Fundamentals of Business Law

Fundamentals of
Business Law
MELISSA RANDALL AND
COMMUNITY COLLEGE OF DENVER
STUDENTS

Fundamentals of Business Law by Melissa Randall is licensed under a
Creative Commons Attribution 4.0 International License, except where
otherwise noted.

Fundamentals of Business Law by Melissa Randall and Community
College of Denver Students is licensed under a Creative Commons
Attribution 4.0 International License, except where otherwise noted.
More information about this license may be found at
https://creativecommons.org/licenses/by/4.0.

Contents

Introduction

1

What is an Open Textbook?

1

The Authors and Contributors

2

Feedback Requested

3

1. Introduction to Law and Types of Legal

4

Systems
1.1 Introduction to Law and Types of Legal

4

Systems
1.2 What Is Law and What Functions Does It

6

Serve?
1.3 Modern Legal Systems of the World

8

1.4 Sources of Law

14

1.5 Concluding Thoughts

22

2. The United States Court System

24

2.1 Introduction

24

2.2 Separation of Powers

25

2.3 Federalism

29

2.4 Trial and Appellate Courts

32

2.5 Concluding Thoughts

35

3. Litigation

37

3.1 Introduction

37

3.2 The Parties, Attorneys, and Jury

38

3.3 Standing

42

3.4 Subject Matter and Personal Jurisdiction

42

3.5 Venue

44

3.6 Pretrial Procedures

45

3.7 The Trial and Appeal

52

3.8 Concluding Thoughts

55

4. Alternative Dispute Resolution

56

4.1 Introduction

56

4.2 Negotiation

58

4.3 Mediation

60

4.4 Arbitration

62

4.5 Concluding Thoughts

65

5. The Constitution

66

5.1 Introduction

66

5.2 Federalism and Preemption

67

5.3 The Commerce Clause

75

5.4 Business and the Bill of Rights

76

5.5 Concluding Thoughts

86

6. International Law

89

6.1 Introduction

89

6.2 The Nature of International Law

91

6.3 Sources of International Law

93

6.4 US Laws that Apply to US Nationals

99

Abroad
6.5 Concluding Thoughts

100

7. Administrative Law

101

7.1 Introduction

101

7.2 Creation of Administrative Agencies

102

7.3 Agency Functions

105

7.4 Judicial Review of Agency Actions

109

7.5 Public Access to Agency Information

111

7.6 Concluding Thoughts

113

8. Criminal Law

114

8.1 Introduction

114

8.2 The Nature of Criminal Law

115

8.3 Constitutional Rights and Defenses

122

8.4 Common Business Crimes

129

8.5 Concluding Thoughts

133

9. Torts

134

9.1 Introduction

134

9.2 Intentional Torts

137

9.3 Negligence

145

9.4 Strict Liability

153

9.5 Concluding Thoughts

156

10. Contracts

159

10.1 Introduction

159

10.2 Contract Elements

161

10.3 Types of Contracts

165

10.4 Performance and Breach of Contract

168

10.5 Defenses to Contracts

171

10.6 Assignment, Delegation, and Third Party

177

Beneficiaries
10.7 Parol Evidence Rule

179

10.8 Remedies

179

10.9 Concluding Thoughts

186

11. Sales Contracts

187

11.1 Introduction

187

11.2 Scope of the UCC

188

11.3 Sales Contract Formation

193

11.4 Performance

198

11.5 Warranties

199

11.6 Concluding Thoughts

200

12. Writing Contracts

201

12.1 Writing Contracts

201

12.2 Structure of Contracts

202

12.3 Common Mistakes

211

12.4 Tips for Writing a Contract

213

12.5 Concluding Thoughts

218

13. Employment Law

219

13.1 Introduction

219

13.2 Employment At Will

220

13.3 Common Employment Law Torts

225

13.4 Wage and Hour Laws

225

13.5 Family Medical Leave Act

228

13.6 Occupational Safety and Health Act

229

13.7 Employee Retirement Income Security Act

230

13.8 Workers’ Compensation Laws

231

13.9 Unemployment Compensation

233

13.10 Labor Relations

234

13.11 Concluding Thoughts

242

14. Anti-Discrimination Law

243

14.1 Introduction

243

14.2 The Equal Pay Act of 1963

246

14.3 Title VII of the Civil Rights Act of 1964

248

14.4 Enforcement of Title VII

258

14.5 The Age Discrimination in Employment

261

Act of 1967
14.6 The Americans with Disabilities Act of

262

1990
14.7 Genetic Information Nondiscrimination

265

Act of 2008
14.8 Concluding Thoughts

266

15. Agency

268

15.1 Introduction

268

15.2 The Agency Relationship

269

15.3 Duties of Agents and Principals

273

15.4 Liability to Third Parties

277

15.5 Termination of Agency Relationship

280

15.6 Concluding Thoughts

281

16. Business Organizations

283

16.1 Introduction

283

16.2 Sole Proprietorship

285

16.3 Partnerships

286

16.4 Franchises

289

16.5 Joint Venture

290

16.6 Corporations

292

16.7 Limited Liability Entities

297

16.8 Concluding Thoughts

302

17. Partnerships

303

17.1 Introduction

303

17.2 Types of Partnerships

303

17.3 Partnership Agreements

305

17.4 Rights and Duties of Partners

308

17.5 Termination of a Partnership

311

17.6 Concluding Thoughts

313

18. Corporations

314

18.1 Introduction

314

18.2 Corporate Structure

315

18.3 Shareholder Rights

316

18.4 Corporate Officer and Directors

321

18.5 Legal Theories

324

18.6 Mergers, Consolidations, and Dissolutions

326

18.7 Concluding Thoughts

329

19. Antitrust Law

331

19.1 Introduction

331

19.2 Historical Development

332

19.3 Monopoly

335

19.4 Unreasonable Restraints on Trade

339

19.5 Price Discrimination

345

19.6 Enforcement

349

19.7 Concluding Thoughts

350

20. Consumer Law

351

20.1 Introduction

351

20.2 Protecting the Purchaser

352

20.3 Protecting the Debtor

355

20.4 Enforcement

363

20.5 Concluding Thoughts

364

21. Workplace Privacy and Information Security

365

21.1 Introduction

365

21.2 Right to Privacy

366

21.3 Workplace Privacy

370

21.4 Information Security Issues

380

21.5 Concluding Thoughts

386

22. Property

387

22.1 Introduction

387

22.2 Personal Property

388

22.3 Real Property

393

22.4 Wills and Trusts

404

22.5 Land Use Regulation

408

22.6 Environmental Law

410

22.7 Concluding Thoughts

417

23. Intellectual Property

419

23.1 Introduction

419

23.2 Intellectual Property

420

23.3 Constitutional Roots

423

23.4 Patents

425

23.5 Trade Secrets

431

23.6 Trademarks

432

23.7 Copyright

440

23.8 Concluding Thoughts

444

24. Bankruptcy

445

24.1 Introduction

445

24.2 Types of Bankruptcy

446

24.3 Bankruptcy Proceedings

452

24.4 Concluding Thoughts

456

Introduction
What is an Open Textbook?
Open textbooks are complete textbooks that have been
funded, published, and licensed to be freely used, adapted, and
distributed. As a particular type of Open Educational Resource
(OER), this open textbook may be used and reused freely with
no direct cost to the user.
Unless otherwise noted, all content in this book is licensed
with a Creative Commons Attribution 4.0 license (CC BY 4.0),
which allows it to be adapted, remixed, and shared under the
same license with attribution. Instructors and students may
be interested in rearranging and adapting content or in
transforming content into other formats. If so, please include
the appropriate attribution under the Creative Commons
license. More information about this license is available at
https://creativecommons.org/licenses/by/4.0.

1 | Introduction

The Authors and Contributors
Melissa Randall is an attorney who teaches business law and
Constitutional law at the Community College of Denver.
Frustrated that the expensive textbook her business students
were using contained legal errors, heavily edited case studies
that confused students, and was a roadblock to their learning,
Ms. Randall sought a better option, which ultimately led her
down the OER path. Special thanks to Terence Lau and Lisa
Johnson for their OER textbook “Introduction to Business Law,”
which served as the inspiration for several chapters of this
book.
Ms. Randall’s business law students edited, updated, and
revised the chapters contained in this textbook. They are also
responsible for the visual depictions of the material. Although
Ms. Randall is the subject matter expert who ensured the
accuracy of the material, her students ensured the effective
delivery of the content to undergraduate business students. It
was truly a collaborative effort. Special thanks to Lucy Reyes
and Krissy Main who turned the students’ rough visual
concepts into professional quality graphics.
Thanks also to the Colorado Department of Higher Education
(CDHE) for the grant that partially funded the development of
this book. Without it, we could not have hired Lucy and Krissy
to be our graphic designers. Nor would we have been able to
have written so many chapters so quickly. The CDHE’s support
of OER and open pedagogy validated our classes’ commitment
to doing meaningful work and to contribute to the future of
higher education.
Last, and certainly not least, thanks to the professionals who
contributed their expertise to our book. Judges and attorneys
filled our Counselor’s Corner with practical insights and advice

Introduction | 2

to business professionals. Their insight from “the trenches” was
an invaluable contribution. Subject matter experts peer
reviewed chapters and worked with our students to ensure
accurate information in dynamic areas of the law. Kathy was
our dedicated copy editor who thoroughly proofread anything
we gave her. Special thanks to the professional who was in
the trenches the most: Tom. A successful businessman, Tom
put his MBA to use by tirelessly editing the entire textbook
to ensure that it was consistent and accurate in a business
context. Our professional contributors volunteered their
expertise and gave enthusiastically to our project. Words
cannot express our gratitude for accompanying us on this
journey.

Feedback Requested
The authors seek content-related suggestions from faculty,
students, and users of this book. Please email Ms. Randall at
Melissa.Randall@ccd.edu with any suggestions or feedback
you may have. Also, faculty are invited to contact Ms. Randall to
discuss other OER used in the business law course, including
judicial opinions we use as case studies in lieu of heavily edited
excerpts in textbook dialogue boxes.
This textbook was finalized during the Spring 2020 semester.
With the outbreak of covid-19, our collaborative efforts were
curtailed. As a result, readers may find that some chapters are
better edited than others. Please help us with any constructive
feedback you may have to improve the book.
If you are an instructor reviewing, adopting, or adapting this
textbook, please help us understand how this book is being
used. This helps all of us in the OER community understand our
impact and justify future grant money.
3 | Introduction

1. Introduction to Law
and Types of Legal
Systems
1.1 Introduction to Law and Types of
Legal Systems
LEARNING OBJECTIVES
1. Understand the nature and sources of law.
2. Know the types of modern legal systems in the world.
3. Understand the various functions of a legal system.
4. Learn the primary sources of law in the United States.
It is important for business people to understand the legal
environment in which they are operating. To be successful,
businesses must understand how law and economic principles
influence each other. Businesses want to be successful, which
usually means they want to be profitable. While a basic
economic principle is that businesses act in their own selfinterest, they must do so within the parameters of the law.
Sometimes businesses weigh the penalties of violating the law
against the chances of getting caught to determine how they
should behave. In both instances, the law is a restraint on
behavior.
Most people want to conduct their business legally. Following
the rules saves money, time, and frustration, and it preserves
individual and professional reputations. So, if businesses have
Introduction to Law & Legal
Systems | 4

an incentive to operate legally, why are do so many legal
disputes occur? There are many reasons for this, including that
many of our laws are poorly written, and reasonable people
may disagree about what is “right.” Legal injuries happen even
under the best of circumstances, and parties need a method to
be compensated for their damages.
A common theme in the study of law is responsibility. Law
seeks to answer the questions:
1. Who is responsible, and what is their liability? and
2. How does a business limit exposure to liability in the first
place?
A solid understanding of business law minimizes the risk of
liability and avoids legal disputes. The law provides a
reasonable expectation of how things will be in the future
based on how they have been in the past. It provides
predictability and stability.
This book does not teach how to practice law or conduct legal
research. The goals of this book are practical. Think about
studying business law as a map by which to navigate business
dealings. We want to help you minimize the risk of legal liability
and avoid serious legal disputes. This book serves as an
introduction to legal topics that affect businesses. By
understanding the legal landscape, you will have a better
opportunity for business success.

Counselor’s Corner Even if a business is not officially
“international,” it is important to understand the
legal systems of the world because consumers
come from all over. Consumers, business partners,

5 | Introduction to Law & Legal Systems

and competitors are products of their environments,
including their societies and legal systems.
Therefore, their expectations and how they interact
with each other are influenced directly by their legal
systems of origin. The most successful businesses
take this into account. Not only for avoiding legal
liability, but also for enhanced consumer
satisfaction.
~Arham M.,
attorney

1.2 What Is Law and What Functions
Does It Serve?
Law is the system of rules which a particular nation or
community recognizes as regulating the actions of its
members and which it may enforce by the imposition of
penalties. In a nation, the law can serve to (1) keep the peace,
(2) maintain the status quo, (3) preserve individual rights, (4)
protect minorities, (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.,

China,

Zimbabwe, or Syria). Under colonialism, European nations
often imposed peace in nations whose borders were created
by those same European nations. With regard to the functions
of the law, the empires may have kept the peace—largely with
Introduction to Law & Legal Systems | 6

force—but they changed the status quo and seldom promoted
the native peoples’ rights or social justice.
In nations with various ethnic and tribal groups, it is often
difficult for a single, united government to rule effectively. In
Rwanda, for example, power struggles between Hutus and
Tutsis resulted in the genocide of the Tutsi minority. In nations
of the former Soviet Union, the withdrawal of a central power
created power vacuums that were exploited by local leaders.
When

Yugoslavia

broke

up,

the

different

ethnic

groups—Croats, Bosniaks, and Serbs—fought bitterly rather
than share power. In Iraq and Afghanistan, the blending of
different groups of families, tribes, sects, and ethnic groups
into an effective national governing body continues to be a
challenge.
These situations highlight the struggle of a nation to
implement and maintain the Rule of Law. The Rule of Law
is a system in which laws are public knowledge, are clear in
meaning, and apply equally to everyone. These systems uphold
national political and civil liberties. Rule of law systems
establish authority, create expectations for behavior, and
establish redress for grievances and penalties for deviance.
Governance of conflict and the attainment of peace among the
governed are its primary goals. One of the greatest benefits of
the Rule of Law is that it allows people to understand what is
expected of them.
The United States is a Rule of Law System. The US Constitution
is based on the principle that people have rights that cannot
be taken away by the government. Instead, the role of the
government is to protect the individual rights of its citizens. The
US Constitution’s preamble states, “We the People…in Order
to…insure domestic Tranquility.” This is just one example of how
the US legal system was established to address the functions of
a legal system.

7 | Introduction to Law & Legal Systems

1.3 Modern Legal Systems of the
World
There are four main legal systems in the modern world:
1. Common law;
2. Civil law;
3. Religious law; and
4. Customary law/monarchy.
As the world becomes more interdependent, a fifth category of
legal systems has developed — the hybrid legal system, which
is a legal system that is a combination of two or more legal
systems.

Introduction to Law & Legal Systems | 8

Type of
Legal
System

Characteristics

Common
Law

• Written judicial decisions of appellate courts are
binding legal authority on lower courts when
interpreting and applying the same or similar
questions of law
• The legal system is adversarial
• The outcome of a case is often decided by a jury of
the parties’ peers

Civil Law

• All legal rules are in comprehensive legislative
enactments often called Codes
• Written judicial decisions of appellate courts are
not binding legal authority
• The legal system is inquisatorial

Religious
Law

• Religious documents are used as legal sources
• All major world religions have a religious legal
system
• Most nations that have religious legal systems use
them to supplement a secular national system

Customary
Law

• Legal system used by a monarchy or tribe
• Grants specific legal powers to kings, queens,
sultans or tribal leaders as heads of state
• Monarchs and leaders often seen to be “above the
law”

Hybrid
Law

• Combination of 2 or more legal systems within a
nation

Common Law Systems
The legal system in the United States comes from the English
common law tradition and the US Constitution. English
9 | Introduction to Law & Legal Systems

common law is a system that gives written judicial decisions
the force of law. As a result, the US legal system recognizes an
appellate court’s ability to interpret and apply the law to future
litigants through precedent. Precedent is a judicial opinion
that is considered legal authority for future cases involving the
same or similar questions of law. The benefit of this system is
consistency and resolution of disputes without requiring the
parties to take legal matters to court.
A famous example of how precedent works is the US Supreme
Court case Brown v. Board of Education of Topeka. In this
landmark 1954 case, the Justices unanimously ruled that racial
segregation of children in public schools is unconstitutional.
Brown v. Board of Education is one of the cornerstones of
the Civil Rights Movement and helped establish the precedent
that “separate-but-equal” education and other services were
not, in fact, equal at all. The case required all racially segregated
public schools to integrate, not just in Topeka, Kansas. In
addition, Brown has been cited as legal precedent in
thousands of cases nationwide involving racial equality.
The common law legal system is adversarial. This means that
the parties bring their cases to the court for resolution. The
judge or jury hears the parties’ evidence and arguments before
making a final decision. It is the parties’ burden to investigate
the facts, argue the law, and present their best case. Judges
and juries do not do independent investigations nor are they
responsible for helping parties argue their cases. It is a party’s
responsibility to raise all legal issues.
Another characteristic of common law systems is that cases
are often decided by juries of the parties’ peers. In both civil
and criminal matters, the parties usually have a right to have
a jury pulled from local citizens to resolve the dispute. When
a jury determines the outcome of a case, the judge acts as a
“gatekeeper,” who decides what evidence and legal arguments

Introduction to Law & Legal Systems | 10

the jury can properly consider. The judge ensures the parties
receive a fair trial while the jury decides the outcome of the
trial.
The common law tradition is unique to England, the United
States, and former British colonies. Although there are
differences among common law systems (e.g., whether
judiciaries may declare legislative acts unconstitutional and
how frequently juries may be used), all of them recognize the
use of precedent, and none of them relies solely on the
comprehensive, legislative codes that are prevalent in civil law
systems.

Civil Law Systems
Civil law systems were developed in Europe and are based on
Roman and Napoleonic law. Civil law systems are also called
code systems because 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 and procedure,
non-criminal law and procedure, and commercial law. The
code is used to resolve only cases brought to the courts, which
are usually decided by judges without a jury.
Civil law systems are inquisitorial systems in which judges
actively investigate cases. Judges have the authority to request
documents and testimony, as well as to shape the parties’ legal
claims. In addition, judges are not required to follow the
decisions of other courts in similar cases. The law is in the code,
not in the cases. The legislature, not the courts, is the primary
place to enact and modify laws.
Civil law systems are used throughout Europe, Central and
South America, Asia and Africa. France, Germany, Holland,
11 | Introduction to Law & Legal Systems

Spain, and Portugal had colonies outside of Europe, and many
of these colonies adopted the legal practices that were
imposed on them by colonial rule.
There are also communist and socialist legal systems that differ
significantly from traditional civil law systems. Legal scholars
debate whether this is a separate type of legal system or a
subset of modern civil law systems. In a communist or socialist
legal system, the nation has a code but most property is owned
by the government or agricultural cooperatives. In addition, the
judiciary is subservient to the Communist party and is not an
independent branch of government.

Religious Law Systems
Religious law systems arise from the sacred texts of religious
traditions and usually apply to all aspects of life, including social
and business relations. In religious legal systems, a religious
document is used as a primary legal source. All major world
religions–Judaism,

Christianity,

Islam,

Buddhism

and

Hinduism–have a religious legal system. The Islamic legal
system (Sharia) with Islamic jurisprudence (Fiqh) is the most
widely used religious legal system in the world. Most nations
that have religious legal systems use them to supplement their
secular national system. Only Saudi Arabia (Islamic) and the
Vatican (Christian) are pure theocracies that have only a
religious legal system in their nations.

Customary Law Systems
Customary legal systems are becoming increasingly less
common. A customary system is used by a monarchy and
grants specific legal powers to the kings, queens, sultans or
Introduction to Law & Legal Systems | 12

tribal leaders as heads of state. A challenge of a customary
system is that the ruler is seen to be “above the law” because
the laws do not apply equally to the ruler and subjects. There
are only a handful of monarchies remaining in the world, and
most of them have evolved into hybrid legal systems or have
adopted a different type of legal system.

Hybrid Law Systems
Hybrid legal systems are a combination of two or more legal
systems within a nation. India is a classic example of a nation
with a hybrid legal system. As a former British colony, India has
a common law legal system, which recognizes the power of
the Supreme Court and High Courts to make binding judicial
decisions as a form of precedent. However, most of its laws
are integrated codes found in a Napoleonic code system. In
addition, India has separate personal codes that apply to
Muslims, Christians, and Hindus. As a result, India has a hybrid
system made up of common law, civil law and religious law
systems.
Figure 1.1 Legal Systems of the World Map

13 | Introduction to Law & Legal Systems

1.4 Sources of Law
Where does law come from? How do individuals and
businesses know right from wrong? Not all actions that are
considered “wrong” or inappropriate are violations of the law.
They simply may represent social norms. So what is the
difference? There are two types of rules in our society—social
norms and laws.
Social norms are the informal rules that govern behavior in
groups and societies. Social norms and cultural expectations
may

be

violated

with

negative

social

or

professional

consequences for doing so. However, no legal repercussions
follow violating social norms alone.
Violations of law are different. Violating the law carries
penalties, such as civil liability, fines, or loss of liberty. While it is
optional to conform to social customs, people are compelled to
obey the law under threat of penalty.
Laws are generally classified as public law or private law. Public
law applies to everyone. It is law that has been created by a
legitimate authority with the power to create law, and it applies
to the people within its jurisdiction. In the United States, the
lawmaking authority itself is also subject to those laws, because
no one is “above” the law. If the law is violated, penalties may
be levied against violators. Examples of public law include
constitutions, criminal laws, and administrative laws. For
example, if someone steals items from a store, the thief is
violating public law. He committed the crime of theft which
affects the community as a whole (not just the store owners),
and the crime is defined in public legislation.
Private law is law that is binding on specific parties. For
instance, parties to a contract are involved in a private law
agreement. The terms of the contract apply to the parties of
Introduction to Law & Legal Systems | 14

the contract but not anyone else. If the parties have a contract
dispute, the terms of the contract and the remedy for breach
will apply only to the parties of the contract. In addition to
contracts, other examples of private law include tort and
property laws. For example, if someone installs an industrial
smoker on his property and the smoke creates a dense haze
in the neighbor’s yard, there may be a violation of private law
because the smoke is interfering with the neighbor’s right to
peacefully enjoy one’s property.
Laws are also classified as civil or criminal. Civil law is usually
brought by a private party against another private party. For
example, one company decides to sue another for breach of
contract. Or a customer sues a business when injured by the
company’s product. Most laws affecting businesses are civil.
Criminal law involves a governmental decision to prosecute
someone for violating a criminal statute. If someone breaks a
criminal law, he or she could lose their freedom (i.e. be sent to
prison) or lose their life (i.e. if convicted of a capital offense). In
a civil action, no one is sent to prison. Usually, liability results in
the loss of property such as money or assets.
Civil

Criminal

Source of
Law

statute or common law

statutes defining crimes

Who files
case?

business or individual
suffering harm

the government (e.g.
District Attorney)

Burden of
Proof

preponderance of
evidence

beyond a reasonable doubt

Remedy

damages, injunction,
specific performance

punishment (e.g. fine or
imprisonment)

Purpose

provide compensation
or private relief

protect society

Additionally, some law is procedural and some law is
substantive. Procedural law describes the legal process and
15 | Introduction to Law & Legal Systems

rules that are required and must be followed. For instance,
parties who are sued in court must receive notice of the lawsuit
before the court can impose judgment against them.
Substantive law refers to the actual substance of the law or the
merits of the claim, case, or action. Substantive law embodies
the ideas of legal rights and duties and is captured by different
sources of law, including the Constitution, statutes, and
common law.
For example, if someone drives fifty-five miles per hour in a
forty mile-per-hour zone, she has broken the substantive rule
of law of the speed limit. However, how and what gets decided
in court related to the speeding ticket is a matter of procedural
law. For example, whether the driver is entitled to a hearing
before a judge, whether she has a right to be represented by
legal counsel, whether the hearing takes place within a certain
amount of time after the ticket was issued, and what type of
evidence can be presented are procedural law issues.

Sources of Law
In the United States, our laws come primarily from:
• Federal and state constitutions;
• Statutory law from Congress, the state legislatures, and
local legislative bodies;
• Common law from federal and state appellate courts;
• Administrative rules and regulations;
• Treaties and conventions; and
• Executive orders.

Introduction to Law & Legal Systems | 16

Constitutions
The most fundamental law in the United States is the US
Constitution, which is the supreme law of the nation. Any law
that conflicts with it is void. The Constitution serves three
important functions. First, it establishes the structure of our
national government and identifies the powers of the
legislative, executive, and judicial branches. Second, it defines
the boundaries of each branch’s authority and creates “checks”
on each branch by the other branches. For example, the
president is the commander-in-chief of the armed forces, but
does not have the power to declare war. That duty falls to
Congress. And, third, the Constitution guarantees civil liberties
and individual rights.
The power granted to the federal government by the
Constitution is limited. Any powers not expressly granted to
the federal government by the Constitution are reserved to
the states. This means that if the Constitution does not give
the federal government power over a particular area, then the
states regulate it.
The first ten amendments to the Constitution are known as the
Bill of Rights. Despite the limited power granted to the federal
government by the Constitution, the Bill of Rights protects
certain individual civil rights and liberties from governmental
interference. These rights include the freedom of speech and
religion, the right to bear arms, and the rights of individuals
who are suspected and accused of crimes.
Figure 1.2 Separation of Powers of the Federal Government

17 | Introduction to Law & Legal Systems

Each state also has its own constitution, which serves
essentially the same function for the state government as the
US Constitution serves for the federal government. Specifically,
they establish limits of state government power, establish the
organization

and

duties

of

the

different

branches

of

government at the state level, and protect fundamental rights
of state citizens. This dual system of government in the United
States is called federalism, which is a governance structure
whereby the federal government and the state governments
coexist through a shared power scheme.
Figure 1.3 Separation of Powers of the State Governments

Introduction to Law & Legal Systems | 18

Statutes
Statutes are laws created by a legislative body. Congress is
the federal legislative body, and each state also has its own
legislative body. Almost all statutes are created by the same
method. An idea for a new law is proposed in the legislature.
This proposal is called a bill. The House of Representatives and
Senate independently vote on a bill. If the majority of both
chambers approves it, the bill is sent to the president or
governor for approval. If the president or governor signs the bill,
then it becomes a statute.
Local governments, such as counties, cities, and townships,
may be authorized under a state constitution to create or adopt
ordinances. An ordinance is a legislative act of a local

19 | Introduction to Law & Legal Systems

government entity. Examples of ordinances include building
codes, zoning laws, and misdemeanors such as jaywalking.

Common Law
Binding legal principles also come from the courts. When
appellate courts decide a case, they may interpret and apply
legal principles in a way that are binding on lower courts in the
future. The process of applying a prior appellate decision to a
case is called precedent. Simply put, precedent is when judges
use past decisions to guide them. The benefit of precedent is
that it makes the law predictable and furthers the rule of law
by applying legal principles to the greater community, not just
the parties to a lawsuit. Businesses value common law systems
because they reduce the cost of business. For example, if a
business is unsure of how its contract rights will be applied by
the court, it can understand its rights by learning how courts
interpreted similar contract provisions in past lawsuits. This
allows businesses to assess their risks, determine their liability,
and make rational business decisions without the expense of
litigation.

Administrative Rules and Regulations
Administrative law is the collection of rules and decisions
made by agencies to fill in particular details missing from
constitutions and statutes. For example, the Internal Revenue
Service (IRS) is the federal agency responsible for collecting
national taxes and administering the Internal Revenue Code
enacted by Congress. All businesses and individuals must
follow the IRS rules and regulations about how to report, file,
and pay applicable taxes that Congress levies. Congress passes

Introduction to Law & Legal Systems | 20

statute defining “what” taxes need to be paid. The IRS adopts
the rules about “how” those taxes are paid.
In the United States, many of the day-to-day regulation of
businesses is done by administrative agencies. These agencies
are created by the legislature to implement and enforce a
particular statute. Agencies often report to the executive
branch, but some are run by independent commissions.
Legislative bodies give agencies the power to create rules and
regulations that individuals and businesses must follow to
comply with the statute. For example, the Environmental
Protection Agency (EPA) was created to implement and
enforce the Clean Air Act and the Clean Water Act.

Treaties and Conventions
A treaty is a binding agreement between two nations. A
convention is a binding agreement among a group of nations.
In the US, a treaty or convention is generally negotiated by the
executive branch. To be binding, the US Constitution requires
the Senate to ratify treaties by a two-thirds vote. Once ratified,
a treaty becomes part of federal law with the same weight and
effect as a statute passed by the entire Congress. Therefore,
treaties and conventions have equal standing as statutes in US
law.

Executive Orders
Article II, Section 1 of the US Constitution gives the president
the power to “take care that the laws be faithfully executed.”
Under this power, the president may issue executive orders
requiring officials in the executive branch to perform their
duties in a particular manner. State governors have the same
21 | Introduction to Law & Legal Systems

authority under state constitutions. Although they are not laws
that apply directly to individuals and businesses, executive
orders are important legal documents because they direct the
government’s enforcement efforts.
Hierarchy of Sources of Law
Priority

Source

Comment

1

Constitutions

Exist at both federal and state levels

2 (tie)

Statutes

Laws passed by the federal or state
legislatures

2 (tie)

Treaties and
Conventions

International agreements that have the
same standing as statutes

4

Judicial
Opinions

Court interpretation and application of
constitutions, statutes, treaties, agency
regulations, and executive orders

5

Agency
Regulations

Rules and regulations adopted by
administrative agencies at the federal,
state, or local level

6

Executive
Orders

Guidance from the president or
governor to executive branch officials
about how to perform their duty

1.5 Concluding Thoughts
Understanding business law is essential to successfully
running any type of business because a solid understanding
of laws and regulations helps avoid liability and minimizes risk.
In business, it is not enough to conduct business ethically.
Knowledge of business law is essential to successful business
practices. Ultimately, business people should be able to
recognize legal issues, minimize liability exposure, and know
when to consult an attorney.
Legal systems vary widely in their aims and in the way they

Introduction to Law & Legal Systems | 22

resolve disputes. Common law systems are adversarial, use
juries and adhere to precedent. Civil law systems are
inquisatorial, do not use juries and do not recognize precedent.
All major world religions have a legal system, although only two
nations have a purely national religious system. Many nations
have hybrid legal systems that combine two or more legal
systems.
The legal system in the United States is composed of multiple
jurisdictions at the local, state and federal levels. Local and state
laws may not conflict with federal laws. Primary sources of law
in the United States include constitutional law, statutory law,
common law, administrative law, treaties, and executive orders.

23 | Introduction to Law & Legal Systems

2. The United States
Court System
2.1 Introduction
LEARNING OBJECTIVES
1. Understand the US court system and how it affects the
conduct of businesses.
2. Understand the three branches of government and how
they check and balance each other’s powers.
3. Explore the state and federal court systems.
In the United States, law and government are interdependent.
The US Constitution establishes the basic framework of the
federal 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. Most law comes from Congress and the
state legislatures. Courts interpret the laws and apply them to
cases.
Laws are meaningless if they are not enforced. Companies have
to make many decisions daily, from product development to
marketing to maintaining growth. These decisions are based
on financial considerations and legal requirements. If a
company violates a law, it is often held accountable through
litigation in courts.

The United States Court
System | 24

Counselor’s Corner Under the Supreme
Court’s Citizens United decision, business entities
enjoy the same right as natural persons to influence
the political process through contributions.
Because federal judges are appointed for life,
businesses cannot directly influence actions of the
judicial branch. However, they can do so indirectly
by lobbying Congress on laws that it considers and
lobbying the president concerning enforcement
priorities. While all states have a comparable threebranch system, in some states (not in Colorado),
judges obtain office through partisan elections. In
such states, businesses can seek to influence the
judicial branch through supporting judges whose
philosophy favors business generally or a particular
industry. For these reasons, in choosing whether to
litigate in state or federal court, businesses should
consider that federal judges may be more likely to
take politically unpopular actions.

~John W., judge

2.2 Separation of Powers
Under the US Constitution, power is separated among three
branches of government. Article I of the Constitution allocates
the legislative power to Congress, which is composed of the
House of Representatives and the Senate. Congress makes
laws and represents the will of the people. Article II of the
Constitution creates the executive power in the president and
makes the president responsible for enforcing the laws passed
by Congress. Article III of the Constitution establishes a
25 | The United States Court System

separate and independent judiciary, which is in charge of
applying and interpreting the meaning of the law. The US
Supreme Court is the highest court in the federal judiciary and
consists of nine Justices.
Figure 2.1 Separation of Powers of the Branches of the Federal
Government

The Constitution is remarkably short in describing the judicial
branch.

Under

the

Constitution,

there

are

only

two

requirements to becoming a federal judge: nomination by the
president and confirmation by the Senate. Article III provides:
“The judicial power of the United States, shall be vested in one
Supreme Court, and in such inferior courts as the Congress
may from time to time ordain and establish.” The Constitution
also guarantees that how judges decide cases does not affect

The United States Court System | 26

their jobs because they have lifetime tenure and a salary that
cannot be reduced.
Separation of powers is discussed in more detail in Chapter 5.

Marbury v. Madison
In 1800, the presidential election between John Adams and
Thomas Jefferson nearly tore the nation apart. John Adams
was the President and his Vice-President, Thomas Jefferson,
ran against him. They were both Founding Fathers but were
members of different political parties that had opposing
visions for the future of the new nation. The election was bitter,
partisan, and divisive. Jefferson won but wasn’t declared the
winner until early in 1801. In the meantime, Adams and other
Federalists in Congress attempted to leave their mark on
government by creating a slate of new life-tenured judgeships
and appointing Federalists to those positions. For the
judgeships to become effective, official commissions had to
be delivered in person to the new judges. At the time power
transitioned from Adams to Jefferson, several commissions
had not been delivered, and Jefferson ordered his acting
secretary of state to stop delivering them. When Jefferson
came to power, there was not a single federal judge from his
Democratic-Republican Party, and he refused to expand the
Federalist influence any further.
One Federalist judge, William Marbury, sued Secretary of State
James Madison to deliver his commission. The case was filed
in the Supreme Court, led by Chief Justice John Marshall, who
was also a Federalist. In a shrewd move, Marshall ruled against
Marbury while declaring that it was the Supreme Court’s role
to decide the meaning of the Constitution. This is called judicial
review, and it makes the US Supreme Court an equal branch
of government to the Executive and Legislative branches.
Because President Jefferson won the case, he was willing to

27 | The United States Court System

accept the Supreme Court’s assertion of power as an equal
branch of government.

Checks and Balances
The US Constitution establishes the three branches of the
federal government as independent branches with their own
authority. The Founding Fathers were fearful of setting up an
authoritarian regime, where the rulers of the government are
above the law and often rule arbitrarily. Therefore, the
Founding Fathers ensured that each branch of government
had a “check” on the other two branches in order to “balance”
the power of the government among the branches. Therefore,
if a president decided to become a dictator, the other two
branches could prevent him.
Figure 2.2 Checks and Balances of the Federal Government

Judicial review means that any federal court can hold any act

The United States Court System | 28

of the president or Congress to be unconstitutional. This is the
power of the Judicial Branch to ensure that the Executive and
Legislative branches do not overstep their powers and violate
the Constitution.
The other branches each have a “check” on the judiciary. For
example, the president (Executive branch) can control the
judiciary by nominating judges. The president can also pardon
those convicted by a federal court. A pardon is an executive
order vacating a criminal sentence for a crime.
Congress also plays an important role in “checking” the
judiciary. The most obvious role is in confirming judicial
selections. In addition to confirmation, Congress also controls
the judiciary through its annual budgetary process. Although
the Constitution protects judicial salaries from any reductions,
Congress is not obligated to grant any raises. Finally, Congress
can control the judiciary by determining how the courts are
organized and what kind of cases the courts can hear, except
for the types of cases the Constitution lists as the original
jurisdiction of the Supreme Court.

2.3 Federalism
There are fifty-six separate legal systems in the United States:
those of the fifty states, the federal government, the District
of Columbia, the military, and three territorial systems. Within
each legal system is a complex interplay among executive,
legislative, and judicial branches of government. This division
of authority between a central, federal government and state
governments is known as federalism.
In the United States, the federal government only has the
authority given to it by the states via the US Constitution. If

29 | The United States Court System

a power is not granted to the federal government, the states
retain the power. For example, the federal government cannot
tax the exchange of goods between states as “exports.” The
Constitution limits the power of the federal government, and
the

state

constitutions

limit

the

power

of

the

state

governments.
Figure 2.3 Federalism Between Federal and State Governments

Federalism is discussed in more detail in Chapter 5.

Jurisdiction
The authority of a court to hear a particular type of case is
called jurisdiction. State and federal courts hear different types
of cases, involving different laws, different law enforcement
agencies, and different judicial systems. The rules governing
the procedures used in these courts are known as civil
procedure or criminal procedure.

The United States Court System | 30

The rules of subject matter jurisdiction dictate whether a case
is heard in federal or state court. The vast majority of civil
lawsuits are filed in state courts, including lawsuits involving
state laws such as property, contracts, probate law, and torts.
State laws also involve most criminal cases, and domestic
issues such as divorce and child custody. Torts are any civil
wrong other than a breach of contract and include a variety of
situations in which people and businesses suffer legal injury.
Some states are friendlier toward torts than others, and the
resulting patchwork of tort laws means that companies that
do business across the nation need to know the different
standards they are held to based on the state their customers
live in.
Given the wide array of subject areas regulated by state law,
most businesses deal with state courts. Federal court subject
matter jurisdiction is generally limited to federal question
jurisdiction. In other words, federal courts hear cases involving
the Constitution or a federal law. Cases involving the
interpretation of treaties to which the United States is a party
are also subject to federal court jurisdiction. Finally, lawsuits
between states can be filed directly in the US Supreme Court.
Sometimes a federal court may hear a case involving state law.
These cases are called diversity jurisdiction cases, and they
arise when all plaintiffs in a civil case are from different states
than all defendants, and the amount claimed by the plaintiffs
exceeds seventy-five thousand dollars. For example, 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 York,
the plaintiff would be limited to the state court of New York.
Diversity jurisdiction cases allow one party who feels it may
not receive a fair trial where its opponent has a “home court
advantage” to seek a neutral forum to try the case.

31 | The United States Court System

Type of
Jurisdiction

Description

Minimum
Dollar
Requirement

Applicable
Law

Federal
Question

Cases involving
the US
Constitution,
treaties, or
federal laws &
regulations

None

Federal law

Diversity of
Citizenship

Cases brought
between
citizens of
different states

$75,000

State law

2.4 Trial and Appellate Courts
Within the federal court and the state court systems, there are
a hierarchy of courts. The first level of court is a trial court or
a court of limited jurisdiction such as traffic court and small
claims court. Trial courts accept evidence and testimony to
determine what happened in a case. Appellate courts review
the decisions of the trial court, without holding a new trial, to
determine whether the parties received a fair trial and whether
the appropriate law was applied.
Figure 2.4 Court System Hierarchy

The United States Court System | 32

In the federal court system, cases are filed in the US District
Court. There are ninety-four judicial districts in the nation,
which are named for their geographical location. However,
some states with low population have only one judicial district,
while more populous states have multiple judicial districts. The
US Department of Justice, which acts as the prosecutor
representing the federal government in both civil and criminal
cases, divides its attorneys among the ninety-four judicial
districts.
As a trial court, the US District Courts hear both civil and
criminal cases. At trial, witnesses are called and their
testimonies are recorded into a trial record. The losing party is
entitled to appeal the case to the US Circuit Court of Appeals.
There are thirteen circuit courts in the United States. A party
losing an appeal at the circuit court level may ask the US
Supreme Court to hear its case. However, the Constitution only
requires the Supreme Court to hear a few types of appeals.
Figure 2.5 Map of Federal Circuit Courts

33 | The United States Court System

In the state court system, a trial court of general jurisdiction
accepts most types of civil and criminal cases. These courts are
called various names such as superior court, circuit court, or
district court. There may be other courts of limited jurisdiction
at the state level, such as traffic court, family court, or small
claims court. Like their federal counterparts, state trial courts
hold trials, and preserve a trial record for review by an appellate
court. Finally, in certain state cases that involve a federal
constitutional right, a party that loses at the state supreme
court level can appeal to the US Supreme Court. These cases
typically involve the application of the Constitution to criminal
procedure, evidence collection, or punishment.
Whenever an appeal is filed, the trial record is forwarded to
the appellate court for review. Appellate courts do not conduct
new trials and are unable to recall witnesses or call new
witnesses. The trial court’s duty is to figure out the facts of the
case—who did what, when, why, or how. This process of factfinding is an important part of the judicial process, and a great
deal of deference is placed on the judgment of the fact finder,
which is usually the jury. The issues on appeal are therefore
limited to questions of law or legal errors. The deference to the

The United States Court System | 34

fact finder means that, as a practical matter, appeals are hard
to win.
Figure 2.6 Roles of Trial and Appellate Courts

2.5 Concluding Thoughts
The US Constitution establishes the three branches of the
federal government and gives them the ability to check each
other’s authority. The Judicial branch oversees the actions of
the Executive and Legislative branches through judicial review
to ensure that they do not violate the Constitution. While not
perfect, the US federalist system was designed to restrain
governmental power and to prevent the rise of an authoritarian
regime.
35 | The United States Court System

The Judicial Branch is the only unelected branch of
government. Marbury v. Madison established the doctrine of
judicial review, which allows courts to determine the final
validity of laws as well as the meaning of the Constitution. The
president can check the judiciary through appointments and
the pardon power. Congress can check the judiciary through
confirming judges, administrative control of court calendars
and funds, and legislation about the types of cases a court can
hear.
There are fifty-six separate legal systems in the United States.
Subject matter jurisdiction is the authority of a court to hear
a case based on the type of dispute. State law claims are
generally heard in state courts, while federal question cases
are generally heard in federal court. Federal courts may hear
state law claims under diversity jurisdiction. Federal cases are
filed in a US District Court and appealed to a US Circuit Court
of Appeals. State cases are typically filed in a trial court and
appealed to an intermediate court of appeals.

The United States Court System | 36

3. Litigation
3.1 Introduction
LEARNING OBJECTIVES
1. Identify the parties involved in litigation.
2. Explore the responsibilities of attorneys.
3. Understand the roles and types of juries.
4. Explore the standing requirement.
5. Follow a trial from opening statements to closing
arguments.
Litigation provides an opportunity for each side in a dispute to
tell their story to an impartial jury or judge to decide who wins.
Business professionals have a responsibility to their company
and stakeholders to avoid legal liability. Acting ethically helps
achieve this goal. Agreeing to mediation or arbitration may
help businesses avoid court. However, litigation may be the
only dispute-resolution mechanism available or the one that is
best for the situation.

Counselor’s Corner Litigation is like any other
business effort: you are trying to get someone to see
things your way. The best way to do that is to be
likable and persuasive to the judge, other lawyers,
and the jury. Construct your theory of the case early
on. Meet your deadlines. Maintain a strict ethical

37 | Litigation

standard in your professional life. Work hard to
explore both sides of the case, and develop a short
and compelling statement about why your side
should prevail. If you do all that, you will make it easy
for others to want to find in your favor. Why does
this work? Because as humans, we want good to
prevail. Be good.

~Valerie M., magistrate

3.2 The Parties, Attorneys, and Jury
The Parties
The litigation system relies on parties to bring forth and defend
their respective claims. The party that begins a civil lawsuit is
called the plaintiff. The plaintiff sues the defendant to recover
damages for, or to stop, a legal wrong. In a criminal trial, the
party that initiates litigation is the prosecution, representing
the people within a state or federal government. In a criminal
trial the accused wrongdoer is also called the defendant.
Cases may involve multiple plaintiffs and multiple defendants.
Civil procedure encourages parties to bring their complaints
against each other at once. All parties, and every possible claim
(each claim is a separate violation of law) arising out of a single
incident or series of related incidents, should be identified and
raised in a lawsuit.
Except in some small-claims courts, parties may hire attorneys
to represent them. Individuals who represent themselves are
called pro se litigants. The complexities of litigation require
Litigation | 38

knowledge and objectivity to succeed. Courts hold pro se
litigants to the same standards as they do attorneys. Therefore,
a pro se litigant is expected to understand and follow all the
rules of the court and applicable laws.

Attorneys
In the United States, law school is a graduate-level program
that usually takes three years to complete. Law school
graduates earn a Juris Doctorate degree, or JD. Graduates then
take the bar exam in the state where they wish to practice. If
they pass the exam and background check, they can apply to
be licensed in that state. Because the practice of law in the
United States varies widely by jurisdiction, attorneys are only
permitted to practice in jurisdictions where they are licensed.
Attorneys are bound by a professional code of ethics that is
overseen by the supreme court of the state where they are
licensed. One of the most important rules of professional
responsibility is the obligation to keep a client’s secrets. The
communications between a client and his or her attorney are
absolutely confidential under the attorney-client privilege
doctrine. The privilege belongs to the client, and the attorney is
not permitted to reveal any of these communications without
the client’s consent. A narrow exception exists for clients who
tell their attorneys they intend to harm others or themselves.
Attorneys must avoid violating the privilege because it exists
for the client’s benefit. Someone who cannot communicate
with his or her attorney freely is unable to help the attorney
prepare the best possible case.
In spite of an attorney’s professional obligations to his or her
client, it’s important to remember that ultimately an attorney’s
first duty is to the administration of justice. The requirements

39 | Litigation

for attorneys to be civil, honest, and fair are written to ensure
that attorneys represent the very best aspects of the judicial
system. For example, a client admits to his attorney that he is
guilty of a crime. The client then wants to testify under oath
that he is innocent. Although an attorney cannot reveal what
her client has told her, the attorney is prohibited from
knowingly suborning perjury. The attorney must either
convince the client to not testify or withdraw from the case.
An attorney owes her client zealous advocacy, but her zeal
must be constrained within the bounds placed on her as an
officer of the Court and under the Court’s rules. Attorneys
cannot assert legal claims or arguments that are not wellfounded under existing law or through the modification or
expansion of law. Attorneys are also prohibited from using the
courts for a purpose unrelated to the resolution of a legitimate
legal cause of action.

The Jury
In the US legal system, the jury has a very special role of citizen
participation in the administration of justice. As the trier of fact,
the jury has the duty of determining the truth in any given
situation: who said and did what, why, and when. The litigation
system is a process in which each side gets to present its case
to a group of unbiased citizens, and then ask them to decide
who wins the case.
There are two types of juries. A grand jury is a group of citizens
convened by the prosecution in serious criminal cases to
determine (1) whether probable cause exists to believe that a
crime has occurred, and (2) whether it’s more likely than not
that the defendant committed the crime. If the grand jury
decides probable cause exists, then the government may bring

Litigation | 40

criminal charges against the defendant. The grand jury
prevents prosecutors from abusing their powers of arrest and
indictment. The grand jury requirement exists at the federal
level and in most states. A grand jury typically meets for an
extended period of time and hears several different cases.
The grand jury does not determine guilt or innocence. A petit
jury does that. This jury is impaneled for a specific trial. During
the trial, members of the jury listen to the evidence presented
and then deliberate as a group on the facts of the case. They
then apply the law, as instructed by the judge, to the facts.
There are typically twelve members in a petit jury in criminal
trials and from six to twelve members in civil trials. In a criminal
trial, a jury must arrive at a unanimous verdict to convict a
defendant of the crimes charged.
The jury system is incredibly important because ordinary
citizens adjudicate all sorts of disputes. There are problems
with administering this system, however.
Both grand and petit juries are drawn from citizen voter and
driver license rolls. In high-profile cases, it may be difficult to
find citizens who have not heard about the case or who can be
impartial. Another problem arises from the burdens placed on
jurors’ personal lives through their service. While most states
have laws that prevent an employer from firing a worker or
taking any negative action against workers on jury duty, there
is no legal requirement that an employer continue to pay a
worker on jury duty. Some citizens, such as those who are selfemployed, risk losing personal income by serving on juries.
Another potential problem arises in the composition of the jury.
To provide a fair jury, courts attempt to draw from a crosssection of society to reflect the diversity of the surrounding
community. Local court rules typically allow judges to excuse
potential jurors for hardship or extreme inconvenience. The
only professions that are automatically exempt are active-duty
41 | Litigation

military members, police officers, firefighters, and public
officers. In spite of these administrative problems, the jury
system remains a cornerstone of the US legal system.

3.3 Standing
Standing is a constitutional requirement. Article III of the US
Constitution grants the judiciary the power to hear “cases” and
“controversies.” This means actual cases and controversies, not
merely hypothetical ones. The standing requirement means
that courts are unable to give advisory opinions. Standing is a
doctrine that limits judicial overreach by limiting the types of
cases that are litigated in court.
To demonstrate standing, a party has to prove that it has an
actual case to proceed. This is a procedural matter, and it
requires the case to be brought at the right time. If a case is
brought too early, it is not yet ripe. If it’s brought too late, then
the case is moot.
The case also has to be brought by the right person. To show
standing, a plaintiff has to demonstrate that he or she has an
actual stake in the litigation, or something of value that would
be lost if he or she loses the case. It’s important to note that
standing is not related to the merits of the case. It only means
that a party may proceed with litigation.

3.4 Subject Matter and Personal
Jurisdiction
In order to hear a case, courts must have subject matter
jurisdiction over the type of dispute and personal jurisdiction
Litigation | 42

over the parties. As discussed in Chapter 2, subject matter
jurisdiction is the legal authority to hear and decide a case or
controversy. The court must dismiss a case if it lacks either form
of jurisdiction.
Personal jurisdiction is the power of the court to compel the
parties to appear in court. Personal jurisdiction requires
litigants to have some form of minimum contacts with the
state where the case is filed. Personal jurisdiction seeks to avoid
inconvenient litigation, even if the case has merit.
A court obtains personal jurisdiction over the plaintiff when the
plaintiff files a lawsuit. The court obtains personal jurisdiction
over a defendant when he or she is served with process or
waives service.
Obtaining personal jurisdiction over the defendant requires
some connection between the defendant and the state where
the court is located. Businesses that incorporate, have a
physical location, or do business in a state create personal
jurisdiction through their actions within the state. Owning
property in a state also creates personal jurisdiction.
Personal

jurisdiction,

like

standing,

is

a

constitutional

requirement. Most states have long-arm statutes that set forth
the procedure by which out-of-state defendants can be
required to appear before a court. The statutes provide for how
service of process occurs. Service of process is the process
by which a defendant is notified that it is being sued. Service
of process typically requires a copy of the notice to appear
before a court to be personally delivered to the defendant or
the defendant’s agent. In the case of businesses, service of
process is usually delivering a copy of the notice to appear to
their registered agent. Service can be more challenging with
individuals.

43 | Litigation

Basis of
Personal
Jurisdiction

Description

Consent

• A business or individual agrees to the
jurisdiction of the court

Residence

• A business or individual resides in the state

Service of
Process

• The defendant is served a summons and
complaint within the state

Long-arm
Statute

• A resident business or individual was
involved in an incident in another state; or
• A non-resident business or individual was
involved in an incident within the state

3.5 Venue
Venue is the proper geographic location of the court to hear a
case because the place has some connection with the events
that give rise to the lawsuit. While multiple courts may have
subject matter and personal jurisdiction over a dispute, only a
few may be the proper venue. For example, by doing business
in Colorado a company is subject to the jurisdiction of Colorado
courts. However, the court in the county where the plaintiff was
injured or where the business maintains an office would be the
proper court to hear the dispute.

Litigation | 44

3.6 Pretrial Procedures
Figure 3.1 Litigation Flowchart

Pleadings
In civil cases, litigation begins with the filing of a complaint by
the plaintiff. The complaint is a legal document setting forth
who the parties are, the facts of the case, and what laws the
plaintiff claims defendant has violated. The complaint ends
with a prayer for relief. The plaintiff may be seeking damages
(money), specific performance in certain types of contract
cases, or an injunction.
The complaint is filed with the clerk of the court where the
lawsuit is to be heard. The clerk will issue a summons, which is

45 | Litigation

an official notice that a lawsuit has been filed with the court
and summons the defendant(s) to court to defend against it.
To be effective, the defendant(s) must be served the summons
and a copy of the complaint.
In certain types of cases, there may be a large number of
plaintiffs injured by a defendant’s actions. This may happen
in a product liability lawsuit where a product is purchased by
many thousands of consumers, all of whom experience the
same product failure. In these cases, several lead plaintiffs may
attempt to form a class in a class action lawsuit against the
defendant(s). Under federal civil procedure rules, class actions
may be granted when:
1. There are so many plaintiffs that
2. It is impractical for them to file separate lawsuits;
3. There are questions of law or fact that are common to
members of the class; and
4. The lead plaintiffs will fairly and adequately protect the
interests of the class.
The defendant must file an answer to the complaint within a
specified period of time, usually thirty days. The answer is a
paragraph-by-paragraph response to the complaint, admitting
certain allegations and denying others. The answer may admit,
for example, noncontroversial claims by the plaintiff such as the
defendant’s name, address, and the nature of the defendant’s
relationship with the plaintiff. Each time the defendant denies
a plaintiff’s claim in the complaint, that sets up a controversy or
argument that must be litigated. The answer may also contain
any affirmative defenses and counterclaims the defendant
wishes to pursue. Taken together, the complaint and answer
are known as the pleadings.

Litigation | 46

Discovery
After pleadings are filed, litigation moves into the discovery
phase. Discovery is a process in which each side finds out
information about the other’s case. Discovery is designed to
prevent trial by surprise, where either side may suddenly
produce a damning piece of evidence. Because trials are based
on the discovery of truth, they should be tried on the merits of
the case rather than a party’s deceit. In that spirit, the rules of
discovery are broad. Relevant evidence is discoverable even if
it is later ruled to be inadmissible at trial by the judge. Parties
are also obligated to turn over material that supports their case,
without demand from the other side unless it is protected by
the attorney-client privilege.

47 | Litigation

Type of
Discovery

Description

Request for
Admission

• Ask opposing party to admit specific facts or
claims
• Ex: confirm legal name and address, existence
of contract, etc.

Interrogatory

• Written questions to opposing party about
nature of claim
• Ex: identity of witnesses, extent of injuries,
description of injury, etc.

Request for
Production

• Ask opposing party to produce documents and
evidence relevant to lawsuit
• Ex: copies of contracts, records, reports, emails,
etc.

Deposition

• Sworn testimony of potential witnesses at trial
• Court reporter is present and makes official
transcript of questions and answers but judge is
not present

There are four types of discovery. The simplest is a request
for admission. Remember that a complaint contains a series
of claims the plaintiff is making against the defendant. The
parties may ask each other to admit that certain facts are true
or that a contested claim is true. Doing so narrows the issues
for trial because it is one less thing that the jury has to decide.
Even if the parties dispute legal liability, if they agree upon the
facts that caused the dispute, the case may take less time and
money to resolve.
The second type of discovery is an interrogatory. These are
written questions addressed to the other party. The questions
tend to be simple and straightforward. Interrogatories seek to
gather information about what happened, who was involved,
Litigation | 48

a company’s structure, and the names and addresses of
witnesses.
A third form of discovery is a request for production. A party
can request another party produce relevant documents to the
lawsuit, including internal company reports, emails, product
manuals, and employee records. In some cases physical
evidence may also be produced. For example, if a consumer
sued a vehicle manufacturer because a wheel fell off while
driving, the manufacturer may ask the consumer to produce
the vehicle so that its engineers can inspect it. Failure to
preserve and produce key evidence in litigation can lead to
charges of spoliation, which may result in severe sanctions
against the offending party.
Finally, discovery can take the form of a deposition. A
deposition is a sworn oral statement, in response to questions,
given by a potential witness in a trial to the attorneys in the
case. A deposition is attended by the witness being deposed,
attorneys from all the parties, and a court reporter who keeps a
written or video transcript of the deposition. There is no judge
present, so there is great latitude for parties to ask questions,
even if the answers are not admissible in court. Depositions
help prepare for trial by knowing everything a witness may say
in court. They also serve to pin down a witness’s testimony,
because a witness who changes testimony between a
deposition and trial can be impeached.

Motions
At any point in litigation, either party may file motions with the
court. A motion is a request to the court to rule on an issue or
claim.
If a defendant is properly served and does not answer the
49 | Litigation

complaint, the plaintiff can file a motion for default judgment.
In essence, the plaintiff asks the court to enter judgment in his
or her favor because the defendant refused to show up to court
to defend against the case. The alleged facts are admitted by
default and the plaintiff may receive all the relief requested.
At the beginning of a lawsuit, a party can file a motion to
dismiss for failure to state a claim. In this motion, the
defendant argues that even if everything in the complaint is
factually true, the plaintiff is not entitled to legal relief. In other
words, the defendant’s conduct has not broken any laws.
If a long period of time has passed since the incident in
question and the filing of the lawsuit, a defendant may file a
motion to dismiss based on the statute of limitations. Every
civil and criminal action has a statute of limitations, which
requires lawsuits to be brought within a specified period of
time. Statutes of limitations exists to encourage parties to file
their lawsuits quickly, while evidence is still fresh and relevant
witnesses remember what occurred. As time passes, evidence
may be destroyed, witnesses may die or move away, and those
who can be located can’t remember what they saw or heard. In
other words, the quicker a lawsuit is filed, the more likely that
the truth will be discovered through litigation. For businesses, a
statute of limitations also allows it to “close the books” on past
liabilities.
Another motion that is filed before discovery and trial is
a motion for judgment on the pleadings. This motion asks the
court to determine whether a genuine issue of material fact
exists that allows the case to proceed. These motions are not
as common as motions to dismiss but they are an important
tool to dismiss lawsuits that are fatally flawed before the parties
spend too much money. For example, if a business is sued
by several parties for injuries resulting from a common cause
but the complaints allege conflicting facts, the business may

Litigation | 50

file a motion for judgment on the pleadings. In other words,
the defendant is asking the court to dismiss the complaints
because they contradict each other in a way that it is
impossible to reconcile. If dismissed, the plaintiffs may file new
complaints that are not flawed.
Similar to a motion for judgment on the pleadings, a motion
for summary judgment asks the court to enter judgment in
a party’s favor instead of trying the case. Filed after discovery,
this motion asks the court to rule that there are no genuine
issues of facts for trial. For example, if a plaintiff admits during
his deposition that he lied about being involved in an accident,
the defendant may bring a motion for summary judgment
because the plaintiff brought a fraudulent lawsuit. Although
any party may file a motion for summary judgment,
defendants file and win many more motions for summary
judgment than plaintiffs.

51 | Litigation

Pretrial Motion

Description

Motion for
Default
Judgment

• Defendant was served but does not answer
the complaint
• Plaintiff wins because defendant does not
defend against the lawsuit

Motion to
Dismiss for
Failure to State a
Claim

• Determination of whether the law supports
the plaintiff’s claim(s)
• Defendant wins because conduct did not
break the law

Motion for
Judgment on
the Pleadings

• Determination of whether plaintiff is
entitled to judgment or damages, even if
the facts alleged are true
• Defendant wins because complaint is fatally
flawed

Motion for
Summary
Judgment

• Determination of whether genuine issue of
material fact exists to support plaintiff’s
claim(s) based on pleadings and evidence
during discovery
• Defendant wins because evidence does not
support plaintiff’s claim(s)

A party may submit an affidavit in support of any motion. An
affidavit is a written statement made under oath. Affidavits
play an important role in pretrial procedure because they are
an effective way for parties to tell their side of the story to the
judge.

3.7 The Trial and Appeal
After discovery is completed, the case is scheduled for a trial. In
civil litigation, well over 90 percent of cases filed are resolved

Litigation | 52

or settled before trial. If a case goes to trial, it means there are
genuine issues of fact that the parties cannot resolve, and both
sides are determined to win.
The first step in this process is to select a jury. The process of
selecting a jury is called voir dire. Voir dire typically begins with
the jurors filling out a written questionnaire. The questionnaire
asks the jurors to identify their occupation, any work or
occupational conflicts, and any potential conflicts of interest
with the case. The process then continues with attorneys
quizzing each potential juror to determine if he or she has any
biases against upholding the law and whether he or she can
keep an open mind during the trial.
After a jury has been selected and sworn in, the trial begins. The
plaintiff or prosecution begins by giving an opening statement
that is a preview of the trial. Attorneys inform the jury during
opening statements what they expect to prove at trial.
Attorneys do not make any arguments during the opening
statement; they simply lay out what jurors can expect from the
trial ahead. After plaintiff’s opening statement, the defendant
may give an opening statement.
After opening statements, the trial moves into the examination
phase. The plaintiff presents evidence first. Evidence may be
in the form of documents and witness testimony. The other
parties have the right to cross-examine witnesses who testify
at trial. During the cross-examination, the attorney will try to
discredit the witness to convince the jury that the witness is
not credible. The attorney may probe into any potential biases
the witness may have or try to prove that the witness’s
recollection of events may not be as clear or certain as the
witness believes.
Once the plaintiff has called all their witnesses and introduced
all their evidence, the plaintiff will rest their case. The
defendant then has an opportunity to present witnesses and
53 | Litigation

evidence on their behalf. After the defense has rested its case,
the attorneys once again address the jury in closing
arguments. Here, the attorneys summarize the case for the
jury. They address what witnesses were called and what the
witnesses said. During closing arguments, the attorneys are
permitted to be much more persuasive and argumentative
than during the opening statement. They appeal to the jury’s
emotions and argue how the jury should interpret the
evidence before them.
After closing arguments are made, the judge instructs the jury
on the relevant law. The jury then deliberates. During
deliberations, the jury will decide what facts are true. Then
it will apply those facts to the law as outlined in the jury
instructions.
Central to the jury’s deliberations is the burden of proof
applicable to the case. In civil cases the burden of proof is
preponderance of the evidence. This standard requires the
scales of justice to tilt ever so slightly toward one party. If the
jury believes one side is 51 percent correct and the other is 49
percent correct, that is enough to declare a winner. It is an easy
standard to meet because it only requires a party to prove that
its side is more likely than not telling the truth.
During jury deliberations, the jurors are permitted to ask the
judge for clarification about the law and to request to see the
evidence again. If the jury is unable to come to a verdict, the
jury is said to be deadlocked, and a mistrial results. Since trials
are expensive and time consuming, the judge will usually
instruct the jury to try its best before giving up. If the jury
arrives at a decision, it is called a verdict.
The judge enters the jury’s verdict as a judgment of the court.
After that, the losing party has the right to file an appeal. The
appellate court only reviews the record for legal errors and

Litigation | 54

cannot call new witnesses or substitute its judgment on the
facts for the jury’s.
Once all appeals are exhausted, the winning party may collect
the judgment entered in its favor. This process is called
execution. If a party is unable or unwilling to pay the judgment,
the court can order the party’s assets to be sold to satisfy the
judgment.
A party cannot refile a lawsuit once it has been decided in
the hopes of a more favorable outcome. The doctrine of res
judicata holds that once a dispute is litigated and resolved,
the parties are barred from relitigating the issue again. Res
judicata is a Latin phrase that means “the thing has been
decided” and it is a rule of finality in the legal system.

3.8 Concluding Thoughts
Litigation is a method for parties who cannot resolve their
disputes to have a judge or jury determine what happened and
whether legal liability exists. Although it may be challenging
to keep the names of the parties, motions, and parts of the
process straight, businesses need to understand the process
to navigate it successfully. Litigation is a long and expensive
process, but is often a part of a business’s activities.
The goal of civil litigation is to find the truth. An attorney’s
highest duty is to the administration of justice. Attorneys are
ethically bound to represent their clients with zealous
advocacy. A grand jury acts as a body of citizens to prevent
abuse by prosecutors. A petit jury sits in trials as the trier of
fact to ascertain the truth through their observations of the
presented evidence.

55 | Litigation

4. Alternative Dispute
Resolution
4.1 Introduction
LEARNING OBJECTIVES
1. Understand alternative dispute resolution (ADR) methods.
2. Learn the benefits and drawbacks of different methods of
dispute resolution.
Imagine that someone has a legal claim against a supplier,
employer, or a business where he or she is a customer. What
will happen? They probably don’t want to immediately initiate
litigation because litigation is very expensive and time
consuming. Besides, they may want to continue doing
business with the supplier, employer, or business. Perhaps the
matter is of a private nature, and they do not want to engage in
a public process to determine the outcome. They would like the
dispute to be resolved, but do not want to engage in a public,
time-consuming, expensive process like litigation to do it.
A common method of dispute resolution that avoids many of
the challenges associated with litigation is alternative dispute
resolution. Alternative dispute resolution (ADR) encompasses
many different methods of resolving disputes outside of the
judicial process. Some ADR methods vest power to resolve the
dispute in a neutral third party, while other strategies vest that
power in the parties themselves.
Figure 4.1 Alternative Dispute Resolution Continuum
Alternative Dispute
Resolution | 56

The most common methods of ADR are negotiation,
mediation, and arbitration. ADR is often used to resolve
disputes among businesses, employers and employees, and
businesses and consumers.
ADR methods are used outside of the courtroom, but
participation in ADR has important legal consequences. For
instance, parties that have agreed by contract to be subject
to binding arbitration give up their constitutional right to go
to court. The Federal Arbitration Act (FAA) is a federal statute
that requires parties to participate in arbitration when they
have agreed by contract to do so, even in state court matters.
The FAA preempts state power to create a judicial forum for
disputes arising under contracts with mandatory arbitration
clauses. The FAA encompasses transactions within the
broadest permissible exercise of congressional power under
the Commerce Clause in the US Constitution. This means that
the FAA requires mandatory arbitration clauses to be
enforceable for virtually any transaction involving interstate
commerce, which is very broadly construed. This is an example
57 | Alternative Dispute Resolution

of federal preemption exercised through the Supremacy
Clause in the US Constitution.

Counselor’s Corner “Alternative dispute resolution.”
The term suggests that litigation is the primary
means of dispute resolution and that mediation,
arbitration, and other means are “alternatives.” But,
actually, negotiation is the primary means of
dispute resolution and the others are the alternative
means—with litigation being the last (legal)
alternative. In negotiation and mediation, the
participants make decisions based on their values
and predispositions, needs, criteria for satisfying
those needs, pertinent information they are aware
of, and available ways to satisfy their needs.
Negotiation is the most used means of resolving
disputes. It is an invaluable life skill. Don’t wing
it—learn how to do it well.

~Russell C., judge

4.2 Negotiation
Imagine that Han is a tent manufacturer. Han’s supplier of tent
fabric routinely supplies him with appropriate water-resistant
fabric to construct tents, so that he can make and sell them.
After many years of a good working relationship, Han’s fabric
supplier delivered nonconforming goods. Specifically, the
fabric delivered was not water-resistant, despite the need for
water-resistant fabric to make tents. However, when Han
notified the supplier of the problem, the supplier denied that
the fabric was nonconforming to his order. Han refused to pay

Alternative Dispute Resolution | 58

for the goods. The fabric supplier insisted on payment before
future delivery of any additional fabric. Without water-resistant
fabric, Han cannot continue to make tents.
This is an example of a business to business dispute. Despite
the problem, Han wants to continue working with this supplier,
since they have a good, long-standing relationship. This
problem seems to be a “hiccup” in the regular business
relationship so they want to resolve this dispute quickly and
without hard feelings. It is very unlikely that Han will
immediately hire an attorney to file a formal complaint against
his supplier. However, that does not change the fact that there
is a dispute that needs to be resolved.
One of the first strategies that Han and his supplier are likely
to use is negotiation. Negotiation is a method of alternative
dispute resolution in which the parties retain power to resolve
their dispute. No outside party is vested with decision-making
power. Negotiation requires the parties to define the conflict
and agree to an outcome. Often, this can take the form of
a compromise. Note that a compromise does not mean that
anyone “loses.” If both parties are satisfied with the result of
the negotiation and the business relationship can continue
moving forward, then both parties will likely consider the
settlement a “win.”
Benefits to negotiation as a method of ADR include its
potential for a speedy resolution, the inexpensive nature of
participation, and the fact that parties participate voluntarily.
Drawbacks include the fact that there are no set rules, and
either party may bargain badly or even unethically. In a
negotiation, there is no neutral third party to ensure that rules
are followed, that the negotiation strategy is fair, or that the
overall outcome is sound. Moreover, any party can walk away
whenever it wishes. There is no guarantee of resolution

59 | Alternative Dispute Resolution

through this method. The result may not be “win-win” or “winlose,” but no resolution at all.
In addition, the parties may not have equal bargaining power.
If Han’s business and the supplier are both dependent on each
other for roughly equal portions of their businesses, then they
are most likely relatively equal with respect to bargaining
power. However, if Han has a small business but his supplier
has

a

large

business,

then

negotiation

is

potentially

unbalanced, since one party has a much more powerful
bargaining position than the other. For example, if Han needs
that particular type of fabric, which is only available from one
supplier. But the supplier does not need Han’s business
because he do not provide a significant amount of its profit.
This would be an example of unequal bargaining power.

4.3 Mediation
Mediation is a method of ADR in which parties work to form
a mutually acceptable agreement to resolve their dispute with
the help of a neutral third party. Like negotiation, parties in
mediation do not vest authority in a third party to decide the
dispute. Instead, this authority remains with the parties
themselves, who are free to end mediation if it is not working.
Often, when parties end mediation, they pursue another form
of ADR, such as arbitration, or they choose to litigate their
claims in court. Like negotiation, mediation seeks a “win-win”
outcome for the parties involved. Additionally, mediation is
confidential, which may be attractive to people who wish to
avoid the public nature of litigation. Discussions during a
mediation are not admissible as evidence if the parties proceed
to litigation. This encourages parties to be open with each
other when trying to resolve their dispute. Finally, the

Alternative Dispute Resolution | 60

mediation process is usually much faster than litigation, and
the associated costs can be substantially less.
Unlike negotiation, a third party is involved in mediation.
Indeed, a neutral mediator is crucial to the mediation process.
Mediators act as a go-between for the parties, seeking to
facilitate the agreement. Mediators do not provide advice on
the subject matter of the dispute. Mediators might not possess
any subject-matter expertise concerning the nature of the
dispute. The value of mediators, however, is their training and
experience in conflict resolution, which they use to facilitate an
agreement between the parties.
Advantages of Mediation
• Quick resolution
• Less expensive than
litigation & arbitration
• Non-adversarial process that
can preserve the
relationship between the
parties
• Allows parties to work
together to solve shared
problem
• Confidentiality
• Set ground rules by a third
party
• Possibility of a “win-win”
outcome

Drawbacks of Mediation

• Requires genuine
participation by parties
• Results may depend on skill
of mediator
• No uniform rules or
procedures that apply to all
mediations
• No guarantee of a mutually
agreeable outcome

Parties often enter into a legally binding contract that
embodies the terms of the resolution immediately after a
successful mediation. Therefore, the terms of the mediation
can become binding if they are reduced to a contract.
Mediation is often required by courts as part of the litigation
process. In an effort to reduce the court’s docket and
encourage the parties to settle their own disputes, parties to
lawsuits often must mediate their disputes after discovery and

61 | Alternative Dispute Resolution

before trial. If the parties cannot settle their dispute with the
help of a mediator, the case will proceed to trial before a judge
or jury who will determine the outcome of the case.

4.4 Arbitration
Arbitration is a method of ADR in which parties vest authority
in a neutral third-party decision maker to hear their case and
issue a decision, which is called an arbitration award.
An arbitrator presides over arbitration proceedings. Arbitrators
are neutral decision makers who are often experts in the law
and subject matter at issue in the dispute. Arbitrators act like
judges during trials. For instance, they determine which
evidence can be introduced, hear the parties’ cases, and issue
decisions. They may be certified by the state in which they
arbitrate, and they may arbitrate only certain types of claims.
For instance, the Better Business Bureau trains its own
arbitrators to hear common complaints between businesses
and consumers (B2C). However, their decisions do not form
binding precedent like appellate court decisions.
Participation in the arbitration proceeding is sometimes
mandatory. Parties must arbitrate if they signed a contract
requiring mandatory arbitration for that type of dispute.
Arbitration is also mandatory when state law requires it.
Voluntary arbitration is frequently used in business disputes.
Sometimes parties simply agree that they do not want to
litigate a dispute because they believe that the benefits of
arbitration outweigh the costs of litigation, so they choose
arbitration in hopes of a speedy and relatively inexpensive
outcome.
In binding arbitration, the arbitration award is final. Therefore,
Alternative Dispute Resolution | 62

appealing the merits of a binding arbitration award to court
is not available. An arbitration award may be converted to a
judgment by the court, thereby creating the legal mechanism
through which the judgment can be collected. This process is
called confirmation.
Although courts review arbitration awards, their review is very
limited and all doubts are resolved in favor of the validity of the
award. Courts review whether (1) the arbitration award covered
matters beyond the issues submitted; (2) the arbitrator failed to
apply the law correctly; and (3) fraud occurred. Courts do not
review the merits of the award.
Like any other form of dispute resolution, arbitration has
certain benefits and drawbacks. Arbitration is an adversarial
process like a trial, and it will produce a “winner” and a “loser.”
Arbitration is more formal than negotiation and mediation and,
in many ways, it resembles a trial. Parties present their cases
to the arbitrator by introducing evidence. After both sides have
presented their cases, the arbitrator issues an arbitration
award.
The rules of procedure during arbitration are often less formal
or less restrictive on the presentation of evidence than in
litigation. Arbitrators decide which evidence to allow, and they
are not required to follow precedents or to provide their
reasoning in the final award. In short, arbitration adheres to
rules, but those rules are not the same as the rules for litigation.
Arbitration can be more expensive than negotiation or
mediation, but it is often less expensive than litigation. Parties
must pay the costs of the arbitrator, and they often hire
attorneys to represent them. Additionally, in mandatory
arbitration clause cases, the arbitration may be required to take
place far from one of the parties. This means that a party may
have to pay travel costs during the arbitration proceeding.
Arbitration is also faster than litigation.
63 | Alternative Dispute Resolution

A common issue is whether mandatory arbitration is fair in
certain circumstances. It’s easy to imagine that arbitration is
fair when both parties are equally situated. For example,
business to business (B2B) arbitration is often perceived as
fair, especially if businesses are roughly the same size or have
roughly equal bargaining power. This is because they will be
able to devote approximately the same amount of resources
to resolve the dispute, and they both understand the issues
involved.
However, issues of fairness often arise in business to employee
(B2E) and business to consumer (B2C) disputes, particularly
where parties with unequal bargaining power have entered
into a contract that contains a mandatory arbitration clause. In
such cases, the weaker party has no real negotiating power to
modify or to delete the mandatory arbitration clause, so that
party is required to agree to such a clause if it wants to engage
in certain types of transactions. In B2E contexts, unequal
bargaining power alone is insufficient to hold arbitration
agreements unenforceable.
In B2C cases, different issues of fairness exist. As noted
previously, when the parties possess unequal power, these
issues can be magnified. Consumers tend to fare better in
litigation than in arbitration. Incentives exist to favor businesses
over consumers in the arbitration process, including the lack of
appeal rights to the courts, the limits on consumers’ remedies,
prohibitions against class-action suits, limitations on access to
jury trials, limitations on abilities to collect evidence, and
greater out-of-pocket expenses.
Not all binding arbitration clauses have been upheld by courts
in B2C cases. The FAA does not prevent the courts from
applying state law, including the unconscionability of contract
terms. In other words, if the terms of the contract make it

Alternative Dispute Resolution | 64

unreasonable to enforce the arbitration provision, then a party
may still bring claims to court for resolution.
Similarly, arbitration agreements may be rescinded on the
same grounds as other contracts. Fraud, mutual mistake, and
lack of capacity are grounds for voiding arbitration contracts.
Revocation is also possible in the event of death or bankruptcy
of one of the parties, as well as destruction of the subject
matter of the underlying contract.

4.5 Concluding Thoughts
ADR is the body of dispute-resolution methods outside of the
litigation process. ADR is often faster, less expensive, and more
private than litigation. For this reason, ADR may be the
preferred dispute resolution method, particularly when an
ongoing relationship between parties is desired. Common
methods of dispute resolution are negotiation, mediation, and
arbitration. Mandatory arbitration clauses are common in
contracts, and such clauses are usually enforceable against the
parties even if they wish to litigate their claims.

65 | Alternative Dispute Resolution

5. The Constitution
5.1 Introduction
LEARNING OBJECTIVES
1. Explore how the US Constitution creates a limited
government through the separation of powers and
through checks and balances among the three branches
of government.
2. Learn how the US Constitution resolves conflicts between
state and federal laws.
3. Explore how the US Constitution grants Congress the
power to regulate interstate commerce.
4. Understand how the US Constitution protects the civil
liberties of business entities.
Our

first

national

constitution

was

the

Articles

of

Confederation. The Articles granted limited authority to the
federal government, including the power to wage wars,
conduct foreign policy, and resolve issues regarding claims by
the states on western lands. Many leading statesmen, known
as

Federalists,

thought

the

Articles

created

a

federal

government that was too weak to survive. The lack of power
to tax, for example, meant that the federal government was
frequently near bankruptcy. Larger states resented the
structure under the Articles, which gave small states an equal
vote as larger states. Finally, the Articles reserved the power to
regulate commerce to the states, meaning each pursued its
own trade and tariff policy with other states and with foreign
nations. Because the federal government was too weak to

The Constitution | 66

function, the Articles were abandoned and the current
Constitution was adopted in 1787.

Counselor’s Corner The Constitution is the
fundamental law of our nation and is extremely
powerful. It’s also beautiful in its simplicity. The
Constitution in action, though, is often messy.
People’s rights conflict with each other. Branches of
government clash over which has the power to act.
Federal and state governments argue over who has
ultimate authority to govern. But as long as we
continue to cherish the values instilled in the
document, the Constitution will remain a living
protection against tyranny. We must protect it at all
costs if we expect it to protect us. Tyranny starts
when our dedication to Constitutional principles
ends.

~John K., judge

5.2 Federalism and Preemption
Much of the Constitution deals with the allocation of power
among three separate and coequal branches of government.
Substantively, much more attention is paid to the limitations
on the power given to each of the three branches than to
any positive grant of rights. The Constitution is a document of
prohibition, outlining what government cannot do as opposed
to what government must do. This is the result of the Founders’
distrust of authoritarian regimes.

67 | The Constitution

Separation of Powers
The Constitution provides for the separation of powers, which
requires each branch of government to play its own unique role
in governing the people.
Figure 5.1 Separation of Powers of the Branches of the Federal
Government

Article I of the Constitution establishes the legislative branch
through a bicameral legislature. The House of Representatives,
with elections every even-numbered year, has 435 members,
with representation determined proportionately by state
population as determined by a census every decade. The most
populous state, California, has fifty-three representatives, while
several states have only one representative. The House is led by
The Constitution | 68

the Speaker of the House, typically from the party that holds
the majority seats in the House. The House is generally thought
to represent the most contemporary views of the American
public, with its large body of members and frequent elections.
As a check on the majority will, and on the power of larger
states, the Senate is a smaller body with one hundred
members (two from each state) and with less frequent
elections (every six years). The Senate is meant to be a
deliberative body to ensure debate of significant issues and
prevent hastily rushed law. The makeup of the Senate means
that citizens from smaller states, representing many fewer
people, may frustrate the will of the majority of Americans. The
Constitution places the power to legislate with both chambers,
but the House retains the exclusive right to originate bills
raising revenue (taxation), while the Senate maintains the
exclusive right to ratify treaties.
Article II of the Constitution establishes the executive branch
of government. It sets forth some of the mechanisms for
becoming president—and is the only place in the Constitution
that prescribes a specific oath of office. Article II grants the
president power to be the primary architect of foreign affairs,
including the power to negotiate treaties and appoint
ambassadors. The president is also commander-in-chief of the
armed forces. The president is mainly responsible for enforcing
the laws of the nation. Through prosecutorial and police
functions, the president ensures that the will of the people, as
expressed through Congress, is carried out.
Article III of the Constitution establishes the judicial branch of
the federal government. The judicial branch plays a critical role
in interpreting the Constitution and outlining the powers of the
legislature and executive branches. The power to adjudicate
disputes is given to the Supreme Court and any other lower
courts established by Congress. Federal courts have the power

69 | The Constitution

to hear disputes under the Constitution, federal laws and
treaties. Also, if disputes arise between citizens of different
states, a federal court may have diversity jurisdiction. Federal
judges are nominated by the president and confirmed by the
Senate. Federal judges serve for life, which helps insulate them
from political pressures.

Checks and Balances
The Constitution establishes a system of checks and balances
among the legislative, executive, and judicial branches. Under
this system, each branch of government restrains the power
of the other two branches of government. For example, the
president may veto a bill passed by Congress. And Congress
can override a presidential veto by a two-thirds vote.
Figure 5.2 Checks and Balances of the Federal Government

The judicial branch has the power of judicial review of

The Constitution | 70

executive and legislative actions to determine whether they
violate the Constitution. Although not expressly written in the
Constitution, judicial review was established in 1803 in a
landmark case, Marbury v. Madison. Judicial review also
includes review of state action for violations of the US
Constitution. As a result, judicial review ensures that the US
Constitution is the supreme law of the land and that the
judicial branch has the authority to interpret the Constitution.

Federalism
Another aspect of the separation of powers is the separation
of power between the federal and state governments, known
as federalism. To avoid tyranny, the Constitution grants certain
powers to Congress, reserving all other powers to the states.
This is a result of the Founders’ distrust of a central government
and their effort to address the failures of the Articles of
Confederation. These powers are listed in Article I, Section 8
and are called enumerated powers.
Congress has the power to borrow money, lay and collect taxes,
regulate interstate commerce, establish a uniform law on
bankruptcy and naturalization, make money and establish its
value, punish the counterfeiting of US money, and establish a
uniform system of weights and measures. Congress also has
the power to establish post offices and to protect intellectual
property in copyrights and patents. Congress can create lower
courts under the Supreme Court created in Article III and to
define crimes committed on the “high seas” and against the
“law of nations.” Congress is also given fiscal responsibility over
the armed forces.

71 | The Constitution

State Police Powers
The Constitution reinforces that states have police power,
which is the authority to regulate public safety, health, welfare,
and morals. States may grant more civil rights to its citizens
than the federal government does. For example, some states
have passed anti-discrimination laws that protect more
minority

groups

than

are

recognized

by

the

federal

government. States are permitted to do so as long as the
exercise of their power does not violate the US Constitution.
Generally, this means the state legislation must be reasonable
and applied fairly rather than arbitrarily.

Concurrent Powers
The federal and state governments have some of the same
powers, which are called concurrent powers. For example,
both federal and state governments may tax businesses and
individuals. States are permitted to tax, but only if the activity
taxed has a nexus to the state. A transaction (such as a sale)
that takes place inside the state creates a nexus for a sales tax.
Working in the state typically creates a nexus for state or local
income tax to apply, and owning real property creates a nexus
for real estate tax to apply.
Figure 5.3 Venn Diagram of the Powers of the Federal and State
Governments

The Constitution | 72

What happens, however, if a state’s citizen purchases goods
from a seller out of state? Traditionally, buyers do not pay sales
tax to the government directly—rather, they pay the sales tax
to the seller, who collects the tax on behalf of the government
and turns it over to the government at regular intervals. As
the popularity of e-commerce has skyrocketed, more and more
states are reexamining how to tax transactions from out-ofstate sellers by compelling those sellers to collect the
applicable state sales tax. In June 2018, the US Supreme Court
ruled that states may impose sales tax on e-commerce sales
on businesses that do not have a physical presence within the
states’ boundaries. If the business has a clear connection to
state consumers and generate a certain threshold of sales, a
state can collect sales tax.

Preemption
What happens when state and federal laws exist on the same
subject matter and they contradict each other? Under the
Constitution’s Supremacy Clause (Article VI, Section 2), the
73 | The Constitution

Constitution, federal laws and treaties are the “supreme law of
the land” and judges in every state “shall be bound” by those
laws. This means that federal laws are superior to state laws.
Therefore, when a federal law conflicts with a state law, the
federal law prevails.
When Congress states its intent to regulate an area completely,
this is called express preemption. Implied preemption occurs
when Congress intends to completely regulate an area but
does not say so explicitly. Instead, Congress passes laws that
“occupy the field” so much that no room for state regulation
exists. Finally, some areas of the law allow both state and
federal governments to regulate together. For example, both
federal and state governments have laws to protect consumer
rights.

Constitutional Rules Between the States
There are several important Constitutional provisions that
ensure our federalist system works properly. The first is the
Privileges and Immunities Clause in Article IV. This Clause
ensures that people in different states are treated equally by
the government. For example, the federal government cannot
pass laws that subject citizens in the West to more regulations
than citizens in the East. Federal laws must be applied equally
across the nation. The Founders included this provision to
encourage travel and business between the states.
Another important Constitutional provision is the Full Faith
and Credit Clause in Article IV. This Clause requires states to
“respect the public acts, records, and judicial proceedings of
every other state.” This is important for businesses because
it ensures that state courts respect the judgments of courts
from other states. Therefore, a judgment won in Colorado may

The Constitution | 74

be enforced in another state, without relitigating the
underlying issues. This facilitates business because litigation
can be finalized without subjecting a company to endless
liability across states.

5.3 The Commerce Clause
The most important Constitutional provision related to the
federal regulation of business is the Commerce Clause, which
grants Congress the power to “regulate Commerce with
foreign Nations, and among the several States, and with the
Indian Tribes” (Article I, sec. 8). Over time, the Commerce
Clause has been interpreted to apply to more and more
businesses and industries. In addition to business transactions
across state lines, the Commerce Clause now applies to
business activity within one state that substantially affects or
impacts commerce in other states. The growth of e-commerce,
the internet, and federally-insured banks results in most
businesses today being subject to federal regulation under the
Commerce Clause.

Dormant Commerce Clause
States cannot interfere with Congress’s power to regulate
interstate commerce. This concept is known as the Dormant
Commerce Clause. This clause restricts the states’ abilities to
regulate commerce, rather than the federal government’s.
A state law that discriminates against out-of-state commerce,
or places an undue burden on interstate commerce, violates
the dormant commerce clause. For example, if a state required
out-of-state corporations to pay a higher tax or fee than an

75 | The Constitution

in-state corporation, that is unconstitutional. However, this
prohibition against out-of-state discrimination does not
prevent a state from exercising its police power to protect state
citizens, as long as the power is exercised evenly and equally.
For example, a state may weigh trucks on highways to ensure
they do not exceed maximum weight rules, even if the trucks
came from out of state, as long as all trucks on the highways
are weighed.

5.4 Business and the Bill of Rights
During the debate surrounding the Constitution, there was
much discussion about whether an explicit protection of civil
liberty was necessary. Some believed that the common law
system adequately protected civil liberties, so a written
declaration of rights wasn’t necessary. Others believed that a
written declaration of rights was necessary to protect the
people from government overreach. In 1791, the first ten
amendments to the Constitution were ratified and became
known as the Bill of Rights.
When we speak of civil liberties protected in the Constitution,
we often think of how these liberties apply to people. Although
the Constitution does not contain the word “corporation,”
Congress has defined “person” to include “corporations” so
many civil rights also apply to business entities.
It’s worth making some observations about civil liberties in
general. First, there are no absolute rights, in spite of the
wording of any specific amendment. For example, the First
Amendment states that “Congress shall make no law
abridging the freedom of speech.” In fact, there are many laws
that limit the freedom of speech. People aren’t allowed to libel
or slander someone, for example, or incite a crowd into a riot.
The Constitution | 76

Instead of absolute rights, courts have to constantly balance
competing interests in deciding where the limits of individual
rights lie. The right of the public to know information about the
lives of politicians and other high-profile figures, for example,
must often be balanced by the right those citizens have to their
own privacy.
Second, while the Constitution sets up a system of government
based on principles of representative democracy, the Bill of
Rights exists to protect the minority, not the majority. Other
than the right to vote, the civil liberties protected by the
Constitution extend to all persons physically on US soil, not
just citizens or legal immigrants. Persons visiting the United
States temporarily, such as tourists and students, as well as
undocumented aliens, are also entitled to the full protections
of the US Constitution.
Third, the extent of civil liberty protections vary from time to
time. Society evolves with progress and challenges. The
Founders could not contemplate a digital world where an act
of defamation on social media can spread to millions of people
in a matter of minutes. The Eighth Amendment illustrates how
time shifts the meaning of a right. The Eighth Amendment
prohibits “cruel and unusual” punishment. The Supreme Court,
in defining what “cruel and unusual” is, looks to “evolving
standards of decency” in making the determination—in other
words, what is cruel and unusual today may have been normal
in years past.
Finally, major portions of the Bill of Rights apply equally to the
states as they do the federal government. When adopted, the
amendments were meant to restrict the federal government
only. For example, the First Amendment states “Congress shall
make no law respecting an establishment of religion.” States
were not similarly restricted, and many states established
official churches. After the Civil War, the Constitution was

77 | The Constitution

amended to include the Fourteenth Amendment, which
prevents any state from depriving citizens of their rights
without “due process of law.” Gradually, the Supreme Court
developed a doctrine called incorporation, by which the
limitations on government behavior in the Bill of Rights were
extended to apply to the states as well. While many portions
of the Bill of Rights apply to the states, not all of it does. There
is no requirement, for example, that states use a grand jury
system to indict criminals. There is also no requirement that
states provide juries in civil trials.

First Amendment
Figure 5.4 Language of the First Amendment

The First Amendment contains several important clauses
pertaining to speech and religion. The two different clauses on
religion may conflict with each other in some circumstances.
On the one hand, the First Amendment prohibits the
government from establishing any religion—this is called the
The Constitution | 78

Establishment

Clause.

On

the

other

hand,

the

First

Amendment prohibits the government from restricting the
free exercise of religion—this is called the Free Exercise Clause.
In theory, this allows individuals the right to freely practice
their religion while prohibiting the government from doing so.
Conflict arises when people choose to practice their religion
freely and openly on government property, such as in a public
school or city hall.
As is often true in Bill of Rights cases, courts have had to fashion
a test to draw the line between the Establishment and Free
Exercise Clauses. The use of public funds for religious purposes
and the public display of religious life is generally acceptable
as long as the primary motivation is not to advance a specific
religion. A city that wishes to display a Christmas tree or nativity
scene, for example, is permitted to do so as part of a general
holiday-themed cultural display that also includes a menorah.
The First Amendment also protects the right to freedom of
speech. While many nations believe in the right of citizens to
think and speak freely, the United States is fairly unique in
enshrining those principles into constitutional law.
Not all speech is protected by the First Amendment, and the
type of speech drives its level of protection. Political speech,
which relates to matters of public interest, receives the most
protection. Political dissent, displeasure with the government,
party membership, and even speech advocating the overthrow
of government, all deserve extraordinary protection under the
First Amendment.
Figure 5.5 Spectrum of First Amendment Protection of Speech

79 | The Constitution

On the other end of the spectrum is speech that deserves no
protection under the First Amendment at all, such as speech
that incites a panic (e.g. yelling “Fire” in a crowded theater
when there is no fire). Defamation, libel and slander are all
actionable torts. Obscene speech and fighting words are also
not protected under the First Amendment.
In the middle of the spectrum is commercial speech, which
relates to business transactions. Commercial speech is entitled
to some protection under the First Amendment as long as it
is not false or misleads consumers. If the information is false
or misleading, it is not protected at all. Under an intermediate
level of scrutiny test, freedom of commercial speech is not
violated as long as (1) there is a substantial government interest
in restricting or regulating speech; (2) the restriction directly
advances that interest, and (3) the restriction is no more
extensive than necessary.
The prior restraint doctrine prohibits formal censorship before
the publication of speech. In other words, the government
cannot restrict speech or publications before their actual
expression. Prior restraints violate the First Amendment unless
the speech is obscene, is defamatory, or creates a clear and
present danger to society.
The US Supreme Court has ruled that corporations are
“persons” entitled to First Amendment rights to speech and

The Constitution | 80

religion. In striking down federal and twenty-two state
restrictions on corporate spending on political campaigns, the
Supreme Court held that corporations are persons and
therefore entitled to engage in political speech. Since
corporations are unable to literally “speak,” they speak through
spending money, and thus restrictions on how corporations
may

spend

money

during

political

campaigns

are

unconstitutional. Similarly, Congress defined “persons” to
include

corporations,

companies,

associations,

firms,

partnerships, societies, and joint stock companies. As a result,
those types of businesses have religious rights that allow them
to opt out of providing healthcare insurance to their employees
that violates the businesses’ religious beliefs.
Not all protected speech is protected all the time in all places.
The government is permitted to place reasonable time, place,
and manner restrictions on speech to maintain important
governmental functions. These restrictions are generally
upheld

if

they

further

an

important

or

substantial

governmental interest, they are content neutral, and any
restriction on First Amendment freedoms is no greater than
that necessary to further governmental interests (i.e. the
restriction is not overbroad). Thus, for example, courts have
upheld restrictions on posting signs on city-owned utility poles,
as well as picketing and protest permit requirements.

Fifth Amendment
Figure 5.6 Langue of the Fifth Amendment

81 | The Constitution

Another important restriction on governmental authority
actually appears twice in the Constitution. The due process
clause appears in both the Fifth Amendment (“No person
shall…be deprived of life, liberty or property without due
process of law”) and the Fourteenth Amendment (“Nor shall
any State deprive any person of life, liberty, or property, without
due process of law”). The Fifth Amendment applies to the
federal government and to the states. At its core, due process
means “fundamental fairness and decency.” The clause
requires that all government action that involves the taking
of life, liberty, or property be done fairly and for fair reasons.
Notice that the due process clause applies only to government
action—it does not apply to the actions of private citizens or
entities such as corporations.
Due process contains two components. The first is called
procedural due process. Procedural due process requires that
any government action that takes away life, liberty, or property
must be made fairly and using fair procedures. Procedural due
process includes: (1) notice that the government is going to act
and why; (2) a hearing prior to the governmental action; and

The Constitution | 82

(3) the ability to appeal the determination made at the hearing.
This ensures those affected by a government action have a fair
chance to oppose it.
The second type of the due process is substantive due process.
Substantive

due

process

focuses

on

the

content

of

government legislation itself. Generally speaking, government
regulation is justified whenever the government can articulate
a rational reason for the regulation. In certain categories,
however, the government must articulate a compelling reason
for the regulation. This is the case when the regulation affects a
fundamental right, which is a right deeply rooted in American
history and implicit in the concept of ordered liberty. The
government must also set forth compelling reasons for
restricting the right to vote or the right to travel. Substantive
due process is often used as a basis for any lawsuit challenging
government procedures or laws that affect an individual’s or
company’s civil liberties.
Governments have the power of eminent domain, which is the
power to take privately owned property and convert it for
public use. The Takings Clause of the Fifth Amendment
prohibits the government from taking private property for
public use without just compensation. A law or regulation that
denies all beneficial use of property is a taking that requires
compensation. A common issue in eminent domain cases is
what constitutes “just compensation.” What the value of the
property was before the government announces its intent to
take the property or after? Property includes land, intellectual
property, and personal property.

Fourteenth Amendment
Figure 5.7 Language of the Fourteenth Amendment

83 | The Constitution

The Equal Protection Clause of the Fourteenth Amendment
states that “No state shall deny to any person within its
jurisdiction the equal protection of the laws.” In other words,
it requires the government to treat people equally. This clause
incorporates Constitutional protections against the states in
addition to the federal government.
The Equal Protection Clause is implicated anytime a law limits
the liberty of some people but not others. It scrutinizes
government-sponsored
“discrimination”
discrimination

has
is

discrimination.
a

negative

illegal.

For

While

the

connotation,

example,

a

word

not

all

criminal

law

discriminates against those who steal. The Equal Protection
Clause seeks to determine what forms of discrimination are
permissible.
To establish a guideline for courts to use in answering equal
protection cases, the US Supreme Court has established three
standards

of

review

when

examining

statutes

that

discriminate: minimal scrutiny, intermediate scrutiny, and strict
scrutiny.

The Constitution | 84

Under the minimal scrutiny test, the government needs only a
rational basis for the law—the law simply has to be reasonably
related to some legitimate government interest. If the law is
based on some rational basis, then the law passes equal
protection. Thus, a law that imprisons thieves easily passes
minimal scrutiny, since there are many rational reasons to
imprison thieves. The majority of cases that are scrutinized
under minimal scrutiny pass review.
The intermediate scrutiny test applies to cases where the
government discriminates on the basis of gender. Under this
test, the government has to prove that the law in question
is substantially related to an important government interest.
Using this test, courts have invalidated gender restrictions on
admissions to nursing school, laws that state only wives can
receive alimony, and a higher minimum drinking age for men.
The strict scrutiny test is used when the government
discriminates against a suspect class. Under this test, the
government has to prove that the law is justified by a
compelling governmental interest, that the law is narrowly
tailored to achieve that goal or interest, and that the law is the
least restrictive means to achieve that interest. The standard
is reserved for only a few classifications: laws that affect
“fundamental rights” such as the rights in the Bill of Rights
and any government discrimination that affects a “suspect
classification” such as race or national origin. In practice, the
government has a hard time meeting this burden.

85 | The Constitution

Test

Relationship

Governmental
Likely Result
Interest

Strict
Scrutiny

Necessarily
relates

Compelling

Governmental action
is likely
unconstitutional

Intermediate Substantially
Scrutiny
relates

Important

Case-by case
determination

Rational
Basis

Legitimate

Governmental action
is likely
constitutional

Reasonably
relates

There are a few cases where the Supreme Court has held that
racial discrimination may be permissible even under strict
scrutiny. For example, cases challenging affirmative action
policies in higher education have held that admission
preferences for underrepresented racial groups does not
violate the Constitution. The Supreme Court has found that
diversity in higher education is a compelling state interest, and
that schools could consider race in deciding whether to admit
students, as long as race is a “potential plus factor” considered
with other factors.

5.5 Concluding Thoughts
The US Constitution is the most important and fundamental
law in the nation. The Constitution establishes our government
structure, identifies the powers of the branches, and identifies
our fundamental rights. In this age of e-commerce, the vast
majority of businesses are engaged in interstate commerce
and are, therefore, regulated by Congress under the Commerce
Clause. The Dormant Commerce Clause prevents states from
unfairly burdening interstate commerce. Although the Bill of
Rights is often thought of as applying to individuals, it also
grants civil liberties to businesses.

The Constitution | 86

The Constitution is mainly a structural document, setting forth
the allocation of power among the three branches of the
federal government and the limitations on that power. It is
concerned mainly with what the government cannot do, as
opposed to what the government must do. Article I of the
Constitution establishes a bicameral legislature, with the
House of Representatives and Senate. Both chambers must
agree before legislation can be passed. Article II of the
Constitution establishes the executive power in the president,
who must enforce the laws passed by Congress. Power is also
divided between state and federal governments under
federalism. The Supremacy Clause states that when there is a
conflict between state and federal law, federal law wins. If there
is no direct conflict, the state law survives unless Congress
expressly preempts state law or occupies the field. The
Constitution also provides rules to facilitate state laws across
state lines.
The Bill of Rights provides key civil liberties to all people on US
soil. These liberties are not absolute. Many of the restrictions on
government activity found in the Bill of Rights also apply to the
states through incorporation.
The First Amendment prohibits the government from
establishing religion and from restricting the free exercise
thereof. The First Amendment also prohibits the government
from restricting the freedom of speech. Political speech is
protected to the fullest extent by the First Amendment, while
obscene and defamatory speech is not protected at all but
subject to the doctrine of prior restraint. Generally speaking,
the government may impose reasonable time, place, and
manner restrictions on the delivery of speech.
Procedural due process requires that the government use fair
procedures anytime it seeks to deprive a citizen of life, liberty,
or property. Substantive due process requires the government

87 | The Constitution

to articulate a rational basis for passing laws or, when
fundamental rights are involved, to articulate a compelling
reason to do so.

The Constitution | 88

6. International Law
6.1 Introduction
LEARNING OBJECTIVES
1. Define international law.
2. Understand sovereignty and the principles of international
jurisdiction.
3. Know what types of laws apply to businesses operating
internationally.
4. Understand the types of international jurisdiction.
According to the Small Business Association, 96 percent of the
world’s customers live outside of the United States. The
international market is lucrative but the international legal
environment is different from the US legal environment.
Therefore, it is important to be familiar with the basic concepts
of doing business in the global economy.
Any business that operates across a national border is an
International Business Entity (IBE). IBEs may be large, such
as Samsung, or they may be small, such a souvenir stand that
sells products across the border at Niagara Falls. When an IBE
conducts business in another nation, it must comply with
applicable laws in its nation of origin, in all nations where it
does business, and applicable international laws. For example,
if the Molson Coors Brewing Company, which is headquartered
in Colorado, wants to sell its products in Mexico, it would need
to comply with all applicable US, Mexican, and international

89 | International Law

laws, such as the US-Mexico-Canada Agreement (USMCA). This
includes local and state laws within both the US and Mexico.
US Laws

Foreign Laws

• Federal laws
(including
import & export
regulations)
• State laws
• Local laws
(including city &
county
regulations)

• National laws
(including
import & export
regulations)
• State or province
law
• Local laws
(including city &
county
regulations)

International Laws
• Bilateral treaties
• Multilateral
treaties (e.g.
GATT)
• UN Conventions
(e.g. CISG)
• Regional trade
blocs (e.g.
USMCA, EU,
ASEAN)

International law consists of rules and principles that apply
to the conduct of nations, international organizations, and
individuals across borders. There are two types of international
law: public and private.
Public

international

law governs the relations among

governments and international organizations. It includes the
law of war, the acquisition of territory, and the settlement of
disputes among nations. Public international law also includes
agreements governing property rights, trade, outer space, and
natural resources, such as the seas and mineral rights. For
businesses, public international law is important because it
defines human rights, such as the prohibition against child
labor, slavery, and trafficking in people and stolen goods.
Private international law applies to private parties engaged
in international commercial and legal transactions. Essentially,
private international law identifies what law applies to an
agreement and how the parties will settle any disputes with
parties in other nations.

International Law | 90

Counselor’s Corner US nationals and businesses
need to understand that they are subject to the laws
of the nations where they travel and operate. For
example, many US nationals do not understand that
they are restricted in what they can say and publish
within China. The US Constitution’s freedom of
speech does not apply when visiting or working in
other nations, especially communist ones. It is worth
the time to understand the culture of the nation a
business wants to work in before investing too
much time and resources into developing
operations there. Culture is just as important as
finances when developing a business plan to
expand into another nation. If the culture is not one
that the business is comfortable with, then it should
look at business opportunities elsewhere.
~Wei Z., attorney

6.2 The Nature of International Law
A sovereign state is a political entity that governs the affairs
of its own territory without being subjected to an outside
authority. Nations are sovereign states. Sovereign states
have sovereign immunity, which is the principle that courts of
one nation lack the jurisdiction to hear cases against foreign
governments. In the US, this principle is enacted in the Foreign
Sovereign Immunities Act (FSIA) which prohibits US courts
from

hearing

cases

against

foreign

governments.

Two

exceptions are: (1) when the foreign government waives its
right to immunity and agrees to the jurisdiction of the US court;
91 | International Law

and (2) when the foreign government is engaged in
commercial, not political, activity.
In domestic law, or law that is applicable within the nation
where it is created, some authority has the power to create,
apply, and enforce a rule of law system. There is a legitimate
law-creating authority at the “top,” and the people to be
governed at the “bottom.” This is a vertical structure of law,
because there is some “higher” authority that imposes a rule
of law on the people. In the United States, laws are made by
the legislative branch (statutory law), by the judicial branch
(common law), and by the executive branch (executive orders,
rules, and regulations). This authority is derived from the US
Constitution.
Figure 6.1 Vertical Nature of Domestic Law

It’s important to note, however, that not all law can be
conceived as a vertical structure. Some, such as international
laws, are best thought of as a horizontal structure. Treaties have
a horizontal structure because sovereign nations are parties

International Law | 92

to international treaties. Since each nation is sovereign, that
means that one nation is not legally dominant over another.
Figure 6.2 Horizontal Nature of International Law

If a party to a treaty has breached the agreement, enforcement
can be difficult because no overarching power “above” the
parties to a treaty exists. For this reason, many horizontal laws,
like treaties, contain provisions that require the parties to
submit to a treaty-created dispute resolution panel or other
neutral tribunal, such as the International Court of Justice (ICJ).
Another common challenge in international law is that the
laws are applicable only to parties who voluntarily choose to
participate in them. This means that a sovereign nation cannot
generally be compelled to submit to the authority of the
international law if it chooses not to participate. Compare this
with domestic law. Everyone within the United States is subject
to the jurisdiction of certain state and federal courts, whether
they voluntarily choose to submit to the jurisdiction or not. This
is why fleeing criminals can legally be caught and brought to
justice through extradition.

6.3 Sources of International Law
There are two main sources of international law: customary
international law and treaties. It is important for all companies

93 | International Law

to understand the laws that apply to their activities so they can
avoid criminal and civil liability.

Customary International Law
A custom is a widely accepted way of doing something. Before
treaties and conventions started to become common during
the 1900s, custom was the primary way international law was
created. Customary international law is a body of international
rules that has become binding through the pattern of
consistent, long-standing behavior through a sense of legal
obligation. For example, granting diplomatic immunity to
visiting heads of state is customary international law.
Historically, customary international law governed the rules of
war, treatment of prisoners of war, and human rights. After
World War II, many areas of customary law became the basis
for UN Conventions. While customary international law still
exists, the modern trend is to reduce legal obligations to
writing and have nations expressly agree to their terms.

Treaties
A treaty is an agreement between two or more nations
governed by international law. In essence, a treaty is a contract
between sovereign nations. A bilateral treaty is an agreement
between two nations. A multilateral treaty is an agreement
between three or more nations. A convention is a multilateral
treaty on a specific issue that concerns issues of worldwide
importance, such as human rights, property rights, and
international trade rules. For businesses, one of the most
important conventions is the UN Convention on Contracts for

International Law | 94

the International Sale of Goods (CISG). This convention sets the
global standard for international trade.
Treaties are adopted when the parties agree to its final form.
Then

the

treaty

needs

to

be ratified

by

the

nations’

governments. To take effect in the US, treaties must be
approved by two-thirds of the Senate. At that point, the treaty
becomes part of US law. Finally, a treaty enters into force when
it becomes legally binding on the parties. This may be a
specific date identified in the treaty or when it is ratified by the
parties.
Although many treaties may impact businesses, a few are
particularly important to international trade.

GATT
The General Agreement on Tariffs and Trade (GATT) is a
multilateral treaty to promote international trade by reducing
or eliminating trade barriers, such as tariffs and quotas,
between the member nations. GATT has been negotiated on
and off since the 1940s as nations have sought to grow their
economies through global commerce. In 1995, GATT members
created the World Trade Organization (WTO) to stimulate
international commerce and resolve trade disputes.
GATT and WTO are founded on three principles:
1. Free trade. The major purpose of the treaty is to reduce
trade barriers to increase global trade.
2. Most Favored Nation Status. Member nations agree to
treat every other member nation equally. If one nation
receives a special discount on customs duties, then the
discount must be extended to all other member nations.
3. National Treatment. Member nations agree to treat
95 | International Law

imported goods the same as domestic ones after they
have entered the nation. In other words, members cannot
discriminate against foreign goods by imposing additional
taxes after being subject to import taxes and duties.
The WTO resolves trade disputes between member nations
and has the power to impose trade sanctions for noncompliance with GATT. If a member nation refuses to comply
with a WTO ruling, affected members may retaliate by
imposing punitive tariffs or other sanctions. For example, in
the famous “banana battle,” the US and four Latin American
nations filed a complaint with the WTO alleging that the
European Union (EU) placed unfair restrictions on imported
bananas and showed favoritism to their former colonies by
buying bananas from them in violation of GATT. The WTO
agreed and granted the US and the Latin American nations the
right to impose sanctions on EU imports to their nations. The
banana battle ended in 2009 after 20 years of trade restrictions.

CISG
The United

Nations

Convention

on

Contracts

for

the

International Sale of Goods (CISG) promotes international
trade by making sales law uniform and predictable across
international boundaries. The US and most of its trading
partners (except the United Kingdom) have adopted CISG,
which results in the convention governing over two-thirds of
the world’s trade. Some of its provisions include:
• CISG applies to contracts for the sale of commercial goods
between merchants. It does not apply to the sale of goods
to consumers for personal use.
• CISG applies automatically to contracts between parties
located in different signatory nations. The convention does
International Law | 96

not depend on nationality; it depends on location.
• Contract parties can opt out. Parties can contract to be
governed by a nation’s laws instead of CISG but they must
expressly state their intention to not be bound by CISG.
• CISG does not require a written contract.
• CISG requires parties to negotiate in good faith and to
modify contracts in the case of unforeseen circumstances.
• A buyer can avoid payment only after giving the seller
notice and an opportunity to remedy the problem.

Regional Trade Agreements
Regional trade agreements promote international commerce
by reducing trade barriers among member nations that are
located near each other. One of the most famous is the
European Union (EU) but more than half of international trade
is covered by regional trade agreements throughout the world.
An important trade bloc agreement is the Association of South
East Asian Nations (ASEAN), which is a ten-nation trade bloc in
Southeast Asia. ASEAN + 3 includes the ASEAN nations, as well
as China, Japan and South Korea.
The

US

is

part

of

the

United

States-Mexico-Canada

Agreement (USMCA), which was formerly the North American
Free Trade Agreement (NAFTA). USMCA reduces trade barriers
among the three nations and updated NAFTA provisions,
especially as it relates to e-commerce, labor, and intellectual
property

rights.

These

agreements

create

tremendous

opportunities for businesses because they lower the costs
associated with importing and exporting within the region.

97 | International Law

Trade Regulations
Companies wishing to export or import products are subject to
federal trade regulations. To export simply means to transport
products to another nation. Export controls prohibit or restrict
certain products from leaving a nation.
Companies wishing to import products are also subject to
import controls. Import controls take many forms including
tariffs, quotas, bans and restrictions. The US Department of
Homeland Security Customs and Border Protection Agency
(CBA) has a primary role in import control administration and
regulation. For example, it inspects imports to classify them
and to establish their tariff schedule.
Tariffs are import taxes that apply to certain goods imported
from other nations. They make the imported product more
expensive and keep the cost of domestic products attractive to
consumers. CBA customs officers classify the imported goods,
which determines the applicable tariff. The importer is
responsible for complying with all import laws.
Quotas are simply limits on the quantity of particular imported
goods. To protect domestic industries, a nation may limit the
number of a competitor’s goods that are sold within the nation.
Bans apply to goods that are illegal to be imported, because
they are dangerous to public safety, health, the environment,
or national interests. For example, it is illegal to import items of
cultural heritage from other nations without permission.
Along with the CBA, the US International Trade Commission
investigates import injuries to the United States, such as
dumping and subsidized imports. Dumping occurs when a
foreign producer sells products for less than the cost of
manufacturing. Subsidized imports are produced overseas for

International Law | 98

which a government has provided financial assistance. When
dumping or subsidized imports materially injure or threaten
to injure domestic producers, the United States may impose
a countervailing duty for subsidized products or anti-dumping
duty for dumped products. These duties, which are particular
types of tariffs, reduce the negative impact that such practices
could have on US companies. Safeguards are limited duration
growth restrictions that are imposed when domestic markets
are threatened or injured from imports. This allows for
domestic markets to adjust to the surge from the import
market. For example, the United States imposed safeguards
on Chinese textiles in response to actual or threatened market
disruption of the US textile industry.

6.4 US Laws that Apply to US
Nationals Abroad
Extraterritoriality is the power of a nation’s laws to reach
activities outside of its physical borders. In other words, it is the
power of a nation to impose its laws in other nations. Congress
expressly applies several important laws to US nationals
working abroad.
US citizens working for US companies overseas are protected
by US federal employment laws, such as Title VII of the Civil
Rights Act and the Americans with Disabilities Act. This means
that US companies may not illegally discriminate against US
employees because those employees happen to work for the
company on foreign soil rather than within the United States.
Business practices abroad are also regulated by the US
government. For example, price-fixing conducted abroad by
US companies is a violation of the Sherman Antitrust Act.
Similarly, the Alien Torts Claims Act allows non-citizens to bring
99 | International Law

suit in US federal court against US businesses or citizens that
have committed torts or human rights violations in foreign
nations.

The Foreign Corrupt Practices Act
The Foreign Corrupt Practices Act (FCPA) is an anti-corruption
law that prohibits the payment of bribes by US companies and
their employees to foreign officials. Violation of this law is a
criminal offense. It does, however, permit grease payments,
or facilitating payments. Grease payments are only allowed to
individuals who are not decision makers. For example, a small
payment to a clerk to process paperwork, after a project has
already been approved, is a grease payment.
US citizens are also prohibited from conducting transactions
with

terrorists

or

terrorist

organizations.

Conducting

transactions with prohibited persons, entities or businesses
can result in serious criminal violations, which carry significant
financial penalties and long prison sentences.

6.5 Concluding Thoughts
Tremendous opportunities exist for companies that wish to
operate in international markets. However, the international
legal environment requires careful planning to avoid costly
mistakes associated with violations of trade regulations, the
formation of international contracts, and criminal and civil
liability.

International Law | 100

7. Administrative Law
7.1 Introduction
LEARNING OBJECTIVES
1. Understand the roles and functions of administrative
agencies.
2. Explore judicial review of agency actions.
3. Learn how administrative agencies impact the daily
operation of businesses.
An administrative agency is a governmental body with the
authority to implement and administer particular legislation.
They also are called government agencies or regulatory
agencies.
The day-to-day operations of businesses across industries are
shaped primarily by the actions of administrative agencies. This
is because Congress and state legislatures often create
agencies to regulate and enforce important legislation.
Agencies

exist

at

all

levels

of

government

and

considerable power to achieve their regulatory objectives.

Counselor’s Corner The most important thing
about interacting with any government agency is
not to ignore the communication sent to you by
that agency. If an agency asks you for information,
send it. If the agency asks you to do something, or

101 | Administrative Law

have

provide documentation, or to respond to a request,
do that thing, provide that documentation, and
respond to the request. The agency is not making
those requests aimlessly, or to cause you angst and
frustration. The agency is doing so because its own
rules and regulations require it to gather more
information, which the agency needs from you. Your
reluctance or failure to respond will only cause
delay, or have negative consequences. So, ignore
those letters at your peril.

~Sara C.,

attorney

7.2 Creation of Administrative
Agencies
Administrative agencies are created by Congress or state
legislatures through an enabling act. An enabling act is a
statute that creates an administrative agency and determines
the scope of power granted to that agency. Some enabling
acts are quite general and grant the agency a lot of discretion.
Other enabling acts are more limited and identify the specific
type of power an agency has.
While the legislative branch creates administrative agencies,
they are usually part of the executive branch because their
primary purpose is to enforce the law. Agencies in the
executive branch are called executive agencies. At the federal
level, these agencies are within the president’s cabinet. The
president is granted the power to appoint and oversee the
leadership of executive agencies, including replacing existing
Administrative Law | 102

leadership when the president is sworn into office. A governor
has similar power over executive agencies at the state level.
An independent agency is an agency, commission, or board
that is not under the direction of the president or governor.
Congress and and state legislatures create independent
agencies when they want to insulate the work of the agencies
from politics and to address concerns that go beyond the
scope of ordinary legislation. These agencies are responsible
for keeping the government and economy running smoothly,
especially when different political parties come to power.
Examples of independent agencies include the Federal Trade
Commission and the Central Intelligence Agency.
Independent agencies are often run by boards or commissions
made up of five to seven members, who are from both major
political parties, as well as political independents or smaller
political

parties.

The

term

of

board

members

and

commissioners is usually four to nine years, with terms being
staggered to prevent complete turnover all at once.
Figure 7.1 Differences Between Executive and Independent
Agencies

103 | Administrative Law

Congress passed the Administrative Procedures Act (APA) to
ensure the rights of businesses and individuals are protected
when interacting with federal agencies. The APA is a very
complex statute that controls all aspects of agency activity to
guarantee uniformity and fairness across agencies. For
example, the APA establishes the mechanisms for rulemaking,
conducting adjudications, and giving notice to the public. The
APA also establishes the process for judicial review of agency
decisions. Most states have similar statutes to regulate state
and local agencies.
Figure 7.2 Organizational Chart of Federal Agencies

Administrative Law | 104

7.3 Agency Functions
Administrative agencies carry out their purpose through the
exercise of power in three ways that mirror the three branches
of government:
1. Agencies engage in rulemaking, which is a quasilegislative function;
2. Agencies engage in enforcement, which is a quasiexecutive function; and
3. Agencies engage in adjudication, which is a quasi-judicial
function.
Figure

7.3

Roles

and

Agencies

105 | Administrative Law

Responsibilities

of

Administrative

Rulemaking
The enabling statute dictates the types of rules an agency can
make to implement and enforce the legislation for which it is
responsible. Generally, administrative rules are characterized as
internal, procedural, interpretive, and legislative.
Types of
Description
Rulemaking
Internal

Policies and procedures adopted for in-house
operations

Procedural

Policies and procedures related to how the agency
functions & interacts with businesses and individuals

Interpretive

Guidelines issued by the agency to businesses and
individuals about how to comply with the law

Legislative

Regulations that have the full force of law because
they are an extension of the underlying statute

Administrative Law | 106

Legislative rulemaking may be formal or informal. Formal
rulemaking is agency rulemaking that, when required by the
enabling statute, must be on the record after an opportunity
for an agency hearing, and must comply with certain
procedures, such as allowing evidence and the crossexamination of witnesses. Formal rulemaking provides an
opportunity to publicly and thoroughly debate the propriety of
a suggested rule. However, this process is very expensive and is
sometimes subject to political delays.
Informal rulemaking occurs when the agency publishes a
proposed regulation and receives public comments on it, after
which the regulation can take effect without the necessity of
a formal hearing on the record. Informal rulemaking is the
most common procedure followed by an agency when issuing
substantive rules because it is less expensive and more
efficient.
Agencies will sometimes blend the the two types of
rulemaking into a hybrid rulemaking approach. This type of
rulemaking requires notice and a hearing on a proposed rule
but the hearing is not as extensive as in formal rulemaking and
cross-examination of witnesses is not available.

Enforcement
Agencies are empowered to enforce administrative rules and
the underlying legislation identified in the agency’s enabling
act. Unlike law enforcement investigations, agencies do not
need probable cause to initiate an investigation. Generally,
agencies are authorized to investigate simply to ensure the
rules are being followed. For example, the Internal Revenue
Service may audit a business’s taxes without any suspicion of
wrongdoing.

107 | Administrative Law

Agencies are limited in their power to subpoena evidence in
the form of testimony from witnesses and in obtaining
documents and evidence. To be lawful, an agency’s subpoena
must:
• Establish that the purpose of the investigation is
legitimate;
• Establish that the agency has the power to conduct the
investigation;
• Describe the requested information;
• Explain the relationship between the purpose of the
investigation and the requested information; and
• Show that the requested information does not create an
unreasonable burden on the business or individual in
possession of it.
Businesses do not have all the Constitutional protections as
individuals

do,

especially

when

it

comes

to

agency

investigations. In particular, a business cannot assert a Fifth
Amendment

right

against

self-incrimination

to

prevent

agencies from obtaining business records. If an agency
subpoenas documents, a business is required to turn them
over, even if doing so exposes the business and individuals to
potential criminal liability.

Adjudication
Adjudication is the legal process of resolving a dispute. In an
agency context, this is the trial-like procedure or hearing used
by agencies to enforce their actions and determine whether a
business or individual has violated the law or regulations.
Adjudication can be either formal or informal. Formal
adjudication is like a trial and is usually overseen by an

Administrative Law | 108

administrative law judge (ALJ). The ALJ will decide what
evidence is relevant and admissible, hear testimony, and
determine the outcome of the dispute in a written finding. If
appropriate, the ALJ also will determine a penalty.
Like the judiciary, agencies have an internal appeal process for
adjudication. If a party wants to appeal a hearing officer or ALJ’s
decision, the case will be reviewed internally by the agency.
Often, appeals boards will consist of three to five agency
experts who review the determination.

7.4 Judicial Review of Agency Actions
The APA provides for judicial review of almost all agency
decisions. However, before going to court, a business or
individual must try to get the agency to reconsider its action.
To this end, two requirements must be satisfied:
1. Administrative remedies must be exhausted; and
2. The party must have standing.
Exhaustion of administrative remedies is the doctrine that, if
an administrative remedy is provided by statute, a party must
seek relief first from the agency before judicial relief is
available. The purpose of this doctrine is to ensure that courts
will not be burdened by cases in which judicial relief is
unnecessary. Often courts cite the agency’s subject matter
expertise as a reason to allow it to reconsider its action and fix
errors, especially common ones that may impact more than
just the party involved in the hearing.
Figure 7.4 Exhaustion of Administrative Remedies Flowchart

109 | Administrative Law

Standing is the requirement that only individuals and entities
with a personal stake in the outcome of a controversy may seek
judicial review. Standing is discussed more in Chapter 3. With
respect to agency actions, this is often a litigated issue when
advocacy groups want to challenge an agency’s decision but
were not a party to the agency’s actions.
Because agencies have significant discretion in regulating
their areas of expertise, judicial review of agency actions is
limited. A court will review an agency’s actions in five
situations:

Administrative Law | 110

Basis for Judicial
Review

Description

Agency exceeded
its authority

Agency acted beyond the authority given to it
in the enabling act

Agency
incorrectly
interpreted the
law

Agency misunderstands or misapplies the law;
courts are the legal experts

Agency made a
procedural error

Agency failed to follow the APA or its own
procedural rules

Agency violated
the Constitution

Agency violated the Constitutional rights of
businesses or individuals

Agency made
arbitrary or
capricious
decision

Agency’s decision is neither based on the facts
nor grounded in the law

7.5 Public Access to Agency
Information
Accountability

and

transparency

are

concerns

when

governmental entities have a lot of discretion and limited
judicial oversight. To ensure that the government remains
responsive to the people as required by the Constitution,
Congress has passed a series of laws to protect the rights of
businesses and individuals.
The Freedom of Information Act (FOIA) was passed by
Congress in 1966 to give a mechanism for private citizens to
request information from the federal government. The central
purpose of FOIA is to open up the workings of government
to public scrutiny to keep the government accountable to the
people and electorate.
The process is simple. A business or individual sends a letter
to the head of an agency requesting information regarding a
111 | Administrative Law

particular subject. The agency then has ten days to respond.
If the agency denies the request, the party may either appeal
the decision within the agency or sue in federal court for the
information.
Not all information is subject to disclosure under FOIA. FOIA
has nine exceptions:
• National security and foreign policy;
• Internal personnel rules and practices of an agency;
• Information that Congress prohibits the disclosure of;
• Trade secrets and confidential commercial or financial
information;
• Documents protected by the attorney-client privilege;
• Personnel and medical files that would constitute an
unwarranted invasion of personal privacy;
• Some law enforcement information;
• Documents related to the regulation of financial
institutions; and
• Geological and geophysical information and data,
including well maps.
The media makes about ten percent of FOIA requests, which
is part of investigative reporting. However, most requests come
from

businesses,

exception

attorneys,

applies,

the

and

individuals.

government

must

Unless

an

disclose

the

requested information. This has become a tool for businesses
seeking advantage over their competition.
For example, AT&T received a federal grant to promote
communications in school. AT&T self-reported to the Federal
Communications

Commission

(FCC)

that

it

may

have

overcharged the government for its services. This resulted in an
investigation into AT&T’s services and billing practices. Several
months after AT&T and the FCC reached a settlement in which
AT&T reimbursed the FCC $500,000, a trade association

Administrative Law | 112

representing some of AT&T’s competitors made a FOIA request
to the FCC for documents related to the investigation and
settlement. AT&T tried to block the request, arguing that it was
an unwarranted invasion of personal privacy. In a unanimous
decision, the US Supreme Court held that corporations do not
have a personal privacy right like individuals do. As a result, the
FCC disclosed the information to AT&T’s competitors.
Over the years, FOIA has been amended and supplemented
through

complementary

legislation.

Businesses

and

individuals have the right to correct information that was
submitted to an agency, as well as the right to specific reasons
regarding any information that is withheld or redacted under
FOIA. In addition, many agency meetings must be open to the
public.
Most states have passed legislation similar to FOIA requiring
state and local governments to disclose information to the
public.

7.6 Concluding Thoughts
The vast majority of governmental work is done through
administrative agencies. Given their functions, they are often
referred to as the “Fourth Branch” of government. Agencies
exist at all levels of government and have a lot of discretion
in implementing and enforcing laws. Most businesses and
individuals have contact with the government through
agencies so it is incredibly important to understand how they
work

to

be

successful

consequences.

113 | Administrative Law

in

business

and

avoid

legal

8. Criminal Law
8.1 Introduction
LEARNING OBJECTIVES
1. Understand what crime is and learn about common
business crimes.
2. Compare and contrast the differences between criminal
law and civil law.
3. Understand the constitutional protections given to those
accused of committing a crime.
4. Explore the exceptions to the Fourth Amendment’s
warrant requirement.
A crime is a social harm that the law punishes. At the most
basic level, criminal statutes reflect the rules that must be
followed for a civil society to function. Like individuals,
businesses can be both victims and perpetrators of crime.
Crime affects businesses both from outside and inside the
organization. Criminal activity “from the outside” may include
property damage, theft, shoplifting, corporate espionage,
fraud, and arson. Threats “from the inside” may include crimes
such as embezzlement, computer crimes, and fraud. Moreover,
businesses must also protect themselves from the bad
judgment and behavior of their employees. If an employee
acting within the scope of employment commits a crime from
which the business will benefit, then the business can be
convicted of the crime, too. Businesses may actively perpetrate

Criminal Law | 114

crime, through a bad corporate culture or through organized
crime, such as money laundering.

Counselor’s Corner Criminal convictions result in
more than loss of liberty. Having a conviction on
your record can mean inability to obtain certain
jobs, to gain admission to college, to vote, and to
rent or lease a home. Convictions affect a person’s
life for much longer than the actual sentence
imposed. Make sure you hire an attorney if you are
ever faced with a criminal charge. Know your rights
and understand the specific laws applicable to your
field. When in doubt, consult with an attorney,
accountant, or other professional in your field.
~Krista S., attorney

8.2 The Nature of Criminal Law
When crime occurs in the context of business, some people
think that no one is “really” injured. When an insurance
company has to pay for a claim arising from a crime, the
insurance company is injured, as are the victim and society at
large. Crime undermines confidence in the social order and
public safety. No crime is victimless.
In general, a crime requires someone to (1) commit a criminal
act, known as actus reus, and (2) possess the required criminal
state of mind, or mens rea. Therefore, intent to commit a crime,
without more, is not enough to convict someone. For example,
if an accountant thinks about stealing money from her
company but does not take any steps to do it, then no crime
115 | Criminal Law

has been committed. Similarly, if an accountant makes a
mistake

and

transfers

money

inappropriately

between

accounts, he has not committed fraud unless he had the
required criminal state of mind.
Strict liability crimes are an exception to the mens rea element.
Strict liability crimes are acts that the legislature defines as
social wrongs that do not need proof of the defendant’s intent
to complete the act. For example, speeding while driving a
motor vehicle, possession of child pornography, and sale of
tobacco and alcohol to minors all carry criminal liability without
the government needing to prove the defendant’s intent.

Criminal Law versus Civil Law
Criminal law differs from civil law in several important ways.

Criminal Law | 116

Criminal Law

Civil Law

• An injury to the public

• A private injury or wrong

• Prosecuted by the
government

• Plaintiff sues defendant

• Attorney provided, if
defendant cannot afford one

• Parties must provide their
own attorneys

• Burden of proof is beyond a
reasonable doubt

• Burden of proof is usually
the preponderance of
evidence

• Conviction may result in
fines or loss of liberty

• Penalties are usually
monetary

Because crimes are public injuries, they are punishable by the
government. It is the government’s responsibility to bring
charges against criminals. In fact, private citizens may not
prosecute each other for crimes. When a crime has been
committed, the government collects the evidence and files
charges against the defendant. When someone is charged
with committing a crime, he or she is charged by the
government in an indictment.
Our civil tort system allows victims to bring a civil suit against
someone for injuries inflicted upon them. Indeed, criminal laws
and torts often have parallel causes of action. Sometimes these
claims have the same or similar names. For instance, a victim
of fraud may bring a civil action for fraud and may also be a
witness for the government during the criminal trial for fraud.

117 | Criminal Law

Burden of Proof
In a criminal case, the defendant is presumed to be innocent
unless he or she is proven guilty. This presumption of
innocence means that the government must prove the case
against the defendant before it can impose punishment. If the
government cannot prove its case, then the person charged
with the crime must be acquitted. This means that the
defendant will be released, and he or she may not be tried
for that crime again. This important protection from double
jeopardy is guaranteed by the Fifth Amendment.
The prosecution has the burden to prove its case beyond a
reasonable doubt. This means that the evidence must be so
compelling that no reasonable doubt exists as to the
defendant’s guilt. The defendant does not have to prove
anything, because the burden is on the government to prove
its case. It is useful to think of the criminal standard of
proof—beyond a reasonable doubt—as something like 95
percent certainty, with 5 percent doubt. Perhaps there is some
doubt about the precise time of day or the victim’s exact words
to the defendant. However, there is no doubt about the
essential elements of the crime, such as the defendant’s
identity as the perpetrator of the crime, his or her mens rea,
and the actus reus.
Figure 8.1 Burden of Proof in Criminal Trials

Criminal Law | 118

Compare this to the standard of proof in a civil trial, which
requires

the

plaintiff

to

prove

the

case

only

by

a preponderance of the evidence. This means that the
evidence to support the plaintiff’s civil case is greater than the
evidence that does not. Preponderance of the evidence could
mean 51 percent in favor of the plaintiff’s case, and 49 percent
in doubt. Therefore, it is much more difficult to prosecute a
criminal defendant than to bring a successful civil claim. Since
a criminal action and a civil action may be brought against a
defendant for the same incident, these differences in burdens
of proof can result in verdicts that seem, at first glance, to
contradict each other. For example, O.J. Simpson was acquitted
of murder in a criminal trial because the government did not
prove to the jury that he committed the crimes beyond a
reasonable doubt. However, a different jury found O.J. Simpson
liable for wrongful death in a subsequent civil action.
Figure 8.2 Burden of Proof in Civil Trials

119 | Criminal Law

This extra burden reflects the fact that the defendant in a
criminal case stands to lose much more than a defendant in a
civil case. Although no one wants to lose assets in a civil case,
the loss of liberty through imprisonment is a more significant
loss. Therefore, more protections are given to a criminal
defendant than are given to defendants in civil proceedings.
Because so much is at stake in a criminal case, our
Constitutional due process requirements are very high for
defendants in criminal proceedings.
Due process procedures vary depending on the type of penalty
that can be levied against someone. For example, in a civil
case, the due process requirements might simply be notice
and an opportunity to be heard. If the government intends to
revoke a professional license, then the defendant might receive
notice by way of a letter, and the opportunity to be heard might
exist by way of written appeal. In a criminal case, however, the
due process requirements are higher. For example, a criminal
defendant is entitled to confront all witnesses against him or
her, and to see the evidence the prosecution intends to
Criminal Law | 120

introduce at trial. More protections must be in place because
a criminal case carries the potential for the most serious
penalties.

Classification of Crimes
Felonies versus Misdemeanors
Crimes

are

generally

classified

as

either

felonies

or

misdemeanors. Felonies are serious crimes punishable by a
year or more in prison. These type of crimes include fraud,
arson, homicide, and most other crimes that are mentioned
in news headlines. Misdemeanors are less serious crimes that
are often punishable by fines, probation or time served in jail
pending conviction. Examples of misdemeanors include
trespassing, vandalism, and failure to report for jury duty.

White-Collar Crime Versus Blue-Collar Crime
White-collar crime is a term used to describe nonviolent
crimes committed by people in their professional capacity, or
by organizations. These crimes are committed for financial
gain, often through deception. White-collar crimes are not
typical street crimes, like burglary or robbery, and they are not
personal crimes, like murder or rape. White-collar criminals
frequently commit their crimes on the job, in broad daylight,
while sitting at a desk. For example, Bernie Madoff was
sentenced to 150 years in prison for stealing $20 billion in a
Ponzi scheme that had $65 billion in fabricated gains.
Blue-collar crime is a generic term used to describe crimes
that are more traditional street crimes. In business, property

121 | Criminal Law

crimes (rather than crimes against people) are a primary
concern. A property crime is a crime involving damage to
property, while a person crime is a crime involving injury to a
person’s body. Examples of blue-collar crime that often affect
businesses include shoplifting, vandalism and destruction of
property.

8.3 Constitutional Rights and
Defenses
A person accused of a crime has rights guaranteed by the
US Constitution to ensure the federal government does not
unfairly prosecute them. The Bill of Rights–especially the
Fourth, Fifth, Sixth, and Eighth Amendments–list the rights of
criminal defendants. The Fourteenth Amendment makes
these rights applicable to defendants accused of crimes by
state governments. In addition, most states have constitutions
that have similar protections.

Fourth Amendment
Figure 8.3 Language of the Fourth Amendment

Criminal Law | 122

The Fourth Amendment prohibits illegal searches and seizures.
If evidence is obtained in violation of the Fourth Amendment,
it cannot be used against the defendant in a court of law. For
Fourth Amendment requirements to be met, law enforcement
officers (the Executive Branch) must obtain a search warrant
from a judge (the Judicial Branch) to search a specific area
or person for specific items. A search warrant is issued only
when a judge determines that probable cause exists. Probable
cause exists when the known facts and circumstances would
lead a reasonable person to believe that an item sought by the
warrant is contraband, is stolen, or is evidence of a crime.
If a valid search warrant is issued, then law enforcement may
search the area identified in the warrant for the named item(s)
or person. Even if there was no warrant, the items found may
still be admissible as evidence. This is because several
exceptions to the requirements for a search warrant exist to
help law enforcement protect the public and stop crimes as
they occur.

123 | Criminal Law

Warrant
Exception

Example

• Plain View

Officer is lawfully in store parking lot and sees
stolen goods for sale in store window. The
officer can seize the items without a warrant.

• Crime in
Process

Officer sees man running down the street with
a purse while witnesses are yelling that he
stole the purse from a woman on the sidewalk.
Officer can seize the man and purse without a
warrant.

• Destruction of
Evidence

Officer responds to suspected drug deal and
hears toilet flushing repeatedly and quickly.
Officer may enter bathroom and seize drugs.

• Emergency/
Officer responds to a situation where someone
Exigent
may be injured. Officer may enter premises to
Circumstances locate and help injured person.

• Consent

Officer may ask permission to search area that
a person owns or controls. If the individual says
“yes,” then officer can lawfully search.

• Officer Safety

Officer may do a protective sweep of a
suspect’s clothes and immediate area for
weapons and contraband within the suspect’s
reach to protect the officer’s physical safety.

• Incident to a
Lawful Arrest

Once someone is placed under arrest, an
officer may search them for weapons and
contraband. Officers will also do an inventory
search upon arrival at the jail.

Two other common exceptions are the automobile exception
and stop and frisk exception. The automobile exception
means that the passenger compartment of an automobile
may be searched if the car has been lawfully stopped. When a
police officer approaches a stopped car at night and shines a
light into the interior of the car, the car has been searched. No
warrant is required. If the police officer spots something that
is incriminating, it may be seized without a warrant. Similarly,
if someone is stopped lawfully, that person may be frisked

Criminal Law | 124

without a warrant. This is the stop and frisk exception to the
warrant requirement. Both of these exceptions are based on
officer safety, but are often labeled based on the circumstances
of the search.
In the business context, it is also important to note that some
administrative agencies may conduct warrantless searches of
closely regulated businesses, such as junkyards, where stolen
cars may be disassembled for parts that can be sold.

Fifth Amendment
Figure 8.4 Language of the Fifth Amendment

The Fifth Amendment guarantees four important rights:
1. The right to avoid self-incrimination;
2. The right to due process so that all court proceedings are
fundamentally fair;
3. The right to be indicted by a grand jury for capital offenses
and infamous crimes; and
125 | Criminal Law

4. The right to be free from double jeopardy.
The Fifth Amendment guarantees that people can choose to
remain silent. No one can be compelled to testify against
himself or herself or to make self-incriminating statements. If
a person does not want to cooperate with the government’s
investigation and prosecution of a crime, he or she does not
have to. During trial, the prosecution cannot comment on a
defendant’s silence and it cannot be used as evidence of guilt
against the defendant.
The prohibition against double jeopardy means that a person
cannot be tried twice for the same offense by the same
governmental body. This prevents the government from
harassing individuals with endless prosecutions until they find
the “right” jury that is willing to convict. It also requires the
government to do its job well the first time it prosecutes a case.

Sixth Amendment
Figure 8.5 Language of the Sixth Amendment

Criminal Law | 126

The Sixth Amendment entitles a criminal defendant to:
1. A speedy trial;
2. A trial by jury;
3. A public trial;
4. An attorney; and
5. The right to confront witnesses.
The

purpose

of

the

Sixth

Amendment

is

to

ensure

transparency in criminal proceedings so the government
cannot selectively prosecute dissidents or employ unfair
tactics. Defendants are entitled to an attorney during any
phase of a criminal proceeding where there is a possibility of
incarceration. This means that if a defendant cannot afford
an attorney, then one is appointed for him or her at the
government’s expense.

Eighth Amendment
Figure 8.6 Language of the Eighth Amendment

127 | Criminal Law

The

Eighth

Amendment

prohibits

cruel

and

unusual

punishment and excessive fines and bail. Simply put, the
Eighth Amendment is an anti-torture amendment. It also
prohibits jails from being used against the poor as was
commonly practiced in Europe at the time the Constitution
was written.

Defenses
Under the exclusionary rule, any evidence the government
acquires illegally may not be used at trial. This rule prevents
governmental misconduct during the investigation of crimes.
The theory is simple: if law enforcement and prosecutors know
that illegally obtained evidence cannot be used in court, they
will not be tempted to make improper searches or engage in
other illegal behavior. The exclusionary rule is one of the most
powerful limits on the police power of the government.
Because the exclusionary rule is intended to prevent law
enforcement from intentionally overstepping its authority, an
exception exists to the rule for when the police act in good
faith. Therefore, the exclusionary rule does not protect
individuals and businesses from all governmental errors.
Instead, it prevents intentional misconduct.
If someone is subject to a custodial interrogation, he or she
must first be informed of their Miranda rights. These rights are
usually stated as:
You have the right to remain silent. Anything that you
say can and will be used against you in a court of law.
You have the right to an attorney. If you cannot afford an
attorney, one will be provided to you by the state. Do you
understand your rights?

Criminal Law | 128

The purpose of the Miranda warnings is to ensure that people
understand their constitutional rights so they make informed
decisions about whether to speak with law enforcement.
Entrapment is another defense available to people accused of
crimes. Entrapment means that the criminal intent originated
with the police, and therefore the mens rea of the crime cannot
be placed on the defendant. Essentially, the rule against
entrapment limits the ability of the police to play the role of
criminals during undercover investigations. For example, if the
police provide a drug dealer with the opportunity to sell drugs
to an undercover agent, there is no defense of entrapment
because the dealer had the mens rea to commit a crime
regardless of the identity of the buyer. However, if the police
knock on someone’s door who is not known to be a drug dealer
and continues to demand drugs until the person cannot resist
and sells the police drugs, then entrapment occurs.

8.4 Common Business Crimes
Each jurisdiction has the power to define what a crime is.
Therefore, criminal laws can vary between states and federal
governments. However, there are some common crimes that
affect businesses across jurisdictions.
Fraud is the use of deception to acquire money or property.
Securities

fraud is when someone uses deception to

circumvent the regulations or statutes interpreted by the US
Securities and Exchange Commission (SEC) to acquire money
or property. Goldman Sachs was charged with securities fraud
when it misrepresented material facts to investors to gain
financially.
Financial institution fraud is fraud against banks and other

129 | Criminal Law

similar institutions, such as credit unions. The IRS investigates
financial institution fraud. Cases of financial institution fraud
can involve people who commit money laundering and those
who falsify tax documents, or profit and loss statements, to
gain funding from banks.
A Ponzi scheme is a fraudulent pyramid scheme, where
innocent people pay in to participate. Those at the top of the
pyramid may receive something that appears to be a return
on their investment (ROI), but those at the bottom do not.
Those who operate Ponzi schemes generally solicit investors,
and those who invest in such schemes are expecting a
legitimate ROI. However, the head of the Ponzi scheme keeps
his early investors happy by bringing in new investors, whose
money he gives to the old investors as their ROI. This allows the
Ponzi scheme to continue, because it appears from the outside
that investors are receiving a legitimate ROI. The problem is
that the capital contributions eventually disappear, since they
are never invested but are simply used by the head for his own
purposes, including paying investors with fake ROI payments
as necessary. Pyramids will eventually collapse under their own
unsustainable structure. Bernie Madoff was convicted of
running the largest known Ponzi scheme that defrauded
investors of approximately $65 billion.
Embezzlement occurs when someone takes property that was
in his or her possession lawfully and then converts it to his
or her own use. Embezzlement often happens by people who
are in a position of trust over the assets of another person.
This includes financial advisors, brokers, accountants, lawyers,
and guardians. Embezzlement strategies can involve forgery,
which is counterfeiting a document or someone else’s
signature.
Embezzlement differs from larceny, because larceny requires
the trespassory taking of property with the intent to deprive

Criminal Law | 130

the owner of the property. In other words, in a larceny, the thief
is not supposed to have possession of the property to begin
with. For example, larceny includes shoplifting and basic theft
of personal property.
It is illegal to make false statements or engage in a cover up
during dealings with the federal government. Making False
Statements is a crime that is often easier to prove against
a defendant than a more complex crime that is being
investigated. For example, Martha Stewart was investigated for
insider trading. Although the insider trading charges were
dismissed, Martha Stewart was convicted by a jury of making
false statements because she lied to officers during the
investigation. As a result, she served five months in prison.

RICO
The Racketeer Influenced and Corrupt Organizations Act
(RICO) is a federal statute that was passed to prevent gangsters
from taking money earned illegally and investing it in
legitimate businesses. Although RICO was written to target
traditional organized crime, less than 10 percent of RICO cases
filed have been against the mafia. Instead, 75 percent of RICO
cases involve business fraud.
A racket is a dishonest or fraudulent scheme, which usually is
an organized criminal activity. The two most common rackets
are protection rackets and fencing rackets. In a protection
racket, a criminal offers to protect the victim from violence
or destruction of property. If the victim refuses to pay for
protection, then the criminal will engage in violence against
the victim or destroy his or her property. In a fencing racket, a
criminal will steal property from a victim then offer to resell it

131 | Criminal Law

to them. The victim must pay for the return of his or her own
property.
RICO punishes those engaged in three or more racketeering
activities over a ten-year period when funds from those
activities were used to maintain, operate, or acquire a
legitimate

business.

embezzlement,

mail

Racketeering
fraud,

wire

activities
fraud,

include

loan-sharking,

bookmaking, money laundering, counterfeiting, smuggling,
blackmailing, arson, and other similar crimes. RICO is now used
against insurance companies, stock brokerages, tobacco
companies, banks, and other large commercial enterprises. If
convicted, a defendant can be punished with large fines and a
prison sentence of up to twenty years.
RICO also has a civil provision allowing a competitor to file
RICO charges, which come with triple damages if the suit is
successful. In other words, a civil plaintiff can recover a
judgment for three times the harm actually suffered, as well as
attorneys’ fees.
Art Cohen vs. Donald J. Trump was a civil RICO class action
lawsuit filed in 2013, accusing Donald Trump of fraudulently
misrepresenting the nature of Trump University. Within weeks
of winning the presidential election in 2016, Trump settled this
case and two others for $25 million in damages to the plaintiffs.
Many states also have organized crime statutes. State penalties
often are much more severe under the organized crime
statutes than they would be if the accused worked alone. For
this reason, businesses and individuals need to be careful to
protect themselves from another’s wrongful conduct.

Criminal Law | 132

8.5 Concluding Thoughts
Crime has an enormous impact on society, including business.
Crime is a very important consideration in the business world.
Businesses can be both victims and perpetrators of crime.
Although jurisdictions may define crimes differently, there are
some types of crime that businesses often face, including
fraud, embezzlement, and larceny. Successful businesses must
be vigilant to protect themselves from those who wish to harm
them, both from inside and out.
Crime is a public injury. Criminal law can be classified both
by the nature of the punishment and the type of offense it is.
Criminal law differs from civil law in important ways, including
who brings the claim, the burden of proof, due process, and
penalties. The most important distinction is the elevated
burden of proof in criminal cases. The prosecution must prove
that a defendant committed a crime beyond a reasonable
doubt.
Those who are accused of committing a crime are protected
by the US Constitution. Important constitutional protections
include the prohibition against illegal searches and seizures,
self-incrimination, and cruel and unusual punishment. If the
government obtains evidence illegally, it cannot use it against
a defendant in a criminal trial. Criminal defendants have the
right to a public and speedy trial, an attorney, and to remain
silent.

133 | Criminal Law

9. Torts
9.1 Introduction
LEARNING OBJECTIVES
1. Define torts.
2. Understand intentional torts, and how to defend against
an accusation of one.
3. Explore negligence.
4. Explain strict liability and how product liability affects
manufacturers.
A tort can be understood as a civil wrong to a person or
property other than breach of contract. A tort is any legally
recognizable injury arising from the conduct (or sometimes
failure to act) of persons or corporations. There are several key
differences between torts and contracts, which are also
different than crimes:

Torts | 134

Contract

Tort

Crime

Obligation

The parties
agree to a
contract;
which imposes
duties on
them

Civil law
imposes duties

Legislatures
pass laws
prohibiting
certain
conduct

Enforcement

Party to
contract or
beneficiary
sues for breach
of contract

Injured party
sues for tort
claims

Government
prosecutes

Monetary
damages;
injunction

Criminal
conviction
may include
fine,
imprisonment,
& restitution

Consequences

Monetary
damages

Some conduct can be both a crime and a tort. If Allie punches
Bentley without provocation, then Allie has committed both
the tort of battery and the crime of battery. In the tort case,
Bentley could sue Allie in civil court for money damages
(typically for his medical bills). That case would be tried based
on the civil burden of proof—preponderance of the evidence.
That same action, however, could result in Allie being charged
with criminal battery. If convicted beyond a reasonable doubt,
Allie may have to pay a fine or go to jail.
The standard of proof in a criminal case (beyond a reasonable
doubt) is far higher than the standard of proof in a civil case (a
preponderance of evidence). Therefore, victims of crimes often
wait to bring related tort claims against a defendant until after
the criminal trial is over. If the defendant is convicted of a crime,
it is easier and less expensive to prove liability at a civil trial.
Torts can be broadly categorized into three categories,
depending on the level of intent demonstrated by the
tortfeasor (the person committing the tort). If the tortfeasor
acted with intent to cause the damage or harm, then

135 | Torts

an intentional tort has occurred. If the tortfeasor didn’t act
intentionally but failed to act as a reasonable person,
then negligence occurs. Finally, strict liability occurs where
the tortfeasor is held responsible regardless of intent.
Figure 9.1 Tort Liability Diagram

Counselor’s Corner Not every injury or harm gives
rise to a legal claim. You can’t sue someone just
because your feelings are hurt or something bad
happened. Even though you may have been
through something harmful, if the law doesn’t
recognize the injury as something you can recover
for, you don’t have a legal claim. Lawsuits are meant
to address really bad injuries or really bad behavior.
Many things that drive us crazy when dealing with
other people are things that we just have to learn to

Torts | 136

deal with. Or resolve in another forum. ~Heather C.,
attorney

9.2 Intentional Torts
In an intentional tort, the tortfeasor intends the consequences
of his or her act, or knew with substantial certainty that certain
consequences would result. This intent can be transferred. For
example, if someone swings a baseball bat at someone else but
the person ducks and the bat hits a third person, the person hit
is the victim of a tort even if the person swinging the bat had
no intention of hitting the person actually injured.
It is useful to think of torts based on the type of rights being
protected.

137 | Torts

Theory of Liability

Description

Interference with
Personal Freedom
Assault

Causing the apprehension or fear of
immediate harmful or offensive contact

Battery

Application of force that results in
harmful or offensive contact with a
person’s body

False Imprisonment

Intentional confinement or restrain of a
person’s movements without justification
or consent

Intentional Infliction of
Emotional Distress

Intentionally or recklessly causing
another person severe emotional distress
through extreme or outrageous acts

Interference with
Property Rights
Trespass to Land

Unauthorized entry onto land that is
visibly enclosed & owned by another

Trespass to Personal
Property

Taking or harming another’s personal
property without permission

Conversion

Wrongful possession or disposition of
property as if it were one’s own with the
intent to do so permanently

Nuisance

Condition or situation that interferes with
the use or enjoyment of property

Interference with
Economic Relations
Disparagement

False & injurious statement that
discredits or detracts from the reputation
of another’s property, product or
business

Interference with
Contractual Relations

Intentional inducement of a party to
break an existing contract

Interference with
Prospective Advantage

Intentional interference with a potential
business relationship

Misappropriation

Using another’s property dishonestly for
one’s own use

Wrongful
Communications
Defamation

Harming the reputation of another by
making a false statement

Torts | 138

Slander

Spoken defamation

Libel

Written defamation
Violating someone’s right to be left alone
or to restrict public access to confidential
information through:

Invasion of Privacy

Fraud

• appropriating the person’s name or
likeness;
• invasion of physical solitude;
• publicly disclosing private facts; or
• false light
Intentional misstatement of a material
fact that is relied upon by a third party

Interference with Personal Freedom
Assault is the threat of force on another that causes that
person to have a reasonable apprehension or fear of immediate
harmful or offensive contact. Actual fear or physical injuries
are not required for assault. It is also not necessary for the
tortfeasor to intend to cause apprehension or fear. If someone
points a realistic-looking toy pistol at a stranger and says “give
me all your money” as a joke, it is still assault if a reasonable
person would have had apprehension or fear in that situation.
The intentional element of assault exists here, because the
tortfeasor intended to point the realistic-looking toy at the
stranger.
Battery is the application of force to another that results in
harmful or offensive conduct. It includes any non-consensual
touching, even if physical injuries are not present. In battery,
the contact or touching does not have to be to the person.
Grabbing someone’s clothing or possessions they are holding
is battery. Notice that assault and battery are not always
present together. Assault can occur without physically
touching the victim. Similarly, a surgeon who performs
139 | Torts

unwanted surgery or inappropriately touches a patient who is
sedated has committed battery but not assault because the
patient did not feel fear or apprehension.
When someone is sued for assault or battery, several defenses
are available. The first is consent. Boxers have consented to
being battered when competing. Self-defense and defense of
others also may be available defenses, as long as the selfdefense is proportionate to the initial force.
False imprisonment occurs when someone intentionally
confines or restrains another person’s movement or activities
without justification. The protected interest is the right to travel
and move freely without impediment. This tort requires actual
and present confinement. False imprisonment is challenging
for retailers and other businesses that interact regularly with
the public, such as hotels and restaurants. The shopkeeper’s
privilege allows businesses to detain suspected thieves until
law enforcement arrives. The detention must be reasonable,
however. Store employees must not use excessive force in
detaining the suspect, and the justification, manner, and time
of the detention must be reasonable.
Intentional infliction of emotional distress occurs when a
tortfeasor intentionally or recklessly causes another person
severe emotional distress through extreme and outrageous
acts. A plaintiff has to prove the defendant’s actions would be
outrageous to a reasonable member of the community. The
standard is objective. It is not enough for the plaintiff to believe
the defendant acted outrageously.
Although the standard for outrageous conduct is objective,
the measurement is made against the particular sensitivities
of the plaintiff. Exploiting a known sensitivity in a child, the
elderly, or pregnant women can constitute intentional infliction
of emotional distress. Businesses must be careful when
handling sensitive employment situations to avoid potential
Torts | 140

liability. This is especially true when firing or laying off
employees. Such actions must be taken with care and civility.
Similarly, bill collectors and foreclosure agencies must be
careful not to harass, intimidate, or threaten people.

Interference with Property Rights
Intentional torts can also be committed against property.
Trespass to land occurs when someone enters onto, above,
or below the surface of land that is visibly enclosed without
the owner’s permission. The trespass can be momentary or
fleeting. Soot, smoke, noise, odor, or even a flying arrow or
bullet can all become the basis for trespass. These can also
be the basis for nuisance claims. Nuisance is a condition or
situation that interferes with the use or enjoyment of property.
Nuisance claims can be public (applying to community areas
such as parks or the environment) or private (applying to
privately owned property such as houses).
Trespass can be innocent or willful. An innocent trespass occurs
when someone enters another’s property by mistake or when
they believe they have permission but do not. Willful trespass
occurs when someone intentionally enters another’s property
knowing they do not have permission to be there.
There are times when trespass is justified. Someone may have
a license to trespass, such as a meter reader or utility repair
technician. There may also be times when it may be necessary
to trespass—for example, to rescue someone during an
emergency.
Some states do not require the land to be visibly enclosed to be
protected from trespass. Therefore, residential homes in urban
and suburban areas do not always need a fence around the
property to be protected from trespass.
141 | Torts

Trespass to personal property is the unlawful taking or
harming of another’s personal property without the owner’s
permission. The tort of conversion is the wrongful possession
or disposition of property as if it were one’s own with the intent
to do so permanently. It is the civil equivalent to the crime of
theft. An employer who refuses to pay an employee for work
commits conversion. Similarly, conversion occurs when a
business returns personal property to the wrong customer.

Interference with Economic Relations
Torts can also take place against goods or products instead
of people. Disparagement is a false and injurious statement
that discredits or detracts from the reputation of another’s
property, product, or business. To recover, the injured party
must prove that the statement caused a third party to take
some action resulting in economic loss to the plaintiff. In other
words, the victim of the statement must prove that it lost
customers or goodwill as a result of the false statement made
about its business or products. These types of false statements
are considered unfair competition and, therefore, are unlawful.
Similarly, unfair competition can also be in the form of
interfering with a competitor’s contracts. Tortious interference
with

contractual

relations

prohibits

the

intentional

interference with an existing valid and enforceable contract by
intentionally inducing one of the parties to break the contract,
causing damage to the relationship between the contracting
parties. This occurs when a business tries to break up a
competitor’s contract with vendors, suppliers, or customers in
an effort to harm them.
There are four elements to prove intentional interference with
contractual relations:

Torts | 142

1. A contract exists between the plaintiff and a third party;
2. Defendant knew of the contract;
3. Defendant improperly induced the third party to breach
the contract or made performance of the contract
impossible; and
4. Plaintiff was injured.
Similarly, tortious interference with prospective advantage
is an intentional, damaging intrusion on another’s potential
business relationship, such as the opportunity to obtain
customers or employment. Fair competition does not give rise
to this tort. However, if a business engages in fraud,
intimidation, or threats to drive away potential customers from
its competitors, then it is liable. Tortious interference with
prospective advantage applies to conduct before a contract
exists.
Misappropriation occurs when a person or business uses
someone else’s property dishonestly for one’s own use.
Misappropriation is a very broad tort because it covers any
likeness or identifying characteristic, as well as property such
as patents, copyrights, and trademarks. It also applies to a
business’s name and goodwill.

Wrongful Communications
Another intentional tort is defamation, which is the act of
harming the reputation of another by making a false
statement

to

a

third

party.

Spoken

defamation

is

considered slander, while written defamation is libel. To be
liable for defamation, the words must be made to a third party,
which may include emails, text messages, and social media.
The First Amendment provides strong protection for news
organizations, and courts have held that public figures must

143 | Torts

show actual malice before they can win a defamation lawsuit.
This means celebrities and famous individuals must prove the
media knew that it was publishing false information, or that it
published the information with reckless disregard for the truth.
Truth is a complete defense to defamation.
The invasion of the right of privacy is essentially the violation
of a person’s right to be left alone and to restrict public access
to personal information, such as tax returns and medical
records. There are four forms of this tort:
Form of Invasion of
Privacy

Description

1. Appropriating a
person’s name or
likeness

Using someone’s name, photograph, or
other identifying characteristic for
commercial purposes without permission

2. Invasion of physical
solitude

Window peeping, eavesdropping, using
drones to video private areas, going
through garage to find confidential
information, etc.

3. Public disclosure of
private facts

Disclosure of a private citizen’s finances,
medical conditions, or personal
relationships through a public medium
such as social media

4. False light

Using publicity to place a person in false
light in the public eye, such as
objectionable hobbies or attributing
beliefs and opinions to the person that he
or she does not hold

Fraud is the intentional misstatement of a material fact that is
relied upon by a third party to the detriment of the targeted
party. It requires the tortfeasor to misrepresent facts (not
opinions) with knowledge that they are false or with reckless
disregard for the truth. An “innocent” misrepresentation is not
enough—the defendant must know he or she is lying. Fraud
can arise in any number of business situations, such as lying
on a résumé to gain employment, lying on a credit application
to obtain credit, or in product marketing. Here, there is a fine
line between puffery, or seller’s talk, and an actual lie. If an
Torts | 144

advertisement claims that a particular car gets a certain gas
mileage or meets emissions standards, then fraud occurs if
those statements are untrue. Conversely, an advertisement
that promises “unparalleled luxury” is only puffery since it is
opinion.

9.3 Negligence
Everyone has the duty to act reasonably and to exercise a
reasonable amount of care in their dealings and interactions
with others. Breach of that duty, which causes injury, is
negligence. Negligence is distinguished from intentional torts
because there is a lack of intent to cause harm.
The definition of negligence is purposefully broad. Negligence
is the failure to exercise the standard of care that a reasonably
prudent person would have exercised in a similar situation. This
legal standard is to protect people against unreasonable risk of
harm.
To succeed on a negligence claim, a plaintiff must prove five
elements:
1. The defendant owed a duty of care to the plaintiff;
2. The defendant breached that duty;
3. The defendant’s conduct was the actual cause of the
plaintiff’s injuries;
4. The defendant’s conduct was the proximate cause of the
plaintiff’s injuries; and
5. The plaintiff was damaged.

145 | Torts

Duty of Care
First, the plaintiff has to demonstrate that the defendant owed
it a duty of care. The general rule is that people are free to
act any way they want, as long as they do not harm others.
This means strangers are generally not responsible for caring
for each other unless a special relationship exists. For example,
parents owe their children a duty of care and doctors owe their
patients a duty of care because of their underlying relationship.
In a business context, businesses owe a duty of care to their
customers and managers owe a duty of care to their
employees. Some business relationships involve a fiduciary
duty, which is a duty to act with the utmost faith, trust, and
candor towards another. Doctors, lawyers, accountants, and
corporate officers all have fiduciary duties towards their
patients, clients, and shareholders.
It is important to understand that businesses and individuals
owe a general duty to the community as a whole. Drivers owe
other drivers and pedestrians a duty of care not to cause
accidents. However, drivers are not required to report accidents
or to stop and help others when they are not involved because
they do not owe a duty of care to strangers.
Businesses have a duty to warn and protect customers from
crimes committed by other customers. When a business
knows about, or should know about, a high likelihood of crime
occurring, then the business must warn or take steps to protect
its customers. These businesses include bars frequented by
biker gangs, hotels where frequent sexual assaults occur, and
any business with escalating violence on their premises.
Businesses also owe a duty to exercise a reasonable degree of
care to protect the public from foreseeable risks that the owner
knew or should have known about. There are many foreseeable
ways for customers to be injured in retail stores, including
Torts | 146

objects falling from shelves, spilled liquids, and icy entryways.
If a store knows about a hazardous condition, or should have
known about it, then the store must quickly warn customers
and remedy the situation.

Breach of Duty of Care
Once a duty has been established, plaintiffs have to prove that
the defendant breached that duty. A breach is demonstrated
by showing the defendant failed to act reasonably. It is
important to keep in mind that the reasonable person is an
objective standard. The reasonable person is never sleepdeprived, angry, or intoxicated. He or she is reasonably careful
and considers consequences carefully before acting. A jury
does not put themselves in the shoes of the defendant to
determine what they would have done in that situation. Nor
do they take into account the defendant’s subjective situation,
such as being intoxicated or sleep-deprived at the time.
In practical terms, the presence of injury or harm is usually
enough to satisfy the “breach of duty” requirement. Often the
harm is the evidence of the breach because it would not have
occurred if the defendant had acted as they should.
Breach of the duty of care can be both an action (such as
causing a car accident) or it can be a failure to act (such as
not clearing ice from the sidewalk). These are fact-specific
determinations because what a reasonable person would do in
a given situation varies.
There are two special doctrines that establish breach of duty
of care in limited circumstances. The first, res ipsa loquitur,
means “the thing speaks for itself” in Latin and holds that a
breach of a party’s duty of care may be inferred from the events
that occurred. It is used in cases where:
147 | Torts

1. The injury would not have occurred unless someone was
negligent;
2. The defendant had exclusive control over the property
causing injury; and
3. The plaintiff had no role in causing the harm.
For example, if a patient discovers surgical equipment inside
his or her body after surgery, the patient does not have to
prove which person in the operating room negligently left the
equipment. Instead, the plaintiff can sue the surgeon under
the res ipsa loquitur doctrine because the surgeon is in charge
of the surgery room. When res ipsa loquitur is raised, the
burden shifts to the defendant to prove that he or she did not
cause the harm.
Figure 9.2 X-Ray Image of Scissors Left Inside a Patient

The second doctrine is negligence per se. Legislatures
sometimes pass laws defining negligence under certain
circumstances. If a defendant violates the statute or ordinance,
then the defendant is legally negligent. To recover under this
theory, a plaintiff has to prove:
1. The defendant broke the law;
2. The plaintiff is in the class of people intended to be
protected by the law; and
Torts | 148

3. The violation of the law caused plaintiff’s injuries.
Negligence per se is often argued in car accidents where the
defendant is ticketed for reckless driving by the police, as well
as dog bite cases where the victim has physical injuries. When
defending against negligence per se claims, defendants may
argue:
1. They were unable to comply with the law through
reasonable care;
2. It was an emergency situation not caused by them; or
3. Complying with the law would have presented a greater
risk of harm.

Actual Cause
The third element of negligence is actual causation, which is
also known as but-for causation. This form of causation is fairly
easy to prove. But for the defendant’s actions, would the
plaintiff have been injured? If yes, then but-for causation is
proven. For example, if a customer slips on ice on a store’s
property, would the plaintiff been injured but for the store’s
failure to remove the ice? This is the form of causation that
most people describe in their daily interactions. Because the
store did not remove the ice, the customer slipped and was
injured.

Proximate Cause
The second form of causation asks whether the defendant’s
actions were the proximate cause of the plaintiff’s injury.
Sometimes the chain of events results in the injury being too

149 | Torts

remote from the defendant’s conduct to be legally recoverable.
In other words, proximate cause means that the act or
omission must be related closely enough to the injury to justify
imposing legal liability. Proximate cause places a limit on a
defendant’s responsibility to immediate (or foreseeable) harm.
This ensures that no intervening causes of the plaintiff’s injuries
exist.
A customer slips on ice on a store’s property and breaks a leg.
On the way to the hospital in an ambulance, there is a car
accident and the customer is killed. Although the customer
would not have been in the ambulance if she had not fallen
on the store’s property, the store would not be responsible in a
wrongful death claim. The car accident is an intervening event
that breaks the causal chain. Put another way, the car accident
was not a foreseeable consequence of the store’s failure to
remove ice on its premises.
Proximate cause prevents actual causation to be taken to a
logical but extreme conclusion. At some point, the law has to
break the chain of causation to hold parties to a reasonable
amount of liability for their actions.

Damages
The final element in negligence is legally recognizable injuries,
or damages. If someone walks on a discarded banana peel and
does not slip, then no tort occurs. Only when someone has
been injured are damages awarded.
There are two types of damages awarded in tort law. The first,
compensatory damages, seek to compensate the plaintiff for
his or her injuries. Compensatory damages can be awarded for
medical injuries, economic injuries (such as loss of property or
income), and pain and suffering. They can also be awarded for
Torts | 150

past, present, and future losses. While medical and economic
damages can be calculated using available standards, it is far
more difficult to assign a monetary value to pain and suffering.
Juries often use the severity and duration of the injury and its
impact on the plaintiff’s life to calculate damages.
The second type of damages is punitive damages, which are
intended to deter the defendant from engaging in similar
conduct in the future. The idea behind punitive damages is
that compensatory damages may be inadequate to deter
future bad conduct, so additional damages are necessary to
ensure the defendant corrects its ways. Punitive damages are
available in cases where the defendant acted with willful and
wanton negligence, a higher level of negligence than ordinary
negligence. There are constitutional limits to the award of
punitive damages.

Defenses to Negligence Claims
A defendant being sued for negligence has two main defenses:
(1) assumption of risk by the plaintiff; and (2) comparative
negligence.

Assumption of Risk
The first defense is assumption of risk. If the plaintiff knowingly
and voluntarily assumes the risk of participating in a dangerous
activity, then the defendant is not liable for injuries incurred.
However, a plaintiff can only assume known risks. A skier
assumes the known risks of downhill skiing, including falling,
avalanches, and skiing in poor conditions. However, a skier who
is injured from a defective chair lift does not assume the risk of
injury as a result of a manufacturing defect.
151 | Torts

A related doctrine, the open and obvious doctrine, is used to
defend against lawsuits by persons injured while on someone
else’s property. For example, if there is a spill on a store’s floor
and

the

store

owner

has

put

up

a

sign

that

says

“Caution—Slippery Floor,” yet someone decides to run through
the spill anyway, then that person would lose a negligence
lawsuit because the spill was open and obvious.
Both the assumption of risk and open and obvious defenses
are not available to the defendant who caused a dangerous
situation in the first place.

Comparative Negligence
The second defense to negligence is when the plaintiff’s own
negligence contributed to his or her injuries. Most jurisdictions,
including Colorado, follow the comparative negligence rule.
Under this rule, the jury determines the percentage of fault
of all the parties for the plaintiff’s injuries. If the jury finds the
plaintiff responsible for some of his or her own injuries, then
any compensatory damages are reduced by that percentage.
For example, if a customer is 40 percent at fault for his injuries,
then the compensatory damage award will be reduced by 40
percent. The reasoning for this rule is to hold people and
businesses accountable for their own negligence.
Figure

9.3

Recovery

of

Damages

under

Comparative

Negligence

Torts | 152

This rule applies only to compensatory damages, and not
punitive damages. Because punitive damages are meant to
deter the defendant from committing future bad acts, the
purpose would be undercut if the amount of punitive damages
was reduced, too.

9.4 Strict Liability
Intentional torts require some level of intent to be committed,
such as the intent to batter someone. Negligence torts require
carelessness or neglect. Some torts require neither intent nor
carelessness. In strict liability, it is irrelevant how carefully the
defendant acted. If someone is harmed in a situation where

153 | Torts

strict liability applies, then the defendant is liable regardless of
lack of intent.
Strict liability applies when restaurants and bars serve alcohol
to minors or visibly intoxicated persons. This is dangerous
because there is a high risk that drunk patrons will injure
others if they drive. Sale of tobacco and firearms to minors
are also strict liability crimes, as well as possession of child
pornography.

Ultrahazardous Activity
An ultrahazardous activity is an undertaking that cannot be
performed safely even if reasonable care is used while
performing it, and it does not ordinarily happen in the
community. Ultrahazardous activities include using dynamite,
transporting dangerous chemicals, keeping wild animals, and
using nuclear and radioactive materials. Some states have
passed laws defining offshore drilling for oil and gas as an
ultrahazardous activity as well.
Defendants engaged in ultrahazardous activities are almost
always liable for resulting harm. Plaintiffs do not have to prove
duty of care or breach of duty of care. The “reasonable person”
test is also irrelevant, as well as the issue of whether the harm
was foreseeable.

Product Liability
Product liability cases address situations in which products,
not people, cause injury. Plaintiffs can raise either negligence
or strict liability claims for injuries caused by products. There

Torts | 154

are three main product liability theories: design defect,
manufacturing defects, and failure to warn.
Design defects occur when the foreseeable risk of harm can be
reduced or avoided by the adoption of a reasonable alternative
design. In other words, the manufacturer poorly designed a
product that caused injuries which could have been avoided.
The law does not require products to be perfect. Litigation in
these cases centers on what is a foreseeable risk and whether
there was a reasonable alternative. As a result, plaintiffs must
show that an alternative design was reasonable.
For example, Takata manufactured airbags that were installed
by most major car manufacturers. After many airbags failed
to deploy in car accidents, leading to severe injury and death,
Takata recalled its airbags. Takata is strictly liable for injuries
caused by its defective design.
Manufacturing defects occur when a product fails to conform
to the manufacturer’s design for the product. In other words,
the product may have been designed adequately but the
manufacturer allowed a dangerous product to leave the plant.
These claims often involve allegations of failure to adequately
inspect products before distribution.
For example, a light bulb factory is strictly liable for
manufacturing a batch of faulty bulbs that explode when
turned on due to some glitch in the production process.
Failure to warn occurs when the defect is not in the product
itself but in the instructions (or lack of them). The plaintiff
argues that the manufacturer failed to warn users about the
dangers of normal use or a foreseeable misuse. However, there
is no duty to warn about obvious dangers.

155 | Torts

Defenses to Product Liability
There are several defenses to product liability claims.
First, strict liability applies only to commercial sellers. If an
individual sells her car to another person, she would not be
strictly liable for selling an unreasonably dangerous product if
it had Takata airbags.
Second, plaintiff’s assumption of risk can be a defense. The
user must know of the risk of harm and voluntarily assume
that risk. Someone cutting carrots with a sharp knife voluntarily
assumes the risk of being cut by the knife. However, if the knife
blade unexpectedly detaches from the knife handle because of
a design or production defect, no assumption of risk occurs.
Third, product misuse is another defense to strict product
liability. If the consumer misuses the product in a way that is
unforeseeable by the manufacturer, then strict liability does
not apply. Modifying a lawn mower to operate as a go-kart, for
instance, is product misuse.
A final related defense is known as the commonly known
danger doctrine. If a manufacturer can convince a jury that
the plaintiff’s injury resulted from a commonly known danger,
then the defendant may escape liability.

9.5 Concluding Thoughts
Tort law significantly impacts businesses, regardless of
industry. Businesses must not engage in activities with the
intention to harm employees, customers, and the public. They
also must act reasonably to avoid injuries caused by their
negligence. Similarly, manufacturers can be strictly liable for

Torts | 156

design defects, manufacturing defects, and failure to warn
consumers. Because many businesses are seen to have “deep
pockets,” they are often targeted by plaintiffs when injured by
their products and services.
Intentional torts occur when the tortfeasor intends the
consequences of his or her act or knew with substantial
certainty what the consequences would be. Businesses are
affected by intentional torts and need to be careful not to
commit them against their employees, customers, and
members of the public. It is useful to categorize intentional
torts based on the types of rights being protected, such as
preventing injuries to persons, property or privacy.
Negligence imposes a duty on all persons to act reasonably
and to exercise due care in dealing and interacting with others.
Negligence has five elements. First, the plaintiff must
demonstrate the defendant owed the plaintiff a duty of care.
Second, there must be a breach of that duty. A breach occurs
when the defendant fails to act like a reasonable person. The
plaintiff must also demonstrate that the defendant caused the
plaintiff’s injuries. Both causation-in-fact and proximate
causation

must

be

proven.

Finally,

the

plaintiff

must

demonstrate legally recognizable injuries, which include past,
present, and future economic, medical, and pain and suffering
damages. Defendants can raise several affirmative defenses
to negligence, including assumption of risk and comparative
negligence.
In areas where strict liability applies, the defendant is liable
no matter how carefully it tried to prevent harm. Carrying out
ultrahazardous activities results in strict liability for defendants.
Another area where strict liability applies is in the serving of
alcohol to minors or visibly intoxicated persons. A large area
of strict liability applies to the manufacture, distribution, and
sale of unreasonably dangerous products. Products can be

157 | Torts

unreasonably dangerous because of a production defect,
design

defect,

or

both.

A

product’s

warnings

and

documentation are a part of a product’s design, and therefore
inadequate warnings can be a basis for strict product liability.
Assumption of risk, product misuse, and commonly known
dangers are all defenses to strict product liability.

Torts | 158

10. Contracts
10.1 Introduction
LEARNING OBJECTIVES
1. Explain what constitutes a contract.
2. Understand how a contract is formed.
3. Know the defenses to performance of a contract.
4. Understand breach of contract and its consequences.
5. Identify remedies for breach of contract.
Although businesses tend to use the terms “agreement” and
“contract” interchangeably, legally the terms have very
different meanings. An agreement is a mutual understanding
between two or more parties about their rights and duties
toward each other. A contract is a legally enforceable
agreement between two or more parties. All contracts are
agreements, but not all agreements are contracts.
When contracts are broken, or breached, the injured party can
seek damages. In contracts, this usually means an amount that
would make that party whole again.
Generally speaking, contracts are a form of private law,
because the terms of the contract are binding on the parties
to the contract but not anyone else. Parties may enter into
contracts for whatever they wish and under any terms that
they agree on. In other words, parties may assent to
agreements even if those agreements represent bad bargains.
Contracts may restrict parties’ future activity. For example, a

159 | Contracts

non-compete clause in an employment contract may be
enforceable

in

the

future

against

an

employee

after

termination of employment.
However, contracts that are illegal or against public policy are
not enforceable.
Contract law performs three significant economic functions:
1. It helps individuals and businesses exchange goods and
services efficiently.
2. It reduces the costs of economic transactions because
parties do not need to negotiate a variety of rules and
terms with each separate transaction.
3. It alerts the parties to problems that have arisen in the
past, making it easier to avoid potential pitfalls.

Counselor’s Corner We live in a world of contracts,
which are the bread and butter of business
transactions. However, many consumers,
employees, and small businesses are afraid to read
and understand contracts. That fear allows others to
take advantage of them. Take the time to read
contracts provided to you. Ask questions about
anything you don’t understand before you sign.
Have the courage to revise and edit contracts to
ensure your interests are protected. Or even write
your own. It’s not hard and the more you do it, the
more confidence you will have to negotiate
business transactions and protect your interests.
~Darnell T., attorney

Contracts | 160

10.2 Contract Elements
There are three required elements of a contract: offer,
acceptance, and consideration. It is important to note that
some states and legal scholars expand this list to include
whether the subject matter is legal, whether the parties have
capacity to enter into a contract, and whether the law requires
the contract to be in writing to be enforceable. However, these
are best understood as defenses to contract formation,
especially in light of the fact that the only elements that all
states agree on are offer, acceptance, and consideration.

Offer
All contracts start when an individual or business proposes
a deal. It might involve buying or selling goods, performing
services, or making an exchange. An offer is a conditional
promise to do or refrain from doing something now or in the
future. In other words, it is willingness to enter into a contract.
Offers can be formal or informal. In some industries, such as
retail and restaurants, offers are often posted on menus, signs,
and advertisements. For example, a sign hanging above a cash
register listing menu items and their prices is the restaurant’s
offer to sell customers those items at those prices.
There are not a lot of legal requirements about what an offer
must contain, but there are some things that cannot be a legal
offer:

161 | Contracts

Type of
Invalid Offers

Definition

Example

Illusory
Promise

No offer exists because
there is no duty to
perform

“If I decide to buy a new
car, I’ll give you my old
one.”

Pre-existing
Duty

A party cannot leverage
an existing duty to get
more out of someone
else

“I agree to teach you
business law for $100
even though you have
already paid tuition for
the course.”

Forbearance

An offer cannot be a
promise not to pursue a
legal claim that is
known to be invalid
(Note: if the claim is
valid, then forbearance
may be a valid offer)

“I know the accident was
completely my fault but I
promise not to sue you.”

Past
An offer cannot be
Consideration based on past actions

I paint your house. Two
months later you say that
you will pay me $500 for
doing it. If you change
your mind and decide
not to pay me, I cannot
enforce your promise
because it was in
consideration of a past
event.

Once made, offers can be terminated in a number of ways. An
offer that has been properly communicated continues to exist
until it:
1. Is rejected;
2. Is replaced by a counteroffer;
3. Lapses or expires;
4. Is revoked; or
5. Is terminated by operation of law.
Unless it states a specific time, an offer remains open for a
reasonable time. A lapsed offer is an offer that is no longer
valid because a reasonable time to accept it has expired. An
expired coupon is an example of a lapsed offer.

Contracts | 162

Acceptance
To constitute an agreement, there must be an acceptance of
the offer. Legally, acceptance is an implied or express act that
shows willingness to be bound by the terms of an offer. To be
effective, both parties must understand and agree to be bound
by the contract.
Acceptance

can

be

both

express

or

implied.

Express

acceptance occurs when a party states that they accept the
offer. Acceptance may be implied based on the parties’
conduct. For example, a retailer offers to sell a product to
consumers for the price listed on the shelf. A consumer may
accept that offer by handing the cashier the item and money
to pay for it. The consumer does not need to say anything
to complete the transaction. But the consumer must
do something to accept. Silence, without more (such as
handing over payment), is not acceptance. This is because
silence may be evidence that the consumer either does not
know about the offer or has rejected it.
A common problem in the business community is knowing
what constitutes acceptance and what is negotiation. If an
acceptance changes, adds, or modifies terms of the offer, it is
a counter-offer and no contract is formed. The original party
may decide to accept, reject, or propose another offer as a
result. Although this sounds straightforward, with today’s fastpaced communications, parties may respond to part of an
offer, negotiate various parts of the contract simultaneously,
or agree to terms in installments. As a result, there may be
confusion about what the full terms of a contract are.
Offer and acceptance form mutual assent, which is also called
“meeting of the minds.” This is the parties’ intention to enter
into a binding contract on the terms they agreed upon. If
parties do not agree on the essential terms, then there can be
163 | Contracts

no meeting of the minds to enter into a contract. This is the
basis for many of the defenses to contract formation.

Consideration
Consideration is the bargained-for exchange of something of
value that shows the parties intend to be bound by the
contract. There are two elements to consideration:
1. Something of value
2. Is exchanged between the parties.
The “something” that is promised or delivered must be a legal
detriment. A legal detriment is giving up a legal or property
right.
Consideration may be concurrent or a promise to perform in
the future. However, it cannot be “past consideration” based
on something that has occurred before the formation of the
current contract. In other words, an act or promise made
before the current contract is not adequate consideration
because it was not given in exchange for the current promise.
When bargained-for consideration is not present, a court may
validate a promise based on promissory estoppel. Promissory
estoppel is the principle that a promise made without
consideration may nonetheless be enforced to prevent
injustice if the promisor should have reasonably expected the
promisee to rely on the promise, and the promisee actually
relied on the promise to his or her detriment. Promissory
estoppel is an equitable doctrine used as a substitute for
consideration that allows the imposition of contractual liability
to prevent unfairness.
To establish promissory estoppel, a party must show:

Contracts | 164

1. A definite promise;
2. The party making the promise should have expected that
the other party would rely on the promise;
3. A reasonable person would have relied on the promise;
4. The party relied on the promise and it resulted in a
substantial detriment; and
5. Basic justice and fairness require that the promise be
enforced.

10.3 Types of Contracts
Bilateral and Unilateral Contracts
In a bilateral contract, both parties make a promise of
performance. These contracts are also called mutual or
reciprocal contracts. Bilateral contracts are the most common
form of contracts. They include ordering food in a restaurant,
buying gas for vehicles, purchasing goods and services, etc.
A unilateral contract, on the other hand, is a contract where
one party makes a promise that the other party can accept only
by doing something. For example, a business offers a reward
for information leading to the arrest of a thief. A person cannot
collect the reward money by promising to give information–he
or she must perform under the contract by providing the
information.

Express and Implied Contracts
An express contract is a contract in words (orally or in writing)
in which the terms are spelled out directly. The parties to an

165 | Contracts

express contract, whether written or oral, clearly intend to
make a legally enforceable agreement. For example, an
agreement to buy a car for $1,000 and to take title next Monday
is an express contract.
An implied contract is a contract that is inferred from the
parties’ actions. Although no discussion of terms took place,
an implied contract exists if it is clear from the conduct of the
parties that they have an agreement. A delicatessen patron
who asks for a “turkey sandwich to go” has made a contract
and is obligated to pay when the sandwich is made. By
ordering the food, the patron is implicitly agreeing to the price,
whether posted or not.

Quasi-contract: Contract Implied in Law
Both express and implied contracts embody an actual
agreement of the parties. A quasi-contract, by contrast, is an
obligation imposed by law to avoid unjust enrichment of one
person at the expense of another. In fact, a quasi-contract is
not a contract at all. It is a judicial remedy in which the court
decides what a contract should look like between the parties to
prevent injustice. For example, a carpenter mistakenly believes
a homeowner hired him to repair her porch, when it was
actually the neighbor who hired him. One morning the
carpenter arrives and begins work. Rather than stop him, the
homeowner lets him proceed, excited to get her porch fixed
for free. Although no contract exists because there was no
offer, acceptance or consideration, the law will imply a contract
between the carpenter and homeowner for the value of the
work.

Contracts | 166

Enforceability
A contract that is fully enforceable and reflects the parties’
intent is valid. Conversely, an unenforceable contract is a
contract where the parties intend to form a valid bargain but
the court declares that it cannot be enforced for legal reasons.
For example, Ramesh owes Jai money, but Jai has waited too
long to collect it and the statute of limitations has run out. The
contract for repayment is unenforceable and Jai is out of luck
unless Ramesh makes a new promise to pay or actually pays
part of the debt.
An agreement that is lacking one of the legal elements of a
contract is void because it never was a contract. In other words,
it is not legally enforceable because it is not a contract at all. An
agreement that is illegal is also void. For example, a promise to
commit a crime in return for payment is void because neither
side can enforce the agreement in court.
By contrast, a voidable contract is a contract that can be
annulled. It is a contract that is unenforceable by one party but
enforceable by the other. For example, a minor may “avoid” a
contract with an adult; meaning the adult may not enforce the
contract against the minor if the minor refuses to carry out
the bargain. The adult must comply if the minor wishes the
contract to be performed. A contract may be voidable by both
parties if they are both minors. Usually, the parties to a voidable
contract are entitled to be restored to their original position.
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 does not wish to be bound by it. When minors
become adults, they have two choices:
1. Ratify the contract–that is, agree to be bound by it; or
2. Disaffirm the contract–that is, disavow or avoid it.
167 | Contracts

Ratification may be explicit or implicit. For example, by
continuing to make payments or retaining goods for an
unreasonable period of time, a party may ratify the contract. If
a party has not disaffirmed the contract while still a minor, she
may do so within a reasonable time after becoming an adult.

Degree of Completion
An executory contract is a contract that has yet to be
completed. Most executory contracts are enforceable. If some,
but not all, of the terms of the contract have been performed,
the contract is called partially executed. A contract that has
been completed or carried out fully by both parties is called an
executed contract.

10.4 Performance and Breach of
Contract
Performance simply means undertaking the legal duties
imposed by the terms of the contract.
But how do we know whether the contract terms have been
performed? Sometimes it’s easy to determine. For instance,
if someone offers to sell his scooter for four hundred dollars,
a purchaser agrees, and they exchange the scooter for the
money, then the contract has been fully performed. A contract
was formed, the parties performed their obligations under it
(known as complete performance), and they are subsequently
discharged from further duties arising under the contract.
Complete performance results in an executed contract.
When a party fails to perform under the terms of the contract

Contracts | 168

without a legally justifiable reason, the party is in breach of
contract. Not all breach of contract situations give rise to
litigation. Some breaches are minor and may be overlooked by
parties, especially if there is a long-term business relationship
between them. Others may be major and give rise to
significant issues between the parties.
In a service contract, the standard used to judge performance
is substantial performance. This means that the performing
party acted in good faith and conveyed enough benefit to the
other party under the contract that any breach may be
remedied by money damages. A material breach in a service
contract occurs when a party has not substantially performed
under the terms of the contract. A minor breach occurs when
the party has substantially performed but has not strictly
performed.
Performance to the standard of personal satisfaction can be
enforced if the contract expressly requires it. This means that
contract performance is evaluated subjectively, either by one
party to the contract or by a third-party beneficiary specified
in the contract. If the subject of the contract is something for
which approval is dependent on someone’s subjective opinion,
like personal taste, then assessment can be made on a
subjective standard providing this standard is clearly specified
in

the

contract.

These

contracts

often

occur

in

the

entertainment industry, as well as the building of custom
homes.

Conditions
A condition is an act or event (other than the lapse of time) that
must occur before performance under a contract becomes
due. Conditions determine when a party must perform.

169 | Contracts

Type of
Condition

Description

Condition
precedent

A condition must occur before a party’s performance
is required

Concurrent
condition

Each party’s performance is dependent on the other
party’s performance

Subsequent
condition

A condition follows the duty to perform that
completely eliminates or discharges a duty to
perform

Constructive Equitable doctrine that serves as an implied-in-law
condition
condition to prevent injustice

A condition precedent is an act or event that must occur
before a duty of immediate performance of a promise arises.
For example, an inspection of property is a condition precedent
to the sale of a home.
A concurrent condition occurs when mutually dependent
conditions must be performed at the same time by the parties.
For example, delivery of goods and payment in a cash sale are
concurrent conditions.
A subsequent condition is an event that discharges a duty of
performance that becomes absolute. They are rare and tend
to occur in the insurance industry. For example, an insurance
company may require notice within thirty days of a claim. The
insurance company does not have a duty to pay until the
insured gives notice. Notice is the subsequent condition that
triggers the insurance company’s performance.
A constructive condition is a condition contained in an
essential contractual term that, though omitted by the parties
from their agreement, a court has supplied as being
reasonable in the circumstances. It is an equitable doctrine
that serves to imply conditions to prevent injustice.

Contracts | 170

10.5 Defenses to Contracts
A party may have a valid reason for breaching, or not
performing, a contract. These reasons are known as defenses to
contract. Many of the defenses to contracts go to the heart of
whether an agreement ever existed. In other words, if a party
does not voluntarily consent or there was no “meeting of the
minds,” then a valid contract was never formed.

Illegality
Illegal contracts are unenforceable because they are void.
There are two common types of illegalities: (1) statutory
violations, and (2) violations of public policy. An example of a
statutory violation is where a company in the US wants to avoid
import regulations and quotas by purchasing Cuban cigars
through an intermediary in Mexico. If the US buyer pays the
Mexican intermediary for the cigars but does not receive them,
the buyer cannot sue the intermediary for breach of contract.
The law will not provide a remedy to someone who intends to
violate the law.
Examples of violations of public policy often occur in an
employment context. An employer that tries to bind its
employees to unreasonable non-compete agreements violates
the public policy of freedom to work. Another common
example is contracts with professionals who do not maintain
a current license in their field. If they are not legally licensed
for the work they perform, they are not entitled to payment
for their services. Here, the public policy is that the law does
not want to encourage a black market for services outside of
government regulation.

171 | Contracts

Incapacity
If someone lacks mental capacity to understand the terms of
the agreement, there cannot be a true meeting of the minds to
form a contract. Capacity is the mental state of mind sufficient
to understand that a contract is made and its legal
consequences.
Incapacity can be permanent, such as from mental illness,
physical illness, or insanity. Incapacity may also be temporary,
such as being intoxicated, under the influence of drugs, or
underage (i.e. under eighteen years old).

Undue Influence
Undue influence occurs when one party overpowers the free
will of another by use of superior power or influence. In other
words, it is unfair persuasion. Undue influence is not a normal
level of persuasion. Rather, it occurs when a party agrees to
a contract that they would not have otherwise consented to
without the unreasonable pressure of the other party. For
example, an elderly person who is isolated from others due
to poor health and living conditions may be lonely and eager
for company. If a caretaker exerted influence over the elder to
the extent that he or she could no longer exercise free will,
then undue influence occurs. Contracts and transactions in
which elders transfer most or all of their wealth to others are
frequently reviewed for undue influence.

Duress
Duress occurs when there is a threat to a person, family or

Contracts | 172

property. Economic pressure may constitute duress if it is
wrongful and oppressive. Cases involving duress often occur in
emergency situations. For example, when someone is required
to sign legal paperwork in an emergency room before
receiving medical treatment for themselves or their children.
If a person enters into a contract under duress, he or she is able
to get out of the contract after the emergency situation is over.
Duress essentially overcomes a person’s free will to voluntarily
choose to enter into the contract.

Unconscionability
Unconscionability

occurs

when

the

contract

contains

markedly unfair terms against the party with less bargaining
power or sophistication than the party who created the terms
and induced the other party to sign it. Common cases involving
unconscionability

claims

occur

when

one

party

is

an

experienced business dealer, while the other party is an
average consumer. If the business dealer uses a very small font
and inserts terms into the contract in a way that intentionally
misleads the consumer into signing on unfair terms, then the
contract may be deemed unconscionable.

Statute of Frauds
The Statute of Frauds requires certain contracts to be in
writing and signed to be enforceable. The Statute of Frauds
originated in England in 1677 to prevent fraud when one party
tries to claim a contract existed when it did not. The Statute of
Frauds requires a written contract for:
1. Real property interests;
173 | Contracts

2. Marriage;
3. Payment of another’s debt;
4. Contracts that cannot be completely performed within
one year;
5. Contracts for the sale of goods of five hundred dollars or
more; and
6. Acting as another’s executor/administrator.

Statute of Limitations
The statute of limitations is an affirmative defense that can be
raised by a defendant to argue that a lawsuit is being brought
too late. This means that if a dispute arises under a contract,
then the plaintiff must bring a lawsuit concerning that dispute
within a certain time period. States have different statutes of
limitations. If a contract has a choice of law provision, then that
state’s statute of limitations will apply to disputes related to the
contract.

Mistake
In the context of contracts, a mistake is the situation in which
the parties did not mean the same thing or when one or both
parties formed untrue conclusions about the subject matter of
the contract. In other words, a mistake is an erroneous belief.
Mutual mistake refers to something that is a mistake by both
parties that relates to an essential term of the contract. For
example, a contract to buy property that is not actually owned
by the seller would be a mutual mistake, if the seller believed in
good faith that he owned the property. When mutual mistakes
occur, either party may rescind the contract.

Contracts | 174

Unilateral mistake occurs when only one party is laboring
under a mistake. Mistake does not mean bad bargaining.
Courts will not step in to save parties from bad bargaining
absent evidence of undue influence or unconscionability. In
general, parties cannot rescind the contract when unilateral
mistakes occur except when the mistake makes the contract
unconscionable, the error is apparent to the other party, or
when significant mathematical errors occur.
Figure 10.1 Types of Mistakes Affecting Contracts and Their
Remedies

Misrepresentation and Fraud
Misrepresentation and fraud are also defenses to contract.
Misrepresentation is when a party makes a false statement
that induces the other party to enter into the contract. Fraud
is a closely related concept, and it simply means that one party

175 | Contracts

has used deception to acquire money or property. Fraud may
also be a basis for criminal charges, depending on the
circumstances leading to the contract.

Commercial impracticability
Commercial impracticability is a defense that can be used
when fulfilling a contract has become extraordinarily difficult
or unfair for one party. For example, a sales contract relating
to the sale of goods destroyed by a natural disaster would fall
under this defense. It becomes impossible for the seller to
deliver goods that no longer exist, and would be unfair to
enforce damages against the seller for breach of contract. This
is also called frustration of purpose or impossibility in some
jurisdictions.

Bankruptcy
Sometimes a party to a contract files for bankruptcy
protection. The bankruptcy court will determine which debts
the bankrupt party must pay and which are dischargeable.
Contract obligations are suspended temporarily through the
bankruptcy court’s automatic stay. In other words, the debt
does not have to be paid during the course of the bankruptcy.
At the conclusion of the bankruptcy, if the contract obligation is
determined to be a dischargeable debt, then the debt will not
have to be paid.

Contracts | 176

10.6 Assignment, Delegation, and
Third Party Beneficiaries
Contracts are by law assignable and delegable. This means
that the rights conveyed by the contract may be transferred to
another party by assignment, unless an express restriction on
assignment exists within the contract, or unless an assignment
violates public policy. Likewise, the duties imposed on a party
may be transferred to another party by delegation, unless the
contract expressly restricts delegation, there is a substantial
interest in personal performance by the original party to the
contract, or if delegation would violate public policy.
As a general rule, a party may assign contract rights without
the consent of the other party. This is common in the
construction industry where a general contractor may assign
rights and delegate duties to subcontractors for specific work
that needs to be performed under the main contract. For
example, the general contractor may delegate the duty to
perform electrical work to an electrician, as well as assign the
right to be paid for the work performed.
In delegation and assignment, the original contracting party is
not “off the hook” if it transfers its duties or rights to another
party. For instance, a subtenant assumed the rights and duties
imposed on the original tenant in a lease. If the subletting
tenant does not pay the rent, the original tenant is still liable.
The way to excuse oneself from legal liability under a contract
is through novation. Novation is essentially a new contract that
transfers all rights and duties to a new party to the contract
and releases the previous party from any further obligation. It
is the procedure in which one party is dismissed completely
from the contract because a third party is substituted. In this
situation, the dismissed party no longer has any liability under

177 | Contracts

the original contract. To be effective, all parties must agree to
the novation.

Third Party Beneficiaries
Assignment and delegation under a contract should not be
confused with rights of third party beneficiaries. A third party
beneficiary is someone who is not a party to the contract but
stands to benefit from it. Life insurance policies are a classic
example of contracts with third party beneficiaries. The
insurance company and the insured are parties to the contract.
But the person who receives payment upon the death of the
insured is the third party beneficiary.
Third party beneficiaries can either be intended or incidental.
An intended beneficiary is someone who the parties intend to
receive the benefit of the contract. For example, the named
beneficiary of a life insurance policy. The beneficiary does not
need to know about the contract to have his or her rights vest.
An incidental beneficiary is someone who benefits from a
contract but was not intended by the parties to benefit. For
example, if a business pays for a professional to landscape its
property, the neighbors are incidental beneficiaries to the
landscaping contract. They benefit from the improved
appearance and property values, but the business did not enter
the contract with an intent to benefit them. Incidental
beneficiaries do not have a legally enforceable interest in the
contract.

Contracts | 178

10.7 Parol Evidence Rule
Courts often must interpret the meaning of a contract. When
the contract is written, courts will look within the “four corners”
of the document and apply the contract as written. The Parol
Evidence Rule is the principle that a writing intended by the
parties to be a final embodiment of their agreement cannot
be modified by evidence that adds to, varies, or contradicts
the writing. This rule usually prevents a party from introducing
evidence of negotiations that occurred before or while the
agreement was being reduced to its final written form.
However, there are several important exceptions that allow oral
statements to be admitted:
1. Subsequent modifications;
2. Evidence of intentional misrepresentations by a party;
3. Correcting errors in drafting;
4. Clarifying ambiguities and filling in gaps; and
5. Supplements to a partially integrated contract.
As a result of the parol evidence rule, businesses should do
their due diligence to ensure any written contracts fully and
adequately include the essential terms of their agreement.

10.8 Remedies
The four main remedies for breach of contract are damages,
specific performance, rescission, and restitution. The purpose
of contract remedies is to compensate the non-breaching
party for the losses suffered. In other words, remedies must put
the non-breaching party in the position it would have been if
there had been no breach.
179 | Contracts

Damages
Damages are the money paid by one party to another to
discharge a legal liability.
Types of
Monetary
Damages

Purpose

Compensatory

To make the non-breaching party “whole” as if
breach did not occur

Consequential

To cover indirect but foreseeable losses flowing
from the breach

Incidental

To cover direct losses flowing from the breach & to
avoid further loss

Nominal

To recognize legal breach although no actual
damages resulted

Punitive

To punish and deter future wrongful behavior;
only available if breach itself is a tort

Liquidated

To allow parties to determine value of contract in
case of breach

Compensatory Damages
Compensatory damages are paid to compensate the nonbreaching party for the loss suffered as a result of the breach. It
is the general category of damages awarded to make the party
whole. Compensatory damages include out-of-pocket losses
and costs associated with the loss of the bargain. They are the
primary damages in contract breach cases and are a direct,
foreseeable result of the breach of contract.

Contracts | 180

Consequential Damages
A basic principle of contract law is that a person injured by
breach of contract is not entitled to compensation unless the
breaching party, at the time the contract was made, had
reason to foresee the loss as a probable result of the breach.
Consequential

damages are damages that flow as a

foreseeable but indirect result of the breach of contract. For
example, a roofer takes longer to fix a leaky roof than specified
in a contract. The delay results in a retailer remaining closed for
an additional week until the roof is repaired. The loss of sales
from that week are consequential damages.
Consequential damages often include:
• Loss of profits due to the interruption of normal business
practices;
• Loss of customers due to delays or cancellations; and
• Cost of replacement goods or services.

Incidental Damages
Incidental damages are damages that are paid to the nonbreaching party in an attempt to avoid further loss on account
of the breach. These damages include additional costs incurred
by the non-breaching party after the breach in a reasonable
attempt to avoid further loss, even if that attempt was
unsuccessful.
For example, an electrician contracts to install light fixtures in
a warehouse within seven days. The electrician enters into a
purchase agreement with a supplier to buy the fixtures which
are to be delivered within three days. On the fifth day, the

181 | Contracts

supplier notifies the electrician that it cannot fill the order,
breaching the contract. Because he cannot fulfill his contract
with another supplier in time, the electrician breaches his
contract with the warehouse and has to refund the warehouse
its money. The losses incurred by the electrician to the
warehouse are a direct result of the supplier’s breach of
contract, and are incidental damages.
Incidental costs often include:
• Inspection of items;
• Transportation or care of items;
• Expenses or commissions incurred in connection with
incident or delay of items; and
• Storing of defective items until the supplier can retrieve
them.
The

difference

between

incidental

and

consequential

damages is the cause of the expense or loss. Incidental
damages are the direct result of one party’s breach of contract.
Consequential damages are more indirect, being incurred not
as a result of the breach itself, but due to the end result of the
breach.

Nominal Damages
If the breach of contract caused no actual loss, the nonbreaching party may be awarded nominal damages. Nominal
damages are a token amount of money paid when the breach
has caused no actual loss. Nominal damages are often
awarded symbolically by juries when they find legal liability
but believe the breach was minor or could have been
accommodated in another way. For example, a buyer could

Contracts | 182

have purchased the same commodity at the same price
without spending any extra time or money.

Punitive Damages
Punitive damages are awarded to a non-breaching party in
excess of any loss suffered to punish the breaching party.
Punitive damages are awarded when the defendant acted
willfully and maliciously, and the purpose is to deter similar
future bad conduct. Punitive damages are not usually available
for breach of contract claims, unless the breach of contract
itself constitutes a tort. In other words, punitive damages may
be available when the contract breach itself is fraudulent or
malicious. Punitive damages have been awarded against
insurance companies that have refused to honor disability
payments and that have acted in bad faith in denying
legitimate claims.

Liquidated Damages
Liquidated damages are damages agreed upon by parties to
a contract to be paid in the event of a breach. Because the
parties are often in the best position to know the value of their
contract, they can negotiate a fixed sum or method to
calculate damages in the event of a breach. To be enforceable,
liquidated damage provisions must apply equally to all parties,
be negotiated fairly at the time the contract is executed, and
must bear a reasonable relation to the probable damage in
case of a breach.

Equitable Remedies for Breach of
183 | Contracts

Contract
Equitable remedies involve a request for relief that does not
include money damages. Equitable remedies are useful for
when money does not provide adequate relief to the nonbreaching party.
Equitable
Remedy

Purpose

The object of the
contract is unique &
Specific
the loss cannot be
Performance
easily compensated
through money

Description

Party must perform under
terms of contract

Rescission

Contract was executed
based on mutual
mistake or fraud

Parties are put back into
position they were in
before contract was made

Restitution

Parties must return
any benefit received

Benefit or item unjustly
obtained is returned

Specific Performance
Specific performance is a judicial order directing a party to
deliver the exact property (real or personal) under the terms
of a contract. Specific performance is an alternative remedy
to damages and may be issued at the discretion of the court.
Specific performance is granted when money damages are not
an adequate remedy. For example, sale of specific real property
(real estate is always unique), artwork, antiques, and heirlooms.
To warrant specific performance, a contract must be clear,
definite, complete, and free from fraud and duress.
Specific performance is generally not available for service
contracts. This is because ordering someone to perform a
contract against their will is a type of involuntary servitude

Contracts | 184

banned by the Thirteenth Amendment of the US Constitution.
However,

courts

have

occasionally

entered

injunctions

prohibiting entertainers from performing at alternative venues
until they perform at the venue under their original contract.
These cases are in response to unethical forum shopping in the
entertainment industry, and are very limited in nature.

Rescission
Rescission occurs when one party seeks to undo a contract
and return to the position it was in before the contract was
made. Rescission often occurs when fraud and mutual mistake
occur and enforcing the contract would be unjust. Rescission
may also be available when one party materially breaches the
contract to such an extent that requiring the other party to
perform would be unjust.
A party seeking rescission must notify the other party within a
reasonable time after discovery of the facts that are the basis
for rescission. The reason is that restoring the parties to their
pre-contractual positions is easiest before too much time and
performance has passed. Failure to rescind a contract in a
timely manner may be held to affirm the contract or waive a
breach of contract.

Restitution
Restitution is restoring property to the original owners. In other
words, parties must return any benefit received under the
contract. Therefore, only to the extent that the injured party
conferred a benefit on the other party may the injured party
be awarded restitution. Restitution often follows rescission of a
contract. The purpose of restitution is to prevent a party from
185 | Contracts

being unjustly enriched when a contract has been legally
annulled.

10.9 Concluding Thoughts
Contracts are a fundamental part of business. It is important
to understand how contracts are formed, performed, and
executed in order to be successful. This understanding also
includes understanding what performance is required, what
defenses are available when someone breaches a contract, and
what remedies are available in the event of a breach.

Contracts | 186

11. Sales Contracts
11.1 Introduction
LEARNING OBJECTIVES
1. Explore the differences between the Uniform Commercial
Code and common law contract principles.
2. Understand important provisions of the Uniform
Commercial Code and how they apply to merchants who
sell goods.
3. Learn when the Uniform Commercial Code applies to
mixed contracts.
One of the drawbacks of federalism is that states can
implement different laws. This was a serious problem as the
US economy grew beyond local and state-based industries to
economies of scale during the Twentieth Century because it
hampered economic growth. In response, business leaders
demanded consistent laws to facilitate trade across the nation,
especially for the sale of goods across state lines.
The Uniform Commercial Code (UCC) is a proposed set of laws
developed by legal experts and business leaders to govern
commercial transactions, including sale of goods, secured
transactions, and negotiable instruments. The UCC was
created in 1952 and its advocates lobbied the states and
territories to adopt it. The UCC has been adopted in some form
by all fifty states, the District of Columbia, and US territories.
Interestingly, it is the only “national” law not enacted by
Congress.

187 | Sales Contracts

This chapter will focus on important provisions that relate to
sales contracts that have been adopted by most, if not all,
states.

Counselor’s Corner When writing something for
work, I offer the following advice. First, take time to
review and edit your writing. You will be surprised at
the number of typos that can be discovered when
you give your work fresh eyes. Don’t be afraid to
reach out to others to review your work as
well. Excellence in writing will help to convey your
message clearly and credibly. Second, write with
honesty. If your reader doubts the sincerity of your
work, the message you are trying to convey will be
lost. The strongest advocates I have encountered are
the most honest ones. Third, be clear and
concise. Tell your reader a story but give them the
information they need in an organized fashion.
~Tiffany M., attorney

11.2 Scope of the UCC
The UCC deals with commercial transactions from start to
finish. The power of the UCC is that if the parties do not have a
contract with express terms, then the UCC “fills the gaps” with
legal requirements. For example, if the parties do not negotiate
the terms of delivery, then the UCC states where and when
delivery should occur. This is incredibly beneficial to businesses
because it provides legal certainty and consistency across
jurisdictions.

If

parties

have

a

dispute,

or

unforeseen

Sales Contracts | 188

circumstances result in a breach of contract, the parties can
resolve the problem without having to litigate the issue in
court. This saves businesses a lot of time, money and resources,
as well as helps them maintain good working relationships.
The UCC also addresses four important problems that
merchants struggled with under the common law:

189 | Sales Contracts

Problem

Contract
Formation

Required
Writing

Common
Law

UCC

Example

Mirror Image
Rule: Offer
must be
followed by
acceptance
showing
meeting of
the minds on
all essential
terms

Contract can
be made in
any manner
that shows
agreement
and some
terms,
including
price and time
of delivery,
may be left
open (§2-204
& §2-305)

Jimena writes Ahn
that she needs a
new computer. Ahn
delivers the
computer and
Jimena starts to use
it. Under the
common law, there
is no contract
because price was
not discussed.
Under the UCC a
contract exists for a
reasonable price.

All essential
terms must
be in writing

Any writing
that intends
to be a
contract is
enforceable;
“merchant”
exception can
create a
contract
against party
that does not
object to
writing within
ten days
(§2-201)

Home Depot sends
a purchase order to
a wholesaler. The
wholesaler receives
the order but does
not respond. Under
the common law, no
contract exists.
Under the UCC, a
contract exists after
ten days that Home
Depot may enforce
against the
wholesaler.

Sales Contracts | 190

Additional
Terms

An
acceptance
with any
additional
terms is a
counteroffer

To be valid, a
modification
must be
Modification
supported by
new
consideration

Additional
and different
terms are not
necessarily
counteroffers,
may just be
part of
negotiation
process
(§2-207)

A florist sends a
preprinted order
form to buy specific
supplies from a
manufacturer for a
stated price. The
manufacturer
responds with its
own preprinted
form accepting the
order but adding
the term that
unpaid balances
incur interest.
Under the common
law, the additional
term is a
counteroffer and no
contract is formed
until the florist
accepts it. Under
the UCC, there is a
valid contract that
includes the interest
term.

A
modification
does not need
to be
supported by
new
consideration
(§2-209)

Fred Farmer agrees
to sell produce to
Aponi for her
restaurant. They
agree to all essential
terms, including
goods, price, and
delivery. The next
day a hurricane
floods the interstate
doubling the
delivery costs. Fred
calls Aponi who
agrees to pay half of
the increased cost.
Under the common
law, the
modification is void.
Under the UCC, the
modification is
enforceable.

A common problem is determining when the UCC applies. The
UCC does not apply to contracts related to the sale of land,
intangible personal property, construction, or for services. The
UCC applies to the sale of goods, which the Code defines as
191 | Sales Contracts

any moveable physical object except for money and securities.
In other words, goods are tangible personal property.
Figure 11.1 Determination of when the UCC Applies to Sales
Transactions

Mixed contracts are for both the sale of goods and services. For
example, a contract for the sale of a dishwasher that includes
the service of installation is a mixed contract. The UCC only
applies to mixed contracts when the primary purpose of the
contract is the sale of goods. In the dishwasher example, the
UCC applies because installation would not occur without the
sale of the dishwasher.
The UCC also does not apply if none of the parties are a
merchant. In other words, the sale of goods between
individuals is governed by the common law. If a sales
transaction involves a merchant, then the UCC usually applies.
A merchant is someone who routinely deals in the goods
involved in the transaction or who, by his or her occupation,

Sales Contracts | 192

holds himself or herself out as having special knowledge with
respect to the goods. Suppliers of services are not merchants.
The UCC provides merchants with rules that facilitate their
business needs. For example, contract formation is more
informal and flexible than under the common law. However,
the UCC often holds merchants to a higher standard of
conduct than non-merchants. Merchants are required to act in
good faith and to observe reasonable commercial standards of
fair dealing.

11.3 Sales Contract Formation
The common law expects parties to form a contract by making
an offer, with an acceptance that mirrors the offer and includes
all material terms. Modern business transactions, however,
frequently do not follow that pattern. As a result, UCC §2-204
provides that a contract may be formed in any manner that
shows the parties reached an agreement.
The terms of sales contracts are supplied by three sources:
1. The express agreement of the parties;
2. Course of dealing, usage of trade, and course of
performance; and
3. The UCC.

Express Agreement
The general rule is that parties are free to make their own sales
contract. When parties agree on terms–especially for quality,
quantity, price, delivery and payment–those terms control over

193 | Sales Contracts

UCC provisions. The parties’ freedom to contract, however, is
not limitless. Parties cannot disclaim their obligation of good
faith, diligence, and due care. Similarly, liquidated damages
provisions must be based on the value of the contract and
cannot be a penalty for breach of contract. Further, limitations
on consequential damages cannot be unconscionable.

Course of Dealing, Usage of Trade &
Course of Performance
The parties’ agreement may be based on their actions. Course
of dealing is an established pattern of prior conduct between
the parties to a particular transaction. If a dispute arises, the
parties’ course of dealing can be used as evidence of how they
intended to carry out the transaction. In other words, the
current contract is interpreted based on past contracts.
Course of performance relates to the conduct of the parties
under the contract in question after its formation. It occurs
when a contract involves repeated performance and looks at
how the parties have acted when performing this particular
contract, not contracts in the past.
Usage of trade is a practice or custom in a particular trade
used so frequently that it justifies the expectation that it will be
followed in the current transaction. It is industry standards and
customs related to a particular industry.

UCC Provisions
When sales contracts do not have all the necessary terms, the
UCC “fills in the gaps” of the contract. The most important UCC

Sales Contracts | 194

gap-filler provisions relate to price, quantity, delivery, and time
of performance.
Figure 11.2 UCC Gap-Filler Provisions

195 | Sales Contracts

Provision Subject

§2-305

Price

Description
Price can be left open to be fixed at later
time;
Reasonable price determined upon delivery
“Output” and “Requirement” amounts can
be determined at a later time;

§2-306

No quantity that is unreasonably
Quantity disproportionate to the estimate will be
enforced;
Reasonable amount in keeping with normal
or prior comparable output or requirements
is implied

§2-507
& §2-308

Delivery

Delivery occurs at seller’s place of business
unless contract provides otherwise

§2-309

Time

Reasonable time for performance

When these sources of contract terms are in conflict, the UCC
applies the following hierarchy:
1. Express terms;
2. Course of performance;
3. Course of dealing;
4. Usage of trade; and
5. UCC gap-filler provisions.
The logic is that the parties are free to contract the terms they
would like. In absence of an express agreement, the parties’
conduct shows their intent. In practical terms, usage of trade
and UCC provisions often go hand-in-hand. For example, what
constitutes “reasonable time” for performance is often based
on relevant industry standards. Although the UCC identifies a
hierarchy, in practice it is not rigidly applied by the courts when
determining usage of trade and UCC provisions.

Sales Contracts | 196

Additional and Different Terms
Under UCC §2-207, an acceptance that adds or alters terms
will often create a contract. Unlike the common law that treats
modifications as a counter-offer, the UCC has a more flexible
concept of acceptance. This is to address the “battle of the
forms” that happens when merchants buy and sell goods with
pre-printed forms. Frequently buyers use pre-printed forms to
place an order that are then acknowledged by the seller on its
own pre-printed forms. These forms typically contain language
favorable to the party sending it and rarely agree.
Section 2-207 still requires the parties to intend to create a
contract. If the differing forms show that the parties never
reached an agreement, then no contract exists.
However, if the acceptance contains an additional term, then
a contract is usually formed. An additional term is a proposed
contract term that addresses issues not included in the offer.
Additional terms expand the offer to cover more essential
terms to ensure a meeting of the minds.
If both parties are merchants, the additional terms usually
become part of the contract unless:
1. The offer states that it cannot be accepted with additional
or different terms;
2. The additional terms materially alter the offer; or
3. The party making the offer promptly rejects the additional
terms.
A different term is a proposed contract term that contradicts
the term(s) in the offer. Under the UCC, different terms cancel
each other out. In most states, different terms are replaced by
UCC gap-filler provisions.

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11.4 Performance
A seller is expected to deliver what the buyer ordered.
Conforming goods meet contractual specifications and satisfy
performance requirements. Non-conforming goods are goods
that fail to meet contractual specifications, allowing the buyer
to reject the goods or to revoke acceptance.
A buyer has the right to inspect the goods before paying or
accepting them. A buyer may also reject non-conforming
goods by notifying the seller within a reasonable time.
If a buyer rejects the goods, the seller has the right to cure,
which is the right to deliver conforming goods before the
contract deadline. The UCC also allows the right to cure after
the contract deadline in some situations. If the seller delivers
conforming goods, then it is entitled to full payment under the
contract.
If the seller breaches the contract, the buyer is entitled to
cover. Cover is obtaining reasonable substitute goods because
another party failed to perform under a contract. If the seller
obtains reasonable substitute goods, the seller is entitled to the
difference between the contract price and its cover price, plus
incidental and consequential damages, minus expenses saved.
If the buyer breaches the contract, the seller may refuse to
deliver the goods. If a buyer refuses to accept or pay for goods
without justification, the seller may resell them to another
party. When the resale is commercially reasonable, the seller
may recover the difference between the resale price and the
contract price, plus incidental damages, minus expenses
saved.
If the buyer has accepted the goods and refuses to pay, or if the
goods are conforming but resale is impossible, the seller may

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sue the buyer for the contract price. This is common when the
buyer orders goods with unique specifications.

11.5 Warranties
A warranty is a contractual assurance that goods will meet a
certain standard. An express warranty is a guarantee, created
by the words or actions of the seller, that goods will meet
certain standards. Under the UCC, a seller may create an
express warranty in three ways:
1. With an affirmation of a fact or a promise;
2. With a description of the goods; or
3. With a sample or model.
To constitute a warranty, the seller’s words or actions must be
part of the basis of the bargain. For example, if a salesperson
says that a car’s timing belt was just replaced and will not
need to be replaced for another 100,000 miles, and the buyer
relied on that statement when deciding to buy the car, then
the salesperson’s statement becomes an express warranty.
An implied warranty is a guarantee created by the UCC and
imposed on the seller of goods. There are two main implied
warranties: merchantability and fitness for a particular
purpose.
The implied warranty of merchantability is a warranty that
the goods are fit for the ordinary purposes for which they are
used. To disclaim this warranty, a merchant must use the term
“merchantability.” The novel or unusual use of goods is not
protected by this warranty. If a buyer uses goods for something
other than their intended purpose, the warranty does not
apply.

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The implied warranty of fitness for a particular purpose is a
warranty that the property is suitable for the buyer’s special
purpose. For the warranty to apply, the seller must know what
the buyer’s purpose is and the buyer must rely on the seller’s
judgment that the goods meet the buyer’s needs.

11.6 Concluding Thoughts
The UCC is a national law that was proposed by legal experts
and business leaders to address the need for consistent laws
related to the sale of goods across state lines. The UCC also
applies to secured transactions and negotiable instruments,
which are areas beyond the scope of this book. For individuals
and businesses who buy or sell goods with merchants, it is
important to understand how the UCC fills in gaps with terms
that are not expressly contained in a contract, as well as to
understand applicable warranties. The flexibility of the UCC
facilitates business by making commercial transactions more
consistent and predictable.

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12. Writing Contracts
12.1 Writing Contracts
LEARNING OBJECTIVES
1. Learn how to write valid contracts.
2. Understand strategies for drafting contracts.
Knowing how to write legally enforceable contracts that
protect their interests is a vital skill for businesses. In fact, most
contracts are not written by attorneys. Individuals and
businesses write contracts without legal help because they are
trying to save time, money, and tension with others. However,
hiring an attorney to write or review a contract to protect
personal or business interests is sometimes necessary and
worthwhile.
There are no magic words that a contract must have to be
enforceable. Some are short and informal, while others are long
and formal. No one style, format, or approach will always serve
the parties’ needs. The only legal requirement that contracts
must have are the elements of a contract: offer, acceptance,
and consideration. This chapter offers some guidelines for
business people to consider when writing their own contracts.

Counselor’s Corner It has been said that a poorly

201 | Writing Contracts

drafted contract will work if everyone gets the
benefit of their bargain. This may be true, but it does
not excuse sloppy drafting. Address all essential
matters, clearly, succinctly, and at once. Nonessential terms, inconsistent use of defined terms,
and repetition create fertile ground for disputes. You
cannot control how the other party will perform.
However, you put yourself in the best position
possible by ensuring that the intent, obligations and
rights of all parties are stated clearly and
unambiguously. ~Kathy K., attorney

12.2 Structure of Contracts
Written contracts can be organized in many different ways.
However, having a structure can help keep information
organized, clear, and easy to find. The best contracts have clear
headings that accurately describe what is contained in that
section. Using emphasis, such as bold and underlining, work
better than italics alone for capturing the reader’s eye.
In general, contracts often contain a structure like this:
1. Title
2. Introduction of Parties and Purpose
3. Definitions of Material Terms
4. Covenants and Promises of Performance
5. Conditions
6. Breach and Its Consequences

Writing Contracts | 202

7. Representations and Warranties
8. Standard (often called “Boilerplate”) Provisions
◦ Procedure to Modify Contract
◦ Rights of Assignment and Delegation
◦ Alternative Dispute Resolution
◦ Choice of Law and Forum
◦ Integration
◦ Severability
◦ Exculpatory Clause
◦ Force Majeure
◦ Attorney Fees
9. Signature Block
Not all contracts will contain all these elements and provisions.
The parties’ needs and the purpose of the contract drive the
structure of the document.

Title
Contracts have a title, often in bold or CAPITAL letters, at the
top of the page. Titles should be as descriptive as possible.
“Contract” or “Agreement” are not useful because they require
the reader to read through the contract to know what it is
about. The best contracts capture the nature of the document
in the title. For example, “Employment Agreement Between
Jane Doe and Stanford University.”

Introduction of Parties and Purpose
The introduction should name the parties and describe the

203 | Writing Contracts

nature of the contract. If background information is useful in
explaining the parties’ interests and objectives, then it should
be included here.

Definitions of Material Terms
Most business contracts contain some definitions, unless the
subject matter and parties are clear. Definitions are useful
because it is an area readers can reference to ensure
compliance with the contract. For example, did the seller
provide the specific goods as defined by the contract?
Definitions are not necessary for every term, though. If not
defined, legal terms are given their legal meaning. And
ordinary words are given their common, ordinary meaning.
Therefore, businesses should define the material terms of the
transaction: goods, services, quantity, quality, price, etc.
Definitions that are specific to the industry are also helpful to
include.

Covenants and Promises of Performance
A covenant is a formal promise to perform. This is the section
of the contract where the parties state exactly how they will
perform the contract. Buyer will pay a specific amount for the
goods or service. Seller will deliver a specific item at a particular
location.
To ensure clarity, the best contracts use active verbs in this
section. For example, “Buyer will pay Seller ten dollars.” It is
clear who will be paying whom, and how much is owed. Passive
voice injects ambiguity, which can be problematic. For
example, “Seller shall be paid ten dollars.” Will Buyer pay Seller

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the money or will someone else tender payment? If payment is
not made, is Buyer in breach of contract?

Conditions
As discussed in Chapter 10, conditions are things that must
occur before performance is due. Usually conditions must be
expressly stated in a contract to be legally enforceable. The
best contracts identify any conditions and delineate a timeline
for when performance is due after the condition is met. For
example, if an inspection of a property is a condition precedent
of purchasing it, how long after the inspection is completed
must the buyer perform?

Breach and Its Consequences
To constitute a violation of the contract, a breach must be
material. A material breach is a substantial breach of contract
that excuses aggrieved parties from further performance and
affords them the right to sue for damages.
In contracts that require performance over a period of time,
or payments in installments, it is helpful to define what
constitutes a material breach. This clarifies when the nonbreaching party can seek a remedy. The best contracts
anticipate reasons for breach and identify consequences for
them.

Acceleration Clause
An acceleration clause makes all future payments due

205 | Writing Contracts

immediately under the contract. Acceleration clauses often
exists in contracts where periodic payments occur. For
example, a contract to purchase a vehicle may require
payment of all remaining money owed under the contract if
the buyer misses a monthly payment. This allows the business
that sold the vehicle or the bank that issued the loan to sue
for breach of contract once, rather than filing a new lawsuit for
each month.

Liquidated Damages
A liquidated damages clause allows parties to determine the
amount of damages in the event of a material breach. Agreeing
to the value of the contract before any breach occurs often
saves time and money should the case be litigated. To be
enforceable, the liquidated damages must apply to all parties
equally, and be based on the value of the contract rather than
act as a penalty.

Representations and Warranties
Representations are statements of fact made to induce
someone to enter into a contract. Common representations by
businesses include:
• They are properly licensed;
• They are insured;
• Their financial statements are accurate;
• They own all relevant assets;
• They have legal authority to enter into contracts.
Warranties in a contract are express promises that guarantee

Writing Contracts | 206

something in furtherance of the contract by one of the parties.
For example, a seller warrants that the object being sold is as
represented or promised.
Warranties differ from representations in four ways:
1. A warranty is an essential part of a contract, while a
representation is usually only a collateral inducement;
2. A warranty is written in a contract; while a representation
may be written or oral;
3. A warranty is conclusively presumed to be material, while
a representation must be proven to be material by the
party claiming breach; and
4. A warranty must be strictly complied with, while a
representation must be substantially true.
Please note that express contract warranties are different from
implied warranties under the Uniform Commercial Code (UCC).
A party may disavow implied warranties under the UCC
through a written contract.

Modification
Often with contracts that require an extended period for
performance, modification becomes a concern. What happens
if prices or deadlines need to be altered? Does that require a
new contract or can the existing contract be modified? Good
contracts often include a procedure for how to modify a
contract. This may be as informal as writing changes directly
on the original contract with the parties’ initials and date. Or it
could be through a formal addendum procedure.
Regardless of the chosen procedure, it is a best practice for
businesses to discuss modification procedures when entering

207 | Writing Contracts

into a contract. If the procedure is clear, less friction occurs
when a party seeks modification.

Assignment and Delegation
In general, parties are free to assign and delegate their rights
and duties under a contract. Parties can limit those rights or
they can request notice if an assignment or delegation occurs.
This is a provision that is often not needed unless a party has a
concern about assignment, such as in the insurance industry.

Alternative Dispute Resolution
As discussed in Chapter 4, many businesses want to reduce
their risk of litigation by participating in alternative dispute
resolution (ADR). Mandatory arbitration clauses are common
in consumer and employment contracts. Before including an
ADR provision in a contract, parties should be fully comfortable
with the option that they choose. If a party agrees to mediation
or arbitration, a court will enforce that choice even if the parties
change their mind.

Choice of Law and Forum
Choice of law provisions determine which state’s laws will be
used to interpret the contract. Choice of forum provisions
determine the state in which any litigation will take place.
This provision is often unnecessary for contracts involving
individuals and entities in the same state. If the parties do not
select that state law or location for litigation, the courts look to:

Writing Contracts | 208

1. Where the contract was signed;
2. Where the contract is performed;
3. Where the parties are residents; and
4. The court’s jurisdictional rules.

Integration
An integration clause is a provision stating that the contract
represents the parties’ complete and final agreement and
supersedes all informal understandings and oral agreements
relating to the subject matter of the contract. In other words, it
is the agreement.
The purpose of an integration clause is to prevent the parties
from later claiming that they agreed to additional or different
terms than what the contract states. This means that any
statements made before the parties signed the contract are
not part of the contract and they will not be used to interpret
the meaning of the contract.

Severability
A severability clause is a provision that keeps the remaining
provisions of a contract in force if any portion of the contract
is declared unenforceable by the court. It is also known as a
savings clause because it “saves” the whole contract from
being declared unenforceable.
For example, if a non-compete clause in an employment
contract is declared unenforceable by a court, then the rest of
the employment contract remains in effect.

209 | Writing Contracts

Exculpatory Clause
An exculpatory clause is a provision relieving a party from any
liability resulting from a negligent or wrongful act. They are
often employed when the risk of injury exists. Exculpatory
clauses cannot limit liability when a party acts with gross
negligence, commits an intentional tort, or when public policy
or state laws prohibit them. Exculpatory clauses have been
struck down by courts in some cases where parties to a
contract have greatly unequal bargaining power, especially
when the party with greater power acts unethically or with
gross negligence.

Force Majeure
A force majeure clause is a provision allocating risk to a certain
party if performance becomes impossible as a result of an
event that the parties could not have anticipated or controlled.
Force majeure events are big, disruptive events such as natural
disasters, war, terrorist attacks, and fires.
For example, if the subject matter of an international sales
contract is destroyed by a hurricane, does the buyer or seller
lose the money in the sale?

Attorney Fees
Business contracts often have an attorney fees clause that
entitles a party successful in litigation over the contract to be
reimbursed its attorney fees. This clause often has the effect of
limiting frivolous lawsuits because it becomes more expensive

Writing Contracts | 210

for parties to litigate weaker claims. It may also give leverage to
a winning party to prevent or end appeals of a court judgment.
Courts will usually enforce an attorney fees provision in a
contract. However, courts review attorney fee awards for
reasonableness. Therefore, the amount of fees usually must be
deemed reasonable by a court or arbitrator before a party can
collect under a contract.

12.3 Common Mistakes
Four of the most common mistakes when writing a contract
are not understanding the content, vagueness, ambiguity, and
typographical errors.

Not Understanding the Content
One common mistake is using free online resources without
ensuring that they are appropriate for the circumstances. Just
because it sounds official, a document generated by a
computer algorithm may not be helpful. Better to read the
contract and ensure that it accurately reflects the parties’
agreement.
Courts presume that parties have read a contract before
signing it. Any mistakes in drafting go against the party who
wrote the contract. In other words, if the contract is unclear,
the party who did not write it gets the benefit of the doubt.
The idea is that the party who wrote it should have done a
better job, and the party who read and signed it should not be
penalized as a result of someone else’s error. When writing a
contract, better to keep it simple and clear.

211 | Writing Contracts

It is also important to exclude provisions that are irrelevant to
the contract. Contracts that are too long and contain irrelevant
and contradictory terms are hard to understand. The best
contracts are used as a reference between the parties during
the period of performance. If a contract is too broad, too
confusing, or contains too much irrelevant information, it
hinders the effectiveness of the document.

Vagueness
In the context of contracts, vagueness means the language is
imprecise, uncertain, and not clearly expressed. Vagueness is
problematic because it could mean that the parties did not
have a meeting of the minds because they were not talking
about the same things.
Some business people think that keeping the contract
“general” will facilitate a business transaction and that the
details can be worked out later. However, if the parties are not
in agreement up front, it is uncommon that things will work
out smoothly later.
Another risk with vagueness is that it is not clear how a court
will interpret the contract. If there are two or more reasonable
interpretations, it is possible that the court will decide another
interpretation is more reasonable. Again, mistakes in drafting
are held against the drafter so if a court concludes that the
vague term was a mistake, then it is hard to win in litigation.

Ambiguity
In contracts, ambiguity means an uncertainty of meaning or
intention. Ambiguities can be either patent or latent. A patent

Writing Contracts | 212

ambiguity is where the language of the contract itself creates
uncertainty because it is contradictory. For example, a contract
states two different sale prices.
A latent ambiguity exists where the uncertainty arises during
the performance of the contract. For example, the contract
states that goods will ship via a carrier that has a common
name and could be referring to different carriers.

Typographical Errors
Typographical errors are common in contracts. Some are
harmless, some are embarrassing, and others are harmful.
Although some typos are easy to ignore because they do not
carry legal consequences, some can be fatal to the agreement.
Minor errors are called scrivener’s errors. The scrivener’s error
doctrine permits typographical errors in a written contract to
be corrected when clear and convincing evidence exists that
the mistake does not reflect the intent of the parties.
However, errors related to dates, price, quantity, legal names
of individuals and entities, and property descriptions (such as
addresses and lot numbers) may not qualify as scrivener’s
errors. Such errors may be fatal to the contract or may be
enforced with adverse consequences against one of the
parties.

12.4 Tips for Writing a Contract
Regardless of the purpose of the contract, some tips for writing
good contracts include:

213 | Writing Contracts

Naming the Parties
Be sure to use the correct name of the business entity or
individual who is a party to the contract. This may seem
obvious, but people often write the name of a representative of
the entity rather than the legal name of the entity.
For sole proprietorships, it is appropriate to identify the party
as Ling Chen doing business as Chen Bookkeeping. If the
business is a Limited Liability Company (LLC), identifying an
individual in the contract by name may remove any personal
liability protection that a LLC provides. Similar issues may arise
with a partnership if each individual is identified as a party to
the contract.
Except for sole proprietors who do not have a separate business
name, use the business entity’s name and not a personal name
as a party to the contract. Otherwise, parties may lose the
benefit of limited liability. There may also be tax consequences.

Define the Scope of the Work
Clearly define the scope of work or service being provided, and
the proposed timeline to complete the work. Be specific. For
example, instead of a broad “renovate the kitchen,” provide
details of the cabinet designs, counter tops, and other
materials and work to be provided.
If applicable, a time frame for each phase of the project is
useful, along with procedures to follow if there are delays. This
is especially helpful when delays occur as a result of a supply
shortage or a third party. Breach of contract may not always
be the fault of the parties. Having procedures in place in the

Writing Contracts | 214

case of delay often saves business relationships when things go
wrong.

Specify Time and Amounts of Payments
Entering an hourly rate and projected time for completion, or
the total amount of payment for a project, may be insufficient.
Depending on the nature of the goods or services, the contract
should include:
• Who is paying whom;
• How much is being paid;
• The method of payment (such as check, cashier’s check or
bank transfer);
• Any portion of fees to be paid upfront;
• Any fees to be paid at project milestones;
• Payment for work completed if contract is canceled;
• Any late fees; and
• Hourly/per diem rate for time due to delays caused by the
other party.

Termination Clause
Few contracts go on forever, so including an end date for the
agreement or procedures for a party to cancel the contract are
helpful. For example, parties often want to end the agreement
if the other party fails to pay or misses too many important
deadlines.
Termination procedures should be as specific as possible and
include how much notice needs to be given, the type of notice
required, and whether there is a time period where the other
party may cure the deficiency.
215 | Writing Contracts

Termination clauses should anticipate termination by all
parties and address the parties’ rights based on which party
requests termination and why.

Sign and Date the Contract
The signature block should name the business entity, then
under the signature, the name and title of the person signing.
Figure 12.1 Signature Block Example

For example, Ahmad’s Construction, LLC By: __________ Khalid
Ahmad, President
Each person signing the contract should date it next to his or
her signature.
For partnerships, only general partners can sign a contract on

Writing Contracts | 216

the partnership’s behalf. For corporations, the president or
chief executive officer is presumed to have authority to sign.
For an organization or association, a board president would
have authority, but it may require a vote of the governing board
to approve the contract.

Minor Changes
Minor changes can be made directly to the contract. Both
parties need to initial and date beside the changes to show
that both parties agree to the change.
This is common when people buy property and the amount
held in escrow changes (usually based on interest accrued)
from the time the contract was prepared to the time it was
signed.

Legal Terms
Courts interpret legal terms to have their legal meaning,
regardless of the parties’ intent. Avoid using legal terminology
unless all parties fully understand the legal definition and how
it will be applied by the court. Again, simple and clear language
is more effective than confusing legal jargon.

Allow for Flexibility
Contracts are usually the result of negotiation and the majority
of them never end up in court. Contracts cannot cover every
possible future situation but serve as a working document for
the parties’ business relationship. When writing contracts, it is

217 | Writing Contracts

best to think of them as an agreement between parties that
need some flexibility for the transaction(s) to take place. Life is
dynamic and the best contracts give structure without being
too rigid.

12.5 Concluding Thoughts
Writing valid contracts is an essential skill to be successful in
business. Most contracts are not written by attorneys but they
are critical to capturing an agreement between parties.
Successful business people see contracts not just as a way to
protect their interests, but also as a document that governs
their business relationships with others. A well-written contract
can be used throughout a transaction to guide the parties in
their interactions and responsibilities.

Writing Contracts | 218

13. Employment Law
13.1 Introduction
LEARNING OBJECTIVES
1. Understand the principle of employment at will and the
exceptions to the doctrine.
2. Learn important employment laws that affect businesses
across industries.
3. Examine the laws that govern the relationship between
employers and employees who belong to a union.
Until the early Twentieth Century, there were not many laws
that regulated the employer-employee relationship. The belief
was that the free market system would ensure that employers
treat employees fairly or else they would not be able to attract
and keep good workers. However, the reality of the Industrial
Revolution

proved

that

the

traditional

employment

relationship favored the interests of the employers at the
expense of workers, including children. As a result, Congress
and state legislatures started passing employment and labor
laws to protect the interests of employees. Today, employment
law is a very robust area of the law that impacts businesses
across industries.

Counselor’s Corner As working remotely is the
norm now for many employees who formerly went

219 | Employment Law

in to work each day, debates have arisen regarding
where employees are more productive—at home or
back at the office? According to data gathered by
various sources, most workers are more productive
at home, including both those who enjoy and prefer
this arrangement, and those who’d rather be in the
office. According to data gathered by
RescueTime, remote workers had a 4% increase in
average daily time spent on their core work and an
18% decrease in time spent on communication,
compared with employees in the office. Translated,
working from home for many means spending
more time on meaningful work and less time on
communication, all without the commute. The
latest Census data indicates that the average
commute for Americans is 27 minutes each way, so
almost an hour a day roundtrip. These data raise
interesting questions about what the workplace will
look like when it is safe for most workers to return to
the office. ~Denise K., attorney

13.2 Employment At Will
In general, employees are free to quit a job at any time for any
reason, with or without notice. Similarly, employers are free to
end a worker’s employment at any time for any reason, with or
without notice. This principle is called employment at will. This
doctrine is based on the concept that employment is a form
of an implied contractual relationship. Therefore, as long as
both parties want to continue their contract to work together,
Employment Law | 220

the law presumes they will. When one party does not want to
continue, then they may end their working relationship.
There are five major exceptions to the employment at will
doctrine:
1. Contract;
2. Good cause;
3. Discrimination against an employee based on
membership in a protected class;
4. Violation of public policy; and
5. Whistleblowing.
Figure 13.1 Exceptions to the Employment at Will Doctrine

221 | Employment Law

Contract
Employers and employees may modify the employment at will
doctrine through contract. In addition to formal, written
employment

contracts,

courts

have

also

enforced

oral

promises made during the hiring process. Promises made to
job applicants are generally enforceable, even when the
promises are not approved by the employer’s executives or
upper management. Therefore, it is important when hiring
employees that companies do not make promises that can
be reasonably interpreted to be guaranteed employment or
employment for a certain period of time.
Employee handbooks also may create implied contracts that
modify the employment at will doctrine. Often handbooks
state that the company follows a progressive discipline policy
and that employees may only be fired for “just cause” or after
receiving warnings, notice, hearing, or other procedures.
Policies such as this create an implied contract that require
businesses to follow the progressive discipline policy before
terminating a worker’s employment, in absence of good cause.

Good Cause
The definition of “good cause” for terminating the employment
of a worker varies from state to state. And businesses often
define “good cause” in their policies. However, most states
recognize the following as good cause to fire an employee
without going through progressive discipline first:
• Theft;
• Fraud;
• Damage to company property;
• Being under the influence of illegal drugs or alcohol at
Employment Law | 222

work;
• Fighting;
• Threats against other employees or customers;
• Domestic violence;
• Having weapons on premises;
• Unethical behavior; and
• Willful or malicious misbehavior.
Poor performance also constitutes good cause for firing an
employee. Employers need to be careful, however, to
document

the

performance

issues

and

to

engage

in

progressive discipline when appropriate. If an employee has
not been counseled that their performance is unsatisfactory,
then the employee is more likely to bring a charge of wrongful
discharge against the employer. Courts are more likely to rule
that poor performance constitutes good cause when an
employee has notice of the performance issue(s) and has a
reasonable opportunity to fix them.

Discrimination Against a Protected Class
Member
Anti-discrimination laws make it illegal to take adverse actions
against a member of a protected class based on their
membership in the class. A protected class is a group of people
who are protected by laws that prohibit discrimination based
on a personal characteristic, such as race, color, religion,
gender, national origin, age or disability.
As discussed in Chapter 14, adverse actions include failure to
hire, failure to promote, demotion, and termination of
employment. That is not to say that someone who is a member
of a protected class may never be fired. Rather, it is illegal to

223 | Employment Law

fire them because of their race, color, religion, gender, national
origin, age or disability.

Violation of Public Policy
The public policy exception occurs when an employee is fired
for:
• Refusing to perform an action that violates a law or public
policy; or
• For exercising a legal right or advancing a public policy.
In other words, an employee can’t be fired for refusing to do
something illegal or doing something legal that the employer
does not want done. For example, an employee cannot be fired
for not falsifying reports, for refusing to testify falsely in court,
for filing a workers’ compensation claim, or for serving on a jury.

Whistleblowing
A whistleblower is an employee who reports the employer’s
illegal behavior to a governmental or law enforcement agency.
Many different laws have whistleblower provisions that
encourage people who have knowledge of illegal activity to
report it without fear of retribution or losing their jobs.
Whistleblower protections apply to good faith reports of
wrongdoing, even if it turns out that the activity is not illegal.
However, whistleblower protection does not usually protect
employees who make reports that they either know, or should
have known, do not include illegal activity.

Employment Law | 224

13.3 Common Employment Law Torts
Employees may assert various tort claims against their
employers. Tort claims are often decided on the basis of
generalized duties of care rather than specific types of conduct
prohibited by law. Tort claims vary state to state but most states
recognize the following claims between employers and
employees:
• Negligent hiring, retention, and supervision;
• Negligent investigation;
• Negligent infliction of emotional distress;
• Intentional infliction of emotional distress (also called
outrageous conduct);
• Tortious interference with contract and/or prospective
business advantage;
• Defamation (libel and slander);
• Invasion of privacy; and
• Fraud.
Torts are discussed in more detail in Chapter 9. However, it is
important for businesses to understand that they owe their
employees and managers a duty of care. If they violate that
duty, then they may be subject to legal liability.

13.4 Wage and Hour Laws
The Fair Labor Standards Act (FLSA) is a federal law that was
passed in 1938 that nationalized standards for pay, record
keeping and child labor for businesses with two or more
employees that engage in interstate commerce. The FLSA
prohibits “oppressive child labor,” which means that children

225 | Employment Law

under fourteen cannot work unless it is a family business,
babysitting, newspaper delivery, entertainment, or agriculture.
Fourteen and fifteen year olds are permitted to work limited
hours after school in nonhazardous jobs, such as retail and
restaurants. Sixteen and seventeen year olds may work
unlimited hours in nonhazardous jobs.
Figure 13.2 FLSA Facts

The FLSA also provides for a national minimum wage and a
standard forty hour work week. Under the FLSA, an employee
who works more than forty hours is entitled to overtime pay.
However, the Act provides exemptions to the overtime
requirement. Employees who earn more than a certain
amount and perform specific types of work are not entitled to
overtime pay.
Exempt Categories to Overtime Pay under the FLSA
•
•
•
•
•

Executive
Administrative
Professional
Outside sales
Computer workers

Employment Law | 226

Figure 13.3 Overtime under the FLSA

The Department of Labor (DOL) is charged with enforcing the
FLSA and other federal wage and hour laws. As a general rule,
federal wage and hour laws do not preempt state and local
laws. Therefore, employers must comply with federal, state, and
local laws regarding employees’ wages. Many state and local
governments have set a higher minimum wage than is

227 | Employment Law

required federally. Therefore, businesses must ensure that they
comply with all wage and hour laws applicable to them.

13.5 Family Medical Leave Act
The Family Medical Leave Act of 1993 (FMLA) is a federal law
that guarantees employees up to twelve weeks of unpaid leave
each year for childbirth, adoption, or a serious health condition
of their own or their immediate family member. Under the
FMLA, a qualifying family member is a spouse, child, or parent.
Siblings, grandchildren, and in-laws are not usually qualifying
family members. The FMLA applies to businesses with at least
fifty workers that engage in interstate commerce.
Figure 13.4 FMLA

An employee must work for the company for at least one year
before being eligible to take leave under the FMLA. The Act
requires that employees who take leave be allowed to return to
the same or equivalent job with the same pay and benefits.
What constitutes a “serious health condition” is a heavily
litigated issue. In general, a serious health condition requires

Employment Law | 228

continued treatment by a health provider and results in at least
three days of incapacitation. Sometimes this aligns with
recognized disabilities but it does not always. Also, a condition
such as migraines may incapacitate people to varying degrees.
To avoid legal liability, businesses should request appropriate
documentation from medical providers rather than relying on
a subjective determination of what constitutes serious health
conditions.

13.6 Occupational Safety and Health
Act
In a heavily industrialized society, workplace safety is a major
concern. To that end, Congress passed the Occupational Safety
and Health Act (OSHA) in 1970. The Act requires employers to
provide a workplace that is free from recognized hazards likely
to cause death or serious physical harm to employees.
Employers must comply with specific health and safety
standards for their industry. For example, standards for
restaurants differ from standards for health care providers or
those for the mining industry. Employers must also keep
records of all workplace injuries and accidents, and under some
circumstances

must

automatically

report

them

to

the

government. Employees may also report violations.
The Occupational Safety and Health Administration (also
known as OSHA) is an agency within the Department of Labor
that is responsible for enforcing the Act. The Agency may
inspect workplaces to ensure they are safe and impose fines for
violations of the Act. The Act also provides for criminal penalties
when the violations are willful.
Figure 13.5 Common OSHA Violations
229 | Employment Law

States and local governments also have a variety of health and
safety laws and regulations. Therefore, businesses must ensure
that they comply with all laws applicable to them.

13.7 Employee Retirement Income
Security Act
In 1974, Congress passed the Employee Retirement Income
Security Act (ERISA) to regulate employer-sponsored pension
plans. ERISA requires employers disclose a large amount of
information regarding the funding and vesting of pension
plans. This Act was in response to fraudulent handling of
pension plans that deprived employees of savings at the time
of their retirement.
ERISA also applies to employer-sponsored medical, disability,
and welfare benefit programs. Although the Act does not
require employers to provide these types of benefits to their
employees, if employers choose to do so, ERISA regulates what
types of information employees are entitled to, along with their
enforcement rights under the plans.

Employment Law | 230

Figure 13.6 ERISA Areas of Regulation

13.8 Workers’ Compensation Laws
Workers’ compensation laws provide payment to employees
for injuries incurred at work. In essence, workers’ compensation
is a type of no-fault insurance system that every state has. The
intent of these laws is to provide quick and efficient delivery
of disability and medical benefits to injured workers at a
reasonable cost to employers.
Figure 13.7 Workers’ Compensation

231 | Employment Law

Workers’ compensation is the exclusive remedy for injury
claims. In other words, if an employee makes a workers’
compensation claim, he or she may not sue the employer for
his or her injury. The amounts provided for medical expenses
and lost wages are often lower than an employee may receive
in a successful lawsuit. However, the employee benefits from
receiving payment upfront and does not have to risk the
uncertain outcome of a lawsuit or pay attorney fees associated
with litigation.
There are two exceptions to the exclusive remedy doctrine:
1. Intentional actions resulting in harm; and
2. Product liability claims against a manufacturer of a
defective product.
State law varies with respect to types of workers who are
excluded from coverage, as well as types and amount of
compensation. All states cover medical costs, rehabilitation
costs, and lost wages and benefits as a result of the injury.
In general, an employee may recover workers’ compensation
benefits when:
1. The employer has complied with the state’s legal
Employment Law | 232

requirements;
2. The employee was acting in the course of his or her
employment when injured;
3. The injury was proximately caused by his or her
employment (i.e. the injury was not caused by off work
activities); and
4. The employee did not intentionally injure himself or
herself.
An employer may not retaliate against an employee who files a
workers’ compensation claim.

13.9 Unemployment Compensation
Every

state

provides

an

unemployment

compensation

insurance program that is funded by a tax paid by employers.
To draw from the program, an employee must:
• Have worked for the employer for a certain amount of
time;
• Not have quit without good cause;
• Not have been fired for egregious behavior;
• Be capable of work; and
• Actively look for a new job.
Unemployment compensation is meant to help workers who
are subject to lay offs and reductions in force while they look
for new employment. It is generally not available to employees
who voluntarily leave a job and want to continue receiving
income from their former employer.
States have different formulas for calculating unemployment
compensation, but in general benefits are a percentage of past
earnings and are available for a limited period of time.
233 | Employment Law

13.10 Labor Relations
Labor law affects the working relationship of employees who
are represented by a union in their workplace. A union is an
organization formed to negotiate with employers, on behalf
of workers collectively, about job-related issues such as salary,
benefits, hours, and working conditions. Labor law essentially
creates a framework for employers, employees, and unions to
create a contract unique to that business for the purpose of
regulating

the

employment

relationship

and

resolving

disputes.

National Labor Relations Act
The first unions in the United States were formed after the Civil
War and began to flourish during the Industrial Revolution.
In 1935, Congress enacted the National Labor Relations Act
(NLRA) to provide workers three important rights:
1. The right to organize;
2. The right to collectively bargain; and
3. The right to strike.
The NLRA also prohibits employers and unions from engaging
in unfair labor practices. Unfair labor practices by employers
include:
• Interfering with protected employee rights, such as the
right to self-organize;
• Discriminating against employees for union-related
activities;
• Retaliating against employees who invoke their labor
rights;

Employment Law | 234

• Refusing to engage in collective bargaining;
• Interfering with the administration of a union; and
• Discouraging employees from forming or joining a union.
Unfair labor practices by unions include:
• Causing an employer to discriminate against an employee
who is not a union member;
• Engaging in an illegal strike or boycott;
• Requiring an employer to hire more employees than
necessary (called featherbedding);
• Coordinating a secondary boycott (an action against a
third party who deals with the employer but has no direct
contact with the union);
• Refusing to engage in collective bargaining; and
• Charging excessive dues.
Most states also have laws that make it illegal for an employer
to mandate union membership as a condition of employment.
The NLRA also states that supervisors are not employees and
do not have a right to join a union. Supervisors are individuals
with the authority to make independent decisions on hiring,
firing, disciplining, or promoting other employees.
Under the NLRA, a validly recognized union is the exclusive
representative of the employees. This means that the union
represents all the employees, even if a particular worker is not
a member of the union or has not paid dues. The employer
may not bargain directly either with employees or with another
organization representing the employees.
Unions have a duty of fair representation, which requires
unions to treat all members fairly, impartially, and in good faith.
A union may not favor some members over others and may not

235 | Employment Law

discriminate against members based on their membership in
a protected class, such as race or gender.

Organizing a Union
A union trying to represent employees follows these steps:
Union organizers try to persuade employees to
form a union. An employer may not restrict
organizing discussions unless they interfere
with business operations. An employer may
present anti-union views but may not use
threats or rewards to defeat a union drive.

1.

Campaign

2.

Union organizers ask employees to sign
Authorization
authorization cards stating that they want the
Cards
union to represent them.

3.

Petition

If a union obtains authorization cards from 30%
of the workforce, it may petition the NLRB for
an election.

4. Election

If more than 50% of the employees vote for the
union, the NLRB designates it as the exclusive
representative of the employees.

Figure 13.8 Process of Union Organizing

Employment Law | 236

237 | Employment Law

Collective Bargaining
Once a union is formed, the employer and union must
negotiate to create a new employment contract that regulates
employment

conditions

called

a

collective

bargaining

agreement (CBA). The bargaining unit is a group of employees
authorized to engage in collective bargaining on behalf of all of
the employees of a company or an industry sector.
The NLRA allows the parties to bargain almost any subject
they wish but it requires them to bargain wages, hours, and
other terms and conditions of employment. Conditions of
employment include:
• Benefits;
• Retirement benefits;
• Order of layoffs and recalls;
• Production quotas;
• Work rules, such as safety practices; and
• Onsite food service and prices.
The parties are not required to reach an agreement but they
are required to bargain in good faith. In other words, they must
meet with open minds and make a reasonable effort to reach a
contract.

Concerted Activity
Concerted activity is an action by employees concerning
wages or working conditions. It is action taken by members
of a union to gain a bargaining advantage. Concerted activity
is protected by the NLRA and cannot be used as a basis for
disciplining or discharging an employee.

Employment Law | 238

The most common forms of concerted activity are strikes and
picketing. A strike is an organized cessation or slowdown of
work by employees to compel the employer to meet the
employees’ demands. The NLRA protects the employees’ right
to strike when:
• The parties are unable to reach a CBA;
• The employer engages in an unfair labor practice; or
• The employer is considering sending work elsewhere.
However, a strike is illegal when:
• The union does not provide the employer with sixty days
notice (when issue is modifying or terminating a CBA);
• The union represents public employees;
• The union engages in a sit-down strike, in which
employees stop working but physically block replacement
workers from taking their places; and
• The union engages in partial strikes, in which employees
strike intermittently to disrupt operations but prevent the
employer from hiring replacement workers.
When unions go on strike, employers have the right to hire
replacement workers to keep the business operating. If the
union engages in an economic strike to obtain increased
wages and benefits, the employer may hire permanent
replacement workers. When an economic strike ends, the
employer is under no obligation to lay off replacement workers
to allow strikers to return to work. However, if and when the
employer hires additional employees, it may not discriminate
against the employees who went on strike. If the union
engages in an unfair labor practices strike to protest an
employer’s unfair labor practice, union members are entitled to
their jobs after the strike ends.
Picketing is the demonstration by one or more employees
239 | Employment Law

outside a business to protest its activities or policies and to
pressure it to meet the protesters’ demands. The power of
picketing is to publicize a labor dispute and influence the
public to withhold business from the employer. Picketing is
usually lawful, as long as the picketers do not prevent other
employees, replacement workers, or customers from entering
the business.
Employers have their own form of legal pressure on union
members called a lockout. A lockout occurs when an employer
closes a business or prevents workers from entering the
premises and earning their paychecks because of a labor
dispute. By withholding work and wages, the employer tries to
pressure the union to bargain less aggressively. Most lockouts
are legal.

Grievance Procedure
One of the main benefits to union members is that they are
able to participate in a grievance procedure when issues at
work exist. A grievance is a formal employee complaint about
a violation of a workplace policy or the collective bargaining
agreement between the union and employer.
Figure 13.9 Grievance Procedure

Employment Law | 240

The grievance procedure defines the rules and process for
documenting, presenting, and resolving workplace disputes.
The exact steps are usually defined in the collective bargaining
agreement. However, most grievance procedures start with a
discussion between the employee and his or her manager,
often with a union representative present. Issues often are
resolved informally at this step.
If the issue is not resolved, then the employee may write a
formal grievance, which is then sent to management. After
receiving a written grievance, management of the company
investigates and discusses how to address the issues contained
in the grievance. This process often involves the human
resource department, union representatives, and consultation
with legal counsel.
Management will then issue a written decision. If the union is
not satisfied with the company’s response, it may decide to
241 | Employment Law

refer the grievance to the national union. If the national union
decides to pursue the issue further, then arbitration before the
NLRB or a private arbitrator often occurs.

13.11 Concluding Thoughts
Employment and labor laws regulate the employer-employee
relationship. Although most laws are written to provide rights
to employees, the laws try to balance the need of employers
to run a profitable business with the right of employees to
fair treatment. While the law does not always strike the right
balance, it is helpful to understand that employers retain a
lot of control in their day-to-day business operations and in
establishing the business culture.

Employment Law | 242

14. Anti-Discrimination
Law
14.1 Introduction
LEARNING OBJECTIVES
1. Understand the primary federal anti-discrimination laws.
2. Learn the procedure for bringing and defending against
discrimination complaints.
3. Explore how businesses can protect themselves from
discrimination claims.
The Civil Rights Movement of the 1960s resulted in several
important federal laws that addressed discrimination. The first
was the Equal Pay Act of 1963, which requires equal pay for
equal work, regardless of the worker’s gender. Title VII of the
Civil Rights Act of 1964 is probably the most well-known of
the civil rights legislation. Title VII prohibits employment
discrimination on the basis of race, color, religion, gender and
national origin. Since the 1960s, more laws have been passed
to refine what constitutes discriminatory practices and expand
coverage to additional groups, such as people with disabilities.
Figure 14.1 Participants in the 1963 March on Washington

243 | Anti-Discrimination Law

It is important for businesses to know and comply with these
laws so they are not liable for discriminating against their
employees, customers, and members of the public. State and
local governments may pass laws that expand or provide
protections to additional groups but they cannot reduce
protections found in federal law.

Anti-Discrimination Law | 244

Type of
Discrimination

Federal Anti-Discrimination Laws

Race

Title VII of the Civil Rights Act of 1964

Color

Title VII of the Civil Rights Act of 1964

Religion

Title VII of the Civil Rights Act of 1964

National Origin

Title VII of the Civil Rights Act of 1964;
Immigration Reform and Control Act of 1986
Equal Pay Act of 1963;

Gender

Title VII of the Civil Rights Act of 1964;
Pregnancy Discrimination Act of 1978

Age

Age Discrimination in Employment Act of 1967
Americans with Disabilities Act of 1990;

Disability

Genetic
Information

Americans with Disabilities Amendments Act of
2008
Genetic Information Nondiscrimination Act of
2008

Counselor’s Corner We live in a multicultural society
and our anti-discrimination laws are intended to
address inequality in employment. While not
perfect, they have addressed the some of the most
blatant discriminatory practices. However, all
employers (even those who see themselves as
having “good intentions”) need to review their
practices to ensure that they are not perpetuating
systemic discrimination against protected classes of
people. Although this may seem like a backburner
issue to some employers, it will help protect them
from legal liability (which is costly) and send a
positive message to their employees about how

245 | Anti-Discrimination Law

they value them (which is invaluable). ~ LaTeesha S.,
attorney

14.2 The Equal Pay Act of 1963
The Equal Pay Act of 1963 seeks to eliminate the wage gap
between men and women. In 1963, women earned roughly
fifty-nine cents for every dollar men earned. In 2019, that
number increased to seventy-nine cents. The Equal Pay Act
requires employers to provide equal pay for equal work, and it
applies to all employers. All forms of compensation are covered
by

the

Act,

including

benefits

such

as

vacation

and

by

Gender

and

compensation such as salary and bonuses.
Figure

14.2

Median

Weekly

Earnings

Educational Level from US Department of Labor

Anti-Discrimination Law | 246

Victims do not need to file a complaint with the Equal
Employment Opportunity Commission (EEOC) but may file an
equal pay claim in federal court, as long as they do so within
two years after learning of the inequality in pay or benefits.
Victims typically also pursue Title VII claims at the same time
they pursue Equal Pay Act claims.
The Equal Pay Act is difficult to enforce. Since demanding
identical pay is virtually impossible due to differences in jobs
and job performance, courts have essentially interpreted the
law as requiring equal pay for substantially equal work. A
common problem occurs when women voluntarily leave the
workforce to raise children. This can result in a challenging
comparison between a woman’s experience for pay purposes
and her male counterparts, who may not have an interruption
in their careers.
247 | Anti-Discrimination Law

Figure 14.3 Participation Rates for Women Professionals from
Equal Employment Opportunity Commission

14.3 Title VII of the Civil Rights Act of
1964
The Civil Rights Act of 1964 has broad significance for all racial
minorities, religious organizations, and women. The bill has
several provisions, but the most important for businesses is
known widely as “Title VII.” It applies to employers with more
than fifteen employees. Its aim is to eliminate discrimination
on the basis of:
• Race;
• Color;
• Religion;
• Gender; and
• National origin.

Anti-Discrimination Law | 248

Discrimination on any of these bases is illegal. These acts may
be a refusal to hire, a failure to fully compensate, a failure for
opportunities for advancement, a demotion, a temporary
layoff, a termination of employment, or any other term or
condition of employment.
Figure 14.4 Employment Discrimination Claims Made to the
Equal Employment Opportunity Commission

Race and Color
Race discrimination involves treating someone unfavorably
because he or she is of a certain race or because of personal
characteristics associated with race, such as hair texture, skin
color, or certain facial features. Color discrimination involves
treating someone unfavorably because of skin color or
complexion.
Race and color discrimination also can involve treating
someone unfavorably because the person is married to, or
associated with, a person of a certain race or color. Race and
color discrimination can occur within the same racial group.

249 | Anti-Discrimination Law

Figure

14.5

Professionals

Participation
from

Rates

Equal

for

African

Employment

Americans
Opportunity

Commission

Religion
The prohibition against religious discrimination protects
anyone who has sincerely held religious or moral beliefs.
Therefore, Native American tribes are protected, as well as
major religions such as Buddhism, Christianity, Hinduism,
Islam, and Judaism. In general, employees cannot be required
to participate in religious activities as a condition of
employment, unless the place of employment is a church,
synagogue, mosque, or temple.
Employers must reasonably accommodate an employee’s
religious beliefs or practices as long as it does not cause an
undue hardship on the employer’s operation of its business.
Typically, this involves being flexible in schedule changes and
leaves for sabbath observance or religious holidays. Issues of
dress and appearance are often grounds for charges of
Anti-Discrimination Law | 250

religious discrimination. For example, if a Muslim woman wears
a hijab, or traditional headscarf, then she should be permitted
to do so unless it places an undue hardship on business
operations.

Gender
The

prohibition

on

gender

discrimination

means

that

employers cannot categorize certain jobs as single-sex only
unless a bona fide occupational qualification (BFOQ) applies.
Customer preferences or market realities are not the basis for
BFOQ. However, an example of a legitimate BFOQ is hiring
female security officers to monitor women’s changing areas for
loss prevention in retail stores.
Gender discrimination also includes making stereotypical
assumptions about women simply because they might be the
primary caregiver to children at home. If there are two equally
qualified job applicants, for example, and both have young
children at home, it would be illegal to give preference to the
male candidate over the female candidate. Once a female
employee has children, it would be illegal to assume that she is
less committed to her job, or would like to work fewer hours. It’s
important to note that these protections extend to men as well.
If an employer voluntarily provides time off to new mothers, for
example, it must extend identical benefits to new fathers.
Figure 14.6 Pew Research Center Results Regarding Gender
Discrimination at Work

251 | Anti-Discrimination Law

In 2019, unmarried childless women earned 95 percent of what
men did, while married mothers earned 75 percent (averaging
to 79 percent as discussed above). This discrepancy has led
to an increase in family responsibility discrimination claims
under Title VII. This includes claims that mothers are given less-

Anti-Discrimination Law | 252

appealing assignments than fathers based on misconceptions
about being less qualified or lacking commitment to the job.
The Pregnancy Discrimination Act of 1978 amended Title VII
to make it illegal to discriminate on the basis of pregnancy,
childbirth, or related medical conditions. This means employers
cannot refuse to hire a woman because she is pregnant or is
considering becoming pregnant, or because of prejudices held
by coworkers or customers about pregnant women. A female
worker who becomes pregnant is entitled to work as long as
she can perform her tasks, and her job must be held open for
her while she is on maternity leave. Furthermore, pregnancyrelated benefits cannot be limited only to married employees.
Gender discrimination can also take the form of workplace
sexual harassment. Courts have generally recognized two
forms of sexual harassment. The first, known as quid pro quo,
involves asking for sexual favors in return for job opportunities
or advancement. Courts reason that if a male worker asks a
female worker for sex in return for favorable treatment, it is
because that worker is female, and therefore a Title VII violation
has occurred. If a supervisor fires a subordinate for breaking up
with him or her, then quid pro quo harassment has taken place.
The second is hostile work environment, which is discussed in
more detail below.

National Origin
Discrimination on the basis of national origin involves treating
workers unfavorably because of where they are from (specific
nation or region) or ethnicity. It is illegal to discriminate against
a worker because of his or her foreign accent unless it seriously
interferes with work performance. Workplace “English-only”

253 | Anti-Discrimination Law

rules are also illegal unless they are required for the job being
performed.
The protected class of national origin means that it is illegal to
discriminate against noncitizens. Therefore, employers should
not ask job applicants about their nation of origin. Instead,
they are permitted to ask whether the applicant is authorized
to work in the US. If they applicant answers “yes,” then the
employer cannot ask for evidence of authorization until the
applicant is hired and completes the Employment Eligibility
Verification (I-9) Form.
Title

VII

creates

only

five

protected

classes.

Other

characteristics, such as obesity, attractiveness, and political
affiliation, are not protected classes. Note too that Title VII does
not prohibit all discrimination. Employers are free to consider
factors such as experience, business acumen, personality, and
even seniority, as long as those factors are related to the job
in question. Title VII requires employers to treat employees
equally, but not identically.

Prohibited Activities
There are four types of illegal activities under Title VII:
1. Disparate Treatment;
2. Disparate Impact;
3. Hostile Work Environment; and
4. Retaliation.
To prove a disparate treatment case, a plaintiff must show that
he or she was treated differently because of his or her race,
color, religion, gender or national origin. In other words,
disparate treatment is intentional discrimination. Winning a
disparate treatment case is hard because it is unusual for a
Anti-Discrimination Law | 254

defendant to say explicitly that his or her intention is
discriminatory. Evidence of discriminatory intent is often
inferred through someone’s conduct. For example, a hiring
manager refuses to hire women because he does not want
to deal with maternity leave requests would be evidence of
disparate treatment.
Disparate impact, on the other hand, applies when a rule or
policy is not discriminatory on its face but negatively impacts
a protected group when it is applied. In other words, disparate
impact is unintentional discrimination. Business policies that
raise suspicions of disparate impact include educational
qualifications, written tests, intelligence or aptitude tests,
height and weight requirements, credit checks, and subjective
procedures such as interviews. Businesses that have these
sorts of policies need to be very careful that the policies are
directly related to, and necessary for, the job function under
consideration.
Figure 14.7 Disparate Impact Cartoon

255 | Anti-Discrimination Law

Proving a disparate impact case is not easy for victims of
discrimination. It is not enough for the employee to use
statistics alone to show a policy or practice has a disparate
impact on the victim’s protected class. Victims must show that
they were harmed from the discriminatory practice.
Employers also violate Title VII if they have a hostile work
environment towards people in a protected category that
affects their ability to work. These cases often involve
allegations where a company or employees try to get a
member of a protected group to quit through name calling,
undesirable work assignments, slurs, and threats. Employers
are liable for hostile work environment claims if the victim
suffered a “tangible employment action” such as a demotion,
undesirable reassignment, or termination of employment.
Even if the victim did not suffer a tangible employment action,
an employer may be liable unless it can prove (1) it used
reasonable care to prevent and correct the inappropriate
behavior, and (2) the victim unreasonably failed to take
advantage of the company’s complaint procedures.
Hostile work environment claims often involve allegations of
constructive discharge. Constructive discharge occurs when
an employer makes the employee’s working conditions so
intolerable that a reasonable employee would feel compelled
to

quit.

Constructive

discharge

claims

recognize

that

employees should not be forced to stay in situations that risk
their physical, mental, and emotional safety.
Title VII also prohibits acts of retaliation against anyone who
complains

about,

or

participates

in,

any

employment

discrimination complaint. Employers need to be very careful
about this provision, because while the employer may be
innocent of the first charge of discrimination, taking any
subsequent action after an employee has complained can be
a separate charge of discrimination. Once an employee has

Anti-Discrimination Law | 256

made a complaint of discrimination, it is very important that
the employer not alter any condition of his or her employment
until the complaint has been resolved. Similarly, if a witness
takes part in an investigation or hearing of another employee’s
complaint, the witness could also bring charges of retaliation.

Bona Fide Occupational Qualification
The law does, however, allow discrimination on the basis of
religion,

gender,

and

national

origin

if

a bona

fide

occupational qualification (BFOQ) reasonably necessary for
normal business operations exists. For example, a Jewish
synagogue may restrict hiring of rabbis to Jewish people only,
and a Catholic church can restrict hiring priests to Catholic
men only. Since BFOQ discrimination extends to national
origin, a producer casting for a role that specifically calls for a
Filipino actor can legally restrict hiring to Filipinos only.
Managers

should

be

very

careful

in

applying

BFOQ

discrimination. It is an exception that is very much based on
individual cases and subject to strict interpretation. The BFOQ
must be directly related to an essential job function to be “bona
fide.” Customer preference is not a basis for BFOQ. For
example, airlines cannot refuse to hire men even if surveys
show customers prefer female flight attendants.

257 | Anti-Discrimination Law

14.4 Enforcement of Title VII
Equal Employment Opportunity
Commission
The Civil Rights Act of 1964 is a federal law, but it does not give
victims of discrimination the immediate right to file a federal
lawsuit. Instead, the Act created a federal agency, the Equal
Employment Opportunity Commission (EEOC) to enforce civil
rights in the workplace. The EEOC publishes guidelines to
assist businesses in deciding what employment practices are
lawful. The EEOC also investigates complaints filed by workers
who believe they are victims of unlawful discrimination. If the
EEOC believes that unlawful discrimination has taken place,
the EEOC can file charges against the employer.
Employees must file a Title VII charge with the EEOC before
going to court. If the EEOC investigates and decides not to
pursue the case any further, the EEOC will issue a “right to
sue” letter. With that letter, the employee can then file a case
in federal court within 90 days of the date of the letter. Any
EEOC complaint must be filed within 180 days of the alleged
discriminatory act taking place. If employees wait beyond 180
days, their claims will be dismissed.
In 2009, the Lilly Ledbetter Fair Pay Act clarified that
discriminatory pay decisions occur every time unequal
compensation is paid and the statute of limitations begins
again on the date of each unequal paycheck. Therefore,
plaintiffs have 180 days from the time they receive a
discriminatory paycheck to file a complaint with the EEOC.
The EEOC has the authority to award several remedies to
victims of discrimination. These include the award of back pay

Anti-Discrimination Law | 258

for any lost wages, the issuance of an injunction to stop the
employer

from

continuing

any

acts

or

policies

of

discrimination, ordering a terminated or demoted employee
reinstated to his or her prior position, and the award of
compensatory damages for out-of-pocket costs resulting from
the discrimination as well as emotional harm. In cases of severe
or reckless discrimination, punitive damages are also available.

EEOC Procedure
After receiving the charge, the EEOC will investigate the
allegations. If there is sufficient proof of discrimination, the
EEOC may (1) help the parties reach a settlement; (2) impose
sanctions; or (3) prosecute the case in federal court. The EEOC’s
investigative and enforcement powers are broad.
When filing a complaint, the plaintiff must show a prima facie
case of discrimination. This means that “on first look,” the
plaintiff has evidence that the defendant discriminated against
him or her based on membership in a protected class. The
plaintiff is not required to prove discrimination at this stage.
Instead, the plaintiff must show only a presumption that
discrimination occurred.
The defendant then files a response and may present evidence
that its decision was based on a legitimate, non-discriminatory
reason or business necessity. For example, an employee was
fired for poor performance rather than membership in a
protected class.
After the defendant presents its case, the plaintiff must show
that the defendant’s reason is pretext. In other words, the
reason the defendant gave was a “cover” for discrimination.
In disparate impact cases, the plaintiff may show that less
discriminatory rules would achieve the same result.
259 | Anti-Discrimination Law

The case is investigated and decided by the EEOC hearing
officer. The officer will issue either a finding on the charge or a
notice of the right to sue, after which an employee has 180 days
to file a discrimination complaint in federal court.
Figure 14.8 Burden of Proof in Equal Employment Opportunity
Commission Charges

Affirmative Action
To correct past mistakes in treatment of women and minorities,
many

businesses

employers

by

go

beyond

adopting

being

equal

opportunity

affirmative

action

programs.

Businesses are not legally required to undertake affirmative
action programs, but many do. Businesses may voluntarily
undertake affirmative action programs, as long as those
programs are meant to correct an imbalance in the workforce,

Anti-Discrimination Law | 260

are temporary, and do not unnecessarily infringe on the rights
of non-beneficiaries.
Affirmative action plans can be tricky to administer because
Caucasian Americans can also be the victims of race
discrimination, which is often called reverse discrimination.
The provisions of Title VII are meant to protect all individuals
from race discrimination.
The EEOC will take into consideration if a defendant’s actions
are part of an affirmative action program. However, businesses
may still be liable for discrimination even if they adopt an
affirmative action program. Therefore, businesses should be
careful that they are not adopting a program that results in
disparate impact claims from other protected groups.

14.5 The Age Discrimination in
Employment Act of 1967
The Age Discrimination in Employment Act of 1967 (ADEA)
makes it illegal to discriminate against workers over the age
of forty. It does not protect younger workers so an employer
may favor an older worker over a younger worker. The ADEA
applies to any employer with over twenty workers, including
state governments. The ADEA prohibits employers from
treating any covered person unfavorably in any term or
condition of employment, including the hiring decision. It is
illegal, for example, to hire an inexperienced twenty-five-yearold for a job when a fifty-year-old is better qualified and willing
to work under the same conditions. Mandatory retirement age
is illegal under the ADEA, except for very high-level executives
over the age of sixty-five who are entitled to a pension.
Employers may discriminate against older workers if there is
261 | Anti-Discrimination Law

a bona fide occupational qualification such as a production
company casting for a young actor to play a young character,
or airlines setting a mandatory retirement age for pilots.
Of course, older workers can still be dismissed for good cause,
such as poor job performance or employee misconduct.
Companies may also administer a layoff plan or early
retirement plan that is evenly applied across all workers, and
can offer early retirement incentives to induce workers to retire.
In 2005, the Supreme Court held that the disparate impact
theory can apply to age discrimination cases. For example, an
employer

cannot

require

office

workers

to

undertake

strenuous physical tests if those tests are not related to the job
being performed and would have a disparate impact on older
workers.

14.6 The Americans with Disabilities
Act of 1990
The Americans with Disabilities Act of 1990 (ADA) and the
Americans with Disabilities Amendments Act of 2008 (ADAA)
expand the promise of equal opportunity in the workplace to
cover persons with disabilities. It is illegal for employers with
fifteen or more employees to discriminate against “qualified
individuals with disabilities.”
The ADA only applies to the qualified disabled. To be qualified,
the individual must meet the legitimate skill, experience,
education, or other requirements for the position he or she is
seeking and be able to perform the “essential functions” of the
job without reasonable accommodation. In other words, the
first step an employer must take is to define what the essential
functions of the job are, and then see if a disabled individual
Anti-Discrimination Law | 262

who has applied for the job meets the requirements for the job
and can perform those essential functions. Obviously, someone
who is legally blind will not be permitted to be a bus driver or
airline pilot under this test.
On the other hand, the “essential functions” test means that
employers must be very careful in denying employment to
someone

who

is

disabled.

If

the

reason

for

denying

employment is the disabled person’s inability to perform some
incidental task (rather than an essential function), then that
is illegal discrimination. The ADA also permits employers to
exclude any disabled individual who poses a direct threat to
the health or safety to the individual or of others, if the risk of
substantial harm cannot be reduced below the level of “direct
threat” through reasonable accommodation.
The ADA makes it illegal for an employer to require a job
applicant take a medical exam before an employment offer is
made. However, after a job offer has been made, applicants can
be asked to take medical and drug exams. Tests for illegal use
of drugs, any time during employment, are permitted under
the ADA.
One of the hardest challenges is defining who is disabled. The
ADA states that an individual is disabled if he or she has a
“physical or mental impairment that substantially limits one or
more major life activities,” has a record of such impairment, or
is regarded as having such an impairment. Major life activities
include seeing, hearing, speaking, walking, running, breathing,
learning, and caring for oneself.
Consider a person being actively treated for cancer. During
the treatment, many major life activities may be substantially
limited, so the person is disabled. However, if a major life
activity is not limited but the person loses his or her hair as a
result of chemotherapy, he or she may be “regarded” as having
an impairment, which makes him or her disabled under the
263 | Anti-Discrimination Law

ADA. An employer who purposefully refuses to hire a qualified
job applicant with no hair because the employer believes the
applicant has cancer (regardless of whether the cancer is active
or in remission) is therefore violating the ADA. Finally, if the
cancer patient recovers fully and has no physical sign of cancer,
that patient is still considered protected by the ADA because
he has a “record” of a qualifying disability.
Employers must provide reasonable accommodations to any
disabled worker who asks for it. A reasonable accommodation
is any change or adjustment to the work environment that
would allow the disabled worker to perform the essential
functions of the job or to allow the disabled worker to enjoy
the benefits and privileges of employment equal to employees
without

disabilities.

Reasonable

accommodation

might

include allowing the worker to work part-time; reassigning the
worker to a vacant position; purchasing special equipment or
software; providing e-readers; or making an exception to an
employment policy. Employers do not have to undertake
reasonable accommodation if doing so would cause them
undue hardship, meaning it would require significant difficulty
or expense, or significantly alter the nature or operation of
the business. Among factors to be considered in whether an
accommodation would pose an undue hardship are the cost
of the accommodation as well as the employer’s size and
financial resources.

Anti-Discrimination Law | 264

Figure 14.9 Americans with Disability Act Decision Tree

14.7 Genetic Information
Nondiscrimination Act of 2008
In

2008,

Congress

passed

265 | Anti-Discrimination Law

the

Genetic

Information

Nondiscrimination Act (GINA) to protect individuals from
adverse decisions based on their genetics. Under GINA,
employers may not require genetic testing, or use information
about genetics (including family medical history) as a factor in
hiring, promoting, demoting, or firing employees. This includes
if an employee is a caretaker for someone with a genetic
disorder. Health insurers cannot use genetic information when
making coverage and premium decisions. Finally, an employer
wellness program cannot require participants to answer
questions about their family medical history.

14.8 Concluding Thoughts
Anti-discrimination laws are important for businesses to
understand and follow. State and local laws may expand
protections and identify more protected classes. Therefore, it
is important for businesses to research all levels of antidiscrimination laws that apply to them to ensure they are not
liable for discrimination against their employees, customers,
and members of the public.
The 1964 Civil Rights Act is an important law that affects most
employers in the United States. Originally created to ensure the
integration of African Americans into mainstream society, the
law prohibits discrimination on the basis of race, color, religion,
gender, and national origin. Some forms of discrimination on
the basis of religion, gender, or national origin are permitted
if a bona fide occupational qualification exists. The Equal
Employment Opportunity Commission (EEOC) investigates
charges of illegal workplace discrimination. These charges
must be filed by workers within 180 days of the alleged
discriminatory act occuring.
The EEOC’s investigation and enforcement powers are broad.
Anti-Discrimination Law | 266

Both parties have an opportunity to present evidence and
argue their case to the EEOC. Filing a charge with the EEOC is
required before filing a lawsuit alleging violations of Title VII in
federal court.
The Americans with Disabilities Act prohibits employment
discrimination against the qualified disabled and prohibits preemployment medical testing. To be considered disabled, an
individual must demonstrate a mental or physical impairment
that substantially limits a major life activity. Disabled persons
are entitled to reasonable accommodation in the workplace, as
long as reasonable accommodation does not place any undue
hardship on the employer.

267 | Anti-Discrimination Law

15. Agency
15.1 Introduction
LEARNING OBJECTIVES
1. Know the basic principles of an agency relationship.
2. Identify the different duties principals and agents owe
each other.
3. Understand the consequences of legal liability for
principals regarding an agent’s actions.
Fundamentally, the principles of agency hold individuals and
businesses liable for the acts of others. For example, if an
employee uses a racial slur against a customer, the business
is liable for that employee’s discriminatory act. Likewise, if an
agent signs a contract in the name of a business, that business
may be bound by the terms of the contract.
Agents cannot give themselves power without the express or
implied authority of the principal. Once an agency relationship
is formed, agents and principals owe each other certain duties.
This ensures fair dealings between them and gives third parties
some assurance regarding their rights.

Counselor’s Corner Agency is not a sexy area of the
law. Most people don’t give much thought about it.
But I often see cases in my courtroom where people
and businesses are liable for the acts of their agents.

Agency | 268

It doesn’t matter if you didn’t know the person was
legally your agent. You are still responsible for their
actions under the law. While there is no way to
prevent all mistakes and bad behavior of others, the
best way you can insulate yourself from liability of
an agent is to surround yourself with people who
have integrity. If your grandmother wouldn’t
approve of them, then you shouldn’t work with
them. ~Christopher W., judge

15.2 The Agency Relationship
An agency relationship is created when one person or entity
agrees to perform a task for, and under the direction of,
another individual or entity. An agent is the person who is
authorized to act for or in place of another. A principal is the
person who authorizes another to act on his, her, or its behalf
as an agent.
Agency is a fiduciary relationship created by express contract
or implied actions, in which the agent has the authority to act
on behalf of the principal and legally bind the principal to third
parties.
A fiduciary relationship is a relationship in which one person
is under a duty to act for the benefit of the other on matters
within the scope of the relationship. Fiduciary relationships
require trust, good faith, and acting in the best interest of the
other. In fiduciary relationships, the law requires the fiduciary
to act with the highest duty of care. This means that the
fiduciary must put the interests of the other party before their
269 | Agency

own. Examples of fiduciary relationships include doctorpatient, attorney-client, accountant-client, trustee-beneficiary,
and guardian-child. An agent is also a fiduciary of a principal.

Types of Principals
There are three types of principals, which are described from
the perspective of a third party: disclosed, partially disclosed,
and undisclosed.
A disclosed principal is a principal whose identity is revealed
by the agent to a third party. These are the most common
types of principals. For example, employees work for a
disclosed principal when they are on the employer’s premise,
wear a name badge or uniform identifying the employer, or
answer the phone by identifying the employer’s name.
A partially disclosed principal is a principal whose existence,
but not actual identity, is revealed by the agent to a third party.
In other words, a third party knows that the agent represents
a principal but does not know the identity of the principal.
For example, a realtor in Aspen may represent celebrities and
wealthy individuals who want to purchase property but do not
want the paparazzi to publicize the information.
An undisclosed principal is a principal whose identity is kept
secret by the agent. Often third parties do not realize that an
agency relationship exists and believe that the agent is
working on his or her own behalf. Undisclosed principals occur
when the identity of the principal can lead to increased
purchase prices, unwanted publicity, and security concerns.

Agency | 270

Types of Agents
An agent is someone who is authorized to act on behalf of a
principal. Because there is a variety of authority that a principal
can grant an agent, there are many different types of agents.
In general, agents are described as either general or
special. General agents have the authority to transact all the
principal’s business of a particular kind or in a particular place.
General agents often include partners, managers, factors and
brokers. Special agents, in contrast, only have the authority
to conduct a particular transaction or to perform a specific
act. Special agents often include realtors, athlete’s agents, and
employment recruiters.
Some of the most common business agents include:
Agent

Description

Broker

Receives a commission to make contracts with third
parties on behalf of a principal

Business
agent

Has general power involving the exercise of
judgment and discretion, such as a manager or
officer

Factor

Receives and sells goods or property for a
commission

Forwarding
agent

Receives and ships goods for a principal

Independent
contractor

Exercises independent judgment on the means
used to accomplish the result demanded by
principal

Local agent

Acts as a representative to transact business within
a specified area

Ordinary
agent

Acts under the direction and control of the
principal, such as an employee

Process
agent

Authorized to accept legal service of process on
behalf of the principal

Registered
agent

Authorized to accept legal service of process for a
corporation in a particular jurisdiction

271 | Agency

Types of Authority
Authority is the right or permission to act legally on another’s
behalf.

In

general,

apparent. Actual
authority, occurs

authority

authority,
when

a

can

be

either

sometimes

principal

actual

called

intentionally

or
real

confers

authority on an agent. Actual authority can be either express
or implied. Express authority is authority given by an express
agreement, either orally or in writing. Implied authority is
authority granted to the agent as a result of the principal’s
conduct.
Figure 15.1 Types of Authority

Apparent authority is authority that a third party reasonably
believes an agent has, based on the third party’s dealings with
the principal. If a principal’s words or actions lead others to
believe that he or she gave authority to someone else, then the
principal is held accountable even if no authority was actually

Agency | 272

given to the agent. For example, if a principal fails to give notice
that an agent is no longer working for the principal, the agent
may still bind the principal through apparent authority when
dealing with third parties.
To constitute apparent authority, three elements must be met:
1. The principal’s words or actions lead others to believe the
agent has authority;
2. A third party reasonably relies on the principal’s words or
actions; and
3. The third party is injured.
Sometimes an agent acts without authority. If a disclosed
principal likes what an agent does, even if done without
authority at the time, the principal can still benefit from the
agent’s actions. Ratification occurs when a disclosed principal
adopts or confirms a contract entered into on his or her behalf
by an agent who did not have authority to act. Unlike apparent
authority, the third party does not have to be injured. Rather,
ratification allows principals to enter into contracts for their
benefit. Ratification is an “all or nothing” doctrine that prevents
principals from ratifying only part of the contract or
renegotiating its terms.

15.3 Duties of Agents and Principals
Because they are in a fiduciary relationship, agents and
principals owe each other specific duties. While the duties are
similar in nature, there are differences based on their roles.

273 | Agency

Duties of Agents
Figure 15.2 Duties of Agents

Agents are fiduciaries of principals and so they are required
to act with the highest duty of care. In particular, agents owe
principals the following duties:

Agency | 274

Duty

Description

Account

Agent must keep proper records to account for all
principal’s money and property given to agent

Care

Agent must act reasonably, in good faith, and
avoid negligence at all times

Inform

Agent must inform principal of all material facts
that affect principal’s interests

Loyalty

Agent cannot engage in any dealings that
compete or interfere with the principal’s business
or interests

Obedience

Agent must obey all principal’s instructions
within scope of agency unless they are illegal or
unethical

Protect
confidential
information

Agent cannot use or disclose principal’s
confidential information

If an agent breaches a duty owed to the principal, the principal
has three available remedies:
1. The principal may recover damages the breach has
caused;
2. The principal may receive any profit the agent received as
a result of a breach of the duty of loyalty; and
3. The principal may rescind a transaction when the duty of
loyalty is violated.

Duties of Principals
Principals also owe duties to agents as part of the fiduciary
relationship. These duties are:

275 | Agency

Duty

Description

Compensation

Principal must pay agent for work performed

Honesty

Principals cannot deceive agents about the
nature and scope of the work they are to
perform

Indemnification

Principal must hold agent harmless and free
from legal liability for actions properly taken on
principal’s behalf

Loyalty

Principal cannot engage in any dealings that
prevent agent from performing agency tasks

Reimbursement

Principal must reimburse agent for money
reasonably expended on behalf of principal

Figure 15.3 Duties of Principals

If a principal breaches a duty owed to the agent, the agent has
two available remedies:
1. The agent may recover damages the breach has caused;
and
2. The agent may terminate the agency relationship.

Agency | 276

15.4 Liability to Third Parties
An agency relationship affects liability to third parties. The
scope of liability depends on the type of principal involved, the
type of authority involved, and the nature of the dispute.

Contractual Liability
A principal is always liable on a contract if the the agent had
authority. However, the agent’s liability on a contract depends
on how much the third party knows about the principal.
Disclosure, when allowed by the principal, is the agent’s best
protection against legal liability.
Figure 15.4 When Agents are Liable on Contracts

277 | Agency

An agent is not liable for any contracts he or she makes with
authority on behalf of a fully disclosed principal. Therefore, if a
third party knows the existence and identity of the principal,
then all legal liability lies with the principal. The only exception
to this is when an agent exceeds his or her authority. In that
case, the agent has not acted with authority and becomes
personally responsible to the third party. If the agent did not
have authority, but the principal later ratifies the contract, then
the principal will be liable for the contract.
If a principal is partially disclosed, then the third party may
recover from either the principal or agent. In this situation,
the principal and agent are jointly and severally liable, and the
third party may sue either or both of them to recover the full
amount of damages owed. However, the third party cannot
seek “double damages” and recover more than the total
amount owed for the contractual breach.
In the event of an undisclosed principal, a third party may
recover from either the agent or the principal. The fact that
a principal’s existence or identity is hidden from third parties
does not change the nature of the agent-principal relationship.
Therefore, undisclosed principals may become liable for
contracts entered into by agents acting with actual authority.
An undisclosed principal has no liability to an agent or third
party when the agent exceeds the actual authority granted
by the principal. In addition, the type of contract must be the
type that can be assigned to the undisclosed principal. If the
contract is for personal services, then liability cannot be
assigned to the principal in case of a breach.

Tort Liability
Agents,

employees,

and

independent

contractors

are

Agency | 278

personally liable for their own torts. This concept is rooted in
the notion that every individual who commits a tort is
personally liable to the party who is damaged by the tortious
act. The law holds wrongdoers personally accountable.
However, the reverse is not true. Agents, employees, and
independent contractors are not liable for the torts of the
principal or employer. If a principal or employer is engaged
in tortious behavior, its liability cannot be passed down to its
agents and employees.
Figure 15.5 When Principals Have Tort Liability for Employees
and Independent Contractors

An employer is liable for the torts of an employee if the
employee is acting within the scope of employment. This
doctrine is called respondeat superior and imposes vicarious
liability on employers as a matter of public policy. Even if the
employer does not direct its employees to act negligently or
intentionally, the employer is responsible because employers

279 | Agency

are usually in a better position to pay for damages than
employees. There is also a strong public policy consideration
to not allow employers to turn a blind eye to an employee’s
bad behavior. By making an employer responsible for an
employee’s actions, it incentivizes the employer to address
situations promptly that could lead to potential liability.
Conversely, a principal is not usually liable for the torts of an
independent contractor. Independent contractors have the
power to control the details of the work they perform and
generally are only responsible to a principal for the results of
their work. Therefore, independent contractors are not directed
and controlled by a principal as employees are by their
employers. As a result, the doctrine of respondeat superior
does not apply to independent contractors.
Two exceptions exist that may impose liability on a principal for
the work of an independent contractor. The first exception is
where the work is inherently dangerous. Public policy prevents
principals from insulating themselves from the risks of liability
by selecting an independent contractor rather than an
employee to perform the dangerous work. The second
exception is where the work is illegal. Public policy also
prevents principals from hiring independent contractors to
perform a task that is illegal.

15.5 Termination of Agency
Relationship
Agents and principals may end their agency relationship in
various ways. The most common way is through mutual
agreement. As a matter of contract, principals and agents may
decide to end their relationship. For example, an employee

Agency | 280

may decide to quit his or her job, or the agency agreement may
only be for a set period of time or for a specific transaction.
In addition, there are some events that will terminate an
agency relationship as a matter of law. Death of a principal or
agent automatically terminates the agency agreement, even if
the other party is unaware of the death. Once the time of death
is established, any transactions afterward are deemed void.
Similar to death, mental incapacity of a principal or agent
terminates an agency relationship. It is often hard to determine
the precise time someone loses mental capacity. Therefore,
courts often hold that an agent’s contract with a third party is
binding on the principal unless the third party was aware of the
principal’s incapacity.
Bankruptcy terminates an agency relationship when the
bankruptcy

affects

the

subject

matter

of

the

agency

agreement. For example, if a principal declares bankruptcy and
the real property that an agent is authorized to sell is part of
the bankruptcy estate, then the bankruptcy will automatically
terminate the agency relationship.
Finally, the destruction or illegality of the subject matter will
terminate the agency relationship. For example, if Congress
passes a law making it illegal for private parties to sell specific
types of weapons, the agency relationship between a gun
dealer

and

its

factor

for

selling

those

weapons

will

automatically end.

15.6 Concluding Thoughts
Agency relationships are flexible and varied depending on the
needs and interest of the principals and agents. Because the
agency relationship is fiduciary in nature, agents and principals
281 | Agency

owe each other certain duties. Third parties may hold principals
legally liable for the actions of their agents. Therefore, it is
important for businesses to select their agents carefully to
minimize their risk of liability.

Agency | 282

16. Business
Organizations
16.1 Introduction
LEARNING OBJECTIVES
1. Know the available entity choices when forming a
business.
2. Identify the factors that determine entity selection.
3. Understand common business entities and their
advantages and disadvantages.
At its most fundamental level, a business exists to make a profit
for its owners. Some businesses make things in factories
(manufacturers), other businesses sell things that other
businesses make (retailers), and still other businesses exist to
help both the makers and sellers make and sell better
(business consultants). Some businesses don’t make things at
all, and instead profit by selling their services or by lending
money.
With this diversity, it’s not surprising that there is no “one size
fits all” approach to choosing a business organization. When
choosing what form of entity is best, several factors are
important to consider:
1. How much it costs to create the entity and how hard it is
to create.
2. How easy it is for the business to continue if the founder

283 | Business Organizations

dies or retires.
3. How difficult it is to raise money to grow or expand the
business.
4. What type of managerial control they wish to keep on the
business, and whether they are willing to cede control to
outsiders.
5. If expanding ownership to members of the public is
desired.
6. How to minimize the taxes paid on earnings and income.
7. How to protect personal assets from claims, a feature
known as limited liability.
Depending on the type of business and its goals, different
business entities may be appropriate.

Counselor’s Corner Selection of business entities is
often the first step when going into business. Many
entrepreneurs and small businesses do not spend
enough time thinking about the legal and tax
consequences of the entity they choose. Ironically,
an important discussion to have at the beginning is
an exit strategy. What happens if one of the
business owners becomes ill, dies, or wants to leave
the business? What if the economic situation
changes and the business no longer is profitable?
Discussing exit strategies up front helps people
make the best decisions when crises happen. Don’t
avoid hard conversations up front. It may be
uncomfortable but will save a lot of problems down
the road. ~Allison W., attorney

Business Organizations | 284

16.2 Sole Proprietorship
A sole proprietorship is an unincorporated business owned
by one person or married couple. The legal name for a sole
proprietorship is usually the owner’s name.
There are many advantages to doing business as a sole
proprietor. First, it’s easy to create a sole proprietorship. In
effect, no creation costs or time is required because there is
nothing to create. The entrepreneur in charge of the business
simply starts doing business, charging money, and providing
goods or services.
Another key advantage to sole proprietorship is autonomy. The
owner can decide how he or she wants to run the business. The
owner can set her own hours, grow as quickly or slowly as she
wants, and expand into new lines of businesses. That autonomy
also comes with total ownership of the business’s finances. All
the money that the owner takes in, even if it is in a separate
bank account, belongs to her, and she can do with that money
whatever she wants.
A sole proprietorship is a flow-through tax entity, which means
the business does not pay tax on its profits and does not file a
separate tax return. Instead, the owner pays personal income
tax on all business profits.
These

advantages

must

be

weighed

against

some

disadvantages. First, because a sole proprietorship can have
only one owner, it is impossible to bring in others to the
business. In addition, the business and the owner are identical
so it is impossible to pass on the business.
Raising working capital can be a problem for sole proprietors,
especially those early in their business ventures. Many
entrepreneurial ventures are built on great ideas but need

285 | Business Organizations

capital to flourish and develop. If the entrepreneur lacks
individual wealth, then he or she must seek those funds from
other sources. Outsiders can make a loan to the owner, or enter
into a profit-sharing contract with her, but there is no way for
him to own any part of the owner’s business. Traditionally, most
sole proprietors seek funding from banks. Banks approach
these loans just like any other personal loan to an individual,
such as a car loan or mortgage. Down payment requirements
may be high, and typically the banks require some form of
personal collateral to guarantee the loan, even though the loan
is to be used to grow the business.
Sole proprietors are personally liable for all the business’s debts
and obligations. Unlimited liability puts all the personal assets
of the sole proprietor at risk. Personal homes, automobiles,
bank accounts and retirement accounts—all are within reach
of creditors.
Advantages of Sole
Proprietorship

• Easy to create
• No formal documents or
governmental filings
required to start business
• No formation start up costs
• Autonomy
• Total control over finances
and management decisions

Disadvantages of Sole
Proprietorship
• Flow-through tax entity
(owner pays personal
income tax on all business
profits)
• Cannot bring someone else
into business
• Impossible to pass on the
business
• Hard to raise capital
• Unlimited liability

16.3 Partnerships
A partnership is an unincorporated association of two or more

Business Organizations | 286

co-owners who operate a business for profit. Each owner is
called a general partner.

General Partnerships
A general partnership is when all partners participate fully in
running the business and share equally in profits and losses,
even if the partners’ monetary contributions vary. No legal
documents are required to file with the government to form
a partnership. If two or more people do business together,
sharing management of the business, profits and losses, they
have a partnership.
If a partnership is formed formally, then the written agreement
is called the articles of partnership. The articles can set forth
anything the partners wish to include about how the
partnership will be run. Normally, all general partners have an
equal voice in management, but as a creation of contract, the
partners can modify this if they wish.
A general partnership is taxed just like a sole proprietorship.
A partnership is a flow-through tax entity, where the
partnership’s income “flows through” the business to the
partners, who then pay individual tax on the business income.
The partnership may file an information return, reporting total
income and losses for the partnership, and how those profits
and losses are allocated among the general partners. However,
an information return is usually not required.
General partnerships are also similar to sole proprietorships in
unlimited liability. Every partner in the partnership is jointly
and severally liable for the partnership’s debts and obligations.
This is a very unattractive feature of general partnerships. One
partner may be completely innocent of any wrongdoing and
still be liable for another partner’s malpractice or bad acts.
287 | Business Organizations

General partnerships are dissolved as easily as they are formed.
Since the central feature of a general partnership is an
agreement to share profits and losses, once that agreement
ends, the general partnership ends with it. In a general
partnership with more than two persons, the remaining
partners can reconstitute the partnership if they wish, without
the old partner. A common issue that arises in this situation is
how to value the withdrawing partner’s share of the business.
Articles of partnership therefore typically include a buy/sell
agreement, setting forth the agreement of the partners on
how to account for a withdrawing partner’s share, which the
remaining partners then agree to pay to the withdrawing
partner.

Management Duties
Partners have a fiduciary duty to the partnership. This means
that partners have a duty to act for the benefit of the
partnership. In particular:
• Partners have an obligation of good faith and fair dealing
with each other and the partnership.
• Partners are liable to the partnership for gross negligence
or intentional misconduct. Partners are not liable for
ordinary negligence.
• Partners cannot compete with the partnership.
• Partners cannot take opportunities away from the
partnership unless the other partners consent.
• Partners cannot engage in conflicts of interest.

Business Organizations | 288

Limited Partnerships
In most states, owners can form a limited partnership. A limited
partnership has both general partners and limited partners. As
a limited partner, the most he or she can lose is the amount
of his investment into the business, nothing more. Limited
partnerships have to be formed in compliance with state law,
and

limited

partners

are

generally

prohibited

from

participating in day-to-day management of the business. This
often occurs when someone invests money in the partnership
but is not interested in running the business.
Advantages of Partnerships

Disadvantages of Partnerships

• Easy to create
• No formal documents or
governmental filings
required to start business
• Flexibility in sharing
management decisions
• Allows for investment by
limited partners to raise
capital
• Easy to dissolve

• Flow-through tax entity
(owner pays personal
income tax on all business
profits)
• Unlimited liability
• May be hard to value
individual partner’s share of
business
• Dissolution occurs any time
a new partner is added or
old partner leaves

16.4 Franchises
A franchise is when a business grants to another the sole right
of engaging in a certain business or in a business using a
particular trademark in a certain area. Franchises are not a
separate form of business organization. Rather, they are a form
of contract between businesses. Most franchises involve
corporations or limited liability corporations, but they may
include sole proprietorships and partnerships.

289 | Business Organizations

The advantage of a franchise is that under a franchise
agreement, an entrepreneur can open and run a business
under

a

proven

business

model.

The

local

owner,

the franchisee, uses the franchisor’s trademark, intellectual
property, and business model under a license agreement. The
franchisee offers goods or services to the public and keeps
any income earned. In exchange for the right to sell goods or
services developed by the franchisor, the franchisee pays a fee
to the franchisor.
Franchises are common in some industries such as fast food
restaurants, hotels, and tax preparation services. Franchise
agreements are very detailed and often require the franchisee
to use specific vendors, ingredients, store layouts, colors, etc.
Franchises are also very popular with US businesses interested
in conducting business abroad. US businesses collect franchise
fees from owners in other nations who are responsible for
running the business abroad. This allows US companies to have
a presence in nations that may restrict business ownership by
foreigners because the businesses themselves are owned and
operated by locals.

16.5 Joint Venture
A joint venture is when two or more individuals or businesses
combine their efforts in a particular business enterprise and
agree to share the profits and losses jointly or in proportion
to their contributions. Unlike a partnership, which operates as
a general business for as long as the partners desire, a joint
venture is for a single transaction or a limited activity. The
businesses remain separate entities and they do not share
financial or confidential information unless they decide to.

Business Organizations | 290

Joint ventures automatically terminate at the conclusion of an
event or project.
Joint ventures are often formed to address a common need
or to reach a mutual goal. For example, Google and National
Aeronautics and Space Administration (NASA) developed
Google Earth as a joint venture. To do so, they shared resources
and information necessary to develop Google Earth but Google
did not become part of the government, nor did NASA share
any confidential information or intellectual property more than
necessary.
Joint ventures are also common to share the costs of major
research or infrastructure projects within an industry. This
occurs frequently when industries are impacted by advances
in technology. For example, BMW and Toyota created a joint
venture to research hydrogen fuel cells, electric vehicles, and
ultra-lightweight materials needed in next generation vehicles.
By sharing the cost of research and development, the
companies are able to be on the forefront of technological
advancements in their industry.
Franchises

• The right to use a trademark
by paying a fee to the
franchisor
• Contract isn’t separate from
the business
• Franchise either offers a
good or a service
• Mainly used in conducting
business abroad

291 | Business Organizations

Joint Ventures
• Share a mutual goal/cost/
losses
• Combines efforts in a single
transaction or a limited
activity
• Agreement becomes
terminated at the end of the
event or project
• Financial and confidential
information is not shared

16.6 Corporations
Unlike a sole proprietorship or general partnership, a
corporation is a legal entity separate and distinct from its
owners. It can be created for a limited duration, or it can have
a perpetual existence. Since it is a separate legal entity, a
corporation has continuity regardless of its owners. Similarly,
in a publicly traded company, the identity of shareholders can
change, but the corporation continues its business operations
without being affected.
Corporations must be formed in compliance with the law of
the state law where they are incorporated. Most corporations
incorporate where their principal place of business is located,
but not all do. Many companies choose to incorporate in
Delaware. Delaware chancery courts have developed a
reputation for fairly and quickly applying a very well-developed
body of corporate law in Delaware. The courts also operate
without a jury, meaning that disputes heard in Delaware courts
are usually predictable and transparent, with well-written
opinions explaining how the judges decided the cases.
To start a corporation, the corporate founders must file articles
of incorporation with the Secretary of State where they are
incorporated. Articles of incorporation typically include:
• The name of the company;
• Whether the company is for-profit or nonprofit;
• The founders’ names;
• The company’s purpose;
• How many shares the corporation will issue initially; and
• The par value of any shares issued.
Unlike

sole

proprietorships,

corporations

can

be

quite

complicated to manage and often require attorneys and

Business Organizations | 292

accountants to maintain corporate books in good order. In
addition to the foundation requirements, corporate law
requires ongoing annual maintenance of corporations. In
addition to filing fees due at the time of incorporation, there
are typically annual license fees, franchise fees and taxes, and
fees related to maintaining minute books, corporate seals,
stock certificates and registries, as well as out-of-state
registration. A domestic corporation is entitled to operate in
its state of incorporation but must register as a foreign
corporation to do business in other states.

Corporate Legal Structure
Owners of corporations are called shareholders. Corporations
can have as few as one shareholder or as many as millions
of shareholders, and those shareholders can hold as few as
one share or as many as millions of shares. In a closely held
corporation, the number of shareholders tends to be small,
while

in

a

publicly

traded

corporation,

the

body

of

shareholders tends to be large.
In a publicly traded corporation, the value of a share is
determined by the laws of supply and demand, with various
markets or exchanges providing trading space for buyers and
sellers of certain shares to be traded. Shareholders own shares
in the company but have no legal right to the company’s
assets. As a separate legal entity, the corporation owns any
property in its name.
Shareholders of a corporation enjoy limited liability. The most
they can lose is the amount of their investment. Shareholders’
personal assets are not available to the corporation’s creditors.
Shareholders can be individuals or other business entities, such
as partnerships or corporations. If one corporation owns all the
293 | Business Organizations

stock of another corporation, the owner is said to be a parent
company, while the company being owned is a wholly owned
subsidiary. Often large corporations form subsidiaries for
specific purposes so that the parent company has limited
liability or advantageous tax treatment. For example, large
companies may form subsidiaries to hold real property so that
premises liability is limited to that real estate subsidiary only,
shielding the parent company and its assets from lawsuits.
Companies that deal in a lot of intellectual property may form
subsidiaries to hold their intellectual property, which is then
licensed back to the parent company so that the parent
company can deduct royalty payments for those licenses from
its taxes. This type of sophisticated liability and tax planning
makes the corporate form very attractive for larger businesses
in the United States.
An exception to the rule of limited liability arises in certain
cases involving closely held corporations. Many sole proprietors
incorporate their businesses to gain limited liability but fail to
realize when they do so that they are creating a separate legal
entity that must be respected as such. If sole proprietors fail to
respect the legal corporation with an arm’s length transaction,
then creditors can ask a court to pierce the corporate veil. If
a court agrees, then limited liability disappears and those
creditors can reach the shareholder’s personal assets.

Rights of Shareholders
Not all shareholders in a corporation are necessarily equal. US
corporate law allows for the creation of different types, or
classes, of shareholders. Shareholders in different classes may
be given preferential treatment when it comes to corporate
actions such as paying dividends or voting at shareholder
meetings.

Business Organizations | 294

Shareholder rights are generally outlined in a company’s
articles of incorporation or bylaws. Some of these rights may
include the right to obtain a dividend, but only if the board of
directors approves one. They also include the right to attend
shareholder meetings, the right to examine the company’s
financial records, and the right to a portion of liquidated
company assets.
Under most state laws, shareholders are also given a unique
right to sue a third party on behalf of the corporation. This
is called a shareholder derivative lawsuit. In essence, a
shareholder alleges that the people who are ordinarily charged
with acting in the corporation’s best interests (the officers and
directors) are failing to do so, and therefore the shareholder
must step in to protect the corporation.
One of the most important functions for shareholders is to
elect the board of directors of a corporation. Only shareholders
elect a director. The board is responsible for making major
decisions that affect a corporation, such as declaring and
paying a corporate dividend to shareholders; authorizing major
decisions;

appointing

and

removing

corporate

officers;

determining employee compensation, especially bonus and
incentive plans; and issuing new shares and corporate bonds.
One critical function for boards of directors is to appoint
corporate officers. These officers often hold titles such as chief
executive officer, chief operating officer, chief marketing
officer, and so on. Officers are involved in everyday decision
making for the company and implement the board’s decisions.
As officers of the company, they have legal authority to sign
contracts on behalf of the corporation, binding the corporation
to legal obligations. Officers are employees of the company
and work full-time for the company, but can be removed by the
board.

295 | Business Organizations

Corporate Taxation
Corporations

are

subject

to

double

taxation.

Because

corporations are separate legal entities, they must pay federal,
state, and local tax on net income. Then, if the board of
directors declares a dividend, shareholders are taxed on the
dividend that they receive in the form of a dividend tax.
One way for closely held corporations (such as small familyrun businesses) to avoid double taxation is to form an S
corporation. An S corporation (the name comes from the
applicable subsection of the tax law) can choose to be taxed
like a partnership or sole proprietorship. In other words, taxes
are only collected when a dividend is declared and not on
corporate net income. An S corporation is formed and treated
just like any other corporation; the only difference is in tax
treatment.
S

corporations

provide

the

limited

liability

feature

of

corporations but the single-level taxation benefits of sole
proprietorships. There are some important restrictions on S
corporations, however. They cannot have more than one
hundred shareholders, all of whom must be US citizens or
resident

aliens

and

cannot

include

partnerships

and

corporations. S corporations can have only one class of stock
and there are restrictions on how shares may be transferred.
Finally, all shareholders must agree that the company should
be an S corporation. These restrictions ensure that “S” tax
treatment is reserved only for small businesses.

Business Organizations | 296

Advantages of Corporations

Disadvantages of Corporations

• Separate legal entity from
owners
• Corporation unaffected by
change of ownership/
shareholders
• Limited liability for
shareholders
• Not subject to some laws
• Considered as an
“individual” with
Constitutional rights

• Formal documents required
to filed in state of
incorporation
• Can be complicated to
manage
• High formation and
maintenance costs
• Subject to double taxation
• Heavily regulated by
government

16.7 Limited Liability Entities
Limited Liability Companies
A limited liability company (LLC) is a “hybrid” form of business
organization

that

offer

the

limited

liability

feature

of

corporations but the tax benefits of partnerships. Owners of
LLCs are called members. Just like a sole proprietorship, it is
possible to create an LLC with only one member. LLC members
can be individuals or other LLCs, corporations, or partnerships.
LLC members can participate in day-to-day management of
the business.
Members are not personally liable for the debts of the business.
Like shareholders of a corporation, members of an LLC risk only
their financial investment in the company.
Taxation of LLCs is very flexible. Every year the LLC can choose
how it will be taxed. It may want to be taxed as a corporation,
for example, and pay corporate income tax on net income.
Or it may choose instead to have income “flow through” the

297 | Business Organizations

corporate form to the member-shareholders, who then pay
personal income tax just as in a partnership. Sophisticated tax
planning becomes possible with LLCs because tax treatment
can vary by year.
Figure 16.1 LLC Taxation

LLCs are formed by filing the articles of organization with the
state agency charged with chartering business entities,
typically the Secretary of State. Starting an LLC is often easier
than starting a corporation. Typical LLC statutes require only
the name of the LLC and the contact information for the LLC’s
legal agent. Unlike corporations, there is no requirement for an
LLC to issue stock certificates, maintain annual filings, elect a
board of directors, hold shareholder meetings, appoint officers,
or engage in any regular maintenance of the entity. Most states
require LLCs to have the letters “LLC” or words “Limited Liability
Company” in the official business name.
Although the articles of organization are all that is necessary to
start an LLC, it is advisable for the LLC members to enter into
a written LLC operating agreement. The operating agreement
typically sets forth how the business will be managed and
Business Organizations | 298

operated. It may also contain a buy/sell agreement just like
a partnership agreement. The operating agreement allows
members to run their LLCs any way they wish.
Since LLCs are a separate legal entity from their members,
members must take care to interact with LLCs at arm’s length,
because the risk of piercing the veil exists with LLCs as much
as it does with corporations. Fundraising for an LLC can be as
difficult as it is for a sole proprietorship, especially in the early
stages of an LLC’s business operations. Most lenders require
LLC members to personally guarantee any loans the LLC may
take out. Finally, LLCs are not the right form for taking a
company public and selling stock. Fortunately, it is not difficult
to convert an LLC into a corporation, so many start-up business
begin as LLCs and eventually convert into corporations prior to
their initial public offering (IPO).
Advantages of LLCs
• Limited liability for owners
• Flow-through tax entity so
not subject to double
taxation
• Easier to form and operate
than corporation or S
corporation
• Owners can deduct losses
for personal taxes

Disadvantages of LLCs

• Subject to state laws so
lacks consistency in
enforcement
• Laws not as developed as
corporate law & partnership
law

Limited Liability Partnerships
A related entity to the LLC is the limited liability partnership, or
LLP. Be careful not to confuse limited liability partnerships with
limited partnerships. LLPs are just like LLCs but are designed
for professionals who do business as partners. They allow the
partnership to pass through income for tax purposes, but

299 | Business Organizations

retain limited liability for all partners. LLPs are especially
popular with doctors, architects, accountants, and lawyers.
Most of the major accounting firms have now converted their
corporate forms into LLPs.

Professional Corporations
Professional Corporations (PCs) are mostly a legacy form of
organization. In other words, before LLCs and LLPs were an
option, PCs were the only option available to professionals who
wanted limited liability. Some states still require doctors,
lawyers, and accountants to organize as a PC.
If a member of a PC commits malpractice, the PC’s assets
are at risk along with the personal assets of the member who
committed malpractice. However, the personal assets of the
non-involved members are not at risk. PCs do not shield
individuals from their own malpractice but they offer limited
liability to innocent members.
PCs are a separate taxable entity but they are not flow-through
entities like partnerships. As a result, taxation of PCs is
complicated and a major drawback of this form of business
entity.

Business Organizations | 300

Type of
Business
Organization

Ease of
Funding
Formation

Personal
Liability for
Owners

Taxes

Ease of
Transferr
Ownersh

Sole
Very easy
Proprietorship

Same as
owner

Yes

Must sell
Flow-through entire
business

General
Partnership

Partners
contribute
capital

Yes

Flow-through Hard

Flow-through Hard

Easy

Limited
Partnership

Easy

Partners
contribute
capital

General
partner is
personally
liable;
limited
liability for
limited
partners

Corporations

Difficult

Sell stock to
raise capital

No

Subject to
double
taxation

Easy

S
Corporations

Difficult

Sell stock to
raise capital

No

Taxed only on
dividends

Transfer
restrictio

Limited
Liability
Companies
(LLCs)

Medium

Members
make capital No
contributions

301 | Business Organizations

Depends
Flow-through operating
agreeme

Limited
Liability
Partnerships
(LLPs)

Professional
Corporations

Difficult

Non-acting
partners
have
limited
liability;
Depends
Members
state law
the
make capital
Flow-through
varies
partnersh
contributions
regarding
agreeme
liability of
acting
partners vs.
partnership

Difficult

Members
make capital No
contributions

Complex tax
issues

16.8 Concluding Thoughts
Depending on a business’s type and goals, different business
entities may fit the needs of owners better than others. It is
important when starting a business to decide how to minimize
tax and liability exposure and to maximize profits. Because
there is no perfect “fit” for every business need, understanding
the advantages and disadvantages of the various business
entities is important.

Business Organizations | 302

Transfer
restricted
member
the same
professio

17. Partnerships
17.1 Introduction
LEARNING OBJECTIVES
1. Learn when a partnership exists.
2. Understand the rights and duties of partners.
3. Comprehend how a partnership is terminated and the
priority of distributing assets.
Partnerships are the most common business form in the
United States. Partnerships may be express or implied, and
they are the default business organization when two or more
people work together who are not legally married. People do
not need to call themselves partners for a partnership to exist,
so it is important for business professionals to understand what
constitutes a partnership so they do not inadvertently form a
business entity that they do not intend. And, if they do intend
to form a partnership, partners should understand their rights
and duties towards each other.

17.2 Types of Partnerships
A partnership is a voluntary association of two or more people
who jointly own and carry on a business for profit. Under the
Uniform Partnership Act, a partnership is presumed to exist if
the parties agree to share proportionally the business’s profits
or losses.

303 | Partnerships

There are only two required elements to form a partnership:
1. A common interest to conduct business together; and
2. An understanding to share profits and losses.
A general partnership is a partnership in which all partners
participate fully in running the business and share equally in
profits and losses, even if the partners’ monetary contributions
vary.
A limited partnership is composed of one or more people who
control the business and are personally liable for the
partnership’s debts. These partners are called general partners
and they have the power to make all types of business
decisions and manage all aspects of the partnership. A limited
partnership also has one or more people who contribute
capital and share profits but who cannot manage the business
and are liable only for the amount of their contribution. These
partners are called limited partners. The main purpose of a
limited partnership is to allow people to invest in a business
without having to manage the business, and without risking
more than the invested sum.
Partnerships may also have silent and secret partners. A silent
partner is a partner who shares in the profits, has no active
voice in management of the business, and whose existence
is not publicly disclosed. A secret partner is a partner whose
connection to the business is concealed from the public but
may participate in the management of the business. The
difference between a silent and secret partner relates to
whether the partner may make management decisions.
A partnership by estoppel is an equitable doctrine in which
a partnership is implied when one or more people represent
themselves as partners to a third party who relies on that
representation. A person who is deemed a partner by estoppel

Partnerships | 304

becomes liable for any credit extended to the partnership by
the third party.

Counselor’s Corner When a business is seeking to
innovate their operations, become more efficient,
introduce new products or seek competitive
advantages, corporate or business attorneys are
most effective if they are business partners from the
outset. Consulting with legal counsel early and often
allows the business to avoid legal pitfalls without
wasting valuable time and other resources by
making legal counsel a true business partner. So
often in business, the legal consulting occurs at the
end of the process but by forming the consulting
relationship early and often, it avoids being
blindsided by possible legal restrictions or
impediments and more importantly allows the
business to adjust and adapt to any legal
implications during the process.

~Rick T.,

attorney

17.3 Partnership Agreements
A written partnership agreement is not required to form a
partnership, but it is a best business practice. Given the variety
of different types of partnerships, it is understandable that no
formal requirements for a partnership agreement exist.
However, the following provisions are ones that should be
considered when writing a partnership agreement.

305 | Partnerships

• Name of partnership. Partnerships may choose almost
any name they would like. However, partnerships may not
use the word “company” or any other word that would
imply the business is a corporation. If partners choose a
name that does not include their names, the fictitious
name statement requires that they must give public
notice as to the identities of the partners.
• Purpose and duration. Is the partnership for a limited
time or for a specific purpose? Is it a joint venture between
businesses that grants partners only limited authority and
property rights? Is it a general partnership with the
flexibility to grow the business as the market allows?
• Capital contributions. Partners may contribute cash,
intellectual property rights, real and personal property,
and goodwill to the partnership. Capital contributions do
not include the partners’ business experience. An
individual may also become a partner without making a
capital contribution as long as the other partners agree to
it.
• Methods of sharing profits and losses. Without this
provision, the default rule is that each partner shares
equally in the profits and losses of the partnership. These
provisions often include any credit for capital
contributions partners may receive in the event of
dissolution.
• Effects of advances. If the partnership is short of cash and
a partner agrees to advance money to the partnership,
that cash advance could be considered either a personal
loan or a capital contribution to the partnership.
Determining in advance how that money will be spent,
repaid, and/or credited within the partnership helps
facilitate these types of transactions.
• Compensation. If general partners receive any salary or
additional compensation for their management of the
business, the terms of compensation should be clearly

Partnerships | 306

defined. In addition, the procedure for setting the amount
and type of compensation should also be addressed.
• Fiscal year and accounting methods. How a partnership
will handle accounting and tax liabilities are important to
clearly define, especially because partnerships are flowthrough tax entities.
• Property. Partnerships often use personal property of
partners as well as property of the business. The default
rule is that all property brought into the partnership or
acquired by it becomes partnership property. If a partner
does not want to lose property rights to the partnership or
its creditors, he or she should specify that it remains
personal property.
• Dispute resolution. If partners are unable to agree on how
to manage the business, how will the deadlock be
resolved? These provisions are especially helpful when
there are an even number of partners to avoid dissolution
when deadlock occurs.
• Modification. How may the partners modify the
partnership agreement? Is unanimous consent required
to add new partners or add new terms to the contract?
• Rights and obligations at dissolution. Partners should
think about what will happen if a partner chooses to leave
the partnership or dies. Can the remaining partner(s) buy
out that partner’s share of the business? If so, under what
terms or process?
It is important to remember that partnership agreements exist
between partners in a business, not between the partners and
third parties. Partnership agreements are contracts between
individuals who want to work together. Therefore, provisions
that help facilitate that business relationship within the
particular industry may be appropriate.

307 | Partnerships

17.4 Rights and Duties of Partners
Rights of Partners
Figure 17.1 Rights of Partners

All general partners have an equal right to manage the
partnership’s business. This does not mean that partners
cannot

divide

up

responsibility

for

the

day-to-day

management of the business. Rather, partners have the right
to enter into contracts on behalf of the partnership, hire
employees, and engage in business transactions.
Partners also have a right to compensation for services on

Partnerships | 308

behalf of the partnership if they have an agreement for
compensation beyond profit sharing. Compensation provisions
are particularly common in limited partnerships where some
partners are active in the management of business and others
are not.
Partners also have the right to receive interest on cash
advances made to the partnership. Similar to a loan, an
advance is not automatically considered a capital contribution
unless determined to be so under the partnership agreement.
Every partner is entitled to full and complete access to inspect
the business records of the partnership. Each partner has the
right to receive notices and information from all other partners
regarding the business. Therefore, partners must notify other
partners about material information related to the business
and business interests.
Similarly, partners are entitled to an accounting when another
partner has withheld profits from the partnership, when there
are legal proceedings against the partnership, or upon
dissolution.
Partners also have the right to indemnification from the
partnership for actions of other partners. For example, if the
partnership is sued because a partner commits a tort, the other
partners

may

lose

their

monetary

investment

in

the

partnership but their personal assets are not at risk.
Partners are co-owners of partnership property. Unless altered
by a partnership agreement, partners have an equal right to
possess partnership property for business purposes.

309 | Partnerships

Duties of Partners
Figure 17.2 Duties of Partners

A partnership is a fiduciary relationship. Therefore, partners
owe each other duties as a result of their relationship of trust
and confidence.
Partners owe each other a duty of care. In a partnership, this
generally means refraining from intentional and reckless
misconduct. A partner is not liable to the other partners for
simple negligence. Thus, the duty of care for partnerships is not
particularly burdensome.
Partners also owe each other the duty of loyalty, which requires
the partner to put the interests of the partnership before his
or her own personal interests. Self-dealing and taking business
opportunities away from the partnership are examples of
breaches of the duty of loyalty.
From the duty of loyalty rise the remaining duties that partners
owe each other: the duty of service, obedience, accounting,
and to inform other partners of material information. When

Partnerships | 310

loyal to the partnership, a partner will work in service of the
partnership, follow reasonable directions of other partners,
provide an accounting of business assets, and inform the other
partners of material information that affects the business.

17.5 Termination of a Partnership
The legal end of a partnership is called dissolution. Dissolution
may occur when partners mutually agree to stop working
together, a partner dies or withdraws from the partnership,
or a new partner is added. A new partnership is formed when
there is a change in partners, whether an existing partner
leaves or a new partner is added. Often, these types of changes
do not impact the day-to-day operations of the business
significantly. However, a new partnership agreement, and
sometimes a new partnership name, is necessary.
If the partnership ceases to operate, then winding up
occurs. Winding up is the process in which a partnership is
liquidated. Partnership assets are reduced to cash, creditors are
paid off, and any remaining profit and assets are distributed to
the partners. Partial winding up occurs when the partnership
has insufficient cash to operate its business and needs to sell
its assets to pay off debts. Complete winding up occurs when
the partnership is no longer viable or the partners decide not
to work together any more. Termination is when the process of
winding up is finished and the partnership no longer exists.
Figure 17.3 Dissolution of Partnership

311 | Partnerships

Many factors can determine whether there is partial or
complete winding up. For example, bankruptcy of a partner or
the partnership, change in laws that make the subject matter
of the business illegal, the death or incapacity of a partner,
change in economic circumstances, or litigation.
During winding up, there is a priority of distributing the
partnership assets. In general, all creditors other than partners
are entitled to be paid before the partners divide up the
partnership’s assets.
The priority of distributing the partnership assets is:
1. Third party creditors;
2. Partnership advances;
3. Partnership capital; then
4. Remaining profits to partners.
If the partnership does not have enough assets to cover its
Partnerships | 312

debts, then the priority of paying creditors is governed by the
state law where the partnership exists. State laws vary
regarding the priority of distributing assets, but most states
follow a process called marshaling of assets. Marshaling of
assets is an equitable doctrine for a fair distribution of a
debtor’s assets among multiple creditors.

17.6 Concluding Thoughts
Partnerships are the most common business form in the
United States, in large part because of their flexibility and ease
of creation. However, if individuals want to create a partnership,
a best practice would be to create a partnership agreement
that identifies the rights and obligations of the partners.
Partnerships are fiduciary relationships in which the law
creates certain rights and obligations even if there is not a
partnership agreement.

313 | Partnerships

18. Corporations
18.1 Introduction
LEARNING OBJECTIVES
1. Understand how corporations are structured and
managed.
2. Learn about shareholder rights and the powers and
liabilities of corporate officers and directors.
3. Learn the legal theories under which limited liability is
taken away from corporations.
4. Comprehend how corporations merge, consolidate, and
dissolve.
Corporations are incredibly important to the stability and
growth of the US economy. Without corporations, industries
such as pharmaceuticals and technology would not be able
to raise the capital needed to fund their research and
development of new drugs and products. As discussed in
Chapter 16, corporations are incorporated under state law and
are subject to double taxation. Corporations are separate legal
entities from the shareholders who own them.

Counselor’s Corner “Corporations are [often] people
too!” Although the word “corporation” is not found
in the Constitution, US corporations are increasingly
considered US persons for legal purposes. The

Corporations | 314

Supreme Court has ruled that corporations are
entitled to equal protection, to make political
contributions, and to refuse certain employee health
plans on religious grounds. Congress now generally
defines “person” as including “corporations,” which
allows them to enter contracts, own property, sue
and be sued, and pay taxes. The president has
issued Executive Orders giving corporations certain
privacy protections regarding the government’s
authority to collect and use information about them.
Corporations do not, however, have all the legal
protections that people have, such as the right to
avoid self-incrimination. Nevertheless, generally
thinking of US corporations as US persons will often
help you better understand their legal rights,
responsibilities, and protections, and make you a
more educated business person, lawyer, or citizen.
~Tom M., attorney

18.2 Corporate Structure
Under most state laws, corporations are required to have at
least one director. A director is a person appointed or elected to
sit on a board that manages the business of a corporation and
supervises its officers. Directors are elected by shareholders
and collectively are called the Board of Directors. Directors
elect officers, who are responsible for the daily operations of
the corporation. Officers often have titles such as president,
chief operating officer, chief financial officer, or controller.
315 | Corporations

Figure 18.1 Corporate Legal Structure

18.3 Shareholder Rights
As owners of the corporation, shareholders have specific rights
to help them assess their investment decisions. Shareholders
are not entitled to manage the day-to-day operations of the
business, but they enjoy the following rights.
Figure 18.2 Corporate Shareholder Rights

Corporations | 316

Inspection
Shareholders have the right to inspect the certified financial
records of a corporation. This right also extends to other
information related to exercising their voting privilege and
making investment decisions.
The right, however, is limited to good-faith inspections for
proper purposes at an appropriate time and place. A proper
purpose is one that seeks to protect the interests of both the
corporation and the shareholder seeking the information. In
other words, the inspection cannot be against the best interest
of the corporation.
Courts have held that proper purposes include:

317 | Corporations

• Reasons for lack of dividend payments or low dividend
amounts;
• Suspicion of mismanagement of assets or dividends; and
• Holding management accountable.
Corporations have a legitimate interest in keeping their
financial and managerial documents private. Therefore,
inspection of documents usually occurs at the corporation’s
headquarters during regular business hours. Documents made
available for inspection do not have to be allowed off premise if
the corporation does not want them to be removed.

Shareholder Meetings
Shareholders have the right to notice and to attend
shareholder meetings. Shareholder meetings must occur at
least annually, and special meetings may be called to discuss
important issues such as mergers, consolidations, change in
bylaws, and sale of significant assets. Failure to give proper
notice invalidates the action taken at the meeting.
A quorum of shareholders must be present at the meeting
to conduct business. A quorum is the minimum number of
shareholders (usually a majority) who must be present to take
a vote. The corporation’s bylaws define what constitutes a
quorum, if not set by state law.
If a shareholder is not able to be physically present during
a meeting, he or she may vote by proxy. A proxy is a person
authorized to vote on another’s stock shares.

Corporations | 318

Vote
Depending on the type of share owned, shareholders may have
the right to vote. In general, shareholders of common stock are
entitled to a vote for each share of stock owned. Owners of
preferred stock often do not have a voting right in exchange for
a higher dividend amount or preference in receiving dividends.
Common issues that shareholders vote on include:
• Election of directors;
• Mergers, consolidations, and dissolutions;
• Change of bylaws;
• Change in major corporate policies; and
• Sale of major assets.

Preemptive Rights
The Preemptive right is a shareholder’s privilege to buy newly
issued stock in the corporation before the shares are offered
to the public. Shareholders are allowed to buy shares in an
amount proportionate to their current holdings to prevent
dilution of the existing ownership interests.
Preemptive rights usually must be exercised within thirty to
sixty days of being offered. This allows the corporation to
complete the sale to shareholders before offering any
remaining shares to the public.

Derivative Suit
A derivative suit is a lawsuit brought by a shareholder on the
corporation’s behalf against a third party because of the
319 | Corporations

corporation’s failure to take action on its own. Derivative
actions are usually brought by shareholders against officers or
directors for not acting in the best interest of the corporation.
To be eligible to bring a derivative action, a shareholder must
own shares in the corporation at the time of the alleged injury.
An individual or business cannot buy shares in a corporation to
file a derivative suit for actions that occurred before becoming
a shareholder.
Before bringing a derivative suit, shareholders must show that
they attempted to get the officers and directors to act on
behalf of the corporation first. Only after the officers and
directors refuse to act may a derivative suit be filed.
Dissatisfaction

with

the

corporation’s

management

is

insufficient to justify a derivative suit. Derivative suits have
been successful when misconduct or fraud of a director or
officer is involved. If successful, any damages are awarded to
the corporation, not the shareholders who brought the lawsuit.

Dividends
A dividend is a portion of a corporation’s profits distributed to
its shareholders on a pro rata basis. Dividends are usually paid
in the form of cash or additional shares in the corporation.
Although shareholders have a right to a dividend when
declared, the board of directors has the discretion to decide
whether to declare a dividend. The board may decide to
reinvest profits into the corporation, pay for a capital expense,
purchase additional assets, or to expand the business. As long
as the board of directors acts reasonably and in good faith,
its decision regarding whether to declare a dividend is usually
upheld by the courts.

Corporations | 320

18.4 Corporate Officer and Directors
Although shareholders own the corporation, the officers and
directors are empowered to manage the day-to-day business
of the corporation. The officers and directors owe a fiduciary
duty to both the corporation and its shareholders. This means
that the officers and directors must act in the best interest of
the corporation and shareholders.

Duty of Loyalty
As part of their fiduciary duty, officers and directors have a duty
of loyalty to the corporation and its shareholders. The duty of
loyalty requires them to act:
• In good faith;
• For a lawful purpose;
• Without a conflict of interest; and
• To advance the best interests of the corporation.
Duty of loyalty issues frequently arise in the context of a
director entering into a contract with the corporation or
loaning it money. Other situations may involve a director taking
a business opportunity away from the corporation for his or
her own personal gain. The corporate opportunity doctrine
prevents officers and directors from taking personal advantage
of a business opportunity that properly belongs to the
corporation.

Duty of Care
The duty of care requires officers and directors to act with the
321 | Corporations

care that an ordinary prudent person would take in a similar
situation. In other words, they have a duty not to be negligent.
The extent of this duty depends on the nature of the
corporation and the type of role the director or officer fills. For
example, the duty of care imposed on the board of directors of
a federally-insured bank will be higher than the duty imposed
on a small nonprofit organization.
In general, though, directors should understand the nature and
scope of the corporation’s business and industry, as well as
have any particular skills necessary to be successful in their
role. Officers and directors also should stay informed about
the corporation’s activities and hire experts when they lack
the expertise necessary to make the best decisions for the
corporation. The duty of care requires officers and directors to
make informed decisions.

Compensation
Officers and directors are usually entitled to compensation for
their work on behalf of the corporation. Some states restrict
whether directors may receive compensation and, if so, how
much. The issue of executive compensation has been a hot
button issue in recent decades.

Business Judgment Rule
The business judgment rule is the presumption that corporate
directors act in good faith, are well-informed, and honestly
believe their actions are in the corporation’s best interest. The
rule shields directors and officers from liability for unsuccessful

Corporations | 322

or unprofitable decisions, as long as they were made in good
faith, with due care, and within their authority.
It is important to understand that courts do not focus on the
result of the business decision. Instead, courts look at the
process that the decision makers went through. If the process
is careless or not in the best interest of the corporation and
shareholders, the business judgment rule will not protect
them.
The business judgment rule does not protect officers and
directors from decisions made in their own self-interest or selfdealing. In those situations, the action must be approved by
disinterested

members

of

the

board

of

directors

or

shareholders. If the decision is subject to a derivative suit, the
court may determine that the decision was fair to the
corporation. If the decision is approved by the court or
disinterested board members or shareholders, then the
decision may be valid.
The business judgment rule does not protect officers and
directors from decisions made in bad faith, as a result of fraud,
through gross negligence, or as an abuse of discretion. In those
situations, the officers and directors may be personally liable
for their actions.
Figure 18.3 Business Judgment Rule Flowchart

323 | Corporations

18.5 Legal Theories
One of the main benefits of corporations is limiting
shareholders’ liability to the amount of their investment in the
corporation. In general, a shareholder may lose his or her
investment in the corporation if it is not a successful business
or if it is sued. Because corporations are a separate legal entity
than their shareholders, shareholders are generally shielded
from corporate liability. However, three exceptions to this rule
allow shareholders to be held liable for the corporation’s
actions.

Corporations | 324

Piercing the Corporate Veil
Piercing the Corporate Veil is a legal theory under which
shareholders or the parent company are held liable for the
corporation’s actions or debts. Under this theory, plaintiffs ask
the court to look beyond the corporate structure and allow
them to sue the shareholders or parent company as if no
corporation existed. In essence, the court strips the “veil” of
limited liability that incorporation provides and hold a
corporation’s shareholders or directors personally liable.
This theory applies most often in closely held corporations.
While legal requirements vary by state, courts are usually
reluctant to pierce the corporate veil. However, courts will do
so in cases involving serious misconduct, fraud, commingling
of

personal

and

corporate

funds,

and

deliberate

undercapitalization during incorporation.

Alter Ego Theory
The Alter Ego Theory is the doctrine that shareholders will be
treated as the owners of a corporation’s property or as the real
parties in interest when necessary to prevent fraud or to do
justice. In other words, the court finds a corporation lacks a
separate identity from an individual or corporate shareholder.
This theory applies most often when a corporation is a whollyowned subsidiary of another company. Courts allow the alter
ego theory when evidence exists that the parent company is
controlling the actions of the subsidiary, and the corporate
form is disregarded by the shareholders themselves. The
rationale is that shareholders cannot benefit from limited
liability when there is such unity of ownership and interest that
a separate entity does not actually exist. To allow shareholders

325 | Corporations

to “have it both ways” would result in injustice to the
corporation’s debtors and those hurt by its actions.

Promotion of Justice Theory
The Promotion of Justice Theory is used when the corporate
form is used to defraud shareholders or to avoid compliance
with the law. Courts use this theory to prevent shareholders
from using a corporation to achieve what they could not do
directly themselves. For example, if a state limits the number of
liquor licenses an individual may obtain at one time, a person
cannot form multiple corporations to obtain more licenses.

18.6 Mergers, Consolidations, and
Dissolutions
Once incorporated, corporations may last forever. However,
they also may be merged or consolidated into other business
entities or dissolved.
Often businesses will buy the assets of another business. When
this happens, the seller remains in existence and retains its
liabilities. The buyer does not become legally responsible for
the seller’s actions through a mere purchase of assets.
Mergers and consolidations, however, involve the termination
of the seller.

Merger
A merger occurs when one corporation absorbs another. The
Corporations | 326

acquiring corporation continues to exist but the target
corporation ceases to exist. The acquiring corporation acquires
all the assets and liabilities of the target corporation.
Corporate mergers must conform to state laws and usually
must be approved by the majority of shareholders of both
corporations. Many states require approval by two-thirds of the
shareholders. If approved, articles of merger must be filed in
the state(s) where the corporations exist.
Figure 18.4 Merger

Consolidation
Consolidation occurs when two or more corporations are
dissolved and a new corporation is created. The new
corporation owns all the assets and liabilities of the former
corporations.
Like mergers, consolidations must be approved by the majority
or two-thirds of shareholders of all corporations involved. If
approved, articles of consolidation must be filed in the state(s)
where the corporations existed.
Mergers and consolidations are often scrutinized under
antitrust laws to ensure that the resulting corporation is not a
monopoly in the relevant market. Antitrust laws are discussed
in Chapter 19.
Figure 18.5 Consolidation

327 | Corporations

Voluntary Dissolution
A corporation that has obtained its charter but has not begun
its business may be dissolved voluntarily by its incorporators.
They simply need to file articles of dissolution in the state of
incorporation.
If a corporation has been in business, voluntary dissolution is
possible when either (1) all shareholders give written consent or
(2) the board of directors vote for dissolution and two-thirds of
the shareholders approve.
To dissolve a corporation voluntarily, the corporation must file
a statement of intent to dissolve. At that point, the corporation
must cease all business operations except those necessary to
wind up its business affairs. The corporation must give notice
to all known creditors of its dissolution. If the corporation fails to
give notice, then the directors become personally responsible
for any debt and legal liability. The corporation is required to
pay off all debts before distributing any remaining assets to
shareholders.
Until the state issues the articles of dissolution, the statement
of intent may be revoked if shareholders change their mind.

Corporations | 328

Involuntary Dissolution
States have the power to create corporations through granting
corporate charters. Similarly, states have the right to revoke
corporate charters. Actions brought by the state to cancel a
corporate charter are called quo warranto proceedings.
Corporate charters may be canceled when a corporation:
• Did not file its annual report;
• Failed to pay its taxes and licensing fees;
• Obtained its charter through fraud;
• Abused or misused its authority;
• Failed to appoint or maintain a registered agent; or
• Ceased to do business for a certain period of time.
Shareholders may also request dissolution when:
• The shareholders are deadlocked and cannot elect a board
of directors;
• When there is illegal, fraudulent or oppressive conduct by
the directors or officers;
• When majority shareholders breach their fiduciary duty to
the minority shareholders;
• Corporate assets are being wasted or looted; or
• The corporation is unable to carry out its purpose.
Finally, dissolution may occur as a result of bankruptcy or when
the corporation is unable to cover its debts to creditors.

18.7 Concluding Thoughts
Corporations are owned by shareholders but are run by

329 | Corporations

directors and officers. As a legal entity separate from its
shareholders,

corporations

provide

limited

liability

to

shareholders who invest in them. However, personal liability
may be imposed when fraud or other serious misconduct
occurs. As long as their decisions are made in good faith, with
due care, and within their authority, officers and directors are
protected by the business judgment rule. Finally, corporations
have a perpetual existence unless they are dissolved through
their own action, by the state, or initiated by shareholders or
creditors.

Corporations | 330

19. Antitrust Law
19.1 Introduction
LEARNING OBJECTIVES
1. Understand the important federal antitrust laws, along
with their exemptions.
2. Learn the factors used to determine whether a monopoly
exists.
3. Comprehend the common types of unreasonable
restraints on trade.
Antitrust laws are designed to protect trade and commerce
from unreasonable restraints, monopolies, price fixing, and
price discrimination. Antitrust laws regulate the market just
enough to foster economic growth and competition while
preventing stagnation and unethical practices by monopolies
that prevent the free market from operating as it should.
The main federal antitrust laws are the Sherman Act, the
Clayton Act, and the Federal Trade Commission Act. The
legislative declarations of these Acts make it clear that
Congress wants to promote fair competition within the market
economy.

Counselor’s Corner It is difficult at first blush to
determine if a business’s strong market presence is
the result of a superior product or service that the

331 | Antitrust Law

public demands or unfair business practices. In the
technology industry, the big players have invested
so much into research and development to bring
cutting edge products to market. But if their
products are not user friendly and do not meet
customer needs, they will not get a return on their
investment. As a result, we see an uptick in antitrust
complaints from competitors to bring down
businesses when they can’t do so on the open
market. Antitrust laws are not a sword of
competitors to be used for unjust means. Thus,
antitrust allegations require examining the entire
relevant market, including the complaining party.
~Robert S., judge

19.2 Historical Development
The United States economy was founded on the capitalist
principle of free enterprise. Free enterprise is a private and
consensual system of production and distribution, usually
conducted for profit in a competitive environment, that is
relatively free of governmental interference. The theory is that,
given the freedom, businesses will operate efficiently and be
responsive to consumer needs and demands.
The weakness of the free enterprise system is that it assumes
that businesses will be ethical and compete with each other
fairly. During the Industrial Revolution, powerful businessmen
took advantage of the free enterprise system to increase their

Antitrust Law | 332

wealth at the expense of their workers, competitors, and
consumers.
These Industrialists bought shares in competing companies
then transferred the shares to a trust. The trust then set prices
for goods within the industry, determined which companies
could operate in a given geographic area, and micromanaged
the business operations of companies within an industry. As
a result, companies that were not part of the trust went
bankrupt, new competitors were prevented from entering the
market,

and

consumer

prices

rose

beyond

market

requirements.
States tried to stop the abuses of the Industrialists through
the trusts. State attempts failed because the US economy was
growing beyond state industries to national ones. As a result,
national legislation was needed to restore balance to the
market. The resulting legislation is called “antitrust law”
because its purpose was to break up the power of the
Industrialists’ trusts.
In 1890, Congress passed the Sherman Antitrust Act under its
power to regulate interstate commerce. The Sherman
Antitrust Act (also known as the Sherman Act) prohibits direct
or indirect interference with the freely competitive interstate
production and distribution of goods. The Act addresses two
main concerns:
1. Unreasonable restraints on trade between two or more
parties; and
2. Monopolies.
In 1914, Congress passed the Clayton Act. The Clayton Act
amended the Sherman Act and expanded antitrust regulations
to prohibit:

333 | Antitrust Law

1. Price discrimination;
2. Tying arrangements;
3. Exclusive-dealing contracts; and
4. Mergers resulting in monopolies or substantially lessening
competition.
Congress also passed the Federal Trade Commission Act in
1914. The Federal Trade Commission Act established the
Federal Trade Commission (FTC) to protect consumers against
deceptive practices and enforce antitrust laws. The Act
prohibits false, deceptive, and unfair advertising and trade
practices. Some of these practices are discussed in more detail
in Chapter 20.
Figure 19.1 The Federal Trade Commission Act

The last major antitrust law is the Robinson-Patman Act, which
was passed by Congress in 1936. The Robinson-Patman Act
amended the Clayton Act and prohibits price discrimination
that hinders competition or that tends to create a monopoly.

Antitrust Law | 334

19.3 Monopoly
A monopoly is the control or advantage obtained by one
supplier or producer over the commercial market within a
given region. Not all monopolies are illegal. In fact, some
industries are exempted from antitrust laws:
• Highly regulated industries;
◦ Utilities;
◦ Railroads;
◦ Airlines;
◦ Insurance companies;
◦ Securities; and
◦ Banks
• Labor unions;
• Agricultural and fishing cooperatives (farmers not
distributors);
• Exporters;
• Lobbyists;
• States (unclear if includes US territories); and
• Professional baseball.
To be an illegal monopoly, a business must have (1) monopoly
power (2) in the relevant market and (3) the intent to acquire
and use such power.

Monopoly Power
Monopoly power is the power of a business to fix prices
unilaterally or to exclude competition. The size of a business’s
market share is a primary factor of whether monopoly power
exists.

335 | Antitrust Law

Courts have found monopoly power when a business controls
seventy percent or more of a market.
If a business controls 51-69 percent of a market, then it is
possible that monopoly power exists. Courts examine other
factors such as number of competitors, market concentration,
degree of difficulty for new businesses to enter the industry,
and the nature of the industry. If the entry costs and barriers
are high and there are few other competitors, a business may
have monopoly power when it controls slightly more than half
the market.
If a business controls fifty percent or less of a market, then no
monopoly power exists.

Relevant Market
To determine whether a business has monopoly power, it must
be determined whether it has monopoly power within the
relevant market. However, defining the relevant market can be
challenging. The relevant market includes both the product or
service market and the geographic area.

Product or Service Market
The first element in determining the relevant market is to
determine what goods or services are interchangeable in
consumers’ minds. This is sometimes called substitutability or
functional interchangeability. Defining the exact product or
service market is usually heavily litigated because it may result
in market concentration or dilution, and ultimately whether a
business has enough market share to be deemed a monopoly.

Antitrust Law | 336

For example, Ford shares the passenger truck market with
manufacturers such as Chevrolet, GMC, Dodge, Toyota, Nissan,
and Honda. However, Ford shares the commercial truck
market with manufacturers such as Peterbilt, Volvo, Daimler,
and Volkswagen. If sued for violation of antitrust law, Ford
would want a broad definition of the product market, such
as “trucks,” to include a greater number of competitors and
lessen its own market share. Plaintiffs would want to define
the product narrowly, such as “three-quarter ton passenger
trucks,” to lessen the number of competitors and heighten
Ford’s market share.
As large companies expand their products and services across
industries, this inquiry becomes more complex and expensive
to litigate.

Geographic Area
Determining

a

business’s

market

power

also

requires

determining the geographic area in which the business
operates. As globalization and e-commerce increase the
geographic reach of businesses, this inquiry is also becoming
more difficult.
For example, should the market for Ford passenger trucks be
determined by city, state, nation, continent, hemisphere, or
globally? Ford trucks may have higher sales in Detroit,
Michigan than in Tokyo, Japan. Determining the geographic
area of the relevant market may include areas of higher or
lesser concentrations of sales. Therefore, parties also heavily
litigate what is the appropriate geographic area for the relevant
market.

337 | Antitrust Law

Intent
The third factor is the business’s intent to acquire and use its
monopoly power.
Not all monopolies are the result of a business’s predatory
actions. Some “boom and bust” industries, such as mining and
oil and gas, are difficult to maintain long-term success. If an
industry goes through a difficult time and competitors go out
of business, the remaining company may end up as a
monopoly without engaging in anticompetitive behavior.
To determine intent, courts look at the conduct of the business.
Purchasing smaller competitors to increase its market share
and engaging in predatory pricing is often evidence of a
company’s intent to become a monopoly.
Specifically, an intent to monopolize requires:
1. Predatory or anticompetitive conduct;
2. Specific intent to control prices or destroy competition;
and
3. A dangerous probability of success.
A business’s intent is evaluated in the context of the current
industry and economic conditions. For example, are there
significant changes to the law that affect the profitability of the
industry or an economic downturn that impacts competition?
Just because a company is large enough to successfully survive
a challenging time, it may not have the necessary intent to
become an illegal monopoly.

Antitrust Law | 338

19.4 Unreasonable Restraints on
Trade
Antitrust laws prohibit unreasonable restraints on trade.
A restraint on trade is an agreement between two or more
businesses intended to eliminate competition, create a
monopoly, artificially raise prices, or adversely affect the free
market. A restraint on trade that produces a significant
anticompetitive effect and, therefore, violates antitrust laws is
an unreasonable restraint on trade.

Concerted Action
Concerted action is an action that has been planned, arranged,
and agreed on by parties acting together to further some
scheme or cause. Concerted action can be either horizontal
or vertical. Horizontal agreements occur between direct
competitors. For example, cell phone providers decide to lock
customers into two-year contracts. Customers are required to
agree to terms that benefit the companies, regardless of which
provider they choose.
Figure 19.2 Horizontal Restraints on Trade

339 | Antitrust Law

Horizontal agreements are almost always struck down as per
se violations of antitrust laws. Because competitors appear to
make decisions based on their own self-interest rather than
letting the market forces decide price and conditions, courts
conclude that such agreements are not in the interest of
consumers and the free market.
Vertical agreements occur between businesses at different
places along the distribution chain of a given product. For
example, a manufacturer suggests a sale price to a wholesaler
of its product (i.e. “manufacturer’s suggested retail price”).
Figure 19.3 Vertical Restraints on Trade

Vertical agreements are usually subject to a “rule of reason” test
to determine if they are illegal. The rule of reason test is a caseby-case analysis of the agreement, industry, effects, and intent
of the businesses. Although it is possible to show that a vertical

Antitrust Law | 340

agreement is legal, it usually costs businesses a lot to litigate
these types of cases.

Price Fixing
Price fixing is the artificial setting or maintaining of prices
at a certain level, contrary to the workings of the free
market. Horizontal

price

fixing

is

price

fixing

among

competitors at the same level, such as retailers throughout an
industry. Vertical price fixing is price fixing among businesses
in the same chain of distribution, such as manufacturers and
retailers attempting to control a product’s resale price.
One form of price fixing is predatory pricing. Predatory pricing
occurs when a company lowers its prices below cost to drive
competitors out of business. Once a predator rids the market of
competition, it raises prices to make up lost profits. The goal of
predatory pricing is to win control of a market or to maintain it.
Predatory pricing has three elements:
1. The alleged predator is selling products below cost;
2. The alleged predator intends that its competition goes out
of business; and
3. If the competitors go out of business, the alleged predator
will be able to earn sufficient profits to recover its prior
losses.
Predatory pricing cases are often hard to win because it is
difficult to prove the alleged predator’s intent.

341 | Antitrust Law

Division of the Market
Division of the market occurs when businesses agree to
exclusively sell products or services in specific geographic
territories. A horizontal division of the market is when
competitors enter into an agreement to not compete for
customers by dividing a geographic area into separate sales
territories. A vertical division of the market is when a
manufacturer

and

its

wholesalers

agree

to

exclusive

distributorships in a given territory.
Exclusive

distributorships

are

usually

legal

unless

the

manufacturer has dominant power in the overall market. For
example, Wendy’s grants exclusive distributorships to its
franchisees to avoid oversaturation in a given geographic area.
As long as Wendy’s is not the only fast food restaurant within a
particular market, the exclusive distributorships will be upheld.
This is because Wendy’s has a legitimate business interest in
not diluting the value of its franchises, which does not restrict
consumers’ choice of fast food restaurants in the overall
market.

Group boycotts
A boycott is an action designed to socially or economically
isolate an adversary. A group boycott is an agreement between
two competitors who refuse to do business with a third party
unless it refrains from doing business with an actual or
potential competitor of the boycotters. Group boycotts may be
either horizontal or vertical.
Figure 19.4 Horizontal Group Boycott

Antitrust Law | 342

Exclusionary Contracts
Exclusionary contracts require businesses to buy or lease
products on the condition that they do not use the goods
of a competitor of the seller. The most common types of
exclusionary contracts are tying arrangements and exclusive
dealing arrangements.
A tying arrangement occurs when a buyer is not permitted
to purchase one item without purchasing another. These are
often called “bundling packages.” These arrangements benefit
a seller because it allows the seller to wed a popular item with
one that is less desirable and would not get as many sales
independently.
Under the rule of reason test, a tying arrangement is illegal
when:
1. The agreement involves two distinct products not closely
related to each other;
2. Commerce is impacted significantly; and

343 | Antitrust Law

3. The seller has sufficient economic power in the tying
product to enforce the tie-in.
An exclusive dealing arrangement exists when a buyer agrees
to purchase all of its requirements from a single seller or a seller
agrees to sell all of its output to a single buyer. Exclusive dealing
arrangements are illegal when they substantially lessen
competition or tend to create a monopoly.

Mergers and Acquisitions
Regardless of a business’s intention when merging or
acquiring another business, a merger or acquisition is
prohibited when it may substantially lessen competition or
may create a monopoly. When analyzing a potential merger,
the court considers:
1. The relevant market;
2. The pre-merger profile of the business; and
3. The post-merger profile of the business.
As discussed above, the relevant market is determined by
examining the relevant product or service market, as well as
the geographic area of the business’s operations.
The pre-merger profile is determined by analyzing the type
of merger, the size of the companies involved, and the
concentration of the industry. Mergers may be horizontal,
vertical, or conglomerate. Horizontal mergers are between
competitors. Vertical mergers are between businesses within
a supply chain. And conglomerate mergers are between
companies

in

different

industries.

An

example

of

a

conglomerate merger is Amazon’s acquisition of Whole Foods
in 2107.

Antitrust Law | 344

The post-merger profile uses the same factors as the premerger profile but looks at the anticipated business after the
merger.

19.5 Price Discrimination
Price discrimination is the practice of offering identical or
similar goods to different buyers at different prices when the
costs

of

producing

the

goods

are

the

same.

Price

discrimination may violate antitrust laws if it reduces
competition.
Price discrimination may be either direct or indirect. Direct
price discrimination occurs when a seller charges different
prices to different buyers. Indirect price discrimination occurs
when a seller offers special concessions (such as favorable
credit terms) to some, but not all, buyers.
The Robinson-Patman Act defines discrimination in terms of
first, second and third lines. First line price discrimination is
when the seller directly offers different prices to different
buyers. For example, coffee sold to individual customers is
priced differently. First line price discrimination is legal when
the lower price is offered to customers who buy large
quantities, use coupons, or are part of a loyalty program. It is
also legal if the price difference is the result of manufacturing,
sales or delivery costs. For example, coffee prices may be lower
for Hawaiian coffee in Hawaii because there are less
transportation costs involved than shipping coffee to the
Continental United States.
Figure 19.5 First Line Discrimination

345 | Antitrust Law

Second line price discrimination occurs when a manufacturer
demands lower prices from suppliers. For example, large
retailers often demand discount prices from manufacturers
because they buy goods in large quantities. Second line price
discrimination is legal as long as the negotiations for the lower
price

are

done

fairly

and

there

is

not

a

substantial

anticompetitive impact in the market. When second line price
discrimination results in larger businesses freezing out smaller
competitors, it violates antitrust laws.
Figure 19.6 Second Line Price Discrimination

Antitrust Law | 346

Third line price discrimination occurs when a customer of a
customer of the seller is benefited by the seller’s actions. For
example, a clothing manufacturer gives a price discount to a
clothing wholesaler, who then passes the savings on to the
retailer,

who

then

reduces

prices

for

consumers.

The

consumers ultimately benefit from the price discount given to
the wholesaler by the manufacturer.
Figure 19.7 Third Line Price Discrimination

347 | Antitrust Law

Price discrimination, at any line, is legal when a seller lowers
prices in good faith to meet an equally low price offered by
a competitor. If lower prices are a result of good faith, courts
determine that the prices reflect market forces at work. In
other words, the businesses are honestly competing for
consumers. However, if the lowered prices are not done in good
faith but are an attempt to undercut competition, then the
business commits predatory pricing.

Antitrust Law | 348

19.6 Enforcement
Antitrust laws impose both civil and criminal penalties. A
private business that has been injured by anticompetitive
practices may sue for damages. To encourage private
enforcement, the Sherman and Clayton Acts award successful
litigants treble (i.e. triple) damages and attorneys’ fees. To be
successful, a plaintiff must show that an anticompetitive act
directly resulted in a tangible injury.
However,

most

antitrust

actions

involve

governmental

enforcement. This makes sense because the government has
the power to investigate and subpoena that private businesses
do not. It also saves businesses a lot of money for the
government to enforce the laws rather than through private
litigation.
Both the Department of Justice and the Federal Trade
Commission enforce antitrust laws. Both agencies may pursue
civil and criminal remedies for violations of the law.
Civil remedies include:
• Injunctions (court orders prohibiting the business from
committing further violations);
• Consent decrees (court-approved agreements in which a
party does not admit wrongdoing but agrees to change its
behavior); and
• Divesture orders (court orders requiring a company to sell
its interest in an acquired company).
The Department of Justice may also pursue criminal charges
for violations of antitrust laws. If convicted of a felony,
individuals may be fined up to $1 million per violation and may
be sentenced up to ten years in prison. A business may be fined
as much as $100 million per violation.
349 | Antitrust Law

19.7 Concluding Thoughts
The underlying tension of antitrust laws is the appropriate
amount of regulation in a free enterprise system. By definition,
a free enterprise market-oriented system should be free from
governmental regulation. However, it is clear that some
regulation and oversight is necessary to protect individuals and
businesses from unethical and anticompetitive business
practices. Even absent unethical practices, some businesses
may be so successful that over time they gain enough market
share to freeze out competition, and have less incentive to
deliver quality products and services. As a result, the market
may become stagnant, which is not in the best interest of
the national economy or consumers. Antitrust laws attempt
to protect consumers and the economy while allowing free
enterprise to operate.

Antitrust Law | 350

20. Consumer Law
20.1 Introduction
LEARNING OBJECTIVES
1. Learn the primary consumer laws that protect purchasers
and debtors.
2. Understand the enforcement role of the Consumer
Financial Protection Bureau.
Consumer law is the area of law dealing with consumer
transactions, including an individual’s ability to obtain credit,
goods, real property, or services for personal, family, or
household purposes. Business to business transactions are
usually governed by contract law and are not considered part
of consumer law.
Consumer protection laws are laws designed to protect
consumers against unfair trade and credit practices involving
consumer goods, as well as to protect consumers against faulty
and dangerous goods. The focus of these laws is to ensure that
businesses do not take advantage of individual consumers.

Counselor’s Corner Approximately 80 percent of
Americans are in debt. Consequently, consumer
protection laws, especially those that protect
debtors, are incredibly important to the majority of
Americans, even if they don’t realize it. Debt

351 | Consumer Law

collection agencies can be aggressive and unethical.
Know your rights so that you are not bullied or taken
advantage of. ~Maria M., attorney

20.2 Protecting the Purchaser
Consumer protection laws that protect purchasers of goods
and services generally fall into four categories:
• Labeling and packaging;
• Sales;
• Deceptive advertising; and
• Hazardous materials.

Labeling and Packaging
How goods are labeled and packaged influences whether
consumers will buy them. As a result, regulations require that
labels must be truthful and allow consumers to understand
what the product is, what it contains, and any potential
hazards.
Labeling and packaging regulations fall into four categories:

Consumer Law | 352

Type

Example

Product
comparison

Nutrition labels on food and beverages

Preventing
injury

Warning not to use lawn mower to trim hedges

Preventing
access

Childproof caps on medications; tobacco
secured in retail stores

Informing of
potential
hazards

Potential side effects of hazardous items and
drugs

Sales
The general principle in sales regulations is that advertising
must be honest. Consumers should be able to make informed
decisions based on what products and services really are and
not based on false claims or empty promises. These regulations
apply to all sales materials regardless of medium: print,
electronic, social media, or radio.
One

important

regulation

involves

door-to-door

sales.

Consumers who buy goods or services from door-to-door
salespeople have three days to cancel purchases without
penalty. This is called a cooling off period and is intended to
protect consumers from high pressure sales tactics. The
exception to the cooling off period is when services are
immediately rendered. For example, someone who aerates a
lawn or removes snow as soon as a consumer consents to pay
for the service is entitled to payment without being subject to
a cooling off period.
Another important regulation involves delivery of goods
ordered online, through catalogs, or by door-to-door sales.
Goods must be shipped within the promised time period or
notice must be given to the consumer. If the goods are not

353 | Consumer Law

shipped and proper notice is not given, then the consumer
has the right to cancel the order for a full refund. Similarly, if a
consumer receives goods that he or she did not order through
the mail, the consumer can treat it as a gift and does not have
to pay for it.
Sellers are allowed to promote their goods and services and
make them appealing to consumers. Puffery is a broad
promotional statement made by a business about goods or
services that is not intended to be taken literally. In other words,
puffery is an exaggerated opinion, such as “the best,” “most
popular,” and “nobody can beat it!” As long as puffery remains
an opinion and does not contain false factual statements,
puffery is legal. However, if puffery contains false statements,
then the statements are deceptive advertising and illegal.

Deceptive Advertising
Deceptive advertising is a material misrepresentation or
omission likely to mislead a potential customer and would
mislead a reasonable customer. In other words, deceptive
advertising is a lie.
For example, if a car manufacturer advertises a vehicle as “the
best in its class” or “the most popular” sedan, such statements
are legal puffery. If the manufacturer advertises that the vehicle
gets 35 miles per gallon when it only gets 30 miles per gallon,
then that statement is deceptive advertising.
Another form of deceptive advertising is called bait and switch
or bait advertising. Bait and switch is a sales practice where
a seller advertises a low-priced product to lure consumers into
a store only to induce them to buy a higher-priced product.
Often the advertised product is not actually available as
advertised or the seller refuses to sell it on the advertised terms.
Consumer Law | 354

The low-priced product is the “bait” that brings consumers in
but then the seller “switches” the higher-priced product as the
subject of the transaction. Bait and switch advertising can also
apply to sales of services.

Hazardous Materials
In

the

context

of

consumer

protection

law,

hazardous materials are products deemed dangerous to the
consuming public. Hazardous materials include drugs that
may be consumed safely in small amounts under supervision
of a medical provider, as well as toxic chemicals that are
banned for certain public uses such as lead and asbestos.
Hazardous materials regulations are extensive to ensure that
products reaching consumers are safe for their intended use
and other reasonable, foreseeable uses. These regulations also
control product recalls.
Regulations vary depending on the business’s industry. To help
consumers understand their rights and report harmful
products,

the

Consumer

Product

Safety

Commission

established the www.SaferProducts.gov website.

20.3 Protecting the Debtor
A debtor is someone who owes an obligation to another
individual or business, especially the obligation to pay money.
Consumers become debtors when they owe a business money
for the purchase price of goods and services. If consumers pay
the purchase price at the time of the transaction or shortly
afterward, then the transaction is completed. If, however, the

355 | Consumer Law

consumer does not immediately pay but receives the goods
or services, then the consumer becomes a debtor under
consumer protection laws.
Consumer protection laws that protect debtors generally fall
into five categories:
• Obtaining credit;
• Reporting credit information;
• Electronic fund transfers;
• Identity theft; and
• Debt collection.

Obtaining Credit
The process of obtaining credit is regulated by two federal laws.
The Truth in Lending Act regulates what information must be
provided by creditors who wish to extend credit to consumers.
The Equal Credit Opportunity Act prohibit creditors from
discriminating against consumers based on their membership
in certain protected classes.

Truth in Lending Act
Congress passed the Truth in Lending Act (TILA) in 1968 to help
consumers understand and compare various credit options
available to them. TILA only applies to consumer credit
transactions and leasing. The law does not apply to commercial
credit transactions.
TILA applies to all real estate transactions and consumer credit
transactions of $25,000 or less. The law also applies to credit

Consumer Law | 356

transactions involving finance charges or when the loan
repayment involves four or more installments.
TILA also regulates credit cards. The law prohibits credit card
companies from issuing credit cards unless they were
requested by the consumer. Any changes to interest rates or
policies to existing credit card accounts must be provided in
writing to consumers, who must be allowed to cancel their
credit cards without penalty. Consumers are required to pay
any outstanding balance accrued to that point, but they
cannot be forced to accept altered terms.
TILA requires certain disclosures be made to applicants for
credit. These disclosures include:
• Minimum rate of repayment;
• Billing period;
• Interest rate in the form of the annual percentage rate;
• Type of interest (simple or compound);
• Service charges and fees; and
• Prepayment penalties.
All disclosures must be in ordinary language that makes sense
to the ordinary customer. Disclosures must also be clear and
conspicuous, meaning that the terms cannot be buried in a
contract to hide them from consumers.

Equal Credit Opportunity Act
Congress passed the Equal Credit Opportunity Act (ECOA) in
1975 to protect consumers from discrimination when applying
for credit. ECOA prohibits creditors from discriminating against
creditors based on their:
• Race;
357 | Consumer Law

• Color;
• National origin;
• Religion;
• Gender;
• Age;
• Marital status; and
• Welfare status.
The purpose of ECOA is to require creditors to consider only
those

characteristics

of

an

applicant

related

to

creditworthiness rather than social status or stereotypes.
Therefore, creditors may consider an applicant’s marital or
welfare status only to the extent that it relates to the applicant’s
creditworthiness. For example, an applicant’s marital assets
and debts are relevant factors when determining how much
credit, if any, should be extended to the applicant. However,
denying or granting credit solely on the basis of marital and
welfare status is illegal.
ECOA also requires creditors to provide specific reasons for
denying credit to applicants. This allows applicants to
determine whether the denial was for discriminatory reasons
or as pretext to hide the discriminatory reason, in violation of
the law.

Reporting Credit Information
Congress passed the Fair Credit Reporting Act (FCRA) in 1970
to regulate the gathering, storage, and reporting of creditrelated information. FCRA applies to individual consumer
information only. FCRA does not apply to business entities’
credit reports.
A credit bureau is an organization that maintains and

Consumer Law | 358

distributes information regarding a person’s credit worthiness
to potential creditors, insurance companies, and employers.
The three main credit bureaus in the United States are Equifax,
Experian, and Transunion.
Before releasing consumer information, a credit bureau must
confirm the identity of the party making the request and verify
the reason for its use. The credit bureau then provides
information about a consumer’s credit in the form of a credit
report.
In general, consumers do not have to consent to the release of
their information. FCRA requires notice to consumers in three
specific circumstances:
• A credit report is provided to an employer and includes
negative information that could prevent the consumer
from being hired;
• When the consumer is denied credit, insurance, or
employment based on information contained in the
report;
• An investigative report is requested about the consumer’s
character, personal attributes, and living arrangements.
Credit bureaus must delete general information that is more
than seven years old, and bankruptcies that are more than
ten years old. If debts were incurred over seven years ago, or
bankruptcies filed more than ten years ago, but are still “open”
because the debt has not been paid off, then that information
may be reported.
FCRA gives consumers some specific rights regarding their
consumer reports. First, consumers are entitled to one free
report per year from each of the credit bureaus. Consumers
may pay for additional copies of their credit reports.
Second, consumers are entitled to dispute information
359 | Consumer Law

included in a credit report. If the credit bureau determines that
the report contained an error, the erroneous information must
be removed. If the credit bureau confirms the information or
cannot determine that it was erroneous, then the consumer
has the right to add an objection to the information in the
report.
Finally, consumers are entitled to place a credit freeze on their
credit reports. A credit freeze is when the consumer restricts or
prohibits creditors from requesting credit reports about them.
In essence, a credit freeze prevents third parties from
requesting a consumer’s credit report without the consumer’s
permission. If the consumer wants to apply for credit or a new
job, then the consumer may lift the credit freeze for a limited
period of time or give authority to specific entities to request a
credit report.

Electronic Fund Transfers
The Electronic Fund Transfer Act (EFTA) was passed by
Congress in 1978 to protect consumers from unauthorized
electronic fund transfers from their accounts. EFTA applies to
electronic direct deposits and withdrawals, automatic teller
machines

(ATMs),

and

point-of-sale

transactions

with

merchants.
EFTA requires banks to investigate errors and reported fraud
promptly and to correct any errors within one business day. A
consumer’s liability for unauthorized transfers is limited to $50
or the amount of the transfer (whichever is less) for transfers
made before the consumer notified the bank of the
unauthorized use. After the consumer notifies the bank, the
consumer is not liable for any additional unauthorized
transfers. However, if the consumer fails to notify the bank

Consumer Law | 360

within two business days of the unauthorized transfer, then the
consumer’s liability rises to $500.
A preauthorized

transfer is an electronic fund transfer

authorized in advance to recur at regular intervals. For
example, a consumer authorizes her monthly mortgage
payment to be automatically withdrawn from her banking
account on the first of every month. Preauthorized transfers
require banks to:
• Receive written instructions from the consumer about the
timing, amount, and duration of the transfers; and
• Allow the consumer to stop payment up to three business
days before the scheduled transfer date.

Identity Theft
Identity theft is an increasing concern for businesses and
consumers. The Federal Trade Commission estimates that at
least ten million consumers are victims of identity theft each
year.
While consumers cannot completely prevent identity theft,
there are some steps that they can take to minimize their risk.
First, consumers should monitor their bank accounts and
charges on their credit and debit cards. If they notify their
banks of unauthorized transactions as soon as possible, then
they will minimize their personal liability. Second, consumers
should request their credit report at least annually. Parents
are entitled to request credit reports for their minor children.
Third, consumers can place a credit freeze on their credit report
to prevent third parties from accessing their financial and
personal information and from obtaining credit under their
name.

361 | Consumer Law

If a consumer is a victim of identity theft, he or she can post
a fraud alert with the credit bureaus to be included in his or
her credit report. A fraud alert requires businesses to verify the
identity of an applicant for credit before extending any credit to
him or her.

Debt Collection
Businesses that are owed money from debtors may seek a
court judgment to collect the debt. However, the judicial
process is often expensive and time consuming. As a result,
many businesses prefer to collect debts outside of the court
system.
To prevent abusive practices by debt collectors, Congress
passed the Fair Debt Collection Practices Act (FDCPA) in 1978.
Under FDCPA, a debt collector must, within five days of
contacting a debtor, send a written notice containing:
• The amount of the debt;
• The name of the creditor to whom the debt is owed; and
• A statement that if the debtor disputes the debt in writing,
all collection efforts must stop until the creditor receives
evidence of the debt.
FDCPA also prohibits certain debt collection practices. Debt
collectors cannot:
• Contact a debtor who has notified the collector in writing
that he or she wants no further contact;
• Contact a debtor who is represented by an attorney;
• Call a debtor before 8:00 a.m. or after 9:00 p.m.;
• Threaten a debtor or use obscene or abusive language;
• Contact a debtor at work if the employer prohibits such

Consumer Law | 362

contact;
• Imply or say that they are attorneys or government
officials when they are not;
• Use a false name;
• Make any false, deceptive, or misleading statements;
• Contact family and acquaintances of the debtor more
than once or for any reason other than to locate the
debtor;
• Tell family and acquaintances of the debtor that he or she
is in debt;
• Publish the debtor’s name and address on a “bad debt” list
on the internet or in the newspaper; or
• Collect charges in addition to the debt unless permitted
by state law or contract signed by the debtor.
Filing a collection action in court does not violate any of these
rules.

20.4 Enforcement
Congress empowered both the Federal Trade Commission and
the Consumer Financial Protection Bureau to enforce the
primary federal consumer protection laws. However, numerous
federal and state laws contain provisions to protect consumers.
As a result, there are many federal and state agencies that have
regulations related to consumer protection.
The Consumer Financial Protection Bureau (CFPB) was
created by Congress in 2010 to be a single point of contact for
consumers who seek financial consumer protection. The CFPB
is intended to consolidate enforcement efforts and to make
them more consistent than when they were shared among
agencies. The CFPB is authorized to enforce the federal

363 | Consumer Law

consumer protection laws discussed in this chapter, as well as
others.

20.5 Concluding Thoughts
Consumer protection laws are intended to protect consumers
from unethical and unfair business practices. These laws are
broad in range, from advertising and marketing to recalling
delivered products that are hazardous. With the continued
evolution of electronic transactions and banking, consumer
law will continue to evolve to address areas of concern as they
develop.

Consumer Law | 364

21. Workplace Privacy
and Information
Security
21.1 Introduction
LEARNING OBJECTIVES
1. Identify some of the most important privacy laws
impacting businesses today.
2. Understand the Constitutional basis for privacy rights.
3. Explore the legal issues involved with modern technology
and information security.
Privacy is a fundamental right of individuals that is often
compromised by government and businesses. Sometimes
individuals and businesses voluntarily give up their privacy
rights, without considering the consequences of doing so.
Workplace privacy and information security is a fast growing
area of the law that has important implications across
industries.

Counselor’s Corner Privacy and cybersecurity are
two of the most dynamic areas of the law. As our
society becomes more and more dependent on
technology, and as the Internet of Things continues

365 | Workplace Privacy and
Information Security

to expand, we are seeing privacy issues explode in
personal and professional contexts. Businesses
would do well to consult with cybersecurity and
privacy experts to ensure that they are complying
with the law and protecting their networks and
confidential information as much as possible.
Bringing in experts after you have a security breach
or lawsuit filed is way too late. Be proactive. It just
may save your business. ~Katie D., attorney

21.2 Right to Privacy
Privacy is the right of a person or person’s property to be free
from unwarranted public scrutiny or exposure. In other words,
it is the right to personal autonomy and to express oneself
selectively. Privacy includes both bodily integrity and the
protection of confidential information, including medical and
financial records.

Implied Constitutional Right
Privacy is an implied Constitutional right, meaning it is a right
based on the “zones of privacy” created by the US Constitution.
However, the word “privacy” is not in the Constitution itself.
The right to privacy was first mentioned in a Harvard Law
Review article in 1890 by Samuel Warren and Louis Brandeis,
who later served on the US Supreme Court from 1916 until
1939. Warren and Brandeis argued the right to privacy is an
Workplace Privacy and Information Security | 366

important civil liberty which should not be violated by
sensational journalists and developments in technology. The
technology in the late 1890s they were the most concerned
with was photography and telephones. In particular, they were
concerned about people losing their right to privacy when
others

take

photographs

of

them

or

listen

to

their

conversations.
Privacy was discussed in the legal community for 75 years
before the US Supreme Court expressly held individuals have
a Constitutional right to privacy in the 1965 Griswold v.
Connecticut decision.
Privacy cases involve different circumstances, such as the right
to choose whether to marry and to whom, the right to choose
whether to have children, and the right to protect confidential
information such as medical and financial records.
The Framers of the Constitution did not include the word
“privacy” in the Constitution but it is a fundamental right
underlying the core tenets of the document. The Bill of Rights
begins by recognizing fundamental rights that are essential to
an individual’s identity: speech, religion, press, assembly, and
petition for redress from the government. From there, the Bill
of Rights expands protection of individuals to include their
homes and possessions. For example, the Fourth Amendment
prohibits

unreasonable

searches

and

seizures

by

the

government. As reflected in the Bill of Rights, privacy is an
essential right the Constitution intends to protect.
When analyzing privacy cases, courts ask whether an
individual has a reasonable expectation of privacy. To establish
a “reasonable expectation of privacy,” a person must meet two
requirements:
1. The individual has an actual, subjective expectation of
privacy. In other words, did that particular person think he
367 | Workplace Privacy and Information Security

or she was doing something in private that others could
not observe?
2. Society accepts the individual’s expectation of privacy as
reasonable. In other words, as a community do we expect
those circumstances to be private?
This legal test has both a subjective and objective standard. If
an individual does not expect their actions to be private, then
no right to privacy exists under the circumstances. Similarly,
if society as a whole does not expect to have privacy under
the circumstances, it does not matter what the individual may
personally believe, no right of privacy exists.
For example, if a person calls her doctor to discuss medical
test results, then she has a subjective expectation of privacy. If
she calls her doctor from her home, then she has an objective
expectation of privacy because society recognizes the right of
people to have private conversations in their own homes.
However, if she has the conversation on her cell phone while
riding the bus, then she does not have a right to privacy
because it is not objectively reasonable to expect privacy on
public transportation.
Privacy cases also focus on whether a person has given either
express or implied consent to disclose or use personal
information. Express consent is often given in the form of
contracts, including end user agreements. Implied consent is
usually based on the person’s actions, such as a history of
business transactions. In essence, implied consent means that
a business has reason to believe that a person would give
consent if the business asked for it. For example, customers
who sign up for a loyalty program may give implied consent to
receive marketing emails from that particular business.
While consent and the expectation of privacy are interrelated
concepts, they are legally different concepts.

Workplace Privacy and Information Security | 368

Statutes
Congress and state legislatures have also passed various laws
to protect the privacy of individuals and their property. Some
of the most important federal laws related to workplace privacy
are discussed below.
There is a growing trend among states to require internet
service providers to obtain consent from consumers before
sharing any of their personal information, including websites
visited and consumer habits.
Businesses

engaged

in

e-commerce

with

residents

of

California must post their privacy policy conspicuously on their
websites and abide by their policies. California law also requires
disclosure of consumer software tracking policies.

International Law
The right to privacy is contained in Article 12 of the Universal
Declaration of Human Rights, which was adopted in 1948 in
response to the horrors of World War II. The Universal
Declaration of Human Rights states:
No one shall be subjected to arbitrary interference with
his privacy, family, home or correspondence, nor to
attacks upon his honor and reputation.
The Universal Declaration of Human Rights has been adopted
by the majority of nations, including the United States.
Many other bilateral treaties and conventions recognize the
right to privacy in various circumstances. Currently, about 150
nations recognize privacy as part of their international legal

369 | Workplace Privacy and Information Security

obligations. However, enforcement of the right to privacy is
inconsistent across nations.
It is important for US businesses operating in Europe or
conducting

business

understand

that

the

transactions

with

Europeans

to

European

Union

(EU)

a

has

comprehensive set of laws to protect the privacy of European
individuals and businesses. The EU General Data Protection
Regulation (GDPR) applies to all businesses, even located
outside of Europe, that collect, store, or process data about
any European. Under GDPR, individuals have the right to know
how their personal data is being collected and used, to remove
information from the internet, and to stop companies from
processing their data. GDPR has significant penalties. For
example, businesses mishandling customer information may
be fined up to four percent of their annual worldwide revenue.
Under GDPR, businesses must comply with six data processing
principles. Personal information must be:
1. Processed lawfully, fairly and transparently;
2. Collected only for specific legitimate purposes;
3. Adequate, relevant and limited to what is necessary;
4. Accurate and, where necessary, kept up to date;
5. Stored only as long as is necessary; and
6. Processed in a manner that ensures appropriate security.

21.3 Workplace Privacy
Employees generally do not have a reasonable expectation of
privacy in the workplace, especially when using company
equipment or when the employer has a policy stating
employees may be monitored. However, some areas such as
employee restrooms and locker rooms may not be monitored.

Workplace Privacy and Information Security | 370

Courts have held employees do not give up all expectations
of privacy by the nature of their employment. Therefore,
employers should ensure that they limit monitoring activities
to reasonable places where the employer has a legitimate
business interest for doing so.

Hiring Process
Employers often run background checks on prospective
employees as part of their hiring process. Depending on what
type of background check is done and the information used, a
range of privacy issues are involved. Some states regulate the
type of documents that a prospective employer may consider
when making hiring decisions. Businesses need to ensure they
comply with all state laws where they hire employees.
The use of artificial intelligence (AI) is a growing trend in
recruiting and hiring. AI is often used to review resumes,
applications, and publicly available social media. AI-powered
video-interview platforms apply algorithms to video-recorded
interviews to facilitate an employer’s assessment of applicants.
Illinois was the first state to pass an AI Interview Act, which
requires prospective employers to notify applicants of their use
of AI and to obtain their consent before using AI tools on their
application materials. Although limited to its state, the Illinois
law has been cited by many legal experts as a template for
other federal and state laws.
Based on the Illinois law, employers who use AI during their
hiring process should adopt the following best practices:
• Give notice to applicants of the use of AI-powered videointerview platforms;
• Explain what the AI is and how it works in ordinary
371 | Workplace Privacy and Information Security

language to applicants;
• Obtain consent of applicants to use and record their video
interviews;
• Offer an alternative interview method for interviews; and
• Have a procedure in place for the destruction of
recordings.

Drug and Alcohol Testing
Employers with drug and alcohol testing policies are highly
regulated by the states where they operate. State requirements
vary about required notice of testing, the nature and location
of testing, and when testing may occur. All states protect
employee privacy regarding who receives the test result and
how those results are to be collected, stored, and destroyed.
Employers who engage in drug and alcohol testing need to
be informed about the legal consequences of enforcing their
policies.
Employees frequently challenge drug and alcohol testing as a
violation of their right to privacy. Employers generally win these
lawsuits when:
• The employer complies with all state requirements for
drug and alcohol testing;
• Conducts the test with the employee’s consent;
• Conducts the test in a manner that was not offensive; and
• The test results do not reveal information unrelated to the
purpose of the test.
Employers must be careful to limit disclosure of test results
to only those with a need to know. Businesses may lawfully
conduct a drug or alcohol test but still be liable for privacy
violations based on how they handled the results.

Workplace Privacy and Information Security | 372

Health Insurance Portability and
Accountability Act
The Health Insurance Portability and Accountability Act of 1996
(HIPAA) seeks to protect confidential health information and
mandates standards for handling such information.
HIPAA has a Privacy Rule regulating the use and disclosure
of individually identifiable health information. The Privacy Rule
protects Protected Health Information (PHI), which includes
all information related to the past, present or future health
status of an identified individual, of treatment received, or of
payment for treatment. PHI also includes billing records,
information about premium payments, and enrollment
information. As a result, PHI includes medical information
required by employers to carry out their obligations under the
Americans with Disabilities Act, the Family Medical Leave Act,
workers’ compensation, drug testing, and employer-sponsored
health care plans.
HIPAA also has a Security Rule to ensure the confidentiality,
integrity and availability of electronic PHI. Under the Security
Rule,
• Confidentiality means PHI is not made available or
disclosed to unauthorized individuals or processes;
• Integrity means PHI is not altered or destroyed in an
unauthorized manner; and
• Availability means PHI is accessible and usable upon
demand by an authorized individual.
The Security Rule also requires businesses to protect electronic
PHI against reasonably anticipated threats and reasonably
anticipated violations of the Privacy Rule.
Figure 21.1 HIPAA Security Rule
373 | Workplace Privacy and Information Security

HIPAA requires businesses to designate a single person who
is ultimately responsible for the security of electronic PHI. This
person is also responsible for ensuring the business engages
in the mandatory security management process under HIPAA.
This process starts with a risk analysis of the potential
vulnerabilities in the business’s system and management of
Workplace Privacy and Information Security | 374

PHI.

The

security

management

process

is

extensively

regulated.
Importantly, HIPAA applies to “covered entities” rather than
specific types of information. Personal fitness trackers such
as Fitbit, gather what is essentially healthcare data of its
consumers. However, Fitbit data can be sold as consumer
information because Fitbit is not a covered entity under HIPAA
with regard to its consumers. However, if Fitbit gathers PHI
of its employees who request medical leaves of absence, then
Fitbit is a covered entity as an employer.

Electronic Monitoring
Federal law and most state laws allow employers to monitor
their employees’ electronic communications occurring over
the employer’s hardware, software, and servers. If the employer
provides the computer system, the employer has the right to
monitor electronic communications on the system, even if
those communications are not work related.
Employers

may

also

monitor

communications

when

employees consent to the monitoring. Therefore, many
employers require employees to sign a waiver consenting to
private communications sent via the employer’s equipment to
be monitored. This helps defend against invasion of privacy
claims better than having a policy in the employee handbook
alone.
Businesses may also monitor conversations with customers in
the ordinary course of business as long as they give notice. As
a result, many customer service lines use a recorded message
that “this call may be monitored for training purposes” before
customers are connected to a customer service agent.

375 | Workplace Privacy and Information Security

The most important federal law regarding monitoring of
electronic communications is the Electronic Communications
Privacy Act (ECPA), which was passed by Congress in 1986.
ECPA has two parts. The first part is known as the Wiretap
Act and the second as the Stored Communications Act. ECPA
prohibits the acquisition of the the content of a wire, oral or
electronic communication using an electronic, mechanical or
other device. ECPA also prohibits the use or disclosure of an
unlawfully intercepted communication.
ECPA exposes businesses to multiple levels of liability within
a business. For example, personnel in the IT department may
be liable for unlawfully intercepting an employee’s email, and
human resource personnel who use and disclose the email
may

be

liable

as

well.

Each

unlawfully

intercepted

communication may give rise to liability. Therefore, a handful of
communications may result in multiple individuals throughout
a business repeatedly violating ECPA.

Workplace Recordings
Although recordings may be useful to capture the content of
a conversation, recordings pose legal and business risks to
employers. Both employers and employees may violate federal
and state wiretapping laws by recording conversations without
consent of the other parties. Even with consent, businesses
that engage in recording employees and customers damage
employee morale and risk losing customers.
Twelve states prohibit recording a conversation unless all
parties consent. The majority of states allow customers and
employees to hold a business liable for wiretapping violations
under the respondeat superior doctrine. As a result, businesses
may be liable for their employees’ unlawful recordings if done

Workplace Privacy and Information Security | 376

in the course and scope of employment or done to help the
business.
State and federal wiretapping laws carry both civil and criminal
penalties. Many state laws provide for treble damages or a
statutory damage amount. Federal wiretapping laws impose
fines up to one hundred dollars per day or ten thousand dollars,
whichever is greater.
Another

potential

problem

for

businesses

is

putting

confidential business information at risk. For example,
employees may capture trade secrets, proprietary information,
or business strategies that the business wants to protect.
Recorded information can be compromised or shared against
the business’s interests.

Social Media
An employer’s right to monitor electronic communications
generally does not include social media. As a result, employers
are not entitled to monitor social media accounts through
coercion or deceit. For example, an employer cannot require
employees to provide passwords to their social media
accounts. Employers also cannot log onto the social media
accounts of others (including employees) and pose as them to
see private accounts.
However, if social media accounts are public, then employers
are entitled to review them to the same extent as other
members of the public.

377 | Workplace Privacy and Information Security

Videotaping and Surveillance Cameras
ECPA only protects electronic communications. As a result,
ECPA does not apply to video or camera surveillance without
an audio component. To avoid violating ECPA, businesses
should ensure their security and surveillance cameras do not
capture human voices.
Security cameras cannot be used in areas in which employees
and customers have a reasonable expectation of privacy. For
example, retailers cannot use cameras in changing rooms,
restrooms, and locker rooms. Businesses need to place
cameras so that private activity cannot, and is not, monitored
and recorded.
Businesses engaged in surveillance must use the most limited
means available to conduct the surveillance. Companies
should have a legitimate business reason to use security
cameras, and they need to ensure the surveillance is targeted
and limited in duration and scope.
Retailers who use cameras to prevent theft at entryways and
cash registers should place cameras in positions that are open
and obvious to act as notice to customers. Signs giving express
notice are also a best practice to avoid legal liability.

Biometrics and Wearable Technology
Biometrics is the automated identification of people using
their physical characteristics. While many metrics can be used,
fingerprints and facial recognition are the most common. It is
helpful to think of biometrics as measurements of some aspect
of a person.
There is a growing trend among businesses to move from
Workplace Privacy and Information Security | 378

traditional time clocks to biometric time clocks that scan
fingerprints, retinas, or irises to verify an employee’s identity
and clock the employee in and out of work. Biometric time
clocks prevent time clock fraud, increase timekeeping
efficiency, and increase accuracy of wages.
The type of biometric technology used impacts the privacy
rights involved. Technology storing biometric data directly
impacts privacy rights more than technology creating a
“template” through an algorithm to create a representation
of a fingerprint. Whether the technology captures and uses
existing personal information or creates a replica has legal
consequences.
There have been a series of class action lawsuits against
employers that have not notified employees when their
biometric identifiers and data were being shared with third
party timekeeping vendors. Consent is only a defense for
employers if they give notice and obtain consent for all uses of
the information.
Another

technology

trend

is

the

use

of

wearable

technology. Wearable technology is a category of electronic
devices that can be worn as accessories, embedded in clothing,
implanted in the user’s body, or even tattooed on skin. The
devices are intended to be hands-free, are powered by
microprocessors and connect with the Internet. Wearable
technology includes smartwatches, fitness trackers, and
medical devices. It is helpful to think of wearable technology as
something that an employee has.
Wearable technology is often used to track employee locations
and grant access to areas. Concerned about private companies
coercing employees to be microchipped, states are passing
laws prohibiting employers to require, coerce, or compel an
individual to receive a microchip implant or use wearable
technology as a condition of employment.
379 | Workplace Privacy and Information Security

21.4 Information Security Issues
Information security is one of the fastest growing areas of the
law affecting businesses today. Any business that collects, uses,
and stores personal information about employees and
customers is subject to these laws. Businesses are also
increasingly targeted by hackers who seek to steal private
information on a large scale.

Security Analysis
A simple but widely-used security model is the CIA Principle
or CIA Security Rule, which stands for Confidentiality, Integrity
and Availability. The principle is applicable across points of
contact from access to a user’s internet history to security of
encrypted data across the Internet.
Figure 21.2 CIA Principle

Workplace Privacy and Information Security | 380

Confidentiality is the ability to hide information from those
without authorization to view it. While perhaps the most
obvious principle, it is usually the one that is attacked most
often. Cryptography and Encryption are methods used to
protect confidentiality of data transferred across the Internet.
Integrity is the ability to ensure that data is an accurate and
unchanged representation of the original information. One
common security attack is to intercept some important data
and make changes to it before sending it on to the intended
receiver.
Availability is the ability to make information readily accessible
to authorized users at all times. Some security attacks attempt
to deny access to appropriate users, either to inconvenience
them or to achieve another goal such as redirecting business
to a competitor.

381 | Workplace Privacy and Information Security

As discussed in Section 21.3 above, HIPAA’s Security Rule
requires covered entities to implement the CIA principle to
protect PHI.

Data Breaches
According to the Pew Research Center, almost eighty-five
percent of individuals in the US shop online. And most retailers
collect customer’s personal and financial data. If a customer
uses a form of payment other than cash, then the customer’s
personal and financial information will be shared with the
business.
Rather than pickpocket an individual consumer, thieves today
are targeting businesses to collect personal and financial
information of entire consumer sets. Data breaches affect all
industries, such as retail, credit bureaus, hospitals, and
government agencies. In the first half of 2019, there were over
4.1 billion compromised documents reported as part of only
3,800 disclosed data breaches.
Cybersecurity

experts

advise

that

cyber

criminals

run

automated online scripts looking for unsecured databases.
While some larger businesses are particularly targeted, cyber
criminals are the most successful when targeting small to
medium-sized businesses that are unaware of the threat or do
not want to spend adequate resources on cybersecurity.
Businesses should be aware, though, that approximately sixty
percent of data breaches are the result of human error rather
than outdated or insufficient technology. Therefore, by
adequately training employees, many data breaches may be
avoided. For example, breaches often result from sending
emails to the wrong person, responding to phishing attacks,
sharing passwords, and leaving computer screens open.
Workplace Privacy and Information Security | 382

Another big risk is when people use the same password for
multiple accounts, such as email accounts, bank accounts, and
social media. If the password is obtained by cyber criminals and
added to the database of passwords, all the accounts will be at
risk.

Big Data
In addition to financial data, businesses collect personal
information about consumers and their habits. This is
called big data. Consumer information is very valuable because
businesses can search the data to identify spending habits to
target marketing to likely customers. This reduces costs and
increases profit for businesses, especially as e-commerce
increases the number of competitors across industries.
Another benefit to mining the data available about consumers
is businesses can make more profitable decisions. For example,
health insurance companies are heavily invested in big data
because they want information about the lifestyle habits of
the people they insure and potentially insure. If they know
someone is a smoker, eats a lot of sugary foods, or has a
sedentary lifestyle, then they can adjust premiums accordingly
to minimize their risk. Insurance companies look for trends
not just for individuals but also regions, types of occupations
(including those with the highest risk of addiction or obesity),
and socio-economic status.
Big data is also connected to the Internet of Things. The
Internet of Things (IoT) is a system of interrelated computing
devices, mechanical and digital machines, objects, animals or
people that are provided with unique identifiers and the ability
to transfer data over a network without requiring human-tohuman or human-to-computer interaction. In other words, the

383 | Workplace Privacy and Information Security

IoT includes everyday devices connected to the internet,
including medical devices, appliances, vehicles, and buildings.
As more businesses seek big data about consumers and sell
IoT items to consumers, privacy rights are impacted. Data
collection in public spaces, such as billboards tracking who
stops to read them, may be lawful. However, the location and
manner of data collection involves different expectations of
privacy. For example, businesses argue that by purchasing and
installing “smart home” appliances and products, consumers
have consented to surveillance and data collection. Consumer
advocacy groups argue that purchasing goods for a particular
use does not give consent to businesses to invade consumer
privacy in their homes. These issues will be heavily litigated in
the years to come.

Transborder Data Transfers
As discussed previously, the EU has a comprehensive set of
privacy laws and regulations. The EU has strict limits on the
export of all human resources data and consumer information
to the US, even when the data export occurs within the same
business. To help US businesses comply with the EU laws, the
US Department of Commerce negotiated a “safe harbor” of
data protection practices that the EU approved. If a US
business can certify its compliance with the Safe Harbor
Principles, then the EU will approve data transfers to that
business.

Workplace Privacy and Information Security | 384

Security Incident Preparation and
Response
Businesses are not able to prevent all data security breaches.
However, businesses need to take steps to protect against
known and reasonably anticipated threats to confidential
information.

For

businesses

without

sufficient

in-house

cybersecurity staff or expertise, Managed Security Service
Providers (MSSPs) offer a wide range of security services,
including setting up security infrastructure and incident
response.
Although

federal

and

state

laws

vary

regarding

legal

requirements, a business should have a written cybersecurity
program

that

conforms

to

their

industry’s

recognized

cybersecurity framework.
In general, a cybersecurity program should:
• Protect the security and confidentiality of all electronically
stored records containing an employee or customer’s
social security number, driver’s license number, state
identification card number, credit and debit card
information, dates of birth, passwords, and personal
information;
• Protect against any anticipated threats or hazards to the
security or integrity of the confidential information;
• Provide for reliable and accurate backups of data; and
• Protect against unauthorized access to and acquisition of
information likely to result in an employee or customer
being exposed to a material risk of identity theft or fraud.
Many laws, including HIPAA, have cybersecurity regulations
with which businesses must comply. Certain industries have
also issued their own security standards. For example, the

385 | Workplace Privacy and Information Security

Payment Card Industry (PCI) Security Standards Council has
issued standards for the safety of credit and debit cardholder
data across the globe.
Businesses

wanting

information

about

implementing

cybersecurity programs that are appropriate for their industry
should consider the National Institute of Standards and
Technology’s

(NIST)

Framework

for

Improving

Critical

Infrastructure Cybersecurity. The mission of NIST is to help
organizations understand and improve their management of
cybersecurity risks. It is an excellent place to start when
analyzing cybersecurity issues.

21.5 Concluding Thoughts
The internet and technology are changing the world at an
incredibly fast pace. With those changes come the challenges
to individuals and businesses to maintain privacy and protect
personal information. Privacy is an implied Constitutional right
deeply impacted by the use of technology. Regardless of type
of industry, businesses need to have adequate cybersecurity
policies and practices in place to protect confidential business,
employee, and customers information.

Workplace Privacy and Information Security | 386

22. Property
22.1 Introduction
LEARNING OBJECTIVES
1. Distinguish between personal property and real property.
2. Understand classifications of property.
3. Examine methods of acquisition of real and personal
property.
4. Examine the landlord-tenant relationship.
5. Understand how property is transferred through wills and
trusts.
6. Explore common land use regulations and environmental
laws that businesses face.
Property refers to tangible and intangible items that can be
owned. Ownership is a concept that means the right to
exclude others. Legal systems create a peaceful means to
acquire, retain, and divest property, and to settle property
disputes. Businesses need to understand the legal system
regarding both personal and real property because they often
own or lease both. In addition, the government regulates how
real property can be used as well as any environmental impact
a business has.

Counselor’s Corner Property is regulated by state
laws. Because of the variation of laws from state to

387 | Property

state, it is imperative that businesses understand all
legal requirements where they have property
interests. Property can be a great seducer–it seems
like owning or possessing property is an asset.
However, the liability that comes with it may not be
in the business’s best interest. Take the time to
assess the financial and legal risks and rewards
before acquiring property interests to ensure that
you are not overextending yourself. ~Elizabeth H.,
judge

22.2 Personal Property
Property can be classified as real or personal. Real property is
land, and certain things that are attached to it or associated
with it. Real property is raw land, such as a forest or a field, as
well as buildings, like a house or an office. Additionally, things
associated with land, like mineral rights, are also real property.
People often talk about real property by using the term real
estate, which includes both real property and its related
ownership interest.
Figure 22.1 Types of Real Estate Legal Issues

Property | 388

Personal property is property that is not real property. Tangible
property is something that can be touched. Moveable, tangible
personal property is called chattel. Many businesses exist to
sell personal property. For example, the primary purpose of
retailers is to sell personal property. Some property can also
be described as fungible property. Property that can easily be
substituted with identical property is said to be fungible. Types
of fungible goods include juices, oil, metals such as steel or
aluminum, and physical monetary currency.
Intangible property does not physically exist, but it is still
subject to ownership principles, including acquisition, transfer,
and sale. For instance, the right to payment under a contract,
the right to exclude others from a patented product, and the
right to prohibit others from using copyrighted materials are all
examples of intangible property.

389 | Property

Personal property can become attached to the land as a
fixture. A fixture is something that used to be personal
property, but it has become attached to the land so that it is
legally a part of the land. Fixtures are treated like real property
so when real property is transferred, fixtures are transferred as
a part of the real property. A ceiling fan for sale at a store is
personal property. However, once the fan is installed in a house,
it becomes a fixture and is part of the real property.
Some things that are attached to the land are not fixtures but
are part of the real property itself. Imagine a farm with planted
corn. The corn crop is an example of real property that can
become personal property. While the corn is growing and still
attached to the land, the corn is real property. Once it is picked
from the stalk, the ear of corn becomes personal property.
Property also can be classified by ownership. Personal and real
property can be private or public. Private property is owned
by someone or some entity that is not the government, such
as individuals, corporations, and partnerships. Private property
can include real property like land or buildings, and personal
property, such as vehicles, furniture, and computers. Property
that is owned by the government is public property. Rocky
Mountain National Park is an example of public property that
is real property. Public property can also include personal
property, such as vehicles and computers owned by state or
local governments.

Methods of Acquisition of Personal Property
Personal property may be acquired in several different ways.
For example, ownership by production occurs when one
produces something. However, if an employee produces a
good as part of his or her job, then the employer will own

Property | 390

the property, not the employee. Ownership by purchase is the
most common method of acquiring property. For example, if
a customer buys a good, then the customer owns it through
purchase from the manufacturer.
Property may also be gifted. A gift is a voluntary transfer of
property. Generally, the donor of the gift must intend to gift the
property, the donor must deliver the gift, and the gift must be
accepted by the intended recipient. A conditional gift is a gift
that requires a condition to be met before the gift will transfer,
such as a wedding or graduation.
Property that someone finds can be classified in several ways.
If property is abandoned, a person who finds it may claim
ownership. However, the original owners of abandoned
property must intend to relinquish ownership in it. For
example, if someone takes a chair to the landfill, he or she
has abandoned the chair. Someone may come along and take
legal possession of it. However, if the property is simply lost or
mislaid, then the finder must relinquish it once the rightful
owner demands its return. Another classification of personal
property applicable to found property is treasure trove.
A treasure trove is money or precious metals, like gold, which
is hidden in the ground or other private place by an unknown
owner. Whoever finds a treasure trove becomes the owner
unless the true owner (i.e. the person who hid it) comes
forward.

391 | Property

Type of
Property

Rights of
Finder

Rights of
Owner

Finder
acquires
rights to the
property

None

Finder has
rights to the
property
against
everyone
except the
owner

Owner has
right to have
property
returned
because
owner never
lost
ownership
interest

Owner intentionally
placed property in a
specific place but
has forgotten where

Finder has no
rights and
cannot keep
property

Owner has
right to have
property
returned
because
owner never
lost
ownership
interest

Owner intentionally
hid property

Finder
acquires
rights to the
property
unless the
owner comes
forward

Owner must
come forward
to maintain
right to
property; if
not, finder
becomes new
owner

Description

Owner intentionally
parted with
Abandoned property with intent
to relinquish
ownership rights

Lost

Mislaid

Treasure
Trove

Owner
unintentionally
parted with
possession of the
property

Bailment
Sometimes it is necessary to intentionally leave personal
property with someone else. A bailor is someone in the rightful
possession of personal property who gives the property to
someone else to hold, who is called a bailee. A bailment is the
arrangement in which the personal property is exchanged. The
bailee agrees to accept the property and has the duty to return
it. For example, a customer gives clothes to a dry cleaner. The
Property | 392

dry cleaner is a bailee and has a duty to return the clothes
(personal property) upon demand by the customer, who is the
bailor.
Bailments may be voluntary or involuntary. A voluntary
bailment is created when intention exists to create the
bailment, as described in the dry cleaner example above. An
involuntary bailment is created when someone finds lost or
mislaid property. The finder may not destroy the property,
though the duties that he or she owes regarding the property
may vary from state to state.
Bailment is common in business, including placing packages
with common carriers for delivery, warehousing goods with a
third party, or taking clients’ or customers’ automobiles in a
valet service.
The duty of care that the bailee owes to a bailor depends on
the nature and value of the property involved, as well as who
benefits from the bailment. In general, a higher standard of
care is required for more valuable property. Damages in a
bailment case are based on the retail replacement value of the
property.

22.3 Real Property
Real property is land, and certain things that are attached to
or associated with it. Real property includes undeveloped land,
like a field, and it includes buildings, such as houses, and office
buildings. Real property also includes things associated with
the land, like subsurface rights (rights to minerals and things
found beneath the surface).

393 | Property

Methods of Acquisition
Real property may be acquired by purchase, inheritance, gift, or
through adverse possession. Ownership rights are transferred
by title. Ownership of real property means that the owner has
the right to possess the property, as well as the right to exclude
others, within the boundaries of the law. If someone
substantially interferes with the use and enjoyment of real
property, the owner may bring a nuisance claim. Similarly, the
owner may bring a trespass claim against those who enter the
land without consent or permission.

Purchase
Land owners may convey or sell part or all of their land
interests. Different types of deeds convey different types of
interests. A quitclaim deed, for instance, conveys whatever
interests in title that the grantor has in the property to the
party to whom the quitclaim is given. That means if the grantor
has no interests in the real property, a conveyance by quitclaim
will not grant any interests in the property. By comparison,
a warranty deed conveys title and the seller gives a warranty
against defects in title as well as encumbrances. Buyers
typically demand a warranty deed when they purchase
property because the seller assumes the risk of the title not
being clear.
After title is transferred by the deed, the deed is recorded in
the county where the property is located. Recording a deed
is important because it places others on notice about who
owns the property. States have different rules about who is
considered the legitimate owner when a conflict in ownership
claim exists. A bona fide purchaser is a purchaser who takes
title in good faith, with no knowledge of competing claims to

Property | 394

title. Many states recognize a bona fide purchaser’s rights to
ownership over those who did not properly record a deed.

Inheritance
Another common way in which real property may be obtained
is through inheritance. Real property may be bequeathed
through a will or may be transferred by state law when
someone dies without a will. Generally speaking, people have
the right to dispose of their property as they wish when they
die, providing that their will or other transfer instrument meets
their state’s requirements for validity. If someone dies without
living relatives, the government becomes the owner of the
property.

Gift
Real property may also be acquired through a gift. A gift is valid
when:
1. The person giving property intends to make the gift;
2. The person delivers the deed to the recipient; and
3. The recipient accepts the gift.
If one of these elements is not met, then title will not be
conveyed.
Figure 22.2 Comparison of Contract and Gift

395 | Property

Adverse Possession
A less common way to acquire real property is through the
doctrine of adverse possession. Adverse possession is when
someone who is not the owner of real property has claimed the
real property for his own. This is referred to as “squatter’s rights.”
If land sits idle at the owner’s hands but someone else puts it
to use, then the law may favor the user’s claim to the land over
that of the actual owner. Adverse possession claims often occur
around property lines, where one party has routinely used
another’s property because a fence has been misplaced.

Property | 396

Figure 22.3 Adverse Possession Cartoon

Interests and Scope
Owning real property carries many responsibilities, as well as
the potential for great profit and great liability. It is important
to learn how to protect against potential liability of property
ownership. For instance, if a toxic waste site is discovered on
real property, the owner may be liable for its cleanup, even
if he or she did not realize that such a site was there when
purchasing the land. Each buyer of real property has a duty
to exercise due diligence when purchasing land. A purchaser

397 | Property

should never agree to buy land “sight unseen” or without a
professional inspector.
It is important to know the duties of landowners, how to limit
liability associated with the ownership of land, and when
severance of liability occurs.

Duties of Landowners
Landowners owe different duties to different types of people
who enter their land. These responsibilities vary, depending on
whether the person is a trespasser, a licensee, or an invitee.
A trespasser is a person who intentionally enters the land of
another without permission. A landowner has a duty to not
intentionally injure a trespasser. For instance, booby traps and
pitfalls are illegal. Trespassers injured from such traps have
valid claims against the landowner. However, if trespassers are
injured from unknown or unforeseeable dangers, the owner is
not usually liable.
A licensee is someone who has permission to be on the land.
Landowners have a higher duty of care to such a person.
Licensees include delivery people, meter readers, and utility
workers. A landowner must not intentionally injure a licensee
and must warn the licensee of known defects. For example, if
a landowner knows that the steps to his or her porch are icy,
he or she has a duty to warn a licensee that those steps are icy.
Failure to do so may result in liability for the landowner.
An invitee is someone who has entered real property by
invitation. Businesses and public places that want members of
the community to visit have issued invitations to the public.
Landowners must inspect their property for defects, correct
those defects when found, and warn invitees about such

Property | 398

defects. For example, a grocery store must clean up spills as
quickly as possible and put up a “caution” sign in that area.

Ownership Interests in Real Property
Different types of interests may be owned in real property. For
example, real property may be owned without restriction,
subject only to local, state, and federal laws. Sometimes
ownership interests may be narrower, subject to conditions,
the violation of which can lead to loss of those ownership
interests.
The most complete ownership interest recognized by law is
called fee simple absolute. This ownership allows the owner
complete control over the land and lasts until the owner dies
or conveys the property to someone else. Generally, if someone
wants to buy real property, he or she is looking to buy property
in fee simple absolute.
Compare that with a defeasible fee. A fee simple defeasible is
subject to a condition of ownership or to some future event.
For instance, if an owner donates land to a city “so long as it
is used as a public greenway,” then the land would be owned
in defeasible fee by the city as long as it maintains it as a
public greenway. Once the condition is violated, the land would
revert back to either the original owner or whoever owned
the reversion interest, which is a future interest in real
property.
Another ownership interest is a life estate. This interest is
measured by the life of the owner. For example, a person could
grant ownership rights in real property to a parent for the
length of his or her life, but then the property would be
returned upon the parent’s death. A common investment,
known as a reverse mortgage, employs the concept of life
399 | Property

estate. A reverse mortgage is an arrangement where the
purchaser of real property agrees to allow the seller of the
property to retain possession of the property for a specified
period of time (such as the remainder of his or her life) in
exchange for the ability to purchase the property at today’s
price.

These

arrangements

essentially

gamble

on

life

expectancies of the sellers of real property by granting life
estates to them in the property.
Property can be owned by more than one owner. Several types
of co-ownership interests are recognized in law. These
ownership interests are important for matters of possession,
right to transfer, right to profits from the land, and liability. For
example, tenancy in common describes an ownership interest
in which all owners have an equal right to possess the whole
property. Compare this to joint tenancy, in which the surviving
owner has the right of survivorship. If one of the owners dies,
his or her property interests automatically transfers to the
remaining owner(s).
These different interests are created by specific wording in the
instrument of conveyance. An owner in tenancy in common
may sell or transfer his or her rights without seeking permission
from the other owners. This is because owners in a tenancy
in common have the unilateral right to transfer their interests
in property. Conversely, to transfer one’s interests in a joint
tenancy, the consent and approval of the other owners is
required.

Scope of Interests in Real Property
Scope of ownership determines what can (or cannot) be done
with the land. The surface of the land and the buildings that
are attached to the land are what most people think of about

Property | 400

ownership of real property. However, land interests also include
subsurface or mineral rights, and right to light or to a view.
Moreover, water rights are granted differently, depending on
whether the property is in the western or the eastern United
States. Additionally, easements (the right to cross or otherwise
use someone’s land for a specified purpose) and covenants
(guides or restraints on how one may build on their land) grant
certain rights to non-possessors of land.

Subsurface Rights
Subsurface or mineral rights are rights to the substances
beneath the actual surface of the land. Purchasing mineral
rights allows the owner to extract and sell whatever exists
under the surface of the land, such as oil, natural gas, and gold.

Water Rights
Water rights are determined in two different ways in the United
States. Generally speaking, states east of the Mississippi River
follow a riparian water rights doctrine, which means that those
who live next to the water have a right to use the water. The
water is shared among the riparian owners. However, most
western states use the prior appropriation doctrine, which
grants rights to those who used those rights “first in time.”
Under this concept, the use must be beneficial, but the owner
of the right need not be an adjacent landowner. This policy has
resulted in claims by “downstream” users having priority over
landowners where water runs through the land. For example,
casinos in Las Vegas, Nevada may have priority of water rights
over ranchers in Colorado where a tributary runs through the
ranch. Prior appropriation is a “use it or lose it” doctrine.

401 | Property

Easements and Covenants
Easements and covenants are nonpossessory interests in real
property. An easement can be express or implied and it gives
people the right to use another’s land for a particular purpose.
For example, a common easement is for utility companies to
enter private property to maintain poles and power lines. Other
examples include sidewalks and a landlocked property having
an easement across another piece of property for the purpose
of a driveway or walkway.
A covenant is a voluntary restriction on the use of land.
Common covenants are homeowners associations’ rules,
which restrict the rights of the owners to use their land in
certain ways, often for aesthetic purposes. For instance, such
covenants might require houses subject to the covenant to be
painted only in certain approved colors, or they might contain
prohibitions against building swimming pools.
Some covenants and easements “run with the land,” which
means that the restrictions will apply to subsequent owners of
the property. Whether a covenant or easement runs with the
land depends on the type of interest granted.

Landlord-Tenant Relationships
A leasehold interest also may be created in real property. A
tenant has the right to exclusive possession of the real property
and the duty to follow the rules of occupancy set out by the
landlord. The landlord has the right to be paid rent and the
duty to ensure that the premises are habitable. If one party
does not perform under the lease as required, the other party
may seek a legal remedy for breach of contract. Most state laws
also impose duties on landlords to maintain safe and habitable

Property | 402

conditions on the property. Tenants also have a duty to use
the premises properly and not to damage the property beyond
normal wear and tear.
Different types of tenancies may be created:
Type of
Tenancy

Description

Tenancy for
years

• Lease lasts for a specified period of time;
• Called tenancy for years regardless of how long
the tenancy is for;
• Once the time expires, so does the tenancy

Periodic
tenancy

• Lease states when rent is due but does not have
a set duration;
• E.g. a month-to-month lease

Tenancy at
will

• Lease may be terminated at any time by
landlord or tenant;
• Tenancy often created through actions of parties
rather than written lease

Tenancy at
Sufferance

• Tenant remains on the property after the right
of possession has ended and without the
landlord’s consent;
• Law views tenant as trespasser who is
responsible for paying rent during holdover
period;
• Most states require landlord to evict tenant
through formal eviction or unlawful detainer
proceedings

Tenancies may be created for residential or commercial
purposes. Commercial leases typically last for longer periods of
time than residential leases. Many of the same responsibilities
and duties exist with commercial leases, but there are some
important differences. For example, a commercial tenant may

403 | Property

demand that the landlord refuse to rent to a competitor of the
tenant within the same building.
Lease interests are assignable unless those rights are expressly
restricted by agreement. This means that the rights conveyed
by the lease may be transferred to another party by
assignment, unless expressly prohibited by the lease. Common
restrictions on assignment in residential leases is a nosubletting clause. Just as the owner of real property may sell
any or all of his or her interests, any ownership interest in real
property may also be leased. For example, someone who owns
the subsurface rights of land may lease the right to drill for oil
or gas to another.

22.4 Wills and Trusts
Both real and personal property may be transferred to another
owner through wills and trusts. Although most people think
of wills and trusts as a tool for conveying property owned by
individuals, businesses property often needs to be transferred
when the business owner dies. This is especially true for sole
proprietorships and partnerships.
A will is a document by which an individual directs his or her
estate to be distributed upon death. Wills must be in writing
and signed by the individual(s) making them. Although state
laws regarding wills vary slightly, most states require:

Property | 404

Requirement

Description

Legal age

• The individual must be 18 (16 in Louisiana, 14 in
Georgia, under 18 in the military)

Testamentary
intent

• Must make clear that document is a will
through words such as “last will and testament”

Testamentary
capacity

• The individual must be “of sound mind” and
understand that he or she is creating a will,
what property is being transferred & to whom it
is being given

Signature

• The individual must sign the document

Witnesses

• There must be 2 adult witnesses to the
individual signing the will;
• Most states do not require the will to be
notarized but this step is recognized as a best
legal practice

A trust is a property interest held by one person or entity at the
request of another for the benefit of a third party. For a trust to
be valid, it must involve specific property, reflect the person’s or
entity’s intent, and be created for a lawful purpose. Trusts are
very popular for leaving property to benefit children who are
under 18 years old, elderly, and people with disabilities.
When planning how to distribute property upon death, it is
important to understand the difference between probate and
non-probate assets. Probate is the process through which a
court determines how to distribute property after someone
dies. Some assets are distributed to heirs by the court (probate
assets) and some assets bypass the court process and go

405 | Property

directly to beneficiaries (non-probate assets). Probate assets
generally are subject to inheritance taxes and distribution can
be delayed until the court orders the distribution of the assets.
Because of these drawbacks, many individuals prefer nonprobate assets.
Probate Assets

• Real property titled solely in
the decedent’s name or
held in tenancy in common
• Personal property, such as
jewelry, furniture & vehicles
• Bank accounts solely in the
decedent’s name
• Interest in a partnership,
corporation or limited
liability company
• Life insurance policies or
brokerage accounts
identifying the decedent or
his or her estate as a
beneficiary

Non-Probate Assets
• Real property held in joint
tenancy or tenancy by the
entirety
• Bank or brokerage accounts
held in joint tenancy or with
payable on death (POD) or
transfer on death (TOD)
beneficiaries
• Real property, personal
property, and money held in
a trust
• Life insurance or brokerage
accounts identifying
someone other than the
decedent as a beneficiary
• Retirement accounts

Death of a property owner impacts the ability to transfer
property. The ownership interest dictates how the property
may be transferred.

Property | 406

Type of
Ownership

Death of
Owner

Transfer

Where
Available

Tenancy in
Common

Owner’s
interest passes
to heirs

Owner may
transfer
interest
without
agreement of
co-owners

All states

Joint Tenancy

Owner’s
interest passes
to the
remaining
joint tenants as
non-probate
asset

Owner may
not transfer
interest
without
agreement of
co-owners

All states

Tenancy by
Entirety

Owner’s
interest passes
to the
surviving
spouse

Owner may
not transfer
interest
without
agreement of
spouse

Approximately
half of the
states

Community
Property

Half of owner’s
interest passes
to the
surviving
spouse & other
half passes to
other heirs

Owner may
not transfer
interest
without
agreement of
spouse

Only 9 states:
Arizona,
California,
Idaho,
Louisiana,
Nevada, New
Mexico, Texas &
Washington

If someone dies without a will or trust, the probate court will
determine:
1. The nature and value of the decedent’s estate;
2. The nature and value of any outstanding debts and tax
obligations;
3. Whether the decedent has any heirs;
4. The identity of the heirs and their relationship to the
decedent; and
5. What, if anything, the heirs are entitled to receive from the
decedent’s estate.
The essential role of the probate court is to ensure that the

407 | Property

deceased person’s creditors are paid and that any remaining
assets are distributed to the proper beneficiaries. However, this
process takes time and costs money from the deceased
person’s estate. And there is no guarantee that the deceased
person intended his or her property to be distributed based
on the state’s rules on who qualifies as an heir and what they
are entitled to receive. Business assets owned by the deceased
person may complicate the probate process even more.

22.5 Land Use Regulation
A nuisance is a condition or situation, such as a loud noise or
foul odor, that interferes with the use or enjoyment of property.
Courts balance the utility of the act that is causing the problem
against the harm done to neighboring property owners. For
example, restrictions exist on when manufacturing plants may
operate to not interfere with sleeping patterns of neighbors.
Nuisance can be both intentional and unintentional, as well
as public or private. A public nuisance is an unreasonable
interference with a right common to the general public, such
as a condition dangerous to the public’s health or a restriction
on the public’s access to public property. Many jurisdictions
also include conduct that is offensive to the community’s moral
standard to regulate the placement of adult industries in
residential neighborhoods. Public nuisance claims often
include manufacturing noises, smoke and smells. A private
nuisance is a condition that interferes with a person’s
enjoyment of their property that does not involve a trespass.
For example, cigarette smoke entering a neighbor’s house
from a smoker on an adjacent property is a private nuisance.
Figure 22.4 Public Nuisance Street Sign

Property | 408

Figure 22.5 Private Nuisance Example

409 | Property

Most states have passed laws
that allow local governments
to regulate zoning. Zoning
ordinances are laws passed
by

counties,

cities,

and

municipalities that regulate
land

development.

ordinances

These

determine

whether commercial or residential buildings can be built in an
area, how tall buildings may be, and how much green space
must be maintained. They also apply to existing buildings and
regulate whether a building may be converted from residential
property to commercial, as well as what type of commercial
property it may be. For example, many zoning ordinances
regulate the types of businesses that may be located next to
schools and hospitals.
Eminent domain is the power of the government to take
private property for public use. A governmental entity may
need to build or expand highways, public transport systems, or
public housing. To address the public’s need, the government
can take private property and use it for the good of the
community. All levels of government–federal, state, and
local–have

the

power

of

eminent

domain.

The

Fifth

Amendment of the US Constitution requires that any owners
of private property taken for public use must be given “just
compensation.” Just compensation means fair market value for
the land.

22.6 Environmental Law
Federal and state governments have passed environmental
laws to limit pollution and protect the health and welfare of

Property | 410

the public. Although most people are supportive of these laws
in theory, the practical implementation of them has been
controversial. Underlying the political debate is the question,
how should the law balance the costs and benefits of
environmental decisions?

Clean Air Act
In 1963, Congress passed the Clean Air Act to regulate air
pollution. Under the Clean Air Act, the Environmental
Protection Agency (EPA) has the authority to regulate both
the total amount of existing air pollution and its ongoing
production. The Clean Air Act was passed to address concerns
of global warming and acid rain.
Figure 22.6 EPA Seal

The Clean Air Act requires the EPA to set national air quality
standards that protect public health and provide an adequate
margin of safety without regard to cost and to implement
them if appropriate and necessary. This “without regard to
cost” directive has been heavily litigated. In 2015, the US
Supreme Court ruled that the EPA must consider costs as part
of its analysis of whether the standards are “appropriate” and
411 | Property

necessary. In other words, a regulation is not “appropriate” if it
does more harm than good.
The Clean Air Act is a federal law that is implemented through
the states. After the EPA sets air quality standards, states must
enforce them. States may implement more stringent air quality
standards than the EPA requires, but they cannot do less.
Therefore, businesses must comply with both state and federal
agencies to ensure their compliance with the Clean Air Act.
A controversial aspect of the Clean Air Act is that it allows for
trading of credits. For example, a manufacturer who removes
more carbon monoxide than necessary from its emissions is
given a “credit” from the EPA. These credits can then be sold
to another manufacturer that does not remove enough to be
compliant with the law. The rationale is that credits make it
profitable for manufacturers to invest in technology that
pollutes less than is legally required. By giving a market
incentive to industries to protect the environment, there will be
less need for governmental enforcement.
The Clean Air Act imposes daily fines for emission violations,
as well as punitive damages and criminal liability for corporate
officers who knowingly and willfully violate the law. As a result,
the Clean Air Act is a law that manufacturers must take
seriously.
Figure 22.7 Common Air Pollutants

Property | 412

Clean Water Act
Congress passed the Clean Water Act in 1972 to regulate water
quality of navigable waters. Similar to the Clean Air Act, the EPA
sets standards that are enforced by the states. The intent of
the Clean Water Act is to keep water clean for recreational use
and to protect fish and wildlife. It requires a discharge permit
to release waste into navigable water.
Figure 22.8 Photo of discharge of industrial waste into river

413 | Property

The EPA sets limits, by industry, on the amount of each type
of pollution that can be discharged in a given area, as well
as the type of technology that can be used to treat water.
As a result, the two biggest issues when enforcing the Clean
Water Act are (1) is the waterway navigable? and (2) what is the
best available technology that each industry can use to reduce
pollution. Both issues are heavily litigated.
The Clean Water Act also requires the EPA to set national
standards for water quality in general. It is worth noting that
water quality standards vary depending on the use of the
water. Water quality for drinking is the highest, with wildlife
and recreation higher than irrigation and industry. As a result,
even businesses that are not discharging waste into navigable
waterways are subject to EPA standards of water quality on
their premises. For example, a retailer must comply with water
quality requirements in its drinking fountains and bathrooms.
Like the Clean Air Act, the Clean Water Act imposes daily fines
for emission violations, as well as punitive damages and

Property | 414

criminal liability for corporate officers who knowingly and
willfully violate the law.

Waste Disposal
Waste disposal, especially of chemicals, has been an area of
increased regulation over the past decades. The disposal of
ordinary garbage is primarily regulated by the states. However,
the federal government sets minimum standards for landfills
and regulates how states manage garbage. Most of these
regulations are “invisible” to businesses and individuals.
Figure 22.9 Improper Toxic Waste Disposal

Toxic waste, on the other hand, directly impacts manufacturers.
In 1976 Congress passed several laws to address the problem

415 | Property

of industrial waste and toxic waste. Toxic waste is hazardous or
poisonous substances that cause an increase in the death rate
or serious irreversible illnesses. Toxic waste includes arsenic,
asbestos, clinical waste (i.e. syringes), cyanide, lead, and
mercury. Many of these chemicals are found in batteries,
electronics, and household cleaners. Manufacturers have a
“cradle to grave” responsibility for all hazardous and toxic
waste. This means that hazardous waste must be (1) tracked
from creation to final disposal and (2) disposed of at a certified
facility.
To clean up hazardous waste that was illegally dumped in the
past, Congress passed the Comprehensive Environmental
Response, Compensation, and Liability Act (CERCLA), which is
popularly known as “Superfund.” The philosophy of Superfund
is that the polluter pays. Therefore, former and current owners
of a site on which hazardous waste is found or who transported
waste to the site are strictly liable for remediation of the land.
The law has an exception for innocent landowners who
unknowingly purchased the land. However, that exception is
narrowly applied.

Environmental Impact Statements
The National Environmental Policy Act (NEPA) requires all
federal

agencies

to

prepare

an environmental

impact

statement (EIS) for every major federal action that significantly
affects the quality of the human environment. An EIS is
required not only for actions by the federal government, but
also activities regulated or approved by the government.
Therefore, private businesses that need federal approval to
open

or

expand

their

operations

are

subject

to

this

requirement. For example, an EIS was needed before

Property | 416

expanding the Snowmass ski area in Aspen because the US
Forest Service was required to approve the expansion.
An EIS must include:
• A description of the environmental impact of the
proposed action;
• An estimate of the energy requirements for the project;
• A description of potential adverse effects on the urban
quality, including historic and cultural resources;
• Identification of the short-term and long-term impact on
the environment;
• A description of any irreversible impact on the
environment;
• A plan of how to mitigate any adverse environmental
impact; and
• A discussion of possible alternatives.
The process of preparing an EIS can be long and expensive.
After an EIS is written, the federal agency must allow for public
comments and hold a hearing. Therefore, a private business
may have its EIS scrutinized and commented on by interest
groups and competitors before receiving federal approval.
There is also a risk to the business that the government agency
denies the business’s request based on public comments and
concerns.

22.7 Concluding Thoughts
Property is classified as real property or personal property,
tangible or intangible, and private or public. Personal property
can be transformed into real property when it is affixed to the
land. Real property can be transformed into personal property
when it is severed from the land. Personal property can be
417 | Property

acquired for ownership through production, purchase, or gift
or, in certain circumstances, by finding it. Bailments are legal
arrangements in which the rightful possessor of personal
property leaves the property with someone else who agrees to
hold it and return it on demand.
When thinking about acquiring property, it is important to
understand the rights and duties associated with acquiring it,
the protections afforded to the owner, and how to transfer it to
another party at the time of sale, lease, or licensing the right to
use it. Real property includes land and the buildings attached
to it, as well as the minerals below it. Personal property is
everything

else.

Because

property

ownership

includes

exposure to liability, businesses need to take steps to protect
people on their real property from hazards. Businesses are also
subject to land use regulations and environmental laws for the
use of their real property.
Real and personal property may be transferred to another
owner through wills and trusts upon the death of the original
owner. Businesses property often needs to be transferred when
the business owner dies, and not having a will or trust in place
to convey the property can complicate the probate process.
Non-probate assets are popular to avoid inheritance taxes and
delays in distributing assets.
Environmental laws have a big impact on businesses,
especially manufacturers. The Clean Air Act and the Clean
Water Act are federal laws that are implemented through the
states, so businesses must work with both state and federal
governments to ensure they are legally compliant. Businesses
that want to open or expand their operations are required to
prepare an environmental impact statement if they need
federal approval.

Property | 418

23. Intellectual
Property
23.1 Introduction
LEARNING OBJECTIVES
1. Understand what intellectual property is.
2. Define the four types of intellectual property.
3. Explore the Constitutional roots for providing legal
protection to intellectual property.
Regardless of size and industry, a business’s Intellectual
Property (IP) is often more valuable than its physical assets. In
fact, Fortune 500 companies have 45-75% of their assets tied
to IP. Companies invest tremendous resources in developing
innovative new products and services. Intellectual property law
prevents

competitors

from

immediately

profiting

from

another’s invention and provides incentives for continued
innovation.

Counselor’s Corner Intellectual property is one of a
business’s most important assets. But it can also be
hard to define and, thus, hard to protect. A good IP
attorney will understand the nuances of your
invention and help you identify ways to get the
most protection for your intellectual property. You

419 | Intellectual Property

may find that working with her contributes to your
inventive process! ~ Jenny C., attorney

23.2 Intellectual Property
Intellectual

Property is

a

form

of

intangible

property

representing the commercially valuable product of the human
mind. IP can be in either an abstract or concrete form. For
example, a composer may have IP interests to both the
abstract sound of the music he or she composed, as well as the
concrete sheet music that instructs musicians how to play the
musical composition.
Protection of IP rights generally fall into one of four categories:
patents, trade secrets, copyrights, and trademarks.

Intellectual Property | 420

Patent

Trade Secret

Copyright

Trademark

Inventions &
methods

Valuable secrets
that give a
business a
competitive
advantage

Tangible
expression of
an idea; but
not the idea
itself

Words &
symbols
used to
identify
products or
services

Distinctiveness

Original
expression

Reasonable
measures in
place to
protect
secrecy

Information
must be kept
secret but no
formal process is
necessary

Protection is
automatic
once creative
expression
takes
tangible
form; does
not have to
be filed with
the CO but
receives
greater
protection if
it is

Mark is use
in
commerce
does not
have to be
filed with
USPTO but
receives
greater
protection
it is

20 years (14
years for a
design
patent)

Forever, as long
as information is
kept secret

70 years after
death of
author, 95
years from
publication,
or 120 years
from
creation
(whichever is
shorter)

10 years bu
can be
renewed an
unlimited
number of
times as lon
as mark is
still being
used

Type of Law

Federal only

State (Economic
Espionage Act
may provide
some federal
protection
depending on
facts of case)

Federal only

Federal and
state

Type of
Enforcement
Action

Infringement Misappropriation Infringement

Infringeme
& dilution

Criminal Liability

No

Yes

Protects

Elements

Filing
Requirements

Duration

Novel &
non-obvious

Application
must be
approved by
USPTO

421 | Intellectual Property

Yes

Yes

Expensive

Yes

No

No

Maybe
(depends o
policing
costs)

Search Required
for Existing IP
Holders

Yes

No

No

Yes

Different types of IP may attach to aspects of the same product
or service. For example, Coca-Cola has trademarks for its name
and logo, a patent for the shape of its original glass bottle, a
copyright for its commercial jingle, and a trade secret for its
cola recipe.
Figure 23.1 Examples of Coca-Cola trademarks

Intellectual Property | 422

23.3
Constitutional
Roots
The

US

Patent

Trademark

Office

and

(USPTO)

was established to protect
patents as enumerated in
Article I, Section 8 of the
Constitution.

That

known

the Copyright

as

clause,

Clause, says that Congress
may “promote the Progress
of Science and useful Arts, by
securing for limited Times to
Authors and Inventors the
exclusive

Right

to

respective

Writings

Discoveries.”

The

website

a

has

their
and
USPTO

searchable

database for trademarks and
patents.
The Copyright Clause directs
the federal government to
protect certain products of
the mind, just as much as it protects personal land or money.
The Copyright Clause essentially allows the government to
create a special kind of monopoly around IP. For example, a
pharmaceutical company invents a drug and applies for a
patent. If the patent is granted, then the company can charge
as much as it needs to recover its research and development
costs because competitors are shut out of that drug market by

423 | Intellectual Property

virtue of the patent. Violations of patent law carry severe
penalties.
How can Congress outlaw most monopolies when the
Constitution grants monopolies for IP? The answer lies in the
genius of the Copyright Clause itself. As in all monopolies, there
are two sides: the producer and the consumer. The producer
wants the monopoly to last as long as possible, while the
consumer wants the monopoly to end as quickly as possible.
The Copyright Clause strikes a compromise between the
producer and the consumer in two ways.
First, the Clause states that Congress can grant the monopoly
only to “promote the progress of Science and Useful Arts,”
which is a very specific purpose. Note that making an inventor
rich is not the purpose. Rather, the purpose is progress.
Granting temporary monopolies encourages progress by
providing

a

financial

incentive

to

producers.

Singers,

songwriters, inventors, drug companies, and manufacturers
invent and create in the hope of making money. If they were
not protected, they would either not invent at all or would
simply do it for themselves, without sharing the fruits of their
labor with the rest of society.
Second, the Clause states whatever monopoly Congress grants
has to be for a “limited time.” Congress makes the decision on
how long a monopoly can last based on how best to promote
progress. When the monopoly ends, science is advanced again
because others can freely copy and improve upon the
producer’s products. Society benefits greatly from the
expiration of IP monopolies. Important drugs such as aspirin
and penicillin, for example, can now be purchased for pennies
and are accessible to the entire human population. Similarly,
literary works, such as Shakespeare’s Hamlet or Beethoven’s
Fifth Symphony, can be performed and enjoyed by anyone at
any time without seeking permission or paying royalties

Intellectual Property | 424

because copyrights last for only seventy years after the death
of the author or creator. These inventions and works are now in
the public domain to be enjoyed by all.

23.4 Patents
A patent is the exclusive right to make, use or sell an invention
for a specified period of time (usually seventeen years), granted
by the federal government to the inventor. A patent holder
owns a patent. Patents may be legally sold to others. Therefore,
an inventor may sell a patent to others, which ends his or her
property interest in the invention.
Many inventors and designers work for employers in creative
and inventive capacities. If an employee invents something
as part of his or her employment, then the employer is the
patent holder. This arrangement allows innovative ideas to be
adequately funded and to prevent employees working against
the best interests of their employers. However, if an employee
invents something outside of work on his or her own time, and
the invention is not related to his or her employment, then the
employee is the patent holder.
To apply for a patent, an inventor must meet two requirements:
the invention must be (1) novel and (2) non-obvious. To be
novel, the invention must not have been previously invented
and must not come from a trivial improvement to an existing
invention. In other words, it must not have been previously
known or used. To be non-obvious, the invention must not be
obvious to a reasonable person in an appropriate field with
ordinary skill. In other words, patents reward creativity that
results in something new and is not considered common
knowledge by someone in the industry.

425 | Intellectual Property

Patent
Description
Requirement
Novel

New; cannot be something that was already
invented or in use

Non-obvious

Not common knowledge to a reasonable person
with ordinary skills in the industry

Not all things can be patented. An idea alone (without a
definite description) cannot be patented. Similarly, the laws of
nature (such as gravity) and things that occur naturally (such
as DNA) cannot be patented. This is because some items found
in nature are not the result of the human mind or creativity.
If not the product of human invention, then a patent cannot
apply. This distinction can be narrow in some industries. For
example, DNA cannot be patented but the scientific process
of synthetically reproducing DNA can be patented. Likewise, oil
cannot be patented but the process for extracting it from the
ground can be.

Types of Patents
Three types of patents exist. The most common type of patent
is the utility patent. Utility patents are granted for a useful
innovative machine, process, manufacture, composition of
matter (such as a new chemical) or an improvement to an
existing item or process. These patents usually are granted for
twenty years.
A design patent may be granted for new, original, and
ornamental designs for an article of manufacture. This type
of patent protects a product’s appearance or nonfunctional
aspects. These patents last for only fourteen years.
A plant patent covers inventions or discoveries of asexually
reproduced plants (e.g., plants produced through methods

Intellectual Property | 426

such as grafting, root cuttings, and budding). In other words,
the plant is able to multiply without using seeds. For example,
one

company

patented

a

unique

rose

whose

color

combination did not exist in nature.
Type of
Patent

Description

Utility

• Protects the way an invention is used and operates
• Useful innovative machine (e.g. table saw), process
(e.g. software program), manufacture (e.g. thumb
drive that fits into USB port), composition of matter
(e.g. new chemical) or an improvement to an
existing item or process
• Must be useful and functional
• Inventor does not have to show invention has
monetary value
• Lasts 20 years (unless patent granted before June
8, 1995)

Design

• Protects appearance of product (e.g. Jeep’s grill
design)
• Lasts 14 years

Plant

• Protects any distinct and new variety of plant
• Plant cannot have been sold or released in US for
more than 1 year
• Involves many controversial patents involving
genetically modified plants used for food
• Lasts 20 years

Patent Enforcement
The USPTO grants property rights to patent holders within the
United States. Patent law is complicated, and attorneys who
wish to practice patent law must have an engineering or
science background and pass a separate patent bar exam.

427 | Intellectual Property

When an application is filed, the USPTO assigns a patent
examiner to decide whether the patent application should be
approved. While the application is pending, the applicant is
permitted to use the term “patent pending” in marketing the
product to warn others that a patent claim has been filed. Even
after a patent has been issued by the USPTO, however, the
patent is only presumed to be valid. If someone challenges a
patent in a lawsuit, final validity rests with the US federal courts.
In the last decade there has been more than a 400 percent
increase in the number of patents filed, resulting in a multiyear
delay in processing applications. An increase in the number of
business method patents contributed to this dramatic increase
in patent applications. A business method patent seeks to
monopolize a new way of conducting a business process. For
example, “Patent Filing for One-Click Web Ordering” describes
a method of e-commerce by which a customer can order an
item and pay for it immediately with just one click of a button.
This one-click patent was granted to Amazon.com. Amazon
licensed the patent to Apple so that it could feature one-click
on its website. This in turn allowed Amazon to recover some of
its development costs from Apple, which also wanted to use
the technology.
IP protection sometimes involves controversial issues. For
example, pharmaceutical companies rely on patent law to
protect their massive investment in research and development
of new drugs. For the few drugs that eventually get
governmental

approval

and

commercial

success,

manufacturers seek to extract the highest possible price
during

the

period

of

patent

monopoly.

For

example,

antiretroviral drugs has greatly extended the lives of HIV/AIDS
patients, but the drugs cost between $10,000 and $12,000 per
year in the United States. In many developing nations,
individuals

cannot

afford

US

prices.

Therefore,

some

governments have declared national health emergencies, a
Intellectual Property | 428

procedure under international treaties called compulsory
licensing, that forces drug companies to license the formula
to generic drugmakers. As a result, Cipla, a generic drug
manufacturer in India, manufactures the same antiretrovirals
for about $350 a year.
Outside the United States, a patent granted by the USPTO
does not automatically protect the inventor’s interest in that
property. Instead, IP is protected by a series of international
conventions. Because international law is only binding on
nations who agree to be bound by it, IP is not protected
internationally in nations that have not signed the conventions.

Patent Infringement
If someone uses a patented invention without permission from
the patent holder, then the user violates the patent holder’s
rights. Patent infringement is the act of making, using, selling,
or offering to sell a patented invention without the permission
of the patent holder. Patent infringement can be either direct
or indirect. Direct infringement occurs when someone copies
and uses an invention, or uses an invention with a slight
variation or addition. Indirect infringement occurs when
someone “designs around” a patent by creating a product that
is substantially the same and performs a similar function.
If patent holders successfully sue for patent infringement, they
may be entitled to an injunction forcing their competitors to
stop using the invention, treble damages, costs, and attorney’s
fees. The most common defense to patent infringement claims
is to challenge the validity of the patent. Given the scientific
and technical nature of patent cases, litigating these cases is
expensive.
As a result of the cost of litigation, patent trolls exist in certain
429 | Intellectual Property

industries such as technology and pharmaceuticals. Patent
trolls are individuals or companies who obtain the rights to one
or more patents to profit by means of licensing or litigation,
rather than by producing their own goods or services. The main
source of revenue for patent trolls comes from suing
companies for infringement and hoping the companies settle.
For a relatively minor cost of applying for a patent and
attorneys’ fees, patent trolls look for a big payout. For example,
NTP, a patent troll, sued the maker of BlackBerry, claiming
patent infringement for the technology used to deliver the
BlackBerry’s push email feature. Faced with a potential
shutdown of service, BlackBerry settled the case for more than
six hundred million dollars.
Over

the

past

decade,

there

have

been

some

legal

developments to help protect companies from patent trolls.
For example, the US Supreme Court unanimously ruled that
patent infringement cases must be filed in the federal court
where the defending company is based rather than a court
of the plaintiff’s choice. This reduces the exposure and cost
to the company of defending against cases filed across the
nation, and for the patent trolls to “forum shop” for districts
they believe will be more beneficial to their claims.
More companies are choosing to fight patent trolls in court
rather than payout. For example, Apple has been defending
itself in court against patent troll VirnetX over patents that
VirnetX obtained in FaceTime and iMessage delivery systems.
Although Apple has a large enough budget to engage in
protracted litigation, not every company does. Therefore,
patent trolls often target start-up companies hoping that the
economic threat of a lawsuit encourages quick settlements.

Intellectual Property | 430

23.5 Trade Secrets
A Trade secret is a formula, process, device, or other business
information that is kept confidential to maintain an advantage
over competitors. The scope of trade secret protection goes
well beyond patent law. Unlike patent law, protection under
trade secret law is not tied to the information’s novelty. Instead,
the essence of a trade secret is its relative secrecy.
Information that:
Elements of
a Trade
Secret

1. Is not generally known or ascertainable;
2. Provides a competitive advantage;
3. Has been developed at the owner’s expense & is
used continuously in the owner’s business; and
4. The owner intends to keep it confidential.

A trade secret is, in short, secret information. This information
may include a process, formula, pattern, program, device,
method, technique, or compilation. For many companies, lists
of suppliers, costs, margins, and customers are all trade secrets.
Soft drink recipes, the Big Mac’s special sauce, and even the
combination of wood that is used in the burning process to
make Budweiser beer are all trade secrets. Additionally,
Google’s algorithm for conducting web searches is a trade
secret.
Trade secrets are unlike patents in that with a patent, the
inventor must specifically disclose in the application the details
of the invention. Thus, the inventor has not protected the secret
of the invention. However, in exchange for this disclosure, a
patent owner has a legal monopoly over the property for a
specified period of time. Even if others discover how the
invention works (which often is not difficult because patent
applications are public record), they are prohibited from
making, using, or selling it without the patent holder’s
431 | Intellectual Property

permission. After the patent expires, the patent holder no
longer has a property right to exclude others.
Trade secrets can last forever if the owner of the secret keeps
it a secret. If someone uses lawful means to uncover the secret,
then the secret is no longer protected. Therefore, some
companies

would

rather

not

make

their

confidential

information public knowledge through a patent application
in return for a temporary monopoly. Instead, they choose to
protect the confidentiality of the information or product
internally with the hope of a longer period of protection. For
example, Google protects its search algorithm as a trade secret
to maintain a competitive advantage in the market for as long
as possible.
A claim for misappropriation may be brought when a trade
secret has been wrongfully obtained, such as through
corporate espionage or bribery. Generally, misappropriation
occurs if the secret was acquired by improper means, or if
the secret was disclosed or used without permission from the
secret’s owner. Damages may include actual loss and unjust
enrichment not captured by actual loss. Additionally, in cases
of willful or malicious misappropriation, double damages may
be awarded, as well as attorney’s fees.

23.6 Trademarks
A trademark is any word, name, logo, motto, device, sound,
color, or graphic symbol used by a manufacturer or seller to
distinguish its products. The main purpose of a trademark is
to guarantee a product’s genuineness. In effect, the trademark
is the commercial substitute for one’s signature. To receive
federal protection, a trademark must be (1) distinctive rather

Intellectual Property | 432

than merely descriptive, (2) affixed to a product that is actually
sold in the marketplace, and (3) registered with the USPTO.
Symbol
Associated with
Trademarks

Meaning

®

The mark is officially registered with the USPTO

™

The mark is not registered with the USPTO & is
used with goods

SM

The mark is not registered with the USPTO & is
used with services

The Lanham Act protects trademarks. Unlike copyrights and
patents, trademarks can last forever and are not subject to the
Constitution’s limited time restriction. Since the objective of
trademark law is to prevent consumer confusion, the public
good is best served by allowing companies to maintain their
trademarks as long as consumers associate a trademark with
a specific origin. The moment they no longer make that
association, however, the trademark ceases to exist.
When it comes to trademarks, distinctiveness is good.
Therefore, an invented word is the easiest type of trademark.
In 1997, Larry Page and Sergey Brin were brainstorming names
for their new Internet search engine, and invented the word
“Google,” which is a play on “googol” that means 1 followed by
100 zeroes. They felt the name reflected their goal to organize
the staggering amount of information available on the
Internet. Common words can also become trademarks as long
as consumers identify them with a particular source. For
example, Amazon is the name of the world’s longest river, but
it is also the name of an online retailer. Since consumers now
identify Amazon.com as an online retailer, the name can be
trademarked.
People’s names may also be trademarked as long as they have
a business presence. Over time, if consumers begin to identify a
433 | Intellectual Property

person’s name with their business, then the name has acquired
secondary meaning and can be trademarked. Thus, Sam
Adams is a trademark for a beer, Ben & Jerry’s is a trademark
for ice cream, and Ford is a trademark for motor vehicles.
Figure 23.1 Photo of Samuel Adams Beer Bottle

Figure 23.2 Photo of Ben &
Jerry’s Justice ReMix’d Ice Cream

Intellectual Property | 434

In addition to names and logos, slogans may also be
trademarked. For example, “Built Ford Tough” and the “Quicker
Picker Upper” are both trademarked slogans. Trademarks can
also apply to a combination of distinctive words, logos, and
slogans. McDonald’s has a trademark for its name, a trademark
for its “golden arches,” and a trademark for its slogan “i’m lovin’
it.” McDonald’s could also trademark the combination of how
those three items are displayed together in its advertising
materials.
Trademarks are usually granted for a specific category of
goods. The same name can sometimes be used for multiple
categories of goods. The name Delta is a trademark for both
an airline and a brand of faucets. Since there is little chance
that consumers will confuse an airline with a faucet brand,
trademark law allows these dual registrations.
On the other hand, some brands are so strong that they may
stop registration even for a completely different category of
goods. McDonald’s is a good example of this. The McDonald’s
trademark is one of the strongest in the world and is instantly
recognizable. In 1988, hotel chain Quality Inns launched a new
line of budget motels called “McSleep.” McDonald’s sued,
claiming trademark infringement. McDonald’s claimed that
consumers might be confused and believe that McDonald’s
owned the hotel chain. A federal judge agreed and ordered
Quality Inns to change the name of the chain, which it did, to
Sleep Inns.
Trademarks go beyond a company’s name or its logo. A color
can be trademarked if it is strong enough to create consumer
identification. Pink, for example, is trademarked when used
for building insulation by Owens Corning. All other insulation
manufacturers must use different colors. Sounds can be
trademarked too, such as MGM Studios’ lion’s roar. Distinctive
colors, materials, textures, and signage of a Starbucks or T.G.I.

435 | Intellectual Property

Friday’s are considered trade dress and cannot be copied. A
unique bottle shape also can be trade dress. Trade dress is the
overall appearance and image in the marketplace of a product
or commercial enterprise, including any packaging, labeling,
design and decor. Interestingly, courts have been reluctant to
grant certain smells trademark protection, even though it can
be argued that certain fragrances such as Old Spice or CK One
are distinctive.
Companies

providing

services

may

receive

trademark

protection called a service mark. Instagram, for example, is a
service mark.
A trademark can also be used to demonstrate certification
meeting certain standards, such as the Good Housekeeping
Seal

of

Approval.

The

International

Organization

for

Standardization (ISO) and its various standards for quality
management (ISO 9000) or environmental quality (ISO 14000).
The Forest Stewardship Council (FSC) allows its logo to be used
on paper products that come from sustainable forests, while
certain foods can be labeled “Organic” or “Fair Trade” if they
meet certain standards as established by governmental or
nongovernmental organizations. Each of these marks is an
example of a certification mark.
Finally, a mark can represent membership in an organization,
such as the National Football League, Girl Scouts of America,
Chartered Financial Analyst, or Realtor. Each of these is known
as a collective mark. The rules that apply to trademarks apply
equally to service marks, collective marks, and certification
marks.
The Lanham Act excludes a few categories from trademark
registration, mainly for public policy purposes. Obviously,
trademarks will not be granted if they are similar or identical to
a trademark already granted. When starting a new company,
businesses need to make sure that their business name is not
Intellectual Property | 436

already trademarked by someone else. Trademarks also cannot
contain the US flag, any government symbol (such as the
White House or Capitol buildings), or anything immoral.
Trademarks cannot be merely descriptive. Therefore, every
restaurant is allowed to offer a “Kid’s Meal,” but only McDonald’s
can offer a “Happy Meal.”
A trademark is valid as long as consumers believe that the
mark is associated with a specific producer or origin. If the
mark refers to a class of goods instead, then the trademark
no longer exists. This process is called genericide. Many words
today once started as trademarks: furnace, aspirin, escalator,
thermos, asphalt, zipper, lite beer, Q-tip, and yo-yo are all
examples of trademarks that are now generic and have
therefore lost legal protection. To prevent genericide from
occurring, trademark owners must actively police their use. If
trademarks become generic, the owners will lose control of
the marks and the public (and competitors) will be free to use
those words just as they use “aspirin” and “yo-yo” today.
Trademark

infringement

occurs

when

someone

uses

someone else’s mark, either completely or to a substantial
degree, when marketing goods or services without the
permission of the mark’s owner. When Apple first released the
iPhone, it found out that “iPhone” was already a registered
trademark belonging to Cisco for a phone used for calling over
the Internet. To avoid trademark infringement liability, Apple
purchased the trademark from Cisco.
The elements of trademark infringement are:
• Distinctiveness (strength) of plaintiff’s mark;
• Similarity of the two marks;
• Similarity of goods or services associated with marks;
• Similarity of the parties’ facilities/operations;
• Similarity of the parties’ advertising;

437 | Intellectual Property

• Defendant’s intent; and
• Proof of actual confusion.
Even if a trademark owner does not believe a similar use of
its mark would lead to any consumer confusion, it can protect
its trademark through a concept called dilution. Trademark
dilution occurs when a trademark’s strength or effectiveness is
impaired by the use of the mark by an unrelated product, often
blurring the trademark’s distinctive character or tarnishing it
with an unsavory association. For example, when an adult
novelty store in Kentucky opened as “Victor’s Secret,” Victoria’s
Secret filed a dilution suit in response. Under dilution concepts,
the trademark owner only needs to show a likelihood that its
mark will be diluted or tarnished in some way.
Companies or persons accused of trademark infringement can
rely on several defenses:
• Marks are sufficiently different;
• Fair use;
• Parody;
• Comedy and satire; and
• Consumer advocacy.
The most obvious is arguing that no infringement has occurred
because the two marks are sufficiently different enough that
consumers will not be misled. For example, in 2002 Jeep sued
General Motors for infringing on what Jeep called its
trademark grill. GM’s Hummer division released the H2 that
year, with a similar seven-bar grill. A district court held that
there was no trademark infringement because the grills were
too dissimilar to cause consumer confusion.
Figure 23.3 Photos of Hummer H2 and Jeep Grills

Intellectual Property | 438

Another defense is fair use. The Lanham Act prohibits the use
of someone else’s trademark when selling goods. However,
when a company mentions a competitor’s product to draw a
comparison, this is called comparative advertising and is fair
use of the competitor’s trademark. Honda, therefore, is free to
claim that the “Honda Accord is better than the Toyota Camry”
in its advertising even though Toyota and Camry are both
trademarks.
The First Amendment also recognizes the use of parody,
comedy, or satire as fair use. Comedy skits on television that
make fun of, or use, company logos are an example of this fair
use. The First Amendment is also a defense for websites run by
consumer activists who seek to criticize or parody companies,

439 | Intellectual Property

such

as

“www.fordreallysucks.com”

or

“www.peopleofwalmart.com.”

23.7 Copyright
The final form of intellectual property protection is copyright.
A copyright is a property interest in an original work of
authorship (such as literary, musical, artistic, photographic, or
film work) fixed in any durable medium of expression. The
owner of a copyright has the exclusive right to reproduce,
adapt, distribute, perform, and display the work. The durable
medium requirement exists because otherwise it would be
impossible to prove who is the original author of a work. Ideas,
by themselves, cannot be copyrighted.
Like patents and trademarks, federal law protects copyrights.
Copyright is designed to protect creativity. It is one of the two
types of IP specifically mentioned in the Copyright Clause of
the US Constitution. Copyright extends to any form of creative
expression, including digital forms.
Because computer software is a compilation of binary code
expressed in 1 and 0, software can be copyrighted. Similarly,
if a group of students were given a camera and asked to
photograph the same subject, each student would frame the
subject differently, which is an expression of their creativity.
A copyrighted work is automatically protected upon its
creation. Unlike patents and trademarks, which must go
through an expensive and rigorous application process,
authors do not need to send their work to the government
for approval. In 1989, the United States signed the Berne
Convention, which is an international copyright treaty. This
treaty eliminated the need to write “Copyright” or place a ©

Intellectual Property | 440

symbol on the work itself to receive legal protection. Copyrights
may be registered with the US Copyright Office, if the author
chooses.
Copyright protection lasts for seventy years after the death of
the author. If there is more than one author, the copyright
expires seventy years after the death of the last surviving
author. If a company, such as a publisher, owns a copyrighted
work, the copyright expires ninety-five years from the date of
publication, or one hundred twenty years from the date of
creation, whichever comes first. After the copyright expires, the
work falls into the public domain. The works of Shakespeare
and Beethoven are in the public domain, and may be freely
recorded or modified without permission.
The copyright owner may allow the public to view or use a
copyrighted work for free or for a fee. This use is contained in
a copyright license. A license is essentially permission from the
copyright holder to use the copyrighted material, within the
terms of the license. When purchasing a book, MP3 or DVD, for
example, the copyright license allows the purchaser to read the
book, listen to the music, and view the movie in private. The
license does not allow the purchaser to show the movie to a
broad audience, to modify the music, or to photocopy the book
to give away or sell. These rights of reproduction, exhibition,
and sale are not part of a license. The purchaser does have the
right of first sale. This means that the owner of the physical
work can do with it as he or she pleases, including resell the
original work.
There are common licenses that authors can easily refer to if
they wish to distribute their work easily. The General Public
License (GPL) for software and Creative Commons (CC) license
for text and media are well-known examples.
Licenses in the digital arena can be very restrictive. Copyright
holders may use schemes such as Digital Rights Management
441 | Intellectual Property

(DRM) to limit ownership rights in digital media. DRM limits the
number of copies and devices a digital file can be transferred
to, and in some cases even permits the copyright holder to
delete the purchased work.
Copyright infringement occurs when someone uses a
copyrighted work without permission or violates the terms of
a license. Copyright infringement is common when someone
takes someone else’s work and simply repackages it as their
own. For example, J. K. Rowling’s Harry Potter series created an
international following, and many fans gather online to discuss
her books. One website, called the Harry Potter Lexicon, served
as an encyclopedia to the Harry Potter world, with reference
notes on characters, places, spells, and other details. When the
site announced plans to publish the contents of the Lexicon
in a book format, J. K. Rowling successfully sued, claiming
copyright infringement.
Copyright infringement also may be indirect, such as helping
others violate a copyright. Websites such as Napster and
Grokster, which existed solely for the purpose of facilitating
illegal downloading of music, were copyright infringers even
though the websites themselves did not directly violate any
copyrights. The music recording industry pursues these cases
aggressively.
Copyright law makes a distinction between “fair” and
“infringing” use. Fair use includes copying a work for purposes
of commentary, criticism, news reporting, teaching, or
research. Just because a work is used in a news article or in a
classroom, however, does not make its use fair.

Intellectual Property | 442

Factors to determine Fair Use of Copyrighted Materials:
1. The purpose and character of the use
• Is it for educational purposes or to make a profit?
2. The nature of the copyrighted work
• Is the work part of the “core” of the intended protection that
copyright provides?
3. The amount and substance of the portion used
• Is the amount used a small portion or the entire work?
4. The effect of the use on the potential market for the copyrighted
work
• Does the use of the copyrighted work unfairly impact the
owner’s business?

In an attempt to tackle the problem of copyright infringement
on the Internet, Congress passed the Digital Millennium
Copyright Act (DCMA) in 1998. One portion of the law helps
Internet service providers by expressly stating that those
providers cannot be sued for copyright infringement if others
use their networks for infringing uses. Another portion of the
law helps websites by stating that if a user uploads infringing
material and the website complies with a copyright holder’s
request to remove the material, the website is not liable for
infringement. For example, if an individual uploads a portion
of a copyrighted song, movie, or television show to YouTube,
YouTube may remove the clip at the request of the copyright
holder. Finally, the DMCA makes it illegal to attempt to disable
a copy protection device, such as DVD and Blu-ray Discs.
Anyone who writes software that disables a copy protection
device violates the DMCA.

443 | Intellectual Property

23.8 Concluding Thoughts
The framers of the Constitution recognized the value of
intellectual property by including the Copyright Clause into
Article I, Section 8. As IP law evolved, laws that govern trade
secrets, patents, trademarks, and copyright have emerged.
These legal protections provide a foundation for businesses,
entrepreneurs, and artists to create useful and innovative
works. Without the financial incentives provided by IP law,
innovation would grind to a halt.
The Constitution states the primary purpose of providing
temporary IP monopolies is to advance science and the useful
arts. This advance can take place when IP owners create IP, but
it can also take place when the IP falls into the public domain
at the end of its limited time.

Intellectual Property | 444

24. Bankruptcy
24.1 Introduction
LEARNING OBJECTIVES
1. Examine the three primary chapters of the federal
bankruptcy code affecting businesses.
2. Compare and contrast the different types of bankruptcies.
3. Explore the priority of payment of debts in a bankruptcy
estate.
Bankruptcy occurs when an individual or business is financially
unable to pay off debts and meet financial obligations.
Bankruptcy is a proceeding under federal law in which an
individual or business is relieved of most debts and undergoes
a court-supervised reorganization or liquidation for the benefit
of the creditors. Bankruptcies may be either voluntary or
involuntary. A voluntary bankruptcy is a proceeding initiated
by the debtor. An involuntary bankruptcy is a proceeding
initiated by creditors to force the debtor to be legally declared
bankrupt so the creditors may recover their assets.
The purpose of bankruptcy is to preserve as much of the
debtor’s property as possible and to divide it as fairly as possible
between the debtor and creditors. Bankruptcy encourages
businesses to take risks and engage in entrepreneurial
activities. It ultimately allows debtors in difficult financial
situations to have a fresh start financially. However, critics
allege

that

it

allows

some

businesses

to

avoid

the

consequences of their mistakes and mismanagement. The

445 | Bankruptcy

United States has the highest bankruptcy rate in the world,
with individuals filing for bankruptcies more frequently than
businesses.

Counselor’s Corner Bankruptcy is a vehicle for
individuals and businesses to get out of crushing
debt. But it comes at a cost: bankruptcy upends a
person’s life and may end a business. Before filing
for bankruptcy, people and businesses should see if
they can negotiate a settlement to some of their
debt. Often creditors will accept partial payment
that is guaranteed over a claim for a larger debt that
they will never receive. Cash in hand has value to
unsecured creditors. So pick up the phone and put
your negotiation skills to work. It just may save your
business and prevent needing to file for
bankruptcy.

~M. Mo, attorney

24.2 Types of Bankruptcy
There are three main types of bankruptcy under the federal
bankruptcy laws that impact businesses the most. They are
identified by the chapter number in the bankruptcy code.
Regardless of the type of bankruptcy, there are some
important terms under bankruptcy law. A debtor is the
individual or business entity who owes money to others.
Debtors either file a bankruptcy petition (in a voluntary
bankruptcy) or a petition is filed against them (in an
involuntary bankruptcy). A claim is the right of payment from
the

debtor.

A creditor

is

an

individual,

business

or

Bankruptcy | 446

governmental entity to whom money is owed by the debtor.
Therefore, a creditor has a claim against the debtor.
Figure 24.1 Types of Bankruptcy

Chapter 7 of the bankruptcy code involves the liquidation of
an individual’s or business’s assets to satisfy creditor claims.
The debtor loses most, if not all, of current assets but keeps all
future earnings free of claims by current creditors. Chapter 7
bankruptcy results in the end of the current business entity.
Chapters 11 and 13, on the other hand, aim to reorganize and
rehabilitate the debtor. Chapter 11 may apply to either an
individual or business entity, while Chapter 13 only applies to
individuals. Under Chapter 11, businesses continue to operate
and their creditors are entitled to a portion of both current and
future assets and earnings.

447 | Bankruptcy

Chapter 7

Chapter 11

Chapter 13

Objective

Liquidation

Reorganization

Reorganization

Type of Debtor

Individual &
business

Individual &
business

Individual

Voluntariness

Voluntary or
involuntary

Voluntary or
involuntary

Voluntary

Who
Distributes
Assets

Trustee

Debtor

Trustee

Who Selects
Trustee

Creditors or US
Trustee
Program

—–

US Trustee
Program

Who Proposes
Plan

—–

Debtor &
creditors

Debtor

Creditor
Approval
Needed?

No

Creditors can
vote but court
retains power
to approve
plan without
creditor
approval

No

Future Income

Debtor keeps
all future
income

Debtor must
pay debts
under court
approved plan

Debtor must
pay debts
under court
approved plan

To prevent individuals and businesses from using bankruptcy
as a tool to avoid all negative financial situations, the law
requires waiting periods between bankruptcy filings. In other
words, a debtor must wait a certain amount of time before
being able to file for bankruptcy again.
First Bankruptcy
Case

To File under
Chapter 7, must
wait:

To File under
Chapter 13, must
wait:

Chapter 7

8 years

4 years

Chapter 11

8 years

4 years

Chapter 13

6 years

2 years

Bankruptcy | 448

Chapter 7 Liquidation
Under Chapter 7 of the bankruptcy code, most or all of a
debtor’s assets are liquidated and used to satisfy creditor
claims. Liquidation is the process of converting assets into cash
to settle debts. Under Chapter 7, liquidation includes winding
up the affairs of a business entity because it will no longer
exist after the bankruptcy is complete. As a result, discharge
of debts under Chapter 7 applies to all debts incurred before
bankruptcy was filed.
Before filing for Chapter 7 bankruptcy, individual debtors must
meet two requirements:
1. The individual must receive credit counseling from an
approved agency within 180 days before filing for
bankruptcy; and
2. The individual must financially qualify under the
Department of Justice’s means test.
The means test for individuals is complex and dependent on
the median income in the state where the individual debtor
resides.
Chapter 7 has some advantages for debtors. The first is that it
immediately protects them from collection efforts and wage
garnishments from creditors. The exception to this is child
support. Regardless of the status of other creditors, the law
prioritizes the right of children to receive financial support
from their parents. A second advantage is that most income
received after the bankruptcy filing date is not part of the
bankruptcy estate. The main exception to this rule is that
inheritance is added to the bankruptcy estate and may be used
to satisfy creditors. A third advantage is that no minimum
amount of debt is required and bankruptcy may be filed if
the debtor owns assets but faces cash flow problems. The final
449 | Bankruptcy

advantage is that it is a relatively quick proceeding, with most
bankruptcies discharged within three to six months.
Chapter 7 has some disadvantages to debtors, too. The first is
that the debtor is not in charge of distributing the bankruptcy
estate. Instead, a trustee is appointed by the United States
Trustee Program, which is a part of the Department of Justice
responsible for overseeing the administration of bankruptcy
cases. Trustees in Chapter 7 cases usually sell all non-exempt
property, including homes and vehicles. Therefore, individual
debtors risk losing a significant amount of their personal
property without being able to retain any control of the
process. A second disadvantage is that co-signors of any
affected loans may be responsible for the full amount of the
debt under the loan. Sometimes trustees will prioritize
payment of debts without co-signors, which may result in cosignors filing for bankruptcy as well.

Chapter 11 Reorganization
The goal of reorganization under Chapter 11 is to restructure the
debtor’s finances and pay creditors’ claims over an extended
period of time. Ultimately, the goal of Chapter 11 is to help
debtors remain in business.
One advantage of Chapter 11 bankruptcies is that a trustee is
not always required. If the debtor is cooperative and able to
distribute assets according to the court-approved plan, then
a trustee will not be appointed. However, if the debtor is
uncooperative or lacks the skills necessary to successfully
implement the bankruptcy plan, a trustee may be appointed.
Another advantage is that the debtor and creditors are allowed
to propose payment plans to the bankruptcy court. Although
the court is not required to adopt the plans, creditors are given
Bankruptcy | 450

an opportunity to vote on a proposed plan before the court
decides whether to adopt it. This gives the interested parties an
opportunity to create a reasonable solution that addresses the
needs of both the debtor and creditors.
A final advantage of Chapter 11 is that it provides an expedited
process for small business bankruptcies. The process allows
small businesses to resolve their bankruptcies quickly so that
they can move forward with their reorganization plans.
Chapters 7 and 11 have an interesting relationship. Businesses
may file for bankruptcy under Chapter 11 with an intent to
reorganize their debt and stay in business. However, if creditors
do not believe that reorganization is viable for a business, they
may request the court to convert the bankruptcy to Chapter 7.
For example, in March 2016, Sports Authority filed for Chapter 11
bankruptcy. When creditors discovered the extent and nature
of Sports Authority’s debt, they successfully requested the
court convert the bankruptcy to Chapter 7. When the court
granted the creditors’ request, Sports Authority was forced to
liquidate its assets and wind up its affairs.

Chapter 13 Reorganization
Chapter 13 bankruptcy is only available to individual debtors.
The purpose of Chapter 13 is to adjust the debts of individuals
whose debts are small enough and income is large enough
that a substantial repayment plan is feasible. In other words,
the proceedings help individuals keep most of their existing
assets but must use most, if not all, future income to pay off
debts.
A primary advantage of Chapter 13 is that it allows individual
debtors to stop the cycle of compound interest on debts from
spiraling to a point where they are forced to file for bankruptcy
451 | Bankruptcy

under Chapter 7. Chapter 13 provides for an automatic
injunction against collection efforts and wage garnishments,
except for child support. And debtors are allowed to keep their
property as long as they make the required payments under
the bankruptcy plan.
One characteristic of Chapter 13 is that it provides for long
periods to pay off debts. The average payment plan under
Chapter 13 lasts between 3 to 5 years. This can be either an
advantage or disadvantage to a debtor. On one hand, it allows
for reasonable payment plans that balance the interests of the
debtor and creditors. On the other hand, it ties up future
income for a long time to pay off existing debt.

24.3 Bankruptcy Proceedings
Although there are some differences among Chapter 7, 11, and
13,

bankruptcy

proceedings

have

some

common

characteristics.

Bankruptcy Estate
The bankruptcy estate is the debtor’s legal and equitable
interests in property at the time a bankruptcy petition is filed.
Under the bankruptcy code, the bankruptcy estate includes
real and personal property, bank and investment accounts, life
insurance benefits, and inheritances. Debtors are allowed to
claim some property as exemptions. In other words, certain
property is returned to the debtor from the bankruptcy estate.
Common exemptions include:

Bankruptcy | 452

• Equity interest in a residence, vehicle, and personal
property (up to a certain value);
• Prescribed health aids, such as walkers and wheelchairs;
• Benefits, such as social security, unemployment
compensation, public assistance, disability benefits, and
child support;
• Retirement funds and pension (up to a certain value); and
• Education savings accounts.

Debts that Cannot be Discharged
Bankruptcy does not discharge all debts. There are some types
of debts that a debtor remains legally liable for, regardless of
being bankrupt.
Common debts that are not discharged through bankruptcy
include:
• Child support and maintenance to a former spouse;
• Taxes and fines payable to a governmental agency;
• Debt incurred by fraud;
• Liability for intentional torts;
• Liability for accidents caused while driving while
intoxicated;
• Student loans less than 5 years old; and
• Debts owed under a prior bankruptcy plan.

Grounds for Denying Bankruptcy Relief
Discharge of debts through bankruptcy is a privilege, not a
legal right. Therefore, Congress specified certain situations in
which a debtor is not eligible for bankruptcy relief. These
grounds include:
453 | Bankruptcy

• Fraudulent transfers;
• Keeping inadequate records;
• Committing a “bankruptcy crime,” such as perjury, making
a false claim, bribery, and withholding or destroying
records;
• Failure to explain a loss or deficiency of assets;
• Refusing to testify in the proceedings or to obey a court
order; and
• Failure to complete the required consumer credit
education course.
The grounds for denying a discharge in bankruptcy usually
exist when wrongful conduct occurs by the debtor, the debtor
does not fully cooperate in the proceedings, or the debtor does
not maintain sufficient records to allow the proceedings to
move forward.

Procedural Steps
Bankruptcy proceedings begin when a debtor or creditor files
a petition for bankruptcy with the bankruptcy court. Married
couples may file a joint petition. The petition lists the identity
of the debtor(s), the identity of all secured and unsecured
creditors, the property in the bankruptcy estate, any claimed
exemptions, and a statement of affairs of the debtor.
Filing a bankruptcy petition results in an automatic stay, which
prevents creditors from beginning or continuing collection
efforts against the debtor. The stay is designed to protect both
the debtor and creditors. Debtors are protected from collection
efforts while they focus on creating plans for reorganization
and repaying debts. Creditors are protected from assets being
transferred to prevent payment of debts and the inequitable
distribution of assets among creditors.

Bankruptcy | 454

The

bankruptcy

court

has

decision-making

power

in

bankruptcy cases. The court decides matter connected with a
bankruptcy case, from the filing of the petition through final
discharge of the bankruptcy. The court determines whether a
debtor is eligible for bankruptcy, approves the bankruptcy plan,
and oversees the bankruptcy proceedings.
If a trustee is required or needed, a trustee will be appointed
by the U.S. Trustee and approved by the bankruptcy court. The
trustee takes charge of and administers the debtor’s estate
during bankruptcy proceedings. A trustee is the representative
of the estate and is responsible for prioritizing and satisfying
creditors’ claims. To achieve this goal, trustees may hire
professionals such as accountants, attorneys, and appraisers.
The main job of the trustee is to execute the bankruptcy plan.
The bankruptcy plan is a detailed plan of action for the
liquidation or reorganization of the debtor’s assets and to
satisfy creditors’ claims.
Bankruptcy plans identify and prioritize debts. The first debts
to be paid off are to secured creditors who have interest is a
particular property to “secure” the debt. Mortgages, car loans,
and liens are common examples of secured debts. If the
individual or business defaults on the loan payments, a secured
creditor may force the debtor to sell or forfeit the property to
satisfy the debt. The second category of debts are to unsecured
creditors, who do not have an interest in any particular
property.
The bankruptcy code prioritizes claims from unsecured
creditors as follows:
1. Child support and maintenance to a former spouse;
2. Administrative expenses of the bankruptcy estate,
including the trustees’ and accountants’ fees;
3. Creditors who loan money to the debtor during the
455 | Bankruptcy

bankruptcy;
4. Wages, salaries and commissions;
5. Contributions to employee benefit plans;
6. Consumer deposits;
7. Specific taxes and governmental fees;
8. Wrongful death and personal injury claims; and
9. General creditors.
Once the bankruptcy plan is completely implemented,
a discharge occurs. A bankruptcy discharge releases the
debtor from monetary obligations that existed at the time the
petition was filed and ends the bankruptcy case.

24.4 Concluding Thoughts
A fundamental goal of bankruptcy is to give debtors a financial
“fresh

start”

from

overwhelming

debts.

This

goal

is

accomplished through discharging debts, which releases the
debtor from liability from specific debts and prohibits creditors
from undertaking collection actions against the debtor.
However, bankruptcy does have a cost to it. It negatively
impacts a debtor’s credit history and impacts an individual
or business’s ability to get a loan or build up assets again.
Businesses also run the risk of liquidation and the business
terminating, even if intending only to reorganize. Before filing
for bankruptcy a business should consider if there are better
alternatives available to manage and pay off their debt.

Bankruptcy | 456