage Provision
The rule: if any part of the marriage or the promise to marry consists also of a promise to exchange some
consideration, the Statute of Frauds requires that part to be evidenced by some writing.

[4]

Mutual

promises to marry are not within the rule. John and Sally exchange promises to marry; the promise would
not be unenforceable for failure to be evidenced by some writing. (Of course courts are very unlikely to
force anybody to keep a promise to marry; the point is, the Statute of Frauds doesn’t apply). But if Sally
understands John to say, “If you marry me, I will deed to you my property in the Catskill Mountains,” the
part about the property would need to be evidenced by some writing to be enforced over John’s denial.
The Statute of Frauds governs such promises regardless of who makes them. Suppose John’s father had

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said, “If you marry Sally and settle down, I will give you $1 million,” and John agrees and marries Sally.
The father’s promise is not enforceable unless written, if he denies it.
Sometimes couples—especially rich people like movie stars—execute written property settlement
agreements to satisfy the statute, stipulating how their assets will be treated upon marriage or upon
divorce or death. If done before marriage, they are called prenuptial (premarital) agreements; if after
marriage, postnuptial (after marriage) agreements (“prenupts” and “postnupts” in lawyer lingo).
The exception: there is no “named” exception here, but courts are free to make equitable adjustments of
property of the marriage to avoid an injustice.
The factors to be considered in the division of the marital estate are set forth at [Citation], which states,
inter alia [among other things], that the court shall finally and equitably apportion the property of the
parties, however and whenever acquired. The statute vests wide discretion in the district court. [Citation].
The court is free to adopt any reasonable valuation of marital property which is supported by the
record.

[5]

Contracts Affecting an Interest in Real Estate
The rule: almost all contracts involving an interest in real estate are subject to the Statute of Frauds. “An
interest in land” is a broad description, including the sale, mortgaging, and leasing of real property
(including homes and buildings); profits from the land; the creation of easements; and the establishment
of other interests through restrictive covenants and agreements concerning use. Short-term leases, usually
for a term of one year or less, are exempt from the provision.
The exception: the part performance doctrine. The name here is a misnomer, because it is a doctrine of
reliance, and the acts taken in reliance on the contract are not necessarily partial performances under it.
As in all such cases, the rationale is that it is unjust not to give the promisee specific performance if he or
she acted in reasonable reliance on the contract and the promisor has continued to manifest assent to its
terms. An oral contract to sell land is not binding simply because the buyer has paid the purchase price;
payment is not by itself reliance, and if the seller refuses to transfer title, the buyer may recover the
purchase price. However, if the buyer has taken possession and made improvements on the property,

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courts will usually say the case is out of the statute, and the party claiming an oral contract can attempt to
prove the existence of the oral contract.

The One-Year Rule
The rule: any agreement that cannot be performed within one year from its making must be evidenced
by some writing to be enforceable. The purpose of this part is perhaps more obvious than most of the
statute’s provisions: memories fade regarding the terms of oral contracts made long ago; people die;
disputes are not uncommon. Notice the critical time frame is not how long it will take to perform the
contract, but how long from the time it is made until performance is complete. If a contract is made on
January 1 for a house to be constructed starting on June 1 and to be completed on February 1 of the next
year, the performance will be completed in eight months from the time it was begun, but thirteen months
from the time the contract was made. It falls within the statute.
The exception: the possibility test. The statute’s one-year rule has been universally interpreted to mean
a contract that is impossible to be fully performed within one year; if there is even the slightest chance of
carrying out the agreement completely within the year, an oral contract is enforceable. Thus an oral
agreement to pay a sum of money on a date thirteen months hence is within the statute and not
enforceable, but one calling for payment “within thirteen months” would be enforceable, since it is
possible under the latter contract to pay in less than a year. Because in many cases strict application of the
statute would dictate harsh results, the courts often strain for an interpretation that finds it possible to
perform the agreement within the year. Courts will even hold that because any person may die within the
year, a contract without a fixed term may be fully performed in under a year and does not, therefore, fall
within the statute.

Under the UCC
The rule: contracts for the sale of goods in an amount greater than $500 must be evidenced by some
writing to be enforceable. Section 2-201 of the UCC requires all contracts for the sale of goods for the price
of $500 or more to be in writing, but oral agreements for the sale of goods valued at less than $500 are
fully enforceable without exception.

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Other Writing Requirements
In addition to these requirements, the UCC provides that agreements for the sale of securities (e.g., most
stocks and bonds) usually need to be evidenced by a writing, and agreements for property not included in
[6]

the sales or securities articles of the UCC that exceed $5,000 in value need to be so evidenced. Included
here would be intangible property such as rights to royalties and to mortgage payments, and other rights
created by contract. And in many states, other statutes require a writing for several different kinds of
contracts. These include agreements to pay commissions to real estate brokers, to make a will, to pay
debts already discharged in bankruptcy, to arbitrate rather than litigate, to make loans, and to make
installment contracts.

Exceptions under the UCC
There are four exceptions to the UCC’s Statute of Frauds requirement that are relevant here.

The Ten-Day-Reply Doctrine
This provides that, as between merchants, if an oral agreement is reached and one party sends the other a
written statement confirming it, the other party has ten days to object in writing or the agreement is
enforceable.

[7]

“Specially Manufactured Goods”
This exception provides that a seller who has manufactured goods to the buyer’s specifications or who has
made “either a substantial beginning of their manufacture or commitments for their procurement” will
not be stuck if the buyer repudiates, assuming that the goods are unsuitable for sale to others.

[8]

The “Admission” Exception
This exception arises—reasonably enough—when the party against whom enforcement is sought admits in
testimony or legal papers that a contract was in fact made.

[9]

However, the admission will not permit

enforcement of all claimed terms of the contract; enforcement is limited to the quantity of goods
admitted.

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The “Payment or Delivery and Acceptance” Exception
The UCC provides that an oral contract for goods in excess of $500 will be upheld if payment has already
been made and accepted, or if the goods have been received and accepted.

[10]

Sufficiency of the Required Writing
At Common Law
We have been careful not to say “the contract needs to be in writing.” We have said, “a contractual
intention must be evidenced by some writing, signed by the party to be bound.” A signed contract is not
required. What is required in most states, following the wording of the original statute, is that there be at
least some memorandum or note concerning the agreement—a logical consequence of the statute’s
purpose to evidence the making of the contract. The words need not appear in a formal document; they
are sufficient in any form in a will, or on a check or receipt, or in longhand on the back of an envelope—so
long as the document is signed by the party to be charged (i.e., the party being sued on the contract).
Although the writing need not contain every term, it must recite the subject matter of the contract. It need
not do so, however, in terms comprehensible to those who were not party to the negotiations; it is enough
if it is understandable in context. A written agreement to buy a parcel of land is usually sufficiently
definitive if it refers to the parcel in such a way that it could be mistaken for no other—for example,
“seller’s land in Tuscaloosa,” assuming that the seller owned only one parcel there. Beyond the subject
matter, the essential terms of promises to be performed must be written out; all details need not be. If an
essential term is missing, it cannot be enforced, unless it can be inferred or imposed by rule of law. A
written contract for the sale of land containing every term but the time for payment, which the parties
orally agreed would be upon delivery of the deed, is sufficient. (A contract that omitted the selling price
would not be.)
The parties must be named in the writing in a manner sufficient to identify them. Their whole names need
not be given if initials or some other reference makes it inescapable that the writing does concern the
actual parties. Reference to the agent of a party identifies the party. Possession of the writing may even be
sufficient: if a seller gives a memorandum of an oral agreement for the sale of his land, stating all the

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terms, to the buyer, the latter may seek specific performance even though the writing omits to name or
describe him or his agent.

[11]

In a few states, consideration for the promise must be stated in writing, even if the consideration has
already been given. Consequently, written contracts frequently contain such language as “for value
received.” But in most states, failure to refer to consideration already given is unnecessary: “the prevailing
view is that error or omission in the recital of past events does not affect the sufficiency of a
memorandum.”

[12]

The situation is different, however, when the consideration is a return promise yet to

be performed. Usually the return promise is an essential term of the agreement, and failure to state it will
vitiate the writing.

Under the UCC
In contracts for the sale of goods, the writing must be signed by the party to be charged, and the parties
must be sufficiently identified.

[13]

But consideration, including the selling price, need not be set forth for

the memorandum to meet the requirements of the UCC (“a writing is not insufficient because it omits or
incorrectly states a term agreed upon”), though obviously it makes sense to do so whenever possible. By
contrast, UCC Sections 1-206 and 3-319 concerning intangible personal property and investment
securities require “a defined or stated price.”

Electronic Communications
One of the primary purposes of the Electronic Signatures in Global and National Commerce Act, S. 761,
popularly referred to as ESign, is to repeal state law requirements for written instruments as they apply to
electronic agreements and to make almost anything reasonably indicative of a signature good enough
electronically.

[14]

It provides the following:

Notwithstanding any statute, regulation, or other rule of law [other than subsequent parts of this same
statute], with respect to any transactions in or affecting interstate or foreign commerce—
1.

a signature, contract, or other record relating to such transaction may not be denied legal effect,
validity or enforceability solely because it is in electronic form; and

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2. a contract relating to such transaction may not be denied legal effect, validity or enforceability solely
because an electronic signature or electronic record was used in its formation.…
The term “transaction” means an action or set of actions relating to the conduct of a business, consumer
or commercial affairs between two or more persons, including any of the following types of conduct—
1.

the sale, lease, exchange, or other disposition of [personal property and intangibles]

2. the sale, lease, exchange or other disposition of any interest in real property, or any combination
thereof.
The term “electronic signature” means an electronic sound, symbol, or process, attached to or logically
associated with a contract or other record and executed or adopted by a person with the intent to sign the
record.

Effect of Noncompliance and Exceptions; Oral Rescission
The basic rule is that contracts governed by the Statute of Frauds are unenforceable if they are not
sufficiently written down. If the agreement contains several promises, the unenforceability of one will
generally render the others unenforceable also.
The Statute of Frauds can work injustices. In addition to the exceptions already noted, there are some
general exceptions.

Full Performance
First, certainly, if the contract has been performed fully by both sides, its unenforceability under the
statute is moot. Having fulfilled its function (neither side having repudiated the contract), the agreement
cannot be rescinded on the ground that it should have been, but was not, reduced to writing.

Detrimental Reliance
Second, some relief may be granted to one who has relied on an oral contract to her detriment (similar to
the part performance doctrine mentioned already). For a partially performed contract unenforceable
under the Statute of Frauds, restitution may be available. Suppose George agrees orally to landscape

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Arthur’s fifteen acres, in return for which George is to receive title to one acre at the far end of the lot.
George is not entitled to the acre if Arthur defaults, but he may recover for the reasonable value of the
services he has performed up to the time of repudiation. Somewhat related, if one side has reasonably and
foreseeably relied upon a promise in such a way that injustice can only be avoided by enforcing it, some
courts will use promissory estoppel to preclude the necessity of a writing, but the connection between the
alleged oral contract and the detrimental reliance must be convincing.

Oral Rescission
Third, most contracts required to be in writing may be rescinded orally. The new agreement is treated in
effect as a modification of the old one, and since a complete rescission will not usually trigger any action
the statute requires to be in writing, the rescission becomes effective in the absence of any signed
memorandum.
Some agreements, however, may not be rescinded orally. Those that by their terms preclude oral
rescission are an obvious class. Under the UCC, certain agreements for the sale of goods may not be orally
rescinded, depending on the circumstances. For instance, if title has already passed to the buyer under a
written agreement that satisfies the statute, the contract can be rescinded only by a writing. Contracts for
the sale of land are another class of agreements that generally may not be orally rescinded. If title has
already been transferred, or if there has been a material change of position in reliance on the contract,
oral agreements to rescind are unenforceable. But a contract that remains wholly executory, even though
enforceable because in writing, may be rescinded orally in most states.

Contract Modification
Fourth, contracts governed by the Statute of Frauds may be modified orally if the resulting contract, taken
as a whole, falls outside the statute. The same rule applies under the UCC.

[15]

Thus a written contract for

the sale of a new bicycle worth $1,200 may be orally modified by substituting the sale of a used bicycle
worth $450, but not by substituting the sale of a used bike worth $600. The modified contract effectively
rescinds the original contract.

KEY TAKEAWAY

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The Statute of Frauds, an ancient legislative intrusion into common-law contracts, requires that certain
contracts be evidenced by some writing, signed by the party to be bound, to be enforceable. Among those
affected by the statute are contracts for an interest in real estate, contracts that by their terms cannot be
performed within one year, contracts whereby one person agrees to pay the debt of another, contracts
involving the exchange of consideration upon promise to marry (except mutual promises to marry), and,
under the UCC, contracts in an amount greater than $500. For each contract affected by the statute, there are
various exceptions intended to prevent the statute from being used to avoid oral contracts when it is very
likely such were in fact made.
The writing need not be a contract; anything in writing, signed by the person to be bound, showing adequate
contractual intention will take the matter out of the statute and allow a party to attempt to show the
existence of the oral contract.
There may be relief under restitution or promissory estoppel. Contracts affected by the statute can usually be
orally rescinded. Any contract can be modified or rescinded; if the new oral contract as modified does not fall
within the statute, the statute does not apply.

EXERCISES
1.

What is the purpose of the Statute of Frauds?

2.

What common-law contracts are affected by it, and what are the exceptions?

3.

How does the UCC deal with the Statute of Frauds?

4.

How is the requirement of the statute satisfied?

5.

Contracts can always be modified. How does the Statute of Frauds play with contract modification?

[1] Restatement (Second) of Contracts, Chapter 5, statutory note.
[2] Of course, if Jessica really did orally promise Miss Juliette’s to pay in case Lydia didn’t, it would be bad faith to
lie about it. The proper course for Jessica is not to say, “Ha, ha, I promised, but it was only oral, so I’m not bound.”
Jessica should say, “I raise the Statute of Frauds as a defense.”
[3] Stuart Studio, Inc. v. National School of Heavy Equipment, Inc., 214 S.E.2d 192 (N.C. 1975).
[4] Restatement (Second) of Contracts, Section 125.
[5] In re Marriage of Rada, 402, 869 P.2d 254 (Mont. 1994).

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[6] Uniform Commercial Code, Sections 8-319 and 1-206.
[7] Uniform Commercial Code, Section 2-201(2).
[8] Uniform Commercial Code, Section 2-201(3)(a).
[9] Uniform Commercial Code, Section 2-201(3)(b).
[10] Uniform Commercial Code, Section 2-20l(3)(c).
[11] Restatement (Second) of Contracts, Section 207(f).
[12] Restatement (Second) of Contracts, Section 207(h).
[13] Uniform Commercial Code, Section 2-210(1).
[14] Electronic Signatures in Global and National Commerce Act, 15 U.S.C. § 96, 106th Congress (2000).
[15] Uniform Commercial Code, Section 2-209(3).

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13.2 The Parol Evidence Rule
LEARNING OBJECTIVES
1.

Understand the purpose and operation of the parol evidence rule, including when it applies and when
it does not.

2.

Know how the Uniform Commercial Code (UCC) deals with evidence to show a contract’s meaning.

The Purpose of the Rule
Unlike Minerva sprung forth whole from the brow of Zeus in Greek mythology, contracts do not appear at
a stroke memorialized on paper. Almost invariably, negotiations of some sort precede the concluding of a
deal. People write letters, talk by telephone, meet face-to-face, send e-mails, and exchange thoughts and
views about what they want and how they will reciprocate. They may even lie and cajole in duplicitous
ways, making promises they know they cannot or will not keep in order not to kill the contract talks. In
the course of these discussions, they may reach tentative agreements, some of which will ultimately be
reflected in the final contract, some of which will be discarded along the way, and some of which perhaps
will not be included in the final agreement but will nevertheless not be contradicted by it. Whether any
weight should be given to these prior agreements is a problem that frequently arises.

Parol Evidence at Common-Law
The Rule
The rule at common law is this: a written contract intended to be the parties’ complete understanding
discharges all prior or contemporaneous promises, statements, or agreements that add to, vary, or conflict
with it.
The parol evidence rule (parol means oral; it is related to parliament andparly—talking) is a substantive
rule of law that operates to bar the introduction of evidence intended to show that the parties had agreed
to something different from what they finally arrived at and wrote down. It applies to prior written as well
as oral discussions that don’t make it into the final written agreement. Though its many apparent
exceptions make the rule seem difficult to apply, its purposes are simple: to give freedom to the parties to

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negotiate without fear of being held to the consequences of asserting preliminary positions, and to give
finality to the contract.
The rule applies to all written contracts, whether or not the Statute of Frauds requires them to be in
writing. The Statute of Frauds gets to whether there was a contract at all; the parol evidence rule says,
granted there was a written contract, does it express the parties’ understanding? But the rule is concerned
only with events that transpired before the contract in dispute was signed. It has no bearing on
agreements reached subsequently that may alter the terms of an existing contract.

The Exemptions and Exceptions
Despite its apparent stringency, the parol evidence rule does not negate all prior agreements or
statements, nor preclude their use as evidence. A number of situations fall outside the scope of the rule
and hence are not technically exceptions to it, so they are better phrased as exemptions (something not
within the scope of a rule).

Not an Integrated Contract
If the parties never intended the written contract to be their full understanding—if they intended it to be
partly oral—then the rule does not apply. If the document is fully integrated, no extrinsic evidence will be
permitted to modify the terms of the agreement, even if the modification is in addition to the existing
terms, rather than a contradiction of them. If the contract is partially integrated, prior consistent
additional terms may be shown. It is the duty of the party who wants to exclude the parol evidence to
show the contract was intended to be integrated. That is not always an easy task. To prevent a party later
from introducing extrinsic evidence to show that there were prior agreements, the contract itself can
recite that there were none. Here, for example, is the final clause in the National Basketball Association
Uniform Player Contract: “This agreement contains the entire agreement between the parties and there
are no oral or written inducements, promises or agreements except as contained herein.” Such a clause is
known as a merger clause.

Void or Voidable Contracts

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Parol evidence is admissible to show the existence of grounds that would cause the contract to be void.
Such grounds include illegality, fraud, duress, mistake, and lack of consideration. And parol evidence is
allowed to show evidence of lack of contractual capacity. Evidence of infancy, incompetency, and so on
would not change the terms of the contract at all but would show it was voidable or void.

Contracts Subject to a Condition Precedent
When the parties orally agree that a written contract is contingent on the occurrence of an event or some
other condition (a condition precedent), the contract is not integrated and the oral agreement may be
introduced. The classic case is that of an inventor who sells in a written contract an interest in his
invention. Orally, the inventor and the buyer agree that the contract is to take effect only if the buyer’s
engineer approves the invention. (The contract was signed in advance of approval so that the parties
would not need to meet again.) The engineer did not approve it, and in a suit for performance, the court
permitted the evidence of the oral agreement because it showed “that in fact there never was any
agreement at all.”

[1]

Note that the oral condition does not contradict a term of the written contract; it

negates it. The parol evidence rule will not permit evidence of an oral agreement that is inconsistent with
a written term, for as to that term the contract is integrated.

Untrue Recital or Errors
The parol evidence rule does not prevent a showing that a fact stated in a contract is untrue. The rule
deals with prior agreements; it cannot serve to choke off inquiry into the facts. Thus the parol evidence
rule will not bar a showing that one of the parties is a minor, even if the contract recites that each party is
over eighteen. Nor will it prevent a showing that a figure in the contract had a typographical error—for
example, a recital that the rate charged will be the plumber’s “usual rate of $3 per hour” when both parties
understood that the usual rate was in fact $30 per hour. A court would allow reformation(correction) of
such errors.

Ambiguity
To enforce a contract, its terms must be understood, so parol evidence would be allowed, but a claim of
ambiguity cannot be used to alter, vary, or change the contract’s meaning.

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Postcontract Modification
Ordinarily, an additional consistent oral term may be shown only if the contract was partially integrated.
The parol evidence rule bars evidence of such a term if the contract was fully integrated. However, when
there is additional consideration for the term orally agreed, it lies outside the scope of the
integrated contract and may be introduced. In effect, the law treats each separate consideration as
creating a new contract; the integrated written document does not undercut the separate oral agreement,
as long as they are consistent. Buyer purchases Seller’s business on a contract; as part of the agreement,
Seller agrees to stay on for three weeks to help Buyer “learn the ropes.” Buyer realizes she is not yet
prepared to go on her own. She and Seller then agree that Seller will stay on as a salaried employee for five
more weeks. Buyer cannot use the parol evidence rule to preclude evidence of the new agreement: it is a
postcontract modification supported by new consideration. Similarly, parties could choose to rescind a
previously made contract, and the parol evidence rule would not bar evidence of that.

The UCC Approach
Under Section 2-202 of the UCC, a course of dealing, a usage of trade, or a course of performance can be
introduced as evidence to explain or supplement any written contract for the sale of goods.
A course of dealing is defined as “a sequence of previous conduct between the parties to a particular
transaction which is fairly to be regarded as establishing a common basis of understanding for
interpreting their expressions and other conduct.” A usage of trade is “any practice or method of dealing
having such regularity of observance in a place, vocation or trade as to justify an expectation that it will be
observed with respect to the transaction in question.” A course of performance is the conduct of a party in
response to a contract that calls for repeated action (e.g., a purchase agreement for a factory’s monthly
output, or an undertaking to wash a neighbor’s car weekly).

KEY TAKEAWAY
The parol evidence rule is intended to preserve “the four corners” of the contract: it generally prohibits the
introduction of contemporaneous oral or written elements of negotiation that did not get included in the
written contract, subject to a number of exemptions.

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The UCC allows evidence of course of dealing, course of performance, or usage of trade to give meaning to the
contract.

EXERCISES
1.

What is the purpose of the parol evidence rule?

2.

How does it operate to crystallize the intention of the contracting parties?

3.

To what kinds of contract issues does the rule not apply?

4.

What “help” does the UCC give to fleshing out the parties’ contractual understanding?

[1] Pym v. Campbell, 119 Eng. Rep. 903 (Q.B. 1856).

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13.3 Interpretation of Agreements: Practicalities versus
Legalities
LEARNING OBJECTIVES
1.

Understand the purpose of contractual interpretation.

2.

Know the tools courts use to interpret contracts.

3.

Recognize that in everyday life, businesspeople tolerate oral contracts or poorly written ones, but a
writing remains useful.

The General Problem and the Purpose of Contractual Interpretation
The General Problem
As any reader knows, the meaning of words depends in part on context and in part on the skill and care of
the writer. As Justice Oliver Wendell Holmes Jr. once succinctly noted, “A word is not a crystal,
transparent and unchanged; it is the skin of a living thought and may vary greatly in color and content
according to the circumstances and the time in which it is used.”

[1]

Words and phrases can be ambiguous,

either when they stand alone or when they take on a different coloration from words and phrases near
them. A writer can be careless and contradict himself without intending to; people often read hurriedly
and easily miss errors that a more deliberate perusal might catch. Interpretation difficulties can arise for
any of a number of reasons: a form contract might contain language that is inconsistent with provisions
specifically annexed; the parties might use jargon that is unclear; they might forget to incorporate a
necessary term; assumptions about prior usage or performance, unknown to outsiders like judges, might
color their understanding of the words they do use. Because ambiguities do arise, courts are frequently
called on to give content to the words on paper.

The Basic Rule of Interpretation
Courts attempt to give meaning to the parties’ understanding when they wrote the contract.
The intention of the parties governs, and if their purpose in making the contract is known or can be
ascertained from all the circumstances, it will be given great weight in determining the meaning of an
obscure, murky, or ambiguous provision or a pattern of conduct. A father tells the college bookstore that

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in consideration of its supplying his daughter, a freshman, with books for the coming year, he will
guarantee payment of up to $350. His daughter purchases books totaling $400 the first semester, and he
pays the bill. Midway through the second semester, the bookstore presents him with a bill for an
additional $100, and he pays that. At the end of the year, he refuses to pay a third bill for $150. A court
could construe his conduct as indicating a purpose to ensure that his daughter had whatever books she
needed, regardless of cost, and interpret the contract to hold him liable for the final bill.

Tools of Interpretation
The policy of uncovering purpose has led to a number of tools of judicial interpretation:
•

More specific terms or conduct are given more weight than general terms or unremarkable conduct.
Thus a clause that is separately negotiated and added to a contract will be counted as more significant
than a standard term in a form contract.

•

A writing is interpreted as a whole, without undue attention to one clause.

•

Common words and terms are given common meaning; technical terms are given their technical
meaning.

•

In the range of language and conduct that helps in interpretation, the courts prefer the following
items in the order listed: express terms, course of performance, course of dealing, and usage of trade.

•

If an amount is given in words and figures that differ, the words control.

•

Writing controls over typing; typing controls over printed forms.

•

Ambiguities are construed against the party that wrote the contract.

In this chapter, we have considered a set of generally technical legal rules that spell out the consequences
of contracts that are wholly or partially oral or that, if written, are ambiguous or do not contain every term
agreed upon. These rules fall within three general headings: the Statute of Frauds, the parol evidence rule,
and the rules of interpretation. Obviously, the more attention paid to the contract before it is formally
agreed to, the fewer the unforeseen consequences. In general, the conclusion is inescapable that a written
contract will avoid a host of problems. Writing down an agreement is not always sensible or practical, but
it can probably be done more often than it is. Writing almost fifty years ago—and it is still true—a law
professor studying business practices noted the following:

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Businessmen often prefer to rely on “a man’s word” in a brief letter, a handshake or “common honesty
and decency”—even when the transaction involves exposure to serious risks. Seven lawyers from law firms
with business practices were interviewed. Five thought that businessmen often entered contracts with
only a minimal degree of advanced planning. They complained that businessmen desire to “keep it simple
and avoid red tape” even where large amounts of money and significant risks are involved.…Another said
that businessmen when bargaining often talk only in pleasant generalities, think they have a contract, but
fail to reach agreement on any of the hard, unpleasant questions until forced to do so by a lawyer.

[2]

Written contracts do not, to be sure, guarantee escape from disputes and litigation. Sometimes
ambiguities are not seen; sometimes they are necessary if the parties are to reach an agreement at all.
Rather than back out of the deal, it may be worth the risk to one or both parties deliberately to go along
with an ambiguous provision and hope that it never arises to be tested in a dispute that winds up in court.
Nevertheless, it is generally true that a written contract has at least three benefits over oral ones, even
those that by law are not required to be in writing. (1) The written contract usually avoids ambiguity. (2) It
can serve both as a communications device and as a device for the allocation of power, especially within
large companies. By alerting various divisions to its formal requirements, the contract requires the sales,
design, quality-control, and financial departments to work together. By setting forth requirements that
the company must meet, it can place the power to take certain actions in the hands of one division or
another. (3) Finally, should a dispute later arise, the written contract can immeasurably add to proof both
of the fact that a contract was agreed to and of what its terms were.

KEY TAKEAWAY
It is not uncommon for the meaning of a contract to be less than entirely clear. When called upon to interpret
the meaning of a contract, courts try to give it the meaning the parties intended when they made it. Various
tools of interpretation are used.
Businesspeople usually do not like to seem overbearing; they do not wish to appear untrusting; they often
dislike unpleasantries. Therefore it is not uncommon for even big deals to be sealed with a handshake. But it’s
a trade-off, because a written contract has obvious benefits, too.

EXERCISES
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1.

Why do courts fairly frequently have to interpret the meaning of contracts?

2.

What is the purpose of contractual interpretation?

3.

What tools do the courts use in interpreting contracts?

4.

What is the social “cost” of insisting upon a written contract in a business setting? What are the benefits
of the contract?

[1] Towne v. Eisner, 245 US 418, 425 (1917).
[2] Stewart Macaulay, “Non-contractual Relations in Business: A Preliminary Study,”American Sociological
Review 28, no. 1 (1963): 58–59.

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13.4 Cases
The Statute of Frauds’ Main Purpose Doctrine
Wilson Floors Co. v. Sciota Park, Ltd., and Unit, Inc.
377 N.E.2d 514 (1978)
Sweeny, J.
In December of 1971, Wilson Floors Company (hereinafter “Wilson”) entered into a contract with Unit,
Inc. (hereinafter “Unit”), a Texas corporation to furnish and install flooring materials for “The Cliffs”
project, a development consisting of new apartments and an office building to be located in Columbus,
Ohio. Unit…was the general manager for the project. The Pittsburgh National Bank (hereinafter the
bank), as the construction lender for the project, held mortgages on The Cliffs property security for
construction loans which the bank had made to Unit.
As the work progressed on the project Unit fell behind in making payments to Wilson for its completed
work in the spring of 1973. At that time, the project was approximately two-thirds completed, the first
mortgage money of seven million dollars having been fully dispersed by the bank to Unit. Appellant
[Wilson] thereupon stopped work in May of 1973 and informed Unit that it would not continue until
payments were forthcoming. On May 15, 1973, the bank conducted a meeting with the subcontractors in
The Cliffs project, including Wilson.
At the meeting, the bank sought to determine whether it would be beneficial at that stage of the project to
lend more money to Unit, foreclose on the mortgage and hire a new contractor to complete the work, or
do nothing. Subcontractors were requested to furnish the bank an itemized account of what Unit owed
them, and a cost estimate of future services necessary to complete their job contracts. Having reviewed
the alternatives, the bank determined that it would be in its best interest to provide additional financing
for the project. The bank reasoned that to foreclose on the mortgage and hire a new contractor at this
stage of construction would result in higher costs.

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There is conflicting testimony in regard to whether the bank made assurances to Wilson at this meeting
that it would be paid for all work to be rendered on the project. However, after the May meeting, Wilson,
along with the other subcontractors, did return to work.
Payments from Unit again were not forthcoming, resulting in a second work stoppage. The bank then
arranged another meeting to be conducted on June 28, 1973.
At this second meeting, there is conflicting testimony concerning the import of the statements made by
the bank representative to the subcontractors. The bank representative who spoke at the meeting testified
at trial that he had merely advised the subcontractors that adequate funds would be available to complete
the job. However, two representatives of Wilson, also in attendance at the meeting, testified that the bank
representative had assured Wilson that if it returned to work, it would be paid.
After the meeting, Wilson returned to work and continued to submit its progress billings to Unit for
payment. Upon completion of its portion of The Cliffs project, Wilson submitted its final invoice of
$15,584.50 to Unit. This amount was adjusted downward to $15,443.06 upon agreement of Unit and
Wilson. However, Wilson was not paid this amount.
As a result of nonpayment, Wilson filed suit…against Unit and the bank to recover the $15,443.06 [about
$60,700 in 2010 dollars]. On September 26, 1975, Wilson and Unit stipulated that judgment for the sum
of $15,365.84, plus interest, be entered against Unit. When Unit failed to satisfy the judgment, appellant
proceeded with its action against the bank. [The trial court decided in favor of Wilson, but the
intermediate appellate court reversed the trial court decision.]…[The Ohio statute of frauds provides]:
No action shall be brought whereby to charge the defendant, upon a special promise, to answer for the
debt, default, or miscarriage of another person…unless the agreement…or some memorandum thereof, is
in writing and signed by the party to be charged.…
In paragraph one of Crawford v. Edison [an 1887 Ohio case], however, this court stated:
When the leading object of the promisor is, not to answer for another, but to subserve some pecuniary or
business purpose of his own, involving a benefit to himself…his promise is not within the statute of frauds,

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although it may be in form a promise to pay the debt of another and its performance may incidentally
have the effect of extinguishing that liability.…
So long as the promisor undertakes to pay the subcontractor whatever his services are worth irrespective
of what he may owe the general contractor and so long as the main purpose of the promisor is to further
his own business or pecuniary interest, the promise is enforceable.…
The facts in the instant case reflect that the bank made its guarantee to Wilson to subserve its own
business interest of reducing costs to complete the project. Clearly, the bank induced Wilson to remain on
the job and rely on its credit for future payments. To apply the statute of frauds and hold that the bank
had no contractual duty to Wilson despite its oral guarantees would not prevent the wrong which the
statute’s enactment was to prevent, but would in reality effectuate a wrong.
Therefore, this court affirms the finding of the Court of Common Pleas that the verbal agreement made by
the bank is enforceable by Wilson, and reverses the judgment of the Court of Appeals.

CASE QUESTIONS
1.

The exception to the Statute of Frauds in issue here is the main purpose doctrine. How does this doctrine
relate to the concept of promissory estoppel?

2.

What was the main purpose behind the bank’s purported promise?

The Statute of Frauds’ One-Year Rule
Iacono v. Lyons
16 S.W.3d 92 (Texas Ct. App. 2000)
O’Connor, J.
Mary Iacono, the plaintiff below and appellant here, appeals from a take-nothing summary judgment
rendered in favor of Carolyn Lyons, the defendant below and appellee here. We reverse and remand.
The plaintiff [Iacono] and defendant [Lyons] had been friends for almost 35 years. In late 1996, the
defendant invited the plaintiff to join her on a trip to Las Vegas, Nevada. There is no dispute that the
defendant paid all the expenses for the trip, including providing money for gambling.

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The plaintiff contended she was invited to Las Vegas by the defendant because the defendant thought the
plaintiff was lucky. Sometime before the trip, the plaintiff had a dream about winning on a Las Vegas slot
machine. The plaintiff’s dream convinced her to go to Las Vegas, and she accepted the defendant’s offer to
split “50-50” any gambling winnings.
In February 1997, the plaintiff and defendant went to Las Vegas. They started playing the slot machines at
Caesar’s Palace. The plaintiff contends that, after losing $47, the defendant wanted to leave to see a show.
The plaintiff begged the defendant to stay, and the defendant agreed on the condition that she (the
defendant) put the coins into the machines because doing so took the plaintiff too long. (The plaintiff, who
suffers from advanced rheumatoid arthritis, was in a wheelchair.) The plaintiff agreed, and took the
defendant to a dollar slot machine that looked like the machine in her dream. The machine did not pay on
the first try. The plaintiff then said, “Just one more time,” and the defendant looked at the plaintiff and
said, “This one’s for you, Puddin.”
The slot machine paid $1,908,064. The defendant refused to share the winnings with the plaintiff, and
denied they had an agreement to split any winnings. The defendant told Caesar’s Palace she was the sole
winner and to pay her all the winnings.
The plaintiff sued the defendant for breach of contract. The defendant moved for summary judgment on
the grounds that any oral agreement was unenforceable under the statute of frauds or was voidable for
lack of consideration. The trial court rendered summary judgment in favor of the defendant.…
[Regarding the “consideration” argument:] The defendant asserted the agreement, if any, was voidable
because there was no consideration. The defendant contended the plaintiff’s only contribution was the
plaintiff’s dream of success in Las Vegas and her “luck.” The plaintiff asserted the defendant bargained
with her to go to Las Vegas in return for intangibles that the defendant thought the plaintiff offered (good
luck and the realization of the dream). The plaintiff said she gave up her right to remain in Houston in
return for the agreement to split any winnings. The plaintiff also asserted the agreement was an exchange
of promises.
…The plaintiff alleged she promised to share one-half of her winnings with the defendant in exchange for
the defendant’s promise to share one-half of her winnings with the plaintiff. These promises, if made,

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represent the respective benefits and detriments, or the bargained for exchange, necessary to satisfy the
consideration requirement. See [Citation] (when no other consideration is shown, mutual obligations by
the parties to the agreement will furnish sufficient consideration to constitute a binding
contract).…[Regarding the Statute of Frauds argument:] The defendant asserted the agreement, if any,
was unenforceable under the statute of frauds because it could not be performed within one year. There is
no dispute that the winnings were to be paid over a period of 20 years.…
[The statute] does not apply if the contract, from its terms, could possibly be performed within a year—
however improbable performance within one year may be. [Citations] [It bars] only oral contracts that
cannot be completed within one year. [Citation] (If the agreement, either by its terms or by the nature of
the required acts, cannot be performed within one year, it falls within the statute of frauds and must be in
writing).
To determine the applicability of the statute of frauds with indefinite contracts, this Court may use any
reasonably clear method of ascertaining the intended length of performance. [Citation] The method is
used to determine the parties’ intentions at the time of contracting. The fact that the entire performance
within one year is not required, or expected, will not bring an agreement within the
statute. See [Citations].
Assuming without deciding that the parties agreed to share their gambling winnings, such an agreement
possibly could have been performed within one year. For example, if the plaintiff and defendant had won
$200, they probably would have received all the money in one pay-out and could have split the winnings
immediately. Therefore, the defendant was not entitled to summary judgment based on her affirmative
defense of the statute of frauds.
We reverse the trial court’s judgment and remand for further proceedings.

CASE QUESTIONS
1.

The defendant contended there was no consideration to support her alleged promise to split the winnings
fifty-fifty. What consideration did the court find here?

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2.

The defendant contended that the Statute of Frauds’ one-year rule prohibited the plaintiff from
attempting to prove the existence of the alleged oral contract to split the winnings. What reasoning did
the court give here as to why the statute did not apply?

3.

After this case, the court remanded the matter to the lower court. What has to happen there before
plaintiff gets her money?

The Parol Evidence Rule: Postcontract Modification
Hampden Real Estate, Inc. v. Metropolitan Management Group, Inc.
142 Fed. Appx. 600 (Fed. Ct. App. Pa. 2005)
Cowen, J.
[The court has jurisdiction based on diversity of citizenship.]
Hampden Real Estate sold Metropolitan Management a residential property pursuant to an Agreement of
Sale (the “Sale Agreement”). The Sale Agreement provided that the property would be sold for $3.7
million, that Metropolitan would assume Hampden’s mortgage on the building, and that Hampden would
receive a credit in the amount of $120,549.78—the amount being held in escrow pursuant to the mortgage
(the “Escrow Account Credit”).
Between the execution of the Sale Agreement and the closing, the parties negotiated certain adjustments
to the purchase price to compensate for required repairs. During these negotiations, the parties reviewed
a draft and final Settlement Statement (the “Settlement Statement”), prepared by the closing agent, which
did not list the Escrow Account Credit among the various debits and credits. A few weeks after the closing,
Hampden demanded payment of the Escrow Account Credit.
Following Metropolitan’s refusal to pay the Escrow Account Credit, Hampden filed a complaint claiming
breach of contract, unjust enrichment, and conversion. Metropolitan brought counterclaims for breach of
contract, unjust enrichment, and fraudulent or negligent misrepresentation. Hampden brought a partial
motion for summary judgment as to the breach of contract claim, which was granted and its unjust
enrichment and conversion claims were dismissed as moot.…

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The District Court correctly determined that the threshold issue is the role of the Settlement Statement,
“based on both the intent of the parties and the custom and usage of the document.” However, the Court
refused to consider extrinsic or parol evidence to determine the intent of the parties, reasoning that the
parol evidence rule precluded such consideration absent ambiguity in the written contract. We find that
the District Court misapplied the rule. The parol evidence rule seeks to preserve the integrity of written
agreements by precluding the introduction of contemporaneous or prior declarations to alter the meaning
of written agreements. [Citation] The rule does not apply, however, where a party seeks to introduce
evidence of subsequent oral modifications. See [Citation:] a “written agreement may be modified by a
subsequent written or oral agreement and this modification may be shown by writings or by words or by
conduct or by all three. In such a situation the parol evidence rule is inapplicable.” Here, the parol
evidence rule does not preclude testimony regarding the parties’ intention to alter the final purchase price
by executing a Settlement Statement, after the execution of the Sale Agreement, which omitted the Escrow
Account Credit.
The cases cited by Hampden are not to the contrary as each involved the admissibility of prior
negotiations to demonstrate misrepresentations made in the inducement of the contract. As example, the
court in [Citation], held that “[i]f a party contends that a writing is not an accurate expression of the
agreement between the parties, and that certain provisions were omitted therefrom, the parol evidence
rule does not apply.” (Permitting the introduction of parol evidence to establish that the contract omitted
provisions which appellees represented would be included in the writing).…
The District Court further held that the integration clause contained in the written contract supports the
conclusion that the Settlement Statement, which mentioned neither the Escrow Account Credit nor that it
was amending the Sale Agreement, is not a modification of the Sale Agreement. The Court explained that
the outcome might be different if the Settlement Statement mentioned “the escrow credit but provided
different details, but as the [Settlement Statement] in this case simply ignored the escrow credit, and both
parties agree that there were no oral discussions regarding the escrow credit, the [Settlement Statement]
cannot be said to modify the escrow credit provision in the Agreement of Sale.” We disagree.
It is well-settled law in Pennsylvania that a “written contract which is not for the sale of goods may be
modified orally, even when the contract provides that modifications may only be made in writing.”

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[Citition] “The modification may be accomplished either by words or conduct,” [Citation] demonstrating
that the parties intended to waive the requirement that amendments be made in writing. [Citation] An
oral modification of a written contract must be proven by “clear, precise and convincing evidence.”
[Citation] Viewing the evidence in the light most favorable to Metropolitan, we find that the District Court
erred in concluding that there was insufficient evidence in the record to raise a genuine issue of material
fact as to whether the parties intended to orally modify the Sale Agreement. Metropolitan introduced a
Settlement Statement which omitted the Escrow Account Credit, while listing all other debits and credits
and submitted an affidavit from its President who “reviewed the Draft Settlement Statement and
understood that the Escrow Account Credit had been omitted as part of the ongoing negotiations between
the parties concerning the amount of the credit to which Metropolitan was entitled” due to the poor
condition of the property.
Accordingly, the District Court erred in granting summary judgment in favor of Hampden. At a minimum,
there was a triable issue of fact concerning whether the Settlement Statement was intended to modify the
prior written Sale Agreement and serve as the final and binding manifestation of the purchase price.
Specifically, whether the parties intended to exclude the Escrow Account Credit from the purchase price
as part of the negotiations to address Hampden’s failure to maintain the property.
[Reversed and remanded.]

CASE QUESTIONS
1.

The contract had an integration clause. Why didn’t that bar admission of the subsequent oral
modification to the contract?

2.

What rule of law was the plaintiff relying on in support of its contention that the original agreement
should stand?

3.

What rule of law was the defendant relying on in support of its contention that the original agreement
had been modified?

4.

According to the defendant, how had the original agreement been modified, and why?

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13.5 Summary and Exercises
Summary
In an economic system mostly governed by contract, parties may not only make the kinds of deals they
wish but may make them in any form they wish—with some significant exceptions. The most significant
issue of form in contract law is whether the contract must be written or may be oral and still be
enforceable. The question can be answered by paying close attention to the Statute of Frauds and court
decisions interpreting it. In general, as we have seen, the following types of contracts must be in writing:
interests in real property, promises to pay the debt of another, certain agreements of executors and
administrators, performances that cannot be completed within one year, sale of goods for $500 or more,
and sale of securities. There are exceptions to all these rules.
Another significant rule that permeates contract law is the parol evidence rule: prior statements,
agreements, or promises, whether oral or written, made during the negotiation process are often
discharged by a subsequent written agreement. No matter what you were promised before you signed on
the dotted line, you are stuck if you sign an integrated agreement without the promise. Again, of course,
exceptions lie in wait for the unwary: Is the agreement only partially integrated? Are there grounds to
invalidate the entire agreement? Is the contract subject to an oral condition? Is a fact recited in the
contract untrue?
Contracts are not always clear and straightforward. Often they are murky and ambiguous. Interpreting
them when the parties disagree is for the courts. To aid them in the task, the courts over the years have
developed a series of guidelines such as these: Does the agreement have a plain meaning on its face? If
there is an ambiguity, against whom should it be construed? Are there usages of trade or courses of
dealing or performance that would help explain the terms?

EXERCISES
1.

Plaintiff’s and Defendant’s cars crashed. Plaintiff hired an attorney, who negotiated with Defendant’s
insurance adjuster. Plaintiff’s attorney claimed he and the adjuster reached an oral settlement, but the
insurance company refused to honor it and filed for summary judgment, raising the Statute of Frauds’

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suretyship provision as a defense: a promise by one person (the insurance company here) to pay the
debts of another (the insured) must be evidenced by some writing, and there was no writing. Is the
defense good? Explain.
2.

Plaintiff Irma Kozlowski cohabited with Defendant Thaddeus Kozlowski for fifteen years without marriage.
She repeatedly asked him specifically about her financial situation should he predecease her, and he
assured her—she said—that he would arrange to provide for her for the rest of her life. She had provided
the necessary household services and emotional support to permit him to successfully pursue his business
career; she had performed housekeeping, cleaning, and shopping services and had run the household and
raised the children, her own as well as his. When they separated and she was “literally forced out of the
house,” she was sixty-three years old and had no means or wherewithal for survival. When she sued, he
raised the Statute of Frauds’ one-year rule as a defense. Is the defense good?

3.

[1]

Carlson purchased a parcel of real estate that was landlocked. Carlson called his neighbor, Peterson, and
asked if he could use an abandoned drive on Peterson’s property to travel to his (Carlson’s) property from
the highway. Peterson said, “Sure, anytime.” Later the two became engaged in a dispute, and Peterson
blocked the drive. May Carlson enforce Peterson’s promise that he could use the drive “anytime”? Why?

4.

Silverman, who was elderly and somewhat disabled, lived alone on a farm. Silverman called Burch and
said, “Burch, if you will move in with me and help me take care of the farm, it will be yours when I die.”
Burch did as Silverman requested and on Silverman’s death two years later, claimed the farm on the basis
of their oral agreement, but the estate resisted. Is Burch entitled to the farm? Why?

5.

On February 12, Sally was hired to manage a company for a period of one year. She reported for work on
February 26 but was fired two weeks later. She sued the owner of the company for breach of their oneyear oral contract. May she recover? Why?

6.

Baker entered into an oral contract to sell her car to Clyde for $8,600. She delivered the car to Clyde;
Clyde inspected it, found no problems, kept it for three days, but then refused to pay and now wants to
return the car. Is the contract enforceable? Why?

7.

Wayne, a building contractor, built a new house and offered it for sale. A young couple accepted the
offer, and the parties entered into an oral agreement covering all the terms of sale. The couple later tried
to back out of the agreement. Wayne filed suit, and during the trial, the couple admitted making the
contract. Is the contract enforceable? Why?

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8.

Plaintiff leased commercial space from Defendant for a florist shop. After the lease was signed, Plaintiff
learned that the county code allowed only one freestanding sign on the property, and one was already
up, advertising Defendant’s business. Plaintiff claimed Defendant breached the lease by not providing
them space for a sign; Defendant pointed to the lease, paragraph 16 of which provided that “Tenant shall
not erect or install any sign…without written consent of the Landlord.” But Plaintiff claimed Defendant
said during negotiations he could have a sign, evidence Defendant objected to based on the parol
evidence rule. Defendant admitted that during negotiations he told Plaintiff that despite paragraph 16, he
could have a sign (but not freestanding); that despite language in the lease requiring renovation plans to
be in writing, they did not have to be. Defendant also testified that the written form lease he used was
not drafted specifically for this property, and that although the lease required attachments of exhibits,
there were no attachments. Is Plaintiff barred by the parol evidence rule from showing that Defendant
said he could have a freestanding sign?

9.

On March 1, 2010, Milton talked to Harriet and, as Harriet claimed, said, “I will hire you as sales manager
for one year at a salary of $57,000. You start next Monday, March 8.” Harriet agreed. Four months later
Milton discharged Harriet and she sued, claiming breach of employment contract. Is the alleged contract
enforceable?

10. Al Booth’s Inc. sued Boyd-Scarp (a contractor) and James Rathmann for nonpayment following delivery of
various appliances to Rathmann’s new home being built by Boyd-Scarp. Booth’s was aware that BoydScarp was having financial problems and allegedly contacted Rathmann prior to delivery, asking him to
guarantee payment. Evidence was adduced that Rathmann orally promised to pay in the event the builder
did not and that the goods were then delivered. Rathmann denied any such promise, raising the Statute
of Frauds, and Al Booth’s sued. Will Al Booth’s prevail?

SELF-TEST QUESTIONS
1.

As a general rule
a.

contracts do not have to be in writing to be enforceable

b.

contracts that can be performed in one year must be in writing

c.

all oral contracts are unenforceable

d.

a suretyship agreement need not be in writing to be enforceable
An exception to the UCC Statute of Frauds provision is

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a.

the one-year rule

b.

the reply doctrine

c.

executor agreements

d.

all of the above
Rules that require certain contracts to be in writing are found in

a.

state statutory law

b.

the UCC

c.

the Statute of Frauds

d.

all of the above
The parol evidence rule

a.

applies only when contracts must be in writing

b.

does not apply to real estate contracts

c.

states that a written contract discharges all prior or contemporaneous promises that add to,
vary, or conflict with it

d.

is designed to hold parties to promises they made during negotiations
A merger clause

a.

is required when goods are sold for $500 or more

b.

is used when two parcels of real estate are sold in the same contract

c.

invalidates a contract for the sale of securities

d.

evidences an intention that the written contract is the parties’ full understanding

SELF-TEST ANSWERS
1.

a

2.

b

3.

d

4.

c

5.

d

[1] Kozlowski v. Kozlowski, 395 A.2d 913 (N.J. 1978).

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Chapter 14

Third-Party Rights
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

How an assignment of contract rights is made and how it operates

2.

What a delegation of duties is and how it operates

3.

Under what circumstances a person not a party to a contract can enforce it

To this point, we have focused on the rights and duties of the two parties to the contract. In this
chapter, we turn our attention to contracts in which outsiders acquire rights or duties or both. Three
types of outsiders merit examination:
1.

Assignees (outsiders who acquire rights after the contract is made)

2. Delegatees (outsiders who acquire duties after the contract is made)
3. Third-party beneficiaries (outsiders who acquire rights when the original contract is made)

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14.1 Assignment of Contract Rights
LEARNING OBJECTIVES
1.

Understand what an assignment is and how it is made.

2.

Recognize the effect of the assignment.

3.

Know when assignments are not allowed.

4.

Understand the concept of assignor’s warranties.

The Concept of a Contract Assignment
Contracts create rights and duties. By an assignment, an obligee (one who has the right to receive a
contract benefit) transfers a right to receive a contract benefit owed by the obligor (the one who has a duty
to perform) to a third person (assignee); the obligee then becomes an assignor (one who makes an
assignment).
The Restatement (Second) of Contracts defines an assignment of a right as “a manifestation of the
assignor’s intention to transfer it by virtue of which the assignor’s right to performance by the obligor is
extinguished in whole or in part and the assignee acquires the right to such performance.”

[1]

The one who

makes the assignment is both an obligee and a transferor. The assignee acquires the right to receive the
contractual obligations of the promisor, who is referred to as the obligor (see Figure 14.1 "Assignment of
Rights"). The assignor may assign any right unless (1) doing so would materially change the obligation of
the obligor, materially burden him, increase his risk, or otherwise diminish the value to him of the
original contract; (2) statute or public policy forbids the assignment; or (3) the contract itself precludes
assignment. The common law of contracts and Articles 2 and 9 of the Uniform Commercial Code (UCC)
govern assignments. Assignments are an important part of business financing, such as factoring.
Afactor is one who purchases the right to receive income from another.
Figure 14.1 Assignment of Rights

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Method of Assignment
Manifesting Assent
To effect an assignment, the assignor must make known his intention to transfer the rights to the third
person. The assignor’s intention must be that the assignment is effective without need of any further
action or any further manifestation of intention to make the assignment. In other words, the assignor
must intend and understand himself to be making the assignment then and there; he is not promising to
make the assignment sometime in the future.
Under the UCC, any assignments of rights in excess of $5,000 must be in writing, but otherwise,
assignments can be oral and consideration is not required: the assignor could assign the right to the
assignee for nothing (not likely in commercial transactions, of course). Mrs. Franklin has the right to
receive $750 a month from the sale of a house she formerly owned; she assigns the right to receive the
money to her son Jason, as a gift. The assignment is good, though such a gratuitous assignment is usually
revocable, which is not the case where consideration has been paid for an assignment.

Acceptance and Revocation
For the assignment to become effective, the assignee must manifest his acceptance under most
circumstances. This is done automatically when, as is usually the case, the assignee has given
consideration for the assignment (i.e., there is a contract between the assignor and the assignee in which

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the assignment is the assignor’s consideration), and then the assignment is not revocable without the
assignee’s consent. Problems of acceptance normally arise only when the assignor intends the assignment
as a gift. Then, for the assignment to be irrevocable, either the assignee must manifest his acceptance or
the assignor must notify the assignee in writing of the assignment.

Notice
Notice to the obligor is not required, but an obligor who renders performance to the assignor without
notice of the assignment (that performance of the contract is to be rendered now to the assignee) is
discharged. Obviously, the assignor cannot then keep the consideration he has received; he owes it to the
assignee. But if notice is given to the obligor and she performs to the assignor anyway, the assignee can
recover from either the obligor or the assignee, so the obligor could have to perform twice, as in Exercise 2
at the chapter’s end, Aldana v. Colonial Palms Plaza. Of course, an obligor who receives notice of the
assignment from the assignee will want to be sure the assignment has really occurred. After all, anybody
could waltz up to the obligor and say, “I’m the assignee of your contract with the bank. From now on, pay
me the $500 a month, not the bank.” The obligor is entitled to verification of the assignment.

Effect of Assignment
General Rule
An assignment of rights effectively makes the assignee stand in the shoes of the assignor. He gains all the
rights against the obligor that the assignor had, but no more. An obligor who could avoid the assignor’s
attempt to enforce the rights could avoid a similar attempt by the assignee. Likewise, under UCC Section
9-318(1), the assignee of an account is subject to all terms of the contract between the debtor and the
creditor-assignor. Suppose Dealer sells a car to Buyer on a contract where Buyer is to pay $300 per month
and the car is warranted for 50,000 miles. If the car goes on the fritz before then and Dealer won’t fix it,
Buyer could fix it for, say, $250 and deduct that $250 from the amount owed Dealer on the next
installment (called a setoff). Now, if Dealer assigns the contract to Assignee, Assignee stands in Dealer’s
shoes, and Buyer could likewise deduct the $250 from payment to Assignee.

Exceptions
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The “shoe rule” does not apply to two types of assignments. First, it is inapplicable to the sale of a
negotiable instrument to a holder in due course. Second, the rule may be waived: under the UCC and at
common law, the obligor may agree in the original contract not to raise defenses against the assignee that
could have been raised against the assignor.

[2]

While a waiver of defenses makes the assignment more

marketable from the assignee’s point of view, it is a situation fraught with peril to an obligor, who may
sign a contract without understanding the full import of the waiver. Under the waiver rule, for example, a
farmer who buys a tractor on credit and discovers later that it does not work would still be required to pay
a credit company that purchased the contract; his defense that the merchandise was shoddy would be
unavailing (he would, as used to be said, be “having to pay on a dead horse”).
For that reason, there are various rules that limit both the holder in due course and the waiver rule.
Certain defenses, the so-called real defenses (infancy, duress, and fraud in the execution, among others),
may always be asserted. Also, the waiver clause in the contract must have been presented in good faith,
and if the assignee has actual notice of a defense that the buyer or lessee could raise, then the waiver is
ineffective. Moreover, in consumer transactions, the UCC’s rule is subject to state laws that protect
consumers (people buying things used primarily for personal, family, or household purposes), and many
states, by statute or court decision, have made waivers of defenses ineffective in
suchconsumer transactions. Federal Trade Commission regulations also affect the ability of many sellers
to pass on rights to assignees free of defenses that buyers could raise against them. Because of these
various limitations on the holder in due course and on waivers, the “shoe rule” will not govern in
consumer transactions and, if there are real defenses or the assignee does not act in good faith, in
business transactions as well.

When Assignments Are Not Allowed
The general rule—as previously noted—is that most contract rights are assignable. But there are
exceptions. Five of them are noted here.

Material Change in Duties of the Obligor
When an assignment has the effect of materially changing the duties that the obligor must perform, it is
ineffective. Changing the party to whom the obligor must make a payment is not a material change of duty

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that will defeat an assignment, since that, of course, is the purpose behind most assignments. Nor will a
minor change in the duties the obligor must perform defeat the assignment.
Several residents in the town of Centerville sign up on an annual basis with the Centerville Times to
receive their morning paper. A customer who is moving out of town may assign his right to receive the
paper to someone else within the delivery route. As long as the assignee pays for the paper, the
assignment is effective; the only relationship the obligor has to the assignee is a routine delivery in
exchange for payment. Obligors can consent in the original contract, however, to a subsequent assignment
of duties. Here is a clause from the World Team Tennis League contract: “It is mutually agreed that the
Club shall have the right to sell, assign, trade and transfer this contract to another Club in the League, and
the Player agrees to accept and be bound by such sale, exchange, assignment or transfer and to faithfully
perform and carry out his or her obligations under this contract as if it had been entered into by the Player
and such other Club.” Consent is not necessary when the contract does not involve a personal
relationship.

Assignment of Personal Rights
When it matters to the obligor who receives the benefit of his duty to perform under the contract, then the
receipt of the benefit is a personal right that cannot be assigned. For example, a student seeking to earn
pocket money during the school year signs up to do research work for a professor she admires and with
whom she is friendly. The professor assigns the contract to one of his colleagues with whom the student
does not get along. The assignment is ineffective because it matters to the student (the obligor) who the
person of the assignee is. An insurance company provides auto insurance covering Mohammed Kareem, a
sixty-five-year-old man who drives very carefully. Kareem cannot assign the contract to his seventeenyear-old grandson because it matters to the insurance company who the person of its insured is. Tenants
usually cannot assign (sublet) their tenancies without the landlord’s permission because it matters to the
landlord who the person of their tenant is. Section 14.4.1 "Nonassignable Rights", Nassau Hotel Co. v.
Barnett & Barse Corp., is an example of the nonassignability of a personal right.

Assignment Forbidden by Statute or Public Policy

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Various federal and state laws prohibit or regulate some contract assignment. The assignment of future
wages is regulated by state and federal law to protect people from improvidently denying themselves
future income because of immediate present financial difficulties. And even in the absence of statute,
public policy might prohibit some assignments.

Contracts That Prohibit Assignment
Assignability of contract rights is useful, and prohibitions against it are not generally favored. Many
contracts contain general language that prohibits assignment of rights or of “the contract.” Both the
Restatement and UCC Section 2-210(3) declare that in the absence of any contrary circumstances, a
provision in the agreement that prohibits assigning “the contract” bars “only the delegation to the
assignee of the assignor’s performance.”

[3]

In other words, unless the contract specifically prohibits

assignment of any of its terms, a party is free to assign anything except his or her own duties.
Even if a contractual provision explicitly prohibits it, a right to damages for breach of the whole contract is
assignable under UCC Section 2-210(2) in contracts for goods. Likewise, UCC Section 9-318(4) invalidates
any contract provision that prohibits assigning sums already due or to become due. Indeed, in some
states, at common law, a clause specifically prohibiting assignment will fail. For example, the buyer and
the seller agree to the sale of land and to a provision barring assignment of the rights under the contract.
The buyer pays the full price, but the seller refuses to convey. The buyer then assigns to her friend the
right to obtain title to the land from the seller. The latter’s objection that the contract precludes such an
assignment will fall on deaf ears in some states; the assignment is effective, and the friend may sue for the
title.

Future Contracts
The law distinguishes between assigning future rights under an existing contract and assigning rights that
will arise from a future contract. Rights contingent on a future event can be assigned in exactly the same
manner as existing rights, as long as the contingent rights are already incorporated in a contract. Ben has
a long-standing deal with his neighbor, Mrs. Robinson, to keep the latter’s walk clear of snow at twenty
dollars a snowfall. Ben is saving his money for a new printer, but when he is eighty dollars shy of the
purchase price, he becomes impatient and cajoles a friend into loaning him the balance. In return, Ben

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assigns his friend the earnings from the next four snowfalls. The assignment is effective. However, a right
that will arise from a future contract cannot be the subject of a present assignment.

Partial Assignments
An assignor may assign part of a contractual right, but only if the obligor can perform that part of his
contractual obligation separately from the remainder of his obligation. Assignment of part of a payment
due is always enforceable. However, if the obligor objects, neither the assignor nor the assignee may sue
him unless both are party to the suit. Mrs. Robinson owes Ben one hundred dollars. Ben assigns fifty
dollars of that sum to his friend. Mrs. Robinson is perplexed by this assignment and refuses to pay until
the situation is explained to her satisfaction. The friend brings suit against Mrs. Robinson. The court
cannot hear the case unless Ben is also a party to the suit. This ensures all parties to the dispute are
present at once and avoids multiple lawsuits.

Successive Assignments
It may happen that an assignor assigns the same interest twice (see Figure 14.2 "Successive
Assignments"). With certain exceptions, the first assignee takes precedence over any subsequent assignee.
One obvious exception is when the first assignment is ineffective or revocable. A subsequent assignment
has the effect of revoking a prior assignment that is ineffective or revocable. Another exception: if in good
faith the subsequent assignee gives consideration for the assignment and has no knowledge of the prior
assignment, he takes precedence whenever he obtains payment from, performance from, or a judgment
against the obligor, or whenever he receives some tangible evidence from the assignor that the right has
been assigned (e.g., a bank deposit book or an insurance policy).
Some states follow the different English rule: the first assignee to give notice to the obligor has priority,
regardless of the order in which the assignments were made. Furthermore, if the assignment falls within
the filing requirements of UCC Article 9 (see Chapter 33 "Secured Transactions and Suretyship"), the first
assignee to file will prevail.
Figure 14.2 Successive Assignments

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Assignor’s Warranties
An assignor has legal responsibilities in making assignments. He cannot blithely assign the same interests
pell-mell and escape liability. Unless the contract explicitly states to the contrary, a person who assigns a
right for value makes certain assignor’s warranties to the assignee: that he will not upset the assignment,
that he has the right to make it, and that there are no defenses that will defeat it. However, the assignor
does not guarantee payment; assignment does not by itself amount to a warranty that the obligor is
solvent or will perform as agreed in the original contract. Mrs. Robinson owes Ben fifty dollars. Ben
assigns this sum to his friend. Before the friend collects, Ben releases Mrs. Robinson from her obligation.
The friend may sue Ben for the fifty dollars. Or again, if Ben represents to his friend that Mrs. Robinson
owes him (Ben) fifty dollars and assigns his friend that amount, but in fact Mrs. Robinson does not owe
Ben that much, then Ben has breached his assignor’s warranty. The assignor’s warranties may be express
or implied.

KEY TAKEAWAY
Generally, it is OK for an obligee to assign the right to receive contractual performance from the obligor to a
third party. The effect of the assignment is to make the assignee stand in the shoes of the assignor, taking all
the latter’s rights and all the defenses against nonperformance that the obligor might raise against the
assignor. But the obligor may agree in advance to waive defenses against the assignee, unless such waiver is
prohibited by law.
There are some exceptions to the rule that contract rights are assignable. Some, such as personal rights, are
not circumstances where the obligor’s duties would materially change, cases where assignability is forbidden
by statute or public policy, or, with some limits, cases where the contract itself prohibits assignment. Partial

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assignments and successive assignments can happen, and rules govern the resolution of problems arising from
them.
When the assignor makes the assignment, that person makes certain warranties, express or implied, to the
assignee, basically to the effect that the assignment is good and the assignor knows of no reason why the
assignee will not get performance from the obligor.

EXERCISES
1.

If Able makes a valid assignment to Baker of his contract to receive monthly rental payments from
Tenant, how is Baker’s right different from what Able’s was?

2.

Able made a valid assignment to Baker of his contract to receive monthly purchase payments from Carr,
who bought an automobile from Able. The car had a 180-day warranty, but the car malfunctioned within
that time. Able had quit the auto business entirely. May Carr withhold payments from Baker to offset the
cost of needed repairs?

3.

Assume in the case in Exercise 2 that Baker knew Able was selling defective cars just before his (Able’s)
withdrawal from the auto business. How, if at all, does that change Baker’s rights?

4.

Why are leases generally not assignable? Why are insurance contracts not assignable?

[1] Restatement (Second) of Contracts, Section 317(1).
[2] Uniform Commercial Code, Section 9-206.
[3] Restatement (Second) of Contracts, Section 322.

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14.2 Delegation of Duties
LEARNING OBJECTIVES
1.

Know what a delegation of duty is.

2.

Recognize how liability remains on the delegator following a delegation.

3.

Understand what duties may not be delegated.

Basic Rules Regarding Delegation
General Rule
To this point, we have been considering the assignment of the assignor’s rights (usually, though not solely,
to money payments). But in every contract, a right connotes a corresponding duty, and these may be
delegated. A delegation is the transfer to a third party of the duty to perform under a contract. The one
who delegates is the delegator. Because most obligees are also obligors, most assignments of rights will
simultaneously carry with them the delegation of duties. Unless public policy or the contract itself bars the
delegation, it is legally enforceable.
In most states, at common law, duties must be expressly delegated. Under Uniform Commercial Code
(UCC) Section 2-210(4) and in a minority of states at common law (as illustrated in Section 14.4.2
"Assignment Includes Delegation",Rose v. Vulcan Materials Co.), an assignment of “the contract” or of
“all my rights under the contract” is not only an assignment of rights but also a delegation of duties to be
performed; by accepting the assignment, thedelegatee (one to whom the delegation is made) implies a
promise to perform the duties. (See Figure 14.3 "Delegation of Duties")
Figure 14.3 Delegation of Duties

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Effect on Obligor
An obligor who delegates a duty (and becomes a delegator) does not thereby escape liability for
performing the duty himself. The obligee of the duty may continue to look to the obligor for performance
unless the original contract specifically provides for substitution by delegation. This is a big difference
between assignment of contract rights and delegation of contract duties: in the former, the assignor is
discharged (absent breach of assignor’s warranties); in the latter, the delegator remains liable. The obligee
(again, the one to whom the duty to perform flows) may also, in many cases, look to the delegatee,
because the obligee becomes an intended beneficiary of the contract between the obligor and the
delegatee, as discussed in Section 14.3 "Third-Party Beneficiaries". Of course, the obligee may
subsequently agree to accept the delegatee and discharge the obligor from any further responsibility for
performing the duty. A contract among three persons having this effect is called a novation; it is a new
contract. Fred sells his house to Lisa, who assumes his mortgage. Fred, in other words, has delegated the
duty to pay the bank to Lisa. If Lisa defaults, Fred continues to be liable to the bank, unless in the original
mortgage agreement a provision specifically permitted any purchaser to be substituted without recourse
to Fred, or unless the bank subsequently accepts Lisa and discharges Fred.

Nondelegable Duties
Personal Services
Personal services are not delegable. If the contract is such that the promisee expects the obligor personally
to perform the duty, the obligor may not delegate it. Suppose the Catskill Civic Opera Association hires a

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famous singer to sing in its production of Carmen and the singer delegates the job to her understudy. The
delegation is ineffective, and performance by the understudy does not absolve the famous singer of
liability for breach.
Many duties may be delegated, however. Indeed, if they could not be delegated, much of the world’s work
would not get done. If you hire a construction company and an architect to design and build your house to
certain specifications, the contractor may in turn hire individual craftspeople—plumbers, electricians, and
the like—to do these specialized jobs, and as long as they are performed to specification, the contract
terms will have been met. If you hired an architecture firm, though, you might not be contracting for the
specific services of a particular individual in that firm.

Public Policy
Public policy may prohibit certain kinds of delegations. A public official, for example, may not delegate
the duties of her office to private citizens, although various statutes generally permit the delegation of
duties to her assistants and subordinates.

Delegations Barred by Contract
As we have already noted, the contract itself may bar assignment. The law generally disfavors restricting
the right to assign a benefit, but it will uphold a contract provision that prohibits delegation of a duty.
Thus, as we have seen, UCC Section 2-210(3) states that in a contract for sale of goods, a provision against
assigning “the contract” is to be construed only as a prohibition against delegating the duties.

KEY TAKEAWAY
The duty to perform a contractual obligation may usually be delegated to a third party. Such delegation,
however, does not discharge the delegator, who remains liable on the contract absent a novation.
Some duties may not be delegated: personal services cannot be, and public policy or the contract itself may
bar delegation.

EXERCISES
1.

What is the difference between an assignment and a delegation?

2.

Under what circumstances is the delegator discharged from liability on the contract?

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14.3 Third-Party Beneficiaries
LEARNING OBJECTIVES
1.

Know what a third-party beneficiary is, and what the types of such beneficiaries are.

2.

Recognize the rights obtained by third-party beneficiaries.

3.

Understand when the public might be a third-party beneficiary of government contracts.

The fundamental issue with third-party beneficiaries gets to this: can a person who is not a party to a
contract sue to enforce its terms?

The General Rule
The general rule is this: persons not a party to a contract cannot enforce its terms; they are said to
lack privity, a private, face-to-face relationship with the contracting parties. But if the persons are
intended to benefit from the performance of a contract between others, then they can enforce it: they are
intended beneficiaries.

Two Types of Third-Party Beneficiaries
In the vocabulary of the Restatement, a third person whom the parties to the contract intend to benefit is
an intended beneficiary—that is, one who is entitled under the law of contracts to assert a right arising
from a contract to which he or she is not a party. There are two types of intended beneficiaries.

Creditor Beneficiary
A creditor beneficiary is one to whom the promisor agrees to pay a debt of the promisee. For example, a
father is bound by law to support his child. If the child’s uncle (the promisor) contracts with the father
(the promisee) to furnish support for the child, the child is a creditor beneficiary and could sue the uncle.
Or again, suppose Customer pays Ace Dealer for a new car, and Ace delegates the duty of delivery to Beta
Dealer. Ace is now a debtor: he owes Customer something: a car. Customer is a creditor; she is owed
something: a car. When Beta performs under his delegated contract with Ace, Beta is discharging the debt
Ace owes to Customer. Customer is a creditor beneficiary of Dealers’ contract and could sue either one for

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nondelivery. She could sue Ace because she made a contract with him, and she could sue Beta because—
again—she was intended to benefit from the performance of Dealers’ agreement.

Donee Beneficiary
The second type of intended beneficiary is a donee beneficiary. When the promisee is not indebted to the
third person but intends for him or her to have the benefit of the promisor’s performance, the third
person is a donee beneficiary (and the promise is sometimes called a gift promise). For example, an
insurance company (the promisor) promises to its policyholder (the promisee), in return for a premium,
to pay $100,000 to his wife on his death; this makes the wife a donee beneficiary (see Figure 14.1
"Assignment of Rights"). The wife could sue to enforce the contract although she was not a party to it. Or
if Able makes a contract with Woodsman for the latter to cut the trees in Able’s backyard as a Christmas
gift to Able’s uphill Neighbor (so that Neighbor will have a view), Neighbor could sue Woodsman for
breach of the contract.
If a person is not an intended beneficiary—not a creditor or donee beneficiary—then he or she is said to be
only an incidental beneficiary, and that person has no rights. So if Able makes the contract with
Woodsman not to benefit Neighbor but for Able’s own benefit, the fact that the tree removal would benefit
Neighbor does not make Neighbor an intended beneficiary.
The beneficiary’s rights are always limited by the terms of the contract. A failure by the promisee to
perform his part of the bargain will terminate the beneficiary’s rights if the promisee’s lapse terminates
his own rights, absent language in the contract to the contrary. If Able makes the contract as a gift to
Neighbor but doesn’t make the required down payment to Woodsman, Neighbor’s claim fails. In a suit by
the beneficiary, the promisor may avail himself of any defense he could have asserted against the
promisee. Woodsman may defend himself against Neighbor’s claim that Woodsman did not do the whole
job by showing that Able didn’t make full payment for the work.

Modification of the Beneficiary’s Rights
Conferring rights on an intended beneficiary is relatively simple. Whether his rights can be modified or
extinguished by subsequent agreement of the promisor and promisee is a more troublesome issue. The

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general rule is that the beneficiary’s rights may be altered as long as there has been
novesting of rights (the rights have not taken effect). The time at which the beneficiary’s rights vest differs
among jurisdictions: some say immediately, some say when the beneficiary assents to the receipt of the
contract right, some say the beneficiary’s rights don’t vest until she has detrimentally relied on the right.
The Restatement says that unless the contract provides that its terms cannot be changed without the
beneficiary’s consent, the parties may change or rescind the benefit unless the beneficiary has sued on the
promise, has detrimentally relied, or has assented to the promise at the request of one of the
parties.

[1]

Some contracts provide that the benefit never vests; for example, standard insurance policies

today reserve to the insured the right to substitute beneficiaries, to borrow against the policy, to assign it,
and to surrender it for cash.

Government Contracts
The general rule is that members of the public are only incidental beneficiaries of contracts made by the
government with a contractor to do public works. It is not illogical to see a contract between the
government and a company pledged to perform a service on behalf of the public as one creating rights in
particular members of the public, but the consequences of such a view could be extremely costly because
everyone has some interest in public works and government services.
A restaurant chain, hearing that the county was planning to build a bridge that would reroute commuter
traffic, might decide to open a restaurant on one side of the bridge; if it let contracts for construction only
to discover that the bridge was to be delayed or canceled, could it sue the county’s contractor? In general,
the answer is that it cannot. A promisor under contract to the government is not liable for the
consequential damages to a member of the public arising from its failure to perform (or from a faulty
performance) unless the agreement specifically calls for such liability or unless the promisee (the
government) would itself be liable and a suit directly against the promisor would be consistent with the
contract terms and public policy. When the government retains control over litigation or settlement of
claims, or when it is easy for the public to insure itself against loss, or when the number and amount of
claims would be excessive, the courts are less likely to declare individuals to be intended beneficiaries. But
the service to be provided can be so tailored to the needs of particular persons that it makes sense to view
them as intended beneficiaries—in the case, for example, of a service station licensed to perform

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emergency road repairs, as in Section 14.4.3 "Third party Beneficiaries and Foreseeable
Damages", Kornblut v. Chevron Oil Co.

KEY TAKEAWAY
Generally, a person who is not a party to a contract cannot sue to enforce its terms. The exception is if the
person is an intended beneficiary, either a creditor beneficiary or a donee beneficiary. Such third parties can
enforce the contract made by others but only get such rights as the contract provides, and beneficiaries are
subject to defenses that could be made against their benefactor.
The general rule is that members of the public are not intended beneficiaries of contracts made by the
government, but only incidental beneficiaries.

EXERCISES
1.

What are the two types of intended beneficiaries?

2.

Smith contracted to deliver a truck on behalf of Truck Sales to Byers, who had purchased it from Truck
Sales. Smith was entitled to payment by Byers for the delivery. The truck was defective. May Byers
withhold payment from Smith to offset the repair costs?

3.

Why is the public not usually considered an intended beneficiary of contracts made by the government?

[1] Restatement (Second) of Contracts, Section 311.

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14.4 Cases
Nonassignable Rights
Nassau Hotel Co. v. Barnett & Barse Corporation
147 N.Y.S. 283 (1914)
McLaughlin, J.
Plaintiff owns a hotel at Long Beach, L. I., and on the 21st of November, 1912, it entered into a written
agreement with the individual defendants Barnett and Barse to conduct the same for a period of
years.…Shortly after this agreement was signed, Barnett and Barse organized the Barnett & Barse
Corporation with a capital stock of $10,000, and then assigned the agreement to it. Immediately following
the assignment, the corporation went into possession and assumed to carry out its terms. The plaintiff
thereupon brought this action to cancel the agreement and to recover possession of the hotel and
furniture therein, on the ground that the agreement was not assignable. [Summary judgment in favor of
the plaintiff, defendant corporation appeals.]
The only question presented is whether the agreement was assignable. It provided, according to the
allegations of the complaint, that the plaintiff leased the property to Barnett and Barse with all its
equipment and furniture for a period of three years, with a privilege of five successive renewals of three
years each. It expressly provided:
‘That said lessees…become responsible for the operation of the said hotel and for the upkeep and
maintenance thereof and of all its furniture and equipment in accordance with the terms of this
agreement and the said lessees shall have the exclusive possession, control and management thereof. * * *
The said lessees hereby covenant and agree that they will operate the said hotel at all times in a first-class
business-like manner, keep the same open for at least six (6) months of each year, * * *’ and ‘in lieu of
rental the lessor and lessees hereby covenant and agree that the gross receipts of such operation shall be,
as received, divided between the parties hereto as follows: (a) Nineteen per cent. (19%) to the lessor. * * *
In the event of the failure of the lessees well and truly to perform the covenants and agreements herein
contained,’ they should be liable in the sum of $50,000 as liquidated damages. That ‘in consideration and

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upon condition that the said lessees shall well and faithfully perform all the covenants and agreements by
them to be performed without evasion or delay the said lessor for itself and its successors, covenants and
agrees that the said lessees, their legal representatives and assigns may at all times during said term and
the renewals thereof peaceably have and enjoy the said demised premises.’ And that ‘this agreement shall
inure to the benefit of and bind the respective parties hereto, their personal representatives, successors
and assigns.’
The complaint further alleges that the agreement was entered into by plaintiff in reliance upon the
financial responsibility of Barnett and Barse, their personal character, and especially the experience of
Barnett in conducting hotels; that, though he at first held a controlling interest in the Barnett & Barse
Corporation, he has since sold all his stock to the defendant Barse, and has no interest in the corporation
and no longer devotes any time or attention to the management or operation of the hotel.
…[C]learly…the agreement in question was personal to Barnett and Barse and could not be assigned by
them without the plaintiff’s consent. By its terms the plaintiff not only entrusted them with the care and
management of the hotel and its furnishings—valued, according to the allegations of the complaint, at
more than $1,000,000—but agreed to accept as rental or compensation a percentage of the gross receipts.
Obviously, the receipts depended to a large extent upon the management, and the care of the property
upon the personal character and responsibility of the persons in possession. When the whole agreement is
read, it is apparent that the plaintiff relied, in making it, upon the personal covenants of Barnett and
Barse. They were financially responsible. As already said, Barnett had had a long and successful
experience in managing hotels, which was undoubtedly an inducing cause for plaintiff’s making the
agreement in question and for personally obligating them to carry out its terms.
It is suggested that because there is a clause in the agreement to the effect that it should ‘inure to the
benefit of and bind the respective parties hereto, their personal representatives and assigns,’ that Barnett
and Barse had a right to assign it to the corporation. But the intention of the parties is to be gathered, not
from one clause, but from the entire instrument [Citation] and when it is thus read it clearly appears that
Barnett and Barse were to personally carry out the terms of the agreement and did not have a right to
assign it. This follows from the language used, which shows that a personal trust or confidence was
reposed by the plaintiff in Barnett and Barse when the agreement was made.

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In [Citation] it was said: “Rights arising out of contract cannot be transferred if they…involve a relation of
personal confidence such that the party whose agreement conferred those rights must have intended them
to be exercised only by him in whom he actually confided.”
This rule was applied in [Citation] the court holding that the plaintiff—the assignee—was not only
technically, but substantially, a different entity from its predecessor, and that the defendant was not
obliged to entrust its money collected on the sale of the presses to the responsibility of an entirely
different corporation from that with which it had contracted, and that the contract could not be assigned
to the plaintiff without the assent of the other party to it.
The reason which underlies the basis of the rule is that a party has the right to the benefit contemplated
from the character, credit, and substance of him with whom he contracts, and in such case he is not bound
to recognize…an assignment of the contract.
The order appealed from, therefore, is affirmed.

CASE QUESTIONS
1.

The corporation created to operate the hotel was apparently owned and operated by the same two men
the plaintiff leased the hotel to in the first place. What objection would the plaintiff have to the corporate
entity—actually, of course, a legal fiction—owning and operating the hotel?

2.

The defendants pointed to the clause about the contract inuring to the benefit of the parties “and
assigns.” So the defendants assigned the contract. How could that not be allowed by the contract’s own
terms?

3.

What is the controlling rule of law upon which the outcome here depends?

Assignment Includes Delegation
Rose v. Vulcan Materials Co.
194 S.E.2d 521 (N.C. 1973)
Huskins, J.

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…Plaintiff [Rose], after leasing his quarry to J. E. Dooley and Son, Inc., promised not to engage in the
rock-crushing business within an eight-mile radius of [the city of] Elkin for a period of ten years. In return
for this promise, J. E. Dooley and Son, Inc., promised, among other things, to furnish plaintiff stone f.o.b.
the quarry site at Cycle, North Carolina, at stipulated prices for ten years.…
By a contract effective 23 April 1960, Vulcan Materials Company, a corporation…, purchased the stone
quarry operations and the assets and obligations of J. E. Dooley and Son, Inc.…[Vulcan sent Rose a letter,
part of which read:]
Mr. Dooley brought to us this morning the contracts between you and his companies, copies of which are
attached. This is to advise that Vulcan Materials Company assumes all phases of these contracts and
intends to carry out the conditions of these contracts as they are stated.
In early 1961 Vulcan notified plaintiff that it would no longer sell stone to him at the prices set out in [the
agreement between Rose and Dooley] and would thereafter charge plaintiff the same prices charged all of
its other customers for stone. Commencing 11 May 1961, Vulcan raised stone prices to the plaintiff to a
level in excess of the prices specified in [the Rose-Dooley agreement].
At the time Vulcan increased the prices of stone to amounts in excess of those specified in [the RoseDooley contract], plaintiff was engaged in his ready-mix cement business, using large quantities of stone,
and had no other practical source of supply. Advising Vulcan that he intended to sue for breach of
contract, he continued to purchase stone from Vulcan under protest.…
The total of these amounts over and above the prices specified in [the Rose-Dooley contract] is
$25,231.57, [about $152,000 in 2010 dollars] and plaintiff seeks to recover said amount in this action.
The [Rose-Dooley] agreement was an executory bilateral contract under which plaintiff’s promise not to
compete for ten years gained him a ten-year option to buy stone at specified prices. In most states, the
assignee of an executory bilateral contract is not liable to anyone for the nonperformance of the assignor’s
duties thereunder unless he expressly promises his assignor or the other contracting party to perform, or
‘assume,’ such duties.…These states refuse to imply a promise to perform the duties, but if the assignee
expressly promises his assignor to perform, he is liable to the other contracting party on a third-party

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beneficiary theory. And, if the assignee makes such a promise directly to the other contracting party upon
a consideration, of course he is liable to him thereon. [Citation]
A minority of states holds that the assignee of an executory bilateral contract under a general assignment
becomes not only assignee of the rights of the assignor but also delegatee of his duties; and that, absent a
showing of contrary intent, the assignee impliedly promises the assignor that he will perform the duties so
delegated. This rule is expressed in Restatement, Contracts, s 164 (1932) as follows:
(1) Where a party under a bilateral contract which is at the time wholly or partially executory on both
sides purports to assign the whole contract, his action is interpreted, in the absence of circumstances
showing a contrary intention, as an assignment of the assignor’s rights under the contract and a
delegation of the performance of the assignor’s duties.
(2) Acceptance by the assignee of such an assignment is interpreted, in the absence of circumstances
showing a contrary intention, as both an assent to become an assignee of the assignor’s rights and as a
promise to the assignor to assume the performance of the assignor’s duties.’ (emphasis
added)
We…adopt the Restatement rule and expressly hold that the assignee under a general assignment of an
executory bilateral contract, in the absence of circumstances showing a contrary intention, becomes the
delegatee of his assignor’s duties and impliedly promises his assignor that he will perform such duties.
The rule we adopt and reaffirm here is regarded as the more reasonable view by legal scholars and
textwriters. Professor Grismore says:
It is submitted that the acceptance of an assignment in this form does presumptively import a tacit
promise on the part of the assignee to assume the burdens of the contract, and that this presumption
should prevail in the absence of the clear showing of a contrary intention. The presumption seems
reasonable in view of the evident expectation of the parties. The assignment on its face indicates an intent
to do more than simply to transfer the benefits assured by the contract. It purports to transfer the contract
as a whole, and since the contract is made up of both benefits and burdens both must be intended to be

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included.…Grismore, Is the Assignee of a Contract Liable for the Nonperformance of Delegated Duties? 18
Mich.L.Rev. 284 (1920).
In addition, with respect to transactions governed by the Uniform Commercial Code, an assignment of a
contract in general terms is a delegation of performance of the duties of the assignor, and its acceptance
by the assignee constitutes a promise by him to perform those duties. Our holding in this case maintains a
desirable uniformity in the field of contract liability.
We further hold that the other party to the original contract may sue the assignee as a third-party
beneficiary of his promise of performance which he impliedly makes to his assignor, under the rule above
laid down, by accepting the general assignment. Younce v. Lumber Co., [Citation] (1908), holds that
where the assignee makes an express promise of performance to his assignor, the other contracting party
may sue him for breach thereof. We see no reason why the same result should not obtain where the
assignee breaches his promise of performance implied under the rule of Restatement s 164. ‘That the
assignee is liable at the suit of the third party where he expressly assumes and promises to perform
delegated duties has already been decided in a few cases (citing Younce). If an express promise will
support such an action it is difficult to see why a tacit promise should not have the same effect.’ Grismore,
supra. Parenthetically, we note that such is the rule under the Uniform Commercial Code, [2-210].
We now apply the foregoing principles to the case at hand. The contract of 23 April 1960, between
defendant and J. E. Dooley and Son, Inc., under which, as stipulated by the parties, ‘the defendant
purchased the assets and obligations of J. E. Dooley and Son, Inc.,’ was a general assignment of all the
assets and obligations of J. E. Dooley and Son, Inc., including those under [the Rose-Dooley contract].
When defendant accepted such assignment it thereby became delegatee of its assignor’s duties under it
and impliedly promised to perform such duties.
When defendant later failed to perform such duties by refusing to continue sales of stone to plaintiff at the
prices specified in [the Rose-Dooley contract], it breached its implied promise of performance and
plaintiff was entitled to bring suit thereon as a third-party beneficiary.
The decision…is reversed with directions that the case be certified to the Superior Court of Forsyth County
for reinstatement of the judgment of the trial court in accordance with this opinion.

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CASE QUESTIONS
1.

Why did Rose need the crushed rock from the quarry he originally leased to Dooley?

2.

What argument did Vulcan make as to why it should not be liable to sell crushed rock to Rose at the price
set out in the Rose-Dooley contract?

3.

What rule did the court here announce in deciding that Vulcan was required to sell rock at the price set
out in the Rose-Dooley contract? That is, what is the controlling rule of law in this case?

Third party Beneficiaries and Foreseeable Damages
Kornblut v. Chevron Oil Co.
62 A.D.2d 831 (N.Y. 1978)
Hopkins, J.
The plaintiff-respondent has recovered a judgment after a jury trial in the sum of $519,855.98 [about $1.9
million in 2010 dollars] including interest, costs and disbursements, against Chevron Oil Company
(Chevron) and Lawrence Ettinger, Inc. (Ettinger) (hereafter collectively referred to as defendants) for
damages arising from the death and injuries suffered by Fred Kornblut, her husband. The case went to the
jury on the theory that the decedent was the third-party beneficiary of a contract between Chevron and
the New York State Thruway Authority and a contract between Chevron and Ettinger.
On the afternoon of an extremely warm day in early August, 1970 the decedent was driving northward on
the New York State Thruway. Near Sloatsburg, New York, at about 3:00 p.m., his automobile sustained a
flat tire. At the time the decedent was accompanied by his wife and 12-year-old son. The decedent waited
for assistance in the 92 degree temperature.
After about an hour a State Trooper, finding the disabled car, stopped and talked to the decedent. The
trooper radioed Ettinger, which had the exclusive right to render service on the Thruway under an
assignment of a contract between Chevron and the Thruway Authority. Thereafter, other State Troopers
reported the disabled car and the decedent was told in each instance that he would receive assistance
within 20 minutes.

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Having not received any assistance by 6:00 p.m., the decedent attempted to change the tire himself. He
finally succeeded, although he experienced difficulty and complained of chest pains to the point that his
wife and son were compelled to lift the flat tire into the trunk of the automobile. The decedent drove the
car to the next service area, where he was taken by ambulance to a hospital; his condition was later
diagnosed as a myocardial infarction. He died 28 days later.
Plaintiff sued, inter alia, Chevron and Ettinger alleging in her complaint causes of action sounding in
negligence and breach of contract. We need not consider the issue of negligence, since the Trial Judge
instructed the jury only on the theory of breach of contract, and the plaintiff has recovered damages for
wrongful death and the pain and suffering only on that theory.
We must look, then, to the terms of the contract sought to be enforced. Chevron agreed to provide “rapid
and efficient roadside automotive service on a 24-hour basis from each gasoline service station facility for
the areas…when informed by the authority or its police personnel of a disabled vehicle on the Thruway”.
Chevron’s vehicles are required “to be used and operated in such a manner as will produce adequate
service to the public, as determined in the authority’s sole judgment and discretion”. Chevron specifically
covenanted that it would have “sufficient roadside automotive service vehicles, equipment and personnel
to provide roadside automotive service to disabled vehicles within a maximum of thirty (30) minutes from
the time a call is assigned to a service vehicle, subject to unavoidable delays due to extremely adverse
weather conditions or traffic conditions.”…
In interpreting the contract, we must bear in mind the circumstances under which the parties bargained.
The New York Thruway is a limited access toll highway, designed to move traffic at the highest legal
speed, with the north and south lanes separated by green strips. Any disabled vehicle on the road
impeding the flow of traffic may be a hazard and inconvenience to the other users. The income realized
from tolls is generated from the expectation of the user that he will be able to travel swiftly and smoothly
along the Thruway. Consequently, it is in the interest of the authority that disabled vehicles will be
repaired or removed quickly to the end that any hazard and inconvenience will be minimized. Moreover,
the design and purpose of the highway make difficult, if not impossible, the summoning of aid from
garages not located on the Thruway. The movement of a large number of vehicles at high speed creates a
risk to the operator of a vehicle who attempts to make his own repairs, as well as to the other users. These

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considerations clearly prompted the making of contracts with service organizations which would be
located at points near in distance and time on the Thruway for the relief of distressed vehicles.
Thus, it is obvious that, although the authority had an interest in making provision for roadside calls
through a contract, there was also a personal interest of the user served by the contract. Indeed, the
contract provisions regulating the charges for calls and commanding refunds be paid directly to the user
for overcharges, evince a protection and benefit extended to the user only. Hence, in the event of an
overcharge, the user would be enabled to sue on the contract to obtain a recovery.…Here the contract
contemplates an individual benefit for the breach running to the user.…
By choosing the theory of recovery based on contract, it became incumbent on the plaintiff to show that
the injury was one which the defendants had reason to foresee as a probable result of the breach, under
the ancient doctrine of Hadley v Baxendale [Citation], and the cases following it…in distinction to the
requirement of proximate cause in tort actions.…
The death of the decedent on account of his exertion in the unusual heat of the midsummer day in
changing the tire cannot be said to have been within the contemplation of the contracting parties as a
reasonably foreseeable result of the failure of Chevron or its assignee to comply with the contract.…
The case comes down to this, then, in our view: though the decedent was the intended beneficiary to sue
under certain provisions of the contract—such as the rate specified for services to be rendered—he was not
the intended beneficiary to sue for consequential damages arising from personal injury because of a
failure to render service promptly. Under these circumstances, the judgment must be reversed and the
complaint dismissed, without costs or disbursements.
[Martuscello, J., concurred in the result but opined that the travelling public was not an intended
beneficiary of the contract.]

CASE QUESTIONS
1.

Chevron made two arguments as to why it should not be liable for Mr. Kornblut’s death. What were they?

2.

Obviously, when Chevron made the contract with the New York State Thruway Authority, it did not know
Mr. Kornblut was going to be using the highway. How could he, then, be an intended beneficiary of the
contract?

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3.

Why was Chevron not found liable for Mr. Kornblut’s death when, clearly, had it performed the contract
properly, he would not have died?

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14.5 Summary and Exercises
Summary
The general rule that the promisee may assign any right has some exceptions—for example, when the
promisor’s obligation would be materially changed. Of course the contract itself may prohibit assignment,
and sometimes statutes preclude it. Knowing how to make the assignment effective and what the
consequences of the assignment are on others is worth mastering. When, for example, does the assignee
not stand in the assignor’s shoes? When may a future right be assigned?
Duties, as well as rights, may be transferred to third parties. Most rights (promises) contained in contracts
have corresponding duties (also expressed as promises). Often when an entire contract is assigned, the
duties go with it; the transferee is known, with respect to the duties, as the delegatee. The transferor
himself does not necessarily escape the duty, however. Moreover, some duties are nondelegable, such as
personal promises and those that public policy require to be carried out by a particular official. Without
the ability to assign rights and duties, much of the modern economy would grind to a halt.
The parties to a contract are not necessarily the only people who acquire rights or duties under it. One
major category of persons acquiring rights is third-party beneficiaries. Only intended beneficiaries acquire
rights under the contract, and these are of two types: creditor and donee beneficiaries. The rules for
determining whether rights have been conferred are rather straightforward; determining whether rights
can subsequently be modified or extinguished is more troublesome. Generally, as long as the contract
does not prohibit change and as long as the beneficiary has not relied on the promise, the change may be
made.

EXERCISES
1.

The Dayton Country Club offered its members various social activities. Some members were entitled, for
additional payment, to use the golf course, a coveted amenity. Golfing memberships could not be
transferred except upon death or divorce, and there was a long waiting list in this special category; if a
person at the top of the list declined, the next in line was eligible. Golfing membership rules were drawn
up by a membership committee. Magness and Redman were golfing members. They declared bankruptcy,

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and the bankruptcy trustee sought, in order to increase the value of their debtors’ estates, to assume and
sell the golfing memberships to members on the waiting list, other club members, or the general public,
provided the persons joined the club. The club asserted that under relevant state law, it was “excused
from rendering performance to an entity other than the debtor”—that is, it could not be forced to accept
strangers as members. Can these memberships be assigned?
2.

Tenant leased premises in Landlord’s shopping center, agreeing in the lease “not to assign, mortgage,
pledge, or encumber this lease in whole or in part.” Under the lease, Tenant was entitled to a
construction allowance of up to $11,000 after Tenant made improvements for its uses. Prior to the
completion of the improvements, Tenant assigned its right to receive the first $8,000 of the construction
allowance to Assignee, who, in turn, provided Tenant $8,000 to finance the construction. Assignee
notified Landlord of the assignment, but when the construction was complete, Landlord paid Tenant
anyway; when Assignee complained, Landlord pointed to the nonassignment clause. Assignee sued
Landlord. Who wins?

3.

[1]

Marian contracted to sell her restaurant to Billings for $400,000. The contract provided that Billings would
pay $100,000 and sign a note for the remainder. Billings sold the restaurant to Alice, who agreed to
assume responsibility for the balance due on the note held by Marian. But Alice had difficulties and
declared bankruptcy. Is Billings still liable on the note to Marian?

4.

Yellow Cab contracted with the Birmingham Board of Education to transport physically handicapped
students. The contract provided, “Yellow Cab will transport the physically handicapped students of
the School System…and furnish all necessary vehicles and personnel and will perform all
maintenance and make all repairs to the equipment to keep it in a safe and efficient operating
condition at all times.”
Yellow Cab subcontracted with Metro Limousine to provide transportation in connection with its
contract with the board. Thereafter, Metro purchased two buses from Yellow Cab to use in
transporting the students. DuPont, a Metro employee, was injured when the brakes on the bus
that he was driving failed, causing the bus to collide with a tree. DuPont sued Yellow Cab, alleging
that under its contract with the board, Yellow Cab had a nondelegable duty to properly maintain
the bus so as to keep it in a safe operating condition; that that duty flowed to him as an intended

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third-party beneficiary of the contract; and that Yellow Cab had breached the contract by failing to
properly maintain the bus. Who wins?
5.

[2]

Joan hired Groom to attend to her herd of four horses at her summer place in the high desert. The job
was too much for Groom, so he told Tony that he (Groom) would pay Tony, who claimed expertise in
caring for horses, to take over the job. Tony neglected the horses in hot weather, and one of them
needed veterinarian care for dehydration. Is Groom liable?

6.

Rensselaer Water Company contracted with the city to provide water for business, domestic, and firehydrant purposes. While the contract was in effect, a building caught on fire; the fire spread to Plaintiff’s
(Moch Co.’s) warehouse, destroying it and its contents. The company knew of the fire but was unable to
supply adequate water pressure to put it out. Is the owner of the warehouse able to maintain a claim
against the company for the loss?

7.

Rusty told Alice that he’d do the necessary overhaul on her classic car for $5,000 during the month of
May, and that when the job was done, she should send the money to his son, Jim, as a graduation
present. He confirmed the agreement in writing and sent a copy to Jim. Subsequently, Rusty changed his
mind. What right has Jim?

8.

Fox Brothers agreed to convey to Clayton Canfield Lot 23 together with a one-year option to purchase Lot
24 in a subdivision known as Fox Estates. The agreement contained no prohibitions, restrictions, or
limitations against assignments. Canfield paid the $20,000 and took title to Lot 23 and the option to Lot
24. Canfield thereafter assigned his option rights in Lot 24 to the Scotts. When the Scotts wanted to
exercise the option, Fox Brothers refused to convey the property to them. The Scotts then brought suit
for specific performance. Who wins?

9.

Rollins sold Byers, a businessperson, a flatbed truck on a contract; Rollins assigned the contract to Frost,
and informed Byers of the assignment. Rollins knew the truck had problems, which he did not reveal to
Byers. When the truck needed $3,200 worth of repairs and Rollins couldn’t be found, Byers wanted to
deduct that amount from payments owed to Frost, but Frost insisted he had a right to payment. Upon
investigation, Byers discovered that four other people in the state had experienced similar situations with
Rollins and with Frost as Rollins’s assignee. What recourse has Byers?

10. Merchants and resort owners in the San Juan Islands in Washington State stocked extra supplies, some
perishable, in anticipation of the flood of tourists over Labor Day. They suffered inconvenience and

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monetary damage due to the union’s Labor Day strike of the state ferry system, in violation of its
collective bargaining agreement with the state and of a temporary restraining order. The owners sued the
union for damages for lost profits, attorney fees, and costs, claiming the union should be liable for
intentional interference with contractual relations (the owners’ relations with their would-be customers).
Do the owners have a cause of action?

SELF-TEST QUESTIONS
1.

A creditor beneficiary is

a.

the same as a donee beneficiary

b.

a third-party beneficiary

c.

an incidental beneficiary

d.

none of the above

2.

Assignments are not allowed

a.

for rights that will arise from a future contract

b.

when they will materially change the duties that the obligor must perform

c.

where they are forbidden by public policy

d.

for any of the above
When an assignor assigns the same interest twice,

a.

the subsequent assignee generally takes precedence

b.

the first assignee generally takes precedence

c.

the first assignee always takes precedence

d.

the assignment violates public policy
Factoring

a.

is an example of delegation of duties

b.

involves using an account receivable as collateral for a loan

c.

involves the purchase of a right to receive income from another

d.

is all of the above
Personal promises

a.

are always delegable

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b.

are generally not delegable

c.

are delegable if not prohibited by public policy

d.

are delegable if not barred by the contract

SELF-TEST ANSWERS
1.

b

2.

d

3.

b

4.

c

5.

b

[1] Aldana v. Colonial Palms Plaza, Inc., 591 So.2d 953 (Fla. Ct. App., 1991).
[2] DuPont v. Yellow Cab Co. of Birmingham, Inc., 565 So.2d 190 (Ala. 1990).

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Chapter 15

Discharge of Obligations
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

What is meant by discharge of contract obligations

2.

How contract obligations are discharged

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15.1 Discharge of Contract Duties
LEARNING OBJECTIVES
1.

Understand how performance, partial performance, or no performance may discharge contractual
obligations.

2.

Recognize what rights accrue to the nonbreaching party when the other side announces, before the
time for performance, that performance will not be forthcoming—anticipatory breach.

3.

Understand the concept of the right to adequate assurances, and the consequences if no such
assurances are forthcoming.

A person is liable to perform agreed-to contract duties until or unless he or she is discharged. If the
person fails to perform without being discharged, liability for damages arises. Here we deal with the
second-to-the-last of the four broad themes of contract law: how contract duties are discharged.

Discharge by Performance (or Nonperformance) of the Duty
A contract can be discharged by complete performance or material nonperformance of the contractual
duty. Note, in passing, that the modern trend at common law (and explicit under the Uniform
Commercial Code [UCC], Section 1-203) is that the parties have a good-faith duty to perform to each
other. There is in every contract “an implied covenant of good faith” (honesty in fact in the transaction)
that the parties will deal fairly, keep their promises, and not frustrate the other party’s reasonable
expectations of what was given and what received.

Full Performance
Full performance of the contractual obligation discharges the duty. If Ralph does a fine job of plumbing
Betty’s new bathroom, she pays him. Both are discharged.

Nonperformance, Material Breach
If Ralph doesn’t do any work at all on Betty’s bathroom, or almost none, then Betty owes him nothing.
She—the nonbreaching party—is discharged, and Ralph is liable for breach of contract.

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Under UCC Section 2-106(4), a party that ends a contract breached by the other party is said to have
effected a cancellation. The cancelling party retains the right to seek a remedy for breach of the whole
contract or any unperformed obligation. The UCC distinguishes cancellation from termination, which
occurs when either party exercises a lawful right to end the contract other than for breach. When a
contract is terminated, all executory duties are discharged on both sides, but if there has been a partial
breach, the right to seek a remedy survives.

[1]

Substantial Performance
Logically, anything less than full performance, even a slight deviation from what is owed, is sufficient to
prevent the duty from being discharged and can amount to a breach of contract. So if Ralph does all the
plumbing for Betty’s new bathroom except hook up the toilet feed, he has not really “plumbed the new
bathroom.” He has only plumbed part of it. At classic common law, that was it: either you did the thing
you promised completely or you had materially breached. But under modern theories, an ameliorative
doctrine has developed, called substantial performance: if one side has substantially, but not completely,
performed, so that the other side has received a benefit, the nonbreaching party owes something for the
value received. The Restatement (Second) of Contracts puts it this way:

[2]

Substantial Performance.
In an important category of disputes over failure of performance, one party asserts the right to payment
on the ground that he has completed his performance, while the other party refuses to pay on the ground
that there is an uncured material failure of performance.…In such cases it is common to state the issue…in
terms of whether there has been substantial performance.…If there has been substantial although not full
performance, the building contractor has a claim for the unpaid balance and the owner has a claim only
for damages. If there has not been substantial performance, the building contractor has no claim for the
unpaid balance, although he may have a claim in restitution.
The contest here is between the one who claims discharge by the other’s material breach and the one who
asserts there has been substantial performance. What constitutes substantial performance is a question of
fact, as illustrated in Section 15.2.1 "Substantial Performance; Conditions Precedent", TA Operating Corp.
v. Solar Applications Engineering, Inc. The doctrine has no applicability where the breaching party

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willfully failed to follow the contract, as where a plumber substitutes a different faucet for the one
ordered; installation of the incorrect faucet is a breach, even if it is of equal or greater value than the one
ordered.
Under the UCC, there is no such thing as substantial performance. Section 2-601 requires that the goods
delivered according to the contract be the exact things ordered—that there be a perfect tender (unless the
parties agree otherwise).

Anticipatory Breach and Demand for Reasonable Assurances
When a promisor announces before the time his performance is due that he will not perform, he is said to
have committed ananticipatory breach (or repudiation). Of course a person cannot fail to perform a duty
before performance is due, but the law allows the promisee to treat the situation as a material breach that
gives rise to a claim for damages and discharges the obligee from performing duties required of him under
the contract. The common-law rule was first recognized in the well-known 1853 British case Hochster v.
De La Tour. In April, De La Tour hired Hochster as his courier, the job to commence in June. In May, De
La Tour changed his mind and told Hochster not to bother to report for duty. Before June, Hochster
secured an appointment as courier to Lord Ashburton, but that job was not to begin until July. Also in
May, Hochster sued De La Tour, who argued that he should not have to pay Hochster because Hochster
had not stood ready and willing to begin work in June, having already agreed to work for Lord Ashburton.
The court ruled for the plaintiff Hochster:
[I]t is surely much more rational, and more for the benefit of both parties, that, after the renunciation of
the agreement by the defendant, the plaintiff should be at liberty to consider himself absolved from any
future performance of it, retaining his right to sue for any damage he has suffered from the breach of it.
Thus, instead of remaining idle and laying out money in preparations which must be useless, he is at
liberty to seek service under another employer, which would go in mitigation of the damages to which he
would otherwise be entitled for a breach of the contract. It seems strange that the defendant, after
renouncing the contract, and absolutely declaring that he will never act under it, should be permitted to
object that faith is given to his assertion, and that an opportunity is not left to him of changing his mind.

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Another type of anticipatory breach consists of any voluntary act by a party that destroys, or seriously
impairs, that party’s ability to perform the promise made to the other side. If a seller of land, having
agreed to sell a lot to one person at a date certain, sells it instead to a third party before that time, there is
an anticipatory breach. If Carpenter announces in May that instead of building Owner’s deck in July, as
agreed, he is going on a trip to Europe, there is an anticipatory breach. In the first instance, there would
be no point to showing up at the lawyer’s office when the date arrives to await the deed, so the law gives a
right to sue when the land is sold to the other person. In the second instance, there would be no point to
waiting until July, when indeed Carpenter does not do the job, so the law gives the right to sue when the
future nonperformance is announced.
These same general rules prevail for contracts for the sale of goods under UCC Section 2-610.
Related to the concept of anticipatory breach is the idea that the obligee has a right to demand reasonable
assurances from the obligor that contractual duties will be performed. If the obligee makes such
ademand for reasonable assurances and no adequate assurances are forthcoming, the obligee may assume
that the obligor will commit an anticipatory breach, and consider it so. That is, after making the contract,
the obligee may come upon the disquieting news that the obligor’s ability to perform is shaky. A change in
financial condition occurs, an unknown claimant to rights in land appears, a labor strike arises, or any of a
number of situations may crop up that will interfere with the carrying out of contractual duties. Under
such circumstances, the obligee has the right to a demand for reasonable assurance that the obligor will
perform as contractually obligated. The general reason for such a rule is given in UCC Section 2-609(1),
which states that a contract “imposes an obligation on each party that the other’s expectation of receiving
due performance will not be impaired.” Moreover, an obligee would be foolish not to make alternative
arrangements, if possible, when it becomes obvious that his original obligor will be unable to perform.
The obligee must have reasonable grounds to believe that the obligor will breach. The fear must be that of
a failure of performance that would amount to a total breach; a minor defect that can be cured and that at
most would give rise to an offset in price for damages will not generally support a demand for assurances.
Under UCC Section 2-609(1), the demand must be in writing, but at common law the demand may be oral
if it is reasonable in view of the circumstances. If the obligor fails within a reasonable time to give

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adequate assurance, the obligee may treat the failure to do so as an anticipatory repudiation, or she may
wait to see if the obligor might change his mind and perform.

KEY TAKEAWAY
Contracts can be discharged by performance: complete performance discharges both sides; material breach
discharges the breaching party, who has a right to claim damages; substantial performance obligates the
promisee to pay something for the benefit conferred but is a breach. A party may demand reasonable
assurances of performance, which, if not forthcoming, may be treated as an anticipatory breach (or
repudiation).

EXERCISES
1.

What types of performance discharge a contractual obligation?

2.

Under the UCC, what is the difference between cancellation and termination of a contract?

3.

What is an anticipatory breach, and under what circumstances can a party claim it?

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Discharge by Conditions
LEARNING OBJECTIVES
1.

Understand the concept of conditions in a contract.

2.

Recognize that conditions can be classified on the basis of how they are created, their effect on the
duty to perform, the essentialness of timely performance, or performance to someone’s satisfaction.

Usually contracts consist of an exchange of promises—a pledge or commitment by each party that
somebody will or will not do something. Andy’s promise to cut Anne’s lawn “over the weekend” in return
for Anne’s promise to pay twenty-five dollars is a commitment to have the lawn mowed by Sunday night
or Monday morning. Andy’s promise “not to tell anyone what I saw you doing Saturday night” in return
for Anne’s promise to pay one hundred dollars is a commitment that an event (the revealing of a secret)
will not occur. These promises are known as independent or absolute or unconditional, because their
performance does not depend on any outside event. Such promises, if contractually binding, create a
present duty to perform (or a duty to perform at the time stated).
However, it is common that the obligation to perform a contract is conditioned (or conditional).
A condition is an event the happening or nonhappening of which gives rise to a duty to perform (or
discharges a duty to perform). Conditions may be express or implied; they may also be precedent,
concurrent, subsequent, or to the satisfaction of a party.

Conditions Classified Based on How They Are Created
Express conditions are stated in words in the contract, orally or written. Andy promises to mow Anne’s
lawn “provided it doesn’t rain.” “Provided it doesn’t rain” is an express condition. If rain comes, there is
no duty to cut the lawn, and Andy’s failure to do so is not a breach of promise. Express conditions are
usually introduced by language such as “provided that,” “if,” “when,” “assuming that,” “as soon as,”
“after,” and the like. Implied conditions are unexpressed but understood to be part of the contract. If Mr.
Olson guarantees Jack’s used car for ninety days, it is implied that his obligation to fix any defects doesn’t
arise until Jack lets him know the car is defective. If Ralph is hired to plumb Betty’s new bathroom, it is
implied that Betty’s duty to pay is conditioned on Ralph’s completion of the job.

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Conditions Classified Based on Their Effect on Duty to Perform
A condition precedent is a term in a contract (express or implied) that requires performance only in the
event something else happens first. Jack will buy a car from Mr. Olson if Jack gets financing. “If Jack gets
financing” is a condition precedent. A concurrent condition arises when the duty to perform the contract
is simultaneous: the promise of a landowner to transfer title to the purchaser and the purchaser to tender
payment to the seller. The duty of each to perform is conditioned on the performance by the other. (As a
practical matter, of course, somebody has to make the first move, proffering deed or tendering the check.)
A condition that terminates an already existing duty of performance is known as a condition subsequent.
Ralph agrees to do preventive plumbing maintenance on Deborah Dairy’s milking equipment for as long
as David Dairy, Deb’s husband, is stationed overseas. When David returns, Ralph’s obligation to do the
maintenance (and Deb’s duty to pay him) terminates.

Condition of Timeliness
If, as often occurs, it does not matter a great deal whether a contract is performed exactly on time, failure
to do so is not a material breach, and the promisee has to accept the performance and deduct any losses
caused by the delay. If, though, it makes a difference to the promisee whether the promisor acts on time,
then it is said that “time is of the essence.” Time as a condition can be made explicit in a clause reciting
that time is of the essence. If there is no express clause, the courts will read it in when the purpose of the
contract was clearly to provide for performance at or by a certain time, and the promisee will gain little
from late performance. But even express clauses are subject to a rule of reason, and if the promisor would
suffer greatly by enforcement of the clause (and the promisee would suffer only slightly or not at all from a
refusal to invoke it), the courts will generally excuse the untimely performance, as long as it was
completed within a reasonable time. A builder’s failure to finish a house by July 1 will not discharge the
buyer’s obligation to pay if the house is finished a week or even a month later, although the builder will be
liable to the buyer for expenses incurred because of the lateness (storage charges for furniture, costs for
housing during the interim, extra travel, and the like).

Condition That a Party Must Be Satisfied

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“You must be satisfied or your money back” is a common advertisement. A party to a contract can require
that he need not pay or otherwise carry out his undertaking unless satisfied by the obligor’s performance,
or unless a third party is satisfied by the performance.
Parties may contract to perform to one side’s personal satisfaction. Andy tells Anne, a prospective client,
that he will cut her hair better than her regular hairdresser, and that if she is not satisfied, she need not
pay him. Andy cuts her hair, but Anne frowns and says, “I don’t like it.” Assume that Andy’s work is
excellent. Whether Anne must pay depends on the standard for judging to be employed—a standard of
objective or subjective satisfaction. The objective standard is that which would satisfy the reasonable
purchaser. Most courts apply this standard when the contract involves the performance of a mechanical
job or the sale of a machine whose performance is capable of objective measurement. So even if the
obligee requires performance to his “personal satisfaction,” the courts will hold that the obligor has
performed if the service performed or the goods produced are in fact satisfactory. By contrast, if the goods
or services contracted for involve personal judgment and taste, the duty to pay will be discharged if the
obligee states personal (subjective) dissatisfaction. No reason at all need be given, but it must be for a
good-faith reason, not just to escape payment.
The duty to make a contract payment may be conditioned on the satisfaction of a third party. Building
contracts frequently make the purchaser’s duty to pay conditional on the builder’s receipt of an architect’s
certificate of compliance with all contractual terms; road construction contracts often require that the
work be done “to the satisfaction of the County Engineer.” These conditions can be onerous. The builder
has already erected the structure and cannot “return” what he has done. Nevertheless, because the
purchaser wants assurance that the building (obviously a major purchase) or road meets his
specifications, the courts will hold the contractor to the condition unless it is impossible to provide a
certificate (e.g., architect may have died) or the architect has acted in bad faith, or the purchaser has
somehow prevented the certificate from issuing. The third party’s refusal to issue a certificate needs to be
reasonable.

KEY TAKEAWAY
Parties may, expressly or implicitly, condition the requirement for contractual performance on the happening
or nonhappening of an event, or on timeliness. They may condition performance on satisfaction to one of the

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parties to the contract or to the satisfaction of a third party; in any event, dissatisfaction must be in good
faith.

EXERCISES
1.

What is “conditioned” by a condition in a contract?

2.

What conditions are based on how they are made?

3.

What conditions are based on their effect on the duty of performance?

4.

What typical situations involve performance to a party’s satisfaction?

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Discharge by Agreement of the Parties
LEARNING OBJECTIVE
1.

Recognize that there are various ways the parties may agree between themselves to terminate mutual
obligations under the contract.

Parties are free to agree to almost any contract they want, and they are free to agree to end the contract
whenever they want. There are several ways this is done.

Mutual Rescission
The parties may agree to give up the duties to perform, called mutual rescission. This may be by a formal
written release saying the obligor is discharged upon delivery of the writing or upon occurrence of a
condition. Or an obligation may be discharged by a contract not to sue about it.
The Restatement terms this an agreement of rescission.

[4]

An agreement to rescind will be given effect

even though partial performance has been made or one or both parties have a claim for partial breach.
The agreement need not be in writing or even expressed in words. By their actions, such as failure to take
steps to perform or enforce, the parties may signal their mutual intent to rescind. Andy starts to mow
Anne’s lawn as they agreed. He begins the job, but it is unbearably hot. She sees how uncomfortable he is
and readily agrees with him when he says, “Why don’t we just forget the whole thing?” Andy’s duty to
finish mowing is discharged, as is Anne’s duty to pay Andy, either for the whole job or for the part he has
done.
Business executives live by contracts, but they do not necessarily die by them. A sociologist who studied
business behavior under contract discovered a generation ago—and it is still valid—that in the great
majority of cases in which one party wishes to “cancel an order,” the other party permits it without
renegotiation, even though the cancellation amounts to a repudiation of a contract. As one lawyer was
quoted as saying,
Often business[people] do not feel they have “a contract”—rather they have an “order.” They speak of
“cancelling the order” rather than “breaching our contract.” When I began practice I referred to order
cancellations as breaches of contract, but my clients objected since they do not think of cancellation as

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wrong. Most clients, in heavy industry at least, believe that there is a right to cancel as part of the buyerseller relationship. There is a widespread attitude that one can back out of any deal within some very
vague limits. Lawyers are often surprised by this attitude.

[5]

This attitude is understandable. People who depend for their economic survival on continuing
relationships will be loath to react to every change in plans with a lawsuit. The legal consequences of most
of these cancellations are an agreement of rescission. Under UCC Section 2-720, the use of a word like
“cancellation” or “rescission” does not by itself amount to a renunciation of the right to sue for breach of a
provision that occurred before the rescission. If the parties mean to discharge each other fully from all
duties owed, they must say so explicitly. Actions continue to speak more loudly than words, however, and
in law, so can inactions. Legal rights under contracts may be lost by both parties if they fail to act; by
abandoning their claims, they can affect rescission.

Waiver
A second means of discharge is by waiver, whereby a party voluntarily gives up a right she has under a
contract but doesn’t give up the entire right to performance by the other side. Tenant is supposed to pay
rent on the first of the month, but because his employer pays on the tenth, Tenant pays Landlady on that
day. If Landlady accepts the late payment without objection, she has waived her right to insist on payment
by the first of the month, unless the lease provides that no waiver occurs from the acceptance of any late
payments. SeeSection 15.2.2 "Waiver of Contract Rights; Nonwaiver Provisions", Minor v. Chase Auto
Finance Corporation. A “waiver” is permission to deviate from the contract; a “release” means to let go of
the whole thing.

Substituted Agreement
Discharge by substituted agreement is a third way of mutual rescission. The parties may enter into
a novation, either a new contract or one whereby a new person is substituted for the original obligor, and
the latter is discharged. If Mr. Olson is obligated to deliver a car to Jack, Jack and Mr. Olson may agree
that Dewey Dealer should deliver the car to Jack instead of Mr. Olson; the latter is discharged by this
novation. A substituted agreement may also simply replace the original one between the original parties.

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Accord and Satisfaction
Discharge by accord and satisfaction is a fourth way of mutual rescission. Here the parties to a contract
(usually a disputed one) agree to substitute some performance different from what was originally agreed,
and once this new agreement is executed, the original contract (as well as the more recent accord) is
satisfied. But before then, the original agreement is only suspended: if the obligor does not satisfy the
accord, the other side can sue on the original obligation or on the accord.

KEY TAKEAWAY
Parties to a contract may agree to give it up. This may be by mutual rescission, release, waiver, novation,
substituted agreement, or accord and satisfaction.

EXERCISES
1.

How does mutual rescission discharge a common-law contract without apparent new consideration?

2.

What is the difference between a substituted agreement and a novation?

3.

What happens if the parties negotiate an accord and satisfaction and one side fails to perform it?

4.

If an obligee accepts performance from the obligor that deviates from the contract, under what
circumstances can the obligee nevertheless insist on strict compliance in the future?

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Discharge When Performance Becomes Impossible or Very Difficult
LEARNING OBJECTIVE
1.

Recognize that there are several circumstances when performance of the contract becomes variously
impossible, very difficult, or useless, and that these may give rise to discharge.

There are at least five circumstances in which parties may be discharged from contractual obligations
because performance is impossible, difficult, or useless.

Overview
Every contract contains some element of risk: the buyer may run out of money before he can pay; the
seller may run out of goods before he can deliver; the cost of raw materials may skyrocket, throwing off
the manufacturer’s fine financial calculations. Should the obligor’s luck run out, he is stuck with the
consequences—or, in the legal phrase, his liability is strict: he must either perform or risk paying damages
for breach of contract, even if his failure is due to events beyond his control. Of course, an obligor can
always limit his liability through the contract itself. Instead of obligating himself to deliver one million
units, he can restrict his obligation to “one million units or factory output, whichever is less.” Instead of
guaranteeing to finish a job by a certain date, he can agree to use his “best efforts” to do so. Similarly,
damages in the event of breach can be limited. A party can even include a clause canceling the contract in
the event of an untoward happening. But if these provisions are absent, the obligor is generally held to the
terms of his bargain.
Exceptions include the concepts of impossibility, impracticability, and frustration of purpose.

Impossibility
If performance is impossible, the duty is discharged. The categories here are death or incapacity of a
personal services contractor, destruction of a thing necessary for performance, and performance
prohibited by government order.

Death or Incapacity of a Personal Services Contractor

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If Buyer makes a contract to purchase a car and dies before delivery, Buyer’s estate could be held liable; it
is not impossible (for the estate) to perform. The estate of a painter hired to do a portrait cannot be sued
for damages because the painter died before she could complete the work.

Destruction or Deterioration of a Thing Necessary for Performance
When a specific object is necessary for the obligor’s performance, its destruction or deterioration making
its use impracticable (or its failure to come into existence) discharges the obligor’s duty. Diane’s Dyers
contracts to buy the annual wool output of the Sheepish Ranch, but the sheep die of an epidemic disease
before they can be shorn. Since the specific thing for which the contract was made has been destroyed,
Sheepish is discharged from its duty to supply Diane’s with wool, and Diane’s has no claim against the
Ranch. However, if the contract had called for a quantity of wool, without specifying that it was to be from
Sheepish’s flock, the duty would not be discharged; since wool is available on the open market, Sheepish
could buy that and resell it to Diane’s.

Performance Prohibited by Government Regulation or Order
When a government promulgates a rule after a contract is made, and the rule either bars performance or
will make it impracticable, the obligor’s duty is discharged. An obligor is not required to break the law and
risk the consequences. Financier Bank contracts to sell World Mortgage Company certain collateralized
loan instruments. The federal government, in a bank reform measure, prohibits such sales. The contract is
discharged. If the Supreme Court later declared the prohibition unconstitutional, World Mortgage’s duty
to buy (or Financier Bank’s to sell) would not revive.

Impracticability
Less entirely undoable than impossibility, but still grounds for discharge, are common-law
impracticability and its relative, commercial impracticability.

Common-Law Impracticability
Impracticability is said to exist when there is a radical departure from the circumstances that the parties
reasonably contemplated would exist at the time they entered into the contract; on such facts, the courts

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might grant relief. They will do so when extraordinary circumstances (often called “acts of God” or “force
majeure”) make it unjust to hold a party liable for performance. Although the justification for judicial
relief could be found in an implied condition in all contracts that extraordinary events shall not occur, the
Restatement eschews so obvious a bootstrap logic and adopts the language of UCC Section 2-615(a),
which states that the crux of the analysis is whether the nonoccurrence of the extraordinary circumstance
was “a basic assumption on which the contract was made.”

[6]

If it was—if, that is, the parties assumed that

the circumstance would not occur—then the duty is discharged if the circumstance later does occur.
In one well-known case, Autry v. Republic Productions, the famous cowboy movie star Gene Autry had a
contract to perform to the defendant. He was drafted into the army in 1942; it was temporarily, at least,
impossible for him to perform his movie contractual obligations incurred prior to his service. When he
was discharged in 1945, he sued to be relieved of the prewar obligations. The court took notice that there
had been a long interruption in Autry’s career and of “the great decrease in the purchasing power of the
dollar”—postwar inflation—and determined that to require him to perform under the old contract’s terms
would work a “substantial hardship” on him. A world war is an extraordinary circumstance. The
temporary impossibility had transformed into impracticability.

[7]

Impracticability refers to the performance, not to the party doing it. Only if the performance is
impracticable is the obligor discharged. The distinction is between “the thing cannot be done” and “I
cannot do it.” The former refers to that which is objectively impracticable, and the latter to that which is
subjectively impracticable. That a duty is subjectively impracticable does not excuse it if the circumstances
that made the duty difficult are not extraordinary. A buyer is liable for the purchase price of a house, and
his inability to raise the money does not excuse him or allow him to escape from a suit for damages when
the seller tenders the deed.

[8]

If Andy promises to transport Anne to the football stadium for ten dollars,

he cannot wriggle out of his agreement because someone smashed into his car (rendering it inoperable) a
half hour before he was due to pick her up. He could rent a car or take her in a taxi, even though that will
cost considerably more than the sum she agreed to pay him. But if the agreement was that he would
transport her in his car, then the circumstances make his performance objectively impracticable—the
equivalent of impossible—and he is excused.

Commercial Impracticability
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[9]

This common-law concept of impracticability has been adopted by the UCC. When performance cannot
be undertaken except with extreme difficulty or at highly unreasonable expense, it might be excused on
the theory ofcommercial impracticability. However, “impracticable” (the action is impossible) is not the
same as “impractical” (the action would yield an insufficient return or would have little practical value).
The courts allow a considerable degree of fluctuation in market prices, inflation, weather, and other
economic and natural conditions before holding that an extraordinary circumstance has occurred. A
manufacturer that based its selling price on last year’s costs for raw materials could not avoid its contracts
by claiming that inflation within the historical range had made it difficult or unprofitable to meet its
commitments. Examples of circumstances that could excuse might be severe limitations of supply due to
war, embargo, or a natural disaster. Thus a shipowner who contracted with a purchaser to carry goods to a
foreign port would be excused if an earthquake destroyed the harbor or if war broke out and the military
authorities threatened to sink all vessels that entered the harbor. But if the shipowner had planned to
steam through a canal that is subsequently closed when a hostile government seizes it, his duty is not
discharged if another route is available, even if the route is longer and consequently more expensive.

Frustration of Purpose
If the parties made a basic assumption, express or implied, that certain circumstances would not arise, but
they do arise, then a party is discharged from performing his duties if his principal purpose in making the
contract has been “substantially frustrated.” This is not a rule of objective impossibility. It operates even
though the parties easily might be able to carry out their contractual duties.
The frustration of purpose doctrine comes into play when circumstances make the value of one party’s
performance virtually worthless to the other. This rule does not permit one party to escape a contract
simply because he will make less money than he had planned or because one potential benefit of the
contract has disappeared. The purpose that is frustrated must be the core of the contract, known and
understood by both parties, and the level of frustration must be severe; that is, the value of the contract to
the party seeking to be discharged must be destroyed or nearly destroyed.
The classic illustration of frustration of purpose is the litigation that gave birth to the rule: the so-called
coronation cases. In 1901, when King Edward VII was due to be crowned following the death of Queen
Victoria, a parade route was announced for the coronation. Scores of people rented rooms in buildings

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that lined the streets of the route to watch the grand spectacle. But the king fell ill, and the procession was
canceled. Many expectant viewers failed to pay, and the building owners took them to court; many lessees
who had paid took the owners to court to seek refunds. The court declared that the lessees were not liable
because the purpose of the contract had been frustrated by the king’s illness.
Supervening government regulations (though here different from illegality), floods that destroy buildings
in which an event was to take place, and business failures may all contribute to frustration of purpose. But
there can be no general rule: the circumstances of each case are determinative. Suppose, for example, that
a manufacturer agrees to supply a crucial circuit board to a computer maker who intends to sell his
machine and software to the government for use in the international space station’s ventilation systems.
After the contract is made but before the circuit boards are delivered, the government decides to scrap
that particular space station module. The computer manufacturer writes the circuit board maker,
canceling the contract. Whether the manufacturer is discharged depends on the commercial prospects for
the computer and the circuit board. If the circuit board can be used only in the particular computer, and it
in turn is only of use on the space station, the duty to take the boards is discharged. But if the computer
can be sold elsewhere, or the circuit boards can be used in other computers that the manufacturer makes,
it is liable for breach of contract, since its principal purpose—selling computers—is not frustrated.
As before, the parties can provide in the contract that the duty is absolute and that no supervening event
shall give rise to discharge by reason of frustration of purpose.

KEY TAKEAWAY
The obligations to perform under a contract cannot be dismissed lightly, but a person’s duty to perform a
contract duty may be discharged if it becomes impossible or very difficult to do it. This includes impossibility,
common-law impracticability, commercial impracticability under the UCC, and frustration of purpose.

EXERCISES
1.

If it is possible to perform a contract, why might a party be excused because of frustration of purpose?

2.

What is the difference between impractical and impracticable?

3.

How would supervening government regulation be different from supervening illegality?

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Other Methods of Discharge
LEARNING OBJECTIVES
1.

Recognize when alteration, power of avoidance, the statute of limitations, and bankruptcy discharge
parties from contracts.

2.

In addition to performance (or lack of it), agreement of the parties, the happening or nonhappening of
conditions, and variations on the theme of impossibility, there are several other ways contract duties
may be discharged.

Cancellation, Destruction, or Surrender
An obligee may unilaterally discharge the obligor’s duty toward him by canceling, destroying, or
surrendering the written document embodying the contract or other evidence of the duty. No
consideration is necessary; in effect, the obligee is making a gift of the right that he possesses. No
particular method of cancellation, destruction, or surrender is necessary, as long as the obligee manifests
his intent that the effect of his act is to discharge the duty. The entire document can be handed over to the
obligor with the words, “Here, you don’t owe me anything.” The obligee can tear the paper into pieces and
tell the obligor that he has done so because he does not want anything more. Or he can mutilate the
signatures or cross out the writing.

Power of Avoidance
A contractual duty can be discharged if the obligor can avoid the contract. As discussed in Chapter 10
"Real Assent", a contract is either void or can be avoided if one of the parties lacked capacity (infancy,
insanity); if there has been duress, undue influence, misrepresentation, or mistake; or the contract is
determined to be unconscionable. Where a party has a power of avoidance and exercises it, that party is
discharged from further obligation.

Statute of Limitations
When an obligor has breached a contract, the obligee has the right to sue in court for a remedy. But that
right does not last forever. Every state has statutes of limitations that establish time periods within which
the suit must be brought (different time periods are spelled out for different types of legal wrongs:

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contract breach, various types of torts, and so on). The time period for contract actions under most
statutes of limitations ranges between two and six years. The UCC has a fouryear statute of limitations.

[10]

The period begins to run from the day on which the suit could have been

filed in court—for example, from the moment of contract breach. An obligee who waits until after the
statute has run—that is, does not seek legal relief within the period prescribed by the statute of
limitations—is barred from going to court thereafter (unless she is under some incapacity like infancy),
but the obligor is not thereby discharged. The effect is simply that the obligee has no legal remedy. If the
parties have a continuing relationship, the obligee might be able to recoup—for example, by applying a
payment for another debt to the one barred by the statute, or by offsetting a debt the obligee owes to the
obligor.

Bankruptcy
Under the federal bankruptcy laws as discussed in Chapter 35 "Bankruptcy", certain obligations are
discharged once a court declares a debtor to be bankrupt. The law spells out the particular types of debts
that are canceled upon bankruptcy.

KEY TAKEAWAY
Contract duties may be discharged by cancellation, destruction, or surrender of the written contract; by the
running of the statute of limitations; or by bankruptcy.

[1] Uniform Commercial Code, Section 2-106(3).
[2] Restatement (Second) of Contracts, Section 237(d).
[3] Hochster v. De La Tour, 2 Ellis & Blackburn 678 (Q.B. 1853).
[4] Restatement (Second) of Contracts, Section 283.
[5] Stewart Macaulay, “Non-contractual Relations in Business: A Preliminary Study,”American Sociological
Review 28, no. 1 (1963): 55, 61.
[6] Restatement (Second) of Contracts, Section 261.
[7] Autry v. Republic Productions, 180 P.2d 144 (Calif. 1947).
[8] Christy v. Pilkinton, 273 S.W.2d 533 (Ark. 1954).
[9] Uniform Commercial Code, Section 2-615.

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[10] Uniform Commercial Code, Section 2-725.

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15.2 Cases
Substantial Performance; Conditions Precedent
TA Operating Corp. v. Solar Applications Engineering, Inc.
191 S.W.3d 173 (Tex. Ct. App. 2005)
TA Operating Corporation, a truck stop travel center company, contracted with Solar Applications
Engineering, Inc. to construct a prototype multi-use truck stop in San Antonio for a fixed price of
$3,543,233.…
[When the project was near] completion, TA sent Solar a “punch list” of items that needed to be finished
to complete the building. Solar disputed several items on the list and delivered a response to TA listing the
items Solar would correct.…Solar began work on the punch list items and filed a lien affidavit [a property
that carries a lien can be forced into sale by the creditor in order to collect what is owed] against the
project on October 2, 2000 in the amount of $472,392.77. TA understood the lien affidavit to be a request
for final payment.
On October 18, 2000, TA sent notice to Solar that Solar was in default for not completing the punch list
items, and for failing to keep the project free of liens. TA stated in the letter that Solar was not entitled to
final payment until it completed the remainder of the punch list items and provided documentation that
liens filed against the project had been paid.…Solar acknowledged at least two items on the punch list had
not been completed, and submitted a final application for payment in the amount of $472,148,77.…TA
refused to make final payment, however, contending that Solar had not complied with section 14.07 of the
contract, which expressly made submission of a [lien-release] affidavit a condition precedent to final
payment:…
The final Application for Payment shall be accompanied by:…complete and legally effective releases or
waivers…of all lien rights arising out of or liens filed in connection with the work.
Although Solar did not comply with this condition precedent to final payment, Solar sued TA for breach of
contract under the theory of substantial performance.…TA [asserts that] the doctrine of substantial

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performance does not excuse Solar’s failure to comply with an express condition precedent to final
payment.…
The first issue we must resolve is whether the doctrine of substantial performance excuses the breach of
an express condition precedent to final payment that is unrelated to completion of the building. TA
acknowledges that Solar substantially performed its work on the project, but contends its duty to pay was
not triggered until Solar pleaded or proved it provided TA with documentation of complete and legally
effective releases or waivers of all liens filed against the project.…TA contends that when the parties have
expressly conditioned final payment on submission of [a liens-release] affidavit, the owner’s duty to pay is
not triggered until the contractor pleads or proves it complied with the condition precedent.
Solar contends that although it did not submit [a liens-release] affidavit in accordance with the contract, it
may still recover under the contract pursuant to the substantial performance doctrine. Solar argues that to
hold otherwise would bring back the common law tradition that the only way for a contractor to recover
under a contract is full, literal performance of the contract’s terms.…
While the common law did at one time require strict compliance with the terms of a contract, this rule has
been modified for building or construction contracts by the doctrine of substantial performance.
“Substantial performance” was defined by the Texas [court] in [Citation]:
To constitute substantial compliance the contractor must have in good faith intended to comply with the
contract, and shall have substantially done so in the sense that the defects are not pervasive, do not
constitute a deviation from the general plan contemplated for the work, and are not so essential that the
object of the parties in making the contract and its purpose cannot without difficulty, be accomplished by
remedying them. Such performance permits only such omissions or deviation from the contract as are
inadvertent and unintentional, are not due to bad faith, do not impair the structure as a whole, and are
remediable without doing material damage to other parts of the building in tearing down and
reconstructing.
…The doctrine of substantial performance recognizes that the contractor has not completed construction,
and therefore is in breach of the contract. Under the doctrine, however, the owner cannot use the
contractor’s failure to complete the work as an excuse for non-payment. “By reason of this rule a

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contractor who has in good faith substantially performed a building contract is permitted to sue under the
contract, substantial performance being regarded as full performance, so far as a condition precedent to a
right to recover thereunder is concerned.” [Citation]…
Solar argues that by agreeing substantial performance occurred, TA acknowledged that Solar was in “full
compliance” with the contract and any express conditions to final payment did not have to be met.
[Citation]: “[a] finding that a contract has been substantially completed is the legal equivalent of full
compliance, less any offsets for remediable defects.” Solar argues that TA may not expressly provide for
substantial performance in its contract and also insist on strict compliance with the conditions precedent
to final payment. We disagree. While the substantial performance doctrine permits contractors to sue
under the contract, it does not ordinarily excuse the non-occurrence of an express condition precedent:
The general acceptance of the doctrine of substantial performance does not mean that the parties may not
expressly contract for literal performance of the contract terms.…Stated otherwise, if the terms of an
agreement make full or strict performance an express condition precedent to recovery, then substantial
performance will not be sufficient to enable recovery under the contract.
15 Williston on Contracts § 44.53 (4th Ed.2000) (citing Restatement (Second) of Contracts, § 237, cmt. d
(1981)).…
TA, seeking protection from double liability and title problems, expressly conditioned final payment on
Solar’s submission of a [liens-release] affidavit. Solar did not dispute that it was contractually obligated to
submit the affidavit as a condition precedent to final payment, and it was undisputed at trial that
$246,627.82 in liens had been filed against the project. Though the doctrine of substantial performance
permitted Solar to sue under the contract, Solar did not plead or prove that it complied with the express
condition precedent to final payment. Had Solar done so, it would have been proper to award Solar the
contract balance minus the cost of remediable defects. While we recognize the harsh results occasioned
from Solar’s failure to perform this express condition precedent, we recognize that parties are free to
contract as they choose and may protect themselves from liability by requesting literal performance of
their conditions for final payment.…

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[T]he trial court erred in awarding Solar the contract balance [as] damages, and we render judgment that
Solar take nothing on its breach of contract claim.

CASE QUESTIONS
1.

Why did Solar believe it was entitled to the contract balance here?

2.

Why did the court determine that Solar should not have been awarded the contract damages that it
claimed, even though it substantially complied?

3.

How has the common law changed in regard to demanding strict compliance with a contract?

Waiver of Contract Rights; Nonwaiver Provisions
Minor v. Chase Auto Finance Corporation
—S.W.3d——, 2010 WL 2006401 (Ark. 2010)
Sheffield, J.
We have been asked to determine whether non-waiver and no-unwritten-modifications clauses in a
[contract] preclude a creditor from waiving future strict compliance with the agreement by accepting late
payments.…
Appellant Mose Minor (Minor) entered into a Simple Interest Motor Vehicle Contract and Security
Agreement with Appellee Chase Auto Finance Corporation (Chase) to finance the purchase of a 2003
Toyota Tundra. By the terms of the agreement, Minor was to make sixty-six payments of $456.99 on the
fourteenth of each month.…The agreement also included the following relevant provisions:
G. Default: If you…default in the performance of any promise you make in this contract or any other
contract you have with us, including, but not limited to, failing to make any payments when due, or
become insolvent, or file any proceeding under the U.S. Bankruptcy Code,…we may at our option and
without notice or demand (1) declare all unpaid sums immediately due and payable subject to any right of
reinstatement as required by law (2) file suit against you for all unpaid sums (3) take immediate
possession of the vehicle (4) exercise any other legal or equitable remedy.…Our remedies are cumulative
and taking of any action shall not be a waiver or prohibit us from pursuing any other remedy. You agree
that upon your default we shall be entitled to recover from you our reasonable collection costs, including,

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but not limited to, any attorney’s fee. In addition, if we repossess the vehicle, you grant to us and our
agents permission to enter upon any premises where the vehicle is located. Any repossession will be
performed peacefully.…
J. Other Agreements of Buyer:…(2) You agree that if we accept moneys in sums less than those due or
make extensions of due dates of payments under this contract, doing so will not be a waiver of any later
right to enforce the contract terms as written.…(12) All of the agreements between us and you are set forth
in this contract and no modification of this contract shall be valid unless it is made in writing and signed
by you and us.…
K. Delay in Enforcement: We can delay or waive enforcement of any of our rights under this contract
without losing them.
Minor’s first payment was late, as were several subsequent payments. At times he failed to make any
payment for months. Chase charged a late fee for each late payment, and sent several letters requesting
payment and offering to assist Minor with his account. Chase also warned Minor that continued failure to
make payments would result in Chase exercising its legal options available under the agreement,
including repossession of the vehicle.…At one point, Minor fell so far behind in his payments that Chase
was on the verge of repossessing the vehicle. However…the parties agreed to a two-month extension of the
agreement.…The extension agreement indicated that all other terms and conditions of the original
contract would remain the same.
On November 2, 2004, Minor filed for Chapter 7 "Introduction to Tort Law"bankruptcy [after which]
Chase sent Minor a letter acknowledging that Minor’s debt to Chase had been discharged in bankruptcy.
The letter further stated that Chase still had a valid lien on the vehicle, and if Minor wished to keep the
vehicle, he would have to continue to make payments to Chase. Otherwise, Chase would repossess the
vehicle.…
On September 28, 2006, a repossession agent…arrived at Minor’s home some time in the afternoon to
repossess the vehicle.…[Notwithstanding Minor’s insistence that the agent stop] the agent removed
Minor’s possessions from the vehicle and towed it away. Chase sold the vehicle. The amount of the
purchase price was reflected on Minor’s account.…

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On January 7, 2008, Minor filed a complaint against Chase [alleging] that, during the course of the
contract, the parties had altered the provisions of the contract regarding Chase’s right to repossess the
vehicle and Chase had waived the right to strictly enforce the repossession clause. Minor further claimed
that the repossession agent committed trespass and repossessed the vehicle forcibly, without Minor’s
permission, and through trickery and deceit, in violation of [state law]. Also, Minor asserted that he was
not in default on his payments, pursuant to the repayment schedule, at the time Chase authorized
repossession. Therefore, according to Minor, Chase committed conversion, and breached the Arkansas
Deceptive Trade Practices Act [Citation], and enhanced by Arkansas Code Annotated section 4-88-202,
because Minor is an elderly person. Minor sought compensatory and punitive damages.…
After hearing these arguments, the circuit court ruled that Minor had presented no evidence that the
conduct of Chase or the repossession agent constituted grounds for punitive damages; that by the express
terms of the contract Chase’s acceptance of late payments did not effect a waiver of its rights in the future;
that at the time of repossession, Minor was behind in his payments and in breach of the contract; that
Chase had the right under the contract to repossess the vehicle and did not commit conversion; and that
there was no evidence to support a claim that Chase had violated the Arkansas Deceptive Trade Practices
Act.…
[W]e affirm our previous decisions that when a contract does not contain a non-waiver and a nounwritten-modification provision and the creditor has established a course of dealing in accepting late
payments from the debtor, the creditor waives its right to insist on strict compliance with the contract and
must give notice to the debtor that it will no longer accept late payments before it can declare default of
the debt. However, we announce today that, if a contract includes non-waiver and no-unwrittenmodification clauses, the creditor, in accepting late payments, does not waive its right under the contract
to declare default of the debt, and need not give notice that it will enforce that right in the event of future
late payments.…
In arriving at this conclusion, we adhere to the principle that “a [contract] is effective according to its
terms between the parties.”…We have long held that non-waiver clauses are legal and
valid. See [Citations] Also, [the Arkansas UCC 2-209(2)] declares that no-unwritten-modification
provisions are binding.

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We acknowledge that there is a difference of opinion amongst the courts in other jurisdictions over the
effect of non-waiver and no-unwritten-modification clauses.…
We concur with the Supreme Court of Indiana’s decision in [Citation], that a rule providing that nonwaiver clauses could themselves be waived by the acceptance of late payments is “illogical, since the very
conduct which the [non-waiver] clause is designed to permit[,] acceptance of late payment[,] is turned
around to constitute waiver of the clause permitting the conduct.” We also agree that the approach of
jurisdictions that require creditors who have accepted late payments in the past to notify debtors that they
expect strict compliance in the future, despite the existence of a non-waiver provision in the contract, is
not “sound.” Such a rule, we recognize, “begs the question of validity of the non-waiver clause.” Finally,
our holding is in line with the Indiana Supreme Court’s ruling that it would enforce the provisions of the
contract, since the parties had agreed to them, and that it would not require the creditor to give notice,
because the non-waiver clause placed the [creditor] in the same position as one who had never accepted a
late payment. [Citations]…
Certified question answered; remanded to court of appeals.

CASE QUESTIONS
1.

What is a nonwaiver clause?

2.

Why did Mose think his late payments were not grounds for repossession of his truck?

3.

Why would a creditor accept late payments instead of immediately repossessing the collateral?

4.

Why did Mose lose?

Impossibility as a Defense
Parker v. Arthur Murray, Inc.
295 N.E.2d 487 (Ill. Ct. App. 1973)
Stamos, J.
The operative facts are not in dispute. In November, 1959 plaintiff went to the Arthur Murray Studio in
Oak Park to redeem a certificate entitling him to three free dancing lessons. At that time he was a 37 yearold college-educated bachelor who lived alone in a one-room attic apartment in Berwyn, Illinois. During

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the free lessons the instructor told plaintiff he had ‘exceptional potential to be a fine and accomplished
dancer’ and generally encouraged further participation. Plaintiff thereupon signed a contract for 75 hours
of lessons at a cost of $1000. At the bottom of the contract were the bold-type words, ‘NONCANCELABLE, NEGOTIABLE CONTRACT.’ This initial encounter set the pattern for the future
relationship between the parties. Plaintiff attended lessons regularly. He was praised and encouraged
regularly by the instructors, despite his lack of progress. Contract extensions and new contracts for
additional instructional hours were executed. Each written extension contained the bold-type words,
‘NON-CANCELABLE CONTRACT,’ and each written contract contained the bold-type words, ‘NONCANCELABLE NEGOTIABLE CONTRACT.’ Some of the agreements also contained the bold-type
statement, ‘I UNDERSTAND THAT NO REFUNDS WILL BE MADE UNDER THE TERMS OF THIS
CONTRACT.’
On September 24, 1961 plaintiff was severely injured in an automobile collision, rendering him incapable
of continuing his dancing lessons. At that time he had contracted for a total of 2734 hours of lessons, for
which he had paid $24,812.80 [about $176,000 in 2010 dollars]. Despite written demand defendants
refused to return any of the money, and this suit in equity ensued. At the close of plaintiff’s case the trial
judge dismissed the fraud count (Count II), describing the instructors’ sales techniques as merely ‘a
matter of pumping salesmanship.’ At the close of all the evidence a decree was entered under Count I in
favor of plaintiff for all prepaid sums, plus interest, but minus stipulated sums attributable to completed
lessons.
Plaintiff was granted rescission on the ground of impossibility of performance. The applicable legal
doctrine is expressed in the Restatement of Contracts, s 459, as follows:
A duty that requires for its performance action that can be rendered only by the promisor or some other
particular person is discharged by his death or by such illness as makes the necessary action by him
impossible or seriously injurious to his health, unless the contract indicates a contrary intention or there
is contributing fault on the part of the person subject to the duty.…
Defendants do not deny that the doctrine of impossibility of performance is generally applicable to the
case at bar. Rather they assert that certain contract provisions bring this case within the Restatement’s

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limitation that the doctrine is inapplicable if ‘the contract indicates a contrary intention.’ It is contended
that such bold type phrases as ‘NON-CANCELABLE CONTRACT,’ ‘NON-CANCELABLE NEGOTIABLE
CONTRACT’ and ‘I UNDERSTAND THAT NO REFUNDS WILL BE MADE UNDER THE TERMS OF
THIS CONTRACT’ manifested the parties’ mutual intent to waive their respective rights to invoke the
doctrine of impossibility. This is a construction which we find unacceptable. Courts engage in the
construction and interpretation of contracts with the sole aim of determining the intention of the parties.
We need rely on no construction aids to conclude that plaintiff never contemplated that by signing a
contract with such terms as ‘NON-CANCELABLE’ and ‘NO REFUNDS’ he was waiving a remedy expressly
recognized by Illinois courts. Were we also to refer to established tenets of contractual construction, this
conclusion would be equally compelled. An ambiguous contract will be construed most strongly against
the party who drafted it. [Citation] Exceptions or reservations in a contract will, in case of doubt or
ambiguity, be construed least favorably to the party claiming the benefit of the exceptions or reservations.
Although neither party to a contract should be relieved from performance on the ground that good
business judgment was lacking, a court will not place upon language a ridiculous construction. We
conclude that plaintiff did not waive his right to assert the doctrine of impossibility.
Plaintiff’s Count II, which alleged fraud and sought punitive damages, was dismissed by the trial judge at
the close of plaintiff’s case. It is contended on appeal that representations to plaintiff that he had
‘exceptional potential to be a fine and accomplished dancer,’ that he had ‘exceptional potential’ and that
he was a ‘natural born dancer’ and a ‘terrific dancer’ fraudulently induced plaintiff to enter into the
contracts for dance lessons.
Generally, a mere expression of opinion will not support an action for fraud. [Citation] In addition,
misrepresentations, in order to constitute actionable fraud, must pertain to present or pre-existing facts,
rather than to future or contingent events, expectations or probabilities. [Citation] Whether particular
language constitutes speculation, opinion or averment of fact depends upon all the attending facts and
circumstances of the case. [Citation] Mindful of these rules, and after carefully considering the
representations made to plaintiff, and taking into account the business relationship of the parties as well
as the educational background of plaintiff, we conclude that the instructors’ representations did not
constitute fraud. The trial court correctly dismissed Count II. We affirm.

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Affirmed.

CASE QUESTIONS
1.

Why is it relevant that the plaintiff was “a bachelor who lived alone in a one-room attic apartment”?

2.

The contract here contained a “no cancellation” clause; how did the court construe the contract to allow
cancellation?

3.

Plaintiff lost on his claim of fraud (unlike Mrs. Vokes in the similar case inChapter 10 "Real Assent" against
another franchisee of Arthur Murray, Inc.). What defense was successful?

4.

What is the controlling rule of law here?

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15.3 Summary and Exercises
Summary
The law of contracts has various rules to determine whether obligations have been discharged. Of course,
if both parties have fully performed the contract, duties will have terminated. But many duties are subject
to conditions, including conditions precedent and subsequent, conditions requiring approval of the
promisee or someone else, and clauses that recite time to be of the essence.
A contract obligation may be discharged if the promisor has not received the benefit of the promisee’s
obligation. In some cases, failure to carry out the duty completely will discharge the corresponding
obligation (material breach); in other cases, the substantial performance doctrine will require the other
party to act.
A contract may have terminated because one of the parties tells the other in advance that he will not carry
out his obligations; this is called anticipatory breach. The right to adequate assurance allows one party to
determine whether the contract will be breached by the other party.
There are other events, too, that may excuse performance: impracticability (including the UCC rules
governing impracticability in contracts for the sale of goods), death or incapacity of the obligor,
destruction of the thing necessary for the performance, government prohibition, frustration of purpose,
and power of avoidance.
Finally, note that not all obligations are created by contract, and the law has rules to deal with discharge
of duties in general. Thus, in the appropriate cases, the obligee may cancel or surrender a written contract,
may enter into an accord, may agree to rescind the agreement, or may release the obligor. Or the obligor
may show a material alteration in the contract, may become bankrupt, or may plead the statute of
limitations—that is, plead that the obligee waited too long to sue. Or the parties may, by word or deed,
mutually abandon the agreement. In all these ways, duties may be discharged.

EXERCISES

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1.

Theresa hired Contractor to construct a large office building. Theresa’s duty to pay Contractor was
conditioned on receipt of a statement from her architect that the building complied with the terms of the
contract. Contractor completed the building but used the wrong color fixtures in the bathrooms. The
architect refused to approve the work, but under state law, Contractor was considered to have
substantially performed the contract. Is he entitled to payment, less damages for the improper fixtures?
Explain.

2.

In early 1987, Larry McLanahan submitted a claim to Farmers Insurance for theft of his 1985 Lamborghini
while it was on consignment for sale in the Los Angeles area. The car had sustained extensive damage,
which McLanahan had his mechanic document. The insurance policy contained this language: “Allow us to
inspect and appraise the damaged vehicle before its repair or disposal.” But after considerable delay by
Farmers, McLanahan sold the car to a cash buyer without notifying Farmers. He then sued Farmers for its
refusal to pay for damages to his car. Upon what legal theory did Farmers get a summary judgment in its
favor?

3.

Plaintiff sold a tavern to Defendants. Several months later, Defendants began to experience severe
problems with the septic tank system. They informed Plaintiff of the problem and demanded the return
of their purchase money. Plaintiff refused. Defendants took no formal action against Plaintiff at that time,
and they continued to operate the tavern and make their monthly payments under the contract. Some
months later, Defendants met with state officials from the Departments of Environmental Quality, Health,
and Liquor Control Commission. The officials warned Defendants that because of the health hazards
posed by the septic tank problems, Defendants’ licenses might not be renewed. As a result, Defendants
decided to close the tavern and attempt to reopen when the septic tank was repaired. Defendants
advertised a going-out-of-business sale. The purpose of the sale was to deplete the tavern’s inventory
before closing. Plaintiff learned about the sale and discovered that Defendants had removed certain
personal property from the tavern. He sued the Defendants, claiming, among other things, that they had
anticipatorily breached their contract with him, though he was receiving payments on time. Did the
Defendants’ actions amount to an anticipatory breach?

4.

[1]

Julius, a manufacturer of neckties, contracted to supply neckties to a wholesaler. When Julius’s factory
burned, he failed to supply any, and the wholesaler sued. Is Julius excused from performance by
impossibility?

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5.

The Plaintiff (a development corporation) contracted to buy Defendant’s property for $1.8 million. A term
in the contract read: “The sale…shall be closed at the office of Community Title Company on May 16th at
10:00 am.…Time is of the essence in this contract.” Defendant appeared at the office at 10:00 a.m. on the
day designated, but the Plaintiff’s agent was not there. Defendant waited for twenty minutes, then left.
Plaintiff’s agent arrived at 10:30 a.m. and announced that he would not have funds for payment until 1:30
p.m., but Defendant refused to return; she had already made other arrangements to finance her purchase
of other real estate. Plaintiff sued Defendant for specific performance. Who wins, and why?

6.

A contract between the Koles and Parker-Yale provided for completion of the Koles’s condominium unit
within 180 days. It also authorized the Koles to make written changes in the plans and specifications.
Construction was not completed within the 180-day period, and the Koles, prior to completion, sent a
letter to Parker-Yale rescinding the contract. Were the Koles within their rights to rescind the contract?

7.

Plaintiff contracted to buy Defendant’s commercial property for $1,265,000. Under the terms of the
agreement, Defendant paid $126,000 as an earnest-money deposit, which would be retained by Plaintiff
as liquidated damages if Defendant failed to close by the deadline. Tragically, Defendant’s husband died
four days before the closing deadline, and she was not able to close by the deadline. She was relying on
her husband’s business to assist her in obtaining the necessary financing to complete the purchase, and
after his death, she was not able to obtain it. Plaintiff sued for the $126,000; Defendant argued that the
purpose of the contract was frustrated due to the untimely death of her husband. Is this a good
argument?

8.

Buyer contracted to buy Seller’s house for $290,000; the contract included a representation by Buyer
“that he has sufficient cash available to complete this purchase.” Buyer was a physician who practiced
with his uncle. He had received assurances from his uncle of a loan of $200,000 in order to finance the
purchase. Shortly after the contract was executed, the uncle was examined by a cardiologist, who found
his coronary arteries to be dangerously clogged. As a result, the uncle immediately had triple bypass
surgery. After the operation, he told Buyer that his economic future was now uncertain and that
therefore it was impossible for him to finance the house purchase. Meanwhile, Seller, who did not know
of Buyer’s problem, committed herself to buy a house in another state and accepted employment there
as well. Buyer was unable to close; Seller sued. Buyer raised as a defense impossibility or impracticability
of performance. Is the defense good?

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9.

Pursuant to a contract for the repair and renovation of a swimming pool owned by Defendant (City of Fort
Lauderdale), Plaintiff commenced the work, which included resurfacing the inside of the pool, and had
progressed almost to completion. Overnight, vandals damaged the work Plaintiff had done inside the
pool, requiring that part of the work be redone. Plaintiff proceeded to redo the work and billed
Defendant, who paid the contract price but refused to pay for the additional work required to repair the
damage. Did the damage constitute destruction of subject matter discharging Plaintiff from his obligation
to complete the job without getting paid extra?

10. Apache Plaza (the landlord) leased space to Midwest Savings to construct a bank building in Apache’s
shopping mall, based on a prototype approved by Apache. Midwest constructed the building and used it
for twelve years until it was destroyed by a tornado. Midwest submitted plans for a new building to
Apache, but Apache rejected the plans because the new building was larger and had less glass than the
old building or the prototype. Midwest built it anyway. Its architect claimed that certain changes in the
structure of the new building were required by new regulations and building codes, but he admitted that
a building of the stipulated size could have been constructed in compliance with the applicable codes.
Apache claimed $210,000 in damages over the term of the lease because the new building consumed
more square feet of mall space and required more parking. Midwest claimed it had substantially complied
[2]

with the lease requirements. Is this a good defense?

SELF-TEST QUESTIONS
1.

A condition precedent

a.

is a condition that terminates a duty

b.

is always within the control of one of the parties

c.

is an event giving rise to performance

d.

is a condition that follows performance
If Al and Betty have an executory contract, and if Betty tells Al that she will not be fulfilling her
side of the bargain,

a.

Al must wait until the date of performance to see if Betty in fact performs

b.

Al can sue immediately for full contract damages

c.

Al can never sue because the contract was executory when Betty notified him of
nonperformance

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d.

none of the above
Jack contracts with Anne to drive her to the airport Wednesday afternoon in his specially
designed stretch limousine. On Wednesday morning Jack’s limousine is hit by a drunken driver,
and Jack is unable to drive Anne. This is an example of

a.

impossibility of performance

b.

frustration of purpose

c.

discharge by merger

d.

none of the above
Jack is ready and willing to drive Anne to the airport. But Anne’s flight is cancelled, and she
refuses to pay. This is an example of

a.

impracticability of performance

b.

frustration of purpose

c.

discharge of merger

d.

none of the above
Rescission is

a.

the discharge of one party to a contract through substitution of a third person

b.

an agreement to settle for substitute performance

c.

a mutual agreement between parties to a contract to discharge each other’s contractual duties

d.

none of the above

SELF-TEST ANSWERS
1.

c

2.

b

3.

a

4.

b

5.

c

[1] Crum v. Grant, 692 P.2d 147 (Or. App., 1984).
[2] Apache Plaza, Ltd. v. Midwest Sav. Ass’n, 456 N.W.2d 729 (Minn. App. 1990).

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Chapter 16

Remedies
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

The basic theory of contract remedies, and why courts don’t just order the promisor to perform as
promised

2.

The interests that are protected by contract remedies

3.

The types of legal remedies

4.

The types of equitable remedies

5.

The limitations on remedies

We come at last to the question of remedies. A valid agreement has been made, the promisor’s duties
have not been discharged; he or she has breached the contract. When one party has failed to
perform, what are the rights of the parties? Or when the contract has been avoided because of
incapacity or misrepresentation and the like, what are the rights of the parties after disaffirmance?
These questions form the focus of this chapter.

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16.1 Theory of Contract Remedies
LEARNING OBJECTIVES
1.

Understand the basic purpose of remedies.

2.

Recognize that there are two general categories of remedies: legal and equitable.

3.

See that courts do not simply order obligors to keep their promise but instead allow them to breach
and the nonbreaching party to have remedies for that breach.

Purpose of Remedies
The fundamental purpose of remedies in noncriminal cases is not to punish the breaching party but—if
possible—to put the nonbreaching party in the position he or she would have been in had there been no
breach. Or, as is said, the purpose is to make the nonbreaching party whole.
There are two general categories of remedies—legal and equitable. In the category of legal remedies
are damages. Damages are money paid by one party to another; there are several types of damages. In the
category of equitable remedies are these three: specific performance, which means a person is ordered to
deliver a unique thing (land or a unique personal property, such as a painting or an antique
car); injunction, a judicial order directing a person to stop doing what he or she should not do (such as
competing with a former employer in violation of a noncompete agreement); and restitution, which
means putting the parties back into the position they were in before the contract was made.

Parties Have the Power—but Not the Right—to Breach
In view of the importance given to the intention of the parties in forming and interpreting contracts, it
may seem surprising that the remedy for every breach is not a judicial order that the obligor carry out his
or her undertakings. But it is not. Of course, some duties cannot be performed after a breach, because
time and circumstances will have altered their purpose and rendered many worthless. Still, there are
numerous occasions on which it would be theoretically possible for courts to order the parties to carry out
their contracts, yet the courts will not do it. In 1897, Justice Oliver Wendell Holmes Jr. declared in a
famous line that “the duty to keep a contract at common law means a prediction that you must pay
damages if you do not keep it.” By that, he meant simply that the common law looks more toward

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compensating the promisee for his or her loss than toward compelling the promisor to perform. Indeed,
the law of remedies often provides the parties with an incentive to break the contract. In short, the
promisor has a choice: perform or pay.
The logic of this position is clear in many typical cases. The computer manufacturer orders specially
designed circuit boards, then discovers before the circuits are made that a competitor has built a better
machine and destroyed his market. The manufacturer cancels the order. It would make little economic
sense for the circuit board maker to fabricate the boards if they could not be used elsewhere. A damage
remedy to compensate the maker for out-of-pocket loss or lost profits is sensible; a judicial decree forcing
the computer manufacturer to pay for and take delivery of the boards would be wasteful.
In general and if possible, the fundamental purpose of contract remedies is to put the nonbreaching party
in the position it would have been in had there been no breach.

KEY TAKEAWAY
Remedies are intended to make the nonbreaching party whole. The two categories of remedies for breach of
contract are legal and equitable. In the legal category are damages; in the equitable category are specific
performance, injunctions, and restitution. The law does not force a party to perform; he or she always has the
power (though not the right) to breach, and may do so if it is economically more advantageous to breach and
suffer the consequence than to perform. Remedies, though, are not (usually) intended to punish the
breaching party.

EXERCISES
1.

Remedies are not supposed to punish the breaching party, generally. In what circumstances might
punishment be a remedy, and what is that called?

2.

What is the difference between legal and equitable remedies?

3.

Why shouldn’t people be forced to perform as they contracted, instead of giving them the power to
breach and then be required to pay damages?

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16.2 Promisee’s Interests Protected by Contract
LEARNING OBJECTIVE
1.

Understand that the nonbreaching party to a contract has certain expectations that contract remedies
seek to fulfill to make the nonbreaching party whole.

Contract remedies serve to protect three different interests: an expectation interest, a reliance
interest, and a restitution interest. A promisee will have one of these and may have two or all three.
An expectation interest is the benefit for which the promisee bargained, and the remedy is to put him
in a position as good as that which he would have been in had the contract been performed.
A reliance interest is the loss suffered by relying on the contract and taking actions consistent with the
expectation that the other party will abide by it; the remedy is reimbursement that restores the
promisee to his position before the contract was made. A restitution interestis that which restores to
the promisee any benefit he conferred on the promisor. These interests do not dictate the outcome
according to a rigid formula; circumstances and the nature of the contract, as usual, will play a large
role. But in general, specific performance is a remedy that addresses the expectation interest,
monetary damages address all three interests, and, not surprisingly, restitution addresses the
restitution interest.
Consider some simple examples. A landowner repudiates an executory contract with a builder to
construct a garage on her property for $100,000. The builder had anticipated a $10,000 profit (the
garage would have cost him $90,000 to build). What can he expect to recover in a lawsuit against the
owner? The court will not order the garage to be built; such an order would be wasteful, since the
owner no longer wants it and may not be able to pay for it. Instead, the court will look to the builder’s
three possible interests. Since the builder has not yet started his work, he has given the owner
nothing, and therefore has no restitution interest. Nor has he any reliance interest, since we are
assuming that he has not paid out any money for supplies, hired a work crew, or advanced money to
subcontractors. But he anticipated a profit, and so he has an expectation interest of $10,000.
Now suppose that the builder had dug out the foundation and poured concrete, at a cost of $15,000.
His expectation interest has become $25,000 (the difference between $100,000 and $75,000, the

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money he will save by not having to finish the job). His reliance interest is $15,000, because this is
the amount he has already spent. He may also have a restitution interest, depending on how much
the foundation of the house is worth to the owner. (The value could be more or less than the sum of
money actually expended to produce the foundation; for example, the builder might have had to pay
his subcontractors for a greater share of the job than they had completed, and those sums therefore
would not be reflected in the worth of the foundation.)
Normally, the promisee will choose which of the three interests to pursue. As is to be expected, the
choice hinges on the circumstances of the case, his feelings, and the amount at stake.

KEY TAKEAWAY
A nonbreaching party might have one or more interests that the law seeks to realize: expectation, reliance,
and restitution.

EXERCISES
1.

What is the expectation interest? The reliance interest? The restitution interest?

2.

How are these concepts useful in understanding contract remedies?

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16.3 Legal Remedies: Damages
LEARNING OBJECTIVES
1.

Understand what is meant when it is said that damages are a legal remedy (as opposed to an
equitable remedy).

2.

Understand the names and purposes of the six types of remedies.

3.

Know when liquidated damages will be allowed.

4.

Recognize the circumstances that might allow punitive damages.

Overview
The promisee, whom we will hereafter refer to as the nonbreaching party, has the right to damages (a
money award), if that is required to make her whole, whenever the other party has breached the contract,
unless, of course, the contract itself or other circumstances suspend or discharge that right.
Damages refers to money paid by one side to the other; it is a legal remedy. For historical and political
reasons in the development of the English legal system, the courts of law were originally only able to grant
monetary relief. If a petitioner wanted something other than money, recourse to a separate system of
equity was required. The courtrooms and proceedings for each were separate. That actual separation is
long gone, but the distinction is still recognized; a judge may be said to be “sitting in law” or “sitting in
equity,” or a case may involve requests for both money and some action. We take up the legal remedies of
damages first.

Types of Damages
There are six different types of damages: compensatory, incidental, consequential, nominal, liquidated,
and (sometimes) punitive.

Compensatory Damages
Damages paid to directly compensate the nonbreaching party for the value of what was not done or
performed are compensatory damages. Sometimes calculating that value of the promisor’s performance is
easy—for example, when the nonbreaching party has ascertainable costs and profits, as in the case of the
builder who would have earned $10,000 profit on a $100,000 house. When the performance is a service,

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a useful measure of loss is what it would cost to substitute performance by someone else. But the
calculation is frequently difficult, especially when the performance is a service that is not easily
duplicated. If Rembrandt breached a contract to paint your portrait, the loss could not be measured
simply by inquiring how much Van Gogh would charge to do the same thing. Nevertheless, in theory,
whatever net value would ultimately have been conferred on the nonbreaching party is the proper
measure of compensatory damages. An author whose publisher breaches its contract to publish the book
and who cannot find another publisher is entitled to lost royalties (if ascertainable) plus the value that
would have accrued from her enhanced reputation.
Since the nonbreaching party usually has obligations under the contract also, a breach by the other party
discharges his duty to perform and may result in savings. Or he may have made substitute arrangements
and realized at least a partial profit on the substitution. Or, as in the case of the builder, he may have
purchased goods intended for the job that can be used elsewhere. In all these situations, the losses he has
avoided—savings, profits, or value of goods—are subtracted from the losses incurred to arrive at the net
damages. The nonbreaching party may recover his actual losses, not more. Suppose an employer breaches
a contract with a prospective employee who was to begin work for a year at a salary of $35,000. The
employee quickly finds other, similar work at a salary of $30,000. Aside from whatever he might have had
to spend searching for the job (incidental damages), his compensatory damages are limited to $5,000, the
difference between what he would have earned and what he is earning.
Lost volume can be a troublesome problem in calculating damages. This problem arises when the
nonbreaching party, a supplier of goods or services, enters a second contract when the buyer repudiates.
The question is whether the second contract is a substituted performance or an additional one. If it is
substituted, damages may be little or nothing; if additional, the entire expectation interest may be
recovered. An automobile dealer contracts to sell a car in his inventory. Shortly before the deal is closed,
the buyer calls up and repudiates the contract. The dealer then sells the car to someone else. If the dealer
can show that he could have sold an identical car to the second purchaser regardless of what the first
purchaser did, then the second sale stands on its own and cannot be used to offset the net profit
recoverable from the first purchaser. The factual inquiry in lost volume cases is whether the nonbreaching
party would have engaged in the second transaction if the breach had never occurred.

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Incidental Damages
In addition to compensatory damages, the nonbreaching party may recoverincidental damages. Incidental
loss includes expenditures that the nonbreaching party incurs in attempting to minimize the loss that
flows from the breach. To arrange for substitute goods or services, the nonbreaching party might have to
pay a premium or special fees to locate another supplier or source of work.

Consequential Damages
A consequential loss is addressed with consequential damages. These are damages incurred by the
nonbreaching party without action on his part because of the breach. For example, if Ralph does a poor
job of plumbing Betty’s bathroom and the toilet leaks, damaging the floor, the downstairs ceiling, and the
downstairs rug, Ralph would owe for those loses in consequential damages. Or, again, lost sales stemming
from a failure to fix a manufacturer’s machine in time or physical and property injury due to a defective
machine sold by the promisor would be addressed with consequential damages. Note, however, that one
obvious, and often large, expenditure occasioned by a breach—namely, legal expenses in bringing a
lawsuit to remedy the particular breach—is not an element of damages, unless the contract explicitly
states that it is, and cannot be charged to the defendant. There is one situation, however, in which legal
costs can be added to damages: when the breach causes the nonbreaching party to be involved in a lawsuit
with someone else. Consequential damages will not be allowed if those damages are not foreseeable. This
issue is taken up in Section 16.5 "Limitations on Contract Remedies".

Nominal Damages
In the situation where there has been a breach but the nonbreaching party has really suffered no loss or
cannot prove what his loss is, he is entitled tonominal damages. Ricardo contracts to buy a new car from a
dealer; the dealer breaches the contract. Ricardo finds and buys the same car from another dealer at the
same price that the first one was to sell it for. Ricardo has suffered nominal damages: five dollars,
perhaps.

Liquidated Damages

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Precisely because damages are sometimes difficult to assess, the parties themselves may specify how
much should be paid in the event of a breach. Courts will enforce a liquidated damages provision as long
as the actual amount of damages is difficult to ascertain (in which case proof of it is simply made at trial)
and the sum is reasonable in light of the expected or actual harm. If the liquidated sum is unreasonably
large, the excess is termed a penalty and is said to be against public policy and unenforceable. Section
16.6.2 "Liquidated Damages", Watson v. Ingram, illustrates liquidated damages.

Punitive Damages
Punitive damages are those awarded for the purpose of punishing a defendant in a civil action, in which
criminal sanctions are of course unavailable. They are proper in cases in which the defendant has acted
willfully and maliciously and are thought to deter others from acting similarly. Since the purpose of
contract law is compensation, not punishment, punitive damages have not traditionally been awarded,
with one exception—when the breach of contract is also a tort for which punitive damages may be
recovered. Punitive damages are permitted in the law of torts (in all but four states) when the behavior is
malicious or willful (reckless conduct causing physical harm, deliberate defamation of one’s character, a
knowingly unlawful taking of someone’s property), and some kinds of contract breach are also tortious.
For example, when a creditor holding collateral as security under a contract for a loan sells the collateral
to a good-faith purchaser for value even though the debtor was not in default, he has breached the
contract and committed the tort of conversion; punitive damages may be awarded, assuming the behavior
was willful and not merely mistaken.
Punitive damages are not fixed by law. The judge or jury may award at its discretion whatever sum is
believed necessary to redress the wrong or deter like conduct in the future. This means that a richer
person may be slapped with much heavier punitive damages than a poorer one in the appropriate case.
But the judge in all cases may remit (reduce) some or all of a punitive damage award if he or she considers
it excessive.

KEY TAKEAWAY
As the purpose of contract remedies is, in general, to make the nonbreaching party whole, the law allows
several types of damages (money paid) to reflect the losses suffered by the nonbreaching party.
Compensatory damages compensate for the special loss suffered; consequential damages compensate for the

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foreseeable consequences of the breach; incidental damages compensate for the costs of keeping any more
damages from occurring; nominal damages are awarded if the actual amount cannot be shown or there are
no actual damages; liquidated damages are agreed to in advance where the actual amount is difficult to
ascertain, and they are allowed if not a penalty; and punitive damages may sometimes be allowed if the
breaching party’s behavior is an egregious tort, an outrage.

EXERCISES
1.

What is the difference between a legal remedy and an equitable remedy?

2.

What types of remedies are there, and what purpose does each serve?

3.

What must be shown if liquidated damages are to be allowed?

4.

Under what circumstances may punitive damages be allowed?

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16.4 Equitable Remedies
LEARNING OBJECTIVES
1.

Know when equitable (as opposed to legal) remedies will be allowed.

2.

Understand the different types of equitable remedies: specific performance, injunction, and
restitution.

Overview
Really the only explanation for the differences between law and equity is to be found in the history and
politics of England dating to the twelfth century, but in practical terms, the distinctions are notable. First,
juries are not used in equitable cases. Second, equity relies less on precedent and more on the sense that
justice should be served. Third, and of most significance, where what is sought by the nonbreaching party
is not money—that is, where there is no adequate legal remedy—equity may afford relief. In equity a
person may get a judge to order the breaching party to deliver some actual property, or to stop doing
something that he should not do, or to return the consideration the nonbreaching party gave so as to
return the parties to the precontract status (specific performance, injunction, and restitution,
respectively).

Types of Remedies in Equity
There are three types of equitable remedies: specific performance, injunction, and restitution.

Specific Performance
Specific performance is a judicial order to the promisor that he undertake the performance to which
he obligated himself in a contract. Specific performance is an alternative remedy to damages and may be
issued at the discretion of the court, subject to a number of exceptions. Emily signs a contract to sell
Charlotte a gold samovar, a Russian antique of great sentimental value because it once belonged to
Charlotte’s mother. Emily then repudiates the contract while still executory. A court may properly grant
Charlotte an order of specific performance against Emily.

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Once students understand the basic idea of specific performance, they often want to pounce upon it as the
solution to almost any breach of contract. It seems reasonable that the nonbreaching party could ask a
court to simply require the promisor to do what she promised she would. But specific performance is a
very limited remedy: it is only available for breach of contract to sell a unique item, that is, a unique item
of personal property (the samovar), or a parcel of real estate (all real estate is unique). But if the item is
not unique, so that the nonbreaching party can go out and buy another one, then the legal remedy of
money damages will solve the problem. And specific performance will never be used to force a person to
perform services against his will, which would be involuntary servitude. A person may be forced to stop
doing that which he should not do (injunction), but not forced to do what he will not do.

Injunction
An injunction is the second type of equitable remedy available in contract (it is also available in tort). It
is a court order directing a person to stop doing that which she should not do. For example, if an employer
has a valid noncompete contract with an employee, and the employee, in breach of that contract,
nevertheless undertakes to compete with his former employer, a court may enjoin (issue an order of
injunction), directing the former employee to stop such competition. A promise by a person not to do
something—in this example, not to compete—is called a negative covenant (a covenant is a promise in a
contract, itself a contract). Or if Seller promises to give Buyer the right of first refusal on a parcel of real
estate or a unique work of art, but Seller, in breach of a written promise, offers the thing to a third party, a
court may enjoin Seller from selling it to the third party. If a person violates an injunction, he may be held
in contempt of court and put in jail for a while. Madison Square Garden v. Carnera Corporation, Section
16.6.3 "Injunctions and Negative Covenants", is a classic case involving injunctions for breach of contract.

Restitution
The third type of equitable relief is restitution. Restitution is a remedy applicable to several different
types of cases: those in which the contract was avoided because of incapacity or misrepresentation, those
in which the other party breached, and those in which the party seeking restitution breached. As the word
implies, restitution is a restoring to one party of what he gave to the other. Therefore, only to the extent
that the injured party conferred a benefit on the other party may the injured party be awarded restitution.

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The point is, a person who breaches a contract should not suffer a punishment, and the nonbreaching
party should not be unjustly enriched.

Total Nonperformance by Breaching Party
The nonbreaching party is always entitled to restitution in the event of total breach by nonperformance or
repudiation, unless both parties have performed all duties except for payment by the other party of a
definite sum of money for the injured party’s performance.

[1]

Calhoun, a contractor, agrees to build

$3,000 worth of fences for only $2,000 and completes the construction. Arlene, the landowner, refuses to
pay. Calhoun’s only right is to get the $2,000; he does not have a restitution right to $2,500, the market
price of his services (or $3,000, the amount by which her property increased in value); he is entitled,
instead, only to $2,000, his contract price. Had Arlene repudiated prior to completion, however, Calhoun
would then have been entitled to restitution based either on the market price of the work or on the
amount by which he enhanced her property. If the one party breaches, the nonbreaching party is generally
entitled to restitution of property that can be returned. Arlene gives Calhoun a valuable Ming vase in
return for his promise to construct the fences. Upon Calhoun’s breach, Arlene is entitled to specific
restitution of the vase.
Measuring restitution interest can be problematic. The courts have considerable discretion to award
either what it would have cost to hire someone else to do the work that the nonbreaching party performed
(generally, the market price of the service) or the value that was added to the property of the party in
breach by virtue of the claimant’s performance. Calhoun, the contractor, agrees to construct ten fences
around Arlene’s acreage at the market price of $25,000. After erecting three, Calhoun has performed
services that would cost $7,500, market value. Assume that he has increased the value of Arlene’s grounds
by $8,000. If Arlene repudiated, there are two measures of Calhoun’s restitution interest: $8,000, the
value by which the property was enhanced, or $7,500, the amount it would have cost Arlene to hire
someone else to do the work. Which measure to use depends on who repudiated the contract and for what
reason. In some cases, the enhancement of property or wealth measurement could lead to an award vastly
exceeding the market price for the service. In such cases, the smaller measure is used. For a doctor
performing lifesaving operations on a patient, restitution would recover only the market value of the
doctor’s services—not the monetary value of the patient’s life.

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Part Performance and Then Breach
A party who has substantially performed and then breached is entitled to restitution of a benefit conferred
on the injured party, if the injured party has refused (even though justifiably) to complete his own
performance owing to the other’s breach. Since the party in breach is liable to the injured party for
damages for loss, this rule comes into play only when the benefit conferred is greater than the amount the
nonbreaching party has lost. Arlene agrees to sell her property to Calhoun for $120,000, and Calhoun
makes a partial payment of $30,000. He then repudiates. Arlene turns around and sells the property to a
third party for $110,000. Calhoun—the breaching party—can get his money back, less the damages Arlene
suffered as a result of his breach. He gets $30,000 minus the $10,000 loss Arlene incurred. He gets
$20,000 in restitution. Otherwise Arlene would be enriched by Calhoun’s breach: she’d get $140,000 in
total for real estate worth $120,000. But if he gets $20,000 of his $30,000 back, she receives $110,000
from the third party and $10,000 from Calhoun, so she gets $120,000 total (plus, we hope, incidental
damages, at least).

Restitution in Other Cases
Upon repudiation of an oral contract governed by the Statute of Frauds, the nonbreaching party is not
entitled to her expectation interest, but she may recover in restitution unless the purpose of the statute
would be frustrated. When one party avoids a contract owing to lack of capacity, mistake,
misrepresentation, duress, or the like, she is entitled to restitution for benefit conferred on the other
party. Restitution is also available if a contract duty is discharged or never arises because (1) performance
was impracticable, (2) the purpose of the contract was frustrated, (3) a condition did not occur, or (4) a
beneficiary disclaimed his benefit.

KEY TAKEAWAY
Equitable remedies for breach of contract are available when legal remedies won’t make the nonbreaching
party whole. The equitable remedies are specific performance (an order directing a person to deliver to the
buyer the unique thing the seller contracted to sell), injunction (an order directing a person to stop doing that
which he should not do), and restitution (the return by one party of the benefit conferred on him when the
contract is not performed, to the extent necessary to avoid imposing a penalty on the breaching party).

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EXERCISES
1.

Buyer contracts to buy a 1941 four-door Cadillac convertible from Seller for $75,000. Seller, having found
a Third Party who will pay $85,000 for the car, refuses to sell to Buyer. What is Buyer’s remedy?

2.

Assume Third Party had paid the $85,000 and Seller was ordered to sell to Buyer. What is Third Party’s
remedy?

3.

Professor Smith contracts to teach business law at State University for the academic year. After the first
term is over, she quits. Can State University get an order of specific performance or an injunction
requiring Professor Smith to return for the second term?

4.

Now suppose that the reason Professor Smith quit work at State University is because she got a better job
at Central University, fifteen miles away. Can State University get an injunction prohibiting her from
teaching at Central University?

[1] Restatement (Second) of Contracts, Section 373.

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16.5 Limitations on Contract Remedies
LEARNING OBJECTIVES
1.

Understand that there are various rules that limit recovery for the nonbreaching party in a contract
case.

2.

Know how these concepts serve to limit contract remedies: foreseeability, mitigation of damages,
certainty of damages, loss of power of avoidance, election of remedies, and agreement of the parties.

Overview
We have observed that the purpose of remedies in contract law is, where possible, to put the nonbreaching
party in as good a position as he would have been in had there been no breach. There are, however,
several limitations or restrictions affecting when a person can claim remedies, in both law (damages) and
equity. Of course the contract itself may—if not unconscionable—limit remedies. Beyond that, the
nonbreaching party must be able to articulate with some degree of certainty what her damages are; the
damages must be foreseeable; the nonbreaching party must have made a reasonable effort to mitigate the
damages; she must sometime elect to go with one remedy and forgo another; she cannot seek to avoid a
contract if she has lost the power to do so. We turn to these points.

Foreseeability
If the damages that flow from a breach of contract lack foreseeability, they will not be recoverable.
Failures to act, like acts themselves, have consequences. As the old fable has it, “For want of a nail, the
kingdom was lost.” To put a nonbreaching party in the position he would have been in had the contract
been carried out could mean, in some cases, providing compensation for a long chain of events. In many
cases, that would be unjust, because a person who does not anticipate a particular event when making a
contract will not normally take steps to protect himself (either through limiting language in the contract
or through insurance). The law is not so rigid; a loss is not compensable to the nonbreaching party unless
the breaching party, at the time the contract was made, understood the loss was foreseeable as a probable
result of his breach.

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Of course, the loss of the contractual benefit in the event of breach is always foreseeable. A company that
signs an employment contract with a prospective employee knows full well that if it breaches, the
employee will have a legitimate claim to lost salary. But it might have no reason to know that the
employee’s holding the job for a certain length of time was a condition of his grandfather’s gift of $1
million.
The leading case, perhaps the most studied case, in all the common law is Hadley v. Baxendale, decided
in England in 1854. Joseph and Jonah Hadley were proprietors of a flour mill in Gloucester. In May 1853,
the shaft of the milling engine broke, stopping all milling. An employee went to Pickford and Company, a
common carrier, and asked that the shaft be sent as quickly as possible to a Greenwich foundry that would
use the shaft as a model to construct a new one. The carrier’s agent promised delivery within two days.
But through an error, the shaft was shipped by canal rather than by rail and did not arrive in Greenwich
for seven days. The Hadleys sued Joseph Baxendale, managing director of Pickford, for the profits they
lost because of the delay. In ordering a new trial, the Court of Exchequer ruled that Baxendale was not
liable because he had had no notice that the mill was stopped:
Where two parties have made a contract which one of them has broken, the damages which the other
party ought to receive in respect of such breach of contract should be such as may fairly and reasonably be
considered either arising naturally, i.e., according to the usual course of things, from such breach of
contract itself, or such as may reasonably be supposed to have been in the contemplation of both parties,
at the time they made the contract, as the probable result of the breach of it.

[1]

Thus when the party in breach has not known and has had no reason to know that the contract entailed a
special risk of loss, the burden must fall on the nonbreaching party. As we have seen, damages
attributable to losses that flow from events that do not occur in the ordinary course of events are known as
consequential or special damages. The exact amount of a loss need not be foreseeable; it is the nature of
the event that distinguishes between claims for ordinary or consequential damages. A repair shop agrees
to fix a machine that it knows is intended to be resold. Because it delays, the sale is lost. The repair shop,
knowing why timeliness of performance was important, is liable for the lost profit, as long as it was
reasonable. It would not be liable for an extraordinary profit that the seller could have made because of
circumstances peculiar to the particular sale unless they were disclosed.

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The special circumstances need not be recited in the contract. It is enough for the party in breach to have
actual knowledge of the loss that would occur through his breach. Moreover, the parol evidence rule
(Chapter 13 "Form and Meaning") does not bar introduction of evidence bearing on the party’s knowledge
before the contract was signed. So the lesson to a promisee is that the reason for the terms he bargains for
should be explained to the promisor—although too much explanation could kill a contract. A messenger
who is paid five dollars to deliver a letter across town is not likely to undertake the mission if he is told in
advance that his failure for any reason to deliver the letter will cost the sender $1 million, liability to be
placed on the messenger.
Actual knowledge is not the only criterion, because the standard of foreseeability is objective, not
subjective. That means that if the party had reason to know—if a reasonable person would have
understood—that a particular loss was probable should he breach, then he is liable for damages. What one
has reason to know obviously depends on the circumstances of the case, the parties’ prior dealings, and
industry custom. A supplier selling to a middleman should know that the commodity will be resold and
that delay or default may reduce profits, whereas delay in sale to an end user might not. If it was
foreseeable that the breach might cause the nonbreaching party to be sued, the other party is liable for
legal fees and a resulting judgment or the cost of a settlement.
Even though the breaching party may have knowledge, the courts will not always award full consequential
damages. In the interests of fairness, they may impose limitations if such an award would be manifestly
unfair. Such cases usually crop up when the parties have dealt informally and there is a considerable
disproportion between the loss caused and the benefit the nonbreaching party had agreed to confer on the
party who breached. The messenger may know that a huge sum of money rides on his prompt delivery of a
letter across town, but unless he explicitly contracted to bear liability for failure to deliver, it is unlikely
that the courts would force him to ante up $1 million when his fee for the service was only five dollars.
EBWS, LLC v. Britly Corp., Section 16.6.1 "Consequential Damages", is a case that represents a modern
application of the rule of Hadley v. Baxendale on the issue of foreseeability of consequential damages.

Mitigation of Damages

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Contract law encourages the nonbreaching party to avoid loss wherever possible; this is
called mitigation of damages. The concept is a limitation on damages in law. So there can be no recovery if
the nonbreaching party had an opportunity to avoid or limit losses and failed to take advantage of it. Such
an opportunity exists as long as it does not impose, in the Restatement’s words, an “undue risk, burden or
humiliation.”

[2]

The effort to mitigate need not be successful. As long as the nonbreaching party makes a

reasonable, good-faith attempt to mitigate his losses, damages are recoverable.
Mitigation crops up in many circumstances. Thus a nonbreaching party who continues to perform after
notice that the promisor has breached or will breach may not recover for expenses incurred in continuing
to perform. And losses from the use of defective goods delivered in breach of contract are not
compensable if the nonbreaching party knew before use that they were defective. Often the nonbreaching
party can make substitute arrangements—find a new job or a new employee, buy substitute goods or sell
them to another buyer—and his failure to do so will limit the amount of damages he will recover from the
party who breaches. Under the general rule, failure to mitigate when possible permits the promisor to
deduct from damages the amount of the loss that the nonbreaching party could have avoided. When there
is a readily ascertainable market price for goods, damages are equal to the difference between the contract
price and the market price.
A substitute transaction is not just any possible arrangement; it must be suitable under the circumstances.
Factors to be considered include the similarity, time, and place of performance, and whether the
difference between the contracted-for and substitute performances can be measured and compensated. A
prospective employee who cannot find substitute work within her field need not mitigate by taking a job
in a wholly different one. An advertising salesperson whose employment is repudiated need not mitigate
by taking a job as a taxi driver. When the only difference between the original and the substitute
performances is price, the nonbreaching party must mitigate, even if the substitute performer is the
original promisor.
The nonbreaching party must mitigate in timely fashion, but each case is different. If it is clear that the
promisor has unconditionally repudiated before performance is due, the nonbreaching party must begin
to mitigate as soon as practicable and should not wait until the day performance is due to look for an
alternative.

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As long as the nonbreaching party makes a reasonable effort to mitigate, the success of that effort is not an
issue in assessing damages. If a film producer’s original cameraman breaches the contract, and if the
producer had diligently searched for a substitute cameraman, who cost $150 extra per week and it later
came to light that the producer could have hired a cameraman for $100, the company is entitled
nevertheless to damages based on the higher figure. Shirley MacLaine v. Twentieth Century-Fox
Corporation, Section 16.6.4 "Limitation on Damages: Mitigation of Damages", is a well-known case
involving mitigation of damages.

Certainty of Damages
A party can recover only that amount of damage in law which can be proved with reasonable certainty.
Especially troublesome in this regard are lost profits and loss of goodwill. Alf is convinced that next spring
the American public will be receptive to polka-dotted belts with his name monogrammed in front. He
arranges for a garment factory to produce 300,000 such belts, but the factory, which takes a large deposit
from him in advance, misplaces the order and does not produce the belts in time for the selling season.
When Alf discovers the failure, he cannot raise more money to go elsewhere, and his project fails. He
cannot recover damages for lost profits because the number is entirely speculative; no one can prove how
much he would have made, if anything. He can, instead, seek restitution of the monies advanced. If he had
rented a warehouse to store the belts, he would also be able to recover his reliance interest.
Proof of lost profits is not always difficult: a seller can generally demonstrate the profit he would have
made on the sale to the buyer who has breached. The problem is more difficult, as Alf’s case demonstrates,
when it is the seller who has breached. A buyer who contracts for but does not receive raw materials,
supplies, and inventory cannot show definitively how much he would have netted from the use he planned
to make of them. But he is permitted to prove how much money he has made in the past under similar
circumstances, and he may proffer financial and market data, surveys, and expert testimony to support
his claim. When proof of profits is difficult or impossible, the courts may grant a nonmonetary award,
such as specific performance.

Loss of Power of Avoidance

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You will recall that there are several circumstances when a person may avoid a contract: duress, undue
influence, misrepresentation (fraudulent, negligent, or innocent), or mistake. But a party may lose the
right to avoid, and thus the right to any remedy, in several ways.

Delay
If a party is the victim of fraud, she must act promptly to rescind at common law, or she will lose the right
and her remedy will be limited to damages in tort. (This is discussed a bit more in Section 16.5.7 "Election
of Remedies".)

Affirmation
An infant who waits too long to disaffirm (again, delay) will have ratified the contract, as will one who—
notwithstanding being the victim of duress, undue influence, mistake, or any other grounds for
avoidance—continues to operate under the contract with full knowledge of his right to avoid. Of course the
disability that gave rise to the power of avoidance must have passed before affirmation works.

Rights of Third Parties
The intervening rights of third parties may terminate the power to avoid. For example, Michelle, a minor,
sells her watch to Betty Buyer. Up to and within a reasonable time after reaching majority, Michelle could
avoid—disaffirm—the contract. But if, before that time, Betty sells the watch to a third party, Michelle
cannot get it back from the third party. Similarly, Salvador Seller sells his car to Bill Buyer, who pays for it
with a bad check. If the check bounces, Salvador can rescind the deal—Bill’s consideration (the money
represented by the check) has failed: Salvador could return the check and get his car back. But if, before
the check from Bill bounces, Bill in turn sells the car to Pat Purchaser, Salvador cannot avoid the contract.
Pat gets to keep the car. There are some exceptions to this rule.

Agreement of the Parties Limiting Remedies
Certainly it is the general rule that parties are free to enter into any kind of a contract they want, so long as
it is not illegal or unconscionable. The inclusion into the contract of a liquidated damages clause—
mentioned previously—is one means by which the parties may make an agreement affecting damages. But

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beyond that, as we saw in Chapter 12 "Legality", it is very common for one side to limit its liability, or for
one side to agree that it will pursue only limited remedies against the other in case of breach. Such agreeto limitations on the availability of remedies are generally OK provided they are conspicuous, bargainedfor, and not unconscionable. In consumer transactions, courts are more likely to find a contracted-for
limitation of remedies unconscionable than in commercial transactions, and under the Uniform
Commercial Code (UCC) there are further restrictions on contractual remedy limitations.
For example, Juan buys ten bags of concrete to make a counter and stand for his expensive new barbecue.
The bags have this wording in big print: “Attention. Our sole liability in case this product is defective will
be to provide you with a like quantity of nondefective material. We will not be liable for any other
damages, direct or indirect, express or implied.” That’s fine. If the concrete is defective, the concrete top
breaks, and Juan’s new barbecue is damaged, he will get nothing but some new bags of good concrete. He
could have shopped around to find somebody who would deliver concrete with no limitation on liability.
As it is, his remedies are limited by the agreement he entered into.

Election of Remedies
At Common Law
Another limitation on remedies—at common law—is the concept ofelection of remedies. The nature of a
loss resulting from a contract breach may be such as to entitle one party to a choice among two or more
means to redress the grievance, where the choices are mutually exclusive.
At classic common law, a person who was defrauded had an election of remedies: she could, immediately
upon discovering the fraud, rescind, or she could retain the item (real estate or personal property) and
attempt to remedy the fraudulently defective performance by suing for damages, but not both. Buyer
purchases real estate from Seller for $300,000 and shortly discovers that Seller fraudulently
misrepresented the availability of water. Buyer spends $60,000 trying to drill wells. Finally he gives up
and sues Seller for fraud, seeking $360,000. Traditionally at common law, he would not get it. He should
have rescinded upon discovery of the fraud. Now he can only get $60,000 in damages in tort.

[3]

The

purpose of the election of remedies doctrine is to prevent the victim of fraud from getting a double
recovery, but it has come under increasing criticism. Here is one court’s observation: “A host of

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commentators support elimination of the election of remedies doctrine. A common theme is that the
doctrine substitutes labels and formalism for inquiry into whether double recovery results in fact. The
rigid doctrine goes to the other extreme, actually resulting in the under compensation of fraud victims and
the protection of undeserving wrongdoers.”

[4]

Under the UCC
The doctrine of election of remedy has been rejected by the UCC, which means that the remedies are
cumulative in nature. According to Section 2-703(1): “Whether the pursuit of one remedy bars another
depends entirely on the facts of the individual case.” UCC, Section 2-721, provides that neither demand for
rescission of the contract in the case of misrepresentation or fraud, nor the return or rejection of goods,
bars a claim for damages or any other remedy permitted under the UCC for nonfraudulent breach.

Tort versus Contract
Frequently a contract breach may also amount to tortious conduct. A physician warrants her treatment as
perfectly safe but performs the operation negligently, scarring the patient for life. The patient could sue
for malpractice (tort) or for breach of warranty (contract). The choice involves at least four
considerations:
1.

Statute of limitations. Most statutes of limitations prescribe longer periods for contract than for tort
actions.

2. Allowable damages. Punitive damages are more often permitted in tort actions, and certain kinds of
injuries are compensable in tort but not in contract suits—for example, pain and suffering.
3. Expert testimony. In most cases, the use of experts would be the same in either tort or contract suits,
but in certain contract cases, the expert witness could be dispensed with, as, for example, in a contract
case charging that the physician abandoned the patient.
4. Insurance coverage. Most policies do not cover intentional torts, so a contract theory that avoids the
element of willfulness would provide the plaintiff with a surer chance of recovering money damages.

Legal versus Extralegal Remedies

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A party entitled to a legal remedy is not required to pursue it. Lawsuits are disruptive not merely to the
individuals involved in the particular dispute but also to the ongoing relationships that may have grown
up around the parties, especially if they are corporations or other business enterprises. Buyers must
usually continue to rely on their suppliers, and sellers on their buyers. Not surprisingly, therefore, many
businesspeople refuse to file suits even though they could, preferring to settle their disputes privately or
even to ignore claims that they might easily press. Indeed, the decision whether or not to sue is not one for
the lawyer but for the client, who must analyze a number of pros and cons, many of them not legal ones at
all.

KEY TAKEAWAY
There are several limitations on the right of an aggrieved party to get contract remedies for a breach besides
any limitations fairly agreed to by the parties. The damages suffered by the nonbreaching party must be
reasonably foreseeable. The nonbreaching party must make a reasonable effort to mitigate damages, or the
amount awarded will be reduced by the damages that could have been avoided. The party seeking damages
must be able to explain within reason how much loss he has suffered as a result of the breach. If he cannot
articulate with any degree of certainty—if the damages are really speculative—he will be entitled to nominal
damages and that’s all. There are circumstances in which a party who could have got out of a contractual
obligation—avoided it—loses the power to do so, and her remedy of avoidance is lost. Not infrequently, a
person will enter into a contract for services or goods that contains a limitation on her right to damages in
case the other side breaches. That’s all right unless the limitation is unconscionable. Sometimes parties are
required to make an election of remedies: to choose among two or more possible bases of recovery. If the
remedies are really mutually exclusive and one is chosen, the aggrieved party loses the right to pursue the
others. And of course a person is always free not to pursue any remedy at all for breach of contract; that may
be strategically or economically smart in some circumstances.

EXERCISES
1.

When one party to a contract breaches, what duty, if any, is then imposed on the other party?

2.

A chef who has never owned her own restaurant sues a contractor who failed to finish building the chef’s
first restaurant on time. She presents evidence of the profits made by similar restaurants that have been
in business for some time. Is this good evidence of the damages she has suffered by the delay? To what
damages is she entitled?

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3.

Rebecca, seventeen years and ten months old, buys a party dress for $300. She wears it to the junior
prom but determines it doesn’t look good on her. She puts it in her closet and forgets about it until six
months later, when she decides to return it to the store. Is she now entitled to the remedy of rescission?

4.

What is the difference between rescission and restitution?

5.

Why are parties sometimes required to make an election of remedies?

[1] Hadley v. Baxendale (1854), 9 Ex. 341, 354, 156 Eng.Rep. 145, 151.
[2] Restatement (Second) of Contracts, Section 350.
[3] Merritt v. Craig, 746 A.2d 923 (Md. 2000).
[4] Head & Seemann, Inc. v. Gregg, 311 N.W.2d 667 (Wis. App. 1981).

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16.6 Cases
Consequential Damages
EBWS, LLC v. Britly Corp.
928 A.2d 497 (Vt. 2007)
Reiber, C.J.
The Ransom family owns Rock Bottom Farm in Strafford, Vermont, where Earl Ransom owns a dairy
herd and operates an organic dairy farm. In 2000, the Ransoms decided to build a creamery on-site to
process their milk and formed EBWS, LLC to operate the dairy-processing plant and to market the plant’s
products. In July 2000, Earl Ransom, on behalf of EBWS, met with Britly’s president to discuss building
the creamery.…In January 2001, EBWS and Britly entered into a contract requiring Britly to construct a
creamery building for EBWS in exchange for $160,318.…The creamery was substantially completed by
April 15, 2001, and EBWS moved in soon afterward. On June 5, 2001, EBWS notified Britly of alleged
defects in construction. [EBWS continued to use the creamery pending the necessity to vacate it for three
weeks when repairs were commenced].
On September 12, 2001, EBWS filed suit against Britly for damages resulting from defective design and
construction.…
Following a three-day trial, the jury found Britly had breached the contract and its express warranty, and
awarded EBWS: (1) $38,020 in direct damages, and (2) $35,711 in consequential damages.…
…The jury’s award to EBWS included compensation for both direct and consequential damages that
EBWS claimed it would incur while the facility closed for repairs. Direct damages [i.e., compensatory
damages] are for “losses that naturally and usually flow from the breach itself,” and it is not necessary that
the parties actually considered these damages. [Citation]. In comparison, special or consequential
damages “must pass the tests of causation, certainty and foreseeability, and, in addition, be reasonably
supposed to have been in the contemplation of both parties at the time they made the contract.”

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…The court ruled that EBWS could not recover for lost profits because it was not a going concern at the
time the contract was entered into, and profits were too speculative. The court concluded, however, that
EBWS could submit evidence of other business losses, including future payment for unused milk and staff
wages.…
At trial, Huyffer, the CEO of EBWS, testified that during a repairs closure the creamery would be required
to purchase milk from adjacent Rock Bottom Farm, even though it could not process this milk. She
admitted that such a requirement was self-imposed as there was no written output contract between
EBWS and the farm to buy milk. In addition, Huyffer testified that EBWS would pay its employees during
the closure even though EBWS has no written contract to pay its employees when they are not working.
The trial court allowed these elements of damages to be submitted to the jury, and the jury awarded
EBWS consequential damages for unused milk and staff wages.
On appeal, Britly contends that because there is no contractual or legal obligation for EBWS to purchase
milk or pay its employees, these are not foreseeable damages. EBWS counters that it is common
knowledge that cows continue to produce milk, even if the processing plant is not working, and thus it is
foreseeable that this loss would occur. We conclude that these damages are not the foreseeable result of
Britly’s breach of the construction contract and reverse the award.…
[W]e conclude that…it is not reasonable to expect Britly to foresee that its failure to perform under the
contract would result in this type of damages. While we are sympathetic to EBWS’s contention that the
cows continue to produce milk, even when the plant is closed down, this fact alone is not enough to
demonstrate that buying and dumping milk is a foreseeable result of Britly’s breach of the construction
contract. Here, the milk was produced by a separate and distinct entity, Rock Bottom Farm, which sold
the milk to EBWS.…
Similarly, EBWS maintained no employment agreements with its employees obligating it to pay wages
during periods of closure for repairs, dips in market demand, or for any other reason. Any losses EBWS
might suffer in the future because it chooses to pay its employees during a plant closure for repairs would
be a voluntary expense and not in Britly’s contemplation at the time it entered the construction contract.
It is not reasonable to expect Britly to foresee losses incurred as a result of agreements that are informal in

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nature and carry no legal obligation on EBWS to perform. “[P]arties are not presumed to know the
condition of each other’s affairs nor to take into account contracts with a third party that is not
communicated.” [Citation] While it is true that EBWS may have business reasons to pay its employees
even without a contractual obligation, for example, to ensure employee loyalty, no evidence was
introduced at trial by EBWS to support a sound rationale for such considerations. Under these
circumstances, this business decision is beyond the scope of what Britly could have reasonably foreseen as
damages for its breach of contract.…
In addition, the actual costs of the wages and milk are uncertain.…[T]he the milk and wages here are
future expenses, for which no legal obligation was assumed by EBWS, and which are separate from the
terms of the parties’ contract. We note that at the time of the construction contract EBWS had not yet
begun to operate as a creamery and had no history of buying milk or paying employees. See [Citation]
(explaining that profits for a new business are uncertain and speculative and not recoverable). Thus, both
the cost of the milk and the number and amount of wages of future employees that EBWS might pay in
the event of a plant closure for repairs are uncertain.
Award for consequential damages is reversed.…

CASE QUESTIONS
1.

Why, according to EBWS’s CEO, would EBWS be required to purchase milk from adjacent Rock Bottom
Farm, even though it could not process this milk?

2.

Surely it is well known in Vermont dairy country that dairy farmers can’t simply stop milking cows when
no processing plant is available to take the milk—the cows will soon stop producing. Why was EBWS then
not entitled to those damages which it will certainly suffer when the creamery is down for repairs?

3.

Britly (the contractor) must have known EBWS had employees that would be idled when the creamery
shut down for repairs. Why was it not liable for their lost wages?

4.

What could EBWS have done at the time of contracting to protect itself against the damages it would
incur in the event the creamery suffered downtime due to faulty construction?

Liquidated Damages
Watson v. Ingram

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881 P.2d 247 (Wash. 1994)
Johnson, J.
…In the summer of 1990, Wayne Watson offered to buy James Ingram’s Bellingham home for $355,000,
with a $15,000 [about $24,000 in 2010 dollars] earnest money deposit.…
Under the agreement, the entire amount of the purchase price was due in cash on or before December 3,
1990.…The agreement required Watson to pay a $15,000 earnest money deposit into escrow at Kelstrup
Realty, and provided that “[i]n the event of default by Buyer, earnest money shall be forfeited to Seller as
liquidated damages, unless Seller elects to seek actual damages or specific performance. Lastly, the
agreement contained a provision entitled “BUYER’S REPRESENTATIONS,” which stated, “Buyer
represents that buyer has sufficient funds available to close this sale in accordance with this agreement,
and is not relying on any contingent source of funds unless otherwise set forth in this agreement”.…
On November 10, 1990, Watson sent a written proposal to Ingram seeking to modify the original
agreement. The proposed modification would have allowed Watson to defer paying $54,000 of the
$355,000 sale price for between 6 and 12 months after the scheduled December closing date. In exchange,
Ingram would receive a second lien position on certain real estate Watson owned.
According to Ingram, the November 10 proposal was the first time he realized Watson did not have
financing readily available for the purchase of the house. Ingram notified Watson on November 12, 1990,
that he would not agree to modify the original agreement and intended to strictly enforce its terms.
Ingram was involved in a child custody suit in California and wanted to move to that state as soon as
possible.…[Further efforts by Ingram to sell to third parties and by Watson to get an extension from
Ingram failed.]
In September 1991, Ingram finally sold the house to a third party for $355,000, the same price that
Watson had agreed to pay in December 1990.
Ingram and Watson each sought to recover Watson’s $15,000 earnest money held in escrow. On
December 4, 1990, Ingram wrote to Kelstrup Realty, indicating he was entitled to the $15,000 earnest

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money in escrow because Watson had defaulted. In January 1991, Watson filed this action to recover the
earnest money, alleging it amounted to a penalty and Ingram had suffered no actual damages.…
The trial court found the earnest money “was clearly intended by both parties to be non-refundable” if
Watson defaulted and determined $15,000 was “a reasonable forecast by [Ingram and Watson] of
damages that would be incurred by [Ingram] if [Watson] failed to complete the purchase”. The court
entered judgment in favor of Ingram for the amount of the earnest money plus interest. The court also
awarded Ingram his attorney fees pursuant to the parties’ agreement. The Court of Appeals, Division One,
affirmed. Watson now appeals to this court.
This case presents a single issue for review: whether the parties’ contract provision requiring Watson to
forfeit a $15,000 nonrefundable earnest money deposit is enforceable as liquidated damages. Liquidated
damages clauses are favored in Washington, and courts will uphold them if the sums involved do not
amount to a penalty or are otherwise unlawful. [Citation] To determine whether liquidated damages
clauses are enforceable, Washington courts have applied a 2-part test from the Restatement of
Contracts.…Liquidated damages clauses are upheld if the following two factors are satisfied:
First, the amount fixed must be a reasonable forecast of just compensation for the harm that is caused by
the breach. Second, the harm must be such that it is incapable or very difficult of ascertainment.
The question before this court is whether this test is to be applied as of the time of contract formation
(prospectively) or as of the time of trial (retrospectively). We have previously held, the “[r]easonableness
of the forecast will be judged as of the time the contract was entered”. [Citations]
In contrast, a prior Division One opinion relied upon by Petitioner held the reasonableness of the estimate
of damages and the difficulty of ascertainment of harm should be measured as of the time of trial, and
earnest money agreements should not be enforceable as liquidated damages if the nonbreaching party
does not suffer actual damage. [Citations]
We…adopt the date of contract formation as the proper timeframe for evaluating the Restatement test.
The prospective approach concentrates on whether the liquidated sum represents a reasonable prediction

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of the harm to the seller if the buyer breaches the agreement, and ignores actual damages except as
evidence of the reasonableness of the estimate of potential damage.
We believe this approach better fulfills the underlying purposes of liquidated damages clauses and gives
greater weight to the parties’ expectations. Liquidated damages permit parties to allocate business and
litigation risks. Even if the estimates of damages are not exact, parties can allocate and quantify those
risks and can negotiate adjustments to the contract price in light of the allocated risks. Under the
prospective approach, courts will enforce the parties’ allocation of risk so long as the forecasts appear
reasonable when made. [Citations]
In addition to permitting parties to allocate risks, liquidated damages provisions lend certainty to the
parties’ agreements and permit parties to resolve disputes efficiently in the event of a breach. Rather than
litigating the amount of actual damages, the nonbreaching party must only establish the reasonableness of
the agreement. The prospective approach permits parties to rely on their stipulated amounts without
having to precisely establish damages at trial. In contrast, if the reasonableness of the amount is judged
retrospectively, against the damage actually suffered, the “parties must fully litigate (at great expense and
delay) that which they sought not to litigate.” [Citation].
Petitioner argues the prospective approach treats buyers unfairly because it permits sellers to retain
earnest money deposits even when the seller suffers no actual damage, and this violates the principle that
contract damages should be compensatory only. He further contends that by evaluating parties’ liquidated
damages agreements against actual damages established at trial, courts can most effectively determine
whether such agreements were reasonable and fair.
We disagree. As this court has previously explained, “[w]e are loath to interfere with the rights of parties
to contract as they please between themselves [Citations] It is not the role of the court to enforce contracts
so as to produce the most equitable result. The parties themselves know best what motivations and
considerations influenced their bargaining, and, while, “[t]he bargain may be an unfortunate one for the
delinquent party,…it is not the duty of courts of common law to relieve parties from the consequences of
their own improvidence…” [Citations]

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The retrospective approach fails to give proper weight to the parties’ negotiations. At the time of contract
formation, unpredictable market fluctuations and variations in possible breaches make it nearly
impossible for contracting parties to predict “precisely or within a narrow range the amount of damages
that would flow from breach.” [Citations]. However, against this backdrop of uncertainty, the negotiated
liquidated damages sum represents the parties’ best estimate of the value of the breach and permits the
parties to allocate and incorporate these risks in their negotiations. Under the prospective approach, a
court will uphold the parties’ agreed upon liquidated sum so long as the amount represents a reasonable
attempt to compensate the nonbreaching party. On the other hand, if the reasonableness of a liquidated
damages provision is evaluated under a retrospective approach, the parties cannot confidently rely on
their agreement because the liquidated sum will not be enforced if, at trial, it is not a close approximation
of the damage suffered or if no actual damages are proved.…
Having adopted the date of contract formation as the proper timeframe for evaluating the Restatement
test, the Restatement’s second requirement loses independent significance. The central inquiry is whether
the specified liquidated damages were reasonable at the time of contract formation.…
We also agree with the Court of Appeals that in the context of real estate agreements, a requirement that
damages be difficult to prove at trial would undermine the very purposes of the liquidated damage
provision: “certainty, assurance that the contract will be performed, and avoidance of litigation”.
[Citation] It would “encourage litigation in virtually every case in which the sale did not close, regardless
of whether the earnest money deposit was a reasonable estimate of the seller’s damages.” [Citation]
In sum, so long as the agreed upon earnest money agreement, viewed prospectively, is a reasonable
prediction of potential damage suffered by the seller, the agreement should be enforced “without regard to
the retrospective calculation of actual damages or the ease with which they may be proved”. The
prospective difficulty of estimating potential damage is a factor to be used in assessing the reasonableness
of the earnest money agreement…
The decision of the Court of Appeals is affirmed.

CASE QUESTIONS

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1.

What does the court here mean when it says that liquidated damages clauses allow the parties to
“allocate and incorporate the risks [of the transaction] in their negotiations”?

2.

Why is it relevant that the plaintiff Ingram was engaged in a child-custody dispute and wanted to move to
California as soon as possible?

3.

What, in plain language, is the issue here?

4.

How does the court’s resolution of the issue seem to the court the better analysis?

5.

Why did the plaintiff get to keep the $15,000 when he really suffered no damages?

6.

Express the controlling rule of law out of this case.

Injunctions and Negative Covenants
Madison Square Garden Corporation v. Carnera
52 F.2d 47 (2d Cir. Ct. App. 1931)
Chase, J.
On January 13, 1931, the plaintiff and defendant by their duly authorized agents entered into the following
agreement in writing:
1. Carnera agrees that he will render services as a boxer in his next contest (which contest, hereinafter
called the ‘First Contest.’…
9. Carnera shall not, pending the holding of the First Contest, render services as a boxer in any major
boxing contest, without the written permission of the Garden in each case had and obtained. A major
contest is understood to be one with Sharkey, Baer, Campolo, Godfrey, or like grade heavyweights, or
heavyweights who shall have beaten any of the above subsequent to the date hereof. If in any boxing
contest engaged in by Carnera prior to the holding of the First Contest, he shall lose the same, the Garden
shall at its option, to be exercised by a two weeks’ notice to Carnera in writing, be without further liability
under the terms of this agreement to Carnera. Carnera shall not render services during the continuance of
the option referred to in paragraph 8 hereof for any person, firm or corporation other than the Garden.
Carnera shall, however, at all times be permitted to engage in sparring exhibitions in which no decision is

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rendered and in which the heavy weight championship title is not at stake, and in which Carnera boxes
not more than four rounds with any one opponent.’…
Thereafter the defendant, without the permission of the plaintiff, written or otherwise, made a contract to
engage in a boxing contest with the Sharkey mentioned in paragraph 9 of the agreement above quoted,
and by the terms thereof the contest was to take place before the first contest mentioned in the
defendant’s contract with the plaintiff was to be held.
The plaintiff then brought this suit to restrain the defendant from carrying out his contract to box
Sharkey, and obtained the preliminary injunction order, from which this appeal was taken. Jurisdiction is
based on diversity of citizenship and the required amount is involved.
The District Court has found on affidavits which adequately show it that the defendant’s services are
unique and extraordinary. A negative covenant in a contract for such personal services is enforceable by
injunction where the damages for a breach are incapable of ascertainment. [Citations]
The defendant points to what is claimed to be lack of consideration for his negative promise, in that the
contract is inequitable and contains no agreement to employ him. It is true that there is no promise in so
many words to employ the defendant to box in a contest with Stribling or Schmeling, but the agreement
read as a whole binds the plaintiff to do just that, provided either Stribling or Schmeling becomes the
contestant as the result of the match between them and can be induced to box the defendant. The
defendant has agreed to ‘render services as a boxer’ for the plaintiff exclusively, and the plaintiff has
agreed to pay him a definite percentage of the gate receipts as his compensation for so doing. The promise
to employ the defendant to enable him to earn the compensation agreed upon is implied to the same force
and effect as though expressly stated. [Citations] The fact that the plaintiff’s implied promise is
conditioned, with respect to the contest with the winner of the Stribling-Schmeling match, upon the
consent of that performer, does not show any failure of consideration for the defendant’s promise,
[Citation].
As we have seen, the contract is valid and enforceable. It contains a restrictive covenant which may be
given effect. Whether a preliminary injunction shall be issued under such circumstances rests in the

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sound discretion of the court. [Citation] The District Court, in its discretion, did issue the preliminary
injunction.…
Order affirmed.

CASE QUESTIONS
1.

Why did the plaintiff not want the defendant to engage in any boxing matches until and except the ones
arranged by the plaintiff?

2.

What assertion did the defendant make as to why his promise was not enforceable? Why wasn’t that
argument accepted by the court?

3.

If the defendant had refused to engage in a boxing match arranged by the plaintiff, would a court force
him to do what he had promised?

Limitation on Damages: Mitigation of Damages
Shirley MacLaine Parker v. Twentieth Century-Fox Film Corporation
474 P.2d 689 (Cal. 1970)
Burke, Justice.
Defendant Twentieth Century-Fox Film Corporation appeals from a summary judgment granting to
plaintiff the recovery of agreed compensation under a written contract for her services as an actress in a
motion picture. As will appear, we have concluded that the trial court correctly ruled in plaintiff’s favor
and that the judgment should be affirmed.
Plaintiff is well known as an actress.…Under the contract, dated August 6, 1965, plaintiff was to play the
female lead in defendant’s contemplated production of a motion picture entitled “Bloomer Girl.” The
contract provided that defendant would pay plaintiff a minimum “guaranteed compensation” of
$53,571.42 per week for 14 weeks commencing May 23, 1966, for a total of $750,000 [about $5,048,000
in 2010 dollars]. Prior to May 1966 defendant decided not to produce the picture and by a letter dated
April 4, 1966, it notified plaintiff of that decision and that it would not “comply with our obligations to you
under” the written contract.

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By the same letter and with the professed purpose “to avoid any damage to you,” defendant instead
offered to employ plaintiff as the leading actress in another film tentatively entitled “Big Country, Big
Man” (hereinafter, “Big Country”). The compensation offered was identical, as were 31 of the 34
numbered provisions or articles of the original contract. Unlike “Bloomer Girl,” however, which was to
have been a musical production, “Big Country” was a dramatic “western type” movie. “Bloomer Girl” was
to have been filmed in California; “Big Country” was to be produced in Australia. Also, certain terms in the
proffered contract varied from those of the original. Plaintiff was given one week within which to accept;
she did not and the offer lapsed. Plaintiff then commenced this action seeking recovery of the agreed
guaranteed compensation.
The complaint sets forth two causes of action. The first is for money due under the contract; the second,
based upon the same allegations as the first, is for damages resulting from defendant’s breach of contract.
Defendant in its answer admits the existence and validity of the contract, that plaintiff complied with all
the conditions, covenants and promises and stood ready to complete the performance, and that defendant
breached and “anticipatorily repudiated” the contract. It denies, however, that any money is due to
plaintiff either under the contract or as a result of its breach, and pleads as an affirmative defense to both
causes of action plaintiff’s allegedly deliberate failure to mitigate damages, asserting that she
unreasonably refused to accept its offer of the leading role in “Big Country.”
Plaintiff moved for summary judgment…[T]he motion was granted…for $750,000 plus interest…in
plaintiff’s favor. This appeal by defendant followed.…
The general rule is that the measure of recovery by a wrongfully discharged employee is the amount of
salary agreed upon for the period of service, less the amount which the employer affirmatively proves the
employee has earned or with reasonable effort might have earned from other employment. [Citation]
However, before projected earnings from other employment opportunities not sought or accepted by the
discharged employee can be applied in mitigation, the employer must show that the other employment
was comparable, or substantially similar, to that of which the employee has been deprived; the employee’s
rejection of or failure to seek other available employment of a different or inferior kind may not be
resorted to in order to mitigate damages. [Citations]

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In the present case defendant has raised no issue of reasonableness of efforts by plaintiff to obtain other
employment; the sole issue is whether plaintiff’s refusal of defendant’s substitute offer of “Big Country”
may be used in mitigation. Nor, if the “Big Country” offer was of employment different or inferior when
compared with the original “Bloomer Girl” employment, is there an issue as to whether or not plaintiff
acted reasonably in refusing the substitute offer. Despite defendant’s arguments to the contrary, no case
cited or which our research has discovered holds or suggests that reasonableness is an element of a
wrongfully discharged employee’s option to reject, or fail to seek, different or inferior employment lest the
possible earnings therefrom be charged against him in mitigation of damages.
Applying the foregoing rules to the record in the present case, with all intendments in favor of the party
opposing the summary judgment motion—here, defendant—it is clear that the trial court correctly ruled
that plaintiff’s failure to accept defendant’s tendered substitute employment could not be applied in
mitigation of damages because the offer of the “Big Country” lead was of employment both different and
inferior, and that no factual dispute was presented on that issue. The mere circumstance that “Bloomer
Girl” was to be a musical review calling upon plaintiff’s talents as a dancer as well as an actress, and was to
be produced in the City of Los Angeles, whereas “Big Country” was a straight dramatic role in a “Western
Type” story taking place in an opal mine in Australia, demonstrates the difference in kind between the two
employments; the female lead as a dramatic actress in a western style motion picture can by no stretch of
imagination be considered the equivalent of or substantially similar to the lead in a song-and-dance
production.
Additionally, the substitute “Big Country” offer proposed to eliminate or impair the director and
screenplay approvals accorded to plaintiff under the original “Bloomer Girl” contract, and thus
constituted an offer of inferior employment. No expertise or judicial notice is required in order to hold
that the deprivation or infringement of an employee’s rights held under an original employment contract
converts the available “other employment” relied upon by the employer to mitigate damages, into inferior
employment which the employee need not seek or accept. [Citation]
In view of the determination that defendant failed to present any facts showing the existence of a factual
issue with respect to its sole defense—plaintiff’s rejection of its substitute employment offer in mitigation
of damages—we need not consider plaintiff’s further contention that for various reasons, including the

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provisions of the original contract set forth in footnote 1, Ante, plaintiff was excused from attempting to
mitigate damages.
The judgment is affirmed.

CASE QUESTIONS
1.

Why did Ms. MacLaine refuse to accept the employment opportunity offered by the defendant?

2.

Why did the defendant think it should not be liable for any damages as a result of its admitted breach of
the original contract?

3.

Who has the burden of proof on mitigation issues—who has to show that no mitigation occurred?

4.

Express the controlling rule of law out of this case.

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16.7 Summary and Exercises
Summary
Contract remedies serve to protect three different interests: an expectation interest (the benefit bargained
for), a reliance interest (loss suffered by relying on the contract), and a restitution interest (benefit
conferred on the promisor). In broad terms, specific performance addresses the expectation interest,
monetary damages address all three, and restitution addresses the restitution interest.
The two general categories of remedies are legal and equitable. In the former category are compensatory,
consequential, incidental, nominal, liquated, and (rarely) punitive damages. In the latter category—if legal
remedies are inadequate—are specific performance, injunction, and restitution.
There are some limitations or restrictions on the availability of damages: they must pass the tests of
foreseeability and certainty. They must be reasonably mitigated, if possible. And liquidated damages must
be reasonable—not a penalty. In some situations, a person can lose the remedy of rescission—the power to
avoid a contract—when the rights of third parties intervene. In some cases a person is required to make an
election of remedies: to choose one remedy among several, and when the one is chosen, the others are not
available any more.

EXERCISES
1.

Owner of an auto repair shop hires Contractor to remodel his shop but does not mention that two days
after the scheduled completion date, Owner is to receive five small US Army personnel carrier trucks for
service, with a three-week deadline to finish the job and turn the trucks over to the army. The contract
between Owner and the army has a liquidated damages clause calling for $300 a day for every day trucks
are not operable after the deadline. Contractor is five days late in finishing the remodel. Can Owner claim
the $1,500 as damages against Contractor as a consequence of the latter’s tardy completion of the
contract? Explain.

2.

Inventor devised an electronic billiard table that looked like a regular billiard table, but when balls
dropped into the pocket, various electronic lights and scorekeeping devices activated. Inventor
contracted with Contractor to manufacture ten prototypes and paid him $50,000 in advance, on a total
owing of $100,000 ($10,000 for each completed table). After the tables were built to accommodate

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electronic fittings, Inventor repudiated the contract. Contractor broke the ten tables up, salvaged $1,000
of wood for other billiard tables, and used the rest for firewood. The ten intact tables, without
electronics, could have been sold for $500 each ($5,000 total). Contractor then sued Inventor for the
profit Contractor would have made had Inventor not breached. To what, if anything, is Contractor entitled
by way of damages and why?
3.

Calvin, a promising young basketball and baseball player, signed a multiyear contract with a professional
basketball team after graduating from college. After playing basketball for one year, he decided he would
rather play baseball and breached his contract with the basketball team. What remedy could the team
seek?

4.

Theresa leased a one-bedroom apartment from Landlady for one year at $500 per month. After three
months, she vacated the apartment. A family of five wanted to rent the apartment, but Landlady refused.
Three months later—six months into what would have been Theresa’s term—Landlady managed to rent
the apartment to Tenant for $400 per month. How much does Theresa owe, and why?

5.

Plaintiff, a grocery store, contracted with Defendant, a burglar alarm company, for Defendant to
send guards to Plaintiff's premises and to notify the local police if the alarm was activated. The
contract had this language: “It is agreed that the Contractor is not an insurer, that the payments here
are based solely on the value of the service in the maintenance of the system described, that it is
impracticable and extremely difficult to fix the actual damages, if any, which may proximately result
from a failure to perform its services, and in case of failure to perform such services and a resulting
loss, its liability shall be limited to $500 as liquidated damages, and not as a penalty, and this liability
shall be exclusive.”
A burglary took place and the alarm was activated, but Defendant failed to respond promptly. The
burglars left with $330,000. Is the liquidated damages clause—the limitation on Plaintiff’s right to
recover—valid?

6.

The decedent, father of the infant Plaintiff, was killed in a train accident. Testimony showed he was a
good and reliable man. Through a representative, the decedent’s surviving child, age five, recovered
judgment against the railroad (Defendant). Defendant objected to expert testimony that inflation would
probably continue at a minimum annual rate of 5 percent for the next thirteen years (until the boy

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attained his majority), which was used to calculate the loss in support money caused by the father’s
death. The calculations, Defendant said, were unreasonably speculative and uncertain, and damages must
be proven with reasonable certainty. Is the testimony valid?
7.

Plaintiff produced and directed a movie for Defendant, but contrary to their agreement, Plaintiff was not
given screen credit in the edited film (his name was not shown). The film was screened successfully for
nearly four years. Plaintiff then sued (1) for damages for loss of valuable publicity or advertising because
his screen credits were omitted for the years and (2) for an injunction against future injuries. The jury
awarded Plaintiff $25,000 on the first count. On the second count, the court held Plaintiff should be able
to “modify the prints in his personal possession to include his credits.” But Plaintiff appealed, claiming
that Defendant still had many unmodified prints in its possession and that showing those films would
cause future damages. What remedy is available to Plaintiff?

8.

[1]

In 1929 Kerr Steamship Company, Inc. (Plaintiff), delivered to Defendant, the Radio Corporation of
America (RCA), a fairly long telegram—in code—to be transmitted to Manila, Philippine Islands, with
instructions about loading one of Kerr’s ships. By mistake, the telegraph was mislaid and not delivered. As
a result of the failure to transmit it, the cargo was not loaded and the freight was lost in an amount of
$6,675.29 [about $84,000 in 2010 dollars], profit that would have been earned if the message had been
carried. Plaintiff said that because the telegram was long and because the sender was a ship company,
RCA personnel should have known it was important information dealing with shipping and therefore RCA
should be liable for the consequential damages flowing from the failure to send it. Is RCA liable?

9.

Defendant offered to buy a house from Plaintiff. She represented, verbally and in writing, that she had
$15,000 to $20,000 of equity in another house and would pay this amount to Plaintiff after selling it. She
knew, however, that she had no such equity. Relying on these intentionally fraudulent representations,
Plaintiff accepted Defendant’s offer to buy, and the parties entered into a land contract. After taking
occupancy, Defendant failed to make any of the contract payments. Plaintiff’s investigation then revealed
the fraud. Based on the fraud, Plaintiff sought rescission, ejectment, and recovery for five months of lost
use of the property and out-of-pocket expenses. Defendant claimed that under the election of remedies
doctrine, Plaintiff seller could not both rescind the contract and get damages for its breach. How should
the court rule?

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10. Buyers contracted to purchase a house being constructed by Contractor. The contract contained this
clause: “Contractor shall pay to the owners or deduct from the total contract price $100.00 per day as
liquidated damages for each day after said date that the construction is not completed and accepted by
the Owners and Owners shall not arbitrarily withhold acceptance.” Testimony established the rental value
of the home at $400–$415 per month. Is the clause enforceable?

SELF-TEST QUESTIONS
1.

Contract remedies protect

a.

a restitution interest

b.

a reliance interest

c.

an expectation interest

d.

all of the above
A restitution interest is

a.

the benefit for which the promisee bargained

b.

the loss suffered by relying on the contract

c.

that which restores any benefit one party conferred on the other

d.

none of the above
When breach of contract caused no monetary loss, the plaintiff is entitled to

a.

special damages

b.

nominal damages

c.

consequential damages

d.

no damages
Damages attributable to losses that flow from events that do not occur in the ordinary course of
events are

a.

incidental damages

b.

liquidated damages

c.

consequential damages

d.

punitive damages
Restitution is available

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a.

when the contract was avoided because of incapacity

b.

when the other party breached

c.

when the party seeking restitution breached

d.

all of the above

SELF-TEST ANSWERS
1.

d

2.

c

3.

b

4.

c

5.

d

[1] Tamarind Lithography Workshop v. Sanders, 193 Cal. Rptr. 409 (Calif. Ct. App., 1983).

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Chapter 17

Products Liability
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

How products-liability law allocates the costs of a consumer society

2.

How warranty theory works in products liability, and what its limitations are

3.

How negligence theory works, and what its problems are

4.

How strict liability theory works, and what its limitations are

5.

What efforts are made to reform products-liability law, and why

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17.1 Introduction: Why Products-Liability Law Is Important
LEARNING OBJECTIVES
1.

Understand why products-liability law underwent a revolution in the twentieth century.

2.

Recognize that courts play a vital role in policing the free enterprise system by adjudicating how the
true costs of modern consumer culture are allocated.

3.

Know the names of the modern causes of action for products-liability cases.

In previous chapters, we discussed remedies generally. In this chapter, we focus specifically on remedies
available when a defective product causes personal injury or other damages. Products liability describes a
type of claim, not a separate theory of liability. Products liability has strong emotional overtones—ranging
from the prolitigation position of consumer advocates to the conservative perspective of the
manufacturers.

History of Products-Liability Law
The theory of caveat emptor—let the buyer beware—that pretty much governed consumer law from the
early eighteenth century until the early twentieth century made some sense. A horse-drawn buggy is a
fairly simple device: its workings are apparent; a person of average experience in the 1870s would know
whether it was constructed well and made of the proper woods. Most foodstuffs 150 years ago were grown
at home and “put up” in the home kitchen or bought in bulk from a local grocer, subject to inspection and
sampling; people made home remedies for coughs and colds and made many of their own clothes. Houses
and furnishings were built of wood, stone, glass, and plaster—familiar substances. Entertainment was a
book or a piano. The state of technology was such that the things consumed were, for the most part,
comprehensible and—very important—mostly locally made, which meant that the consumer who suffered
damages from a defective product could confront the product’s maker directly. Local reputation is a
powerful influence on behavior.
The free enterprise system confers great benefits, and no one can deny that: materialistically, compare the
image sketched in the previous paragraph with circumstances today. But those benefits come with a cost,
and the fundamental political issue always is who has to pay. Consider the following famous passage from
Upton Sinclair’s great novel The Jungle. It appeared in 1906. He wrote it to inspire labor reform; to his

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644

dismay, the public outrage focused instead on consumer protection reform. Here is his description of the
sausage-making process in a big Chicago meatpacking plant:
There was never the least attention paid to what was cut up for sausage; there would come all the way
back from Europe old sausage that had been rejected, and that was moldy and white—it would be dosed
with borax and glycerin, and dumped into the hoppers, and made over again for home consumption.
There would be meat that had tumbled out on the floor, in the dirt and sawdust, where the workers had
tramped and spit uncounted billions of consumption germs. There would be meat stored in great piles in
rooms; and the water from leaky roofs would drip over it, and thousands of rats would race about on it. It
was too dark in these storage places to see well, but a man could run his hand over these piles of meat and
sweep off handfuls of the dried dung of rats. These rats were nuisances, and the packers would put
poisoned bread out for them; they would die, and then rats, bread, and meat would go into the hoppers
together. This is no fairy story and no joke; the meat would be shoveled into carts, and the man who did
the shoveling would not trouble to lift out a rat even when he saw one—there were things that went into
the sausage in comparison with which a poisoned rat was a tidbit. There was no place for the men to wash
their hands before they ate their dinner, and so they made a practice of washing them in the water that
was to be ladled into the sausage. There were the butt-ends of smoked meat, and the scraps of corned
beef, and all the odds and ends of the waste of the plants, that would be dumped into old barrels in the
cellar and left there.
Under the system of rigid economy which the packers enforced, there were some jobs that it only paid to
do once in a long time, and among these was the cleaning out of the waste barrels. Every spring they did
it; and in the barrels would be dirt and rust and old nails and stale water—and cartload after cartload of it
would be taken up and dumped into the hoppers with fresh meat, and sent out to the public’s breakfast.
Some of it they would make into “smoked” sausage—but as the smoking took time, and was therefore
expensive, they would call upon their chemistry department, and preserve it with borax and color it with
gelatin to make it brown. All of their sausage came out of the same bowl, but when they came to wrap it
they would stamp some of it “special,” and for this they would charge two cents more a pound.

[1]

It became clear from Sinclair’s exposé that associated with the marvels of then-modern meatpacking and
distribution methods was food poisoning: a true cost became apparent. When the true cost of some

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645

money-making enterprise (e.g., cigarettes) becomes inescapably apparent, there are two possibilities.
First, the legislature can in some way mandate that the manufacturer itself pay the cost; with the
meatpacking plants, that would be the imposition of sanitary food-processing standards. Typically,
Congress creates an administrative agency and gives the agency some marching orders, and then the
agency crafts regulations dictating as many industry-wide reform measures as are politically possible.
Second, the people who incur damages from the product (1) suffer and die or (2) access the machinery of
the legal system and sue the manufacturer. If plaintiffs win enough lawsuits, the manufacturer’s insurance
company raises rates, forcing reform (as with high-powered muscle cars in the 1970s); the business goes
bankrupt; or the legislature is pressured to act, either for the consumer or for the manufacturer.
If the industry has enough clout to blunt—by various means—a robust proconsumer legislative response
so that government regulation is too lax to prevent harm, recourse is had through the legal system. Thus
for all the talk about the need for tort reform (discussed later in this chapter), the courts play a vital role in
policing the free enterprise system by adjudicating how the true costs of modern consumer culture are
allocated.
Obviously the situation has improved enormously in a century, but one does not have to look very far to
find terrible problems today. Consider the following, which occurred in 2009–10:
•

In the United States, Toyota recalled 412,000 passenger cars, mostly the Avalon model, for steering
problems that reportedly led to three accidents.

•

Portable baby recliners that are supposed to help fussy babies sleep better were recalled after the
death of an infant: the Consumer Product Safety Commission announced the recall of 30,000 Nap
Nanny recliners made by Baby Matters of Berwyn, Pennsylvania.

•

More than 70,000 children and teens go to the emergency room each year for injuries and
complications from medical devices. Contact lenses are the leading culprit, the first detailed national
estimate suggests.

•

Smith and Noble recalled 1.3 million Roman shades and roller shades after a child was nearly
strangled: the Consumer Product Safety Commission says a five-year-old boy in Tacoma, Washington,
was entangled in the cord of a roller shade in May 2009.

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[2]

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•

The Consumer Product Safety Commission reported that 4,521 people were killed in the United States
in consumer-product-related incidences in 2009, and millions of people visited hospital emergency
rooms from consumer-product-related injuries.

•

[3]

Reports about the possibility that cell-phone use causes brain cancer continue to be hotly debated.
Critics suggest that the studies minimizing the risk were paid for by cell-phone manufacturers.

[4]

Products liability can also be a life-or-death matter from the manufacturer’s perspective. In 2009,
Bloomberg BusinessWeek reported that the costs of product safety for manufacturing firms can be
enormous: “Peanut Corp., based in Lynchberg, Va., has been driven into bankruptcy since health officials
linked tainted peanuts to more than 600 illnesses and nine deaths. Mattel said the first of several toy
recalls it announced in 2007 cut its quarterly operating income by $30 million. Earlier this decade, Ford
Motor spent roughly $3 billion replacing 10.6 million potentially defective Firestone tires.”

[5]

Businesses

complain, with good reason, about the expenses associated with products-liability problems.

Current State of the Law
Although the debate has been heated and at times simplistic, the problem of products liability is complex
and most of us regard it with a high degree of ambivalence. We are all consumers, after all, who profit
greatly from living in an industrial society. In this chapter, we examine the legal theories that underlie
products-liability cases that developed rapidly in the twentieth century to address the problems of
product-caused damages and injuries in an industrial society.
In the typical products-liability case, three legal theories are asserted—a contract theory and two tort
theories. The contract theory is warranty, governed by the UCC, and the two tort theories
are negligence and strict products liability, governed by the common law. See Figure 17.1 "Major Products
Liability Theories".
Figure 17.1 Major Products Liability Theories

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KEY TAKEAWAY
As products became increasingly sophisticated and potentially dangerous in the twentieth century, and as the
separation between production and consumption widened, products liability became a very important issue
for both consumers and manufacturers. Millions of people every year are adversely affected by defective
products, and manufacturers and sellers pay huge amounts for products-liability insurance and damages. The
law has responded with causes of action that provide a means for recovery for products-liability damages.

EXERCISES
1.

How does the separation of production from consumption affect products-liability issues?

2.

What other changes in production and consumption have caused the need for the development of
products-liability law?

3.

How can it be said that courts adjudicate the allocation of the costs of a consumer-oriented economy?

[1] Upton Sinclair, The Jungle (New York: Signet Classic, 1963), 136.
[2] FindLaw, AP reports.
[3] US Consumer Product Safety Commission, 2009 Report to the President and the Congress, accessed March 1,
2011,http://www.cpsc.gov/cpscpub/pubs/reports/2009rpt.pdf.
[4] Matt Hamblen, “New Study Warns of Cell Phone Dangers,” Computerworld US, August 9, 2009, accessed March
1, 2011, http://news.techworld.com/personal-tech/3200539/new-study-warns-of-cell-phone-dangers.
[5] Michael Orey, “Taking on Toy Safety,” BusinessWeek, March 6, 2009, accessed March 1,
2011,http://www.businessweek.com/managing/content/mar2009/ca2009036_271002.htm.

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17.1 Introduction: Why Products-Liability Law Is Important
LEARNING OBJECTIVES
1.

Understand why products-liability law underwent a revolution in the twentieth century.

2.

Recognize that courts play a vital role in policing the free enterprise system by adjudicating how the
true costs of modern consumer culture are allocated.

3.

Know the names of the modern causes of action for products-liability cases.

In previous chapters, we discussed remedies generally. In this chapter, we focus specifically on remedies
available when a defective product causes personal injury or other damages. Products liability describes a
type of claim, not a separate theory of liability. Products liability has strong emotional overtones—ranging
from the prolitigation position of consumer advocates to the conservative perspective of the
manufacturers.

History of Products-Liability Law
The theory of caveat emptor—let the buyer beware—that pretty much governed consumer law from the
early eighteenth century until the early twentieth century made some sense. A horse-drawn buggy is a
fairly simple device: its workings are apparent; a person of average experience in the 1870s would know
whether it was constructed well and made of the proper woods. Most foodstuffs 150 years ago were grown
at home and “put up” in the home kitchen or bought in bulk from a local grocer, subject to inspection and
sampling; people made home remedies for coughs and colds and made many of their own clothes. Houses
and furnishings were built of wood, stone, glass, and plaster—familiar substances. Entertainment was a
book or a piano. The state of technology was such that the things consumed were, for the most part,
comprehensible and—very important—mostly locally made, which meant that the consumer who suffered
damages from a defective product could confront the product’s maker directly. Local reputation is a
powerful influence on behavior.
The free enterprise system confers great benefits, and no one can deny that: materialistically, compare the
image sketched in the previous paragraph with circumstances today. But those benefits come with a cost,
and the fundamental political issue always is who has to pay. Consider the following famous passage from
Upton Sinclair’s great novel The Jungle. It appeared in 1906. He wrote it to inspire labor reform; to his

Saylor URL: http://www.saylor.org/books

Saylor.org
649

dismay, the public outrage focused instead on consumer protection reform. Here is his description of the
sausage-making process in a big Chicago meatpacking plant:
There was never the least attention paid to what was cut up for sausage; there would come all the way
back from Europe old sausage that had been rejected, and that was moldy and white—it would be dosed
with borax and glycerin, and dumped into the hoppers, and made over again for home consumption.
There would be meat that had tumbled out on the floor, in the dirt and sawdust, where the workers had
tramped and spit uncounted billions of consumption germs. There would be meat stored in great piles in
rooms; and the water from leaky roofs would drip over it, and thousands of rats would race about on it. It
was too dark in these storage places to see well, but a man could run his hand over these piles of meat and
sweep off handfuls of the dried dung of rats. These rats were nuisances, and the packers would put
poisoned bread out for them; they would die, and then rats, bread, and meat would go into the hoppers
together. This is no fairy story and no joke; the meat would be shoveled into carts, and the man who did
the shoveling would not trouble to lift out a rat even when he saw one—there were things that went into
the sausage in comparison with which a poisoned rat was a tidbit. There was no place for the men to wash
their hands before they ate their dinner, and so they made a practice of washing them in the water that
was to be ladled into the sausage. There were the butt-ends of smoked meat, and the scraps of corned
beef, and all the odds and ends of the waste of the plants, that would be dumped into old barrels in the
cellar and left there.
Under the system of rigid economy which the packers enforced, there were some jobs that it only paid to
do once in a long time, and among these was the cleaning out of the waste barrels. Every spring they did
it; and in the barrels would be dirt and rust and old nails and stale water—and cartload after cartload of it
would be taken up and dumped into the hoppers with fresh meat, and sent out to the public’s breakfast.
Some of it they would make into “smoked” sausage—but as the smoking took time, and was therefore
expensive, they would call upon their chemistry department, and preserve it with borax and color it with
gelatin to make it brown. All of their sausage came out of the same bowl, but when they came to wrap it
they would stamp some of it “special,” and for this they would charge two cents more a pound.

[1]

It became clear from Sinclair’s exposé that associated with the marvels of then-modern meatpacking and
distribution methods was food poisoning: a true cost became apparent. When the true cost of some

Saylor URL: http://www.saylor.org/books

Saylor.org
650

money-making enterprise (e.g., cigarettes) becomes inescapably apparent, there are two possibilities.
First, the legislature can in some way mandate that the manufacturer itself pay the cost; with the
meatpacking plants, that would be the imposition of sanitary food-processing standards. Typically,
Congress creates an administrative agency and gives the agency some marching orders, and then the
agency crafts regulations dictating as many industry-wide reform measures as are politically possible.
Second, the people who incur damages from the product (1) suffer and die or (2) access the machinery of
the legal system and sue the manufacturer. If plaintiffs win enough lawsuits, the manufacturer’s insurance
company raises rates, forcing reform (as with high-powered muscle cars in the 1970s); the business goes
bankrupt; or the legislature is pressured to act, either for the consumer or for the manufacturer.
If the industry has enough clout to blunt—by various means—a robust proconsumer legislative response
so that government regulation is too lax to prevent harm, recourse is had through the legal system. Thus
for all the talk about the need for tort reform (discussed later in this chapter), the courts play a vital role in
policing the free enterprise system by adjudicating how the true costs of modern consumer culture are
allocated.
Obviously the situation has improved enormously in a century, but one does not have to look very far to
find terrible problems today. Consider the following, which occurred in 2009–10:
•

In the United States, Toyota recalled 412,000 passenger cars, mostly the Avalon model, for steering
problems that reportedly led to three accidents.

•

Portable baby recliners that are supposed to help fussy babies sleep better were recalled after the
death of an infant: the Consumer Product Safety Commission announced the recall of 30,000 Nap
Nanny recliners made by Baby Matters of Berwyn, Pennsylvania.

•

More than 70,000 children and teens go to the emergency room each year for injuries and
complications from medical devices. Contact lenses are the leading culprit, the first detailed national
estimate suggests.

•

Smith and Noble recalled 1.3 million Roman shades and roller shades after a child was nearly
strangled: the Consumer Product Safety Commission says a five-year-old boy in Tacoma, Washington,
was entangled in the cord of a roller shade in May 2009.

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•

The Consumer Product Safety Commission reported that 4,521 people were killed in the United States
in consumer-product-related incidences in 2009, and millions of people visited hospital emergency
rooms from consumer-product-related injuries.

•

[3]

Reports about the possibility that cell-phone use causes brain cancer continue to be hotly debated.
Critics suggest that the studies minimizing the risk were paid for by cell-phone manufacturers.

[4]

Products liability can also be a life-or-death matter from the manufacturer’s perspective. In 2009,
Bloomberg BusinessWeek reported that the costs of product safety for manufacturing firms can be
enormous: “Peanut Corp., based in Lynchberg, Va., has been driven into bankruptcy since health officials
linked tainted peanuts to more than 600 illnesses and nine deaths. Mattel said the first of several toy
recalls it announced in 2007 cut its quarterly operating income by $30 million. Earlier this decade, Ford
Motor spent roughly $3 billion replacing 10.6 million potentially defective Firestone tires.”

[5]

Businesses

complain, with good reason, about the expenses associated with products-liability problems.

Current State of the Law
Although the debate has been heated and at times simplistic, the problem of products liability is complex
and most of us regard it with a high degree of ambivalence. We are all consumers, after all, who profit
greatly from living in an industrial society. In this chapter, we examine the legal theories that underlie
products-liability cases that developed rapidly in the twentieth century to address the problems of
product-caused damages and injuries in an industrial society.
In the typical products-liability case, three legal theories are asserted—a contract theory and two tort
theories. The contract theory is warranty, governed by the UCC, and the two tort theories
are negligence and strict products liability, governed by the common law. See Figure 17.1 "Major Products
Liability Theories".
Figure 17.1 Major Products Liability Theories

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KEY TAKEAWAY
As products became increasingly sophisticated and potentially dangerous in the twentieth century, and as the
separation between production and consumption widened, products liability became a very important issue
for both consumers and manufacturers. Millions of people every year are adversely affected by defective
products, and manufacturers and sellers pay huge amounts for products-liability insurance and damages. The
law has responded with causes of action that provide a means for recovery for products-liability damages.

EXERCISES
1.

How does the separation of production from consumption affect products-liability issues?

2.

What other changes in production and consumption have caused the need for the development of
products-liability law?

3.

How can it be said that courts adjudicate the allocation of the costs of a consumer-oriented economy?

[1] Upton Sinclair, The Jungle (New York: Signet Classic, 1963), 136.
[2] FindLaw, AP reports.
[3] US Consumer Product Safety Commission, 2009 Report to the President and the Congress, accessed March 1,
2011,http://www.cpsc.gov/cpscpub/pubs/reports/2009rpt.pdf.
[4] Matt Hamblen, “New Study Warns of Cell Phone Dangers,” Computerworld US, August 9, 2009, accessed March
1, 2011, http://news.techworld.com/personal-tech/3200539/new-study-warns-of-cell-phone-dangers.
[5] Michael Orey, “Taking on Toy Safety,” BusinessWeek, March 6, 2009, accessed March 1,
2011,http://www.businessweek.com/managing/content/mar2009/ca2009036_271002.htm.

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17.2 Warranties
LEARNING OBJECTIVES
1.

Recognize a UCC express warranty and how it is created.

2.

Understand what is meant under the UCC by implied warranties, and know the main types of implied
warranties: merchantability, fitness for a particular purpose, and title.

3.

Know that there are other warranties: against infringement and as may arise from usage of the trade.

4.

See that there are difficulties with warranty theory as a cause of action for products liability; a federal
law has addressed some of these.

The UCC governs express warranties and various implied warranties, and for many years it was the only
statutory control on the use and meanings of warranties. In 1975, after years of debate, Congress passed
and President Gerald Ford signed into law the Magnuson-Moss Act, which imposes certain requirements
on manufacturers and others who warrant their goods. We will examine both the UCC and the MagnusonMoss Act.

Types of Warranties
Express Warranties
An express warranty is created whenever the seller affirms that the product will perform in a certain
manner. Formal words such as “warrant” or “guarantee” are not necessary. A seller may create an express
warranty as part of the basis for the bargain of sale by means of (1) an affirmation of a fact or promise
relating to the goods, (2) a description of the goods, or (3) a sample or model. Any of these will create an
express warranty that the goods will conform to the fact, promise, description, sample, or model. Thus a
seller who states that “the use of rustproof linings in the cans would prevent discoloration and
adulteration of the Perform solution” has given an express warranty, whether he realized it or
not.

[1]

Claims of breach of express warranty are, at base, claims of misrepresentation.

But the courts will not hold a manufacturer to every statement that could conceivably be interpreted to be
an express warranty. Manufacturers and sellers constantly “puff” their products, and the law is content to
let them inhabit that gray area without having to make good on every claim. UCC 2-313(2) says that “an

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affirmation merely of the value of the goods or a statement purporting to be merely the seller’s opinion or
commendation of the goods does not create a warranty.” Facts do.
It is not always easy, however, to determine the line between an express warranty and a piece of puffery. A
salesperson who says that a strawberry huller is “great” has probably puffed, not warranted, when it turns
out that strawberries run through the huller look like victims of a massacre. But consider the classic cases
of the defective used car and the faulty bull. In the former, the salesperson said the car was in “A-1 shape”
and “mechanically perfect.” In the latter, the seller said not only that the bull calf would “put the buyer on
the map” but that “his father was the greatest living dairy bull.” The car, carrying the buyer’s sevenmonth-old child, broke down while the buyer was en route to visit her husband in the army during World
War II. The court said that the salesperson had made an express warranty.

[2]

The bull calf turned out to be

sterile, putting the farmer on the judicial rather than the dairy map. The court said the seller’s spiel was
trade talk, not a warranty that the bull would impregnate cows.

[3]

Is there any qualitative difference between these decisions, other than the quarter century that separates
them and the different courts that rendered them? Perhaps the most that can be said is that the more
specific and measurable the statement’s standards, the more likely it is that a court will hold the seller to a
warranty, and that a written statement is easier to construe as a warranty than an oral one. It is also
possible that courts look, if only subliminally, at how reasonable the buyer was in relying on the
statement, although this ought not to be a strict test. A buyer may be unreasonable in expecting a car to
get 100 miles to the gallon, but if that is what the seller promised, that ought to be an enforceable
warranty.
The CISG (Article 35) provides, “The seller must deliver goods which are of the quantity,
quality and description required by the contract and which are contained or packaged in
the manner required by the contract. [And the] goods must possess the qualities of goods
which the seller has held out to the buyer as a sample or model.”

Implied Warranties
Express warranties are those over which the parties dickered—or could have. Express warranties go to the
essence of the bargain. An implied warranty, by contrast, is one that circumstances alone, not specific

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language, compel reading into the sale. In short, an implied warranty is one created by law, acting from an
impulse of common sense.

Implied Warranty of Merchantability
Section 2-314 of the UCC lays down the fundamental rule that goods carry an
implied warranty of merchantability if sold by a merchant-seller. What is merchantability? Section 2314(2) of the UCC says that merchantable goods are those that conform at least to the following six
characteristics:
1.

Pass without objection in the trade under the contract description

2. In the case of fungible goods, are of fair average quality within the description
3. Are fit for the ordinary purposes for which such goods are used
4. Run, within the variations permitted by the agreement, of even kind, quality, and quantity within each
unit and among all units involved
5.

Are adequately contained, packaged, and labeled as the agreement may require

6. Conform to the promise or affirmations of fact made on the container or label if any
For the purposes of Section 2-314(2)(c) of the UCC, selling and serving food or drink for consumption on
or off the premises is a sale subject to the implied warranty of merchantability—the food must be “fit for
the ordinary purposes” to which it is put. The problem is common: you bite into a cherry pit in the cherryvanilla ice cream, or you choke on the clam shells in the chowder. Is such food fit for the ordinary
purposes to which it is put? There are two schools of thought. One asks whether the food was natural as
prepared. This view adopts the seller’s perspective. The other asks what the consumer’s reasonable
expectation was.
The first test is sometimes said to be the “natural-foreign” test. If the substance in the soup is natural to
the substance—as bones are to fish—then the food is fit for consumption. The second test, relying on
reasonable expectations, tends to be the more commonly used test.
The Convention provides (Article 35) that “unless otherwise agreed, the goods sold are fit
for the purposes for which goods of the same description would ordinarily be used.”

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Fitness for a Particular Purpose
Section 2-315 of the UCC creates another implied warranty. Whenever a seller, at the time she contracts to
make a sale, knows or has reason to know that the buyer is relying on the seller’s skill or judgment to
select a product that is suitable for the particular purpose the buyer has in mind for the goods to be sold,
there is an implied warranty that the goods are fit for that purpose. For example, you go to a hardware
store and tell the salesclerk that you need a paint that will dry overnight because you are painting your
front door and a rainstorm is predicted for the next day. The clerk gives you a slow-drying oil-based paint
that takes two days to dry. The store has breached an implied warranty of fitness for particular purpose.
Note the distinction between “particular” and “ordinary” purposes. Paint is made to color and when dry to
protect a surface. That is its ordinary purpose, and had you said only that you wished to buy paint, no
implied warranty of fitness would have been breached. It is only because you had a particular purpose in
mind that the implied warranty arose. Suppose you had found a can of paint in a general store and told
the same tale, but the proprietor had said, “I don’t know enough about that paint to tell you anything
beyond what’s on the label; help yourself.” Not every seller has the requisite degree of skill and knowledge
about every product he sells to give rise to an implied warranty. Ultimately, each case turns on its
particular circumstances: “The Convention provides (Article 35): [The goods must be] fit for
any particular purpose expressly or impliedly made known to the seller at the time of the
conclusion of the contract, except where the circumstances show that the buyer did not
rely, or that it was unreasonable for him to rely, on the seller’s skill and judgment.”

Other Warranties
Article 2 contains other warranty provisions, though these are not related specifically to products liability.
Thus, under UCC, Section 2-312, unless explicitly excluded, the seller warrants he is conveying good
title that is rightfully his and that the goods are transferred free of any security interest or other lien or
encumbrance. In some cases (e.g., a police auction of bicycles picked up around campus and never
claimed), the buyer should know that the seller does not claim title in himself, nor that title will
necessarily be good against a third party, and so subsection (2) excludes warranties in these

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circumstances. But the circumstances must be so obvious that no reasonable person would suppose
otherwise.
In Menzel v. List, an art gallery sold a painting by Marc Chagall that it purchased in Paris.

[4]

The painting

had been stolen by the Germans when the original owner was forced to flee Belgium in the 1930s. Now in
the United States, the original owner discovered that a new owner had the painting and successfully sued
for its return. The customer then sued the gallery, claiming that it had breached the implied warranty of
title when it sold the painting. The court agreed and awarded damages equal to the appreciated value of
the painting. A good-faith purchaser who must surrender stolen goods to their true owner has a claim for
breach of the implied warranty of title against the person from whom he bought the goods.
A second implied warranty, related to title, is that the merchant-seller warrants the goods are free of any
rightful claim by a third person that the seller has infringed his rights (e.g., that a gallery has not
infringed a copyright by selling a reproduction). This provision only applies to a seller who regularly deals
in goods of the kind in question. If you find an old print in your grandmother’s attic, you do not warrant
when you sell it to a neighbor that it is free of any valid infringement claims.
A third implied warranty in this context involves the course of dealing or usage of trade. Section 2-314(3)
of the UCC says that unless modified or excluded implied warranties may arise from a course of dealing or
usage of trade. If a certain way of doing business is understood, it is not necessary for the seller to state
explicitly that he will abide by the custom; it will be implied. A typical example is the obligation of a dog
dealer to provide pedigree papers to prove the dog’s lineage conforms to the contract.

Problems with Warranty Theory
In General
It may seem that a person asserting a claim for breach of warranty will have a good chance of success
under an express warranty or implied warranty theory of merchantability or fitness for a particular
purpose. In practice, though, claimants are in many cases denied recovery. Here are four general
problems:
•

The claimant must prove that there was a sale.

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•

The sale was of goods rather than real estate or services.

•

The action must be brought within the four-year statute of limitations under Article 2-725, when the
tender of delivery is made, not when the plaintiff discovers the defect.

•

Under UCC, Section 2-607(3)(a) and Section 2A-516(3)(a), which covers leases, the claimant who fails
to give notice of breach within a reasonable time of having accepted the goods will see the suit
dismissed, and few consumers know enough to do so, except when making a complaint about a
purchase of spoiled milk or about paint that wouldn’t dry.

In addition to these general problems, the claimant faces additional difficulties stemming directly from
warranty theory, which we take up later in this chapter.

Exclusion or Modification of Warranties
The UCC permits sellers to exclude or disclaim warranties in whole or in part. That’s reasonable, given
that the discussion here is about contract, and parties are free to make such contracts as they see fit. But a
number of difficulties can arise.

Exclusion of Express Warranties
The simplest way for the seller to exclude express warranties is not to give them. To be sure, Section 2316(1) of the UCC forbids courts from giving operation to words in fine print that negate or limit express
warranties if doing so would unreasonably conflict with express warranties stated in the main body of the
contract—as, for example, would a blanket statement that “this contract excludes all warranties express or
implied.” The purpose of the UCC provision is to prevent customers from being surprised by unbargainedfor language.

Exclusion of Implied Warranties in General
Implied warranties can be excluded easily enough also, by describing the product with language such as
“as is” or “with all faults.” Nor is exclusion simply a function of what the seller says. The buyer who has
either examined or refused to examine the goods before entering into the contract may not assert an
implied warranty concerning defects an inspection would have revealed.

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The Convention provides a similar rule regarding a buyer’s rights when he has failed to
inspect the goods (Article 35): “The seller is not liable…for any lack of conformity of the
goods if at the time of the conclusion of the contract the buyer knew or could not have been
unaware of such lack of conformity.”

Implied Warranty of Merchantability
Section 2-316(2) of the UCC permits the seller to disclaim or modify the implied warranty of
merchantability, as long as the statement actually mentions “merchantability” and, if it is written, is
“conspicuous.” Note that the disclaimer need not be in writing, and—again—all implied warranties can be
excluded as noted.

Implied Warranty of Fitness
Section 2-316(2) of the UCC permits the seller also to disclaim or modify an implied warranty of fitness.
This disclaimer or modification must be in writing, however, and must be conspicuous. It need not
mention fitness explicitly; general language will do. The following sentence, for example, is sufficient to
exclude all implied warranties of fitness: “There are no warranties that extend beyond the description on
the face of this contract.”
Here is a standard disclaimer clause found in a Dow Chemical Company agreement: “Seller warrants that
the goods supplied here shall conform to the description stated on the front side hereof, that it will convey
good title, and that such goods shall be delivered free from any lawful security interest, lien, or
encumbrance. SELLER MAKES NO WARRANTY OF MERCHANTABILITY OR FITNESS FOR A
PARTICULAR USE. NOR IS THERE ANY OTHER EXPRESS OR IMPLIED WARRANTY.”

Conflict between Express and Implied Warranties
Express and implied warranties and their exclusion or limitation can often conflict. Section 2-317 of the
UCC provides certain rules for deciding which should prevail. In general, all warranties are to be
construed as consistent with each other and as cumulative. When that assumption is unreasonable, the
parties’ intention governs the interpretation, according to the following rules: (a) exact or technical
specifications displace an inconsistent sample or model or general language of description; (b) a sample

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from an existing bulk displaces inconsistent general language of description; (c) express warranties
displace inconsistent implied warranties other than an implied warranty of fitness for a particular
purpose. Any inconsistency among warranties must always be resolved in favor of the implied warranty of
fitness for a particular purpose. This doesn’t mean that warranty cannot be limited or excluded altogether.
The parties may do so. But in cases of doubt whether it or some other language applies, the implied
warranty of fitness will have a superior claim.

The Magnuson-Moss Act and Phantom Warranties
After years of debate over extending federal law to regulate warranties, Congress enacted the MagnusonMoss Federal Trade Commission Warranty Improvement Act (more commonly referred to as the
Magnuson-Moss Act) and President Ford signed it in 1975. The act was designed to clear up confusing and
misleading warranties, where—as Senator Magnuson put it in introducing the bill—“purchasers of
consumer products discover that their warranty may cover a 25-cent part but not the $100 labor charge or
that there is full coverage on a piano so long as it is shipped at the purchaser’s expense to the
factory.…There is a growing need to generate consumer understanding by clearly and conspicuously
disclosing the terms and conditions of the warranty and by telling the consumer what to do if his
guaranteed product becomes defective or malfunctions.” The Magnuson-Moss Act only applies to
consumer products (for household and domestic uses); commercial purchasers are presumed to be
knowledgeable enough not to need these protections, to be able to hire lawyers, and to be able to include
the cost of product failures into the prices they charge.
The act has several provisions to meet these consumer concerns; it regulates the content of warranties and
the means of disclosing those contents. The act gives the Federal Trade Commission (FTC) the authority
to promulgate detailed regulations to interpret and enforce it. Under FTC regulations, any written
warranty for a product costing a consumer more than ten dollars must disclose in a single document and
in readily understandable language the following nine items of information:
1.

The identity of the persons covered by the warranty, whether it is limited to the original purchaser or
fewer than all who might come to own it during the warranty period.

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2. A clear description of the products, parts, characteristics, components, or properties covered, and
where necessary for clarity, a description of what is excluded.
3. A statement of what the warrantor will do if the product fails to conform to the warranty, including
items or services the warranty will pay for and, if necessary for clarity, what it will not pay for.
4. A statement of when the warranty period starts and when it expires.
5.

A step-by-step explanation of what the consumer must do to realize on the warranty, including the
names and addresses of those to whom the product must be brought.

6. Instructions on how the consumer can be availed of any informal dispute resolution mechanism
established by the warranty.
7.

Any limitations on the duration of implied warranties—since some states do not permit such
limitations, the warranty must contain a statement that any limitations may not apply to the
particular consumer.

8. Any limitations or exclusions on relief, such as consequential damages—as above, the warranty must
explain that some states do not allow such limitations.
9. The following statement: “This warranty gives you specific legal rights, and you may also have other
rights which vary from state to state.”
In addition to these requirements, the act requires that the warranty be labeled either a full or limited
warranty. A full warranty means (1) the defective product or part will be fixed or replaced for free,
including removal and reinstallation; (2) it will be fixed within a reasonable time; (3) the consumer need
not do anything unreasonable (like shipping the piano to the factory) to get warranty service; (4) the
warranty is good for anyone who owns the product during the period of the warranty; (5) the consumer
gets money back or a new product if the item cannot be fixed within a reasonable number of attempts. But
the full warranty may not cover the whole product: it may cover only the hard drive in the computer, for
example; it must state what parts are included and excluded. A limited warranty is less inclusive. It may
cover only parts, not labor; it may require the consumer to bring the product to the store for service; it
may impose a handling charge; it may cover only the first purchaser. Both full and limited warranties may
exclude consequential damages.

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Disclosure of the warranty provisions prior to sale is required by FTC regulations; this can be done in a
number of ways. The text of the warranty can be attached to the product or placed in close conjunction to
it. It can be maintained in a binder kept in each department or otherwise easily accessible to the
consumer. Either the binders must be in plain sight or signs must be posted to call the prospective buyer’s
attention to them. A notice containing the text of the warranty can be posted, or the warranty itself can be
printed on the product’s package or container.
Phantom warranties are addressed by the Magnuson-Moss Act. As we have seen, the UCC permits the
seller to disclaim implied warranties. This authority often led sellers to give what were called phantom
warranties—that is, the express warranty contained disclaimers of implied warranties, thus leaving the
consumer with fewer rights than if no express warranty had been given at all. In the words of the
legislative report of the act, “The bold print giveth, and the fine print taketh away.” The act abolished
these phantom warranties by providing that if the seller gives a written warranty, whether express or
implied, he cannot disclaim or modify implied warranties. However, a seller who gives a limited warranty
can limit implied warranties to the duration of the limited warranty, if the duration is reasonable.
A seller’s ability to disclaim implied warranties is also limited by state law in two ways. First, by
amendment to the UCC or by separate legislation, some states prohibit disclaimers whenever consumer
products are sold.

[5]

Second, the UCC at 2-302 provides that unconscionable contracts or clauses will not

be enforced. UCC 2-719(3) provides that limitation of damages for personal injury in the sale of
“consumer goods is prima facie unconscionable, but limitation of damages where the loss is commercial is
not.” (Unconscionability was discussed in Chapter 12 "Legality".)
A first problem with warranty theory, then, is that it’s possible to disclaim or limit the warranty. The worst
abuses of manipulative and tricky warranties are eliminated by the Magnuson-Moss Act, but there are
several other reasons that warranty theory is not the panacea for claimants who have suffered damages or
injuries as a result of defective products.

Privity
A second problem with warranty law (after exclusion and modification of warranties) is that of privity.
Privity is the legal term for the direct connection between the seller and buyer, the two contracting parties.

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For decades, the doctrine of privity has held that one person can sue another only if they are in privity.
That worked well in the days when most commerce was local and the connection between seller and buyer
was immediate. But in a modern industrial (or postindustrial) economy, the product is transported
through a much larger distribution system, as depicted in Figure 17.2 "Chain of Distribution". Two
questions arise: (1) Is the manufacturer or wholesaler (as opposed to the retailer) liable to the buyer under
warranty theory? and (2) May the buyer’s family or friends assert warranty rights?
Figure 17.2 Chain of Distribution

Horizontal Privity
Suppose Carl Consumer buys a new lamp for his family’s living room. The lamp is defective: Carl gets a
serious electrical shock when he turns it on. Certainly Carl would be covered by the implied warranty of
merchantability: he’s in direct privity with the seller. But what if Carl’s spouse Carlene is injured? She
didn’t buy the lamp; is she covered? Or suppose Carl’s friend David, visiting for an afternoon, gets zapped.
Is David covered? This gets to horizontal privity, noncontracting parties who suffer damages from
defective goods, such as nonbuyer users, consumers, and bystanders. Horizontal privity determines to

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whose benefit the warranty “flows”—who can sue for its breach. In one of its rare instances of
nonuniformity, the UCC does not dictate the result. It gives the states three choices, labeled in Section 2318 as Alternatives A, B, and C.
Alternative A says that a seller’s warranty extends “to any natural person who is in the family or
household of his buyer or who is a guest in his home” provided (1) it is reasonable to expect the person
suffering damages to use, consume, or be affected by the goods and (2) the warranty extends only to
damages for personal injury.
Alternative B “extends to any natural person who may reasonably be expected to use, consume, or be
affected by the goods, and who is injured in person by breach of the warranty.” It is less restrictive than
the first alternative: it extends protection to people beyond those in the buyer’s home. For example, what
if Carl took the lamp to a neighbor’s house to illuminate a poker table: under Alternative B, anybody at the
neighbor’s house who suffered injury would be covered by the warranty. But this alternative does not
extend protection to organizations; “natural person” means a human being.
Alternative C is the same as B except that it applies not only to any “natural person” but “to any person
who is injured by breach of the warranty.” This is the most far-reaching alternative because it provides
redress for damage toproperty as well as for personal injury, and it extends protection to corporations
and other institutional buyers.
One may incidentally note that having three different alternatives for when third-party nonpurchasers can
sue a seller or manufacturer for breach of warranty gives rise to unintended consequences. First, different
outcomes are produced among jurisdictions, including variations in the common law. Second, the great
purpose of the Uniform Commercial Code in promoting national uniformity is undermined. Third, battles
over choice of law—where to file the lawsuit—are generated.
UCC, Section 2A-216, provides basically the same alternatives as applicable to the leasing of goods.

Vertical Privity
The traditional rule was that remote selling parties were not liable: lack of privity was a defense by the
manufacturer or wholesaler to a suit by a buyer with whom these entities did not themselves contract. The

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buyer could recover damages from the retailer but not from the original manufacturer, who after all made
the product and who might be much more financially able to honor the warranty. The UCC takes no
position here, but over the last fifty years the judicial trend has been to abolish
this vertical privity requirement. (SeeFigure 17.2 "Chain of Distribution"; the entities in the distribution
chain are those in vertical privity to the buyer.) It began in 1958, when the Michigan Supreme Court
overturned the old theory in an opinion written by Justice John D. Voelker (who also wrote the
novel Anatomy of a Murder, under the pen name Robert Traver).

[6]

Contributory Negligence, Comparative Negligence, and Assumption of Risk
After disclaimers and privity issues are resolved, other possible impediments facing the plaintiff in a
products-liability warranty case are issues of assumption of the risk, contributory negligence, and
comparative negligence (discussed inChapter 7 "Introduction to Tort Law" on torts).
Courts uniformly hold that assumption of risk is a defense for sellers against a claim of breach of
warranty, while there is a split of authority over whether comparative and contributory negligence are
defenses. However, the courts’ use of this terminology is often conflicting and confusing. The ultimate
question is really one of causation: was the seller’s breach of the warranty the cause of the plaintiff’s
damages?
The UCC is not markedly helpful in clearing away the confusion caused by years of discussion of
assumption of risk and contributory negligence. Section 2-715(2)(b) of the UCC says that among the forms
of consequential damage for which recovery can be sought is “injury to person or
property proximatelyresulting from any breach of warranty” (emphasis added). But “proximately” is a
troublesome word. Indeed, ultimately it is a circular word: it means nothing more than that the defendant
must have been a direct enough cause of the damages that the courts will impose liability. Comment 5 to
this section says, “Where the injury involved follows the use of goods without discovery of the defect
causing the damage, the question of ‘proximate’ turns on whether it was reasonable for the buyer to use
the goods without such inspection as would have revealed the defects. If it was not reasonable for him to
do so, or if he did in fact discover the defect prior to his use, the injury would not proximately result from
the breach of warranty.”

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Obviously if a sky diver buys a parachute and then discovers a few holes in it, his family would not likely
prevail in court when they sued to recover for his death because the parachute failed to function after he
jumped at 5,000 feet. But the general notion that it must have been reasonable for a buyer to use goods
without inspection can make a warranty case difficult to prove.

KEY TAKEAWAY
A first basis of recovery in products-liability theory is breach of warranty. There are two types of warranties:
express and implied. Under the implied category are three major subtypes: the implied warranty of
merchantability (only given by merchants), the implied warranty of fitness for a particular purpose, and the
implied warranty of title. There are a number of problems with the use of warranty theory: there must have
been a sale of the goods; the plaintiff must bring the action within the statute of limitations; and the plaintiff
must notify the seller within a reasonable time. The seller may—within the constraints of the Magnuson-Moss
Act—limit or exclude express warranties or limit or exclude implied warranties. Privity, or lack of it, between
buyer and seller has been significantly eroded as a limitation in warranty theory, but lack of privity may still
affect the plaintiff’s recovery; the plaintiff’s assumption of the risk in using defective goods may preclude
recovery.

EXERCISES
1.

What are the two main types of warranties and the important subtypes?

2.

Who can make each type of warranty?

3.

What general problems does a plaintiff have in bringing a products-liability warranty case?

4.

What problems are presented concerning exclusion or manipulative express warranties, and how does
the Magnuson-Moss Act address them?

5.

How are implied warranties excluded?

6.

What is the problem of lack of privity, and how does modern law deal with it?

[1] Rhodes Pharmacal Co. v. Continental Can Co., 219 N.E.2d 726 (Ill. 1976).
[2] Wat Henry Pontiac Co. v. Bradley, 210 P.2d 348 (Okla. 1949).
[3] Frederickson v. Hackney, 198 N.W. 806 (Minn. 1924).
[4] Menzel v. List, 246 N.E.2d 742 (N.Y. 1969).

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[5] A number of states have special laws that limit the use of the UCC implied warranty disclaimer rules in
consumer sales. Some of these appear in amendments to the UCC and others are in separate statutes. The
broadest approach is that of the nine states that prohibit the disclaimer of implied warranties in consumer sales
(Massachusetts, Connecticut, Maine, Vermont, Maryland, the District of Columbia, West Virginia, Kansas,
Mississippi, and, with respect to personal injuries only, Alabama). There is a difference in these states whether the
rules apply to manufacturers as well as retailers.
[6] Spence v. Three Rivers Builders & Masonry Supply, Inc., 90 N.W.2d 873 (Mich. 1958).

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17.3 Negligence
LEARNING OBJECTIVES
1.

Recognize how the tort theory of negligence may be of use in products-liability suits.

2.

Understand why negligence is often not a satisfactory cause of action in such suits: proof of it may be
difficult, and there are powerful defenses to claims of negligence.

Negligence is the second theory raised in the typical products-liability case. It is a tort theory (as
compared to breach of warranty, which is of course a contract theory), and it does have this advantage
over warranty theory: privity is never relevant. A pedestrian is struck in an intersection by a car whose
brakes were defectively manufactured. Under no circumstances would breach of warranty be a useful
cause of action for the pedestrian—there is no privity at all. Negligence is considered in detail in
the Chapter 7 "Introduction to Tort Law" on torts; it basically means lack of due care.

Typical Negligence Claims: Design Defects and Inadequate Warnings
Negligence theory in products liability is most useful in two types of cases: defective design and defective
warnings.

Design Defects
Manufacturers can be, and often are, held liable for injuries caused by products that were defectively
designed. The question is whether the designer used reasonable care in designing a product reasonably
safe for its foreseeable use. The concern over reasonableness and standards of care are elements of
negligence theory.
Defective-design cases can pose severe problems for manufacturing and safety engineers. More safety
means more cost. Designs altered to improve safety may impair functionality and make the product less
desirable to consumers. At what point safety comes into reasonable balance with performance, cost, and
desirability (see Figure 17.3 "The Reasonable Design Balance") is impossible to forecast accurately, though
some factors can be taken into account. For example, if other manufacturers are marketing comparable
products whose design are intrinsically safer, the less-safe products are likely to lose a test of
reasonableness in court.

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Figure 17.3 The Reasonable Design Balance

Warning Defects
We noted that a product may be defective if the manufacturer failed to warn the user of potential dangers.
Whether a warning should have been affixed is often a question of what is reasonably foreseeable, and the
failure to affix a warning will be treated as negligence. The manufacturer of a weed killer with poisonous
ingredients is certainly acting negligently when it fails to warn the consumer that the contents are
potentially lethal.
The law governing the necessity to warn and the adequacy of warnings is complex. What is reasonable
turns on the degree to which a product is likely to be misused and, as the disturbing Laaperi case (Section
17.6.3 "Failure to Warn") illustrates, whether the hazard is obvious.

Problems with Negligence Theory
Negligence is an ancient cause of action and, as was discussed in the torts chapter, it carries with it a
number of well-developed defenses. Two categories may be mentioned: common-law defenses and
preemption.

Common-Law Defenses against Negligence
Among the problems confronting a plaintiff with a claim of negligence in products-liability suits (again,
these concepts are discussed in the torts chapter) are the following:
•

Proving negligence at all: just because a product is defective does not necessarily prove the
manufacturer breached a duty of care.

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•

Proximate cause: even if there was some negligence, the plaintiff must prove her damages flowed
proximately from that negligence.

•

Contributory and comparative negligence: the plaintiff’s own actions contributed to the damages.

•

Subsequent alteration of the product: generally the manufacturer will not be liable if the product has
been changed.

•

Misuse or abuse of the product: using a lawn mower to trim a hedge or taking too much of a drug are
examples.

•

Assumption of the risk: knowingly using the product in a risky way.

Preemption
Preemption (or “pre-emption”) is illustrated by this problem: suppose there is a federal standard
concerning the product, and the defendant manufacturer meets it, but the standard is not really very
protective. (It is not uncommon, of course, for federal standard makers of all types to be significantly
influenced by lobbyists for the industries being regulated by the standards.) Is it enough for the
manufacturer to point to its satisfaction of the standard so that such satisfaction preempts (takes over)
any common-law negligence claim? “We built the machine to federal standards: we can’t be liable. Our
compliance with the federal safety standard is an affirmative defense.”
Preemption is typically raised as a defense in suits about (1) cigarettes, (2) FDA-approved medical devices,
(3) motor-boat propellers, (4) pesticides, and (5) motor vehicles. This is a complex area of law. Questions
inevitably arise as to whether there was federal preemption, express or implied. Sometimes courts find
preemption and the consumer loses; sometimes the courts don’t find preemption and the case goes
forward. According to one lawyer who works in this field, there has been “increasing pressure on both the
regulatory and congressional fronts to preempt state laws.” That is, the usual defendants (manufacturers)
push Congress and the regulatory agencies to state explicitly in the law that the federal standards preempt
and defeat state law.

[1]

KEY TAKEAWAY
Negligence is a second possible cause of action for products-liability claimants. A main advantage is that no
issues of privity are relevant, but there are often problems of proof; there are a number of robust commonlaw defenses, and federal preemption is a recurring concern for plaintiffs’ lawyers.

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EXERCISES
1.

What two types of products-liability cases are most often brought under negligence?

2.

How could it be said that merely because a person suffers injury as the result of a defective product,
proof of negligence is not necessarily made?

3.

What is “preemption” and how is it used as a sword to defeat products-liability plaintiffs?

[1] C. Richard Newsome and Andrew F. Knopf, “Federal Preemption: Products Lawyers Beware,” Florida Justice
Association Journal, July 27, 2007, accessed March 1,
2011,http://www.newsomelaw.com/resources/articles/federal-preemption-products-lawyers-beware.

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17.4 Strict Liability in Tort
LEARNING OBJECTIVES
1.

Know what “strict products liability” means and how it differs from the other two products-liability
theories.

2.

Understand the basic requirements to prove strict products liability.

3.

See what obstacles to recovery remain with this doctrine.

The warranties grounded in the Uniform Commercial Code (UCC) are often ineffective in assuring
recovery for a plaintiff’s injuries. The notice requirements and the ability of a seller to disclaim the
warranties remain bothersome problems, as does the privity requirement in those states that continue to
adhere to it.
Negligence as a products-liability theory obviates any privity problems, but negligence comes with a
number of familiar defenses and with the problems of preemption.
To overcome the obstacles, judges have gone beyond the commercial statutes and the ancient concepts of
negligence. They have fashioned a tort theory of products liability based on the principle of strict
products liability. One court expressed the rationale for the development of the concept as follows:
“The rule of strict liability for defective products is an example of necessary paternalism judicially shifting
risk of loss by application of tort doctrine because [the UCC] scheme fails to adequately cover the
situation. Judicial paternalism is to loss shifting what garlic is to a stew—sometimes necessary to give full
flavor to statutory law, always distinctly noticeable in its result, overwhelmingly counterproductive if
excessive, and never an end in itself.”

[1]

Paternalism or not, strict liability has become a very important

legal theory in products-liability cases.

Strict Liability Defined
The formulation of strict liability that most courts use is Section 402A of the Restatement of Torts
(Second), set out here in full:

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(1) One who sells any product in a defective condition unreasonably dangerous to the user or consumer or
to his property is subject to liability for physical harm thereby caused to the ultimate user or consumer, or
to his property, if
(a) the seller is engaged in the business of selling such a product, and
(b) it is expected to and does reach the user or consumer without substantial change in the condition in
which it is sold.
(2) This rule applies even though
(a) the seller has exercised all possible care in the preparation and sale of his product, and
(b) the user or consumer has not bought the product from or entered into any contractual relation with
the seller.
Section 402A of the Restatement avoids the warranty booby traps. It states a rule of law not governed by
the UCC, so limitations and exclusions in warranties will not apply to a suit based on the Restatement
theory. And the consumer is under no obligation to give notice to the seller within a reasonable time of
any injuries. Privity is not a requirement; the language of the Restatement says it applies to “the user or
consumer,” but courts have readily found that bystanders in various situations are entitled to bring
actions under Restatement, Section 402A. The formulation of strict liability, though, is limited to physical
harm. Many courts have held that a person who suffers economic loss must resort to warranty law.
Strict liability avoids some negligence traps, too. No proof of negligence is required. See Figure 17.4
"Major Difference between Warranty and Strict Liability".
Figure 17.4 Major Difference between Warranty and Strict Liability

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Section 402A Elements
Product in a Defective Condition
Sales of goods but not sales of services are covered under the Restatement, Section 402A. Furthermore,
the plaintiff will not prevail if the product was safe for normal handling and consumption when sold. A
glass soda bottle that is properly capped is not in a defective condition merely because it can be broken if
the consumer should happen to drop it, making the jagged glass dangerous. Chocolate candy bars are not
defective merely because you can become ill by eating too many of them at once. On the other hand, a
seller would be liable for a product defectively packaged, so that it could explode or deteriorate and
change its chemical composition. A product can also be in a defective condition if there is danger that
could come from an anticipated wrongful use, such as a drug that is safe only when taken in limited doses.
Under those circumstances, failure to place an adequate dosage warning on the container makes the
product defective.
The plaintiff bears the burden of proving that the product is in a defective condition, and this burden can
be difficult to meet. Many products are the result of complex feats of engineering. Expert witnesses are
necessary to prove that the products were defectively manufactured, and these are not always easy to
come by. This difficulty of proof is one reason why many cases raise the failure to warn as the dispositive
issue, since in the right case that issue is far easier to prove. The Anderson case (detailed in the exercises
at the end of this chapter) demonstrates that the plaintiff cannot prevail under strict liability merely
because he was injured. It is not the fact of injury that is dispositive but the defective condition of the
product.

Unreasonably Dangerous
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The product must be not merely dangerous but unreasonably dangerous. Most products have
characteristics that make them dangerous in certain circumstances. As the Restatement commentators
note, “Good whiskey is not unreasonably dangerous merely because it will make some people drunk, and
is especially dangerous to alcoholics; but bad whiskey, containing a dangerous amount of fuel oil, is
unreasonably dangerous.…Good butter is not unreasonably dangerous merely because, if such be the case,
it deposits cholesterol in the arteries and leads to heart attacks; but bad butter, contaminated with
poisonous fish oil, is unreasonably dangerous.”

[2]

Under Section 402A, “the article sold must be

dangerous to an extent beyond that which would be contemplated by the ordinary consumer who
purchases it, with the ordinary knowledge common to the community as to its characteristics. ”
Even high risks of danger are not necessarily unreasonable. Some products are unavoidably unsafe; rabies
vaccines, for example, can cause dreadful side effects. But the disease itself, almost always fatal, is worse.
A product is unavoidably unsafe when it cannot be made safe for its intended purpose given the present
state of human knowledge. Because important benefits may flow from the product’s use, its producer or
seller ought not to be held liable for its danger.
However, the failure to warn a potential user of possible hazards can make a product defective under
Restatement, Section 402A, whether unreasonably dangerous or even unavoidably unsafe. The dairy
farmer need not warn those with common allergies to eggs, because it will be presumed that the person
with an allergic reaction to common foodstuffs will be aware of them. But when the product contains an
ingredient that could cause toxic effects in a substantial number of people and its danger is not widely
known (or if known, is not an ingredient that would commonly be supposed to be in the product), the lack
of a warning could make the product unreasonably dangerous within the meaning of Restatement, Section
402A. Many of the suits brought by asbestos workers charged exactly this point; “The utility of an
insulation product containing asbestos may outweigh the known or foreseeable risk to the insulation
workers and thus justify its marketing. The product could still be unreasonably dangerous, however, if
unaccompanied by adequate warnings. An insulation worker, no less than any other product user, has a
right to decide whether to expose himself to the risk.”

[3]

This rule of law came to haunt the Manville

Corporation: it was so burdened with lawsuits, brought and likely to be brought for its sale of asbestos—a
known carcinogen—that it declared Chapter 11 bankruptcy in 1982 and shucked its liability.

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Engaged in the Business of Selling
Restatement, Section 402A(1)(a), limits liability to sellers “engaged in the business of selling such a
product.” The rule is intended to apply to people and entities engaged in business, not to casual one-time
sellers. The business need not be solely in the defective product; a movie theater that sells popcorn with a
razor blade inside is no less liable than a grocery store that does so. But strict liability under this rule does
not attach to a private individual who sells his own automobile. In this sense, Restatement, Section 402A,
is analogous to the UCC’s limitation of the warranty of merchantability to the merchant.
The requirement that the defendant be in the business of selling gets to the rationale for the whole
concept of strict products liability: businesses should shoulder the cost of injuries because they are in the
best position to spread the risk and distribute the expense among the public. This same policy has been
the rationale for holding bailors and lessors liable for defective equipment just as if they had been
sellers.

[5]

Reaches the User without Change in Condition
Restatement, Section 402A(1)(b), limits strict liability to those defective products that are expected to and
do reach the user or consumer without substantial change in the condition in which the products are sold.
A product that is safe when delivered cannot subject the seller to liability if it is subsequently mishandled
or changed. The seller, however, must anticipate in appropriate cases that the product will be stored;
faulty packaging or sterilization may be the grounds for liability if the product deteriorates before being
used.

Liability Despite Exercise of All Due Care
Strict liability applies under the Restatement rule even though “the seller has exercised all possible care in
the preparation and sale of his product.” This is the crux of “strict liability” and distinguishes it from the
conventional theory of negligence. It does not matter how reasonably the seller acted or how exemplary is
a manufacturer’s quality control system—what matters is whether the product was defective and the user
injured as a result. Suppose an automated bottle factory manufactures 1,000 bottles per hour under
exacting standards, with a rigorous and costly quality-control program designed to weed out any bottles

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showing even an infinitesimal amount of stress. The plant is “state of the art,” and its computerized
quality-control operation is the best in the world. It regularly detects the one out of every 10,000 bottles
that analysis has shown will be defective. Despite this intense effort, it proves impossible to weed out
every defective bottle; one out of one million, say, will still escape detection. Assume that a bottle, filled
with soda, finds its way into a consumer’s home, explodes when handled, sends glass shards into his eye,
and blinds him. Under negligence, the bottler has no liability; under strict liability, the bottler will be
liable to the consumer.

Liability without Contractual Relation
Under Restatement, Section 402A(2)(b), strict liability applies even though the user has not purchased
the product from the seller nor has the user entered into any contractual relation with the seller. In short,
privity is abolished and the injured user may use the theory of strict liability against manufacturers and
wholesalers as well as retailers. Here, however, the courts have varied in their approaches; the trend has
been to allow bystanders recovery. The Restatement explicitly leaves open the question of the bystander’s
right to recover under strict liability.

Problems with Strict Liability
Strict liability is liability without proof of negligence and without privity. It would seem that strict liability
is the “holy grail” of products-liability lawyers: the complete answer. Well, no, it’s not the holy grail. It is
certainly true that 402A abolishes the contractual problems of warranty. Restatement, Section 402A,
Comment m, says,
The rule stated in this Section is not governed by the provisions of the Uniform Commercial Code, as to
warranties; and it is not affected by limitations on the scope and content of warranties, or by limitation to
“buyer” and “seller” in those statutes. Nor is the consumer required to give notice to the seller of his injury
within a reasonable time after it occurs, as provided by the Uniform Act. The consumer’s cause of action
does not depend upon the validity of his contract with the person from whom he acquires the product, and
it is not affected by any disclaimer or other agreement, whether it be between the seller and his immediate
buyer, or attached to and accompanying the product into the consumer’s hands. In short, “warranty” must

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be given a new and different meaning if it is used in connection with this Section. It is much simpler to
regard the liability here stated as merely one of strict liability in tort.
Inherent in the Restatement’s language is the obvious point that if the product has been altered, losses
caused by injury are not the manufacturer’s liability. Beyond that there are still some limitations to strict
liability.

Disclaimers
Comment m specifically says the cause of action under Restatement, Section 402A, is not affected by
disclaimer. But in nonconsumer cases, courts have allowed clear and specific disclaimers. In 1969, the
Ninth Circuit observed: “InKaiser Steel Corp. the [California Supreme Court] court upheld the dismissal
of a strict liability action when the parties, dealing from positions of relatively equal economic strength,
contracted in a commercial setting to limit the defendant’s liability. The court went on to hold that in this
situation the strict liability cause of action does not apply at all. In reaching this conclusion, the court
in Kaiserreasoned that strict liability ‘is designed to encompass situations in which the principles of sales
warranties serve their purpose “fitfully at best.”’ [Citation]” It concluded that in such commercial settings
the UCC principles work well and “to apply the tort doctrines of products liability will displace the
statutory law rather than bring out its full flavor.”

[6]

Plaintiff’s Conduct
Conduct by the plaintiff herself may defeat recovery in two circumstances.

Assumption of Risk
Courts have allowed the defense of assumption of the risk in strict products-liability cases. A plaintiff
assumes the risk of injury, thus establishing defense to claim of strict products liability, when he is aware
the product is defective, knows the defect makes the product unreasonably dangerous, has reasonable
opportunity to elect whether to expose himself to the danger, and nevertheless proceeds to make use of
the product. The rule makes sense.

Misuse or Abuse of the Product
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Where the plaintiff does not know a use of the product is dangerous but nevertheless uses for an incorrect
purpose, a defense arises, but only if such misuse was not foreseeable. If it was, the manufacturer should
warn against that misuse. In Eastman v. Stanley Works, a carpenter used a framing hammer to drive
[7]

masonry nails; the claw of the hammer broke off, striking him in the eye. He sued. The court held that
while a defense does exist “where the product is used in a capacity which is unforeseeable by the
manufacturer and completely incompatible with the product’s design…misuse of a product suggests a use
which was unanticipated or unexpected by the product manufacturer, or unforeseeable and unanticipated
[but] it was not the case that reasonable minds could only conclude that appellee misused the [hammer].
Though the plaintiff’s use of the hammer might have been unreasonable, unreasonable use is not a
defense to a strict product-liability action or to a negligence action.”

Limited Remedy
The Restatement says recovery under strict liability is limited to “physical harm thereby caused to the
ultimate user or consumer, or to his property,” but not other losses and not economic losses. In Atlas Air
v. General Electric, a New York court held that the “economic loss rule” (no recovery for economic losses)
barred strict products-liability and negligence claims by the purchaser of a used airplane against the
airplane engine manufacturer for damage to the plane caused by an emergency landing necessitated by
engine failure, where the purchaser merely alleged economic losses with respect to the plane itself, and
not damages for personal injury (recovery for damage to the engine was allowed).

[8]

But there are exceptions. In Duffin v. Idaho Crop Imp. Ass’n, the court recognized that a party generally
owes no duty to exercise due care to avoid purely economic loss, but if there is a “special relationship”
[9]

between the parties such that it would be equitable to impose such a duty, the duty will be imposed. “In
other words, there is an extremely limited group of cases where the law of negligence extends its
protections to a party’s economic interest.”

The Third Restatement
The law develops. What seemed fitting in 1964 when the Restatement (Second) announced the state of the
common-law rules for strict liability in Section 402A seemed, by 1997, not to be tracking common law
entirely closely. The American Law Institute came out with the Restatement (Third) in that year. The

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Restatement changes some things. Most notably it abolishes the “unreasonably dangerous” test and
substitutes a “risk-utility test.” That is, a product is not defective unless its riskiness outweighs its utility.
More important, the Restatement (Third), Section 2, now requires the plaintiff to provide a reasonable
alternative design to the product in question. In advancing a reasonable alternative design, the plaintiff is
not required to offer a prototype product. The plaintiff must only show that the proposed alternative
design exists and is superior to the product in question. The Restatement (Third) also makes it more
difficult for plaintiffs to sue drug companies successfully. One legal scholar commented as follows on the
Restatement (Third):
The provisions of the Third Restatement, if implemented by the courts, will establish a degree of fairness
in the products liability arena. If courts adopt the Third Restatement’s elimination of the “consumer
expectations test,” this change alone will strip juries of the ability to render decisions based on potentially
subjective, capricious and unscientific opinions that a particular product design is unduly dangerous
based on its performance in a single incident. More important, plaintiffs will be required to propose a
reasonable alternative design to the product in question. Such a requirement will force plaintiffs to prove
that a better product design exists other than in the unproven and untested domain of their experts’
imaginations.

[10]

Of course some people put more faith in juries than is evident here. The new Restatement has been
adopted by a few jurisdictions and some cases the adopting jurisdictions incorporate some of its ideas, but
courts appear reluctant to abandon familiar precedent.

KEY TAKEAWAY
Because the doctrines of breach of warranty and negligence did not provide adequate relief to those suffering
damages or injuries in products-liability cases, beginning in the 1960s courts developed a new tort theory:
strict products liability, restated in the Second Restatement, section 402A. Basically the doctrine says that if
goods sold are unreasonably dangerous or defective, the merchant-seller will be liable for the immediate
property loss and personal injuries caused thereby. But there remain obstacles to recovery even under this
expanded concept of liability: disclaimers of liability have not completely been dismissed, the plaintiff’s
conduct or changes to the goods may limit recovery, and—with some exceptions—the remedies available are
limited to personal injury (and damage to the goods themselves); economic loss is not recoverable. Almost

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forty years of experience with the Second Restatement’s section on strict liability has seen changes in the law,
and the Third Restatement introduces those, but it has not been widely accepted yet.

EXERCISES
1.

What was perceived to be inadequate about warranty and negligence theories that necessitated the
development of strict liability?

2.

Briefly describe the doctrine.

3.

What defects in goods render their sellers strictly liable?

4.

Who counts as a liable seller?

5.

What obstacles does a plaintiff have to overcome here, and what limitations are there to recovery?

[1] Kaiser Steel Corp. v. Westinghouse Electric Corp., 127 Cal. Rptr. 838 (Cal. 1976).
[2] Restatement (Second) of Contracts, Section 402A(i).
[3] Borel v. Fibreboard Paper Products Corp., 493 F.Zd 1076 (5th Cir. 1973).
[4] In re Johns-Manville Corp., 36 R.R. 727 (So. Dist. N.Y. 1984).
[5] Martin v. Ryder Rental, Inc., 353 A.2d 581 (Del. 1976).
[6] Idaho Power Co. v. Westinghouse Electric Corp., 596 F.2d 924, 9CA (1979).
[7] Eastman v. Stanley Works, 907 N.E.2d 768 (Ohio App. 2009).
[8] Atlas Air v. General Electric, 16 A.D.3d 444 (N.Y.A.D. 2005).
[9] Duffin v. Idaho Crop Imp. Ass’n, 895 P.2d 1195 (Idaho 1995).
[10] Quinlivan Wexler LLP, “The 3rd Restatement of Torts—Shaping the Future of Products Liability Law,” June 1,
1999, accessed March 1, 2011,http://library.findlaw.com/1999/Jun/1/127691.html.

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17.5 Tort Reform
LEARNING OBJECTIVES
1.

See why tort reform is advocated, why it is opposed, and what interests take each side.

2.

Understand some of the significant state reforms in the last two decades.

3.

Know what federal reforms have been instituted.

The Cry for Reform
In 1988, The Conference Board published a study that resulted from a survey of more than 500 chief
executive officers from large and small companies regarding the effects of products liability on their firms.
The study concluded that US companies are less competitive in international business because of these
effects and that products-liability laws must be reformed. The reform effort has been under way ever
since, with varying degrees of alarms and finger-pointing as to who is to blame for the “tort crisis,” if there
even is one. Business and professional groups beat the drums for tort reform as a means to guarantee
“fairness” in the courts as well as spur US economic competitiveness in a global marketplace, while
plaintiffs’ attorneys and consumer advocates claim that businesses simply want to externalize costs by
denying recovery to victims of greed and carelessness.
Each side vilifies the other in very unseemly language: probusiness advocates call consumer-oriented
states “judicial hell-holes” and complain of “well-orchestrated campaign[s] by tort lawyer lobbyists and
allies to undo years of tort reform at the state level,”
“scant evidence” of any tort abuse.

[2]

[1]

while pro-plaintiff interests claim that there is

It would be more amusing if it were not so shrill and partisan.

Perhaps the most one can say with any certainty is that peoples’ perception of reality is highly colored by
their self-interest. In any event, there have been reforms (or, as the detractors say, “deforms”).

State Reforms
Prodded by astute lobbying by manufacturing and other business trade associations, state legislatures
responded to the cries of manufacturers about the hardships that the judicial transformation of the
products-liability lawsuit ostensibly worked on them. Most state legislatures have enacted at least one of
some three dozen “reform” proposal pressed on them over the last two decades. Some of these measures

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do little more than affirm and clarify case law. Among the most that have passed in several states are
outlined in the next sections.

Statutes of Repose
Perhaps nothing so frightens the manufacturer as the occasional reports of cases involving products that
were fifty or sixty years old or more at the time they injured the plaintiff. Many states have addressed this
problem by enacting the so-called statute of repose. This statute establishes a time period, generally
ranging from six to twelve years; the manufacturer is not liable for injuries caused by the product after
this time has passed.

State-of-the-Art Defense
Several states have enacted laws that prevent advances in technology from being held against the
manufacturer. The fear is that a plaintiff will convince a jury a product was defective because it did not use
technology that was later available. Manufacturers have often failed to adopt new advances in technology
for fear that the change will be held against them in a products-liability suit. These new statutes declare
that a manufacturer has a valid defense if it would have been technologically impossible to have used the
new and safer technology at the time the product was manufactured.

Failure to Warn
Since it is often easier to prove that an injury resulted because the manufacturer failed to warn against a
certain use than it is to prove an injury was caused by a defective design, manufacturers are subjected to a
considerable degree of hindsight. Some of the state statutes limit the degree to which the failure to warn
can be used to connect the product and the injury. For example, the manufacturer has a valid defense if it
would have been impossible to foresee that the consumer might misuse the product in a certain way.

Comparative Fault for Consumer Misuse
Contributory negligence is generally not a defense in a strict liability action, while assumption of risk is. In
states that have enacted so-called comparative fault statutes, the user’s damages are pegged to the
percentage of responsibility for the injury that the defendant bears. Thus if the consumer’s misuse of the

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product is assessed as having been 20 percent responsible for the accident (or for the extent of the
injuries), the consumer is entitled to only 80 percent of damages, the amount for which the defendant
manufacturer is responsible.

Criminal Penalties
Not all state reform is favorable to manufacturers. Under the California Corporate Criminal Liability Act,
which took effect twenty years ago, companies and managers must notify a state regulatory agency if they
know that a product they are selling in California has a safety defect, and the same rule applies under
certain federal standards, as Toyota executives were informed by their lawyers following alarms about
sudden acceleration in some Toyota automobiles. Failure to provide notice may result in corporate and
individual criminal liability.

Federal Reform
Piecemeal reform of products-liability law in each state has contributed to the basic lack of uniformity
from state to state, giving it a crazy-quilt effect. In the nineteenth century, this might have made little
difference, but today most manufacturers sell in the national market and are subjected to the varying
requirements of the law in every state. For years there has been talk in and out of Congress of enacting a
federal products-liability law that would include reforms adopted in many states, as discussed earlier. So
far, these efforts have been without much success.
Congressional tort legislation is not the only possible federal action to cope with products-related injuries.
In 1972, Congress created the Consumer Product Safety Commission (CPSC) and gave the commission
broad power to act to prevent unsafe consumer products. The CPSC can issue mandatory safety standards
governing design, construction, contents, performance, packaging, and labeling of more than 10,000
consumer products. It can recall unsafe products, recover costs on behalf of injured consumers, prosecute
those who violate standards, and require manufacturers to issue warnings on hazardous products. It also
regulates four federal laws previously administered by other departments: the Flammable Fabrics Act, the
Hazardous Substances Act, the Poison Prevention Packaging Act, and the Refrigerator Safety Act. In its
early years, the CPSC issued standards for bicycles, power mowers, television sets, architectural glass,
extension cords, book matches, pool slides, and space heaters. But the list of products is long, and the

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CPSC’s record is mixed: it has come under fire for being short on regulation and for taking too long to
promulgate the relatively few safety standards it has issued in a decade.

KEY TAKEAWAY
Business advocates claim the American tort system—products-liability law included—is broken and corrupted
by grasping plaintiffs’ lawyers; plaintiffs’ lawyers say businesses are greedy and careless and need to be
smacked into recognition of its responsibilities to be more careful. The debate rages on, decade after decade.
But there have been some reforms at the state level, and at the federal level the Consumer Product Safety Act
sets out standards for safe products and requires recalls for defective ones. It is regularly castigated for (1)
being officious and meddling or (2) being too timid.

EXERCISES
1.

Why is it so difficult to determine if there really is a “tort crisis” in the United States?

2.

What reforms have been made to state tort law?

3.

What federal legislation affects consumer safety?

[1] American Tort Reform Association website, accessed March 1, 2011,http://www.atra.org.
[2] http://www.shragerlaw.com/html/legal_rights.html.

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17.6 Cases
Implied Warranty of Merchantability and the Requirement of a “Sale”
Sheeskin v. Giant Food, Inc.
318 A.2d 874 (Md. App. 1974)
Davidson, J.
Every Friday for over two years Nathan Seigel, age 73, shopped with his wife at a Giant Food Store. This
complex products liability case is before us because on one of these Fridays, 23 October 1970, Mr. Seigel
was carrying a six-pack carton of Coca-Cola from a display bin at the Giant to a shopping cart when one or
more of the bottles exploded. Mr. Seigel lost his footing, fell to the floor and was injured.
In the Circuit Court for Montgomery County, Mr. Seigel sued both the Giant Food, Inc., and the
Washington Coca-Cola Bottling Company, Inc., for damages resulting from their alleged negligence and
breach of an implied warranty. At the conclusion of the trial Judge Walter H. Moorman directed a verdict
in favor of each defendant.…
In an action based on breach of warranty it is necessary for the plaintiff to show the existence of the
warranty, the fact that the warranty was broken and that the breach of warranty was the proximate cause
of the loss sustained. [UCC] 2-314.…The retailer, Giant Food, Inc., contends that appellant failed to prove
that an implied warranty existed between himself and the retailer because he failed to prove that there
was a sale by the retailer to him or a contract of sale between the two. The retailer maintains that there
was no sale or contract of sale because at the time the bottles exploded Mr. Seigel had not yet paid for
them. We do not agree.
[UCC] 2-314(1) states in pertinent part:
Unless excluded or modified, a warranty that the goods shall be merchantable is implied in a contract
for their sale if the seller is a merchant with respect to goods of that kind.

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Thus, in order for the implied warranties of 2-314 to be applicable there must be a “contract for sale.” In
Maryland it has been recognized that neither a completed ‘sale’ nor a fully executed contract for sale is
required. It is enough that there be in existence an executory contract for sale.…
Here, the plaintiff has the burden of showing the existence of the warranty by establishing that at the time
the bottles exploded there was a contract for their sale existing between himself and the Giant. [Citation]
Mr. Titus, the manager of the Giant, testified that the retailer is a “self-service” store in which “the only
way a customer can buy anything is to select it himself and take it to the checkout counter.” He stated that
there are occasions when a customer may select an item in the store and then change his mind and put the
item back. There was no evidence to show that the retailer ever refused to sell an item to a customer once
it had been selected by him or that the retailer did not consider himself bound to sell an item to the
customer after the item had been selected. Finally, Mr. Titus said that an employee of Giant placed the
six-pack of Coca-Cola selected by Mr. Seigel on the shelf with the purchase price already stamped upon it.
Mr. Seigel testified that he picked up the six-pack with the intent to purchase it.
We think that there is sufficient evidence to show that the retailer’s act of placing the bottles upon the
shelf with the price stamped upon the six-pack in which they were contained manifested an intent to offer
them for sale, the terms of the offer being that it would pass title to the goods when Mr. Seigel presented
them at the check-out counter and paid the stated price in cash. We also think that the evidence is
sufficient to show that Mr. Seigel’s act of taking physical possession of the goods with the intent to
purchase them manifested an intent to accept the offer and a promise to take them to the checkout
counter and pay for them there.
[UCC] 2-206 provides in pertinent part:
(1) Unless otherwise unambiguously indicated by the language or circumstances
(a) An offer to make a contract shall be construed as inviting acceptance in any manner and by any
medium reasonable in the circumstances.…
The Official Comment 1 to this section states:

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Any reasonable manner of acceptance is intended to be regarded as available unless the offeror has made
quite clear that it will not be acceptable.
In our view the manner by which acceptance was to be accomplished in the transaction herein involved
was not indicated by either language or circumstances. The seller did not make it clear that acceptance
could not be accomplished by a promise rather than an act. Thus it is equally reasonable under the terms
of this specific offer that acceptance could be accomplished in any of three ways: 1) by the act of delivering
the goods to the check-out counter and paying for them; 2) by the promise to pay for the goods as
evidenced by their physical delivery to the check-out counter; and 3) by the promise to deliver the goods
to the check-out counter and to pay for them there as evidenced by taking physical possession of the goods
by their removal from the shelf.
The fact that customers, having once selected goods with the intent to purchase them, are permitted by
the seller to return them to the shelves does not preclude the possibility that a selection of the goods, as
evidenced by taking physical possession of them, could constitute a reasonable mode of acceptance.
Section 2-106(3) provides:
“Termination” occurs when either party pursuant to a power created by agreement or law puts an end to
the contract otherwise then for its breach. On “termination” all obligations which are still executory on
both sides are discharged but any right based on prior breach or performance survives.
Here the evidence that the retailer permits the customer to “change his mind” indicates only an
agreement between the parties to permit the consumer to end his contract with the retailer irrespective of
a breach of the agreement by the retailer. It does not indicate that an agreement does not exist prior to the
exercise of this option by the consumer.…
Here Mr. Seigel testified that all of the circumstances surrounding his selection of the bottles were
normal; that the carton in which the bottles came was not defective; that in lifting the carton from the
shelf and moving it toward his basket the bottles neither touched nor were touched by anything other than
his hand; that they exploded almost instantaneously after he removed them from the shelf; and that as a
result of the explosion he fell injuring himself. It is obvious that Coca-Cola bottles which would break
under normal handling are not fit for the ordinary use for which they were intended and that the

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relinquishment of physical control of such a defective bottle to a consumer constitutes a breach of
warranty. Thus the evidence was sufficient to show that when the bottles left the retailer’s control they did
not conform to the representations of the warranty of merchantability, and that this breach of the
warranty was the cause of the loss sustained.…
[Judgment in favor of Giant Foods is reversed and the case remanded for a new trial. Judgment in favor of
the bottler is affirmed because the plaintiff failed to prove that the bottles were defective when they were
delivered to the retailer.]

CASE QUESTIONS
1.

What warranty did the plaintiff complain was breached here?

2.

By displaying the soda pop, the store made an offer to its customers. How did the court say such offers
might be accepted?

3.

Why did the court get into the discussion about “termination” of the contract?

4.

What is the controlling rule of law applied in this case?

Strict Liability and Bystanders
Embs v. Pepsi-Cola Bottling Co. of Lexington, Kentucky, Inc.
528 S.W.2d 703 (Ky. 1975)
Jukowsky, J.
On the afternoon of July 25, 1970 plaintiff-appellant entered the self-service retail store operated by the
defendant-appellee, Stamper’s Cash Market, Inc., for the purpose of “buying soft drinks for the kids.” She
went to an upright soft drink cooler, removed five bottles and placed them in a carton. Unnoticed by her, a
carton of Seven-Up was sitting on the floor at the edge of the produce counter about one foot from where
she was standing. As she turned away from the cooler she heard an explosion that sounded “like a
shotgun.” When she looked down she saw a gash in her leg, pop on her leg, green pieces of a bottle on the
floor and the Seven-Up carton in the midst of the debris. She did not kick or otherwise come into contact
with the carton of Seven-Up prior to the explosion. Her son, who was with her, recognized the green
pieces of glass as part of a Seven-Up bottle.

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She was immediately taken to the hospital by Mrs. Stamper, a managing agent of the store. Mrs. Stamper
told her that a Seven-Up bottle had exploded and that several bottles had exploded that week. Before
leaving the store Mrs. Stamper instructed one of her children to clean up the mess. Apparently, all of the
physical evidence went out with the trash. The location of the Seven-Up carton immediately before the
explosion was not a place where such items were ordinarily kept.…
When she rested her case, the defendants-appellees moved for a directed verdict in their favor. The trial
court granted the motion on the grounds that the doctrine of strict product liability in tort does not extend
beyond users and consumers and that the evidence was insufficient to permit an inference by a reasonably
prudent man that the bottle was defective or if it was, when it became so.
In [Citation] we adopted the view of strict product liability in tort expressed in Section 402 A of the
American Law Institute’s Restatement of Torts 2d.

402 A. Special Liability of Seller of Product for Physical Harm to User or
Consumer
(1) One who sells any product in a defective condition unreasonably dangerous to the user or to his
property is subject to liability for physical harm thereby caused to the ultimate user or consumer, or to his
property, if
(a) the seller is engaged in the business of selling such a product, and
(b) it is expected to and does reach the user or consumer without substantial change in the condition in
which it was sold.
(2) The rule stated in Subsection (1) applies although
(a) the seller has exercised all possible care in the preparation and sale of his product, and
(b) the user or consumer has not bought the product from or entered into any contractual relation with
the seller.

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Comment f on that section makes it abundantly clear that this rule applies to any person engaged in the
business of supplying products for use or consumption, including any manufacturer of such a product and
any wholesale or retail dealer or distributor.
Comment c points out that on whatever theory, the justification for the rule has been said to be that the
seller, by marketing his product for use and consumption, has undertaken and assumed a special
responsibility toward any member of the consuming public who may be injured by it; that the public has
the right to and does expect that reputable sellers will stand behind their goods; that public policy
demands that the burden of accidental injuries caused by products intended for consumption be placed
upon those who market them, and be treated as a cost of production against which liability insurance can
be obtained; and that the consumer of such products is entitled to the maximum of protection at the
hands of someone, and the proper persons to afford it are those who market the products.
The caveat to the section provides that the Institute expresses no opinion as to whether the rule may not
apply to harm to persons other than users or consumers. Comment on caveat o states the Institute
expresses neither approval nor disapproval of expansion of the rule to permit recovery by casual
bystanders and others who may come in contact with the product, and admits there may be no essential
reason why such plaintiffs should not be brought within the scope of protection afforded, other than they
do not have the same reasons for expecting such protection as the consumer who buys a marketed
product, and that the social pressure which has been largely responsible for the development of the rule
has been a consumer’s pressure, and there is not the same demand for the protection of casual
strangers.…
The caveat articulates the essential point: Once strict liability is accepted, bystander recovery is fait
accompli.
Our expressed public policy will be furthered if we minimize the risk of personal injury and property
damage by charging the costs of injuries against the manufacturer who can procure liability insurance and
distribute its expense among the public as a cost of doing business; and since the risk of harm from
defective products exists for mere bystanders and passersby as well as for the purchaser or user, there is
no substantial reason for protecting one class of persons and not the other. The same policy requires us to

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maximize protection for the injured third party and promote the public interest in discouraging the
marketing of products having defects that are a menace to the public by imposing strict liability upon
retailers and wholesalers in the distributive chain responsible for marketing the defective product which
injures the bystander. The imposition of strict liability places no unreasonable burden upon sellers
because they can adjust the cost of insurance protection among themselves in the course of their
continuing business relationship.
We must not shirk from extending the rule to the manufacturer for fear that the retailer or middleman
will be impaled on the sword of liability without regard to fault. Their liability was already established
under Section 402 A of the Restatement of Torts 2d. As a matter of public policy the retailer or
middleman as well as the manufacturer should be liable since the loss for injuries resulting from defective
products should be placed on those members of the marketing chain best able to pay the loss, who can
then distribute such risk among themselves by means of insurance and indemnity agreements.
[Citation]…
The result which we reach does not give the bystander a “free ride.” When products and consumers are
considered in the aggregate, bystanders, as a class, purchase most of the same products to which they are
exposed as bystanders. Thus, as a class, they indirectly subsidize the liability of the manufacturer,
middleman and retailer and in this sense do pay for the insurance policy tied to the product.…
For the sake of clarity we restate the extension of the rule. The protections of Section 402 A of the
Restatement of Torts 2d extend to bystanders whose injury from the defective product is reasonably
foreseeable.…
The judgment is reversed and the cause is remanded to the Clark Circuit Court for further proceedings
consistent herewith.
Stephenson, J. (dissenting):
I respectfully dissent from the majority opinion to the extent that it subjects the seller to liability. Every
rule of law in my mind should have a rational basis. I see none here.

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Liability of the seller to the user, or consumer, is based upon warranty. Restatement, Second, Torts s
403A. To extend this liability to injuries suffered by a bystander is to depart from any reasonable basis
and impose liability by judicial fiat upon an otherwise innocent defendant. I do not believe that the
expression in the majority opinion which justifies this rule for the reason that the seller may procure
liability insurance protection is a valid legal basis for imposing liability without fault. I respectfully
dissent.

CASE QUESTIONS
1.

Why didn’t the plaintiff here use warranty as a theory of recovery, as Mr. Seigel did in the previous case?

2.

The court offers a rationale for the doctrine of strict products liability. What is it?

3.

Restatement, Section 402A, by its terms extends protection “to the ultimate user or consumer,” but Mrs.
Embs [plaintiff-appellant] was not that. What rationale did the court give for expanding the protection
here?

4.

Among the entities in the vertical distribution chain—manufacturer, wholesaler, retailer—who is liable
under this doctrine?

5.

What argument did Judge Stephenson have in dissent? Is it a good one?

6.

What is the controlling rule of law developed in this case?

Failure to Warn
Laaperi v. Sears, Roebuck & Co., Inc.
787 F.2d 726 C.A.1 (Mass. 1986)
Campbell, J.
In March 1976, plaintiff Albin Laaperi purchased a smoke detector from Sears. The detector,
manufactured by the Pittway Corporation, was designed to be powered by AC (electrical) current. Laaperi
installed the detector himself in one of the two upstairs bedrooms in his home.
Early in the morning of December 27, 1976, a fire broke out in the Laaperi home. The three boys in one of
the upstairs bedrooms were killed in the blaze. Laaperi’s 13-year-old daughter Janet, who was sleeping in

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the other upstairs bedroom, received burns over 12 percent of her body and was hospitalized for three
weeks.
The uncontroverted testimony at trial was that the smoke detector did not sound an alarm on the night of
the fire. The cause of the fire was later found to be a short circuit in an electrical cord that was located in a
cedar closet in the boys’ bedroom. The Laaperi home had two separate electrical circuits in the upstairs
bedrooms: one which provided electricity to the outlets and one which powered the lighting fixtures. The
smoke detector had been connected to the outlet circuit, which was the circuit that shorted and cut off.
Because the circuit was shorted, the AC-operated smoke detector received no power on the night of the
fire. Therefore, although the detector itself was in no sense defective (indeed, after the fire the charred
detector was tested and found to be operable), no alarm sounded.
Laaperi brought this diversity action against defendants Sears and Pittway, asserting negligent design,
negligent manufacture, breach of warranty, and negligent failure to warn of inherent dangers. The parties
agreed that the applicable law is that of Massachusetts. Before the claims went to the jury, verdicts were
directed in favor of defendants on all theories of liability other than failure to warn.…
Laaperi’s claim under the failure to warn theory was that he was unaware of the danger that the very short
circuit which might ignite a fire in his home could, at the same time, incapacitate the smoke detector. He
contended that had he been warned of this danger, he would have purchased a battery-powered smoke
detector as a back-up or taken some other precaution, such as wiring the detector to a circuit of its own, in
order better to protect his family in the event of an electrical fire.
The jury returned verdicts in favor of Laaperi in all four actions on the failure to warn claim. The jury
assessed damages in the amount of $350,000 [$1,050,000, or about $3,400,000 in 2010 dollars] each of
the three actions brought on behalf of the deceased sons, and $750,000 [about $2,500,000 in 2010
dollars] in the action brought on behalf of Janet Laaperi. The defendants’ motions for directed verdict and
judgment notwithstanding the verdict were denied, and defendants appealed.
Defendants ask us to declare that the risk that an electrical fire could incapacitate an AC-powered smoke
detector is so obvious that the average consumer would not benefit from a warning. This is not a trivial
argument; in earlier—some might say sounder—days, we might have accepted it.… Our sense of the

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current state of the tort law in Massachusetts and most other jurisdictions, however, leads us to conclude
that, today, the matter before us poses a jury question; that “obviousness” in a situation such as this would
be treated by the Massachusetts courts as presenting a question of fact, not of law. To be sure, it would be
obvious to anyone that an electrical outage would cause this smoke detector to fail. But the average
purchaser might not comprehend the specific danger that a fire-causing electrical problem can
simultaneously knock out the circuit into which a smoke detector is wired, causing the detector to fail at
the very moment it is needed. Thus, while the failure of a detector to function as the result of an electrical
malfunction due, say, to a broken power line or a neighborhood power outage would, we think, be obvious
as a matter of law, the failure that occurred here, being associated with the very risk—fire—for which the
device was purchased, was not, or so a jury could find.…
Finally, defendants contend that the award of $750,000 [$2.5 million in 2010 dollars] in damages to
Janet Laaperi was excessive, and should have been overturned by the district court.…
Janet Laaperi testified that on the night of the fire, she woke up and smelled smoke. She woke her friend
who was sleeping in her room, and they climbed out to the icy roof of the house. Her father grabbed her
from the roof and took her down a ladder. She was taken to the hospital. Although she was in “mild
distress,” she was found to be “alert, awake, [and] cooperative.” Her chest was clear. She was diagnosed as
having first and second degree burns of her right calf, both buttocks and heels, and her left lower back, or
approximately 12 percent of her total body area. She also suffered from a burn of her tracheobronchial
mucosa (i.e., the lining of her airway) due to smoke inhalation, and multiple superficial lacerations on her
right hand.
The jury undoubtedly, and understandably, felt a great deal of sympathy for a young girl who, at the age of
13, lost three brothers in a tragic fire. But by law the jury was only permitted to compensate her for those
damages associated with her own injuries. Her injuries included fright and pain at the time of and after
the fire, a three-week hospital stay, some minor discomfort for several weeks after discharge, and a
permanent scar on her lower back. Plaintiff has pointed to no cases, and we have discovered none, in
which such a large verdict was sustained for such relatively minor injuries, involving no continuing
disability.

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The judgments in favor of Albin Laaperi in his capacity as administrator of the estates of his three sons are
affirmed. In the action on behalf of Janet Laaperi, the verdict of the jury is set aside, the judgment of the
district court vacated, and the cause remanded to that court for a new trial limited to the issue of
damages.

CASE QUESTIONS
1.

The “C.A. 1” under the title of the case means it is a US Court of Appeals case from the First Circuit in
Massachusetts. Why is this case in federal court?

2.

Why does the court talk about its “sense of the current state of tort law in Massachusetts” and how this
case “would be treated by the Massachusetts courts,” as if it were not in the state at all but somehow
outside?

3.

What rule of law is in play here as to the defendants’ liability?

4.

This is a tragic case—three boys died in a house fire. Speaking dispassionately—if not heartlessly—
though, did the fire actually cost Mr. Laaperi, or did he lose $3.4 million (in 2010 dollars) as the result of
his sons’ deaths? Does it make sense that he should become a millionaire as a result? Who ends up paying
this amount? (The lawyers’ fees probably took about half.)

5.

Is it likely that smoke-alarm manufactures and sellers changed the instructions as a result of this case?

[1] Uniform Commercial Code, Section 2-316.

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17.7 Summary and Exercises
Summary
Products liability describes a type of claim—for injury caused by a defective product—and not a separate
theory of liability. In the typical case, three legal doctrines may be asserted: (1) warranty, (2) negligence,
and (3) strict liability.
If a seller asserts that a product will perform in a certain manner or has certain characteristics, he has
given an express warranty, and he will be held liable for damages if the warranty is breached—that is, if
the goods do not live up to the warranty. Not every conceivable claim is an express warranty; the courts
permit a certain degree of “puffing.”
An implied warranty is one created by law. Goods sold by a merchant-seller carry an implied warranty of
merchantability, meaning that they must possess certain characteristics, such as being of average quality
for the type described and being fit for the ordinary purposes for which they are intended.
An implied warranty of fitness for a particular purpose is created whenever a seller knows or has reason to
know that the buyer is relying on the seller’s knowledge and skill to select a product for the buyer’s
particular purposes.
Under UCC Article 2, the seller also warrants that he is conveying good title and that the goods are free of
any rightful claim by a third person.
UCC Article 2 permits sellers to exclude or disclaim warranties in whole or in part. Thus a seller may
exclude express warranties. He may also disclaim many implied warranties—for example, by noting that
the sale is “as is.” The Magnuson-Moss Act sets out certain types of information that must be included in
any written warranty. The act requires the manufacturer or seller to label the warranty as either “full” or
“limited” depending on what types of defects are covered and what the customer must do to obtain repair
or replacement. The act also abolishes “phantom warranties.”

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Privity once stood as a bar to recovery in suits brought by those one or more steps removed in the
distribution chain from the party who breached a warranty. But the nearly universal trend in the state
courts has been to abolish privity as a defense.
Because various impediments stand in the way of warranty suits, courts have adopted a tort theory of
strict liability, under which a seller is liable for injuries resulting from the sale of any product in a
defective condition if it is unreasonably dangerous to the user or consumer. Typical issues in strict liability
cases are these: Is the defendant a seller engaged in the business of selling? Was the product sold in a
defective condition? Was it unreasonably dangerous, either on its face or because of a failure to warn? Did
the product reach the consumer in an unchanged condition? Strict liability applies regardless of how
careful the seller was and regardless of his lack of contractual relation with the consumer or user.
Manufacturers can also be held liable for negligence—most often for faulty design of products and
inadequate warnings about the hazards of using the product.
The products-liability revolution prompted many state legislatures to enact certain laws limiting to some
degree the manufacturer’s responsibility for defective products. These laws include statutes of repose and
provide a number of other defenses.

EXERCISES
1.

Ralph’s Hardware updated its accounting system and agreed to purchase a computer system from a
manufacturer, Bits and Bytes (BB). During contract negotiations, BB’s sales representative promised that
the system was “A-1” and “perfect.” However, the written contract, which the parties later signed,
disclaimed all warranties, express and implied. After installation the computer produced only random
numbers and letters, rather than the desired accounting information. Is BB liable for breaching an express
warranty? Why?

2.

Kate owned a small grocery store. One day John went to the store and purchased a can of chip dip that
was, unknown to Kate or John, adulterated. John became seriously ill after eating the dip and sued Kate
for damages on the grounds that she breached an implied warranty of merchantability. Is Kate liable?
Why?

3.

Carrie visited a neighborhood store to purchase some ham, which a salesperson cut by machine in the
store. The next day she made a ham sandwich. In eating the sandwich, Carrie bit into a piece of cartilage

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in the ham. As a result, Carrie lost a tooth, had to undergo root canal treatments, and must now wear a
full-coverage crown to replace the tooth. Is the store liable for the damage? Why?
4.

Clarence, a business executive, decided to hold a garage sale. At the sale, his neighbor Betty mentioned to
Clarence that she was the catcher on her city-league baseball team and was having trouble catching
knuckleball pitches, which required a special catcher’s mitt. Clarence pulled an old mitt from a pile of
items that were on sale and said, “Here, try this.” Betty purchased the mitt but discovered during her next
game that it didn’t work. Has Clarence breached an express or implied warranty? Why?

5.

Sarah purchased several elegant picture frames to hang in her dorm room. She also purchased a package
of self-sticking hangers. Late one evening, while Sarah was studying business law in the library, the
hangers came loose and her frames came crashing to the floor. After Sarah returned to her room and
discovered the rubble, she examined the box in which the hangers were packaged and found the
following language: “There are no warranties except for the description on this package and specifically
there is NO IMPLIED WARRANTY OF MERCHANTABILITY.” Assuming the hangers are not of fair, average,
ordinary quality, would the hanger company be liable for breaching an implied warranty of
merchantability? Why?

6.

A thirteen-year-old boy received a Golfing Gizmo—a device for training novice golfers—as a gift from his
mother. The label on the shipping carton and the cover of the instruction booklet urged players to “drive
the ball with full power” and further stated: “COMPLETELY SAFE BALL WILL NOT HIT PLAYER.” But while
using the device, the boy was hit in the eye by the ball. Should lack of privity be a defense to the
manufacturer? The manufacturer argued that the Gizmo was a “completely safe” training device only
when the ball is hit squarely, and—the defendant argued—plaintiffs could not reasonably expect the
Gizmo to be “completely safe” under all circumstances, particularly those in which the player hits beneath
the ball. What legal argument is this, and is it valid?

7.

A bank repossessed a boat and sold it to Donald. During the negotiations with Donald, Donald stated that
he wanted to use the boat for charter service in Florida. The bank officers handling the sale made no
representations concerning the boat during negotiations. Donald later discovered that the boat was
defective and sued the bank for breach of warranty. Is the bank liable? Why?

8.

Tom Anderson, the produce manager at the Thriftway Market in Pasco, Washington, removed a box of
bananas from the top of a stack of produce. When he reached for a lug of radishes that had been under

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the bananas, a six-inch spider—Heteropoda venatoria, commonly called a banana spider—leaped from
some wet burlap onto his left hand and bit him. Nine months later he died of heart failure. His wife
brought an action against Associated Grocers, parent company of Thriftway Market, on theories of (1)
strict products liability under Restatement, Section 402(a); (2) breach of the implied warranty of
merchantability; and (3) negligence. The trial court ruled against the plaintiff on all three theories. Was
that a correct ruling? Explain.
9.

A broken water pipe flooded a switchboard at RCA’s office. The flood tripped the switchboard circuit
breakers and deactivated the air-conditioning system. Three employees were assigned to fix it: an
electrical technician with twelve years on-the-job training, a licensed electrician, and an electrical
engineer with twenty years of experience who had studied power engineering in college. They switched
on one of the circuit breakers, although the engineer said he knew that one was supposed to test the
operation of a wet switchboard before putting it back into use. There was a “snap” and everyone ran
from the room up the stairs and a “big ball of fire” came after them up the stairs. The plaintiffs argued
that the manufacturer of the circuit breaker had been negligent in failing to give RCA adequate warnings
about the circuit breakers. How should the court rule, and on what theory should it rule?

10. Plaintiff’s business was to convert vans to RVs, and for this purpose it had used a 3M adhesive to laminate
carpeting to the van walls. This adhesive, however, failed to hold the fabric in place in hot weather, so
Plaintiff approached Northern Adhesive Co., a manufacturer of adhesives, to find a better one. Plaintiff
told Northern why it wanted the adhesive, and Northern—Defendant—sent several samples to Plaintiff to
experiment with. Northern told Plaintiff that one of the adhesives, Adhesive 7448, was “a match” for the
3M product that previously failed. Plaintiff tested the samples in a cool plant and determined that
Adhesive 7448 was better than the 3M product. Defendant had said nothing except that “what they
would ship would be like the sample. It would be the same chemistry.” Plaintiff used the adhesive during
the fall and winter; by spring complaints of delamination came in: Adhesive 7448 failed just as the 3M
product had. Over 500 vans had to be repaired. How should the court rule on Plaintiff’s claims of breach
of (1) express warranty, (2) implied warranty of merchantability, and (3) implied warranty of fitness for a
particular purpose?

SELF-TEST QUESTIONS
1.

In a products-liability case

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a.

only tort theories are typically asserted

b.

both tort and contract theories are typically asserted

c.

strict liability is asserted only when negligence is not asserted

d.

breach of warranty is not asserted along with strict liability

An implied warranty of merchantability
a.

is created by an express warranty

b.

is created by law

c.

is impossible for a seller to disclaim

d.

can be disclaimed by a seller only if the disclaimer is in writing
A possible defense to breach of warranty is

a.

lack of privity

b.

absence of an express warranty

c.

disclaimer of implied warranties

d.

all of the above
Under the strict liability rule in Restatement, Section 402A, the seller is liable for all injuries
resulting from a product

a.

even though all possible care has been exercised

b.

regardless of the lack of a contract with the user

c.

in both of the above situations

d.

in none of the above situations
An individual selling her car could be liable

a.

for breaching the implied warranty of merchantability

b.

under the strict liability theory

c.

for breaching the implied warranty of fitness

d.

under two of the above

SELF-TEST ANSWERS
1.

b

2.

b

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3.

d

4.

c

5.

d

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Chapter 18

Intellectual Property
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

The principal kinds of intellectual property

2.

The difference between patents and trade secrets, and why a company might choose to rely on
trade secrets rather than obtain a patent

3.

What copyrights are, how to obtain them, and how they differ from trademarks

4.

Why some “marks” may not be eligible for trademark protection, and how to obtain trademark
protection for those that are

Few businesses of any size could operate without being able to protect their rights to a particular type
of intangible personal property: intellectual property. The major forms of intellectual property are
patents, copyrights, and trademarks. Unlike tangible personal property (machines, inventory) or real
property (land, office buildings), intellectual property is formless. It is the product of the human
intellect that is embodied in the goods and services a company offers and by which the company is
known.
A patent is a grant from government that gives an inventor the exclusive right to make, use, and sell
an invention for a period of twenty years from the date of filing the application for a patent.
A copyright is the right to exclude others from using or marketing forms of expression. A trademark is
the right to prevent others from using a company’s product name, slogan, or identifying design.
Other forms of intellectual property are trade secrets (particular kinds of information of commercial
use to a company that created it) and right of publicity (the right to exploit a person’s name or
image). Note that the property interest protected in each case is not the tangible copy of the
invention or writing—not the machine with a particular serial number or the book lying on
someone’s shelf—but the invention or words themselves. That is why intellectual property is said to
be intangible: it is a right to exclude any others from gaining economic benefit from your own

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intellectual creation. In this chapter, we examine how Congress, the courts, and the Patent and
Trademark Office have worked to protect the major types of intellectual property.

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18.1 Patents
LEARNING OBJECTIVES
1.

Explain why Congress would grant exclusive monopolies (patents) for certain periods of time.

2.

Describe what kinds of things may be patentable and what kinds of things may not be patentable.

3.

Explain the procedures for obtaining a patent, and how patent rights may be an issue where the
invention is created by an employee.

4.

Understand who can sue for patent infringement, on what basis, and with what potential remedies.

Source of Authority and Duration
Patent and copyright law are federal, enacted by Congress under the power given by Article I of the
Constitution “to promote the Progress of Science and useful Arts, by securing for limited Times to Authors
and Inventors the exclusive Right to their respective Writings and Discoveries.” Under current law, a
patent gives an inventor exclusive rights to make, use, or sell an invention for twenty years. (If the patent
is a design patent—protecting the appearance rather than the function of an item—the period is fourteen
years.) In return for this limited monopoly, the inventor must fully disclose, in papers filed in the US
Patent and Trademark Office (PTO), a complete description of the invention.

Patentability
What May Be Patented
The patent law says that “any new and useful process, machine, manufacture, or composition of matter, or
any new and useful improvement thereof” may be patented.

[1]

A process is a “process, art or method, and
[2]

includes a new use of a known process, machine, manufacture, composition of matter, or material.” A
process for making rolled steel, for example, qualifies as a patentable process under the statute.
A machine is a particular apparatus for achieving a certain result or carrying out a distinct process—
lathes, printing presses, motors, and the cotton gin are all examples of the hundreds of thousands of
machines that have received US patents since the first Patent Act in 1790. A manufacture is an article or a
product, such as a television, an automobile, a telephone, or a lightbulb. A composition of matter is a new
arrangement of elements so that the resulting compound, such as a metal alloy, is not found in nature.

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InCommissioner of Patents v. Chakrabarty,

[3]

the Supreme Court said that even living organisms—in

particular, a new “genetically engineered” bacterium that could “eat” oil spills—could be patented.
The Chakrabarty decision has spawned innovation: a variety of small biotechnology firms have attracted
venture capitalists and other investors.
According to the PTO, gene sequences are patentable subject matter, provided they are isolated from their
natural state and processed in a way that separates them from other molecules naturally occurring with
them. Gene patenting, always controversial, generated new controversy when the PTO issued a patent to
Human Genome Sciences, Inc. for a gene found to serve as a platform from which the AIDS virus can
infect cells of the body. Critics faulted the PTO for allowing “ownership” of a naturally occurring human
gene and for issuing patents without requiring a showing of the gene’s utility. New guidelines from the
PTO followed in 2000; these focused on requiring the applicant to make a strong showing on the utility
aspect of patentability and somewhat diminished the rush of biotech patent requests.
There are still other categories of patentable subjects. An improvement is an alteration of a process,
machine, manufacture, or composition of matter that satisfies one of the tests for patentability given later
in this section. New, original ornamental designs for articles of manufacture are patentable (e.g., the
shape of a lamp); works of art are not patentable but are protected under the copyright law. New varieties
of cultivated or hybridized plants are also patentable, as are genetically modified strains of soybean, corn,
or other crops.

What May Not Be Patented
Many things can be patented, but not (1) the laws of nature, (2) natural phenomena, and (3) abstract
ideas, including algorithms (step-by-step formulas for accomplishing a specific task).
One frequently asked question is whether patents can be issued for computer software. The PTO was
reluctant to do so at first, based on the notion that computer programs were not “novel”—the software
program either incorporated automation of manual processes or used mathematical equations (which
were not patentable). But in 1998, the Supreme Court held in Diamond v. Diehr

[4]

that patents could be

obtained for a process that incorporated a computer program if the process itself was patentable.

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A business process can also be patentable, as the US Court of Appeals for the Federal Circuit ruled in 1998
in State Street Bank and Trust v. Signature Financial Group, Inc.

[5]

Signature Financial had a patent for

a computerized accounting system that determined share prices through a series of mathematical
calculations that would help manage mutual funds. State Street sued to challenge that patent. Signature
argued that its model and process was protected, and the court of appeals upheld it as a “practical
application of a mathematical, algorithm, formula, or calculation,” because it produces a “useful, concrete
and tangible result.” Since State Street, many other firms have applied for business process patents. For
example, Amazon.com obtained a business process patent for its “one-click” ordering system, a method of
processing credit-card orders securely. (But see Amazon.com v. Barnesandnoble.com,

[6]

in which the

court of appeals rejected Amazon’s challenge to Barnesandnoble.com using its Express Land one-click
ordering system.)

Tests for Patentability
Just because an invention falls within one of the categories of patentable subjects, it is not necessarily
patentable. The Patent Act and judicial interpretations have established certain tests that must first be
met. To approve a patent application, the PTO (as part of the Department of Commerce) will require that
the invention, discovery, or process be novel, useful, and nonobvious in light of current technology.
Perhaps the most significant test of patentability is that of obviousness. The act says that no invention
may be patented “if the differences between the subject matter sought to be patented and the prior art are
such that the subject matter as a whole would have been obvious at the time the invention was made to a
person having ordinary skill in the art to which said subject matter pertains.” This provision of the law has
produced innumerable court cases, especially over improvement patents, when those who wish to use an
invention on which a patent has been issued have refused to pay royalties on the grounds that the
invention was obvious to anyone who looked.

Procedures for Obtaining a Patent
In general, the United States (unlike many other countries) grants a patent right to the first person to
invent a product or process rather than to the first person to file for a patent on that product or process.
As a practical matter, however, someone who invents a product or process but does not file immediately

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should keep detailed research notes or other evidence that would document the date of invention. An
inventor who fails to apply for a patent within a year of that date would forfeit the rights granted to an
inventor who had published details of the invention or offered it for sale. But until the year has passed, the
PTO may not issue a patent to X if Y has described the invention in a printed publication here or abroad
or the invention has been in public use or on sale in this country.
An inventor cannot obtain a patent automatically; obtaining a patent is an expensive and time-consuming
process, and the inventor will need the services of a patent attorney, a highly specialized practitioner. The
attorney will help develop the required specification, a description of the invention that gives enough
detail so that one skilled in the art will be able to make and use the invention. After receiving an
application, a PTO examiner will search the records and accept or reject the claim. Usually, the attorney
will negotiate with the examiner and will rewrite and refine the application until it is accepted. A rejection
may be appealed, first to the PTO’s Board of Appeals and then, if that fails, to the federal district court in
the District of Columbia or to the US Court of Appeals for the Federal Circuit, the successor court to the
old US Court of Customs and Patent Appeals.
Once a patent application has been filed, the inventor or a company to which she has assigned the
invention may put the words “patent pending” on the invention. These words have no legal effect. Anyone
is free to make the invention as long as the patent has not yet been issued. But they do put others on
notice that a patent has been applied for. Once the patent has been granted, infringers may be sued even if
the infringed has made the product and offered it for sale before the patent was granted.
In today’s global market, obtaining a US patent is important but is not usually sufficient protection. The
inventor will often need to secure patent protection in other countries as well. Under the Paris Convention
for the Protection of Industrial Property (1883), parties in one country can file for patent or trademark
protection in any of the other member countries (172 countries as of 2011). The World Trade
Organization’s Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) established
standards for protecting intellectual property rights (patents, trademarks, and copyrights) and provides
that each member nation must have laws that protect intellectual property rights with effective access to
judicial systems for pursuing civil and criminal penalties for violations of such rights.

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Patent Ownership
The patent holder is entitled to make and market the invention and to exclude others from doing so.
Because the patent is a species of property, it may be transferred. The inventor may assign part or all of
his interest in the patent or keep the property interest and license others to manufacture or use the
invention in return for payments known as royalties. The license may be exclusive with one licensee, or
the inventor may license many to exploit the invention. One important limitation on the inventor’s right
to the patent interest is the so-called shop right. This is a right created by state courts on equitable
grounds giving employers a nonexclusive royalty-free license to use any invention made by an employee
on company time and with company materials. The shop right comes into play only when a company has
no express or implied understanding with its employees. Most corporate laboratories have contractual
agreements with employees about who owns the invention and what royalties will be paid.

Infringement and Invalidity Suits
Suits for patent infringement can arise in three ways: (1) the patent holder may seek damages and an
injunction against the infringer in federal court, requesting damages for royalties and lost profits as well;
(2) even before being sued, the accused party may take the patent holder to court under the federal
Declaratory Judgment Act, seeking a court declaration that the patent is invalid; (3) the patent holder may
sue a licensee for royalties claimed to be due, and the licensee may counterclaim that the patent is invalid.
Such a suit, if begun in state court, may be removed to federal court.
In a federal patent infringement lawsuit, the court may grant the winning party reimbursement for
attorneys’ fees and costs. If the infringement is adjudged to be intentional, the court can triple the amount
of damages awarded. Prior to 2006, courts were typically granting permanent injunctions to prevent
future infringement. Citing eBay, Inc. v. Merc Exchange, LLC,

[7]

the Supreme Court ruled that patent

holders are not automatically entitled to a permanent injunction against infringement during the life of
the patent. Courts have the discretion to determine whether justice requires a permanent injunction, and
they may conclude that the public interest and equitable principles may be better satisfied with
compensatory damages only.

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Proving infringement can be a difficult task. Many companies employ engineers to “design around” a
patent product—that is, to seek ways to alter the product to such an extent that the substitute product no
longer consists of enough of the elements of the invention safeguarded by the patent. However, infringing
products, processes, or machines need not be identical; as the Supreme Court said in Sanitary
Refrigerator Co. v. Winers,

[8]

“one device is an infringement of another…if two devices do the same work

in substantially the same way, and accomplish substantially the same result…even though they differ in
name, form, or shape.” This is known as the doctrine of equivalents. In an infringement suit, the court
must choose between these two extremes: legitimate “design around” and infringement through some
equivalent product.
An infringement suit can often be dangerous because the defendant will almost always assert in its answer
that the patent is invalid. The plaintiff patent holder thus runs the risk that his entire patent will be taken
away from him if the court agrees. In ruling on validity, the court may consider all the tests, such as prior
art and obviousness, discussed in Section 18.1.2 "Patentability" and rule on these independently of the
conclusions drawn by the PTO.

Patent Misuse
Although a patent is a monopoly granted to the inventor or his assignee or licensee, the monopoly power
is legally limited. An owner who misuses the patent may find that he will lose an infringement suit. One
common form of misuse is to tie the patented good to some unpatented one—for example, a patented
movie projector that will not be sold unless the buyer agrees to rent films supplied only by the
manufacturer of the movie projector, or a copier manufacturer that requires buyers to purchase plain
paper from it. Various provisions of the federal antitrust laws, including, specifically, Section 3 of the
Clayton Act, outlaw certain kinds of tying arrangements. Another form of patent misuse is a provision in
the licensing agreement prohibiting the manufacturer from also making competing products. Although
the courts have held against several other types of misuse, the general principle is that the owner may not
use his patent to restrain trade in unpatented goods.

KEY TAKEAWAY
Many different “things” are patentable, include gene sequences, business processes, and any other “useful
invention.” The US Patent and Trademark Office acts on initial applications and may grant a patent to an

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applicant. The patent, which allows a limited-time monopoly, is for twenty years. The categories of patentable
things include processes, machines, manufactures, compositions of matter, and improvements. Ideas, mental
processes, naturally occurring substances, methods of doing business, printed matter, and scientific principles
cannot be patented. Patent holders may sue for infringement and royalties from an infringer user.

EXERCISES
1.

Calera, Inc. discovers a way to capture carbon dioxide emissions at a California power plant and use them
to make cement. This is a win for the power company, which needs to reduce its carbon dioxide
emissions, and a win for Calera. Calera decides to patent this invention. What kind of patent would this
be? A machine? A composition of matter? A manufacture?

2.

In your opinion, what is the benefit of allowing companies to isolate genetic material and claim a patent?
What kind of patent would this be? A machine? A composition of matter? A manufacture?

3.

How could a “garage inventor,” working on her own, protect a patentable invention while yet
demonstrating it to a large company that could bring the invention to market?

[1] 35 United States Code, Section 101.
[2] 35 United States Code, Section 101.
[3] Commissioner of Patents v. Chakrabarty, 444 U.S. 1028 (1980).
[4] Diamond v. Diehr, 450 U.S. 175 (1981).
[5] State Street Bank and Trust v. Signature Financial Group, Inc., 149 F.3d 1368 (Fed. Cir. 1998).
[6] Amazon.com v. Barnesandnoble.com, Inc., 239 F.3d 1343 (Fed. Cir. 2001).
[7] eBay, Inc. v. Merc Exchange, LLC, 546 U.S. 388 (2006).
[8] Sanitary Refrigerator Co. v. Winers, 280 U.S. 30 (1929).

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18.2 Trade Secrets
LEARNING OBJECTIVES
1.

Describe the difference between trade secrets and patents, and explain why a firm might prefer
keeping a trade secret rather than obtaining a patent.

2.

Understand the dimensions of corporate espionage and the impact of the federal Economic Espionage
Act.

Definition of Trade Secrets
A patent is an invention publicly disclosed in return for a monopoly. A trade secret is a means to a
monopoly that a company hopes to maintain by preventing public disclosure. Why not always take out a
patent? There are several reasons. The trade secret might be one that is not patentable, such as a customer
list or an improvement that does not meet the tests of novelty or nonobviousness. A patent can be
designed around; but if the trade secret is kept, its owner will be the exclusive user of it. Patents are
expensive to obtain, and the process is extremely time consuming. Patent protection expires in twenty
years, after which anyone is free to use the invention, but a trade secret can be maintained for as long as
the secret is kept.
However, a trade secret is valuable only so long as it is kept secret. Once it is publicly revealed, by
whatever means, anyone is free to use it. The critical distinction between a patent and a trade secret is
this: a patent gives its owner the right to enjoin anyone who infringes it from making use of it, whereas a
trade secret gives its “owner” the right to sue only the person who improperly took it or revealed it.
According to the Restatement of Torts, Section 757, Comment b, a trade secret may consist of
any formula, pattern, device or compilation of information which is used in one’s business, and which
gives him an opportunity to obtain an advantage over competitors who do not know or use it. It may be a
formula for a chemical compound, a process of manufacturing, treating or preserving materials, a pattern
for a machine or other device, or a list of customers.…A trade secret is a process or device for continuous
use in the operation of a business. Generally it relates to the production of goods, as, for example, a
machine or formula for the production of an article.

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Other types of trade secrets are customer information, pricing data, marketing methods, sources of
supply, and secret technical know-how.

Elements of Trade Secrets
To be entitled to protection, a trade secret must be (1) original and (2) secret.

Originality
The trade secret must have a certain degree of originality, although not as much as would be necessary to
secure a patent. For example, a principle or technique that is common knowledge does not become a
protectable trade secret merely because a particular company taught it to one of its employees who now
wants to leave to work for a competitor.

Secrecy
Some types of information are obviously secret, like the chemical formula that is jealously guarded
through an elaborate security system within the company. But other kinds of information might not be
secret, even though essential to a company’s business. For instance, a list of suppliers that can be devised
easily by reading through the telephone directory is not secret. Nor is a method secret simply because
someone develops and uses it, if no steps are taken to guard it. A company that circulates a product
description in its catalog may not claim a trade secret in the design of the product if the description
permits someone to do “reverse engineering.” A company that hopes to keep its processes and designs
secret should affirmatively attempt to do so—for example, by requiring employees to sign a nondisclosure
agreement covering the corporate trade secrets with which they work. However, a company need not go to
every extreme to guard a trade secret.
Trade-secrets espionage has become a big business. To protect industrial secrets, US corporations spend
billions on security arrangements. The line between competitive intelligence gathering and espionage can
sometimes be difficult to draw. The problem is by no means confined to the United States; companies and
nations all over the world have become concerned about theft of trade secrets to gain competitive
advantage, and foreign governments are widely believed to be involved in espionage and cyberattacks.

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Economic Espionage Act
The Economic Espionage Act (EEA) of 1996 makes the theft or misappropriation of a trade secret a
federal crime. The act is aimed at protecting commercial information rather than classified national
defense information. Two sorts of activities are criminalized. The first section of the act

[1]

criminalizes the

misappropriation of trade secrets (including conspiracy to misappropriate trade secrets and the
subsequent acquisition of such misappropriated trade secrets) with the knowledge or intent that the theft
will benefit a foreign power. Penalties for violation are fines of up to US$500,000 per offense and
imprisonment of up to fifteen years for individuals, and fines of up to US$10 million for organizations.
The second section

[2]

criminalizes the misappropriation of trade secrets related to or included in a

product that is produced for or placed in interstate (including international) commerce, with the
knowledge or intent that the misappropriation will injure the owner of the trade secret. Penalties for
violation are imprisonment for up to ten years for individuals (no fines) and fines of up to US$5 million
for organizations.
In addition to these specific penalties, the fourth section of the EEA

[3]

also requires criminal forfeiture of

(1) any proceeds of the crime and property derived from proceeds of the crime and (2) any property used,
or intended to be used, in commission of the crime.
The EEA authorizes civil proceedings by the Department of Justice to enjoin violations of the act but does
not create a private cause of action. This means that anyone believing they have been victimized must go
through the US attorney general in order to obtain an injunction.
The EEA is limited to the United States and has no extraterritorial application unless (1) the offender is a
US company or a citizen operating from abroad against a US company or (2) an act in furtherance of the
espionage takes place in the United States. Other nations lack such legislation, and some may actively
support industrial espionage using both their national intelligence services. The US Office of the National
Counterintelligence Executive publishes an annual report, mandated by the US Congress, on foreign
economic collection and industrial espionage, which outlines these espionage activities of many foreign
nations.

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Right of Employees to Use Trade Secrets
A perennial source of lawsuits in the trade secrets arena is the employee who is hired away by a
competitor, allegedly taking trade secrets along with him. Companies frequently seek to prevent piracy by
requiring employees to sign confidentiality agreements. An agreement not to disclose particular trade
secrets learned or developed on the job is generally enforceable. Even without an agreement, an employer
can often prevent disclosure under principles of agency law. Sections 395 and 396 of the Restatement
(Second) of Agency suggest that it is an actionable breach of duty to disclose to third persons information
given confidentially during the course of the agency. However, every person is held to have a right to earn
a living. If the rule were strictly applied, a highly skilled person who went to another company might be
barred from using his knowledge and skills. The courts do not prohibit people from using elsewhere the
general knowledge and skills they developed on the job. Only specific trade secrets are protected.
To get around this difficulty, some companies require their employees to sign agreements not to compete.
But unless the agreements are limited in scope and duration to protect a company against only specific
misuse of trade secrets, they are unenforceable.

KEY TAKEAWAY
Trade secrets, if they can be kept, have indefinite duration and thus greater potential value than patents.
Trade secrets can be any formula, pattern, device, process, or compilation of information to be used in a
business. Customer information, pricing data, marketing methods, sources of supply, and technical know-how
could all be trade secrets. State law has protected trade secrets, and federal law has provided criminal
sanctions for theft of trade secrets. With the importance of digitized information, methods of theft now
include computer hacking; theft of corporate secrets is a burgeoning global business that often involves
cyberattacks.

EXERCISES
1.

Wu Dang, based in Hong Kong, hacks into the Hewlett-Packard database and “steals” plans and
specifications for HP’s latest products. The HP server is located in the United States. He sells this
information to a Chinese company in Shanghai. Has he violated the US Economic Espionage Act?

2.

What are the advantages of keeping a formula as a trade secret rather than getting patent protection?

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[1] Economic Espionage Act, 18 United States Code, Section 1831(a) (1996)
[2] Economic Espionage Act, 18 United States Code, Section 1832 (1996).
[3] Economic Espionage Act, 18 United States Code, Section 1834 (1996).

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18.3 Copyright
LEARNING OBJECTIVES
1.

Describe and explain copyrights, how to obtain one, and how they differ from trademarks.

2.

Explain the concept of fair use and describe its limits.

Definition and Duration
Copyright is the legal protection given to “authors” for their “writings.” Copyright law is federal; like
patent law, its source lies in the Constitution. Copyright protects the expression of ideas in some tangible
form, but it does not protect the ideas themselves. Under the 1976 Copyright Act as amended, a copyright
in any work created after January 1, 1978, begins when the work is fixed in tangible form—for example,
when a book is written down or a picture is painted—and generally lasts for the life of the author plus 70
years after his or her death. This is similar to copyright protection in many countries, but in some
countries, the length of copyright protection is the life of the author plus 50 years. For copyrights owned
by publishing houses, done as works for hire, common copyright expires 95 years from the date of
publication or 120 years from the date of creation, whichever is first. For works created before 1978, such
as many of Walt Disney’s movies and cartoons, the US Sonny Bono Copyright Term Extension Act of 1998
provided additional protection of up to 95 years from publication date. Thus works created in 1923 by
Disney would not enter the public domain until 2019 or after, unless the copyright had expired prior to
1998 or unless the Disney company released the work into the public domain. In general, after expiration
of the copyright, the work enters thepublic domain.
In 1989, the United States signed the Berne Convention, an international copyright treaty. This law
eliminated the need to place the symbol © or the word Copyright or the abbreviation Copr. on the work
itself. Copyrights can be registered with the US Copyright Office in Washington, DC.

Protected Expression
The Copyright Act protects a variety of “writings,” some of which may not seem written at all. These
include literary works (books, newspapers, and magazines), music, drama, choreography, films, art,

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sculpture, and sound recordings. Since copyright covers the expression and not the material or physical
object, a book may be copyrighted whether it is on paper, microfilm, tape, or computer disk.

Rights Protected by the Copyright Act
Preventing Copying
A copyright gives its holder the right to prevent others from copying his or her work. The copyright holder
has the exclusive right to reproduce the work in any medium (paper, film, sound recording), to perform it
(e.g., in the case of a play), or to display it (a painting or film). A copyright also gives its holder the
exclusive right to prepare derivative works based on the copyrighted work. Thus a playwright could not
adapt to the stage a novelist’s book without the latter’s permission.

Fair Use
One major exception to the exclusivity of copyrights is the fair use doctrine. Section 107 of the Copyright
Act provides as follows:
Fair use of a copyrighted work, including such use by reproduction in copies or phonorecords or by any
other means specified by section 106 of the copyright, for purposes such as criticism, comment, news
reporting, teaching (including multiple copies for classroom use), scholarship, or research, is not an
infringement of copyright. In determining whether the use made of a work in any particular case is a fair
use, the factors to be considered shall include–
(1) the purpose and character of the use, including whether such use is of a commercial nature or is for
nonprofit educational purposes;
(2) the nature of the copyrighted work;
(3) the amount and substantiality of the portion used in relation to the copyrighted work as a whole; and
(4) the effect of the use upon the potential market for or value of the copyrighted work.

[1]

These are broad guidelines. Accordingly, any copying could be infringement, and fair use could become a
question of fact on a case-by-case basis. In determining fair use, however, courts have often considered

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the fourth factor (effect of the use upon the potential market for the copyrighted work) to be the most
important.
Clear examples of fair use would be when book reviewers or writers quote passages from copyrighted
books. Without fair use, most writing would be useless because it could not readily be discussed. But the
doctrine of fair use grew more troublesome with the advent of plain-paper copiers and is now even more
troublesome with electronic versions of copyrighted materials that are easily copied and distributed. The
1976 act took note of the new copier technology, listing “teaching (including multiple copies for classroom
use)” as one application of fair use. The Copyright Office follows guidelines specifying just how far the
copying may go—for example, multiple copies of certain works may be made for classroom use, but copies
may not be used to substitute for copyrighted anthologies.

Infringement
Verbatim use of a copyrighted work is easily provable. The more difficult question arises when the
copyrighted work is altered in some way. As in patent law, the standard is one of substantial similarity.

Copyrightability Standards
To be subject to copyright, the writing must be “fixed” in some “tangible medium of expression.” A
novelist who composes a chapter of her next book in her mind and tells it to a friend before putting it on
paper could not stop the friend from rushing home, writing it down, and selling it (at least the federal
copyright law would offer no protection; some states might independently offer a legal remedy, however).
The work also must be creative, at least to a minimal degree. Words and phrases, such as names, titles,
and slogans, are not copyrightable; nor are symbols or designs familiar to the public. But an author who
contributes her own creativity—like taking a photograph of nature—may copyright the resulting work,
even if the basic elements of the composition were not of her making.
Finally, the work must be “original,” which means simply that it must have originated with the author.
The law does not require that it be novel or unique. This requirement was summarized pithily by Judge
Learned Hand: “If by some magic a man who had never known it were to compose anew Keats’s Ode on a
Grecian Urn, he would be an author, and, if he copyrighted it, others might not copy that poem, though

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they might of course copy Keats’s.”

[2]

Sometimes the claim is made that a composer, for example, just

happened to compose a tune identical or strikingly similar to a copyrighted song; rather than assume the
unlikely coincidence that Judge Hand hypothesized, the courts will look for evidence that the alleged
copier had access to the copyrighted song. If he did—for example, the song was frequently played on the
air—he cannot defend the copying with the claim that it was unconscious, because the work would not
then have been original.
Section 102 of the Copyright Act excludes copyright protection for any “idea, procedure, process, system,
method of operation, concept, principle, or discovery, regardless of the form in which it is described,
explained, illustrated, or embodied.”

[3]

Einstein copyrighted books and monographs he wrote on the theory of relativity, but he could not
copyright the famous formula E = mc2, nor could he prevent others from writing about the theory. But he
could protect the particular way in which his ideas were expressed. In general, facts widely known by the
public are not copyrightable, and mathematical calculations are not copyrightable. Compilations of facts
may be copyrightable, if the way that they are coordinated or arranged results in a work that shows some
originality. For example, compiled information about yachts listed for sale may qualify for copyright
protection.

[4]

One of the most troublesome recent questions concerning expression versus ideas is whether a computer
program may be copyrighted. After some years of uncertainty, the courts have accepted the
copyrightability of computer programs.

[5]

Now the courts are wrestling with the more difficult question of

the scope of protection: what constitutes an “idea” and what constitutes its mere “expression” in a
program.
How far the copyright law will protect particular software products is a hotly debated topic, sparked by a
federal district court’s ruling in 1990 that the “look and feel” of Lotus 1-2-3’s menu system is
copyrightable and was in fact infringed by Paperback Software’s VP-Planner, a competing
spreadsheet.

[6]

The case has led some analysts to “fear that legal code, rather than software code, is

emerging as the factor that will determine which companies and products will dominate the 1990s.”

[7]

Who May Obtain a Copyright?
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With one important exception, only the author may hold the initial copyright, although the author may
assign it or license any one or more of the rights conveyed by the copyright. This is a simple principle
when the author has written a book or painted a picture. But the law is unclear in the case of a motion
picture or a sound recording. Is the author the script writer, the producer, the performer, the director, the
engineer, or someone else? As a practical matter, all parties involved spell out their rights by contract.
The exception, which frequently covers the difficulties just enumerated, is for works for hire. Any person
employed to write—a journalist or an advertising jingle writer, for example—is not the “author.” For
purposes of the statute, the employer is the author and may take out the copyright. When the employee is
in fact an “independent contractor” and the work in question involves any one of nine types (book,
movies, etc.) spelled out in the Copyright Act, the employer and the creator must spell out their
entitlement to the copyright in a written agreement.

[8]

Obtaining a Copyright
Until 1978, a work could not be copyrighted unless it was registered in the Copyright Office or was
published and unless each copy of the work carried a copyright notice, consisting of the word Copyright,
the abbreviation Copr., or the common symbol ©, together with the date of first publication and the name
of the copyright owner. Under the 1976 act, copyright became automatic whenever the work was fixed in a
tangible medium of expression (e.g., words on paper, images on film or videotape, sound on tape or
compact disc), even if the work remained unpublished or undistributed. However, to retain copyright
protection, the notice had to be affixed once the work was “published” and copies circulated to the public.
After the United States entered the Berne Convention, an international treaty governing copyrights,
Congress enacted the Berne Implementation Act, declaring that, effective in 1989, notice, even after
publication, was no longer required.
Notice does, however, confer certain benefits. In the absence of notice, a copyright holder loses the right
to receive statutory damages (an amount stated in the Copyright Act and not required to be proved) if
someone infringes the work. Also, although it is no longer required, an application and two copies of the
work (for deposit in the Library of Congress) filed with the Copyright Office, in Washington, DC, will
enable the copyright holder to file suit should the copyright be infringed. Unlike patent registration, which

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requires elaborate searching of Patent and Trademark Office (PTO) records, copyright registration does
not require a reading of the work to determine whether it is an original creation or an infringement of
someone else’s prior work. But copyright registration does not immunize the holder from an infringement
suit. If a second work has been unlawfully copied from an earlier work, the second author’s copyright will
not bar the infringed author from collecting damages and obtaining an injunction.

Computer Downloads and the Digital Millennium Copyright Act
The ubiquity of the Internet and the availability of personal computers with large capacities have greatly
impacted the music business. Sharing of music files took off in the late 1990s with Napster, which lost a
legal battle on copyright and had to cease doing business. By providing the means by which individuals
could copy music that had been purchased, major record labels were losing substantial profits. Grokster, a
privately owned software company based in the West Indies, provided peer-to-peer file sharing from 2001
to 2005 until the US Supreme Court’s decision in MGM Studios, Inc. v. Grokster, Ltd.

[9]

For computers with the Microsoft operating system, the Court disallowed the peer-to-peer file sharing,
even though Grokster claimed it did not violate any copyright laws because no files passed through its
computers. (Grokster had assigned certain user computers as “root supernodes” that acted as music hubs
for the company and was not directly involved in controlling any specific music-file downloads.)
Grokster had argued, based on Sony v. Universal Studios,

[10]

that the sale of its copying equipment (like

the Betamax videocassette recorders at issue in that case) did not constitute contributory infringement “if
the product is widely used for legitimate, unobjectionable purposes.” Plaintiffs successfully argued that
the Sony safe-harbor concept requires proof that the noninfringing use is the primary use in terms of the
product’s utility.
The Digital Millennium Copyright Act (DMCA), passed into law in 1998, implements two 1996 treaties of
the World Intellectual Property Organization. It criminalizes production and sale of devices or services
intended to get around protective measures that control access to copyrighted works. In addition, the
DMCA heightens the penalties for copyright infringement on the Internet. The DMCA amended Title 17 of
the United States Code to extend the reach of copyright, while limiting the liability of the providers of
online services for copyright infringement by their users.

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KEY TAKEAWAY
Copyright is the legal protection given to “authors” for their “writings.” It protects ideas in fixed, tangible
form, not ideas themselves. Copyright protection can extend as long as 120 years from the date of creation or
publication. Expression found in literary works, music, drama, film, art, sculpture, sound recordings, and the
like may be copyrighted. The fair use doctrine limits the exclusivity of copyright in cases where scholars,
critics, or teachers use only selected portions of the copyrighted material in a way that is unlikely to affect the
potential market for or value of the copyrighted work.

EXERCISES
1.

Explain how a list could be copyrightable.

2.

An author wrote a novel, Brunch at Bruno’s, in 1961. She died in 1989, and her heirs now own the
copyright. When do the rights of the heirs come to an end? That is, when does Brunch at Bruno’s enter
the public domain?

3.

Keith Bradsher writes a series of articles on China for the New York Times and is paid for doing so.
Suppose he wants to leave the employ of the Times and be a freelance writer. Can he compile his best
articles into a book, Changing Times in China, and publish it without the New York Times’s permission?
Does it matter that he uses the word Times in his proposed title?

4.

What kind of file sharing of music is now entirely legal? Shaunese Collins buys a Yonder Mountain String
Band CD at a concert at Red Rocks in Morrison, Colorado. With her iMac, she makes a series of CDs for
her friends. She does this six times. Has she committed six copyright violations?

[1] 17 United States Code, Section 107.
[2] Sheldon v. Metro-Goldwyn Pictures Corp., 81 F.2d 49 (2d Cir. 1936).
[3] 17 United States Code, Section 102.
[4] BUC International Corp. v. International Yacht Council, Ltd., 489 F.3d 1129 (11th Cir. 2007).
[5] Apple Computer, Inc. v. Franklin Computer Corp., 714 F.2d 1240 (3d Cir. 1983).
[6] Lotus Development Corp. v. Paperback Software International, 740 F.Supp. 37 (D. Mass. 1990).
[7] Peter H. Lewis, “When Computing Power Is Generated by the Lawyers,” New York Times, July 22 1990.
[8] Community for Creative Non-Violence v. Reid, 109 S.Ct. 2166 (1989).
[9] MGM Studios, Inc. v. Grokster, Ltd., 545 U.S. 913 (2005).

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[10] Sony v. Universal Studios, 464 U.S. 417 (1984).

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18.4 Trademarks
LEARNING OBJECTIVES
1.

Understand what a trademark is and why it deserves protection.

2.

Know why some “marks” may not be eligible for trademark protection, and how to obtain trademark
protection for those that are.

3.

Explain what “blurring” and “tarnishment” are and what remedies are available to the holder of the
mark.

Definitions of Trademarks
A trademark is defined in the federal Lanham Act of 1946 as “any word, name, symbol, or device or any
combination thereof adopted and used by a manufacturer or merchant to identify his goods and
distinguish them from goods manufactured or sold by others.”

[1]

Examples of well-known trademarks are Coca-Cola, Xerox, and Apple. Aservice mark is used in the sale or
advertising of services to identify the services of one person and distinguish them from the services of
others. Examples of service marks are McDonald’s, BP, and Hilton. Acertification mark is used in
connection with many products “to certify regional or other origin, material, mode of manufacture,
quality, accuracy or other characteristics of such goods or services or that the work or labor on the goods
or services was performed by members of a union or other organization.” Examples are the Good
Housekeeping Seal of Approval and UL (Underwriters Laboratories, Inc., approval mark). Unlike other
forms of trademark, the owner of the certification mark (e.g., Good Housekeeping, or the Forest
Stewardship Council’s FSC mark) is not the owner of the underlying product.

Extent of Trademark Protection
Kinds of Marks
Trademarks and other kinds of marks may consist of words and phrases, pictures, symbols, shapes,
numerals, letters, slogans, and sounds. Trademarks are a part of our everyday world: the sounds of a radio
or television network announcing itself (NBC, BBC), the shape of a whiskey bottle (Haig & Haig’s Pinch
Bottle), a series of initials (GE, KPMG, IBM), or an animal’s warning growl (MGM’s lion).

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Limitations on Marks
Although trademarks abound, the law limits the subjects that may fall into one of the defined categories.
Not every word or shape or symbol will be protected in an infringement action. To qualify for protection, a
trademark must be used to identify and distinguish. The courts employ a four-part test: (1) Is the mark so
arbitrary and fanciful that it merits the widest protection? (2) Is it “suggestive” enough to warrant
protection without proof of secondary meaning? (3) Is it “descriptive,” warranting protection if secondary
meaning is proved? (4) Is the mark generic and thus unprotectable?
These tests do not have mechanical answers; they call for judgment. Some marks are wholly fanciful,
clearly identify origin of goods, and distinguish them from others—Kodak, for example. Other marks may
not be so arbitrary but may nevertheless be distinctive, either when adopted or as a result of advertising—
for example, Crest, as the name of a toothpaste.
Marks that are merely descriptive of the product are entitled to protection only if it can be shown that the
mark has acquired secondary meaning. This term reflects a process of identification on the mark in the
public mind with the originator of the product. Holiday Inn was initially deemed too descriptive: an inn
where people might go on holiday. But over time, travelers came to identify the source of the Great Sign
and the name Holiday Inn as the Holiday Inn Corporation in Memphis, and secondary meaning was
granted. Holiday Inn could thus protect its mark against other innkeepers, hoteliers, and such; however,
the trademark protection for the words Holiday Inn was limited to the corporation’s hotel and motel
business, and no other.
Certain words and phrases may not qualify at all for trademark protection. These include generic terms
like “straw broom” (for a broom made of straw) and ordinary words like “fast food.” In one case, a federal
appeals court held that the word “Lite” is generic and cannot be protected by a beer manufacturer to
describe a low-calorie brew.

[2]

Donald Trump’s effort to trademark “You’re fired!” and Paris Hilton’s

desire to trademark “That’s hot!” were also dismissed as being generic.
Deceptive words will not be accepted for registration. Thus the US Patent and Trademark Office (PTO)
denied registration to the word Vynahyde because it suggested that the plastic material to which it was
applied came from animal skin. Geographic terms are descriptive words and may not be used as protected

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trademarks unless they have acquired a secondary meaning, such as Hershey when used for chocolates.
(Hershey’s chocolates are made in Hershey, Pennsylvania.) A design that reflects a common style cannot
be protected in a trademark to exclude other similar designs in the same tradition. Thus the courts have
ruled that a silverware pattern that is a “functional feature” of the “baroque style” does not qualify for
trademark protection. Finally, the Lanham Act denies federal registration to certain marks that fall within
categories of words and shapes, including the following: the flag; the name, portrait, or signature of any
living person without consent, or of a deceased US president during the lifetime of his widow; and
immoral, deceptive, or scandalous matter (in an earlier era, the phrase “Bubby Trap” for brassieres was
denied registration).

Dilution, Tarnishment, and Blurring
Under the federal Trademark Dilution Act of 1995, companies with marks that dilute the value of a senior
mark may be liable for damages. The act provides that owners of marks of significant value have property
rights that should not be eroded, blurred, tarnished, or diluted in any way by another. But as a plaintiff,
the holder of the mark must show (1) that it is a famous mark, (2) that the use of a similar mark is
commercial, and (3) that such use causes dilution of the distinctive quality of the mark. Thus a T-shirt
maker who promotes a red-and-white shirt bearing the mark Buttweiser may be liable to Anheuser-Busch,
or a pornographic site called Candyland could be liable to Parker Brothers, the board game company.
Interesting cases have already been brought under this act, including a case brought by Victoria’s Secret
against a small adult store in Kentucky called Victor’s Little Secret. Notice that unlike most prior
trademark law, the purpose is not to protect the consumer from confusion as to the source or origin of the
goods or services being sold; for example, no one going to the Candyland site would think that Parker
Brothers was the source.

Acquiring Trademark Rights
For the first time in more than forty years, Congress, in 1988, changed the way in which trademarks can
be secured. Under the Lanham Act, the fundamental means of obtaining a trademark was through use.
The manufacturer or distributor actually must have placed the mark on its product—or on related
displays, labels, shipping containers, advertisements, and the like—and then have begun selling the

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product. If the product was sold in interstate commerce, the trademark was entitled to protection under
the Lanham Act (or if not, to protection under the common law of the state in which the product was
sold).
Under the Trademark Law Revision Act of 1988, which went into effect in 1989, trademarks can be
obtained in advance by registering with the PTO an intention to use the mark within six months (the
applicant can gain extensions of up to thirty more months to put the mark into use). Once obtained, the
trademark will be protected for ten years (before the 1988 revision, a federal trademark remained valid
for twenty years); if after that time the mark is still being used, the registration can be renewed. Obtaining
a trademark registration lies between obtaining patents and obtaining copyrights in difficulty. The PTO
will not routinely register a trademark; it searches its records to ensure that the mark meets several
statutory tests and does not infringe another mark. Those who feel that their own marks would be hurt by
registration of a proposed mark may file an opposition proceeding with the PTO. Until 1990, the office
received about 77,000 applications each year. With the change in procedure, some experts predicted that
applications would rise by 30 percent.
In many foreign countries, use need not be shown to obtain trademark registration. It is common for
some people in these countries to register marks that they expect to be valuable so that they can sell the
right to use the mark to the company that established the mark’s value. Companies that expect to market
abroad should register their marks early.

Loss of Rights
Trademark owners may lose their rights if they abandon the mark, if a patent or copyright expires on
which the mark is based, or if the mark becomes generic. A mark is abandoned if a company goes out of
business and ceases selling the product. Some marks are based on design patents; when the patent
expires, the patent holder will not be allowed to extend the patent’s duration by arguing that the design or
name linked with the design is a registrable trademark.
The most widespread difficulty that a trademark holder faces is the prospect of too much success: if a
trademark comes to stand generically for the product itself, it may lose exclusivity in the mark. Famous

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examples are aspirin, escalator, and cellophane. The threat is a continual one. Trademark holders can
protect themselves from their marks’ becoming generic in several ways.
1.

Use a descriptive term along with the trademark. Look on a jar of Vaseline and you will see that the
label refers to the contents as Vaseline petroleum jelly.

2. Protest generic use of the mark in all publications by writing letters and taking out advertisements.
3. Always put the words Trademark, Registered Trademark, or the symbol ® (meaning “registered”)
next to the mark itself, which should be capitalized.

KEY TAKEAWAY
Trademark protection is federal, under the Lanham Act. Branding of corporate logos, names, and products is
essential to business success, and understanding trademarks is pivotal to branding. A “mark” must be
distinctive, arbitrary, or fanciful to merit protection: this means that it must not be generic or descriptive.
Marks can be words, symbols, pictures, slogans, sounds, phrases, and even shapes. In the United States, rights
to marks are obtained by registration and intent to use in commerce and must be renewed every ten years.

EXERCISES
1.

How will Google protect its trademark, assuming that people begin using “google” as a verb substitute for
“Internet search,” just like people began using the word “cellophane” for all brands of plastic wrap?

2.

Do a small amount of web searching and find out what “trade dress” protection is, and how it differs from
trademark protection.

3.

LexisNexis is a brand for a database collection offered by Mead Data Central. Lexus is a high-end
automobile. Can Lexus succeed in getting Mead Data Central to stop using “Lexis” as a mark?

[1] 15 United States Code, Section 1127.
[2] Miller Brewing Co. v. Falstaff Brewing Corp., 655 F.2d 5 (1st Cir. 1981).

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18.5 Cases
Fair Use in Copyright
Elvis Presley Enterprises et al. v. Passport Video et al.
349 F.3d 622 (9th Circuit Court of Appeals, 2003)
TALLMAN, CIRCUIT JUDGE:
Plaintiffs are a group of companies and individuals holding copyrights in various materials relating to
Elvis Presley. For example, plaintiff SOFA Entertainment, Inc., is the registered owner of several Elvis
appearances on The Ed Sullivan Show. Plaintiff Promenade Trust owns the copyright to two television
specials featuring Elvis: The Elvis 1968 Comeback Special and Elvis Aloha from Hawaii.…Many Plaintiffs
are in the business of licensing their copyrights. For example, SOFA Entertainment charges $10,000 per
minute for use of Elvis’ appearances on The Ed Sullivan Show.
Passport Entertainment and its related entities (collectively “Passport”) produced and sold The Definitive
Elvis, a 16-hour video documentary about the life of Elvis Presley. The Definitive Elvis sold for $99 at
retail. Plaintiffs allege that thousands of copies were sent to retail outlets and other distributors. On its
box, The Definitive Elvis describes itself as an all-encompassing, in-depth look at the life and career of a
man whose popularity is unrivaled in the history of show business and who continues to attract millions
of new fans each year.…
The Definitive Elvis uses Plaintiffs’ copyrighted materials in a variety of ways. With the video footage, the
documentary often uses shots of Elvis appearing on television while a narrator or interviewee talks over
the film. These clips range from only a few seconds in length to portions running as long as 30 seconds. In
some instances, the clips are the subject of audio commentary, while in other instances they would more
properly be characterized as video “filler” because the commentator is discussing a subject different from
or more general than Elvis’ performance on a particular television show. But also significant is the
frequency with which the copyrighted video footage is used. The Definitive Elvisemploys these clips, in
many instances, repeatedly. In total, at least 5% to 10% of The Definitive Elvis uses Plaintiffs’ copyrighted
materials.

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Use of the video footage, however, is not limited to brief clips.…Thirty-five percent of his appearances
on The Ed Sullivan Show is replayed, as well as three minutes from The 1968 Comeback Special.
***
Plaintiffs sued Passport for copyright infringement.…Passport, however, asserts that its use of the
copyrighted materials was “fair use” under 17 U.S.C. § 107. Plaintiffs moved for a preliminary injunction,
which was granted by the district court after a hearing. The district court found that Passport’s use of
Plaintiffs’ copyrighted materials was likely not fair use. The court enjoined Passport from selling or
distributing The Definitive Elvis. Passport timely appeals.
***
We first address the purpose and character of Passport’s use of Plaintiffs’ copyrighted materials. Although
not controlling, the fact that a new use is commercial as opposed to non-profit weighs against a finding of
fair use. Harper & Row Publishers, Inc. v. Nation Enters., 471 U.S. 539, 562, 85 L. Ed. 2d 588, 105 S.Ct.
2218 (1985). And the degree to which the new user exploits the copyright for commercial gain—as
opposed to incidental use as part of a commercial enterprise—affects the weight we afford commercial
nature as a factor. More importantly for the first fair-use factor, however, is the “transformative” nature of
the new work. Specifically, we ask “whether the new work…merely supersedes the objects of the original
creation, or instead adds something new, with a further purpose or different character, altering the first
with new expression, meaning, or message.…” The more transformative a new work, the less significant
other inquiries, such as commercialism, become.
***
The district court below found that the purpose and character of The Definitive Elvis will likely weigh
against a finding of fair use. We cannot say, based on this record, that the district court abused its
discretion.
First, Passport’s use, while a biography, is clearly commercial in nature. But more significantly, Passport
seeks to profit directly from the copyrights it uses without a license. One of the most salient selling points
on the box of The Definitive Elvis is that “Every Film and Television Appearance is represented.” Passport

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is not advertising a scholarly critique or historical analysis, but instead seeks to profit at least in part from
the inherent entertainment value of Elvis’ appearances on such shows as The Steve Allen Show, The Ed
Sullivan Show, andThe 1968 Comeback Special. Passport’s claim that this is scholarly research containing
biographical comments on the life of Elvis is not dispositive of the fair use inquiry.
Second, Passport’s use of Plaintiffs’ copyrights is not consistently transformative. True, Passport’s use of
many of the television clips is transformative because the clips play for only a few seconds and are used
for reference purposes while a narrator talks over them or interviewees explain their context in Elvis’
career. But voice-overs do not necessarily transform a work.…
It would be impossible to produce a biography of Elvis without showing some of his most famous
television appearances for reference purposes. But some of the clips are played without much
interruption, if any. The purpose of showing these clips likely goes beyond merely making a reference for
a biography, but instead serves the same intrinsic entertainment value that is protected by Plaintiffs’
copyrights.
***
The third factor is the amount and substantiality of the portion used in relation to the copyrighted work as
a whole. This factor evaluates both the quantity of the work taken and the quality and importance of the
portion taken. Regarding the quantity, copying “may not be excused merely because it is insubstantial
with respect to the infringing work.” Harper & Row, 471 U.S. at 565 (emphasis in original). But if the
amount used is substantial with respect to the infringing work, it is evidence of the value of the copyrighted work.
Passport’s use of clips from television appearances, although in most cases of short duration, were
repeated numerous times throughout the tapes. While using a small number of clips to reference an event
for biographical purposes seems fair, using a clip over and over will likely no longer serve a biographical
purpose. Additionally, some of the clips were not short in length. Passport’s use of Elvis’ appearance
on The Steve Allen Show plays for over a minute and many more clips play for more than just a few
seconds.

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Additionally, although the clips are relatively short when compared to the entire shows that are
copyrighted, they are in many instances the heart of the work. What makes these copyrighted works
valuable is Elvis’ appearance on the shows, in many cases singing the most familiar passages of his most
popular songs. Plaintiffs are in the business of licensing these copyrights. Taking key portions extracts the
most valuable part of Plaintiffs’ copyrighted works. With respect to the photographs, the entire picture is
often used. The music, admittedly, is usually played only for a few seconds.
***
The last, and “undoubtedly the single most important” of all the factors, is the effect the use will have on
the potential market for and value of the copyrighted works. Harper & Row, 471 U.S. at 566. We must
“consider not only the extent of market harm caused by the particular actions of the alleged infringer, but
also whether unrestricted and widespread conduct of the sort engaged in by the defendant…would result
in a substantially adverse impact on the potential market for the original.” Campbell, 510 U.S. at 590. The
more transformative the new work, the less likely the new work’s use of copyrighted materials will affect
the market for the materials. Finally, if the purpose of the new work is commercial in nature, “the
likelihood [of market harm] may be presumed.” A&M Records, 239 F.3d at 1016 (quoting Sony, 464 U.S.
at 451).
The district court found that Passport’s use of Plaintiffs’ copyrighted materials likely does affect the
market for those materials. This conclusion was not clearly erroneous.
First, Passport’s use is commercial in nature, and thus we can assume market harm. Second, Passport has
expressly advertised that The Definitive Elviscontains the television appearances for which Plaintiffs
normally charge a licensing fee. If this type of use became wide-spread, it would likely undermine the
market for selling Plaintiffs’ copyrighted material. This conclusion, however, does not apply to the music
and still photographs. It seems unlikely that someone in the market for these materials would
purchase The Definitive Elvisinstead of a properly licensed product. Third, Passport’s use of the television
appearances was, in some instances, not transformative, and therefore these uses are likely to affect the
market because they serve the same purpose as Plaintiffs’ original works.
***

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We emphasize that our holding today is not intended to express how we would rule were we examining
the case ab initio as district judges. Instead, we confine our review to whether the district court abused its
discretion when it weighed the four statutory fair-use factors together and determined that Plaintiffs
would likely succeed on the merits. Although we might view this case as closer than the district court saw
it, we hold there was no abuse of discretion in the court’s decision to grant Plaintiffs’ requested relief.
AFFIRMED.

CASE QUESTIONS
1.

How would you weigh the four factors in this case? If the trial court had found fair use, would the appeals
court have overturned its ruling?

2.

Why do you think that the fourth factor is especially important?

3.

What is the significance of the discussion on “transformative” aspects of the defendant’s product?

Trademark Infringement and Dilution
Playboy Enterprises v. Welles
279 F.3d 796 (9th Circuit Court of Appeals, 2001)
T. G. NELSON, Circuit Judge:
Terri Welles was on the cover of Playboy in 1981 and was chosen to be the Playboy Playmate of the Year
for 1981. Her use of the title “Playboy Playmate of the Year 1981,” and her use of other trademarked terms
on her website are at issue in this suit. During the relevant time period, Welles’ website offered
information about and free photos of Welles, advertised photos for sale, advertised memberships in her
photo club, and promoted her services as a spokesperson. A biographical section described Welles’
selection as Playmate of the Year in 1981 and her years modeling for PEI. The site included a disclaimer
that read as follows: “This site is neither endorsed, nor sponsored, nor affiliated with Playboy Enterprises,
Inc. PLAYBOY tm PLAYMATE OF THE YEAR tm AND PLAYMATE OF THE MONTH tm are registered
trademarks of Playboy Enterprises, Inc.”
Wells used (1) the terms “Playboy ”and “Playmate” in the metatags of the website; (2) the phrase
“Playmate of the Year 1981” on the masthead of the website; (3) the phrases “Playboy Playmate of the Year

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1981” and “Playmate of the Year 1981” on various banner ads, which may be transferred to other websites;
and (4) the repeated use of the abbreviation “PMOY ’81” as the watermark on the pages of the website.
PEI claimed that these uses of its marks constituted trademark infringement, dilution, false designation of
origin, and unfair competition. The district court granted defendants’ motion for summary judgment. PEI
appeals the grant of summary judgment on its infringement and dilution claims. We affirm in part and
reverse in part.
A. Trademark Infringement
Except for the use of PEI’s protected terms in the wallpaper of Welles’ website, we conclude that Welles’
uses of PEI’s trademarks are permissible, nominative uses. They imply no current sponsorship or
endorsement by PEI. Instead, they serve to identify Welles as a past PEI “Playmate of the Year.”
We articulated the test for a permissible, nominative use in New Kids On The Block v. New America
Publishing, Inc. The band, New Kids On The Block, claimed trademark infringement arising from the use
of their trademarked name by several newspapers. The newspapers had conducted polls asking which
member of the band New Kids On The Block was the best and most popular. The papers’ use of the
trademarked term did not fall within the traditional fair use doctrine. Unlike a traditional fair use
scenario, the defendant newspaper was using the trademarked term to describe not its own product, but
the plaintiff’s. Thus, the factors used to evaluate fair use were inapplicable. The use was nonetheless
permissible, we concluded, based on its nominative nature.
We adopted the following test for nominative use:
First, the product or service in question must be one not readily identifiable without use of the trademark;
second, only so much of the mark or marks may be used as is reasonably necessary to identify the product
or service; and third, the user must do nothing that would, in conjunction with the mark, suggest
sponsorship or endorsement by the trademark holder.
We group the uses of PEI’s trademarked terms into three for the purpose of applying the test for
nominative use.
1. Headlines and banner advertisements.

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...
The district court properly identified Welles’ situation as one which must… be excepted. No descriptive
substitute exists for PEI’s trademarks in this context.…Just as the newspapers in New Kids could only
identify the band clearly by using its trademarked name, so can Welles only identify herself clearly by
using PEI’s trademarked title.
The second part of the nominative use test requires that “only so much of the mark or marks may be used
as is reasonably necessary to identify the product or service[.]” New Kids provided the following examples
to explain this element: “[A] soft drink competitor would be entitled to compare its product to Coca-Cola
or Coke, but would not be entitled to use Coca-Cola’s distinctive lettering.” Similarly, in a past case, an
auto shop was allowed to use the trademarked term “Volkswagen” on a sign describing the cars it
repaired, in part because the shop “did not use Volkswagen’s distinctive lettering style or color scheme,
nor did he display the encircled ‘VW’ emblem.” Welles’ banner advertisements and headlines satisfy this
element because they use only the trademarked words, not the font or symbols associated with the
trademarks.
The third element requires that the user do “nothing that would, in conjunction with the mark, suggest
sponsorship or endorsement by the trademark holder.” As to this element, we conclude that aside from
the wallpaper, which we address separately, Welles does nothing in conjunction with her use of the marks
to suggest sponsorship or endorsement by PEI. The marks are clearly used to describe the title she
received from PEI in 1981, a title that helps describe who she is. It would be unreasonable to assume that
the Chicago Bulls sponsored a website of Michael Jordan’s simply because his name appeared with the
appellation “former Chicago Bull.” Similarly, in this case, it would be unreasonable to assume that PEI
currently sponsors or endorses someone who describes herself as a “Playboy Playmate of the Year in
1981.” The designation of the year, in our case, serves the same function as the “former” in our example. It
shows that any sponsorship or endorsement occurred in the past.
For the foregoing reasons, we conclude that Welles’ use of PEI’s marks in her headlines and banner
advertisements is a nominative use excepted from the law of trademark infringement.
2. Metatags

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Welles includes the terms “playboy” and “playmate” in her metatags. Metatags describe the contents of a
website using keywords. Some search engines search metatags to identify websites relevant to a search.
Thus, when an internet searcher enters “playboy” or “playmate” into a search engine that uses metatags,
the results will include Welles’ site. Because Welles’ metatags do not repeat the terms extensively, her site
will not be at the top of the list of search results. Applying the three-factor test for nominative use, we
conclude that the use of the trademarked terms in Welles’ metatags is nominative.
As we discussed above with regard to the headlines and banner advertisements, Welles has no practical
way of describing herself without using trademarked terms. In the context of metatags, we conclude that
she has no practical way of identifying the content of her website without referring to PEI’s trademarks.
...
Precluding their use would have the unwanted effect of hindering the free flow of information on the
internet, something which is certainly not a goal of trademark law. Accordingly, the use of trademarked
terms in the metatags meets the first part of the test for nominative use.…We conclude that the metatags
satisfy the second and third elements of the test as well. The metatags use only so much of the marks as
reasonably necessary and nothing is done in conjunction with them to suggest sponsorship or
endorsement by the trademark holder. We note that our decision might differ if the metatags listed the
trademarked term so repeatedly that Welles’ site would regularly appear above PEI’s in searches for one
of the trademarked terms.
3. Wallpaper/watermark.
The background, or wallpaper, of Welles’ site consists of the repeated abbreviation “PMOY ’81,” which
stands for “Playmate of the Year 1981.” Welles’ name or likeness does not appear before or after “PMOY
’81.” The pattern created by the repeated abbreviation appears as the background of the various pages of
the website. Accepting, for the purposes of this appeal, that the abbreviation “PMOY” is indeed entitled to
protection, we conclude that the repeated, stylized use of this abbreviation fails the nominative use test.
The repeated depiction of “PMOY ‘81” is not necessary to describe Welles. “Playboy Playmate of the Year
1981” is quite adequate. Moreover, the term does not even appear to describe Welles—her name or

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likeness do not appear before or after each “PMOY ’81.” Because the use of the abbreviation fails the first
prong of the nominative use test, we need not apply the next two prongs of the test.
Because the defense of nominative use fails here, and we have already determined that the doctrine of fair
use does not apply, we remand to the district court. The court must determine whether trademark law
protects the abbreviation “PMOY,” as used in the wallpaper.
B. Trademark Dilution [At this point, the court considers and rejects PEI’s claim for trademark dilution.]
Conclusion
For the foregoing reasons, we affirm the district court’s grant of summary judgment as to PEI’s claims for
trademark infringement and trademark dilution, with the sole exception of the use of the abbreviation
“PMOY.” We reverse as to the abbreviation and remand for consideration of whether it merits protection
under either an infringement or a dilution theory.

CASE QUESTIONS
1.

Do you agree with the court’s decision that there is no dilution here?

2.

If PMOY is not a registered trademark, why does the court discuss it?

3.

What does “nominative use” mean in the context of this case?

4.

In business terms, why would PEI even think that it was losing money, or could lose money, based on
Welles’s use of its identifying marks?

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18.6 Summary and Exercises
Summary
The products of the human mind are at the root of all business, but they are legally protectable only to a
certain degree. Inventions that are truly novel may qualify for a twenty-year patent; the inventor may then
prohibit anyone from using the art (machine, process, manufacture, and the like) or license it on his own
terms. A business may sue a person who improperly gives away its legitimate trade secrets, but it may not
prevent others from using the unpatented trade secret once publicly disclosed. Writers or painters,
sculptors, composers, and other creative artists may generally protect the expression of their ideas for the
duration of their lives plus seventy years, as long as the ideas are fixed in some tangible medium. That
means that they may prevent others from copying their words (or painting, etc.), but they may not prevent
anyone from talking about or using their ideas. Finally, one who markets a product or service may protect
its trademark or service or other mark that is distinctive or has taken on a secondary meaning, but may
lose it if the mark becomes the generic term for the goods or services.

EXERCISES
1.

Samuel Morse filed claims in the US Patent Office for his invention of the telegraph and also for the “use
of the motive power of the electric or galvanic current…however developed, for marking or printing
intelligible characters, signs or letters at any distances.” For which claim, if any, was he entitled to a
patent? Why?

2.

In 1957, an inventor dreamed up and constructed a certain new kind of computer. He kept his invention a
secret. Two years later, another inventor who conceived the same machine filed a patent application. The
first inventor, learning of the patent application, filed for his own patent in 1963. Who is entitled to the
patent, assuming that the invention was truly novel and not obvious? Why?

3.

A large company discovered that a small company was infringing one of its patents. It wrote the small
company and asked it to stop. The small company denied that it was infringing. Because of personnel
changes in the large company, the correspondence file was lost and only rediscovered eight years later.
The large company sued. What would be the result? Why?

4.

Clifford Witter was a dance instructor at the Arthur Murray Dance Studios in Cleveland. As a condition of
employment, he signed a contract not to work for a competitor. Subsequently, he was hired by the Fred

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Astaire Dancing Studios, where he taught the method that he had learned at Arthur Murray. Arthur
Murray sued to enforce the noncompete contract. What would be result? What additional information, if
any, would you need to know to decide the case?
5.

Greenberg worked for Buckingham Wax as its chief chemist, developing chemical formulas for products
by testing other companies’ formulas and modifying them. Brite Products bought Buckingham’s goods
and resold them under its own name. Greenberg went to work for Brite, where he helped Brite make
chemicals substantially similar to the ones it had been buying from Buckingham. Greenberg had never
made any written or oral commitment to Buckingham restricting his use of the chemical formulas he
developed. May Buckingham stop Greenberg from working for Brite? May it stop him from working on
formulas learned while working at Buckingham? Why?

SELF-TEST QUESTIONS
1.

Which of the following cannot be protected under patent, copyright, or trademark law?
a.

a synthesized molecule

b.

a one-line book title

c.

a one-line advertising jingle

d.

a one-word company name

Which of the following does not expire by law?
a.

a closely guarded trade secret not released to the public

b.

a patent granted by the US Patent and Trademark Office

c.

a copyright registered in the US Copyright Office

d.

a federal trademark registered under the Lanham Act
A sculptor casts a marble statue of a three-winged bird. To protect against copying, the sculptor
can obtain which of the following?

a.

a patent

b.

a trademark

c.

a copyright

d.

none of the above

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A stock analyst discovers a new system for increasing the value of a stock portfolio. He may
protect against use of his system by other people by securing
a.

a patent

b.

a copyright

c.

a trademark

d.

none of the above
A company prints up its customer list for use by its sales staff. The cover page carries a notice
that says “confidential.” A rival salesman gets a copy of the list. The company can sue to recover
the list because the list is

a.

patented

b.

copyrighted

c.

a trade secret

d.

none of the above

SELF-TEST ANSWERS
1.

b

2.

a

3.

c

4.

d

5.

c

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Chapter 19

Insurance
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

The basic terms and distinctions in the law of insurance

2.

The basic types of insurance for property, liability, and life

3.

The basic defenses to claims against insurance companies by the insured: representation,
concealment, and warranties

We conclude our discussions about property with a focus on insurance law, not only because
insurance is a means of compensating an owner for property losses but also because the insurance
contract itself represents a property right. In this chapter, we begin by examining regulation of the
insurance industry. We then look at legal issues relating to specific types of insurance. Finally, we
examine defenses that insurance companies might raise to avoid making payments under insurance
policies.

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19.1 Definitions and Types of Insurance
LEARNING OBJECTIVES
1.

Know the basic types of insurance for individuals.

2.

Name and describe the various kinds of business insurance.

Certain terms are usefully defined at the outset. Insurance is a contract of reimbursement. For
example, it reimburses for losses from specified perils, such as fire, hurricane, and earthquake.
An insurer is the company or person who promises to reimburse. The insured (sometimes called the
assured) is the one who receives the payment, except in the case of life insurance, where payment
goes to the beneficiary named in the life insurance contract. The premium is the consideration paid
by the insured—usually annually or semiannually—for the insurer’s promise to reimburse. The
contract itself is called the policy. The events insured against are known as risks or perils.
Regulation of insurance is left mainly in the hands of state, rather than federal, authorities. Under
the McCarran-Ferguson Act, Congress exempted state-regulated insurance companies from the
federal antitrust laws. Every state now has an insurance department that oversees insurance rates,
policy standards, reserves, and other aspects of the industry. Over the years, these departments have
come under fire in many states for being ineffective and “captives” of the industry. Moreover, large
insurers operate in all states, and both they and consumers must contend with fifty different state
regulatory schemes that provide very different degrees of protection. From time to time, attempts
have been made to bring insurance under federal regulation, but none have been successful.
We begin with an overview of the types of insurance, from both a consumer and a business
perspective. Then we examine in greater detail the three most important types of insurance:
property, liability, and life.

Public and Private Insurance
Sometimes a distinction is made between public and private insurance. Public (or social) insurance
includes Social Security, Medicare, temporary disability insurance, and the like, funded through

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government plans. Private insurance plans, by contrast, are all types of coverage offered by private
corporations or organizations. The focus of this chapter is private insurance.

Types of Insurance for the Individual
Life Insurance
Life insurance provides for your family or some other named beneficiaries on your death. Two general
types are available: term insurance provides coverage only during the term of the policy and pays off only
on the insured’s death; whole-life insurance provides savings as well as insurance and can let the insured
collect before death.

Health Insurance
Health insurance covers the cost of hospitalization, visits to the doctor’s office, and prescription
medicines. The most useful policies, provided by many employers, are those that cover 100 percent of the
costs of being hospitalized and 80 percent of the charges for medicine and a doctor’s services. Usually, the
policy will contain a deductible amount; the insurer will not make payments until after the deductible
amount has been reached. Twenty years ago, the deductible might have been the first $100 or $250 of
charges; today, it is often much higher.

Disability Insurance
A disability policy pays a certain percentage of an employee’s wages (or a fixed sum) weekly or monthly if
the employee becomes unable to work through illness or an accident. Premiums are lower for policies with
longer waiting periods before payments must be made: a policy that begins to pay a disabled worker
within thirty days might cost twice as much as one that defers payment for six months.

Homeowner’s Insurance
A homeowner’s policy provides insurance for damages or losses due to fire, theft, and other named perils.
No policy routinely covers all perils. The homeowner must assess his needs by looking to the likely risks in
his area—earthquake, hailstorm, flooding, and so on. Homeowner’s policies provide for reduced coverage
if the property is not insured for at least 80 percent of its replacement costs. In inflationary times, this

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requirement means that the owner must adjust the policy limits upward each year or purchase a rider that
automatically adjusts for inflation. Where property values have dropped substantially, the owner of a
home (or a commercial building) might find savings in lowering the policy’s insured amount.

Automobile Insurance
Automobile insurance is perhaps the most commonly held type of insurance. Automobile policies are
required in at least minimum amounts in all states. The typical automobile policy covers liability for
bodily injury and property damage, medical payments, damage to or loss of the car itself, and attorneys’
fees in case of a lawsuit.

Other Liability Insurance
In this litigious society, a person can be sued for just about anything: a slip on the walk, a harsh and
untrue word spoken in anger, an accident on the ball field. A personal liability policy covers many types of
these risks and can give coverage in excess of that provided by homeowner’s and automobile insurance.
Such umbrella coverage is usually fairly inexpensive, perhaps $250 a year for $1 million in liability.

Types of Business Insurance
Workers’ Compensation
Almost every business in every state must insure against injury to workers on the job. Some may do this
through self-insurance—that is, by setting aside certain reserves for this contingency. Most smaller
businesses purchase workers’ compensation policies, available through commercial insurers, trade
associations, or state funds.

Automobile Insurance
Any business that uses motor vehicles should maintain at least a minimum automobile insurance policy
on the vehicles, covering personal injury, property damage, and general liability.

Property Insurance

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No business should take a chance of leaving unprotected its buildings, permanent fixtures, machinery,
inventory, and the like. Various property policies cover damage or loss to a company’s own property or to
property of others stored on the premises.

Malpractice Insurance
Professionals such as doctors, lawyers, and accountants will often purchase malpractice insurance to
protect against claims made by disgruntled patients or clients. For doctors, the cost of such insurance has
been rising over the past thirty years, largely because of larger jury awards against physicians who are
negligent in the practice of their profession.

Business Interruption Insurance
Depending on the size of the business and its vulnerability to losses resulting from damage to essential
operating equipment or other property, a company may wish to purchase insurance that will cover loss of
earnings if the business operations are interrupted in some way—by a strike, loss of power, loss of raw
material supply, and so on.

Liability Insurance
Businesses face a host of risks that could result in substantial liabilities. Many types of policies are
available, including policies for owners, landlords, and tenants (covering liability incurred on the
premises); for manufacturers and contractors (for liability incurred on all premises); for a company’s
products and completed operations (for liability that results from warranties on products or injuries
caused by products); for owners and contractors (protective liability for damages caused by independent
contractors engaged by the insured); and for contractual liability (for failure to abide by performances
required by specific contracts).
Some years ago, different types of individual and business coverage had to be purchased separately and
often from different companies. Today, most insurance is available on a package basis, through single
policies that cover the most important risks. These are often called multiperil policies.

KEY TAKEAWAY

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Although insurance is a need for every US business, and many businesses operate in all fifty states, regulation
of insurance has remained at the state level. There are several forms of public insurance (Social Security,
disability, Medicare) and many forms of private insurance. Both individuals and businesses have significant
needs for various types of insurance, to provide protection for health care, for their property, and for legal
claims made against them by others.

EXERCISES
1.

Theresa Conley is joining the accounting firm of Hunter and Patton in Des Moines, Iowa. She is a certified
public accountant. What kind of insurance will she (or the firm, on her behalf) need to buy because of her
professional activities?

2.

Nate Johnson has just signed a franchise agreement with Papa Luigi’s Pizza and will be operating his own
Papa Luigi’s store in Lubbock, Texas. The franchise agreement requires that he personally contract for “all
necessary insurance” for the successful operation of the franchise. He expects to have twelve employees,
five full-time and seven part-time (the delivery people), at his location, which will be on a busy boulevard
in Lubbock and will offer take-out only. Pizza delivery employees will be using their own automobiles to
deliver orders. What kinds of insurance will be “necessary”?

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19.2 Property Insurance, Liability Insurance, and Life Insurance
LEARNING OBJECTIVES
1.

Distinguish and define the basic types of insurance for property, liability, and life.

2.

Explain the concepts of subrogation and assignment.

We turn now to a more detailed discussion of the law relating to the three most common types of
insurance: property, liability, and life insurance.

Property Insurance
It is sometimes said that property is the foundation for a system of free market capitalism. If so, then
protecting property is a necessary part of being part of that system, whether as an individual or as a
business entity.

Coverage
As we have noted, property insurance provides coverage for real and personal property owned by a
business or an individual. Property insurance is also part of automobile policies covering damage to the
car caused by an accident (collision coverage) or by other events such as vandalism or fire (comprehensive
coverage). Different levels of coverage are available. For example, many basic homeowners’ policies cover
damage resulting from the following types of perils only: fire and lightning, windstorm and hail,
explosions, riots and civil commotions, aircraft and vehicular accidents, smoke, vandalism and malicious
mischief, theft, and breakage of glass that is part of a building.
A broader policy, known as broad coverage, also includes these perils: falling objects; weight of ice, snow,
and sleet; collapse of buildings; sudden and accidental damage to heating systems; accidental discharge
from plumbing, heating, or air-conditioning systems; freezing of heating, plumbing, and air conditioning
systems; and sudden and accidental injury from excess currents to electrical appliances and wiring. Even
with the broadest form of coverage, known as comprehensive, which covers all perils except for certain
named exclusions, the homeowner can be left without protection. For example, comprehensive policies do
not usually cover damage resulting from flooding, earthquakes, war, or nuclear radiation. The homeowner
can purchase separate coverage for these perils but usually at a steep premium.

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Insurable Interest in Property
To purchase property insurance, the would-be insured must have aninsurable interest in the property.
Insurable interest is a real and substantial interest in specific property such that a loss to the insured
would ensue if the property were damaged. You could not, for instance, take out an insurance policy on a
motel down the block with which you have no connection. If a fire destroyed it, you would suffer no
economic loss. But if you helped finance the motel and had an investment interest in it, you would be
permitted to place an insurance policy on it. This requirement of an insurable interest stems from the
public policy against wagering. If you could insure anything, you would in effect be betting on an accident.
To insure property, therefore, you must have a legal interest and run the risk of a pecuniary loss. Any legal
interest is sufficient: a contractual right to purchase, for instance, or the right of possession (a bailee may
insure). This insurable interest must exist both at the time you take out the policy and at the time the loss
occurs. Moreover, coverage is limited to the extent of the interest. As a mortgagee, you could ensure only
for the amount still due.
Prior to the financial meltdown of 2008, many investment banks took insurance against possible losses
from collateralized debt obligations (CDOs) and other financial products based on subprime loans. The
principal insurer was American International Group, Inc. (AIG), which needed a US government bailout
when the risks covered by AIG turned out to be riskier than AIG’s models had projected.

Subrogation
Figure 19.1 Subrogation

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Subrogation is the substitution of one person for another in pursuit of a legal claim. When an insured is
entitled to recover under a policy for property damage, the insurer is said to be subrogated to the
insured’s right to sue any third party who caused the damage. For example, a wrecking company
negligently destroys an insured’s home, mistaking it for the building it was hired to tear down. The
insured has a cause of action against the wrecking company. If the insured chooses instead to collect
against a homeowner’s policy, the insurance company may sue the wrecking company in the insured’s
place to recover the sum it was obligated to pay out under the policy (see Figure 19.1 "Subrogation").

Assignment
Assignment is the transfer of any property right to another. In property insurance, a distinction is made
between assignment of the coverage and assignment of the proceeds. Ordinarily, the insured may not
assign the policy itself without the insurer’s permission—that is, he may not commit the insurer to insure
someone else. But the insured may assign any claims against the insurer—for example, the proceeds not
yet paid out on a claim for a house that has already burned down.

Intentional Losses
Insurance is a means of spreading risk. It is economically feasible because not every house burns down
and not every car is stolen. The number that do burn down or that are stolen can be calculated and the
premium set accordingly. Events that will certainly happen, like ordinary wear and tear and the

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destruction of property through deliberate acts such as arson, must be excluded from such calculations.
The injury must result from accidental, not deliberate, causes.

Coinsurance Clause
Most commercial property policies contain a so-called coinsurance clause, which requires the insured to
maintain insurance equal to a specified percentage of the property value. It is often 80 percent but may be
higher or lower. If the property owner insures for less than that percentage, the recovery will be reduced.
In effect, the owner becomes a coinsurer with the insurance company. The usual formula establishes the
proportion that the insurer must pay by calculating the ratio of (1) the amount of insurance actually taken
to (2) the coinsurance percentage multiplied by the total dollar value of the property. Suppose a fire
causes $160,000 damage to a plant worth $1,000,000. The plant should have been insured for 80 percent
($800,000), but the insured took out only a $500,000 policy. He will recover only $100,000. To see why,
multiply the total damages of $160,000 by the coinsurance proportion of five-eighths ($500,000 of
insurance on the required minimum of $800,000). Five-eighths of $160,000 equals $100,000, which
would be the insured’s recovery where the policy has a coinsurance clause.

Liability Insurance
Liability insurance has taken on great importance for both individuals and businesses in contemporary
society. Liability insurance covers specific types of legal liabilities that a homeowner, driver, professional,
business executive, or business itself might incur in the round of daily activities. A business is always at
risk in sending products into the marketplace. Doctors, accountants, real estate brokers, insurance agents,
and lawyers should obtain liability insurance to cover the risk of being sued for malpractice. A prudent
homeowner will acquire liability insurance as part of homeowner’s policy and a supplemental umbrella
policy that insures for liability in excess of a limit of, say, $100,000 in the regular homeowner’s policy.
And businesses, professionals, and individuals typically acquire liability insurance for driving-related
activities as part of their automobile insurance. In all cases, liability policies cover not only any settlement
or award that might ultimately have to be paid but also the cost of lawyers and related expenses in
defending any claims.

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Liability insurance is similar in several respects to property insurance and is often part of the same
package policy. As with property insurance, subrogation is allowed with liability insurance, but
assignment of the policy is not allowed (unless permission of the insurer is obtained), and intentional
losses are not covered. For example, an accountant who willfully helps a client conceal fraud will not
recover from his malpractice insurance policy if he is found guilty of participating in the fraud.

No-Fault Trends
The major legal development of the century relating to liability insurance has been the elimination of
liability in the two areas of greatest exposure: in the workplace and on the highway. In the next unit on
agency law, we discuss the no-fault system of workers’ compensation, under which a worker receives
automatic benefits for workplace injuries and gives up the right to sue the employer under common-law
theories of liability. Here we will look briefly at the other major type of no-fault system: recovery for
damages stemming from motor vehicle accidents.
“No-fault” means that recovery for damages in an accident no longer depends on who was at fault in
causing it. A motorist will file a claim to recover his actual damages (medical expenses, income loss)
directly from his own insurer. The no-fault system dispenses with the costly and uncertain tort system of
having to prove negligence in court. Many states have adopted one form or another of no-fault automobile
insurance, but even in these states the car owner must still carry other insurance. Some no-fault systems
have a dollar “threshold” above which a victim may sue for medical expenses or other losses. Other states
use a “verbal threshold,” which permits suits for “serious” injury, defined variously as “disfigurement,”
“fracture,” or “permanent disability.” These thresholds have prevented no-fault from working as
efficiently as theory predicts. Inflation has reduced the power of dollar thresholds (in some states as low
as $200) to deter lawsuits, and the verbal thresholds have standards that can only be defined in court, so
much litigation continues.
No state has adopted a “pure” no-fault system. A pure no-fault system trades away entirely the right to sue
in return for the prompt payment of “first-party” insurance benefits—that is, payment by the victim’s own
insurance company instead of traditional “third-party” coverage, in which the victim collects from the
defendant’s insurance company.

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Among the criticisms of no-fault insurance is the argument that it fails to strengthen the central purpose
of the tort system: to deter unsafe conduct that causes accidents. No-fault lessens, it is said, the incentive
to avoid accidents. In any event, no-fault automobile insurance has been a major development in the
insurance field since 1970 and seems destined to be a permanent fixture of insurance law.

Life Insurance
Insurable Interest
The two types of life insurance mentioned in Section 19.1.2 "Types of Insurance for the Individual", term
and whole-life policies, are important both to individuals and to businesses (insurance for key
employees). As with property insurance, whoever takes out a life insurance policy on a person’s life must
have an insurable interest. Everyone has an insurable interest in his own life and may name whomever he
pleases as beneficiary; the beneficiary need not have an insurable interest. But the requirement of
insurable interest restricts those who may take out insurance on someone else’s life. A spouse or children
have an insurable interest in a spouse or parent. Likewise, a parent has an insurable interest in any minor
child. That means that a wife, for example, may take out a life insurance policy on her husband without
his consent. But she could not take out a policy on a friend or neighbor. As long as the insurable interest
existed when the policy was taken out, the owner may recover when the insured dies, even if the insurable
interest no longer exists. Thus a divorced wife who was married when the policy was obtained may collect
when her ex-husband dies as long as she maintained the payments. Likewise, an employer has an
insurable interest in his key employees and partners; such insurance policies help to pay off claims of a
partner’s estate and thus prevent liquidation of the business.

Subrogation
Unlike property insurance, life insurance does not permit subrogation. The insurer must pay the claim
when the insured dies and may not step into the shoes of anyone entitled to file a wrongful death claim
against a person who caused the death. Of course, if the insured died of natural causes, there would be no
one to sue anyway.

Change of Beneficiary and Assignment
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Unless the insured reserves the right to change beneficiaries, his or her initial designation is irrevocable.
These days, however, most policies do reserve the right if certain formalities are observed, including
written instructions to the insurer’s home office to make the change and endorsement of the policy. The
insured may assign the policy, but the beneficiary has priority to collect over the assignee if the right to
change beneficiaries has not been reserved. If the policy permits beneficiaries to be changed, then the
assignee will have priority over the original beneficiary.

Intentional Losses
Two types of intentional losses are especially important in life insurance: suicide and murder of the
insured by the beneficiary.

Suicide
In a majority of states, in the absence of a suicide clause in the policy, when an insured commits suicide,
the insurer need not pay out if the policy is payable to the insured’s estate. However, if the policy is
payable to a third person (e.g., the insured’s company), payment will usually be allowed. And if an insured
kills himself while insane, all states require payment, whether to the estate or a third party. Most life
insurance policies today have a provision that explicitly excepts suicide from coverage for a limited period,
such as two years, after the policy is issued. In other words, if the insured commits suicide within the first
two years, the insurer will refund the premiums to his estate but will not pay the policy amount. After two
years, suicide is treated as any other death would be.

Murder
Under the law in every state, a beneficiary who kills the insured in order to collect the life insurance is
barred from receiving it. But the invocation of that rule does not absolve the insurer of liability to pay the
policy amount. An alternate beneficiary must be found. Sometimes the policy will name contingent
beneficiaries, and many, but not all, states require the insurer to pay the contingent beneficiaries. When
there are no contingent beneficiaries or the state law prohibits paying them, the insurer will pay the
insured’s estate. Not every killing is murder; the critical question is whether the beneficiary intended his
conduct to eliminate the insured in order to collect the insurance.

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The willful, unlawful, and felonious killing of the insured by the person named as beneficiary in a life
policy results in the forfeiture of all rights of such person therein. It is unnecessary that there should be an
express exception in the contract of insurance forbidding a recovery in favor of such a person in such an
event. On considerations of public policy, the death of the insured, willfully and intentionally caused by
the beneficiary of the policy, is an excepted risk so far as the person thus causing the death is concerned.

KEY TAKEAWAY
Many kinds of insurance are available for individuals and businesses. For individuals, life insurance,
homeowner’s insurance, and automobile insurance are common, with health insurance considered essential
but often expensive. Businesses with sufficient employees will obtain workers’ compensation insurance,
property insurance, and liability insurance, and auto insurance for any employees driving company vehicles.
Insurance companies will often pay a claim for their insured and take over the insured’s claim against a third
party.
Liability insurance is important for individuals, companies, and licensed professionals. A trend toward no-fault
in liability insurance is seen in claims for work-related injuries (workers’ compensation) and in automobile
insurance. Life insurance is common for most families and for businesses that want to protect against the loss
of key employees.

EXERCISES
1.

Helen Caldicott raises a family and then begins a career as a caterer. As her business grows, she hires
several employees and rents space near downtown that has a retail space, parking, and a garage for the
three vehicles that bear her business’s name. What kinds of insurance does Helen need for her business?

2.

One of Helen’s employees, Bob Zeek, is driving to a catered event when another car fails to stop at a red
light and severely injures Bob and nearly totals the van Bob was driving. The police issue a ticket for
careless and reckless driving to the other driver, who pleads guilty to the offense. The other driver is
insured, but Helen’s automobile insurance carrier goes ahead and pays for the damages to the company
vehicle. What will her insurance company likely do next?

3.

The health insurance provider for Helen’s employees pays over $345,000 of Bob’s medical and
hospitalization bills. What will Helen’s insurance company likely do next?

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4.

Many homeowners live on floodplains but have homeowner’s insurance nonetheless. Must insurance
companies write such policies? Do homeowners on floodplains pay more in premiums? If insurance
companies are convinced that global climate change is happening, with rising sea levels and stronger
storms, can they simply avoid writing policies for homes and commercial buildings in coastal areas?

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19.3 Insurer’s Defenses
LEARNING OBJECTIVES
1.

Understand the principal defenses available to insurers when claims are made.

2.

Recognize that despite these defenses, insurance companies must act in good faith.

Types of Defenses
It is a common perception that because insurance contracts are so complex, many insureds who believe
they are covered end up with uninsured losses. In other words, the large print giveth, and the small print
taketh away. This perception is founded, to some extent, on the use by insurance companies of three
common defenses, all of which relate to a duty of good faith on the part of the insured: (1) representation,
(2) concealment, and (3) warranties.

Representation
A representation is a statement made by someone seeking an insurance policy—for example, a statement
that the applicant did (or did not) consult a doctor for any illness during the previous five years. An
insurer has grounds to avoid the contract if the applicant makes a false representation. The
misrepresentation must have been material; that is, a false description of a person’s hair coloring should
not defeat a claim under an automobile accident policy. But a false statement, even if innocent, about a
material fact—for instance, that no one in the family uses the car to go to work, when unbeknownst to the
applicant, his wife uses the car to commute to a part-time job she hasn’t told him about—will at the
insurer’s option defeat a claim by the insured to collect under the policy. The accident need not have
arisen out of the misrepresentation to defeat the claim. In the example given, the insurance company
could refuse to pay a claim for any accident in the car, even one occurring when the car was driven by the
husband to go to the movies, if the insurer discovered that the car was used in a manner in which the
insured had declared it was not used. This chapter’s case, Mutual Benefit Life Insurance Co. v. JMR
Electronics Corp., (see Section 19.4.1 "Misrepresentation to Insurer"), illustrates what happens when an
insured misrepresents his smoking habits.

Concealment
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An insured is obligated to volunteer to the insurer all material facts that bear on insurability. The failure
of an insured to set forth such information is aconcealment, which is, in effect, the mirror image of a false
representation. But the insured must have had a fraudulent intent to conceal the material facts. For
example, if the insured did not know that gasoline was stored in his basement, the insurer may not refuse
to pay out on a fire insurance policy.

Warranties
Many insurance policies covering commercial property will contain warranties. For example, a policy may
have a warranty that the insured bank has installed or will install a particular type of burglar alarm
system. Until recently, the rule was strictly enforced: any breach of a warranty voided the contract, even if
the breach was not material. A nonmaterial breach might be, for example, that the bank obtained the
alarm system from a manufacturer other than the one specified, even though the alarm systems are
identical. In recent years, courts or legislatures have relaxed the application of this rule. But a material
breach still remains absolute grounds for the insurer to avoid the contract and refuse to pay.

Incontestable Clause
In life insurance cases, the three common defenses often are unavailable to the insurer because of the socalled incontestable clause. This states that if the insured has not died during a specified period of time in
which the life insurance policy has been in effect (usually two years), then the insurer may not refuse to
pay even if it is later discovered that the insured committed fraud in applying for the policy. Few nonlife
policies contain an incontestable clause; it is used in life insurance because the effect on many families
would be catastrophic if the insurer claimed misrepresentation or concealment that would be difficult to
disprove years later when the insured himself would no longer be available to give testimony about his
intentions or knowledge.

Requirement of Insurer’s Good Faith
Like the insured, the insurer must act in good faith. Thus defenses may be unavailable to an insurer who
has waived them or acted in such a manner as to create an estoppel. Suppose that when an insured seeks
to increase the amount on his life insurance policy, the insurance company learns that he lied about his

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age on his original application. Nevertheless, the company accepts his application for an increase. The
insured then dies, and the insurer refuses to pay his wife any sum. A court would hold that the insurer had
waived its right to object, since it could have cancelled the policy when it learned of the misrepresentation.
Finally, an insurer that acts in bad faith by denying a claim that it knows it should pay may find itself open
to punitive damage liability.

KEY TAKEAWAY
Some claims by insured parties can be legally denied by insurance companies where the insured has made a
material misrepresentation. Some claims can be legally denied if the insured has deliberately concealed
important matters in applying for insurance coverage. Because insurance coverage is by contract, courts often
strictly construe the contract language, and if the language does not cover the insured, the courts will typically
not bend the language of the contract to help the insured.

EXERCISES
1.

Amir Labib gets a reduced rate from his auto insurance company because he represents in his application
that he commutes less than ten miles a day to work. Three years later, he and his wife buy a new
residence, farther away from work, and he begins a fifteen-mile-a-day commute. The rate would be
raised if he were to mention this to his insurance company. The insurance company sees that he has a
different address, because they are mailing invoices to his new home. But the rate remains the same.
Amir has a serious accident on a vacation to Yellowstone National Park, and his automobile is totaled. His
insurance policy is a no-fault policy as it relates to coverage for vehicle damage. Is the insurance company
within its rights to deny any payment on his claim? How so, or why not?

2.

In 2009, Peter Calhoun gets a life insurance policy from Northwest Mutual Life Insurance Company, and
the death benefit is listed as $250,000. The premiums are paid up when he dies in 2011 after a getaway
car being chased by the police slams into his car at fifty miles per hour on a street in suburban Chicago.
The life insurance company gets information that he smoked two packs of cigarettes a day, whereas in his
application in 2009, he said he smoked only one pack a day. In fact, he had smoked about a pack and a
half every day since 1992. Is the insurance company within its rights to deny any payment on his claim?
How so, or why not?

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19.4 Case
Misrepresentation to Insurer
Mutual Benefit Life Insurance Co. v. JMR Electronics Corp.
848 F.2d 30 (2nd Cir. 1988)
PER CURIAM
JMR Electronics Corporation (“JMR”) appeals from a judgment of the District Court for the Southern
District of New York (Robert W. Sweet, Judge) ordering rescission of a life insurance policy issued by
plaintiff-appellant The Mutual Benefit Life Insurance Company (“Mutual”) and dismissing JMR’s
counterclaim for the policy’s proceeds. Judge Sweet ruled that a misrepresentation made in the policy
application concerning the insured’s history of cigarette smoking was material as a matter of law.
Appellant contends that the misrepresentation was not material because Mutual would have provided
insurance—albeit at a higher premium rate—even if the insured’s smoking history had been disclosed. We
agree with the District Court that summary judgment was appropriate and therefore affirm.
The basic facts are not in dispute. On June 24, 1985, JMR submitted an application to Mutual for a $
250,000 “key man” life insurance policy on the life of its president, Joseph Gaon, at the non-smoker’s
discounted premium rate. Mutual’s 1985 Ratebook provides: “The Non-Smoker rates are available when
the proposed insured is at least 20 years old and has not smoked a cigarette for at least twelve months
prior to the date of the application.” Question 13 of the application inquired about the proposed insured’s
smoking history. Question 13(a) asked, “Do you smoke cigarettes? How many a day?” Gaon answered this
question, “No.” Question 13(b) asked, “Did you ever smoke cigarettes? “ Gaon again answered, “No.”
Based on these representations, Mutual issued a policy on Gaon’s life at the non-smoker premium rate.
Gaon died on June 22, 1986, within the period of contestability contained in policy, see N.Y. Ins. Law §
3203 (a)(3) (McKinney 1985). Upon routine investigation of JMR’s claim for proceeds under the policy,
Mutual discovered that the representations made in the insurance application concerning Gaon’s smoking
history were untrue. JMR has stipulated that, at the time the application was submitted, Gaon in fact “had
been smoking one-half of a pack of cigarettes per day for a continuous period of not less than 10 years.”

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Mutual brought this action seeking a declaration that the policy is void. Judge Sweet granted Mutual’s
motion for summary judgment, dismissed JMR’s counterclaim for the proceeds of the policy, and ordered
rescission of the insurance policy and return of JMR’s premium payments, with interest.
Under New York law, which governs this diversity suit, “it is the rule that even an innocent
misrepresentation as to [the applicant’s medical history], if material, is sufficient to allow the insurer to
avoid the contract of insurance or defeat recovery thereunder.” Process Plants Corp. v. Beneficial
National Life Insurance Co., 366 N.E.2d 1361 (1977). A “misrepresentation” is defined by statute as a false
“statement as to past or present fact, made to the insurer…at or before the making of the insurance
contract as an inducement to the making thereof.” N.Y. Ins. Law § 3105(a) (McKinney 1985). A
misrepresentation is “material” if “knowledge by the insurer of the facts misrepresented would have led to
a refusal by the insurer to make such contract.” Id. § 3105(b).…
In the present case JMR has stipulated that Gaon’s smoking history was misrepresented in the insurance
application. However, JMR disputes that this misrepresentation is material as a matter of law. JMR
argues that under New York law a misrepresentation is not material unless the insurer can demonstrate
that, had the applicant provided complete and accurate information, coverage either would have been
refused or at the very least withheld pending a more detailed underwriting examination. In JMR’s view
summary judgment was inappropriate on the facts of this case because a jury could reasonably have found
that even “had appellee been aware of Gaon’s smoking history, a policy at the smoker’s premium rate
would have been issued.” JMR takes the position that the appropriate remedy in this situation is to permit
recovery under the policy in the amount that the premium actually paid would have purchased for a
smoker.
We agree with Judge Sweet that this novel theory is without basis in New York law. The plain language of
the statutory definition of “materiality,” found in section 3105(b), permits avoidance of liability under the
policy where “knowledge by the insurer of the facts misrepresented would have led to a refusal by the
insurer to make such contract.” (emphasis added) Moreover, numerous courts have observed that the
materiality inquiry under New York law is made with respect to the particular policy issued in reliance
upon the misrepresentation.

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***
There is no doubt that Mutual was induced to issue the non-smoker, discounted-premium policy to JMR
precisely as a result of the misrepresentations made by Gaon concerning his smoking history. That Mutual
might not have refused the risk on any terms had it known the undisclosed facts is irrelevant. Most risks
are insurable at some price. The purpose of the materiality inquiry is not to permit the jury to rewrite the
terms of the insurance agreement to conform to the newly disclosed facts but to make certain that the risk
insured was the risk covered by the policy agreed upon. If a fact is material to the risk, the insurer may
avoid liability under a policy if that fact was misrepresented in an application for that policy whether or
not the parties might have agreed to some other contractual arrangement had the critical fact been
disclosed. As observed by Judge Sweet, a contrary result would reward the practice of misrepresenting
facts critical to the underwriter’s task because the unscrupulous (or merely negligent) applicant “would
have everything to gain and nothing to lose” from making material misrepresentations in his application
for insurance. Such a claimant could rest assured not only that he may demand full coverage should he
survive the contestability period, N.Y. Ins. Law § 3203 (a)(3), but that even in the event of a contested
claim, he would be entitled to the coverage that he might have contracted for had the necessary
information been accurately disclosed at the outset. New York law does not permit this anomalous result.
The judgment of the District Court is affirmed.

CASE QUESTIONS
1.

When you read this case, did you assume that Gaon died from lung cancer or some other smoking-related
cause? Does the court actually say that?

2.

Can you reasonably infer from the facts here that Gaon himself filled out the form and signed it? That is,
can you know with some degree of certainty that he lied to the insurance company? Would it make any
difference if he merely signed a form that his secretary filled out? Why or why not?

3.

What if Gaon died of causes unrelated to smoking (e.g., he was in a fatal automobile accident), and the
insurance company was looking for ways to deny the claim? Does the court’s opinion and language still
seem reasonable (e.g., the statement “there is no doubt that Mutual was induced to issue the nonsmoker, discounted-premium policy to JMR precisely as a result of the misrepresentations made by Gaon
concerning his smoking history”)?

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4.

If Gaon had accurately disclosed his smoking history, is it clear that the insurance company would have
refused to write any policy at all? Why is this question important? Do you agree with the court that the
question is irrelevant?

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19.5 Summary and Exercises
Summary
Insurance is an inescapable cost of doing business in a modern economy and an important service for any
individual with dependents or even a modest amount of property. Most readers of this book will someday
purchase automobile, homeowner’s, and life insurance, and many readers will deal with insurance in the
course of a business career.
Most insurance questions are governed by contract law, since virtually all insurance is voluntary and
entered into through written agreements. This means that the insured must pay careful attention to the
wording of the policies to determine what is excluded from coverage and to ensure that he makes no
warranties that he cannot keep and no misrepresentations or concealments that will void the contract. But
beyond contract law, some insurance law principles—such as insurable interest and subrogation rights—
are important to bear in mind. Defenses available to an insurance company may be based upon
representation, concealment, or warranties, but an insurer that is overzealous in denying coverage may
find itself subject to punitive damages.

EXERCISES
1.

Martin and Williams, two business partners, agreed that each would insure his life for the benefit of the
other. On his application for insurance, Martin stated that he had never had any heart trouble when in
fact he had had a mild heart attack some years before. Martin’s policy contained a two-year incontestable
clause. Three years later, after the partnership had been dissolved but while the policy was still in force,
Martin’s car was struck by a car being negligently driven by Peters. Although Martin’s injuries were
superficial, he suffered a fatal heart attack immediately after the accident—an attack, it was established,
that was caused by the excitement. The insurer has refused to pay the policy proceeds to Williams. Does
the insurer have a valid defense based on Martin’s misrepresentation? Explain.

2.

In Exercise 1, was it necessary for Williams to have an insurable interest in Martin’s life to recover under
the policy? Why?

3.

In Exercise 1, if Williams had taken out the policy rather than Martin, could the insurer defend the claim
on the ground that at the time of Martin’s death, Williams had no insurable interest? Why?

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4.

If Williams had no insurable interest, would the incontestable clause prevent the company from asserting
this defense? Why?

5.

If the insurer pays Williams’s claim, may it recover from Peters? Why?

6.

Skidmore Trucking Company decided to expand its operations into the warehousing field. After examining
several available properties, it decided to purchase a carbarn for $100,000 from a local bus company and
to convert it into a warehouse. The standard contract for a real estate purchase was signed by the parties.
The contract obligated Skidmore to pay the seller on an apportioned basis for the prepaid premiums on
the existing fire insurance policy ($100,000 extended coverage). The policy expired two years and one
month from the closing date. At the closing, the seller duly assigned the fire insurance policy to Skidmore
in return for the payment of the apportioned amount of the prepaid premiums, but Skidmore failed to
notify the insurance company of the change in ownership. Skidmore took possession of the premises and,
after extensive renovation, began to use the building as a warehouse. Soon afterward, one of Skidmore’s
employees negligently dropped a lighted cigarette into a trash basket and started a fire that totally
destroyed the building. Was the assignment of the policy to Skidmore valid? Why?

7.

In Exercise 6, assuming the assignment is valid, would the insurer be obligated to pay for the loss resulting
from the employee’s negligence? Why?

SELF-TEST QUESTIONS
1.

The substitution of one person for another in pursuit of a legal claim is called
a.

assignment

b.

coinsurance

c.

subrogation

d.

none of the above
Most insurance questions are covered by

a.

tort law

b.

criminal law

c.

constitutional law

d.

contract law
Common defenses used by insurance companies include

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a.

concealment

b.

false representation

c.

breach of warranty

d.

all of the above
A coinsurance clause

a.

requires the insured to be insured by more than one policy

b.

requires the insured to maintain insurance equal to a certain percentage of the property’s value

c.

allows another beneficiary to be substituted for the insured

d.

is none of the above

2.

Property insurance typically covers

a.

ordinary wear and tear

b.

damage due to theft

c.

intentional losses

d.

damage due to earthquakes

SELF-TEST ANSWERS
1.

c

2.

d

3.

d

4.

b

5.

b

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Chapter 20

Relationships between Principal and Agent
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

Why agency is important, what an agent is, and the types of agents

2.

What an independent contractor is

3.

The duties owed by the agent to the principal

4.

The duties owed by the principal to the agent

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20.1 Introduction to Agency and the Types of Agents
LEARNING OBJECTIVES
1.

Understand why agency law is important.

2.

Recognize the recurring legal issues in agency law.

3.

Know the types of agents.

4.

Understand how the agency relationship is created.

Introduction to Agency Law
Why Is Agency Law Important, and What Is an Agent?
An agent is a person who acts in the name of and on behalf of another, having been given and assumed
some degree of authority to do so. Most organized human activity—and virtually all commercial activity—
is carried on through agency. No corporation would be possible, even in theory, without such a concept.
We might say “General Motors is building cars in China,” for example, but we can’t shake hands with
General Motors. “The General,” as people say, exists and works through agents. Likewise, partnerships
and other business organizations rely extensively on agents to conduct their business. Indeed, it is not an
exaggeration to say that agency is the cornerstone of enterprise organization. In a partnership each
partner is a general agent, while under corporation law the officers and all employees are agents of the
corporation.
The existence of agents does not, however, require a whole new law of torts or contracts. A tort is no less
harmful when committed by an agent; a contract is no less binding when negotiated by an agent. What
does need to be taken into account, though, is the manner in which an agent acts on behalf of his principal
and toward a third party.

Recurring Issues in Agency Law
Several problematic fact scenarios recur in agency, and law has developed in response.

John Alden

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Consider John Alden (1599–1687), one of the most famous agents in American literature. He is said to
have been the first person from the Mayflower to set foot on Plymouth Rock in 1620; he was a carpenter,
a cooper (barrel maker), and a diplomat. His agency task—of interest here—was celebrated in Henry
Wadsworth Longfellow’s “The Courtship of Miles Standish.” He was to woo Priscilla Mullins (d. 1680),
“the loveliest maiden of Plymouth,” on behalf of Captain Miles Standish, a valiant soldier who was too shy
to propose marriage. Standish turned to John Alden, his young and eloquent protégé, and beseeched
Alden to speak on his behalf, unaware that Alden himself was in love with Priscilla. Alden accepted his
captain’s assignment, despite the knowledge that he would thus lose Priscilla for himself, and sought out
the lady. But Alden was so tongue-tied that his vaunted eloquence fell short, turned Priscilla cold toward
the object of Alden’s mission, and eventually led her to turn the tables in one of the most famous lines in
American literature and poetry: “Why don’t you speak for yourself, John?” John eventually did: the two
were married in 1623 in Plymouth.

Recurring Issues in Agency
Let’s analyze this sequence of events in legal terms—recognizing, of course, that this example is an
analogy and that the law, even today, would not impose consequences on Alden for his failure to carry out
Captain Standish’s wishes. Alden was the captain’s agent: he was specifically authorized to speak in his
name in a manner agreed on, toward a specified end, and he accepted the assignment in consideration of
the captain’s friendship. He had, however, a conflict of interest. He attempted to carry out the assignment,
but he did not perform according to expectations. Eventually, he wound up with the prize himself. Here
are some questions to consider, the same questions that will recur throughout the discussion of agency:
•

How extensive was John’s authority? Could he have made promises to Priscilla on the captain’s
behalf—for example, that Standish would have built her a fine house?

•

Could he, if he committed a tort, have imposed liability on his principal? Suppose, for example, that
he had ridden at breakneck speed to reach Priscilla’s side and while en route ran into and injured a
pedestrian on the road. Could the pedestrian have sued Standish?

•

Suppose Alden had injured himself on the journey. Would Standish be liable to Alden?

•

Is Alden liable to Standish for stealing the heart of Priscilla—that is, for taking the “profits” of the
enterprise for himself?

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As these questions suggest, agency law often involves three parties—the principal, the agent, and a third
party. It therefore deals with three different relationships: between principal and agent, between principal
and third party, and between agent and third party. These relationships can be summed up in a simple
diagram (see Figure 20.1 "Agency Relationships").
Figure 20.1 Agency Relationships

In this chapter, we will consider the principal-agent side of the triangle. In the next chapter we will turn to
relationships involving third parties.

Types of Agents
There are five types of agents.

General Agent
The general agent possesses the authority to carry out a broad range of transactions in the name and on
behalf of the principal. The general agent may be the manager of a business or may have a more limited
but nevertheless ongoing role—for example, as a purchasing agent or as a life insurance agent authorized

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to sign up customers for the home office. In either case, the general agent has authority to alter the
principal’s legal relationships with third parties. One who is designated a general agent has the authority
to act in any way required by the principal’s business. To restrict the general agent’s authority, the
principal must spell out the limitations explicitly, and even so the principal may be liable for any of the
agent’s acts in excess of his authority.
Normally, the general agent is a business agent, but there are circumstances under which an individual
may appoint a general agent for personal purposes. One common form of a personal general agent is the
person who holds another’s power of attorney. This is a delegation of authority to another to act in his
stead; it can be accomplished by executing a simple form, such as the one shown inFigure 20.2 "General
Power of Attorney". Ordinarily, the power of attorney is used for a special purpose—for example, to sell
real estate or securities in the absence of the owner. But a person facing a lengthy operation and
recuperation in a hospital might give a general power of attorney to a trusted family member or friend.
Figure 20.2 General Power of Attorney

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Special Agent
The special agent is one who has authority to act only in a specifically designated instance or in a
specifically designated set of transactions. For example, a real estate broker is usually a special agent hired
to find a buyer for the principal’s land. Suppose Sam, the seller, appoints an agent Alberta to find a buyer
for his property. Alberta’s commission depends on the selling price, which, Sam states in a letter to her,
“in any event may be no less than $150,000.” If Alberta locates a buyer, Bob, who agrees to purchase the
property for $160,000, her signature on the contract of sale will not bind Sam. As a special agent, Alberta
had authority only to find a buyer; she had no authority to sign the contract.

Agency Coupled with an Interest
An agent whose reimbursement depends on his continuing to have the authority to act as an agent is said
to have an agency coupled with an interest if he has a property interest in the business. A literary or
author’s agent, for example, customarily agrees to sell a literary work to a publisher in return for a
percentage of all monies the author earns from the sale of the work. The literary agent also acts as a
collection agent to ensure that his commission will be paid. By agreeing with the principal that the agency
is coupled with an interest, the agent can prevent his own rights in a particular literary work from being
terminated to his detriment.

Subagent
To carry out her duties, an agent will often need to appoint her own agents. These appointments may or
may not be authorized by the principal. An insurance company, for example, might name a general agent
to open offices in cities throughout a certain state. The agent will necessarily conduct her business
through agents of her own choosing. These agents are subagents of the principal if the general agent had
the express or implied authority of the principal to hire them. For legal purposes, they are agents of both
the principal and the principal’s general agent, and both are liable for the subagent’s conduct although
normally the general agent agrees to be primarily liable (see Figure 20.3 "Subagent").
Figure 20.3 Subagent

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Servant
The final category of agent is the servant. Until the early nineteenth century, any employee whose work
duties were subject to an employer’s control was called a servant; we would not use that term so broadly
in modern English. The Restatement (Second) of Agency, Section 2, defines a servant as “an agent
employed by a master [employer] to perform service in his affairs whose physical conduct in the
performance of the service is controlled or is subject to the right to control by the master.”

Independent Contractor

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Not every contract for services necessarily creates a master-servant relationship. There is an important
distinction made between the status of a servant and that of an independent contractor. According to the
Restatement (Second) of Agency, Section 2, “an independent contractor is a person who contracts with
another to do something for him but who is not controlled by the other nor subject to the other’s right to
control with respect to his physical conduct in the performance of the undertaking.” As the name implies,
the independent contractor is legally autonomous. A plumber salaried to a building contractor is an
employee and agent of the contractor. But a plumber who hires himself out to repair pipes in people’s
homes is an independent contractor. If you hire a lawyer to settle a dispute, that person is not your
employee or your servant; she is an independent contractor. The terms “agent” and “independent
contractor” are not necessarily mutually exclusive. In fact, by definition, “… an independent contractor is
an agent in the broad sense of the term in undertaking, at the request of another, to do something for the
other. As a general rule the line of demarcation between an independent contractor and a servant is not
clearly drawn.”

[1]

This distinction between agent and independent contractor has important legal consequences for
taxation, workers’ compensation, and liability insurance. For example, employers are required to withhold
income taxes from their employees’ paychecks. But payment to an independent contractor, such as the
plumber for hire, does not require such withholding. Deciding who is an independent contractor is not
always easy; there is no single factor or mechanical answer. In Robinson v. New York Commodities Corp.,
an injured salesman sought workers’ compensation benefits, claiming to be an employee of the New York
Commodities Corporation.

[2]

But the state workmen’s compensation board ruled against him, citing a

variety of factors. The claimant sold canned meats, making rounds in his car from his home. The company
did not establish hours for him, did not control his movements in any way, and did not reimburse him for
mileage or any other expenses or withhold taxes from its straight commission payments to him. He
reported his taxes on a form for the self-employed and hired an accountant to prepare it for him. The
court agreed with the compensation board that these facts established the salesman’s status as an
independent contractor.
The factual situation in each case determines whether a worker is an employee or an independent
contractor. Neither the company nor the worker can establish the worker’s status by agreement. As the

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North Dakota Workmen’s Compensation Bureau put it in a bulletin to real estate brokers, “It has come to
the Bureau’s attention that many employers are requiring that those who work for them sign ‘independent
contractor’ forms so that the employer does not have to pay workmen’s compensation premiums for his
employees. Such forms are meaningless if the worker is in fact an employee.” Vizcaino v. Microsoft
Corporation, discussed in Section 20.3.2 "Employee versus Independent Contractor", examines the
distinction.
In addition to determining a worker’s status for tax and compensation insurance purposes, it is
sometimes critical for decisions involving personal liability insurance policies, which usually exclude from
coverage accidents involving employees of the insureds. General Accident Fire & Life Assurance Corp v.
Pro Golf Association

[3]

involved such a situation. The insurance policy in question covered members of

the Professional Golfers Association. Gerald Hall, a golf pro employed by the local park department, was
afforded coverage under the policy, which excluded “bodily injury to any employee of the insured arising
out of and in the course of his employment by the insured.” That is, no employee of Hall’s would be
covered (rather, any such person would have coverage under workers’ compensation statutes). Bradley
Martin, age thirteen, was at the golf course for junior league play. At Hall’s request, he agreed to retrieve
or “shag” golf balls to be hit during a lesson Hall was giving; he was—as Hall put it—to be compensated
“either through golf instructions or money or hotdogs or whatever.” During the course of the lesson, a golf
ball hit by Hall hit young Martin in the eye. If Martin was an employee, the insurance company would be
liable; if he was not an employee, the insurance company would not liable. The trial court determined he
was not an employee. The evidence showed: sometimes the boys who “shagged” balls got paid, got golfing
instructions, or got food, so the question of compensation was ambiguous. Martin was not directed in how
to perform (the admittedly simple) task of retrieving golf balls, no control was exercised over him, and no
equipment was required other than a bag to collect the balls: “We believe the evidence is susceptible of
different inferences.…We cannot say that the decision of the trial court is against the manifest weight of
the evidence.”

Creation of the Agency Relationship
The agency relationship can be created in two ways: by agreement (expressly) or by operation of law
(constructively or impliedly).

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Agency Created by Agreement
Most agencies are created by contract. Thus the general rules of contract law covered in Chapter 8
"Introduction to Contract Law" through Chapter 16 "Remedies" govern the law of agency. But agencies
can also be created without contract, by agreement. Therefore, three contract principles are especially
important: the first is the requirement for consideration, the second for a writing, and the third concerns
contractual capacity.

Consideration
Agencies created by consent—agreement—are not necessarily contractual. It is not uncommon for one
person to act as an agent for another without consideration. For example, Abe asks Byron to run some
errands for him: to buy some lumber on his account at the local lumberyard. Such
agratuitous agency gives rise to no different results than the more common contractual agency.

Formalities
Most oral agency contracts are legally binding; the law does not require that they be reduced to writing. In
practice, many agency contracts are written to avoid problems of proof. And there are situations where an
agency contract must be in writing: (1) if the agreed-on purpose of the agency cannot be fulfilled within
one year or if the agency relationship is to last more than one year; (2) in many states, an agreement to
pay a commission to a real estate broker; (3) in many states, authority given to an agent to sell real estate;
and (4) in several states, contracts between companies and sales representatives.
Even when the agency contract is not required to be in writing, contracts that agents make with third
parties often must be in writing. Thus Section 2-201 of the Uniform Commercial Code specifically requires
contracts for the sale of goods for the price of five hundred dollars or more to be in writing and “signed by
the party against whom enforcement is sought or by his authorized agent.”

Capacity
A contract is void or voidable when one of the parties lacks capacity to make one. If both principal and
agent lack capacity—for example, a minor appoints another minor to negotiate or sign an agreement—

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there can be no question of the contract’s voidability. But suppose only one or the other lacks capacity.
Generally, the law focuses on the principal. If the principal is a minor or otherwise lacks capacity, the
contract can be avoided even if the agent is fully competent. There are, however, a few situations in which
the capacity of the agent is important. Thus a mentally incompetent agent cannot bind a principal.

Agency Created by Operation of Law
Most agencies are made by contract, but agency also may arise impliedly or apparently.

Implied Agency
In areas of social need, courts have declared an agency to exist in the absence of an agreement. The agency
relationship then is said to have been implied “by operation of law.” Children in most states may purchase
necessary items—food or medical services—on the parent’s account. Long-standing social policy deems it
desirable for the head of a family to support his dependents, and the courts will put the expense on the
family head in order to provide for the dependents’ welfare. The courts achieve this result by supposing
the dependent to be the family head’s agent, thus allowing creditors to sue the family head for the debt.
Implied agencies also arise where one person behaves as an agent would and the “principal,” knowing that
the “agent” is behaving so, acquiesces, allowing the person to hold himself out as an agent. Such are the
basic facts in Weingart v. Directoire Restaurant, Inc. in Section 20.3.1 "Creation of Agency: Liability of
Parent for Contracts Made by “Agent” Child".

Apparent Agency
Suppose Arthur is Paul’s agent, employed through October 31. On November 1, Arthur buys materials at
Lumber Yard—as he has been doing since early spring—and charges them to Paul’s account. Lumber Yard,
not knowing that Arthur’s employment terminated the day before, bills Paul. Will Paul have to pay? Yes,
because the termination of the agency was not communicated to Lumber Yard. It appeared that Arthur
was an authorized agent. This issue is discussed further in Chapter 21 "Liability of Principal and Agent;
Termination of Agency".

KEY TAKEAWAY

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An agent is one who acts on behalf of another. Many transactions are conducted by agents so acting. All
corporate transactions, including those involving governmental organizations, are so conducted because
corporations cannot themselves actually act; they are legal fictions. Agencies may be created expressly,
impliedly, or apparently. Recurring issues in agency law include whether the “agent” really is such, the scope
of the agent’s authority, and the duties among the parties. The five types of agents include: general agent,
special agent, subagent, agency coupled with an interest, and servant (or employee). The independent
contractor is not an employee; her activities are not specifically controlled by her client, and the client is not
liable for payroll taxes, Social Security, and the like. But it is not uncommon for an employer to claim workers
are independent contractors when in fact they are employees, and the cases are often hard-fought on the
facts.

EXERCISES
1.

Why is agency law especially important in the business and government context?

2.

What are the five types of agents?

3.

What distinguishes an employee from an independent contractor?

4.

Why do employers frequently try to pass off employees as independent contractors?

[1] 1. Flick v. Crouch, 434 P.2d 256, 260 (OK, 1967).
[2] Robinson v. New York Commodities Corp., 396 N.Y.S.2d 725, App. Div. (1977).
[3] General Accident Fire & Life Assurance Corp v. Pro Golf Association, 352 N.E.2d 441 (Ill. App. 1976).

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20.2 Duties between Agent and Principal
LEARNING OBJECTIVES
1.

Understand that the agent owes the principal two types of duties: a special duty—the fiduciary
duty—and other general duties as recognized in agency law.

2.

Recognize that the principal owes the agent duties: contract, tort, and workers’ compensation.

Agent’s Duty to Principal
The agent owes the principal duties in two categories: the fiduciary duty and a set of general duties
imposed by agency law. But these general duties are not unique to agency law; they are duties owed by any
employee to the employer.

Fiduciary Duty
In a nonagency contractual situation, the parties’ responsibilities terminate at the border of the contract.
There is no relationship beyond the agreement. This literalist approach is justified by the more general
principle that we each should be free to act unless we commit ourselves to a particular course.
But the agency relationship is more than a contractual one, and the agent’s responsibilities go beyond the
border of the contract. Agency imposes a higher duty than simply to abide by the contract terms. It
imposes a fiduciary duty. The law infiltrates the contract creating the agency relationship and reverses the
general principle that the parties are free to act in the absence of agreement. As a fiduciary of the
principal, the agent stands in a position of special trust. His responsibility is to subordinate his selfinterest to that of his principal. The fiduciary responsibility is imposed by law. The absence of any clause
in the contract detailing the agent’s fiduciary duty does not relieve him of it. The duty contains several
aspects.

Duty to Avoid Self-Dealing
A fiduciary may not lawfully profit from a conflict between his personal interest in a transaction and his
principal’s interest in that same transaction. A broker hired as a purchasing agent, for instance, may not

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sell to his principal through a company in which he or his family has a financial interest. The penalty for
breach of fiduciary duty is loss of compensation and profit and possible damages for breach of trust.

Duty to Preserve Confidential Information
To further his objectives, a principal will usually need to reveal a number of secrets to his agent—how
much he is willing to sell or pay for property, marketing strategies, and the like. Such information could
easily be turned to the disadvantage of the principal if the agent were to compete with the principal or
were to sell the information to those who do. The law therefore prohibits an agent from using for his own
purposes or in ways that would injure the interests of the principal, information confidentially given or
acquired. This prohibition extends to information gleaned from the principal though unrelated to the
agent’s assignment: “[A]n agent who is told by the principal of his plans, or who secretly examines books
or memoranda of the employer, is not privileged to use such information at his principal’s
expense.”

[1]

Nor may the agent use confidential information after resigning his agency. Though he is free,

in the absence of contract, to compete with his former principal, he may not use information learned in
the course of his agency, such as trade secrets and customer lists. Section 20.3.3 "Breach of Fiduciary
Duty", Bacon v. Volvo Service Center, Inc., deals with an agent’s breach of the duty of confidentiality.

Other Duties
In addition to fiduciary responsibility (and whatever special duties may be contained in the specific
contract) the law of agency imposes other duties on an agent. These duties are not necessarily unique to
agents: a nonfiduciary employee could also be bound to these duties on the right facts.

Duty of Skill and Care
An agent is usually taken on because he has special knowledge or skills that the principal wishes to tap.
The agent is under a legal duty to perform his work with the care and skill that is “standard in the locality
for the kind of work which he is employed to perform” and to exercise any special skills, if these are
greater or more refined than those prevalent among those normally employed in the community. In short,
the agent may not lawfully do a sloppy job.

[2]

Duty of Good Conduct
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In the absence of an agreement, a principal may not ordinarily dictate how an agent must live his private
life. An overly fastidious florist may not instruct her truck driver to steer clear of the local bar on his way
home from delivering flowers at the end of the day. But there are some jobs on which the personal habits
of the agent may have an effect. The agent is not at liberty to act with impropriety or notoriety, so as to
bring disrepute on the business in which the principal is engaged. A lecturer at an antialcohol clinic may
be directed to refrain from frequenting bars. A bank cashier who becomes known as a gambler may be
fired.

Duty to Keep and Render Accounts
The agent must keep accurate financial records, take receipts, and otherwise act in conformity to standard
business practices.

Duty to Act Only as Authorized
This duty states a truism but is one for which there are limits. A principal’s wishes may have been stated
ambiguously or may be broad enough to confer discretion on the agent. As long as the agent acts
reasonably under the circumstances, he will not be liable for damages later if the principal ultimately
repudiates what the agent has done: “Only conduct which is contrary to the principal’s manifestations to
him, interpreted in light of what he has reason to know at the time when he acts,…subjects the agent to
liability to the principal.”

[3]

Duty Not to Attempt the Impossible or Impracticable
The principal says to the agent, “Keep working until the job is done.” The agent is not obligated to go
without food or sleep because the principal misapprehended how long it would take to complete the job.
Nor should the agent continue to expend the principal’s funds in a quixotic attempt to gain business, sign
up customers, or produce inventory when it is reasonably clear that such efforts would be in vain.

Duty to Obey
As a general rule, the agent must obey reasonable directions concerning the manner of performance.
What is reasonable depends on the customs of the industry or trade, prior dealings between agent and

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principal, and the nature of the agreement creating the agency. A principal may prescribe uniforms for
various classes of employees, for instance, and a manufacturing company may tell its sales force what
sales pitch to use on customers. On the other hand, certain tasks entrusted to agents are not subject to the
principal’s control; for example, a lawyer may refuse to permit a client to dictate courtroom tactics.

Duty to Give Information
Because the principal cannot be every place at once—that is why agents are hired, after all—much that is
vital to the principal’s business first comes to the attention of agents. If the agent has actual notice or
reason to know of information that is relevant to matters entrusted to him, he has a duty to inform the
principal. This duty is especially critical because information in the hands of an agent is, under most
circumstances, imputed to the principal, whose legal liabilities to third persons may hinge on receiving
information in timely fashion. Service of process, for example, requires a defendant to answer within a
certain number of days; an agent’s failure to communicate to the principal that a summons has been
served may bar the principal’s right to defend a lawsuit. The imputation to the principal of knowledge
possessed by the agent is strict: even where the agent is acting adversely to the principal’s interests—for
example, by trying to defraud his employer—a third party may still rely on notification to the agent, unless
the third party knows the agent is acting adversely.

“Shop Rights” Doctrine
In Grip Nut Co. v. Sharp, Sharp made a deal with Grip Nut Company that in return for a salary and
bonuses as company president, he would assign to the company any inventions he made.

[4]

When the five-

year employment contract expired, Sharp continued to serve as chief executive officer, but no new
contract was negotiated concerning either pay or rights to inventions. During the next ten years, Sharp
invented a number of new products and developed new machinery to manufacture them; patent rights
went to the company. However, he made one invention with two other employees and they assigned the
patent to him. A third employee invented a safety device and also assigned the patent to Sharp. At one
time, Sharp’s son invented a leakproof bolt and a process to manufacture it; these, too, were assigned to
Sharp. These inventions were developed in the company’s plants at its expense.

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When Sharp died, his family claimed the rights to the inventions on which Sharp held assignments and
sued the company, which used the inventions, for patent infringement. The family reasoned that after the
expiration of the employment contract, Sharp was employed only in a managerial capacity, not as an
inventor. The court disagreed and invoked the shop rights doctrine, under which an invention “developed
and perfected in [a company’s] plant with its time, materials, and appliances, and wholly at its expense”
may be used by the company without payment of royalties: “Because the servant uses his master’s time,
facilities and materials to attain a concrete result, the employer is entitled to use that which embodies his
own property and to duplicate it as often as he may find occasion to employ similar appliances in his
business.” The company would have been given complete ownership of the patents had there been an
express or implied (e.g., the employee is hired to make inventions) contract to this effect between Sharp
and the company.

Principal’s Duty to Agent
In this category, we may note that the principal owes the agent duties in contract, tort, and—statutorily—
workers’ compensation law.

Contract Duties
The fiduciary relationship of agent to principal does not run in reverse—that is, the principal is not the
agent’s fiduciary. Nevertheless, the principal has a number of contractually related obligations toward his
agent.

General Contract Duties
These duties are analogues of many of the agent’s duties that we have just examined. In brief, a principal
has a duty “to refrain from unreasonably interfering with [an agent’s] work.”

[5]

The principal is allowed,

however, to compete with the agent unless the agreement specifically prohibits it. The principal has a duty
to inform his agent of risks of physical harm or pecuniary loss that inhere in the agent’s performance of
assigned tasks. Failure to warn an agent that travel in a particular neighborhood required by the job may
be dangerous (a fact unknown to the agent but known to the principal) could under common law subject
the principal to a suit for damages if the agent is injured while in the neighborhood performing her job. A

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principal is obliged to render accounts of monies due to agents; a principal’s obligation to do so depends
on a variety of factors, including the degree of independence of the agent, the method of compensation,
and the customs of the particular business. An agent’s reputation is no less valuable than a principal’s,
and so an agent is under no obligation to continue working for one who sullies it.

Employment at Will
Under the traditional “employment-at-will” doctrine, an employee who is not hired for a specific period
can be fired at any time, for any reason (except bad reasons: an employee cannot be fired, for example, for
reporting that his employer’s paper mill is illegally polluting groundwater). This doctrine has been much
criticized.

Duty to Indemnify
Agents commonly spend money pursuing the principal’s business. Unless the agreement explicitly
provides otherwise, the principal has a duty to indemnify or reimburse the agent. A familiar form of
indemnity is the employee expense account.

Tort and Workers’ Compensation Duties
The employer owes the employee—any employee, not just agents—certain statutorily imposed tort and
workers’ compensation duties.

Background to Workers’ Compensation
Andy, who works in a dynamite factory, negligently stores dynamite in the wrong shed. Andy warns his
fellow employee Bill that he has done so. Bill lights up a cigarette near the shed anyway, a spark lands on
the ground, the dynamite explodes, and Bill is injured. May Bill sue his employer to recover damages? At
common law, the answer would be no—three times no. First, the “fellow-servant” rule would bar recovery
because the employer was held not to be responsible for torts committed by one employee against
another. Second, Bill’s failure to heed Andy’s warning and his decision to smoke near the dynamite
amounted to contributory negligence. Hence even if the dynamite had been negligently stored by the
employer rather than by a fellow employee, the claim would have been dismissed. Third, the courts might

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have held that Bill had “assumed the risk”: since he was aware of the dangers, it would not be fair to
saddle the employer with the burden of Bill’s actions.
The three common-law rules just mentioned ignited intense public fury by the turn of the twentieth
century. In large numbers of cases, workers who were mutilated or killed on the job found themselves and
their families without recompense. Union pressure and grass roots lobbying led
toworkers’ compensation acts—statutory enactments that dramatically overhauled the law of torts as it
affected employees.

The System in General
Workers’ compensation is a no-fault system. The employee gives up the right to sue the employer (and, in
some states, other employees) and receives in exchange predetermined compensation for a job-related
injury, regardless of who caused it. This trade-off was felt to be equitable to employer and employee: the
employee loses the right to seek damages for pain and suffering—which can be a sizable portion of any
jury award—but in return he can avoid the time-consuming and uncertain judicial process and assure
himself that his medical costs and a portion of his salary will be paid—and paid promptly. The employer
must pay for all injuries, even those for which he is blameless, but in return he avoids the risk of losing a
big lawsuit, can calculate his costs actuarially, and can spread the risks through insurance.
Most workers’ compensation acts provide 100 percent of the cost of a worker’s hospitalization and
medical care necessary to cure the injury and relieve him from its effects. They also provide for payment
of lost wages and death benefits. Even an employee who is able to work may be eligible to receive
compensation for specific injuries. Part of the table of benefits for specific injuries under the Kansas
statute is shown in Note 20.16 "Kansas Workers’ Compensation Benefits for Specific Injuries".

Kansas Workers’ Compensation Benefits for Specific Injuries
Article 5.—Workers’ Compensation
44-510d. Compensation for certain permanent partial disabilities; schedule. If there is an award of
permanent disability as a result of the injury there shall be a presumption that disability existed

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immediately after the injury and compensation is to be paid for not to exceed the number of weeks
allowed in the following schedule:
(1) For loss of a thumb, 60 weeks.
(2) For the loss of a first finger, commonly called the index finger, 37 weeks.
(3) For the loss of a second finger, 30 weeks.
(4) For the loss of a third finger, 20 weeks.
(5) For the loss of a fourth finger, commonly called the little finger, 15 weeks.
(6) Loss of the first phalange of the thumb or of any finger shall be considered to be equal to the loss of
1/2 of such thumb or finger, and the compensation shall be 1/2 of the amount specified above. The loss of
the first phalange and any part of the second phalange of any finger, which includes the loss of any part of
the bone of such second phalange, shall be considered to be equal to the loss of 2/3 of such finger and the
compensation shall be 2/3 of the amount specified above. The loss of the first phalange and any part of
the second phalange of a thumb which includes the loss of any part of the bone of such second phalange,
shall be considered to be equal to the loss of the entire thumb. The loss of the first and second phalanges
and any part of the third proximal phalange of any finger, shall be considered as the loss of the entire
finger. Amputation through the joint shall be considered a loss to the next higher schedule.
(7) For the loss of a great toe, 30 weeks.
(8) For the loss of any toe other than the great toe, 10 weeks.
(9) The loss of the first phalange of any toe shall be considered to be equal to the loss of 1/2 of such toe
and the compensation shall be 1/2 of the amount above specified.
(10) The loss of more than one phalange of a toe shall be considered to be equal to the loss of the entire
toe.
(11) For the loss of a hand, 150 weeks.
(12) For the loss of a forearm, 200 weeks.

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(13) For the loss of an arm, excluding the shoulder joint, shoulder girdle, shoulder musculature or any
other shoulder structures, 210 weeks, and for the loss of an arm, including the shoulder joint, shoulder
girdle, shoulder musculature or any other shoulder structures, 225 weeks.
(14) For the loss of a foot, 125 weeks.
(15) For the loss of a lower leg, 190 weeks.
(16) For the loss of a leg, 200 weeks.
(17) For the loss of an eye, or the complete loss of the sight thereof, 120 weeks.
Source:http://www.kslegislature.org/li/statute/044_000_0000_chapter/044_005_0000_article/044_
005_0010d_section/044_005_0010d_k/.
The injured worker is typically entitled to two-thirds his or her average pay, not to exceed some specified
maximum, for two hundred weeks. If the loss is partial (like partial loss of sight), the recovery is decreased
by the percentage still usable.

Coverage
Although workers’ compensation laws are on the books of every state, in two states—New Jersey and
Texas—they are not compulsory. In those states the employer may decline to participate, in which event
the employee must seek redress in court. But in those states permitting an employer election, the old
common-law defenses (fellow-servant rule, contributory negligence, and assumption of risk) have been
statutorily eliminated, greatly enhancing an employee’s chances of winning a suit. The incentive is
therefore strong for employers to elect workers’ compensation coverage.
Those frequently excluded are farm and domestic laborers and public employees; public employees,
federal workers, and railroad and shipboard workers are covered under different but similar laws. The
trend has been to include more and more classes of workers. Approximately half the states now provide
coverage for household workers, although the threshold of coverage varies widely from state to state.
Some use an earnings test; other states impose an hours threshold. People who fall within the domestic

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category include maids, baby-sitters, gardeners, and handymen but generally not plumbers, electricians,
and other independent contractors.

Paying for Workers’ Compensation
There are three general methods by which employers may comply with workers’ compensation laws. First,
they may purchase employer’s liability and workers’ compensation policies through private commercial
insurance companies. These policies consist of two major provisions: payment by the insurer of all claims
filed under workers’ compensation and related laws (such as occupational disease benefits) and coverage
of the costs of defending any suits filed against the employer, including any judgments awarded. Since
workers’ compensation statutes cut off the employee’s right to sue, how can such a lawsuit be filed? The
answer is that there are certain exceptions to the ban: for instance, a worker may sue if the employer
deliberately injures an employee.
The second method of compliance with workers’ compensation laws is to insure through a state fund
established for the purpose. The third method is to self-insure. The laws specify conditions under which
companies may resort to self-insurance, and generally only the largest corporations qualify to do so. In
short, workers’ compensation systems create a tax on employers with which they are required (again, in
most states) to buy insurance. The amount the employer has to pay for the insurance depends on the
number and seriousness of claims made—how dangerous the work is. For example, Washington State’s
2011 proposed hourly rates for employers to purchase insurance include these items: for egg and poultry
farms, $1.16 per hour; shake and shingle mills, $18.06 per hour; asphalt paving, $2.87 per hour; lawn care
maintenance, $1.22 per hour; plastic products manufacturing, $0.87 per hour; freight handling, $1.81 per
hour; supermarkets, $0.76; restaurants, $0.43; entertainers and dancers, $7.06; colleges and universities,
$0.31.

[6]

Recurring Legal Issues
There are a number of legal issues that recur in workers’ compensation cases. The problem is, from the
employer’s point of view, that the cost of buying insurance is tied to the number of claims made. The
employer therefore has reason to assert the injured employee is not eligible for compensation. Recurring
legal issues include the following:

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•

Is the injury work related? As a general rule, on-the-job injuries are covered no matter what their
relationship to the employee’s specific duties. Although injuries resulting from drunkenness or
fighting are not generally covered, there are circumstances under which they will be, as Section 20.3.2
"Employee versus Independent Contractor" shows.

•

Is the injured person an employee? Courts are apt to be liberal in construing statutes to include those
who might not seem to be employed. In Betts v. Ann Arbor Public Schools, a University of Michigan
student majoring in physical education was a student teacher in a junior high school.

[7]

During a four-

month period, he taught two physical education courses. On the last day of his student teaching, he
walked into the locker room and thirty of his students grabbed him and tossed him into the swimming
pool. This was traditional, but he “didn’t feel like going in that morning” and put up a struggle that
ended with a whistle on an elastic band hitting him in the eye, which he subsequently lost as a result
of the injury. He filed a workers’ compensation claim. The school board argued that he could not be
classified as an employee because he received no pay. Since he was injured by students—not
considered agents of the school—he would probably have been unsuccessful in filing a tort suit; hence
the workers’ compensation claim was his only chance of recompense. The state workers’
compensation appeal board ruled against the school on the ground that payment in money was not
required: “Plaintiff was paid in the form of training, college credits towards graduation, and meeting
of the prerequisites of a state provisional certificate.” The state supreme court affirmed the award.
•

How palpable must the “injury” be? A difficult issue is whether a worker is entitled to compensation
for psychological injury, including cumulative trauma. Until the 1970s, insurance companies and
compensation boards required physical injury before making an award. Claims that job stresses led to
nervous breakdowns or other mental disorders were rejected. But most courts have liberalized the
definition of injury and now recognize that psychological trauma can be real and that job stress can
bring it on, as shown by the discussion of Wolfe v. Sibley, Lindsay & Curr Co. in Section 20.3.4
"Workers’ Compensation: What “Injuries” Are Compensable?".

KEY TAKEAWAY
The agent owes the principal two categories of duties: fiduciary and general. The fiduciary duty is the duty to
act always in the interest of the principal; the duty here includes that to avoid self-dealing and to preserve
confidential information. The general duty owed by the agent encompasses the sorts of obligations any

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employee might have: the duty of skill and care, of good conduct, to keep and render accounts, to not
attempt the impossible or impracticable, to obey, and to give information. The shop rights doctrine provides
that inventions made by an employee using the employer’s resources and on the employer’s time belong to
the employer.
The principal owes the agent duties too. These may be categorized as contract and tort duties. The contract
duties are to warn the agent of hazards associated with the job, to avoid interfering with the agent’s
performance of his job, to render accounts of money due the agent, and to indemnify the agent for business
expenses according to their agreement. The tort duty owed by the principal to the agent—employee—is
primarily the statutorily imposed duty to provide workers’ compensation for injuries sustained on the job. In
reaction to common-law defenses that often exonerated the employer from liability for workers’ injuries, the
early twentieth century saw the rise of workers’ compensation statutes. These require the employer to
provide no-fault insurance coverage for any injury sustained by the employee on the job. Because the
employer’s insurance costs are claims rated (i.e., the cost of insurance depends on how many claims are
made), the employer scrutinizes claims. A number of recurring legal issues arise: Is the injury work related? Is
the injured person an employee? What constitutes an “injury”?

EXERCISES
1.

Judge Learned Hand, a famous early-twentieth-century jurist (1872–1961), said, “The fiduciary duty is not
the ordinary morals of the marketplace.” How does the fiduciary duty differ from “the ordinary morals of
the marketplace”? Why does the law impose a fiduciary duty on the agent?

2.

What are the nonfiduciary duties owed by the agent to the principal?

3.

What contract duties are owed by the principal to the agent?

4.

Why were workers’ compensation statutes adopted in the early twentieth century?

5.

How do workers’ compensation statutes operate, and how are the costs paid for?

[1] Restatement (Second) of Agency, Section 395.
[2] Restatement (Second) of Agency, Section 379.
[3] Restatement (Second) of Agency, Section 383.
[4] Grip Nut Co. v. Sharp, 150 F.2d 192 (7th Cir. 1945).

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[5] Restatement (Second) of Agency, Section 434.
[6] Washington State Department of Labor & Industries, Rates for Workers’ Compensation, Proposed 2011
Rates,http://www.lni.wa.gov/ClaimsIns/Insurance/RatesRisk/Check/RatesHistory.
[7] Betts v. Ann Arbor Public Schools, 271 N.W.2d 498 (Mich. 1978).

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20.3 Cases
Creation of Agency: Liability of Parent for Contracts Made by “Agent” Child
Weingart v. Directoire Restaurant, Inc.
333 N.Y.S.2d 806 (N.Y., 1972)
KASSEL, J.
The issue here is whether defendant restaurant by permitting an individual to park patrons’ cars thereby
held him out as its “employee” for such purposes. Admittedly, this individual, one Buster Douglas, is not
its employee in the usual sense but with the knowledge of defendant, he did station himself in front of its
restaurant, wore a doorman’s uniform and had been parking its customers’ autos. The parties stipulated
that if he were held to be defendant’s employee, this created a bailment between the parties [and the
“employer” would have to rebut a presumption of negligence if the customer’s property was not returned
to the customer].
On April 20, 1968, at about 10 P.M., plaintiff drove his 1967 Cadillac Coupe de Ville to the door of the
Directoire Restaurant at 160 East 48th Street in Manhattan. Standing in front of the door was Buster
Douglas, dressed in a self-supplied uniform, comprised of a regular doorman’s cap and matching jacket.
Plaintiff gave the keys to his vehicle to Douglas and requested that he park the car. He gave Douglas a
$1.00 tip and received a claim check. Plaintiff then entered defendant’s restaurant, remained there for
approximately 45 minutes and when he departed, Douglas was unable to locate the car which was never
returned to plaintiff.
At the time of this occurrence, the restaurant had been open for only nine days, during which time
plaintiff had patronized the restaurant on at least one prior occasion.
Defendant did not maintain any sign at its entrance or elsewhere that it would provide parking for its
customers (nor, apparently, any sign warning to the contrary).
Buster Douglas parked cars for customers of defendant’s restaurant and at least three or four other
restaurants on the block. He stationed himself in front of each restaurant during the course of an evening

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and was so engaged during the evening of April 20, 1968. Defendant clearly knew of and did not object to
Douglas’ activities outside its restaurant. Defendant’s witness testified at an examination before trial:
Q. Did anybody stand outside your restaurant in any capacity whatsoever?
A. There was a man out there parking cars for the block, but he was in no way connected with us or
anything like that. He parked cars for the Tamburlaine and also for the Chateau Madrid, Nepentha and a
few places around the block.
Q. Did you know that this gentleman was standing outside your restaurant?
A. Yes, I knew he was there.
Q. How did you know that he was standing outside your restaurant?
A. Well, I knew the man’s face because I used to work in a club on 55th Street and he was there. When we
first opened up here, we didn’t know if we would have a doorman or have parking facilities or what we
were going to do at that time. We just let it hang and I told this Buster, Buster was his name, that you are a
free agent and you do whatever you want to do. I am tending bar in the place and what you do in the street
is up to you, I will not stop you, but we are not hiring you or anything like that, because at that time, we
didn’t know what we were going to use the parking lot or get a doorman and put on a uniform or what.
These facts establish to the court’s satisfaction that, although Douglas was not an actual employee of the
restaurant, defendant held him out as its authorized agent or “employee” for the purpose of parking its
customers’ cars, by expressly consenting to his standing, in uniform, in front of its door to receive
customers, to park their cars and issue receipts therefor—which services were rendered without charge to
the restaurant’s customers, except for any gratuity paid to Douglas. Clearly, under these circumstances,
apparent authority has been shown and Douglas acted within the scope of this authority.
Plaintiff was justified in assuming that Douglas represented the restaurant in providing his services and
that the restaurant had placed him there for the convenience of its customers. A restaurateur knows that
this is the impression created by allowing a uniformed attendant to so act. Facility in parking is often a
critical consideration for a motorist in selecting a restaurant in midtown Manhattan, and the Directoire

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was keenly aware of this fact as evidenced by its testimony that the management was looking into various
other possibilities for solving customers’ parking problems.
There was no suitable disclaimer posted outside the restaurant that it had no parking facilities or that
entrusting one’s car to any person was at the driver’s risk. It is doubtful that any prudent driver would
entrust his car to a strange person on the street, if he thought that the individual had no authorization
from the restaurant or club or had no connection with it, but was merely an independent operator with
questionable financial responsibility.
The fact that Douglas received no compensation directly from defendant is not material. Each party
derived a benefit from the arrangement: Douglas being willing to work for gratuities from customers, and
the defendant, at no cost to itself, presenting the appearance of providing the convenience of free parking
and doorman services to its patrons. In any case, whatever private arrangements existed between the
restaurant and Douglas were never disclosed to the customers.
Even if such person did perform these services for several restaurants, it does not automatically follow
that he is a freelance entrepreneur, since a shared employee working for other small or moderately sized
restaurants in the area would seem a reasonable arrangement, in no way negating the authority of the
attendant to act as doorman and receive cars for any one of these places individually.
The case most analogous to the instant one is Klotz v. El Morocco [Citation, 1968], and plaintiff here
relies on it. That case similarly involved the theft of a car parked by a uniformed individual standing in
front of defendant’s restaurant who, although not employed by it, parked vehicles for its patrons with the
restaurant’s knowledge and consent. Defendant here attempts to distinguish this case principally upon the
ground that the parties in El Morocco stipulated that the ‘doorman’ was an agent or employee of the
defendant acting within the scope of his authority. However, the judge made an express finding to that
effect: ‘* * * there was sufficient evidence in plaintiff’s case on which to find DiGiovanni, the man in the
uniform, was acting within the scope of his authority as agent of defendant.” Defendant here also points to
the fact that in Klotz DiGiovanni placed patrons’ car keys on a rack inside El Morocco; however, this is
only one fact to be considered in finding a bailment and is, to me, more relevant to the issue of the degree
of care exercised.

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When defendant’s agent failed to produce plaintiff’s automobile, a presumption of negligence arose which
now requires defendant to come forward with a sufficient explanation to rebut this presumption.
[Citation] The matter should be set down for trial on the issues of due care and of damages.

CASE QUESTIONS
1.

Buster Douglas was not the restaurant’s employee. Why did the court determine his negligence could
nevertheless be imputed to the restaurant?

2.

The plaintiff in this case relied on Klotz, very similar in facts, in which the car-parking attendant was found
to be an employee. The defendant, necessarily, needed to argue that the cases were not very similar.
What argument did the defendant make? What did the court say about that argument?

3.

The restaurant here is a bailee—it has rightful possession of the plaintiff’s (bailor’s) property, the car. If
the car is not returned to the plaintiff a rebuttable presumption of negligence arises. What does that
mean?

Employee versus Independent Contractor
Vizcaino v. Microsoft Corp.
97 F.3d 1187 (9th Cir. 1996)
Reinhardt, J.
Large corporations have increasingly adopted the practice of hiring temporary employees or
independent contractors as a means of avoiding payment of employee benefits, and thereby increasing
their profits. This practice has understandably led to a number of problems, legal and otherwise. One of
the legal issues that sometimes arises is exemplified by this lawsuit. The named plaintiffs, who were
classified by Microsoft as independent contractors, seek to strip that label of its protective covering and
to obtain for themselves certain benefits that the company provided to all of its regular or permanent
employees. After certifying the named plaintiffs as representatives of a class of “common-law
employees,” the district court granted summary judgment to Microsoft on all counts. The
plaintiffs…now appeal as to two of their claims: a) the claim…that they are entitled to savings benefits
under Microsoft’s Savings Plus Plan (SPP); and b) that…they are entitled to stock-option benefits under

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Microsoft’s Employee Stock Purchase Plan (ESPP). In both cases, the claims are based on their
contention that they are common-law employees.
Microsoft, one of the country’s fastest growing and most successful corporations and the world’s largest
software company, produces and sells computer software internationally. It employs a core staff of
permanent employees. It categorizes them as “regular employees” and offers them a wide variety of
benefits, including paid vacations, sick leave, holidays, short-term disability, group health and life
insurance, and pensions, as well as the two benefits involved in this appeal. Microsoft supplements its
core staff of employees with a pool of individuals to whom it refuses to pay fringe benefits. It previously
classified these individuals as “independent contractors” or “freelancers,” but prior to the filing of the
action began classifying them as “temporary agency employees.” Freelancers were hired when Microsoft
needed to expand its workforce to meet the demands of new product schedules. The company did not, of
course, provide them with any of the employee benefits regular employees receive.
The plaintiffs…performed services as software testers, production editors, proofreaders, formatters and
indexers. Microsoft fully integrated the plaintiffs into its workforce: they often worked on teams along
with regular employees, sharing the same supervisors, performing identical functions, and working the
same core hours. Because Microsoft required that they work on site, they received admittance card keys,
office equipment and supplies from the company.
Freelancers and regular employees, however, were not without their obvious distinctions. Freelancers
wore badges of a different color, had different electronic-mail addresses, and attended a less formal
orientation than that provided to regular employees. They were not permitted to assign their work to
others, invited to official company functions, or paid overtime wages. In addition, they were not paid
through Microsoft’s payroll department. Instead, they submitted invoices for their services, documenting
their hours and the projects on which they worked, and were paid through the accounts receivable
department.
The plaintiffs were told when they were hired that, as freelancers, they would not be eligible for benefits.
None has contended that Microsoft ever promised them any benefits individually. All eight named
plaintiffs signed [employment agreements] when first hired by Microsoft or soon thereafter. [One]

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included a provision that states that the undersigned “agrees to be responsible for all federal and state
taxes, withholding, social security, insurance and other benefits.” The [other one] states that “as an
Independent Contractor to Microsoft, you are self-employed and are responsible to pay all your own
insurance and benefits.” Eventually, the plaintiffs learned of the various benefits being provided to regular
employees from speaking with them or reading various Microsoft publications concerning employee
benefits.
In 1989 and 1990, the Internal Revenue Service (IRS)[,]…applying common-law principles defining the
employer-employee relationship, concluded that Microsoft’s freelancers were not independent contractors
but employees for withholding and employment tax purposes, and that Microsoft would thereafter be
required to pay withholding taxes and the employer’s portion of Federal Insurance Contribution Act
(FICA) tax. Microsoft agreed.…
After learning of the IRS rulings, the plaintiffs sought various employee benefits, including those now at
issue: the ESPP and SPP benefits. The SPP…is a cash or deferred salary arrangement under § 401k of the
Internal Revenue Code that permits Microsoft’s employees to save and invest up to fifteen percent of their
income through tax-deferred payroll deductions.…Microsoft matches fifty percent of the employee’s
contribution in any year, with [a maximum matching contribution]. The ESPP…permits employees to
purchase company stock [with various rules].
Microsoft rejected the plaintiffs’ claims for benefits, maintaining that they were independent contractors
who were personally responsible for all their own benefits.…
The plaintiffs brought this action, challenging the denial of benefits.
Microsoft contends that the extrinsic evidence, including the [employment agreements], demonstrates its
intent not to provide freelancers or independent contractors with employee benefits[.]…We have no doubt
that the company did not intend to provide freelancers or independent contractors with employee
benefits, and that if the plaintiffs had in fact been freelancers or independent contractors, they would not
be eligible under the plan. The plaintiffs, however, were not freelancers or independent contractors. They
were common-law employees, and the question is what, if anything, Microsoft intended with respect to
persons who were actually common-law employees but were not known to Microsoft to be such. The fact

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that Microsoft did not intend to provide benefits to persons who it thought were freelancers or
independent contractors sheds little or no light on that question.…
Microsoft’s argument, drawing a distinction between common-law employees on the basis of the manner
in which they were paid, is subject to the same vice as its more general argument. Microsoft regarded the
plaintiffs as independent contractors during the relevant period and learned of their common-lawemployee status only after the IRS examination. They were paid through the accounts receivable
department rather than the payroll department because of Microsoft’s mistaken view as to their legal
status. Accordingly, Microsoft cannot now contend that the fact that they were paid through the accounts
receivable department demonstrates that the company intended to deny them the benefits received by all
common-law employees regardless of their actual employment status. Indeed, Microsoft has pointed to no
evidence suggesting that it ever denied eligibility to any employees, whom it understood to be commonlaw employees, by paying them through the accounts receivable department or otherwise.
We therefore construe the ambiguity in the plan against Microsoft and hold that the plaintiffs are eligible
to participate under the terms of the SPP.
[Next, regarding the ESPP] we hold that the plaintiffs…are covered by the specific provisions of the ESPP.
We apply the “objective manifestation theory of contracts,” which requires us to “impute an intention
corresponding to the reasonable meaning of a person’s words and acts.” [Citation] Through its
incorporation of the tax code provision into the plan, Microsoft manifested an objective intent to make all
common-law employees, and hence the plaintiffs, eligible for participation. The ESPP specifically
provides:
It is the intention of the Company to have the Plan qualify as an “employee stock purchase plan” under
Section 423 of the Internal Revenue Code of 1954. The provisions of the Plan shall, accordingly, be
construed so as to extend and limit participation in a manner consistent with the requirements of that
Section of the Code. (emphasis added)
[T]he ESPP, when construed in a manner consistent with the requirements of § 423, extends participation
to all common-law employees not covered by one of the express exceptions set forth in the plan.
Accordingly, we find that the ESPP, through its incorporation of § 423, expressly extends eligibility for

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participation to the plaintiff class and affords them the same options to acquire stock in the corporation as
all other employees.
Microsoft next contends that the [employment agreements] signed by the plaintiffs render them ineligible
to participate in the ESPP. First, the label used in the instruments signed by the plaintiffs does not control
their employment status. Second, the employment instruments, if construed to exclude the plaintiffs from
receiving ESPP benefits, would conflict with the plan’s express incorporation of § 423. Although Microsoft
may have generally intended to exclude individuals who were in fact independent contractors, it could
not, consistent with its express intention to extend participation in the ESPP to all common-law
employees, have excluded the plaintiffs. Indeed, such an exclusion would defeat the purpose of including §
423 in the plan, because the exclusion of common-law employees not otherwise accepted would result in
the loss of the plan’s tax qualification.
Finally, Microsoft maintains that the plaintiffs are not entitled to ESPP benefits because the terms of the
plan were never communicated to them and they were therefore unaware of its provisions when they
performed their employment services.…In any event, to the extent that knowledge of an offer of benefits is
a prerequisite, it is probably sufficient that Microsoft publicly promulgated the plan. In [Citation], the
plaintiff was unaware of the company’s severance plan until shortly before his termination. The Oklahoma
Supreme Court concluded nonetheless that publication of the plan was “the equivalent of constructive
knowledge on the part of all employees not specifically excluded.”
We are not required to rely, however, on the [this] analysis or even on Microsoft’s own unwitting
concession. There is a compelling reason, implicit in some of the preceding discussion, that requires us to
reject the company’s theory that the plaintiffs’ entitlement to ESPP benefits is defeated by their previous
lack of knowledge regarding their rights. It is “well established” that an optionor may not rely on an
optionee’s failure to exercise an option when he has committed any act or failed to perform any duty
“calculated to cause the optionee to delay in exercising the right.” [Citation] “[T]he optionor may not
make statements or representations calculated to cause delay, [or] fail to furnish [necessary]
information.…” Similarly, “[I]t is a principle of fundamental justice that if a promisor is himself the cause
of the failure of performance, either of an obligation due him or of a condition upon which his own
liability depends, he cannot take advantage of the failure.” [Citation]…

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Applying these principles, we agree with the magistrate judge, who concluded that Microsoft, which
created a benefit to which the plaintiffs were entitled, could not defend itself by arguing that the plaintiffs
were unaware of the benefit, when its own false representations precluded them from gaining that
knowledge. Because Microsoft misrepresented both the plaintiffs’ actual employment status and their
eligibility to participate in the ESPP, it is responsible for their failure to know that they were covered by
the terms of the offer. It may not now take advantage of that failure to defeat the plaintiffs’ rights to ESPP
benefits. Thus, we reject Microsoft’s final argument.
Conclusion
For the reasons stated, the district court’s grant of summary judgment in favor of Microsoft and denial of
summary judgment in favor of the plaintiffs is REVERSED and the case REMANDED for the
determination of any questions of individual eligibility for benefits that may remain following issuance of
this opinion and for calculation of the damages or benefits due the various class members.

CASE QUESTIONS
1.

In a 1993 Wall Street Journal article, James Bovard asserted that the IRS “is carrying out a sweeping
campaign to slash the number of Americans permitted to be self-employed—and to punish the
companies that contract with them…IRS officials indicate that more than half the nation’s self-employed
should no longer be able to work for themselves.” Why did Microsoft want these employees to “be able
to work for themselves”?

2.

Why did the employees accept employment as independent contractors?

3.

It seems unlikely that the purpose of the IRS’s campaign was really to keep people from working for
themselves, despite Mr. Bovard’s assumption. What was the purpose of the campaign?

4.

Why did the IRS and the court determine that these “independent contractors” were in fact employees?

Breach of Fiduciary Duty
Bacon v. Volvo Service Center, Inc.
597 S.E.2d 440 (Ga. App. 2004)
Smith, J.

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[This appeal is] taken in an action that arose when two former employees left an existing business and
began a new, competing business.…Bacon and Johnson, two former employees of Volvo Service Center,
Inc. (VSC), and the new company they formed, South Gwinnett Volvo Service, Ltd. (SGVS), appeal from
the trial court’s denial of their motion for judgment notwithstanding the jury’s verdict in favor of VSC.…
VSC filed suit against appellants, alleging a number of claims arising from the use by Bacon, who had
been a service technician at VSC, of VSC’s customer list, and his soliciting Johnson, a service writer, and
another VSC employee to join SGVS. SGVS moved for a directed verdict on certain claims at the close of
plaintiff’s evidence and at the close of the case, which motions were denied. The jury was asked to respond
to specific interrogatories, and it found for VSC and against all three appellants on VSC’s claim for
misappropriation of trade secrets. The jury also found for plaintiff against Bacon for breach of fiduciary
duty,…tortious interference with business relations, employee piracy, and conversion of corporate assets.
The jury awarded VSC attorney fees, costs, and exemplary damages stemming from the claim for
misappropriation of trade secrets. Judgment was entered on the jury’s verdict, and appellants’ motion for
j.n.o.v. was denied. This appeal ensued. We find that VSC did not meet its burden of proof as to the claims
for misappropriation of trade secrets, breach of fiduciary duty, or employee piracy, and the trial court
should have granted appellants’ motion for j.n.o.v.
Construed to support the jury’s verdict, the evidence of record shows that Bacon was a technician at VSC
when he decided to leave and open a competing business. Before doing so, he printed a list of VSC’s
customers from one of VSC’s two computers. Computer access was not password restricted, was easy to
use, and was used by many employees from time to time.
About a year after he left VSC, Bacon gave Johnson and another VSC employee an offer of employment at
his new Volvo repair shop, which was about to open. Bacon and Johnson advertised extensively, and the
customer list was used to send flyers to some VSC customers who lived close to the new shop’s location.
These activities became the basis for VSC’s action against Bacon, Johnson, and their new shop, SGVS.…
1. The Georgia Trade Secrets Act of 1990, [Citation], defines a “trade secret” as
information, without regard to form, including, but not limited to,…a list of actual or potential customers
or suppliers which is not commonly known by or available to the public and which information:

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(A) Derives economic value, actual or potential, from not being generally known to, and not being readily
ascertainable by proper means by, other persons who can obtain economic value from its disclosure or
use; and
(B) Is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.
If an employer does not prove both prongs of this test, it is not entitled to protection under the Act. Our
Supreme Court held in [Citation, 1991] for instance, that information was not a trade secret within the
meaning of the Act because no evidence showed that the employer “made reasonable efforts under the
circumstances…to maintain the confidentiality of the information it sought to protect.”
While a client list may be subject to confidential treatment under the Georgia Trade Secrets Act, the
information itself is not inherently confidential. Customers are not trade secrets. Confidentiality is
afforded only where the customer list is not generally known or ascertainable from other sources and was
the subject of reasonable efforts to maintain its secrecy.…
Here, VSC took no precautions to maintain the confidentiality of its customer list. The information was on
both computers, and it was not password-protected. Moreover, the same information was available to the
technicians through the repair orders, which they were permitted to retain indefinitely while Bacon was
employed there. Employees were not informed that the information was confidential. Neither Bacon nor
Johnson was required to sign a confidentiality agreement as part of his employment.
Because no evidence was presented from which the jury could have concluded that VSC took any steps,
much less reasonable ones, to protect the confidentiality of its customer list, a material requirement for
trade secret status was not satisfied. The trial court should have granted appellants’ motion for j.n.o.v.
2. To prove tortious interference with business relations, “a plaintiff must show defendant: (1) acted
improperly and without privilege, (2) acted purposely and with malice with the intent to injure, (3)
induced a third party or parties not to enter into or continue a business relationship with the plaintiff, and
(4) caused plaintiff financial injury.” [Citation] But “[f]air competition is always legal.” [Citations] Unless
an employee has executed a valid non-compete or non-solicit covenant, he is not barred from soliciting
customers of his former employer on behalf of a new employer. [Citation]

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No evidence was presented that Bacon acted “improperly,” that any of VSC’s former customers switched
to SGVS because of any improper act by Bacon, or that these customers would have continued to
patronize VSC but for Bacon’s solicitations. Therefore, it was impossible for a jury to calculate VSC’s
financial damage, if any existed.
3. With regard to VSC’s claim for breach of fiduciary duty, “[a]n employee breaches no fiduciary duty to
the employer simply by making plans to enter a competing business while he is still employed. Even
before the termination of his agency, he is entitled to make arrangements to compete and upon
termination of employment immediately compete.” [Citation] He cannot solicit customers for a rival
business or do other, similar acts in direct competition with his employer’s business before his
employment ends. But here, no evidence was presented to rebut the evidence given by Bacon and Johnson
that they engaged in no such practices before their employment with VSC ended. Even assuming,
therefore, that a fiduciary relationship existed, no evidence was presented showing that it was breached.
4. The same is true for VSC’s claim for employee piracy. The evidence simply does not show that any
employees of VSC were solicited for SGVS before Bacon left VSC’s employ.…
Judgment reversed.

CASE QUESTIONS
1.

Why was it determined that the defendants were not liable for any breach of trade secrecy?

2.

What would have been necessary to show tortious interference with business relations?

3.

The evidence was lacking that there was any breach of fiduciary duty. What would have been necessary
to show that?

4.

What is “employee piracy”? Why was it not proven?

Workers’ Compensation: What “Injuries” Are Compensable?
Wolfe v. Sibley, Lindsay & Curr Co.
330 N.E.2d 603 (N.Y. 1975)
Wachtler, J.

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This appeal involves a claim for workmen’s compensation benefits for the period during which the
claimant was incapacitated by severe depression caused by the discovery of her immediate supervisor’s
body after he had committed suicide.
The facts as adduced at a hearing before the Workmen’s Compensation Board are uncontroverted. The
claimant, Mrs. Diana Wolfe, began her employment with the respondent department store, Sibley,
Lindsay & Curr Co. in February, 1968. After working for some time as an investigator in the security
department of the store she became secretary to Mr. John Gorman, the security director. It appears from
the record that as head of security, Mr. Gorman was subjected to intense pressure, especially during the
Christmas holidays. Mrs. Wolfe testified that throughout the several years she worked at Sibley’s Mr.
Gorman reacted to this holiday pressure by becoming extremely agitated and nervous. She noted,
however, that this anxiety usually disappeared when the holiday season was over. Unfortunately, Mr.
Gorman’s nervous condition failed to abate after the 1970 holidays.…
Despite the fact that he followed Mrs. Wolfe’s advice to see a doctor, Mr. Gorman’s mental condition
continued to deteriorate. On one occasion he left work at her suggestion because he appeared to be so
nervous. This condition persisted until the morning of June 9, 1971 when according to the claimant, Mr.
Gorman looked much better and even smiled and ‘tousled her hair’ when she so remarked.
A short time later Mr. Gorman called her on the intercom and asked her to call the police to room 615.
Mrs. Wolfe complied with this request and then tried unsuccessfully to reach Mr. Gorman on the
intercom. She entered his office to find him lying in a pool of blood caused by a self-inflicted gunshot
wound in the head. Mrs. Wolfe became extremely upset and was unable to continue working that day.
She returned to work for one week only to lock herself in her office to avoid the questions of her fellow
workers. Her private physician perceiving that she was beset by feelings of guilt referred her to a
psychiatrist and recommended that she leave work, which she did. While at home she ruminated about
her guilt in failing to prevent the suicide and remained in bed for long periods of time staring at the
ceiling. The result was that she became unresponsive to her husband and suffered a weight loss of 20
pounds. Her psychiatrist, Dr. Grinols diagnosed her condition as an acute depressive reaction.

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After attempting to treat her in his office Dr. Grinols realized that the severity of her depression mandated
hospitalization. Accordingly, the claimant was admitted to the hospital on July 9, 1971 where she
remained for two months during which time she received psychotherapy and medication. After she was
discharged, Dr. Grinols concluded that there had been no substantial remission in her depression and
ruminative guilt and so had her readmitted for electroshock treatment. These treatments lasted for three
weeks and were instrumental in her recovery. She was again discharged and, in mid-January, 1972,
resumed her employment with Sibley, Lindsay & Curr.
Mrs. Wolfe’s claim for workmen’s compensation was granted by the referee and affirmed by the
Workmen’s Compensation Board. On appeal the Appellate Division reversed citing its opinions in
[Citations], [concluding]…that mental injury precipitated solely by psychic trauma is not compensable as
a matter of law. We do not agree with this conclusion.
Workmen’s compensation, as distinguished from tort liability which is essentially based on fault, is
designed to shift the risk of loss of earning capacity caused by industrial accidents from the worker to
industry and ultimately the consumer. In light of its beneficial and remedial character the Workmen’s
Compensation Law should be construed liberally in favor of the employee [Citation].
Liability under the act is predicated on accidental injury arising out of and in the course of
employment.…Applying these concepts to the case at bar we note that there is no issue raised concerning
the causal relationship between the occurrence and the injury. The only testimony on this matter was
given by Dr. Grinols who stated unequivocally that the discovery of her superior’s body was the competent
producing cause of her condition. Nor is there any question as to the absence of physical impact.
Accordingly, the focus of our inquiry is whether or not there has been an accidental injury within the
meaning of the Workmen’s Compensation Law.
Since there is no statutory definition of this term we turn to the relevant decisions. These may be divided
into three categories: (1) psychic trauma which produces physical injury, (2) physical impact which
produces psychological injury, and (3) psychic trauma which produces psychological injury. As to the first
class our court has consistently recognized the principle that an injury caused by emotional stress or
shock may be accidental within the purview of the compensation law. [Citation] Cases falling into the

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second category have uniformly sustained awards to those incurring nervous or psychological disorders as
a result of physical impact [Citation]. As to those cases in the third category the decisions are not as
clear.…
We hold today that psychological or nervous injury precipitated by psychic trauma is compensable to the
same extent as physical injury. This determination is based on two considerations. First, as noted in the
psychiatric testimony there is nothing in the nature of a stress or shock situation which ordains physical
as opposed to psychological injury. The determinative factor is the particular vulnerability of an individual
by virtue of his physical makeup. In a given situation one person may be susceptible to a heart attack
while another may suffer a depressive reaction. In either case the result is the same—the individual is
incapable of functioning properly because of an accident and should be compensated under the
Workmen’s Compensation Law.
Secondly, having recognized the reliability of identifying psychic trauma as a causative factor of injury in
some cases and the reliability by identifying psychological injury as a resultant factor in other cases, we
see no reason for limiting recovery in the latter instance to cases involving physical impact. There is
nothing talismanic about physical impact.
We would note in passing that this analysis reflects the view of the majority of jurisdictions in this country
and England. [Citations]…
Accordingly, the order appealed from should be reversed and the award to the claimant reinstated, with
costs.

CASE QUESTIONS
1.

Why did the appeals court deny workers’ compensation benefits for Wolfe?

2.

On what reasoning did the New York high court reverse?

3.

There was a dissent in this case (not included here). Judge Breitel noted that the evidence was that Mrs.
Wolfe had a psychological condition such that her trauma “could never have occurred unless she, to begin
with, was extraordinarily vulnerable to severe shock at or away from her place of employment or one
produced by accident or injury to those close to her in employment or in her private life.” The judge
worried that “one can easily call up a myriad of commonplace occupational pursuits where employees are

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often exposed to the misfortunes of others which may in the mentally unstable evoke precisely the
symptoms which this claimant suffered.” He concluded, “In an era marked by examples of overburdening
of socially desirable programs with resultant curtailment or destruction of such programs, a realistic
assessment of impact of doctrine is imperative. An overburdening of the compensation system by
injudicious and open-ended expansion of compensation benefits, especially for costly, prolonged, and
often only ameliorative psychiatric care, cannot but threaten its soundness or that of the enterprises
upon which it depends.” What is the concern here?

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20.4 Summary and Exercises
Summary
An agent is one who acts on behalf of another. The law recognizes several types of agents, including (1) the
general agent, one who possesses authority to carry out a broad range of transactions in the name of and
on behalf of the principal; (2) the special agent, one with authority to act only in a specifically designated
instance or set of transactions; (3) the agent whose agency is coupled with an interest, one who has a
property interest in addition to authority to act as an agent; (4) the subagent, one appointed by an agent
with authority to do so; and (5) the servant (“employee” in modern English), one whose physical conduct
is subject to control of the principal.
A servant should be distinguished from an independent contractor, whose work is not subject to the
control of the principal. The difference is important for purposes of taxation, workers’ compensation, and
liability insurance.
The agency relationship is usually created by contract, and sometimes governed by the Statute of Frauds,
but some agencies are created by operation of law.
An agent owes his principal the highest duty of loyalty, that of a fiduciary. The agent must avoid selfdealing, preserve confidential information, perform with skill and care, conduct his personal life so as not
to bring disrepute on the business for which he acts as agent, keep and render accounts, and give
appropriate information to the principal.
Although the principal is not the agent’s fiduciary, the principal does have certain obligations toward the
agent—for example, to refrain from interfering with the agent’s work and to indemnify. The employer’s
common-law tort liability toward his employees has been replaced by the workers’ compensation system,
under which the employee gives up the right to sue for damages in return for prompt payment of medical
and job-loss expenses. Injuries must have been work related and the injured person must have been an
employee. Courts today allow awards for psychological trauma in the absence of physical injury.

EXERCISES

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1.

A woman was involved in an automobile accident that resulted in the death of a passenger in her car.
After she was charged with manslaughter, her attorney agreed to work with her insurance company’s
claims adjuster in handling the case. As a result of the agreement, the woman gave a statement about the
accident to the claims adjuster. When the prosecuting attorney demanded to see the statement, the
woman’s attorney refused on the grounds that the claims adjuster was his—the attorney’s—agent, and
therefore the statement was covered by the attorney-client privilege. Is the attorney correct? Why?

2.

A local hotel operated under a franchise agreement with a major hotel chain. Several customers charged
the banquet director of the local hotel with misconduct and harassment. They sued the hotel chain (the
franchisor) for acts committed by the local hotel (the franchisee), claiming that the franchisee was the
agent of the franchisor. Is an agency created under these circumstances? Why?

3.

A principal hired a mortgage banking firm to obtain a loan commitment of $10,000,000 from an insurance
company for the construction of a shopping center. The firm was promised a fee of $50,000 for obtaining
the commitment. The firm was successful in arranging for the loan, and the insurance company, without
the principal’s knowledge, agreed to pay the firm a finder’s fee. The principal then refused to pay the firm
the promised $50,000, and the firm brought suit to recover the fee. May the firm recover the fee? Why?

4.

Based on his experience working for the CIA, a former CIA agent published a book about certain CIA
activities in South Vietnam. The CIA did not approve of the publication of the book although, as a
condition of his employment, the agent had agreed not to publish any information relating to the CIA
without specific approval of the agency. The government brought suit against the agent, claiming that all
the agent’s profits from publishing the book should go to the government. Assuming that the government
suffered only nominal damages because the agent published no classified information, will the
government prevail? Why?

5.

Upon graduation from college, Edison was hired by a major chemical company. During the time when he
was employed by the company, Edison discovered a synthetic oil that could be manufactured at a very
low cost. What rights, if any, does Edison’s employer have to the discovery? Why?

6.

A US company hired MacDonald to serve as its resident agent in Bolivia. MacDonald entered into a
contract to sell cars to Bolivia and personally guaranteed performance of the contract as required by
Bolivian law. The cars delivered to Bolivia were defective, and Bolivia recovered a judgment of $83,000
from MacDonald. Must the US company reimburse MacDonald for this amount? Explain.

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7.

According to the late Professor William L. Prosser, “The theory underlying the workmen’s compensation
acts never has been stated better than in the old campaign slogan, ‘The cost of the product should bear
the blood of the workman.’” What is meant by this statement?

8.

An employee in a Rhode Island foundry inserted two coins in a coin-operated coffee machine in the
company cafeteria. One coin stuck in the machine, and the worker proceeded to “whack” the machine
with his right arm. The arm struck a grate near the machine, rupturing the biceps muscle and causing a 10
percent loss in the use of the arm. Is the worker entitled to workers’ compensation? Explain.

9.

Paulson engaged Arthur to sell Paul’s restored 1948 Packard convertible to Byers for $23,000. A few days
later, Arthur saw an advertisement showing that Collector was willing to pay $30,000 for a 1948 Packard
convertible in “restored” condition. Arthur sold the car to Byers, and subsequently Paulson learned of
Collector’s interest. What rights, if any, has Paulson against Arthur?

SELF-TEST QUESTIONS
1.

One who has authority to act only in a specifically designated instance or in a specifically
designated set of transactions is called
a.

a subagent

b.

a general agent

c.

a special agent

d.

none of the above

An agency relationship may be created by
a.

contract

b.

operation of law

c.

an oral agreement

d.

all of the above
An agent’s duty to the principal includes

a.

the duty to indemnify

b.

the duty to warn of special dangers

c.

the duty to avoid self dealing

d.

all of the above

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A person whose work is not subject to the control of the principal, but who arranges to perform
a job for him is called
a.

a subagent

b.

a servant

c.

a special agent

d.

an independent contractor
An employer’s liability for employees’ on-the-job injuries is generally governed by

a.

tort law

b.

the workers’ compensation system

c.

Social Security

d.

none of the above

SELF-TEST ANSWERS
1. c
2. d
3. c
4. d
5. b

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Chapter 21

Liability of Principal and Agent; Termination of Agency
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

The principal’s liability in contract

2.

The principal’s liability in tort

3.

The principal’s criminal liability

4.

The agent’s personal liability in tort and contract

5.

How agency relationships are terminated

In Chapter 20 "Relationships between Principal and Agent" we considered the relationships between
agent and principal. Now we turn to relationships between third parties and the principal or agent.
When the agent makes a contract for his principal or commits a tort in the course of his work, is the
principal liable? What is the responsibility of the agent for torts committed and contracts entered
into on behalf of his principal? How may the relationship be terminated so that the principal or agent
will no longer have responsibility toward or liability for the acts of the other? These are the questions
addressed in this chapter.

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21.1 Principal’s Contract Liability
LEARNING OBJECTIVES
1.

Understand that the principal’s liability depends on whether the agent was authorized to make the
contract.

2.

Recognize how the agent’s authority is acquired: expressly, impliedly, or apparently.

3.

Know that the principal may also be liable—even if the agent had no authority—if the principal ratifies
the agent’s contract after the fact.

Principal’s Contract Liability Requires That Agent Had Authority
The key to determining whether a principal is liable for contracts made by his agent is authority: was the
agent authorized to negotiate the agreement and close the deal? Obviously, it would not be sensible to
hold a contractor liable to pay for a whole load of lumber merely because a stranger wandered into the
lumberyard saying, “I’m an agent for ABC Contractors; charge this to their account.” To be liable, the
principal must have authorized the agent in some manner to act in his behalf, and that authorization must
be communicated to the third party by the principal.

Types of Authority
There are three types of authority: express, implied, and apparent (see Figure 21.1 "Types of Authority").
We will consider each in turn.

Express Authority
The strongest form of authority is that which is expressly granted, often in written form. The principal
consents to the agent’s actions, and the third party may then rely on the document attesting to the agent’s
authority to deal on behalf of the principal. One common form of express authority is the standard
signature card on file with banks allowing corporate agents to write checks on the company’s credit. The
principal bears the risk of any wrongful action of his agent, as demonstrated in Allen A. Funt Productions,
[1]

Inc. v. Chemical Bank. Allen A. Funt submitted to his bank through his production company various
[2]

certificates permitting his accountant to use the company’s checking accounts. In fact, for several years
the accountant embezzled money from the company by writing checks to himself and depositing them in

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his own account. The company sued its bank, charging it with negligence, apparently for failing to monitor
the amount of money taken by the accountant. But the court dismissed the negligence complaint, citing a
state statute based on the common-law agency principle that a third party is entitled to rely on the express
authorization given to an agent; in this case, the accountant drew checks on the account within the
monetary limits contained in the signature cards on file with the bank. Letters of introduction and work
orders are other types of express authority.
Figure 21.1 Types of Authority

Implied Authority
Not every detail of an agent’s work can be spelled out. It is impossible to delineate step-by-step the duties
of a general agent; at best, a principal can set forth only the general nature of the duties that the agent is
to perform. Even a special agent’s duties are difficult to describe in such detail as to leave him without
discretion. If express authority were the only valid kind, there would be no efficient way to use an agent,
both because the effort to describe the duties would be too great and because the third party would be
reluctant to deal with him.
But the law permits authority to be “implied” by the relationship of the parties, the nature and customs of
the business, the circumstances surrounding the act in question, the wording of the agency contract, and

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the knowledge that the agent has of facts relevant to the assignment. The general rule is that the agent has
implied or “incidental” authority to perform acts incidental to or reasonably necessary to carrying out the
transaction. Thus if a principal instructs her agent to “deposit a check in the bank today,” the agent has
authority to drive to the bank unless the principal specifically prohibits the agent from doing so.
The theory of implied authority is especially important to business in the realm of the business manager,
who may be charged with running the entire business operation or only a small part of it. In either event,
the business manager has a relatively large domain of implied authority. He can buy goods and services;
hire, supervise, and fire employees; sell or junk inventory; take in receipts and pay debts; and in general,
direct the ordinary operations of the business. The full extent of the manager’s authority depends on the
circumstances—what is customary in the particular industry, in the particular business, and among the
individuals directly concerned.
On the other hand, a manager does not have implicit authority to undertake unusual or extraordinary
actions on behalf of his principal. In the absence of express permission, an agent may not sell part of the
business, start a new business, change the nature of the business, incur debt (unless borrowing is integral
to the business, as in banking, for example), or move the business premises. For example, the owner of a
hotel appoints Andy manager; Andy decides to rename the hotel and commissions an artist to prepare a
new logo for the hotel’s stationery. Andy has no implied authority to change the name or to commission
the artist, though he does have implied authority to engage a printer to replenish the stationery supply—
and possibly to make some design changes in the letterhead.
Even when there is no implied authority, in an emergency the agent may act in ways that would in the
normal course require specific permission from the principal. If unforeseen circumstances arise and it is
impracticable to communicate with the principal to find out what his wishes would be, the agent may do
what is reasonably necessary in order to prevent substantial loss to his principal. During World War II,
Eastern Wine Corporation marketed champagne in a bottle with a diagonal red stripe that infringed the
trademark of a French producer. The French company had granted licenses to an American importer to
market its champagne in the United States. The contract between producer and importer required the
latter to notify the French company whenever a competitor appeared to be infringing its rights and to
recommend steps by which the company could stop the infringement. The authority to institute suit was

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not expressly conferred, and ordinarily the right to do so would not be inferred. Because France was under
German occupation, however, the importer was unable to communicate with the producer, its principal.
The court held that the importer could file suit to enjoin Eastern Wine from continuing to display the
infringing red diagonal stripe, since legal action was “essential to the preservation of the principal’s
property.”

[3]

The rule that a person’s position can carry with it implied authority is fundamental to American business
practice. But outside the United States this rule is not applicable, and the business executive traveling
abroad should be aware that in civil-law countries it is customary to present proof of authority to transact
corporate business—usually in the form of a power of attorney. This is not always an easy task. Not only
must the power of the traveling executive be shown but the right of the corporate officer back in the
United States to delegate authority must also be proven.

Apparent Authority
In the agency relationship, the agent’s actions in dealing with third parties will affect the legal rights of the
principal. What the third party knows about the agency agreement is irrelevant to the agent’s legal
authority to act. That authority runs from principal to agent. As long as an agent has authorization, either
express or implied, she may bind the principal legally. Thus the seller of a house may be ignorant of the
buyer’s true identity; the person he supposes to be the prospective purchaser might be the agent of an
undisclosed principal. Nevertheless, if the agent is authorized to make the purchase, the seller’s ignorance
is not a ground for either seller or principal to void the deal.
But if a person has no authority to act as an agent, or an agent has no authority to act in a particular way,
is the principal free from all consequences? The answer depends on whether or not the agent
has apparent authority—that is, on whether or not the third person reasonably believes from the
principal’s words, written or spoken, or from his conduct that he has in fact consented to the agent’s
actions. Apparent authority is a manifestation of authority communicated to the third person; it runs from
principal to third party, not to the agent.
Apparent authority is sometimes said to be based on the principle of estoppel. Estoppel is the doctrine
that a person will not now be allowed to deny a promise or assertion she previously made where there has

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been detrimental reliance on that promise or assertion. Estoppel is commonly used to avoid injustice. It
may be a substitute for the requirement of consideration in contract (making the promise of a gift
enforceable where the donee has relied upon the promise), and it is sometimes available to circumvent the
requirement of a writing under the Statute of Frauds.
Apparent authority can arise from prior business transactions. On July 10, Meggs sold to Buyer his
business, the right to use the trade name Rose City Sheet Metal Works, and a list of suppliers he had used.
Three days later, Buyer began ordering supplies from Central Supply Company, which was on Meggs’s list
but with which Meggs had last dealt four years before. On September 3, Central received a letter from
Meggs notifying it of Meggs’s sale of the business to Buyer. Buyer failed to pay Central, which sued Meggs.
The court held that Rose City Sheet Metal Works had apparent authority to buy on Meggs’s credit; Meggs
was liable for supplies purchased between July 10 and September 3.

[4]

In such cases, and in cases

involving the firing of a general manager, actual notice should be given promptly to all customers. See the
discussion of Kanavos v. Hancock Bank & Trust Company in Section 21.4.1 "Implied Authority".

Ratification
Even if the agent possessed no actual authority and there was no apparent authority on which the third
person could rely, the principal may still be liable if he ratifies or adopts the agent’s acts before the third
person withdraws from the contract. Ratification usually relates back to the time of the undertaking,
creating authority after the fact as though it had been established initially. Ratification is a voluntary act
by the principal. Faced with the results of action purportedly done on his behalf but without authorization
and through no fault of his own, he may affirm or disavow them as he chooses. To ratify, the principal may
tell the parties concerned or by his conduct manifest that he is willing to accept the results as though the
act were authorized. Or by his silence he may find under certain circumstances that he has ratified. Note
that ratification does not require the usual consideration of contract law. The principal need be promised
nothing extra for his decision to affirm to be binding on him. Nor does ratification depend on the position
of the third party; for example, a loss stemming from his reliance on the agent’s representations is not
required. In most situations, ratification leaves the parties where they expected to be, correcting the
agent’s errors harmlessly and giving each party what was expected.

KEY TAKEAWAY
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The principal is liable on an agent’s contract only if the agent was authorized by the principal to make the
contract. Such authority is express, implied, or apparent.Express means made in words, orally or in
writing; implied means the agent has authority to perform acts incidental to or reasonably necessary to
carrying out the transaction for which she has express authority. Apparent authority arises where the principal
gives the third party reason to believe that the agent had authority. The reasonableness of the third party’s
belief is based on all the circumstances—all the facts. Even if the agent has no authority, the principal may,
after the fact, ratify the contract made by the agent.

EXERCISES
1.

Could express authority be established by silence on the part of the principal?

2.

Why is the concept of implied authority very important in business situations?

3.

What is the rationale for the doctrine of apparent authority—that is, why would the law impose a
contract on a “principal” when in fact there was no principal-agent relationship with the “agent” at all?

[1] Allen A. Funt Productions, Inc. v. Chemical Bank, 405 N.Y.S.2d 94 (1978).
[2] Allen Funt (1914–99) was an American television producer, director, and writer, best known as the creator and
host of Candid Camera from the 1940s to 1980s, which was broadcast as either a regular show or a series of
specials. Its most notable run was from 1960 to 1967 on CBS.
[3] G. H. Mumm Champagne v. Eastern Wine Corp., 52 F.Supp. 167 (S.D.N.Y. 1943).
[4] Meggs v. Central Supply Co., 307 N.E.2d 288 (Ind. App. 1974).

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21.2 Principal’s Tort and Criminal Liability
LEARNING OBJECTIVES
1.

Understand in what circumstances a principal will be vicariously liable for torts committed by
employees.

2.

Recognize the difference between agents whose tort and criminal liability may be imputed to the
employer and those whose liability will not be so imputed.

3.

Know when the principal will be vicariously liable for intentional torts committed by the agent.

4.

Explain what is meant by “the scope of employment,” within which the agent’s actions may be
attributed to the principal and without which they will not.

5.

Name special cases of vicarious liability.

6.

Describe the principal’s liability for crimes committed by the agent.

Principal’s Tort Liability
The Distinction between Direct and Vicarious Liability
When is the principal liable for injuries that the agent causes another to suffer?

Direct Liability
There is a distinction between torts prompted by the principal himself and torts of which the principal
was innocent. If the principal directed the agent to commit a tort or knew that the consequences of the
agent’s carrying out his instructions would bring harm to someone, the principal is liable. This is an
application of the general common-law principle that one cannot escape liability by delegating an
unlawful act to another. The syndicate that hires a hitman is as culpable of murder as the man who pulls
the trigger. Similarly, a principal who is negligent in his use of agents will be held liable for their
negligence. This rule comes into play when the principal fails to supervise employees adequately, gives
faulty directions, or hires incompetent or unsuitable people for a particular job. Imposing liability on the
principal in these cases is readily justifiable since it is the principal’s own conduct that is the underlying
fault; the principal here is directly liable.

Vicarious Liability
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But the principle of liability for one’s agent is much broader, extending to acts of which the principal had
no knowledge, that he had no intention to commit nor involvement in, and that he may in fact have
expressly prohibited the agent from engaging in. This is the principle of respondeat superior (“let the
master answer”) or the master-servant doctrine, which imposes on the
principalvicarious liability (vicarious means “indirectly, as, by, or through a substitute”) under which the
principal is responsible for acts committed by the agent within the scope of the employment (see Figure
21.2 "Principal’s Tort Liability").
Figure 21.2 Principal’s Tort Liability

The modern basis for vicarious liability is sometimes termed the “deep pocket” theory: the principal
(usually a corporation) has deeper pockets than the agent, meaning that it has the wherewithal to pay for
the injuries traceable one way or another to events it set in motion. A million-dollar industrial accident is
within the means of a company or its insurer; it is usually not within the means of the agent—employee—
who caused it.
The “deep pocket” of the defendant-company is not always very deep, however. For many small
businesses, in fact, the principle of respondeat superior is one of life or death. One example was the
closing in San Francisco of the much-beloved Larraburu Brothers Bakery—at the time, the world’s second
largest sourdough bread maker. The bakery was held liable for $2 million in damages after one of its

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delivery trucks injured a six-year-old boy. The bakery’s insurance policy had a limit of $1.25 million, and
the bakery could not absorb the excess. The Larraburus had no choice but to cease operations.
(Seehttp://www.outsidelands.org/larraburu.php.)
Respondeat superior raises three difficult questions: (1) What type of agents can create tort liability for
the principal? (2) Is the principal liable for the agent’s intentional torts? (3) Was the agent acting within
the scope of his employment? We will consider these questions in turn.

Agents for Whom Principals Are Vicariously Liable
In general, the broadest liability is imposed on the master in the case of tortious physical conduct by a
servant, as discussed in Chapter 20 "Relationships between Principal and Agent". If the servant acted
within the scope of his employment—that is, if the servant’s wrongful conduct occurred while performing
his job—the master will be liable to the victim for damages unless, as we have seen, the victim was another
employee, in which event the workers’ compensation system will be invoked. Vicarious tort liability is
primarily a function of the employment relationship and not agency status.
Ordinarily, an individual or a company is not vicariously liable for the tortious acts of independent
contractors. The plumber who rushes to a client’s house to repair a leak and causes a traffic accident does
not subject the homeowner to liability. But there are exceptions to the rule. Generally, these exceptions
fall into a category of duties that the law deems nondelegable. In some situations, one person is obligated
to provide protection to or care for another. The failure to do so results in liability whether or not the
harm befell the other because of an independent contractor’s wrongdoing. Thus a homeowner has a duty
to ensure that physical conditions in and around the home are not unreasonably dangerous. If the owner
hires an independent contracting firm to dig a sewer line and the contractor negligently fails to guard
passersby against the danger of falling into an open trench, the homeowner is liable because the duty of
care in this instance cannot be delegated. (The contractor is, of course, liable to the homeowner for any
damages paid to an injured passerby.)

Liability for Agent’s Intentional Torts

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In the nineteenth century, a principal was rarely held liable for intentional wrongdoing by the agent if the
principal did not command the act complained of. The thought was that one could never infer authority to
commit a willfully wrongful act. Today, liability for intentional torts is imputed to the principal if the
agent is acting to further the principal’s business. See the very disturbingLyon v. Carey in Section 21.4.2
"Employer’s Liability for Employee’s Intentional Torts: Scope of Employment".

Deviations from Employment
The general rule is that a principal is liable for torts only if the servant committed them “in the scope of
employment.” But determining what this means is not easy.

The “Scope of Employment” Problem
It may be clear that the person causing an injury is the agent of another. But a principal cannot be
responsible for every act of an agent. If an employee is following the letter of his instructions, it will be
easy to determine liability. But suppose an agent deviates in some way from his job. The classic test of
liability was set forth in an 1833 English case, Joel v. Morrison.

[1]

The plaintiff was run over on a highway

by a speeding cart and horse. The driver was the employee of another, and inside was a fellow employee.
There was no question that the driver had acted carelessly, but what he and his fellow employee were
doing on the road where the plaintiff was injured was disputed. For weeks before and after the accident,
the cart had never been driven in the vicinity in which the plaintiff was walking, nor did it have any
business there. The suggestion was that the employees might have gone out of their way for their own
purposes. As the great English jurist Baron Parke put it, “If the servants, being on their master’s business,
took a detour to call upon a friend, the master will be responsible.…But if he was going on a frolic of his
own, without being at all on his master’s business, the master will not be liable.” In applying this test, the
court held the employer liable.
The test is thus one of degree, and it is not always easy to decide when a detour has become so great as to
be transformed into a frolic. For a time, a rather mechanical rule was invoked to aid in making the
decision. The courts looked to the servant’s purposes in “detouring.” If the servant’s mind was fixed on
accomplishing his own purposes, then the detour was held to be outside the scope of employment; hence
the tort was not imputed to the master. But if the servant also intended to accomplish his master’s

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purposes during his departure from the letter of his assignment, or if he committed the wrong while
returning to his master’s task after the completion of his frolic, then the tort was held to be within the
scope of employment.
This test is not always easy to apply. If a hungry deliveryman stops at a restaurant outside the normal
lunch hour, intending to continue to his next delivery after eating, he is within the scope of employment.
But suppose he decides to take the truck home that evening, in violation of rules, in order to get an early
start the next morning. Suppose he decides to stop by the beach, which is far away from his route. Does it
make a difference if the employer knows that his deliverymen do this?

The Zone of Risk Test
Court decisions in the last forty years have moved toward a different standard, one that looks to the
foreseeability of the agent’s conduct. By this standard, an employer may be held liable for his employee’s
conduct even when devoted entirely to the employee’s own purposes, as long as it was foreseeable that the
agent might act as he did. This is the “zone of risk” test. The employer will be within the zone of risk for
vicarious liability if the employee is where she is supposed to be, doing—more or less—what she is
supposed to be doing, and the incident arose from the employee’s pursuit of the employer’s interest
(again, more or less). That is, the employer is within the zone of risk if the servant is in the place within
which, if the master were to send out a search party to find a missing employee, it would be reasonable to
look. See Section 4, Cockrell v. Pearl River Valley Water Supply Dist.

Special Cases of Vicarious Liability
Vicarious liability is not limited to harm caused in the course of an agency relationship. It may also be
imposed in other areas, including torts of family members, and other torts governed by statute or
regulation. We will examine each in turn.

Use of Automobiles
A problem commonly arises when an automobile owner lends his vehicle to a personal friend, someone
who is not an agent, and the borrower injures a third person. Is the owner liable? In many states, the
owner is not liable; in other states, however, two approaches impose liability on the owner.

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The first approach is legislative: owner’s consent statutes make the owner liable when the automobile is
being driven with his consent or knowledge. The second approach to placing liability on the owner is
judicial and known as thefamily purpose doctrine. Under this doctrine, a family member who negligently
injures someone with the car subjects the owner to liability if the family member was furthering family
purposes. These are loosely defined to include virtually every use to which a child, for example, might put
a car. In a Georgia case, Dixon v. Phillips, the father allowed his minor son to drive the car but expressly
forbade him from letting anyone else do so.

[2]

Nevertheless, the son gave the wheel to a friend and a

collision occurred while both were in the car. The court held the father liable because he made the car
available for the pleasure and convenience of his son and other family members.

Torts of Family Members
At common law, the husband was liable for the torts of his wife, not because she was considered an agent
but because she was considered to be an extension of him. “Husband and wife were only one person in
law,”

[3]

says Holmes, and any act of the wife was supposed to have been done at the husband’s direction

(to which Mr. Dickens’s Mr. Bumble responded, in the memorable line, “If the law supposes that, the law
[4]

is a ass—a idiot” ). This ancient view has been abrogated by statute or by court ruling in all the states, so
that now a wife is solely responsible for her own torts unless she in fact serves as her husband’s agent.
Unlike wives, children are not presumed at common law to be agents or extensions of the father so that
normally parents are not vicariously liable for their children’s torts. However, they can be held liable for
failing to control children known to be dangerous.
Most states have statutorily changed the common-law rule, making parents responsible for willful or
malicious tortious acts of their children whether or not they are known to be mischief-makers. Thus the
Illinois Parental Responsibility Law provides the following: “The parent or legal guardian of an
unemancipated minor who resides with such parent or legal guardian is liable for actual damages for the
willful or malicious acts of such minor which cause injury to a person or property.”

[5]

Several other states

impose a monetary limit on such liability.

Other Torts Governed by Statute or Regulation

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There are certain types of conduct that statutes or regulation attempt to control by placing the burden of
liability on those presumably in a position to prevent the unwanted conduct. An example is the
“Dramshop Act,” which in many states subjects the owner of a bar to liability if the bar continues to serve
an intoxicated patron who later is involved in an accident while intoxicated. Another example involves the
sale of adulterated or short-weight foodstuffs: the employer of one who sells such may be liable, even if
the employer did not know of the sales.

Principal’s Criminal Liability
As a general proposition, a principal will not be held liable for an agent’s unauthorized criminal acts if the
crimes are those requiring specific intent. Thus a department store proprietor who tells his chief buyer to
get the “best deal possible” on next fall’s fashions is not liable if the buyer steals clothes from the
manufacturer. A principal will, however, be liable if the principal directed, approved, or participated in
the crime. Cases here involve, for example, a corporate principal’s liability for agents’ activity in antitrust
violations—price-fixing is one such violation.
There is a narrow exception to the broad policy of immunity. Courts have ruled that under certain
regulatory statutes and regulations, an agent’s criminality may be imputed to the principal, just as civil
liability is imputed under Dramshop Acts. These include pure food and drug acts, speeding ordinances,
building regulations, child labor rules, and minimum wage and maximum hour legislation. Misdemeanor
criminal liability may be imposed upon corporations and individual employees for the sale or shipment of
adulterated food in interstate commerce, notwithstanding the fact that the defendant may have had no
actual knowledge that the food was adulterated at the time the sale or shipment was made.

KEY TAKEAWAY
The principal will be liable for the employee’s torts in two circumstances: first, if the principal was directly
responsible, as in hiring a person the principal knew or should have known was incompetent or dangerous;
second, if the employee committed the tort in the scope of business for the principal. This is the masterservant doctrine or respondeat superior. It imposes vicarious liability on the employer: the master (employer)
will be liable if the employee was in the zone of activity creating a risk for the employer (“zone of risk” test),
that is—generally—if the employee was where he was supposed to be, when he was supposed to be there,

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and the incident arose out of the employee’s interest (however perverted) in promoting the employer’s
business.
Special cases of vicarious liability arise in several circumstances. For example, the owner of an automobile may
be liable for torts committed by one who borrows it, or if it is—even if indirectly—used for family purposes.
Parents are, by statute in many states, liable for their children’s torts. Similarly by statute, the sellers and
employers of sellers of alcohol or adulterated or short-weight foodstuffs may be liable. The employer of one
who commits a crime is not usually liable unless the employer put the employee up to the crime or knew that
a crime was being committed. But some prophylactic statutes impose liability on the employer for the
employee’s crime—even if the employee had no intention to commit it—as a means to force the employer to
prevent such actions.

EXERCISES
1.

What is the difference between direct and vicarious employer tort liability?

2.

What is meant by the “zone of risk” test?

3.

Under what circumstances will an employer be liable for intentional torts of the employee?

4.

When will the employer be liable for an employee’s criminal acts?

[1] Joel v. Morrison, 6 Carrington & Payne 501.
[2] Dixon v. Phillips, 217 S.E.2d 331 (Ga. 1975).
[3] O.W. Holmes, Agency, 4 Harvard Law Rev. 353 (1890–91).
[4] Charles Dickens, Oliver Twist, (London: 1838), chap 51.
[5] Ill. Rev. Stat. (2005), chapter 70, paragraph 51.http://law.justia.com/illinois/codes/2005/chapter57/2045.html.

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21.3 Agent’s Personal Liability for Torts and Contracts;
Termination of Agency
LEARNING OBJECTIVES
1.

Understand the agent’s personal liability for tort.

2.

Understand the agent’s personal liability for contract.

3.

Recognize the ways the agency relationship is terminated.

Agent’s Personal Liability for Torts and Contracts
Tort Liability
That a principal is held vicariously liable and must pay damages to an injured third person does not
excuse the agent who actually committed the tortious acts. A person is always liable for his or her own
torts (unless the person is insane, involuntarily intoxicated, or acting under extreme duress). The agent is
personally liable for his wrongful acts and must reimburse the principal for any damages the principal was
forced to pay, as long as the principal did not authorize the wrongful conduct. The agent directed to
commit a tort remains liable for his own conduct but is not obliged to repay the principal. Liability as an
agent can be burdensome, sometimes perhaps more burdensome than as a principal. The latter normally
purchases insurance to cover against wrongful acts of agents, but liability insurance policies frequently do
not cover the employee’s personal liability if the employee is named in a lawsuit individually. Thus
doctors’ and hospitals’ malpractice policies protect a doctor from both her own mistakes and those of
nurses and others that the doctor would be responsible for; nurses, however, might need their own
coverage. In the absence of insurance, an agent is at serious risk in this lawsuit-conscious age. The risk is
not total. The agent is not liable for torts of other agents unless he is personally at fault—for example, by
negligently supervising a junior or by giving faulty instructions. For example, an agent, the general
manager for a principal, hires Brown as a subordinate. Brown is competent to do the job but by failing to
exercise proper control over a machine negligently injures Ted, a visitor to the premises. The principal
and Brown are liable to Ted, but the agent is not.

Contract Liability
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It makes sense that an agent should be liable for her own torts; it would be a bad social policy indeed if a
person could escape tort liability based on her own fault merely because she acted in an agency capacity. It
also makes sense that—as is the general rule—an agent is not liable on contracts she makes on the
principal’s behalf; the agent is not a party to a contract made by the agent on behalf of the principal. No
public policy would be served by imposing liability, and in many cases it would not make sense. Suppose
an agent contracts to buy $25 million of rolled aluminum for a principal, an airplane manufacturer. The
agent personally could not reasonably perform such contract, and it is not intended by the parties that she
should be liable. (Although the rule is different in England, where an agent residing outside the country is
liable even if it is clear that he is signing in an agency capacity.) But there are three exceptions to this rule:
(1) if the agent is undisclosed or partially disclosed, (2) if the agent lacks authority or exceeds it, or (3) if
the agent entered into the contract in a personal capacity. We consider each situation.

Agent for Undisclosed or Partially Disclosed Principal
An agent need not, and frequently will not, inform the person with whom he is negotiating that he is
acting on behalf of a principal. The secret principal is usually called an “undisclosed principal.” Or the
agent may tell the other person that he is acting as an agent but not disclose the principal’s name, in
which event the principal is “partially disclosed.” To understand the difficulties that may occur, consider
the following hypothetical but common example. A real estate developer known for building amusement
parks wants to acquire several parcels of land to construct a new park. He wants to keep his identity secret
to hold down the land cost. If the landowners realized that a major building project was about to be
launched, their asking price would be quite high. So the developer obtains two options to purchase land by
using two secret agents—Betty and Clem.
Betty does not mention to sellers that she is an agent; therefore, to those sellers the developer is an
undisclosed principal. Clem tells those with whom he is dealing that he is an agent but refuses to divulge
the developer’s name or his business interest in the land. Thus the developer is, to the latter sellers, a
partially disclosed principal. Suppose the sellers get wind of the impending construction and want to back
out of the deal. Who may enforce the contracts against them?

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The developer and the agents may sue to compel transfer of title. The undisclosed or partially disclosed
principal may act to enforce his rights unless the contract specifically prohibits it or there is a
representation that the signatories are not signing for an undisclosed principal. The agents may also bring
suit to enforce the principal’s contract rights because, as agents for an undisclosed or partially disclosed
principal, they are considered parties to their contracts.
Now suppose the developer attempts to call off the deal. Whom may the sellers sue? Both the developer
and the agents are liable. That the sellers had no knowledge of the developer’s identity—or even that there
was a developer—does not invalidate the contract. If the sellers first sue agent Betty (or Clem), they may
still recover the purchase price from the developer as long as they had no knowledge of his identity prior
to winning the first lawsuit. The developer is discharged from liability if, knowing his identity, the
plaintiffs persist in a suit against the agents and recover a judgment against them anyway. Similarly, if the
seller sues the principal and recovers a judgment, the agents are relieved of liability. The seller thus has a
“right of election” to sue either the agent or the undisclosed principal, a right that in many states may be
exercised any time before the seller collects on the judgment.

Lack of Authority in Agent
An agent who purports to make a contract on behalf of a principal, but who in fact has no authority to do
so, is liable to the other party. The theory is that the agent has warranted to the third party that he has the
requisite authority. The principal is not liable in the absence of apparent authority or ratification. But the
agent does not warrant that the principal has capacity. Thus an agent for a minor is not liable on a
contract that the minor later disavows unless the agent expressly warranted that the principal had
attained his majority. In short, the implied warranty is that the agent has authority to make a deal, not
that the principal will necessarily comply with the contract once the deal is made.

Agent Acting on Own Account
An agent will be liable on contracts made in a personal capacity—for instance, when the agent personally
guarantees repayment of a debt. The agent’s intention to be personally liable is often difficult to determine
on the basis of his signature on a contract. Generally, a person signing a contract can avoid personal
liability only by showing that he was in fact signing as an agent. If the contract is signed “Jones, Agent,”

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Jones can introduce evidence to show that there was never an intention to hold him personally liable. But
if he signed “Jones” and neither his agency nor the principal’s name is included, he will be personally
liable. This can be troublesome to agents who routinely indorse checks and notes. There are special rules
governing these situations.

Termination of Agency
The agency relationship is not permanent. Either by action of the parties or by law, the relationship will
eventually terminate.

By Act of the Parties
Certainly the parties to an agency contract can terminate the agreement. As with the creation of the
relationship, the agreement may be terminated either expressly or implicitly.

Express Termination
Many agreements contain specified circumstances whose occurrence signals the end of the agency. The
most obvious of these circumstances is the expiration of a fixed period of time (“agency to terminate at the
end of three months” or “on midnight, December 31”). An agreement may also terminate on the
accomplishment of a specified act (“on the sale of the house”) or following a specific event (“at the
conclusion of the last horse race”).
Mutual consent between the parties will end the agency. Moreover, the principal may revoke the agency or
the agent may renounce it; such a revocation orrenunciation of agency would be an express termination.
Even a contract that states the agreement is irrevocable will not be binding, although it can be the basis
for a damage suit against the one who breached the agreement by revoking or renouncing it. As with any
contract, a person has the power to breach, even in absence of the right to do so. If the agency is coupled
with an interest, however, so that the authority to act is given to secure an interest that the agent has in
the subject matter of the agency, then the principal lacks the power to revoke the agreement.

Implied Termination

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There are a number of other circumstances that will spell the end of the relationship by implication.
Unspecified events or changes in business conditions or the value of the subject matter of the agency
might lead to a reasonable inference that the agency should be terminated or suspended; for example, the
principal desires the agent to buy silver but the silver market unexpectedly rises and silver doubles in
price overnight. Other circumstances that end the agency include disloyalty of the agent (e.g., he accepts
an appointment that is adverse to his first principal or embezzles from the principal), bankruptcy of the
agent or of the principal, the outbreak of war (if it is reasonable to infer that the principal, knowing of the
war, would not want the agent to continue to exercise authority), and a change in the law that makes a
continued carrying out of the task illegal or seriously interferes with it.

By Operation of Law
Aside from the express termination (by agreement of both or upon the insistence of one), or the necessary
or reasonable inferences that can be drawn from their agreements, the law voids agencies under certain
circumstances. The most frequent termination by operation of law is the death of a principal or an agent.
The death of an agent also terminates the authority of subagents he has appointed, unless the principal
has expressly consented to the continuing validity of their appointment. Similarly, if the agent or principal
loses capacity to enter into an agency relationship, it is suspended or terminated. The agency terminates if
its purpose becomes illegal.
Even though authority has terminated, whether by action of the parties or operation of law, the principal
may still be subject to liability. Apparent authority in many instances will still exist; this is
called lingering authority. It is imperative for a principal on termination of authority to notify all those
who may still be in a position to deal with the agent. The only exceptions to this requirement are when
termination is effected by death, loss of the principal’s capacity, or an event that would make it impossible
to carry out the object of the agency.

KEY TAKEAWAY
A person is always liable for her own torts, so an agent who commits a tort is liable; if the tort was in the
scope of employment the principal is liable too. Unless the principal put the agent up to committing the tort,
the agent will have to reimburse the principal. An agent is not generally liable for contracts made; the

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principal is liable. But the agent will be liable if he is undisclosed or partially disclosed, if the agent lacks
authority or exceeds it, or, of course, if the agent entered into the contract in a personal capacity.
Agencies terminate expressly or impliedly or by operation of law. An agency terminates expressly by the terms
of the agreement or mutual consent, or by the principal’s revocation or the agent’s renunciation. An agency
terminates impliedly by any number of circumstances in which it is reasonable to assume one or both of the
parties would not want the relationship to continue. An agency will terminate by operation of law when one
or the other party dies or becomes incompetent, or if the object of the agency becomes illegal. However, an
agent may have apparent lingering authority, so the principal, upon termination of the agency, should notify
those who might deal with the agent that the relationship is severed.

EXERCISES
1.

Pauline, the owner of a large bakery business, wishes to expand her facilities by purchasing the adjacent
property. She engages Alice as an agent to negotiate the deal with the property owner but instructs her
not to tell the property owner that she—Alice—is acting as an agent because Pauline is concerned that
the property owner would demand a high price. A reasonable contract is made. When the economy
sours, Pauline decides not to expand and cancels the plan. Who is liable for the breach?

2.

Peter, the principal, instructs his agent, Alice, to tour England and purchase antique dining room furniture
for Peter’s store. Alice buys an antique bed set. Who is liable, Peter or Alice? Suppose the seller did not
know of the limit on Alice’s authority and sells the bed set to Alice in good faith. What happens when
Peter discovers he owes the seller for the set?

3.

Under what circumstances will the agency terminate expressly?

4.

Agent is hired by Principal to sell a new drug, Phobbot. Six months later, as it becomes apparent that
Phobbot has nasty side effects (including death), the Food and Drug Administration orders the drug pulled
from the shelves. Agent’s agency is terminated; what terminology is appropriate to describe how?

5.

Principal engages Agent to buy lumber, and in that capacity Agent deals with several large timber owners.
Agent’s contract ends on July 31; on August 1, Agent buys $150,000 worth of lumber from a seller with
whom he had dealt previously on Principal’s behalf. Who is liable and why?

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21.4 Cases
Implied Authority
Kanavos v. Hancock Bank & Trust Company
439 N.E.2d 311 (Mass. 1982)
KASS, J.
At the close of the plaintiff’s evidence, the defendant moved for a directed verdict, which the trial judge
allowed. The judge’s reason for so doing was that the plaintiff, in his contract action, failed to introduce
sufficient evidence tending to prove that the bank officer who made the agreement with which the plaintiff
sought to charge the bank had any authority to make it. Upon review of the record we are of opinion that
there was evidence which, if believed, warranted a finding that the bank officer had the requisite authority
or that the bank officer had apparent authority to make the agreement in controversy. We therefore
reverse the judgment.
For approximately ten years prior to 1975, Harold Kanavos and his brother borrowed money on at least
twenty occasions from the Hancock Bank & Trust Company (the Bank), and, during that period, the loan
officer with whom Kanavos always dealt was James M. Brown. The aggregate loans made by the Bank to
Kanavos at any given time went as high as $800,000.
Over that same decade, Brown’s responsibilities at the Bank grew, and he had become executive vicepresident. Brown was also the chief loan officer for the Bank, which had fourteen or fifteen branches in
addition to its head office. Physically, Brown’s office was at the head office, toward the rear of the main
banking floor, opposite the office of the president—whose name was Kelley. Often Brown would tell
Kanavos that he had to check an aspect of a loan transaction with Kelley, but Kelley always backed Brown
up on those occasions.…
[The plaintiff, Harold Kanavos, entered into an agreement with the defendant Bank whereby stock owned
by the Kanavos brothers was sold to the Bank and the plaintiff was given an option to repurchase the
stock. Kanavos’ suit against the Bank was based on an amendment to the agreement offered by Brown.]

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Kanavos was never permitted to introduce in evidence the terms of the offer Brown made. That offer was
contained in a writing, dated July 16, 1976, on bank letterhead, which read as follows: “This letter is to
confirm our conversation regarding your option to re-purchase the subject property. In lieu of your not
exercising your option, we agree to pay you $40,000 representing a commission upon our sale of the
subject property, and in addition, will give you the option to match the price of sale of said property to
extend for a 60 day period from the time our offer is received.” Brown signed the letter as executive vicepresident. The basis of exclusion was that the plaintiff had not established the authority of Brown to make
with Kanavos the arrangement memorialized in the July 16, 1976, letter.
Whether Brown’s job description impliedly authorized the right of last refusal or cash payment
modification is a question of how, in the circumstances, a person in Brown’s position could reasonably
interpret his authority. Whether Brown had apparent authority to make the July 16, 1976, modification is
a question of how, in the circumstances, a third person, e.g., a customer of the Bank such as Kanavos,
would reasonably interpret Brown’s authority in light of the manifestations of his principal, the Bank.
Titles of office generally do not establish apparent authority. Brown’s status as executive vice-president
was not, therefore, a badge of apparent authority to modify agreements to which the Bank was a party.
Trappings of office, e.g., office and furnishing, private secretary, while they may have some tendency to
suggest executive responsibility, do not without other evidence provide a basis for finding apparent
authority. Apparent authority is drawn from a variety of circumstances. Thus in Federal Nat. Bank v.
O’Connell…(1940), it was held apparent authority could be found because an officer who was a director,
vice-president and treasurer took an active part in directing the affairs of the bank in question and was
seen by third parties talking with customers and negotiating with them. In Costonis v. Medford Housing
Authy.…(1961), the executive director of a public housing authority was held to have apparent authority to
vary specifications on the basis of the cumulative effect of what he had done and what the authority
appeared to permit him to do.
In the instant case there was evidence of the following variety of circumstances: Brown’s title of executive
vice-president; the location of his office opposite the president; his frequent communications with the
president; the long course of dealing and negotiations; the encouragement of Kanavos by the president to

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deal with Brown; the earlier amendment of the agreement by Brown on behalf of the Bank on material
points, namely the price to be paid by the Bank for the shares and the repurchase price; the size of the
Bank (fourteen or fifteen branches in addition to the main office); the secondary, rather than
fundamental, nature of the change in the terms of the agreement now repudiated by the Bank, measured
against the context of the overall transaction; and Brown’s broad operating authority…all these added
together would support a finding of apparent authority. When a corporate officer, as here, is allowed to
exercise general executive responsibilities, the “public expectation is that the corporation should be bound
to engagements made on its behalf by those who presume to have, and convincingly appear to have, the
power to agree.” [Citation] This principle does not apply, of course, where in the business context, the
requirement of specific authority is presumed, e.g., the sale of a major asset by a corporation or a
transaction which by its nature commits the corporation to an obligation outside the scope of its usual
activity. The modification agreement signed by Brown and dated July 16, 1976, should have been admitted
in evidence, and a verdict should not have been directed.
Judgment reversed.

CASE QUESTIONS
1.

Why are “titles of office” insufficient to establish apparent authority?

2.

Why are “trappings of office” insufficient to establish apparent authority?

3.

What is the relationship between apparent authority and estoppel? Who is estopped to do what, and
why?

Employer’s Liability for Employee’s Intentional Torts: Scope of Employment
Lyon v. Carey
533 F.2d 649 (Cir. Ct. App. DC 1976)
McMillan, J.:
Corene Antoinette Lyon, plaintiff, recovered a $33,000.00 verdict [about $142,000 in 2010 dollars] in the
United States District Court for the District of Columbia before Judge Barrington T. Parker and a jury,
against the corporate defendants, George’s Radio and Television Company, Inc., and Pep Line Trucking

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Company, Inc. The suit for damages arose out of an assault, including rape, committed with a knife and
other weapons upon the plaintiff on May 9, 1972, by Michael Carey, a nineteen-year-old deliveryman for
Pep Line Trucking Company, Inc. Three months after the trial, Judge Parker set aside the verdict and
rendered judgment for both defendants notwithstanding the verdict. Plaintiff appealed.…
Although the assault was perhaps at the outer bounds of respondeat superior, the case was properly one
for the jury. Whether the assault in this case was the outgrowth of a job-related controversy or simply a
personal adventure of the deliveryman, was a question for the jury. This was the import of the trial judge’s
instructions. The verdict as to Pep Line should not have been disturbed.
Irene Lyon bought a mattress and springs for her bed from the defendant George’s Radio and Television
Company, Inc. The merchandise was to be delivered on May 9, 1972. Irene Lyon had to be at work and the
plaintiff [Irene’s sister] Corene Lyon, had agreed to wait in her sister’s apartment to receive the delivery.
A C.O.D. balance of $13.24 was due on the merchandise, and Irene Lyon had left a check for $13.24 to
cover that balance. Plaintiff had been requested by her sister to “wait until the mattress and the springs
came and to check and make sure they were okay.”
Plaintiff, fully clothed, answered the door. Her description of what happened is sufficiently brief and
unqualified that it will bear repeating in full. She testified, without objection, as follows:
I went to the door, and I looked in the peephole, and I asked who was there. The young man told me he
was a delivery man from George’s. He showed me a receipt, and it said, ‘George’s.’ He said he [needed
cash on delivery—COD], so I let him in, and I told him to bring the mattress upstairs and he said, ‘No,’
that he wasn’t going to lug them upstairs, and he wanted the COD first, and I told him I wanted to see the
mattress and box springs to make sure they were okay, and he said no, he wasn’t going to lug them
upstairs [until he got the check].
So this went back and forwards and so he was getting angry, and I told him to wait right here while I go
get the COD. I went to the bedroom to get the check, and I picked it up, and I turned around and he was
right there.

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And then I was giving him the check and then he told me that his boss told him not to accept a check, that
he wanted cash money, and that if I didn’t give him cash money, he was going to take it on my ass, and he
told me that he was no delivery man, he was a rapist and then he threw me on the bed.
[The Court] Talk louder, young lady, the jury can’t hear you.
[The witness] And then he threw me on the bed, and he had a knife to my throat.
[Plaintiff’s attorney] Then what happened?
And then he raped me.
Plaintiff’s pre-trial deposition was a part of the record on appeal, and it shows that Carey raped plaintiff at
knife point; that then he chased her all over the apartment with a knife and scissors and cut plaintiff in
numerous places on her face and body, beat and otherwise attacked her. All of the physical injury other
than the rape occurred after rather than before the rape had been accomplished.…
[Carey was convicted of rape and sent to prison. The court determined that George’s was properly
dismissed because Pep Line, Carey’s employer, was an independent contractor over which George’s had
no control.]
The principal question, therefore, is whether the evidence discloses any other basis upon which a jury
could reasonably find Pep Line, the employer of Carey, liable for the assault.
Michael Carey was in the employment of the defendant Pep Line as a deliveryman. He was authorized to
make the delivery of the mattress and springs plaintiff’s sister had bought. He gained access to the
apartment only upon a showing of the delivery receipt for the merchandise. His employment
contemplated that he visit and enter that particular apartment. Though the apartment was not owned by
nor in the control of his employer, it was nevertheless a place he was expected by his employer to enter.
After Carey entered, under the credentials of his employment and the delivery receipt, a dispute arose
naturally and immediately between him and the plaintiff about two items of great significance in
connection with his job. These items were the request of the plaintiff, the customer’s agent, to inspect the

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mattress and springs before payment (which would require their being brought upstairs before the
payment was made), and Carey’s insistence on getting cash rather than a check.
The dispute arose out of the very transaction which had brought Carey to the premises, and, according to
the plaintiff’s evidence, out of the employer’s instructions to get cash only before delivery.
On the face of things, Pep Line Trucking Company, Inc. is liable, under two previous decisions of the
Court of Appeals for the District of Columbia Circuit. [Citation (1953)] held a taxi owner liable for
damages (including a broken leg) sustained by a customer who had been run over by the taxi in pursuit of
a dispute between the driver and the customer about a fare. [Citation (1939)], held a restaurant owner
liable to a restaurant patron who was beaten with a stick by a restaurant employee, after a disagreement
over the service. The theory was that:
It is well established that an employer may be held responsible in tort for assaults committed by an
employee while he is acting within the scope of his employment, even though he may act wantonly and
contrary to his employer’s instructions. [Citations] “…having placed [the employee] in charge and
committed the management of the business to his care, defendants may not escape liability either on the
ground of his infirmity of temperament or because, under the influence of passion aroused by plaintiff’s
threat to report the circumstances, he went beyond the ordinary line of duty and inflicted the injury
shown in this case. [Citations]”
Munick v. City of Durham ([Citation], Supreme Court of North Carolina, 1921), though not a binding
precedent, is informative and does show that the theory of liability advanced by the plaintiff is by no
means recent in origin. The plaintiff, Munick, a Russian born Jew, testified that he went to the Durham,
North Carolina city water company office on April 17, 1919, and offered to pay his bill with “three paper
dollars, one silver dollar, and fifty cents in pennies.” The pennies were in a roll “like the bank fixes them.”
The clerk gave a receipt and the plaintiff prepared to leave the office. The office manager came into the
room, saw the clerk counting the pennies, became enraged at the situation, shoved the pennies onto the
floor and ordered Munick to pick them up. Bolton, the manager, “locked the front door and took me by
the jacket and called me ‘God damned Jew,’ and said, ‘I want only bills.’ I did not say anything and he hit
me in the face. I did not resist, and the door was locked and I could not get out.…” With the door locked,

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Bolton then repeatedly choked and beat the plaintiff, finally extracted a bill in place of the pennies, and
ordered him off the premises with injuries including finger marks on his neck that could be seen for eight
or ten days. Bolton was convicted of unlawful assault [but the case against the water company was
dismissed].
The North Carolina Supreme Court (Clark, C. J.) reversed the trial court’s dismissal and held that the case
should have gone to the jury. The court…said [Citation]:
“‘It is now fully established that corporations may be held liable for negligent and malicious torts, and that
responsibility will be imputed whenever such wrongs are committed by their employees and agents in the
course of their employment and within its scope * * * in many of the cases, and in reliable textbooks * * *
‘course of employment’ is stated and considered as sufficiently inclusive; but, whether the one or the other
descriptive term is used, they have the same significance in importing liability on the part of the principal
when the agent is engaged in the work that its principal has employed or directed him to do and * * * in
the effort to accomplish it. When such conduct comes within the description that constitutes an actionable
wrong, the corporation principal, as in other cases of principal and agent, is liable not only for ‘the act
itself, but for the ways and means employed in the performance thereof.’
“In 1 Thompson, Negligence, s 554, it is pointed out that, unless the above principle is maintained:
“‘It will always be more safe and profitable for a man to conduct his business vicariously than in his own
person. He would escape liability for the consequences of many acts connected with his business,
springing from the imperfections of human nature, because done by another, for which he would be
responsible if done by himself. Meanwhile, the public, obliged to deal or come in contact with his agent,
for injuries done by them must be left wholly without redress. He might delegate to persons pecuniarily
irresponsible the care of large factories, of extensive mines, of ships at sea, or of railroad trains on land,
and these persons, by the use of the extensive power thus committed to them, might inflict wanton and
malicious injuries on third persons, without other restraint than that which springs from the imperfect
execution of the criminal laws. A doctrine so fruitful of mischief could not long stand unshaken in an
enlightened jurisprudence.’ This court has often held the master liable, even if the agent was willful,
provided it was committed in the course of his employment. [Citation]”

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“The act of a servant done to effect some independent purpose of his own and not with reference to the
service in which he is employed, or while he is acting as his own master for the time being, is not within
the scope of his employment so as to render the master liable therefor. In these circumstances the servant
alone is liable for the injury inflicted.” [Citation].…”The general idea is that the employee at the time of
doing the wrongful act, in order to fix liability on the employer, must have been acting in behalf of the
latter and not on his own account [Citation].”
The principal physical (as opposed to psychic) damage to the plaintiff is a number of disfiguring knife
wounds on her head, face, arms, breasts and body. If the instrumentalities of assault had not included
rape, the case would provoke no particular curiosity nor interest because it comes within all the classic
requirements for recovery against the master. The verdict is not attacked as excessive, and could not be
excessive in light of the physical injuries inflicted.
It may be suggested that [some of the cases discussed] are distinguishable because in each of those cases
the plaintiff was a business visitor on the defendant’s “premises.”…Home delivery customers are usually
in their homes, sometimes alone; and deliveries of merchandise may expose householders to one-on-one
confrontations with deliverymen. It would be a strange rule indeed which, while allowing recovery for
assaults committed in “the store,” would deny a master’s liability for an assault committed on a lone
woman in her own home, by a deliveryman required by his job to enter the home.…
If, as in [one case discussed], the assault was not motivated or triggered off by anything in the
employment activity but was the result of only propinquity and lust, there should be no liability. However,
if the assault, sexual or otherwise, was triggered off or motivated or occasioned by a dispute over the
conduct then and there of the employer’s business, then the employer should be liable.
It is, then, a question of fact for the trier of fact, rather than a question of law for the court, whether the
assault stemmed from purely and solely personal sources or arose out of the conduct of the employer’s
business; and the trial judge so instructed the jury.
It follows that, under existing decisions of the District of Columbia Circuit, plaintiff has made out a case
for the jury against Pep Line Trucking, Inc. unless the sexual character of one phase of the assault bars her
from recovery for damages from all phases of the assault.

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We face, then, this question: Should the entire case be taken from the jury because, instead of a rod of
wood (as in [one case]), in addition to weapons of steel (as in [one case, a knife]); and in addition to his
hands (as in [the third case, regarding the dispute about the pennies]), Carey also employed a sexual
weapon, a rod of flesh and blood in the pursuit of a job-related controversy?
The answer is, No. It is a jury’s job to decide how much of plaintiff’s story to believe, and how much if any
of the damages were caused by actions, including sexual assault, which stemmed from job-related sources
rather than from purely personal origins.…
The judgment is affirmed as to the defendant George’s and reversed as to the defendant Pep Line
Trucking Company, Inc.

CASE QUESTIONS
1.

What triggered the dispute here?

2.

The court observes, “On the face of things, Pep Line Trucking Company, Inc. is liable.” But there are two
issues that give the court cause for more explanation. (1) Why does the court discuss the point that the
assault did not occur on the employer’s premises? (2) Why does the court mention that the knife assault
happened after the rape?

3.

It is difficult to imagine that a sexual assault could be anything other than some “purely and solely
personal” gratification, unrelated to the employer’s business. How did the court address this?

4.

What is the controlling rule of law as to the employer’s liability for intentional torts here?

5.

What does the court mean when it says, “the assault was perhaps at the outer bounds of respondeat
superior”?

6.

Would the jury think about who had the “deep pocket” here? Who did have it?

Employer’s Liability for Employee’s Intentional Torts: Scope of Employment
Cockrell v. Pearl River Valley Water Supply Dist.
865 So.2d 357 (Miss. 2004)
The Pearl River Valley Water Supply District (“District”) was granted summary judgment pursuant to the
Mississippi Tort Claims Act (MTCA) dismissing with prejudice all claims asserted against it by Sandra

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Cockrell. Cockrell appeals the ruling of the circuit court citing numerous errors. Finding the motion for
summary judgment was properly granted in favor of the District, this Court affirms the final judgment
entered by the Circuit Court of Rankin County.

Facts and Proceedings in the Trial Court
On June 28, 1998, Sandra Cockrell was arrested for suspicion of driving under the influence of alcohol by
Officer Joey James who was employed as a security patrol officer with the Reservoir Patrol of the Pearl
River Valley Water Supply District. Officer James then transported Cockrell to the Reservoir Patrol office
and administered an intoxilyzer test. The results of the test are not before us; however, we do know that
after the test was administered, Officer James apologized to Cockrell for arresting her, and he assured her
that he would prepare her paperwork so that she would not have to spend much time in jail. As they were
leaving the Reservoir Patrol office, Officer James began asking Cockrell personal questions such as where
she lived, whether she was dating anyone and if she had a boyfriend. Officer James then asked Cockrell
for her cell phone number so that he could call and check on her. As they were approaching his patrol car
for the trip to the Rankin County jail, Officer James informed Cockrell that she should be wearing
handcuffs; however, he did not handcuff Cockrell, and he allowed her to ride in the front seat of the patrol
car with him. In route to the jail, Cockrell became emotional and started crying. As she was fixing her
makeup using the mirror on the sun visor, Officer James pulled his patrol car into a church parking lot
and parked the car. He then pulled Cockrell towards him in an embrace and began stroking her back and
hair telling her that things would be fine. Cockrell told Officer James to release her, but he continued to
embrace her for approximately five minutes before continuing on to the jail.
On June 30, 1998, Cockrell returned to the Reservoir Patrol office to retrieve her driver’s license. Officer
James called Cockrell into his office and discussed her DUI charge with her. As she was leaving, Officer
James grabbed her from behind, turned her around, pinned both of her arms behind her and pulled her to
his chest. When Officer James bent down to kiss her, she ducked her head, thus causing Officer James to
instead kiss her forehead. When Officer James finally released Cockrell, she ran out of the door and drove
away. [Subsequently, Cockrell’s attorney threatened civil suit against Patrol; James was fired in October
1998.]

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On September 22, 1999, Cockrell filed a complaint for damages against the District alleging that on the
nights of June 28 and June 30, 1998, Officer James was acting within the course and scope of his
employment with the District and that he acted with reckless disregard for her emotional well-being and
safety.…On April 2, 2002, the District filed its motion for summary judgment alleging that there was no
genuine issue of material fact regarding Cockrell’s claim of liability. The motion alleged that the conduct
described by Cockrell was outside the course and scope of Officer James’s public employment as he was
intending to satisfy his lustful urges. Cockrell responded to the motion arguing that the misconduct did
occur in the course and scope of Officer James’s employment with the District and also that the
misconduct did not reach the level of a criminal offense such that the District could be found not liable
under the MTCA.
The trial court entered a final judgment granting the District’s motion for summary judgment and
dismissing the complaint with prejudice. The trial court found that the District could not be held liable
under the MTCA for the conduct of Officer James which was both criminal and outside the course and
scope of his employment. Cockrell…appeal[ed].

Discussion
Summary judgment is granted in cases where there is “no genuine issue as to any material fact and that
the moving party is entitled to a judgment as a matter of law.”…
Cockrell contends there is a genuine issue of material of fact regarding whether Officer James was acting
in the course and scope of his employment with the District during the incidents which occurred on the
nights of June 28 and June 30, 1998. Cockrell argues Officer James’s conduct, although inappropriate,
did not rise to the level of criminal conduct. Cockrell contends Officer James’s action of hugging Cockrell
was similar to an officer consoling a victim of a crime. Cockrell does admit that Officer James’s action of
kissing her is more difficult to view as within the course and scope of his employment…
The District argues that although Officer James acted within the course and scope of his duties when he
arrested Cockrell, his later conduct, which was intended to satisfy his lustful desires, was outside the
scope of his employment with it.…

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“Mississippi law provides that an activity must be in furtherance of the employer’s business to be within
the scope and course of employment.” [Citation] To be within the course and scope of employment, an
activity must carry out the employer’s purpose of the employment or be in furtherance of the employer’s
business. [Citations] Therefore, if an employee steps outside his employer’s business for some reason
which is not related to his employment, the relationship between the employee and the employer “is
temporarily suspended and this is so ‘no matter how short the time and the [employer] is not liable for
[the employee’s] acts during such time.’” “An employee’s personal unsanctioned recreational endeavors
are beyond the course and scope of his employment.” [Citation]
[In one case cited,] Officer Kerry Collins, a Jackson Police officer, was on duty when he came upon the
parked car of L.T., a minor, and her boyfriend, who were about to engage in sexual activity. [Citation]
Officer Collins instructed L.T. to take her boyfriend home, and he would follow her to make sure she
followed his orders. After L.T. dropped off her boyfriend, Officer Collins continued to follow her until he
pulled L.T. over. Officer Collins then instructed L.T. to follow him to his apartment or else he would
inform L.T.’s parents of her activities. L.T. followed Officer Collins to his apartment where they engaged
in sexual activity. Upon returning home, L.T. told her parents everything that had happened. L.T. and her
parents filed suit against Officer Collins, the City of Jackson and the Westwood Apartments, where Officer
Collins lived rent free in return for his services as a security guard.…The district court granted summary
judgment in favor of the City finding that Officer Collins acted outside the course and scope of his
employment with the Jackson Police Department. [Citation]
In [Citation] the plaintiff sued the Archdiocese of New Orleans for damages that allegedly resulted from
his sexual molestation by a Catholic priest. The Fifth Circuit found that the priest was not acting within
the course and scope of his employment. The Fifth Circuit held that “smoking marijuana and engaging in
sexual acts with minor boys” in no way furthered the interests of his employer.
The Southern District of Mississippi and the Fifth Circuit, applying Mississippi law, have held that sexual
misconduct falls outside the course and scope of employment. There is no question that Officer James was
within the course and scope of his employment when he first stopped Cockrell for suspicion of driving
under the influence of alcohol. However, when Officer James diverted from his employment for personal
reasons, he was no longer acting in the furtherance of his employer’s interests…Therefore, the District

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cannot be held liable…for the misconduct of Officer James which occurred outside the course and scope of
his employment.
Affirmed.

CASE QUESTIONS
1.

How can this case and Lyon v. Carey (Section 21.4.2 "Employer’s Liability for Employee’s Intentional Torts:
Scope of Employment") be reconciled? Both involve an agent’s unacceptable behavior—assault—but
in Lyon the agent’s actions were imputed to the principal, and in Cockrell the agent’s actions were not
imputed to the principal.

2.

What is the controlling rule of law governing the principal’s liability for the agent’s actions?

3.

The law governing the liability of principals for acts of their agents is well settled. Thus the cases turn on
the facts. Who decides what the facts are in a lawsuit?

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21.5 Summary and Exercises
Summary
A contract made by an agent on behalf of the principal legally binds the principal. Three types of authority
may bind the principal: (1) express authority—that which is actually given and spelled out, (2) implied
authority—that which may fairly be inferred from the parties’ relationship and which is incidental to the
agent’s express authority, and (3) apparent authority—that which reasonably appears to a third party
under the circumstances to have been given by the principal. Even in the absence of authority, a principal
may ratify the agent’s acts.
The principal may be liable for tortious acts of the agent but except under certain regulatory statutes may
not be held criminally liable for criminal acts of agents not prompted by the principal. Under the doctrine
of respondeat superior, a principal is generally liable for acts by a servant within the scope of employment.
A principal usually will not be held liable for acts of nonservant agents that cause physical damage,
although he will be held liable for nonphysical torts, such as misrepresentation. The principal will not be
held liable for tortious acts of independent contractors, although the principal may be liable for injuries
resulting from his failure to act in situations in which he was not legally permitted to delegate a duty to
act. Whenever an agent is acting to further the principal’s business interests, the principal will be held
vicariously liable for the agent’s intentional torts. What constitutes scope of employment is not easy to
determine; the modern trend is to hold a principal liable for the conduct of an agent if it was foreseeable
that the agent might act as he did.
Most states have special rules of vicarious liability for special situations; for example, liability of an
automobile owner for use by another. Spouses are not vicariously liable for each other, nor are parents for
children, except for failing to control children known to be dangerous.
In general, an agent is not personally liable on contracts he has signed on behalf of a principal. This
general rule has several exceptions recognized in most states: (1) when the agent is serving an undisclosed
or partially disclosed principal, (2) when the agent lacks authority or exceeds his authority, and (3) if the
agent entered into the contract in a personal capacity.

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The agency relationship may be terminated by mutual consent, by express agreement of the parties that
the agency will end at a certain time or on the occurrence of a certain event, or by an implied agreement
arising out of the circumstances in each case. The agency may also be unilaterally revoked by the
principal—unless the agency is coupled with an interest—or renounced by the agent. Finally, the agency
will terminate by operation of law under certain circumstances, such as death of the principal or agent.

EXERCISES
1.

Parke-Bernet Galleries, acting as agent for an undisclosed principal, sold a painting to Weisz. Weisz later
discovered that the painting was a forgery and sued Parke-Bernet for breach of contract. In defense,
Parke-Bernet argued that as a general rule, agents are not liable on contracts made for principals. Is this a
good defense? Explain.

2.

Lynch was the loan officer at First Bank. Patterson applied to borrow $25,000. Bank policy required that
Lynch obtain a loan guaranty from Patterson’s employer, a milk company. The manager of the milk
company visited the bank and signed a guaranty on behalf of the company. The last paragraph of the
guaranty stated, “This guaranty is signed by an officer having legal right to bind the company through
authorization of the Board of Directors.” Should Lynch be satisfied with this guaranty? Would he be
satisfied if the president of the milk company, who was also a director, affirmed that the manager had
authority to sign the guaranty? Explain.

3.

Ralph owned a retail meat market. Ralph’s agent Sam, without authority but purporting to act on Ralph’s
behalf, borrowed $7,500 from Ted. Although he never received the money, Ralph repaid $700 of the
alleged loan and promised to repay the rest. If Sam had no authority to make the loan, is Ralph liable?
Why?

4.

A guest arrived early one morning at the Hotel Ohio. Clemens, a person in the hotel office who appeared
to be in charge, walked behind the counter, registered the guest, gave him a key, and took him to his
room. The guest also checked valuables (a diamond pin and money) with Clemens, who signed a receipt
on behalf of the hotel. Clemens in fact was a roomer at the hotel, not an employee, and had no authority
to act on behalf of the hotel. When Clemens absconded with the valuables, the guest sued the hotel. Is
the hotel liable? Why?

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5.

A professional basketball player punched an opposing player in the face during the course of a game. The
opponent, who was seriously injured, sued the owner of the team for damages. A jury awarded the player
$222,000 [about $800,000 in 2010 dollars] for medical expenses, $200,000 [$700,000] for physical pain,
$275,000 [$963,000] for mental anguish, $1,000,000 [$3.5 million] for lost earnings, and $1,500,000 [$5.2
million] in punitive damages (which was $500,000 more than requested by the player). The jury also
awarded $50,000 [$150,000] to the player’s wife for loss of companionship. If we assume that the player
who threw the punch acted out of personal anger and had no intention to further the business, how
could the damage award against his principal be legally justified?

6.

A doctor in a University of Chicago hospital seriously assaulted a patient in an examining room. The
patient sued the hospital on the theory that the doctor was an agent or employee of the hospital and the
assault occurred within the hospital. Is the hospital liable for the acts of its agent? Why?

7.

Hector was employed by a machine shop. One day he made a delivery for his employer and proceeded
back to the shop. When he was four miles from the shop and on the road where it was located, he turned
left onto another road to visit a friend. The friend lived five miles off the turnoff. On the way to the
friend’s house, Hector caused an accident. The injured person sued Hector’s employer. Is the employer
liable? Discuss.

8.

A fourteen-year-old boy, who had no driver’s license, took his parents’ car without permission and caused
an automobile accident. A person injured in the accident sued the boy’s parents under the relevant
state’s Parental Responsibility Law (mentioned in Section 21.2.1 "Principal’s Tort Liability"). Are the
parents liable? Discuss.

9.

In the past decades the Catholic Church has paid out hundreds of millions of dollars in damage awards to
people—mostly men—who claimed that when they were boys and teenagers they were sexually abused
by their local parish priests, often on Church premises. That is, the men claimed they had been victims of
child rape. Obviously, such behavior is antithetical to any reasonable standard of clergy behavior: the
priests could not have been in the scope of employment. How is the Church liable?

SELF-TEST QUESTIONS
1.

Authority that legally may bind the principal includes

a.

implied authority

b.

express authority

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c.

apparent authority

d.

all of the above
As a general rule, a principal is not

a.

liable for tortious acts of an agent, even when the principal is negligent

b.

liable for acts of a servant within the scope of employment

c.

criminally liable for acts of the agent

d.

liable for nondelegable duties performed by independent contractors
An agent may be held personally liable on contracts signed on behalf of a principal when

a.

the agent is serving an undisclosed or partially disclosed principal

b.

the agent exceeds his authority

c.

the agent entered into the contract in a personal capacity

d.

all of the above are true
An agency relationship may be terminated by

a.

an implied agreement arising out of the circumstances

b.

mutual consent of parties

c.

death of the principal or agent

d.

all of the above
The principal’s liability for the agent’s acts of which the principal had no knowledge or intention
to commit is called

a.

contract liability

b.

implied liability

c.

respondeat superior

d.

all of the above

SELF-TEST ANSWERS
1.

d

2.

c

3.

d

4.

c

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5.

b

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Chapter 22

Partnerships: General Characteristics and Formation
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

The importance of partnership and the present status of partnership law

2.

The extent to which a partnership is an entity

3.

The tests that determine whether a partnership exists

4.

Partnership by estoppel

5.

Partnership formation

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22.1 Introduction to Partnerships and Entity Theory
LEARNING OBJECTIVES
1.

Describe the importance of partnership.

2.

Understand partnership history.

3.

Identify the entity characteristics of partnerships.

Importance of Partnership Law
It would be difficult to conceive of a complex society that did not operate its businesses through
organizations. In this chapter we study partnerships, limited partnerships, and limited liability
companies, and we touch on joint ventures and business trusts.
When two or more people form their own business or professional practice, they usually consider
becoming partners. Partnership law defines a partnership as “the association of two or more persons to
carry on as co-owners a business for profit…whether or not the persons intend to form a
partnership.”

[1]

In 2011, there were more than three million business firms in the United States as

partnerships (see Table 22.1 "Selected Data: Number of US Partnerships, Limited Partnerships, and
Limited Liability Companies", showing data to 2006), and partnerships are a common form of
organization among accountants, lawyers, doctors, and other professionals. When we use the
word partnership, we are referring to the general business partnership. There are also limited
partnerships and limited liability partnerships, which are discussed in Chapter 24 "Hybrid Business
Forms".
Table 22.1 Selected Data: Number of US Partnerships, Limited Partnerships, and Limited Liability
Companies

2003

2004

2005

2006

Total number of active partnerships

2,375,375

2,546,877

2,763,625

2,947,116

Number of partners

14,108,458 15,556,553 16,211,908 16,727,803

Number of limited partnerships

378,921

402,238

413,712

432,550

Number of partners

6,262,103

7,023,921

6,946,986

6,738,737

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2003

2004

2005

2006

Number of limited liability companies 1,091,502

1,270,236

1,465,223

1,630,161

Number of partners

4,949,808

5,640,146

6,361,958

4,226,099

Source: IRS, http://www.irs.gov/pub/irs-soi/09sprbul.pdf.
Partnerships are also popular as investment vehicles. Partnership law and tax law permit an investor to
put capital into a limited partnership and realize tax benefits without liability for the acts of the general
partners.
Even if you do not plan to work within a partnership, it can be important to understand the law that
governs it. Why? Because it is possible to become someone’s partner without intending to or even
realizing that a partnership has been created. Knowledge of the law can help you avoid partnership
liability.

History of Partnership Law
Through the Twentieth Century
Partnership is an ancient form of business enterprise, and special laws governing partnerships date as far
back as 2300 BC, when the Code of Hammurabi explicitly regulated the relations between partners.
Partnership was an important part of Roman law, and it played a significant role in the law merchant, the
international commercial law of the Middle Ages.
In the nineteenth century, in both England and the United States, partnership was a popular vehicle for
business enterprise. But the law governing it was jumbled. Common-law principles were mixed with
equitable standards, and the result was considerable confusion. Parliament moved to reduce the
uncertainty by adopting the Partnership Act of 1890, but codification took longer in the United States. The
Commissioners on Uniform State Laws undertook the task at the turn of the twentieth century. The
Uniform Partnership Act (UPA), completed in 1914, and the Uniform Limited Partnership Act (ULPA),
completed in 1916, were the basis of partnership law for many decades. UPA and ULPA were adopted by
all states except Louisiana.

The Current State of Partnership Law
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Despite its name, UPA was not enacted uniformly among the states; moreover, it had some shortcomings.
So the states tinkered with it, and by the 1980s, the National Conference of Commissioners on Uniform
Laws (NCCUL) determined that a revised version was in order. An amended UPA appeared in 1992, and
further amendments were promulgated in 1993, 1994, 1996, and 1997. The NCCUL reports that thirtynine states have adopted some version of the revised act. This chapter will discuss the Revised Uniform
Partnership Act (RUPA) as promulgated in 1997, but because not all jurisdictions have not adopted it,
where RUPA makes significant changes, the original 1914 UPA will also be considered.

[2]

The NCCUL

observes in its “prefatory note” to the 1997 act: “The Revised Act is largely a series of ‘default rules’ that
govern the relations among partners in situations they have not addressed in a partnership agreement.
The primary focus of RUPA is the small, often informal, partnership. Larger partnerships generally have a
partnership agreement addressing, and often modifying, many of the provisions of the partnership act.”

[3]

Entity Theory
Meaning of “Legal Entity”
A significant difference between a partnership and most other kinds of business organization relates to
whether, and the extent to which, the business is a legal entity. A legal entity is a person or group that the
law recognizes as having legal rights, such as the right to own and dispose of property, to sue and be sued,
and to enter into contracts; the entity theory is the concept of a business firm as a legal person, with
existence and accountability separate from its owners. When individuals carry out a common enterprise
as partners, a threshold legal question is whether the partnership is a legal entity. The common law said
no. In other words, under the common-law theory, a partnership was but a convenient name for an
aggregate of individuals, and the rights and duties recognized and imposed by law are those of the
individual partners. By contrast, the mercantile theory of the law merchant held that a partnership is a
legal entity that can have rights and duties independent of those of its members.
During the drafting of the 1914 UPA, a debate raged over which theory to adopt. The drafters resolved the
debate through a compromise. In Section 6(1), UPA provides a neutral definition of partnership (“an
association of two or more persons to carry on as co-owners a business for profit”) and retained the
common-law theory that a partnership is an aggregation of individuals—theaggregate theory.

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RUPA moved more toward making partnerships entities. According to the NCCUL, “The Revised Act
enhances the entity treatment of partnerships to achieve simplicity for state law purposes, particularly in
matters concerning title to partnership property. RUPA does not, however, relentlessly apply the entity
approach. The aggregate approach is retained for some purposes, such as partners’ joint and several
liability.”

[4]

Section 201(a) provides, “A partnership is an entity distinct from its partners.”

[5]

Entity Characteristics of a Partnership
Under RUPA, then, a partnership has entity characteristics, but the partners remain guarantors of
partnership obligations, as always—that is the partners’ joint and several liability noted in the previous
paragraph (and discussed further in Chapter 23 "Partnership Operation and Termination"). This is a very
important point and a primary weakness of the partnership form: all partners are, and each one of them
is, ultimately personally liable for the obligations of the partnership, without limit, which includes
personal and unlimited liability. This personal liability is very distasteful, and it has been abolished,
subject to some exceptions, with limited partnerships and limited liability companies, as discussed
in Chapter 24 "Hybrid Business Forms". And, of course, the owners of corporations are also not generally
liable for the corporation’s obligations, which is a major reason for the corporate form’s popularity.

For Accounting Purposes
Under both versions of the law, the partnership may keep business records as if it were a separate entity,
and its accountants may treat it as such for purposes of preparing income statements and balance sheets.

For Purposes of Taxation
Under both versions of the law, partnerships are not taxable entities, so they do not pay income taxes.
Instead, each partner’s distributive share, which includes income or other gain, loss, deductions, and
credits, must be included in the partner’s personal income tax return, whether or not the share is actually
distributed.

For Purposes of Litigation

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In litigation, the aggregate theory causes some inconvenience in naming and serving partnership
defendants: under UPA, lawsuits to enforce a partnership contract or some other right must be filed in the
name of all the partners. Similarly, to sue a partnership, the plaintiff must name and sue each of the
partners. This cumbersome procedure was modified in many states, which enacted special statutes
expressly permitting suits by and against partnerships in the firm name. In suits on a claim in federal
court, a partnership may sue and be sued in its common name. The move by RUPA to make partnerships
entities changed very little. Certainly it provides that “a partnership may sue and be sued in the name of
the partnership”—that’s handy where the plaintiff hopes for a judgment against the partnership, without
recourse to the individual partners’ personal assets.

[6]

But a plaintiff must still name the partnership and

the partners individually to have access to both estates, the partnership and the individuals’: “A judgment
against a partnership is not by itself a judgment against a partner. A judgment against a partnership may
not be satisfied from a partner’s assets unless there is also a judgment against the partner.”

[7]

For Purposes of Owning Real Estate
Aggregate theory concepts bedeviled property co-ownership issues, so UPA finessed the issue by stating
that partnership property, real or personal, could be held in the name of the partners as “tenants in
partnership”—a type of co-ownership—or it could be held in the name of the partnership.

[8]

Under RUPA,

“property acquired by the partnership is property of the partnership and not of the partners.”

[9]

But RUPA

is no different from UPA in practical effect. The latter provides that “property originally brought into the
partnership stock or subsequently acquired by purchase…on account of the partnership, is partnership
property.”

[10]

Under either law, a partner may bring onto the partnership premises her own property, not

acquired in the name of the partnership or with its credit, and it remains her separate property. Under
neither law can a partner unilaterally dispose of partnership property, however labeled, for the obvious
reason that one cannot dispose of another’s property or property rights without permission.

[11]

And keep

in mind that partnership law is the default: partners are free to make up partnership agreements as they
like, subject to some limitations. They are free to set up property ownership rules as they like.

For Purposes of Bankruptcy

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Under federal bankruptcy law—state partnership law is preempted—a partnership is an entity that may
voluntarily seek the haven of a bankruptcy court or that may involuntarily be thrust into a bankruptcy
proceeding by its creditors. The partnership cannot discharge its debts in a liquidation proceeding under
Chapter 7 of the bankruptcy law, but it can be rehabilitated under Chapter 11 (see Chapter 35
"Bankruptcy").

KEY TAKEAWAY
Partnership law is very important because it is the way most small businesses are organized and because it is
possible for a person to become a partner without intending to. Partnership law goes back a long way, but in
the United States, most states—but not all—have adopted the Revised Uniform Partnership Act (RUPA, 1997)
over the previous Uniform Partnership Act, originally promulgated in 1914. One salient change made by RUPA
is to directly announce that a partnership is an entity: it is like a person for purposes of accounting, litigation,
bankruptcy, and owning real estate. Partnerships do not pay taxes; the individual partners do. But in practical
terms, what RUPA does is codify already-existing state law on these matters, and partners are free to organize
their relationship as they like in the partnership agreement.

EXERCISES
1.

When was UPA set out for states to adopt? When was RUPA promulgated for state adoption?

2.

What does it mean to say that the partnership act is the “default position”? For what types of partnership
is UPA (or RUPA) likely to be of most importance?

3.

What is the aggregate theory of partnership? The entity theory?

[1] Revised Uniform Partnership Act, Section 202(a).
[2] NCCUSL, Uniform Law Commission, “Acts: Partnership
Act,”http://www.nccusl.org/Act.aspx?title=Partnership%20Act. The following states haveadopted the RUPA:
Alabama, Alaska, Arizona, Arkansas, California, Colorado, Delaware, District of Columbia, Florida, Hawaii, Idaho,
Illinois, Iowa, Kansas, Kentucky, Maine, Maryland, Minnesota, Mississippi, Montana, Nebraska, Nevada, New
Jersey, New Mexico, North Dakota, Oklahoma, Oregon, Puerto Rico, South Dakota (substantially similar),
Tennessee, Texas (substantially similar), US Virgin Islands, Vermont, Virginia, and Washington. Connecticut, West
Virginia, and Wyoming adopted the 1992 or 1994 version. Here are the states that have not adopted RUPA

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(Louisiana never adopted UPA at all): Georgia, Indiana, Massachusetts, Michigan, Mississippi, New Hampshire,
New York, North Carolina, Ohio, Pennsylvania, Rhode Island, and Wisconsin.
[3] University of Pennsylvania Law School, Biddle Law Library, “Uniform Partnership Act (1997),” NCCUSL
Archives,http://www.law.upenn.edu/bll/archives/ulc/fnact99/1990s/upa97fa.pdf.
[4] University of Pennsylvania Law School, Biddle Law Library, “Uniform Partnership Act (1997),” NCCUSL
Archives,http://www.law.upenn.edu/bll/archives/ulc/fnact99/1990s/upa97fa.pdf.
[5] RUPA, Section 201(a).
[6] RUPA, Section 307(a).
[7] RUPA, Section 307(c).
[8] Uniform Partnership Act, Section 25(1); UPA, Section 8(3).
[9] RUPA, Section 203.
[10] UPA, Section 8(1).
[11] UPA, Sections 9(3)(a) and 25; RUPA, Section 302.

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22.2 Partnership Formation
LEARNING OBJECTIVES
1.

Describe the creation of an express partnership.

2.

Describe the creation of an implied partnership.

3.

Identify tests of partnership existence.

4.

Understand partnership by estoppel.

Creation of an Express Partnership
Creation in General
The most common way of forming a partnership is expressly—that is, in words, orally or in writing. Such a
partnership is called an express partnership. If parties have an express partnership with no partnership
agreement, the relevant law—the Uniform Partnership Act (UPA) or the Revised Uniform Partnership Act
(RUPA)—applies the governing rules.
Assume that three persons have decided to form a partnership to run a car dealership. Able contributes
$250,000. Baker contributes the building and space in which the business will operate. Carr contributes
his services; he will manage the dealership.
The first question is whether Able, Baker, and Carr must have a partnership agreement. As should be clear
from the foregoing discussion, no agreement is necessary as long as the tests of partnership are met.
However, they ought to have an agreement in order to spell out their rights and duties among themselves.
The agreement itself is a contract and should follow the principles and rules spelled out in Chapter 8
"Introduction to Contract Law" through Chapter 16 "Remedies" of this book. Because it is intended to
govern the relations of the partners toward themselves and their business, every partnership contract
should set forth clearly the following terms: (1) the name under which the partners will do business; (2)
the names of the partners; (3) the nature, scope, and location of the business; (4) the capital contributions
of each partner; (5) how profits and losses are to be divided; (6) how salaries, if any, are to be determined;
(7) the responsibilities of each partner for managing the business; (8) limitations on the power of each
partner to bind the firm; (9) the method by which a given partner may withdraw from the partnership;

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(10) continuation of the firm in the event of a partner’s death and the formula for paying a partnership
interest to his heirs; and (11) method of dissolution.

Specific Issues of Concern
In forming a partnership, three of these items merit special attention. And note again that if the parties do
not provide for these in their agreement, RUPA will do it for them as the default.

Who Can Be a Partner?
As discussed earlier in this chapter, a partnership is not limited to a direct association between human
beings but may also include an association between other entities, such as corporations or even
partnerships themselves.

[1]

Family members can be partners, and partnerships between parents and

minor children are lawful, although a partner who is a minor may disaffirm the agreement.

Written versus Oral Agreements
If the business cannot be performed within one year from the time that the agreement is entered into, the
partnership agreement should be in writing to avoid invalidation under the Statute of Frauds. Most
partnerships have no fixed term, however, and are partnerships “at will” and therefore not covered by the
Statute of Frauds.

Validity of the Partnership Name
Able, Baker, and Carr decide that it makes good business sense to choose an imposing, catchy, and wellknown name for their dealership—General Motors Corporation. There are two reasons why they cannot
do so. First, their business is a partnership, not a corporation, and should not be described as one.
Second, the name is deceptive because it is the name of an existing business. Furthermore, if not
registered, the name would violate the assumed or fictitious name statutes of most states. These require
that anyone doing business under a name other than his real name register the name, together with the
names and addresses of the proprietors, in some public office. (Often, the statutes require the proprietors
to publish this information in the newspapers when the business is started.) As Loomis v.

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Whitehead in Section 22.3.2 "Creation of a Partnership: Registering the Name" shows, if a business fails
to comply with the statute, it could find that it will be unable to file suit to enforce its contracts.

Creation of Implied Partnership
An implied partnership exists when in fact there are two or more persons carrying on a business as coowners for profit. For example, Carlos decides to paint houses during his summer break. He gathers some
materials and gets several jobs. He hires Wally as a helper. Wally is very good, and pretty soon both of
them are deciding what jobs to do and how much to charge, and they are splitting the profits. They have
an implied partnership, without intending to create a partnership at all.

Tests of Partnership Existence
But how do we know whether an implied partnership has been created? Obviously, we know if there is an
express agreement. But partnerships can come into existence quite informally, indeed, without any
formality—they can be created accidentally. In contrast to the corporation, which is the creature of
statute, partnership is a catchall term for a large variety of working relationships, and frequently,
uncertainties arise about whether or not a particular relationship is that of partnership. The law can
reduce the uncertainty in advance only at the price of severely restricting the flexibility of people to
associate. As the chief drafter of the Uniform Partnership Act (UPA, 1914) explained,
All other business associations are statutory in origin. They are formed by the happening of an event
designated in a statute as necessary to their formation. In corporations this act may be the issuing of a
charter by the proper officer of the state; in limited partnerships, the filing by the associates of a specified
document in a public office. On the other hand, an infinite number of combinations of circumstances may
result in co-ownership of a business. Partnership is the residuum, including all forms of co-ownership, of
a business except those business associations organized under a specific statute.

[2]

Figure 22.1 Partnership Tests

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Because it is frequently important to know whether a partnership exists (as when a creditor has dealt with
only one party but wishes to also hold others liable by claiming they were partners, see Section 22.3.1
"Tests of Partnership Existence", Chaiken v. Employment Security Commission), a number of tests have
been established that are clues to the existence of a partnership (see Figure 22.1 "Partnership Tests"). We
return to the definition of a partnership: “the association of two or more persons to carry on as co-owners
a business for profit[.]” The three elements are (1) the association of persons, (2) as co-owners, (3) for
profit.

Association of Persons
This element is pretty obvious. A partnership is a contractual agreement among persons, so the persons
involved need to have capacity to contract. But RUPA does not provide that only natural persons can be
partners; it defines person as follows: “‘Person’ means an individual, corporation, business trust, estate,
trust, partnership, association, joint venture, government, governmental subdivision, agency, or
instrumentality, or any other legal or commercial entity.”

[3]

Thus unless state law precludes it, a

corporation can be a partner in a partnership. The same is true under UPA.

Co-owners of a Business
If what two or more people own is clearly a business—including capital assets, contracts with employees
or agents, an income stream, and debts incurred on behalf of the operation—a partnership exists. A
tougher question arises when two or more persons co-own property. Do they automatically become

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partners? The answer can be important: if one of the owners while doing business pertinent to the
property injures a stranger, the latter could sue the other owners if there is a partnership.
Co-ownership comes in many guises. The four most common are joint tenancy, tenancy in common,
tenancy by the entireties, and community property. In joint tenancy, the owners hold the property under a
single instrument, such as a deed, and if one dies, the others automatically become owners of the
deceased’s share, which does not descend to his heirs. Tenancy in common has the reverse rule: the
survivor tenants do not take the deceased’s share. Each tenant in common has a distinct estate in the
property. The tenancy by the entirety and community property (in community-property states) forms of
ownership are limited to spouses, and their effects are similar to that of joint tenancy.
Suppose a husband and wife who own their home as tenants by the entirety (or community property)
decide to spend the summer at the seashore and rent their home for three months. Is their co-ownership
sufficient to establish that they are partners? The answer is no. By UPA Section 7(2) and RUPA Section
202(b)(1), the various forms of joint ownership by themselves do not establish partnership, whether or
not the co-owners share profits made by the use of the property. To establish a partnership, the ownership
must be of a business, not merely of property.

Sharing of Profits
There are two aspects to consider with regard to profits: first, whether the business is for-profit, and
second, whether there is a sharing of the profit.

Business for Profit
Unincorporated nonprofit organizations (UNAs) cannot be partnerships. The paucity of coherent law
governing these organizations gave rise in 2005 to the National Conference of Commissioners of Uniform
Laws’ promulgation of the Revised Uniform Unincorporated Nonprofit Association Act (RUUNAA). The
prefatory note to this act says, “RUUNAA was drafted with small informal associations in mind. These
informal organizations are likely to have no legal advice and so fail to consider legal and organizational
questions, including whether to incorporate. The act provides better answers than the common law for a
limited number of legal problems…There are probably hundreds of thousands of UNAs in the United

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States including unincorporated nonprofit philanthropic, educational, scientific and literary clubs,
sporting organizations, unions, trade associations, political organizations, churches, hospitals, and
condominium and neighborhood associations.”

[4]

At least twelve states have adopted RUUNAA or its

predecessor.

Sharing the Profit
While co-ownership does not establish a partnership unless there is a business, a business by itself is not a
partnership unless co-ownership is present. Of the tests used by courts to determine co-ownership,
perhaps the most important is sharing of profits. Section 202(c) of RUPA provides that “a person who
receives a share of the profits of a business is presumed to be a partner in the business,” but this
presumption can be rebutted by showing that the share of the profits paid out was (1) to repay a debt; (2)
wages or compensation to an independent contractor; (3) rent; (4) an annuity, retirement, or health
benefit to a representative of a deceased or retired partner; (5) interest on a loan, or rights to income,
proceeds, or increase in value from collateral; or (5) for the sale of the goodwill of a business or other
property. Section 7(4) of UPA is to the same effect.

Other Factors
Courts are not limited to the profit-sharing test; they also look at these factors, among others: the right to
participate in decision making, the duty to share liabilities, and the manner in which the business is
operated. Section 22.3.1 "Tests of Partnership Existence", Chaiken v. Employment Security Commission,
illustrates how these factors are weighed in court.

Creation of Partnership by Estoppel
Ordinarily, if two people are not legally partners, then third parties cannot so regard them. For example,
Mr. Tot and Mr. Tut own equal shares of a house that they rent but do not regard it as a business and are
not in fact partners. They do have a loose “understanding” that since Mr. Tot is mechanically adept, he
will make necessary repairs whenever the tenants call. On his way to the house one day to fix its boiler,
Mr. Tot injures a pedestrian, who sues both Mr. Tot and Mr. Tut. Since they are not partners, the
pedestrian cannot sue them as if they were; hence Mr. Tut has no partnership liability.

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Suppose that Mr. Tot and Mr. Tut happened to go to a lumberyard together to purchase materials that Mr.
Tot intended to use to add a room to the house. Short of cash, Mr. Tot looks around and espies Mr. Tat,
who greets his two friends heartily by saying within earshot of the salesman who is debating whether to
extend credit, “Well, how are my two partners this morning?” Messrs. Tot and Tut say nothing but smile
faintly at the salesman, who mistakenly but reasonably believes that the two are acknowledging the
partnership. The salesman knows Mr. Tat well and assumes that since Mr. Tat is rich, extending credit to
the “partnership” is a “sure thing.” Messrs. Tot and Tut fail to pay. The lumberyard is entitled to collect
from Mr. Tat, even though he may have forgotten completely about the incident by the time suit is filed.
Under Uniform Partnership Act Section 16(1), Mr. Tat would be liable for the debt as being part of
a partnership by estoppel. The Revised Uniform Partnership Act is to the same effect:
Section 308. Liability of Purported Partner.
(a) If a person, by words or conduct, purports to be a partner, or consents to being represented by another
as a partner, in a partnership or with one or more persons not partners, the purported partner is liable to
a person to whom the representation is made, if that person, relying on the representation, enters into a
transaction with the actual or purported partnership.
Partnership by estoppel has two elements: (1) a representation to a third party that there is in fact a
partnership and (2) reliance by the third party on the representation. See Section 22.3.3 "Partnership by
Estoppel", Chavers v. Epsco, Inc., for an example of partnership by estoppel.

KEY TAKEAWAY
A partnership is any two or more persons—including corporate persons—carrying on a business as co-owners
for profit. A primary test of whether a partnership exists is whether there is a sharing of profits, though other
factors such as sharing decision making, sharing liabilities, and how the business is operated are also
examined.
Most partnerships are expressly created. Several factors become important in the partnership agreement,
whether written or oral. These include the name of the business, the capital contributions of each partner,
profit sharing, and decision making. But a partnership can also arise by implication or by estoppel, where one
has held herself as a partner and another has relied on that representation.

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EXERCISES
1.

Why is it necessary—or at least useful—to have tests to determine whether a partnership exists?

2.

What elements of the business organization are examined to make this determination?

3.

Jacob rents farmland from Davis and pays Davis a part of the profits from the crop in rent. Is Davis a
partner? What if Davis offers suggestions on what to plant and when? Now is he a partner?

4.

What elements should be included in a written partnership agreement?

5.

What is an implied partnership?

6.

What is a partnership by estoppel, and why are its “partners” estopped to deny its existence?

[1] A joint venture—sometimes known as a joint adventure, coadventure, joint enterprise, joint undertaking,
syndicate, group, or pool—is an association of persons to carry on a particular task until completed. In essence, a
joint venture is a “temporary partnership.” In the United States, the use of joint ventures began with the railroads
in the late 1800s. Throughout the middle part of the twentieth century joint ventures were common in the
manufacturing sector. By the late 1980s, they increasingly appeared in both manufacturing and service industries
as businesses looked for new, competitive strategies. They are aggressively promoted on the Internet: “Joint
Ventures are in, and if you’re not utilizing this strategic weapon, chances are your competition is, or will soon be,
using this to their advantage.…possibly against you!” (Scott Allen, “Joint Venturing 101,” About.com
Entrepreneurs,http://entrepreneurs.about.com/od/beyondstartup/a/jointventures.htm).As a risk-avoiding device,
the joint venture allows two or more firms to pool their differing expertise so that neither needs to “learn the
ropes” from the beginning; neither needs the entire capital to start the enterprise.Partnership rules generally
apply, although the relationship of the joint venturers is closer to that of special than general agency as discussed
in Chapter 20 "Relationships between Principal and Agent". Joint venturers are fiduciaries toward one another.
Although no formality is necessary, the associates will usually sign an agreement. The joint venture need have no
group name, though it may have one. Property may be owned jointly. Profits and losses will be shared, as in a
partnership, and each associate has the right to participate in management. Liability is unlimited.Sometimes two
or more businesses will form a joint venture to carry out a specific task—prospecting for oil, building a nuclear
reactor, doing basic scientific research—and will incorporate the joint venture. In that case, the resulting
business—known as a “joint venture corporation”—is governed by corporation law, not the law of partnership,
and is not a joint venture in the sense described here. Increasingly, companies are forming joint ventures to do

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business abroad; foreign investors or governments own significant interests in these joint ventures. For example,
in 1984 General Motors entered into a joint venture with Toyota to revive GM’s shuttered Fremont, California,
assembly plant to create New United Motor Manufacturing, Inc. (NUMMI). For GM the joint venture was an
opportunity to learn about lean manufacturing from the Japanese company, while Toyota gained its first
manufacturing base in North America and a chance to test its production system in an American labor
environment. Until May 2010, when the copartnership ended and the plant closed, NUMMI built an average of six
thousand vehicles a week, or nearly eight million cars and trucks. These vehicles were the Chevrolet Nova (1984–
88), the Geo Prizm (1989–97), the Chevrolet Prizm (1998–2002), and the Hilux (1991–95, predecessor of the
Tacoma), as well as the Toyota Voltz, the Japanese right-hand-drive version of the Pontiac Vibe. The latter two
were based on the Toyota Matrix. Paul Stenquist, “GM and Toyota’s Joint Venture Ends in California,” New York
Times, April 2, 2010,http://wheels.blogs.nytimes.com/2010/04/02/g-m-and-toyotas-joint-venture-ends-incalifornia.
[2] W. D. Lewis, “The Uniform Partnership Act,” Yale Law Journal 24 (1915): 617, 622.
[3] RUPA, Section 101(10).
[4] Revised Uniform Unincorporated Nonprofit Associations
Act,http://www.abanet.org/intlaw/leadership/policy/RUUNAA_Final_08.pdf.

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22.3 Cases
Tests of Partnership Existence
Chaiken v. Employment Security Commission
274 A.2d 707 (Del. 1971)
STOREY, J.
The Employment Security Commission, hereinafter referred to as the Commission, levied an involuntary
assessment against Richard K. Chaiken, complainant, hereinafter referred to as Chaiken, for not filing his
unemployment security assessment report. Pursuant to the same statutory section, a hearing was held
and a determination made by the Commission that Chaiken was the employer of two barbers in his barber
shop and that he should be assessed as an employer for his share of unemployment compensation
contributions. Chaiken appealed the Commission’s decision.…
Both in the administrative hearing and in his appeal brief Chaiken argues that he had entered into
partnership agreements with each of his barbers and, therefore, was and is not subject to unemployment
compensation assessment. The burden is upon the individual assessed to show that he is outside the
ambit of the statutory sections requiring assessment. If Chaiken’s partnership argument fails he has no
secondary position and he fails to meet his burden.
Chaiken contends that he and his “partners”:
1.

properly registered the partnership name and names of partners in the prothonotary’s office, in
accordance with [the relevant statute],

[1]

2. properly filed federal partnership information returns and paid federal taxes quarterly on an
estimated basis, and
3. duly executed partnership agreements.
Of the three factors, the last is most important. Agreements of “partnership” were executed between
Chaiken and Mr. Strazella, a barber in the shop, and between Chaiken and Mr. Spitzer, similarly situated.
The agreements were nearly identical. The first paragraph declared the creation of a partnership and the

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location of business. The second provided that Chaiken would provide barber chair, supplies, and licenses,
while the other partner would provide tools of the trade. The paragraph also declared that upon
dissolution of the partnership, ownership of items would revert to the party providing them. The third
paragraph declared that the income of the partnership would be divided 30% for Chaiken, 70% for
Strazella; 20% for Chaiken and 80% for Spitzer. The fourth paragraph declared that all partnership policy
would be decided by Chaiken, whose decision was final. The fifth paragraph forbade assignment of the
agreement without permission of Chaiken. The sixth paragraph required Chaiken to hold and distribute
all receipts. The final paragraph stated hours of work for Strazella and Spitzer and holidays.
The mere existence of an agreement labeled “partnership” agreement and the characterization of
signatories as “partners” docs not conclusively prove the existence of a partnership. Rather, the intention
of the parties, as explained by the wording of the agreement, is paramount.
A partnership is defined as an association of two or more persons to carry on as co-owners a business for
profit. As co-owners of a business, partners have an equal right in the decision making process. But this
right may be abrogated by agreement of the parties without destroying the partnership concept, provided
other partnership elements are present.
Thus, while paragraph four reserves for Chaiken all right to determine partnership policy, it is not
standing alone, fatal to the partnership concept. Co-owners should also contribute valuable consideration
for the creation of the business. Under paragraph two, however, Chaiken provides the barber chair (and
implicitly the barber shop itself), mirror, licenses and linen, while the other partners merely provide their
tools and labor—nothing more than any barber-employee would furnish. Standing alone, however, mere
contribution of work and skill can be valuable consideration for a partnership agreement.
Partnership interests may be assignable, although it is not a violation of partnership law to prohibit
assignment in a partnership agreement. Therefore, paragraph five on assignment of partnership interests
does not violate the partnership concept. On the other hand, distribution of partnership assets to the
partners upon dissolution is only allowed after all partnership liabilities are satisfied. But paragraph two
of the agreement, in stating the ground rules for dissolution, makes no declaration that the partnership
assets will be utilized to pay partnership expenses before reversion to their original owners. This

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deficiency militates against a finding in favor of partnership intent since it is assumed Chaiken would have
inserted such provision had he thought his lesser partners would accept such liability. Partners do accept
such liability, employees do not.
Most importantly, co-owners carry on “a business for profit.” The phrase has been interpreted to mean
that partners share in the profits and the losses of the business. The intent to divide the profits is an
indispensable requisite of partnership. Paragraph three of the agreement declares that each partner shall
share in the income of the business. There is no sharing of the profits, and as the agreement is drafted,
there are no profits. Merely sharing the gross returns does not establish a partnership. Nor is the sharing
of profits prima facie evidence of a partnership where the profits received are in payment of wages.
The failure to share profits, therefore, is fatal to the partnership concept here.
Evaluating Chaiken’s agreement in light of the elements implicit in a partnership, no partnership intent
can be found. The absence of the important right of decision making or the important duty to share
liabilities upon dissolution individually may not be fatal to a partnership. But when both are absent,
coupled with the absence of profit sharing, they become strong factors in discrediting the partnership
argument. Such weighing of the elements against a partnership finding compares favorably with Fenwick
v. Unemployment Compensation Commission, which decided against the partnership theory on similar
facts, including the filing of partnership income tax forms.
In addition, the total circumstances of the case taken together indicate the employer-employee
relationship between Chaiken and his barbers. The agreement set forth the hours of work and days off—
unusual subjects for partnership agreements. The barbers brought into the relationship only the
equipment required of all barber shop operators. And each barber had his own individual “partnership”
with Chaiken. Furthermore, Chaiken conducted all transactions with suppliers, and purchased licenses,
insurance, and the lease for the business property in his own name. Finally, the name “Richard’s Barber
Shop” continued to be used after the execution of the so-called partnership agreements. [The
Commission’s decision is affirmed.]

CASE QUESTIONS
1.

Why did the unemployment board sue Chaiken?

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2.

Why did Chaiken set up this “partnership”?

3.

What factors did the court examine to determine whether there was a partnership here? Which one was
the most important?

4.

Why would it be unusual in a partnership agreement to set forth the hours of work and days off?

Creation of a Partnership: Registering the Name
Loomis v. Whitehead
183 P.3d 890 (Nev. 2008)
Per Curiam.
In this appeal, we address whether [Nevada Revised Statute] NRS 602.070 bars the partners of an
unregistered fictitious name partnership from bringing an action arising out of a business agreement that
was not made under the fictitious name. [The statute] prohibits persons who fail to file an assumed or
fictitious name certificate from suing on any contract or agreement made under the assumed or fictitious
name. We conclude that it does not bar the partners from bringing the action so long as the partners did
not conduct the business or enter into an agreement under the fictitious name or otherwise mislead the
other party into thinking that he was doing business with some entity other than the partners themselves.

Background Facts
Appellants Leroy Loomis and David R. Shanahan raised and sold cattle in Elko County, Nevada. Each of
the appellants had certain responsibilities relating to the cattle business. Loomis supplied the livestock
and paid expenses, while Shanahan managed the day-to-day care of the cattle. Once the cattle were
readied for market and sold, Loomis and Shanahan would share the profits equally. While Loomis and
Shanahan often called themselves the 52 Cattle Company, they had no formal partnership agreement and
did not file an assumed or fictitious name certificate in that name. Loomis and Shanahan bring this appeal
after an agreement entered into with respondent Jerry Carr Whitehead failed.
In the fall of 2003, Shanahan entered into a verbal agreement with Whitehead, a rancher, through
Whitehead’s ranch foreman to have their cattle wintered at Whitehead’s ranch. Neither Loomis nor

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Whitehead was present when the ranch foreman made the deal with Shanahan, but the parties agree that
there was no mention of the 52 Cattle Company at the time they entered into the agreement or anytime
during the course of business thereafter. Shanahan and Loomis subsequently alleged that their cattle were
malnourished and that a number of their cattle died from starvation that winter at Whitehead’s ranch.
Whitehead denied these allegations.

Suit against Whitehead
The following summer, Shanahan and Loomis sued Whitehead, claiming negligence and breach of
contract. Later, well into discovery, Whitehead was made aware of the existence of the 52 Cattle Company
when Shanahan stated in his deposition that he did not actually own any of the cattle on Whitehead’s
ranch. In his deposition, he described the partnership arrangement. At about the same time, Whitehead
learned that the name “52 Cattle Company” was not registered with the Elko County Clerk.
Whitehead then filed a motion for partial summary judgment, asserting that, pursuant to NRS 602.070,
Loomis and Shanahan’s failure to register their fictitiously named partnership with the county clerk
barred them from bringing a legal action. The district court agreed with Whitehead, granted the motion,
and dismissed Loomis and Shanahan’s claims. Loomis and Shanahan timely appealed.

Discussion
The district court found that Loomis and Shanahan conducted business under a fictitious name without
filing a fictitious name certificate with the Elko County Clerk as required by NRS 602.010.

[2]

The district

court therefore concluded that, pursuant to NRS 602.070, they were barred from bringing an action
against Whitehead because they did not file a fictitious name certificate for the 52 Cattle Company.

[3]

Loomis and Shanahan contend that the district court erred in granting partial summary judgment
because they did not enter into a contract with Whitehead under the name of the 52 Cattle Company, and
they did not conduct business with Whitehead under that name. Loomis and Shanahan argue that NRS
602.070 is not applicable to their action against Whitehead because they did not mislead Whitehead into
thinking that he was doing business with anyone other than them. We agree.…

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When looking at a statute’s language, this court is bound to follow the statute’s plain meaning, unless the
plain meaning was clearly not intended. Here, in using the phrase “under the assumed or fictitious name,”
the statute clearly bars bringing an action when the claims arise from a contract, transaction, or business
conducted beneath the banner of an unregistered fictitious name. However, NRS 602.070 does not apply
to individual partners whose transactions or business with another party were not performed under the
fictitious name.
Here, Whitehead knew that Shanahan entered into the oral contract under his own name. He initially
thought that Shanahan owned the cattle and Loomis had “some type of interest.” Shanahan did not enter
into the contract under the fictitious “52 Cattle Company” name. Moreover, Whitehead does not allege
that he was misled by either Loomis or Shanahan in any way that would cause him to think he was doing
business with the 52 Cattle Company. In fact, Whitehead did not know of the 52 Cattle Company until
Shanahan mentioned it in his deposition. Under these circumstances, when there simply was no
indication that Loomis and Shanahan represented that they were conducting business as the 52 Cattle
Company and no reliance by Whitehead that he was doing business with the 52 Cattle Company, NRS
602.070 does not bar the suit against Whitehead.
We therefore reverse the district court’s partial summary judgment in this instance and remand for trial
because, while the lawsuit between Loomis and Whitehead involved partnership business, the transaction
at issue was not conducted and the subsequent suit was not maintained under the aegis of the fictitiously
named partnership.

CASE QUESTIONS
1.

The purpose of the fictitious name statute might well be, as the court here describes it, “to prevent fraud
and to give the public information about those entities with which they conduct business.” But that’s not
what the statute says; it says nobody can sue on a cause of action arising out of business conducted under
a fictitious name if the name is not registered. The legislature determined the consequence of failure to
register. Should the court disregard the statute’s plain, unambiguous meaning?

2.

That was one of two arguments by the dissent in this case. The second one was based on this problem:
Shanahan and Loomis agreed that the cattle at issue were partnership cattle bearing the “52” brand. That
is, the cows werenot Shanahan’s; they were the partnership’s. When Whitehead moved to dismiss

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Shanahan’s claim—again, because the cows weren’t Shanahan’s—Shanahan conceded that but for the
existence of the partnership he would have no claim against Whitehead. If there is no claim against the
defendant except insofar as he harmed the partnership business (the cattle), how could the majority
assert that claims against Whitehead did not arise out of “the business” conducted under 52 Cattle
Company? Who has the better argument, the majority or the dissent?
3.

Here is another problem along the same lines but with a different set of facts and a Uniform Partnership
Act (UPA) jurisdiction (i.e., pre–Revised Uniform Partnership Act [RUPA]). Suppose the plaintiffs had a
partnership (as they did here), but the claim by one was that the other partner had stolen several head of
cattle, and UPA was in effect so that the partnership property was owned as “tenant in partnership”—the
cattle would be owned by the partners as a whole. A person who steals his own property cannot be
criminally liable; therefore, a partner cannot be guilty of stealing (or misappropriating) firm property.
Thus under UPA there arise anomalous cases, for example, in People v. Zinke, 555 N.E.2d 263 (N.Y. 1990),
which is a criminal case, Zinke embezzled over a million dollars from his own investment firm but the
prosecutor’s case against him was dismissed because, the New York court said, “partners cannot be
prosecuted for stealing firm property.” If the partnership is a legal entity, as under RUPA, how is this
result changed?

Partnership by Estoppel
Chavers v. Epsco, Inc.
98 S.W.3d 421 (Ark. 2003)
Hannah, J.
Appellants Reggie Chavers and Mark Chavers appeal a judgment entered against them by the Craighead
County Circuit Court. Reggie and Mark argue that the trial court erred in holding them liable for a
company debt based upon partnership by estoppel because the proof was vague and insufficient and there
was no detrimental reliance on the part of a creditor. We hold that the trial court was not clearly
erroneous in finding liability based upon partnership by estoppel. Accordingly, we affirm.

Facts
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Gary Chavers operated Chavers Welding and Construction (“CWC”), a construction and welding business,
in Jonesboro. Gary’s sons Reggie Chavers and Mark Chavers joined their father in the business after
graduating from high school. Gary, Mark, and Reggie maintain that CWC was a sole proprietorship owned
by Gary, and that Reggie and Mark served only as CWC employees, not as CWC partners.
In February 1999, CWC entered into an agreement with Epsco, Inc. (“Epsco”), a staffing service, to
provide payroll and employee services for CWC. Initially, Epsco collected payments for its services on a
weekly basis, but later, Epsco extended credit to CWC. Melton Clegg, President of Epsco, stated that his
decision to extend credit to CWC was based, in part, on his belief that CWC was a partnership.
CWC’s account with Epsco became delinquent, and Epsco filed a complaint against Gary, Reggie, and
Mark, individually, and doing business as CWC, to recover payment for the past due account. Gary
discharged a portion of his obligation to Epsco due to his filing for bankruptcy. Epsco sought to recover
CWC’s remaining debt from Reggie and Mark. After a hearing on March 7, 2002, the trial court issued a
letter opinion, finding that Reggie and Mark “represented themselves to [Epsco] as partners in an existing
partnership and operated in such a fashion to give creditors in general, and Epsco in particular, the
impression that such creditors/potential creditors were doing business with a partnership.…” On May 21,
2002, the trial court entered an order stating that Reggie and Mark were partners by estoppel as relates to
Epsco. The trial court found that Reggie and Mark were jointly and severally liable for the debt of CWC in
the amount of $80,360.92. In addition, the trial court awarded Epsco pre-judgment interest at the rate of
six percent, post-judgment interest at the rate of ten percent, and attorney’s fees in the amount of
$8,036.92.
[The relevant Arkansas statute provides]:
(1) When a person, by words spoken or written or by conduct, represents himself, or consents to another
representing him to any one, as a partner in an existing partnership or with one (1) or more persons not
actual partners, he is liable to any person to whom such representation has been made, who has, on the
faith of such representation, given credit to the actual or apparent partnership, and if he has made such
representation or consented to its being made in a public manner, he is liable to that person, whether the

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representation has or has not been made or communicated to that person so giving credit by or with the
knowledge of the apparent partner making the representation or consenting to it being made.
(a) When a partnership liability results, he is liable as though he were an actual member of the
partnership.
We have long recognized the doctrine of partnership by estoppel. [Citation, 1840], the court stated that
they who hold themselves out to the world as partners in business or trade, are to be so regarded as to
creditors and third persons; and the partnership may be established by any evidence showing that they so
hold themselves out to the public, and were so regarded by the trading community.
Further, we have stated that “[p]artnerships may be proved by circumstantial evidence; and evidence will
sometimes fix a joint liability, where persons are charged as partners, in a suit by a third person, when
they are not, in fact, partners as between themselves.” [Citation, 1843.]
In [Citation, 1906], the court noted that
[a] person who holds himself out as a partner of a firm is estopped to deny such representation, not only
as to those as to whom the representation was directly made, but as to all others who had knowledge of
such holding out and in reliance thereon sold goods to the firm.…
In addition, “if the party himself puts out the report that he is a partner, he will be liable to all those
selling goods to the firm on the faith and credit of such report.” [Citation] When a person holds himself
out as a member of partnership, any one dealing with the firm on the faith of such representation is
entitled to assume the relation continues until notice of some kind is given of its discontinuance.
[Citations]
In [Citation, 1944], the court wrote:
It is a thoroughly well-settled rule that persons who are not as between themselves partners, or as
between whom there is in fact no legal partnership, may nevertheless become subject to the liabilities of
partners, either by holding themselves out as partners to the public and the world generally or to
particular individuals, or by knowingly or negligently permitting another person to do so. All persons who

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hold themselves out, or knowingly permit others to hold them out, to the public as partners, although they
are not in partnership, become bound as partners to all who deal with them in their apparent relation.
The liability as a partner of a person who holds himself out as a partner, or permits others to do so, is
predicated on the doctrine of estoppel and on the policy of the law seeking to prevent frauds on those who
lend their money on the apparent credit of those who are held out as partners. One holding himself out as
a partner or knowingly permitting himself to be so held out is estopped from denying liability as a partner
to one who has extended credit in reliance thereon, although no partnership has in fact existed.
In the present case, the trial court cited specific examples of representations made by Reggie and Mark
indicating that they were partners of CWC, including correspondence to Epsco, checks written to Epsco,
business cards distributed to the public, and credit applications. We will discuss each in turn.

The Faxed Credit References
Epsco argues that Plaintiff’s Exhibit # 1, a faxed list of credit references, clearly indicates that Gary was
the owner and that Reggie and Mark were partners in the business. The fax lists four credit references,
and it includes CWC’s contact information. The contact information lists CWC’s telephone number, fax
number, and federal tax number. The last two lines of the contact information state: “Gary Chavers
Owner” and “Reggie Chavers and Mark Chavers Partners.”
Gary testified that he did not know that the list of credit references was faxed to Epsco. In addition, he
testified that his signature was not at the bottom of the fax. He testified that his former secretary might
have signed his name to the fax; however, he stated that he did not authorize his secretary to sign or fax a
list of credit references to Epsco. Moreover, Gary testified that the first time he saw the list of credit
references was at the bench trial.
This court gives deference to the superior position of the trial judge to determine the credibility of the
witnesses and the weight to be accorded their testimony. [Citations] Though there was a dispute
concerning whether Gary faxed the list to Epsco, the trial court found that Epsco received the faxed credit
references from CWC and relied on CWC’s statement that Reggie and Mark were partners. The trial
court’s finding is not clearly erroneous.

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The Fax Cover Sheet
At trial, Epsco introduced Plaintiff’s Exhibit # 2, a fax cover sheet from “Chavers Construction” to Epsco.
The fax cover sheet was dated July 19, 2000. The fax cover sheet contained the address, telephone
number, and fax number of the business. Listed under this information was “Gary, Reggie, or Mark
Chavers.” Epsco argues that Gary, Reggie, and Mark are all listed on the fax cover sheet, and that this
indicates that they were holding themselves out to the public as partners of the business. The trial court’s
finding that the fax cover sheet indicated that Reggie and Mark were holding themselves out as partners
of CWC is not clearly erroneous.

The Epsco Personnel Credit Application
Epsco introduced Plaintiff’s Exhibit # 9, a personnel credit application, which was received from CWC.
Adams testified that the exhibit represented a completed credit application that she received from CWC.
The type of business checked on the credit application is “partnership.” Adams testified that the
application showed the company to be a partnership, and that this information was relied upon in
extending credit. Clegg testified that he viewed the credit application which indicated that CWC was a
partnership, and that his decision to extend credit to CWC was based, in part, on his belief that CWC was
a partnership. Gary denied filling out the credit application form.
It was within the trial court’s discretion to find Adams’s and Clegg’s testimony more credible than Gary’s
testimony and to determine that Epsco relied on the statement of partnership on the credit application
before extending credit to CWC. The trial court’s finding concerning the credit application is not clearly
erroneous.

The Checks to Epsco
Epsco argues that Plaintiff’s Exhibit # 3 and Plaintiff’s Exhibit # 11, checks written to Epsco showing the
CWC account to be in the name of “Gary A. or Reggie J. Chavers,” indicates that Reggie was holding
himself out to be a partner of CWC. Plaintiff’s Exhibit # 3 was signed by Gary, and Plaintiff’s Exhibit # 11
was signed by Reggie. The checks are evidence that Reggie was holding himself out to the public as a
partner of CWC, and Epsco could have detrimentally relied on the checks before extending credit to CWC.

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The trial court was not clearly erroneous in finding that the checks supported a finding of partnership by
estoppel.

The Business Card
Epsco introduced Plaintiff’s Exhibit # 4, a business card that states “Chavers Welding, Construction &
Crane Service.” Listed on the card as “owners” are Gary Chavers and Reggie Chavers. Gary testified that
the business cards were printed incorrectly, and that Reggie’s name should not have been included as an
owner. He also testified that some of the cards might have been handed out, and that it was possible that
he might have given one of the cards to a business listed as one of CWC’s credit references on Plaintiff’s
Exhibit # 1.
The business card listing Reggie as an owner indicates that Reggie was holding himself out as a partner.
As we stated in [Citation] when a person holds himself out as a member of partnership, any one dealing
with the firm on the faith of such representation is entitled to assume the relation continues until notice of
some kind is given of its discontinuance. There is no indication that Reggie ever informed any person who
received a business card that the business relationship listed on the card was incorrect or had been
discontinued. The trial court’s finding concerning the business card is not clearly erroneous.

The Dealership Application
Epsco introduced Plaintiff’s Exhibit # 5, an application form from “Chavers Welding,” signed by Reggie,
seeking a dealership from Sukup Manufacturing. The application, dated January 23, 1997, lists “Gary &
Reggie Chavers” as owners of “Chavers Welding.” The application is signed by Reggie. Reggie admits that
he signed the dealership application and represented that he was an owner of “Chavers Welding,” but he
dismisses his statement of ownership as mere “puffery” on his part. Epsco argues that instead, the
application shows that Reggie was holding himself out to the public as being a partner. The trial court’s
determination that Reggie’s dealership application supports a finding of partnership by estoppel is not
clearly erroneous.
In sum, the trial court was not clearly erroneous in finding that Reggie and Mark held themselves out as
partners of CWC and that Epsco detrimentally relied on the existence of the partnership before extending

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credit to CWC. The appellants argue that even if we find Reggie liable based upon partnership by estoppel,
there was scant proof of Mark being liable based upon partnership by estoppel. We disagree. We are
aware that some examples of holding out cited in the trial court’s order pertain only to Reggie. However,
the representations attributed to both Reggie and Mark are sufficient proof to support the trial court’s
finding that both Reggie and Mark are estopped from denying liability to Epsco.
Affirmed.

CASE QUESTIONS
1.

What is the rationale for the doctrine of partnership by estoppel?

2.

Gary and Reggie claimed the evidence brought forth to show the existence of a partnership was
unconvincing. How credible were their claims?

[1] The word prothonotary means first notary of the court. The prothonotary is the keeper of the civil records for
the court system. The office is responsible for the creation, maintenance, and certification of matters pending or
determined by the court. The office is also responsible for certain reporting and collection duties to state agencies.
[2] NRS 602.010(1): “Every person doing business in this state under an assumed or fictitious name that is in any
way different from the legal name of each person who owns an interest in the business must file with the county
clerk of each county in which the business is being conducted a certificate containing the information required by
NRS 602.020.”
[3] NRS 602.070: “No action may be commenced or maintained by any person…upon or on account of any contract
made or transaction had under the assumed or fictitious name, or upon or on account of any cause of action
arising or growing out of the business conducted under that name, unless before the commencement of the action
the certificate required by NRS 602.010 has been filed.”

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22.4 Summary and Exercises
Summary
The basic law of partnership is found in the Uniform Partnership Act and Revised Uniform Partnership
Act. The latter has been adopted by thirty-five states. At common law, a partnership was not a legal entity
and could not sue or be sued in the partnership name. Partnership law defines a partnership as “an
association of two or more persons to carry on as co-owners a business for profit.” The Uniform
Partnership Act (UPA) assumes that a partnership is an aggregation of individuals, but it also applies a
number of rules characteristic of the legal entity theory. The Revised Uniform Partnership Act (RUPA)
assumes a partnership is an entity, but it applies one crucial rule characteristic of the aggregate theory:
the partners are ultimately liable for the partnership’s obligations. Thus a partnership may keep business
records as if it were a legal entity, may hold real estate in the partnership name, and may sue and be sued
in federal court and in many state courts in the partnership name.
Partnerships may be created informally. Among the clues to the existence of a partnership are (1) coownership of a business, (2) sharing of profits, (3) right to participate in decision making, (4) duty to
share liabilities, and (5) manner in which the business is operated. A partnership may also be formed by
implication; it may be formed by estoppel when a third party reasonably relies on a representation that a
partnership in fact exists.
No special rules govern the partnership agreement. As a practical matter, it should sufficiently spell out
who the partners are, under what name they will conduct their business, the nature and scope of the
business, capital contributions of each partner, how profits are to be divided, and similar pertinent
provisions. An oral agreement to form a partnership is valid unless the business cannot be performed
wholly within one year from the time that the agreement is made. However, most partnerships have no
fixed terms and hence are “at-will” partnerships not subject to the Statute of Frauds.

EXERCISES
1.

Able, Baker, and Carr own, as partners, a warehouse. The income from the warehouse during the current
year is $300,000, two-thirds of which goes to Able. Who must file a tax return listing this as income, the
partnership or Able? Who pays the tax, the partnership or Able?

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2.

The Havana Club operated in Salt Lake City under a lease running to defendant Dale Bowen, who owned
the equipment, furnishings, and inventory. He did not himself work in operating the club. He made an
oral agreement with Frances Cutler, who had been working for him as a bartender, that she take over the
management of the club. She was to have the authority and the responsibility for the entire active
management and operation: to purchase the supplies, pay the bills, keep the books, hire and fire
employees, and do whatever else was necessary to run the business. As compensation, the arrangement
was for a down-the-middle split; each was to receive $300 per week plus one half of the net profits. This
went on for four years until the city took over the building for a redevelopment project. The city offered
Bowen $30,000 as compensation for loss of business while a new location was found for the club. Failing
to find a suitable location, the parties decided to terminate the business. Bowen then contended he was
entitled to the entire $30,000 as the owner, Cutler being an employee only. She sued to recover half as a
partner. What was the result? Decide and discuss.

3.

Raul, a business student, decided to lease and operate an ice cream stand during his summer vacation.
Because he could not afford rent payments, his lessor agreed to take 30 percent of the profits as rent and
provide the stand and the parcel of real estate on which it stood. Are the two partners?

4.

Able, Baker, and Carr formed the ABC Partnership in 2001. In 2002 Able gave her three sons, Duncan,
Eldon, and Frederick, a gift of her 41 percent interest in the partnership to provide money to pay for their
college expenses. The sons reported income from the partnership on their individual tax returns, and the
partnership reported the payment to them on its information return. The sons were listed as partners on
unaudited balance sheets in 2003, and the 2004 income statement listed them as partners. The sons
never requested information about the management of the firm, never attended any meetings or voted,
and never attempted to withdraw the firm’s money or even speak with the other partners about the firm.
Two of the sons didn’t know where the firm was located, but they all once received “management fees”
totaling $3,000, without any showing of what the “fees” were for. In 2005, the partnership incurred
liability for pension-fund contributions to an employee, and a trustee for the fund asserted that Able's
sons were personally liable under federal law for the money owing because they were partners. The sons
moved for summary judgment denying liability. How should the court rule?

5.

The Volkmans wanted to build a house and contacted David McNamee for construction advice. He told
them that he was doing business with Phillip Carroll. Later the Volkmans got a letter from McNamee on

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stationery that read “DP Associates,” which they assumed was derived from the first names of David and
Phillip. At the DP Associates office McNamee introduced Mr. Volkman to Carroll, who said to Volkman, “I
hope we’ll be working together.” At one point during the signing process a question arose and McNamee
said, “I will ask Phil.” He returned with the answer to the question. After the contract was signed but
before construction began, Mr. Volkman visited the DP Associates office where the two men chatted;
Carroll said to him, “I am happy that we will be working with you.” The Volkmans never saw Carroll on the
construction site and knew of no other construction supervised by Carroll. They understood they were
purchasing Carroll’s services and construction expertise through DP Associates. During construction, Mr.
Volkman visited the DP offices several times and saw Carroll there. During one visit, Mr. Volkman
expressed concerns about delays and expressed the same to Carroll, who replied, “Don’t worry. David will
take care of it.” But David did not, and the Volkmans sued DP Associates, McNamee, and Carroll. Carroll
asserted he could not be liable because he and McNamee were not partners. The trial court dismissed
Carroll on summary judgment; the Volkmans appealed. How should the court rule on appeal?
6.

Wilson and VanBeek want to form a partnership. Wilson is seventeen and VanBeek is twenty-two. May
they form a partnership? Explain.

7.

Diane and Rachel operate a restaurant at the county fair every year to raise money for the local 4-H Club.
They decide together what to serve, what hours to operate, and generally how to run the business. Do
they have a partnership?

SELF-TEST QUESTIONS
1.

The basic law of partnership is currently found in
a.

common law

b.

constitutional law

c.

statutory law

d.

none of the above
Existence of a partnership may be established by

a.

co-ownership of a business for profit

b.

estoppel

c.

a formal agreement

d.

all of the above

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Which is false?
a.

An oral agreement to form a partnership is valid.

b.

Most partnerships have no fixed terms and are thus not subject to the Statute of Frauds.

c.

Strict statutory rules govern partnership agreements.

d.

A partnership may be formed by estoppel.
Partnerships

a.

are not taxable entities

b.

may buy, sell, or hold real property in the partnership name

c.

may file for bankruptcy

d.

have all of the above characteristics
Partnerships

a.

are free to select any name not used by another partnership

b.

must include the partners’ names in the partnership name

c.

can be formed by two corporations

d.

cannot be formed by two partnerships

SELF-TEST ANSWERS
1.

c

2.

d

3.

c

4.

d

5.

c

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Chapter 23

Partnership Operation and Termination
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

The operation of a partnership, including the relations among partners and relations between
partners and third parties

2.

The dissolution and winding up of a partnership

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23.1 Operation: Relations among Partners
LEARNING OBJECTIVES
1.

Recognize the duties partners owe each other: duties of service, loyalty, care, obedience,
information, and accounting.

2.

Identify the rights that partners have, including the rights to distributions of money, to management,
to choice of copartners, to property of the partnership, to assign partnership interest, and to enforce
duties and rights.

Most of the rules discussed in this section apply unless otherwise agreed, and they are really intended for
the small firm.

[1]

The Uniform Partnership Act (UPA) and the Revised Uniform Partnership Act (RUPA)

do not dictate what the relations among partners must be; the acts supply rules in the event that the
partners have not done so for themselves. In this area, it is especially important for the partners to
elaborate their agreement in writing. If the partners should happen to continue their business beyond the
term fixed for it in their agreement, the terms of the agreement continue to apply.

Duties Partners Owe Each Other
Among the duties partners owe each other, six may be called out here: (1) the duty to serve, (2) the duty of
loyalty, (3) the duty of care, (4) the duty of obedience, (5) the duty to inform copartners, and (6) the duty
to account to the partnership. These are all very similar to the duty owed by an agent to the principal, as
partnership law is based on agency concepts.

[2]

Duty to Serve
Unless otherwise agreed, expressly or impliedly, a partner is expected to work for the firm. The
partnership, after all, is a profit-making co-venture, and it would not do for one to loaf about and still
expect to get paid. For example, suppose Joan takes her two-week vacation from the horse-stable
partnership she operates with Sarah and Sandra. Then she does not return for four months because she
has gone horseback riding in the Southwest. She might end up having to pay if the partnership hired a
substitute to do her work.

Duty of Loyalty
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In general, this requires partners to put the firm’s interests ahead of their own. Partners are fiduciaries as
to each other and as to the partnership, and as such, they owe a fiduciary duty to each other and the
partnership. Judge Benjamin Cardozo, in an often-quoted phrase, called the fiduciary duty “something
stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most
sensitive, is then the standard of behavior.”

[3]

Breach of the fiduciary duty gives rise to a claim for

compensatory, consequential, and incidental damages; recoupment of compensation; and—rarely—
punitive damages. See Section 23.4.1 "Breach of Partnership Fiduciary Duty", Gilroy v. Conway, for an
example of breach of fiduciary duty.

Application of the Fiduciary Standard to Partnership Law
Under UPA, all partners are fiduciaries of each other—they are all principals and agents of each other—
though the word fiduciary was not used except in theheading to Section 21. The section reads, “Every
partner must account to the partnership for any benefit, and hold as trustee for it any profits derived by
him without the consent of the other partners from any transaction connected with the formation,
conduct, or liquidation of the partnership or from any use by him of its property.”
Section 404 of RUPA specifically provides that a partner has a fiduciary duty to the partnership and other
partners. It imposes the fiduciary standard on the duty of loyalty in three circumstances:
(1) to account to the partnership and hold as trustee for it any property, profit, or benefit derived by the
partner in the conduct and winding up of the partnership business or derived from a use by the partner of
partnership property, including the appropriation of a partnership opportunity;
(2) to refrain from dealing with the partnership in the conduct or winding up of the partnership business
as or on behalf of a party having an interest adverse to the partnership; and
(3) to refrain from competing with the partnership in the conduct of the partnership business before the
dissolution of the partnership.

Limits on the Reach of the Fiduciary Duty

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This sets out a fairly limited scope for application of the fiduciary standard, which is reasonable because
partners do not delegate open-ended control to their copartners. Further, there are some specific limits on
how far the fiduciary duty reaches (which means parties are held to the lower standard of “good faith”).
Here are two examples. First, RUPA—unlike UPA—does not extend to theformation of the partnership;
Comment 2 to RUPA Section 404 says that would be inappropriate because then the parties are “really
dealing at arm’s length.” Second, fiduciary duty doesn’t apply to a dissociated partner (one who leaves the
firm—discussed in Section 23 "Dissociation") who can immediately begin competing without the others’
consent; and it doesn’t apply if a partner violates the standard “merely because the partner’s conduct
furthers the partner’s own interest.”

[4]

Moreover, the partnership agreement may eliminate the duty of

loyalty so long as that is not “manifestly unreasonable.”

[5]

Activities Affected by the Duty of Loyalty
The duty of loyalty means, again, that partners must put the firm’s interest above their own. Thus it is
held that a partner
•

may not compete with the partnership,

•

may not make a secret profit while doing partnership business,

•

must maintain the confidentiality of partnership information.

This is certainly not a comprehensive list, and courts will determine on a case-by-case basis whether the
duty of loyalty has been breached.

Duty of Care
Stemming from its roots in agency law, partnership law also imposes a duty of care on partners. Partners
are to faithfully serve to the best of their ability. Section 404 of RUPA imposes the fiduciary standard on
the duty of care, but rather confusingly: how does the “punctilio of an honor the most sensitive”—as Judge
Cardozo described that standard—apply when under RUPA Section 404(c) the “the duty of care…is
limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a
knowing violation of law”? Recognize that a person can attend to business both loyally and negligently.
For example, Alice Able, a partner in a law firm who is not very familiar with the firm’s computerized

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bookkeeping system, attempts to trace a missing check and in so doing erases a month’s worth of records.
She has not breached her duty of care: maybe she was negligent, but not grossly negligent under RUPA
Section 404(c). The partnership agreement may reduce the duty of care so long as it is not “unreasonably
reduce[d]”; it may increase the standard too.

[6]

Duty of Obedience
The partnership is a contractual relationship among the partners; they are all agents and principals of
each other. Expressly or impliedly that means no partner can disobey the partnership agreement or fail to
follow any properly made partnership decision. This includes the duty to act within the authority
expressly or impliedly given in the partnership agreement, and a partner is responsible to the other
partners for damages or losses arising from unauthorized activities.

Duty to Inform Copartners
As in the agency relationship, a partner is expected to inform copartners of notices and matters coming to
her attention that would be of interest to the partnership.

Duty to Account
The partnership—and necessarily the partners—have a duty to allow copartners and their agents access to
the partnership’s books and records and to provide “any information concerning the partnership’s
business and affairs reasonably required for the proper exercise of the partner’s rights and duties under
the partnership agreement [or this Act].”

[7]

The fiduciary standard is imposed upon the duty to account

for “it any property, profit, or benefit derived by [a] partner,” as noted in RUPA Section 404.

[8]

The Rights That Partners Have in a Partnership
Necessarily, for every duty owed there is a correlative right. So, for example, if a partner has a duty to
account, the other partners and the partnership have a right to an accounting. Beyond that, partners have
recognized rights affecting the operation of the partnership.

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Here we may call out the following salient rights: (1) to distributions of money, (2) to management, (3) to
choose copartners, (4) to property of the partnership, (5) to assign partnership interest, and (6) to enforce
duties and rights.

Rights to Distributions
The purpose of a partnership is ultimately to distribute “money or other property from a partnership to a
partner in the partner’s capacity.”

[9]

There are, however, various types of money distributions, including

profits (and losses), indemnification, capital, and compensation.

Right to Profits (and Losses)
Profits and losses may be shared according to any formula on which the partners agree. For example, the
partnership agreement may provide that two senior partners are entitled to 35 percent each of the profit
from the year and the two junior partners are entitled to 15 percent each. The next year the percentages
will be adjusted based on such things as number of new clients garnered, number of billable hours, or
amount of income generated. Eventually, the senior partners might retire and each be entitled to 2
percent of the firm’s income, and the previous junior partners become senior, with new junior partners
admitted.
If no provision is stated, then under RUPA Section 401(b), “each partner is entitled to an equal share of
the partnership profits and is chargeable with a share of the partnership losses in proportion to the
partner’s share of the profits.” Section 18(a) of the Uniform Partnership Act is to the same effect. The right
to share in the profits is the reason people want to “make partner”: a partner will reap the benefits of
other partners’ successes (and pay for their failures too). A person working for the firm who is not a
partner is an associate and usually only gets only a salary.

Right to Indemnification
A partner who incurs liabilities in the normal course of business or to preserve its business or property is
entitled to indemnification (UPA Section 18(b), RUPA Section 401(c)). The liability is a loan owing to the
partner by the firm.

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Right to Return of Capital Contribution
When a partner joins a partnership, she is expected to make a capital contribution to the firm; this may be
deducted from her share of the distributed profit and banked by the firm in its capital account. The law
provides that “the partnership must reimburse a partner for an advance of funds beyond the amount of
the partner’s agreed capital contribution, thereby treating the advance as a loan.”

[10]

A partner may get a

return of capital under UPA after creditors are paid off if the business is wound down and terminated.

[11]

Right to Compensation
Section 401(d) of RUPA provides that “a partner is not entitled to remuneration for services performed for
the partnership, except for reasonable compensation for services rendered in winding up the business of
the partnership”; UPA Section 18(f) is to the same effect. A partner gets his money from the firm by
sharing the profits, not by a salary or wages.

Right to Management
All partners are entitled to share equally in the management and conduct of the business, unless the
partnership agreement provides otherwise.

[12]

The partnership agreement could be structured to delegate

more decision-making power to one class of partners (senior partners) than to others (junior partners), or
it may give more voting weight to certain individuals. For example, perhaps those with the most
experience will, for the first four years after a new partner is admitted, have more voting weight than the
new partner.

Right to Choose Partners
A business partnership is often analogized to a marriage partnership. In both there is a relationship of
trust and confidence between (or among) the parties; in both the poor judgment, negligence, or
dishonesty of one can create liabilities on the other(s). In a good marriage or good partnership, the
partners are friends, whatever else the legal relationship imposes. Thus no one is compelled to accept a
partner against his or her will. Section 401(i) of RUPA provides, “A person may become a partner only
with the consent of all of the partners.” UPA Section 18(g) is to the same effect; the doctrine is
called delectus personae. The freedom to select new partners, however, is not absolute. In 1984, the

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Supreme Court held that Title VII of the Civil Rights Act of 1964—which prohibits discrimination in
employment based on race, religion, national origin, or sex—applies to partnerships.

[13]

Right to Property of the Partnership
Partners are the owners of the partnership, which might not include any physical property; that is, one
partner could contribute the building, furnishings, and equipment and rent those to the partnership (or
those could count as her partnership capital contribution and become the partnership’s). But partnership
property consists of all property originally advanced or contributed to the partnership or subsequently
acquired by purchase or contribution. Unless a contrary intention can be shown, property acquired with
partnership funds is partnership property, not an individual partner’s: “Property acquired by a
partnership is property of the partnership and not of the partners individually.”

[14]

Rights in Specific Partnership Property: UPA Approach
Suppose that Able, who contributed the building and grounds on which the partnership business is
conducted, suddenly dies. Who is entitled to her share of the specific property, such as inventory, the
building, and the money in the cash register—her husband and children, or the other partners, Baker and
Carr? Section 25(1) of UPA declares that the partners hold the partnership property
astenants in partnership. As spelled out in Section 25(2), the specific property interest of a tenant in
partnership vests in the surviving partners, not in the heirs. But the heirs are entitled to the deceased
partner’s interest in the partnership itself, so that while Baker and Carr may use the partnership property
for the benefit of the partnership without consulting Able’s heirs, they must account to her heirs for her
proper share of the partnership’s profits.

Rights in Specific Property: RUPA Approach
Section 501 of RUPA provides, “A partner is not a co-owner of partnership property and has no interest in
partnership property which can be transferred, either voluntarily or involuntarily.” Partnership property
is owned by the entity; UPA’s concept of tenants in partnership is abolished in favor of adoption of the
entity theory. The result, however, is not different.

Right to Assign Partnership Interest
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One of the hallmarks of the capitalistic system is that people should be able to dispose of their property
interests more or less as they see fit. Partnership interests may be assigned to some extent.

Voluntary Assignment
At common law, assignment of a partner’s interest in the business—for example, as a mortgage in return
for a loan—would result in a legal dissolution of the partnership. Thus in the absence of UPA, which
changed the law, Baker’s decision to mortgage his interest in the car dealership in return for a $20,000
loan from his bank would mean that the three—Able, Baker, and Carr—were no longer partners. Section
27 of UPA declares that assignment of an interest in the partnership neither dissolves the partnership nor
entitles the assignee “to interfere in the management or administration of the partnership business or
affairs, or to require any information or account of partnership transactions, or to inspect the partnership
books.” The assignment merely entitles the assignee to receive whatever profits the assignor would have
received—this is the assignor’s transferable interest.

[15]

Under UPA, this interest is assignable.

[16]

Under RUPA, the same distinction is made between a partner’s interest in the partnership and a partner’s
transferable interest. The Official Comment to Section 101 reads as follows: “‘Partnership interest’ or
‘partner’s interest in the partnership’ is defined to mean all of a partner’s interests in the partnership,
including the partner’s transferable interest and all management and other rights. A partner’s
‘transferable interest’ is a more limited concept and means only his share of the profits and losses and
right to receive distributions, that is, the partner’s economic interests.”

[17]

This transferable interest is assignable under RUPA 503 (unless the partners agree to restrict transfers,
Section 103(a)). It does not, by itself, cause the dissolution of the partnership; it does not entitle the
transferee to access to firm information, to participate in running the firm, or to inspect or copy the
books. The transferee is entitled to whatever distributions the transferor partner would have been entitled
to, including, upon dissolution of the firm, the net amounts the transferor would have received had there
been no assignment.
RUPA Section 101(b)(3) confers standing on a transferee to seek a judicial dissolution and winding up of
the partnership business as provided in Section 801(6), thus continuing the rule of UPA Section 32(2).
But under RUPA 601(4)(ii), the other partners may by unanimous vote expel a partner who has made “a

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transfer of all or substantially all of that partner’s transferable interest in the partnership, other than a
transfer for security purposes [as for a loan].” Upon a creditor foreclosure of the security interest, though,
the partner may be expelled.

Involuntary Assignment
It may be a misnomer to describe an involuntary assignment as a “right”; it might better be thought of as a
consequence of the right to own property. In any event, if a partner is sued in his personal capacity and a
judgment is rendered against him, the question arises: may the judgment creditor seize partnership
property? Section 28 of UPA and RUPA Section 504 permit a judgment creditor to obtain
a charging order, which charges the partner’s interest in the partnership with obligation to satisfy the
judgment. The court may appoint a receiver to ensure that partnership proceeds are paid to the judgment
creditor. But the creditor is not entitled to specific partnership property. The partner may always pay off
the debt and redeem his interest in the partnership. If the partner does not pay off the debt, the holder of
the charging order may acquire legal ownership of the partner’s interest. That confers upon the judgment
creditor an important power: he may, if the partnership is one at will, dissolve the partnership and claim
the partner’s share of the assets. For that reason, the copartners might wish to redeem the interest—pay
off the creditor—in order to preserve the partnership. As with the voluntary assignment, the assignee of an
involuntary assignment does not become a partner. See Figure 23.1 "Property Rights".
Figure 23.1 Property Rights

Right to Enforce Partnership Rights
The rights and duties imposed by partnership law are, of course, valueless unless they can be enforced.
Partners and partnerships have mechanisms under the law to enforce them.

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Right to Information and Inspection of Books
We noted in Section 23.1.1 "Duties Partners Owe Each Other" of this chapter that partners have a duty to
account; the corollary right is the right to access books and records, which is usually very important in
determining partnership rights. Section 403(b) of RUPA provides, “A partnership shall provide partners
and their agents and attorneys access to its books and records. It shall provide former partners and their
agents and attorneys access to books and records pertaining to the period during which they were
partners. The right of access provides the opportunity to inspect and copy books and records during
ordinary business hours. A partnership may impose a reasonable charge, covering the costs of labor and
material, for copies of documents furnished.”

[18]

Section 19 of UPA is basically in accord. This means that without demand—and for any purpose—the
partnership must provide any information concerning its business and affairs reasonably required for the
proper exercise of the partner’s rights and duties under the partnership agreement or the act; and on
demand, it must provide any other information concerning the partnership’s business and affairs, unless
the demand is unreasonable or improper.

[19]

Generally, the partnership agreement cannot deny the right

to inspection.
The duty to account mentioned in Section 23.1.1 "Duties Partners Owe Each Other" of this chapter
normally means that the partners and the partnership should keep reasonable records so everyone can tell
what is going on. A formal accounting under UPA is different.
Under UPA Section 22, any partner is entitled to a formal account (or accounting) of the partnership
affairs under the following conditions:
1.

If he is wrongfully excluded from the partnership business or possession of its property by his
copartners;

2. If the right exists under the terms of any agreement;
3. If a partner profits in violation of his fiduciary duty (as per UPA 22); and
4. Whenever it is otherwise just and reasonable.

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At common law, partners could not obtain an accounting except in the event of dissolution. But from an
early date, equity courts would appoint a referee, auditor, or special master to investigate the books of a
business when one of the partners had grounds to complain, and UPA broadened considerably the right to
an accounting. The court has plenary power to investigate all facets of the business, evaluate claims,
declare legal rights among the parties, and order money judgments against any partner in the wrong.
Under RUPA Section 405, this “accounting” business is somewhat modified. Reflecting the entity theory,
the partnership can sue a partner for wrongdoing, which is not allowed under UPA. Moreover, to quote
from the Official Comment, RUPA “provides that, during the term of the partnership, partners may
maintain a variety of legal or equitable actions, including an action for an accounting, as well as a final
action for an accounting upon dissolution and winding up. It reflects a new policy choice that partners
should have access to the courts during the term of the partnership to resolve claims against the
partnership and the other partners, leaving broad judicial discretion to fashion appropriate remedies[,
and] an accounting is not a prerequisite to the availability of the other remedies a partner may have
against the partnership or the other partners.”

[20]

KEY TAKEAWAY
Partners have important duties in a partnership, including (1) the duty to serve—that is, to devote herself to
the work of the partnership; (2) the duty of loyalty, which is informed by the fiduciary standard: the obligation
to act always in the best interest of the partnership and not in one’s own best interest; (3) the duty of care—
that is, to act as a reasonably prudent partner would; (4) the duty of obedience not to breach any aspect of
the agreement or act without authority; (5) the duty to inform copartners; and (6) the duty to account to the
partnership.
Partners also have rights. These include the rights (1) to distributions of money, including profits (and losses),
indemnification, and return of capital contribution (but not a right to compensation); (2) to management; (3)
to choose copartners; (4) to property of the partnership, and no partner has any rights to specific property; (5)
to assign (voluntarily or involuntarily) the partnership interest; and (6) to enforce duties and rights by suits in
law or equity. (Under RUPA, a formal accounting is not first required.)

EXERCISES
1.

What is the “fiduciary duty,” and why is it imposed on some partners’ actions with the partnership?

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2.

Distinguish between ownership of partnership property under UPA as opposed to under RUPA.

3.

Carlos obtained a judgment against Pauline, a partner in a partnership, for negligently crashing her car
into Carlos’s while she was not in the scope of partnership business. Carlos wants to satisfy the judgment
from her employer. How can Carlos do that?

4.

What is the difference between the duty to account and a formal partnership accounting?

5.

What does it mean to say a partnership interest has been involuntarily assigned?

[1] “The basic mission of RUPA is to serve the small firm. Large partnerships can fend for themselves by drafting
partnership agreements that suit their special needs.” Donald J. Weidner, “RUPA and Fiduciary Duty: The Texture
of Relationship,” Law and Contemporary Problems 58, no. 2 (1995): 81, 83.
[2] Revised Uniform Partnership Act, Section 404, Comment 3: “Indeed, the law of partnership reflects the broader
law of principal and agent, under which every agent is a fiduciary.”
[3] Meinhard v. Salmon, 164 N.E. 545 (N.Y. 1928).
[4] RUPA, Section 503(b)(2); RUPA, Section 404 (e).
[5] RUPA, Section 103(2)(c).
[6] RUPA, Section 103(2)(d); RUPA, Section 103.
[7] UPA, Sections 19 and 20; RUPA, Section 403.
[8] RUPA, Section 404(1).
[9] RUPA, Section 101(3).
[10] UPA, Section 18(c); RUPA, Section 401(d).
[11] UPA, Section 40(b); RUPA, Section 807(b).
[12] UPA, Section 18(e); RUPA, Section 401(f).
[13] Hishon v. King & Spalding, 467 U.S. 69 (1984).
[14] RUPA, Section 203; UPA, Sections 8(1) and 25.
[15] UPA, Section 26.
[16] UPA, Section 27.
[17] RUPA, Official Comment to Section 101.
[18] RUPA Section 403(b).
[19] RUPA, Section 403(c)(1); RUPA, Section 403(c)(2).

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[20] RUPA Official Comment 2, Section 405(b).

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23.2 Operation: The Partnership and Third Parties
LEARNING OBJECTIVES
1.

Understand the partners’ and partnership’s contract liability.

2.

Understand the partners’ and partnership’s tort and criminal liability.

3.

Describe the partners’ and partnership’s tax liability.

By express terms, the law of agency applies to partnership law. Every partner is an agent of the
partnership for the purpose of its business. Consequently, the following discussion will be a review of
agency law, covered in Chapter 22 "Partnerships: General Characteristics and Formation" as it applies to
partnerships. The Revised Uniform Partnership Act (RUPA) adds a few new wrinkles to the liability issue.

Contract Liability
Liability of the Partnership
Recall that an agent can make contracts on behalf of a principal under three types of authority: express,
implied, and apparent. Express authority is that explicitly delegated to the agent, implied authority is
that necessary to the carrying out of the express authority, and apparent authority is that which a third
party is led to believe has been conferred by the principal on the agent, even though in fact it was not or it
was revoked. When a partner has authority, the partnership is bound by contracts the partner makes on
its behalf. Section 23.4.2 "Partnership Authority, Express or Apparent", Hodge v. Garrett, discusses all
three types of authority.

The General Rule
Section 305 of RUPA restates agency law: “A partnership is liable for loss or injury, or for a penalty
incurred, as a result of a wrongful act or omission, or other actionable conduct, of a partner acting in the
ordinary course”

[1]

of partnership business or with its authority. The ability of a partner to bind the

partnership to contract liability is problematic, especially where the authority is apparent: the firm denies
liability, lawsuits ensue, and unhappiness generally follows.

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But the firm is not liable for an act not apparently in the ordinary course of business, unless the act was
authorized by the others.

[2]

Section 401(j) of RUPA requires the unanimous consent of the partners for a

grant of authority outside the ordinary course of business, unless the partnership agreement provides
otherwise.
Under the Uniform Partnership Act (UPA) Section 9(3), the firm is not liable for five actions that no single
partner has implied or apparent authority to do, because they are not “in the ordinary course of
partnership.” These actions are: (1) assignment of partnership property for the benefit of creditors, (2)
disposing of the firm’s goodwill (selling the right to do business with the firm’s clients to another
business), (3) actions that make it impossible to carry on the business, (4) confessing a judgment against
the partnership, and (5) submitting a partnership claim or liability. RUPA omits that section, leaving it to
the courts to decide the outer limits of the agency power of a partner. In any event, unauthorized actions
by a partner may be ratified by the partnership.

Partnership “Statements”
New under RUPA is the ability of partnerships, partners, or even nonpartners to issue and file
“statements” that announce to the world the establishment or denial of authority. The goal here is to
control the reach of apparent authority. There are several kinds of statements authorized.
A statement of partnership authority is allowed by RUPA Section 303. It specifies the names of the
partners authorized, or not authorized, to enter into transactions on behalf of the partnership and any
other matters. The most important goal of the statement of authority is to facilitate the transfer of real
property held in the name of the partnership. A statement must specify the names of the partners
authorized to execute an instrument transferring that property.
A statement of denial, RUPA Section 304, operates to allow partners (and persons named as partners) an
opportunity to deny any fact asserted in a statement of partnership authority.
A statement of dissociation, RUPA Section 704, may be filed by a partnership or a dissociated partner,
informing the world that the person is no longer a partner. This tells the world that the named person is
no longer in the partnership.

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There are three other statements authorized: a statement of qualificationestablishes that the partnership
has satisfied all conditions precedent to the qualification of the partnership as a limited liability
partnership; a statement of foreign qualification means a limited liability partnership is qualified and
registered to do business in a state other than that in which it is originally registered; and a statement of
amendment or cancellation of any of the foregoing.

[3]

Limited liability partnerships are taken up

in Chapter 24 "Hybrid Business Forms".
Generally, RUPA Section 105 allows partnerships to file these statements with the state secretary of state’s
office; those affecting real estate need to be filed with (or also with) the local county land recorder’s office.
The notices bind those who know about them right away, and they are constructive notice to the world
after ninety days as to authority to transfer real property in the partnership’s name, as to dissociation, and
as to dissolution. However, as to other grants or limitations of authority, “only a third party who knows or
has received a notification of a partner’s lack of authority in an ordinary course transaction is bound.”

[4]

Since RUPA is mostly intended to provide the rules for the small, unsophisticated partnership, it is
questionable whether these arcane “statements” are very often employed.

Personal Liability of Partners, in General
It is clear that the partnership is liable for contracts by authorized partners, as discussed in the preceding
paragraphs. The bad thing about the partnership as a form of business organization is that it imposes
liability on the partnerspersonally and without limit. Section 306 of RUPA provides that “all partners are
liable jointly and severally for all obligations of the partnership unless otherwise agreed by the claimant or
provided by law.”

[5]

Section 13 of UPA is in accord.

Liability of Existing Partners
Contract liability is joint and several: that is, all partners are liable (“joint”) and each is “several.” (We
usually do not use several in modern English to mean “each”; it’s an archaic usage.) But—and here’s the
intrusion of entity theory—generally RUPA requires the judgment creditor to exhaust the partnership’s
assets before going after the separate assets of a partner. Thus under RUPA the partners
are guarantors of the partnership’s liabilities.

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Under UPA, contract liability is joint only, not also several. This means the partners must be sued in a
joint action brought against them all. A partner who is not named cannot later be sued by a creditor in a
separate proceeding, though the ones who were named could see a proportionate contribution from the
ones who were not.

Liability of Incoming Partners
Under RUPA Section 306(b), a new partner has no personal liability to existing creditors of the
partnership, and only her capital investment in the firm is at risk for the satisfaction of existing
partnership debts. Sections 17 and 41(7) of UPA are in accord. But, again, under either statute a new
partner’s personal assets are at risk with respect to partnership liabilities incurred after her admission as a
partner. This is a daunting prospect, and it is the reason for the invention of hybrid forms of business
organization: limited partnerships, limited liability companies, and limited liability partnerships. The
corporate form, of course, also (usually) obviates the owners’ personal liability.

Tort and Criminal Liability
Partnership Liability for Torts
The rules affecting partners’ tort liability (discussed in Section 23.2.1 "Contract Liability") and those
affecting contract liability are the same. Section 13 of UPA says the partnership is liable for “any wrongful
act or omission of any partner acting in the ordinary course of the business of the partnership or with the
[7]

authority of his co-partners.” A civil “wrongful act” is necessarily either a tort or a breach of contract, so
no distinction is made between them. (Section 305 of RUPA changed the phraseology slightly by adding
after any wrongful act or omission the words or other actionable conduct; this makes the partnership
liable for its partner’s no-fault torts.) That the principal should be liable for its agents’ wrongdoings is of
course basic agency law. RUPA does expand liability by allowing a partner to sue during the term of the
partnership without first having to get out of it, as is required under UPA.
For tortious acts, the partners are said to be jointly and severally liable under both UPA and RUPA, and
the plaintiff may separately sue one or more partners. Even after winning a judgment, the plaintiff may
sue other partners unnamed in the original action. Each and every partner is separately liable for the

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entire amount of the debt, although the plaintiff is not entitled to recover more than the total of his
damages. The practical effect of the rules making partners personally liable for partnership contracts and
torts can be huge. In his classic textbook Economics, Professor Paul Samuelson observed that unlimited
liability “reveals why partnerships tend to be confined to small, personal enterprises.…When it becomes a
question of placing their personal fortunes in jeopardy, people are reluctant to put their capital into
complex ventures over which they can exercise little control.…In the field of investment banking, concerns
like JPMorgan Chase used to advertise proudly ‘not incorporated’ so that their creditors could have extra
assurance. But even these concerns have converted themselves into corporate entities.”

[8]

Partners’ Personal Liability for Torts
Of course, a person is always liable for his own torts. All partners are also liable for any partner’s tort
committed in the scope of partnership business under agency law, and this liability is—again—personal
and unlimited, subject to RUPA’s requirement that the judgment creditor exhaust the partnership’s assets
before going after the separate assets of the partners. The partner who commits a tort or breach of trust
must indemnify the partnership for losses paid to the third party.

[9]

Liability for Crimes
Criminal liability is generally personal to the miscreant. Nonparticipating copartners are ordinarily not
liable for crimes if guilty intent is an element. When guilty intent is not an element, as in certain
regulatory offenses, all partners may be guilty of an act committed by a partner in the course of the
business.

Liability for Taxes
Corporate income gets taxed twice under federal law: once to the corporation and again to the
shareholders who receive income as dividends. However, the partnership’s income “passes through” the
partnership and is distributed to the partners under the conduit theory. When partners get income from
the firm they have to pay tax on it, but the partnership pays no tax (it files an information return). This is
perceived to be a significant advantage of the partnership form.

KEY TAKEAWAY
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The partnership is generally liable for any contract made by a partner with authority express, implied, or
apparent. Under RUPA the firm, partners, or even nonpartners may to some extent limit their liability by filing
“statements” with the appropriate state registrar; such statements only affect those who know of them,
except that a notice affecting the right of a partner to sell real estate or regarding dissociation or dissolution is
effective against the world after ninety days.
All partners are liable for contracts entered into and torts committed by any partner acting in or apparently in
the normal course of business. This liability is personal and unlimited, joint and several (although under UPA
contract liability it is only joint). Incoming partners are not liable, in contract or in tort, for activities predating
their arrival, but their capital contribution is at risk. Criminal liability is generally personal unless the crime
requires no intention.

EXERCISES
1.

What is the partnership’s liability for contracts entered into by its partners?

2.

What is the personal liability of partners for breach of a contract made by one of the partnership’s
members?

3.

Why would people feel more comfortable knowing that JPMorgan Bank—Morgan was at one time the
richest man in the United States—was a partnership and not a corporation?

4.

What is the point of RUPA’s “statements”? How can they be of use to a partner who has, for example,
retired and is no longer involved in the firm?

5.

Under what circumstances is the partnership liable for crimes committed by its partners?

6.

How is a partnership taxed more favorably than a corporation?

[1] RUPA Section 305.
[2] RUPA, Section 301(2); UPA, Section 9(2).
[3] RUPA, Section 1001(d); RUPA, Section 1102.
[4] RUPA, Section 303, Comment 3.
[5] RUPA, Section 306.
[6] RUPA Section 306.
[7] UPA, Section 13.

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[8] Paul A. Samuelson, Economics (New York: McGraw-Hill, 1973), 106.
[9] RUPA, Section 405(a).

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23.3 Dissolution and Winding Up
LEARNING OBJECTIVES
1.

Understand the dissolution of general partnerships under the Uniform Partnership Act (UPA).

2.

Understand the dissociation and dissolution of general partnerships under the Revised Uniform
Partnership Act (RUPA).

3.

Explain the winding up of partnerships under UPA and RUPA.

It is said that a partnership is like a marriage, and that extends to its ending too. It’s easier to get into a
partnership than it is to get out of it because legal entanglements continue after a person is no longer a
partner. The rules governing “getting out” of a partnership are different under the Revised Uniform
Partnership Act (RUPA) than under the Uniform Partnership Act (UPA). We take up UPA first.

Dissolution of Partnerships under UPA
Dissolution, in the most general sense, means a separation into component parts.

Meaning of Dissolution under UPA
People in business are sometimes confused about the meaning of dissolution. It does not mean the
termination of a business. It has a precise legal definition, given in UPA Section 29: “The dissolution of a
partnership is the change in the relation of the partners caused by any partner ceasing to be associated in
the carrying on as distinguished from the winding up of the business.” The partnership is not necessarily
terminated on dissolution; rather, it continues until the winding up of partnership affairs is completed,
and the remaining partners may choose to continue on as a new partnership if they want.

[1]

But, again,

under UPA the partnership dissolves upon the withdrawal of any partner.

Causes of Dissolution
Partnerships can dissolve for a number of reasons.

[2]

In Accordance with the Agreement

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The term of the partnership agreement may have expired or the partnership may be at will and one of the
partners desires to leave it. All the partners may decide that it is preferable to dissolve rather than to
continue. One of the partners may have been expelled in accordance with a provision in the agreement. In
none of these circumstances is the agreement violated, though its spirit surely might have been. Professor
Samuelson calls to mind the example of William Dean Howells’s Silas Lapham, who forces his partner to
sell out by offering him an ultimatum: “You may buy me out or I’ll buy you out.” The ultimatum was given
at a time when the partner could not afford to buy Lapham out, so the partner had no choice.

In Violation of the Agreement
Dissolution may also result from violation of the agreement, as when the partners decide to discharge a
partner though no provision permits them to do so, or as when a partner decides to quit in violation of a
term agreement. In the former case, the remaining partners are liable for damages for wrongful
dissolution, and in the latter case, the withdrawing partner is liable to the remaining partners the same
way.

By Operation of Law
A third reason for dissolution is the occurrence of some event, such as enactment of a statute, that makes
it unlawful to continue the business. Or a partner may die or one or more partners or the entire
partnership may become bankrupt. Dissolution under these circumstances is said to be by operation of
law.

[3]

By Court Order
Finally, dissolution may be by court order. Courts are empowered to dissolve partnerships when “on
application by or for a partner” a partner is shown to be a lunatic, of unsound mind, incapable of
performing his part of the agreement, “guilty of such conduct as tends to affect prejudicially the carrying
on of the business,” or otherwise behaves in such a way that “it is not reasonably practicable to carry on
the business in partnership with him.” A court may also order dissolution if the business can only be
carried on at a loss or whenever equitable. In some circumstances, a court will order dissolution upon the
application of a purchaser of a partner’s interest.

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Effect of Dissolution on Authority
For the most part, dissolution terminates the authority of the partners to act for the partnership. The only
significant exceptions are for acts necessary to wind up partnership affairs or to complete transactions
begun but not finished at the time of dissolution.

[5]

Notwithstanding the latter exception, no partner can

bind the partnership if it has dissolved because it has become unlawful to carry on the business or if the
partner seeking to exercise authority has become bankrupt.

After Dissolution
After a partnership has dissolved, it can follow one of two paths. It can carry on business as a new
partnership, or it can wind up the business and cease operating (see Figure 23.2 "Alternatives Following
UPA Dissolution").
Figure 23.2 Alternatives Following UPA Dissolution

Forming a New Partnership
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In order to carry on the business as a new partnership, there must be an agreement—preferably as part of
the original partnership agreement but maybe only after dissolution (and maybe oral)—that upon
dissolution (e.g., if a partner dies, retires, or quits) the others will regroup and carry on.
Under UPA the remaining partners have the right to carry on when (1) the dissolution was in
contravention of the agreement, (2) a partner was expelled according to the partnership agreement, or (3)
all partners agree to carry on.

[6]

Whether the former partner dies or otherwise quits the firm, the noncontinuing one or his, her, or its legal
representative is entitled to an accounting and to be paid the value of the partnership interest, less
[7]

damages for wrongful dissolution. The firm may need to borrow money to pay the former partner or her
estate; or, in the case of a deceased partner, the money to pay the former partner is obtained through a life
insurance buyout policy.
Partnerships routinely insure the lives of the partners, who have no ownership interests in the insurance
policies. The policies should bear a face amount equal to each partner’s interest in the partnership and
should be adjusted as the fortunes of the partnership change. Proceeds of the insurance policy are used on
death to pay the purchase price of the interest inherited by the deceased’s estate. If the insurance policy
pays out more than the interest at stake, the partnership retains the difference. If the policy pays out less,
the partnership agrees to pay the difference in installments.
Another set of issues arises when the partnership changes because an old partner departs and a new one
joins. Suppose that Baker leaves the car dealership business and his interest is purchased by Alice, who is
then admitted to the partnership. Assume that when Baker left, the business owed Mogul Parts Company
$5,000 and Laid Back Upholsterers $4,000. After Baker left and Alice joined, Mogul sells another $5,000
worth of parts to the firm on credit, and Sizzling Radiator Repair, a new creditor, advances $3,000 worth
of radiator repair parts. These circumstances pose four questions.
First, do creditors of the old partnership remain creditors of the new partnership? Yes.

[8]

Second, does Baker, the old partner, remain liable to the creditors of the old partnership? Yes.

[9]

That

could pose uncomfortable problems for Baker, who may have left the business because he lost interest in

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it and wished to put his money elsewhere. The last thing he wants is the threat of liability hanging over his
head when he can no longer profit from the firm’s operations. That is all the more true if he had a falling
out with his partners and does not trust them. The solution is given in UPA Section 36(2), which says that
an old partner is discharged from liability if the creditors and the new partnership agree to discharge him.
Third, is Alice, the new partner, liable to creditors of the old partnership? Yes, but only to the extent of her
capital contribution.

[10]

Fourth, is Baker, the old partner, liable for debts incurred after his withdrawal from the partnership?
Surprisingly, yes, unless Baker takes certain action toward old and new creditors. He must provide actual
notice that he has withdrawn to anyone who has extended credit in the past. Once he has done so, he has
no liability to these creditors for credit extended to the partnership thereafter. Of course, it would be
difficult to provide notice to future creditors, since at the time of withdrawal they would not have had a
relationship with the partnership. To avoid liability to new creditors who knew of the partnership, the
solution required under UPA Section 35(l)(b)(II) is to advertise Baker’s departure in a general circulation
newspaper in the place where the partnership business was regularly carried on.

Winding Up and Termination
Because the differences between UPA’s and RUPA’s provisions for winding up and termination are not as
significant as those between their provisions for dissolution, the discussion for winding up and
termination will cover both acts at once, following the discussion of dissociation and dissolution under
RUPA.

Dissociation and Dissolution of Partnerships under RUPA
Comment 1 to RUPA Section 601 is a good lead-in to this section. According to the comment, RUPA
dramatically changes the law governing partnership breakups and dissolution. An entirely new concept,
“dissociation,” is used in lieu of UPA term “dissolution” to denote the change in the relationship caused by
a partner’s ceasing to be associated in the carrying on of the business. “Dissolution” is retained but with a
different meaning. The entity theory of partnership provides a conceptual basis for continuing the firm
itself despite a partner’s withdrawal from the firm.

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Under UPA, the partnership is an aggregate, a collection of individuals; upon the withdrawal of any
member from the collection, the aggregate dissolves. But because RUPA conforms the partnership as an
entity, there is no conceptual reason for it to dissolve upon a member’s withdrawal. “Dissociation” occurs
when any partner ceases to be involved in the business of the firm, and “dissolution” happens when RUPA
requires the partnership to wind up and terminate; dissociation does not necessarily cause dissolution.

Dissociation
Dissociation, as noted in the previous paragraph, is the change in relations caused by a partner’s
withdrawal from the firm’s business.

Causes of Dissociation
Dissociation is caused in ten possible ways: (1) a partner says she wants out; (2) an event triggers
dissociation as per the partnership agreement; (3) a partner is expelled as per the agreement; (4) a
partner is expelled by unanimous vote of the others because it is unlawful to carry on with that partner,
because that partner has transferred to a transferee all interest in the partnership (except for security
purposes), or because a corporate partner’s or partnership partner’s existence is effectively terminated;
(5) by a court order upon request by the partnership or another partner because the one expelled has been
determined to have misbehaved (engaged in serious wrongful conduct, persists in abusing the agreement,
acts in ways making continuing the business impracticable); (6) the partner has declared bankruptcy; (7)
the partner has died or had a guardian appointed, or has been adjudicated as incompetent; (8) the partner
is a trust whose assets are exhausted; (9) the partner is an estate and the estate’s interest in the
partnership has been entirely transferred; (10) the partner dies or, if the partner is another partnership or
a corporation trust or estate, that entity’s existence is terminated.

[11]

Effect of Dissociation
After a partner dissociates, the partner’s right to participate in management terminates. (However, if the
dissociation goes on to dissolution and winding up, partners who have not wrongfully caused the
dissociation may participate in winding-up activities.)

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[12]

The dissociated partner’s duty of loyalty and

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care terminates; the former partner may compete with the firm, except for matters arising before the
dissociation.

[13]

When partners come and go, as they do, problems may arise. What power does the dissociated partner
have to bind the partnership? What power does the partnership have to impose liability on the dissociated
one? RUPA provides that the dissociated partner loses any actual authority upon dissociation, and his or
her apparent authority lingers for not longer than two years if the dissociated one acts in a way that would
have bound the partnership before dissociation, provided the other party (1) reasonably believed the
dissociated one was a partner, (2) did not have notice of the dissociation, and (3) is not deemed to have
constructive notice from a filed “statement of dissociation.”

[14]

The dissociated partner, of course, is liable

for damages to the partnership if third parties had cause to think she was still a partner and the
partnership became liable because of that; she is liable to the firm as an unauthorized agent.

[15]

A partner’s dissociation does nothing to change that partner’s liability for predissociation
obligations.

[16]

For postdissociation liability, exposure is for two years if at the time of entering into the

transaction the other party (1) reasonably believed the dissociated one was a partner, (2) didn’t have
notice of the dissociation, and (3) is not deemed to have constructive notice from a filed “statement of
dissociation.” For example, Baker withdraws from the firm of Able, Baker, and Carr. Able contracts with
HydroLift for a new hydraulic car lift that costs $25,000 installed. HydroLift is not aware at the time of
contracting that Baker is disassociated and believes she is still a partner. A year later, the firm not having
been paid, HydroLift sues Able, Baker, and Carr and the partnership. Baker has potential liability. Baker
could have protected herself by filing a “statement of dissociation,” or—better—the partnership agreement
should provide that the firm would file such statements upon the dissociation of any partner (and if it
does not, it would be liable to her for the consequences).

Dissolution
Dissociation does not necessarily cause dissolution (see the discussion later in this section of how the firm
continues after a dissociation); dissolution and winding up happen only for the causes stated in RUPA
Section 801, discussed in the following paragraphs.

Causes of Dissolution
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There are three causes of dissolution: (1) by act of the partners—some dissociations do trigger dissolution;
(2) by operation of law; or (3) by court order. The partnership agreement may change or eliminate the
dissolution trigger as to (1); dissolution by the latter two means cannot be tinkered with.

[17]

(1) Dissolution by act of the partners may occur as follows:
•

Any member of an at-will partnership can dissociate at any time, triggering dissolution and
liquidation. The partners who wish to continue the business of a term partnership, though, cannot be
forced to liquidate the business by a partner who withdraws prematurely in violation of the
partnership agreement. In any event, common agreement formats for dissolution will provide for
built-in dispute resolution, and enlightened partners often agree to such mechanisms in advance to
avoid the kinds of problems listed here.

•

Any partnership will dissolve upon the happening of an event the partners specified would cause
dissolution in their agreement. They may change their minds, of course, agree to continue, and amend
the partnership agreement accordingly.

•

A term partnership may be dissolved before its term expires in three ways. First, if a partner
dissociated by death, declaring bankruptcy, becoming incapacitated, or wrongfully dissociates, the
partnership will dissolve if within ninety days of that triggering dissociation at least half the
remaining partners express their will to wind it up. Second, the partnership may be dissolved if the
term expires. Third, it may be dissolved if all the partners agree to amend the partnership agreement
by expressly agreeing to dissolve.

(2) Dissolution will happen in some cases by operation of law if it becomes illegal to continue the
business, or substantially all of it. For example, if the firm’s business was the manufacture and
distribution of trans fats and it became illegal to do that, the firm would dissolve.

[18]

This cause of

dissolution is not subject to partnership agreement.
(3) Dissolution by court order can occur on application by a partner. A court may declare that it is, for
various reasons specified in RUPA Section 801(5), no longer reasonably practicable to continue operation.
Also, a court may order dissolution upon application by a transferee of a partner’s transferable interest or
by a purchaser at a foreclosure of a charging order if the court determines it is equitable. For example, if

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Creditor gets a charging order against Paul Partner and the obligation cannot reasonably be paid by the
firm, a court could order dissolution so Creditor would get paid from the liquidated assets of the firm.

Effect of Dissolution
A partnership continues after dissolution only for the purpose of winding up its business. The partnership
is terminated when the winding up of its business is completed.

[19]

However, before winding up is

completed, the partners—except any wrongfully dissociating—may agree to carry on the partnership, in
which case it resumes business as if dissolution never happened.

[20]

Continuing after Dissociation
Dissociation, again, does not necessarily cause dissolution. In an at-will partnership, the death (including
termination of an entity partner), bankruptcy, incapacity, or expulsion of a partner will not cause
dissolution.

[21]

In a term partnership, the firm continues if, within ninety days of an event triggering

dissociation, fewer than half the partners express their will to wind up. The partnership agreement may
provide that RUPA’s dissolution-triggering events, including dissociation, will not trigger dissolution.
However, the agreement cannot change the rules that dissolution is caused by the business becoming
illegal or by court order. Creditors of the partnership remain as before, and the dissociated partner is
liable for partnership obligations arising before dissociation.
Section 701 of RUPA provides that if the firm continues in business after a partner dissociates, without
winding up, then the partnership must purchase the dissociated partner’s interest; RUPA Section 701(b)
explains how to determine the buyout price. It is the amount that would have been distributed to the
dissociated partner if, on the date of dissociation, the firm’s assets were sold “at a price equal to the
greater of the liquidation value or the value based on a sale of the entire business as a going concern,”
minus damages for wrongful dissociation. A wrongful dissociater may have to wait a while to get paid in
full, unless a court determines that immediate payment “will not cause an undue hardship to the
partnership,” but the longest nonwrongful dissociaters need to wait is 120 days.

[22]

A dissociated partner

can sue the firm to determine the buyout price and the court may assess attorney’s, appraiser’s, and
expert’s fees against a party the court finds “acted arbitrarily, vexatiously, or in bad faith.”

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[23]

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Winding Up the Partnership under UPA and RUPA
If the partners decide not to continue the business upon dissolution, they are obliged to wind up the
business. The partnership continues after dissolution only for the purpose of winding up its business,
after which it is terminated.

[24]

Winding up entails concluding all unfinished business pending at the date

of dissolution and payment of all debts. The partners must then settle accounts among themselves in
order to distribute the remaining assets. At any time after dissolution and before winding up is completed,
the partners (except a wrongfully dissociated one) can stop the process and carry on the business.
UPA and RUPA are not significantly different as to winding up, so they will be discussed together. Two
issues are discussed here: who can participate in winding up and how the assets of the firm are distributed
on liquidation.

Who Can Participate in Winding Up
The partners who have not wrongfully dissociated may participate in winding up the partnership
business. On application of any partner, a court may for good cause judicially supervise the winding up.

[25]

Settlement of Accounts among Partners
Determining the priority of liabilities can be problematic. For instance, debts might be incurred to both
outside creditors and partners, who might have lent money to pay off certain accounts or for working
capital.
An agreement can spell out the order in which liabilities are to be paid, but if it does not, UPA Section
40(a) and RUPA Section 807(1) rank them in this order: (1) to creditors other than partners, (2) to
partners for liabilities other than for capital and profits, (3) to partners for capital contributions, and
finally (4) to partners for their share of profits (see Figure 23.3 "Priority Partnership Liabilities under
RUPA"). However, RUPA eliminates the distinction between capital and profits when the firm pays
partners what is owed to them; RUPA Section 807(b) speaks simply of the right of a partner to a
liquidating distribution.
Figure 23.3 Priority Partnership Liabilities under RUPA

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Partners are entitled to share equally in the profits and surplus remaining after all liabilities, including
those owed to partners, are paid off, although the partnership agreement can state a different share—for
example, in proportion to capital contribution. If after winding up there is a net loss, whether capital or
otherwise, each partner must contribute toward it in accordance with his share in the profits, had there
been any, unless the agreement states otherwise. If any of the partners is insolvent or refuses to contribute
and cannot be sued, the others must contribute their own share to pay off the liabilities and in addition
must contribute, in proportion to their share of the profits, the additional amount necessary to pay the
liabilities of their defaulting partners.
In the event of insolvency, a court may take possession of both partnership property and individual assets
of the partners; this again is a big disadvantage to the partnership form.
The estate of a deceased partner is credited or liable as that partner would have been if she were living at
the time of the distribution.

KEY TAKEAWAY
Under UPA, the withdrawal of any partner from the partnership causes dissolution; the withdrawal may be
caused in accordance with the agreement, in violation of the agreement, by operation of law, or by court
order. Dissolution terminates the partners’ authority to act for the partnership, except for winding up, but
remaining partners may decide to carry on as a new partnership or may decide to terminate the firm. If they
continue, the old creditors remain as creditors of the new firm, the former partner remains liable for
obligations incurred while she was a partner (she may be liable for debts arising after she left, unless proper

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notice is given to creditors), and the former partner or her estate is entitled to an accounting and payment for
the partnership interest. If the partners move to terminate the firm, winding up begins.
Under RUPA, a partner who ceases to be involved in the business is dissociated, but dissociation does not
necessarily cause dissolution. Dissociation happens when a partner quits, voluntarily or involuntarily; when a
partner dies or becomes incompetent; or on request by the firm or a partner upon court order for a partner’s
wrongful conduct, among other reasons. The dissociated partner loses actual authority to bind the firm but
remains liable for predissociation obligations and may have lingering authority or lingering liability for two
years provided the other party thought the dissociated one was still a partner; a notice of dissociation will,
after ninety days, be good against the world as to dissociation and dissolution. If the firm proceeds to
termination (though partners can stop the process before its end), the next step is dissolution, which occurs
by acts of partners, by operation of law, or by court order upon application by a partner if continuing the
business has become untenable. After dissolution, the only business undertaken is to wind up affairs.
However, the firm may continue after dissociation; it must buy out the dissociated one’s interest, minus
damages if the dissociation was wrongful.
If the firm is to be terminated, winding up entails finishing the business at hand, paying off creditors, and
splitting the remaining surplus or liabilities according the parties’ agreement or, absent any, according to the
relevant act (UPA or RUPA).

EXERCISES
1.

Under UPA, what is the effect on the partnership of a partner’s ceasing to be involved in the business?

2.

Can a person no longer a partner be held liable for partnership obligations after her withdrawal? Can such
a person incur liability to the partnership?

3.

What obligation does a partnership or its partners owe to a partner who wrongfully terminates the
partnership agreement?

4.

What bearing does RUPA’s use of the term dissociate have on the entity theory that informs the revised
act?

5.

When a partnership is wound up, who gets paid first from its assets? If the firm winds up toward
termination and has inadequate assets to pay its creditors, what recourse, if any, do the creditors have?

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[1] UPA, Section 30.
[2] UPA, Section 31.
[3] UPA, Section 31.
[4] UPA, Section 32.
[5] UPA, Section 33.
[6] UPA, Sections 37 and 38.
[7] UPA, Section 38.
[8] UPA, Section 41(1).
[9] UPA, Section 36(1).
[10] UPA, Section 17.
[11] RUPA, Section 601.
[12] RUPA. Sections 603(b) and 804(a).
[13] RUPA, Section 603(b)(3).
[14] RUPA, Section 603(b)(1).
[15] RUPA, Section 702.
[16] RUPA, Section 703(a).
[17] RUPA, Section 103.
[18] Trans fats are hydrogenated vegetable oils; the process of hydrogenation essentially turns the oils into
semisolids, giving them a higher melting point and extending their shelf life but, unfortunately, also clogging
consumers’ arteries and causing heart disease. California banned their sale effective January 1, 2010; other
jurisdictions have followed suit.
[19] RUPA, Section 802.
[20] RUPA, Section 802(b).
[21] RUPA, Sections 601 and 801.
[22] RUPA, Section 701(e).
[23] RUPA, Section 701(h)(4)(i).
[24] UPA, Section 30; RUPA, Section 802(a).
[25] UPA, Section 37; RUPA, Section 803(a).

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23.4 Cases
Breach of Partnership Fiduciary Duty
Gilroy v. Conway
391 N.W. 2d 419 (Mich. App. 1986)
PETERSON, J.
Defendant cheated his partner and appeals from the trial court’s judgment granting that partner a
remedy.
Plaintiff was an established commercial photographer in Kalamazoo who also had a partnership interest
in another photography business, Colonial Studios, in Coldwater. In 1974, defendant became plaintiff’s
partner in Colonial Studios, the name of which was changed to Skylight Studios. Under the partnership
agreement, defendant was to be the operating manager of the partnership, in return for which he would
have a guaranteed draw. Except for the guaranteed draw, the partnership was equal in ownership and the
sharing of profits.
Prior to defendant’s becoming a partner, the business had acquired a small contractual clientele of schools
for which the business provided student portrait photographs. The partners agreed to concentrate on this
type of business, and both partners solicited schools with success. Gross sales, which were $40,000 in
1974, increased every year and amounted to $209,085 in 1980 [about $537,000 in 2011 dollars].
In the spring of 1981, defendant offered to buy out plaintiff and some negotiations followed. On June 25,
1981, however, plaintiff was notified by the defendant that the partnership was dissolved as of July 1,
1981. Plaintiff discovered that defendant: had closed up the partnership’s place of business and opened up
his own business; had purchased equipment and supplies in preparation for commencing his own
business and charged them to the partnership; and had taken with him the partnership employees and
most of its equipment.
Defendant had also stolen the partnership’s business. He had personally taken over the business of some
customers by telling them that the partnership was being dissolved; in other cases he simply took over

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partnership contracts without telling the customers that he was then operating on his own. Plaintiff also
learned that defendant’s deceit had included the withdrawal, without plaintiff’s knowledge, of partnership
funds for defendant’s personal use in 1978 in an amount exceeding $11,000 [about $36,000 in 2011
dollars].
The trial judge characterized the case as a “classic study of greed” and found that defendant had in effect
appropriated the business enterprise, holding that defendant had “knowingly and willfully violated his
fiduciary relationship as a partner by converting partnership assets to his use and, in doing so, literally
destroying the partnership.” He also found that the partnership could have been sold as a going business
on June 30, 1981, and that after a full accounting, it had a value on that date of $94,596 less accounts
payable of $17,378.85, or a net value of $77,217.15. The division thereof after adjustments for plaintiff’s
positive equity or capital resulted in an award to plaintiff for his interest in the business of $53,779.46
[about $126,000 in 2011 dollars].…
Plaintiff also sought exemplary [punitive] damages. Count II of the complaint alleged that defendant’s
conduct constituted a breach of defendant’s fiduciary duty to his partner under §§ 19-22 of the Uniform
Partnership Act, and Count III alleged conversion of partnership property. Each count contained
allegations that defendant’s conduct was willful, wanton and in reckless disregard of plaintiff’s rights and
that such conduct had caused injury to plaintiff’s feelings, including humiliation, indignity and a sense of
moral outrage. The prayer for relief sought exemplary damages therefore.
Plaintiff’s testimony on the point was brief. He said:
The effect of really the whole situation, and I think it was most apparent when I walked into the empty
building, was extreme disappointment and really total outrage at the fact that something that I had given
the utmost of my talent and creativity, energy, and whatever time was necessary to build, was totally
destroyed and there was just nothing of any value that was left.…My business had been stolen and there
wasn’t a thing that I could do about it. And to me, that was very humiliating that one day I had something
that I had worked 10 years on, and the next day I had absolutely nothing of any value.
As noted above, the trial judge found that defendant had literally destroyed the partnership by knowingly
and willfully converting partnership assets in violation of his fiduciary duty as a partner. He also found

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that plaintiff had suffered a sense of outrage, indignity and humiliation and awarded him $10,000
[$23,000 in 2011 dollars] as exemplary damages.
Defendant appeals from that award, asserting that plaintiff’s cause of action arises from a breach of the
partnership contract and that exemplary damages may not be awarded for breach of that contract.…
If it were to be assumed that a partner’s breach of his fiduciary duty or appropriation of partnership
equipment and business contract to his own use and profit are torts, it is clear that the duty breached
arises from the partnership contract. One acquires the property interest of a co-tenant in partnership only
by the contractual creation of a partnership; one becomes a fiduciary in partnership only by the
contractual undertaking to become a partner. There is no tortious conduct here existing independent of
the breach of the partnership contract.
Neither do we see anything in the Uniform Partnership Act to suggest that an aggrieved partner is entitled
to any remedy other than to be made whole economically. The act defines identically the partnership
fiduciary duty and the remedy for its breach, i.e., to account:
Sec. 21. (1) Every partner must account to the partnership for any benefit, and hold as trustee for it any
profits derived by him without the consent of the other partners from any transaction connected with the
formation, conduct, or liquidation of the partnership or from any use by him of its property.
So, the cases involving a partner’s breach of the fiduciary duty to their partners have been concerned
solely with placing the wronged partners in the economic position that they would have enjoyed but for
the breach.
[Judgment for plaintiff affirmed, as modified with regard to damages.]

CASE QUESTIONS
1.

For what did the court award the plaintiff $53,000?

2.

The court characterizes the defendant as having “cheated his partner”—that is, Conway committed
fraud. (Gilroy said his business had been “stolen.”) Fraud is a tort. Punitive damages may be awarded
against a tortfeasor, even in a jurisdiction that generally disallows punitive damages in contract. In
fact, punitive damages are sometimes awarded for breach of the partnership fiduciary duty. In

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Cadwalader, Wickersham & Taft v. Beasley, 728 So.2d 253 (Florida Ct. App., 1998), a New York law
firm was found to have wrongfully expelled a partner lawyer, Beasley, from membership in its Palm
Beach, Florida, offices. New York law controlled. The trial court awarded Beasley $500,000 in punitive
damages. The appeals court, construing the same UPA as the court construed in Gilroy, said:
Under New York law, the nature of the conduct which justifies an award of punitive damages is
conduct having a high degree of moral culpability, or, in other words, conduct which shows a
“conscious disregard of the rights of others or conduct so reckless as to amount to such
disregard.”…[S]ince the purpose of punitive damages is to both punish the wrongdoer and deter
others from such wrongful behavior, as a matter of policy, courts have the discretion to award
punitive damages[.]…[The defendant] was participating in a clandestine plan to wrongfully expel
some partners for the financial gain of other partners. Such activity cannot be said to be
honorable, much less to comport with the “punctilio of an honor.” Because these findings
establish that [the defendant] consciously disregarded the rights of Beasley, we affirm the award
of punitive damages.
As a matter of social policy, which is the better ruling, the Michigan court’s in Gilroy or the Florida
court’s in Cadwalader?

Partnership Authority, Express or Apparent
Hodge v Garrett
614 P.2d 420 (Idaho 1980)
Bistline, J.
[Plaintiff] Hodge and defendant-appellant Rex E. Voeller, the managing partner of the Pay-Ont Drive-In
Theatre, signed a contract for the sale of a small parcel of land belonging to the partnership. That parcel,
although adjacent to the theater, was not used in theater operations except insofar as the east 20 feet were
necessary for the operation of the theater’s driveway. The agreement for the sale of land stated that it was
between Hodge and the Pay-Ont Drive-In Theatre, a partnership. Voeller signed the agreement for the
partnership, and written changes as to the footage and price were initialed by Voeller. (The trial court

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found that Hodge and Voeller had orally agreed that this 20 foot strip would be encumbered by an
easement for ingress and egress to the partnership lands.)
Voeller testified that he had told Hodge prior to signing that Hodge would have to present him with a plat
plan which would have to be approved by the partners before the property could be sold. Hodge denied
that a plat plan had ever been mentioned to him, and he testified that Voeller did not tell him that the
approval of the other partners was needed until after the contract was signed. Hodge also testified that he
offered to pay Voeller the full purchase price when he signed the contract, but Voeller told him that that
was not necessary.
The trial court found that Voeller had actual and apparent authority to execute the contract on behalf of
the partnership, and that the contract should be specifically enforced. The partners of the Pay-Ont DriveIn Theatre appeal, arguing that Voeller did not have authority to sell the property and that Hodge knew
that he did not have that authority.
At common law one partner could not, “without the concurrence of his copartners, convey away the real
estate of the partnership, bind his partners by a deed, or transfer the title and interest of his copartners in
the firm real estate.” [Citation] This rule was changed by the adoption of the Uniform Partnership
Act.…[citing the statute].
The meaning of these provisions was stated in one text as follows:
“If record title is in the partnership and a partner conveys in the partnership name, legal title passes. But
the partnership may recover the property (except from a bona fide purchaser from the grantee) if it can
show (A) that the conveying partner was not apparently carrying on business in the usual way or (B) that
he had in fact no authority and the grantee had knowledge of that fact. The burden of proof with respect to
authority is thus on the partnership.” [Citation]
Thus this contract is enforceable if Voeller had the actual authority to sell the property, or, even if Voeller
did not have such authority, the contract is still enforceable if the sale was in the usual way of carrying on
the business and Hodge did not know that Voeller did not have this authority.

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As to the question of actual authority, such authority must affirmatively appear, “for the authority of one
partner to make and acknowledge a deed for the firm will not be presumed.…” [Citation] Although such
authority may be implied from the nature of the business, or from similar past transactions [Citation],
nothing in the record in this case indicates that Voeller had express or implied authority to sell real
property belonging to the partnership. There is no evidence that Voeller had sold property belonging to
the partnership in the past, and obviously the partnership was not engaged in the business of buying and
selling real estate.
The next question, since actual authority has not been shown, is whether Voeller was conducting the
partnership business in the usual way in selling this parcel of land such that the contract is binding under
[the relevant section of the statute] i.e., whether Voeller had apparent authority. Here the evidence
showed, and the trial court found:
1.

“That the defendant, Rex E. Voeller, was one of the original partners of the Pay-Ont Drive In Theatre;
that the other defendants obtained their partnership interest by inheritance upon the death of other
original partners; that upon the death of a partner the partnership affairs were not wound up, but
instead, the partnership merely continued as before, with the heirs of the deceased partner owning
their proportionate share of the partnership interest.

2. “That at the inception of the partnership, and at all times thereafter, Rex E. Voeller was the exclusive,
managing partner of the partnership and had the full authority to make all decisions pertaining to the
partnership affairs, including paying the bills, preparing profit and loss statements, income tax
returns and the ordering of any goods or services necessary to the operation of the business.”
The court made no finding that it was customary for Voeller to sell real property, or even personal
property, belonging to the partnership. Nor was there any evidence to this effect. Nor did the court discuss
whether it was in the usual course of business for the managing partner of a theater to sell real property.
Yet the trial court found that Voeller had apparent authority to sell the property. From this it must be
inferred that the trial court believed it to be in the usual course of business for a partner who has exclusive
control of the partnership business to sell real property belonging to the partnership, where that property
is not being used in the partnership business. We cannot agree with this conclusion. For a theater,
“carrying on in the usual way the business of the partnership,” [Citation to relevant section of the statute]

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means running the operations of the theater; it does not mean selling a parcel of property adjacent to the
theater. Here the contract of sale stated that the land belonged to the partnership, and, even if Hodge
believed that Voeller as the exclusive manager had authority to transact all business for the firm, Voeller
still could not bind the partnership through a unilateral act which was not in the usual business of the
partnership. We therefore hold that the trial court erred in holding that this contract was binding on the
partnership.
Judgment reversed. Costs to appellant.

CASE QUESTIONS
1.

What was the argument that Voeller had actual authority? What did the court on appeal say about that
argument?

2.

What was the argument that Voeller had apparent authority? What did the court on appeal say about
that argument? To rephrase the question, what facts would have been necessary to confer on Voeller
apparent authority?

Partnership Bound by Contracts Made by a Partner on Its Behalf; Partners’
Duties to Each Other; Winding Up
Long v. Lopez
115 S.W.3d 221 (Texas App. 2003)
Holman, J.
Wayne A. Long [plaintiff at the trial court] sued Appellee Sergio Lopez to recover from him, jointly and
severally, his portion of a partnership debt that Long had paid. After a bench trial, the trial court ruled
that Long take nothing from Appellee. We reverse and render, and remand for calculation of attorney’s
fees in this suit and pre- and post-judgment interest.
Long testified that in September 1996, Long, Lopez, and Don Bannister entered into an oral partnership
agreement in which they agreed to be partners in Wood Relo (“the partnership”), a trucking business
located in Gainesville, Texas. Wood Relo located loads for and dispatched approximately twenty trucks it
leased from owner-operators.…

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The trial court found that Long, Lopez, and Bannister formed a partnership, Wood Relo, without a written
partnership agreement. Lopez does not contest these findings.
Long testified that to properly conduct the partnership’s business, he entered into an office equipment
lease with IKON Capital Corporation (“IKON”) on behalf of the partnership. The lease was a thirty-month
contract under which the partnership leased a telephone system, fax machine, and photocopier at a rate of
$577.91 per month. The lease agreement was between IKON and Wood Relo; the “authorized signer” was
listed as Wayne Long, who also signed as personal guarantor.
Long stated that all three partners were authorized to buy equipment for use by the partnership. He
testified that the partners had agreed that it was necessary for the partnership to lease the equipment and
that on the day the equipment was delivered to Wood Relo’s office, Long was the only partner at the
office; therefore, Long was the only one available to sign the lease and personal guaranty that IKON
required. [The partnership disintegrated when Bannister left and he later filed for bankruptcy.]…Long
testified that when Bannister left Wood Relo, the partnership still had “quite a few” debts to pay,
including the IKON lease.…
Eventually, IKON did repossess all the leased equipment. Long testified that he received a demand letter
from IKON, requesting payment by Wood Relo of overdue lease payments and accelerating payment of
the remaining balance of the lease. IKON sought recovery of past due payments in the amount of
$2,889.55 and accelerated future lease payments in the amount of $11,558.20, for a total of $14,447.75,
plus interest, costs, and attorney’s fees, with the total exceeding $16,000. Long testified that he advised
Lopez that he had received the demand letter from IKON.
Ultimately, IKON filed a lawsuit against Long individually and d/b/a Wood Relo, but did not name Lopez
or Bannister as parties to the suit. Through his counsel, Long negotiated a settlement with IKON for a
total of $9,000. An agreed judgment was entered in conjunction with the settlement agreement providing
that if Long did not pay the settlement, Wood Relo and Long would owe IKON $12,000.
After settling the IKON lawsuit, Long’s counsel sent a letter to Lopez and Bannister regarding the
settlement agreement, advising them that they were jointly and severally liable for the $9,000 that
extinguished the partnership’s debt to IKON, plus attorney’s fees.…

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The trial court determined that Long was not entitled to reimbursement from Lopez because Long was not
acting for the partnership when he settled IKON’s claim against the partnership. The court based its
conclusion on the fact that Long had no “apparent authority with respect to lawsuits” and had not notified
Lopez of the IKON lawsuit.

Analysis
To the extent that a partnership agreement does not otherwise specify, the provisions of the Texas Revised
Partnership Act govern the relations of the partners and between the partners and the partnership.
[Citations] Under the Act, each partner has equal rights in the management and conduct of the business
of a partnership. With certain inapplicable exceptions, all partners are liable jointly and severally for all
debts and obligations of the partnership unless otherwise agreed by the claimant or provided by law. A
partnership may be sued and may defend itself in its partnership name. Each partner is an agent of the
partnership for the purpose of its business; unless the partner does not have authority to act for the
partnership in a particular matter and the person with whom the partner is dealing knows that the
partner lacks authority, an act of a partner, including the execution of an instrument in the partnership
name, binds the partnership if “the act is for apparently carrying on in the ordinary course: (1) the
partnership business.” [Citation] If the act of a partner is not apparently for carrying on the partnership
business, an act of a partner binds the partnership only if authorized by the other partners. [Citation]
The extent of authority of a partner is determined essentially by the same principles as those measuring
the scope of the authority of an agent. [Citation] As a general rule, each partner is an agent of the
partnership and is empowered to bind the partnership in the normal conduct of its business. [Citation]
Generally, an agent’s authority is presumed to be coextensive with the business entrusted to his care.
[Citations] An agent is limited in his authority to such contracts and acts as are incident to the
management of the particular business with which he is entrusted. [Citation]

Winding Up the Partnership
A partner’s duty of care to the partnership and the other partners is to act in the conduct and winding up
of the partnership business with the care an ordinarily prudent person would exercise in similar
circumstances. [Citation] During the winding up of a partnership’s business, a partner’s fiduciary duty to

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the other partners and the partnership is limited to matters relating to the winding up of the partnership’s
affairs. [Citation]
Long testified that he entered into the settlement agreement with IKON to save the partnership a
substantial amount of money. IKON’s petition sought over $16,000 from the partnership, and the
settlement agreement was for $9,000; therefore, Long settled IKON’s claim for 43% less than the amount
for which IKON sued the partnership.
Both Long and Lopez testified that the partnership “fell apart,” “virtually was dead,” and had to move
elsewhere.…The inability of the partnership to continue its trucking business was an event requiring the
partners to wind up the affairs of the partnership. See [Citation]…
The Act provides that a partner winding up a partnership’s business is authorized, to the extent
appropriate for winding up, to perform the following in the name of and for and on behalf of the
partnership:
(1) prosecute and defend civil, criminal, or administrative suits;
(2) settle and close the partnership’s business;
(3) dispose of and convey the partnership’s property;
(4) satisfy or provide for the satisfaction of the partnership’s liabilities;
(5) distribute to the partners any remaining property of the partnership; and
(6) perform any other necessary act. [Citation]
Long accrued the IKON debt on behalf of the partnership when he secured the office equipment for
partnership operations, and he testified that he entered into the settlement with IKON when the
partnership was in its final stages and the partners were going their separate ways. Accordingly, Long was
authorized by the Act to settle the IKON lawsuit on behalf of the partnership.…

Lopez’s Liability for the IKON Debt

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If a partner reasonably incurs a liability in excess of the amount he agreed to contribute in properly
conducting the business of the partnership or for preserving the partnership’s business or property, he is
entitled to be repaid by the partnership for that excess amount. [Citation] A partner may sue another
partner for reimbursement if the partner has made such an excessive payment. [Citation]
With two exceptions not applicable to the facts of this case, all partners are liable jointly and severally for
all debts and obligations of the partnership unless otherwise agreed by the claimant or provided by law.
Because Wood Relo was sued for a partnership debt made in the proper conduct of the partnership
business, and Long settled this claim in the course of winding up the partnership, he could maintain an
action against Lopez for reimbursement of Long’s disproportionate payment. [Citations]

Attorneys’ Fees
Long sought to recover the attorney’s fees expended in defending the IKON claim, and attorney’s fees
expended in the instant suit against Lopez. Testimony established that it was necessary for Long to
employ an attorney to defend the action brought against the partnership by IKON; therefore, the
attorney’s fees related to defending the IKON lawsuit on behalf of Wood Relo are a partnership debt for
which Lopez is jointly and severally liable. As such, Long is entitled to recover from Lopez one-half of the
attorney’s fees attributable to the IKON lawsuit. The evidence established that reasonable and necessary
attorney’s fees to defend the IKON lawsuit were $1725. Therefore, Long is entitled to recover from Lopez
$862.50.
Long also seeks to recover the attorney’s fees expended pursuing the instant lawsuit. See [Texas statute
citation] (authorizing recovery of attorney’s fees in successful suit under an oral contract); see also
[Citation] (holding attorney’s fees are recoverable by partner under because action against other partner
was founded on partnership agreement, which was a contract). We agree that Long is entitled to recover
reasonable and necessary attorney’s fees incurred in bringing the instant lawsuit. Because we are
remanding this case so the trial court can determine the amount of pre- and post-judgment interest to be
awarded to Long, we also remand to the trial court the issue of the amount of attorney’s fees due to Long
in pursuing this lawsuit against Lopez for collection of the amount paid to IKON on behalf of the
partnership.

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Conclusion
We hold the trial court erred in determining that Long did not have authority to act for Wood Relo in
defending, settling, and paying the partnership debt owed by Wood Relo to IKON. Lopez is jointly and
severally liable to IKON for $9,000, which represents the amount Long paid IKON to defend and
extinguish the partnership debt. We hold that Lopez is jointly and severally liable to Long for $1725,
which represents the amount of attorney’s fees Long paid to defend against the IKON claim. We further
hold that Long is entitled to recover from Lopez reasonable and necessary attorney’s fees in pursuing the
instant lawsuit.
We reverse the judgment of the trial court. We render judgment that Lopez owes Long $5362.50 (one-half
of the partnership debt to IKON plus one-half of the corresponding attorney’s fees). We remand the case
to the trial court for calculation of the amount of attorney’s fees owed by Lopez to Long in the instant
lawsuit, and calculation of pre- and post-judgment interest.

CASE QUESTIONS
1.

Why did the trial court determine that Lopez owed Long nothing?

2.

Absent a written partnership agreement, what rules control the operation and winding up of the
partnership?

3.

Why did the appeals court determine that Long did have authority to settle the lawsuit with IKON?

4.

Lopez was not named by IKON when it sued Long and the partnership. Why did the court determine that
did not matter, that Lopez was still liable for one-half the costs of settling that case?

5.

Why was Long awarded compensation for the attorneys’ fees expended in dealing with the IKON matter
and in bringing this case?

Dissolution under RUPA
Horizon/CMS Healthcare Corp. v. Southern Oaks Health Care, Inc.
732 So.2d 1156 (Fla. App. 1999)
Goshorn, J.

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Horizon is a large, publicly traded provider of both nursing home facilities and management for nursing
home facilities. It wanted to expand into Osceola County in 1993. Southern Oaks was already operating in
Osceola County[.]…Horizon and Southern Oaks decided to form a partnership to own the proposed [new]
facility, which was ultimately named Royal Oaks, and agreed that Horizon would manage both the
Southern Oaks facility and the new Royal Oaks facility. To that end, Southern Oaks and Horizon entered
into several partnership and management contracts in 1993.
In 1996, Southern Oaks filed suit alleging numerous defaults and breaches of the twenty-year
agreements.…[T]he trial court found largely in favor of Southern Oaks, concluding that Horizon breached
its obligations under two different partnership agreements [and that] Horizon had breached several
management contracts. Thereafter, the court ordered that the partnerships be dissolved, finding that “the
parties to the various agreements which are the subject of this lawsuit are now incapable of continuing to
operate in business together” and that because it was dissolving the partnerships, “there is no entitlement
to future damages.…” In its cross appeal, Southern Oaks asserts that because Horizon unilaterally and
wrongfully sought dissolution of the partnerships, Southern Oaks should receive a damage award for the
loss of the partnerships’ seventeen remaining years’ worth of future profits. We reject its argument.
Southern Oaks argues Horizon wrongfully caused the dissolution because the basis for dissolution cited
by the court is not one of the grounds for which the parties contracted. The pertinent contracts provided
in section 7.3 “Causes of Dissolution”: “In addition to the causes for dissolution set forth in Section 7.2(c),
the Partnership shall be dissolved in the event that:…(d) upon thirty (30) days prior written notice to the
other Partner, either Partner elects to dissolve the Partnership on account of an Irreconcilable Difference
which arises and cannot, after good faith efforts, be resolved.…”
Southern Oaks argues that what Horizon relied on at trial as showing irreconcilable differences—the
decisions of how profits were to be determined and divided—were not “good faith differences of opinion,”
nor did they have “a material and adverse impact on the conduct of the Partnerships’ Business.” Horizon’s
refusal to pay Southern Oaks according to the terms of the contracts was not an “irreconcilable difference”
as defined by the contract, Southern Oaks asserts, pointing out that Horizon’s acts were held to be
breaches of the contracts. Because there was no contract basis for dissolution, Horizon’s assertion of
dissolution was wrongful, Southern Oaks concludes.

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Southern Oaks contends further that not only were there no contractual grounds for dissolution,
dissolution was also wrongful under the Florida Statutes. Southern Oaks argues that pursuant to section
[of that statute] Horizon had the power to dissociate from the partnership, but, in the absence of contract
grounds for the dissociation, Horizon wrongfully dissociated. It asserts that it is entitled to lost future
profits under Florida’s partnership law.…
We find Southern Oaks’ argument without merit. First, the trial court’s finding that the parties are
incapable of continuing to operate in business together is a finding of “irreconcilable differences,” a
permissible reason for dissolving the partnerships under the express terms of the partnership agreements.
Thus, dissolution was not “wrongful,” assuming there can be “wrongful” dissolutions, and Southern Oaks
was not entitled to damages for lost future profits. Additionally, the partnership contracts also permit
dissolution by “judicial decree.” Although neither party cites this provision, it appears that pursuant
thereto, the parties agreed that dissolution would be proper if done by a trial court for whatever reason
the court found sufficient to warrant dissolution.
Second, even assuming the partnership was dissolved for a reason not provided for in the partnership
agreements, damages were properly denied. Under RUPA, it is clear that wrongful dissociation triggers
liability for lost future profits. See[RUPA:] “A partner who wrongfully dissociates is liable to the
partnership and to the other partners for damages caused by the dissociation. The liability is in addition
to any other obligation of the partner to the partnership or to the other partners.” However, RUPA
does not contain a similar provision for dissolution; RUPA does not refer to the dissolutions as rightful or
wrongful. [RUPA sets out] “Events causing dissolution and winding up of partnership business,” [and]
outlines the events causing dissolution without any provision for liability for damages.…[RUPA]
recognizes judicial dissolution:
A partnership is dissolved, and its business must be wound up, only upon the occurrence of any of the
following events:…
(5) On application by a partner, a judicial determination that:
(a) The economic purpose of the partnership is likely to be unreasonably frustrated;

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(b) Another partner has engaged in conduct relating to the partnership business which makes it not
reasonably practicable to carry on the business in partnership with such partner; or
(c) It is not otherwise reasonably practicable to carry on the partnership business in conformity with the
partnership agreement[.]…
Paragraph (5)(c) provides the basis for the trial court’s dissolution in this case. While “reasonably
practicable” is not defined in RUPA, the term is broad enough to encompass the inability of partners to
continue working together, which is what the court found.
Certainly the law predating RUPA allowed for recovery of lost profits upon the wrongful dissolution of a
partnership. See e.g., [Citation]: “A partner who assumes to dissolve the partnership before the end of the
term agreed on in the partnership articles is liable, in an action at law against him by his co-partner for
the breach of the agreement, to respond in damages for the value of the profits which the plaintiff would
otherwise have received.”
However, RUPA brought significant changes to partnership law, among which was the adoption of the
term “dissociation.” Although the term is undefined in RUPA, dissociation appears to have taken the place
of “dissolution” as that word was used pre-RUPA. “Dissolution” under RUPA has a different meaning,
although the term is undefined in RUPA. It follows that the pre-RUPA cases providing for future damages
upon wrongful dissolution are no longer applicable to a partnership dissolution. In other words a
“wrongful dissolution” referred to in the pre-RUPA case law is now, under RUPA, known as “wrongful
dissociation.” Simply stated, under [RUPA], only when a partner dissociates and the dissociation is
wrongful can the remaining partners sue for damages. When a partnership is dissolved, RUPA…provides
the parameters of liability of the partners upon dissolution.…
[Citation]: “Dissociation is not a condition precedent to dissolution.…Most dissolution events are
dissociations. On the other hand, it is not necessary to have a dissociation to cause a dissolution and
winding up.”
Southern Oaks’ attempt to bring the instant dissolution under the statute applicable to dissociation is
rejected. The trial court ordered dissolution of the partnership, not the dissociation of Horizon for

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wrongful conduct. There no longer appears to be “wrongful” dissolution—either dissolution is provided
for by contract or statute or the dissolution was improper and the dissolution order should be reversed. In
the instant case, because the dissolution either came within the terms of the partnership agreements or
[RUPA] (judicial dissolution where it is not reasonably practicable to carry on the partnership business),
Southern Oaks’ claim for lost future profits is without merit. Affirmed.

CASE QUESTIONS
1.

Under RUPA, what is a dissociation? What is a dissolution?

2.

Why did Southern Oaks claim there was no contractual basis for dissolution, notwithstanding the
determination that Horizon had breached the partnership agreement and the management contract?

3.

Given those findings, what did Southern Oaks not get at the lower-court trial that it wanted on this
appeal?

4.

Why didn’t Southern Oaks get what it wanted on this appeal?

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23.5 Summary and Exercises
Summary
Most of the Uniform Partnership Act (UPA) and Revised Uniform Partnership Act (RUPA) rules apply
only in the absence of agreement among the partners. Under both, unless the agreement states otherwise,
partners have certain duties: (1) the duty to serve—that is, to devote themselves to the work of the
partnership; (2) the duty of loyalty, which is informed by the fiduciary standard: the obligation to act
always in the best interest of the partnership and not in one’s own best interest; (3) the duty of care—that
is, to act as a reasonably prudent partner would; (4) the duty of obedience not to breach any aspect of the
agreement or act without authority; (5) the duty to inform copartners; and (6) the duty to account to the
partnership. Ordinarily, partners operate through majority vote, but no act that contravenes the
partnership agreement itself can be undertaken without unanimous consent.
Partners’ rights include rights (1) to distributions of money, including profits (and losses) as per the
agreement or equally, indemnification, and return of capital contribution (but not a right to
compensation); (2) to management as per the agreement or equally; (3) to choose copartners; (4) to
property of the partnership, but no partner has any rights to specific property (under UPA the partners
own property as tenants in partnership; under RUPA the partnership as entity owns property, but it will
be distributed upon liquidation); (5) to assign (voluntarily or involuntarily) the partnership interest; the
assignee does not become a partner or have any management rights, but a judgment creditor may obtain a
charging order against the partnership; and (6) to enforce duties and rights by suits in law or equity
(under RUPA a formal accounting is not required).
Under UPA, a change in the relation of the partners dissolves the partnership but does not necessarily
wind up the business. Dissolution may be voluntary, by violation of the agreement, by operation of law, or
by court order. Dissolution terminates the authority of the partners to act for the partnership. After
dissolution, a new partnership may be formed.
Under RUPA, a change in the relation of the partners is a dissociation, leaving the remaining partners
with two options: continue on; or wind up, dissolve, and terminate. In most cases, a partnership may buy

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out the interest of a partner who leaves without dissolving the partnership. A term partnership also will
not dissolve so long as at least one-half of the partners choose to remain. When a partner’s dissociation
triggers dissolution, partners are allowed to vote subsequently to continue the partnership.
When a dissolved partnership is carried on as a new one, creditors of the old partnership remain creditors
of the new one. A former partner remains liable to the creditors of the former partnership. A new partner
is liable to the creditors of the former partnership, bur only to the extent of the new partner’s capital
contribution. A former partner remains liable for debts incurred after his withdrawal unless he gives
proper notice of his withdrawal; his actual authority terminates upon dissociation and apparent authority
after two years.
If the firm is to be terminated, it is wound up. The assets of the partnership include all required
contributions of partners, and from the assets liabilities are paid off (1) to creditors and (2) to partners on
their accounts. Under RUPA, nonpartnership creditors share equally with unsatisfied partnership
creditors in the personal assets of their debtor-partners.

EXERCISES
1.

Anne and Barbara form a partnership. Their agreement specifies that Anne will receive two-thirds of the
profit and Barbara will get one-third. The firm suffers a loss of $3,000 the first year. How are the losses
divided?

2.

Two lawyers, Glenwood and Higgins, formed a partnership. Glenwood failed to file Client’s paperwork on
time in a case, with adverse financial consequences to Client. Is Higgins liable for Glenwood’s
malpractice?

3.

When Client in Exercise 2 visited the firm’s offices to demand compensation from Glenwood, the two got
into an argument. Glenwood became very agitated; in an apparent state of rage, he threw a law book at
Client, breaking her nose. Is Higgins liable?

4.

Assume Glenwood from Exercise 2 entered into a contract on behalf of the firm to buy five computer
games. Is Higgins liable?

5.

Grosberg and Goldman operated the Chatham Fox Hills Shopping Center as partners. They agreed that
Goldman would deposit the tenants’ rental checks in an account in Grosberg’s name at First Bank.

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Without Grosberg’s knowledge or permission, Goldman opened an account in both their names at Second
Bank, into which Goldman deposited checks payable to the firm or the partners. He indorsed each check
by signing the name of the partnership or the partners. Subsequently, Goldman embezzled over $100,000
of the funds. Second Bank did not know Grosberg and Goldman were partners. Grosberg then sued
Second Bank for converting the funds by accepting checks on which Grosberg’s or the partnership’s
indorsement was forged. Is Second Bank liable? Discuss.
6.

Pearson Collings, a partner in a criminal defense consulting firm, used the firm’s phones and computers to
operate a side business cleaning carpets. The partnership received no compensation for the use of its
equipment. What claim would the other partners have against Collings?

7.

Follis, Graham, and Hawthorne have a general partnership, each agreeing to split losses 20 percent, 20
percent, and 60 percent, respectively. While on partnership business, Follis negligently crashes into a
victim, causing $100,000 in damages. Follis declares bankruptcy, and the firm’s assets are inadequate to
pay the damages. Graham says she is liable for only $20,000 of the obligation, as per the agreement. Is
she correct?

8.

Ingersoll and Jackson are partners; Kelly, after much negotiation, agreed to join the firm effective
February 1. But on January 15, Kelly changed his mind. Meanwhile, however, the other two had already
arranged for the local newspaper to run a notice that Kelly was joining the firm. The notice ran on
February 1. Kelly did nothing in response. On February 2, Creditor, having seen the newspaper notice,
extended credit to the firm. When the firm did not pay, Creditor sought to have Kelly held liable as a
partner. Is Kelly liable?

SELF-TEST QUESTIONS
1.

Under UPA, a partner is generally entitled to a formal accounting of partnership affairs
a.

whenever it is just and reasonable

b.

if a partner is wrongfully excluded from the business by copartners

c.

if the right exists in the partnership agreement

d.

all of the above

Donners, Inc., a partner in CDE Partnership, applies to Bank to secure a loan and assigns to Bank
its partnership interest. After the assignment, which is true?
a.

Bank steps into Donners’s shoes as a partner.

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b.

Bank does not become a partner but has the right to participate in the management of the firm
to protect its security interest until the loan is paid.

c.

Bank is entitled to Donners’s share of the firm’s profits.

d.

Bank is liable for Donners’s share of the firm’s losses.

e.

None of these is true.
Which of these requires unanimous consent of the partners in a general partnership?

a.

the assignment of a partnership interest

b.

the acquisition of a partnership debt

c.

agreement to be responsible for the tort of one copartner

d.

admission of a new partner

e.

agreement that the partnership should stand as a surety for a third party’s obligation
Paul Partner (1) bought a computer and charged it to the partnership’s account; (2) cashed a
firm check and used the money to buy a computer in his own name; (3) brought from home a
computer and used it at the office. In which scenario does the computer become partnership
property?

a.

1 only

b.

1 and 2

c.

1, 2, and 3
That partnerships are entities under RUPA means they have to pay federal income tax in their
own name.

a.

true

b.

false
That partnerships are entities under RUPA means the partners are not personally liable for the
firm’s debts beyond their capital contributions.

a.

true

b.

false

SELF-TEST ANSWERS
1.

d

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2.

c

3.

d

4.

b

5.

a

6.

b

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Chapter 24

Hybrid Business Forms
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

The limited partnership

2.

The limited liability company

3.

Other hybrid business forms: the sub-S corporation, limited liability partnerships, and limited
liability limited partnerships

This chapter provides a bridge between the partnership and the corporate form. It explores several
types of associations that are hybrid forms—that is, they share some aspects of partnerships and
some of corporations. Corporations afford the inestimable benefit of limited liability, partnerships
the inestimable benefit of limited taxation. Businesspeople always seek to limit their risk and their
taxation.
At base, whether to allow businesspeople and investors to grasp the holy grail of limited liability is a
political issue. When we say a person is “irresponsible,” it means he (or she, or it) does not take
responsibility for his harmful actions; the loss is borne by others. Politically speaking, there is an
incentive to allow businesspeople insulation from liability: it encourages them to take risks and
invest, thus stimulating economic activity and forestalling unemployment. So the political trade-off
with allowing various inventive forms of business organization is between providing business actors
with the security that they will lose only their calculable investment, thus stimulating the economy,
versus the “moral hazard” of allowing them to emerge mostly unscathed from their own harmful or
foolish activities, thus externalizing resulting losses upon others. Some people feel that during the
run-up to the “Great Recession” of 2007–09, the economic system allowed too much risk taking.
When the risky investments collapsed, though, instead of forcing the risk takers to suffer loss, the

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government intervened—it “bailed them out,” as they say, putting the consequences of the failed
risks on the taxpayer.
The risk-averseness and inventiveness of businesspeople is seemingly unlimited, as is investors’ urge
to make profits through others’ efforts with as little risk as possible. The rationale for the invention of
these hybrid business forms, then, is (1) risk reduction and (2) tax reduction. Here we take up the
most common hybrid types first: limited partnerships and limited liability companies. Then we cover
them in the approximate chronological order of their invention: sub-S corporations, limited liability
partnerships, and limited liability limited partnerships. All these forms are entities.

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24.1 Limited Partnerships
LEARNING OBJECTIVES
Understand the following aspects of the limited partnership:
1.

Governing law and definition

2.

Creation and capitalization

3.

Control and compensation

4.

Liabilities

5.

Taxation

6.

Termination

Governing Law and Definition
The limited partnership is attractive because of its treatment of taxation and its imposition of limited
liability on its limited partners.

Governing Law
The original source of limited partnership law is the Uniform Limited Partnership Act (ULPA), which was
drafted in 1916. A revised version, the Revised Uniform Limited Partnership Act (RULPA), was adopted
by the National Conference of Commissioners on Uniform Laws in 1976 and further amended in 1985 and
in 2001.
The 2001 act was
drafted for a world in which limited liability partnerships and limited liability companies can meet many
of the needs formerly met by limited partnerships. This Act therefore targets two types of enterprises that
seem largely beyond the scope of LLPs and LLCs: (i) sophisticated, manager-entrenched commercial deals
whose participants commit for the long term, and (ii) estate planning arrangements (family limited
partnerships). The Act accordingly assumes that, more often than not, people utilizing it will want (1)
strong centralized management, strongly entrenched, and (2) passive investors with little control over or
right to exit the entity. The Act’s rules, and particularly its default rules, have been designed to reflect
these assumptions.

[1]

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All states except Louisiana adopted the 1976 or 1985 act—most opting for the 1985 version—and sixteen
states have adopted the 2001 version. The acts may be properly referred to with a hyphen: “ULPA-1985,”
or “ULPA-2001”; the wordrevised has been dropped. Here, we mainly discuss ULPA-1985. The Uniform
Partnership Act (UPA) or the Revised Uniform Partnership Act (RUPA) also applies to limited
partnerships except where it is inconsistent with the limited partnership statutes. The ULPA-2001 is not
so much related to UPA or RUPA as previous versions were.

Definition
A limited partnership (LP) is defined as “a partnership formed by two or more persons under the laws of a
State and having one or more general partners and one or more limited partners.”

[2]

The form tends to be

attractive in business situations that focus on a single or limited-term project, such as making a movie or
developing real estate; it is also widely used by private equity firms.

Creation and Capitalization
Unlike a general partnership, a limited partnership is created in accordance with the state statute
authorizing it. There are two categories of partners: limited and general. The limited partners capitalize
the business and the general partners run it.

Creation
The act requires that the firm’s promoters file acertificate of limited partnership with the secretary of
state; if they do not, or if the certificate is substantially defective, a general partnership is created. The
certificate must be signed by all general partners. It must include the name of the limited partnership
(which must include the words limited partnership so the world knows there are owners of the firm who
are not liable beyond their contribution) and the names and business addresses of the general partners. If
there are any changes in the general partners, the certificate must be amended. The general partner may
be, and often is, a corporation. Having a general partner be a corporation achieves the goal of limited
liability for everyone, but it is somewhat of a “clunky” arrangement. That problem is obviated in the
limited liability company, discussed in Section 24.2 "Limited Liability Companies". Here is an example of

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a limited partnership operating
agreement:http://www.wyopa.com/Articles%20of%20limited%20partnership.htm.
Any natural person, partnership, limited partnership (domestic or foreign), trust, estate, association, or
corporation may become a partner of a limited partnership.

Capitalization
The money to capitalize the business typically comes mostly from thelimited partners, who may
themselves be partnerships or corporations. That is, the limited partners use the business as an
investment device: they hope the managers of the firm (the general partners) will take their contributions
and give them a positive return on it. The contributions may be money, services, or property, or promises
to make such contributions in the future.

Control and Compensation
Control
Control is not generally shared by both classes of partners.

General Partners
The control of the limited partnership is in the hands of the general partners, which may—as noted—be
partnerships or corporations.

Limited Partners
Under ULPA-1985 and its predecessors, a limited partner who exercised any significant control would
incur liability like a general partner as to third parties who believed she was one (the “control rule”).
However, among the things a limited partner could do that would not risk the loss of insulation from
personal liability were these “safe harbors”:
•

Acting as an agent, employee, or contractor for the firm; or being an officer, director, or shareholder
of a corporate general partner

•

Consulting with the general partner of the firm

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•

Requesting or attending a meeting of partners

•

Being a surety for the firm

•

Voting on amendments to the agreement, on dissolution or winding up the partnership, on loans to
the partnership, on a change in its nature of business, on removing or admitting a general or limited
partner

However, see Section 24.3.3 "Limited Liability Limited Partnerships" for how this “control rule” has been
abolished under ULPA-2001.
General partners owe fiduciary duties to other general partners, the firm, and the limited partners; limited
partners who do not exercise control do not owe fiduciary duties. See Figure 24.1 "The Limited
Partnership under ULPA-1985".
Figure 24.1 The Limited Partnership under ULPA-1985

The partnership agreement may specify which general or limited partners have the right to vote on any
matter, but if the agreement grants limited partners voting rights beyond the “safe harbor,” a court may
abolish that partner’s limited liability.

Assignment of Partnership Rights

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Limited partnership interests may be assigned in whole or in part; if in whole, the assignor ceases to be a
partner unless otherwise agreed. An assignment is usually made as security for a loan. The assignee
becomes a new limited partner only if all the others consent or if provided for in the certificate; the
assignment does not cause dissolution. The happy ease with which a limited partner can divest himself of
the partnership interest makes the investment in the firm here more like that in a corporation than in a
general partnership.

Inspection of Books
Limited partners have the right to inspect the firm’s books and records, they may own competing
interests, they may be creditors of the firm, and they may bring derivative suits on the firm’s behalf. They
may not withdraw their capital contribution if that would impair creditors’ rights.

Addition of New Partners
Unless the partnership agreement provides otherwise (it usually does), the admission of additional
limited partners requires the written consent of all. A general partner may withdraw at any time with
written notice; if withdrawal is a violation of the agreement, the limited partnership has a right to claim of
damages. A limited partner can withdraw any time after six months’ notice to each general partner, and
the withdrawing partner is entitled to any distribution as per the agreement or, if none, to the fair value of
the interest based on the right to share in distributions.

Compensation
We noted in discussing partnerships that the partners are not entitled to “compensation,” that is, payment
for their work; they are entitled to a share of the profits. For limited partnerships, the rule is a bit
different.

General Partners
Often, general partners are paid for their management work on a sliding scale, receiving a greater share of
each dollar of cash flow as the limited partners’ cash distributions rise, thus giving the general partner an
incentive to increase limited-partner distributions.

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Limited Partners
Profits or losses are shared as agreed in the certificate or, if there is no agreement, in accordance with the
percentages of capital contributions made.

Liabilities
Liability is not shared.

General Partners
The general partners are liable as in a general partnership, and they have the same fiduciary duty and
duty of care as partners in a general partnership. However, see the discussion in Section 24.3.3 "Limited
Liability Limited Partnerships" of the newest type of LP, the limited liability limited partnership (triple
LP), where the general partner is also afforded limited liability under ULPA-2001.

Limited Partners
The limited partners are only liable up to the amount of their capital contribution, provided the surname
of the limited partner does not appear in the partnership name (unless his name is coincidentally the
same as that of one of the general partners whose name does appear) and provided the limited partner
does not participate in control of the firm. See Section 24.4.1 "Limited Partnerships: Limited Partners’
Liability for Managing Limited Partnership" for a case that highlights liability issues for partners.
We have been discussing ULPA-1985 here. But in a world of limited liability companies, limited liability
partnerships, and limited liability limited partnerships, “the control rule has become an anachronism”;
ULPA-2001 “provides a full, status-based liability shield for each limited partner, ‘even if the limited
partner participates in the management and control of the limited partnership.’

[3]

The section thus

eliminates the so-called control rule with respect to personal liability for entity obligations and brings
[4]

limited partners into parity with LLC members, LLP partners and corporate shareholders.” And as will
be noted in Section 24.3.3 "Limited Liability Limited Partnerships"under ULPA-2001 the general partner
is also shielded from liability.

Taxation
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Assuming the limited partnership meets a minimum number of criteria related to limited liability,
centralized management, duration, and transferability of ownership, it can enjoy the benefits of passthrough taxation; otherwise it will be taxed as a corporation. Pass-through (“conduit”) taxation is usually
very important to partners.

Termination
The limited partnership’s termination involves the same three steps as in a general partnership: (1)
dissolution, (2) winding up, and (3) termination.

Dissolution
Dissolution of a limited partnership is the first step toward termination (but termination does not
necessarily follow dissolution). The limited partners have no power to dissolve the firm except on court
order, and the death or bankruptcy of a limited partner does not dissolve the firm. The following events
may cause dissolution: (1) termination of the partnership as per the certificate’s provisions; (2)
termination upon an event specified in the partnership agreement; (3) the unanimous written consent of
the partners; (4) the withdrawal of a general partner, unless at least one remains and the agreement says
one is enough, or if within ninety days all partners agree to continue; (5) an event that causes the business
to be illegal; and (6) judicial decree of dissolution when it is not reasonable to carry on. If the agreement
has no term, its dissolution is not triggered by some agreed-to event, and none of the other things listed
cause dissolution.
Dissolution requires the filing of a certificate of cancellation with the state if winding up commences.

Winding Up
General partners who have not wrongfully dissolved the partnership may wind it up, and so may the
limited partners if all the general partners have wrongfully dissolved the firm. Any partner or that
person’s legal representative can petition a court for winding up, with cause.
Upon winding up, the assets are distributed (1) to creditors, including creditor-partners, not including
liabilities for distributions of profit; (2) to partners and ex-partners to pay off unpaid distributions; (3) to

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partners as return of capital contributions, unless otherwise agreed; and (4) to partners for partnership
interests in proportion as they share in distributions, unless otherwise agreed. No distinction is made
between general and limited partners—they share equally, unless otherwise agreed. When winding up is
completed, the firm is terminated.
It is worth reiterating the part about “unless otherwise agreed”: people who form any kind of a business
organization—partnership, a hybrid form, or corporations—can to a large extent choose to structure their
relationship as they see fit. Any aspect of the company’s formation, operation, or ending that is not
included in an agreement flops into the default provisions of the relevant law.

KEY TAKEAWAY
A limited partnership is a creature of statute: it requires filing a certificate with the state because it confers on
some of its members the marvel of limited liability. It is an investment device composed of one or more
general partners and one or more limited partners; limited partners may leave with six months’ notice and are
entitled to an appropriate payout. The general partner is liable as a partner is a general partnership; the
limited partners’ liability is limited to the loss of their investment, unless they exercise so much control of the
firm as to become general partners. The general partner is paid, and the general and limited partners split
profit as per the agreement or, if none, in the proportion as they made capital contributions. The firm is
usually taxed like a general partnership: it is a conduit for the partners’ income. The firm is dissolved upon the
end of its term, upon an event specified in the agreement, or in several other circumstances, but it may have
indefinite existence.

EXERCISES
1.

Why does the fact that the limited liability company provides limited liability for some of its members
mean that a state certificate must be filed?

2.

What liability has the general partner? The limited partner?

3.

How easy is it for the limited partner to dispose of (sell) her partnership interest?

[1] “Uniform Limited Partnership Act (2001), Prefatory Note,” NCCUSL
Archives,http://www.law.upenn.edu/bll/archives/ulc/ulpa/final2001.pdf.
[2] ULPA, Section 102(11).

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[3] ULPA-2001, Section 303.
[4] Official Comment to Uniform Limited Partnership Act 2001, Section 303.

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24.2 Limited Liability Companies
LEARNING OBJECTIVES
1.

Understand the history and law governing limited liability companies (LLCs).

2.

Identify the creation and capitalization of an LLC.

3.

Understand control and compensation of a firm.

4.

Recognize liabilities in the LLC form.

5.

Explain the taxation of an LLC.

6.

Identify how LLCs are terminated.

History and Law Governing Limited Liability Companies
History of the Limited Liability Company
The limited liability company (LLC) gained sweeping popularity in the late twentieth century because it
combines the best aspects of partnership and the best aspects of corporations: it allows all its owners
(members) insulation from personal liability and pass-through (conduit) taxation. The first efforts to form
LLCs were thwarted by IRS rulings that the business form was too much like a corporation to escape
corporate tax complications. Tinkering by promoters of the LLC concept and flexibility by the IRS solved
those problems in interesting and creative ways.
Corporations have six characteristics: (1) associates, (2) an objective to carry on a business and divide the
gains, (3) continuity of life, (4) centralized management, (5) limited liability, and (6) free transferability of
interests. Partnerships also, necessarily, have the first two corporate characteristics; under IRS rulings, if
the LLC is not to be considered a corporation for tax purposes, it must lack at least one-half of the
remaining four characteristics of a corporation: the LLC, then, must lack two of these corporate
characteristics (otherwise it will be considered a corporation): (1) limited liability, (2) centralized
management, (3) continuity of life, or (4) free transferability of interests. But limited liability is essential
and centralized management is necessary for passive investors who don’t want to be involved in decision
making, so pass-through taxation usually hinges on whether an LLC has continuity of life and free
transferability of accounts. Thus it is extremely important that the LLC promoters avoid the corporate
characteristics of continuity of life and free transferability of interests.

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We will see how the LLC can finesse these issues.

Governing Law
All states have statutes allowing the creation of LLCs, and while a Uniform Limited Liability Company Act
has been promulgated, only eight states have adopted it as of January 2011. That said, the LLC has
become the entity of choice for many businesses.

Creation and Capitalization
Creation of the LLC
An LLC is created according to the statute of the state in which it is formed. It is required that the LLC
members file a “certificate of organization” with the secretary of state, and the name must indicate that it
is a limited liability company. Partnerships and limited partnerships may convert to LLCs; the partners’
previous liability under the other organizational forms is not affected, but going forward, limited liability
is provided. The members’ operating agreement spells out how the business will be run; it is subordinate
to state and federal law. Unless otherwise agreed, the operating agreement can be amended only by
unanimous vote. The LLC is an entity. Foreign LLCs must register with the secretary of state before doing
business in a “foreign” state, or they cannot sue in state courts.
As compared with corporations, the LLC is not a good form if the owners expect to have multiple investors
or to raise money from the public. The typical LLC has relatively few members (six or seven at most), all of
whom usually are engaged in running the firm.
Most early LLC statutes, at least, prohibited their use by professionals. That is, practitioners who need
professional licenses, such as certified public accountants, lawyers, doctors, architects, chiropractors, and
the like, could not use this form because of concern about what would happen to the standards of practice
if such people could avoid legitimate malpractice claims. For that reason, the limited liability partnership
was invented.

Capitalization

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Capitalization is like a partnership: members contribute capital to the firm according to their agreement.
As in a partnership, the LLC property is not specific to any member, but each has a personal property
interest in general. Contributions may be in the form of cash, property or services rendered, or a promise
to render them in the future.

Control and Compensation
Control
The LLC operating agreement may provide for either a member-managed LLC or a manager-managed
(centralized) LLC. If the former, all members have actual and apparent authority to bind the LLC to
contracts on its behalf, as in a partnership, and all members’ votes have equal weight unless otherwise
agreed. Member-managers have duty of care and a fiduciary duty, though the parameters of those duties
vary from state to state. If the firm is manager managed, only managers have authority to bind the firm;
the managers have the duty of care and fiduciary duty, but the nonmanager members usually do not.
Some states’ statutes provide that voting is based on the financial interests of the members. Most statutes
provide that any extraordinary firm decisions be voted on by all members (e.g., amend the agreement,
admit new members, sell all the assets prior to dissolution, merge with another entity). Members can
make their own rules without the structural requirements (e.g., voting rights, notice, quorum, approval of
major decisions) imposed under state corporate law.
If the firm has a centralized manager system, it gets a check in its “corporate-like” box, so it will need to
make sure there are enough noncorporate-like attributes to make up for this one. If it looks too much like
a corporation, it will be taxed like one.
One of the real benefits of the LLC as compared with the corporation is that no annual meetings are
required, and no minutes need to be kept. Often, owners of small corporations ignore these formalities to
their peril, but with the LLC there are no worries about such record keeping.

Compensation
Distributions are allocated among members of an LLC according to the operating agreement; managing
partners may be paid for their services. Absent an agreement, distributions are allocated among members

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in proportion to the values of contributions made by them or required to be made by them. Upon a
member’s dissociation that does not cause dissolution, a dissociating member has the right to distribution
as provided in the agreement, or—if no agreement—the right to receive the fair value of the member’s
interest within a reasonable time after dissociation. No distributions are allowed if making them would
cause the LLC to become insolvent.

Liability
The great accomplishment of the LLC is, again, to achieve limited liability for all its members: no general
partner hangs out with liability exposure.

Liability to Outsiders
Members are not liable to third parties for contracts made by the firm or for torts committed in the scope
of business (but of course a person is always liable for her own torts), regardless of the owner’s level of
participation—unlike a limited partnership, where the general partner is liable. Third parties’ only
recourse is as against the firm’s property. See Puleo v. Topel, (see Section 24.4.2 "Liability Issues in
LLCs"), for an analysis of owner liability in an LLC.

Internal Liabilities
Unless the operating agreement provides otherwise, members and managers of the LLC are generally not
liable to the firm or its members except for acts or omissions constituting gross negligence, intentional
misconduct, or knowing violations of the law. Members and managers, though, must account to the firm
for any personal profit or benefit derived from activities not consented to by a majority of disinterested
members or managers from the conduct of the firm’s business or member’s or managers use of firm
property—which is the same as in partnership law.

Taxation
Assuming the LLC is properly formed so that it is not too much like a corporation, it will—upon its
members’ election—be treated like a partnership for tax purposes.

Termination
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Termination, loosely speaking, refers either to how the entity’s life as a business ends (continuity of life)
or to how a member’s interest in the firm ends—that is, how freely the interest is transferable.

Continuity of Life
The first step in the termination of the LLC is dissolution, though dissolution is not necessarily followed
by termination.

Dissolution and Winding Up
The IRS has determined that continuity of life does not exist “if the death, insanity, bankruptcy,
retirement, resignation, or expulsion of any member will cause a dissolution of the organization,”

[1]

and

that if one of these events occurs, the entity may continue only with the members’ unanimous consent.
Dissolution may occur even if the business is continued by the remaining members.
The typical LLC statute provides that an LLC will dissolve upon (1) expiration of the LLC’s term as per its
agreement; (2) events specified in the agreement; (3) written consent of all members; (4) an “event of
dissociation” of a member, unless within ninety days of the event all remaining members agree to
continue, or the right to continue is stated in the LLC; (5) the entry of a judicial decree of dissolution; (6) a
change in membership that results in there being fewer than two members; or (7) the expiration of two
years after the effective date of administrative dissolution.
And an “event of dissociation” is typically defined as (1) a member’s voluntary withdrawal, (2) her
assignment of the entire LLC interest, (3) her expulsion, (4) her bankruptcy, (5) her becoming
incompetent, (6) dissolution of an entity member (as an LLC, limited partnership, or corporation), or (7)
any other event specified in the agreement.
Thus under most statutes’ default position, if a member dies, becomes insane or bankrupt, retires, resigns,
or is expelled, the LLC will dissolve unless within ninety days the rest of the members unanimously agree
to continue. And by this means the firm does not have continuity of life. Some states provide
opportunities for even more flexibility regarding the “unanimous” part. In the mid-1990s, the IRS issued
revenue rulings (as opposed to regulations) that it would be enough if a “majority in interest” of
remaining partners agreed to continue the business, and the “flexible” statute states adopted this

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possibility (the ones that did not are called “bulletproof” statutes). “Majority in interests” means a
majority of profits and capital.
If the firm does dissolve, some states require public filings to that effect. If dissolution leads to winding
up, things progress as in a general partnership: the business at hand is finished, accounts are rendered,
bills paid, assets liquidated, and remaining assets are distributed to creditors (including member and
manager creditors, but not for their shares in profits); to members and past members for unpaid
distributions; to members for capital contributions; and to members as agreed or in proportion to
contributions made. Upon dissolution, actual authority of members or managers terminates except as
needed to wind up; members may have apparent authority, though, unless the third party had notice of
the dissolution.

Free Transferability of Interest
Again, the problem here is that if a member’s interest in the LLC is as freely transferable as a
shareholder’s interest in a corporation (an owner can transfer all attributes of his interest without the
others’ consent), the LLC will probably be said to have a check mark in the “corporate-like” box: too many
of those and the firm will not be allowed pass-through taxation. Thus the trick for the LLC promoters is to
limit free transferability enough to pass the test of not being a corporation, but not limit so much as to
make it really difficult to divest oneself of the interest (then it’s not a very liquid or desirable investment).
Some states’ LLC statutes have as the default rule that the remaining members must unanimously consent
to allow an assignee or a transferee of a membership interest to participate in managing the LLC. Since
this prevents a member from transferring all attributes of the interest (the right to participate in
management isn’t transferred or assigned), the LLC formed under the default provision will not have “free
transferability of interest.” But if the LLC agreement allowsmajority consent for the transfer of all
attributes, that also would satisfy the requirement that there not be free transferability of interests. Then
we get into the question of how to define “majority”: by number of members or by value of their
membership? And what if only the managing partners need to consent? Or if there are two classes of
membership and the transfer of interests in one class requires the consent of the other? The point is that

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people keep pushing the boundaries to see how close their LLC can come to corporation-like status
without being called a corporation.
Statutes for LLCs allow other business entities to convert to this form upon application.

KEY TAKEAWAY
The limited liability company has become the entity of choice for many businesspeople. It is created by state
authority that, upon application, issues the “certificate of organization.” It is controlled either by managers or
by members, it affords its members limited liability, and it is taxed like a partnership. But these happy results
are obtained only if the firm lacks enough corporate attributes to escape being labeled as a corporation. To
avoid too much “corporateness,” the firm’s certificate usually limits its continuity of life and the free
transferability of interest. The ongoing game is to finesse these limits: to make them as nonconstraining as
possible, to get right up to the line to preserve continuity, and to make the interest as freely transferable as
possible.

EXERCISES
1.

What are the six attributes of a corporation? Which are automatically relevant to the LLC? Which two
corporate attributes are usually dropped in an LLC?

2.

Why does the LLC not want to be treated like a corporation?

3.

Why does the name of the LLC have to include an indication that it is an LLC?

4.

How did LLCs finesse the requirement that they not allow too-free transferability of the interest?

[1] Treasury Regulation, § 301.7701-2(b)(1).

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24.3 Other Forms
LEARNING OBJECTIVE
1.

Recognize other business forms: sub-S corporations, limited liability partnerships, and limited liability
limited partnerships.

Sub-S Corporation
History
The sub-S corporation or the S corporation gets its name from the IRS Code, Chapter 1, Subchapter S. It
was authorized by Congress in 1958 to help small corporations and to stem the economic and cultural
influence of the relatively few, but increasingly powerful, huge multinational corporations. According to
the website of an S corporation champion, “a half century later, S corporations are the most popular
corporate structure in America. The IRS estimates that there were 4.5 million S corporation owners in the
United States in 2007—about twice the number of C [standard] corporations.”

[1]

Creation and Capitalization
The S corporation is a regular corporation created upon application to the appropriate secretary of state’s
office and operated according to its bylaws and shareholders’ agreements. There are, however, some limits
on how the business is set up, among them the following:
•

It must be incorporated in the United States.

•

It cannot have more than one hundred shareholders (a married couple counts as one shareholder).

•

The only shareholders are individuals, estates, certain exempt organizations, or certain trusts.

•

Only US citizens and resident aliens may be shareholders.

•

The corporation has only one class of stock.

•

With some exceptions, it cannot be a bank, thrift institution, or insurance company.

•

All shareholders must consent to the S corporation election.

•

It is capitalized as is a regular corporation.

Liability
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The owners of the S corporation have limited liability.

Taxation
Taxation is the crux of the matter. The S corporation pays no corporate income tax (unless it has a lot of
passive income). The S corporation’s shareholders include on their personal income statements, and pay
tax on, their share of the corporation’s separately stated items of income, deduction, and loss. That is, the
S corporation avoids the dreaded double taxation of corporate income.

Transferability of Ownership
S corporations’ shares can be bought or sold via share purchase agreements, and all changes in the
ownership are reflected in the share ledger in the corporate minute book.

Limited Liability Partnerships
Background
In 1991, Texas enacted the first limited liability partnership (LLP) statute, largely in response to the
liability that had been imposed on partners in partnerships sued by government agencies in relation to
massive savings and loan failures in the 1980s.

[2]

(Here we see an example of the legislature allowing

business owners to externalize the risks of business operation.) More broadly, the success of the limited
liability company attracted the attention of professionals like accountants, lawyers, and doctors who
sought insulation from personal liability for the mistakes or malpractice of their partners. Their wish was
granted with the adoption in all states of statutes authorizing the creation of the limited liability
partnership in the early 1990s. Most partnership law under the Revised Uniform Partnership Act applies
to LLPs.

Creation
Members of a partnership (only a majority is required) who want to form an LLP must file with the
secretary of state; the name of the firm must include “limited liability partnership” or “LLP” to notify the
public that its members will not stand personally for the firm’s liabilities.

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Liability
As noted, the purpose of the LLP form of business is to afford insulation from liability for its members. A
typical statute provides as follows: “Any obligation of a partnership incurred while the partnership is a
limited liability partnership, whether arising in contract, tort or otherwise, is solely the obligation of the
partnership. A partner is n
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