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

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Chapter 1
Introduction to Law and Legal Systems
LEARNING OBJECTIVES

After reading this chapter, you should be able to do the following:
1. Distinguish different philosophies of law—schools of legal thought—and explain their
relevance.
2. Identify the various aims that a functioning legal system can serve.
3. Explain how politics and law are related.
4. Identify the sources of law and which laws have priority over other laws.
5. Understand some basic differences between the US legal system and other legal systems.
Law has different meanings as well as different functions. Philosophers have considered issues
of justice and law for centuries, and several different approaches, or schools of legal thought,
have emerged. In this chapter, we will look at those different meanings and approaches and will
consider how social and political dynamics interact with the ideas that animate the various
schools of legal thought. We will also look at typical sources of “positive law” in the United
States and how some of those sources have priority over others, and we will set out some basic
differences between the US legal system and other legal systems.

1.1 What Is Law?

Law is a word that means different things at different times. Black’s Law Dictionarysays that
law is “a body of rules of action or conduct prescribed by controlling authority, and having
binding legal force. That which must be obeyed and followed by citizens subject to sanctions or
legal consequence is a law.” [1]

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

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

KEY TAKEAWAY

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

EXERCISES

1. Consider Burma (named Myanmar by its military rulers). What political rights do you have
that the average Burmese citizen does not?
2. What is a nongovernment organization, and what does it have to do with government? Do
you contribute to (or are you active in) a nongovernment organization? What kind of rights
do they espouse, what kind of laws do they support, and what kind of laws do they oppose?

Annotate

[1] Black’s Law Dictionary, 6th ed., s.v. “law.”

1.2 Schools of Legal Thought

LEARNING OBJECTIVES

1. Distinguish different philosophies of law—schools of legal thought—and explain their
relevance.
2. Explain why natural law relates to the rights that the founders of the US political-legal system
found important.
3. Describe legal positivism and explain how it differs from natural law.
4. Differentiate critical legal studies and ecofeminist legal perspectives from both natural law
and legal positivist perspectives.
There are different schools (or philosophies) concerning what law is all about. Philosophy of law
is also called jurisprudence, and the two main schools arelegal positivism and natural law.
Although there are others (see Section 1.2.3 "Other Schools of Legal Thought"), these two are the
most influential in how people think about the law.

Legal Positivism: Law as Sovereign Command
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As legal philosopher John Austin concisely put it, “Law is the command of a sovereign.” Law is
only law, in other words, if it comes from a recognized authority and can be enforced by that
authority, or sovereign—such as a king, a president, or a dictator—who has power within a
defined area or territory. Positivism is a philosophical movement that claims that science
provides the only knowledge precise enough to be worthwhile. But what are we to make of the
social phenomena of laws?
We could examine existing statutes—executive orders, regulations, or judicial decisions—in a
fairly precise way to find out what the law says. For example, we could look at the posted speed
limits on most US highways and conclude that the “correct” or “right” speed is no more than
fifty-five miles per hour. Or we could look a little deeper and find out how the written law is
usually applied. Doing so, we might conclude that sixty-one miles per hour is generally allowed
by most state troopers, but that occasionally someone gets ticketed for doing fifty-seven miles
per hour in a fifty-five miles per hour zone. Either approach is empirical, even if not rigorously
scientific. The first approach, examining in a precise way what the rule itself says, is sometimes
known as the “positivist” school of legal thought. The second approach—which relies on social
context and the actual behavior of the principal actors who enforce the law—is akin to the “legal
realist” school of thought (see Section 1.2.3 "Other Schools of Legal Thought").
Positivism has its limits and its critics. New Testament readers may recall that King Herod,
fearing the birth of a Messiah, issued a decree that all male children below a certain age be
killed. Because it was the command of a sovereign, the decree was carried out (or, in legal
jargon, the decree was “executed”). Suppose a group seizes power in a particular place and
commands that women cannot attend school and can only be treated medically by women, even
if their condition is life-threatening and women doctors are few and far between. Suppose also
that this command is carried out, just because it is the law and is enforced with a vengeance.
People who live there will undoubtedly question the wisdom, justice, or goodness of such a law,
but it is law nonetheless and is generally carried out. To avoid the law’s impact, a citizen would
have to flee the country entirely. During the Taliban rule in Afghanistan, from which this
example is drawn, many did flee.

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The positive-law school of legal thought would recognize the lawmaker’s command as
legitimate; questions about the law’s morality or immorality would not be important. In
contrast, the natural-law school of legal thought would refuse to recognize the legitimacy of laws
that did not conform to natural, universal, or divine law. If a lawmaker issued a command that
was in violation of natural law, a citizen would be morally justified in demonstrating civil
disobedience. For example, in refusing to give up her seat to a white person, Rosa Parks believed
that she was refusing to obey an unjust law.

Natural Law
The natural-law school of thought emphasizes that law should be based on a universal moral
order. Natural law was “discovered” by humans through the use of reason and by choosing
between that which is good and that which is evil. Here is the definition of natural law according
to the Cambridge Dictionary of Philosophy: “Natural law, also called the law of nature in moral
and political philosophy, is an objective norm or set of objective norms governing human
behavior, similar to the positive laws of a human ruler, but binding on all people alike and
usually understood as involving a superhuman legislator.” [1]
Both the US Constitution and the United Nations (UN) Charter have an affinity for the naturallaw outlook, as it emphasizes certain objective norms and rights of individuals and nations. The
US Declaration of Independence embodies a natural-law philosophy. The following short extract
should provide some sense of the deep beliefs in natural law held by those who signed the
document.

The Unanimous Declaration of the Thirteen United States of America
July 4, 1776
When in the Course of human events, it becomes necessary for one people to dissolve the
political bands which have connected them with another, and to assume among the powers of
the earth, the separate and equal station to which the Laws of Nature and of Nature’s God entitle
them, a decent respect to the opinions of mankind requires that they should declare the causes
which impel them to the separation.
We hold these truths to be self-evident, that all men are created equal, that they are endowed by
their Creator with certain unalienable Rights, that among these are Life, Liberty and the Pursuit
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of Happiness. That to secure these rights, Governments are instituted among Men, deriving
their just powers from the consent of the governed.…
The natural-law school has been very influential in American legal thinking. The idea that
certain rights, for example, are “unalienable” (as expressed in the Declaration of Independence
and in the writings of John Locke) is consistent with this view of the law. Individuals may have
“God-given” or “natural” rights that government cannot legitimately take away. Government
only by consent of the governed is a natural outgrowth of this view.
Civil disobedience—in the tradition of Henry Thoreau, Mahatma Gandhi, or Martin Luther King
Jr.—becomes a matter of morality over “unnatural” law. For example, in his “Letter from
Birmingham Jail,” Martin Luther King Jr. claims that obeying an unjust law is not moral and
that deliberately disobeying an unjust law is in fact a moral act that expresses “the highest
respect for law”: “An individual who breaks a law that conscience tells him is unjust, and who
willingly accepts the penalty of imprisonment in order to arouse the conscience of the
community over its injustice, is in reality expressing the highest respect for law.…One who
breaks an unjust law must do so openly, lovingly, and with a willingness to accept the
penalty.” [2]
Legal positivists, on the other hand, would say that we cannot know with real confidence what
“natural” law or “universal” law is. In studying law, we can most effectively learn by just looking
at what the written law says, or by examining how it has been applied. In response, natural-law
thinkers would argue that if we care about justice, every law and every legal system must be held
accountable to some higher standard, however hard that may be to define.
It is easier to know what the law “is” than what the law “should be.” Equal employment laws, for
example, have specific statutes, rules, and decisions about racial discrimination. There are
always difficult issues of interpretation and decision, which is why courts will resolve differing
views. But how can we know the more fundamental “ought” or “should” of human equality? For
example, how do we know that “all men are created equal” (from the Declaration of
Independence)? Setting aside for the moment questions about the equality of women, or that of
slaves, who were not counted as men with equal rights at the time of the declaration—can the
statement be empirically proven, or is it simply a matter of a priori knowledge? (A priori means
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“existing in the mind prior to and independent of experience.”) Or is the statement about
equality a matter of faith or belief, not really provable either scientifically or rationally? The
dialogue between natural-law theorists and more empirically oriented theories of “what law is”
will raise similar questions. In this book, we will focus mostly on the law as it is, but not without
also raising questions about what it could or should be.

Other Schools of Legal Thought
The historical school of law believes that societies should base their legal decisions today on the
examples of the past. Precedent would be more important than moral arguments.
The legal realist school flourished in the 1920s and 1930s as a reaction to the historical school.
Legal realists pointed out that because life and society are constantly changing, certain laws and
doctrines have to be altered or modernized in order to remain current. The social context of law
was more important to legal realists than the formal application of precedent to current or
future legal disputes. Rather than suppose that judges inevitably acted objectively in applying an
existing rule to a set of facts, legal realists observed that judges had their own beliefs, operated
in a social context, and would give legal decisions based on their beliefs and their own social
context.
The legal realist view influenced the emergence of the critical legal studies (CLS) school of
thought. The “Crits” believe that the social order (and the law) is dominated by those with
power, wealth, and influence. Some Crits are clearly influenced by the economist Karl Marx and
also by distributive justice theory (see Chapter 2 "Corporate Social Responsibility and Business
Ethics"). The CLS school believes the wealthy have historically oppressed or exploited those with
less wealth and have maintained social control through law. In so doing, the wealthy have
perpetuated an unjust distribution of both rights and goods in society. Law is politics and is thus
not neutral or value-free. The CLS movement would use the law to overturn the hierarchical
structures of domination in the modern society.
Related to the CLS school, yet different, is the ecofeminist school of legal thought. This school
emphasizes—and would modify—the long-standing domination of men over both women and
the rest of the natural world. Ecofeminists would say that the same social mentality that leads to
exploitation of women is at the root of man’s exploitation and degradation of the natural
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environment. They would say that male ownership of land has led to a “dominator culture,” in
which man is not so much a steward of the existing environment or those “subordinate” to him
but is charged with making all that he controls economically “productive.” Wives, children, land,
and animals are valued as economic resources, and legal systems (until the nineteenth century)
largely conferred rights only to men with land. Ecofeminists would say that even with increasing
civil and political rights for women (such as the right to vote) and with some nations’
recognizing the rights of children and animals and caring for the environment, the legacy of the
past for most nations still confirms the preeminence of “man” and his dominance of both nature
and women.

KEY TAKEAWAY

Each of the various schools of legal thought has a particular view of what a legal system is or
what it should be. The natural-law theorists emphasize the rights and duties of both
government and the governed. Positive law takes as a given that law is simply the command
of a sovereign, the political power that those governed will obey. Recent writings in the
various legal schools of thought emphasize long-standing patterns of domination of the
wealthy over others (the CLS school) and of men over women (ecofeminist legal theory).

EXERCISES

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

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

Annotate

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

1.3 Basic Concepts and Categories of US Positive Law
LEARNING OBJECTIVES

1. In a general way, differentiate contract law from tort law.
2. Consider the role of law in supporting ethical norms in our society.
3. Understand the differing roles of state law and federal law in the US legal system.
4. Know the difference between criminal cases and civil cases.
Most of what we discuss in this book is positive law—US positive law in particular. We will also
consider the laws and legal systems of other nations. But first, it will be useful to cover some
basic concepts and distinctions.

Law: The Moral Minimums in a Democratic Society
The law does not correct (or claim to correct) every wrong that occurs in society. At a minimum,
it aims to curb the worst kind of wrongs, the kinds of wrongs that violate what might be called
the “moral minimums” that a community demands of its members. These include not only
violations of criminal law (see Chapter 6 "Criminal Law") but also torts (see Chapter 7
"Introduction to Tort Law") and broken promises (see Chapter 8 "Contracts"). Thus it may be
wrong to refuse to return a phone call from a friend, but that wrong will not result in a viable
lawsuit against you. But if a phone (or the Internet) is used to libel or slander someone, a tort
has been committed, and the law may allow the defamed person to be compensated.
There is a strong association between what we generally think of as ethical behavior and what
the laws require and provide. For example, contract law upholds society’s sense that promises—
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in general—should be kept. Promise-breaking is seen as unethical. The law provides remedies
for broken promises (in breach of contract cases) but not for all broken promises; some excuses
are accepted when it would be reasonable to do so. For tort law, harming others is considered
unethical. If people are not restrained by law from harming one another, orderly society would
be undone, leading to anarchy. Tort law provides for compensation when serious injuries or
harms occur. As for property law issues, we generally believe that private ownership of property
is socially useful and generally desirable, and it is generally protected (with some exceptions) by
laws. You can’t throw a party at my house without my permission, but my right to do whatever I
want on my own property may be limited by law; I can’t, without the public’s permission,
operate an incinerator on my property and burn heavy metals, as toxic ash may be deposited
throughout the neighborhood.

The Common Law: Property, Torts, and Contracts
Even before legislatures met to make rules for society, disputes happened and judges decided
them. In England, judges began writing down the facts of a case and the reasons for their
decision. They often resorted to deciding cases on the basis of prior written decisions. In relying
on those prior decisions, the judge would reason that since a current case was pretty much like a
prior case, it ought to be decided the same way. This is essentially reasoning by analogy. Thus
the use of precedent in common-law cases came into being, and a doctrine
of stare decisis (pronounced STAR-ay-de-SIGH-sus) became accepted in English courts. Stare
decisis means, in Latin, “let the decision stand.”
Most judicial decisions that don’t apply legislative acts (known as statutes) will involve one of
three areas of law—property, contract, or tort. Property law deals with the rights and duties of
those who can legally own land (real property), how that ownership can be legally confirmed and
protected, how property can be bought and sold, what the rights of tenants (renters) are, and
what the various kinds of “estates” in land are (e.g., fee simple, life estate, future interest,
easements, or rights of way). Contract law deals with what kinds of promises courts should
enforce. For example, should courts enforce a contract where one of the parties was intoxicated,
underage, or insane? Should courts enforce a contract where one of the parties seemed to have
an unfair advantage? What kind of contracts would have to be in writing to be enforced by
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courts? Tort law deals with the types of cases that involve some kind of harm and or injury
between the plaintiff and the defendant when no contract exists. Thus if you are libeled or a
competitor lies about your product, your remedy would be in tort, not contract.
The thirteen original colonies had been using English common law for many years, and they
continued to do so after independence from England. Early cases from the first states are full of
references to already-decided English cases. As years went by, many precedents were
established by US state courts, so that today a judicial opinion that refers to a seventeenth- or
eighteenth-century English common-law case is quite rare.
Courts in one state may look to common-law decisions from the courts of other states where the
reasoning in a similar case is persuasive. This will happen in “cases of first impression,” a fact
pattern or situation that the courts in one state have never seen before. But if the supreme court
in a particular state has already ruled on a certain kind of case, lower courts in that state will
always follow the rule set forth by their highest court.

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

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

•

Torts

•

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

•

Corporations

•

Partnerships

•

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

•

Securities law

•

Environmental law

•

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

Banking

•

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

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

Criminal Cases

Parties

Plaintiff brings case; defendant must answer or
lose by default

Prosecutor brings case; defendant may
remain silent

Proof

Preponderance of evidence

Beyond a reasonable doubt

Reason

To settle disputes peacefully, usually between
private parties

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

Remedies

Money damages (legal remedy)

Fines, jail, and forfeitures

Injunctions (equitable remedy)
Specific performance (equity)
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Regarding plaintiffs and prosecutors, you can often tell a civil case from a criminal case by
looking at the caption of a case going to trial. If the government appears first in the caption of
the case (e.g., U.S. v. Lieberman, it is likely that the United States is prosecuting on behalf of the
people. The same is true of cases prosecuted by state district attorneys (e.g., State v. Seidel). But
this is not a foolproof formula. Governments will also bring civil actions to collect debts from or
settle disputes with individuals, corporations, or other governments. Thus U.S. v. Mayer might
be a collection action for unpaid taxes, or U.S. v. Canada might be a boundary dispute in the
International Court of Justice. Governments can be sued, as well; people occasionally sue their
state or federal government, but they can only get a trial if the government waives its sovereign
immunity and allows such suits. Warner v. U.S., for example, could be a claim for a tax refund
wrongfully withheld or for damage caused to the Warner residence by a sonic boom from a US
Air Force jet flying overhead.

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

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

•

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

•

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

•

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

•

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

•

Do not discharge certain pollutants into the river without first getting a discharge permit.
In contrast, procedural laws are the rules of courts and administrative agencies. They tell us how
to proceed if there is a substantive-law problem. For example, if you drive fifty-three miles per
hour in a forty mile-per-hour zone on Main Street on a Saturday night and get a ticket, you have
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broken a substantive rule of law (the posted speed limit). Just how and what gets decided in
court is a matter of procedural law. Is the police officer’s word final, or do you get your say
before a judge? If so, who goes first, you or the officer? Do you have the right to be represented
by legal counsel? Does the hearing or trial have to take place within a certain time period? A
week? A month? How long can the state take to bring its case? What kinds of evidence will be
relevant? Radar? (Does it matter what kind of training the officer has had on the radar device?
Whether the radar device had been tested adequately?) The officer’s personal observation?
(What kind of training has he had, how is he qualified to judge the speed of a car, and other
questions arise.) What if you unwisely bragged to a friend at a party recently that you went a
hundred miles an hour on Main Street five years ago at half past three on a Tuesday morning?
(If the prosecutor knows of this and the “friend” is willing to testify, is it relevant to the charge of
fifty-three in a forty-mile-per-hour zone?)
In the United States, all state procedural laws must be fair, since the due process clause of the
Fourteenth Amendment directs that no state shall deprive any citizen of “life, liberty, or
property,” without due process of law. (The $200 fine plus court costs is designed to deprive you
of property, that is, money, if you violate the speed limit.) Federal laws must also be fair,
because the Fifth Amendment to the US Constitution has the exact same due process language
as the Fourteenth Amendment. This suggests that some laws are more powerful or important
than others, which is true. The next section looks at various types of positive law and their
relative importance.

KEY TAKEAWAY

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

EXERCISES

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1. Jenna gets a ticket for careless driving after the police come to investigate a car accident she
had with you on Hanover Boulevard. Your car is badly damaged through no fault of your own.
Is Jenna likely to face criminal charges, civil charges, or both?
2. Jenna’s ticket says that she has thirty days in which to respond to the charges against her.
The thirty days conforms to a state law that sets this time limit. Is the thirty-day limit
procedural law or substantive law?

1.4 Sources of Law and Their Priority
LEARNING OBJECTIVES

1. Describe the different sources of law in the US legal system and the principal institutions that
create those laws.
2. Explain in what way a statute is like a treaty, and vice versa.
3. Explain why the Constitution is “prior” and has priority over the legislative acts of a majority,
whether in the US Congress or in a state legislature.
4. Describe the origins of the common-law system and what common law means.

Sources of Law
In the United States today, there are numerous sources of law. The main ones are (1)
constitutions—both state and federal, (2) statutes and agency regulations, and (3) judicial
decisions. In addition, chief executives (the president and the various governors) can issue
executive orders that have the effect of law.
In international legal systems, sources of law include treaties (agreements between states or
countries) and what is known as customary international law (usually consisting of judicial
decisions from national court systems where parties from two or more nations are in a dispute).
As you might expect, these laws sometimes conflict: a state law may conflict with a federal law,
or a federal law might be contrary to an international obligation. One nation’s law may provide
one substantive rule, while another nation’s law may provide a different, somewhat contrary
rule to apply. Not all laws, in other words, are created equal. To understand which laws have
priority, it is essential to understand the relationships between the various kinds of law.
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Constitutions
Constitutions are the foundation for a state or nation’s other laws, providing the country’s
legislative, executive, and judicial framework. Among the nations of the world, the United States
has the oldest constitution still in use. It is difficult to amend, which is why there have only been
seventeen amendments following the first ten in 1789; two-thirds of the House and Senate must
pass amendments, and three-fourths of the states must approve them.
The nation’s states also have constitutions. Along with providing for legislative, executive, and
judicial functions, state constitutions prescribe various rights of citizens. These rights may be
different from, and in addition to, rights granted by the US Constitution. Like statutes and
judicial decisions, a constitution’s specific provisions can provide people with a “cause of action”
on which to base a lawsuit (see Section 1.4.3 "Causes of Action, Precedent, and " on “causes of
action”). For example, California’s constitution provides that the citizens of that state have a
right of privacy. This has been used to assert claims against businesses that invade an
employee’s right of privacy. In the case of Virginia Rulon-Miller, her employer, International
Business Machines (IBM), told her to stop dating a former colleague who went to work for a
competitor. When she refused, IBM terminated her, and a jury fined the company for $300,000
in damages. As the California court noted, “While an employee sacrifices some privacy rights
when he enters the workplace, the employee’s privacy expectations must be balanced against the
employer’s interests.…[T]he point here is that privacy, like the other unalienable rights listed
first in our Constitution…is unquestionably a fundamental interest of our society.” [1]

Statutes and Treaties in Congress
In Washington, DC, the federal legislature is known as Congress and has both a House of
Representatives and a Senate. The House is composed of representatives elected every two years
from various districts in each state. These districts are established by Congress according to
population as determined every ten years by the census, a process required by the Constitution.
Each state has at least one district; the most populous state (California) has fifty-two districts. In
the Senate, there are two senators from each state, regardless of the state’s population. Thus
Delaware has two senators and California has two senators, even though California has far more

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people. Effectively, less than 20 percent of the nation’s population can send fifty senators to
Washington.
Many consider this to be antidemocratic. The House of Representatives, on the other hand, is
directly proportioned by population, though no state can have less than one representative.
Each Congressional legislative body has committees for various purposes. In these committees,
proposed bills are discussed, hearings are sometimes held, and bills are either reported out
(brought to the floor for a vote) or killed in committee. If a bill is reported out, it may be passed
by majority vote. Because of the procedural differences between the House and the Senate, bills
that have the same language when proposed in both houses are apt to be different after approval
by each body. A conference committee will then be held to try to match the two versions. If the
two versions differ widely enough, reconciliation of the two differing versions into one
acceptable to both chambers (House and Senate) is more difficult.
If the House and Senate can agree on identical language, the reconciled bill will be sent to the
president for signature or veto. The Constitution prescribes that the president will have veto
power over any legislation. But the two bodies can override a presidential veto with a two-thirds
vote in each chamber.
In the case of treaties, the Constitution specifies that only the Senate must ratify them. When the
Senate ratifies a treaty, it becomes part of federal law, with the same weight and effect as a
statute passed by the entire Congress. The statutes of Congress are collected in codified form in
the US Code. The code is available online athttp://uscode.house.gov.

Delegating Legislative Powers: Rules by Administrative Agencies
Congress has found it necessary and useful to create government agencies to administer various
laws (see Chapter 5 "Administrative Law"). The Constitution does not expressly provide for
administrative agencies, but the US Supreme Court has upheld the delegation of power to create
federal agencies.
Examples of administrative agencies would include the Occupational Safety and Health
Administration (OSHA), the Environmental Protection Agency (EPA), and the Federal Trade
Commission (FTC).

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It is important to note that Congress does not have unlimited authority to delegate its
lawmaking powers to an agency. It must delegate its authority with some guidelines for the
agency and cannot altogether avoid its constitutional responsibilities (see Chapter 5
"Administrative Law").
Agencies propose rules in the Federal Register, published each working day of the year. Rules
that are formally adopted are published in the Code of Federal Regulations, or CFR, available
online at http://www.access.gpo.gov/nara/cfr/cfr-table-search.html.

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

Judicial Decisions: The Common Law
Common law consists of decisions by courts (judicial decisions) that do not involve
interpretation of statutes, regulations, treaties, or the Constitution. Courts make such
interpretations, but many cases are decided where there is no statutory or other codified law or
regulation to be interpreted. For example, a state court deciding what kinds of witnesses are
required for a valid will in the absence of a rule (from a statute) is making common law.

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United States law comes primarily from the tradition of English common law. By the time
England’s American colonies revolted in 1776, English common-law traditions were well
established in the colonial courts. English common law was a system that gave written judicial
decisions the force of law throughout the country. Thus if an English court delivered an opinion
as to what constituted the common-law crime of burglary, other courts would stick to that
decision, so that a common body of law developed throughout the country. Common law is
essentially shorthand for the notion that a common body of law, based on past written decisions,
is desirable and necessary.
In England and in the laws of the original thirteen states, common-law decisions defined crimes
such as arson, burglary, homicide, and robbery. As time went on, US state legislatures either
adopted or modified common-law definitions of most crimes by putting them in the form of
codes or statutes. This legislative ability—to modify or change common law into judicial law—
points to an important phenomenon: the priority of statutory law over common law. As we will
see in the next section, constitutional law will have priority over statutory law.

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

Statutes and Cases
Statutes generally have priority, or take precedence, over case law (judicial decisions). Under
common-law judicial decisions, employers could hire young children for difficult work, offer any
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wage they wanted, and not pay overtime work at a higher rate. But various statutes changed
that. For example, the federal Fair Labor Standards Act (1938) forbid the use of oppressive child
labor and established a minimum pay wage and overtime pay rules.

Treaties as Statutes: The “Last in Time” Rule
A treaty or convention is considered of equal standing to a statute. Thus when Congress ratified
the North American Free Trade Agreement (NAFTA), any judicial decisions or previous statutes
that were inconsistent—such as quotas or limitations on imports from Mexico that were
opposite to NAFTA commitments—would no longer be valid. Similarly, US treaty obligations
under the General Agreement on Tariffs and Trade (GATT) and obligations made later through
the World Trade Organization (WTO) would override previous federal or state statutes.
One example of treaty obligations overriding, or taking priority over, federal statutes was the
tuna-dolphin dispute between the United States and Mexico. The Marine Mammal Protection
Act amendments in 1988 spelled out certain protections for dolphins in the Eastern Tropical
Pacific, and the United States began refusing to allow the importation of tuna that were caught
using “dolphin-unfriendly” methods (such as purse seining). This was challenged at a GATT
dispute panel in Switzerland, and the United States lost. The discussion continued at the WTO
under its dispute resolution process. In short, US environmental statutes can be ruled contrary
to US treaty obligations.
Under most treaties, the United States can withdraw, or take back, any voluntary limitation on
its sovereignty; participation in treaties is entirely elective. That is, the United States may
“unbind” itself whenever it chooses. But for practical purposes, some limitations on sovereignty
may be good for the nation. The argument goes something like this: if free trade in general helps
the United States, then it makes some sense to be part of a system that promotes free trade; and
despite some temporary setbacks, the WTO decision process will (it is hoped) provide far more
benefits than losses in the long run. This argument invokes utilitarian theory (that the best
policy does the greatest good overall for society) and David Ricardo’s theory of comparative
advantage.
Ultimately, whether the United States remains a supporter of free trade and continues to
participate as a leader in the WTO will depend upon citizens electing leaders who support the
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process. Had Ross Perot been elected in 1992, for example, NAFTA would have been politically
(and legally) dead during his term of office.

Causes of Action, Precedent, and Stare Decisis
No matter how wrong someone’s actions may seem to you, the only wrongs you can right in a
court are those that can be tied to one or more causes of action. Positive law is full of cases,
treaties, statutes, regulations, and constitutional provisions that can be made into a cause of
action. If you have an agreement with Harold Hill that he will purchase seventy-six trombones
from you and he fails to pay for them after you deliver, you will probably feel wronged, but a
court will only act favorably on your complaint if you can show that his behavior gives you a
cause of action based on some part of your state’s contract law. This case would give you a cause
of action under the law of most states; unless Harold Hill had some legal excuse recognized by
the applicable state’s contract law—such as his legal incompetence, his being less than eighteen
years of age, his being drunk at the time the agreement was made, or his claim that the
instruments were trumpets rather than trombones or that they were delivered too late to be of
use to him—you could expect to recover some compensation for his breaching of your agreement
with him.
An old saying in the law is that the law does not deal in trifles, or unimportant issues (in
Latin, de minimis non curat lex). Not every wrong you may suffer in life will be a cause to bring
a court action. If you are stood up for a Saturday night date and feel embarrassed or humiliated,
you cannot recover anything in a court of law in the United States, as there is no cause of action
(no basis in the positive law) that you can use in your complaint. If you are engaged to be
married and your spouse-to-be bolts from the wedding ceremony, there are some states that do
provide a legal basis on which to bring a lawsuit. “Breach of promise to marry” is recognized in
several states, but most states have abolished this cause of action, either by judicial decision or
by legislation. Whether a runaway bride or groom gives rise to a valid cause of action in the
courts depends on whether the state courts still recognize and enforce this now-disappearing
cause of action.
Your cause of action is thus based on existing laws, including decided cases. How closely your
case “fits” with a prior decided case raises the question of precedent.
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As noted earlier in this chapter, the English common-law tradition placed great emphasis on
precedent and what is called stare decisis. A court considering one case would feel obliged to
decide that case in a way similar to previously decided cases. Written decisions of the most
important cases had been spread throughout England (the common “realm”), and judges hoped
to establish a somewhat predictable, consistent group of decisions.
The English legislature (Parliament) was not in the practice of establishing detailed statutes on
crimes, torts, contracts, or property. Thus definitions and rules were left primarily to the courts.
By their nature, courts could only decide one case at a time, but in doing so they would articulate
holdings, or general rules, that would apply to later cases.
Suppose that one court had to decide whether an employer could fire an employee for no reason
at all. Suppose that there were no statutes that applied to the facts: there was no contract
between the employer and the employee, but the employee had worked for the employer for
many years, and now a younger person was replacing him. The court, with no past guidelines,
would have to decide whether the employee had stated a “cause of action” against the employer.
If the court decided that the case was not legally actionable, it would dismiss the action. Future
courts would then treat similar cases in a similar way. In the process, the court might make a
holding that employers could fire employees for any reason or for no reason. This rule could be
applied in the future should similar cases come up.
But suppose that an employer fired an employee for not committing perjury (lying on the
witness stand in a court proceeding); the employer wanted the employee to cover up the
company's criminal or unethical act. Suppose that, as in earlier cases, there were no applicable
statutes and no contract of employment. Courts relying on a holding or precedent that
“employers may fire employees for any reason or no reason” might rule against an employee
seeking compensation for being fired for telling the truth on the witness stand. Or it might make
an exception to the general rule, such as, “Employers may generally discharge employees for any
reason or for no reason without incurring legal liability; however, employers will incur legal
liability for firing an employee who refuses to lie on behalf of the employer in a court
proceeding.”

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

KEY TAKEAWAY

There are different sources of law in the US legal system. The US Constitution is foundational;
US statutory and common law cannot be inconsistent with its provisions. Congress creates
statutory law (with the signature of the president), and courts will interpret constitutional
law and statutory law. Where there is neither constitutional law nor statutory law, the courts
function in the realm of common law. The same is true of law within the fifty states, each of
which also has a constitution, or foundational law.

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Both the federal government and the states have created administrative agencies. An agency
only has the power that the legislature gives it. Within the scope of that power, an agency
will often create regulations (see Chapter 5 "Administrative Law"), which have the same
force and effect as statutes. Treaties are never negotiated and concluded by states, as the
federal government has exclusive authority over relations with other nation-states. A treaty,
once ratified by the Senate, has the same force and effect as a statute passed by Congress
and signed into law by the president.
Constitutions, statutes, regulations, treaties, and court decisions can provide a legal basis in
the positive law. You may believe you have been wronged, but for you to have a right that is
enforceable in court, you must have something in the positive law that you can point to that
will support a cause of action against your chosen defendant.

EXERCISES

1. Give one example of where common law was overridden by the passage of a federal statute.
2. How does common law change or evolve without any action on the part of a legislature?
3. Lindsey Paradise is not selected for her sorority of choice at the University of Kansas. She has
spent all her time rushing that particular sorority, which chooses some of her friends but not
her. She is disappointed and angry and wants to sue the sorority. What are her prospects of
recovery in the legal system? Explain.

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

1.5 Legal and Political Systems of the World
LEARNING OBJECTIVE

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

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

Civil-Law Systems
The main alternative to the common-law legal system was developed in Europe and is based in
Roman and Napoleonic law. A civil-law or code-law system is one where all the legal rules are in
one or more comprehensive legislative enactments. During Napoleon’s reign, a comprehensive
book of laws—a code—was developed for all of France. The code covered criminal law, criminal
procedure, noncriminal law and procedure, and commercial law. The rules of the code are still
used today in France and in other continental European legal systems. The code is used to
resolve particular cases, usually by judges without a jury. Moreover, the judges are not required
to follow the decisions of other courts in similar cases. As George Cameron of the University of
Michigan has noted, “The law is in the code, not in the cases.” He goes on to note, “Where
several cases all have interpreted a provision in a particular way, the French courts may feel
bound to reach the same result in future cases, under the doctrine ofjurisprudence
constante. The major agency for growth and change, however, is the legislature, not the courts.”
Civil-law systems are used throughout Europe as well as in Central and South America. Some
nations in Asia and Africa have also adopted codes based on European civil law. Germany,
Holland, Spain, France, and Portugal all had colonies outside of Europe, and many of these
colonies adopted the legal practices that were imposed on them by colonial rule, much like the
original thirteen states of the United States, which adopted English common-law practices.
One source of possible confusion at this point is that we have already referred to US civil law in
contrast to criminal law. But the European civil law covers both civil and criminal law.
There are also legal systems that differ significantly from the common-law and civil-law
systems. The communist and socialist legal systems that remain (e.g., in Cuba and North Korea)
operate on very different assumptions than those of either English common law or European

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civil law. Islamic and other religion-based systems of law bring different values and assumptions
to social and commercial relations.

KEY TAKEAWAY

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

EXERCISE

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

1.6 A Sample Case
Preliminary Note to Students
Title VII of the Civil Rights Act of 1964 is a federal statute that applies to all employers whose
workforce exceeds fifteen people. The text of Title VII says that
(a) it shall be an unlawful employment practice for an employer—
(1) to fail or refuse to hire or to discharge any individual, or otherwise to discriminate against
any individual with respect to his compensation, terms, conditions, or privileges of employment,
because of such individual’s race, color, religion, sex, or natural origin.
At common law—where judges decide cases without reference to statutory guidance—employers
were generally free to hire and fire on any basis they might choose, and employees were
generally free to work for an employer or quit an employer on any basis they might choose
(unless the employer and the employee had a contract). This rule has been called “employment
at will.” State and federal statutes that prohibit discrimination on any basis (such as the
prohibitions on discrimination because of race, color, religion, sex, or national origin in Title
VII) are essentially legislative exceptions to the common-law employment-at-will rule.
In the 1970s, many female employees began to claim a certain kind of sex discrimination: sexual
harassment. Some women were being asked to give sexual favors in exchange for continued
employment or promotion (quid pro quo sexual harassment) or found themselves in a working

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environment that put their chances for continued employment or promotion at risk. This form
of sexual discrimination came to be called “hostile working environment” sexual harassment.
Notice that the statute itself says nothing about sexual harassment but speaks only in broad
terms about discrimination “because of” sex (and four other factors). Having set the broad
policy, Congress left it to employees, employers, and the courts to fashion more specific rules
through the process of civil litigation.
This is a case from our federal court system, which has a trial or hearing in the federal district
court, an appeal to the Sixth Circuit Court of Appeals, and a final appeal to the US Supreme
Court. Teresa Harris, having lost at both the district court and the Sixth Circuit Court of
Appeals, here has petitioned for a writ of certiorari (asking the court to issue an order to bring
the case to the Supreme Court), a petition that is granted less than one out of every fifty times.
The Supreme Court, in other words, chooses its cases carefully. Here, the court wanted to
resolve a difference of opinion among the various circuit courts of appeal as to whether or not a
plaintiff in a hostile-working-environment claim could recover damages without showing
“severe psychological injury.”
Harris v. Forklift Systems
510 U.S. 17 (U.S. Supreme Court 1992)
JUDGES: O’CONNOR, J., delivered the opinion for a unanimous Court. SCALIA, J., and
GINSBURG, J., filed concurring opinions.
JUSTICE O’CONNOR delivered the opinion of the Court.
In this case we consider the definition of a discriminatorily “abusive work environment” (also
known as a “hostile work environment”) under Title VII of the Civil Rights Act of 1964, 78 Stat.
253, as amended, 42 U.S.C. § 2000e et seq. (1988 ed., Supp. III).
I
Teresa Harris worked as a manager at Forklift Systems, Inc., an equipment rental company,
from April 1985 until October 1987. Charles Hardy was Forklift’s president.
The Magistrate found that, throughout Harris’ time at Forklift, Hardy often insulted her because
of her gender and often made her the target of unwanted sexual innuendoes. Hardy told Harris
on several occasions, in the presence of other employees, “You’re a woman, what do you know”
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and “We need a man as the rental manager”; at least once, he told her she was “a dumbass
woman.” Again in front of others, he suggested that the two of them “go to the Holiday Inn to
negotiate [Harris’s] raise.” Hardy occasionally asked Harris and other female employees to get
coins from his front pants pocket. He threw objects on the ground in front of Harris and other
women, and asked them to pick the objects up. He made sexual innuendoes about Harris’ and
other women’s clothing.
In mid-August 1987, Harris complained to Hardy about his conduct. Hardy said he was
surprised that Harris was offended, claimed he was only joking, and apologized. He also
promised he would stop, and based on this assurance Harris stayed on the job. But in early
September, Hardy began anew: While Harris was arranging a deal with one of Forklift’s
customers, he asked her, again in front of other employees, “What did you do, promise the
guy…some [sex] Saturday night?” On October 1, Harris collected her paycheck and quit.
Harris then sued Forklift, claiming that Hardy’s conduct had created an abusive work
environment for her because of her gender. The United States District Court for the Middle
District of Tennessee, adopting the report and recommendation of the Magistrate, found this to
be “a close case,” but held that Hardy’s conduct did not create an abusive environment. The
court found that some of Hardy’s comments “offended [Harris], and would offend the
reasonable woman,” but that they were not “so severe as to be expected to seriously affect
[Harris’s] psychological well-being. A reasonable woman manager under like circumstances
would have been offended by Hardy, but his conduct would not have risen to the level of
interfering with that person’s work performance.
“Neither do I believe that [Harris] was subjectively so offended that she suffered
injury.…Although Hardy may at times have genuinely offended [Harris], I do not believe that he
created a working environment so poisoned as to be intimidating or abusive to [Harris].”
In focusing on the employee’s psychological well-being, the District Court was following Circuit
precedent. See Rabidue v. Osceola Refining Co., 805 F.2d 611, 620 (CA6 1986), cert. denied, 481
U.S. 1041, 95 L. Ed. 2d 823, 107 S. Ct. 1983 (1987). The United States Court of Appeals for the
Sixth Circuit affirmed in a brief unpublished decision…reported at 976 F.2d 733 (1992).

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We granted certiorari, 507 U.S. 959 (1993), to resolve a conflict among the Circuits on whether
conduct, to be actionable as “abusive work environment” harassment (no quid pro quo
harassment issue is present here), must “seriously affect [an employee’s] psychological wellbeing” or lead the plaintiff to “suffer injury.” Compare Rabidue (requiring serious effect on
psychological well-being); Vance v. Southern Bell Telephone & Telegraph Co., 863 F.2d 1503,
1510 (CA11 1989) (same); and Downes v. FAA, 775 F.2d 288, 292 (CA Fed. 1985) (same), with
Ellison v. Brady, 924 F.2d 872, 877–878 (CA9 1991) (rejecting such a requirement).
II
Title VII of the Civil Rights Act of 1964 makes it “an unlawful employment practice for an
employer…to discriminate against any individual with respect to his compensation, terms,
conditions, or privileges of employment, because of such individual’s race, color, religion, sex, or
national origin.” 42 U.S.C. § 2000e-2(a)(1). As we made clear in Meritor Savings Bank, FSB v.
Vinson, 477 U.S. 57 (1986), this language “is not limited to ‘economic’ or ‘tangible’
discrimination. The phrase ‘terms, conditions, or privileges of employment’ evinces a
congressional intent ‘to strike at the entire spectrum of disparate treatment of men and women’
in employment,” which includes requiring people to work in a discriminatorily hostile or abusive
environment. Id., at 64, quoting Los Angeles Dept. of Water and Power v. Manhart, 435 U.S.
702, 707, n.13, 55 L. Ed. 2d 657, 98 S. Ct. 1370 (1978). When the workplace is permeated with
“discriminatory intimidation, ridicule, and insult,” 477 U.S. at 65, that is “sufficiently severe or
pervasive to alter the conditions of the victim’s employment and create an abusive working
environment,” Title VII is violated.
This standard, which we reaffirm today, takes a middle path between making actionable any
conduct that is merely offensive and requiring the conduct to cause a tangible psychological
injury. As we pointed out in Meritor, “mere utterance of an…epithet which engenders offensive
feelings in an employee,” does not sufficiently affect the conditions of employment to implicate
Title VII. Conduct that is not severe or pervasive enough to create an objectively hostile or
abusive work environment—an environment that a reasonable person would find hostile or
abusive—is beyond Title VII’s purview. Likewise, if the victim does not subjectively perceive the

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environment to be abusive, the conduct has not actually altered the conditions of the victim’s
employment, and there is no Title VII violation.
But Title VII comes into play before the harassing conduct leads to a nervous breakdown. A
discriminatorily abusive work environment, even one that does not seriously affect employees’
psychological well-being, can and often will detract from employees’ job performance,
discourage employees from remaining on the job, or keep them from advancing in their careers.
Moreover, even without regard to these tangible effects, the very fact that the discriminatory
conduct was so severe or pervasive that it created a work environment abusive to employees
because of their race, gender, religion, or national origin offends Title VII’s broad rule of
workplace equality. The appalling conduct alleged in Meritor, and the reference in that case to
environments “‘so heavily polluted with discrimination as to destroy completely the emotional
and psychological stability of minority group workers,’” Id., at 66, quoting Rogers v. EEOC, 454
F.2d 234, 238 (CA5 1971), cert. denied, 406 U.S. 957,32 L. Ed. 2d 343, 92 S. Ct. 2058 (1972),
merely present some especially egregious examples of harassment. They do not mark the
boundary of what is actionable.
We therefore believe the District Court erred in relying on whether the conduct “seriously
affected plaintiff’s psychological well-being” or led her to “suffer injury.” Such an inquiry may
needlessly focus the fact finder’s attention on concrete psychological harm, an element Title VII
does not require. Certainly Title VII bars conduct that would seriously affect a reasonable
person’s psychological well-being, but the statute is not limited to such conduct. So long as the
environment would reasonably be perceived, and is perceived, as hostile or abusive, Meritor,
supra, at 67, there is no need for it also to be psychologically injurious.
This is not, and by its nature cannot be, a mathematically precise test. We need not answer
today all the potential questions it raises, nor specifically address the Equal Employment
Opportunity Commission’s new regulations on this subject, see 58 Fed. Reg. 51266 (1993)
(proposed 29 CFR §§ 1609.1, 1609.2); see also 29 CFR § 1604.11 (1993). But we can say that
whether an environment is “hostile” or “abusive” can be determined only by looking at all the
circumstances. These may include the frequency of the discriminatory conduct; its severity;
whether it is physically threatening or humiliating, or a mere offensive utterance; and whether it
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unreasonably interferes with an employee’s work performance. The effect on the employee’s
psychological well-being is, of course, relevant to determining whether the plaintiff actually
found the environment abusive. But while psychological harm, like any other relevant factor,
may be taken into account, no single factor is required.
III
Forklift, while conceding that a requirement that the conduct seriously affect psychological wellbeing is unfounded, argues that the District Court nonetheless correctly applied the Meritor
standard. We disagree. Though the District Court did conclude that the work environment was
not “intimidating or abusive to [Harris],” it did so only after finding that the conduct was not “so
severe as to be expected to seriously affect plaintiff’s psychological well-being,” and that Harris
was not “subjectively so offended that she suffered injury,” ibid. The District Court’s application
of these incorrect standards may well have influenced its ultimate conclusion, especially given
that the court found this to be a “close case.”
We therefore reverse the judgment of the Court of Appeals, and remand the case for further
proceedings consistent with this opinion.
So ordered.
Note to Students
This was only the second time that the Supreme Court had decided a sexual harassment case.
Many feminist legal studies scholars feared that the court would raise the bar and make hostileworking-environment claims under Title VII more difficult to win. That did not happen. When
the question to be decided is combined with the court’s decision, we get the holding of the case.
Here, the question that the court poses, plus its answer, yields a holding that “An employee need
not prove severe psychological injury in order to win a Title VII sexual harassment claim.” This
holding will be true until such time as the court revisits a similar question and answers it
differently. This does happen, but happens rarely.

CASE QUESTIONS

1. Is this a criminal case or a civil-law case? How can you tell?
2. Is the court concerned with making a procedural rule here, or is the court making a
statement about the substantive law?

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3. Is this a case where the court is interpreting the Constitution, a federal statute, a state
statute, or the common law?
4. In Harris v. Forklift, what if the trial judge does not personally agree that women should have
any rights to equal treatment in the workplace? Why shouldn’t that judge dismiss the case
even before trial? Or should the judge dismiss the case after giving the female plaintiff her
day in court?
5. What was the employer’s argument in this case? Do you agree or disagree with it? What if
those who legislated Title VII gave no thought to the question of seriousness of injury at all?

1.7 Summary and Exercises
Summary

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

EXERCISES

1. What is the common law? Where do the courts get the authority to interpret it and to
change it?
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2. After World War II ended in 1945, there was an international tribunal at Nuremberg that
prosecuted various officials in Germany’s Third Reich who had committed “crimes against
humanity.” Many of them claim that they were simply “following orders” of Adolf Hitler and
his chief lieutenants. What law, if any, have they violated?
3. What does stare decisis mean, and why is it so basic to common-law legal tradition?
4. In the following situations, which source of law takes priority, and why?
a.

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

b. A federal statute conflicts with the US Constitution.
c. A common-law decision in one state conflicts with the US Constitution.
d. A federal statute conflicts with a state constitution.

SELF-TEST QUESTIONS

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

the common law

b. statutory law
c. constitutional law
d. administrative law
“Law is the command of a sovereign” represents what school of legal
thought?
a.

civil law

b. constitutional law
c. natural law
d. ecofeminist law
e. positive law
Which of the following kinds of law are most often found in state law rather
than federal law?
a.

torts and contracts

b. bankruptcy
c. maritime law
d. international law

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Where was natural law discovered?
a.

in nature

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

deductive reasoning

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

Moore is free to decide the case any way he wants, but he may not look at

decisions and reasons in similar cases from other states.
b. Moore must wait for the Colorado legislature and the governor to pass a law that
addresses the issues raised in the Cassidy case.
c. Moore must follow the California case if that is the best precedent.
d. Moore may follow the California case if he believes that it offers the best
reasoning for a similar case.

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1. c
2. e
3. a
4. c
5. d
6. d

Chapter 2
Corporate Social Responsibility and Business Ethics
A great society is a society in which [leaders] of business think greatly about their functions.
Alfred North Whitehead

LEARNING OBJECTIVES

After reading this chapter, you should be able to do the following:
1. Define ethics and explain the importance of good ethics for business people and business
organizations.
2. Understand the principal philosophies of ethics, including utilitarianism, duty-based ethics,
and virtue ethics.
3. Distinguish between the ethical merits of various choices by using an ethical decision model.
4. Explain the difference between shareholder and stakeholder models of ethical corporate
governance.
5. Explain why it is difficult to establish and maintain an ethical corporate culture in a business
organization.
Few subjects are more contentious or important as the role of business in society, particularly,
whether corporations have social responsibilities that are distinct from maximizing shareholder
value. While the phrase “business ethics” is not oxymoronic (i.e., a contradiction in terms), there
is plenty of evidence that businesspeople and firms seek to look out primarily for themselves.
However, business organizations ignore the ethical and social expectations of consumers,
employees, the media, nongovernment organizations (NGOs), government officials, and socially
responsible investors at their peril. Legal compliance alone no longer serves the long-term

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interests of many companies, who find that sustainable profitability requires thinking about
people and the planet as well as profits.
This chapter has a fairly modest aim: to introduce potential businesspeople to the differences
between legal compliance and ethical excellence by reviewing some of the philosophical
perspectives that apply to business, businesspeople, and the role of business organizations in
society.

2.1 What Is Ethics?

LEARNING OBJECTIVES

1. Explain how both individuals and institutions can be viewed as ethical or unethical.
2. Explain how law and ethics are different, and why a good reputation can be more important
than legal compliance.
Most of those who write about ethics do not make a clear distinction between ethics and
morality. The question of what is “right” or “morally correct” or “ethically correct” or “morally
desirable” in any situation is variously phrased, but all of the words and phrases are after the
same thing: what act is “better” in a moral or ethical sense than some other act? People
sometimes speak of morality as something personal but view ethics as having wider social
implications. Others see morality as the subject of a field of study, that field being ethics. Ethics
would be morality as applied to any number of subjects, including journalistic ethics, business
ethics, or the ethics of professionals such as doctors, attorneys, and accountants. We will
venture a definition of ethics, but for our purposes, ethics and morality will be used as
equivalent terms.
People often speak about the ethics or morality of individuals and also about the morality or
ethics of corporations and nations. There are clearly differences in the kind of moral
responsibility that we can fairly ascribe to corporations and nations; we tend to see individuals
as having a soul, or at least a conscience, but there is no general agreement that nations or
corporations have either. Still, our ordinary use of language does point to something significant:
if we say that some nations are “evil” and others are “corrupt,” then we make moral judgments
about the quality of actions undertaken by the governments or people of that nation. For

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example, if North Korea is characterized by the US president as part of an “axis of evil,” or if we
conclude that WorldCom or Enron acted “unethically” in certain respects, then we are making
judgments that their collective actions are morally deficient.
In talking about morality, we often use the word good; but that word can be confusing. If we say
that Microsoft is a “good company,” we may be making a statement about the investment
potential of Microsoft stock, or their preeminence in the market, or their ability to win lawsuits
or appeals or to influence administrative agencies. Less likely, though possibly, we may be
making a statement about the civic virtue and corporate social responsibility of Microsoft. In the
first set of judgments, we use the word goodbut mean something other than ethical or moral;
only in the second instance are we using the word good in its ethical or moral sense.
A word such as good can embrace ethical or moral values but also nonethical values. If I like
Daniel and try to convince you what a “good guy” he is, you may ask all sorts of questions: Is he
good-looking? Well-off? Fun to be with? Humorous? Athletic? Smart? I could answer all of
those questions with a yes, yet you would still not know any of his moral qualities. But if I said
that he was honest, caring, forthright, and diligent, volunteered in local soup kitchens, or tithed
to the church, many people would see Daniel as having certain ethical or moral qualities. If I
said that he keeps the Golden Rule as well as anyone I know, you could conclude that he is an
ethical person. But if I said that he is “always in control” or “always at the top of his game,” you
would probably not make inferences or assumptions about his character or ethics.
There are three key points here:
1. Although morals and ethics are not precisely measurable, people generally have similar
reactions about what actions or conduct can rightly be called ethical or moral.
2. As humans, we need and value ethical people and want to be around them.
3. Saying that someone or some organization is law-abiding does not mean the same as saying a
person or company is ethical.
Here is a cautionary note: for individuals, it is far from easy to recognize an ethical problem,
have a clear and usable decision-making process to deal it, and then have the moral courage to
do what’s right. All of that is even more difficult within a business organization, where corporate
employees vary in their motivations, loyalties, commitments, and character. There is no
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universally accepted way for developing an organization where employees feel valued, respected,
and free to openly disagree; where the actions of top management are crystal clear; and where
all the employees feel loyal and accountable to one another.
Before talking about how ethics relates to law, we can conclude that ethics is the study of
morality—“right” and “wrong”—in the context of everyday life, organizational behaviors, and
even how society operates and is governed.

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

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

•

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

Why Should an Individual or a Business Entity Be Ethical?
The usual answer is that good ethics is good business. In the long run, businesses that pay
attention to ethics as well as law do better; they are viewed more favorably by customers. But
this is a difficult claim to measure scientifically, because “the long run” is an indistinct period of
time and because there are as yet no generally accepted criteria by which ethical excellence can
be measured. In addition, life is still lived in the short run, and there are many occasions when
something short of perfect conduct is a lot more profitable.
Some years ago, Royal Dutch/Shell (one of the world’s largest companies) found that it was in
deep trouble with the public for its apparent carelessness with the environment and human
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rights. Consumers were boycotting and investors were getting frightened, so the company took a
long, hard look at its ethic of short-term profit maximization. Since then, changes have been
made. The CEO told one group of business ethicists that the uproar had taken them by surprise;
they thought they had done everything right, but it seemed there was a “ghost in the machine.”
That ghost was consumers, NGOs, and the media, all of whom objected to the company’s
seeming lack of moral sensitivity.
The market does respond to unethical behavior. In Section 2.4 "Corporations and Corporate
Governance", you will read about the Sears Auto Centers case. The loss of goodwill toward Sears
Auto Centers was real, even though the total amount of money lost cannot be clearly accounted
for. Years later, there are people who will not go near a Sears Auto Center; the customers who
lost trust in the company will never return, and many of their children may avoid Sears Auto
Centers as well.
The Arthur Andersen story is even more dramatic. A major accounting firm, Andersen worked
closely with Enron in hiding its various losses through creative accounting measures.
Suspiciously, Andersen’s Houston office also did some shredding around the clock, appearing to
cover up what it was doing for Enron. A criminal case based on this shredding resulted in a
conviction, later overturned by the Supreme Court. But it was too late. Even before the
conviction, many clients had found other accounting firms that were not under suspicion, and
the Supreme Court’s reversal came too late to save the company. Even without the conviction,
Andersen would have lost significant market share.
The irony of Andersen as a poster child for overly aggressive accounting practices is that the
man who founded the firm built it on integrity and straightforward practices. “Think straight,
talk straight” was the company’s motto. Andersen established the company’s reputation for
integrity over a hundred years ago by refusing to play numbers games for a potentially lucrative
client.
Maximizing profits while being legally compliant is not a very inspiring goal for a business.
People in an organization need some quality or excellence to strive for. By focusing on pushing
the edge of what is legal, by looking for loopholes in the law that would help create short-term

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

KEY TAKEAWAY

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

EXERCISES

1. Think of a person who did something morally wrong, at least to your way of thinking. What
was it? Explain to a friend of yours—or a classmate—why you think it was wrong. Does your
friend agree? Why or why not? What is the basic principle that forms the basis for your
judgment that it was wrong?
2. Think of a person who did something morally right, at least to your way of thinking. (This is
not a matter of finding something they did well, like efficiently changing a tire, but something
good.) What was it? Explain to a friend of yours—or a classmate—why you think it was right.
Does your friend agree? Why or why not? What is the basic principle that forms the basis for
your judgment that it was right?
3. Think of an action by a business organization (sole proprietor, partnership, or corporation)
that was legal but still strikes you as wrong. What was it? Why do you think it was wrong?
4. Think of an act by an individual or a corporation that is ethical but not legal. Compare your
answer with those of your classmates: were you more likely to find an example from
individual action or corporate action? Do you have any thoughts as to why?

2.2 Major Ethical Perspectives

LEARNING OBJECTIVES

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

Utilitarianism
Utilitarianism is a prominent perspective on ethics, one that is well aligned with economics and
the free-market outlook that has come to dominate much current thinking about business,
management, and economics. Jeremy Bentham is often considered the founder of utilitarianism,
though John Stuart Mill (who wrote On Liberty and Utilitarianism) and others promoted it as a
guide to what is good. Utilitarianism emphasizes not rules but results. An action (or set of
actions) is generally deemed good or right if it maximizes happiness or pleasure throughout
society. Originally intended as a guide for legislators charged with seeking the greatest good for
society, the utilitarian outlook may also be practiced individually and by corporations.
Bentham believed that the most promising way to obtain agreement on the best policies for a
society would be to look at the various policies a legislature could pass and compare the good
and bad consequences of each. The right course of action from an ethical point of view would be
to choose the policy that would produce the greatest amount of utility, or usefulness. In brief,
the utilitarian principle holds that an action is right if and only if the sum of utilities produced
by that action is greater than the sum of utilities from any other possible act.
This statement describes “act utilitarianism”—which action among various options will deliver
the greatest good to society? “Rule utilitarianism” is a slightly different version; it asks, what
rule or principle, if followed regularly, will create the greatest good?
Notice that the emphasis is on finding the best possible results and that the assumption is that
we can measure the utilities involved. (This turns out to be more difficult that you might think.)
Notice also that “the sum total of utilities” clearly implies that in doing utilitarian analysis, we
cannot be satisfied if an act or set of acts provides the greatest utility to us as individuals or to a
particular corporation; the test is, instead, whether it provides the greatest utility to society as a
whole. Notice that the theory does not tell us what kinds of utilities may be better than others or
how much better a good today is compared with a good a year from today.
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Whatever its difficulties, utilitarian thinking is alive and well in US law and business. It is found
in such diverse places as cost-benefit analysis in administrative and regulatory rules and
calculations, environmental impact studies, the majority vote, product comparisons for
consumer information, marketing studies, tax laws, and strategic planning. In management,
people will often employ a form of utility reasoning by projecting costs and benefits for plan X
versus plan Y. But the issue in most of these cost-benefit analyses is usually (1) put exclusively in
terms of money and (2) directed to the benefit of the person or organization doing the analysis
and not to the benefit of society as a whole.
An individual or a company that consistently uses the test “What’s the greatest good for me or
the company?” is not following the utilitarian test of the greatest good overall. Another common
failing is to see only one or two options that seem reasonable. The following are some frequent
mistakes that people make in applying what they think are utilitarian principles in justifying
their chosen course of action:
1. Failing to come up with lots of options that seem reasonable and then choosing the one that has
the greatest benefit for the greatest number. Often, a decision maker seizes on one or two
alternatives without thinking carefully about other courses of action. If the alternative does
more good than harm, the decision maker assumes it’s ethically okay.
2. Assuming that the greatest good for you or your company is in fact the greatest good for all—that
is, looking at situations subjectively or with your own interests primarily in mind.
3. Underestimating the costs of a certain decision to you or your company. The now-classic Ford
Pinto case demonstrates how Ford Motor Company executives drastically underestimated the
legal costs of not correcting a feature on their Pinto models that they knew could cause death or
injury. General Motors was often taken to task by juries that came to understand that the
company would not recall or repair known and dangerous defects because it seemed more
profitable not to. In 2010, Toyota learned the same lesson.
4. Underestimating the cost or harm of a certain decision to someone else or some other group of
people.
5. Favoring short-term benefits, even though the long-term costs are greater.

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

Rules and Duty: Deontology
In contrast to the utilitarian perspective, the deontological view presented in the writings of
Immanuel Kant purports that having a moral intent and following the right rules is a better path
to ethical conduct than achieving the right results. A deontologist like Kant is likely to believe
that ethical action arises from doing one’s duty and that duties are defined by rational thought.
Duties, according to Kant, are not specific to particular kinds of human beings but are owed
universally to all human beings. Kant therefore uses “universalizing“ as a form of rational
thought that assumes the inherent equality of all human beings. It considers all humans as
equal, not in the physical, social, or economic sense, but equal before God, whether they are
male, female, Pygmy, Eskimoan, Islamic, Christian, gay, straight, healthy, sick, young, or old.
For Kantian thinkers, this basic principle of equality means that we should be able to
universalize any particular law or action to determine whether it is ethical. For example, if you
were to consider misrepresenting yourself on a resume for a particular job you really wanted and
you were convinced that doing so would get you that job, you might be very tempted to do so.
(What harm would it be? you might ask yourself. When I have the job, I can prove that I was
perfect for it, and no one is hurt, while both the employer and I are clearly better off as a result!)
Kantian ethicists would answer that your chosen course of action should be a universal one—a
course of action that would be good for all persons at all times. There are two requirements for a
rule of action to be universal: consistency and reversibility. Consider reversibility: if you make a
decision as though you didn’t know what role or position you would have after the decision, you
would more likely make an impartial one—you would more likely choose a course of action that
would be most fair to all concerned, not just you. Again, deontologyrequires that we put duty
first, act rationally, and give moral weight to the inherent equality of all human beings.
In considering whether to lie on your resume, reversibility requires you to actively imagine both
that you were the employer in this situation and that you were another well-qualified applicant
who lost the job because someone else padded his resume with false accomplishments. If the
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consequences of such an exercise of the imagination are not appealing to you, your action is
probably not ethical.
The second requirement for an action to be universal is the search for consistency. This is more
abstract. A deontologist would say that since you know you are telling a lie, you must be willing
to say that lying, as a general, universal phenomenon, is acceptable. But if everyone lied, then
there would be no point to lying, since no one would believe anyone. It is only because honesty
works well for society as a whole and is generally practiced that lying even becomes possible!
That is, lying cannot be universalized, for it depends on the preexistence of honesty.
Similar demonstrations can be made for actions such as polluting, breaking promises, and
committing most crimes, including rape, murder, and theft. But these are the easy cases for
Kantian thinkers. In the gray areas of life as it is lived, the consistency test is often difficult to
apply. If breaking a promise would save a life, then Kantian thought becomes difficult to apply.
If some amount of pollution can allow employment and the harm is minimal or distant, Kantian
thinking is not all that helpful. Finally, we should note that the well-known Golden Rule, “Do
unto others as you would have them do unto you,” emphasizes the easier of the two
universalizing requirements: practicing reversibility (“How would I like it if someone did this to
me?”).

Social Justice Theory and Social Contract Theory
Social justice theorists worry about “distributive justice”—that is, what is the fair way to
distribute goods among a group of people? Marxist thought emphasizes that members of society
should be given goods to according to their needs. But this redistribution would require a
governing power to decide who gets what and when. Capitalist thought takes a different
approach, rejecting any giving that is not voluntary. Certain economists, such as the late Milton
Friedman (see the sidebar in Section 2.4 "Corporations and Corporate Governance") also reject
the notion that a corporation has a duty to give to unmet needs in society, believing that the
government should play that role. Even the most dedicated free-market capitalist will often
admit the need for some government and some forms of welfare—Social Security, Medicare,
assistance to flood-stricken areas, help for AIDs patients—along with some public goods (such as
defense, education, highways, parks, and support of key industries affecting national security).
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People who do not see the need for public goods (including laws, court systems, and the
government goods and services just cited) often question why there needs to be a government at
all. One response might be, “Without government, there would be no corporations.” Thomas
Hobbes believed that people in a “state of nature” would rationally choose to have some form of
government. He called this thesocial contract, where people give up certain rights to government
in exchange for security and common benefits. In your own lives and in this course, you will see
an ongoing balancing act between human desires for freedom and human desires for order; it is
an ancient tension. Some commentators also see a kind of social contract between corporations
and society; in exchange for perpetual duration and limited liability, the corporation has some
corresponding duties toward society. Also, if a corporation is legally a “person,” as the Supreme
Court reaffirmed in 2010, then some would argue that if this corporate person commits three
felonies, it should be locked up for life and its corporate charter revoked!
Modern social contract theorists, such as Thomas Donaldson and Thomas Dunfee (Ties that
Bind, 1999), observe that various communities, not just nations, make rules for the common
good. Your college or school is a community, and there are communities within the school
(fraternities, sororities, the folks behind the counter at the circulation desk, the people who work
together at the university radio station, the sports teams, the faculty, the students generally, the
gay and lesbian alliance) that have rules, norms, or standards that people can buy into or not. If
not, they can exit from that community, just as we are free (though not without cost) to reject US
citizenship and take up residence in another country.
Donaldson and Dunfee’s integrative social contracts theory stresses the importance of studying
the rules of smaller communities along with the larger social contracts made in states (such as
Colorado or California) and nation-states (such as the United States or Germany). Our
Constitution can be seen as a fundamental social contract.
It is important to realize that a social contract can be changed by the participants in a
community, just as the US Constitution can be amended. Social contract theory is thus
dynamic—it allows for structural and organic changes. Ideally, the social contract struck by
citizens and the government allows for certain fundamental rights such as those we enjoy in the
United States, but it need not. People can give up freedom-oriented rights (such as the right of
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free speech or the right to be free of unreasonable searches and seizures) to secure order
(freedom from fear, freedom from terrorism). For example, many citizens in Russia now miss
the days when the Kremlin was all powerful; there was less crime and more equality and
predictability to life in the Soviet Union, even if there was less freedom.
Thus the rights that people have—in positive law—come from whatever social contract exists in
the society. This view differs from that of the deontologists and that of the natural-law thinkers
such as Gandhi, Jesus, or Martin Luther King Jr., who believed that rights come from God or, in
less religious terms, from some transcendent moral order.
Another important movement in ethics and society is the communitarian outlook.
Communitarians emphasize that rights carry with them corresponding duties; that is, there
cannot be a right without a duty. Interested students may wish to explore the work of Amitai
Etzioni. Etzioni was a founder of the Communitarian Network, which is a group of individuals
who have come together to bolster the moral, social, and political environment. It claims to be
nonsectarian, nonpartisan, and international in scope.
The relationship between rights and duties—in both law and ethics—calls for some explanations:
1. If you have a right of free expression, the government has a duty to respect that right but can put
reasonable limits on it. For example, you can legally say whatever you want about the US
president, but you can’t get away with threatening the president’s life. Even if your criticisms are
strong and insistent, you have the right (and our government has the duty to protect your right)
to speak freely. In Singapore during the 1990s, even indirect criticisms—mere hints—of the
political leadership were enough to land you in jail or at least silence you with a libel suit.
2. Rights and duties exist not only between people and their governments but also between
individuals. Your right to be free from physical assault is protected by the law in most states, and
when someone walks up to you and punches you in the nose, your rights—as set forth in the
positive law of your state—have been violated. Thus other people have a duty to respect your
rights and to not punch you in the nose.
3. Your right in legal terms is only as good as your society’s willingness to provide legal remedies
through the courts and political institutions of society.

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A distinction between basic rights and nonbasic rights may also be important. Basic rights may
include such fundamental elements as food, water, shelter, and physical safety. Another
distinction is between positive rights (the right to bear arms, the right to vote, the right of
privacy) and negative rights (the right to be free from unreasonable searches and seizures, the
right to be free of cruel or unusual punishments). Yet another is between economic or social
rights (adequate food, work, and environment) and political or civic rights (the right to vote, the
right to equal protection of the laws, the right to due process).

Aristotle and Virtue Theory
Virtue theory, or virtue ethics, has received increasing attention over the past twenty years,
particularly in contrast to utilitarian and deontological approaches to ethics. Virtue theory
emphasizes the value of virtuous qualities rather than formal rules or useful results. Aristotle is
often recognized as the first philosopher to advocate the ethical value of certain qualities, or
virtues, in a person’s character. As LaRue Hosmer has noted, Aristotle saw the goal of human
existence as the active, rational search for excellence, and excellence requires the personal
virtues of honesty, truthfulness, courage, temperance, generosity, and high-mindedness. This
pursuit is also termed “knowledge of the good” in Greek philosophy. [1]
Aristotle believed that all activity was aimed at some goal or perceived good and that there must
be some ranking that we do among those goals or goods. Happiness may be our ultimate goal,
but what does that mean, exactly? Aristotle rejected wealth, pleasure, and fame and embraced
reason as the distinguishing feature of humans, as opposed to other species. And since a human
is a reasoning animal, happiness must be associated with reason. Thus happiness is living
according to the active (rather than passive) use of reason. The use of reason leads to excellence,
and so happiness can be defined as the active, rational pursuit of personal excellence, or virtue.
Aristotle named fourteen virtues: (1) courage, particularly in battle; (2) temperance, or
moderation in eating and drinking; (3) liberality, or spending money well; (4) magnificence, or
living well; (5) pride, or taking pleasure in accomplishments and stature; (6) high-mindedness,
or concern with the noble rather than the petty; (7) unnamed virtue, which is halfway between
ambition and total lack of effort; (8) gentleness, or concern for others; (9) truthfulness; (10) wit,
or pleasure in group discussions; (11) friendliness, or pleasure in personal conduct; (12)
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modesty, or pleasure in personal conduct; (13) righteous indignation, or getting angry at the
right things and in the right amounts; and (14) justice.
From a modern perspective, some of these virtues seem old-fashioned or even odd.
Magnificence, for example, is not something we commonly speak of. Three issues emerge: (1)
How do we know what a virtue is these days? (2) How useful is a list of agreed-upon virtues
anyway? (3) What do virtues have to do with companies, particularly large ones where various
groups and individuals may have little or no contact with other parts of the organization?
As to the third question, whether corporations can “have” virtues or values is a matter of lively
debate. A corporation is obviously not the same as an individual. But there seems to be growing
agreement that organizations do differ in their practices and that these practices are value
driven. If all a company cares about is the bottom line, other values will diminish or disappear.
Quite a few books have been written in the past twenty years that emphasize the need for
businesses to define their values in order to be competitive in today’s global economy. [2]
As to the first two questions regarding virtues, a look at Michael Josephson’s core values may
prove helpful.

Josephson’s Core Values Analysis and Decision Process
Michael Josephson, a noted American ethicist, believes that a current set of core valueshas been
identified and that the values can be meaningfully applied to a variety of personal and corporate
decisions.
To simplify, let’s say that there are ethical and nonethical qualities among people in the United
States. When you ask people what kinds of qualities they admire in others or in themselves, they
may say wealth, power, fitness, sense of humor, good looks, intelligence, musical ability, or some
other quality. They may also value honesty, caring, fairness, courage, perseverance, diligence,
trustworthiness, or integrity. The qualities on the second list have something in common—they
are distinctively ethical characteristics. That is, they are commonly seen as moral or ethical
qualities, unlike the qualities on the first list. You can be, like the Athenian Alcibiades, brilliant
but unprincipled, or, like some political leaders today, powerful but dishonest, or wealthy but
uncaring. You can, in short, have a number of admirable qualities (brilliance, power, wealth)
that are not per se virtuous. Just because Harold is rich or good-looking or has a good sense of
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humor does not mean that he is ethical. But if Harold is honest and caring (whether he is rich or
poor, humorous or humorless), people are likely to see him as ethical.
Among the virtues, are any especially important? Studies from the Josephson Institute of Ethics
in Marina del Rey, California, have identified six core values in our society, values that almost
everyone agrees are important to them. When asked what values people hold dear, what values
they wish to be known by, and what values they wish others would exhibit in their actions, six
values consistently turn up: (1) trustworthiness, (2) respect, (3) responsibility, (4) fairness, (5)
caring, and (6) citizenship.
Note that these values are distinctly ethical. While many of us may value wealth, good looks, and
intelligence, having wealth, good looks, and intelligence does not automatically make us
virtuous in our character and habits. But being more trustworthy (by being honest and by
keeping promises) does make us more virtuous, as does staying true to the other five core
values.
Notice also that these six core values share something in common with other ethical values that
are less universally agreed upon. Many values taught in the family or in places of worship are
not generally agreed on, practiced, or admired by all. Some families and individuals believe
strongly in the virtue of saving money or in abstaining from alcohol or sex prior to marriage.
Others clearly do not, or at least don’t act on their beliefs. Moreover, it is possible to have and
practice core ethical values even if you take on heavy debt, knock down several drinks a night, or
have frequent premarital sex. Some would dispute this, saying that you can’t really lead a
virtuous life if you get into debt, drink heavily, or engage in premarital sex. But the point here is
that since people do disagree in these areas, the ethical traits of thrift, temperance, and sexual
abstinence do not have the unanimity of approval that the six core values do.
The importance of an individual’s having these consistent qualities of character is well known.
Often we remember the last bad thing a person did far more than any or all previous good acts.
For example, Eliot Spitzer and Bill Clinton are more readily remembered by people for their last,
worst acts than for any good they accomplished as public servants. As for a company, its good
reputation also has an incalculable value that when lost takes a great deal of time and work to
recover. Shell, Nike, and other companies have discovered that there is a market for morality,
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however difficult to measure, and that not paying attention to business ethics often comes at a
serious price. In the past fifteen years, the career of ethics and compliance officer has emerged,
partly as a result of criminal proceedings against companies but also because major companies
have found that reputations cannot be recovered retroactively but must be pursued proactively.
For individuals, Aristotle emphasized the practice of virtue to the point where virtue becomes a
habit. Companies are gradually learning the same lesson.

KEY TAKEAWAY

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

EXERCISES

XYZ Motor Corporation begins to get customer complaints about two models of its
automobiles. Customers have had near-death experiences from sudden acceleration; they
would be driving along a highway at normal speed when suddenly the car would begin to
accelerate, and efforts to stop the acceleration by braking fail to work. Drivers could turn off
the ignition and come to a safe stop, but XYZ does not instruct buyers of its cars to do so, nor
is this a common reaction among drivers who experience sudden acceleration.
Internal investigations of half a dozen accidents in US locations come to the conclusion that
the accidents are not being caused by drivers who mistake the gas pedal for the brake pedal.
In fact, there appears to be a possible flaw in both models, perhaps in a semiconductor chip,
that makes sudden acceleration happen. Interference by floor mats and poorly designed gas
pedals do not seem to be the problem.
It is voluntary to report these incidents to the National Highway Traffic and Safety
Administration (NHTSA), but the company decides that it will wait awhile and see if there are
more complaints. Recalling the two models so that local dealers and their mechanics could
examine them is also an option, but it would be extremely costly. Company executives are
aware that quarterly and annual profit-and-loss statements, on which their bonuses depend,
could be decisively worse with a recall. They decide that on a cost-benefit basis, it makes
more sense to wait until there are more accidents and more data. After a hundred or more
accidents and nearly fifteen fatalities, the company institutes a selective recall, still not
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notifying NHTSA, which has its own experts and the authority to order XYZ to do a full recall
of all affected models.
Experts have advised XYZ that standard failure-analysis methodology requires that the
company obtain absolutely every XYZ vehicle that has experienced sudden acceleration,
using microscopic analysis of all critical components of the electronic system. The company
does not wish to take that advice, as it would be—as one top executive put it—“too timeconsuming and expensive.”
1. Can XYZ’s approach to this problem be justified under utilitarian theory? If so, how? If not,
why not?
2. What would Kant advise XYZ to do? Explain.
3. What would the “virtuous” approach be for XYZ in this situation?

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

2.3 An Ethical Decision Model

LEARNING OBJECTIVE

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

Josephson’s Core Values Model
Once you recognize that there is a decision that involves ethical judgment, Michael Josephson
would first have you ask as many questions as are necessary to get a full background on the
relevant facts. Then, assuming you have all the needed information, the decision process is as
follows:
1. Identify the stakeholders. That is, who are the potential gainers and losers in the various
decisions that might be made here?
2. Identify several likely or reasonable decisions that could be made.
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3. Consider which stakeholders gain or lose with each decision.
4. Determine which decision satisfies the greatest number of core values.
5. If there is no decision that satisfies the greatest number of core values, try to determine which
decision delivers the greatest good to the various stakeholders.
It is often helpful to identify who (or what group) is the most important stakeholder, and why.
In Milton Friedman’s view, it will always be the shareholders. In the view of John Mackey, the
CEO of Whole Foods Market, the long-term viability and profitability of the organization may
require that customers come first, or, at times, some other stakeholder group (see “Conscious
Capitalism” in Section 2.4 "Corporations and Corporate Governance").

The Core Values

Here are the core values and their subcomponents as developed by the Josephson Institute of
Ethics.
Trustworthiness: Be honest—tell the truth, the whole truth, and nothing but the truth; be
sincere, forthright; don’t deceive, mislead, or be tricky with the truth; don’t cheat or steal, and
don’t betray a trust. Demonstrate integrity—stand up for what you believe, walk the walk as well
as talking the talk; be what you seem to be; show commitment and courage. Be loyal—stand by
your family, friends, co-workers, community, and nation; be discreet with information that
comes into your hands; don’t spread rumors or engage in harmful gossip; don’t violate your
principles just to win friendship or approval; don’t ask a friend to do something that is
wrong. Keep promises—keep your word, honor your commitments, and pay your debts; return
what you borrow.
Respect: Judge people on their merits, not their appearance; be courteous, polite, appreciative,
and accepting of differences; respect others’ right to make decisions about their own lives; don’t
abuse, demean, mistreat anyone; don’t use, manipulate, exploit, or take advantage of others.
Responsibility: Be accountable—think about the consequences on yourself and others likely to
be affected before you act; be reliable; perform your duties; take responsibility for the
consequences of your choices; set a good example and don’t make excuses or take credit for
other people’s work. Pursue excellence: Do your best, don’t quit easily, persevere, be diligent,

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make all you do worthy of pride. Exercise self-restraint—be disciplined, know the difference
between what you have a right to do and what is right to do.
Fairness: Treat all people fairly, be open-minded; listen; consider opposing viewpoints; be
consistent; use only appropriate considerations; don’t let personal feelings improperly interfere
with decisions; don’t take unfair advantage of mistakes; don’t take more than your fair share.
Caring: Show you care about others through kindness, caring, sharing, compassion, and
empathy; treat others the way you want to be treated; don’t be selfish, mean, cruel, or insensitive
to others’ feelings.
Citizenship: Play by the rules, obey laws; do your share, respect authority, stay informed, vote,
protect your neighbors, pay your taxes; be charitable, help your community; protect the
environment, conserve resources.
When individuals and organizations confront ethical problems, the core values decision model
offered by Josephson generally works well (1) to clarify the gains and losses of the various
stakeholders, which then raises ethical awareness on the part of the decision maker and (2) to
provide a fairly reliable guide as to what the most ethical decision would be. In nine out of ten
cases, step 5 in the decision process is not needed.
That said, it does not follow that students (or managers) would necessarily act in accord with the
results of the core values decision process. There are many psychological pressures and
organizational constraints that place limits on people both individually and in organizations.
These pressures and constraints tend to compromise ideal or the most ethical solutions for
individuals and for organizations. For a business, one essential problem is that ethics can cost
the organization money or resources, at least in the short term. Doing the most ethical thing will
often appear to be something that fails to maximize profits in the short term or that may seem
pointless because if you or your organization acts ethically, others will not, and society will be no
better off, anyway.

KEY TAKEAWAY

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

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

2.4 Corporations and Corporate Governance
LEARNING OBJECTIVES

1. Explain the basic structure of the typical corporation and how the shareholders own the
company and elect directors to run it.
2. Understand how the shareholder profit-maximization model is different from stakeholder
theory.
3. Discern and describe the ethical challenges for corporate cultures.
4. Explain what conscious capitalism is and how it differs from stakeholder theory.

Legal Organization of the Corporation
Figure 2.1 Corporate Legal Structure

Figure 2.1 "Corporate Legal Structure", though somewhat oversimplified, shows the basic legal
structure of a corporation under Delaware law and the laws of most other states in the United
States. Shareholders elect directors, who then hire officers to manage the company. From this

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structure, some very basic realities follow. Because the directors of a corporation do not meet
that often, it’s possible for the officers hired (top management, or the “C-suite”) to be selective of
what the board knows about, and directors are not always ready and able to provide the
oversight that the shareholders would like. Nor does the law require officers to be shareholders,
so that officers’ motivations may not align with the best interests of the company. This is the
“agency problem” often discussed in corporate governance: how to get officers and other top
management to align their own interests with those of the shareholders. For example, a CEO
might trade insider information to the detriment of the company’s shareholders. Even board
members are susceptible to misalignment of interets; for example, board members might resist
hostile takeover bids because they would likely lose their perks (short for perquisites) as
directors, even though the tender offer would benefit stockholders. Among other attempted
realignments, the use of stock options was an attempt to make managers more attentive to the
value of company stock, but the law of unintended consequences was in full force; managers
tweaked and managed earnings in the bubble of the 1990s bull market, and “managing by
numbers” became an epidemic in corporations organized under US corporate law. The rights of
shareholders can be bolstered by changes in state and federal law, and there have been some
attempts to do that since the late 1990s. But as owners, shareholders have the ultimate power to
replace nonperforming or underperforming directors, which usually results in changes at the Csuite level as well.

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

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

“The Social Responsibility of Business Is to Increase Its Profits”
Milton Friedman, New York Times Magazine, September 13, 1970
What does it mean to say that “business” has responsibilities? Only people can have
responsibilities. A corporation is an artificial person and in this sense may have artificial
responsibilities, but “business” as a whole cannot be said to have responsibilities, even in this
vague sense.…
Presumably, the individuals who are to be responsible are businessmen, which means individual
proprietors or corporate executives.…In a free enterprise, private-property system, a corporate
executive is an employee of the owners of the business. He has direct responsibility to his
employers. That responsibility is to conduct the business in accordance with their desires, which
generally will be to make as much money as possible while conforming to the basic rules of the
society, both those embodied in law and those embodied in ethical custom.…
…[T]he manager is that agent of the individuals who own the corporation or establish the
eleemosynary institution, and his primary responsibility is to them…
Of course, the corporate executive is also a person in his own right. As a person, he may have
other responsibilities that he recognizes or assumes voluntarily—to his family, his conscience,
his feeling of charity, his church, his clubs, his city, his country. He may feel impelled by these
responsibilities to devote part of his income to causes he regards as worthy, to refuse to work for
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particular corporations, even to leave his job…But in these respects he is acting as a principal,
not an agent; he is spending his own money or time or energy, not the money of his employers
or the time or energy he has contracted to devote to their purposes. If these are “social
responsibilities,” they are the social responsibilities of individuals, not of business.
What does it mean to say that the corporate executive has a “social responsibility” in his capacity
as businessman? If this statement is not pure rhetoric, it must mean that he has to act in some
way that is not in the interest of his employers. For example, that he is to refrain from increasing
the price of the product in order to contribute to the social objective of preventing inflation, even
though a price increase would be in the best interests of the corporation. Or that he is to make
expenditures on reducing pollution beyond the amount that is in the best interests of the
corporation or that is required by law in order to contribute to the social objective of improving
the environment. Or that, at the expense of corporate profits, he is to hire “hardcore”
unemployed instead of better qualified available workmen to contribute to the social objective of
reducing poverty.
In each of these cases, the corporate executive would be spending someone else’s money for a
general social interest. Insofar as his actions…reduce returns to stockholders, he is spending
their money. Insofar as his actions raise the price to customers, he is spending the customers’
money. Insofar as his actions lower the wages of some employees, he is spending their money.
This process raises political questions on two levels: principle and consequences. On the level of
political principle, the imposition of taxes and the expenditure of tax proceeds are governmental
functions. We have established elaborate constitutional, parliamentary, and judicial provisions
to control these functions, to assure that taxes are imposed so far as possible in accordance with
the preferences and desires of the public.…
Others have challenged the notion that corporate managers have no real duties except toward
the owners (shareholders). By changing two letters in shareholder, stakeholder theorists
widened the range of people and institutions that a corporation should pay moral consideration
to. Thus they contend that a corporation, through its management, has a set of responsibilities
toward nonshareholder interests.

Stakeholder Theory
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Stakeholders of a corporation include its employees, suppliers, customers, and the community.
Stakeholder is a deliberate play on the word shareholder, to emphasize that corporations have
obligations that extend beyond the bottom-line aim of maximizing profits. A stakeholder is
anyone who most would agree is significantly affected (positively or negatively) by the decision
of another moral agent.
There is one vital fact about corporations: the corporation is a creation of the law. Without law
(and government), corporations would not have existence. The key concept for corporations is
the legal fact of limited liability. The benefit of limited liability for shareholders of a corporation
meant that larger pools of capital could be aggregated for larger enterprises; shareholders could
only lose their investments should the venture fail in any way, and there would be no personal
liability and thus no potential loss of personal assets other than the value of the corporate stock.
Before New Jersey and Delaware competed to make incorporation as easy as possible and
beneficial to the incorporators and founders, those who wanted the benefits of incorporation
had to go to legislatures—usually among the states—to show a public purpose that the company
would serve.
In the late 1800s, New Jersey and Delaware changed their laws to make incorporating relatively
easy. These two states allowed incorporation “for any legal purpose,” rather than requiring some
public purpose. Thus it is government (and its laws) that makes limited liability happen through
the corporate form. That is, only through the consent of the state and armed with the charter
granted by the state can a corporation’s shareholders have limited liability. This is a right
granted by the state, a right granted for good and practical reasons for encouraging capital and
innovation. But with this right comes a related duty, not clearly stated at law, but assumed when
a charter is granted by the state: that the corporate form of doing business is legal because the
government feels that it socially useful to do so.
Implicitly, then, there is a social contract between governments and corporations: as long as
corporations are considered socially useful, they can exist. But do they have explicit social
responsibilities? Milton Friedman’s position suggests that having gone along with legal duties,
the corporation can ignore any other social obligations. But there are others (such as advocates
of stakeholder theory) who would say that a corporation’s social responsibilities go beyond just
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staying within the law and go beyond the corporation’s shareholders to include a number of
other important stakeholders, those whose lives can be affected by corporate decisions.
According to stakeholder theorists, corporations (and other business organizations) must pay
attention not only to the bottom line but also to their overall effect on the community. Public
perception of a company’s unfairness, uncaring, disrespect, or lack of trustworthiness often
leads to long-term failure, whatever the short-term successes or profits may be. A socially
responsible corporation is likely to consider the impact of its decisions on a wide range of
stakeholders, not just shareholders. As Table 2.1 "The Stakes of Various Stakeholders" indicates,
stakeholders have very different kinds of interests (“stakes”) in the actions of a corporation.
Table 2.1 The Stakes of Various Stakeholders
Managers
Directors who
own stock
Ownership

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

Shareholders

Salaried
managers
Creditors
Suppliers
Employees
Economic
Dependence

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

Local
communities
Communities

Social
Interests

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

Government
Media

Corporate Culture and Codes of Ethics
A corporation is a “person” capable of suing, being sued, and having rights and duties in our
legal system. (It is a legal or juridical person, not a natural person, according to our Supreme

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Court.) Moreover, many corporations have distinct cultures and beliefs that are lived and
breathed by its members. Often, the culture of a corporation is the best defense against
individuals within that firm who may be tempted to break the law or commit serious ethical
misdeeds.
What follows is a series of observations about corporations, ethics, and corporate culture.

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

Accountability Is Often Weak
Clever managers can learn to shift blame to others, take credit for others’ work, and move on
before “funny numbers” or other earnings management tricks come to light. [1]Again, we see that
the manager is often an agent for himself or herself and will often act more in his or her selfinterest than for the corporate interest.

Killing the Messenger
Where organizations no longer function, inevitably some employees are unhappy. If they call
attention to problems that are being covered up by coworkers or supervisors, they bring bad
news. Managers like to hear good news and discourage bad news. Intentionally or not, those
who told on others, or blew the whistle, have rocked the boat and become unpopular with those
whose defalcations they report on and with the managers who don’t really want to hear the bad
news. In many organizations, “killing the messenger” solves the problem. Consider James
Alexander at Enron Corporation, who was deliberately shut out after bringing problems to CEO
Ken Lay’s attention. [2]When Sherron Watkins sent Ken Lay a letter warning him about Enron’s
accounting practices, CFO Andrew Fastow tried to fire her. [3]

Ethics Codes
Without strong leadership and a willingness to listen to bad news as well as good news,
managers do not have the feedback necessary to keep the organization healthy. Ethics codes
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have been put in place—partly in response to federal sentencing guidelines and partly to
encourage feedback loops to top management. The best ethics codes are aspirational, or having
an ideal to be pursued, not legalistic or compliance driven. The Johnson & Johnson ethics code
predated the Tylenol scare and the company’s oft-celebrated corporate response. [4] The
corporate response was consistent with that code, which was lived and modeled by the top of the
organization.
It’s often noted that a code of ethics is only as important as top management is willing to make
it. If the code is just a document that goes into a drawer or onto a shelf, it will not effectively
encourage good conduct within the corporation. The same is true of any kind of training that the
company undertakes, whether it be in racial sensitivity or sexual harassment. If the message is
not continuously reinforced, or (worse yet) if the message is undermined by management’s
actions, the real message to employees is that violations of the ethics code will not be taken
seriously, or that efforts to stop racial discrimination or sexual harassment are merely token
efforts, and that the important things are profits and performance. The ethics code at Enron
seems to have been one of those “3-P” codes that wind up sitting on shelves—“Print, Post, and
Pray.” Worse, the Enron board twice suspended the code in 1999 to allow outside partnerships
to be led by a top Enron executive who stood to gain financially from them. [5]

Ethics Hotlines and Federal Sentencing Guidelines
The federal sentencing guidelines were enacted in 1991. The original idea behind these
guidelines was for Congress to correct the lenient treatment often given to white-collar, or
corporate, criminals. The guidelines require judges to consider “aggravating and mitigating”
factors in determining sentences and fines. (While corporations cannot go to jail, its officers and
managers certainly can, and the corporation itself can be fined. Many companies will claim that
it is one bad apple that has caused the problem; the guidelines invite these companies to show
that they are in fact tending their orchard well. They can show this by providing evidence that
they have (1) a viable, active code of ethics; (2) a way for employees to report violations of law or
the ethics code; and (3) an ethics ombudsman, or someone who oversees the code.
In short, if a company can show that it has an ongoing process to root out wrongdoing at all
levels of the company, the judge is allowed to consider this as a major mitigating factor in the
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fines the company will pay. Most Fortune 500 companies have ethics hotlines and processes in
place to find legal and ethical problems within the company.

Managing by the Numbers
If you manage by the numbers, there is a temptation to lie about those numbers, based on the
need to get stock price ever higher. At Enron, “15 percent a year or better earnings growth” was
the mantra. Jeffrey Pfeffer, professor of organizational behavior at Stanford University, observes
how the belief that “stock price is all that matters” has been hardwired into the corporate
psyche. It dictates not only how people judge the worth of their company but also how they feel
about themselves and the work that they are doing. And, over time, it has clouded judgments
about what is acceptable corporate behavior. [6]

Managing by Numbers: The Sears Auto Center Story
If winning is the most important thing in your life, then you must be prepared to do anything to
win.
—Michael Josephson
Most people want to be winners or associate with winners. As humans, our desire to associate
with those who have status provides plenty of incentive to glorify winners and ignore losers. But
if an individual, a team, or a company does whatever it takes to win, then all other values are
thrown out in the goal to win at all costs. The desire of some people within Sears & Roebuck
Company’s auto repair division to win by gaining higher profits resulted in the situation
portrayed here.
Sears Roebuck & Company has been a fixture in American retailing throughout the twentieth
century. At one time, people in rural America could order virtually anything (including a house)
from Sears. Not without some accuracy, the company billed itself as “the place where Americans
shop.” But in 1992, Sears was charged by California authorities with gross and deliberate fraud
in many of its auto centers.
The authorities were alerted by a 50 percent increase in consumer complaints over a three-year
period. New Jersey’s division of consumer affairs also investigated Sears Auto Centers and
found that all six visited by investigators had recommended unnecessary repairs. California’s
department of consumer affairs found that Sears had systematically overcharged by an average
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of $223 for repairs and routinely billed for work that was not done. Sears Auto Centers were the
largest providers of auto repair services in the state.
The scam was a variant on the old bait-and-switch routine. Customers received coupons in the
mail inviting them to take advantage of hefty discounts on brake jobs. When customers came in
to redeem their coupons, sales staffers would convince them to authorize additional repairs. As a
management tool, Sears had also established quotas for each of their sales representatives to
meet.
Ultimately, California got Sears to settle a large number of lawsuits against it by threatening to
revoke Sears’ auto repair license. Sears agreed to distribute $50 coupons to nearly a million
customers nationwide who had obtained certain services between August 1, 1990, and January
31, 1992. Sears also agreed to pay $3.5 million to cover the costs of various government
investigations and to contribute $1.5 million annually to conduct auto mechanic training
programs. It also agreed to abandon its repair service quotas. The entire settlement cost Sears
$30 million. Sears Auto Center sales also dropped about 15 to 20 percent after news of the
scandal broke.
Note that in boosting sales by performing unnecessary services, Sears suffered very bad
publicity. Losses were incalculable. The short-term gains were easy to measure; long-term
consequences seldom are. The case illustrates a number of important lessons:
•

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

•

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

•

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

•

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

•

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

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

Conscious Capitalism
One effort to integrate the two viewpoints of stakeholder theory and shareholder primacy is the
conscious capitalism movement. Companies that practiceconscious capitalism embrace the idea
that profit and prosperity can and must go hand in hand with social justice and environmental
stewardship. They operate with a holistic or systems view. This means that they understand that
all stakeholders are connected and interdependent. They reject false trade-offs between
stakeholder interests and strive for creative ways to achieve win-win-win outcomes for all. [7]
The “conscious business” has a purpose that goes beyond maximizing profits. It is designed to
maximize profits but is focused more on its higher purpose and does not fixate solely on the
bottom line. To do so, it focuses on delivering value to all its stakeholders, harmonizing as best it
can the interests of consumers, partners, investors, the community, and the environment. This
requires that company managers take a “servant leadership” role, serving as stewards to the
company’s deeper purpose and to the company’s stakeholders.
Conscious business leaders serve as such stewards, focusing on fulfilling the company’s purpose,
delivering value to its stakeholders, and facilitating a harmony of interests, rather than on
personal gain and self-aggrandizement. Why is this refocusing needed? Within the standard
profit-maximizing model, corporations have long had to deal with the “agency problem.” Actions
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by top-level managers—acting on behalf of the company—should align with the shareholders,
but in a culture all about winning and money, managers sometimes act in ways that are selfaggrandizing and that do not serve the interests of shareholders. Laws exist to limit such selfaggrandizing, but the remedies are often too little and too late and often catch only the most
egregious overreaching. Having a culture of servant leadership is a much better way to see that a
company’s top management works to ensure a harmony of interests.

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

2.5 Summary and Exercises
Summary

Doing good business requires attention to ethics as well as law. Understanding the longstanding perspectives on ethics—utilitarianism, deontology, social contract, and virtue ethics—is
helpful in sorting out the ethical issues that face us as individuals and businesses. Each business
needs to create or maintain a culture of ethical excellence, where there is ongoing dialogue not
only about the best technical practices but also about the company’s ethical challenges and

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practices. A firm that has purpose and passion beyond profitability is best poised to meet the
needs of diverse stakeholders and can best position itself for long-term, sustainable success for
shareholders and other stakeholders as well.

EXERCISES

1. Consider again Milton Friedman’s article.
a.

What does Friedman mean by “ethical custom”?

b.

If the laws of the society are limiting the company’s profitability, would the

company be within its rights to disobey the law?
c.

What if the law is “on the books,” but the company could count on a lack of

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

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

b.

If Kant were his second-in-command and advising him on ethical matters,

would he have approved of Mr. Hardy’s behavior? Why or why not?
Consider the behaviors alleged by Ms. Harris and assume for a moment that they are all
true. In terms of core values, which of these behaviors are not consistent with the core
values Josephson points to? Be specific.

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

SELF-TEST QUESTIONS

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

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

paying careful attention to key stakeholders.
b.

The business of business is business.

c.

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

value to shareholders of the business.
d.

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

a.

Find a path to sustainable profits by looking at the interconnected needs and

desires of all the stakeholders.

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b.

Always remember that the business of business is business.

c.

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

any means possible.
d.

Maximize shareholder wealth by engaging in open competition without fraud or

deceit.
What are some key drawbacks to utilitarian thinking at the corporate level?
a.

The corporation may do a cost-benefit analysis that puts the greatest good of the

firm above all other considerations.
b.

It is difficult to predict future consequences; decision makers in for-profit

organizations will tend to overestimate the upside of certain decisions and underestimate
the downside.
c.

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

d.

all of the above

e.

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

a.

deontology

b.

virtue ethics

c.

utilitarianism

d.

all of the above
Under conscious capitalism,
a.

Virtue ethics is ignored.

b.

Shareholders, whether they be traders or long-term investors, are always

the first and last consideration for the CEO and the board.
c.

Maximizing profits comes from a focus on higher purposes and harmonizing

the interests of various stakeholders.
d.

Kantian duties take precedence over cost-benefit analyses.

SELF-TEST ANSWERS

1. c

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2. d
3. d
4. c
5. c

Chapter 3
Courts and the Legal Process
LEARNING OBJECTIVES

After reading this chapter, you should be able to do the following:
1. Describe the two different court systems in the United States, and explain why some cases
can be filed in either court system.
2. Explain the importance of subject matter jurisdiction and personal jurisdiction and know the
difference between the two.
3. Describe the various stages of a civil action: from pleadings, to discovery, to trial, and to
appeals.
4. Describe two alternatives to litigation: mediation and arbitration.
In the United States, law and government are interdependent. The Constitution establishes the
basic framework of government and imposes certain limitations on the powers of government.
In turn, the various branches of government are intimately involved in making, enforcing, and
interpreting the law. Today, much of the law comes from Congress and the state legislatures. But
it is in the courts that legislation is interpreted and prior case law is interpreted and applied.
As we go through this chapter, consider the case of Harry and Kay Robinson. In which court
should the Robinsons file their action? Can the Oklahoma court hear the case and make a
judgment that will be enforceable against all of the defendants? Which law will the court use to
come to a decision? Will it use New York law, Oklahoma law, federal law, or German law?

Robinson v. Audi

Harry and Kay Robinson purchased a new Audi automobile from Seaway Volkswagen, Inc.
(Seaway), in Massena, New York, in 1976. The following year the Robinson family, who resided
in New York, left that state for a new home in Arizona. As they passed through Oklahoma,

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another car struck their Audi in the rear, causing a fire that severely burned Kay Robinson and
her two children. Later on, the Robinsons brought a products-liability action in the District
Court for Creek County, Oklahoma, claiming that their injuries resulted from the defective
design and placement of the Audi’s gas tank and fuel system. They sued numerous defendants,
including the automobile’s manufacturer, Audi NSU Auto Union Aktiengesellschaft (Audi); its
importer, Volkswagen of America, Inc. (Volkswagen); its regional distributor, World-Wide
Volkswagen Corp. (World-Wide); and its retail dealer, Seaway.
Should the Robinsons bring their action in state court or in federal court? Over which of the
defendants will the court have personal jurisdiction?

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

1. Understand the different but complementary roles of state and federal court systems.
2. Explain why it makes sense for some courts to hear and decide only certain kinds of cases.
3. Describe the difference between a trial court and an appellate court.
Although it is sometimes said that there are two separate court systems, the reality is more
complex. There are, in fact, fifty-two court systems: those of the fifty states, the local court
system in the District of Columbia, and the federal court system. At the same time, these are not
entirely separate; they all have several points of contact.
State and local courts must honor both federal law and the laws of the other states. First, state
courts must honor federal law where state laws are in conflict with federal laws (under the
supremacy clause of the Constitution; see Chapter 4 "Constitutional Law and US Commerce").
Second, claims arising under federal statutes can often be tried in the state courts, where the
Constitution or Congress has not explicitly required that only federal courts can hear that kind
of claim. Third, under the full faith and credit clause, each state court is obligated to respect the
final judgments of courts in other states. Thus a contract dispute resolved by an Arkansas court
cannot be relitigated in North Dakota when the plaintiff wants to collect on the Arkansas
judgment in North Dakota. Fourth, state courts often must consider the laws of other states in
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deciding cases involving issues where two states have an interest, such as when drivers from two
different states collide in a third state. Under these circumstances, state judges will consult their
own state’s case decisions involving conflicts of laws and sometimes decide that they must apply
another state’s laws to decide the case (see Table 3.1 "Sample Conflict-of-Law Principles").
As state courts are concerned with federal law, so federal courts are often concerned with state
law and with what happens in state courts. Federal courts will consider state-law-based claims
when a case involves claims using both state and federal law. Claims based on federal laws will
permit the federal court to take jurisdiction over the whole case, including any state issues
raised. In those cases, the federal court is said to exercise “pendent jurisdiction” over the state
claims. Also, the Supreme Court will occasionally take appeals from a state supreme court where
state law raises an important issue of federal law to be decided. For example, a convict on death
row may claim that the state’s chosen method of execution using the injection of drugs is
unusually painful and involves “cruel and unusual punishment,” raising an Eighth Amendment
issue.
There is also a broad category of cases heard in federal courts that concern only state legal
issues—namely, cases that arise between citizens of different states. The federal courts are
permitted to hear these cases under their so-calleddiversity of citizenship jurisdiction (or
diversity jurisdiction). A citizen of New Jersey may sue a citizen of New York over a contract
dispute in federal court, but if both were citizens of New Jersey, the plaintiff would be limited to
the state courts. The Constitution established diversity jurisdiction because it was feared that
local courts would be hostile toward people from other states and that they would need separate
courts. In 2009, nearly a third of all lawsuits filed in federal court were based on diversity of
citizenship. In these cases, the federal courts were applying state law, rather than
taking federal question jurisdiction, where federal law provided the basis for the lawsuit or
where the United States was a party (as plaintiff or defendant).
Why are there so many diversity cases in federal courts? Defense lawyers believe that there is
sometimes a “home-court advantage” for an in-state plaintiff who brings a lawsuit against a
nonresident in his local state court. The defense attorney is entitled to ask for removal to a
federal court where there is diversity. This fits with the original reason for diversity jurisdiction
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in the Constitution—the concern that judges in one state court would favor the in-state plaintiff
rather than a nonresident defendant. Another reason there are so many diversity cases is that
plaintiffs’ attorneys know that removal is common and that it will move the case along faster by
filing in federal court to begin with. Some plaintiffs’ attorneys also find advantages in pursuing a
lawsuit in federal court. Federal court procedures are often more efficient than state court
procedures, so that federal dockets are often less crowded. This means a case will get to trial
faster, and many lawyers enjoy the higher status that comes in practicing before the federal
bench. In some federal districts, judgments for plaintiffs may be higher, on average, than in the
local state court. In short, not only law but also legal strategy factor into the popularity of
diversity cases in federal courts.

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

Limited Jurisdiction Courts
In most large urban states and many smaller states, there are four and sometimes five levels of
courts. The lowest level is that of the limited jurisdiction courts. These are usually county or
municipal courts with original jurisdiction to hear minor criminal cases (petty assaults, traffic
offenses, and breach of peace, among others) and civil cases involving monetary amounts up to a
fixed ceiling (no more than $10,000 in most states and far less in many states). Most disputes
that wind up in court are handled in the 18,000-plus limited jurisdiction courts, which are
estimated to hear more than 80 percent of all cases.
One familiar limited jurisdiction court is the small claims court, with jurisdiction to hear civil
cases involving claims for amounts ranging between $1,000 and $5,000 in about half the states
and for considerably less in the other states ($500 to $1,000). The advantage of the small claims
court is that its procedures are informal, it is often located in a neighborhood outside the
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business district, it is usually open after business hours, and it is speedy. Lawyers are not
necessary to present the case and in some states are not allowed to appear in court.

General Jurisdiction Courts
All other civil and criminal cases are heard in the general trial courts, or courts of general
jurisdiction. These go by a variety of names: superior, circuit, district, or common pleas court
(New York calls its general trial court the supreme court). These are the courts in which people
seek redress for incidents such as automobile accidents and injuries, or breaches of contract.
These state courts also prosecute those accused of murder, rape, robbery, and other serious
crimes. The fact finder in these general jurisdiction courts is not a judge, as in the lower courts,
but a jury of citizens.
Although courts of general jurisdiction can hear all types of cases, in most states more than half
involve family matters (divorce, child custody disputes, and the like). A third were commercial
cases, and slightly over 10 percent were devoted to car accident cases and other torts (as
discussed in Chapter 7 "Introduction to Tort Law").
Most states have specialized courts that hear only a certain type of case, such as landlord-tenant
disputes or probate of wills. Decisions by judges in specialized courts are usually final, although
any party dissatisfied with the outcome may be able to get a new trial in a court of general
jurisdiction. Because there has been one trial already, this is known as a trial de novo. It is not
an appeal, since the case essentially starts over.

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

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

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

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

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Figure 3.1 The Federal Judicial Circuits

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

KEY TAKEAWAY

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

EXERCISES

1. Why all of this complexity? Why don’t state courts hear only claims based on state law, and
federal courts only federal-law-based claims?
2. Why would a plaintiff in Iowa with a case against a New Jersey defendant prefer to have the
case heard in Iowa?
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3. James, a New Jersey resident, is sued by Jonah, an Iowa resident. After a trial in which James
appears and vigorously defends himself, the Iowa state court awards Jonah $136,750 dollars
in damages for his tort claim. In trying to collect from James in New Jersey, Jonah must have
the New Jersey court certify the Iowa judgment. Why, ordinarily, must the New Jersey court
do so?

3.2 The Problem of Jurisdiction

LEARNING OBJECTIVES

1. Explain the concept of subject matter jurisdiction and distinguish it from personal
jurisdiction.
2. Understand how and where the US Constitution provides a set of instructions as to what
federal courts are empowered by law to do.
3. Know which kinds of cases must be heard in federal courts only.
4. Explain diversity of citizenship jurisdiction and be able to decide whether a case is eligible for
diversity jurisdiction in the federal courts.
Jurisdiction is an essential concept in understanding courts and the legal system. Jurisdiction is
a combination of two Latin words: juris (law) and diction (to speak). Which court has the power
“to speak the law” is the basic question of jurisdiction.
There are two questions about jurisdiction in each case that must be answered before a judge
will hear a case: the question of subject matter jurisdiction and the question of personal
jurisdiction. We will consider the question of subject matter jurisdiction first, because judges do;
if they determine, on the basis of the initial documents in the case (the “pleadings”), that they
have no power to hear and decide that kind of case, they will dismiss it.

The Federal-State Balance: Federalism
State courts have their origins in colonial era courts. After the American Revolution, state courts
functioned (with some differences) much like they did in colonial times. The big difference after
1789 was that state courts coexisted with federal courts.Federalism was the system devised by
the nation’s founders in which power is shared between states and the federal government. This
sharing requires a division of labor between the states and the federal government. It is Article
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III of the US Constitution that spells out the respective spheres of authority (jurisdiction)
between state and federal courts.
Take a close look at Article III of the Constitution. (You can find a printable copy of the
Constitution at http://www.findlaw.com.) Article III makes clear that federal courts are courts
of limited power or jurisdiction. Notice that the only kinds of cases federal courts are authorized
to deal with have strong federal connections. For example, federal courts have jurisdiction when
a federal law is being used by the plaintiff or prosecutor (a “federal question” case) or the case
arises “in admiralty” (meaning that the problem arose not on land but on sea, beyond the
territorial jurisdiction of any state, or in navigable waters within the United States). Implied in
this list is the clear notion that states would continue to have their own laws, interpreted by their
own courts, and that federal courts were needed only where the issues raised by the parties had
a clear federal connection. The exception to this is diversity jurisdiction, discussed later.
The Constitution was constructed with the idea that state courts would continue to deal with
basic kinds of claims such as tort, contract, or property claims. Since states sanction marriages
and divorce, state courts would deal with “domestic” (family) issues. Since states deal with birth
and death records, it stands to reason that paternity suits, probate disputes, and the like usually
wind up in state courts. You wouldn’t go to the federal building or courthouse to get a marriage
license, ask for a divorce, or probate a will: these matters have traditionally been dealt with by
the states (and the thirteen original colonies before them). Matters that historically get raised
and settled in state court under state law include not only domestic and probate matters but also
law relating to corporations, partnerships, agency, contracts, property, torts, and commercial
dealings generally. You cannot get married or divorced in federal court, because federal courts
have no jurisdiction over matters that are historically (and are still) exclusively within the
domain of state law.
In terms of subject matter jurisdiction, then, state courts will typically deal with the kinds of
disputes just cited. Thus if you are Michigan resident and have an auto accident in Toledo with
an Ohio resident and you each blame each other for the accident, the state courts would
ordinarily resolve the matter if the dispute cannot otherwise be settled. Why state courts?
Because when you blame one another and allege that it’s the other person’s fault, you have the
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beginnings of a tort case, with negligence as a primary element of the claim, and state courts
have routinely dealt with this kind of claim, from British colonial times through Independence
and to the present. (See alsoChapter 7 "Introduction to Tort Law" of this text.) People have had a
need to resolve this kind of dispute long before our federal courts were created, and you can tell
from Article III that the founders did not specify that tort or negligence claims should be
handled by the federal courts. Again, federal courts are courts of limited jurisdiction, limited to
the kinds of cases specified in Article III. If the case before the federal court does not fall within
one of those categories, the federal court cannot constitutionally hear the case because it does
not have subject matter jurisdiction.
Always remember: a court must have subject matter jurisdiction to hear and decide a case.
Without it, a court cannot address the merits of the controversy or even take the next
jurisdictional step of figuring out which of the defendants can be sued in that court. The
question of which defendants are appropriately before the court is a question
of personal jurisdiction.
Because there are two court systems, it is important for a plaintiff to file in the right court to
begin with. The right court is the one that has subject matter jurisdiction over the case—that is,
the power to hear and decide the kind of case that is filed. Not only is it a waste of time to file in
the wrong court system and be dismissed, but if the dismissal comes after the filing period
imposed by the applicable statute of limitations, it will be too late to refile in the correct court
system. Such cases will be routinely dismissed, regardless of how deserving the plaintiff might
be in his quest for justice. (The plaintiff’s only remedy at that point would be to sue his lawyer
for negligence for failing to mind the clock and get to the right court in time!)

Exclusive Jurisdiction in Federal Courts
With two court systems, a plaintiff (or the plaintiff’s attorney, most likely) must decide whether
to file a case in the state court system or the federal court system. Federal courts have exclusive
jurisdiction over certain kinds of cases. The reason for this comes directly from the Constitution.
Article III of the US Constitution provides the following:
The judicial Power shall extend to all Cases, in Law and Equity, arising under this Constitution,
the Laws of the United States, and Treaties made, or which shall be made, under their Authority;
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to all Cases affecting Ambassadors, other public Ministers and Consuls; to all Cases of admiralty
and maritime Jurisdiction; to Controversies to which the United States shall be a Party; to
Controversies between two or more States; between a State and Citizens of another State;
between Citizens of different States; between Citizens of the same State claiming Lands under
Grants of different States, and between a State, or the Citizens thereof, and foreign States,
Citizens or Subjects.
By excluding diversity cases, we can assemble a list of the kinds of cases that can only be heard
in federal courts. The list looks like this:
1. Suits between states. Cases in which two or more states are a party.
2. Cases involving ambassadors and other high-ranking public figures. Cases arising between
foreign ambassadors and other high-ranking public officials.
3. Federal crimes. Crimes defined by or mentioned in the US Constitution or those defined or
punished by federal statute. Such crimes include treason against the United States, piracy,
counterfeiting, crimes against the law of nations, and crimes relating to the federal government’s
authority to regulate interstate commerce. However, most crimes are state matters.
4. Bankruptcy. The statutory procedure, usually triggered by insolvency, by which a person is
relieved of most debts and undergoes a judicially supervised reorganization or liquidation for
the benefit of the person’s creditors.
5. Patent, copyright, and trademark cases
a.

Patent. The exclusive right to make, use, or sell an invention for a specified period

(usually seventeen years), granted by the federal government to the inventor if the device or
process is novel, useful, and nonobvious.
b.

Copyright. The body of law relating to a property right in an original work of authorship

(such as a literary, musical, artistic, photographic, or film work) fixed in any tangible medium of
expression, giving the holder the exclusive right to reproduce, adapt, distribute, perform, and
display the work.
c.

Trademark. A word, phrase, logo, or other graphic symbol used by a manufacturer or

seller to distinguish its product or products from those of others.

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Admiralty. The system of laws that has grown out of the practice of admiralty courts:
courts that exercise jurisdiction over all maritime contracts, torts, injuries, and offenses.
Antitrust. Federal laws designed to protect trade and commerce from restraining
monopolies, price fixing, and price discrimination.
Securities and banking regulation. The body of law protecting the public by regulating
the registration, offering, and trading of securities and the regulation of banking practices.
Other cases specified by federal statute. Any other cases specified by a federal statute
where Congress declares that federal courts will have exclusive jurisdiction.

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

Summary of Rules on Subject Matter Jurisdiction
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1. A court must always have subject matter jurisdiction, and personal jurisdiction over at least one
defendant, to hear and decide a case.
2. A state court will have subject matter jurisdiction over any case that is not required to be
brought in a federal court.
Some cases can only be brought in federal court, such as bankruptcy cases, cases involving
federal crimes, patent cases, and Internal Revenue Service tax court claims. The list of cases for
exclusive federal jurisdiction is fairly short. That means that almost any state court will have
subject matter jurisdiction over almost any kind of case. If it’s a case based on state law, a state
court will always have subject matter jurisdiction.
3. A federal court will have subject matter jurisdiction over any case that is either based on a
federal law (statute, case, or US Constitution)
OR
A federal court will have subject matter jurisdiction over any case based on state law where the
parties are (1) from different states and (2) the amount in controversy is at least $75,000.
(1) The different states requirement means that no plaintiff can have permanent residence in a
state where any defendant has permanent residence—there must be complete diversity of
citizenship as between all plaintiffs and defendants.
(2) The amount in controversy requirement means that a good-faith estimate of the amount the
plaintiff may recover is at least $75,000.
NOTE: For purposes of permanent residence, a corporation is considered a resident where it is
incorporated AND where it has a principal place of business.
4. In diversity cases, the following rules apply.
(1) Federal civil procedure rules apply to how the case is conducted before and during trial and
any appeals, but
(2) State law will be used as the basis for a determination of legal rights and responsibilities.
(a) This “choice of law” process is interesting but complicated. Basically, each state has its own
set of judicial decisions that resolve conflict of laws. For example, just because A sues B in a
Texas court, the Texas court will not necessarily apply Texas law. Anna and Bobby collide and
suffer serious physical injuries while driving their cars in Roswell, New Mexico. Both live in
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Austin, and Bobby files a lawsuit in Austin. The court there could hear it (having subject matter
jurisdiction and personal jurisdiction over Bobby) but would apply New Mexico law, which
governs motor vehicle laws and accidents in New Mexico. Why would the Texas judge do that?
(b) The Texas judge knows that which state’s law is chosen to apply to the case can make a
decisive difference in the case, as different states have different substantive law standards. For
example, in a breach of contract case, one state’s version of the Uniform Commercial Code may
be different from another’s, and which one the court decides to apply is often exceedingly good
for one side and dismal for the other. In Anna v. Bobby, if Texas has one kind of comparative
negligence statute and New Mexico has a different kind of comparative negligence statute, who
wins or loses, or how much is awarded, could well depend on which law applies. Because both
were under the jurisdiction of New Mexico’s laws at the time, it makes sense to apply New
Mexico law.
(3) Why do some nonresident defendants prefer to be in federal court?
(a) In the state court, the judge is elected, and the jury may be familiar with or sympathetic to
the “local” plaintiff.
(b) The federal court provides a more neutral forum, with an appointed, life-tenured judge and a
wider pool of potential jurors (drawn from a wider geographical area).
(4) If a defendant does not want to be in state court and there is diversity, what is to be done?
(a) Make a motion for removal to the federal court.
(b) The federal court will not want to add to its caseload, or docket, but must take the case
unless there is not complete diversity of citizenship or the amount in controversy is less
than $75,000.
To better understand subject matter jurisdiction in action, let’s take an example. Wile E. Coyote
wants a federal judge to hear his products-liability action against Acme, Inc., even though the
action is based on state law. Mr. Coyote’s attorney wants to “make a federal case” out of it,
thinking that the jurors in the federal district court’s jury pool will understand the case better
and be more likely to deliver a “high value” verdict for Mr. Coyote. Mr. Coyote resides in
Arizona, and Acme is incorporated in the state of Delaware and has its principal place of
business in Chicago, Illinois. The federal court in Arizona can hear and decide Mr. Coyote’s case
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(i.e., it has subject matter jurisdiction over the case) because of diversity of citizenship. If Mr.
Coyote was injured by one of Acme’s defective products while chasing a roadrunner in Arizona,
the federal district court judge would hear his action—using federal procedural law—and decide
the case based on the substantive law of Arizona on product liability.
But now change the facts only slightly: Acme is incorporated in Delaware but has its principal
place of business in Phoenix, Arizona. Unless Mr. Coyote has a federal law he is using as a basis
for his claims against Acme, his attempt to get a federal court to hear and decide the case will
fail. It will fail because there is not complete diversity of citizenship between the plaintiff and the
defendant.

Robinson v. Audi
Now consider Mr. and Mrs. Robinson and their products-liability claim against Seaway
Volkswagen and the other three defendants. There is no federal products-liability law that could
be used as a cause of action. They are most likely suing the defendants using products-liability
law based on common-law negligence or common-law strict liability law, as found in state court
cases. They were not yet Arizona residents at the time of the accident, and their accident does
not establish them as Oklahoma residents, either. They bought the vehicle in New York from a
New York–based retailer. None of the other defendants is from Oklahoma.
They file in an Oklahoma state court, but how will they (their attorney or the court) know if the
state court has subject matter jurisdiction? Unless the case is requiredto be in a federal court
(i.e., unless the federal courts have exclusive jurisdiction over this kind of case), any state court
system will have subject matter jurisdiction, including Oklahoma’s state court system. But if
their claim is for a significant amount of money, they cannot file in small claims court, probate
court, or any court in Oklahoma that does not have statutory jurisdiction over their claim. They
will need to file in a court of general jurisdiction. In short, even filing in the right court system
(state versus federal), the plaintiff must be careful to find the court that has subject matter
jurisdiction.
If they wish to go to federal court, can they? There is no federal question presented here (the
claim is based on state common law), and the United States is not a party, so the only basis for
federal court jurisdiction would be diversity jurisdiction. If enough time has elapsed since the
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accident and they have established themselves as Arizona residents, they could sue in federal
court in Oklahoma (or elsewhere), but only if none of the defendants—the retailer, the regional
Volkswagen company, Volkswagen of North America, or Audi (in Germany) are incorporated in
or have a principal place of business in Arizona. The federal judge would decide the case using
federal civil procedure but would have to make the appropriate choice of state law. In this case,
the choice of conflicting laws would most likely be Oklahoma, where the accident happened, or
New York, where the defective product was sold.
Table 3.1 Sample Conflict-of-Law Principles
Substantive Law Issue

Law to be Applied

Liability for injury caused by tortious conduct

State in which the injury was inflicted

Real property

State where the property is located

Personal Property: inheritance

Domicile of deceased (not location of property)

Contract: validity

State in which contract was made

Contract: breach

State in which contract was to be performed*

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

Legal Procedure, Including Due Process and Personal Jurisdiction
In this section, we consider how lawsuits are begun and how the court knows that it has both
subject matter jurisdiction and personal jurisdiction over at least one of the named defendants.
The courts are not the only institutions that can resolve disputes. In Section 3.8 "Alternative
Means of Resolving Disputes", we will discuss other dispute-resolution forums, such as
arbitration and mediation. For now, let us consider how courts make decisions in civil disputes.
Judicial decision making in the context of litigation (civil lawsuits) is a distinctive form of
dispute resolution.
First, to get the attention of a court, the plaintiff must make a claim based on existing laws.
Second, courts do not reach out for cases. Cases are brought to them, usually when an attorney
files a case with the right court in the right way, following the various laws that govern all civil

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procedures in a state or in the federal system. (Most US states’ procedural laws are similar to the
federal procedural code.)
Once at the court, the case will proceed through various motions (motions to dismiss for lack of
jurisdiction, for example, or insufficient service of process), the proofs (submission of evidence),
and the arguments (debate about the meaning of the evidence and the law) of contesting parties.
This is at the heart of the adversary system, in which those who oppose each other may attack
the other’s case through proofs and cross-examination. Every person in the United States who
wishes to take a case to court is entitled to hire a lawyer. The lawyer works for his client, not the
court, and serves him as an advocate, or supporter. The client’s goal is to persuade the court of
the accuracy and justness of his position. The lawyer’s duty is to shape the evidence and the
argument—the line of reasoning about the evidence—to advance his client’s cause and persuade
the court of its rightness. The lawyer for the opposing party will be doing the same thing, of
course, for her client. The judge (or, if one is sitting, the jury) must sort out the facts and reach a
decision from this cross-fire of evidence and argument.
The method of adjudication—the act of making an order or judgment—has several important
features. First, it focuses the conflicting issues. Other, secondary concerns are minimized or
excluded altogether. Relevance is a key concept in any trial. The judge is required to decide the
questions presented at the trial, not to talk about related matters. Second, adjudication requires
that the judge’s decision be reasoned, and that is why judges write opinions explaining their
decisions (an opinion may be omitted when the verdict comes from a jury). Third, the judge’s
decision must not only be reasoned but also be responsive to the case presented: the judge is not
free to say that the case is unimportant and that he therefore will ignore it. Unlike other
branches of government that are free to ignore problems pressing upon them,
judges must decide cases. (For example, a legislature need not enact a law, no matter how many
people petition it to do so.) Fourth, the court must respond in a certain way. The judge must pay
attention to the parties’ arguments and his decision must result from their proofs and
arguments. Evidence that is not presented and legal arguments that are not made cannot be the
basis for what the judge decides. Also, judges are bound by standards of weighing evidence: the
burden of proof in a civil case is generally a “preponderance of the evidence.”
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In all cases, the plaintiff—the party making a claim and initiating the lawsuit (in a criminal case
the plaintiff is the prosecution)—has the burden of proving his case. If he fails to prove it, the
defendant—the party being sued or prosecuted—will win.
Criminal prosecutions carry the most rigorous burden of proof: the government must prove its
case against the defendant beyond a reasonable doubt. That is, even if it seems very likely that
the defendant committed the crime, as long as there remains some reasonable doubt—perhaps
he was not clearly identified as the culprit, perhaps he has an alibi that could be legitimate—the
jury must vote to acquit rather than convict.
By contrast, the burden of proof in ordinary civil cases—those dealing with contracts, personal
injuries, and most of the cases in this book—is a preponderance of the evidence, which means
that the plaintiff’s evidence must outweigh whatever evidence the defendant can muster that
casts doubts on the plaintiff’s claim. This is not merely a matter of counting the number of
witnesses or of the length of time that they talk: the judge in a trial without a jury (a bench trial),
or the jury where one is impaneled, must apply the preponderance of evidence test by
determining which side has the greater weight of credible, relevant evidence.
Adjudication and the adversary system imply certain other characteristics of courts. Judges
must be impartial; those with a personal interest in a matter must refuse to hear it. The ruling of
a court, after all appeals are exhausted, is final. This principle is known as res judicata (Latin for
“the thing is decided”), and it means that the same parties may not take up the same dispute in
another court at another time. Finally, a court must proceed according to a public set of formal
procedural rules; a judge cannot make up the rules as he goes along. To these rules we now turn.

How a Case Proceeds
Complaint and Summons
Beginning a lawsuit is simple and is spelled out in the rules of procedure by which each court
system operates. In the federal system, the plaintiff begins a lawsuit by filing a complaint—a
document clearly explaining the grounds for suit—with the clerk of the court. The court’s agent
(usually a sheriff, for state trial courts, or a US deputy marshal, in federal district courts) will
then serve the defendant with the complaint and a summons. The summons is a court document

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stating the name of the plaintiff and his attorney and directing the defendant to respond to the
complaint within a fixed time period.
The timing of the filing can be important. Almost every possible legal complaint is governed by a
federal or state statute of limitations, which requires a lawsuit to be filed within a certain period
of time. For example, in many states a lawsuit for injuries resulting from an automobile accident
must be filed within two years of the accident or the plaintiff forfeits his right to proceed. As
noted earlier, making a correct initial filing in a court that has subject matter jurisdiction is
critical to avoiding statute of limitations problems.

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

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

Summary of Rules on Personal Jurisdiction
1. Once a court determines that it has subject matter jurisdiction, it must find at least one
defendant over which it is “fair” (i.e., in accord with due process) to exercise personal
jurisdiction.
2. If a plaintiff sues five defendants and the court has personal jurisdiction over just one, the case
can be heard, but the court cannot make a judgment against the other four.

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1. But if the plaintiff loses against defendant 1, he can go elsewhere (to another state or states) and
sue defendants 2, 3, 4, or 5.
2. The court’s decision in the first lawsuit (against defendant 1) does not determine the liability of
the nonparticipating defendants.
This involves the principle of res judicata, which means that you can’t bring the same action
against the same person (or entity) twice. It’s like the civil side of double jeopardy. Res means
“thing,” and judicata means “adjudicated.” Thus the “thing” has been “adjudicated” and should
not be judged again. But, as to nonparticipating parties, it is not over. If you have
a different case against the same defendant—one that arises out of a completely different
situation—that case is not barred by res judicata.
3. Service of process is a necessary (but not sufficient) condition for getting personal jurisdiction
over a particular defendant (see rule 4).
1. In order to get a judgment in a civil action, the plaintiff must serve a copy of the complaint and a
summons on the defendant.
2. There are many ways to do this.


The process server personally serves a complaint on the defendant.



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



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



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

4. In addition to successfully serving the defendant with process, a plaintiff must convince the
court that exercising personal jurisdiction over the defendant is consistent with due process and
any statutes in that state that prescribe the jurisdictional reach of that state (the so-called longarm statutes). The Supreme Court has long recognized various bases for judging whether such
process is fair.
1. Consent. The defendant agrees to the court’s jurisdiction by coming to court, answering the
complaint, and having the matter litigated there.
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2. Domicile. The defendant is a permanent resident of that state.
3. Event. The defendant did something in that state, related to the lawsuit, that makes it fair for the
state to say, “Come back and defend!”
4. Service of process within the state will effectively provide personal jurisdiction over the
nonresident.
Again, let’s consider Mrs. Robinson and her children in the Audi accident. She could file a
lawsuit anywhere in the country. She could file a lawsuit in Arizona after she establishes
residency there. But while the Arizona court would have subject matter jurisdiction over any
products-liability claim (or any claim that was not required to be heard in a federal court), the
Arizona court would face an issue of “in personamjurisdiction,” or personal jurisdiction: under
the due process clause of the Fourteenth Amendment, each state must extend due process to
citizens of all of the other states. Because fairness is essential to due process, the court must
consider whether it is fair to require an out-of-state defendant to appear and defend against a
lawsuit that could result in a judgment against that defendant.
Almost every state in the United States has a statute regarding personal jurisdiction, instructing
judges when it is permissible to assert personal jurisdiction over an out-of-state resident. These
are called long-arm statutes. But no state can reach out beyond the limits of what is
constitutionally permissible under the Fourteenth Amendment, which binds the states with its
proviso to guarantee the due process rights of the citizens of every state in the union. The
“minimum contacts” test in Burger King v. Rudzewicz(Section 3.9 "Cases") tries to make the
fairness mandate of the due process clause more specific. So do other tests articulated in the
case (such as “does not offend traditional notions of fair play and substantial justice”). These
tests are posed by the Supreme Court and heeded by all lower courts in order to honor the
provisions of the Fourteenth Amendment’s due process guarantees. These tests are in addition
to any state long-arm statute’s instructions to courts regarding the assertion of personal
jurisdiction over nonresidents.

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

KEY TAKEAWAY
There are two court systems in the United States. It is important to know which system—the
state court system or the federal court system—has the power to hear and decide a
particular case. Once that is established, the Constitution compels an inquiry to make sure

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that no court extends its reach unfairly to out-of-state residents. The question of personal
jurisdiction is a question of fairness and due process to nonresidents.

EXERCISES

1. The Constitution specifies that federal courts have exclusive jurisdiction over admiralty
claims. Mr. and Mrs. Shute have a claim against Carnival Cruise lines for the negligence of the
cruise line. Mrs. Shute sustained injuries as a result of the company’s negligence. Mr. and
Mrs. Shute live in the state of Washington. Can they bring their claim in state court? Must
they bring their claim in federal court?
2. Congress passed Title VII of the Civil Rights Act of 1964. In Title VII, employers are required
not to discriminate against employees on the basis of race, color, sex, religion, or national
origin. In passing Title VII, Congress did not require plaintiffs to file only in federal courts.
That is, Congress made no statement in Title VII that federal courts had “exclusive
jurisdiction” over Title VII claims. Mrs. Harris wishes to sue Forklift Systems, Inc. of Nashville,
Tennessee, for sexual harassment under Title VII. She has gone through the Equal
Employment Opportunity Commission process and has a right-to-sue letter, which is required
before a Title VII action can be brought to court. Can she file a complaint that will be heard
by a state court?
3. Mrs. Harris fails to go to the Equal Employment Opportunity Commission to get her right-tosue letter against Forklift Systems, Inc. She therefore does not have a viable Title VII cause of
action against Forklift. She does, however, have her rights under Tennessee’s equal
employment statute and various court decisions from Tennessee courts regarding sexual
harassment. Forklift is incorporated in Tennessee and has its principal place of business in
Nashville. Mrs. Harris is also a citizen of Tennessee. Explain why, if she brings her
employment discrimination and sexual harassment lawsuit in a federal court, her lawsuit will
be dismissed for lack of subject matter jurisdiction.
4. Suppose Mr. and Mrs. Robinson find in the original paperwork with Seaway Volkswagen that
there is a contractual agreement with a provision that says “all disputes arising between
buyer and Seaway Volkswagen will be litigated, if at all, in the county courts of Westchester

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

3.3 Motions and Discovery

LEARNING OBJECTIVES

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

Initial Pleadings, and Motions to Dismiss
The first papers filed in a lawsuit are called the pleadings. These include the plaintiff’s complaint
and then (usually after thirty or more days) the answer or response from the defendant. The
answer may be coupled with a counterclaim against the plaintiff. (In effect, the defendant
becomes the plaintiff for the claims she has against the original plaintiff.) The plaintiff may reply
to any counterclaim by the defendant.
State and federal rules of civil procedure require that the complaint must state the nature of the
plaintiff’s claim, the jurisdiction of the court, and the nature of the relief that is being asked for
(usually an award of money, but sometimes an injunction, or a declaration of legal rights). In an
answer, the defendant will often deny all the allegations of the complaint or will admit to certain
of its allegations and deny others.
A complaint and subsequent pleadings are usually quite general and give little detail. Cases can
be decided on the pleadings alone in the following situations: (1) If the defendant fails to answer
the complaint, the court can enter a default judgment, awarding the plaintiff what he seeks. (2)
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The defendant can move to dismiss the complaint on the grounds that the plaintiff failed to
“state a claim on which relief can be granted,” or on the basis that there is no subject matter
jurisdiction for the court chosen by the plaintiff, or on the basis that there is no personal
jurisdiction over the defendant. The defendant is saying, in effect, that even if all the plaintiff’s
allegations are true, they do not amount to a legal claim that can be heard by the court. For
example, a claim that the defendant induced a woman to stop dating the plaintiff (a so-called
alienation of affections cause of action) is no longer actionable in US state courts, and any court
will dismiss the complaint without any further proceedings. (This type of dismissal is
occasionally still called a demurrer.)
A third kind of dismissal can take place on a motion for summary judgment. If there is no triable
question of fact or law, there is no reason to have a trial. For example, the plaintiff sues on a
promissory note and, at deposition (an oral examination under oath), the defendant admits
having made no payment on the note and offers no excuse that would be recognizable as a
reason not to pay. There is no reason to have a trial, and the court should grant summary
judgment.

Discovery
If there is a factual dispute, the case will usually involve some degree of discovery, where each
party tries to get as much information out of the other party as the rules allow. Until the 1940s,
when discovery became part of civil procedure rules, a lawsuit was frequently a game in which
each party hid as much information as possible and tried to surprise the other party in court.
Beginning with a change in the Federal Rules of Civil Procedure adopted by the Supreme Court
in 1938 and subsequently followed by many of the states, the parties are entitled to learn the
facts of the case before trial. The basic idea is to help the parties determine what the evidence
might be, who the potential witnesses are, and what specific issues are relevant. Discovery can
proceed by several methods. A party may serve an interrogatory on his adversary—a written
request for answers to specific questions. Or a party may depose the other party or a witness. A
deposition is a live question-and-answer session at which the witness answers questions put to
him by one of the parties’ lawyers. His answers are recorded verbatim and may be used at trial.
Each party is also entitled to inspect books, documents, records, and other physical items in the
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possession of the other. This is a broad right, as it is not limited to just evidence that is
admissible at trial. Discovery of physical evidence means that a plaintiff may inspect a
company’s accounts, customer lists, assets, profit-and-loss statements, balance sheets,
engineering and quality-control reports, sales reports, and virtually any other document.
The lawyers, not the court, run the discovery process. For example, one party simply makes a
written demand, stating the time at which the deposition will take place or the type of
documents it wishes to inspect and make copies of. A party unreasonably resisting discovery
methods (whether depositions, written interrogatories, or requests for documents) can be
challenged, however, and judges are often brought into the process to push reluctant parties to
make more disclosure or to protect a party from irrelevant or unreasonable discovery requests.
For example, the party receiving the discovery request can apply to the court for a protective
order if it can show that the demand is for privileged material (e.g., a party’s lawyers’ records are
not open for inspection) or that the demand was made to harass the opponent. In complex cases
between companies, the discovery of documents can run into tens of millions of pages and can
take years. Depositions can consume days or even weeks of an executive’s time.

KEY TAKEAWAY

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

EXERCISES

1. Mrs. Robinson (in the Volkswagen Audi case) never establishes residency in Arizona, returns
to New York, and files her case in federal district court in New York, alleging diversity
jurisdiction. Assume that the defendants do not want to have the case heard in federal court.
What motion will they make?
2. Under contributory negligence, the negligence of any plaintiff that causes or contributes to
the injuries a plaintiff complains of will be grounds for dismissal. Suppose that in discovery,
Mr. Ferlito in Ferlito v. Johnson & Johnson (Section 3.9 "Cases") admits that he brought the
cigarette lighter dangerously close to his costume, saying, “Yes, you could definitely say I was
being careless; I had a few drinks under my belt.” Also, Mrs. Ferlito admits that she never
reads product instructions from manufacturers. If the case is brought in a state where
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contributory negligence is the law, on what basis can Johnson & Johnson have the case
dismissed before trial?

3.4 The Pretrial and Trial Phase

LEARNING OBJECTIVES

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

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

Trial
At trial, the first order of business is to select a jury. (In a civil case of any consequence, either
party can request one, based on the Sixth Amendment to the US Constitution.) The judge and

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

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Anyone who has watched an actual televised trial or a television melodrama featuring a trial
scene will appreciate the nature of the trial itself: witnesses are asked questions about a number
of issues that may or may not be related, the opposing lawyer will frequently object to the
question or the form in which it is asked, and the jury may be sent from the room while the
lawyers argue at the bench before the judge.
After direct testimony of each witness is over, the opposing lawyer may conduct crossexamination. This is a crucial constitutional right; in criminal cases it is preserved in the
Constitution’s Sixth Amendment (the right to confront one’s accusers in open court). The formal
rules of direct testimony are then relaxed, and the cross-examiner may probe the witness more
informally, asking questions that may not seem immediately relevant. This is when the opposing
attorney may become harsh, casting doubt on a witness’s credibility, trying to trip her up and
show that the answers she gave are false or not to be trusted. This use of cross-examination,
along with the requirement that the witness must respond to questions that are at all relevant to
the questions raised by the case, distinguishes common-law courts from those of authoritarian
regimes around the world.
Following cross-examination, the plaintiff’s lawyer may then question the witness again: this is
called redirect examination and is used to demonstrate that the witness’s original answers were
accurate and to show that any implications otherwise, suggested by the cross-examiner, were
unwarranted. The cross-examiner may then engage the witness in re-cross-examination, and so
on. The process usually stops after cross-examination or redirect.
During the trial, the judge’s chief responsibility is to see that the trial is fair to both sides. One
big piece of that responsibility is to rule on the admissibility of evidence. A judge may rule that a
particular question is out of order—that is, not relevant or appropriate—or that a given
document is irrelevant. Where the attorney is convinced that a particular witness, a particular
question, or a particular document (or part thereof) is critical to her case, she may preserve an
objection to the court’s ruling by saying “exception,” in which case the court stenographer will
note the exception; on appeal, the attorney may cite any number of exceptions as adding up to
the lack of a fair trial for her client and may request a court of appeals to order a retrial.

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For the most part, courts of appeal will not reverse and remand for a new trial unless the trial
court judge’s errors are “prejudicial,” or “an abuse of discretion.” In short, neither party is
entitled to a perfect trial, but only to a fair trial, one in which the trial judge has made only
“harmless errors” and not prejudicial ones.
At the end of the plaintiff’s case, the defendant presents his case, following the same procedure
just outlined. The plaintiff is then entitled to present rebuttal witnesses, if necessary, to deny or
argue with the evidence the defendant has introduced. The defendant in turn may present
“surrebuttal” witnesses.
When all testimony has been introduced, either party may ask the judge for adirected verdict—a
verdict decided by the judge without advice from the jury. This motion may be granted if the
plaintiff has failed to introduce evidence that is legally sufficient to meet her burden of proof or
if the defendant has failed to do the same on issues on which she has the burden of proof. (For
example, the plaintiff alleges that the defendant owes him money and introduces a signed
promissory note. The defendant cannot show that the note is invalid. The defendant must lose
the case unless he can show that the debt has been paid or otherwise discharged.)
The defendant can move for a directed verdict at the close of the plaintiff’s case, but the judge
will usually wait to hear the entire case until deciding whether to do so. Directed verdicts are not
usually granted, since it is the jury’s job to determine the facts in dispute.
If the judge refuses to grant a directed verdict, each lawyer will then present a closing argument
to the jury (or, if there is no jury, to the judge alone). The closing argument is used to tie up the
loose ends, as the attorney tries to bring together various seemingly unrelated facts into a story
that will make sense to the jury.
After closing arguments, the judge will instruct the jury. The purpose of jury instruction is to
explain to the jurors the meaning of the law as it relates to the issues they are considering and to
tell the jurors what facts they must determine if they are to give a verdict for one party or the
other. Each lawyer will have prepared a set of written instructions that she hopes the judge will
give to the jury. These will be tailored to advance her client’s case. Many a verdict has been
overturned on appeal because a trial judge has wrongly instructed the jury. The judge will
carefully determine which instructions to give and often will use a set of pattern instructions
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provided by the state bar association or the supreme court of the state. These pattern jury
instructions are often safer because they are patterned after language that appellate courts have
used previously, and appellate courts are less likely to find reversible error in the instructions.
After all instructions are given, the jury will retire to a private room and discuss the case and the
answers requested by the judge for as long as it takes to reach a unanimous verdict. Some minor
cases do not require a unanimous verdict. If the jury cannot reach a decision, this is called a
hung jury, and the case will have to be retried. When a jury does reach a verdict, it delivers it in
court with both parties and their lawyers present. The jury is then discharged, and control over
the case returns to the judge. (If there is no jury, the judge will usually announce in a written
opinion his findings of fact and how the law applies to those facts. Juries just announce their
verdicts and do not state their reasons for reaching them.)

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

KEY TAKEAWAY

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

EXERCISES

1. What if there was not a doctrine of res judicata? What would the legal system be like?
2. Why do you think cross-examination is a “right,” as opposed to a “good thing”? What kind of
judicial system would not allow cross-examination of witnesses as a matter of right?

3.5 Judgment, Appeal, and Execution
LEARNING OBJECTIVES

1. Understand the posttrial process—how appellate courts process appeals.
2. Explain how a court’s judgment is translated into relief for the winning party.

Judgment or Order
At the end of a trial, the judge will enter an order that makes findings of fact (often with the help
of a jury) and conclusions of law. The judge will also make a judgment as to what relief or
remedy should be given. Often it is an award of money damages to one of the parties. The losing

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party may ask for a new trial at this point or within a short period of time following. Once the
trial judge denies any such request, the judgment—in the form of the court’s order—is final.

Appeal
If the loser’s motion for a new trial or a judgment n.o.v. is denied, the losing party may appeal
but must ordinarily post a bond sufficient to ensure that there are funds to pay the amount
awarded to the winning party. In an appeal, the appellant aims to show that there was some
prejudicial error committed by the trial judge. There will be errors, of course, but the errors
must be significant (i.e., not harmless). The basic idea is for an appellate court to ensure that a
reasonably fair trial was provided to both sides. Enforcement of the court’s judgment—an award
of money, an injunction—is usually stayed (postponed) until the appellate court has ruled. As
noted earlier, the party making the appeal is called the appellant, and the party defending the
judgment is the appellee (or in some courts, the petitioner and the respondent).
During the trial, the losing party may have objected to certain procedural decisions by the judge.
In compiling a record on appeal, the appellant needs to show the appellate court some examples
of mistakes made by the judge—for example, having erroneously admitted evidence, having
failed to admit proper evidence that should have been admitted, or having wrongly instructed
the jury. The appellate court must determine if those mistakes were serious enough to amount
to prejudicial error.
Appellate and trial procedures are different. The appellate court does not hear witnesses or
accept evidence. It reviews the record of the case—the transcript of the witnesses’ testimony and
the documents received into evidence at trial—to try to find a legal error on a specific request of
one or both of the parties. The parties’ lawyers prepare briefs (written statements containing the
facts in the case), the procedural steps taken, and the argument or discussion of the meaning of
the law and how it applies to the facts. After reading the briefs on appeal, the appellate court
may dispose of the appeal without argument, issuing a written opinion that may be very short or
many pages. Often, though, the appellate court will hear oral argument. (This can be months, or
even more than a year after the briefs are filed.) Each lawyer is given a short period of time,
usually no more than thirty minutes, to present his client’s case. The lawyer rarely gets a chance
for an extended statement because he is usually interrupted by questions from the judges.
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Through this exchange between judges and lawyers, specific legal positions can be tested and
their limits explored.
Depending on what it decides, the appellate court will affirm the lower court’s
judgment, modify it, reverse it, or remand it to the lower court for retrial or other action
directed by the higher court. The appellate court itself does not take specific action in the case; it
sits only to rule on contested issues of law. The lower court must issue the final judgment in the
case. As we have already seen, there is the possibility of appealing from an intermediate
appellate court to the state supreme court in twenty-nine states and to the US Supreme Court
from a ruling from a federal circuit court of appeal. In cases raising constitutional issues, there is
also the possibility of appeal to the Supreme Court from the state courts.
Like trial judges, appellate judges must follow previous decisions, or precedent. But not every
previous case is a precedent for every court. Lower courts must respect appellate court
decisions, and courts in one state are not bound by decisions of courts in other states. State
courts are not bound by decisions of federal courts, except on points of federal law that come
from federal courts within the state or from a federal circuit in which the state court sits. A state
supreme court is not bound by case law in any other state. But a supreme court in one state with
a type of case it has not previously dealt with may find persuasive reasoning in decisions of other
state supreme courts.
Federal district courts are bound by the decisions of the court of appeals in their circuit, but
decisions by one circuit court are not precedents for courts in other circuits. Federal courts are
also bound by decisions of the state supreme courts within their geographic territory in diversity
jurisdiction cases. All courts are bound by decisions of the US Supreme Court, except the
Supreme Court itself, which seldom reverses itself but on occasion has overturned its own
precedents.
Not everything a court says in an opinion is a precedent. Strictly speaking, only the exact holding
is binding on the lower courts. A holding is the theory of the law that applies to the particular
circumstances presented in a case. The courts may sometimes declare what they believe to be
the law with regard to points that are not central to the case being decided. These declarations

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are called dicta (the singular, dictum), and the lower courts do not have to give them the same
weight as holdings.

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

KEY TAKEAWAY

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

EXERCISES

1. Mrs. Robinson has a key witness on auto safety that the judge believes is not qualified as an
expert. The judge examines the witness while the jury is in the jury room and disqualifies him
from testifying. The jury does not get to hear this witness. Her attorney objects. She loses her
case. What argument would you expect Mrs. Robinson’s attorney to make in an appeal?
2. Why don’t appellate courts need a witness box for witnesses to give testimony under oath?
3. A trial judge in Nevada is wondering whether to enforce a surrogate motherhood
contract. Penelope Barr, of Reno, Nevada, has contracted with Reuben and Tina
Goldberg to bear the in vitro fertilized egg of Mrs. Goldberg. After carrying the
child for nine months, Penelope gives birth, but she is reluctant to give up the
child, even though she was paid $20,000 at the start of the contract and will earn
an additional $20,000 on handing over the baby to the Goldbergs. (Barr was an
especially good candidate for surrogate motherhood: she had borne two perfect
children and at age 28 drinks no wine, does not smoke or use drugs of any kind,
practices yoga, and maintains a largely vegetarian diet with just enough meat to
meet the needs of the fetus within.)
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The Goldbergs have asked the judge for an order compelling Penelope to give up
the baby, who was five days old when the lawsuit was filed. The baby is now a
month old as the judge looks in vain for guidance from any Nevada statute,
federal statute, or any prior case in Nevada that addressed the issue of surrogate
motherhood. He does find several well-reasoned cases, one from New Jersey, one
from Michigan, and one from Oregon. Are any of these “precedent” that he must
follow? May he adopt the reasoning of any of these courts, if he should find that
reasoning persuasive?

3.6 When Can Someone Bring a Lawsuit?
LEARNING OBJECTIVES

1. Explain the requirements for standing to bring a lawsuit in US courts.
2. Describe the process by which a group or class of plaintiffs can be certified to file a class
action case.
Almost anyone can bring a lawsuit, assuming they have the filing fee and the help of an attorney.
But the court may not hear it, for a number of reasons. There may be no case or controversy,
there may be no law to support the plaintiff’s claim, it may be in the wrong court, too much time
might have lapsed (a statute of limitations problem), or the plaintiff may not have standing.

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

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

KEY TAKEAWAY

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

EXERCISE

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

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3.7 Relations with Lawyers

LEARNING OBJECTIVES

1. Understand the various ways that lawyers charge for services.
2. Describe the contingent fee system in the United States.
3. Know the difference between the American rule and the British rule with regard to who pays
attorneys’ fees.

Legal Fees
Lawyers charge for their services in one of three different ways: flat rate, hourly rate, and
contingent fee. A flat rate is used usually when the work is relatively routine and the lawyer
knows in advance approximately how long it will take her to do the job. Drawing a will or doing
a real estate closing are examples of legal work that is often paid a flat rate. The rate itself may
be based on a percentage of the worth of the matter—say, 1 percent of a home’s selling price.
Lawyers generally charge by the hour for courtroom time and for ongoing representation in
commercial matters. Virtually every sizable law firm bills its clients by hourly rates, which in
large cities can range from $300 for an associate’s time to $500 and more for a senior partner’s
time.
A contingent fee is one that is paid only if the lawyer wins—that is, it is contingent, or depends
upon, the success of the case. This type of fee arrangement is used most often in personal injury
cases (e.g., automobile accidents, products liability, and professional malpractice). Although
used quite often, the contingent fee is controversial. Trial lawyers justify it by pointing to the
high cost of preparing for such lawsuits. A typical automobile accident case can cost at least ten
thousand dollars to prepare, and a complicated products-liability case can cost tens of
thousands of dollars. Few people have that kind of money or would be willing to spend it on the
chance that they might win a lawsuit. Corporate and professional defendants complain that the
contingent fee gives lawyers a license to go big game hunting, or to file suits against those with
deep pockets in the hopes of forcing them to settle.
Trial lawyers respond that the contingent fee arrangement forces them to screen cases and weed
out cases that are weak, because it is not worth their time to spend the hundreds of hours
necessary on such cases if their chances of winning are slim or nonexistent.
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Costs
In England and in many other countries, the losing party must pay the legal expenses of the
winning party, including attorneys’ fees. That is not the general rule in this country. Here, each
party must pay most of its own costs, including (and especially) the fees of lawyers. (Certain
relatively minor costs, such as filing fees for various documents required in court, are chargeable
to the losing side, if the judge decides it.) This type of fee structure is known as the American
rule (in contrast to the British rule).
There are two types of exceptions to the American rule. By statute, Congress and the state
legislatures have provided that the winning party in particular classes of cases may recover its
full legal costs from the loser—for example, the federal antitrust laws so provide and so does the
federal Equal Access to Justice Act. The other exception applies to litigants who either initiate
lawsuits in bad faith, with no expectation of winning, or who defend them in bad faith, in order
to cause the plaintiff great expense. Under these circumstances, a court has the discretion to
award attorneys’ fees to the winner. But this rule is not infinitely flexible, and courts do not have
complete freedom to award attorneys’ fees in any amount, but only "reasonable" attorney's fees.

KEY TAKEAWAY

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

EXERCISES

1. Mrs. Robinson’s attorney estimates that they will recover a million dollars from Volkswagen
in the Audi lawsuit. She has Mrs. Robinson sign a contract that gives her firm one-third of any
recovery after the firm’s expenses are deducted. The judge does in fact award a million
dollars, and the defendant pays. The firm’s expenses are $100,000. How much does Mrs.
Robinson get?
2. Harry Potter brings a lawsuit against Draco Malfoy in Chestershire, England, for slander, a
form of defamation. Potter alleges that Malfoy insists on calling him a mudblood. Ron
Weasley testifies, as does Neville Chamberlain. But Harry loses, because the court has no
conception of wizardry and cannot make sense of the case at all. In dismissing the case,

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however, who (under English law) will bear the costs of the attorneys who have brought the
case for Potter and defended the matter for Malfoy?

3.8 Alternative Means of Resolving Disputes
LEARNING OBJECTIVES

1. Understand how arbitration and mediation are frequently used alternatives to litigation.
2. Describe the differences between arbitration and mediation.
3. Explain why arbitration is final and binding.
Disputes do not have to be settled in court. No law requires parties who have a legal dispute to
seek judicial resolution if they can resolve their disagreement privately or through some other
public forum. In fact, the threat of a lawsuit can frequently motivate parties toward private
negotiation. Filing a lawsuit may convince one party that the other party is serious. Or the
parties may decide that they will come to terms privately rather than wait the three or four years
it can frequently take for a case to move up on the court calendar.

Arbitration
Beginning around 1980, a movement toward alternative dispute resolution began to gain force
throughout the United States. Bar associations, other private groups, and the courts themselves
wanted to find quicker and cheaper ways for litigants and potential litigants to settle certain
types of quarrels than through the courts. As a result, neighborhood justice centers or dispute
resolution centers have sprung up in communities. These are where people can come for help in
settling disputes, of both civil and criminal nature, that should not consume the time and money
of the parties or courts in lengthy proceedings.
These alternative forums use a variety of methods, including arbitration, mediation, and
conciliation, to bring about agreement or at least closure of the dispute. These methods are not
all alike, and their differences are worth noting.

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

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

KEY TAKEAWAY

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

EXERCISES

1. When Mrs. Robinson buys her Audi from Seaway, there is a paragraph in the bill of sale,
which both the dealer and Mrs. Robinson sign, that says, “In the event of any complaint by
customer/buyer against Seaway regarding the vehicle purchased herein, such complaint shall
not be litigated, but may only be arbitrated under the rules of the American Arbitration
Association and in accordance with New York law.” Mrs. Robinson did not see the provision,
doesn’t like it, and wants to bring a lawsuit in Oklahoma against Seaway. What result?
2. Hendrik Koster (Netherlands) contracts with Automark, Inc. (a US company based in Illinois)
to supply Automark with a large quantity of valve cap gauges. He does, and Automark fails to
pay. Koster thinks he is owed $66,000. There is no agreement to arbitrate or mediate. Can
Koster make Automark mediate or arbitrate?
3. Suppose that there is an agreement between Koster and Automark to arbitrate. It says, “The
parties agree to arbitrate any dispute arising under this agreement in accordance with the
laws of the Netherlands and under the auspices of the International Chamber of Commerce’s
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arbitration facility.” The International Chamber of Commerce has arbitration rules and will
appoint an arbitrator or arbitral panel in the event the parties cannot agree on an arbitrator.
The arbitration takes place in Geneva. Koster gets an arbitral award for $66,000 plus interest.
Automark does not participate in any way. Will a court in Illinois enforce the arbitral award?

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

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

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by Florida law, and called for payment of all required fees and forwarding of all relevant notices
to Miami headquarters.
The Drayton Plains restaurant did fairly well at first, but a recession in late 1979 caused the
franchisees to fall far behind in their monthly payments to Miami. Notice of default was sent
from Miami to Rudzewicz, who nevertheless continued to operate the restaurant as a Burger
King franchise. Burger King sued in federal district court for the southern district of Florida.
Rudzewicz contested the court’s personal jurisdiction over him, since he had never been to
Florida.
The federal court looked to Florida’s long arm statute and held that it did have personal
jurisdiction over the non-resident franchisees, and awarded Burger King a quarter of a million
dollars in contract damages and enjoined the franchisees from further operation of the Drayton
Plains facility. Franchisees appealed to the 11th Circuit Court of Appeals and won a reversal
based on lack of personal jurisdiction. Burger King petitioned the Supreme Ct. for a writ of
certiorari.
Justice Brennan delivered the opinion of the court.
The Due Process Clause protects an individual’s liberty interest in not being subject to the
binding judgments of a forum with which he has established no meaningful “contacts, ties, or
relations.” International Shoe Co. v. Washington. By requiring that individuals have “fair
warning that a particular activity may subject [them] to the jurisdiction of a foreign sovereign,”
the Due Process Clause “gives a degree of predictability to the legal system that allows potential
defendants to structure their primary conduct with some minimum assurance as to where that
conduct will and will not render them liable to suit.”…
Where a forum seeks to assert specific jurisdiction over an out-of-state defendant who has not
consented to suit there, this “fair warning” requirement is satisfied if the defendant has
“purposefully directed” his activities at residents of the forum, and the litigation results from
alleged injuries that “arise out of or relate to” those activities, Thus “[t]he forum State does not
exceed its powers under the Due Process Clause if it asserts personal jurisdiction over a
corporation that delivers its products into the stream of commerce with the expectation that
they will be purchased by consumers in the forum State” and those products subsequently injure
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forum consumers. Similarly, a publisher who distributes magazines in a distant State may fairly
be held accountable in that forum for damages resulting there from an allegedly defamatory
story.…
…[T]he constitutional touchstone remains whether the defendant purposefully established
“minimum contacts” in the forum State.…In defining when it is that a potential defendant
should “reasonably anticipate” out-of-state litigation, the Court frequently has drawn from the
reasoning of Hanson v. Denckla, 357 U.S. 235, 253 (1958):
The unilateral activity of those who claim some relationship with a nonresident defendant
cannot satisfy the requirement of contact with the forum State. The application of that rule will
vary with the quality and nature of the defendant’s activity, but it is essential in each case that
there be some act by which the defendant purposefully avails itself of the privilege of conducting
activities within the forum State, thus invoking the benefits and protections of its laws.
This “purposeful availment” requirement ensures that a defendant will not be haled into a
jurisdiction solely as a result of “random,” “fortuitous,” or “attenuated” contacts, or of the
“unilateral activity of another party or a third person,” [Citations] Jurisdiction is proper,
however, where the contacts proximately result from actions by the defendant himself that
create a “substantial connection” with the forum State. [Citations] Thus where the defendant
“deliberately” has engaged in significant activities within a State, or has created “continuing
obligations” between himself and residents of the forum, he manifestly has availed himself of
the privilege of conducting business there, and because his activities are shielded by “the
benefits and protections” of the forum’s laws it is presumptively not unreasonable to require
him to submit to the burdens of litigation in that forum as well.
Jurisdiction in these circumstances may not be avoided merely because the defendant did not
physically enter the forum State. Although territorial presence frequently will enhance a
potential defendant’s affiliation with a State and reinforce the reasonable foreseeability of suit
there, it is an inescapable fact of modern commercial life that a substantial amount of business
is transacted solely by mail and wire communications across state lines, thus obviating the need
for physical presence within a State in which business is conducted. So long as a commercial
actor’s efforts are “purposefully directed” toward residents of another State, we have
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consistently rejected the notion that an absence of physical contacts can defeat personal
jurisdiction there.
Once it has been decided that a defendant purposefully established minimum contacts within
the forum State, these contacts may be considered in light of other factors to determine whether
the assertion of personal jurisdiction would comport with “fair play and substantial
justice.” International Shoe Co. v. Washington, 326 U.S., at 320. Thus courts in “appropriate
case[s]” may evaluate “the burden on the defendant,” “the forum State’s interest in adjudicating
the dispute,” “the plaintiff’s interest in obtaining convenient and effective relief,” “the interstate
judicial system’s interest in obtaining the most efficient resolution of controversies,” and the
“shared interest of the several States in furthering fundamental substantive social policies.”
These considerations sometimes serve to establish the reasonableness of jurisdiction upon a
lesser showing of minimum contacts than would otherwise be required. [Citations] Applying
these principles to the case at hand, we believe there is substantial record evidence supporting
the District Court’s conclusion that the assertion of personal jurisdiction over Rudzewicz in
Florida for the alleged breach of his franchise agreement did not offend due process.…
In this case, no physical ties to Florida can be attributed to Rudzewicz other than MacShara’s
brief training course in Miami. Rudzewicz did not maintain offices in Florida and, for all that
appears from the record, has never even visited there. Yet this franchise dispute grew directly
out of “a contract which had a substantial connection with that State.” Eschewing the option of
operating an independent local enterprise, Rudzewicz deliberately “reach[ed] out beyond”
Michigan and negotiated with a Florida corporation for the purchase of a long-term franchise
and the manifold benefits that would derive from affiliation with a nationwide organization.
Upon approval, he entered into a carefully structured 20-year relationship that envisioned
continuing and wide-reaching contacts with Burger King in Florida. In light of Rudzewicz’
voluntary acceptance of the long-term and exacting regulation of his business from Burger
King’s Miami headquarters, the “quality and nature” of his relationship to the company in
Florida can in no sense be viewed as “random,” “fortuitous,” or “attenuated.” Rudzewicz’ refusal
to make the contractually required payments in Miami, and his continued use of Burger King’s
trademarks and confidential business information after his termination, caused foreseeable
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injuries to the corporation in Florida. For these reasons it was, at the very least, presumptively
reasonable for Rudzewicz to be called to account there for such injuries.
…Because Rudzewicz established a substantial and continuing relationship with Burger King’s
Miami headquarters, received fair notice from the contract documents and the course of dealing
that he might be subject to suit in Florida, and has failed to demonstrate how jurisdiction in that
forum would otherwise be fundamentally unfair, we conclude that the District Court’s exercise
of jurisdiction pursuant to Fla. Stat. 48.193(1)(g) (Supp. 1984) did not offend due process. The
judgment of the Court of Appeals is accordingly reversed, and the case is remanded for further
proceedings consistent with this opinion.
It is so ordered.

CASE QUESTIONS

1. Why did Burger King sue in Florida rather than in Michigan?
2. If Florida has a long-arm statute that tells Florida courts that it may exercise personal
jurisdiction over someone like Rudzewicz, why is the court talking about the due process
clause?
3. Why is this case in federal court rather than in a Florida state court?
4. If this case had been filed in state court in Florida, would Rudzewicz be required to come to
Florida? Explain.

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

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

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To establish a prima facie case that a manufacturer’s breach of its duty to warn was a proximate
cause of an injury sustained, a plaintiff must present evidence that the product would have been
used differently had the proffered warnings been given. [1][Citations omitted] In the absence of
evidence that a warning would have prevented the harm complained of by altering the plaintiff’s
conduct, the failure to warn cannot be deemed a proximate cause of the plaintiff’s injury as a
matter of law. [In accordance with procedure in a diversity of citizenship case, such as this one,
the court cites Michigan case law as the basis for its legal interpretation.]
…
A manufacturer has a duty “to warn the purchasers or users of its product about dangers
associated with intended use.” Conversely, a manufacturer has no duty to warn of a danger
arising from an unforeseeable misuse of its product. [Citation] Thus, whether a manufacturer
has a duty to warn depends on whether the use of the product and the injury sustained by it are
foreseeable. Gootee v. Colt Industries Inc., 712 F.2d 1057, 1065 (6th Cir. 1983); Owens v. AllisChalmers Corp., 414 Mich. 413, 425, 326 N.W.2d 372 (1982). Whether a plaintiff’s use of a
product is foreseeable is a legal question to be resolved by the court. Trotter, supra. Whether the
resulting injury is foreseeable is a question of fact for the jury. [2] Thomas v. International
Harvester Co., 57 Mich. App. 79, 225 N.W.2d 175 (1974).
In the instant action no reasonable jury could find that JJP’s failure to warn of the flammability
of cotton batting was a proximate cause of plaintiffs’ injuries because plaintiffs failed to offer any
evidence to establish that a flammability warning on JJP’s cotton batting would have dissuaded
them from using the product in the manner that they did.
Plaintiffs repeatedly stated in their response brief that plaintiff Susan Ferlito testified that “she
would never again use cotton batting to make a costume…However, a review of the trial
transcript reveals that plaintiff Susan Ferlito never testified that she would never again use
cotton batting to make a costume. More importantly, the transcript contains no statement by
plaintiff Susan Ferlito that a flammability warning on defendant JJP’s product would have
dissuaded her from using the cotton batting to construct the costume in the first place. At oral
argument counsel for plaintiffs conceded that there was no testimony during the trial that either
plaintiff Susan Ferlito or her husband, plaintiff Frank J. Ferlito, would have acted any different
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if there had been a flammability warning on the product’s package. The absence of such
testimony is fatal to plaintiffs’ case; for without it, plaintiffs have failed to prove proximate
cause, one of the essential elements of their negligence claim.
In addition, both plaintiffs testified that they knew that cotton batting burns when it is exposed
to flame. Susan Ferlito testified that she knew at the time she purchased the cotton batting that
it would burn if exposed to an open flame. Frank Ferlito testified that he knew at the time he
appeared at the Halloween party that cotton batting would burn if exposed to an open flame. His
additional testimony that he would not have intentionally put a flame to the cotton batting
shows that he recognized the risk of injury of which he claims JJP should have warned. Because
both plaintiffs were already aware of the danger, a warning by JJP would have been superfluous.
Therefore, a reasonable jury could not have found that JJP’s failure to provide a warning was a
proximate cause of plaintiffs’ injuries.
The evidence in this case clearly demonstrated that neither the use to which plaintiffs put JJP’s
product nor the injuries arising from that use were foreseeable. Susan Ferlito testified that the
idea for the costume was hers alone. As described on the product’s package, its intended uses
are for cleansing, applying medications, and infant care. Plaintiffs’ showing that the product
may be used on occasion in classrooms for decorative purposes failed to demonstrate the
foreseeability of an adult male encapsulating himself from head to toe in cotton batting and then
lighting up a cigarette.
ORDER
NOW, THEREFORE, IT IS HEREBY ORDERED that defendant JJP’s motion for judgment
notwithstanding the verdict is GRANTED.
IT IS FURTHER ORDERED that the judgment entered November 2, 1989, is SET ASIDE.
IT IS FURTHER ORDERED that the clerk will enter a judgment in favor of the defendant JJP.

CASE QUESTIONS

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

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

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

Chapter 4
Constitutional Law and US Commerce
LEARNING OBJECTIVES

After reading this chapter, you should be able to do the following:
1. Explain the historical importance and basic structure of the US Constitution.
2. Know what judicial review is and what it represents in terms of the separation of powers
between the executive, legislative, and judicial branches of government.
3. Locate the source of congressional power to regulate the economy under the Constitution,
and explain what limitations there are to the reach of congressional power over interstate
commerce.
4. Describe the different phases of congressional power over commerce, as adjudged by the US
Supreme Court over time.
5. Explain what power the states retain over commerce, and how the Supreme Court may
sometimes limit that power.
6. Describe how the Supreme Court, under the supremacy clause of the Constitution, balances
state and federal laws that may be wholly or partly in conflict.

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

4.1 Basic Aspects of the US Constitution
LEARNING OBJECTIVES

1. Describe the American values that are reflected in the US Constitution.
2. Know what federalism means, along with separation of powers.
3. Explain the process of amending the Constitution and why judicial review is particularly
significant.

The Constitution as Reflecting American Values
In the US, the one document to which all public officials and military personnel pledge their
unswerving allegiance is the Constitution. If you serve, you are asked to “support and defend”
the Constitution “against all enemies, foreign and domestic.” The oath usually includes a
statement that you swear that this oath is taken freely, honestly, and without “any purpose of
evasion.” This loyalty oath may be related to a time—fifty years ago—when “un-American”
activities were under investigation in Congress and the press; the fear of communism (as
antithetical to American values and principles) was paramount. As you look at the Constitution
and how it affects the legal environment of business, please consider what basic values it may

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impart to us and what makes it uniquely American and worth defending “against all enemies,
foreign and domestic.”
In Article I, the Constitution places the legislature first and prescribes the ways in which
representatives are elected to public office. Article I balances influence in the federal legislature
between large states and small states by creating a Senate in which the smaller states (by
population) as well as the larger states have two votes. In Article II, the Constitution sets forth
the powers and responsibilities of the branch—the presidency—and makes it clear that the
president should be the commander in chief of the armed forces. Article II also gives states
rather than individuals (through the Electoral College) a clear role in the election process.
Article III creates the federal judiciary, and the Bill of Rights, adopted in 1791, makes clear that
individual rights must be preserved against activities of the federal government. In general, the
idea of rights is particularly strong.
The Constitution itself speaks of rights in fairly general terms, and the judicial interpretation of
various rights has been in flux. The “right” of a person to own another person was notably
affirmed by the Supreme Court in the Dred Scott decision in 1857.[1] The “right” of a child to
freely contract for long, tedious hours of work was upheld by the court in Hammer v.
Dagenhart in 1918. Both decisions were later repudiated, just as the decision that a woman has
a “right” to an abortion in the first trimester of pregnancy could later be repudiated if Roe v.
Wade is overturned by the Supreme Court.[2]

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

Federalism

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

Separation of Powers and Judicial Review
Because the Founding Fathers wanted to ensure that no single branch of the government,
especially the executive branch, would be ascendant over the others, they created various checks
and balances to ensure that each of the three principal branches had ways to limit or modify the
power of the others. This is known as theseparation of powers. Thus the president retains veto
power, but the House of Representatives is entrusted with the power to initiate spending bills.
Power sharing was evident in the basic design of Congress, the federal legislative branch. The
basic power imbalance was between the large states (with greater population) and the smaller
ones (such as Delaware). The smaller ones feared a loss of sovereignty if they could be outvoted
by the larger ones, so the federal legislature was constructed to guarantee two Senate seats for
every state, no matter how small. The Senate was also given great responsibility in ratifying
treaties and judicial nominations. The net effect of this today is that senators from a very small
number of states can block treaties and other important legislation. The power of small states is
also magnified by the Senate’s cloture rule, which currently requires sixty out of one hundred
senators to vote to bring a bill to the floor for an up-or-down vote.
Because the Constitution often speaks in general terms (with broad phrases such as “due
process” and “equal protection”), reasonable people have disagreed as to how those terms apply
in specific cases. The United States is unique among industrialized democracies in having a
Supreme Court that reserves for itself that exclusive power to interpret what the Constitution
means. The famous case of Marbury v. Madison began that tradition in 1803, when the
Supreme Court had marginal importance in the new republic. The decision in Bush v. Gore,
decided in December of 2000, illustrates the power of the court to shape our destiny as a nation.
In that case, the court overturned a ruling by the Florida Supreme Court regarding the way to
proceed on a recount of the Florida vote for the presidency. The court’s ruling was purportedly
based on the “equal protection of the laws” provision in the Fourteenth Amendment.
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From Marbury to the present day, the Supreme Court has articulated the view that the US
Constitution sets the framework for all other US laws, whether statutory or judicially created.
Thus any statute (or portion thereof) or legal ruling (judicial or administrative) in conflict with
the Constitution is not enforceable. And as the Bush v. Gore decision indicates, the states are not
entirely free to do what they might choose; their own sovereignty is limited by their union with
the other states in a federal sovereign.
If the Supreme Court makes a “bad decision” as to what the Constitution means, it is not easily
overturned. Either the court must change its mind (which it seldom does) or two-thirds of
Congress and three-fourths of the states must make an amendment (Article V).
Because the Supreme Court has this power of judicial review, there have been many arguments
about how it should be exercised and what kind of “philosophy” a Supreme Court justice should
have. President Richard Nixon often said that a Supreme Court justice should “strictly construe”
the Constitution and not add to its language. Finding law in the Constitution was “judicial
activism” rather than “judicial restraint.” The general philosophy behind the call for “strict
constructionist” justices is that legislatures make laws in accord with the wishes of the majority,
and so unelected judges should not make law according to their own views and values. Nixon
had in mind the 1960s Warren court, which “found” rights in the Constitution that were not
specifically mentioned—the right of privacy, for example. In later years, critics of the Rehnquist
court would charge that it “found” rights that were not specifically mentioned, such as the right
of states to be free from federal antidiscrimination laws. See, for example, Kimel v. Florida
Board of Regents, or the Citizens United v. Federal Election Commission case (Section 4.6.5),
which held that corporations are “persons” with “free speech rights” that include spending
unlimited amounts of money in campaign donations and political advocacy. [3]
Because Roe v. Wade has been so controversial, this chapter includes a seminal case on “the
right of privacy,” Griswold v. Connecticut, Section 4.6.1. Was the court was correct in
recognizing a “right of privacy” in Griswold? This may not seem like a “business case,” but
consider: the manufacture and distribution of birth control devices is a highly profitable (and
legal) business in every US state. Moreover, Griswold illustrates another important and muchdebated concept in US constitutional law: substantive due process (see Section 4.5.3 "Fifth
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Amendment"). The problem of judicial review and its proper scope is brought into sharp focus
in the abortion controversy. Abortion became a lucrative service business after Roe v. Wade was
decided in 1973. That has gradually changed, with state laws that have limited rather than
overruledRoe v. Wade and with persistent antiabortion protests, killings of abortion doctors,
and efforts to publicize the human nature of the fetuses being aborted. The key here is to
understand that there is no explicit mention in the Constitution of any right of privacy. As
Justice Harry Blackmun argued in his majority opinion in Roe v. Wade,
The Constitution does not explicitly mention any right of privacy. In a line of decisions, however,
the Court has recognized that a right of personal privacy or a guarantee of certain areas or zones
of privacy, does exist under the Constitution.…[T]hey also make it clear that the right has some
extension to activities relating to marriage…procreation…contraception…family
relationships…and child rearing and education.…The right of privacy…is broad enough to
encompass a woman’s decision whether or not to terminate her pregnancy.
In short, justices interpreting the Constitution wield quiet yet enormous power through judicial
review. In deciding that the right of privacy applied to a woman’s decision to abort in the first
trimester, the Supreme Court did not act on the basis of a popular mandate or clear and
unequivocal language in the Constitution, and it made illegal any state or federal legislative or
executive action contrary to its interpretation. Only a constitutional amendment or the court’s
repudiation of Roe v. Wade as a precedent could change that interpretation.

KEY TAKEAWAY

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

EXERCISES

1. Suppose the Supreme Court declares that Congress and the president cannot authorize the
indefinite detention of terrorist suspects without a trial of some sort, whether military or
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civilian. Suppose also that the people of the United States favor such indefinite detention
and that Congress wants to pass a law rebuking the court’s decision. What kind of law
would have to be passed, by what institutions, and by what voting percentages?
2. When does a prior decision of the Supreme Court deserve overturning? Name one
decision of the Supreme Court that you think is no longer “good law.” Does the court have
to wait one hundred years to overturn its prior case precedents?

[1] In Scott v. Sanford (the Dred Scott decision), the court states that Scott should remain a slave, that as
a slave he is not a citizen of the United States and thus not eligible to bring suit in a federal court, and
that as a slave he is personal property and thus has never been free.
[2] Roe v. Wade, 410 US 113 (1973).

4.2 The Commerce

[3] Kimel v. Florida Board of Regents, 528 US 62 (2000).

ClauseL E A R N I N G O B J E C T I V E S

1. Name the specific clause through which Congress has the power to regulate commerce.
What, specifically, does this clause say?
2. Explain how early decisions of the Supreme Court interpreted the scope of the commerce
clause and how that impacted the legislative proposals and programs of Franklin Delano
Roosevelt during the Great Depression.
3. Describe both the wider use of the commerce clause from World War II through the 1990s
and the limitations the Supreme Court imposed in Lopez and other cases.
First, turn to Article I, Section 8. The commerce clause gives Congress the exclusive power to
make laws relating to foreign trade and commerce and to commerce among the various states.
Most of the federally created legal environment springs from this one clause: if Congress is not
authorized in the Constitution to make certain laws, then it acts unconstitutionally and its
actions may be ruled unconstitutional by the Supreme Court. Lately, the Supreme Court has not
been shy about ruling acts of Congress unconstitutional.

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Here are the first five parts of Article I, Section 8, which sets forth the powers of the federal
legislature. The commerce clause is in boldface. It is short, but most federal legislation affecting
business depends on this very clause:

Section 8

[Clause 1] The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises,
to pay the Debts and provide for the common Defence and general Welfare of the United States;
but all Duties, Imposts and Excises shall be uniform throughout the United States;
[Clause 2] To borrow Money on the credit of the United States;
[Clause 3] To regulate Commerce with foreign Nations, and among the several
States, and with the Indian Tribes;
[Clause 4] To establish a uniform Rule of Naturalization, and uniform Laws on the subject of
Bankruptcies throughout the United States;
[Clause 5] To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard
of Weights and Measures;

Early Commerce Clause Cases
For many years, the Supreme Court was very strict in applying the commerce clause: Congress
could only use it to legislate aspects of the movement of goods from one state to another.
Anything else was deemed local rather than national. For example, InHammer v. Dagenhart,
decided in 1918, a 1916 federal statute had barred transportation in interstate commerce of
goods produced in mines or factories employing children under fourteen or employing children
fourteen and above for more than eight hours a day. A complaint was filed in the US District
Court for the Western District of North Carolina by a father in his own behalf and on behalf of
his two minor sons, one under the age of fourteen years and the other between fourteen and
sixteen years, who were employees in a cotton mill in Charlotte, North Carolina. The father’s
lawsuit asked the court to enjoin (block) the enforcement of the act of Congress intended to
prevent interstate commerce in the products of child labor.
The Supreme Court saw the issue as whether Congress had the power under the commerce
clause to control interstate shipment of goods made by children under the age of fourteen. The
court found that Congress did not. The court cited several cases that had considered what
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interstate commerce could be constitutionally regulated by Congress. In Hipolite Egg Co. v.
United States, the Supreme Court had sustained the power of Congress to pass the Pure Food
and Drug Act, which prohibited the introduction into the states by means of interstate
commerce impure foods and drugs.[1] In Hoke v. United States, the Supreme Court had
sustained the constitutionality of the so-called White Slave Traffic Act of 1910, whereby the
transportation of a woman in interstate commerce for the purpose of prostitution was
forbidden. In that case, the court said that Congress had the power to protect the channels of
interstate commerce: “If the facility of interstate transportation can be taken away from the
demoralization of lotteries, the debasement of obscene literature, the contagion of diseased
cattle or persons, the impurity of food and drugs, the like facility can be taken away from the
systematic enticement to, and the enslavement in prostitution and debauchery of women, and,
more insistently, of girls.” [2]
In each of those instances, the Supreme Court said, “[T]he use of interstate transportation was
necessary to the accomplishment of harmful results.” In other words, although the power over
interstate transportation was to regulate, that could only be accomplished by prohibiting the use
of the facilities of interstate commerce to effect the evil intended. But in Hammer v. Dagenhart,
that essential element was lacking. The law passed by Congress aimed to standardize among all
the states the ages at which children could be employed in mining and manufacturing, while the
goods themselves are harmless. Once the labor is done and the articles have left the factory, the
“labor of their production is over, and the mere fact that they were intended for interstate
commerce transportation does not make their production subject to federal control under the
commerce power.”
In short, the early use of the commerce clause was limited to the movement of physical goods
between states. Just because something might enter the channels of interstate commerce later
on does not make it a fit subject for national regulation. The production of articles intended for
interstate commerce is a matter of local regulation. The court therefore upheld the result from
the district and circuit court of appeals; the application of the federal law was enjoined. Goods
produced by children under the age of fourteen could be shipped anywhere in the United States
without violating the federal law.
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From the New Deal to the New Frontier and the Great Society:1930s–1970
During the global depression of the 1930s, the US economy saw jobless rates of a third of all
workers, and President Roosevelt’s New Deal program required more active federal legislation.
Included in the New Deal program was the recognition of a “right” to form labor unions without
undue interference from employers. Congress created the National Labor Relations Board
(NLRB) in 1935 to investigate and to enjoin employer practices that violated this right.
In NLRB v. Jones & Laughlin Steel Corporation, a union dispute with management at a large
steel-producing facility near Pittsburgh, Pennsylvania, became a court case. In this case, the
NLRB had charged the Jones & Laughlin Steel Corporation with discriminating against
employees who were union members. The company’s position was that the law authorizing the
NLRB was unconstitutional, exceeding Congress’s powers. The court held that the act was
narrowly constructed so as to regulate industrial activities that had the potential to restrict
interstate commerce. The earlier decisions under the commerce clause to the effect that labor
relations had only an indirect effect on commerce were effectively reversed. Since the ability of
employees to engage in collective bargaining (one activity protected by the act) is “an essential
condition of industrial peace,” the national government was justified in penalizing corporations
engaging in interstate commerce that “refuse to confer and negotiate” with their workers. This
was, however, a close decision, and the switch of one justice made this ruling possible. Without
this switch, the New Deal agenda would have been effectively derailed.

The Substantial Effects Doctrine: World War II to the 1990s
Subsequent to NLRB v. Jones & Laughlin Steel Corporation, Congress and the courts generally
accepted that even modest impacts on interstate commerce were “reachable” by federal
legislation. For example, the case of Wickard v. Filburn, from 1942, represents a fairly long
reach for Congress in regulating what appear to be very local economic decisions (Section 4.6.2).
Wickard established that “substantial effects” in interstate commerce could be very local indeed!
But commerce clause challenges to federal legislation continued. In the 1960s, the Civil Rights
Act of 1964 was challenged on the ground that Congress lacked the power under the commerce
clause to regulate what was otherwise fairly local conduct. For example, Title II of the act

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prohibited racial discrimination in public accommodations (such as hotels, motels, and
restaurants), leading to the famous case of Katzenbach v. McClung (1964).
Ollie McClung’s barbeque place in Birmingham, Alabama, allowed “colored” people to buy
takeout at the back of the restaurant but not to sit down with “white” folks inside. The US
attorney sought a court order to require Ollie to serve all races and colors, but Ollie resisted on
commerce clause grounds: the federal government had no business regulating a purely local
establishment. Indeed, Ollie did not advertise nationally, or even regionally, and had customers
only from the local area. But the court found that some 42 percent of the supplies for Ollie’s
restaurant had moved in the channels of interstate commerce. This was enough to sustain
federal regulation based on the commerce clause. [3]
For nearly thirty years following, it was widely assumed that Congress could almost always find
some interstate commerce connection for any law it might pass. It thus came as something of a
shock in 1995 when the Rehnquist court decided U.S. v. Lopez. Lopez had been convicted under
a federal law that prohibited possession of firearms within 1,000 feet of a school. The law was
part of a twenty-year trend (roughly 1970 to 1990) for senators and congressmen to pass laws
that were tough on crime. Lopez’s lawyer admitted that Lopez had had a gun within 1,000 feet of
a San Antonio school yard but challenged the law itself, arguing that Congress exceeded its
authority under the commerce clause in passing this legislation. The US government’s Solicitor
General argued on behalf of the Department of Justice to the Supreme Court that Congress was
within its constitutional rights under the commerce clause because education of the future
workforce was the foundation for a sound economy and because guns at or near school yards
detracted from students’ education. The court rejected this analysis, noting that with the
government’s analysis, an interstate commerce connection could be conjured from almost
anything. Lopez went free because the law itself was unconstitutional, according to the court.
Congress made no attempt to pass similar legislation after the case was decided. But in passing
subsequent legislation, Congress was often careful to make a record as to why it believed it was
addressing a problem that related to interstate commerce. In 1994, Congress passed the
Violence Against Women Act (VAWA), having held hearings to establish why violence against
women on a local level would impair interstate commerce. In 1994, while enrolled at Virginia
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Polytechnic Institute (Virginia Tech), Christy Brzonkala alleged that Antonio Morrison and
James Crawford, both students and varsity football players at Virginia Tech, had raped her. In
1995, Brzonkala filed a complaint against Morrison and Crawford under Virginia Tech’s sexual
assault policy. After a hearing, Morrison was found guilty of sexual assault and sentenced to
immediate suspension for two semesters. Crawford was not punished. A second hearing again
found Morrison guilty. After an appeal through the university’s administrative system,
Morrison’s punishment was set aside, as it was found to be “excessive.” Ultimately, Brzonkala
dropped out of the university. Brzonkala then sued Morrison, Crawford, and Virginia Tech in
federal district court, alleging that Morrison’s and Crawford’s attack violated 42 USC Section
13981, part of the VAWA), which provides a federal civil remedy for the victims of gendermotivated violence. Morrison and Crawford moved to dismiss Brzonkala’s suit on the ground
that Section 13981’s civil remedy was unconstitutional. In dismissing the complaint, the district
court found that that Congress lacked authority to enact Section 13981 under either the
commerce clause or the Fourteenth Amendment, which Congress had explicitly identified as the
sources of federal authority for the VAWA. Ultimately, the court of appeals affirmed, as did the
Supreme Court.
The Supreme Court held that Congress lacked the authority to enact a statute under the
commerce clause or the Fourteenth Amendment because the statute did not regulate an activity
that substantially affected interstate commerce nor did it redress harm caused by the state. Chief
Justice William H. Rehnquist wrote for the court that “under our federal system that remedy
must be provided by the Commonwealth of Virginia, and not by the United States.” Dissenting,
Justice Stephen G. Breyer argued that the majority opinion “illustrates the difficulty of finding a
workable judicial Commerce Clause touchstone.” Justice David H. Souter, dissenting, noted that
VAWA contained a “mountain of data assembled by Congress…showing the effects of violence
against women on interstate commerce.”
The absence of a workable judicial commerce clause touchstone remains. In 1996, California
voters passed the Compassionate Use Act, legalizing marijuana for medical use. California’s law
conflicted with the federal Controlled Substances Act (CSA), which banned possession of
marijuana. After the Drug Enforcement Administration (DEA) seized doctor-prescribed
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marijuana from a patient’s home, a group of medical marijuana users sued the DEA and US
Attorney General John Ashcroft in federal district court.
The medical marijuana users argued that the CSA—which Congress passed using its
constitutional power to regulate interstate commerce—exceeded Congress’s commerce clause
power. The district court ruled against the group, but the Ninth Circuit Court of Appeals
reversed and ruled the CSA unconstitutional because it applied to medical marijuana use solely
within one state. In doing so, the Ninth Circuit relied on U.S. v. Lopez (1995) and U.S. v.
Morrison (2000) to say that using medical marijuana did not “substantially affect” interstate
commerce and therefore could not be regulated by Congress.
But by a 6–3 majority, the Supreme Court held that the commerce clause gave Congress
authority to prohibit the local cultivation and use of marijuana, despite state law to the contrary.
Justice John Paul Stevens argued that the court’s precedents established Congress’s commerce
clause power to regulate purely local activities that are part of a “class of activities” with a
substantial effect on interstate commerce. The majority argued that Congress could ban local
marijuana use because it was part of such a class of activities: the national marijuana market.
Local use affected supply and demand in the national marijuana market, making the regulation
of intrastate use “essential” to regulating the drug’s national market.
Notice how similar this reasoning is to the court’s earlier reasoning in Wickard v.
Filburn (Section 4.6.2). In contrast, the court’s conservative wing was adamant that federal
power had been exceeded. Justice Clarence Thomas’s dissent in Gonzalez v. Raich stated that
Raich’s local cultivation and consumption of marijuana was not “Commerce…among the several
States.” Representing the “originalist” view that the Constitution should mostly mean what the
Founders meant it to mean, he also said that in the early days of the republic, it would have been
unthinkable that Congress could prohibit the local cultivation, possession, and consumption of
marijuana.

KEY TAKEAWAY

The commerce clause is the basis on which the federal government regulates interstate
economic activity. The phrase “interstate commerce” has been subject to differing
interpretations by the Supreme Court over the past one hundred years. There are certain

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matters that are essentially local or intrastate, but the range of federal involvement in local
matters is still considerable.

EXERCISES

1. Why would Congress have power under the Civil Rights Act of 1964 to require restaurants
and hotels to not discriminate against interstate travelers on the basis of race, color, sex,
religion, or national origin? Suppose the Holiday Restaurant near I-80 in Des Moines, Iowa,
has a sign that says, “We reserve the right to refuse service to any Muslim or person of
Middle Eastern descent.” Suppose also that the restaurant is very popular locally and that
only 40 percent of its patrons are travelers on I-80. Are the owners of the Holiday Restaurant
in violation of the Civil Rights Act of 1964? What would happen if the owners resisted
enforcement by claiming that Title II of the act (relating to “public accommodations” such as
hotels, motels, and restaurants) was unconstitutional?
2. If the Supreme Court were to go back to the days of Hammer v. Dagenhart and rule that only
goods and services involving interstate movement could be subject to federal law, what kinds
of federal programs might be lacking a sound basis in the commerce clause? “Obamacare”?
Medicare? Homeland security? Social Security? What other powers are granted to Congress
under the Constitution to legislate for the general good of society?

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

4.3 Dormant Commerce Clause

LEARNING OBJECTIVES

1. Understand that when Congress does not exercise its powers under the commerce clause,
the Supreme Court may still limit state legislation that discriminates against interstate
commerce or places an undue burden on interstate commerce.
2. Distinguish between “discrimination” dormant-commerce-clause cases and “undue burden”
dormant-commerce-clause cases.
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Congress has the power to legislate under the commerce clause and often does legislate. For
example, Congress might say that trucks moving on interstate highways must not be more than
seventy feet in length. But if Congress does not exercise its powers and regulate in certain areas
(such as the size and length of trucks on interstate highways), states may make their own rules.
States may do so under the so-called historic police powers of states that were never yielded up
to the federal government.
These police powers can be broadly exercised by states for purposes of health, education,
welfare, safety, morals, and the environment. But the Supreme Court has reserved for itself the
power to determine when state action is excessive, even when Congress has not used the
commerce clause to regulate. This power is claimed to exist in the dormant commerce clause.
There are two ways that a state may violate the dormant commerce clause. If a state passes a law
that is an “undue burden” on interstate commerce or that “discriminates” against interstate
commerce, it will be struck down. Kassel v. Consolidated Freightways, in Section 4.7 "Summary
and Exercises", is an example of a case where Iowa imposed an undue burden on interstate
commerce by prohibiting double trailers on its highways. [1] Iowa’s prohibition was judicially
declared void when the Supreme Court judged it to be an undue burden.
Discrimination cases such as Hunt v. Washington Apple Advertising Commission(Section 4.6
"Cases") pose a different standard. The court has been fairly inflexible here: if one state
discriminates in its treatment of any article of commerce based on its state of origin, the court
will strike down the law. For example, in Oregon Waste Systems v. Department of
Environmental Quality, the state wanted to place a slightly higher charge on waste coming from
out of state. [2] The state’s reasoning was that in-state residents had already contributed to roads
and other infrastructure and that tipping fees at waste facilities should reflect the prior
contributions of in-state companies and residents. Out-of-state waste handlers who wanted to
use Oregon landfills objected and won their dormant commerce clause claim that Oregon’s law
discriminated “on its face” against interstate commerce. Under the Supreme Court’s rulings,
anything that moves in channels of interstate commerce is “commerce,” even if someone is
paying to get rid of something instead of buying something.

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Thus the states are bound by Supreme Court decisions under the dormant commerce clause to
do nothing that differentiates between articles of commerce that originate from within the state
from those that originate elsewhere. If Michigan were to let counties decide for themselves
whether to take garbage from outside of the county or not, this could also be a discrimination
based on a place of origin outside the state. (Suppose, for instance, each county were to decide
not to take waste from outside the county; then all Michigan counties would effectively be
excluding waste from outside of Michigan, which is discriminatory.) [3]
The Supreme Court probably would uphold any solid waste requirements that did not
differentiate on the basis of origin. If, for example, all waste had to be inspected for specific
hazards, then the law would apply equally to in-state and out-of-state garbage. Because this is
the dormant commerce clause, Congress could still act (i.e., it could use its broad commerce
clause powers) to say that states are free to keep out-of-state waste from coming into their own
borders. But Congress has declined to do so. What follows is a statement from one of the US
senators from Michigan, Carl Levin, in 2003, regarding the significant amounts of waste that
were coming into Michigan from Toronto, Canada.

Dealing with Unwelcome Waste
Senator Carl Levin, January 2003

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

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Our bill would require the EPA to consider these factors in determining whether to accept
imports of trash from Canada. It is my strong view that such a review should lead the EPA to say
“no” to the status quo of trash imports.

KEY TAKEAWAY

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

EXERCISES

1. Suppose that the state of New Jersey wishes to limit the amount of hazardous waste that
enters into its landfills. The general assembly in New Jersey passes a law that specifically
forbids any hazardous waste from entering into the state. All landfills are subject to tight
regulations that will allow certain kinds of hazardous wastes originating in New Jersey to be
put in New Jersey landfills but that impose significant criminal fines on landfill operators that
accept out-of-state hazardous waste. The Baldessari Brothers Landfill in Linden, New Jersey,
is fined for taking hazardous waste from a New York State transporter and appeals that ruling
on the basis that New Jersey’s law is unconstitutional. What is the result?
2. The state of Arizona determines through its legislature that trains passing through the state
cannot be longer than seventy cars. There is some evidence that in Eastern US states longer
trains pose some safety hazards. There is less evidence that long trains are a problem in
Western states. Several major railroads find the Arizona legislation costly and burdensome
and challenge the legislation after applied-for permits for longer trains are denied. What kind
of dormant commerce clause challenge is this, and what would it take for the challenge to be
successful?

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

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4.4 Preemption: The Supremacy Clause
LEARNING OBJECTIVES

1. Understand the role of the supremacy clause in the balance between state and federal
power.
2. Give examples of cases where state legislation is preempted by federal law and cases where
state legislation is not preempted by federal law.
When Congress does use its power under the commerce clause, it can expressly state that it
wishes to have exclusive regulatory authority. For example, when Congress determined in the
1950s to promote nuclear power (“atoms for peace”), it set up the Nuclear Regulatory
Commission and provided a limitation of liability for nuclear power plants in case of a nuclear
accident. The states were expressly told to stay out of the business of regulating nuclear power
or the movement of nuclear materials. Thus Rochester, Minnesota, or Berkeley, California, could
declare itself a nuclear-free zone, but the federal government would have preempted such
legislation. If Michigan wished to set safety standards at Detroit Edison’s Fermi II nuclear
reactor that were more stringent than the federal Nuclear Regulatory Commission’s standards,
Michigan’s standards would be preempted and thus be void.
Even where Congress does not expressly preempt state action, such action may be impliedly preempted. States cannot constitutionally pass laws that interfere with the accomplishment of the
purposes of the federal law. Suppose, for example, that Congress passes a comprehensive law
that sets standards for foreign vessels to enter the navigable waters and ports of the United
States. If a state creates a law that sets standards that conflict with the federal law or sets
standards so burdensome that they interfere with federal law, the doctrine of preemption will
(in accordance with the supremacy clause) void the state law or whatever parts of it are
inconsistent with federal law.
But Congress can allow what might appear to be inconsistencies; the existence of federal
statutory standards does not always mean that local and state standards cannot be more
stringent. If California wants cleaner air or water than other states, it can set stricter standards—
nothing in the Clean Water Act or Clean Air Act forbids the state from setting stricter pollution
standards. As the auto industry well knows, California has set stricter standards for auto
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emissions. Since the 1980s, most automakers have made both a federal car and a California car,
because federal Clean Air Act emissions restrictions do not preempt more rigorous state
standards.
Large industries and companies actually prefer regulation at the national level. It is easier for a
large company or industry association to lobby in Washington, DC, than to lobby in fifty
different states. Accordingly, industry often asks Congress to put preemptive language into its
statutes. The tobacco industry is a case in point.
The cigarette warning legislation of the 1960s (where the federal government required warning
labels on cigarette packages) effectively preempted state negligence claims based on failure to
warn. When the family of a lifetime smoker who had died sued in New Jersey court, one cause of
action was the company’s failure to warn of the dangers of its product. The Supreme Court
reversed the jury’s award based on the federal preemption of failure to warn claims under state
law. [1]

The Supremacy Clause
Article VI
This Constitution, and the Laws of the United States which shall be made in Pursuance thereof;
and all Treaties made, or which shall be made, under the Authority of the United States, shall be
the supreme Law of the Land; and the Judges in every State shall be bound thereby, any Thing
in the Constitution or Laws of any State to the Contrary notwithstanding.
The preemption doctrine derives from the supremacy clause of the Constitution, which states
that the “Constitution and the Laws of the United States…shall be the supreme Law of the
Land…any Thing in the Constitutions or Laws of any State to the Contrary notwithstanding.”
This means of course, that any federal law—even a regulation of a federal agency—would control
over any conflicting state law.
Preemption can be either express or implied. When Congress chooses to expressly preempt state
law, the only question for courts becomes determining whether the challenged state law is one
that the federal law is intended to preempt. Implied preemption presents more difficult issues.
The court has to look beyond the express language of federal statutes to determine whether
Congress has “occupied the field” in which the state is attempting to regulate, or whether a state
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law directly conflicts with federal law, or whether enforcement of the state law might frustrate
federal purposes.
Federal “occupation of the field” occurs, according to the court in Pennsylvania v.
Nelson (1956), when there is “no room” left for state regulation. Courts are to look to the
pervasiveness of the federal scheme of regulation, the federal interest at stake, and the danger of
frustration of federal goals in making the determination as to whether a challenged state law can
stand.
In Silkwood v. Kerr-McGee (1984), the court, voting 5–4, found that a $10 million punitive
damages award (in a case litigated by famed attorney Gerry Spence) against a nuclear power
plant was not impliedly preempted by federal law. Even though the court had recently held that
state regulation of the safety aspects of a federally licensed nuclear power plant was preempted,
the court drew a different conclusion with respect to Congress’s desire to displace state tort
law—even though the tort actions might be premised on a violation of federal safety regulations.
Cipollone v. Liggett Group (1993) was a closely watched case concerning the extent of an
express preemption provision in two cigarette labeling laws of the 1960s. The case was a
wrongful death action brought against tobacco companies on behalf of Rose Cipollone, a lung
cancer victim who had started smoking cigarette in the 1940s. The court considered the
preemptive effect on state law of a provision that stated, “No requirement based on smoking and
health shall be imposed under state law with respect to the advertising and promotion of
cigarettes.” The court concluded that several types of state tort actions were preempted by the
provision but allowed other types to go forward.

KEY TAKEAWAY

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

EXERCISES

1. For many years, the United States engaged in discussions with friendly nations as to the
reciprocal use of ports and harbors. These discussions led to various multilateral agreements
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between the nations as to the configuration of oceangoing vessels and how they would be
piloted. At the same time, concern over oil spills in Puget Sound led the state of Washington
to impose fairly strict standards on oil tankers and requirements for the training of oil tanker
pilots. In addition, Washington’s state law imposed many other requirements that went
above and beyond agreed-upon requirements in the international agreements negotiated by
the federal government. Are the Washington state requirements preempted by federal law?
2. The Federal Arbitration Act of 1925 requires that all contracts for arbitration be treated as
any other contract at common law. Suppose that the state of Alabama wishes to protect its
citizens from a variety of arbitration provisions that they might enter into unknowingly. Thus
the legislation provides that all predispute arbitration clauses be in bold print, that they be of
twelve-point font or larger, that they be clearly placed within the first two pages of any
contract, and that they have a separate signature line where the customer, client, or patient
acknowledges having read, understood, and signed the arbitration clause in addition to any
other signatures required on the contract. The legislation does preserve the right of
consumers to litigate in the event of a dispute arising with the product or service provider;
that is, with this legislation, consumers will not unknowingly waive their right to a trial at
common law. Is the Alabama law preempted by the Federal Arbitration Act?

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

4.5 Business and the Bill of Rights

LEARNING OBJECTIVES

1. Understand and describe which articles in the Bill of Rights apply to business activities and
how they apply.
2. Explain the application of the Fourteenth Amendment—including the due process clause and
the equal protection clause—to various rights enumerated in the original Bill of Rights.

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We have already seen the Fourteenth Amendment’s application in Burger King v.
Rudzewicz (Section 3.9 "Cases"). In that case, the court considered whether it was
constitutionally correct for a court to assert personal jurisdiction over a nonresident. The states
cannot constitutionally award a judgment against a nonresident if doing so would offend
traditional notions of fair play and substantial justice. Even if the state’s long-arm statute would
seem to allow such a judgment, other states should not give it full faith and credit (see Article V
of the Constitution). In short, a state’s long-arm statute cannot confer personal jurisdiction that
the state cannot constitutionally claim.
The Bill of Rights (the first ten amendments to the Constitution) was originally meant to apply
to federal actions only. During the twentieth century, the court began to apply selected rights to
state action as well. So, for example, federal agents were prohibited from using evidence seized
in violation of the Fourth Amendment, but state agents were not, until Mapp v. Ohio (1960),
when the court applied the guarantees (rights) of the Fourth Amendment to state action as well.
In this and in similar cases, the Fourteenth Amendment’s due process clause was the basis for
the court’s action. The due process clause commanded that states provide due process in cases
affecting the life, liberty, or property of US citizens, and the court saw in this command certain
“fundamental guarantees” that states would have to observe. Over the years, most of the
important guarantees in the Bill of Rights came to apply to state as well as federal action. The
court refers to this process as selective incorporation.
Here are some very basic principles to remember:
1. The guarantees of the Bill of Rights apply only to state and federal government action. They do
not limit what a company or person in the private sector may do. For example, states may not
impose censorship on the media or limit free speech in a way that offends the First Amendment,
but your boss (in the private sector) may order you not to talk to the media.
2. In some cases, a private company may be regarded as participating in “state action.” For
example, a private defense contractor that gets 90 percent of its business from the federal
government has been held to be public for purposes of enforcing the constitutional right to free
speech (the company had a rule barring its employees from speaking out in public against its
corporate position). It has even been argued that public regulation of private activity is sufficient
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to convert the private into public activity, thus subjecting it to the requirements of due process.
But the Supreme Court rejected this extreme view in 1974 when it refused to require private
power companies, regulated by the state, to give customers a hearing before cutting off
electricity for failure to pay the bill. [1]
3. States have rights, too. While “states rights” was a battle cry of Southern states before the Civil
War, the question of what balance to strike between state sovereignty and federal union has
never been simple. In Kimel v. Florida, for example, the Supreme Court found in the words of
the Eleventh Amendment a basis for declaring that states may not have to obey certain federal
statutes.

First Amendment
In part, the First Amendment states that “Congress shall make no law…abridging the freedom of
speech, or of the press.” The Founding Fathers believed that democracy would work best if
people (and the press) could talk or write freely, without governmental interference. But the
First Amendment was also not intended to be as absolute as it sounded. Oliver Wendell
Holmes’s famous dictum that the law does not permit you to shout “Fire!” in a crowded theater
has seldom been answered, “But why not?” And no one in 1789 thought that defamation laws
(torts for slander and libel) had been made unconstitutional. Moreover, because the apparent
purpose of the First Amendment was to make sure that the nation had a continuing, vigorous
debate over matters political, political speech has been given the highest level of protection over
such other forms of speech as (1) “commercial speech,” (2) speech that can and should be
limited by reasonable “time, place, and manner” restrictions, or (3) obscene speech.
Because of its higher level of protection, political speech can be false, malicious, mean-spirited,
or even a pack of lies. A public official in the United States must be prepared to withstand all
kinds of false accusations and cannot succeed in an action for defamation unless the defendant
has acted with “malice” and “reckless disregard” of the truth. Public figures, such as CEOs of the
largest US banks, must also be prepared to withstand accusations that are false. In any
defamation action, truth is a defense, but a defamation action brought by a public figure or
public official must prove that the defendant not only has his facts wrong but also lies to the
public in a malicious way with reckless disregard of the truth. Celebrities such as Lindsay Lohan
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and Jon Stewart have the same burden to go forward with a defamation action. It is for this
reason that the National Enquirer writes exclusively about public figures, public officials, and
celebrities; it is possible to say many things that aren’t completely true and still have the
protection of the First Amendment.
Political speech is so highly protected that the court has recognized the right of people to
support political candidates through campaign contributions and thus promote the particular
viewpoints and speech of those candidates. Fearing the influence of money on politics, Congress
has from time to time placed limitations on corporate contributions to political campaigns. But
the Supreme Court has had mixed reactions over time. Initially, the court recognized the First
Amendment right of a corporation to donate money, subject to certain limits. [2] In another
case, Austin v. Michigan Chamber of Commerce (1990), the Michigan Campaign Finance Act
prohibited corporations from using treasury money for independent expenditures to support or
oppose candidates in elections for state offices. But a corporation could make such expenditures
if it set up an independent fund designated solely for political purposes. The law was passed on
the assumption that “the unique legal and economic characteristics of corporations necessitate
some regulation of their political expenditures to avoid corruption or the appearance of
corruption.”
The Michigan Chamber of Commerce wanted to support a candidate for Michigan’s House of
Representatives by using general funds to sponsor a newspaper advertisement and argued that
as a nonprofit organization, it was not really like a business firm. The court disagreed and
upheld the Michigan law. Justice Marshall found that the chamber was akin to a business group,
given its activities, linkages with community business leaders, and high percentage of members
(over 75 percent) that were business corporations. Furthermore, Justice Marshall found that the
statute was narrowly crafted and implemented to achieve the important goal of maintaining
integrity in the political process. But as you will see in Citizens United v. Federal Election
Commission(Section 4.6 "Cases"), Austin was overruled; corporations are recognized as
“persons” with First Amendment political speech rights that cannot be impaired by Congress or
the states without some compelling governmental interest with restrictions on those rights that
are “narrowly tailored.”
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Fourth Amendment
The Fourth Amendment says, “all persons shall be secure in their persons, houses, papers, and
effects from unreasonable searches and seizures, and no warrants shall issue, but upon probable
cause, before a magistrate and upon Oath, specifically describing the persons to be searched and
places to be seized.”
The court has read the Fourth Amendment to prohibit only those government searches or
seizures that are “unreasonable.” Because of this, businesses that are in an industry that is
“closely regulated” can be searched more frequently and can be searched without a warrant. In
one case, an auto parts dealer at a junkyard was charged with receiving stolen auto parts. Part of
his defense was to claim that the search that found incriminating evidence was unconstitutional.
But the court found the search reasonable, because the dealer was in a “closely regulated
industry.”
In the 1980s, Dow Chemical objected to an overflight by the US Environmental Protection
Agency (EPA). The EPA had rented an airplane to fly over the Midland, Michigan, Dow plant,
using an aerial mapping camera to photograph various pipes, ponds, and machinery that were
not covered by a roof. Because the court’s precedents allowed governmental intrusions into
“open fields,” the EPA search was ruled constitutional. Because the literal language of the
Fourth Amendment protected “persons, houses, papers, and effects,” anything searched by the
government in “open fields” was reasonable. (The court’s opinion suggested that if Dow had
really wanted privacy from governmental intrusion, it could have covered the pipes and
machinery that were otherwise outside and in open fields.)
Note again that constitutional guarantees like the Fourth Amendment apply to governmental
action. Your employer or any private enterprise is not bound by constitutional limits. For
example, if drug testing of all employees every week is done by government agency, the
employees may have a cause of action to object based on the Fourth Amendment. However, if a
private employer begins the same kind of routine drug testing, employees have no constitutional
arguments to make; they can simply leave that employer, or they may pursue whatever statutory
or common-law remedies are available.

Fifth Amendment
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The Fifth Amendment states, “No person shall be…deprived of life, liberty, or property, without
due process of law; nor shall private property be taken for public use, without just
compensation.”
The Fifth Amendment has three principal aspects: procedural due process, thetakings clause,
and substantive due process. In terms of procedural due process, the amendment prevents
government from arbitrarily taking the life of a criminal defendant. In civil lawsuits, it is also
constitutionally essential that the proceedings be fair. This is why, for example, the defendant
in Burger King v. Rudzewicz had a serious constitutional argument, even though he lost.
The takings clause of the Fifth Amendment ensures that the government does not take private
property without just compensation. In the international setting, governments that take private
property engage in what is called expropriation. The standard under customary international
law is that when governments do that, they must provide prompt, adequate, and effective
compensation. This does not always happen, especially where foreign owners’ property is being
expropriated. The guarantees of the Fifth Amendment (incorporated against state action by the
Fourteenth Amendment) are available to property owners where state, county, or municipal
government uses the power of eminent domain to take private property for public purposes. Just
what is a public purpose is a matter of some debate. For example, if a city were to condemn
economically viable businesses or neighborhoods to construct a baseball stadium with public
money to entice a private enterprise (the baseball team) to stay, is a public purpose being
served?
In Kelo v. City of New London, Mrs. Kelo and other residents fought the city of New London, in
its attempt to use powers of eminent domain to create an industrial park and recreation area
that would have Pfizer & Co. as a principal tenant. [3] The city argued that increasing its tax base
was a sufficient public purpose. In a very close decision, the Supreme Court determined that
New London’s actions did not violate the takings clause. However, political reactions in various
states resulted in a great deal of new state legislation that would limit the scope of public
purpose in eminent domain takings and provide additional compensation to property owners in
many cases.

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In addition to the takings clause and aspects of procedural due process, the Fifth Amendment is
also the source of what is called substantive due process. During the first third of the twentieth
century, the Supreme Court often nullified state and federal laws using substantive due process.
In 1905, for example, in Lochner v. New York, the Supreme Court voided a New York statute
that limited the number of hours that bakers could work in a single week. New York had passed
the law to protect the health of employees, but the court found that this law interfered with the
basic constitutional right of private parties to freely contract with one another. Over the next
thirty years, dozens of state and federal laws were struck down that aimed to improve working
conditions, secure social welfare, or establish the rights of unions. However, in 1934, during the
Great Depression, the court reversed itself and began upholding the kinds of laws it had struck
down earlier.
Since then, the court has employed a two-tiered analysis of substantive due process claims.
Under the first tier, legislation on economic matters, employment relations, and other business
affairs is subject to minimal judicial scrutiny. This means that a law will be overturned only if it
serves no rational government purpose. Under the second tier, legislation concerning
fundamental liberties is subject to “heightened judicial scrutiny,” meaning that a law will be
invalidated unless it is “narrowly tailored to serve a significant government purpose.”
The Supreme Court has identified two distinct categories of fundamental liberties. The first
category includes most of the liberties expressly enumerated in the Bill of Rights. Through a
process known as selective incorporation, the court has interpreted the due process clause of the
Fourteenth Amendment to bar states from denying their residents the most important freedoms
guaranteed in the first ten amendments to the federal Constitution. Only the Third Amendment
right (against involuntary quartering of soldiers) and the Fifth Amendment right to be indicted
by a grand jury have not been made applicable to the states. Because these rights are still not
applicable to state governments, the Supreme Court is often said to have “selectively
incorporated” the Bill of Rights into the due process clause of the Fourteenth Amendment.
The second category of fundamental liberties includes those liberties that are not expressly
stated in the Bill of Rights but that can be seen as essential to the concepts of freedom and
equality in a democratic society. These unstated liberties come from Supreme Court precedents,
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common law, moral philosophy, and deeply rooted traditions of US legal history. The Supreme
Court has stressed that he word libertycannot be defined by a definitive list of rights; rather, it
must be viewed as a rational continuum of freedom through which every aspect of human
behavior is protected from arbitrary impositions and random restraints. In this regard, as the
Supreme Court has observed, the due process clause protects abstract liberty interests, including
the right to personal autonomy, bodily integrity, self-dignity, and self-determination.
These liberty interests often are grouped to form a general right to privacy, which was first
recognized in Griswold v. Connecticut (Section 4.6.1), where the Supreme Court struck down a
state statute forbidding married adults from using, possessing, or distributing contraceptives on
the ground that the law violated the sanctity of the marital relationship. According to Justice
Douglas’s plurality opinion, this penumbra of privacy, though not expressly mentioned in the
Bill of Rights, must be protected to establish a buffer zone or breathing space for those freedoms
that are constitutionally enumerated.
But substantive due process has seen fairly limited use since the 1930s. During the 1990s, the
Supreme Court was asked to recognize a general right to die under the doctrine of substantive
due process. Although the court stopped short of establishing such a far-reaching right, certain
patients may exercise a constitutional liberty to hasten their deaths under a narrow set of
circumstances. In Cruzan v. Missouri Department of Health, the Supreme Court ruled that the
due process clause guarantees the right of competent adults to make advanced directives for the
withdrawal of life-sustaining measures should they become incapacitated by a disability that
leaves them in a persistent vegetative state. [4] Once it has been established by clear and
convincing evidence that a mentally incompetent and persistently vegetative patient made such
a prior directive, a spouse, parent, or other appropriate guardian may seek to terminate any
form of artificial hydration or nutrition.

Fourteenth Amendment: Due Process and Equal Protection Guarantees
The Fourteenth Amendment (1868) requires that states treat citizens of other states with due
process. This can be either an issue of procedural due process (as in Section 3.9 "Cases", Burger
King v. Rudzewicz) or an issue of substantive due process. For substantive due process, consider
what happened in an Alabama court not too long ago. [5]
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The plaintiff, Dr. Ira Gore, bought a new BMW for $40,000 from a dealer in Alabama. He later
discovered that the vehicle’s exterior had been slightly damaged in transit from Europe and had
therefore been repainted by the North American distributor prior to his purchase. The vehicle
was, by best estimates, worth about 10 percent less than he paid for it. The distributor, BMW of
North America, had routinely sold slightly damaged cars as brand new if the damage could be
fixed for less than 3 percent of the cost of the car. In the trial, Dr. Gore sought $4,000 in
compensatory damages and also punitive damages. The Alabama trial jury considered that
BMW was engaging in a fraudulent practice and wanted to punish the defendant for a number of
frauds it estimated at somewhere around a thousand nationwide. The jury awarded not only the
$4,000 in compensatory damages but also $4 million in punitive damages, which was later
reduced to $2 million by the Alabama Supreme Court. On appeal to the US Supreme Court, the
court found that punitive damages may not be “grossly excessive.” If they are, then they violate
substantive due process. Whatever damages a state awards must be limited to what is
reasonably necessary to vindicate the state’s legitimate interest in punishment and deterrence.
“Equal protection of the laws” is a phrase that originates in the Fourteenth Amendment,
adopted in 1868. The amendment provides that no state shall “deny to any person within its
jurisdiction the equal protection of the laws.” This is the equal protection clause. It means that,
generally speaking, governments must treat people equally. Unfair classifications among people
or corporations will not be permitted. A well-known example of unfair classification would be
race discrimination: requiring white children and black children to attend different public
schools or requiring “separate but equal” public services, such as water fountains or restrooms.
Yet despite the clear intent of the 1868 amendment, “separate but equal” was the law of the land
until Brown v. Board of Education (1954). [6]
Governments make classifications every day, so not all classifications can be illegal under the
equal protection clause. People with more income generally pay a greater percentage of their
income in taxes. People with proper medical training are licensed to become doctors; people
without that training cannot be licensed and commit a criminal offense if they do practice
medicine. To know what classifications are permissible under the Fourteenth Amendment, we
need to know what is being classified. The court has created three classifications, and the
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outcome of any equal protection case can usually be predicted by knowing how the court is likely
to classify the case:
•

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

•

Intermediate scrutiny: gender. Government classifications are sometimes upheld.

•

Strict scrutiny: race, ethnicity, and fundamental rights. Classifications based on any of these are
almost never upheld.
Under minimal scrutiny for economic and social regulation, laws that regulate economic or
social issues are presumed valid and will be upheld if they are rationally related to legitimate
goals of government. So, for example, if the city of New Orleans limits the number of street
vendors to some rational number (more than one but fewer than the total number that could
possibly fit on the sidewalks), the local ordinance would not be overturned as a violation of
equal protection.
Under intermediate scrutiny, the city of New Orleans might limit the number of street vendors
who are men. For example, suppose that the city council decreed that all street vendors must be
women, thinking that would attract even more tourism. A classification like this, based on sex,
will have to meet a sterner test than a classification resulting from economic or social regulation.
A law like this would have to substantially relate to important government objectives.
Increasingly, courts have nullified government sex classifications as societal concern with
gender equality has grown. (See Shannon Faulkner’s case against The Citadel, an all-male state
school.)[7]
Suppose, however, that the city of New Orleans decided that no one of Middle Eastern heritage
could drive a taxicab or be a street vendor. That kind of classification would be examined with
strict scrutiny to see if there was any compelling justification for it. As noted, classifications such
as this one are almost never upheld. The law would be upheld only if it were necessary to
promote a compelling state interest. Very few laws that have a racial or ethnic classification meet
that test.
The strict scrutiny test will be applied to classifications involving racial and ethnic criteria as
well as classifications that interfere with a fundamental right. In Palmore v. Sidoti, the state
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refused to award custody to the mother because her new spouse was racially different from the
child. [8]This practice was declared unconstitutional because the state had made a racial
classification; this was presumptively invalid, and the government could not show a compelling
need to enforce such a classification through its law. An example of government action
interfering with a fundamental right will also receive strict scrutiny. When New York State gave
an employment preference to veterans who had been state residents at the time of entering the
military, the court declared that veterans who were new to the state were less likely to get jobs
and that therefore the statute interfered with the right to travel, which was deemed a
fundamental right. [9]

KEY TAKEAWAY

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

EXERCISES

1. John Hanks works at ProLogis. The company decides to institute a drug-testing policy. John is
a good and longtime employee but enjoys smoking marijuana on the weekends. The drug
testing will involve urine samples and, semiannually, a hair sample. It is nearly certain that
the drug-testing protocol that ProLogis proposes will find that Hanks is a marijuana user. The
company has made it clear that it will have zero tolerance for any kind of nonprescribed
controlled substances. John and several fellow employees wish to go to court to challenge
the proposed testing as “an unreasonable search and seizure.” Can he possibly succeed?
2. Larry Reed, majority leader in the Senate, is attacked in his reelection campaign by a series of
ads sponsored by a corporation (Global Defense, Inc.) that does not like his voting record.
The corporation is upset that Reed would not write a special provision that would favor
Global Defense in a defense appropriations bill. The ads run constantly on television and
radio in the weeks immediately preceding election day and contain numerous falsehoods.
For example, in order to keep the government running financially, Reed found it necessary to
vote for a bill that included a last-minute rider that defunded a small government program
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for the handicapped, sponsored by someone in the opposing party that wanted to privatize
all programs for the handicapped. The ad is largely paid for by Global Defense and depicts a
handicapped child being helped by the existing program and large letters saying “Does Larry
Reed Just Not Care?” The ad proclaims that it is sponsored by Citizens Who Care for a Better
Tomorrow. Is this protected speech? Why or why not? Can Reed sue for defamation? Why or
why not?

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

4.6 Cases
Griswold v. Connecticut
Griswold v. Connecticut
381 U.S. 479 (U.S. Supreme Court 1965)
A nineteenth-century Connecticut law made the use, possession, or distribution of birth control
devices illegal. The law also prohibited anyone from giving information about such devices.
The executive director and medical director of a planned parenthood association were found
guilty of giving out such information to a married couple that wished to delay having children
for a few years. The directors were fined $100 each.
They appealed throughout the Connecticut state court system, arguing that the state law
violated (infringed) a basic or fundamental right of privacy of a married couple: to live
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together and have sex together without the restraining power of the state to tell them they may
legally have intercourse but not if they use condoms or other birth control devices. At each
level (trial court, court of appeals, and Connecticut Supreme Court), the Connecticut courts
upheld the constitutionality of the convictions.
Plurality Opinion by Justice William O. Douglass
We do not sit as a super legislature to determine the wisdom, need, and propriety of laws that
touch economic problems, business affairs, or social conditions. The [Connecticut] law,
however, operates directly on intimate relation of husband and wife and their physician’s role in
one aspect of that relation.
[Previous] cases suggest that specific guarantees in the Bill of Rights have penumbras, formed
by emanations from those guarantees that help give them life and substance.…Various
guarantees create zones of privacy. The right of association contained in the penumbra of the
First Amendment is one.…The Third Amendment in its prohibition against the quartering of
soldiers “in any house” in time of peace without the consent of the owner is another facet of that
privacy. The Fourth Amendment explicitly affirms the “right of the people to be secure in their
persons, houses, papers and effects, against unreasonable searches and seizures.” The Fifth
Amendment in its Self-Incrimination Clause enables the citizen to create a zone of privacy which
the government may not force him to surrender to his detriment. The Ninth Amendment
provides: “The enumeration in the Constitution, of certain rights, shall not be construed to deny
or disparage others retained by the people.”
The Fourth and Fifth Amendments were described…as protection against all governmental
invasions “of the sanctity of a man’s home and the privacies of life.” We recently referred
in Mapp v. Ohio…to the Fourth Amendment as creating a “right to privacy, no less important
than any other right carefully and particularly reserved to the people.”
[The law in question here], in forbidding the use of contraceptives rather than regulating their
manufacture or sale, seeks to achieve its goals by having a maximum destructive impact on [the
marital] relationship. Such a law cannot stand.…Would we allow the police to search the sacred
precincts of marital bedrooms for telltale signs of the use of contraceptives? The very idea is
repulsive to the notions of privacy surrounding the marital relationship.
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We deal with a right of privacy older than the Bill of Rights—older than our political parties,
older than our school system. Marriage is a coming together for better or for worse, hopefully
enduring, and intimate to the degree of being sacred. It is an association that promotes a way of
life, not causes; a harmony in living, not political faiths; a bilateral loyalty, not commercial or
social projects. Yet it is an association for as noble a purpose as any involved in our prior
decisions.
Mr. Justice Stewart, whom Mr. Justice Black joins, dissenting.
Since 1879 Connecticut has had on its books a law which forbids the use of contraceptives by
anyone. I think this is an uncommonly silly law. As a practical matter, the law is obviously
unenforceable, except in the oblique context of the present case. As a philosophical matter, I
believe the use of contraceptives in the relationship of marriage should be left to personal and
private choice, based upon each individual’s moral, ethical, and religious beliefs. As a matter of
social policy, I think professional counsel about methods of birth control should be available to
all, so that each individual’s choice can be meaningfully made. But we are not asked in this case
to say whether we think this law is unwise, or even asinine. We are asked to hold that it violates
the United States Constitution. And that I cannot do.
In the course of its opinion the Court refers to no less than six Amendments to the Constitution:
the First, the Third, the Fourth, the Fifth, the Ninth, and the Fourteenth. But the Court does not
say which of these Amendments, if any, it thinks is infringed by this Connecticut law.
…
As to the First, Third, Fourth, and Fifth Amendments, I can find nothing in any of them to
invalidate this Connecticut law, even assuming that all those Amendments are fully applicable
against the States. It has not even been argued that this is a law “respecting an establishment of
religion, or prohibiting the free exercise thereof.” And surely, unless the solemn process of
constitutional adjudication is to descend to the level of a play on words, there is not involved
here any abridgment of “the freedom of speech, or of the press; or the right of the people
peaceably to assemble, and to petition the Government for a redress of grievances.” No soldier
has been quartered in any house. There has been no search, and no seizure. Nobody has been
compelled to be a witness against himself.
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The Court also quotes the Ninth Amendment, and my Brother Goldberg’s concurring opinion
relies heavily upon it. But to say that the Ninth Amendment has anything to do with this case is
to turn somersaults with history. The Ninth Amendment, like its companion the Tenth, which
this Court held “states but a truism that all is retained which has not been surrendered,” United
States v. Darby, 312 U.S. 100, 124, was framed by James Madison and adopted by the States
simply to make clear that the adoption of the Bill of Rights did not alter the plan that
the Federal Government was to be a government of express and limited powers, and that all
rights and powers not delegated to it were retained by the people and the individual States. Until
today no member of this Court has ever suggested that the Ninth Amendment meant anything
else, and the idea that a federal court could ever use the Ninth Amendment to annul a law
passed by the elected representatives of the people of the State of Connecticut would have
caused James Madison no little wonder.
What provision of the Constitution, then, does make this state law invalid? The Court says it is
the right of privacy “created by several fundamental constitutional guarantees.” With all
deference, I can find no such general right of privacy in the Bill of Rights, in any other part of the
Constitution, or in any case ever before decided by this Court.
At the oral argument in this case we were told that the Connecticut law does not “conform to
current community standards.” But it is not the function of this Court to decide cases on the
basis of community standards. We are here to decide cases “agreeably to the Constitution and
laws of the United States.” It is the essence of judicial duty to subordinate our own personal
views, our own ideas of what legislation is wise and what is not. If, as I should surely hope, the
law before us does not reflect the standards of the people of Connecticut, the people of
Connecticut can freely exercise their true Ninth and Tenth Amendment rights to persuade their
elected representatives to repeal it. That is the constitutional way to take this law off the books.

CASE QUESTIONS

1. Which opinion is the strict constructionist opinion here—Justice Douglas’s or that of Justices
Stewart and Black?
2. What would have happened if the Supreme Court had allowed the Connecticut Supreme
Court decision to stand and followed Justice Black’s reasoning? Is it likely that the citizens of

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Connecticut would have persuaded their elected representatives to repeal the law
challenged here?

Wickard v. Filburn
Wickard v. Filburn
317 U.S. 111 (U.S. Supreme Court 1942)
Mr. Justice Jackson delivered the opinion of the Court.
Mr. Filburn for many years past has owned and operated a small farm in Montgomery County,
Ohio, maintaining a herd of dairy cattle, selling milk, raising poultry, and selling poultry and
eggs. It has been his practice to raise a small acreage of winter wheat, sown in the Fall and
harvested in the following July; to sell a portion of the crop; to feed part to poultry and livestock
on the farm, some of which is sold; to use some in making flour for home consumption; and to
keep the rest for the following seeding.
His 1941 wheat acreage allotment was 11.1 acres and a normal yield of 20.1 bushels of wheat an
acre. He sowed, however, 23 acres, and harvested from his 11.9 acres of excess acreage 239
bushels, which under the terms of the Act as amended on May 26, 1941, constituted farm
marketing excess, subject to a penalty of 49 cents a bushel, or $117.11 in all.
The general scheme of the Agricultural Adjustment Act of 1938 as related to wheat is to control
the volume moving in interstate and foreign commerce in order to avoid surpluses and
shortages and the consequent abnormally low or high wheat prices and obstructions to
commerce. [T]he Secretary of Agriculture is directed to ascertain and proclaim each year a
national acreage allotment for the next crop of wheat, which is then apportioned to the states
and their counties, and is eventually broken up into allotments for individual farms.
It is urged that under the Commerce Clause of the Constitution, Article I, § 8, clause 3, Congress
does not possess the power it has in this instance sought to exercise. The question would merit
little consideration since our decision in United States v. Darby, 312 U.S. 100, sustaining the
federal power to regulate production of goods for commerce, except for the fact that this Act
extends federal regulation to production not intended in any part for commerce but wholly for
consumption on the farm.

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

I
Appellee Consolidated Freightways Corporation of Delaware (Consolidated) is one of the largest
common carriers in the country: it offers service in 48 States under a certificate of public
convenience and necessity issued by the Interstate Commerce Commission. Among other routes,
Consolidated carries commodities through Iowa on Interstate 80, the principal east-west route
linking New York, Chicago, and the west coast, and on Interstate 35, a major north-south route.
Consolidated mainly uses two kinds of trucks. One consists of a three-axle tractor pulling a 40foot two-axle trailer. This unit, commonly called a single, or “semi,” is 55 feet in length overall.
Such trucks have long been used on the Nation’s highways. Consolidated also uses a two-axle
tractor pulling a single-axle trailer which, in turn, pulls a single-axle dolly and a second singleaxle trailer. This combination, known as a double, or twin, is 65 feet long overall. Many trucking
companies, including Consolidated, increasingly prefer to use doubles to ship certain kinds of
commodities. Doubles have larger capacities, and the trailers can be detached and routed
separately if necessary. Consolidated would like to use 65-foot doubles on many of its trips
through Iowa.
The State of Iowa, however, by statute, restricts the length of vehicles that may use its highways.
Unlike all other States in the West and Midwest, Iowa generally prohibits the use of 65-foot
doubles within its borders.
…
Because of Iowa’s statutory scheme, Consolidated cannot use its 65-foot doubles to move
commodities through the State. Instead, the company must do one of four things: (i) use 55-foot
singles; (ii) use 60-foot doubles; (iii) detach the trailers of a 65-foot double and shuttle each
through the State separately; or (iv) divert 65-foot doubles around Iowa. Dissatisfied with these
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options, Consolidated filed this suit in the District Court averring that Iowa’s statutory scheme
unconstitutionally burdens interstate commerce. Iowa defended the law as a reasonable safety
measure enacted pursuant to its police power. The State asserted that 65-foot doubles are more
dangerous than 55-foot singles and, in any event, that the law promotes safety and reduces road
wear within the State by diverting much truck traffic to other states.
In a 14-day trial, both sides adduced evidence on safety and on the burden on interstate
commerce imposed by Iowa’s law. On the question of safety, the District Court found that the
“evidence clearly establishes that the twin is as safe as the semi.” 475 F.Supp. 544, 549 (SD Iowa
1979). For that reason, “there is no valid safety reason for barring twins from Iowa’s highways
because of their configuration.…The evidence convincingly, if not overwhelmingly, establishes
that the 65-foot twin is as safe as, if not safer than, the 60-foot twin and the 55-foot semi.…”
“Twins and semis have different characteristics. Twins are more maneuverable, are less sensitive
to wind, and create less splash and spray. However, they are more likely than semis to jackknife
or upset. They can be backed only for a short distance. The negative characteristics are not such
that they render the twin less safe than semis overall. Semis are more stable, but are more likely
to ‘rear-end’ another vehicle.”
In light of these findings, the District Court applied the standard we enunciated inRaymond
Motor Transportation, Inc. v. Rice, 434 U.S. 429 (1978), and concluded that the state law
impermissibly burdened interstate commerce: “[T]he balance here must be struck in favor of the
federal interests. The total effect of the law as a safety measure in reducing accidents and
casualties is so slight and problematical that it does not outweigh the national interest in
keeping interstate commerce free from interferences that seriously impede it.”
The Court of Appeals for the Eighth Circuit affirmed. 612 F.2d 1064 (1979). It accepted the
District Court’s finding that 65-foot doubles were as safe as 55-foot singles. Id. at 1069. Thus,
the only apparent safety benefit to Iowa was that resulting from forcing large trucks to detour
around the State, thereby reducing overall truck traffic on Iowa’s highways. The Court of
Appeals noted that this was not a constitutionally permissible interest. It also commented that
the several statutory exemptions identified above, such as those applicable to border cities and
the shipment of livestock, suggested that the law, in effect, benefited Iowa residents at the
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expense of interstate traffic. Id. at 1070-1071. The combination of these exemptions weakened
the presumption of validity normally accorded a state safety regulation. For these reasons, the
Court of Appeals agreed with the District Court that the Iowa statute unconstitutionally
burdened interstate commerce.
Iowa appealed, and we noted probable jurisdiction. 446 U.S. 950 (1980). We now affirm.

II
It is unnecessary to review in detail the evolution of the principles of Commerce Clause
adjudication. The Clause is both a “prolific ‘ of national power and an equally prolific source of
conflict with legislation of the state[s].” H. P. Hood & Sons, Inc. v. Du Mond, 336 U.S. 525, 336
U.S. 534 (1949). The Clause permits Congress to legislate when it perceives that the national
welfare is not furthered by the independent actions of the States. It is now well established, also,
that the Clause itself is “a limitation upon state power even without congressional
implementation.” Hunt v. Washington Apple Advertising Comm’n, 432 U.S. 333 at 350 (1977).
The Clause requires that some aspects of trade generally must remain free from interference by
the States. When a State ventures excessively into the regulation of these aspects of commerce, it
“trespasses upon national interests,” Great A&P Tea Co. v. Cottrell, 424 U.S. 366, 424 U.S. 373
(1976), and the courts will hold the state regulation invalid under the Clause alone.
The Commerce Clause does not, of course, invalidate all state restrictions on commerce. It has
long been recognized that, “in the absence of conflicting legislation by Congress, there is a
residuum of power in the state to make laws governing matters of local concern which
nevertheless in some measure affect interstate commerce or even, to some extent, regulate
it.” Southern Pacific Co. v. Arizona, 325 U.S. 761 (1945).
The extent of permissible state regulation is not always easy to measure. It may be said with
confidence, however, that a State’s power to regulate commerce is never greater than in matters
traditionally of local concern. Washington Apple Advertising Comm’n, supra at 432 U.S. 350.
For example, regulations that touch upon safety—especially highway safety—are those that “the
Court has been most reluctant to invalidate.” Raymond, supra at 434 U.S. 443 (and other cases
cited). Indeed, “if safety justifications are not illusory, the Court will not second-guess legislative
judgment about their importance in comparison with related burdens on interstate
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commerce.”Raymond, supra at 434 U.S. at 449. Those who would challenge such bona fide
safety regulations must overcome a “strong presumption of validity.” Bibb v. Navajo Freight
Lines, Inc., 359 U.S. 520 at (1959).
But the incantation of a purpose to promote the public health or safety does not insulate a state
law from Commerce Clause attack. Regulations designed for that salutary purpose nevertheless
may further the purpose so marginally, and interfere with commerce so substantially, as to be
invalid under the Commerce Clause. In the Court’s recent unanimous decision in Raymond we
declined to “accept the State’s contention that the inquiry under the Commerce Clause is ended
without a weighing of the asserted safety purpose against the degree of interference with
interstate commerce.” This “weighing” by a court requires—and indeed the constitutionality of
the state regulation depends on—“a sensitive consideration of the weight and nature of the state
regulatory concern in light of the extent of the burden imposed on the course of interstate
commerce.” Id. at 434 U.S. at 441; accord, Pike v. Bruce Church, Inc., 397 U.S. 137 at 142
(1970); Bibb, supra, at 359 U.S. at 525-530.

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

A

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

B
Consolidated, meanwhile, demonstrated that Iowa’s law substantially burdens interstate
commerce. Trucking companies that wish to continue to use 65-foot doubles must route them
around Iowa or detach the trailers of the doubles and ship them through separately.
Alternatively, trucking companies must use the smaller 55-foot singles or 65-foot doubles
permitted under Iowa law. Each of these options engenders inefficiency and added expense. The
record shows that Iowa’s law added about $12.6 million each year to the costs of trucking
companies.
Consolidated alone incurred about $2 million per year in increased costs.
In addition to increasing the costs of the trucking companies (and, indirectly, of the service to
consumers), Iowa’s law may aggravate, rather than, ameliorate, the problem of highway
accidents. Fifty-five-foot singles carry less freight than 65-foot doubles. Either more small trucks
must be used to carry the same quantity of goods through Iowa or the same number of larger
trucks must drive longer distances to bypass Iowa. In either case, as the District Court noted, the
restriction requires more highway miles to be driven to transport the same quantity of goods.
Other things being equal, accidents are proportional to distance traveled. Thus, if 65-foot
doubles are as safe as 55-foot singles, Iowa’s law tends to increase the number of accidents and
to shift the incidence of them from Iowa to other States.

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

CASE QUESTIONS

1. Under the Constitution, what gives Iowa the right to make rules regarding the size or
configuration of trucks upon highways within the state?
2. Did Iowa try to exempt trucking lines based in Iowa, or was the statutory rule
nondiscriminatory as to the origin of trucks that traveled on Iowa highways?
3. Are there any federal size or weight standards noted in the case? Is there any kind of truck
size or weight that could be limited by Iowa law, or must Iowa simply accept federal
standards or, if none, impose no standards at all?

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

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[In] 1972, the North Carolina Board of Agriculture adopted an administrative regulation, unique
in the 50 States, which in effect required all closed containers of apples shipped into or sold in
the State to display either the applicable USDA grade or a notice indicating no classification.
State grades were expressly prohibited. In addition to its obvious consequence—prohibiting the
display of Washington State apple grades on containers of apples shipped into North Carolina—
the regulation presented the Washington apple industry with a marketing problem of potentially
nationwide significance. Washington apple growers annually ship in commerce approximately
40 million closed containers of apples, nearly 500,000 of which eventually find their way into
North Carolina, stamped with the applicable Washington State variety and grade. [Compliance]
with North Carolina’s unique regulation would have required Washington growers to obliterate
the printed labels on containers shipped to North Carolina, thus giving their product a damaged
appearance. Alternatively, they could have changed their marketing practices to accommodate
the needs of the North Carolina market, i.e., repack apples to be shipped to North Carolina in
containers bearing only the USDA grade, and/or store the estimated portion of the harvest
destined for that market in such special containers. As a last resort, they could discontinue the
use of the preprinted containers entirely. None of these costly and less efficient options was very
attractive to the industry. Moreover, in the event a number of other States followed North
Carolina’s lead, the resultant inability to display the Washington grades could force the
Washington growers to abandon the State’s expensive inspection and grading system which
their customers had come to know and rely on over the 60-odd years of its existence.…
Unsuccessful in its attempts to secure administrative relief [with North Carolina], the
Commission instituted this action challenging the constitutionality of the statute. [The] District
Court found that the North Carolina statute, while neutral on its face, actually discriminated
against Washington State growers and dealers in favor of their local counterparts [and]
concluded that this discrimination [was] not justified by the asserted local interest—the
elimination of deception and confusion from the marketplace—arguably furthered by the
[statute].
…

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[North Carolina] maintains that [the] burdens on the interstate sale of Washington apples were
far outweighed by the local benefits flowing from what they contend was a valid exercise of
North Carolina’s [police powers]. Prior to the statute’s enactment,…apples from 13 different
States were shipped into North Carolina for sale. Seven of those States, including [Washington],
had their own grading systems which, while differing in their standards, used similar descriptive
labels (e.g., fancy, extra fancy, etc.). This multiplicity of inconsistent state grades [posed]
dangers of deception and confusion not only in the North Carolina market, but in the Nation as
a whole. The North Carolina statute, appellants claim, was enacted to eliminate this source of
deception and confusion. [Moreover], it is contended that North Carolina sought to accomplish
this goal of uniformity in an evenhanded manner as evidenced by the fact that its statute applies
to all apples sold in closed containers in the State without regard to their point of origin.
[As] the appellants properly point out, not every exercise of state authority imposing some
burden on the free flow of commerce is invalid, [especially] when the State acts to protect its
citizenry in matters pertaining to the sale of foodstuffs. By the same token, however, a finding
that state legislation furthers matters of legitimate local concern, even in the health and
consumer protection areas, does not end the inquiry. Rather, when such state legislation comes
into conflict with the Commerce Clause’s overriding requirement of a national “common
market,” we are confronted with the task of effecting an accommodation of the competing
national and local interests. We turn to that task.
As the District Court correctly found, the challenged statute has the practical effect of not only
burdening interstate sales of Washington apples, but also discriminating against them. This
discrimination takes various forms. The first, and most obvious, is the statute’s consequence of
raising the costs of doing business in the North Carolina market for Washington apple growers
and dealers, while leaving those of their North Carolina counterparts unaffected. [This]
disparate effect results from the fact that North Carolina apple producers, unlike their
Washington competitors, were not forced to alter their marketing practices in order to comply
with the statute. They were still free to market their wares under the USDA grade or none at all
as they had done prior to the statute’s enactment. Obviously, the increased costs imposed by the
statute would tend to shield the local apple industry from the competition of Washington apple
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growers and dealers who are already at a competitive disadvantage because of their great
distance from the North Carolina market.
Second, the statute has the effect of stripping away from the Washington apple industry the
competitive and economic advantages it has earned for itself through its expensive inspection
and grading system. The record demonstrates that the Washington apple-grading system has
gained nationwide acceptance in the apple trade. [The record] contains numerous affidavits
[stating a] preference [for] apples graded under the Washington, as opposed to the USDA,
system because of the former’s greater consistency, its emphasis on color, and its supporting
mandatory inspections. Once again, the statute had no similar impact on the North Carolina
apple industry and thus operated to its benefit.
Third, by prohibiting Washington growers and dealers from marketing apples under their
State’s grades, the statute has a leveling effect which insidiously operates to the advantage of
local apple producers. [With] free market forces at work, Washington sellers would normally
enjoy a distinct market advantage vis-à-vis local producers in those categories where the
Washington grade is superior. However, because of the statute’s operation, Washington apples
which would otherwise qualify for and be sold under the superior Washington grades will now
have to be marketed under their inferior USDA counterparts. Such “downgrading” offers the
North Carolina apple industry the very sort of protection against competing out-of-state
products that the Commerce Clause was designed to prohibit. At worst, it will have the effect of
an embargo against those Washington apples in the superior grades as Washington dealers
withhold them from the North Carolina market. At best, it will deprive Washington sellers of the
market premium that such apples would otherwise command.
Despite the statute’s facial neutrality, the Commission suggests that its discriminatory impact on
interstate commerce was not an unintended by-product, and there are some indications in the
record to that effect. The most glaring is the response of the North Carolina Agriculture
Commissioner to the Commission’s request for an exemption following the statute’s passage in
which he indicated that before he could support such an exemption, he would “want to have the
sentiment from our apple producers since they were mainly responsible for this legislation
being passed.” [Moreover], we find it somewhat suspect that North Carolina singled out only
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closed containers of apples, the very means by which apples are transported in commerce, to
effectuate the statute’s ostensible consumer protection purpose when apples are not generally
sold at retail in their shipping containers. However, we need not ascribe an economic protection
motive to the North Carolina Legislature to resolve this case; we conclude that the challenged
statute cannot stand insofar as it prohibits the display of Washington State grades even if
enacted for the declared purpose of protecting consumers from deception and fraud in the
marketplace.
…
Finally, we note that any potential for confusion and deception created by the Washington
grades was not of the type that led to the statute’s enactment. Since Washington grades are in all
cases equal or superior to their USDA counterparts, they could only “deceive” or “confuse” a
consumer to his benefit, hardly a harmful result.
In addition, it appears that nondiscriminatory alternatives to the outright ban of Washington
State grades are readily available. For example, North Carolina could effectuate its goal by
permitting out-of-state growers to utilize state grades only if they also marked their shipments
with the applicable USDA label. In that case, the USDA grade would serve as a benchmark
against which the consumer could evaluate the quality of the various state grades.…
[The court affirmed the lower court’s holding that the North Carolina statute was
unconstitutional.]

CASE QUESTIONS

1. Was the North Carolina law discriminatory on its face? Was it, possibly, an undue burden on
interstate commerce? Why wouldn’t it be?
2. What evidence was there of discriminatory intent behind the North Carolina law? Did that
evidence even matter? Why or why not?

Citizens United v. Federal Election Commission
Citizens United v. Federal Election Commission
588 U.S. ____; 130 S.Ct. 876 (U.S. Supreme Court 2010)
Justice Kennedy delivered the opinion of the Court.

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Federal law prohibits corporations and unions from using their general treasury funds to make
independent expenditures for speech defined as an “electioneering communication” or for
speech expressly advocating the election or defeat of a candidate. 2 U.S.C. §441b. Limits on
electioneering communications were upheld inMcConnell v. Federal Election Comm’n, 540 U.S.
93, 203–209 (2003). The holding ofMcConnell rested to a large extent on an earlier case, Austin
v. Michigan Chamber of Commerce, 494 U.S. 652 (1990). Austin had held that political speech
may be banned based on the speaker’s corporate identity.
In this case we are asked to reconsider Austin and, in effect, McConnell. It has been noted that
“Austin was a significant departure from ancient First Amendment principles,” Federal Election
Comm’n v. Wisconsin Right to Life, Inc., 551 U.S. 449, 490 (2007) (WRTL) (Scalia, J.,
concurring in part and concurring in judgment). We agree with that conclusion and hold
that stare decisis does not compel the continued acceptance of Austin. The Government may
regulate corporate political speech through disclaimer and disclosure requirements, but it may
not suppress that speech altogether. We turn to the case now before us.

I
A
Citizens United is a nonprofit corporation. It has an annual budget of about $12 million. Most of
its funds are from donations by individuals; but, in addition, it accepts a small portion of its
funds from for-profit corporations.
In January 2008, Citizens United released a film entitled Hillary: The Movie. We refer to the
film as Hillary. It is a 90-minute documentary about then-Senator Hillary Clinton, who was a
candidate in the Democratic Party’s 2008 Presidential primary elections. Hillary mentions
Senator Clinton by name and depicts interviews with political commentators and other persons,
most of them quite critical of Senator Clinton.…
In December 2007, a cable company offered, for a payment of $1.2 million, to
makeHillary available on a video-on-demand channel called “Elections ’08.”…Citizens United
was prepared to pay for the video-on-demand; and to promote the film, it produced two 10second ads and one 30-second ad for Hillary. Each ad includes a short (and, in our view,
pejorative) statement about Senator Clinton, followed by the name of the movie and the movie’s
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Website address. Citizens United desired to promote the video-on-demand offering by running
advertisements on broadcast and cable television.

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

C
Citizens United wanted to make Hillary available through video-on-demand within 30 days of
the 2008 primary elections. It feared, however, that both the film and the ads would be covered
by §441b’s ban on corporate-funded independent expenditures, thus subjecting the corporation
to civil and criminal penalties under §437g. In December 2007, Citizens United sought
declaratory and injunctive relief against the FEC. It argued that (1) §441b is unconstitutional as
applied to Hillary; and (2) BCRA’s disclaimer and disclosure requirements, BCRA §§201 and
311, are unconstitutional as applied to Hillary and to the three ads for the movie.
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The District Court denied Citizens United’s motion for a preliminary injunction, and then
granted the FEC’s motion for summary judgment.
…
The court held that §441b was facially constitutional under McConnell, and that §441b was
constitutional as applied to Hillary because it was “susceptible of no other interpretation than to
inform the electorate that Senator Clinton is unfit for office, that the United States would be a
dangerous place in a President Hillary Clinton world, and that viewers should vote against her.”
530 F. Supp. 2d, at 279. The court also rejected Citizens United’s challenge to BCRA’s disclaimer
and disclosure requirements. It noted that “the Supreme Court has written approvingly of
disclosure provisions triggered by political speech even though the speech itself was
constitutionally protected under the First Amendment.” Id. at 281.

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

III
The First Amendment provides that “Congress shall make no law…abridging the freedom of
speech.” Laws enacted to control or suppress speech may operate at different points in the
speech process.…The law before us is an outright ban, backed by criminal sanctions. Section
441b makes it a felony for all corporations—including nonprofit advocacy corporations—either
to expressly advocate the election or defeat of candidates or to broadcast electioneering
communications within 30 days of a primary election and 60 days of a general election. Thus,
the following acts would all be felonies under §441b: The Sierra Club runs an ad, within the
crucial phase of 60 days before the general election, that exhorts the public to disapprove of a
Congressman who favors logging in national forests; the National Rifle Association publishes a
book urging the public to vote for the challenger because the incumbent U.S. Senator supports a
handgun ban; and the American Civil Liberties Union creates a Web site telling the public to
vote for a Presidential candidate in light of that candidate’s defense of free speech. These
prohibitions are classic examples of censorship.
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Section 441b is a ban on corporate speech notwithstanding the fact that a PAC created by a
corporation can still speak. PACs are burdensome alternatives; they are expensive to administer
and subject to extensive regulations. For example, every PAC must appoint a treasurer, forward
donations to the treasurer promptly, keep detailed records of the identities of the persons
making donations, preserve receipts for three years, and file an organization statement and
report changes to this information within 10 days.
And that is just the beginning. PACs must file detailed monthly reports with the FEC, which are
due at different times depending on the type of election that is about to occur.…
PACs have to comply with these regulations just to speak. This might explain why fewer than
2,000 of the millions of corporations in this country have PACs. PACs, furthermore, must exist
before they can speak. Given the onerous restrictions, a corporation may not be able to establish
a PAC in time to make its views known regarding candidates and issues in a current campaign.
Section 441b’s prohibition on corporate independent expenditures is thus a ban on speech. As a
“restriction on the amount of money a person or group can spend on political communication
during a campaign,” that statute “necessarily reduces the quantity of expression by restricting
the number of issues discussed, the depth of their exploration, and the size of the audience
reached.” Buckley v. Valeo, 424 U.S. 1 at 19 (1976).…
Speech is an essential mechanism of democracy, for it is the means to hold officials accountable
to the people. See Buckley, supra, at 14–15 (“In a republic where the people are sovereign, the
ability of the citizenry to make informed choices among candidates for office is essential.”) The
right of citizens to inquire, to hear, to speak, and to use information to reach consensus is a
precondition to enlightened self-government and a necessary means to protect it. The First
Amendment “‘has its fullest and most urgent application’ to speech uttered during a campaign
for political office.”
For these reasons, political speech must prevail against laws that would suppress it, whether by
design or inadvertence. Laws that burden political speech are “subject to strict scrutiny,” which
requires the Government to prove that the restriction “furthers a compelling interest and is
narrowly tailored to achieve that interest.”
…
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The Court has recognized that First Amendment protection extends to corporations. This
protection has been extended by explicit holdings to the context of political speech. Under the
rationale of these precedents, political speech does not lose First Amendment protection “simply
because its source is a corporation.” Bellotti, supra, at 784. The Court has thus rejected the
argument that political speech of corporations or other associations should be treated differently
under the First Amendment simply because such associations are not “natural persons.”
The purpose and effect of this law is to prevent corporations, including small and nonprofit
corporations, from presenting both facts and opinions to the public. This makes Austin’s
antidistortion rationale all the more an aberration. “[T]he First Amendment protects the right of
corporations to petition legislative and administrative bodies.” Bellotti, 435 U.S., at 792, n. 31.…
Even if §441b’s expenditure ban were constitutional, wealthy corporations could still lobby
elected officials, although smaller corporations may not have the resources to do so. And
wealthy individuals and unincorporated associations can spend unlimited amounts on
independent expenditures. See, e.g., WRTL, 551 U.S., at 503–504 (opinion of Scalia, J.) (“In the
2004 election cycle, a mere 24 individuals contributed an astounding total of $142 million to [26
U.S.C. §527 organizations]”). Yet certain disfavored associations of citizens—those that have
taken on the corporate form—are penalized for engaging in the same political speech.
When Government seeks to use its full power, including the criminal law, to command where a
person may get his or her information or what distrusted source he or she may not hear, it uses
censorship to control thought. This is unlawful. The First Amendment confirms the freedom to
think for ourselves.
What we have said also shows the invalidity of other arguments made by the Government. For
the most part relinquishing the anti-distortion rationale, the Government falls back on the
argument that corporate political speech can be banned in order to prevent corruption or its
appearance.…
When Congress finds that a problem exists, we must give that finding due deference; but
Congress may not choose an unconstitutional remedy. If elected officials succumb to improper
influences from independent expenditures; if they surrender their best judgment; and if they put
expediency before principle, then surely there is cause for concern. We must give weight to
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attempts by Congress to seek to dispel either the appearance or the reality of these influences.
The remedies enacted by law, however, must comply with the First Amendment; and, it is our
law and our tradition that more speech, not less, is the governing rule. An outright ban on
corporate political speech during the critical preelection period is not a permissible remedy.
Here Congress has created categorical bans on speech that are asymmetrical to preventing quid
pro quocorruption.
Our precedent is to be respected unless the most convincing of reasons demonstrates that
adherence to it puts us on a course that is sure error. “Beyond workability, the relevant factors in
deciding whether to adhere to the principle of stare decisis include the antiquity of the
precedent, the reliance interests at stake, and of course whether the decision was well reasoned.”
[citing prior cases]
These considerations counsel in favor of rejecting Austin, which itself contravened this Court’s
earlier precedents in Buckley and Bellotti. “This Court has not hesitated to overrule decisions
offensive to the First Amendment.” WRTL, 551 U.S., at 500 (opinion of Scalia, J.). “[S]tare
decisis is a principle of policy and not a mechanical formula of adherence to the latest
decision.” Helvering v. Hallock, 309 U.S. 106 at 119 (1940).
Austin is undermined by experience since its announcement. Political speech is so ingrained in
our culture that speakers find ways to circumvent campaign finance laws. See, e.g., McConnell,
540 U.S., at 176–177 (“Given BCRA’s tighter restrictions on the raising and spending of soft
money, the incentives…to exploit [26 U.S.C. §527] organizations will only increase”). Our
Nation’s speech dynamic is changing, and informative voices should not have to circumvent
onerous restrictions to exercise their First Amendment rights. Speakers have become adept at
presenting citizens with sound bites, talking points, and scripted messages that dominate the
24-hour news cycle. Corporations, like individuals, do not have monolithic views. On certain
topics corporations may possess valuable expertise, leaving them the best equipped to point out
errors or fallacies in speech of all sorts, including the speech of candidates and elected officials.
Rapid changes in technology—and the creative dynamic inherent in the concept of free
expression—counsel against upholding a law that restricts political speech in certain media or by
certain speakers. Today, 30-second television ads may be the most effective way to convey a
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political message. Soon, however, it may be that Internet sources, such as blogs and social
networking Web sites, will provide citizens with significant information about political
candidates and issues. Yet, §441b would seem to ban a blog post expressly advocating the
election or defeat of a candidate if that blog were created with corporate funds. The First
Amendment does not permit Congress to make these categorical distinctions based on the
corporate identity of the speaker and the content of the political speech.
Due consideration leads to this conclusion: Austin should be and now is overruled. We return to
the principle established in Buckley and Bellotti that the Government may not suppress political
speech on the basis of the speaker’s corporate identity. No sufficient governmental interest
justifies limits on the political speech of nonprofit or for-profit corporations.

[IV. Omitted]
V
When word concerning the plot of the movie Mr. Smith Goes to Washington reached the circles
of Government, some officials sought, by persuasion, to discourage its distribution. See
Smoodin, “Compulsory” Viewing for Every Citizen: Mr. Smith and the Rhetoric of Reception, 35
Cinema Journal 3, 19, and n. 52 (Winter 1996) (citing Mr. Smith Riles Washington, Time, Oct.
30, 1939, p. 49); Nugent, Capra’s Capitol Offense, N. Y. Times, Oct. 29, 1939, p. X5.
Under Austin, though, officials could have done more than discourage its distribution—they
could have banned the film. After all, it, likeHillary, was speech funded by a corporation that
was critical of Members of Congress.Mr. Smith Goes to Washington may be fiction and
caricature; but fiction and caricature can be a powerful force.
Modern day movies, television comedies, or skits on YouTube.com might portray public officials
or public policies in unflattering ways. Yet if a covered transmission during the blackout period
creates the background for candidate endorsement or opposition, a felony occurs solely because
a corporation, other than an exempt media corporation, has made the “purchase, payment,
distribution, loan, advance, deposit, or gift of money or anything of value” in order to engage in
political speech. 2 U.S.C. §431(9)(A)(i). Speech would be suppressed in the realm where its
necessity is most evident: in the public dialogue preceding a real election. Governments are

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

CASE QUESTIONS

1. What does the case say about disclosure? Corporations have a right of free speech under the
First Amendment and may exercise that right through unrestricted contributions of money to
political parties and candidates. Can the government condition that right by requiring that
the parties and candidates disclose to the public the amount and origin of the contribution?
What would justify such a disclosure requirement?
2. Are a corporation’s contributions to political parties and candidates tax deductible as a
business expense? Should they be?
3. How is the donation of money equivalent to speech? Is this a strict construction of the
Constitution to hold that it is?
4. Based on the Court’s description of the Austin case, what purpose do you think
the Austin court was trying to achieve by limiting corporate campaign contributions? Was
that purpose consistent (or inconsistent) with anything in the Constitution, or is the
Constitution essentially silent on this issue?

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4.7 Summary and Exercises
Summary

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

EXERCISES

1. For many years, the Supreme Court believed that “commercial speech” was entitled
to less protection than other forms of speech. One defining element of
commercial speech is that its dominant theme is to propose a commercial
transaction. This kind of speech is protected by the First Amendment, but the
government is permitted to regulate it more closely than other forms of speech.
However, the government must make reasonable distinctions, must narrowly
tailor the rules restricting commercial speech, and must show that government
has a legitimate goal that the law furthers.
Edward Salib owned a Winchell’s Donut House in Mesa, Arizona. To attract
customers, he displayed large signs in store windows. The city ordered him to

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remove the signs because they violated the city’s sign code, which prohibited
covering more than 30 percent of a store’s windows with signs. Salib sued,
claiming that the sign code violated his First Amendment rights. What was the
result, and why?
2. Jennifer is a freshman at her local public high school. Her sister, Jackie, attends a nearby
private high school. Neither school allows them to join its respective wrestling team; only
boys can wrestle at either school. Do either of them have a winning case based on the equal
protection clause of the Fourteenth Amendment?
3. The employees of the US Treasury Department that work the border crossing between the
United States and Mexico learned that they will be subject to routine drug testing. The
customs bureau, which is a division of the treasury department, announces this policy along
with its reasoning: since customs agents must routinely search for drugs coming into the
United States, it makes sense that border guards must themselves be completely drug-free.
Many border guards do not use drugs, have no intention of using drugs, and object to the
invasion of their privacy. What is the constitutional basis for their objection?
4. Happy Time Chevrolet employs Jim Bydalek as a salesman. Bydalek takes part in a Gay Pride
March in Los Angeles, is interviewed by a local news camera crew, and reports that he is gay
and proud of it. His employer is not, and he is fired. Does he have any constitutional causes
of action against his employer?
5. You begin work at the Happy-Go-Lucky Corporation on Halloween. On your second day at
work, you wear a political button on your coat, supporting your choice for US senator in the
upcoming election. Your boss, who is of a different political persuasion, looks at the button
and says, “Take that stupid button off or you’re fired.” Has your boss violated your
constitutional rights?
6. David Lucas paid $975,000 for two residential parcels on the Isle of Palms near Charleston,
South Carolina. His intention was to build houses on them. Two years later, the South
Carolina legislature passed a statute that prohibited building beachfront properties. The
purpose was to leave the dunes system in place to mitigate the effects of hurricanes and
strong storms. The South Carolina Coastal Commission created the rules and regulations with
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substantial input from the community and from experts and with protection of the dune
system primarily in mind. People had been building on the shoreline for years, with harmful
results to localities and the state treasury. When Lucas applied for permits to build two
houses near the shoreline, his permits were rejected. He sued, arguing that the South
Carolina legislation had effectively “taken” his property. At trial, South Carolina conceded
that because of the legislation, Lucas’s property was effectively worth zero. Has there been a
taking under the Fifth Amendment (as incorporated through the Fourteenth Amendment),
and if so, what should the state owe to Lucas? Suppose that Lucas could have made an
additional $1 million by building a house on each of his parcels. Is he entitled to recover his
original purchase price or his potential profits?

SELF-TEST QUESTIONS

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

places an undue burden on interstate commerce

b. promotes the public health, safety, morals, or general welfare of Colorado
c. regulates economic activities within the state’s borders
d. a and b
e. b and c
The state legislature in Maine enacts a law that directly conflicts with a
federal law. Mapco Industries, located in Portland, Maine, cannot comply with
both the state and the federal law.
a.

Because of federalism, the state law will have priority, as long as Maine is

using its police powers.
b. Because there’s a conflict, both laws are invalid; the state and the federal
government will have to work out a compromise of some sort.
c. The federal law preempts the state law.
d. Both laws govern concurrently.
Hannah, who lives in Ada, is the owner of Superior Enterprises, Inc. She
believes that certain actions in the state of Ohio infringe on her federal

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constitutional rights, especially those found in the Bill of Rights. Most of these
rights apply to the states under
a.

the supremacy clause

b. the protection clause
c. the due process clause of the Fourteenth Amendment
d. the Tenth Amendment
Minnesota enacts a statute that bans all advertising that is in “bad taste,”
“vulgar,” or “indecent.” In Michigan, Aaron Calloway and his brother, Clarence
“Cab” Calloway, create unique beer that they decide to call Old Fart Ale. In their
marketing, the brothers have a label in which an older man in a dirty T-shirt is
sitting in easy chair, looking disheveled and having a three-day growth of stubble
on his chin. It appears that the man is in the process of belching. He is also holding
a can of Old Fart Ale. The Minnesota liquor commission orders all Minnesota
restaurants, bars, and grocery stores to remove Old Fart Ale from their shelves.
The state statute and the commission’s order are likely to be held by a court to be
a.

a violation of the Tenth Amendment

b. a violation of the First Amendment
c. a violation of the Calloways’ right to equal protection of the laws
d. a violation of the commerce clause, since only the federal laws can prevent an
article of commerce from entering into Minnesota’s market
Raunch Unlimited, a Virginia partnership, sells smut whenever and
wherever it can. Some of its material is “obscene” (meeting the Supreme Court’s
definition under Miller v. California) and includes child pornography. North
Carolina has a statute that criminalizes obscenity. What are possible results if a
store in Raleigh, North Carolina, carries Raunch merchandise?
a.

The partners could be arrested in North Carolina and may well be

convicted.
b. The materials in Raleigh may be the basis for a criminal conviction.
c. The materials are protected under the First Amendment’s right of free speech.
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d. The materials are protected under state law.
e. a and b

SELF-TEST ANSWERS

1. a
2. c
3. c
4. b
5. e

Chapter 5
Administrative Law
LEARNING OBJECTIVES

After reading this chapter, you should be able to do the following:
1. Understand the purpose served by federal administrative agencies.
2. Know the difference between executive branch agencies and independent agencies.
3. Understand the political control of agencies by the president and Congress.
4. Describe how agencies make rules and conduct hearings.
5. Describe how courts can be used to challenge administrative rulings.
From the 1930s on, administrative agencies, law, and procedures have virtually remade our
government and much of private life. Every day, business must deal with rules and decisions of
state and federal administrative agencies. Informally, such rules are often called regulations,
and they differ (only in their source) from laws passed by Congress and signed into law by the
president. The rules created by agencies are voluminous: thousands of new regulations pour
forth each year. The overarching question of whether there is too much regulation—or the wrong
kind of regulation—of our economic activities is an important one but well beyond the scope of
this chapter, in which we offer an overview of the purpose of administrative agencies, their
structure, and their impact on business.

5.1 Administrative Agencies: Their Structure and Powers
LEARNING OBJECTIVES

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1. Explain the reasons why we have federal administrative agencies.
2. Explain the difference between executive branch agencies and independent agencies.
3. Describe the constitutional issue that questions whether administrative agencies could have
authority to make enforceable rules that affect business.

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

Why Regulate the Economy at All?
The market often does not work properly, as economists often note. Monopolies, for example,
happen in the natural course of human events but are not always desirable. To fix this, wellconceived and objectively enforced competition law (what is called antitrust law in the United
States) is needed.
Negative externalities must be “fixed,” as well. For example, as we see in tort law (Chapter 7
"Introduction to Tort Law"), people and business organizations often do things that impose
costs (damages) on others, and the legal system will try—through the award of compensatory
damages—to make fair adjustments. In terms of the ideal conditions for a free market, think of
tort law as the legal system’s attempt to compensate for negative externalities: those costs
imposed on people who have not voluntarily consented to bear those costs.
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In terms of freedoms to enter or leave the market, the US constitutional guarantees of equal
protection can prevent local, state, and federal governments from imposing discriminatory rules
for commerce that would keep minorities, women, and gay people from full participation in
business. For example, if the small town of Xenophobia, Colorado, passed a law that required all
business owners and their employees to be Christian, heterosexual, and married, the equal
protection clause (as well as numerous state and federal equal opportunity employment laws)
would empower plaintiffs to go to court and have the law struck down as unconstitutional.
Knowing that information is power, we will see many laws administered by regulatory agencies
that seek to level the playing field of economic competition by requiring disclosure of the most
pertinent information for consumers (consumer protection laws), investors (securities laws),
and citizens (e.g., the toxics release inventory laws in environmental law).

Ideal Conditions for a Free Market

1. There are many buyers and many sellers, and none of them has a substantial share of the
market.
2. All buyers and sellers in the market are free to enter the market or leave it.
3. All buyers and all sellers have full and perfect knowledge of what other buyers and sellers are up
to, including knowledge of prices, quantity, and quality of all goods being bought or sold.
4. The goods being sold in the market are similar enough to each other that participants do not
have strong preferences as to which seller or buyer they deal with.
5. The costs and benefits of making or using the goods that are exchanged in the market are borne
only by those who buy or sell those goods and not by third parties or people “external” to the
market transaction. (That is, there are no “externalities.”)
6. All buyers and sellers are utility maximizers; each participant in the market tries to get as much
as possible for as little as possible.
7. There are no parties, institutions, or governmental units regulating the price, quantity, or
quality of any of the goods being bought and sold in the market.
In short, some forms of legislation and regulation are needed to counter a tendency toward
consolidation of economic power and discriminatory attitudes toward certain individuals and

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groups and to insist that people and companies clean up their own messes and not hide
information that would empower voluntary choices in the free market.
But there are additional reasons to regulate. For example, in economic systems, it is likely for
natural monopolies to occur. These are where one firm can most efficiently supply all of the
good or service. Having duplicate (or triplicate) systems for supplying electricity, for example,
would be inefficient, so most states have a public utilities commission to determine both price
and quality of service. This is direct regulation.
Sometimes destructive competition can result if there is no regulation. Banking and insurance
are good examples of this. Without government regulation of banks (setting standards and
methods), open and fierce competition would result in widespread bank failures. That would
erode public confidence in banks and business generally. The current situation (circa 2011) of six
major banks that are “too big to fail” is, however, an example of destructive noncompetition.
Other market imperfections can yield a demand for regulation. For example, there is a need to
regulate frequencies for public broadcast on radio, television, and other wireless transmissions
(for police, fire, national defense, etc.). Many economists would also list an adequate supply of
public goods as something that must be created by government. On its own, for example, the
market would not provide public goods such as education, a highway system, lighthouses, a
military for defense.
True laissez-faire capitalism—a market free from any regulation—would not try to deal with
market imperfections and would also allow people to freely choose products, services, and other
arrangements that historically have been deemed socially unacceptable. These would include
making enforceable contracts for the sale and purchase of persons (slavery), sexual services,
“street drugs” such as heroin or crack cocaine, votes for public office, grades for this course in
business law, and even marriage partnership.
Thus the free market in actual terms—and not in theory—consists of commerce legally
constrained by what is economically desirable and by what is socially desirable as well. Public
policy objectives in the social arena include ensuring equal opportunity in employment,
protecting employees from unhealthy or unsafe work environments, preserving environmental
quality and resources, and protecting consumers from unsafe products. Sometimes these
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objectives are met by giving individuals statutory rights that can be used in bringing a complaint
(e.g., Title VII of the Civil Rights Act of 1964, for employment discrimination), and sometimes
they are met by creating agencies with the right to investigate and monitor and enforce statutory
law and regulations created to enforce such law (e.g., the Environmental Protection Agency, for
bringing a lawsuit against a polluting company).

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

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

Powers of Agencies
Agencies have a variety of powers. Many of the original statutes that created them, like the
Federal Communications Act, gave them licensing power. No party can enter into the productive
activity covered by the act without prior license from the agency—for example, no utility can
start up a nuclear power plant unless first approved by the Nuclear Regulatory Commission. In
recent years, the move toward deregulation of the economy has led to diminution of some
licensing power. Many agencies also have the authority to set the rates charged by companies
subject to the agency’s jurisdiction. Finally, the agencies can regulate business practices. The
FTC has general jurisdiction over all business in interstate commerce to monitor and root out
“unfair acts” and “deceptive practices.” The Securities and Exchange Commission (SEC)
oversees the issuance of corporate securities and other investments and monitors the practices
of the stock exchanges.
Unlike courts, administrative agencies are charged with the responsibility of carrying out a
specific assignment or reaching a goal or set of goals. They are not to remain neutral on the
various issues of the day; they must act. They have been given legislative powers because in a
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society growing ever more complex, Congress does not know how to legislate with the kind of
detail that is necessary, nor would it have the time to approach all the sectors of society even if it
tried. Precisely because they are to do what general legislative bodies cannot do, agencies are
specialized bodies. Through years of experience in dealing with similar problems they
accumulate a body of knowledge that they can apply to accomplish their statutory duties.
All administrative agencies have two different sorts of personnel. The heads, whether a single
administrator or a collegial body of commissioners, are political appointees and serve for
relatively limited terms. Below them is a more or less permanent staff—the bureaucracy. Much
policy making occurs at the staff level, because these employees are in essential control of
gathering facts and presenting data and argument to the commissioners, who wield the ultimate
power of the agencies.

The Constitution and Agencies
Congress can establish an agency through legislation. When Congress gives powers to an agency,
the legislation is known as an enabling act. The concept that Congress can delegate power to an
agency is known as the delegation doctrine. Usually, the agency will have all three kinds of
power: executive, legislative, and judicial. (That is, the agency can set the rules that business
must comply with, can investigate and prosecute those businesses, and can hold administrative
hearings for violations of those rules. They are, in effect, rule maker, prosecutor, and judge.)
Because agencies have all three types of governmental powers, important constitutional
questions were asked when Congress first created them. The most important question was
whether Congress was giving away its legislative power. Was the separation of powers violated if
agencies had power to make rules that were equivalent to legislative statutes?
In 1935, in Schechter Poultry Corp. v. United States, the Supreme Court overturned the
National Industrial Recovery Act on the ground that the congressional delegation of power was
too broad. [1] Under the law, industry trade groups were granted the authority to devise a code of
fair competition for the entire industry, and these codes became law if approved by the
president. No administrative body was created to scrutinize the arguments for a particular code,
to develop evidence, or to test one version of a code against another. Thus it was
unconstitutional for the Congress to transfer all of its legislative powers to an agency. In later
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decisions, it was made clear that Congress could delegate some of its legislative powers, but only
if the delegation of authority was not overly broad.
Still, some congressional enabling acts are very broad, such as the enabling legislation for the
Occupational Safety and Health Administration (OSHA), which is given the authority to make
rules to provide for safe and healthful working conditions in US workplaces. Such a broad
initiative power gives OSHA considerable discretion. But, as noted in Section 5.2 "Controlling
Administrative Agencies", there are both executive and judicial controls over administrative
agency activities, as well as ongoing control by Congress through funding and the continuing
oversight of agencies, both in hearings and through subsequent statutory amendments.

KEY TAKEAWAY

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

EXERCISES

1. Explain why Congress needs to delegate rule-making authority to a specialized agency.
2. Explain why there is any need for interference in the market by means of laws or regulations.

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

5.2 Controlling Administrative Agencies
LEARNING OBJECTIVES

1. Understand how the president controls administrative agencies.
2. Understand how Congress controls administrative agencies.
3. Understand how the courts can control administrative agencies.
During the course of the past seventy years, a substantial debate has been conducted, often in
shrill terms, about the legitimacy of administrative lawmaking. One criticism is that agencies are

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“captured” by the industry they are directed to regulate. Another is that they overregulate,
stifling individual initiative and the ability to compete. During the 1960s and 1970s, a massive
outpouring of federal law created many new agencies and greatly strengthened the hands of
existing ones. In the late 1970s during the Carter administration, Congress began to deregulate
American society, and deregulation increased under the Reagan administration. But the
accounting frauds of WorldCom, Enron, and others led to the Sarbanes-Oxley Act of 2002, and
the financial meltdown of 2008 has led to reregulation of the financial sector. It remains to be
seen whether the Deepwater Horizon oil blowout of 2010 will lead to more environmental
regulations or a rethinking on how to make agencies more effective regulators.
Administrative agencies are the focal point of controversy because they are policy-making
bodies, incorporating facets of legislative, executive, and judicial power in a hybrid form that fits
uneasily at best in the framework of American government (seeFigure 5.1 "Major Administrative
Agencies of the United States"). They are necessarily at the center of tugging and hauling by the
legislature, the executive branch, and the judiciary, each of which has different means of
exercising political control over them. In early 1990, for example, the Bush administration
approved a Food and Drug Administration regulation that limited disease-prevention claims by
food packagers, reversing a position by the Reagan administration in 1987 permitting such
claims.

Figure 5.1 Major Administrative Agencies of the United States

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Legislative Control
Congress can always pass a law repealing a regulation that an agency promulgates. Because this
is a time-consuming process that runs counter to the reason for creating administrative bodies,
it happens rarely. Another approach to controlling agencies is to reduce or threaten to reduce
their appropriations. By retaining ultimate control of the purse strings, Congress can exercise
considerable informal control over regulatory policy.

Executive Control
The president (or a governor, for state agencies) can exercise considerable control over agencies
that are part of his cabinet departments and that are not statutorily defined as independent.
Federal agencies, moreover, are subject to the fiscal scrutiny of the Office of Management and
Budget (OMB), subject to the direct control of the president. Agencies are not permitted to go
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directly to Congress for increases in budget; these requests must be submitted through the
OMB, giving the president indirect leverage over the continuation of administrators’ programs
and policies.

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

KEY TAKEAWAY

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

EXERCISES

1. Find the website of the Consumer Product Safety Commission (CPSC). Identify from that site
a product that has been banned by the CPSC for sale in the United States. What reasons were
given for its exclusion from the US market?
2. What has Congress told the CPSC to do in its enabling act? Is this a clear enough mandate to
guide the agency? What could Congress do if the CPSC does something that may be outside
of the scope of its powers? What can an affected business do?

5.3 The Administrative Procedure Act
LEARNING OBJECTIVES

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

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

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Certain types of agency actions that have a direct impact on individuals need not be filtered
through a full-scale hearing. Safety and quality inspections (grading of food, inspection of
airplanes) can be made on the spot by skilled inspectors. Certain licenses can be administered
through tests without a hearing (a test for a driver’s license), and some decisions can be made by
election of those affected (labor union elections).

Rulemaking
Trial-type hearings generally impose on particular parties liabilities based on past or present
facts. Because these cases will serve as precedents, they are a partial guide to future conduct by
others. But they do not directly apply to nonparties, who may argue in a subsequent case that
their conduct does not fit within the holding announced in the case. Agencies can affect future
conduct far more directly by announcing rules that apply to all who come within the agency’s
jurisdiction.
The acts creating most of the major federal agencies expressly grant them authority to engage in
rulemaking. This means, in essence, authority to legislate. The outpouring of federal regulations
has been immense. The APA directs agencies about to engage in rulemaking to give notice in
the <em class="emphasis">Federal Register</em class="emphasis"> of their intent to do so.
The Federal Register is published daily, Monday through Friday, in Washington, DC, and
contains notice of various actions, including announcements of proposed rulemaking and
regulations as adopted. The notice must specify the time, place, and nature of the rulemaking
and offer a description of the proposed rule or the issues involved. Any interested person or
organization is entitled to participate by submitting written “data, views or arguments.”
Agencies are not legally required to air debate over proposed rules, though they often do so.
The procedure just described is known as “informal” rulemaking. A different procedure is
required for “formal” rulemaking, defined as those instances in which the enabling legislation
directs an agency to make rules “on the record after opportunity for an agency hearing.” When
engaging in formal rulemaking, agencies must hold an adversary hearing.
Administrative regulations are not legally binding unless they are published. Agencies must
publish in the Federal Register the text of final regulations, which ordinarily do not become
effective until thirty days later. Every year the annual output of regulations is collected and
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reprinted in
the <em class="emphasis">Code of Federal Regulations (CFR)</em class="emphasis">, a
multivolume paperback series containing all federal rules and regulations keyed to the fifty titles
of the US Code (the compilation of all federal statutes enacted by Congress and grouped
according to subject).

KEY TAKEAWAY

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

EXERCISES

1. Go to http://www.regulations.gov/search/Regs/home.html#home. Browse the site. Find a
topic that interests you, and then find a proposed regulation. Notice how comments on the
proposed rule are invited.
2. Why would there be a trial by an administrative agency? Describe the process.

5.4 Administrative Burdens on Business Operations
LEARNING OBJECTIVES

1. Describe the paperwork burden imposed by administrative agencies.
2. Explain why agencies have the power of investigation, and what limits there are to that
power.
3. Explain the need for the Freedom of Information Act and how it works in the US legal system.

The Paperwork Burden
The administrative process is not frictionless. The interplay between government agency and
private enterprise can burden business operations in a number of ways. Several of these are
noted in this section.
Deciding whether and how to act are not decisions that government agencies reach out of the
blue. They rely heavily on information garnered from business itself. Dozens of federal agencies
require corporations to keep hundreds of types of records and to file numerous periodic reports.
The Commission on Federal Paperwork, established during the Ford administration to consider
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ways of reducing the paperwork burden, estimated in its final report in 1977 that the total
annual cost of federal paperwork amounted to $50 billion and that the 10,000 largest business
enterprises spent $10 billion annually on paperwork alone. The paperwork involved in licensing
a single nuclear power plant, the commission said, costs upward of $15 million.
Not surprisingly, therefore, businesses have sought ways of avoiding requests for data. Since the
1940s, the Federal Trade Commission (FTC) has collected economic data on corporate
performance from individual companies for statistical purposes. As long as each company
engages in a single line of business, data are comparable. When the era of conglomerates began
in the 1970s, with widely divergent types of businesses brought together under the roof of a
single corporate parent, the data became useless for purposes of examining the competitive
behavior of different industries. So the FTC ordered dozens of large companies to break out their
economic information according to each line of business that they carried on. The companies
resisted, but the US Court of Appeals for the District of Columbia Circuit, where much of the
litigation over federal administrative action is decided, directed the companies to comply with
the commission’s order, holding that the Federal Trade Commission Act clearly permits the
agency to collect information for investigatory purposes. [1]
In 1980, responding to cries that businesses, individuals, and state and local governments were
being swamped by federal demands for paperwork, Congress enacted the Paperwork Reduction
Act. It gives power to the federal Office of Management and Budget (OMB) to develop uniform
policies for coordinating the gathering, storage, and transmission of all the millions of reports
flowing in each year to the scores of federal departments and agencies requesting information.
These reports include tax and Medicare forms, financial loan and job applications,
questionnaires of all sorts, compliance reports, and tax and business records. The OMB was
given the power also to determine whether new kinds of information are needed. In effect, any
agency that wants to collect new information from outside must obtain the OMB’s approval.

Inspections
No one likes surprise inspections. A section of the Occupational Safety and Health Act of 1970
empowers agents of the Occupational Safety and Health Administration (OSHA) to search work
areas for safety hazards and for violations of OSHA regulations. The act does not specify
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whether inspectors are required to obtain search warrants, required under the Fourth
Amendment in criminal cases. For many years, the government insisted that surprise
inspections are not unreasonable and that the time required to obtain a warrant would defeat
the surprise element. The Supreme Court finally ruled squarely on the issue in 1978.
In Marshall v. Barlow’s, Inc., the court held that no less than private individuals, businesses are
entitled to refuse police demands to search the premises unless a court has issued a search
warrant. [2]
But where a certain type of business is closely regulated, surprise inspections are the norm, and
no warrant is required. For example, businesses with liquor licenses that might sell to minors
are subject to both overt and covert inspections (e.g., an undercover officer may “search” a
liquor store by sending an underage patron to the store). Or a junkyard that specializes in
automobiles and automobile parts may also be subject to surprise inspections, on the rationale
that junkyards are highly likely to be active in the resale of stolen autos or stolen auto parts. [3]
It is also possible for inspections to take place without a search warrant and without the
permission of the business. For example, the Environmental Protection Agency (EPA) wished to
inspect parts of the Dow Chemical facility in Midland, Michigan, without the benefit of warrant.
When they were refused, agents of the EPA obtained a fairly advanced aerial mapping camera
and rented an airplane to fly over the Dow facility. Dow went to court for a restraining order
against the EPA and a request to have the EPA turn over all photographs taken. But the
Supreme Court ruled that the areas photographed were “open fields” and not subject to the
protections of the Fourth Amendment. [4]

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

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

•

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

•

records exempted from disclosure by another statute

•

interagency memos or decisions reflecting the deliberative process

•

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

•

information compiled for law enforcement purposes

•

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

KEY TAKEAWAY

Government agencies, in order to do their jobs, collect a great deal of information from
businesses. This can range from routine paperwork (often burdensome) to inspections, those
with warrants and those without. Surprise inspections are allowed for closely regulated

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industries but are subject to Fourth Amendment requirements in general. Some information
collected by agencies can be accessed using the Freedom of Information Act.

EXERCISES

1. Give two examples of a closely regulated industry. Explain why some warrantless searches
would be allowed.
2. Find out why FOIA requests often take months or years to accomplish.

[1] In re FTC Line of Business Report Litigation, 595 F.2d 685 (D.C. Cir. 1978).
[2] Marshall v. Barlow’s, Inc., 436 US 307 (1978).
[3] New York v. Burger, 482 US 691 (1987).
[4] Dow Chemical Co. v. United States Environmental Protection Agency, 476 US 227 (1986).

5.5 The Scope of Judicial Review

LEARNING OBJECTIVES

1. Describe the “exhaustion of remedies” requirement.
2. Detail various strategies for obtaining judicial review of agency rules.
3. Explain under what circumstances it is possible to sue the government.
Neither an administrative agency’s adjudication nor its issuance of a regulation is necessarily
final. Most federal agency decisions are appealable to the federal circuit courts. To get to court,
the appellant must overcome numerous complex hurdles. He or she must have standing—that is,
be in some sense directly affected by the decision or regulation. The case must be ripe for
review; administrative remedies such as further appeal within the agency must have been
exhausted.

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

Strategies for Obtaining Judicial Review
Once these obstacles are cleared, the court may look at one of a series of claims. The appellant
might assert that the agency’s action was ultra vires (UL-truh VI-reez)—beyond the scope of its
authority as set down in the statute. This attack is rarely successful. A somewhat more successful
claim is that the agency did not abide by its own procedures or those imposed upon it by the
Administrative Procedure Act.
In formal rulemaking, the appellant also might insist that the agency lacked substantial evidence
for the determination that it made. If there is virtually no evidence to support the agency’s
findings, the court may reverse. But findings of fact are not often overturned by the courts.
Likewise, there has long been a presumption that when an agency issues a regulation, it has the
authority to do so: those opposing the regulation must bear a heavy burden in court to upset it.
This is not a surprising rule, for otherwise courts, not administrators, would be the authors of
regulations. Nevertheless, regulations cannot exceed the scope of the authority conferred by
Congress on the agency. In an important 1981 case before the Supreme Court, the issue was
whether the secretary of labor, acting through the Occupational Health and Safety
Administration (OSHA), could lawfully issue a standard limiting exposure to cotton dust in the
workplace without first undertaking a cost-benefit analysis. A dozen cotton textile
manufacturers and the American Textile Manufacturers Institute, representing 175 companies,
asserted that the cotton dust standard was unlawful because it did not rationally relate the
benefits to be derived from the standard to the costs that the standard would impose.
See Section 5.6 "Cases",American Textile Manufacturers Institute v. Donovan.
In summary, then, an individual or a company may (after exhaustion of administrative
remedies) challenge agency action where such action is the following:
•

not in accordance with the agency’s scope of authority
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•

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

•

not in accordance with the substantial evidence test

•

unwarranted by the facts

•

arbitrary, capricious, an abuse of discretion, or otherwise not in accord with the law
Section 706 of the Administrative Procedure Act sets out those standards. While it is difficult to
show that an agency’s action is arbitrary and capricious, there are cases that have so held. For
example, after the Reagan administration set aside a Carter administration rule from the
National Highway Traffic and Safety Administration on passive restraints in automobiles, State
Farm and other insurance companies challenged the reversal as arbitrary and capricious.
Examining the record, the Supreme Court found that the agency had failed to state enough
reasons for its reversal and required the agency to review the record and the rule and provide
adequate reasons for its reversal. State Farm and other insurance companies thus gained a legal
benefit by keeping an agency rule that placed costs on automakers for increased passenger
safety and potentially reducing the number of injury claims from those it had insured. [1]

Suing the Government
In the modern administrative state, the range of government activity is immense, and
administrative agencies frequently get in the way of business enterprise. Often, bureaucratic
involvement is wholly legitimate, compelled by law; sometimes, however, agencies or
government officials may overstep their bounds, in a fit of zeal or spite. What recourse does the
private individual or company have?
Mainly for historical reasons, it has always been more difficult to sue the government than to
sue private individuals or corporations. For one thing, the government has long had recourse to
the doctrine of sovereign immunity as a shield against lawsuits. Yet in 1976, Congress amended
the Administrative Procedure Act to waive any federal claim to sovereign immunity in cases of
injunctive or other nonmonetary relief. Earlier, in 1946, in the Federal Tort Claims Act,
Congress had waived sovereign immunity of the federal government for most tort claims for
money damages, although the act contains several exceptions for specific agencies (e.g., one
cannot sue for injuries resulting from fiscal operations of the Treasury Department or for
injuries stemming from activities of the military in wartime). The act also contains a major
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exception for claims “based upon [an official’s] exercise or performance or the failure to exercise
or perform a discretionary function or duty.” This exception prevents suits against parole boards
for paroling dangerous criminals who then kill or maim in the course of another crime and suits
against officials whose decision to ship explosive materials by public carrier leads to mass deaths
and injuries following an explosion en route. [2]
In recent years, the Supreme Court has been stripping away the traditional immunity enjoyed by
many government officials against personal suits. Some government employees—judges,
prosecutors, legislators, and the president, for example—have absolute immunity against suit for
official actions. But many public administrators and government employees have at best a
qualified immunity. Under a provision of the Civil Rights Act of 1871 (so-called Section 1983
actions), state officials can be sued in federal court for money damages whenever “under color of
any state law” they deprive anyone of his rights under the Constitution or federal law. In Bivens
v. Six Unknown Federal Narcotics Agents, the Supreme Court held that federal agents may be
sued for violating the plaintiff’s Fourth Amendment rights against an unlawful search of his
home. [3] Subsequent cases have followed this logic to permit suits for violations of other
constitutional provisions. This area of the law is in a state of flux, and it is likely to continue to
evolve.
Sometimes damage is done to an individual or business because the government has given out
erroneous information. For example, suppose that Charles, a bewildered, disabled navy
employee, is receiving a federal disability annuity. Under the regulations, he would lose his
pension if he took a job that paid him in each of two succeeding years more than 80 percent of
what he earned in his old navy job. A few years later, Congress changed the law, making him
ineligible if he earned more than 80 percent in anyone year. For many years, Charles earned
considerably less than the ceiling amount. But then one year he got the opportunity to make
some extra money. Not wishing to lose his pension, he called an employee relations specialist in
the US Navy and asked how much he could earn and still keep his pension. The specialist gave
him erroneous information over the telephone and then sent him an out-of-date form that said
Charles could safely take on the extra work. Unfortunately, as it turned out, Charles did exceed
the salary limit, and so the government cut off his pension during the time he earned too much.
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Charles sues to recover his lost pension. He argues that he relied to his detriment on false
information supplied by the navy and that in fairness the government should be estopped from
denying his claim.
Unfortunately for Charles, he will lose his case. In Office of Personnel Management v.
Richmond, the Supreme Court reasoned that it would be unconstitutional to permit
recovery. [4] The appropriations clause of Article I says that federal money can be paid out only
through an appropriation made by law. The law prevented this particular payment to be made.
If the court were to make an exception, it would permit executive officials in effect to make
binding payments, even though unauthorized, simply by misrepresenting the facts. The harsh
reality, therefore, is that mistakes of the government are generally held against the individual,
not the government, unless the law specifically provides for recompense (as, for example, in the
Federal Tort Claims Act just discussed).

KEY TAKEAWAY

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

EXERCISES

1. Why would US courts require that someone seeking judicial review of an agency order first
exhaust administrative remedies?
2. On the Internet, find a case where someone has successfully sued the US government under
the Federal Tort Claims Act. What kind of case was it? Did the government argue sovereign
immunity? Does sovereign immunity even make sense to you?

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

5.6 Cases
Marshall v. Barlow’s, Inc.
Marshall v. Barlow’s, Inc.
436 U.S. 307 (U.S. Supreme Court 1978)
MR. JUSTICE WHITE delivered the opinion of the Court.
Section 8(a) of the Occupational Safety and Health Act of 1970 (OSHA or Act) empowers agents
of the Secretary of Labor (Secretary) to search the work area of any employment facility within
the Act’s jurisdiction. The purpose of the search is to inspect for safety hazards and violations of
OSHA regulations. No search warrant or other process is expressly required under the Act.
On the morning of September 11, 1975, an OSHA inspector entered the customer service area of
Barlow’s, Inc., an electrical and plumbing installation business located in Pocatello, Idaho. The
president and general manager, Ferrol G. “Bill” Barlow, was on hand; and the OSHA inspector,
after showing his credentials, informed Mr. Barlow that he wished to conduct a search of the
working areas of the business. Mr. Barlow inquired whether any complaint had been received
about his company. The inspector answered no, but that Barlow’s, Inc., had simply turned up in
the agency’s selection process. The inspector again asked to enter the nonpublic area of the
business; Mr. Barlow’s response was to inquire whether the inspector had a search warrant.
The inspector had none. Thereupon, Mr. Barlow refused the inspector admission to the
employee area of his business. He said he was relying on his rights as guaranteed by the Fourth
Amendment of the United States Constitution.
Three months later, the Secretary petitioned the United States District Court for the District of
Idaho to issue an order compelling Mr. Barlow to admit the inspector. The requested order was
issued on December 30, 1975, and was presented to Mr. Barlow on January 5, 1976. Mr. Barlow
again refused admission, and he sought his own injunctive relief against the warrantless
searches assertedly permitted by OSHA.…The Warrant Clause of the Fourth Amendment
protects commercial buildings as well as private homes. To hold otherwise would belie the origin
of that Amendment, and the American colonial experience.
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An important forerunner of the first 10 Amendments to the United States Constitution, the
Virginia Bill of Rights, specifically opposed “general warrants, whereby an officer or messenger
may be commanded to search suspected places without evidence of a fact committed.” The
general warrant was a recurring point of contention in the Colonies immediately preceding the
Revolution. The particular offensiveness it engendered was acutely felt by the merchants and
businessmen whose premises and products were inspected for compliance with the several
parliamentary revenue measures that most irritated the colonists.…
***
This Court has already held that warrantless searches are generally unreasonable, and that this
rule applies to commercial premises as well as homes. In Camara v. Municipal Court, we held:
[E]xcept in certain carefully defined classes of cases, a search of private property without proper
consent is ‘unreasonable’ unless it has been authorized by a valid search warrant.
On the same day, we also ruled: As we explained in Camara, a search of private houses is
presumptively unreasonable if conducted without a warrant. The businessman, like the
occupant of a residence, has a constitutional right to go about his business free from
unreasonable official entries upon his private commercial property. The businessman, too, has
that right placed in jeopardy if the decision to enter and inspect for violation of regulatory laws
can be made and enforced by the inspector in the field without official authority evidenced by a
warrant. These same cases also held that the Fourth Amendment prohibition against
unreasonable searches protects against warrantless intrusions during civil as well as criminal
investigations. The reason is found in the “basic purpose of this Amendment…[which] is to
safeguard the privacy and security of individuals against arbitrary invasions by governmental
officials.” If the government intrudes on a person’s property, the privacy interest suffers whether
the government’s motivation is to investigate violations of criminal laws or breaches of other
statutory or regulatory standards.…
[A]n exception from the search warrant requirement has been recognized for “pervasively
regulated business[es],” United States v. Biswell, 406 U.S. 311, 316 (1972), and for “closely
regulated” industries “long subject to close supervision and inspection,” Colonnade Catering
Corp. v. United States, 397 U.S. 72, 74, 77 (1970). These cases are indeed exceptions, but they
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represent responses to relatively unique circumstances. Certain industries have such a history of
government oversight that no reasonable expectation of privacy could exist for a proprietor over
the stock of such an enterprise. Liquor (Colonnade) and firearms (Biswell) are industries of this
type when an entrepreneur embarks upon such a business, he has voluntarily chosen to subject
himself to a full arsenal of governmental regulation.
***
The clear import of our cases is that the closely regulated industry of the type involved
inColonnade and Biswell is the exception. The Secretary would make it the rule. Invoking the
Walsh-Healey Act of 1936, 41 U.S.C. § 35 et seq., the Secretary attempts to support a conclusion
that all businesses involved in interstate commerce have long been subjected to close
supervision of employee safety and health conditions. But…it is quite unconvincing to argue that
the imposition of minimum wages and maximum hours on employers who contracted with the
Government under the Walsh-Healey Act prepared the entirety of American interstate
commerce for regulation of working conditions to the minutest detail. Nor can any but the most
fictional sense of voluntary consent to later searches be found in the single fact that one
conducts a business affecting interstate commerce. Under current practice and law, few
businesses can be conducted without having some effect on interstate commerce.
***
The critical fact in this case is that entry over Mr. Barlow’s objection is being sought by a
Government agent. Employees are not being prohibited from reporting OSHA violations. What
they observe in their daily functions is undoubtedly beyond the employer’s reasonable
expectation of privacy. The Government inspector, however, is not an employee. Without a
warrant he stands in no better position than a member of the public. What is observable by the
public is observable, without a warrant, by the Government inspector as well. The owner of a
business has not, by the necessary utilization of employees in his operation, thrown open the
areas where employees alone are permitted to the warrantless scrutiny of Government agents.
That an employee is free to report, and the Government is free to use, any evidence of
noncompliance with OSHA that the employee observes furnishes no justification for federal

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agents to enter a place of business from which the public is restricted and to conduct their own
warrantless search.
***
[The District Court judgment is affirmed.]

CASE QUESTIONS

1. State, as briefly and clearly as possible, the argument that Barlow’s is making in this case.
2. Why would some industries or businesses be “closely regulated”? What are some of those
businesses?
3. The Fourth Amendment speaks of “people” being secure in their “persons, houses, papers,
and effects.” Why would the Fourth Amendment apply to a business, which is not in a
“house”?
4. If the Fourth Amendment does not distinguish between closely regulated industries and
those that are not, why does the court do so?

American Textile Manufacturers Institute v. Donovan
American Textile Manufacturers Institute v. Donovan
452 U.S. 490 (1981)
JUSTICE BRENNAN delivered the opinion of the Court.
Congress enacted the Occupational Safety and Health Act of 1970 (Act) “to assure so far as
possible every working man and woman in the Nation safe and healthful working
conditions.…“The Act authorizes the Secretary of Labor to establish, after notice and
opportunity to comment, mandatory nationwide standards governing health and safety in the
workplace. In 1978, the Secretary, acting through the Occupational Safety and Health
Administration (OSHA), promulgated a standard limiting occupational exposure to cotton dust,
an airborne particle byproduct of the preparation and manufacture of cotton products, exposure
to which produces a “constellation of respiratory effects” known as “byssinosis.” This disease
was one of the expressly recognized health hazards that led to passage of the Act.
Petitioners in these consolidated cases representing the interests of the cotton industry,
challenged the validity of the “Cotton Dust Standard” in the Court of Appeals for the District of
Columbia Circuit pursuant to § 6 (f) of the Act, 29 U.S.C. § 655 (f). They contend in this Court, as

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they did below, that the Act requires OSHA to demonstrate that its Standard reflects a
reasonable relationship between the costs and benefits associated with the Standard.
Respondents, the Secretary of Labor and two labor organizations, counter that Congress
balanced the costs and benefits in the Act itself, and that the Act should therefore be construed
not to require OSHA to do so. They interpret the Act as mandating that OSHA enact the most
protective standard possible to eliminate a significant risk of material health impairment,
subject to the constraints of economic and technological feasibility.
The Court of Appeals held that the Act did not require OSHA to compare costs and benefits.
We granted certiorari, 449 U.S. 817 (1980), to resolve this important question, which was
presented but not decided in last Term’s Industrial Union Dept. v. American Petroleum
Institute, 448 U.S. 607 (1980), and to decide other issues related to the Cotton Dust Standard.
***
Not until the early 1960’s was byssinosis recognized in the United States as a distinct
occupational hazard associated with cotton mills. In 1966, the American Conference of
Governmental Industrial Hygienists (ACGIH), a private organization, recommended that
exposure to total cotton dust be limited to a “threshold limit value” of 1,000 micrograms per
cubic meter of air (1,000 g/m3.) averaged over an 8-hour workday. See 43 Fed. Reg. 27351, col. 1
(1978). The United States Government first regulated exposure to cotton dust in 1968, when the
Secretary of Labor, pursuant to the Walsh-Healey Act, 41 U.S.C. 35 (e), promulgated airborne
contaminant threshold limit values, applicable to public contractors, that included the 1,000
g/m3 limit for total cotton dust. 34 Fed. Reg. 7953 (1969). Following passage of the Act in 1970,
the 1,000 g/m3. standard was adopted as an “established Federal standard” under 6 (a) of the
Act, 84 Stat. 1593, 29 U.S.C. 655 (a), a provision designed to guarantee immediate protection of
workers for the period between enactment of the statute and promulgation of permanent
standards.
That same year, the Director of the National Institute for Occupational Safety and Health
(NIOSH), pursuant to the Act, 29 U.S.C. §§ 669(a)(3), 671 (d)(2), submitted to the Secretary of
Labor a recommendation for a cotton dust standard with a permissible exposure limit (PEL)
that “should be set at the lowest level feasible, but in no case at an environmental concentration
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as high as 0.2 mg lint-free cotton dust/cu m,” or 200 g/m3. of lint-free respirable dust. Several
months later, OSHA published an Advance Notice of Proposed Rulemaking, 39 Fed.Reg. 44769
(1974), requesting comments from interested parties on the NIOSH recommendation and other
related matters. Soon thereafter, the Textile Worker’s Union of America, joined by the North
Carolina Public Interest Research Group, petitioned the Secretary, urging a more stringent PEL
of 100 g/m3.
On December 28, 1976, OSHA published a proposal to replace the existing federal standard on
cotton dust with a new permanent standard, pursuant to § 6(b)(5) of the Act, 29 U.S.C. §
655(b)(5). 41 Fed.Reg. 56498. The proposed standard contained a PEL of 200 g/m3 of vertical
elutriated lint-free respirable cotton dust for all segments of the cotton industry. Ibid. It also
suggested an implementation strategy for achieving the PEL that relied on respirators for the
short term and engineering controls for the long-term. OSHA invited interested parties to
submit written comments within a 90-day period.
***
The starting point of our analysis is the language of the statute itself. Section 6(b)(5) of the Act,
29 U.S.C. § 655(b)(5) (emphasis added), provides:
The Secretary, in promulgating standards dealing with toxic materials or harmful physical
agents under this subsection, shall set the standard which most adequately assures, to the
extent feasible, on the basis of the best available evidence, that no employee will suffer
material impairment of health or functional capacity even if such employee has regular exposure
to the hazard dealt with by such standard for the period of his working life. Although their
interpretations differ, all parties agree that the phrase “to the extent feasible” contains the
critical language in § 6(b)(5) for purposes of these cases.
The plain meaning of the word “feasible” supports respondents’ interpretation of the statute.
According to Webster’s Third New International Dictionary of the English Language 831 (1976),
“feasible” means “capable of being done, executed, or effected.” In accord, the Oxford English
Dictionary 116 (1933) (“Capable of being done, accomplished or carried out”); Funk & Wagnalls
New “Standard” Dictionary of the English Language 903 (1957) (“That may be done, performed
or effected”). Thus, § 6(b)(5) directs the Secretary to issue the standard that “most adequately
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assures…that no employee will suffer material impairment of health,” limited only by the extent
to which this is “capable of being done.” In effect then, as the Court of Appeals held, Congress
itself defined the basic relationship between costs and benefits, by placing the “benefit” of
worker health above all other considerations save those making attainment of this “benefit”
unachievable. Any standard based on a balancing of costs and benefits by the Secretary that
strikes a different balance than that struck by Congress would be inconsistent with the
command set forth in § 6(b)(5). Thus, cost-benefit analysis by OSHA is not required by the
statute because feasibility analysis is.
When Congress has intended that an agency engage in cost-benefit analysis, it has clearly
indicated such intent on the face of the statute. One early example is the Flood Control Act of
1936, 33 U.S.C. § 701:
[T]he Federal Government should improve or participate in the improvement of navigable
waters or their tributaries, including watersheds thereof, for flood control purposes if
the benefits to whomsoever they may accrue are in excess of the estimated costs,
and if the lives and social security of people are otherwise adversely affected. (emphasis added)
A more recent example is the Outer Continental Shelf Lands Act Amendments of 1978,
providing that offshore drilling operations shall use the best available and safest technologies
which the Secretary determines to be economically feasible, wherever failure of equipment
would have a significant effect on safety, health, or the environment, except where the Secretary
determines that the incremental benefits are clearly insufficient to justify the incremental costs
of using such technologies.
These and other statutes demonstrate that Congress uses specific language when intending that
an agency engage in cost-benefit analysis. Certainly in light of its ordinary meaning, the word
“feasible” cannot be construed to articulate such congressional intent. We therefore reject the
argument that Congress required cost-benefit analysis in § 6(b)(5).

CASE QUESTIONS

1. What is byssinosis? Why should byssinosis be anything that the textile companies are
responsible for, ethically or legally? If it is well-known that textile workers get cotton dust in

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their systems and develop brown lung, don’t they nevertheless choose to work there and
assume the risk of all injuries?
2. By imposing costs on the textile industry, what will be the net effect on US textile
manufacturing jobs?
3. How is byssinosis a “negative externality” that is not paid for by either the manufacturer or
the consumer of textile products? How should the market, to be fair and efficient, adjust for
these negative externalities other than by setting a reasonable standard that shares the
burden between manufacturers and their employees? Should all the burden be on the
manufacturer?

5.7 Summary and Exercises
Summary

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

EXERCISES

1. The Equal Employment Opportunity Commission seeks data about the racial composition of
Terrific Textiles’ labor force. Terrific refuses on the grounds that inadvertent disclosure of the
numbers might cause certain “elements” to picket its factories. The EEOC takes Terrific to
court to get the data. What is the result?
2. In order to police the profession, the state legislature has just passed a law permitting the
State Plumbers’ Association the power to hold hearings to determine whether a particular
plumber has violated the plumbing code of ethics, written by the association. Sam, a
plumber, objects to the convening of a hearing when he is accused by Roger, a fellow
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plumber, of acting unethically by soliciting business from Roger’s customers. Sam goes to
court, seeking to enjoin the association’s disciplinary committee from holding the hearing.
What is the result? How would you argue Sam’s case? The association’s case?
3. Assume that the new president of the United States was elected overwhelmingly by pledging
in his campaign to “do away with bureaucrats who interfere in your lives.” The day he takes
the oath of office he determines to carry out his pledge. Discuss which of the following
courses he may lawfully follow: (a) Fire all incumbent commissioners of federal agencies in
order to install new appointees. (b) Demand that all pending regulations being considered by
federal agencies be submitted to the White House for review and redrafting, if necessary. (c)
Interview potential nominees for agency positions to determine whether their regulatory
philosophy is consistent with his.
4. Dewey owned a mine in Wisconsin. He refused to allow Department of Labor agents into the
mine to conduct warrantless searches to determine whether previously found safety
violations had been corrected. The Federal Mine Safety and Health Amendments Act of 1977
authorizes four warrantless inspections per year. Is the provision for warrantless inspections
by this agency constitutional?[1]
5. In determining the licensing requirements for nuclear reactors, the Nuclear Regulatory
Commission (NRC) adopted a zero-release assumption: that the permanent storage of certain
nuclear waste would have no significant environmental impact and that potential storage
leakages should not be a factor discussed in the appropriate environmental impact
statement (EIS) required before permitting construction of a nuclear power plant. This
assumption is based on the NRC’s belief that technology would be developed to isolate the
wastes from the environment, and it was clear from the record that the NRC had “digested a
massive material and disclosed all substantial risks” and had considered that the zero-release
assumption was uncertain. There was a remote possibility of contamination by water leakage
into the storage facility. An environmental NGO sued, asserting that the NRC had violated the
regulations governing the EIS by arbitrarily and capriciously ignoring the potential
contamination. The court of appeals agreed, and the power plant appealed. Had the NRC
acted arbitrarily and capriciously? [2]
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SELF-TEST QUESTIONS
1. Most federal administrative agencies are created by
a.

an executive order by the president

b. a Supreme Court decision
c. the passage of enabling legislation by Congress, signed by the president
d. a and c
The Federal Trade Commission, like most administrative agencies of the
federal government, is part of
a.

the executive branch of government

b. the legislative branch of government
c. the judicial branch of government
d. the administrative branch of government
In the Clean Water Act, Congress sets broad guidelines, but it is the
Environmental Protection Agency that proposes rules to regulate industrial
discharges. Where do proposed rules originally appear?
a.

in the Congressional record

b. in the Federal Register
c. in the Code of Federal Regulations
d. in the United States code service
The legal basis for all administrative law, including regulations of the
Federal Trade Commission, is found in
a.

the Administrative Procedure Act

b. the US Constitution
c. the commerce clause
d. none of the above
The Federal Trade Commission, like other administrative agencies, has the
power to
a.

issue proposed rules

b. undertake investigations of firms that may have violated FTC regulations

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c. prosecute firms that have violated FTC regulations
d. none of the above
e. all of the above

SELF-TEST ANSWERS

1. c
2. a
3. b
4. b
5. e

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

Chapter 6
Criminal Law

LEARNING OBJECTIVES
After reading this chapter, you should be able to do the following:
1. Explain how criminal law differs from civil law.
2. Categorize the various types of crimes and define the most serious felonies.
3. Discuss and question the criminal “intent” of a corporation.
4. Explain basic criminal procedure and the rights of criminal defendants.
At times, unethical behavior by businesspeople can be extreme enough that society will respond
by criminalizing certain kinds of activities. Ponzi schemes, arson, various kinds of fraud,
embezzlement, racketeering, foreign corrupt practices, tax evasion, and insider trading are just a
few. A corporation can face large fines, and corporate managers can face both fines and jail
sentences for violating criminal laws. This chapter aims to explain how criminal law differs from
civil law, to discuss various types of crimes, and to relate the basic principles of criminal
procedure.
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6.1 The Nature of Criminal Law
Criminal law is the most ancient branch of the law. Many wise observers have tried to define and
explain it, but the explanations often include many complex and subtle distinctions. A
traditional criminal law course would include a lot of discussions on criminal intent, the nature
of criminal versus civil responsibility, and the constitutional rights accorded the accused. But in
this chapter, we will consider only the most basic aspects of intent, responsibility, and
constitutional rights.
Unlike civil actions, where plaintiffs seek compensation or other remedies for themselves,
crimes involve “the state” (the federal government, a state government, or some subunit of state
government). This is because crimes involve some “harm to society” and not just harm to certain
individuals. But “harm to society” is not always evident in the act itself. For example, two friends
of yours at a party argue, take the argument outside, and blows are struck; one has a bloody nose
and immediately goes home. The crimes of assault and battery have been committed, even
though no one else knows about the fight and the friends later make up. By contrast, suppose a
major corporation publicly announces that it is closing operations in your community and
moving operations to Southeast Asia. There is plenty of harm to society as the plant closes down
and no new jobs take the place of the company’s jobs. Although the effects on society are greater
in the second example, only the first example is a crime.
Crimes are generally defined by legislatures, in statutes; the statutes describe in general terms
the nature of the conduct they wish to criminalize. For government punishment to be fair,
citizens must have clear notice of what is criminally prohibited. Ex post facto laws—laws created
“after the fact” to punish an act that was legal at the time—are expressly prohibited by the US
Constitution. Overly vague statutes can also be struck down by courts under a constitutional
doctrine known as “void for vagueness.”
What is considered a crime will also vary from society to society and from time to time. For
example, while cocaine use was legal in the United States at one time, it is now a controlled
substance, and unauthorized use is now a crime. Medical marijuana was not legal fifty years ago
when its use began to become widespread, and in some states its use or possession was a felony.
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Now, some states make it legal to use or possess it under some circumstances. In the United
States, you can criticize and make jokes about the president of the United States without
committing a crime, but in many countries it is a serious criminal act to criticize a public official.
Attitudes about appropriate punishment for crimes will also vary considerably from nation to
nation. Uganda has decreed long prison sentences for homosexuals and death to repeat
offenders. In Saudi Arabia, the government has proposed to deliberately paralyze a criminal
defendant who criminally assaulted someone and unintentionally caused the victim’s paralysis.
Limits on punishment are set in the United States through the Constitution’s prohibition on
“cruel or unusual punishments.”
It is often said that ignorance of the law is no excuse. But there are far too many criminal laws
for anyone to know them all. Also, because most people do not actually read statutes, the
question of “criminal intent” comes up right away: if you don’t know that the legislature has
made driving without a seat belt fastened a misdemeanor, you cannot have intended to harm
society. You might even argue that there is no harm to anyone but yourself!
The usual answer to this is that the phrase “ignorance of the law is no excuse” means that society
(through its elected representatives) gets to decide what is harmful to society, not you. Still, you
may ask, “Isn’t it my choice whether to take the risk of failing to wear a seat belt? Isn’t this a
victimless crime? Where is the harm to society?” A policymaker or social scientist may answer
that your injuries, statistically, are generally going to be far greater if you don’t wear one and
that your choice may actually impose costs on society. For example, you might not have enough
insurance, so that a public hospital will have to take care of your head injuries, injuries that
would likely have been avoided by your use of a seat belt.
But, as just noted, it is hard to know the meaning of some criminal laws. Teenagers hanging
around the sidewalks on Main Street were sometimes arrested for “loitering.” The constitutional
void-for-vagueness doctrine has led the courts to overturn statutes that are not clear. For
example, “vagrancy” was long held to be a crime, but US courts began some forty years ago to
overturn vagrancy and “suspicious person” statutes on the grounds that they are too vague for
people to know what they are being asked not to do.

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

KEY TAKEAWAY

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

EXERCISES

1. Other than deterring certain kinds of conduct, what purpose does the criminal law serve?
2. Why is ignorance of the law no excuse? Why shouldn’t it be an excuse, when criminal laws
can be complicated and sometimes ambiguous?

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

Offenses against the Person
Homicide
Homicide is the killing of one person by another. Not every killing is criminal. When the law
permits one person to kill another—for example, a soldier killing an enemy on the battlefield
during war, or a killing in self-defense—the death is considered the result of justifiable homicide.
An excusable homicide, by contrast, is one in which death results from an accident in which the
killer is not at fault.
All other homicides are criminal. The most severely punished form is murder, defined as
homicide committed with “malice aforethought.” This is a term with a very long history. Boiled
down to its essentials, it means that the defendant had the intent to kill. A killing need not be
premeditated for any long period of time; the premeditation might be quite sudden, as in a bar
fight that escalates in that moment when one of the fighters reaches for a knife with the intent to
kill.
Sometimes a homicide can be murder even if there is no intent to kill; an intent to inflict great
bodily harm can be murder if the result is the death of another person. A killing that takes place

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while a felony (such as armed robbery) is being committed is also murder, whether or not the
killer intended any harm. This is the so-called felony murder rule. Examples are the accidental
discharge of a gun that kills an innocent bystander or the asphyxiation death of a fireman from
smoke resulting from a fire set by an arsonist. The felony murder rule is more significant than it
sounds, because it also applies to the accomplices of one who does the killing. Thus the driver of
a getaway car stationed a block away from the scene of the robbery can be convicted of murder if
a gun accidentally fires during the robbery and someone is killed. Manslaughter is an act of
killing that does not amount to murder. Voluntary manslaughter is an intentional killing, but
one carried out in the “sudden heat of passion” as the result of some provocation. An example is
a fight that gets out of hand. Involuntary manslaughter entails a lesser degree of willfulness; it
usually occurs when someone has taken a reckless action that results in death (e.g., a death
resulting from a traffic accident in which one driver recklessly runs a red light).

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

Offenses against Property
Theft: Larceny, Robbery, Embezzlement, False Pretenses
The concept of theft is familiar enough. Less familiar is the way the law has treated various
aspects of the act of stealing. Criminal law distinguishes among many different crimes that are
popularly known as theft. Many technical words have entered the language—burglary, larceny,
robbery—but are often used inaccurately. Brief definitions of the more common terms are
discussed here.
The basic crime of stealing personal property is larceny. By its old common-law definition, still
in use today, larceny is the wrongful “taking and carrying away of the personal property of
another with intent to steal the same.”
The separate elements of this offense have given rise to all kinds of difficult cases. Take the theft
of fruit, for example, with regard to the essential element of “personal property.” If a man
walking through an orchard plucks a peach from a tree and eats it, he is not guilty of larceny
because he has not taken away personal property (the peach is part of the land, being connected
to the tree). But if he picks up a peach lying on the ground, he is guilty of larceny. Or consider
the element of “taking” or “carrying away.” Sneaking into a movie theater without paying is not
an act of larceny (though in most states it is a criminal act). Taking electricity by tapping into the
power lines of an electric utility was something that baffled judges late in the nineteenth century
because it was not clear whether electricity is a “something” that can be taken. Modern statutes
have tended to make clear that electricity can be the object of larceny. Or consider the element
of an “intent to steal the same.” If you borrow your friend’s BMW without his permission in
order to go to the grocery store, intending to return it within a few minutes and then do return
it, you have not committed larceny. But if you meet another friend at the store who convinces
you to take a long joyride with the car and you return hours later, you may have committed
larceny.
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A particular form of larceny is robbery, which is defined as larceny from a person by means of
violence or intimidation.
Larceny involves the taking of property from the possession of another. Suppose that a person
legitimately comes to possess the property of another and wrongfully appropriates it—for
example, an automobile mechanic entrusted with your car refuses to return it, or a bank teller
who is entitled to temporary possession of cash in his drawer takes it home with him. The
common law had trouble with such cases because the thief in these cases already had
possession; his crime was in assuming ownership. Today, such wrongful conversion, known
as embezzlement, has been made a statutory offense in all states.
Statutes against larceny and embezzlement did not cover all the gaps in the law. A conceptual
problem arises in the case of one who is tricked into giving up his title to property. In larceny
and embezzlement, the thief gains possession or ownership without any consent of the owner or
custodian of the property. Suppose, however, that an automobile dealer agrees to take his
customer’s present car as a trade-in. The customer says that he has full title to the car. In fact,
the customer is still paying off an installment loan and the finance company has an interest in
the old car. If the finance company repossesses the car, the customer—who got a new car at a
discount because of his false representation—cannot be said to have taken the new car by
larceny or embezzlement. Nevertheless, he tricked the dealer into selling, and the dealer will
have lost the value of the repossessed car. Obviously, the customer is guilty of a criminal act; the
statutes outlawing it refer to this trickery as the crime of false pretenses, defined as obtaining
ownership of the property of another by making untrue representations of fact with intent to
defraud.
A number of problems have arisen in the judicial interpretation of false-pretense statutes. One
concerns whether the taking is permanent or only temporary. The case ofState v. Mills (Section
6.7 "Cases") shows the subtle questions that can be presented and the dangers inherent in
committing “a little fraud.”
In the Mills case, the claim was that a mortgage instrument dealing with one parcel of land was
used instead for another. This is a false representation of fact. Suppose, by contrast, that a
person misrepresents his state of mind: “I will pay you back tomorrow,” he says, knowing full
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well that he does not intend to. Can such a misrepresentation amount to false pretenses
punishable as a criminal offense? In most jurisdictions it cannot. A false-pretense violation
relates to a past event or existing fact, not to a statement of intention. If it were otherwise,
anyone failing to pay a debt might find himself facing criminal prosecution, and business would
be less prone to take risks.
The problem of proving intent is especially difficult when a person has availed himself of the
services of another without paying. A common example is someone leaving a restaurant without
paying for the meal. In most states, this is specifically defined in the statutes as theft of services.

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

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

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the backdating of a document, the modification of a corporate name, or the filling in of lines left
blank on a form can all constitute forgery.

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

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

Arson
Under common law, arson was the malicious burning of the dwelling of another. Burning one’s
own house for purposes of collecting insurance was not an act of arson under common law. The
statutes today make it a felony intentionally to set fire to any building, whether or not it is a
dwelling and whether or not the purpose is to collect insurance.

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

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

White-Collar Crime
White-collar crime, as distinguished from “street crime,” refers generally to fraud-related acts
carried out in a nonviolent way, usually connected with business. Armed bank robbery is not a
white-collar crime, but embezzlement by a teller or bank officer is. Many white-collar crimes are
included within the statutory definitions of embezzlement and false pretenses. Most are
violations of state law. Depending on how they are carried out, many of these same crimes are
also violations of federal law.
Any act of fraud in which the United States postal system is used or which involves interstate
phone calls or Internet connections is a violation of federal law. Likewise, many different acts
around the buying and selling of securities can run afoul of federal securities laws. Other whitecollar crimes include tax fraud; price fixing; violations of food, drug, and environmental laws;
corporate bribery of foreign companies; and—the newest form—computer fraud. Some of these
are discussed here; others are covered in later chapters.

Mail and Wire Fraud

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Federal law prohibits the use of the mails or any interstate electronic communications medium
for the purpose of furthering a “scheme or artifice to defraud.” The statute is broad, and it is
relatively easy for prosecutors to prove a violation. The law also bans attempts to defraud, so the
prosecutor need not show that the scheme worked or that anyone suffered any losses. “Fraud” is
broadly construed: anyone who uses the mails or telephone to defraud anyone else of virtually
anything, not just of money, can be convicted under the law. In one case, a state governor was
convicted of mail fraud when he took bribes to influence the setting of racing dates. The court’s
theory was that he defrauded the citizenry of its right to his “honest and faithful services” as
governor. [1]

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

Environmental Crimes
Many federal environmental statutes have criminal provisions. These include the Federal Water
Pollution Control Act (commonly called the Clean Water Act); the Rivers and Harbors Act of
1899 (the Refuse Act); the Clean Air Act; the Federal Insecticide, Fungicide, and Rodenticide Act
(FIFRA); the Toxic Substances Control Act (TSCA); and the Resource Conservation and
Recovery Act (RCRA). Under the Clean Water Act, for example, wrongful discharge of pollutants
into navigable waters carries a fine ranging from $2,500 to $25,000 per day and imprisonment
for up to one year. “Responsible corporate officers” are specifically included as potential
defendants in criminal prosecutions under the act. They can include officers who have
responsibility over a project where subcontractors and their employees actually caused the
discharge.[2]
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Violations of the Foreign Corrupt Practices Act
As a byproduct of Watergate, federal officials at the Securities and Exchange Commission and
the Internal Revenue Service uncovered many instances of bribes paid by major corporations to
officials of foreign governments to win contracts with those governments. Congress responded
in 1977 with the Foreign Corrupt Practices Act, which imposed a stringent requirement that the
disposition of assets be accurately and fairly accounted for in a company’s books and records.
The act also made illegal the payment of bribes to foreign officials or to anyone who will
transmit the money to a foreign official to assist the payor (the one offering and delivering the
money) in getting business.

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

Computer Crime
Computer crime generally falls into four categories: (1) theft of money, financial instruments, or
property; (2) misappropriation of computer time; (3) theft of programs; and (4) illegal
acquisition of information. The main federal statutory framework for many computer crimes is
the Computer Fraud and Abuse Act (CFAA; see Table 6.1 "Summary of Provisions of the
Computer Fraud and Abuse Act"). Congress only prohibited computer fraud and abuse where
there was a federal interest, as where computers of the government were involved or where the
crime was interstate in nature.
Table 6.1 Summary of Provisions of the Computer Fraud and Abuse Act
Obtaining national security information

Sec. (a)(1)

10 years maximum (20 years second
offense)

Trespassing in a government computer

Sec. (a)(3)

1 year (5)

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Compromising the confidentiality of a
computer

Sec. (a)(2)

1 year (10)

Accessing a computer to defraud and obtain
value

Sec. (a)4

5 years (10)

Intentional access and reckless damage

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

Trafficking in passwords

(a)(6)

1 year (10)

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

EXERCISES

1. Which does more serious harm to society: street crimes or white-collar crimes?
2. Why are various crimes so difficult to define precisely?
3. Hungry Harold goes by the home of Juanita Martinez. Juanita has just finished baking a
cherry pie and sets it in the open windowsill to cool. Harold smells the pie from the sidewalk.
It is twilight; while still light, the sun has officially set. Harold reaches into the window frame
and removes the pie. Technically, has Harold committed burglary? What are the issues here
based on the definition of burglary?
4. What is fraud? How is it different from dishonesty? Is being dishonest a criminal offense? If
so, have you been a criminal already today?

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

6.3 The Nature of a Criminal Act

LEARNING OBJECTIVES

1. Understand how it is possible to commit a criminal act without actually doing anything that
you think might be criminal.
2. Analyze and explain the importance of intention in criminal law and criminal prosecutions.
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3. Explain how a corporation can be guilty of a crime, even though it is a corporation’s agents
that commit the crime.
To be guilty of a crime, you must have acted. Mental desire or intent to do so is insufficient. But
what constitutes an act? This question becomes important when someone begins to commit a
crime, or does so in association with others, or intends to do one thing but winds up doing
something else.

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

Impossibility
What if a defendant is accused of attempting a crime that is factually impossible? For example,
suppose that men believed they were raping a drunken, unconscious woman, and were later
accused of attempted rape, but defended on the grounds of factual impossibility because the
woman was actually dead at the time sexual intercourse took place? Or suppose that a husband
intended to poison his wife with strychnine in her coffee, but put sugar in the coffee instead?
The “mens rea” or criminal intent was there, but the act itself was not criminal (rape requires a
live victim, and murder by poisoning requires the use of poison). States are divided on this, but
thirty-seven states have ruled out factual impossibility as a defense to the crime of attempt.

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Legal impossibility is different, and is usually acknowledged as a valid defense. If the defendant
completes all of his intended acts, but those acts do not fulfill all the required elements of a
crime, there could be a successful “impossibility” defense. If Barney (who has poor sight), shoots
at a tree stump, thinking it is his neighbor, Ralph, intending to kill him, has he committed an
attempt? Many courts would hold that he has not. But the distinction between factual
impossibility and legal impossibility is not always clear, and the trend seems to be to punish the
intended attempt.

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

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

KEY TAKEAWAY

Although proving the intent to commit a crime (the mens rea) is essential, the intent can be
established by inference (circumstantially). Conspirators may not actually commit a crime, for
example, but in preparing for a criminal act, they may be guilty of the crime of conspiracy.
Certain corporate officers, as well, may not be directly committing criminal acts but may be
held criminally responsible for acts of their agents and contractors.

EXERCISES

1. Give an example of how someone can intend to commit a crime but fail to commit one.
2. Describe a situation where there is a conspiracy to commit a crime without the crime actually
taking place.

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

6.4 Responsibility

LEARNING OBJECTIVES

1. Explain why criminal law generally requires that the defendant charged with a crime have
criminal "intent."
2. Know and explain the possible excuses relating to responsibility that are legally recognized by
courts, including lack of capacity.

In General
The mens rea requirement depends on the nature of the crime and all the circumstances
surrounding the act. In general, though, the requirement means that the accused must in some
way have intended the criminal consequences of his act. Suppose, for example, that Charlie gives
Gabrielle a poison capsule to swallow. That is the act. If Gabrielle dies, is Charlie guilty of
murder? The answer depends on what his state of mind was. Obviously, if he gave it to her
intending to kill her, the act was murder.
What if he gave it to her knowing that the capsule was poison but believing that it would only
make her mildly ill? The act is still murder, because we are all liable for the consequences of any
intentional act that may cause harm to others. But suppose that Gabrielle had asked Harry for
aspirin, and he handed her two pills that he reasonably believed to be aspirin (they came from
the aspirin bottle and looked like aspirin) but that turned out to be poison, the act would not be
murder, because he had neither intent nor a state of knowledge from which intent could be
inferred.
Not every criminal law requires criminal intent as an ingredient of the crime. Many regulatory
codes dealing with the public health and safety impose strict requirements. Failure to adhere to
such requirements is a violation, whether or not the violator had mens rea. The United States v.
Park case, Section 6.7 "Cases", a decision of the US Supreme Court, shows the different
considerations involved in mens rea.
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Excuses That Limit or Overcome Responsibility
Mistake of Fact and Mistake of Law
Ordinarily, ignorance of the law is not an excuse. If you believe that it is permissible to turn
right on a red light but the city ordinance prohibits it, your belief, even if reasonable, does not
excuse your violation of the law. Under certain circumstances, however, ignorance of law will be
excused. If a statute imposes criminal penalties for an action taken without a license, and if the
government official responsible for issuing the license formally tells you that you do not need
one (though in fact you do), a conviction for violating the statute cannot stand. In rare cases, a
lawyer’s advice, contrary to the statute, will be held to excuse the client, but usually the client is
responsible for his attorney’s mistakes. Otherwise, as it is said, the lawyer would be superior to
the law.
Ignorance or mistake of fact more frequently will serve as an excuse. If you take a coat from a
restaurant, believing it to be yours, you cannot be convicted of larceny if it is not. Your honest
mistake of fact negates the requisite intent. In general, the rule is that a mistaken belief of fact
will excuse criminal responsibility if (1) the belief is honestly held, (2) it is reasonable to hold it,
and (3) the act would not have been criminal if the facts were as the accused supposed them to
have been.

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

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

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

KEY TAKEAWAY

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

EXERCISES

1. Describe several situations in which compulsion, consent, or other excuses take away
criminal liability.
2. Your employee is drunk on the job and commits the crime of assault and battery on a
customer. He claims lack of capacity as an excuse. Should the courts accept this excuse? Why
or why not?

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6.5 Procedure

LEARNING OBJECTIVES

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

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

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

KEY TAKEAWAY

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

EXERCISES

1. Harold is charged with the crime of assault with a deadly weapon with intent to kill or inflict
serious bodily injury. It is a more serious crime than simple assault. Harold’s attorney wants
the prosecutor to give Harold a break, but Harold is guilty of at least simple assault and may
also have had the intent to kill. What is Harold’s attorney likely to do?
2. Kumar was driving his car, smoking marijuana, and had an accident with another vehicle. The
other driver was slightly injured. When the officer arrived, she detected a strong odor of
marijuana in Kumar’s car and a small amount of marijuana in the glove compartment. The
other driver expects to bring a civil action against Kumar for her injuries after Kumar’s
criminal case. What should Kumar plead in the criminal case—careless driving or driving
under the influence?

6.6 Constitutional Rights of the Accused
LEARNING OBJECTIVES

1. Describe the most significant constitutional rights of defendants in US courts, and name the
source of these rights.
2. Explain the Exclusionary rule and the reason for its existence.

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

Double Jeopardy
The Fifth Amendment prohibits the government from prosecuting a person twice for the same
offense. The amendment says that no person shall be “subject for the same offence to be twice
put in jeopardy of life or limb.” If a defendant is acquitted, the government may not appeal. If a
defendant is convicted and his conviction is upheld on appeal, he may not thereafter be
reprosecuted for the same crime.

Self-Incrimination
The Fifth Amendment is also the source of a person’s right against self-incrimination (no person
“shall be compelled in any criminal case to be a witness against himself”). The debate over the
limits of this right has given rise to an immense literature. In broadest outline, the right against
self-incrimination means that the prosecutor may not call a defendant to the witness stand
during trial and may not comment to the jury on the defendant’s failure to take the stand.
Moreover, a defendant’s confession must be excluded from evidence if it was not voluntarily
made (e.g., if the police beat the person into giving a confession). In Miranda v. Arizona, the
Supreme Court ruled that no confession is admissible if the police have not first advised a
suspect of his constitutional rights, including the right to have a lawyer present to advise him
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during the questioning. [1] These so-called Miranda warnings have prompted scores of follow-up
cases that have made this branch of jurisprudence especially complex.

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

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

Assistance of Counsel
The Sixth Amendment guarantees criminal defendants the right to have the assistance of
defense counsel. During the eighteenth century and before, the British courts frequently refused
to permit defendants to have lawyers in the courtroom during trial. The right to counsel is much
broader in this country, as the result of Supreme Court decisions that require the state to pay for
a lawyer for indigent defendants in most criminal cases.

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

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

KEY TAKEAWAY

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

EXERCISES

1. Do you think it is useful to have a presumption of innocence in criminal cases? What if there
were not a presumption of innocence in criminal cases?
2. Do you think public humiliation, public execution, and unusual punishments would reduce
the amount of crime? Why do you think so?
3. “Due process” is another phrase for “fairness.” Why should the public show fairness toward
criminal defendants?

[1] Miranda v. Arizona, 384 US 436 (1966).
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6.7 Cases
False Pretenses
State v. Mills
96 Ariz. 377, 396 P.2d 5 (Ariz. 1964)
LOCKWOOD, VICE CHIEF JUSTICE
Defendants appeal from a conviction on two counts of obtaining money by false pretenses in
violation of AR.S. §§ 13-661.A3. and 13-663.A1. The material facts, viewed “…in the light most
favorable to sustaining the conviction,” are as follows: Defendant William Mills was a builder
and owned approximately 150 homes in Tucson in December, 1960. Mills conducted his
business in his home. In 1960 defendant Winifred Mills, his wife, participated in the business
generally by answering the telephone, typing, and receiving clients who came to the office.
In December 1960, Mills showed the complainant, Nathan Pivowar, a house at 1155 Knox Drive
and another at 1210 Easy Street, and asked Pivowar if he would loan money on the Knox Drive
house. Pivowar did not indicate at that time whether he would agree to such a transaction. Later
in the same month Nathan Pivowar told the defendants that he and his brother, Joe Pivowar,
would loan $5,000 and $4,000 on the two houses. Three or four days later Mrs. Mills, at
Pivowar’s request, showed him these homes again.
Mills had prepared two typed mortgages for Pivowar. Pivowar objected to the wording, so in
Mills’ office Mrs. Mills retyped the mortgages under Pivowar’s dictation. After the mortgages
had been recorded on December 31, 1960, Pivowar gave Mills a bank check for $5,791.87, some
cash, and a second mortgage formerly obtained from Mills in the approximate sum of $3,000.
In exchange Mills gave Pivowar two personal notes in the sums of $5,250.00 and $4,200.00 and
the two mortgages as security for the loan.
Although the due date for Mills’ personal notes passed without payment being made, the
complainant did not present the notes for payment, did not demand that they be paid, and did
not sue upon them. In 1962 the complainant learned that the mortgages which he had taken as
security in the transaction were not first mortgages on the Knox Drive and Easy Street
properties. These mortgages actually covered two vacant lots on which there were outstanding
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senior mortgages. On learning this, Pivowar signed a complaint charging the defendants with
the crime of theft by false pretenses.
On appeal defendants contend that the trial court erred in denying their motion to dismiss the
information. They urge that a permanent taking of property must be proved in order to establish
the crime of theft. Since the complainant had the right to sue on the defendants’ notes, the
defendants assert that complainant cannot be said to have been deprived of his property
permanently. Defendants misconceive the elements of the crime of theft by false pretenses.
Stated in a different form, their argument is that although the complainant has parted with his
cash, a bank check, and a second mortgage, the defendants intend to repay the loan.
Defendants admit that the proposition of law which they assert is a novel one in this jurisdiction.
Respectable authority in other states persuades us that their contention is without merit. A
creditor has a right to determine for himself whether he wishes to be a secured or an unsecured
creditor. In the former case, he has a right to know about the security. If he extends credit in
reliance upon security which is falsely represented to be adequate, he has been defrauded even if
the debtor intends to repay the debt. His position is now that of an unsecured creditor. At the
very least, an unreasonable risk of loss has been forced upon him by reason of the deceit. This
risk which he did not intend to assume has been imposed upon him by the intentional act of the
debtor, and such action constitutes an intent to defraud.
***
The cases cited by defendants in support of their contention are distinguishable from the instant
case in that they involved theft by larceny. Since the crime of larceny is designed to protect a
person’s possessory interest in property whereas the crime of false pretenses protects one’s title
interest, the requirement of a permanent deprivation is appropriate to the former. Accordingly,
we hold that an intent to repay a loan obtained on the basis of a false representation of the
security for the loan is no defense.
***
Affirmed in part, reversed in part, and remanded for resentencing.

CASE QUESTIONS

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1. False pretenses is a crime of obtaining ownership of property of another by making untrue
representations of fact with intent to defraud. What were the untrue representations of fact
made by Mills?
2. Concisely state the defendant’s argument as to why Pivowar has not been deprived of any
property.
3. If Pivowar had presented the notes and Mills had paid, would a crime have been committed?

White-Collar Crimes
United States v. Park
421 U.S. 658 (1975)
MR. CHIEF JUSTICE BURGER delivered the opinion of the Court.
We granted certiorari to consider whether the jury instructions in the prosecution of a corporate
officer under § 301 (k) of the Federal Food, Drug, and Cosmetic Act, 52 Stat. 1042, as amended,
21 U.S.C. § 331 (k), were appropriate under United States v. Dotterweich, 320 U.S. 277 (1943).
Acme Markets, Inc., is a national retail food chain with approximately 36,000 employees, 874
retail outlets, 12 general warehouses, and four special warehouses. Its headquarters, including
the office of the president, respondent Park, who is chief executive officer of the corporation, are
located in Philadelphia, Pennsylvania. In a five-count information filed in the United States
District Court for the District of Maryland, the Government charged Acme and respondent with
violations of the Federal Food, Drug, and Cosmetic Act. Each count of the information alleged
that the defendants had received food that had been shipped in interstate commerce and that,
while the food was being held for sale in Acme’s Baltimore warehouse following shipment in
interstate commerce, they caused it to be held in a building accessible to rodents and to be
exposed to contamination by rodents. These acts were alleged to have resulted in the food’s
being adulterated within the meaning of 21 U.S.C. §§ 342 (a)(3) and (4), in violation of 21 U.S.C.
§ 331 (k).
Acme pleaded guilty to each count of the information. Respondent pleaded not guilty. The
evidence at trial demonstrated that in April 1970 the Food and Drug Administration (FDA)
advised respondent by letter of insanitary conditions in Acme’s Philadelphia warehouse. In 1971
the FDA found that similar conditions existed in the firm’s Baltimore warehouse. An FDA
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consumer safety officer testified concerning evidence of rodent infestation and other insanitary
conditions discovered during a 12-day inspection of the Baltimore warehouse in November and
December 1971. He also related that a second inspection of the warehouse had been conducted
in March 1972. On that occasion the inspectors found that there had been improvement in the
sanitary conditions, but that “there was still evidence of rodent activity in the building and in the
warehouses and we found some rodent-contaminated lots of food items.”
The Government also presented testimony by the Chief of Compliance of the FDA’s Baltimore
office, who informed respondent by letter of the conditions at the Baltimore warehouse after the
first inspection. There was testimony by Acme’s Baltimore division vice president, who had
responded to the letter on behalf of Acme and respondent and who described the steps taken to
remedy the insanitary conditions discovered by both inspections. The Government’s final
witness, Acme’s vice president for legal affairs and assistant secretary, identified respondent as
the president and chief executive officer of the company and read a bylaw prescribing the duties
of the chief executive officer. He testified that respondent functioned by delegating “normal
operating duties” including sanitation, but that he retained “certain things, which are the big,
broad, principles of the operation of the company and had “the responsibility of seeing that they
all work together.”
At the close of the Government’s case in chief, respondent moved for a judgment of acquittal on
the ground that “the evidence in chief has shown that Mr. Park is not personally concerned in
this Food and Drug violation.” The trial judge denied the motion, stating that United States v.
Dotterweich, 320 U.S. 277 (1943), was controlling.
Respondent was the only defense witness. He testified that, although all of Acme’s employees
were in a sense under his general direction, the company had an “organizational structure for
responsibilities for certain functions” according to which different phases of its operation were
“assigned to individuals who, in turn, have staff and departments under them.” He identified
those individuals responsible for sanitation, and related that upon receipt of the January 1972
FDA letter, he had conferred with the vice president for legal affairs, who informed him that the
Baltimore division vice president “was investigating the situation immediately and would be
taking corrective action and would be preparing a summary of the corrective action to reply to
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the letter.” Respondent stated that he did not “believe there was anything [he] could have done
more constructively than what [he] found was being done.”
On cross-examination, respondent conceded that providing sanitary conditions for food offered
for sale to the public was something that he was “responsible for in the entire operation of the
company” and he stated that it was one of many phases of the company that he assigned to
“dependable subordinates.” Respondent was asked about and, over the objections of his counsel,
admitted receiving, the April 1970 letter addressed to him from the FDA regarding insanitary
conditions at Acme’s Philadelphia warehouse. He acknowledged that, with the exception of the
division vice president, the same individuals had responsibility for sanitation in both Baltimore
and Philadelphia. Finally, in response to questions concerning the Philadelphia and Baltimore
incidents, respondent admitted that the Baltimore problem indicated the system for handling
sanitation “wasn’t working perfectly” and that as Acme’s chief executive officer he was
“responsible for any result which occurs in our company.”
At the close of the evidence, respondent’s renewed motion for a judgment of acquittal was
denied. The relevant portion of the trial judge’s instructions to the jury challenged by
respondent is set out in the margin. Respondent’s counsel objected to the instructions on the
ground that they failed fairly to reflect our decision in United States v. Dotterweich supra, and
to define “‘responsible relationship.’” The trial judge overruled the objection. The jury found
respondent guilty on all counts of the information, and he was subsequently sentenced to pay a
fine of $50 on each count. The Court of Appeals reversed the conviction and remanded for a new
trial.
***
The question presented by the Government’s petition for certiorari in United States v.
Dotterweich, and the focus of this Court’s opinion, was whether the manager of a corporation, as
well as the corporation itself, may be prosecuted under the Federal Food, Drug, and Cosmetic
Act of 1938 for the introduction of misbranded and adulterated articles into interstate
commerce. In Dotterweich, a jury had disagreed as to the corporation, a jobber purchasing
drugs from manufacturers and shipping them in interstate commerce under its own label, but
had convicted Dotterweich, the corporation’s president and general manager. The Court of
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Appeals reversed the conviction on the ground that only the drug dealer, whether corporation or
individual, was subject to the criminal provisions of the Act, and that where the dealer was a
corporation, an individual connected therewith might be held personally only if he was
operating the corporation as his ‘alter ego.’
In reversing the judgment of the Court of Appeals and reinstating Dotterweich’s conviction, this
Court looked to the purposes of the Act and noted that they “touch phases of the lives and health
of people which, in the circumstances of modern industrialism, are largely beyond selfprotection. It observed that the Act is of “a now familiar type” which “dispenses with the
conventional requirement for criminal conduct-awareness of some wrongdoing: In the interest
of the larger good it puts the burden of acting at hazard upon a person otherwise innocent but
standing in responsible relation to a public danger. Central to the Court’s conclusion that
individuals other than proprietors are subject to the criminal provisions of the Act was the
reality that the only way in which a corporation can act is through the individuals, who act on its
behalf.
***
The Court recognized that, because the Act dispenses with the need to prove “consciousness of
wrongdoing,” it may result in hardship even as applied to those who share “responsibility in the
business process resulting in” a violation.…The rule that corporate employees who have “a
responsible share in the furtherance of the transaction which the statute outlaws” are subject to
the criminal provisions of the Act was not formulated in a vacuum. Cf. Morissette v. United
States, 342 U.S. 246, 258 (1952). Cases under the Federal Food and Drugs Act of 1906 reflected
the view both that knowledge or intent were not required to be proved in prosecutions under its
criminal provisions, and that responsible corporate agents could be subjected to the liability
thereby imposed.
***
The rationale of the interpretation given the Act in Dotterweich…has been confirmed in our
subsequent cases. Thus, the Court has reaffirmed the proposition that the public interest in the
purity of its food is so great as to warrant the imposition of the highest standard of care on
distributors.
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Thus Dotterweich and the cases which have followed reveal that in providing sanctions which
reach and touch the individuals who execute the corporate mission—and this is by no means
necessarily confined to a single corporate agent or employee—the Act imposes not only a
positive duty to seek out and remedy violations when they occur but also, and primarily, a duty
to implement measures that will insure that violations will not occur. The requirements of
foresight and vigilance imposed on responsible corporate agents are beyond question
demanding, and perhaps onerous, but they are no more stringent than the public has a right to
expect of those who voluntarily assume positions of authority in business enterprises whose
services and products affect the health and well-being of the public that supports them.
***
Reading the entire charge satisfies us that the jury’s attention was adequately focused on the
issue of respondent’s authority with respect to the conditions that formed the basis of the
alleged violations. Viewed as a whole, the charge did not permit the jury to find guilt solely on
the basis of respondent’s position in the corporation; rather, it fairly advised the jury that to find
guilt it must find respondent “had a responsible relation to the situation,” and “by virtue of his
position…had…authority and responsibility” to deal with the situation.
The situation referred to could only be “food…held in unsanitary conditions in a warehouse with
the result that it consisted, in part, of filth or…may have been contaminated with filth.”
Our conclusion that the Court of Appeals erred in its reading of the jury charge suggests as well
our disagreement with that court concerning the admissibility of evidence demonstrating that
respondent was advised by the FDA in 1970 of insanitary conditions in Acme’s Philadelphia
warehouse. We are satisfied that the Act imposes the highest standard of care and permits
conviction of responsible corporate officials who, in light of this standard of care, have the
power to prevent or correct violations of its provisions.
***
Reversed.

CASE QUESTIONS

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

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

6.8 Summary and Exercises
Summary

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

EXERCISES

1. Bill is the chief executive of a small computer manufacturing company that desperately
needs funds to continue operating. One day a stranger comes to Bill to induce him to take
part in a cocaine smuggling deal that would net Bill millions of dollars. Unbeknownst to Bill,
the stranger is an undercover policeman. Bill tells the stranger to go away. The stranger
persists, and after five months of arguing and cajoling, the stranger wears down Bill’s will to
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resist. Bill agrees to take delivery of the cocaine and hands over a down payment of $10,000
to the undercover agent, who promptly arrests him for conspiracy to violate the narcotics
laws. What defenses does Bill have?
2. You are the manager of a bookstore. A customer becomes irritated at having to stand in line
and begins to shout at the salesclerk for refusing to wait on him. You come out of your office
and ask the customer to calm down. He shouts at you. You tell him to leave. He refuses. So
you and the salesclerk pick him up and shove him bodily out the door. He calls the police to
have you arrested for assault. Should the police arrest you? Assuming that they do, how
would you defend yourself in court?
3. Marilyn is arrested for arson against a nuclear utility, a crime under both state and federal
law. She is convicted in state court and sentenced to five years in jail. Then the federal
government decides to prosecute her for the same offense. Does she have a double-jeopardy
defense against the federal prosecution?
4. Tectonics, a US corporation, is bidding on a project in Nigeria, and its employee wins the bid
by secretly giving $100,000 to the Nigerian public official that has the most say about which
company will be awarded the contract. The contract is worth $80 million, and Tectonics
expects to make at least $50 million on the project. Has a crime under US law been
committed?
5. Suppose that the CEO of Tectonics, Ted Nelson, is not actually involved in bribery of the
Nigerian public official Adetutu Adeleke. Instead, suppose that the CFO, Jamie Skillset, is very
accomplished at insulating both top management and the board of directors from some of
the “operational realities” within the company. Skillset knows that Whoopi Goldmine, a
Nigerian employee of Tectonics, has made the deal with Adeleke and secured the contract
for Tectonics. Is it possible that Nelson, as well as Skillset, can be found guilty of a crime?
6. You have graduated from college and, after working hard for ten years, have scraped enough
money together to make a down payment on a forty-acre farm within driving distance to the
small city where you work in Colorado. In town at lunch one day, you run into an old friend
from high school, Hayley Mills, who tells you that she is saving her money to start a high-end
consignment shop in town. You allow her to have a room in your house for a few months
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until she has enough money to go into business. Over the following weeks, however, you
realize that old acquaintances from high school are stopping by almost daily for short visits.
When you bring this up to Hayley, she admits that many old friends are now relying on her
for marijuana. She is not a licensed caregiver in Colorado and is clearly violating the law. Out
of loyalty, you tell her that she has three weeks to move out, but you do not prevent her
from continuing sales while she is there. What crime have you committed?
7. The Center Art Galleries—Hawaii sells artwork, and much of it involves art by the famous
surrealist painter Salvador Dali. The federal government suspected the center of selling
forged Dali artwork and obtained search warrants for six locations controlled by the center.
The warrants told the executing officer to seize any items that were “evidence of violations
of federal criminal law.” The warrants did not describe the specific crime suspected, nor did
the warrants limit the seizure of items solely to Dali artwork or suspected Dali forgeries. Are
these search warrants valid? [1]

SELF-TEST QUESTIONS

1. Jared has made several loans to debtors who have declared bankruptcy. These are
unsecured claims. Jared “doctors” the documentation to show amounts owed
that are higher than the debtors actually owe. Later, Jared is charged with the
federal criminal offense of filing false claims. The standard (or “burden”) of proof
that the US attorney must meet in the prosecution is
a. beyond all doubt
b. beyond a reasonable doubt
c. clear and convincing evidence
d. a preponderance of the evidence
Jethro, a businessman who resides in Atlanta, creates a disturbance at a
local steakhouse and is arrested for being drunk and disorderly. Drunk and
disorderly is a misdemeanor under Georgia law. A misdemeanor is a crime
punishable by imprisonment for up to
a.

one year
b. two years

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c. five years
d. none of the above
Yuan is charged with a crime. To find him guilty, the prosecutor must show
a.

actus reus and mens rea
b. mens rea only
c. the performance of a prohibited act
d. none of the above
Kira works for Data Systems Ltd. and may be liable for larceny if she steals

a.

a competitor’s trade secrets
b. company computer time
c. the use of Data Systems’ Internet for personal business
d. any of the above
Candace is constructing a new office building that is near its completion.
She offers Paul $500 to overlook certain things that are noncompliant with the
city’s construction code. Paul accepts the money and overlooks the violations.
Later, Candace is charged with the crime of bribery. This occurred when

a.

Candace offered the bribe.
b. Paul accepted the bribe.
c. Paul overlooked the violations.
d. none of the above

SELF-TEST ANSWERS

1. b
2. a
3. a
4. d
5. a

[1] Center Art Galleries—Hawaii, Inc. v. United States, 875 F.2d 747 (9th Cir. 1989).
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Chapter 7
Introduction to Tort Law
LEARNING OBJECTIVES

After reading this chapter, you should be able to do the following:
1. Know why most legal systems have tort law.
2. Identify the three kinds of torts.
3. Show how tort law relates to criminal law and contract law.
4. Understand negligent torts and defenses to claims of negligence.
5. Understand strict liability torts and the reasons for them in the US legal system.
In civil litigation, contract and tort claims are by far the most numerous. The law attempts to
adjust for harms done by awarding damages to a successful plaintiff who demonstrates that the
defendant was the cause of the plaintiff’s losses. Torts can be intentional torts, negligent torts, or
strict liability torts. Employers must be aware that in many circumstances, their employees may
create liability in tort. This chapter explains the different kind of torts, as well as available
defenses to tort claims.

7.1 Purpose of Tort Laws

LEARNING OBJECTIVES

1. Explain why a sound market system requires tort law.
2. Define a tort and give two examples.
3. Explain the moral basis of tort liability.
4. Understand the purposes of damage awards in tort.

Definition of Tort
The term tort is the French equivalent of the English word wrong. The word tort is also derived
from the Latin word tortum, which means twisted or crooked or wrong, in contrast to the
word rectum, which means straight (rectitude uses that Latin root). Thus conduct that is twisted
or crooked and not straight is a tort. The term was introduced into the English law by the
Norman jurists.

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Long ago, tort was used in everyday speech; today it is left to the legal system. A judge will
instruct a jury that a tort is usually defined as a wrong for which the law will provide a remedy,
most often in the form of money damages. The law does not remedy all “wrongs.” The preceding
definition of tort does not reveal the underlying principles that divide wrongs in the legal sphere
from those in the moral sphere. Hurting someone’s feelings may be more devastating than
saying something untrue about him behind his back; yet the law will not provide a remedy for
saying something cruel to someone directly, while it may provide a remedy for "defaming"
someone, orally or in writing, to others.
Although the word is no longer in general use, tort suits are the stuff of everyday headlines.
More and more people injured by exposure to a variety of risks now seek redress (some sort of
remedy through the courts). Headlines boast of multimillion-dollar jury awards against doctors
who bungled operations, against newspapers that libeled subjects of stories, and against oil
companies that devastate entire ecosystems. All are examples of tort suits.
The law of torts developed almost entirely in the common-law courts; that is, statutes passed by
legislatures were not the source of law that plaintiffs usually relied on. Usually, plaintiffs would
rely on the common law (judicial decisions). Through thousands of cases, the courts have
fashioned a series of rules that govern the conduct of individuals in their noncontractual
dealings with each other. Through contracts, individuals can craft their own rights and
responsibilities toward each other. In the absence of contracts, tort law holds individuals legally
accountable for the consequences of their actions. Those who suffer losses at the hands of others
can be compensated.
Many acts (like homicide) are both criminal and tortious. But torts and crimes are different, and
the difference is worth noting. A crime is an act against the people as a whole. Society punishes
the murderer; it does not usually compensate the family of the victim. Tort law, on the other
hand, views the death as a private wrong for which damages are owed. In a civil case, the tort
victim or his family, not the state, brings the action. The judgment against a defendant in a civil
tort suit is usually expressed in monetary terms, not in terms of prison times or fines, and is the
legal system’s way of trying to make up for the victim’s loss.

Kinds of Torts
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There are three kinds of torts: intentional torts, negligent torts, and strict liability torts.
Intentional torts arise from intentional acts, whereas unintentional torts often result from
carelessness (e.g., when a surgical team fails to remove a clamp from a patient’s abdomen when
the operation is finished). Both intentional torts and negligent torts imply some fault on the part
of the defendant. In strict liability torts, by contrast, there may be no fault at all, but tort law will
sometimes require a defendant to make up for the victim’s losses even where the defendant was
not careless and did not intend to do harm.

Dimensions of Tort Liability
There is a clear moral basis for recovery through the legal system where the defendant has been
careless (negligent) or has intentionally caused harm. Using the concepts that we are free and
autonomous beings with basic rights, we can see that when others interfere with either our
freedom or our autonomy, we will usually react negatively. As the old saying goes, “Your right to
swing your arm ends at the tip of my nose.” The law takes this even one step further: under
intentional tort law, if you frighten someone by swinging your arms toward the tip of her nose,
you may have committed the tort of assault, even if there is no actual touching (battery).
Under a capitalistic market system, rational economic rules also call for no negative
externalities. That is, actions of individuals, either alone or in concert with others, should not
negatively impact third parties. The law will try to compensate third parties who are harmed by
your actions, even as it knows that a money judgment cannot actually mend a badly injured
victim.
Figure 7.1 Dimensions of Tort Liability

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Dimensions of Tort: Fault
Tort principles can be viewed along different dimensions. One is the fault dimension. Like
criminal law, tort law requires a wrongful act by a defendant for the plaintiff to recover. Unlike
criminal law, however, there need not be a specific intent. Since tort law focuses on injury to the
plaintiff, it is less concerned than criminal law about the reasons for the defendant’s actions. An
innocent act or a relatively innocent one may still provide the basis for liability. Nevertheless,
tort law—except for strict liability—relies on standards of fault, or blameworthiness.
The most obvious standard is willful conduct. If the defendant (often called thetortfeasor—i.e.,
the one committing the tort) intentionally injures another, there is little argument about tort
liability. Thus all crimes resulting in injury to a person or property (murder, assault, arson, etc.)
are also torts, and the plaintiff may bring a separate lawsuit to recover damages for injuries to
his person, family, or property.
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Most tort suits do not rely on intentional fault. They are based, rather, on negligent conduct that
in the circumstances is careless or poses unreasonable risks of causing damage. Most
automobile accident and medical malpractice suits are examples of negligence suits.
The fault dimension is a continuum. At one end is the deliberate desire to do injury. The middle
ground is occupied by careless conduct. At the other end is conduct that most would consider
entirely blameless, in the moral sense. The defendant may have observed all possible
precautions and yet still be held liable. This is calledstrict liability. An example is that incurred
by the manufacturer of a defective product that is placed on the market despite all possible
precautions, including quality-control inspection. In many states, if the product causes injury,
the manufacturer will be held liable.

Dimensions of Tort: Nature of Injury
Tort liability varies by the type of injury caused. The most obvious type is physical harm to the
person (assault, battery, infliction of emotional distress, negligent exposure to toxic pollutants,
wrongful death) or property (trespass, nuisance, arson, interference with contract). Mental
suffering can be redressed if it is a result of physical injury (e.g., shock and depression following
an automobile accident). A few states now permit recovery for mental distress alone (a mother’s
shock at seeing her son injured by a car while both were crossing the street). Other protected
interests include a person’s reputation (injured by defamatory statements or writings), privacy
(injured by those who divulge secrets of his personal life), and economic interests
(misrepresentation to secure an economic advantage, certain forms of unfair competition).

Dimensions of Tort: Excuses
A third element in the law of torts is the excuse for committing an apparent wrong. The law does
not condemn every act that ultimately results in injury.
One common rule of exculpation is assumption of risk. A baseball fan who sits along the third
base line close to the infield assumes the risk that a line drive foul ball may fly toward him and
strike him. He will not be permitted to complain in court that the batter should have been more
careful or that management should have either warned him or put up a protective barrier.
Another excuse is negligence of the plaintiff. If two drivers are careless and hit each other on the
highway, some states will refuse to permit either to recover from the other. Still another excuse
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is consent: two boxers in the ring consent to being struck with fists (but not to being bitten on
the ear).

Damages
Since the purpose of tort law is to compensate the victim for harm actually done, damages are
usually measured by the extent of the injury. Expressed in money terms, these include
replacement of property destroyed, compensation for lost wages, reimbursement for medical
expenses, and dollars that are supposed to approximate the pain that is suffered. Damages for
these injuries are called compensatory damages.
In certain instances, the courts will permit an award of punitive damages. As the
word punitive implies, the purpose is to punish the defendant’s actions. Because a punitive
award (sometimes called exemplary damages) is at odds with the general purpose of tort law, it
is allowable only in aggravated situations. The law in most states permits recovery of punitive
damages only when the defendant has deliberately committed a wrong with malicious intent or
has otherwise done something outrageous.
Punitive damages are rarely allowed in negligence cases for that reason. But if someone sets out
intentionally and maliciously to hurt another person, punitive damages may well be appropriate.
Punitive damages are intended not only to punish the wrongdoer, by exacting an additional and
sometimes heavy payment (the exact amount is left to the discretion of jury and judge), but also
to deter others from similar conduct. The punitive damage award has been subject to heavy
criticism in recent years in cases in which it has been awarded against manufacturers. One fear
is that huge damage awards on behalf of a multitude of victims could swiftly bankrupt the
defendant. Unlike compensatory damages, punitive damages are taxable.

KEY TAKEAWAY

There are three kinds of torts, and in two of them (negligent torts and strict liability torts),
damages are usually limited to making the victim whole through an enforceable judgment for
money damages. These compensatory damages awarded by a court accomplish only
approximate justice for the injuries or property damage caused by a tortfeasor. Tort laws go
a step further toward deterrence, beyond compensation to the plaintiff, in occasionally

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awarding punitive damages against a defendant. These are almost always in cases where an
intentional tort has been committed.

EXERCISES

1. Why is deterrence needed for intentional torts (where punitive damages are awarded) rather
than negligent torts?
2. Why are costs imposed on others without their consent problematic for a market economy?
What if the law did not try to reimpose the victim’s costs onto the tortfeasor? What would a
totally nonlitigious society be like?

7.2 Intentional Torts

LEARNING OBJECTIVES

1. Distinguish intentional torts from other kinds of torts.
2. Give three examples of an intentional tort—one that causes injury to a person, one that
causes injury to property, and one that causes injury to a reputation.
The analysis of most intentional torts is straightforward and parallels the substantive crimes
already discussed in Chapter 6 "Criminal Law". When physical injury or damage to property is
caused, there is rarely debate over liability if the plaintiff deliberately undertook to produce the
harm. Certain other intentional torts are worth noting for their relevance to business.

Assault and Battery
One of the most obvious intentional torts is assault and battery. Both criminal law and tort law
serve to restrain individuals from using physical force on others. Assault is (1) the threat of
immediate harm or offense of contact or (2) any act that would arouse reasonable apprehension
of imminent harm. Battery is unauthorized and harmful or offensive physical contact with
another person that causes injury.
Often an assault results in battery, but not always. In Western Union Telegraph Co. v. Hill, for
example, the defendant did not touch the plaintiff’s wife, but the case presented an issue of
possible assault even without an actual battery; the defendant employee attempted to kiss a
customer across the countertop, couldn't quite reach her, but nonetheless created actionable
fear (or, as the court put it, “apprehension”) on the part of the plaintiff's wife. It is also possible

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to have a battery without an assault. For example, if someone hits you on the back of the head
with an iron skillet and you didn’t see it coming, there is a battery but no assault. Likewise, if
Andrea passes out from drinking too much at the fraternity party and a stranger (Andre) kisses
her on the lips while she is passed out, she would not be aware of any threat of offensive contact
and would have no apprehension of any harm. Thus there has been no tort of assault, but she
could allege the tort of battery. (The question of what damages, if any, would be an interesting
argument.)
Under the doctrine of transferred intent, if Draco aims his wand at Harry but Harry ducks just
in time and the impact is felt by Hermione instead, English law (and American law) would
transfer Draco’s intent from the target to the actual victim of the act. Thus Hermione could sue
Draco for battery for any damages she had suffered.

False Imprisonment
The tort of false imprisonment originally implied a locking up, as in a prison, but today it can
occur if a person is restrained in a room or a car or even if his or her movements are restricted
while walking down the street. People have a right to be free to go as they please, and anyone
who without cause deprives another of personal freedom has committed a tort. Damages are
allowed for time lost, discomfort and resulting ill health, mental suffering, humiliation, loss of
reputation or business, and expenses such as attorneys’ fees incurred as a result of the restraint
(such as a false arrest). But as the case of Lester v. Albers Super Markets, Inc. (Section 7.5
"Cases") shows, the defendant must be shown to have restrained the plaintiff in order for
damages to be allowed.

Intentional Infliction of Emotional Distress
Until recently, the common-law rule was that there could be no recovery for acts, even though
intentionally undertaken, that caused purely mental or emotional distress. For a case to go to
the jury, the courts required that the mental distress result from some physical injury. In recent
years, many courts have overthrown the older rule and now recognize the so-called new tort. In
an employment context, however, it is rare to find a case where a plaintiff is able to recover. The
most difficult hurdle is proving that the conduct was “extreme” or “outrageous.”

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In an early California case, bill collectors came to the debtor’s home repeatedly and threatened
the debtor’s pregnant wife. Among other things, they claimed that the wife would have to deliver
her child in prison. The wife miscarried and had emotional and physical complications. The
court found that the behavior of the collection company’s two agents was sufficiently outrageous
to prove the tort of intentional infliction of emotional distress. In Roche v. Stern (New York), the
famous cable television talk show host Howard Stern had tastelessly discussed the remains of
Deborah Roche, a topless dancer and cable access television host. [1] The remains had been
brought to Stern’s show by a close friend of Roche, Chaunce Hayden, and a number of crude
comments by Stern and Hayden about the remains were videotaped and broadcast on a national
cable television station. Roche’s sister and brother sued Howard Stern and Infinity broadcasting
and were able to get past the defendant’s motion to dismiss to have a jury consider their claim.
A plaintiff’s burden in these cases is to show that the mental distress is severe. Many states
require that this distress must result in physical symptoms such as nausea, headaches, ulcers,
or, as in the case of the pregnant wife, a miscarriage. Other states have not required physical
symptoms, finding that shame, embarrassment, fear, and anger constitute severe mental
distress.

Trespass and Nuisance
Trespass is intentionally going on land that belongs to someone else or putting something on
someone else’s property and refusing to remove it. This part of tort law shows how strongly the
law values the rights of property owners. The right to enjoy your property without interference
from others is also found in common law of nuisance. There are limits to property owners’
rights, however. In Katko v. Briney, for example, the plaintiff was injured by a spring gun while
trespassing on the defendant’s property. [2] The defendant had set up No Trespassing signs after
ten years of trespassing and housebreaking events, with the loss of some household items.
Windows had been broken, and there was “messing up of the property in general.” The
defendants had boarded up the windows and doors in order to stop the intrusions and finally
had set up a shotgun trap in the north bedroom of the house. One defendant had cleaned and
oiled his 20-gauge shotgun and taken it to the old house where it was secured to an iron bed
with the barrel pointed at the bedroom door. “It was rigged with wire from the doorknob to the
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gun’s trigger so would fire when the door was opened.” The angle of the shotgun was adjusted to
hit an intruder in the legs. The spring could not be seen from the outside, and no warning of its
presence was posted.
The plaintiff, Katko, had been hunting in the area for several years and considered the property
abandoned. He knew it had long been uninhabited. He and a friend had been to the house and
found several old bottles and fruit jars that they took and added to their collection of antiques.
When they made a second trip to the property, they entered by removing a board from a porch
window. When the plaintiff opened the north bedroom door, the shotgun went off and struck
him in the right leg above the ankle bone. Much of his leg was blown away. While Katko knew he
had no right to break and enter the house with intent to steal bottles and fruit jars, the court
held that a property owner could not protect an unoccupied boarded-up farmhouse by using a
spring gun capable of inflicting death or serious injury.
In Katko, there is an intentional tort. But what if someone trespassing is injured by the
negligence of the landowner? States have differing rules about trespass and negligence. In some
states, a trespasser is only protected against the gross negligence of the landowner. In other
states, trespassers may be owed the duty of due care on the part of the landowner. The burglar
who falls into a drained swimming pool, for example, may have a case against the homeowner
unless the courts or legislature of that state have made it clear that trespassers are owed the
limited duty to avoid gross negligence. Or a very small child may wander off his own property
and fall into a gravel pit on a nearby property and suffer death or serious injury; if the pit should
(in the exercise of due care) have been filled in or some barrier erected around it, then there was
negligence. But if the state law holds that the duty to trespassers is only to avoid gross
negligence, the child’s family would lose, unless the state law makes an exception for very young
trespassers. In general, guests, licensees, and invitees are owed a duty of due care; a trespasser
may not be owed such a duty, but states have different rules on this.

Intentional Interference with Contractual Relations
Tortious interference with a contract can be established by proving four elements:
1. There was a contract between the plaintiff and a third party.
2. The defendant knew of the contract.
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3. The defendant improperly induced the third party to breach the contract or made performance
of the contract impossible.
4. There was injury to the plaintiff.
In a famous case of contract interference, Texaco was sued by Pennzoil for interfering with an
agreement that Pennzoil had with Getty Oil. After complicated negotiations between Pennzoil
and Getty, a takeover share price was struck, a memorandum of understanding was signed, and
a press release announced the agreement in principle between Pennzoil and Getty. Texaco’s
lawyers, however, believed that Getty oil was “still in play,” and before the lawyers for Pennzoil
and Getty could complete the paperwork for their agreement, Texaco announced it was offering
Getty shareholders an additional $12.50 per share over what Pennzoil had offered.
Texaco later increased its offer to $228 per share, and the Getty board of directors soon began
dealing with Texaco instead of Pennzoil. Pennzoil decided to sue in Texas state court for tortious
interference with a contract. After a long trial, the jury returned an enormous verdict against
Texaco: $7.53 billion in actual damages and $3 billion in punitive damages. The verdict was so
large that it would have bankrupted Texaco. Appeals from the verdict centered on an obscure
rule of the Securities and Exchange Commission (SEC), Rule 10(b)-13, and Texaco’s argument
was based on that rule and the fact that the contract had not been completed. If there was no
contract, Texaco could not have legally interfered with one. After the SEC filed a brief that
supported Texaco’s interpretation of the law, Texaco agreed to pay $3 billion to Pennzoil to
dismiss its claim of tortious interference with a contract.

Malicious Prosecution
Malicious prosecution is the tort of causing someone to be prosecuted for a criminal act,
knowing that there was no probable cause to believe that the plaintiff committed the crime. The
plaintiff must show that the defendant acted with malice or with some purpose other than
bringing the guilty to justice. A mere complaint to the authorities is insufficient to establish the
tort, but any official proceeding will support the claim—for example, a warrant for the plaintiff’s
arrest. The criminal proceeding must terminate in the plaintiff’s favor in order for his suit to be
sustained.

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A majority of US courts, though by no means all, permit a suit for wrongful civil proceedings.
Civil litigation is usually costly and burdensome, and one who forces another to defend himself
against baseless accusations should not be permitted to saddle the one he sues with the costs of
defense. However, because, as a matter of public policy, litigation is favored as the means by
which legal rights can be vindicated—indeed, the Supreme Court has even ruled that individuals
have a constitutional right to litigate—the plaintiff must meet a heavy burden in proving his
case. The mere dismissal of the original lawsuit against the plaintiff is not sufficient proof that
the suit was unwarranted. The plaintiff in a suit for wrongful civil proceedings must show that
the defendant (who was the plaintiff in the original suit) filed the action for an improper purpose
and had no reasonable belief that his cause was legally or factually well grounded.

Defamation
Defamation is injury to a person’s good name or reputation. In general, if the harm is done
through the spoken word—one person to another, by telephone, by radio, or on television—it is
called slander. If the defamatory statement is published in written form, it is called libel.
The Restatement (Second) of Torts defines a defamatory communication as one that “so tends to
harm the reputation of another as to lower him in the estimation of the community or to deter
third persons from associating or dealing with him.” [3]
A statement is not defamatory unless it is false. Truth is an absolute defense to a charge of libel
or slander. Moreover, the statement must be “published”—that is, communicated to a third
person. You cannot be libeled by one who sends you a letter full of false accusations and
scurrilous statements about you unless a third person opens it first (your roommate, perhaps).
Any living person is capable of being defamed, but the dead are not. Corporations, partnerships,
and other forms of associations can also be defamed, if the statements tend to injure their ability
to do business or to garner contributions.
The statement must have reference to a particular person, but he or she need not be identified
by name. A statement that “the company president is a crook” is defamatory, as is a statement
that “the major network weathermen are imposters.” The company president and the network
weathermen could show that the words were aimed at them. But statements about large groups

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will not support an action for defamation (e.g., “all doctors are butchers” is not defamatory of
any particular doctor).
The law of defamation is largely built on strict liability. That a person did not intend to defame is
ordinarily no excuse; a typographical error that converts a true statement into a false one in a
newspaper, magazine, or corporate brochure can be sufficient to make out a case of libel. Even
the exercise of due care is usually no excuse if the statement is in fact communicated. Repeating
a libel is itself a libel; a libel cannot be justified by showing that you were quoting someone else.
Though a plaintiff may be able to prove that a statement was defamatory, he is not necessarily
entitled to an award of damages. That is because the law contains a number of privileges that
excuse the defamation.
Publishing false information about another business’s product constitutes the tort of slander of
quality, or trade libel. In some states, this is known as the tort of product disparagement. It may
be difficult to establish damages, however. A plaintiff must prove that actual damages
proximately resulted from the slander of quality and must show the extent of the economic harm
as well.

Absolute Privilege
Statements made during the course of judicial proceedings are absolutely privileged, meaning
that they cannot serve as the basis for a defamation suit. Accurate accounts of judicial or other
proceedings are absolutely privileged; a newspaper, for example, may pass on the slanderous
comments of a judge in court. “Judicial” is broadly construed to include most proceedings of
administrative bodies of the government. The Constitution exempts members of Congress from
suits for libel or slander for any statements made in connection with legislative business. The
courts have constructed a similar privilege for many executive branch officials.

Qualified Privilege
Absolute privileges pertain to those in the public sector. A narrower privilege exists for private
citizens. In general, a statement that would otherwise be actionable is held to be justified if made
in a reasonable manner and for a reasonable purpose. Thus you may warn a friend to beware of
dealing with a third person, and if you had reason to believe that what you said was true, you are
privileged to issue the warning, even though false. Likewise, an employee may warn an employer
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about the conduct or character of a fellow or prospective employee, and a parent may complain
to a school board about the competence or conduct of a child’s teacher. There is a line to be
drawn, however, and a defendant with nothing but an idle interest in the matter (an “officious
intermeddler”) must take the risk that his information is wrong.
In 1964, the Supreme Court handed down its historic decision in New York Times v. Sullivan,
holding that under the First Amendment a libel judgment brought by a public official against a
newspaper cannot stand unless the plaintiff has shown “actual malice,” which in turn was
defined as “knowledge that [the statement] was false or with a reckless disregard of whether it
was false or not.” [4] In subsequent cases, the court extended the constitutional doctrine further,
applying it not merely to government officials but to public figures, people who voluntarily place
themselves in the public eye or who involuntarily find themselves the objects of public scrutiny.
Whether a private person is or is not a public figure is a difficult question that has so far eluded
rigorous definition and has been answered only from case to case. A CEO of a private
corporation ordinarily will be considered a private figure unless he puts himself in the public
eye—for example, by starring in the company’s television commercials.

Invasion of Privacy
The right of privacy—the right “to be let alone”—did not receive judicial recognition until the
twentieth century, and its legal formulation is still evolving. In fact there is no single right of
privacy. Courts and commentators have discerned at least four different types of interests: (1)
the right to control the appropriation of your name and picture for commercial purposes, (2) the
right to be free of intrusion on your “personal space” or seclusion, (3) freedom from public
disclosure of embarrassing and intimate facts of your personal life, and (4) the right not to be
presented in a “false light.”

Appropriation of Name or Likeness
The earliest privacy interest recognized by the courts was appropriation of name or likeness:
someone else placing your photograph on a billboard or cereal box as a model or using your
name as endorsing a product or in the product name. A New York statute makes it a
misdemeanor to use the name, portrait, or picture of any person for advertising purposes or for
the purposes of trade (business) without first obtaining written consent. The law also permits
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the aggrieved person to sue and to recover damages for unauthorized profits and also to have
the court enjoin (judicially block) any further unauthorized use of the plaintiff’s name, likeness,
or image. This is particularly useful to celebrities.
Because the publishing and advertising industries are concentrated heavily in New York, the
statute plays an important part in advertising decisions made throughout the country. Deciding
what “commercial” or “trade” purposes are is not always easy. Thus a newsmagazine may use a
baseball player’s picture on its cover without first obtaining written permission, but a chocolate
manufacturer could not put the player’s picture on a candy wrapper without consent.

Personal Space
One form of intrusion upon a person’s solitude—trespass—has long been actionable under
common law. Physical invasion of home or other property is not a new tort. But in recent years,
the notion of intrusion has been broadened considerably. Now, taking photos of someone else
with your cell phone in a locker room could constitute invasion of the right to privacy. Reading
someone else’s mail or e-mail could also constitute an invasion of the right to privacy.
Photographing someone on a city street is not tortious, but subsequent use of the photograph
could be. Whether the invasion is in a public or private space, the amount of damages will
depend on how the image or information is disclosed to others.

Public Disclosure of Embarassing Facts
Circulation of false statements that do injury to a person are actionable under the laws of
defamation. What about true statements that might be every bit as damaging—for example,
disclosure of someone’s income tax return, revealing how much he earned? The general rule is
that if the facts are truly private and of no “legitimate” concern to the public, then their
disclosure is a violation of the right to privacy. But a person who is in the public eye cannot
claim the same protection.

False Light
A final type of privacy invasion is that which paints a false picture in a publication. Though false,
it might not be libelous, since the publication need contain nothing injurious to reputation.
Indeed, the publication might even glorify the plaintiff, making him seem more heroic than he
actually is. Subject to the First Amendment requirement that the plaintiff must show intent or
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extreme recklessness, statements that put a person in a false light, like a fictionalized biography,
are actionable.

KEY TAKEAWAY

There are many kinds of intentional torts. Some of them involve harm to the physical
person or to his or her property, reputation or feelings, or economic interests. In each case
of intentional tort, the plaintiff must show that the defendant intended harm, but the
intent to harm does not need to be directed at a particular person and need not be
malicious, as long as the resulting harm is a direct consequence of the defendant’s actions.

EXERCISES

1. Name two kinds of intentional torts that could result in damage to a business firm’s
bottom line.
2. Name two kinds of intentional torts that are based on protection of a person’s property.
3. Why are intentional torts more likely to result in a verdict not only for compensatory
damages but also for punitive damages?

[1] Roche v. Stern, 675 N.Y.S.2d 133 (1998).
[2] Katko v. Briney, 183 N.W.2d 657 (Iowa 1971).
[3] Restatement (Second) of Torts, Section 559 (1965).
[4] Times v. Sullivan, 376 US 254 (1964).

7.3 Negligence

LEARNING OBJECTIVES

1. Understand how the duty of due care relates to negligence.
2. Distinguish between actual and proximate cause.
3. Explain the primary defenses to a claim of negligence.

Elements of Negligence

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Physical harm need not be intentionally caused. A pedestrian knocked over by an automobile
does not hurt less because the driver intended no wrong but was merely careless. The law
imposes a duty of care on all of us in our everyday lives. Accidents caused by negligence are
actionable.
Determining negligence is not always easy. If a driver runs a red light, we can say that he is
negligent because a driver must always be careful to ascertain whether the light is red and be
able to stop if it is. Suppose that the driver was carrying a badly injured person to a nearby
hospital and that after slowing down at an intersection, went through a red light, blowing his
horn, whereupon a driver to his right, seeing him, drove into the intersection anyway and
crashed into him. Must one always stop at a red light? Is proof that the light was red always
proof of negligence? Usually, but not always: negligence is an abstract concept that must always
be applied to concrete and often widely varying sets of circumstances. Whether someone was or
was not negligent is almost always a question of fact for a jury to decide. Rarely is it a legal
question that a judge can settle.
The tort of negligence has four elements: (1) a duty of due care that the defendant had, (2)
the breach of the duty of due care, (3) connection between cause and injury, and (4) actual
damage or loss. Even if a plaintiff can prove each of these aspects, the defendant may be able to
show that the law excuses the conduct that is the basis for the tort claim. We examine each of
these factors below.

Standard of Care
Not every unintentional act that causes injury is negligent. If you brake to a stop when you see a
child dart out in front of your car, and if the noise from your tires gives someone in a nearby
house a heart attack, you have not acted negligently toward the person in the house. The
purpose of the negligence standard is to protect others against the risk of injury that foreseeably
would ensue from unreasonably dangerous conduct.
Given the infinite variety of human circumstances and conduct, no general statement of a
reasonable standard of care is possible. Nevertheless, the law has tried to encapsulate it in the
form of the famous standard of “the reasonable man.” This fictitious person “of ordinary
prudence” is the model that juries are instructed to compare defendants with in assessing
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whether those defendants have acted negligently. Analysis of this mythical personage has baffled
several generations of commentators. How much knowledge must he have of events in the
community, of technology, of cause and effect? With what physical attributes, courage, or
wisdom is this nonexistent person supposedly endowed? If the defendant is a person with
specialized knowledge, like a doctor or an automobile designer, must the jury also treat the
“reasonable man” as having this knowledge, even though the average person in the community
will not? (Answer: in most cases, yes.)
Despite the many difficulties, the concept of the reasonable man is one on which most
negligence cases ultimately turn. If a defendant has acted “unreasonably under the
circumstances” and his conduct posed an unreasonable risk of injury, then he is liable for injury
caused by his conduct. Perhaps in most instances, it is not difficult to divine what the reasonable
man would do. The reasonable man stops for traffic lights and always drives at reasonable
speeds, does not throw baseballs through windows, performs surgical operations according to
the average standards of the medical profession, ensures that the floors of his grocery store are
kept free of fluids that would cause a patron to slip and fall, takes proper precautions to avoid
spillage of oil from his supertanker, and so on. The "reasonable man" standard imposes
hindsight on the decisions and actions of people in society; the circumstances of life are such
that courts may sometimes impose a standard of due care that many people might not find
reasonable.

Duty of Care and Its Breach
The law does not impose on us a duty to care for every person. If the rule were otherwise, we
would all, in this interdependent world, be our brothers’ keepers, constantly unsure whether any
action we took might subject us to liability for its effect on someone else. The law copes with this
difficulty by limiting the number of people toward whom we owe a duty to be careful.
In general, the law imposes no obligation to act in a situation to which we are strangers. We may
pass the drowning child without risking a lawsuit. But if we do act, then the law requires us to
act carefully. The law of negligence requires us to behave with due regard for the foreseeable
consequences of our actions in order to avoid unreasonable risks of injury.

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During the course of the twentieth century, the courts have constantly expanded the notion of
“foreseeability,” so that today many more people are held to be within the zone of injury than
was once the case. For example, it was once believed that a manufacturer or supplier owed a
duty of care only to immediate purchasers, not to others who might use the product or to whom
the product might be resold. This limitation was known as the rule of privity. And users who
were not immediate purchasers were said not to be in privity with a supplier or manufacturer. In
1916, Judge Benjamin N. Cardozo, then on the New York Court of Appeals, penned an opinion in
a celebrated case that exploded the theory of privity, though it would take half a century before
the last state—Mississippi in 1966—would fall in line.
Determining a duty of care can be a vexing problem. Physicians, for example, are bound by
principles of medical ethics to respect the confidences of their patients. Suppose a patient tells a
psychiatrist that he intends to kill his girlfriend. Does the physician then have a higher legal duty
to warn prospective victim? The California Supreme Court has said yes. [1]
Establishing a breach of the duty of due care where the defendant has violated a statute or
municipal ordinance is eased considerably with the doctrine of negligence per se, a doctrine
common to all US state courts. If a legislative body sets a minimum standard of care for
particular kinds of acts to protect a certain set of people from harm and a violation of that
standard causes harm to someone in that set, the defendant is negligent per se. If Harvey is
driving sixty-five miles per hour in a fifty-five-mile-per-hour zone when he crashes into Haley’s
car and the police accident report establishes that or he otherwise admits to going ten miles per
hour over the speed limit, Haley does not have to prove that Harvey has breached a duty of due
care. She will only have to prove that the speeding was an actual and proximate cause of the
collision and will also have to prove the extent of the resulting damages to her.

Causation: Actual Cause and Proximate Cause
“For want of a nail, the kingdom was lost,” as the old saying has it. Virtually any cause of an
injury can be traced to some preceding cause. The problem for the law is to know when to draw
the line between causes that are immediate and causes too remote for liability reasonably to be
assigned to them. In tort theory, there are two kinds of causes that a plaintiff must prove: actual
cause and proximate cause.Actual cause (causation in fact) can be found if the connection
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between the defendant’s act and the plaintiff’s injuries passes the “but for” test: if an injury
would not have occurred “but for” the defendant’s conduct, then the defendant is the cause of
the injury. Still, this is not enough causation to create liability. The injuries to the plaintiff must
also be foreseeable, or not “too remote,” for the defendant’s act to create liability. This
is proximate cause: a cause that is not too remote or unforseeable.
Suppose that the person who was injured was not one whom a reasonable person could have
expected to be harmed. Such a situation was presented in one of the most famous US tort
cases, Palsgraf v. Long Island Railroad (Section 7.5 "Cases"), which was decided by Judge
Benjamin Cardozo. Although Judge Cardozo persuaded four of his seven brethren to side with
his position, the closeness of the case demonstrates the difficulty that unforeseeable
consequences and unforeseeable plaintiffs present.

Damages
For a plaintiff to win a tort case, she must allege and prove that she was injured. The fear that
she might be injured in the future is not a sufficient basis for a suit. This rule has proved
troublesome in medical malpractice and industrial disease cases. A doctor’s negligent act or a
company’s negligent exposure of a worker to some form of contamination might not become
manifest in the body for years. In the meantime, the tort statute of limitations might have run
out, barring the victim from suing at all. An increasing number of courts have eased the
plaintiff’s predicament by ruling that the statute of limitations does not begin to run until the
victim discovers that she has been injured or contracted a disease.
The law allows an exception to the general rule that damages must be shown when the plaintiff
stands in danger of immediate injury from a hazardous activity. If you discover your neighbor
experimenting with explosives in his basement, you could bring suit to enjoin him from further
experimentation, even though he has not yet blown up his house—and yours.

Problems of Proof
The plaintiff in a tort suit, as in any other, has the burden of proving his allegations.
He must show that the defendant took the actions complained of as negligent, demonstrate the
circumstances that make the actions negligent, and prove the occurrence and extent of injury.
Factual issues are for the jury to resolve. Since it is frequently difficult to make out the requisite
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proof, the law allows certain presumptions and rules of evidence that ease the plaintiff’s task, on
the ground that without them substantial injustice would be done. One important rule goes by
the Latin phraseres ipsa loquitur, meaning “the thing speaks for itself.” The best evidence is
always the most direct evidence: an eyewitness account of the acts in question. But eyewitnesses
are often unavailable, and in any event they frequently cannot testify directly to the
reasonableness of someone’s conduct, which inevitably can only be inferred from the
circumstances.
In many cases, therefore, circumstantial evidence (evidence that is indirect) will be the only
evidence or will constitute the bulk of the evidence. Circumstantial evidence can often be quite
telling: though no one saw anyone leave the building, muddy footprints tracing a path along the
sidewalk are fairly conclusive. Res ipsa loquitur is a rule of circumstantial evidence that permits
the jury to draw an inference of negligence. A common statement of the rule is the following:
“There must be reasonable evidence of negligence but where the thing is shown to be under the
management of the defendant or his servants, and the accident is such as in the ordinary course
of things does not happen if those who have the management use proper care, it affords
reasonable evidence, in the absence of explanation by the defendants, that the accident arose
from want of care.” [2]
If a barrel of flour rolls out of a factory window and hits someone, or a soda bottle explodes, or
an airplane crashes, courts in every state permit juries to conclude, in the absence of contrary
explanations by the defendants, that there was negligence. The plaintiff is not put to the
impossible task of explaining precisely how the accident occurred. A defendant can always offer
evidence that he acted reasonably—for example, that the flour barrel was securely fastened and
that a bolt of lightning, for which he was not responsible, broke its bands, causing it to roll out
the window. But testimony by the factory employees that they secured the barrel, in the absence
of any further explanation, will not usually serve to rebut the inference. That the defendant was
negligent does not conclude the inquiry or automatically entitle the plaintiff to a judgment. Tort
law provides the defendant with several excuses, some of which are discussed briefly in the next
section.

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Excuses
There are more excuses (defenses) than are listed here, but contributory negligence or
comparative negligence, assumption of risk, and act of God are among the principal defenses
that will completely or partially excuse the negligence of the defendant.

Contributory and Comparative Negligence
Under an old common-law rule, it was a complete defense to show that the plaintiff in a
negligence suit was himself negligent. Even if the plaintiff was only mildly negligent, most of the
fault being chargeable to the defendant, the court would dismiss the suit if the plaintiff’s conduct
contributed to his injury. In a few states today, this rule ofcontributory negligence is still in
effect. Although referred to as negligence, the rule encompasses a narrower form than that with
which the defendant is charged, because the plaintiff’s only error in such cases is in being less
careful of himself than he might have been, whereas the defendant is charged with conduct
careless toward others. This rule was so manifestly unjust in many cases that most states, either
by statute or judicial decision, have changed to some version of comparative negligence. Under
the rule of comparative negligence, damages are apportioned according to the defendant’s
degree of culpability. For example, if the plaintiff has sustained a $100,000 injury and is 20
percent responsible, the defendant will be liable for $80,000 in damages.

Assumption of Risk
Risk of injury pervades the modern world, and plaintiffs should not win a lawsuit simply
because they took a risk and lost. The law provides, therefore, that when a person knowingly
takes a risk, he or she must suffer the consequences.
The assumption of risk doctrine comes up in three ways. The plaintiff may have formally agreed
with the defendant before entering a risky situation that he will relieve the defendant of liability
should injury occur. (“You can borrow my car if you agree not to sue me if the brakes fail,
because they’re worn and I haven’t had a chance to replace them.”) Or the plaintiff may have
entered into a relationship with the defendant knowing that the defendant is not in a position to
protect him from known risks (the fan who is hit by a line drive in a ballpark). Or the plaintiff
may act in the face of a risky situation known in advance to have been created by the defendant’s
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negligence (failure to leave, while there was an opportunity to do so, such as getting into an
automobile when the driver is known to be drunk).
The difficulty in many cases is to determine the dividing line between subjectivity and
objectivity. If the plaintiff had no actual knowledge of the risk, he cannot be held to have
assumed it. On the other hand, it is easy to claim that you did not appreciate the danger, and the
courts will apply an objective standard of community knowledge (a “but you should have
known” test) in many situations. When the plaintiff has no real alternative, however,
assumption of risk fails as a defense (e.g., a landlord who negligently fails to light the exit to the
street cannot claim that his tenants assumed the risk of using it).
At the turn of the century, courts applied assumption of risk in industrial cases to bar relief to
workers injured on the job. They were said to assume the risk of dangerous conditions or
equipment. This rule has been abolished by workers’ compensation statutes in most states.

Act of God
Technically, the rule that no one is responsible for an “act of God,” or force majeure as it is
sometimes called, is not an excuse but a defense premised on a lack of causation. If a force of
nature caused the harm, then the defendant was not negligent in the first place. A marina,
obligated to look after boats moored at its dock, is not liable if a sudden and fierce storm against
which no precaution was possible destroys someone’s vessel. However, if it is foreseeable that
harm will flow from a negligent condition triggered by a natural event, then there is liability. For
example, a work crew failed to remove residue explosive gas from an oil barge. Lightning hit the
barge, exploded the gas, and injured several workmen. The plaintiff recovered damages against
the company because the negligence consisted in the failure to guard against any one of a
number of chance occurrences that could ignite the gas. [3]

Vicarious Liability
Liability for negligent acts does not always end with the one who was negligent. Under certain
circumstances, the liability is imputed to others. For example, an employer is responsible for the
negligence of his employees if they were acting in the scope of employment. This rule of
vicarious liability is often called respondeat superior, meaning that the higher authority must

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respond to claims brought against one of its agents. Respondeat superior is not limited to the
employment relationship but extends to a number of other agency relationships as well.
Legislatures in many states have enacted laws that make people vicariously liable for acts of
certain people with whom they have a relationship, though not necessarily one of agency. It is
common, for example, for the owner of an automobile to be liable for the negligence of one to
whom the owner lends the car. So-called dram shop statutes place liability on bar and tavern
owners and others who serve too much alcohol to one who, in an intoxicated state, later causes
injury to others. In these situations, although the injurious act of the drinker stemmed from
negligence, the one whom the law holds vicariously liable (the bartender) is not himself
necessarily negligent—the law is holding him strictly liable, and to this concept we now turn.

KEY TAKEAWAY

The most common tort claim is based on the negligence of the defendant. In each negligence
claim, the plaintiff must establish by a preponderance of the evidence that (1) the defendant
had a duty of due care, (2) the defendant breached that duty, (3) that the breach of duty
both actually and approximately has caused harm to the plaintiff, and (4) that the harm is
measurable in money damages.
It is also possible for the negligence of one person to be imputed to another, as in the case of
respondeat superior, or in the case of someone who loans his automobile to another driver
who is negligent and causes injury. There are many excuses (defenses) to claims of
negligence, including assumption of risk and comparative negligence. In those few
jurisdictions where contributory negligence has not been modified to comparative
negligence, plaintiffs whose negligence contributes to their own injuries will be barred from
any recovery.

EXERCISES

1. Explain the difference between comparative negligence and contributory negligence.
2. How is actual cause different from probable cause?
3. What is an example of assumption of risk?
4. How does res ipsa loquitur help a plaintiff establish a case of negligence?

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[1] Tarasoff v. Regents of University of California, 551 P.2d 334 (Calif. 1976).
[2] Scott v. London & St. Katherine Docks Co., 3 H. & C. 596, 159 Eng.Rep. 665 (Q.B. 1865).
[3] Johnson v. Kosmos Portland Cement Co., 64 F.2d 193 (6th Cir. 1933).

7.4 Strict Liability

LEARNING OBJECTIVES

1. Understand how strict liability torts differ from negligent torts.
2. Understand the historical origins of strict liability under common law.
3. Be able to apply strict liability concepts to liability for defective products.
4. Distinguish strict liability from absolute liability, and understand the major defenses to a
lawsuit in products-liability cases.

Historical Basis of Strict Liability: Animals and Ultrahazardous Activities
To this point, we have considered principles of liability that in some sense depend upon the
“fault” of the tortfeasor. This fault is not synonymous with moral blame.
Aside from acts intended to harm, the fault lies in a failure to live up to a standard of
reasonableness or due care. But this is not the only basis for tort liability. Innocent mistakes can
be a sufficient basis. As we have already seen, someone who unknowingly trespasses on
another’s property is liable for the damage that he does, even if he has a reasonable belief that
the land is his. And it has long been held that someone who engages in ultrahazardous (or
sometimes, abnormally dangerous) activities is liable for damage that he causes, even though he
has taken every possible precaution to avoid harm to someone else.
Likewise, the owner of animals that escape from their pastures or homes and damage
neighboring property may be liable, even if the reason for their escape was beyond the power of
the owner to stop (e.g., a fire started by lightning that burns open a barn door). In such cases,
the courts invoke the principle of strict liability, or, as it is sometimes called, liability without
fault. The reason for the rule is explained in Klein v. Pyrodyne Corporation (Section 7.5
"Cases").

Strict Liability for Products

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Products liability is extremely important. Strict liability may also apply as a legal standard for
products, even those that are not ultrahazardous. In some national legal systems, strict liability
is not available as a cause of action to plaintiffs seeking to recover a judgment of products
liability against a manufacturer, wholesaler, distributor, or retailer. (Some states limit liability to
the manufacturer.) But it is available in the United States and initially was created by a
California Supreme Court decision in the 1962 case of Greenman v. Yuba Power Products, Inc.
In Greenman, the plaintiff had used a home power saw and bench, the Shopsmith, designed and
manufactured by the defendant. He was experienced in using power tools and was injured while
using the approved lathe attachment to the Shopsmith to fashion a wooden chalice. The case
was decided on the premise that Greenman had done nothing wrong in using the machine but
that the machine had a defect that was “latent” (not easily discoverable by the consumer).
Rather than decide the case based on warranties, or requiring that Greenman prove how the
defendant had been negligent, Justice Traynor found for the plaintiff based on the overall social
utility of strict liability in cases of defective products. According to his decision, the purpose of
such liability is to ensure that the “cost of injuries resulting from defective products is borne by
the manufacturers…rather than by the injured persons who are powerless to protect
themselves.”
Today, the majority of US states recognize strict liability for defective products, although some
states limit strict liability actions to damages for personal injuries rather than property damage.
Injured plaintiffs have to prove the product caused the harm but do not have to prove exactly
how the manufacturer was careless. Purchasers of the product, as well as injured guests,
bystanders, and others with no direct relationship with the product, may sue for damages
caused by the product.
The Restatement of the Law of Torts, Section 402(a), was originally issued in 1964. It is a widely
accepted statement of the liabilities of sellers of goods for defective products. The Restatement
specifies six requirements, all of which must be met for a plaintiff to recover using strict liability
for a product that the plaintiff claims is defective:
1. The product must be in a defective condition when the defendant sells it.

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2. The defendant must normally be engaged in the business of selling or otherwise distributing the
product.
3. The product must be unreasonably dangerous to the user or consumer because of its defective
condition.
4. The plaintiff must incur physical harm to self or to property by using or consuming the product.
5. The defective condition must be the proximate cause of the injury or damage.
6. The goods must not have been substantially changed from the time the product was sold to the
time the injury was sustained.
Section 402(a) also explicitly makes clear that a defendant can be held liable even though the
defendant has exercised “all possible care.” Thus in a strict liability case, the plaintiff does not
need to show “fault” (or negligence).
For defendants, who can include manufacturers, distributors, processors, assemblers,
packagers, bottlers, retailers, and wholesalers, there are a number of defenses that are available,
including assumption of risk, product misuse and comparative negligence, commonly known
dangers, and the knowledgeable-user defense. We have already seen assumption of risk and
comparative negligence in terms of negligence actions; the application of these is similar in
products-liability actions.
Under product misuse, a plaintiff who uses a product in an unexpected and unusual way will not
recover for injuries caused by such misuse. For example, suppose that someone uses a rotary
lawn mower to trim a hedge and that after twenty minutes of such use loses control because of
its weight and suffers serious cuts to his abdomen after dropping it. Here, there would be a
defense of product misuse, as well as contributory negligence. Consider the urban (or Internet)
legend of Mervin Gratz, who supposedly put his Winnebago on autopilot to go back and make
coffee in the kitchen, then recovered millions after his Winnebago turned over and he suffered
serious injuries. There are multiple defenses to this alleged action; these would include the
defenses of contributory negligence, comparative negligence, and product misuse. (There was
never any such case, and certainly no such recovery; it is not known who started this legend, or
why.)

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Another defense against strict liability as a cause of action is the knowledgeable user defense. If
the parents of obese teenagers bring a lawsuit against McDonald’s, claiming that its fast-food
products are defective and that McDonald’s should have warned customers of the adverse health
effects of eating its products, a defense based on the knowledgeable user is available. In one
case, the court found that the high levels of cholesterol, fat, salt, and sugar in McDonald’s food is
well known to users. The court stated, “If consumers know (or reasonably should know) the
potential ill health effects of eating at McDonald’s, they cannot blame McDonald’s if they,
nonetheless, choose to satiate their appetite with a surfeit of supersized McDonald’s
products.” [1]

KEY TAKEAWAY

Common-law courts have long held that certain activities are inherently dangerous and that
those who cause damage to others by engaging in those activities will be held strictly liable.
More recently, courts in the United States have applied strict liability to defective products.
Strict liability, however, is not absolute liability, as there are many defenses available to
defendants in lawsuits based on strict liability, such as comparative negligence and product
abuse.

EXERCISES

1. Someone says, “Strict liability means that you’re liable for whatever you make, no matter
what the consumer does with your product. It’s a crazy system.” Respond to and refute this
statement.
2. What is the essential difference between strict liability torts and negligent torts? Should the
US legal system even allow strict liability torts? What reasons seem persuasive to you?

[1] Pellman v. McDonald’s Corp., 237 F.2d 512 (S.D.N.Y. 2003).

7.5 Cases
Intentional Torts: False Imprisonment
Lester v. Albers Super Markets, Inc.
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94 Ohio App. 313, 114 N.E.2d 529 (Ohio 1952)
Facts: The plaintiff, carrying a bag of rolls purchased at another store, entered the defendant’s
grocery store to buy some canned fruit. Seeing her bus outside, she stepped out of line and put
the can on the counter. The store manager intercepted her and repeatedly demanded that she
submit the bag to be searched. Finally she acquiesced; he looked inside and said she could go.
She testified that several people witnessed the scene, which lasted about fifteen minutes, and
that she was humiliated. The jury awarded her $800. She also testified that no one laid a hand
on her or made a move to restrain her from leaving by any one of numerous exits.
***
MATTHEWS, JUDGE.
As we view the record, it raises the fundamental question of what is imprisonment. Before any
need for a determination of illegality arises there must be proof of imprisonment. In 35 Corpus
Juris Secundum (C.J.S.), False Imprisonment, § II, pages 512–13, it is said: “Submission to the
mere verbal direction of another, unaccompanied by force or by threats of any character, cannot
constitute a false imprisonment, and there is no false imprisonment where an employer
interviewing an employee declines to terminate the interview if no force or threat of force is used
and false imprisonment may not be predicated on a person’s unfounded belief that he was
restrained.”
Many cases are cited in support of the text.
***
In Fenn v. Kroger Grocery & Baking Co., Mo. Sup., 209 S.W. 885, 887, the court said:
A case was not made out for false arrest. The plaintiff said she was intercepted as she started to
leave the store; that Mr. Krause stood where she could not pass him in going out. She does not
say that he made any attempt to intercept her. She says he escorted her back to the desk, that he
asked her to let him see the change.
…She does not say that she went unwillingly…Evidence is wholly lacking to show that she was
detained by force or threats. It was probably a disagreeable experience, a humiliating one to her,
but she came out victorious and was allowed to go when she desired with the assurance of Mr.

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Krause that it was all right. The demurrer to the evidence on both counts was properly
sustained.
The result of the cases is epitomized in 22 Am.Jur. 368, as follows:
A customer or patron who apparently has not paid for what he has received may be detained for
a reasonable time to investigate the circumstances, but upon payment of the demand, he has the
unqualified right to leave the premises without restraint, so far as the proprietor is concerned,
and it is false imprisonment for a private individual to detain one for an unreasonable time, or
under unreasonable circumstances, for the purpose of investigating a dispute over the payment
of a bill alleged to be owed by the person detained for cash services.
***
For these reasons, the judgment is reversed and final judgment entered for the defendantappellant.

CASE QUESTIONS

1. The court begins by saying what false imprisonment is not. What is the legal definition of
false imprisonment?
2. What kinds of detention are permissible for a store to use in accosting those that may have
been shoplifting?
3. Jody broke up with Jeremy and refused to talk to him. Jeremy saw Jody get into her car near
the business school and parked right behind her so she could not move. He then stood next
to the driver’s window for fifteen minutes, begging Jody to talk to him. She kept saying, “No,
let me leave!” Has Jeremy committed the tort of false imprisonment?

Negligence: Duty of Due Care
Whitlock v. University of Denver
744 P.2d 54 (Supreme Court of Colorado1987)
On June 19, 1978, at approximately 10:00 p.m., plaintiff Oscar Whitlock suffered a paralyzing
injury while attempting to complete a one-and-three-quarters front flip on a trampoline. The
injury rendered him a quadriplegic. The trampoline was owned by the Beta Theta Pi fraternity
(the Beta house) and was situated on the front yard of the fraternity premises, located on the
University campus. At the time of his injury, Whitlock was twenty years old, attended the

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University of Denver, and was a member of the Beta house, where he held the office of acting
house manager. The property on which the Beta house was located was leased to the local
chapter house association of the Beta Theta Pi fraternity by the defendant University of Denver.
Whitlock had extensive experience jumping on trampolines. He began using trampolines in
junior high school and continued to do so during his brief tenure as a cadet at the United States
Military Academy at West Point, where he learned to execute the one-and-three-quarters front
flip. Whitlock testified that he utilized the trampoline at West Point every other day for a period
of two months. He began jumping on the trampoline owned by the Beta house in September of
1977. Whitlock recounted that in the fall and spring prior to the date of his injury, he jumped on
the trampoline almost daily. He testified further that prior to the date of his injury, he had
successfully executed the one-and-three-quarters front flip between seventy-five and one
hundred times.
During the evening of June 18 and early morning of June 19, 1978, Whitlock attended a party at
the Beta house, where he drank beer, vodka and scotch until 2:00 a.m. Whitlock then retired
and did not awaken until 2:00 p.m. on June 19. He testified that he jumped on the trampoline
between 2:00 p.m. and 4:00 p.m., and again at 7:00 p.m. At 10:00 p.m., the time of the injury,
there again was a party in progress at the Beta house, and Whitlock was using the trampoline
with only the illumination from the windows of the fraternity house, the outside light above the
front door of the house, and two street lights in the area. As Whitlock attempted to perform the
one-and-three-quarters front flip, he landed on the back of his head, causing his neck to break.
Whitlock brought suit against the manufacturer and seller of the trampoline, the University, the
Beta Theta Pi fraternity and its local chapter, and certain individuals in their capacities as
representatives of the Beta Theta Pi organizations. Whitlock reached settlements with all of the
named defendants except the University, so only the negligence action against the University
proceeded to trial. The jury returned a verdict in favor of Whitlock, assessing his total damages
at $ 7,300,000. The jury attributed twenty-eight percent of causal negligence to the conduct of
Whitlock and seventy-two percent of causal negligence to the conduct of the University. The trial
court accordingly reduced the amount of the award against the University to $ 5,256,000.

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The University moved for judgment notwithstanding the verdict, or, in the alternative, a new
trial. The trial court granted the motion for judgment notwithstanding the verdict, holding that
as a matter of law, no reasonable jury could have found that the University was more negligent
than Whitlock, and that the jury’s monetary award was the result of sympathy, passion or
prejudice.
A panel of the court of appeals reversed…by a divided vote. Whitlock v. University of
Denver, 712 P.2d 1072 (Colo. App. 1985). The court of appeals held that the University owed
Whitlock a duty of due care to remove the trampoline from the fraternity premises or to
supervise its use.…The case was remanded to the trial court with orders to reinstate the verdict
and damages as determined by the jury. The University then petitioned for certiorari review, and
we granted that petition.

II.
A negligence claim must fail if based on circumstances for which the law imposes no duty of care
upon the defendant for the benefit of the plaintiff. [Citations] Therefore, if Whitlock’s judgment
against the University is to be upheld, it must first be determined that the University owed a
duty of care to take reasonable measures to protect him against the injury that he sustained.
Whether a particular defendant owes a legal duty to a particular plaintiff is a question of law.
[Citations] “The court determines, as a matter of law, the existence and scope of the duty—that
is, whether the plaintiff’s interest that has been infringed by the conduct of the defendant is
entitled to legal protection.” [Citations] In Smith v. City & County of Denver, 726 P.2d 1125
(Colo. 1986), we set forth several factors to be considered in determining the existence of duty in
a particular case:
Whether the law should impose a duty requires consideration of many factors including, for
example, the risk involved, the foreseeability and likelihood of injury as weighed against the
social utility of the actor’s conduct, the magnitude of the burden of guarding against injury or
harm, and the consequences of placing the burden upon the actor.
…A court’s conclusion that a duty does or does not exist is “an expression of the sum total of
those considerations of policy which lead the law to say that the plaintiff is [or is not] entitled to
protection.”
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…
We believe that the fact that the University is charged with negligent failure to act rather than
negligent affirmative action is a critical factor that strongly militates against imposition of a duty
on the University under the facts of this case. In determining whether a defendant owes a duty
to a particular plaintiff, the law has long recognized a distinction between action and a failure to
act—“that is to say, between active misconduct working positive injury to others [misfeasance]
and passive inaction or a failure to take steps to protect them from harm [nonfeasance].” W.
Keeton, § 56, at 373. Liability for nonfeasance was slow to receive recognition in the law. “The
reason for the distinction may be said to lie in the fact that by ‘misfeasance’ the defendant has
created a new risk of harm to the plaintiff, while by ‘nonfeasance’ he has at least made his
situation no worse, and has merely failed to benefit him by interfering in his
affairs.” Id. The Restatement (Second) of Torts § 314 (1965) summarizes the law on this point as
follows:
The fact that an actor realizes or should realize that action on his part is necessary for another’s
aid or protection does not of itself impose upon him a duty to take such action.
Imposition of a duty in all such cases would simply not meet the test of fairness under
contemporary standards.
In nonfeasance cases the existence of a duty has been recognized only during the last century in
situations involving a limited group of special relationships between parties. Such special
relationships are predicated on “some definite relation between the parties, of such a character
that social policy justifies the imposition of a duty to act.” W. Keeton, § 56, at 374. Special
relationships that have been recognized by various courts for the purpose of imposition of a duty
of care include common carrier/passenger, innkeeper/guest, possessor of land/invited entrant,
employer/employee, parent/child, and hospital/patient. See Restatement (Second) of Torts §
314 A (1965); 3 Harper and James, § 18.6, at 722–23. The authors of theRestatement (Second)
of Torts § 314 A, comment b (1965), state that “the law appears…to be working slowly toward a
recognition of the duty to aid or protect in any relation of dependence or of mutual dependence.”
…

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III.
The present case involves the alleged negligent failure to act, rather than negligent action. The
plaintiff does not complain of any affirmative action taken by the University, but asserts instead
that the University owed to Whitlock the duty to assure that the fraternity’s trampoline was used
only under supervised conditions comparable to those in a gymnasium class, or in the
alternative to cause the trampoline to be removed from the front lawn of the Beta house.…If
such a duty is to be recognized, it must be grounded on a special relationship between the
University and Whitlock. According to the evidence, there are only two possible sources of a
special relationship out of which such a duty could arise in this case: the status of Whitlock as a
student at the University, and the lease between the University and the fraternity of which
Whitlock was a member. We first consider the adequacy of the student-university relationship
as a possible basis for imposing a duty on the University to control or prohibit the use of the
trampoline, and then examine the provisions of the lease for that same purpose.

A.
The student-university relationship has been scrutinized in several jurisdictions, and it is
generally agreed that a university is not an insurer of its students’ safety. [Citations] The
relationship between a university and its students has experienced important change over the
years. At one time, college administrators and faculties stood in loco parentis to their students,
which created a special relationship “that imposed a duty on the college to exercise control over
student conduct and, reciprocally, gave the students certain rights of protection by the
college.” Bradshaw, 612 F.2d at 139. However, in modern times there has evolved a gradual
reapportionment of responsibilities from the universities to the students, and a corresponding
departure from the in loco parentis relationship. Id. at 139–40. Today, colleges and universities
are regarded as educational institutions rather than custodial ones. Beach, 726 P.2d at 419
(contrasting colleges and universities with elementary and high schools).
…
…By imposing a duty on the University in this case, the University would be encouraged to
exercise more control over private student recreational choices, thereby effectively taking away
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much of the responsibility recently recognized in students for making their own decisions with
respect to private entertainment and personal safety. Such an allocation of responsibility would
“produce a repressive and inhospitable environment, largely inconsistent with the objectives of a
modern college education.” Beach, 726 P.2d at 419.
The evidence demonstrates that only in limited instances has the University attempted to
impose regulations or restraints on the private recreational pursuits of its students, and the
students have not looked to the University to assure the safety of their recreational choices.
Nothing in the University’s student handbook, which contains certain regulations concerning
student conduct, reflects an effort by the University to control the risk-taking decisions of its
students in their private recreation.…Indeed, fraternity and sorority self-governance with
minimal supervision appears to have been fostered by the University.
…
Aside from advising the Beta house on one occasion to put the trampoline up when not in use,
there is no evidence that the University officials attempted to assert control over trampoline use
by the fraternity members. We conclude from this record that the University’s very limited
actions concerning safety of student recreation did not give Whitlock or the other members of
campus fraternities or sororities any reason to depend upon the University for evaluation of the
safety of trampoline use.…Therefore, we conclude that the student-university relationship is not
a special relationship of the type giving rise to a duty of the University to take reasonable
measures to protect the members of fraternities and sororities from risks of engaging in extracurricular trampoline jumping.
The plaintiff asserts, however, that we should recognize a duty of the University to take
affirmative action to protect fraternity members because of the foreseeability of the injury, the
extent of the risks involved in trampoline use, the seriousness of potential injuries, and the
University’s superior knowledge concerning these matters. The argument in essence is that a
duty should spring from the University’s natural interest in the welfare and safety of its
students, its superior knowledge of the nature and degree of risk involved in trampoline use, and
its knowledge of the use of trampolines on the University campus. The evidence amply supports
a conclusion that trampoline use involves risks of serious injuries and that the potential for an
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injury such as that experienced by Whitlock was foreseeable. It shows further that prior injuries
resulting from trampoline accidents had been reported to campus security and to the student
clinic, and that University administrators were aware of the number and severity of trampoline
injuries nationwide.
The record, however, also establishes through Whitlock’s own testimony that he was aware of
the risk of an accident and injury of the very nature that he experienced.…
We conclude that the relationship between the University and Whitlock was not one of
dependence with respect to the activities at issue here, and provides no basis for the recognition
of a duty of the University to take measures for protection of Whitlock against the injury that he
suffered.

B.
We next examine the lease between the University and the fraternity to determine whether a
special relationship between the University and Whitlock can be predicated on that document.
The lease was executed in 1929, extends for a ninety-nine year term, and gives the fraternity the
option to extend the term for another ninety-nine years. The premises are to be occupied and
used by the fraternity “as a fraternity house, clubhouse, dormitory and boarding house, and
generally for religious, educational, social and fraternal purposes.” Such occupation is to be
“under control of the tenant.” (emphasis added) The annual rental at all times relevant to this
case appears from the record to be one dollar. The University has the obligation to maintain the
grounds and make necessary repairs to the building, and the fraternity is to bear the cost of such
maintenance and repair.
…
We conclude that the lease, and the University’s actions pursuant to its rights under the lease,
provide no basis of dependence by the fraternity members upon which a special relationship can
be found to exist between the University and the fraternity members that would give rise to a
duty upon the University to take affirmative action to assure that recreational equipment such as
a trampoline is not used under unsafe conditions.

IV.

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Considering all of the factors presented, we are persuaded that under the facts of this case the
University of Denver had no duty to Whitlock to eliminate the private use of trampolines on its
campus or to supervise that use. There exists no special relationship between the parties that
justifies placing a duty upon the University to protect Whitlock from the well-known dangers of
using a trampoline. Here, a conclusion that a special relationship existed between Whitlock and
the University sufficient to warrant the imposition of liability for nonfeasance would directly
contravene the competing social policy of fostering an educational environment of student
autonomy and independence.
We reverse the judgment of the court of appeals and return this case to that court with
directions to remand it to the trial court for dismissal of Whitlock’s complaint against the
University.

CASE QUESTIONS

1. How are comparative negligence numbers calculated by the trial court? How can the jury say
that the university is 72 percent negligent and that Whitlock is 28 percent negligent?
2. Why is this not an assumption of risk case?
3. Is there any evidence that Whitlock was contributorily negligent? If not, why would the court
engage in comparative negligence calculations?

Negligence: Proximate Cause
Palsgraf v. Long Island R.R.
248 N.Y. 339,162 N.E. 99 (N.Y. 1928)
CARDOZO, Chief Judge
Plaintiff was standing on a platform of defendant’s railroad after buying a ticket to go to
Rockaway Beach. A train stopped at the station, bound for another place. Two men ran forward
to catch it. One of the men reached the platform of the car without mishap, though the train was
already moving. The other man, carrying a package, jumped aboard the car, but seemed
unsteady as if about to fall. A guard on the car, who had held the door open, reached forward to
help him in, and another guard on the platform pushed him from behind. In this act, the
package was dislodged, and fell upon the rails. It was a package of small size, about fifteen
inches long, and was covered by a newspaper. In fact it contained fireworks, but there was

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nothing in its appearance to give notice of its contents. The fireworks when they fell exploded.
The shock of· the explosion threw down some scales at the other end of the platform many feet
away. The scales struck the plaintiff, causing injuries for which she sues.
The conduct of the defendant’s guard, if a wrong in its relation to the holder of the package, was
not a wrong in its relation to the plaintiff, standing far away. Relatively to her it was not
negligence at all. Nothing in the situation gave notice that the falling package had in it the
potency of peril to persons thus removed. Negligence is not actionable unless it involves the
invasion of a legally protected interest, the violation of a right. “Proof of negligence in the air, so
to speak, will not do.…If no hazard was apparent to the eye of ordinary vigilance, an act innocent
and harmless, at least to outward seeming, with reference to her, did not take to itself the quality
of a tort because it happened to be a wrong, though apparently not one involving the risk of
bodily insecurity, with reference to someone else.…The plaintiff sues in her own right for a
wrong personal to her, and not as the vicarious beneficiary of a breach of duty to another.
A different conclusion will involve us, and swiftly too, in a maze of contradictions. A guard
stumbles over a package which has been left upon a platform.
It seems to be a bundle of newspapers. It turns out to be a can of dynamite. To the eye of
ordinary vigilance, the bundle is abandoned waste, which may be kicked or trod on with
impunity. Is a passenger at the other end of the platform protected by the law against the
unsuspected hazard concealed beneath the waste? If not, is the result to be any different, so far
as the distant passenger is concerned, when the guard stumbles over a valise which a truckman
or a porter has left upon the walk?…The orbit of the danger as disclosed to the eye of reasonable
vigilance would be the orbit of the duty. One who jostles one’s neighbor in a crowd does not
invade the rights of others standing at the outer fringe when the unintended contact casts a
bomb upon the ground. The wrongdoer as to them is the man who carries the bomb, not the one
who explodes it without suspicion of the danger. Life will have to be made over, and human
nature transformed, before prevision so extravagant can be accepted as the norm of conduct, the
customary standard to which behavior must conform.
The argument for the plaintiff is built upon the shifting meanings of such words as “wrong” and
“wrongful” and shares their instability. For what the plaintiff must show is a “wrong” to herself;
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i.e., a violation of her own right, and not merely a “wrong” to someone else, nor conduct
“wrongful” because unsocial, but not a “wrong” to anyone. We are told that one who drives at
reckless speed through a crowded city street is guilty of a negligent act and therefore of a
wrongful one, irrespective of the consequences.
Negligent the act is, and wrongful in the sense that it is unsocial, but wrongful and unsocial in
relation to other travelers, only because the eye of vigilance perceives the risk of damage. If the
same act were to be committed on a speedway or a race course, it would lose its wrongful
quality. The risk reasonably to be perceived defines the duty to be obeyed, and risk imports
relation; it is risk to another or to others within the range of apprehension. This does not mean,
of course, that one who launches a destructive force is always relieved of liability, if the force,
though known to be destructive, pursues an unexpected path.…Some acts, such as shooting are
so imminently dangerous to anyone who may come within reach of the missile however
unexpectedly, as to impose a duty of prevision not far from that of an insurer. Even today, and
much oftener in earlier stages of the law, one acts sometimes at one’s peril.…These cases aside,
wrong-is defined in terms of the natural or probable, at least when unintentional.…Negligence,
like risk, is thus a term of relation.
Negligence in the abstract, apart from things related, is surely not a tort, if indeed it is
understandable at all.…One who seeks redress at law does not make out a cause of action by
showing without more that there has been damage to his person. If the harm was not willful, he
must show that the act as to him had possibilities of danger so many and apparent as to entitle
him to be protected against the doing of it though the harm was unintended.
***
The judgment of the Appellate Division and that of the Trial Term should be reversed, and the
complaint dismissed, with costs in all courts.

CASE QUESTIONS

1. Is there actual cause in this case? How can you tell?
2. Why should Mrs. Palsgraf (or her insurance company) be made to pay for injuries that were
caused by the negligence of the Long Island Rail Road?
3. How is this accident not foreseeable?

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Klein v. Pyrodyne Corporation
Klein v. Pyrodyne Corporation
810 P.2d 917 (Supreme Court of Washington 1991)
Pyrodyne Corporation (Pyrodyne) is a licensed fireworks display company that contracted to
display fireworks at the Western Washington State Fairgrounds in Puyallup, Washington, on
July 4,1987. During the fireworks display, one of the mortar launchers discharged a rocket on a
horizontal trajectory parallel to the earth. The rocket exploded near a crowd of onlookers,
including Danny Klein. Klein’s clothing was set on fire, and he suffered facial burns and serious
injury to his eyes. Klein sued Pyrodyne for strict liability to recover for his injuries. Pyrodyne
asserted that the Chinese manufacturer of the fireworks was negligent in producing the rocket
and therefore Pyrodyne should not be held liable. The trial court applied the doctrine of strict
liability and held in favor of Klein. Pyrodyne appealed.
Section 519 of the Restatement (Second) of Torts provides that any party carrying on an
“abnormally dangerous activity” is strictly liable for ensuing damages. The public display of
fireworks fits this definition. The court stated: “Any time a person ignites rockets with the
intention of sending them aloft to explode in the presence of large crowds of people, a high risk
of serious personal injury or property damage is created. That risk arises because of the
possibility that a rocket will malfunction or be misdirected.” Pyrodyne argued that its liability
was cut off by the Chinese manufacturer’s negligence. The court rejected this argument, stating,
“Even if negligence may properly be regarded as an intervening cause, it cannot function to
relieve Pyrodyne from strict liability.”
The Washington Supreme Court held that the public display of fireworks is an abnormally
dangerous activity that warrants the imposition of strict liability.
Affirmed.

CASE QUESTIONS

1. Why would certain activities be deemed ultrahazardous or abnormally dangerous so that
strict liability is imposed?
2. If the activities are known to be abnormally dangerous, did Klein assume the risk?

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3. Assume that the fireworks were negligently manufactured in China. Should Klein’s only
remedy be against the Chinese company, as Pyrodyne argues? Why or why not?

7.6 Summary and Exercises
Summary

The principles of tort law pervade modern society because they spell out the duties of care that
we owe each other in our private lives. Tort law has had a significant impact on business because
modern technology poses significant dangers and the modern market is so efficient at
distributing goods to a wide class of consumers.
Unlike criminal law, tort law does not require the tortfeasor to have a specific intent to commit
the act for which he or she will be held liable to pay damages. Negligence—that is, carelessness—
is a major factor in tort liability. In some instances, especially in cases involving injuries caused
by products, a no-fault standard called strict liability is applied.
What constitutes a legal injury depends very much on the circumstances. A person can assume a
risk or consent to the particular action, thus relieving the person doing the injury from tort
liability. To be liable, the tortfeasor must be the proximate cause of the injury, not a remote
cause. On the other hand, certain people are held to answer for the torts of another—for
example, an employer is usually liable for the torts of his employees, and a bartender might be
liable for injuries caused by someone to whom he sold too many drinks. Two types of statutes—
workers’ compensation and no-fault automobile insurance—have eliminated tort liability for
certain kinds of accidents and replaced it with an immediate insurance payment plan.
Among the torts of particular importance to the business community are wrongful death and
personal injury caused by products or acts of employees, misrepresentation, defamation, and
interference with contractual relations.

EXERCISES

1. What is the difference in objectives between tort law and criminal law?
2. A woman fell ill in a store. An employee put the woman in an infirmary but provided no
medical care for six hours, and she died. The woman’s family sued the store for wrongful

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death. What arguments could the store make that it was not liable? What arguments could
the family make? Which seem the stronger arguments? Why?
3. The signals on a railroad crossing are defective. Although the railroad company was notified
of the problem a month earlier, the railroad inspector has failed to come by and repair them.
Seeing the all-clear signal, a car drives up and stalls on the tracks as a train rounds the bend.
For the past two weeks the car had been stalling, and the driver kept putting off taking the
car to the shop for a tune-up. As the train rounds the bend, the engineer is distracted by a
conductor and does not see the car until it is too late to stop. Who is negligent? Who must
bear the liability for the damage to the car and to the train?
4. Suppose in the Katko v. Briney case (Section 7.2 "Intentional Torts") that instead of setting
such a device, the defendants had simply let the floor immediately inside the front door rot
until it was so weak that anybody who came in and took two steps straight ahead would fall
through the floor and to the cellar. Will the defendant be liable in this case? What if they
invited a realtor to appraise the place and did not warn her of the floor? Does it matter
whether the injured person is a trespasser or an invitee?
5. Plaintiff’s husband died in an accident, leaving her with several children and no money
except a valid insurance policy by which she was entitled to $5,000. Insurance Company
refused to pay, delaying and refusing payment and meanwhile “inviting” Plaintiff to accept
less than $5,000, hinting that it had a defense. Plaintiff was reduced to accepting housing and
charity from relatives. She sued the insurance company for bad-faith refusal to settle the
claim and for the intentional infliction of emotional distress. The lower court dismissed the
case. Should the court of appeals allow the matter to proceed to trial?

SELF-TEST QUESTIONS

1. Catarina falsely accuses Jeff of stealing from their employer. The statement is
defamatory only if
a.

a third party hears it
b. Nick suffers severe emotional distress as a result
c. the statement is the actual and proximate cause of his distress
d. the statement is widely circulated in the local media and on Twitter

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Garrett files a suit against Colossal Media Corporation for defamation.
Colossal has said that Garrett is a “sleazy, corrupt public official” (and provided
some evidence to back the claim). To win his case, Garrett will have to show that
Colossal acted with
a.

malice
b. ill will
c. malice aforethought
d. actual malice
Big Burger begins a rumor, using social media, that the meat in Burger
World is partly composed of ground-up worms. The rumor is not true, as Big
Burger well knows. Its intent is to get some customers to shift loyalty from Burger
World to Big Burger. Burger World’s best cause of action would be

a.

trespass on the case
b. nuisance
c. product disparagement
d. intentional infliction of emotional distress
Wilfred Phelps, age 65, is driving his Nissan Altima down Main Street when
he suffers the first seizure of his life. He loses control of his vehicle and runs into
three people on the sidewalk. Which statement is true?
a.

He is liable for an intentional tort.

b. He is liable for a negligent tort.
c. He is not liable for a negligent tort.
d. He is liable under strict liability, because driving a car is abnormally dangerous.
Jonathan carelessly bumps into Amanda, knocking her to the ground. He
has committed the tort of negligence
a.

only if Amanda is injured

b. only if Amanda is not injured
c. whether or not Amanda is injured

SELF-TEST ANSWERS

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1. a
2. d
3. c
4. c
5. a

Chapter 8
Contracts

LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1. What role contracts play in society today
2. What a contract is
3. The sources of contract law
4. Some basic contract taxonomy
5. The required elements of a contract: mutual assent, consideration, legality, and capacity
6. The circumstances when a contract needs to be in writing to be enforceable
7. The remedies for breach of contract
The two fundamental concepts considered the twin cornerstones of business relationships are
contract and tort. Although both involve the concept of duty, creation of the duty differs in a
manner that is important to business. The parties create contractduties through a bargaining
process. The key element in the process is control; individuals are in control of a situation
because they have the freedom to decide whether to enter into a contractual
relationship. Tort duties, in contrast, are obligations the law imposes. Despite the obvious
difficulty in controlling tort liability, an understanding of tort theory is important because it is a
critical factor in strategic planning and risk management.

8.1 General Perspectives on Contracts
LEARNING OBJECTIVES

1. Understand the role of contract in society: it moves society from status to contract.
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2. Know the definition of a contract.
3. Recognize the sources of contract law: the common law, the UCC, and the Convention on the
International Sale of Goods—a treaty (the CISG).
4. Understand some fundamental contract taxonomy and terminology.

The Role of Contract in Society
Contract is probably the most familiar legal concept in our society because it is so central to a
deeply held conviction about the essence of our political, economic, and social life. In common
parlance, the term is used interchangeably with agreement, bargain, undertaking, or deal; but
whatever the word, it embodies our notion of freedom to pursue our own lives together with
others. Contract is central because it is the means by which a free society orders what would
otherwise be a jostling, frenetic anarchy. So commonplace is the concept of contract—and our
freedom to make contracts with each other—that it is difficult to imagine a time when contracts
were rare, an age when people’s everyday associations with one another were not freely
determined. Yet in historical terms, it was not so long ago that contracts were rare, entered into
if at all by very few. In “primitive” societies and in the medieval Europe from which our
institutions sprang, the relationships among people were largely fixed; traditions spelled out
duties that each person owed to family, tribe, or manor. Though he may have oversimplified, Sir
Henry Maine, a nineteenth-century historian, sketched the development of society in his classic
book Ancient Law. As he put it:
(F)rom a condition of society in which all the relations of Persons are summed up in the
relations of Family, we seem to have steadily moved towards a phase of social order in which all
these relations arise from the free agreement of Individuals. . . . Thus the status of the Slave has
disappeared—it has been superseded by the contractual relation of the servant to his master. . . .
The status of the Female under Tutelage . . . has also ceased to exist. . . . So too the status of the
Son under Power has no true place in the law of modern European societies. If any civil
obligation binds together the Parent and the child of full age, it is one to which only contract
gives its legal validity.... If then we employ Status, agreeably with the usage of the best writers, to
signify these personal conditions [arising from ancient legal privileges of the Family] only, we

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may say that the movement of the progressive societies has hitherto been a movement from
Status to Contract. [1]
This movement was not accidental. It went hand-in-glove with the emerging industrial order;
from the fifteenth to the nineteenth centuries, as England, especially, evolved into a booming
mercantile economy with all that that implies—flourishing trade, growing cities, an expanding
monetary system, commercialization of agriculture, mushrooming manufacturing—contract law
was created of necessity.
Contract law did not develop, however, according to a conscious, far-seeing plan. It was a
response to changing conditions, and the judges who created it frequently resisted, preferring
the quieter, imagined pastoral life of their forefathers. Not until the nineteenth century, in both
the United States and England, did a full-fledged law of contracts arise together with modem
capitalism.

Contract Defined
As usual in the law, the legal definition of “contract” is formalistic. The Restatement says: “A
contract is a promise or a set of promises for the breach of which the law gives a remedy, or the
performance of which the law in some way recognizes as a duty.”(Restatement (Second) of
Contracts, Section 1) Similarly, the Uniform Commercial Code says: “‘Contract’ means the total
legal obligation which results from the parties’ agreement as affected by this Act and any other
applicable rules of law.” (Section 1-201(11)) A short-hand definition is: “A contract is a legally
enforceable promise.”

Economic View of Contract Law
In An Economic Analysis of Law (1973), Judge Richard A. Posner (a former University of
Chicago law professor) suggests that contract law performs three significant economic functions.
First, it helps maintain incentives to individuals to exchange goods and services efficiently.
Second, it reduces the costs of economic transactions because its very existence means that the
parties need not go to the trouble of negotiating a variety of rules and terms already spelled out.
Third, the law of contracts alerts the parties to trouble spots that have arisen in the past, thus
making it easier to plan the transactions more intelligently and avoid potential pitfalls.

Sources of Contract Law
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There are four basic sources of contract law: the Constitution, federal and state statutes, federal
and state case law, and administrative law. For our purposes, the most important of these, and
the ones that we will examine at some length, are case lawand statutes.

Case (Common) Law and the Restatement of Contracts
Because contract law was forged in the common-law courtroom, hammered out case by case on
the anvil of individual judges, it grew in the course of time to formidable proportions. By the
early twentieth century, tens of thousands of contract disputes had been submitted to the courts
for resolution, and the published opinions, if collected in one place, would have filled dozens of
bookshelves. Clearly this mass of case law was too unwieldy for efficient use. A similar problem
had developed in the other leading branches of the common law. Disturbed by the profusion of
cases and the resulting uncertainty of the law, a group of prominent American judges, lawyers,
and teachers founded the American law Institute in 1923 to attempt to clarify, simplify, and
improve the law. One of its first projects, and ultimately one of its most successful, was the
drafting of the Restatement of the Law of Contracts, completed in 1932. A revision—
the Restatement (Second) of Contracts—was undertaken in 1946 and finally completed in 1979.
The Restatements (others exist in the fields of torts, agency, conflicts of laws, judgments,
property, restitution, security, and trusts) are detailed analyses of the decided cases in the field.
These analyses are made with an eye to discerning the various principles that have emerged
from the courts, and to the maximum extent possible, the Restatements declare the law as the
courts have determined it to be. The Restatements, guided by a Reporter (the director of the
project) and a staff of legal scholars, go through several so-called “tentative” drafts—sometimes
as many as fifteen or twenty—and are screened by various committees within the American Law
Institute before they are eventually published as final documents.
The Restatement of Contracts won prompt respect in the courts and has been cited in
innumerable cases. The Restatements are not authoritative, in the sense that they are not actual
judicial precedents, but they are nevertheless weighty interpretive texts, and judges frequently
look to them for guidance. They are as close to “black letter” rules of law as exist anywhere in the
American legal system for judge-made (common) law.

Statutory Law: The Uniform Commercial Code
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Common law contract principles govern contracts for real estate and for services, obviously very
important areas of law. But in one area the common law has been superseded by an important
statute: the Uniform Commercial Code (UCC), especially Article 2, which deals with the sale of
goods.

A Brief History
The UCC is a model law developed by the American law Institute and the National Conference of
Commissioners on Uniform State Laws; it has been adopted in one form or another in all fifty
states, the District of Columbia, and the American territories. It is the only “national” law not
enacted by Congress.
Before the UCC was written, commercial law varied, sometimes greatly, from state to state. This
first proved a nuisance and then a serious impediment to business as the American economy
became nationwide during the twentieth century. Although there had been some uniform laws
concerned with commercial deals—including the Uniform Sales Act, first published in 1906—few
were widely adopted and none nationally. As a result, the law governing sales of goods,
negotiable instruments, warehouse receipts, securities, and other matters crucial to doing
business in an industrial, market economy was a crazy quilt of untidy provisions that did not
mesh well from state to state.
Initial drafting of the UCC began in 1942 and was ten years in the making, involving the efforts
of hundreds of practicing lawyers, law teachers, and judges. A final draft, promulgated by the
Institute and the Conference, was endorsed by the American Bar Association and published in
1951.
Pennsylvania enacted the code in its entirety in 1953. It was the only state to enact the original
version, because the Law Revision Commission of the New York State legislature began to
examine it line by line and had serious objections. Three years later, in 1956, a revised code was
issued. This version, known as the 1957 Official Text, was enacted in Massachusetts and
Kentucky. In 1958, the Conference and the Institute amended the Code further and again
reissued it, this time as the 1958 Official Text. Sixteen states, including Pennsylvania, adopted
this version.

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But in so doing, many of these states changed particular provisions. As a consequence, the
Uniform Commercial Code was no longer so uniform. Responding to this development the
American Law Institute established a permanent editorial board to oversee future revisions of
the code. Various subcommittees went to work redrafting, and a 1962 Official Text was
eventually published. Twelve more states adopted the code, eleven of them the 1962 text. By
1966, only three states and two territories had failed to enact any version: Arizona, Idaho,
Louisiana, Guam, and Puerto Rico.
Meanwhile, non-uniform provisions continued to be enacted in various states, particularly in
Article 9, to which 337 such amendments had been made. In 1971, a redraft of that article was
readied and the 1972 Official Text was published. By that time, Louisiana was the only holdout.
Two years later, in 1974, Louisiana made the UCC a truly national law when it enacted some but
not all of the 1972 text (significantly, Louisiana has not adopted Article 2). One more major
change was made, a revision of Article 8, necessitated by the electronics revolution that led to
new ways of transferring investment securities from seller to purchaser. This change was
incorporated in the 1978 Official Text, the version that remains current.
From this brief history, it is clear that the UCC is now a basic law of relevance to every business
and business lawyer in the United States, even though it is not entirely uniform because
different states have adopted it at various stages of its evolution—an evolution that continues
still.

The Basic Framework of the UCC
The UCC embraces the Jaw of “commercial transactions,” a term of some ambiguity. A
commercial transaction may seem to be a series of separate transactions; it may include, for
example, the making of a contract for the sale of goods, the signing of a check, the endorsement
of the check, the shipment of goods under a bill of Lading, and so on. However, the UCC
presupposes that each of these transactions is a facet of one single transaction: the sale of and
payment for goods. The Code deals with phases of this transaction from start to finish. These
phases are organized according to the following “articles”:
•

Sales (Article 2)

•

Commercial Paper (Article 3)
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•

Bank Deposits and Collections (Article 4)

•

Letters of Credit (Article 5)

•

Bulk Transfers (Article 6)

•

Warehouse Receipts, Bills of Lading, and Other Documents of Title (Article 7)

•

Investment Securities (Article 8)

•

Secured Transactions; Sales of Accounts and Chattel Paper (Article 9)
We now turn our attention to the sale—the first facet, and the cornerstone, of the commercial
transaction. Sales law is a special type of contract law in that Article 2 applies only to the sale of
goods, defined (Section 2-105) in part as “all things . . . which are movable at the time of
identification to the contract for sale other than the money in which the price is to be paid. . . .”
The only contracts and agreements covered by Article 2 are those relating to the present or
future sale of goods.
In certain cases, the courts have difficulty in determining the nature of the object of a sales
contract. The problem: How can goods and services be separated in contracts calling for the
seller to deliver a combination of goods and services? This difficulty frequently arises in product
liability cases in which the buyer sues the seller for breach of one of the UCC warranties. For
example, you go to the hairdresser for a permanent and the shampoo gives you a severe scalp
rash. May you recover damages on the grounds that either the hairdresser or the manufacturer
breached an implied warranty in the sale of goods?
When the goods used are incidental to the service, the courts are split on whether the plaintiff
should win. Compare Epstein v. Giannattasio, 197 A.2d 342 (Conn. 1963), in which the court
held that no sale of goods had been made because the plaintiff received a treatment in which the
cosmetics were only incidentally used, with Newmark v.Gimbel’s Inc., 258 A.2d 697 (N.J. 1969),
in which the court said “[i]f the permanent wave lotion were sold … for home consumption . . .
unquestionably an implied warranty of fitness for that purpose would have been an integral
incident of the sale.” The New Jersey court rejected the defendant’s argument that by actually
applying the lotion to the patron’s head the salon lessened the liability it otherwise would have
had if it had simply sold her the lotion.

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In two areas, state legislatures have taken the goods vs. services issue out of the courts’ hands
and resolved the issue through legislation. One area involves restaurant cases, in which typically
the plaintiff charges that he became ill because of tainted food. UCC Section 2·314(1) states that
any seller who is regularly a merchant of the goods sold impliedly warrants their
merchantability in a contract for their sale. This section explicitly declares that serving food or
drink is a sale, whether they are to be consumed on or off the premises.
The second type of case involves blood transfusions, which can give a patient hepatitis, a serious
and sometimes fatal disease. Hospitals and blood banks obviously face large potential liability
under the UCC provision just referred to on implied warranty of merchantability. Because
medical techniques cannot detect the hepatitis virus in any form of blood used, hospitals and
blood banks would be in constant jeopardy, without being able to take effective action to
minimize the danger. Most states have enacted legislation specifically providing that blood
supplies to be used in transfusions are a service, not goods, thus relieving the suppliers and
hospitals of an onerous burden.

Three Basic Contract Types: Sources of Law
With this brief description of the UCC, it should now be clear that the primary sources of law for
the three basic types of contracts are:
•

Real estate: common law;

•

Services: common law;

•

Sale of goods: UCC (as interpreted by the courts).
Common law and UCC rules are often similar. For example, both require good faith in the
performance of a contract. However, there are two general differences worth noting between the
common law of contracts and the UCC’s rules governing the sales of goods. First, the UCC is
more liberal than the common law in upholding the existence of a contract. For example, in a
sales contract (covered by the UCC), “open” terms—that is, those the parties have not agreed
upon—do not require a court to rule that no contract was made. However, open terms in
a nonsales contract will frequently result in a ruling that there is no contract. Second, although
the common law of contracts applies to every person equally, under the UCC “merchants”

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occasionally receive special treatment. By “merchants” the UCC means persons who have special
knowledge or skill who deal in the goods involved in the transaction.

The Convention on Contracts for the International Sale of Goods
A Convention on Contracts for the International Sale of Goods (CISG) was approved in 1980 at a
diplomatic conference in Vienna. (A convention is a preliminary agreement that serves as the
basis for a formal treaty.) The Convention has been adopted by several countries, including the
United States.
The Convention is significant for three reasons. First, the Convention is a uniform law governing
the sale of goods—in effect, an international Uniform Commercial Code. The major goal of the
drafters was to produce a uniform law acceptable to countries with different legal, social and
economic systems. Second, although provisions in the Convention are generally consistent with
the UCC, there are significant differences. For instance, under the Convention, consideration
(discussed below) is not required to form a contract and there is no Statute of Frauds (a
requirement that some contracts be evidenced by a writing to be enforceable—also discussed
below). Finally, the Convention represents the first attempt by the US Senate to reform the
private law of business through its treaty powers, for the Convention preempts the UCC if the
parties to a contract elect to use the CISG.

Basic Contract Taxonomy
Contracts are not all cut from the same die. Some are written, some oral; some are explicit, some
not. Because contracts can be formed, expressed, and enforced in a variety of ways, a taxonomy
of contracts has developed that is useful in lumping together like legal consequences. In general,
contracts are classified along these dimensions: explicitness, mutuality, enforceability, and
degree of completion.Explicitness is concerned with the degree to which the agreement is
manifest to those not party to it. Mutuality takes into account whether promises are exchanged
by two parties or only one. Enforceability is the degree to which a given contract is
binding.Completion considers whether the contract is yet to be performed or the obligations
have been fully discharged by one or both parties. We will examine each of these concepts in
turn.

Explicitness
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Express Contract
An express contract is one in which the terms are spelled out directly; the parties to an express
contract, whether written or oral, are conscious that they are making an enforceable agreement.
For example, an agreement to purchase your neighbor’s car for $500 and to take title next
Monday is an express contract.

Implied Contract
An implied contract is one that is inferred from the actions of the parties. Although no
discussion of terms took place, an implied contract exists if it is clear from the conduct of both
parties that they intended there be one. A delicatessen patron who asks for a “turkey sandwich
to go” has made a contract and is obligated to pay when the sandwich is made. By ordering the
food, the patron is implicitly agreeing to the price, whether posted or not.

Contract Implied in Law: Quasi-contract
Both express and implied contracts embody an actual agreement of the parties. Aquasi-contract,
by contrast, is an obligation said to be ‘‘imposed by law” in order 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
fiction that the courts created to prevent injustice. Suppose, for example, that a carpenter
mistakenly believes you have hired him to repair your porch; in fact, it is your neighbor who has
hired him. One Saturday morning he arrives at your doorstep and begins to work. Rather than
stop him, you let him proceed, pleased at the prospect of having your porch fixed for free (since
you have never talked to the carpenter, you figure you need not pay his bill). Although it is true
there is no contract, the law implies a contract for the value of the work.

Mutuality
The garden-variety contract is one in which the parties make mutual promises. Each is both
promisor and promisee; that is, each pledges to do something and each is the recipient of such a
pledge. This type of contract is called a bilateral contract. But mutual promises are not necessary
to constitute a contract. Unilateral contracts, in which only one party makes a promise, are
equally valid but depend upon performance of the promise to be binding. If Charles says to
Fran, “I will pay you five dollars if you wash my car,” Charles is contractually bound to pay once
Fran washes the car. Fran never makes a promise, but by actually performing she makes Charles
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liable to pay. A common example of a unilateral contract is the offer “$50 for the return of my
lost dog.” Frances never makes a promise to the offeror, but if she looks for the dog and finds it,
she is entitled to the $50.

Enforceability
Not every agreement between two people is a binding contract. An agreement that is lacking one
of the legal elements of a contract is said to be void—that is, not a contract at all. An agreement
that is illegal—for example, a promise to commit a crime in return for a money payment—is
void. Neither party to a void “contract” may enforce it.
By contrast, a voidable contract is one that is unenforceable by one party but enforceable by the
other. For example, a minor (any person under eighteen, in most states) may “avoid” a contract
with an adult; the adult may not enforce the contract against the minor, if the minor refuses to
carry out the bargain. But the adult has no choice if the minor wishes the contract to be
performed. (A contract may be voidable by both parties if both are minors.) Ordinarily, the
parties to a voidable contract are entitled to be restored to their original condition. Suppose you
agree to buy your seventeen-year-old neighbor’s car. He delivers it to you in exchange for your
agreement to pay him next week. He has the legal right to terminate the deal and recover the
car, in which case you will of course have no obligation to pay him. If you have already paid him,
he still may legally demand a return to the status quo ante (previous state of affairs). You must
return the car to him; he must return the cash to you.
A voidable contract remains a valid contract until it is voided. Thus, a contract with a minor
remains in force unless the minor decides he does not wish to be bound by it. When the minor
reaches his majority, he may “ratify” the contract—that is, agree to be bound by it-in which case
the contract will no longer be voidable and will thereafter be fully enforceable.
An unenforceable contract is one that some rule of law bars a court from enforcing. For example,
Tom owes Pete money, but Pete has waited too long to collect it and the statute of limitations
has run out. The contract for repayment is unenforceable and Pete is out of luck, unless Tom
makes a new promise to pay or actually pays part of the debt. (However, if Pete is holding
collateral as security for the debt, he is entitled to keep it; not all rights are extinguished because
a contract is unenforceable.)
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Degree of Completion
In medieval England, contract—defined as set of promises—was not an intuitive concept. The
courts gave relief to one who wanted to collect a debt, for in such a case the creditor presumably
had already given the debtor something of value, and the failure of the debtor to pay up was seen
as manifestly unjust. But the issue was less clear when neither promise had yet been fulfilled.
Suppose John agrees to sell Humphrey a quantity of wheat in one month. On the appointed day,
Humphrey refuses to take the wheat or to pay. The modem law of contracts holds that a valid
contract exists and that Humphrey is required to pay John.
An agreement consisting of a set of promises is called an executory contract before either
promise is carried out. Most executory contracts are enforceable. If one promise or set of terms
has been fulfilled—if, for example, John had delivered the wheat to Humphrey—the contract is
called partially executed. A contract that has been carried out fully by both parties is called
an executed contract.

KEY TAKEAWAYS

Contract is the mechanism by which people in modern society make choices for themselves,
as opposed to being born or placed into a status as is common in feudal societies. A contract
is a legally enforceable promise. The law of contract is the common law (for contracts
involving real estate and services), statutory law (the Uniform Commercial Code for contract
involving the sale or leasing of goods), and treaty law (the Convention on the International
Sale of Goods). Contracts may be described based on the degree of their explicitness,
mutuality, enforceability, and degree of completion.

EXERCISES

1. What did Sir Henry Maine mean when he wrote of society’s movement “from status to
contract?
2. Are all promises “contracts”?
3. What is the source of law for contracts involving real estate? For contracts involving the sale
of goods?
4. In contract taxonomy, what are the degrees of explicitness, mutuality, enforceability, and of
completion?

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[1] Sir Henry Maine, Ancient Law (1869), 180–82.

8.2 Contract Formation

LEARNING OBJECTIVES

1. Understand the elements of common-law contracts: mutuality of agreement (offer and
acceptance), consideration, legality, and capacity.
2. Learn when a contract must be in writing—or evidenced by some writing—to be enforceable.
Although it has countless wrinkles and nuances, contract law asks two principal questions: did
the parties create a valid, enforceable contract? What remedies are available when one party
breaks the contract? The answer to the first question is not always obvious; the range of factors
that must be taken into account can be large and their relationship subtle. Since people in
business frequently conduct contract negotiations without the assistance of a lawyer, it is
important to attend to the nuances to avoid legal trouble at the outset. Whether a valid
enforceable contract has been formed depends in turn on whether:
1. The parties reached an agreement (offer and acceptance);
2. Consideration was present (some “price was paid for what was received in return);
3. The agreement was legal;
4. The parties entered into the contract with capacity to make a contract; and
5. The agreement is in the proper form (something in writing, if required).

The Agreement: Offer and Acceptance
The core of a legal contract is the agreement between the parties. That is not merely a matter of
convenience; it is at the heart of our received philosophical and psychological beliefs. As the
great student of contract law, Samuel Williston, put it:
It was a consequence of the emphasis laid on the ego and the individual will that the formation
of a contract should seem impossible unless the wills of the parties concurred. Accordingly we
find at the end of the eighteenth century, and the beginning of the nineteenth century, the
prevalent idea that there must be a “meeting of the minds” (a new phrase) in order to form a
contract. (1921, p. 365)
Although agreements may take any form, including unspoken conduct between the parties (UCC
Section 2-204(1)), they are usually structured in terms of an offer and anacceptance. Note,
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however, that not every agreement, in the broadest sense of the word, need consist of an offer
and acceptance, and it is entirely possible, therefore, for two persons to reach agreement
without forming a contract. For example, people may agree that the weather is pleasant or that it
would be preferable to go out for Chinese food rather than seeing a foreign film; in neither case
has a contract been formed. One of the major functions of the law of contracts is to sort out
those agreements that are legally binding—those that are contracts—from those that are not.
In interpreting agreements, courts generally apply an objective standard. TheRestatement
(Second) of Contracts defines agreement as a “manifestation of mutual assent by two or more
persons to one another.” (Section 3) The UCC defines agreement as “the bargain of the parties in
fact as found in their language or by implication from other circumstances including course of
dealing or usage of trade or course of performance.” (Section 1-201(3)) The critical question is
what the parties said or did, not what they thought they said or did.
The distinction between objective and subjective standards crops up occasionally when one
person claims he spoke in jest. The vice president of a manufacturer of punchboards, used in
gambling, testified to the Washington State Game Commission that he would pay $100,000 to
anyone who found a “crooked board.” Barnes, a bartender, who had purchased two that were
crooked some time before, brought one to the company office, and demanded payment. The
company refused, claiming that the statement was made in jest (the audience before the
commission had laughed when the offer was made). The court disagreed, holding that it was
reasonable to interpret the pledge of $100,000 as a means of promoting punchboards:
(I)f the jest is not apparent and a reasonable hearer would believe that an offer was being made,
then the speaker risks the formation of a contract which was not intended. It is the objective
manifestations of the offeror that count and not secret, unexpressed intentions. If a party’s
words or acts, judged by a reasonable standard, manifest an intention to agree in regard to the
matter in question, that agreement is established, and it is immaterial what may be the real but
unexpressed state of the party’s mind on the subject. [1]
An offer is a manifestation of willingness to enter into a bargain such that it would be reasonable
for another individual to conclude that assent to the offer would complete the bargain. Offers

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must be communicated and must be definite; that is, they must spell out terms to which the
offeree can assent.
To constitute an agreement, there must be an acceptance of the offer. The offeree must manifest
his assent to the terms of the offer in a manner invited or required by the offer. Complications
arise when an offer is accepted indirectly through correspondence. Although offers and
revocations of offers are not effective until received, an acceptance is deemed accepted when
sent if the offeree accepts in the manner specified by the offeror.
If the offeror specifies no particular mode, then acceptance is effective when transmitted as long
as the offeree uses a reasonable method of acceptance. It is implied that the offeree can use the
same means used by the offeror or a means of communication customary to the industry. For
example, the use of the postal service was so customary that acceptances are considered effective
when mailed, regardless of the method used to transmit the offer. Indeed, the so-called “mailbox
rule” (the acceptance is effective upon dispatch) has an ancient lineage, tracing back nearly two
hundred years to the English courts. [2]

Consideration
Consideration, is the quid pro quo (something given or received for something else) between the
contracting parties in the absence of which the law will not enforce the promise or promises
made. Consider the following three “contracts”:
1. Betty offers to give a book to Lou. Lou accepts.
2. Betty offers Lou the book in exchange for Lou’s promise to pay $15. Lou accepts.
3. Betty offers to give Lou the book if Lou promises to pick it up at Betty’s house. Lou accepts.
The question is which, if any, is a binding contract? In American law, only situation 2 is a
binding contract, because only that contract contains a set of mutual promises in which each
party pledges to give up something to the benefit of the other.
The question of what constitutes a binding contract has been answered differently throughout
history and in other cultures. For example, under Roman law, any contract that was reduced to
writing was binding, whether or not there was consideration in our sense. Moreover, in later
Roman times, certain promises of gifts were made binding, whether written or oral; these would
not be binding in the United States. And in the Anglo-American tradition, the presence of a seal
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was once sufficient to make a contract binding without any other consideration. In most states,
the seal is no longer a substitute for consideration, although in some states it creates a
presumption of consideration. The Uniform Commercial Code has abolished the seal on
contracts for the sale of goods.
The existence of consideration is determined by examining whether the person against whom a
promise is to be enforced (the promisor) received something in return from the person to whom
he made the promise (the promisee). That may seem a simple enough question. But as with
much in the law, the complicating situations are never very far away. The “something” that is
promised or delivered cannot just be anything: a feeling of pride, warmth, amusement,
friendship; it must be something known as alegal detriment—an act, a forbearance, or a promise
of such from the promisee. The detriment need not be an actual detriment; it may in fact be a
benefit to the promisee, or at least not a loss. At the same time, the “detriment” to the promisee
need not confer a tangible benefit on the promisor; the promisee can agree to forego something
without that something being given to the promisor. Whether consideration is legally sufficient
has nothing to do with whether it is morally or economically adequate to make the bargain a fair
one. Moreover, legal consideration need not even be certain; it can be a promise contingent on
an event that may never happen. Consideration is a legalconcept, and it centers on the giving up
of a legal right or benefit.
Consideration has two elements. The first, as just outlined, is whether the promisee has incurred
a legal detriment. (Some courts—although a minority—take the view that a bargained-for legal
benefit to the promisor is sufficient consideration.) The second is whether the legal detriment
was bargained for: did the promisor specifically intend the act, forbearance, or promise in
return for his promise? Applying this two-pronged test to the three examples given at the outset
of the chapter, we can easily see why only in the second is there legally sufficient consideration.
In the first, Lou incurred no legal detriment; he made no pledge to act or to forbear from acting,
nor did he in fact act or forbear from acting. In the third example, what might appear to be such
a promise is not really so. Betty made a promise on a condition that Lou come to her house; the
intent clearly is to make a gift. Betty was not seeking to induce Lou to come to her house by
promising the book.
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There is a widely recognized exception to the requirement of consideration. In cases of
promissory estoppel, the courts will enforce promises without consideration. Simply
stated, promissory estoppel means that the courts will stop the promisor from claiming that
there was no consideration. The doctrine of promissory estoppel is invoked in the interests of
justice when three conditions are met: (1) the promise is one that the promisor should
reasonably expect to induce the promisee to take action or forbear from taking action of a
definite and substantial character; (2) the action or forbearance is taken; and (3) injustice can be
avoided only by enforcing the promise.
Timko served on the board of trustees of a school. He recommended that the school purchase a
building for a substantial sum of money, and to induce the trustees to vote for the purchase, he
promised to help with the purchase and to pay at the end of five years the purchase price less the
down payment. At the end of four years, Timko died. The school sued his estate, which defended
on the ground that there was no consideration for the promise. Timko was promised or given
nothing in return, and the purchase of the building was of no direct benefit to him (which would
have made the promise enforceable as a unilateral contract). The court ruled that under the
three-pronged promissory estoppel test, Timko’s estate was liable. [3]

Illegality
In general, illegal contracts are unenforceable. The courts must grapple with two types of
illegalities: (1) statutory violations (e.g., the practice of law by a non-lawyer is forbidden by
statute), and (2) violations of public policy not expressly declared unlawful by statute, but so
declared by the courts.

Capacity
A contract is a meeting of minds. If someone lacks mental capacity to understand what he is
assenting to—or that he is assenting to anything—it is unreasonable to hold him to the
consequences of his act.
The general rule is that persons younger than eighteen can avoid their contracts. Although the
age of majority was lowered in most states during the 1970s to correspond to the Twenty-sixth
Amendment (ratified in 1971, guaranteeing the right to vote at eighteen), some states still put
the age of majority at twenty-one. Legal rights for those under twenty-one remain ambiguous,
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however. Although eighteen-year-olds may assent to binding contracts, not all creditors and
landlords believe it, and they may require parents to cosign. For those under twenty-one, there
are also legal impediments to holding certain kinds of jobs, signing certain kinds of contracts,
marrying, leaving home, and drinking alcohol. There is as yet no uniform set of rules.
The exact day on which the disability of minority vanishes also varies. The old common law rule
put it on the day before the twenty-first birthday. Many states have changed this rule so that
majority commences on the day of the eighteenth (or twenty-first) birthday.
A minor’s contract is voidable, not void. A child wishing to avoid the contract need do nothing
positive to disaffirm; the defense of minority to a lawsuit is sufficient. Although the adult cannot
enforce the contract, the child can (which is why it is said to be voidable, not void).
When the minor becomes an adult, he has two choices: he may ratify the contract ordisaffirm it.
She may ratify explicitly; no further consideration is necessary. She may also do so by
implication—for instance, by continuing to make payments or retaining goods for an
unreasonable period of time. (In some states, a court may ratify the contract before the child
becomes an adult. In California, for example, a state statute permits a movie producer to seek
court approval of a contract with a child actor in order to prevent the child from disaffirming it
upon reaching majority and suing for additional wages. As quid pro quo, the court can order the
producer to pay a percentage of the wages into a trust fund that the child’s parents or guardians
cannot invade.) If the child has not disaffirmed the contract while still a minor, she may do so
within a reasonable time after reaching majority.
In most cases of disavowal, the only obligation is to return the goods (if he still has them) or
repay the consideration (unless it has been dissipated). However, in two situations, a minor
might incur greater liability: contracts for necessities and misrepresentation of age.

Contract for Necessities
At common law, a “necessity” was defined as an essential need of a human being: food,
medicine, clothing, and shelter. In recent years, however, the courts have expanded the concept,
so that in many states today necessities include property and services that will enable the minor
to earn a living and to provide for those dependent on him. If the contract is executory, the
minor can simply disaffirm. If the contract has been executed, however, the minor must face
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more onerous consequences. Although he will not be required to perform under the contract, he
will be liable under a theory of “quasi-contract” for the reasonable value of the necessity.

Misrepresentation of Age
In most states, a minor may misrepresent his age and disaffirm in accordance with the general
rule, because that’s what kids do, misrepresent their age. That the adult reasonably believed the
minor was also an adult is of no consequence in a contract suit. But some states have enacted
statutes that make the minor liable in certain situations. A Michigan statute, for instance,
prohibits a minor from disaffirming if he has signed a “separate instrument containing only the
statement of age, date of signing and the signature:” And some states “estop” him from claiming
to be a minor if he falsely represented himself as an adult in making the ·contract. “Estoppel” is
a refusal by the courts on equitable grounds to listen to an otherwise valid defense; unless the
minor can return the consideration, the contract will be enforced.
Contracts made by an insane or intoxicated person are also said to have been made by a person
lacking capacity. In general, such contracts are voidable by the person when capacity is regained
(or by the person’s legal representative if capacity is not regained).

Form
As a general rule, a contract need not be in writing to be enforceable. An oral agreement to pay a
high-fashion model $1 million to pose for a photograph is as binding as if the language of the
deal were printed on vellum and signed in the presence of twenty bishops. For centuries,
however, a large exception has grown up around theStatute of Frauds, first enacted in England
in 1677 under the formal name “An Act for the Prevention of Frauds and Perjuries.” The purpose
of the Statute of Frauds is to prevent the fraud that occurs when one party attempts to impose
upon another a contract that did not in fact exist. The two sections dealing with contracts read
as follows:
[Sect. 4] ...no action shall be brought whereby to charge any executor or administrator upon any
special promise, to answer damages out of his own estate; (2) or whereby to charge the
defendant upon any special promise to answer for the debt, default or miscarriages of another
person; (3) or to charge any person upon any agreement made upon consideration of marriage;
(4) or upon any contract or sale of lands, tenements or hereditaments, or any interest in or
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concerning them; (5) or upon any agreement that is not to be performed within the space of one
year from the making thereof; (6) unless the agreement upon which such action shall be
brought, or some memorandum or note thereof, shall be in writing, and signed by the party to
be charged therewith, or some other person thereunto by him lawfully authorized.
[Sect. 17] ...no contract for the sale of any goods, wares and merchandizes, for the price of ten
pounds sterling or upwards, shall be allowed to be good, except the buyer shall accept part of the
goods so sold, and actually receive the same, or give something in earnest to bind the bargain, or
in part of payment, or that some note or memorandum in writing of the said bargain be made
and signed by the parties to be charged by such contract, or their agents thereunto lawfully
authorized.
Again, as may be evident from the title of the act and its language, the general purpose of the law
is to provide evidence, in areas of some complexity and importance, that a contract was actually
made. To a lesser degree, the law serves to caution those about to enter a contract and “to create
a climate in which parties often regard their agreements as tentative until there is a signed
writing.” (Restatement (Second) of ContractsChapter 5, statutory note)
The Statute of Frauds has been enacted in form similar to the seventeenth century act in most
states. However, in the twentieth century Section 7 was been replaced by a section Uniform
Commercial Code. The UCC requires contracts for the sale of goods for $500 or more and for the
sale of securities to be in writing.

KEY TAKEAWAYS

A contract requires mutuality—an offer and an acceptance of the offer; it requires
consideration—a “price” paid for what is obtained; it requires that the parties to the contract
have legal capacity to know what they are doing; it requires legality. Certain contracts—
governed by the statute of frauds—are required to be evidenced by some writing, signed by
the party to be bound. The purpose here is to avoid the fraud that occurs when one person
attempts to impose upon another a contract that did not really exist.

EXERCISES

1. What are the required elements of a contract?
2. When was the Statute of Frauds first enacted, by whom, and why?
3. Basically, what does the Statute of Frauds require?
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[1] Barnes v. Treece, 549 P.2d 1152 (Wash. App. 1976).
[2] Adams v. Lindsell, 1 Bamewall & Alderson 681 (K.B. 1818).
[3] Estate of Timko v. Oral Roberts Evangelistic Assn., 215 N.W.2d 750 (Mich. App. 1974).

8.3 Remedies

LEARNING OBJECTIVES

1. Know the types of damages: compensatory and punitive.
2. Understand specific performance as a remedy.
3. Understand restitution as a remedy.
4. Recognize the interplay between contract and tort as a cause of action.
Monetary awards (called “damages”), specific performance, and restitution are the three
principle remedies.
In view of the importance given to the intention of the parties in forming and interpreting
contracts, it may seem surprising that the remedy for every breach is not a judicial order that the
obligor carry out his undertakings. But it is not. Of course, some duties cannot be performed
after a breach: time and circumstances will have altered their purpose and rendered many
worthless. Still, although there are numerous occasions on which it would be theoretically
possible for courts to order the parties to carry out their contracts, the courts will not do it. In
1897, Justice Oliver Wendell Holmes, Jr., declared in a famous line that “the duty to keep a
contract at common law means a prediction that you must pay damages if you do not keep it.”
By that he meant simply that the common law looks more toward compensating the promisee
for his loss than toward compelling the promisor to perform—a person always has the power,
though not the right, to breach a contract. Indeed, the law of remedies often provides the parties
with an incentive to break the contract. In short, the promisor has a choice: to perform or pay.
The purpose of contract remedies is, for the most part, to compensate the non-breaching party
for the losses suffered—to put the non-breaching party in the position he, she, or it would have
been in had there been no breach.

Compensatory Damages
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One party has the right to damages (money ) when the other party has breached the contract
unless, of course, the contract itself or other circumstances suspend or discharge that
right. Compensatory damages is the general category of damages awarded to make the nonbreaching party whole.

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. The leading case, perhaps the most studied
case in all the common law, is Hadley v. Baxendale, decided in England in 1854. Joseph and
Jonah Hadley were proprietors of a flour mill in Gloucester. In May 1853, the shaft of the milling
engine broke, stopping all milling. An employee went to Pickford and Company, a common
carrier, and asked that the shaft be sent as quickly as possible to a Greenwich foundry that
would use the shaft as a model to construct a new one. The carrier’s agent promised delivery
within two days. But through an error the shaft was shipped by canal rather than by rail and did
not arrive in Greenwich for seven days. The Hadleys sued Joseph Baxendale, managing director
of Pickford, for the profits they lost because of the delay. In ordering a new trial, the Court of
Exchequer ruled that Baxendale was not liable because he had had no notice that the mill was
stopped:
Where two parties have made a contract which one of them has broken, the damages which the
other party ought to receive in respect of such breach of contract should be such as may fairly
and reasonably be considered either arising naturally, i.e., according to the usual course of
things, from such breach of contract itself, or such as may reasonably be supposed to have been
in the contemplation of both parties, at the time they made the contract, as the probable result
of the breach of it. [1]
This rule, it has been argued, was a subtle change from the earlier rule that permitted damages
for any consequences as long as the breach caused the injury and the plaintiff did not exacerbate
it. But the change was evidently rationalized, at least in part, by the observation that in the
“usual course of things,” a mill would have on hand a spare shaft, so that its operations would
not cease. [2]
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This sub-set of compensatory damages is called consequential damages—damages that flow as a
foreseeable consequence of the breach. For example, if you hire a roofer to fix a leak in your
roof, and he does a bad job so that the interior of your house suffers water damage, the roofer is
liable not only for the poor roofing job, but also for the ruined drapes, damaged flooring and
walls, and so on.

Nominal Damages
If the breach caused no loss, the plaintiff is nevertheless entitled to a minor sum, perhaps one
dollar, called nominal damages. When, for example, a buyer could purchase the same
commodity at the same price as that contracted for, without spending any extra time or money,
there can be no real damages in the event of breach.

Incidental Damages
Suppose City College hires Prof. Blake on a two-year contract, after an extensive search. After
one year the professor quits to take a job elsewhere, in breach of her contract. If City College has
to pay $5000 more to find a replacement for year, Blake is liable for that amount—that’s
compensatory damages. But what if it costs City College $1200 to search for, bring to campus
and interview a replacement? City College can claim that, too, as incidental damages which
include additional costs incurred by the non-breaching party after the breach in a reasonable
attempt to avoid further loss, even if the attempt is unsuccessful.

Punitive Damages
Punitive damages are those awarded for the purpose of punishing a defendant in a civil action,
in which criminal sanctions may be unavailable. They are not part of the compensation for the
loss suffered; they are proper in cases in which the defendant has acted willfully and maliciously
and are thought to deter others from acting similarly. Since the purpose of contract law is
compensation, not punishment, punitive damages have not traditionally been awarded, with one
exception: when the breach of contract is also a tort for which punitive damages may be
recovered. Punitive damages are permitted in the law of torts (in most states) when the behavior
is malicious or willful (reckless conduct causing physical harm, deliberate defamation of one’s
character, a knowingly unlawful taking of someone’s property), and some kinds of contract
breach are also tortuous—for example, when a creditor holding collateral as security under a
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contract for a loan sells the collateral to a good-faith purchaser for value even though the debtor
was not in default, he has breached the contract and committed the tort ofconversion. Punitive
damages may be awarded, assuming the behavior was willful and not merely mistaken.
Punitive damages are not fixed by law. The judge or jury may award at its discretion whatever
sum is believed necessary to redress the wrong or deter like conduct in the future. This means
that a richer person may be slapped with much heavier punitive damages than a poorer one in
the appropriate case. But the judge in all cases mayremit (lower) some or all of a punitive
damage award if he or she considers it excessive.
Punitive damage claims have been made in cases dealing with the refusal by insurance
companies to honor their contracts. Many of these cases involve disability payments, and among
the elements are charges of tortious conduct by the company’s agents or employees. California
has been the leader among the state courts in their growing willingness to uphold punitive
damage awards despite insurer complaints that the concept of punitive damages is but a device
to permit plaintiffs to extort settlements from hapless companies. Courts have also awarded
punitive damages against other types of companies for breach of contract.

Specific Performance
Specific performance is a judicial order to the promisor that he undertake the performance to
which he obligated himself in a contract. Specific performance is an alternative remedy to
damages and may be issued at the discretion of the court, subject to a number of exceptions.
(When the promisee is seeking enforcement of a contractual provision for forbearance—a
promise that the promisor will refrain from doing something—an injunction, a judicial order not
to act in a specified manner, may be the appropriate remedy.) Emily signs a contract to sell
Charlotte a gold samovar, a Russian antique of great sentimental value because it once belonged
to Charlotte’s mother. Emily then repudiates the contract while still executory. A court may
properly grant Charlotte an order of specific performance against Emily. Specific performance is
an attractive but limited remedy: it is only available for breach of contract to sell a unique item
(real estate is always unique).

Restitution

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As the word implies, restitution is a restoring to one party of what he gave to the other.
Therefore, only to the extent that the injured party conferred a benefit on the other party may
the injured party be awarded restitution.
If the claimant has given the other party a sum of money, there can be no dispute over the
amount of the restitution interest. Tom gives Tim $100 to chop his tree into firewood. Tim
repudiates. Tom’s restitution interest is $100. But serious difficulties can arise when the benefit
conferred was performance. The courts have considerable discretion to award either the cost of
hiring someone else to do the work that the injured party performed (generally, the market price
of the service) or the value that was added to the property of the party in breach by virtue of the
claimant’s performance. Mellors, a gardener, agrees to construct ten fences around Lady
Chatterley’s flower gardens at the market price of $2,500. After erecting three, Mellors has
performed services that would cost $750, market value. Assume that he has increased the value
of the Lady’s grounds by $800. If the contract is repudiated, there are two measures of Mellors’s
restitution interest: $800, the value by which the property was enhanced; or $750, the amount
it would have cost Lady Chatterley to hire someone else to do the work. Which measure to use
depends on who repudiated the contract and for what reason.

Tort vs. Contract Remedies
Frequently a contract breach may also amount to tortious conduct. A physician warrants her
treatment as perfectly safe but performs the operation negligently, scarring the patient for life.
The patient could sue for malpractice (tort) or for breach of warranty (contract). The choice
involves at least four considerations:
1. Statute of limitations. Most statutes of limitations prescribe longer periods for contract than for
tort actions.
2. Allowable damages. Punitive damages are more often permitted in tort actions, and certain
kinds of injuries are compensable in tort but not in contract suits—for example, pain and
suffering.
3. Expert testimony. In most cases, the use of experts would be the same in either tort or contract
suits, but in certain contract cases, the expert witness could be dispensed with, as, for example,
in a contract case charging that the physician abandoned the patient.
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4. Insurance coverage. Most policies do not cover intentional torts, so a contract theory that
avoids the element of willfulness would provide the plaintiff with a surer chance of recovering
money damages.

KEY TAKEAWAYS

The purpose of remedies in contract is, usually, to put the non-breaching party in the
position he or she would have been in had there been no breach. The remedies are:
compensatory damages (money paid to compensate the non-breaching party for the losses
caused by the breach), which also include sub-categories of incidental and nominal damages;
punitive damages (to punish the breaching party) are sometimes allowed where the breach is
egregious and intentional.

EXERCISES

1. What are compensatory damages?
2. When is specific performance an appropriate remedy? Will it be used to require a person to
perform a service (such as properly repair a leaky roof)?
3. When is restitution used?
4. How could a breach of contract also be a tort, and when is one cause of action chosen over
the other?
5. What is the purpose of punitive damages?

[1] Hadley v. Baxendale (1854), 9 Ex. 341, 354, 156 Eng.Rep. 145, 151.
[2] R. J. Danzig, “Hadley v. Baxendale: A Study in the Industrialization of the Law,” Journal of Legal
Studies 4, no. 249 (1975): 249.

8.4 Cases
Objective Intention
Lucy v. Zehmer
84 S.E.2d 516 (Va. 1954)
Buchanan, J.

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This suit was instituted by W. O. Lucy and J. C. Lucy, complainants, against A. H. Zehmer and
Ida S. Zehmer, his wife, defendants, to have specific performance of a contract by which it was
alleged the Zehmers had sold to W. O. Lucy a tract of land owned by A. H. Zehmer in Dinwiddie
county containing 471.6 acres, more or less, known as the Ferguson farm, for $50,000. J. C.
Lucy, the other complainant, is a brother of W. O. Lucy, to whom W. O. Lucy transferred a half
interest in his alleged purchase.
The instrument sought to be enforced was written by A. H. Zehmer on December 20, 1952, in
these words: “We hereby agree to sell to W. O. Lucy the Ferguson farm complete for
$50,000.00, title satisfactory to buyer,” and signed by the defendants, A. H. Zehmer and Ida S.
Zehmer.
The answer of A. H. Zehmer admitted that at the time mentioned W. O. Lucy offered him
$50,000 cash for the farm, but that he, Zehmer, considered that the offer was made in jest; that
so thinking, and both he and Lucy having had several drinks, he wrote out “the memorandum”
quoted above and induced his wife to sign it; that he did not deliver the memorandum to Lucy,
but that Lucy picked it up, read it, put it in his pocket, attempted to offer Zehmer $5 to bind the
bargain, which Zehmer refused to accept, and realizing for the first time that Lucy was serious,
Zehmer assured him that he had no intention of selling the farm and that the whole matter was
a joke. Lucy left the premises insisting that he had purchased the farm.…
In his testimony Zehmer claimed that he “was high as a Georgia pine,” and that the transaction
“was just a bunch of two doggoned drunks bluffing to see who could talk the biggest and say the
most.” That claim is inconsistent with his attempt to testify in great detail as to what was said
and what was done.…
If it be assumed, contrary to what we think the evidence shows, that Zehmer was jesting about
selling his farm to Lucy and that the transaction was intended by him to be a joke, nevertheless
the evidence shows that Lucy did not so understand it but considered it to be a serious business
transaction and the contract to be binding on the Zehmers as well as on himself. The very next
day he arranged with his brother to put up half the money and take a half interest in the land.
The day after that he employed an attorney to examine the title. The next night, Tuesday, he was
back at Zehmer’s place and there Zehmer told him for the first time, Lucy said, that he wasn’t
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going to sell and he told Zehmer, “You know you sold that place fair and square.” After receiving
the report from his attorney that the title was good he wrote to Zehmer that he was ready to
close the deal.
Not only did Lucy actually believe, but the evidence shows he was warranted in believing, that
the contract represented a serious business transaction and a good faith sale and purchase of the
farm.
In the field of contracts, as generally elsewhere, “We must look to the outward expression of a
person as manifesting his intention rather than to his secret and unexpressed intention. The law
imputes to a person an intention corresponding to the reasonable meaning of his words and
acts.”
At no time prior to the execution of the contract had Zehmer indicated to Lucy by word or act
that he was not in earnest about selling the farm. They had argued about it and discussed its
terms, as Zehmer admitted, for a long time. Lucy testified that if there was any jesting it was
about paying $50,000 that night. The contract and the evidence show that he was not expected
to pay the money that night. Zehmer said that after the writing was signed he laid it down on the
counter in front of Lucy. Lucy said Zehmer handed it to him. In any event there had been what
appeared to be a good faith offer and a good faith acceptance, followed by the execution and
apparent delivery of a written contract. Both said that Lucy put the writing in his pocket and
then offered Zehmer $5 to seal the bargain. Not until then, even under the defendants’ evidence,
was anything said or done to indicate that the matter was a joke. Both of the Zehmers testified
that when Zehmer asked his wife to sign he whispered that it was a joke so Lucy wouldn’t hear
and that it was not intended that he should hear.
The mental assent of the parties is not requisite for the formation of a contract. If the words or
other acts of one of the parties have but one reasonable meaning, his undisclosed intention is
immaterial except when an unreasonable meaning which he attaches to his manifestations is
known to the other party.
“* * * The law, therefore, judges of an agreement between two persons exclusively from those
expressions of their intentions which are communicated between them. * * *.” [Citation]

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An agreement or mutual assent is of course essential to a valid contract but the law imputes to a
person an intention corresponding to the reasonable meaning of his words and acts. If his words
and acts, judged by a reasonable standard, manifest an intention to agree, it is immaterial what
may be the real but unexpressed state of his mind.
So a person cannot set up that he was merely jesting when his conduct and words would warrant
a reasonable person in believing that he intended a real agreement.
Whether the writing signed by the defendants and now sought to be enforced by the
complainants was the result of a serious offer by Lucy and a serious acceptance by the
defendants, or was a serious offer by Lucy and an acceptance in secret jest by the defendants, in
either event it constituted a binding contract of sale between the parties.…
Reversed and remanded.

CASE QUESTIONS

1. What objective evidence was there to support the defendants’ contention that they were
just kidding when they agreed to sell the farm?
2. Suppose the defendants really did think the whole thing was a kind of joke. Would that make
any difference?
3. As a matter of public policy, why does the law use an objective standard to determine the
seriousness of intention, instead of a subjective standard?
4. It’s 85 degrees in July and 5:00 p.m., quitting time. The battery in Mary’s car is out of juice,
again. Mary says, “Arrgh! I will sell this stupid car for $50!” Jason, walking to his car nearby,
whips out his checkbook and says, “It’s a deal. Leave your car here. I’ll give you a ride home
and pick up your car after you give me the title.” Do the parties have a contract?

Consideration: Preexisting Obligation
Denney v. Reppert
432 S.W.2d 647 (Ky. 1968)
R. L. Myre, Sr., Special Commissioner.
The sole question presented in this case is which of several claimants is entitled to an award for
information leading to the apprehension and conviction of certain bank robbers.…

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On June 12th or 13th, 1963, three armed men entered the First State Bank, Eubank, Kentucky,
and with a display of arms and threats robbed the bank of over $30,000 [about $208,000 in
2010 dollars]. Later in the day they were apprehended by State Policemen Garret Godby,
Johnny Simms and Tilford Reppert, placed under arrest, and the entire loot was recovered.
Later all of the prisoners were convicted and Garret Godby, Johnny Simms and Tilford Reppert
appeared as witnesses at the trial.
The First State Bank of Eubank was a member of the Kentucky Bankers Association which
provided and advertised a reward of $500.00 for the arrest and conviction of each bank robber.
Hence the outstanding reward for the three bank robbers was $1,500.00 [about $11,000 in 2010
dollars]. Many became claimants for the reward and the Kentucky State Bankers Association
being unable to determine the merits of the claims for the reward asked the circuit court to
determine the merits of the various claims and to adjudge who was entitled to receive the
reward or share in it. All of the claimants were made defendants in the action.
At the time of the robbery the claimants Murrell Denney, Joyce Buis, Rebecca McCollum and
Jewell Snyder were employees of the First State Bank of Eubank and came out of the grueling
situation with great credit and glory. Each one of them deserves approbation and an accolade.
They were vigilant in disclosing to the public and the peace officers the details of the crime, and
in describing the culprits, and giving all the information that they possessed that would be
useful in capturing the robbers. Undoubtedly, they performed a great service. It is in the
evidence that the claimant Murrell Denney was conspicuous and energetic in his efforts to make
known the robbery, to acquaint the officers as to the personal appearance of the criminals, and
to give other pertinent facts.
The first question for determination is whether the employees of the robbed bank are eligible to
receive or share in the reward. The great weight of authority answers in the negative. [Citation]
states the rule thusly:
‘To the general rule that, when a reward is offered to the general public for the performance of
some specified act, such reward may be claimed by any person who performs such act, is the
exception of agents, employees and public officials who are acting within the scope of their
employment or official duties. * * *.’…
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At the time of the robbery the claimants Murrell Denney, Joyce Buis, Rebecca McCollum, and
Jewell Snyder were employees of the First State Bank of Eubank. They were under duty to
protect and conserve the resources and moneys of the bank, and safeguard every interest of the
institution furnishing them employment. Each of these employees exhibited great courage, and
cool bravery, in a time of stress and danger. The community and the county have recompensed
them in commendation, admiration and high praise, and the world looks on them as heroes. But
in making known the robbery and assisting in acquainting the public and the officers with
details of the crime and with identification of the robbers, they performed a duty to the bank and
the public, for which they cannot claim a reward.
The claims of Corbin Reynolds, Julia Reynolds, Alvie Reynolds and Gene Reynolds also must
fail. According to their statements they gave valuable information to the arresting officers.
However, they did not follow the procedure as set forth in the offer of reward in that they never
filed a claim with the Kentucky Bankers Association. It is well established that a claimant of a
reward must comply with the terms and conditions of the offer of reward. [Citation]
State Policemen Garret Godby, Johnny Simms and Tilford Reppert made the arrest of the bank
robbers and captured the stolen money. All participated in the prosecution. At the time of the
arrest, it was the duty of the state policemen to apprehend the criminals. Under the law they
cannot claim or share in the reward and they are interposing no claim to it.
This leaves the defendant, Tilford Reppert the sole eligible claimant. The record shows that at
the time of the arrest he was a deputy sheriff in Rockcastle County, but the arrest and recovery
of the stolen money took place in Pulaski County. He was out of his jurisdiction, and was thus
under no legal duty to make the arrest, and is thus eligible to claim and receive the reward. In
[Citation] it was said:
‘It is * * * well established that a public officer with the authority of the law to make an arrest
may accept an offer of reward or compensation for acts or services performed outside of his
bailiwick or not within the scope of his official duties. * * *.’…
It is manifest from the record that Tilford Reppert is the only claimant qualified and eligible to
receive the reward. Therefore, it is the judgment of the circuit court that he is entitled to receive
payment of the $1,500.00 reward now deposited with the Clerk of this Court.
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The judgment is affirmed.

CASE QUESTIONS

1. Why did the Bankers Association put the resolution of this matter into the court’s hands?
2. Several claimants came forward for the reward; only one person got it. What was the
difference between the person who got the reward and those who did not?

Consequential Damages
EBWS, LLC v. Britly Corp.
928 A.2d 497 (Vt. 2007)
Reiber, C.J.
The Ransom family owns Rock Bottom Farm in Strafford, Vermont, where Earl Ransom owns a
dairy herd and operates an organic dairy farm. In 2000, the Ransoms decided to build a
creamery on-site to process their milk and formed EBWS, LLC to operate the dairy-processing
plant and to market the plant’s products. In July 2000, Earl Ransom, on behalf of EBWS, met
with Britly’s president to discuss building the creamery.…In January 2001, EBWS and Britly
entered into a contract requiring Britly to construct a creamery building for EBWS in exchange
for $160,318.…The creamery was substantially completed by April 15, 2001, and EBWS moved
in soon afterward. On June 5, 2001, EBWS notified Britly of alleged defects in construction.
[EBWS continued to use the creamery pending the necessity to vacate it for three weeks when
repairs were commenced].
On September 12, 2001, EBWS filed suit against Britly for damages resulting from defective
design and construction.…
Following a three-day trial, the jury found Britly had breached the contract and its express
warranty, and awarded EBWS: (1) $38,020 in direct damages, and (2) $35,711 in consequential
damages.…
…The jury’s award to EBWS included compensation for both direct and consequential damages
that EBWS claimed it would incur while the facility closed for repairs. Direct damages [i.e.,
compensatory damages] are for “losses that naturally and usually flow from the breach itself,”
and it is not necessary that the parties actually considered these damages. [Citation]. In
comparison, special or consequential damages “must pass the tests of causation, certainty and

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foreseeability, and, in addition, be reasonably supposed to have been in the contemplation of
both parties at the time they made the contract.”
…The court ruled that EBWS could not recover for lost profits because it was not a going
concern at the time the contract was entered into, and profits were too speculative. The court
concluded, however, that EBWS could submit evidence of other business losses, including future
payment for unused milk and staff wages.…
At trial, Huyffer, the CEO of EBWS, testified that during a repairs closure the creamery would be
required to purchase milk from adjacent Rock Bottom Farm, even though it could not process
this milk. She admitted that such a requirement was self-imposed as there was no written
output contract between EBWS and the farm to buy milk. In addition, Huyffer testified that
EBWS would pay its employees during the closure even though EBWS has no written contract to
pay its employees when they are not working. The trial court allowed these elements of damages
to be submitted to the jury, and the jury awarded EBWS consequential damages for unused milk
and staff wages.
On appeal, Britly contends that because there is no contractual or legal obligation for EBWS to
purchase milk or pay its employees, these are not foreseeable damages. EBWS counters that it is
common knowledge that cows continue to produce milk, even if the processing plant is not
working, and thus it is foreseeable that this loss would occur. We conclude that these damages
are not the foreseeable result of Britly’s breach of the construction contract and reverse the
award.…
[W]e conclude that…it is not reasonable to expect Britly to foresee that its failure to perform
under the contract would result in this type of damages. While we are sympathetic to EBWS’s
contention that the cows continue to produce milk, even when the plant is closed down, this fact
alone is not enough to demonstrate that buying and dumping milk is a foreseeable result of
Britly’s breach of the construction contract. Here, the milk was produced by a separate and
distinct entity, Rock Bottom Farm, which sold the milk to EBWS.…
Similarly, EBWS maintained no employment agreements with its employees obligating it to pay
wages during periods of closure for repairs, dips in market demand, or for any other reason. Any
losses EBWS might suffer in the future because it chooses to pay its employees during a plant
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closure for repairs would be a voluntary expense and not in Britly’s contemplation at the time it
entered the construction contract. It is not reasonable to expect Britly to foresee losses incurred
as a result of agreements that are informal in nature and carry no legal obligation on EBWS to
perform. “[P]arties are not presumed to know the condition of each other’s affairs nor to take
into account contracts with a third party that is not communicated.” [Citation] While it is true
that EBWS may have business reasons to pay its employees even without a contractual
obligation, for example, to ensure employee loyalty, no evidence was introduced at trial by
EBWS to support a sound rationale for such considerations. Under these circumstances, this
business decision is beyond the scope of what Britly could have reasonably foreseen as damages
for its breach of contract.…
In addition, the actual costs of the wages and milk are uncertain.…[T]he the milk and wages
here are future expenses, for which no legal obligation was assumed by EBWS, and which are
separate from the terms of the parties’ contract. We note that at the time of the construction
contract EBWS had not yet begun to operate as a creamery and had no history of buying milk or
paying employees. See [Citation] (explaining that profits for a new business are uncertain and
speculative and not recoverable). Thus, both the cost of the milk and the number and amount of
wages of future employees that EBWS might pay in the event of a plant closure for repairs are
uncertain.
Award for consequential damages is reversed.…

CASE QUESTIONS

1. Why, according to EBWS’s CEO, would EBWS be required to purchase milk from adjacent
Rock Bottom Farm, even though it could not process this milk?
2. Surely it is well known in Vermont dairy country that dairy farmers can’t simply stop milking
cows when no processing plant is available to take the milk—the cows will soon stop
producing. Why was EBWS then not entitled to those damages which it will certainly suffer
when the creamery is down for repairs?
3. Britly (the contractor) must have known EBWS had employees that would be idled when the
creamery shut down for repairs. Why was it not liable for their lost wages?

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4. What could EBWS have done at the time of contracting to protect itself against the damages
it would incur in the event the creamery suffered downtime due to faulty construction?

8.5 Summary and Exercises
Summary

In this chapter we have seen that two fundamental sources of contract law are the common law
as developed in the state courts and as summarized in theRestatement (Second) of
Contracts, and the Uniform Commercial Code for the sale of goods.
Sales law is a special type of contract law, governed by Article 2 of the UCC. Article 2 governs the
sale of goods only, defined as things movable at the time of identification to the contract for sale.
When the goods are “sold” incidental to a service, the courts do not agree on whether Article 2
applies. For two categories of goods, legislation specifically answers the question: foodstuffs
served by a restaurant are goods; blood supplied for transfusions is not.
Types of contracts can be distinguished along these axes: (1) express and implied, including
quasi-contracts implied by law; (2) bilateral and unilateral; (3) enforceable and unenforceable;
and (4) completed (executed) and uncompleted (executory). To understand contract law, it is
necessary to master these distinctions and their nuances.
In order to determine whether a valid, enforceable contract exists, the following questions must
be answered: (1) Did the parties reach an agreement? (2) Was consideration present? (3) Was
the agreement legal? (4) Did the parties have capacity to make a contract? (5) Was the
agreement in the proper form?
Remedies available against someone who breaches a contract include damages, specific
performance, and restitution. Frequently the party who is not in breach must choose between
tort and contract remedies.

EXERCISES

1. On November 26, Joe wrote to Kate offering to purchase a farm that she owned. Upon
receiving the letter on November 28, Kate immediately sent Joe a letter of acceptance.
However, shortly after mailing the letter, Kate had second thoughts and called Joe to advise

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him that she was rejecting his offer. The call was made before Joe received the letter of
acceptance. Has a contract been formed? Why?
2. On a busy day just before April 15, Albert Accountant received a call from a local car dealer.
The dealer said, “Hi, Mr. Accountant. Now, while you have income from doing clients’ taxes, I
have an excellent offer for you. You can buy a new Buick Century automobile completely
loaded for $36,000. Al, I know you’re busy. If I don’t hear from you by the end of the day, I’ll
assume you want the car.” Albert, distracted, did not respond immediately, and the dealer
hung up. Then followed an exhausting day of working with anxiety-ridden tax clients. Albert
forgot about the conversation. Two days later a statement arrived from the dealer, with
instructions on how Albert should pick up the car at the dealership. Is there a contract?
Explain.
3. Bert purchased Ernie’s car. Before selling the car, Ernie had stated to Bert, “This car runs well
and is reliable. Last week I drove the car all the way from Seattle to San Francisco to visit my
mother and back again to Seattle.” In fact, Ernie was not telling the truth: he had driven the
car to San Francisco to visit his paramour, not his mother. Upon discovery of the truth, may
Bert avoid the contract? Why?
4. Langstraat was seventeen when he purchased a motorcycle. When applying for insurance, he
signed a “Notice of Rejection,” declining to purchase uninsured motorist coverage. He was
involved in an accident with an uninsured motorist and sought to disaffirm his rejection of
the uninsured motorist coverage on the basis of infancy. May he do so?
5. Richard promised to have Darlene’s deck awning constructed by July 10. On June 20, Darlene
called him and asked if he could get the job done by July 3, in time for Independence Day.
Richard said he could, but he failed to do so, and Darlene had to rent two canopies at some
expense. Darlene claims that because Richard breached his promise, he is liable for the cost
of awning rental. Is she correct—was his promise binding? Why?
6. After taking a business law class at State U, Elke entered into a contract to sell her business
law book to a classmate, Matthew, for $45. As part of the same contract, she agreed to
prepare a will for Matthew’s mother for an additional $110. Elke prepared the will and sent
the book to Matthew, but he refused to pay her. Is she entitled to any payment? Explain.
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7. Sara Hohe, a fifteen-year-old junior at Mission Bay High School in San Diego, was injured
during a campus hypnotism show sponsored by the PTSA as a fund-raiser for the senior class.
Hypnotism shows had been held annually since 1980, and Sara had seen the previous year’s
show. She was selected at random from a group of many volunteers. Her participation in the
“Magic of the Mind Show” was conditioned on signing two release forms. Hohe’s father
signed a form entitled “Mission Bay High School PTSA Presents Dr. Karl Santo.” Hohe and her
father both signed a form titled “Karl Santo Hypnotist,” releasing Santo and the school
district from all liability. During the course of the show, while apparently hypnotized, Hohe
slid from her chair and also fell to the floor about six times and was injured. She, through her
father, then sued the school district. The Hohes claimed the release was contrary to public
policy; the trial court dismissed the suit on summary judgment. Was the release contrary to
public policy? Decide.
8. Plaintiff Irma Kozlowski cohabited with Defendant Thaddeus Kozlowski for fifteen years
without marriage. She repeatedly asked him specifically about her financial situation should
he predecease her, and he assured her—she said—that he would arrange to provide for her
for the rest of her life. She had provided the necessary household services and emotional
support to permit him to successfully pursue his business career; she had performed
housekeeping, cleaning, and shopping services and had run the household and raised the
children, her own as well as his. When they separated and she was “literally forced out of the
house,” she was sixty-three years old and had no means or wherewithal for survival. When
she sued, he raised the Statute of Frauds’ one-year rule as a defense. Is the defense good?
9. Owner of an auto repair shop hires Contractor to remodel his shop but does not mention
that two days after the scheduled completion date, Owner is to receive five small US Army
personnel carrier trucks for service, with a three-week deadline to finish the job and turn the
trucks over to the army. The contract between Owner and the army has a liquidated
damages clause calling for $300 a day for every day trucks are not operable after the
deadline. Contractor is five days late in finishing the remodel. Can Owner claim the $1,500 as
damages against Contractor as a consequence of the latter’s tardy completion of the
contract? Explain.
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10. Calvin, a promising young basketball and baseball player, signed a multiyear contract with a
professional basketball team after graduating from college. After playing basketball for one
year, he decided he would rather play baseball and breached his contract with the basketball
team. What remedy could the team seek?

SELF-TEST QUESTIONS

1. An implied contract
a.

must be in writing
b. is one in which the terms are spelled out
c. is one inferred from the actions of the parties
d. is imposed by law to avoid an unjust result
e. may be avoided by one party.
The Convention on Contracts for the International Sale of Goods is

a.

an annual meeting of international commercial purchasing agents.
b. contract law used in overseas US federal territories
c. a customary format or template for drafting contracts
d. a kind of treaty setting out international contract law, to which the United States
is a party
e. the organization that develops uniform international law.
Consideration

a.

can consist of a written acknowledgment of some benefit received, even if in fact

the benefit is not delivered
b. cannot be nominal in amount
c. is a bargained-for act, forbearance, or promise from the promisee
d. is all of the above
An example of valid consideration is a promise
a.

by a seventeen-year-old to refrain from drinking alcohol

b. to refrain from going to court
c. to cook dinner if the promisor can get around to it
d. to repay a friend for the four years of free legal advice he had provided.

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A contract to pay a lobbyist to influence a public official is generally illegal.
a.

true

b. false

SELF-TEST ANSWERS

1. c
2. d
3. c
4. b
5. false

Chapter 9
Introduction to Property: Personal Property and
Fixtures
LEARNING OBJECTIVES

After reading this chapter, you should understand the following:
1. The difference between personal property and other types of property
2. How rights in personal property are acquired and maintained
3. How some kinds of personal property can become real property, and how to determine who
has rights in fixtures that are part of real property
In this chapter, we examine the general nature of property rights and the law relating to
personal property—with special emphasis on acquisition and fixtures. In Chapter 10
"Intellectual Property", we discuss intellectual property, a kind of personal property that is
increasingly profitable. In Chapter 11 "The Nature and Regulation of Real Estate and the
Environment" through Chapter 13 "Landlord and Tenant Law", we focus on real property,
including its nature and regulation, its acquisition by purchase (and some other methods), and
its acquisition by lease (landlord and tenant law).
In Chapter 14 "Estate Planning: Wills, Estates, and Trusts" and Chapter 15 "Insurance", we
discuss estate planning and insurance—two areas of the law that relate to both personal and real
property.

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9.1 The General Nature of Property Rights
LEARNING OBJECTIVES

1. Understand the elastic and evolving boundaries of what the law recognizes as property that
can be bought or sold on the market.
2. Distinguish real property from personal property.

Definition of Property
Property, which seems like a commonsense concept, is difficult to define in an intelligible way;
philosophers have been striving to define it for the past 2,500 years. To say that “property is
what we own” is to beg the question—that is, to substitute a synonym for the word we are trying
to define. Blackstone’s famous definition is somewhat wordy: “The right of property is that sole
and despotic dominion which one man claims and exercises over the external things of the
world, in total exclusion of the right of any other individual in the universe. It consists in the free
use, enjoyment, and disposal of all a person’s acquisitions, without any control or diminution
save only by the laws of the land.” A more concise definition, but perhaps too broad, comes from
the Restatement of the Law of Property, which defines property as the “legal relationship
between persons with respect to a thing.”
The Restatement’s definition makes an important point: property is a legal relationship, the
power of one person to use objects in ways that affect others, to exclude others from the
property, and to acquire and transfer property. Still, this definition does not contain a specific
list of those nonhuman “objects” that could be in such a relationship. We all know that we can
own personal objects like iPods and DVDs, and even more complex objects like homes and
minerals under the ground. Property also embraces objects whose worth is representative or
symbolic: ownership of stock in a corporation is valued not for the piece of paper called a stock
certificate but for dividends, the power to vote for directors, and the right to sell the stock on the
open market. Wholly intangible things or objects like copyrights and patents and bank accounts
are capable of being owned as property. But the list of things that can be property is not fixed,
for our concept of property continues to evolve. Collateralized debt obligations (CDOs) and
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structured investment vehicles (SIVs), prime players in the subprime mortgage crisis, were not
on anyone’s list of possible property even fifteen years ago.

The Economist’s View
Property is not just a legal concept, of course, and different disciplines express different
philosophies about the purpose of property and the nature of property rights. To the jurist,
property rights should be protected because it is just to do so. To an economist, the legal
protection of property rights functions to create incentives to use resources efficiently. For a
truly efficient system of property rights, some economists would require universality (everything
is owned), exclusivity (the owners of each thing may exclude all others from using it), and
transferability (owners may exchange their property). Together, these aspects of property would
lead, under an appropriate economic model, to efficient production and distribution of goods.
But the law of property does not entirely conform to the economic conception of the ownership
of productive property by private parties; there remain many kinds of property that are not
privately owned and some parts of the earth that are considered part of “the commons.” For
example, large areas of the earth’s oceans are not “owned” by any one person or nation-state,
and certain land areas (e.g., Yellowstone National Park) are not in private hands.

Classification of Property
Property can be classified in various ways, including tangible versus intangible, private versus
public, and personal versus real. Tangible property is that which physically exists, like a
building, a popsicle stand, a hair dryer, or a steamroller.Intangible property is something
without physical reality that entitles the owner to certain benefits; stocks, bonds, and
intellectual property would be common examples.Public property is that which is owned by any
branch of government;private property is that which is owned by anyone else, including a
corporation.
Perhaps the most important distinction is between real and personal property.
Essentially, real property is immovable; personal property is movable. At common law, personal
property has been referred to as “chattels.” When chattels become affixed to real property in a
certain manner, they are called fixtures and are treated as real property. (For example, a
bathroom cabinet purchased at Home Depot and screwed into the bathroom wall may be
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converted to part of the real property when it is affixed.) Fixtures are discussed in Section 9.3
"Fixtures" of this chapter.

Importance of the Distinction between Real and Personal Property
In our legal system, the distinction between real and personal property is significant in several
ways. For example, the sale of personal property, but not real property, is governed by Article 2
of the Uniform Commercial Code (UCC). Real estate transactions, by contrast, are governed by
the general law of contracts. Suppose goods are exchanged for realty. Section 2-304 of the UCC
says that the transfer of the goods and the seller’s obligations with reference to them are subject
to Article 2, but not the transfer of the interests in realty nor the transferor’s obligations in
connection with them.
The form of transfer depends on whether the property is real or personal. Real property is
normally transferred by a deed, which must meet formal requirements dictated by state law. By
contrast, transfer of personal property often can take place without any documents at all.
Another difference can be found in the law that governs the transfer of property on death. A
person’s heirs depend on the law of the state for distribution of his property if he dies intestate—
that is, without a will. Who the heirs are and what their share of the property will be may depend
on whether the property is real or personal. For example, widows may be entitled to a different
percentage of real property than personal property when their husbands die intestate.
Tax laws also differ in their approach to real and personal property. In particular, the rules of
valuation, depreciation, and enforcement depend on the character of the property. Thus real
property depreciates more slowly than personal property, and real property owners generally
have a longer time than personal property owners to make good unpaid taxes before the state
seizes the property.

KEY TAKEAWAY

Property is difficult to define conclusively, and there are many different classifications of
property. There can be public property as well as private property, tangible property as well
as intangible property, and, most importantly, real property as well as personal property.
These are important distinctions, with many legal consequences.

EXERCISES

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1. Kristen buys a parcel of land on Marion Street, a new and publicly maintained roadway. Her
town’s ordinances say that each property owner on a public street must also provide a
sidewalk within ten feet of the curb. A year after buying the parcel, Kristen commissions a
house to be built on the land, and the contractor begins by building a sidewalk in accordance
with the town’s ordinance. Is the sidewalk public property or private property? If it snows,
and if Kristen fails to remove the snow and it melts and ices over and a pedestrian slips and
falls, who is responsible for the pedestrian’s injuries?
2. When can private property become public property? Does public property ever become
private property?

9.2 Personal Property

LEARNING OBJECTIVE

1. Explain the various ways that personal property can be acquired by means other than
purchase.
Most legal issues about personal property center on its acquisition. Acquisition by purchase is
the most common way we acquire personal property, but there are at least five other ways to
legally acquire personal property: (1) possession, (2) finding lost or misplaced property, (3) gift,
(4) accession, and (5) confusion.

Possession
It is often said that “possession is nine-tenths of the law.” There is an element of truth to this,
but it’s not the whole truth. For our purposes, the more important question is, what is meant by
“possession”? Its meaning is not intuitively obvious, as a moment’s reflection will reveal. For
example, you might suppose than you possess something when it is physically within your
control, but what do you say when a hurricane deposits a boat onto your land? What if you are
not even home when this happens? Do you possess the boat? Ordinarily, we would say that you
don’t, because you don’t have physical control when you are absent. You may not even have the
intention to control the boat; perhaps instead of a fancy speedboat in relatively good shape, the
boat is a rust bucket badly in need of repair, and you want it removed from your front yard.

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Even the element of physical domination of the object may not be necessary. Suppose you give
your new class ring to a friend to examine. Is it in the friend’s possession? No: the friend has
custody, not possession, and you retain the right to permit a second friend to take it from her
hands. This is different from the case of a bailment, in which the bailor gives possession of an
object to the bailee. For example, a garage (a bailee) entrusted with a car for the evening, and
not the owner, has the right to exclude others from the car; the owner could not demand that the
garage attendants refrain from moving the car around as necessary.
From these examples, we can see that possession or physical control must usually be understood
as the power to exclude others from using the object. Otherwise, anomalies arise from the
difficulty of physically controlling certain objects. It is more difficult to exercise control over a
one-hundred-foot television antenna than a diamond ring. Moreover, in what sense do you
possess your household furniture when you are out of the house? Only, we suggest, in the power
to exclude others. But this power is not purely a physical one: being absent from the house, you
could not physically restrain anyone. Thus the concept of possession must inevitably be mixed
with legal rules that do or could control others.
Possession confers ownership in a restricted class of cases only: when no person was the owner
at the time the current owner took the object into his possession. The most obvious categories of
objects to which this rule of possession applies are wild animals and abandoned goods. The rule
requires that the would-be owner actually take possession of the animal or goods; the hunter
who is pursuing a particular wild animal has no legal claim until he has actually captured it. Two
hunters are perfectly free to pursue the same animal, and whoever actually grabs it will be the
owner.
But even this simple rule is fraught with difficulties in the case of both wild animals and
abandoned goods. We examine abandoned goods in Section 9.2.2 "Lost or Misplaced Property".
In the case of wild game, fish in a stream, and the like, the general rule is subject to the rights of
the owner of the land on which the animals are caught. Thus even if the animals caught by a
hunter are wild, as long as they are on another’s land, the landowner’s rights are superior to the
hunter’s. Suppose a hunter captures a wild animal, which subsequently escapes, and a second

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hunter thereafter captures it. Does the first hunter have a claim to the animal? The usual rule is
that he does not, for once an animal returns to the wild, ownership ceases.

Lost or Misplaced Property
At common law, a technical distinction arose between lost and misplaced property. An object is
lost if the owner inadvertently and unknowingly lets it out of his possession. It is merely
misplaced if the owner intentionally puts it down, intending to recover it, even if he
subsequently forgets to retrieve it. These definitions are important in considering the old saying
“Finders keepers, losers weepers.” This is a misconception that is, at best, only partially true,
and more often false. The following hierarchy of ownership claims determines the rights of
finders and losers.
First, the owner is entitled to the return of the property unless he has intentionally abandoned
it. The finder is said to be a quasi-bailee for the true owner, and as bailee she owes the owner
certain duties of care. The finder who knows the owner or has reasonable means of discovering
the owner’s identity commits larceny if she holds on to the object with the intent that it be hers.
This rule applies only if the finder actually takes the object into her possession. For example, if
you spot someone’s wallet on the street you have no obligation to pick it up; but if you do pick it
up and see the owner’s name in it, your legal obligation is to return it to the rightful owner. The
finder who returns the object is not automatically entitled to a reward, but if the loser has
offered a reward, the act of returning it constitutes performance of a unilateral contract.
Moreover, if the finder has had expenses in connection with finding the owner and returning the
property, she is entitled to reasonable reimbursement as a quasi-bailee. But the rights of the
owner are frequently subject to specific statutes, such as the one discussed in Bishop v.
Ellsworth in Section 9.4.1 "Lost or Misplaced Property".
Second, if the owner fails to claim the property within the time allowed by statute or has
abandoned it, then the property goes to the owner of the real estate on which it was found if (1)
the finder was a trespasser, (2) the goods are found in a private place (though what exactly
constitutes a private place is open to question: is the aisle of a grocery store a private place? the
back of the food rack? the stockroom?), (3) the goods are buried, or (4) the goods are misplaced
rather than lost.
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If none of these conditions apply, then the finder is the owner. These rules are considered in
the Bishop case, (see Section 9.4.1 "Lost or Misplaced Property").

Gift
A gift is a voluntary transfer of property without consideration or compensation. It is
distinguished from a sale, which requires consideration. It is distinguished from a promise to
give, which is a declaration of an intention to give in the future rather than a present transfer. It
is distinguished from a testamentary disposition (will), which takes effect only upon death, not
upon the preparation of the documents. Two other distinctions are worth noting.
An inter vivos (enter VYE vos) gift is one made between living persons without conditions
attached. A causa mortis (KAW zuh mor duz) gift is made by someone contemplating death in
the near future.

Requirements
Figure 9.1 Gift Requirements

To make an effective gift inter vivos or causa mortis, the law imposes three requirements: (1) the
donor must deliver a deed or object to the donee; (2) the donor must actually intend to make a
gift, and (3) the donee must accept (see Figure 9.1 "Gift Requirements").

Delivery
Although it is firmly established that the object be delivered, it is not so clear what constitutes
delivery. On the face of it, the requirement seems to be that the object must be transferred to the

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donee’s possession. Suppose your friend tells you he is making a gift to you of certain books that
are lying in a locked trunk. If he actually gives you the trunk so that you can carry it away, a gift
has been made. Suppose, however, that he had merely given you the key, so that you could come
back the next day with your car. If this were the sole key, the courts would probably construe the
transfer of the key as possession of the trunk. Suppose, instead, that the books were in a bank
vault and the friend made out a legal document giving both you and him the power to take from
the bank vault. This would not be a valid gift, since he retained power over the goods.

Intent
The intent to make a gift must be an intent to give the property at the present time, not later. For
example, suppose a person has her savings account passbook put in her name and a friend’s
name, intending that on her death the friend will be able to draw out whatever money is left. She
has not made a gift, because she did not intend to give the money when she changed the
passbook. The intent requirement can sometimes be sidestepped if legal title to the object is
actually transferred, postponing to the donee only the use or enjoyment of the property until
later. Had the passbook been made out in the name of the donee only and delivered to a third
party to hold until the death of the donor, then a valid gift may have been made. Although it is
sometimes difficult to discern this distinction in practice, a more accurate statement of the rule
of intent is this: Intention to give in the future does not constitute the requisite intent, whereas
present gifts of future interests will be upheld.

Acceptance
In the usual case, the rule requiring acceptance poses no difficulties. A friend hands you a new
book and says, “I would like you to have this.” Your taking the book and saying “thank-you” is
enough to constitute your acceptance. But suppose that the friend had given you property
without your knowing it. For example, a secret admirer puts her stock certificates jointly in your
name and hers without telling you. Later, you marry someone else, and she asks you to transfer
the certificates back to her name. This is the first you have heard of the transaction. Has a gift
been made? The usual answer is that even though you had not accepted the stock when the
name change was made, the transaction was a gift that took effect immediately, subject to your
right to repudiate when you find out about it. If you do not reject the gift, you have joint rights in
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the stock. But if you expressly refuse to accept a gift or indicate in some manner that you might
not have accepted it, then the gift is not effective. For example, suppose you are running for
office. A lobbyist whom you despise gives you a donation. If you refuse the money, no gift has
been made.

Gifts Causa Mortis
Even though the requirements of delivery, intent, and acceptance apply to gifts causa mortis as
well as inter vivos, a gift causa mortis (one made in contemplation of death) may be
distinguished from a gift inter vivos on other grounds. The difference between the two lies in the
power of the donor to revoke the gift before he dies; in other words, the gift is conditional on his
death. Since the law does not permit gifts that take place in the future contingent on some
happening, how can it be that a gift causa mortis is effective? The answer lies in the nature of the
transfer: the donee takes actual title when the gift is made; should the donor not in fact die or
should he revoke the gift before he dies, then and only then will the donee lose title. The
difference is subtle and amounts to the difference between saying “If I die, the watch is yours”
and “The watch is yours, unless I survive.” In the former case, known as a condition precedent,
there is no valid gift; in the latter case, known as a condition subsequent, the gift is valid.

Gifts to Minors
Every state has adopted either the Uniform Gifts to Minors Act (UGMA) or the Uniform
Transfers to Minors Act (UTMA), both of which establish the manner by which irrevocable gifts
are made to minors. Under these acts, a custodian holds the gifts until the minor reaches the age
of eighteen, twenty-one, or twenty-five, depending on state law. Gifts under UGMA are limited
for the most part to money or securities, while UTMA allows other types of gifts as well, such as
real estate or tangible personal property.

Gift Tax
The federal government and many states impose gift taxes on gifts above a certain dollar
amount. We discuss gift taxes in connection with estate taxes in Chapter 14 "Estate Planning:
Wills, Estates, and Trusts".

Accession

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An accession is something that is added to what one already possesses. In general, the rule is
that the owner of the thing owns the additional thing that comes to be attached to it. For
example, the owner of a cow owns her calves when she gives birth. But when one person adds
value to another person’s property, either through labor alone or by adding new materials, the
rule must be stated somewhat differently. The general rule is this: when goods are added to
goods, the owner of the principal goods becomes the owner of the enhanced product. For
example, a garage uses its paint to repaint its customer’s automobile. The car owner, not the
painter, is the owner of the finished product.
When someone has wrongfully converted—that is, taken as her own—the property of another,
the owner may sue for damages, either to recover his property or its value. But a problem arises
when the converter has added to the value of that property. In general, the courts hold that
when the conversion is willful, the owner is entitled to the full value of the goods as enhanced by
the converter. Suppose that a carpenter enters a ten-acre forest that he knows belongs to his
neighbor, cuts down one hundred trees, transports them to his shop, and cuts them up into
standard lumber, thus increasing their market value. The owner is entitled to this full value, and
the carpenter will get nothing for his trouble. Thus the willful converter loses the value of his
labor or materials. If, on the other hand, the conversion was innocent, or at most negligent, the
rule is somewhat more uncertain. Generally the courts will award the forest owner the value of
the standing timber, giving the carpenter the excess attributable to his labor and transportation.
A more favorable treatment of the owner is to give her the full value of the lumber as cut,
remitting to the carpenter the value of his expenses.

Confusion
In accession, the goods of one owner are transformed into a more valuable commodity or are
inextricably united with the goods of another to form a constituent part. Still another type of
joining is known as confusion, and it occurs when goods of different owners, while maintaining
their original form, are commingled. A common example is the intermingling of grain in a silo.
But goods that are identifiable as belonging to a particular person—branded cattle, for
instance—are not confused, no matter how difficult it may be to separate herds that have been
put together.
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When the goods are identical, no particular problem of division arises. Assuming that each
owner can show how much he has contributed to the confused mass, he is entitled to that
quantity, and it does not matter which particular grains or kernels he extracts. So if a person,
seeing a container of grain sitting on the side of the road, mistakes it for his own and empties it
into a larger container in his truck, the remedy is simply to restore a like quantity to the original
owner. When owners of like substances consent to have those substances combined (such as in a
grain silo), they are said to be tenants in common, holding a proportional share in the whole.
In the case of willful confusion of goods, many courts hold that the wrongdoer forfeits all his
property unless he can identify his particular property. Other courts have modified this harsh
rule by shifting the burden of proof to the wrongdoer, leaving it up to him to claim whatever he
can establish was his. If he cannot establish what was his, then he will forfeit all. Likewise, when
the defendant has confused the goods negligently, without intending to do so, most courts will
tend to shift to the defendant the burden of proving how much of the mass belongs to him.

KEY TAKEAWAY

Other than outright purchase of personal property, there are various ways in which to
acquire legal title. Among these are possession, gift, accession, confusion, and finding
property that is abandoned, lost, or mislaid, especially if the abandoned, lost, or mislaid
property is found on real property that you own.

EXERCISES

1. Dan captures a wild boar on US Forest Service land. He takes it home and puts it in a cage,
but the boar escapes and runs wild for a few days before being caught by Romero, some four
miles distant from Dan’s house. Romero wants to keep the boar. Does he “own” it? Or does it
belong to Dan, or to someone else?
2. Harriet finds a wallet in the college library, among the stacks. The wallet has $140 in it, but
no credit cards or identification. The library has a lost and found at the circulation desk, and
the people at the circulation desk are honest and reliable. The wallet itself is unique enough
to be identified by its owner. (a) Who owns the wallet and its contents? (b) As a matter of
ethics, should Harriet keep the money if the wallet is “legally” hers?

9.3 Fixtures
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LEARNING OBJECTIVE
1. Know the three tests for when personal property becomes a fixture and thus becomes real
property.

Definition
A fixture is an object that was once personal property but that has become so affixed to land or
structures that it is considered legally a part of the real property. For example, a stove bolted to
the floor of a kitchen and connected to the gas lines is usually considered a fixture, either in a
contract for sale, or for testamentary transfer (by will). For tax purposes, fixtures are treated as
real property.

Tests
Figure 9.2 Fixture Tests

Obviously, no clear line can be drawn between what is and what is not a fixture. In general, the
courts look to three tests to determine whether a particular object has become a fixture:
annexation, adaptation, and intention (see Figure 9.2 "Fixture Tests").

Annexation
The object must be annexed or affixed to the real property. A door on a house is affixed. Suppose
the door is broken and the owner has purchased a new door made to fit, but the house is sold
before the new door is installed. Most courts would consider that new door a fixture under a rule
of constructive annexation. Sometimes courts have said that an item is a fixture if its removal
would damage the real property, but this test is not always followed. Must the object be attached
with nails, screws, glue, bolts, or some other physical device? In one case, the court held that a
four-ton statue was sufficiently affixed merely by its weight. [1]

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Adaptation
Another test is whether the object is adapted to the use or enjoyment of the real property.
Examples are home furnaces, power equipment in a mill, and computer systems in bank
buildings.

Intention
Recent decisions suggest that the controlling test is whether the person who actually annexes the
object intends by so doing to make it a permanent part of the real estate. The intention is usually
deduced from the circumstances, not from what a person might later say her intention was. If an
owner installs a heating system in her house, the law will presume she intended it as a fixture
because the installation was intended to benefit the house; she would not be allowed to remove
the heating system when she sold the house by claiming that she had not intended to make it a
fixture.

Fixture Disputes
Because fixtures have a hybrid nature (once personal property, subsequently real property), they
generate a large number of disputes. We have already examined disputes between mortgagees
and secured parties (Chapter 16 "Secured Transactions and Suretyship"). Two other types of
disputes are discussed here.

Transfer of Real Estate
When a homeowner sells her house, the problem frequently crops up as to whether certain items
in the home have been sold or may be removed by the seller. Is a refrigerator, which simply
plugs into the wall, a fixture or an item of personal property? If a dispute arises, the courts will
apply the three tests—annexation, adaptation, and intention. Of course, the simplest way of
avoiding the dispute is to incorporate specific reference to questionable items in the contract for
sale, indicating whether the buyer or the seller is to keep them.

Tenant’s Fixtures
Tenants frequently install fixtures in the buildings they rent or the property they occupy. A
company may install tens of thousands of dollars worth of equipment; a tenant in an apartment
may bolt a bookshelf into the wall or install shades over a window. Who owns the fixtures when
the tenant’s lease expires? The older rule was that any fixture, determined by the usual tests,
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must remain with the landlord. Today, however, certain types of fixtures—known
as tenant’s fixtures—stay with the tenant. These fall into three categories: (1) trade fixtures—
articles placed on the premises to enable the tenant to carry on his or her trade or business in
the rented premises; (2) agricultural fixtures—devices installed to carry on farming activities
(e.g., milling plants and silos); (3) domestic fixtures—items that make a tenant’s personal life
more comfortable (carpeting, screens, doors, washing machines, bookshelves, and the like).
The three types of tenant’s fixtures remain personal property and may be removed by the tenant
if the following three conditions are met: (1) They must be installed for the requisite purposes of
carrying on the trade or business or the farming or agricultural pursuits or for making the home
more comfortable, (2) they must be removable without causing substantial damage to the
landlord’s property, and (3) they must be removed before the tenant turns over possession of the
premises to the landlord. Again, any debatable points can be resolved in advance by specifying
them in the written lease.

KEY TAKEAWAY

Personal property is often converted to real property when it is affixed to real property.
There are three tests that courts use to determine whether a particular object has become a
fixture and thus has become real property: annexation, adaptation, and intention. Disputes
over fixtures often arise in the transfer of real property and in landlord-tenant relations.

EXERCISES

1. Jim and Donna Stoner contract to sell their house in Rochester, Michigan, to Clem and Clara
Hovenkamp. Clara thinks that the decorative chandelier in the entryway is lovely and gives
the house an immediate appeal. The chandelier was a gift from Donna’s mother, “to enhance
the entryway” and provide “a touch of beauty” for Jim and Donna’s house. Clem and Clara
assume that the chandelier will stay, and nothing specific is mentioned about the chandelier
in the contract for sale. Clem and Clara are shocked when they move in and find the
chandelier is gone. Have Jim and Donna breached their contract of sale?
2. Blaine Goodfellow rents a house from Associated Properties in Abilene, Texas. He is there for
two years, and during that time he installs a ceiling fan, custom-builds a bookcase for an
alcove on the main floor, and replaces the screening on the front and back doors, saving the
old screening in the furnace room. When his lease expires, he leaves, and the bookcase
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remains behind. Blaine does, however, take the new screening after replacing it with the old
screening, and he removes the ceiling fan and puts back the light. He causes no damage to
Associated Properties’ house in doing any of this. Discuss who is the rightful owner of the
screening, the bookcase, and the ceiling fan after the lease expires.

[1] Snedeker v. Warring, 12 N.Y. 170 (1854).

9.4 Case
Lost or Misplaced Property
Bishop v. Ellsworth
91 Ill. App.2d 386, 234 N.E. 2d 50 (1968)
OPINION BY: STOUDER, Presiding Justice
Dwayne Bishop, plaintiff, filed a complaint alleging that on July 21, 1965, defendants, Mark and
Jeff Ellsworth and David Gibson, three small boys, entered his salvage yard premises at 427
Mulberry Street in Canton, without his permission, and while there happened upon a bottle
partially embedded in the loose earth on top of a landfill, wherein they discovered the sum of
$12,590 in US currency. It is further alleged that said boys delivered the money to the municipal
chief of police who deposited it with defendant, Canton State Bank. The complaint also alleges
defendants caused preliminary notices to be given as required by Ill. Rev. Stats., chapter 50,
subsections 27 and 28 (1965), but that such statute or compliance therewith does not affect the
rights of the plaintiff. [The trial court dismissed the plaintiff’s complaint.]
…It is defendant’s contention that the provisions of Ill Rev Stats, chapter 50, subsections 27 and
28 govern this case. The relevant portions of this statute are as follows:
“27. Lost goods…If any person or persons shall hereafter find any lost goods, money, bank notes,
or other choses in action, of any description whatever, such person or persons shall inform the
owner thereof, if known, and shall make restitution of the same, without any compensation
whatever, except the same shall be voluntarily given on the part of the owner. If the owner be
unknown, and if such property found is of the value of $ 15 or upwards, the finder…shall, within
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five days after such finding…appear before some judge or magistrate…and make affidavit of the
description thereof, the time and place when and where the same was found, that no alteration
has been made in the appearance thereof since the finding of the same, that the owner thereof is
unknown to him and that he has not secreted, withheld or disposed of any part thereof. The
judge or magistrate shall enter the value of the property found as near as he can ascertain in his
estray book together with the affidavit of the finder, and shall also, within ten days after the
proceedings have been entered on his estray book, transmit to the county clerk a certified copy
thereof, to be by him recorded in his estray book and to file the same in his office…28.
Advertisement…If the value thereof exceeds the sum of $ 15, the county clerk, within 20 days
after receiving the certified copy of the judge or magistrate’s estray record shall cause an
advertisement to be set up on the court house door, and in 3 other of the most public places in
the county, and also a notice thereof to be published for 3 weeks successively in some public
newspaper printed in this state and if the owner of such goods, money, bank notes, or other
choses in action does not appear and claim the same and pay the finder’s charges and expenses
within one year after the advertisement thereof as aforesaid, the ownership of such property
shall vest in the finder.”
***
We think it apparent that the statute to which defendants make reference provides a means of
vesting title to lost property in the finder where the prescribed search for the owner proves
fruitless. This statute does not purport to provide for the disposition of property deemed mislaid
or abandoned nor does it purport to describe or determine the right to possession against any
party other than the true owner. The plain meaning of this statute does not support plaintiff’s
position that common law is wholly abrogated thereby. The provisions of the statute are
designed to provide a procedure whereby the discoverer of “lost” property may be vested with
the ownership of said property even as against the true owner thereof, a right which theretofore
did not exist at common law. In the absence of any language in the statute from which the
contrary can be inferred it must be assumed that the term “lost” was used in its generally
accepted legal sense and no extension of the term was intended. Thus the right to possession of
discovered property still depends upon the relative rights of the discoverer and the owner of the
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locus in quo and the distinctions which exist between property which is abandoned, mislaid, lost
or is treasure trove. The statute assumes that the discoverer is in the rightful possession of lost
property and proceedings under such statute is (sic) not a bar where the issue is a claim to the
contrary. There is a presumption that the owner or occupant of land or premises has custody of
property found on it or actually imbedded in the land. The ownership or possession of the locus
in quo is related to the right to possession of property discovered thereon or imbedded therein
in two respects. First, if the premises on which the property is discovered are private it is
deemed that the property discovered thereon is and always has been in the constructive
possession of the owner of said premises and in a legal sense the property can be neither mislaid
nor lost. Pyle v. Springfield Marine Bank, 330 Ill App 1, 70 NE2d 257. Second, the question of
whether the property is mislaid or lost in a legal sense depends upon the intent of the true
owner. The ownership or possession of the premises is an important factor in determining such
intent. If the property be determined to be mislaid, the owner of the premises is entitled to the
possession thereof against the discoverer. It would also appear that if the discoverer is a
trespasser such trespasser can have no claim to possession of such property even if it might
otherwise be considered lost.
…The facts as alleged in substance are that the Plaintiff was the owner and in possession of real
estate, that the money was discovered in a private area of said premises in a bottle partially
imbedded in the soil and that such property was removed from the premises by the finders
without any right or authority and in effect as trespassers. We believe the averment of facts in
the complaint substantially informs the defendants of the nature of and basis for the claim and
is sufficient to state a cause of action. [The trial court’s dismissal of the Plaintiff’s complaint is
reversed and the case is remanded.]

CASE QUESTIONS

1. What is the actual result in this case? Do the young boys get any of the money that they
found? Why or why not?
2. Who is Dwayne Bishop, and why is he a plaintiff here? Was it Bishop that put the $12,590 in
US currency in a bottle in the landfill at the salvage yard? If not, then who did?

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3. If Bishop is not the original owner of the currency, what are the rights of the original owner in
this case? Did the original owner “lose” the currency? Did the original owner “misplace” the
currency? What difference does it make whether the original owner “lost” or “misplaced” the
currency? Can the original owner, after viewing the legal advertisement, have a claim
superior to Dwayne Bishop’s claim?

9.5 Summary and Exercises
Summary

Property is the legal relationship between persons with respect to things. The law spells out
what can be owned and the degree to which one person can assert an interest in someone else’s
things. Property is classified in several ways: personal versus real, tangible versus intangible,
private versus public. The first distinction, between real and personal, is the most important, for
different legal principles often apply to each. Personal property is movable, whereas real
property is immovable.
Among the ways personal property can be acquired are: by (1) possession, (2) finding, (3) gift,
(4) accession, and (5) confusion.
Possession means the power to exclude others from using an object. Possession confers
ownership only when there is no owner at the time the current owner takes possession. “Finders
keepers, losers weepers” is not a universal rule; the previous owner is entitled to return of his
goods if it is reasonably possible to locate him. If not, or if the owner does not claim his
property, then it goes to the owner of the real estate on which it was found, if the finder was a
trespasser, or the goods were buried, were in a private place, or were misplaced rather than lost.
If none of these conditions applies, the property goes to the finder.
A gift is a voluntary transfer of property without consideration. Two kinds of gifts are possible:
inter vivos and causa mortis. To make an effective gift, (1) the donor must make out a deed or
physically deliver the object to the donee, (2) the donor must intend to make a gift, and (3) the
donee must accept the gift. Delivery does not always require physical transfer; sometimes,
surrender of control is sufficient. The donor must intend to give the gift now, not later.

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Accession is an addition to that which is already owned—for example, the birth of calves to a
cow owned by a farmer. But when someone else, through labor or by supplying material, adds
value, the accession goes to the owner of the principal goods.
Confusion is the intermingling of like goods so that each, while maintaining its form, becomes a
part of a larger whole, like grain mixed in a silo. As long as the goods are identical, they can
easily enough be divided among their owners.
A fixture is a type of property that ceases to be personal property and becomes real property
when it is annexed or affixed to land or buildings on the land and adapted to the use and
enjoyment of the real property. The common-law rules governing fixtures do not employ clearcut tests, and sellers and buyers can avoid many disputes by specifying in their contracts what
goes with the land. Tenant’s fixtures remain the property of the tenant if they are for the
convenience of the tenant, do not cause substantial damage to the property when removed, and
are removed before possession is returned to the landlord.

EXERCISES

1. Kate owns a guitar, stock in a corporation, and an antique bookcase that is built into the wall
of her apartment. How would you classify each kind of property?
2. After her last business law class, Ingrid casually throws her textbook into a trash can and
mutters to herself, “I’m glad I don’t have to read that stuff anymore.” Tom immediately
retrieves the book from the can. Days later, Ingrid realizes that the book will come in handy,
sees Tom with it, and demands that he return the book. Tom refuses. Who is entitled to the
book? Why?
3. In Exercise 2, suppose that Ingrid had accidentally left the book on a table in a restaurant.
Tom finds it, and chanting “Finders keepers, losers weepers,” he refuses to return the book.
Is Ingrid entitled to the book? Why?
4. In Exercise 3, if the owner of the book (Ingrid) is never found, who is entitled to the book—
the owner of the restaurant or Tom? Why?
5. Matilda owned an expensive necklace. On her deathbed, Matilda handed the necklace to her
best friend, Sadie, saying, “If I die, I want you to have this.” Sadie accepted the gift and

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placed it in her safe-deposit box. Matilda died without a will, and now her only heir, Ralph,
claims the necklace. Is he entitled to it? Why or why not?

SELF-TEST QUESTIONS

1. Personal property is defined as property that is
a.

not a chattel
b. owned by an individual
c. movable
d. immovable
Personal property can be acquired by

a.

accession
b. finding
c. gift
d. all of the above
A gift causa mortis is

a.

an irrevocable gift
b. a gift made after death
c. a gift made in contemplation of death
d. none of the above
To make a gift effective,
a.

the donor must intend to make a gift

b. the donor must either make out a deed or deliver the gift to the donee
c. the donee must accept the gift
d. all of the above are required
Tenant’s fixtures
a.

remain with the landlord in all cases

b. remain the property of the tenant in all cases
c. remain the property of the tenant if they are removable without substantial
damage to the landlord’s property
d. refer to any fixture installed by a tenant

SELF-TEST ANSWERS

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1. c
2. d
3. c
4. d
5. c

Chapter 10
Intellectual Property
LEARNING OBJECTIVES

After reading this chapter, you should understand the following:
1. The principal kinds of intellectual property
2. The difference between patents and trade secrets, and why a company might choose to rely
on trade secrets rather than obtain a patent
3. What copyrights are, how to obtain them, and how they differ from trademarks
4. Why some “marks” may not be eligible for trademark protection, and how to obtain
trademark protection for those that are
Few businesses of any size could operate without being able to protect their rights to a particular
type of intangible personal property: intellectual property. The major forms of intellectual
property are patents, copyrights, and trademarks. Unlike tangible personal property (machines,
inventory) or real property (land, office buildings), intellectual property is formless. It is the
product of the human intellect that is embodied in the goods and services a company offers and
by which the company is known.
A patent is a grant from government that gives an inventor the exclusive right to make, use, and
sell an invention for a period of twenty years from the date of filing the application for a patent.
A copyright is the right to exclude others from using or marketing forms of expression.
A trademark is the right to prevent others from using a company’s product name, slogan, or
identifying design. Other forms of intellectual property are trade secrets (particular kinds of
information of commercial use to a company that created it) and right of publicity (the right to
exploit a person’s name or image). Note that the property interest protected in each case is not
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the tangible copy of the invention or writing—not the machine with a particular serial number or
the book lying on someone’s shelf—but the invention or words themselves. That is why
intellectual property is said to be intangible: it is a right to exclude any others from gaining
economic benefit from your own intellectual creation. In this chapter, we examine how
Congress, the courts, and the Patent and Trademark Office have worked to protect the major
types of intellectual property.

10.1 Patents

LEARNING OBJECTIVES

1. Explain why Congress would grant exclusive monopolies (patents) for certain periods of time.
2. Describe what kinds of things may be patentable and what kinds of things may not be
patentable.
3. Explain the procedures for obtaining a patent, and how patent rights may be an issue where
the invention is created by an employee.
4. Understand who can sue for patent infringement, on what basis, and with what potential
remedies.

Source of Authority and Duration
Patent and copyright law are federal, enacted by Congress under the power given by Article I of
the Constitution “to promote the Progress of Science and useful Arts, by securing for limited
Times to Authors and Inventors the exclusive Right to their respective Writings and
Discoveries.” Under current law, a patent gives an inventor exclusive rights to make, use, or sell
an invention for twenty years. (If the patent is a design patent—protecting the appearance rather
than the function of an item—the period is fourteen years.) In return for this limited monopoly,
the inventor must fully disclose, in papers filed in the US Patent and Trademark Office (PTO), a
complete description of the invention.

Patentability
What May Be Patented
The patent law says that “any new and useful process, machine, manufacture, or composition of
matter, or any new and useful improvement thereof” may be patented.[1] A process is a “process,
art or method, and includes a new use of a known process, machine, manufacture, composition
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of matter, or material.” [2] A process for making rolled steel, for example, qualifies as a
patentable process under the statute. Amachine is a particular apparatus for achieving a certain
result or carrying out a distinct process—lathes, printing presses, motors, and the cotton gin are
all examples of the hundreds of thousands of machines that have received US patents since the
first Patent Act in 1790. A manufacture is an article or a product, such as a television, an
automobile, a telephone, or a lightbulb. A composition of matter is a new arrangement of
elements so that the resulting compound, such as a metal alloy, is not found in nature.
In Commissioner of Patents v. Chakrabarty, [3] the Supreme Court said that even living
organisms—in particular, a new “genetically engineered” bacterium that could “eat” oil spills—
could be patented. The Chakrabarty decision has spawned innovation: a variety of small
biotechnology firms have attracted venture capitalists and other investors.
According to the PTO, gene sequences are patentable subject matter, provided they are isolated
from their natural state and processed in a way that separates them from other molecules
naturally occurring with them. Gene patenting, always controversial, generated new controversy
when the PTO issued a patent to Human Genome Sciences, Inc. for a gene found to serve as a
platform from which the AIDS virus can infect cells of the body. Critics faulted the PTO for
allowing “ownership” of a naturally occurring human gene and for issuing patents without
requiring a showing of the gene’s utility. New guidelines from the PTO followed in 2000; these
focused on requiring the applicant to make a strong showing on the utility aspect of patentability
and somewhat diminished the rush of biotech patent requests.
There are still other categories of patentable subjects. An improvement is an alteration of a
process, machine, manufacture, or composition of matter that satisfies one of the tests for
patentability given later in this section. New, original ornamental designs for articles of
manufacture are patentable (e.g., the shape of a lamp); works of art are not patentable but are
protected under the copyright law. New varieties of cultivated or hybridized plants are also
patentable, as are genetically modified strains of soybean, corn, or other crops.

What May Not Be Patented
Many things can be patented, but not (1) the laws of nature, (2) natural phenomena, and (3)
abstract ideas, including algorithms (step-by-step formulas for accomplishing a specific task).
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One frequently asked question is whether patents can be issued for computer software. The PTO
was reluctant to do so at first, based on the notion that computer programs were not “novel”—
the software program either incorporated automation of manual processes or used
mathematical equations (which were not patentable). But in 1998, the Supreme Court held
in Diamond v. Diehr [4] that patents could be obtained for a process that incorporated a
computer program if the process itself was patentable.
A business process can also be patentable, as the US Court of Appeals for the Federal Circuit
ruled in 1998 in State Street Bank and Trust v. Signature Financial Group, Inc.[5] Signature
Financial had a patent for a computerized accounting system that determined share prices
through a series of mathematical calculations that would help manage mutual funds. State
Street sued to challenge that patent. Signature argued that its model and process was protected,
and the court of appeals upheld it as a “practical application of a mathematical, algorithm,
formula, or calculation,” because it produces a “useful, concrete and tangible result.” Since State
Street, many other firms have applied for business process patents. For example, Amazon.com
obtained a business process patent for its “one-click” ordering system, a method of processing
credit-card orders securely. (But see Amazon.com v. Barnesandnoble.com, [6] in which the court
of appeals rejected Amazon’s challenge to Barnesandnoble.com using its Express Land one-click
ordering system.)

Tests for Patentability
Just because an invention falls within one of the categories of patentable subjects, it is not
necessarily patentable. The Patent Act and judicial interpretations have established certain tests
that must first be met. To approve a patent application, the PTO (as part of the Department of
Commerce) will require that the invention, discovery, or process be novel, useful, and
nonobvious in light of current technology.
Perhaps the most significant test of patentability is that of obviousness. The act says that no
invention may be patented “if the differences between the subject matter sought to be patented
and the prior art are such that the subject matter as a whole would have been obvious at the time
the invention was made to a person having ordinary skill in the art to which said subject matter
pertains.” This provision of the law has produced innumerable court cases, especially over
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improvement patents, when those who wish to use an invention on which a patent has been
issued have refused to pay royalties on the grounds that the invention was obvious to anyone
who looked.

Procedures for Obtaining a Patent
In general, the United States (unlike many other countries) grants a patent right to the first
person to invent a product or process rather than to the first person to file for a patent on that
product or process. As a practical matter, however, someone who invents a product or process
but does not file immediately should keep detailed research notes or other evidence that would
document the date of invention. An inventor who fails to apply for a patent within a year of that
date would forfeit the rights granted to an inventor who had published details of the invention
or offered it for sale. But until the year has passed, the PTO may not issue a patent to X if Y has
described the invention in a printed publication here or abroad or the invention has been in
public use or on sale in this country.
An inventor cannot obtain a patent automatically; obtaining a patent is an expensive and timeconsuming process, and the inventor will need the services of a patent attorney, a highly
specialized practitioner. The attorney will help develop the requiredspecification, a description
of the invention that gives enough detail so that one skilled in the art will be able to make and
use the invention. After receiving an application, a PTO examiner will search the records and
accept or reject the claim. Usually, the attorney will negotiate with the examiner and will rewrite
and refine the application until it is accepted. A rejection may be appealed, first to the PTO’s
Board of Appeals and then, if that fails, to the federal district court in the District of Columbia or
to the US Court of Appeals for the Federal Circuit, the successor court to the old US Court of
Customs and Patent Appeals.
Once a patent application has been filed, the inventor or a company to which she has assigned
the invention may put the words “patent pending” on the invention. These words have no legal
effect. Anyone is free to make the invention as long as the patent has not yet been issued. But
they do put others on notice that a patent has been applied for. Once the patent has been
granted, infringers may be sued even if the infringed has made the product and offered it for sale
before the patent was granted.
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In today’s global market, obtaining a US patent is important but is not usually sufficient
protection. The inventor will often need to secure patent protection in other countries as well.
Under the Paris Convention for the Protection of Industrial Property (1883), parties in one
country can file for patent or trademark protection in any of the other member countries (172
countries as of 2011). The World Trade Organization’s Agreement on Trade-Related Aspects of
Intellectual Property Rights (TRIPS) established standards for protecting intellectual property
rights (patents, trademarks, and copyrights) and provides that each member nation must have
laws that protect intellectual property rights with effective access to judicial systems for
pursuing civil and criminal penalties for violations of such rights.

Patent Ownership
The patent holder is entitled to make and market the invention and to exclude others from doing
so. Because the patent is a species of property, it may be transferred. The inventor may assign
part or all of his interest in the patent or keep the property interest and license others to
manufacture or use the invention in return for payments known as royalties. The license may be
exclusive with one licensee, or the inventor may license many to exploit the invention. One
important limitation on the inventor’s right to the patent interest is the so-called shop right.
This is a right created by state courts on equitable grounds giving employers a nonexclusive
royalty-free license to use any invention made by an employee on company time and with
company materials. The shop right comes into play only when a company has no express or
implied understanding with its employees. Most corporate laboratories have contractual
agreements with employees about who owns the invention and what royalties will be paid.

Infringement and Invalidity Suits
Suits for patent infringement can arise in three ways: (1) the patent holder may seek damages
and an injunction against the infringer in federal court, requesting damages for royalties and
lost profits as well; (2) even before being sued, the accused party may take the patent holder to
court under the federal Declaratory Judgment Act, seeking a court declaration that the patent is
invalid; (3) the patent holder may sue a licensee for royalties claimed to be due, and the licensee
may counterclaim that the patent is invalid. Such a suit, if begun in state court, may be removed
to federal court.
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In a federal patent infringement lawsuit, the court may grant the winning party reimbursement
for attorneys’ fees and costs. If the infringement is adjudged to be intentional, the court can
triple the amount of damages awarded. Prior to 2006, courts were typically granting permanent
injunctions to prevent future infringement. CitingeBay, Inc. v. Merc Exchange, LLC, [7] the
Supreme Court ruled that patent holders are not automatically entitled to a permanent
injunction against infringement during the life of the patent. Courts have the discretion to
determine whether justice requires a permanent injunction, and they may conclude that the
public interest and equitable principles may be better satisfied with compensatory damages
only.
Proving infringement can be a difficult task. Many companies employ engineers to “design
around” a patent product—that is, to seek ways to alter the product to such an extent that the
substitute product no longer consists of enough of the elements of the invention safeguarded by
the patent. However, infringing products, processes, or machines need not be identical; as the
Supreme Court said in Sanitary Refrigerator Co. v. Winers, [8] “one device is an infringement of
another…if two devices do the same work in substantially the same way, and accomplish
substantially the same result…even though they differ in name, form, or shape.” This is known
as thedoctrine of equivalents. In an infringement suit, the court must choose between these two
extremes: legitimate “design around” and infringement through some equivalent product.
An infringement suit can often be dangerous because the defendant will almost always assert in
its answer that the patent is invalid. The plaintiff patent holder thus runs the risk that his entire
patent will be taken away from him if the court agrees. In ruling on validity, the court may
consider all the tests, such as prior art and obviousness, discussed in Section 10.1.2
"Patentability" and rule on these independently of the conclusions drawn by the PTO.

Patent Misuse
Although a patent is a monopoly granted to the inventor or his assignee or licensee, the
monopoly power is legally limited. An owner who misuses the patent may find that he will lose
an infringement suit. One common form of misuse is to tie the patented good to some
unpatented one—for example, a patented movie projector that will not be sold unless the buyer
agrees to rent films supplied only by the manufacturer of the movie projector, or a copier
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manufacturer that requires buyers to purchase plain paper from it. Various provisions of the
federal antitrust laws, including, specifically, Section 3 of the Clayton Act, outlaw certain kinds
of tying arrangements. Another form of patent misuse is a provision in the licensing agreement
prohibiting the manufacturer from also making competing products. Although the courts have
held against several other types of misuse, the general principle is that the owner may not use
his patent to restrain trade in unpatented goods.

KEY TAKEAWAY

Many different “things” are patentable, include gene sequences, business processes, and any
other “useful invention.” The US Patent and Trademark Office acts on initial applications and
may grant a patent to an applicant. The patent, which allows a limited-time monopoly, is for
twenty years. The categories of patentable things include processes, machines,
manufactures, compositions of matter, and improvements. Ideas, mental processes,
naturally occurring substances, methods of doing business, printed matter, and scientific
principles cannot be patented. Patent holders may sue for infringement and royalties from
an infringer user.

EXERCISES

1. Calera, Inc. discovers a way to capture carbon dioxide emissions at a California power plant
and use them to make cement. This is a win for the power company, which needs to reduce
its carbon dioxide emissions, and a win for Calera. Calera decides to patent this invention.
What kind of patent would this be? A machine? A composition of matter? A manufacture?
2. In your opinion, what is the benefit of allowing companies to isolate genetic material and
claim a patent? What kind of patent would this be? A machine? A composition of matter? A
manufacture?
3. How could a “garage inventor,” working on her own, protect a patentable invention while yet
demonstrating it to a large company that could bring the invention to market?

[1] 35 United States Code, Section 101.
[2] 35 United States Code, Section 101.
[3] Commissioner of Patents v. Chakrabarty, 444 U.S. 1028 (1980).
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[4] Diamond v. Diehr, 450 U.S. 175 (1981).
[5] State Street Bank and Trust v. Signature Financial Group, Inc., 149 F.3d 1368 (Fed. Cir. 1998).
[6] Amazon.com v. Barnesandnoble.com, Inc., 239 F.3d 1343 (Fed. Cir. 2001).
[7] eBay, Inc. v. Merc Exchange, LLC, 546 U.S. 388 (2006).
[8] Sanitary Refrigerator Co. v. Winers, 280 U.S. 30 (1929).

10.2 Trade Secrets

LEARNING OBJECTIVES

1. Describe the difference between trade secrets and patents, and explain why a firm might
prefer keeping a trade secret rather than obtaining a patent.
2. Understand the dimensions of corporate espionage and the impact of the federal Economic
Espionage Act.

Definition of Trade Secrets
A patent is an invention publicly disclosed in return for a monopoly. A trade secret is a means to
a monopoly that a company hopes to maintain by preventing public disclosure. Why not always
take out a patent? There are several reasons. The trade secret might be one that is not
patentable, such as a customer list or an improvement that does not meet the tests of novelty or
nonobviousness. A patent can be designed around; but if the trade secret is kept, its owner will
be the exclusive user of it. Patents are expensive to obtain, and the process is extremely time
consuming. Patent protection expires in twenty years, after which anyone is free to use the
invention, but a trade secret can be maintained for as long as the secret is kept.
However, a trade secret is valuable only so long as it is kept secret. Once it is publicly revealed,
by whatever means, anyone is free to use it. The critical distinction between a patent and a trade
secret is this: a patent gives its owner the right to enjoin anyone who infringes it from making
use of it, whereas a trade secret gives its “owner” the right to sue only the person who
improperly took it or revealed it.
According to the Restatement of Torts, Section 757, Comment b, a trade secret may consist of
any formula, pattern, device or compilation of information which is used in one’s business, and
which gives him an opportunity to obtain an advantage over competitors who do not know or
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use it. It may be a formula for a chemical compound, a process of manufacturing, treating or
preserving materials, a pattern for a machine or other device, or a list of customers.…A trade
secret is a process or device for continuous use in the operation of a business. Generally it relates
to the production of goods, as, for example, a machine or formula for the production of an
article.
Other types of trade secrets are customer information, pricing data, marketing methods, sources
of supply, and secret technical know-how.

Elements of Trade Secrets
To be entitled to protection, a trade secret must be (1) original and (2) secret.

Originality
The trade secret must have a certain degree of originality, although not as much as would be
necessary to secure a patent. For example, a principle or technique that is common knowledge
does not become a protectable trade secret merely because a particular company taught it to one
of its employees who now wants to leave to work for a competitor.

Secrecy
Some types of information are obviously secret, like the chemical formula that is jealously
guarded through an elaborate security system within the company. But other kinds of
information might not be secret, even though essential to a company’s business. For instance, a
list of suppliers that can be devised easily by reading through the telephone directory is not
secret. Nor is a method secret simply because someone develops and uses it, if no steps are
taken to guard it. A company that circulates a product description in its catalog may not claim a
trade secret in the design of the product if the description permits someone to do “reverse
engineering.” A company that hopes to keep its processes and designs secret should
affirmatively attempt to do so—for example, by requiring employees to sign a nondisclosure
agreement covering the corporate trade secrets with which they work. However, a company need
not go to every extreme to guard a trade secret.
Trade-secrets espionage has become a big business. To protect industrial secrets, US
corporations spend billions on security arrangements. The line between competitive intelligence
gathering and espionage can sometimes be difficult to draw. The problem is by no means
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confined to the United States; companies and nations all over the world have become concerned
about theft of trade secrets to gain competitive advantage, and foreign governments are widely
believed to be involved in espionage and cyberattacks.

Economic Espionage Act
The Economic Espionage Act (EEA) of 1996 makes the theft or misappropriation of a trade
secret a federal crime. The act is aimed at protecting commercial information rather than
classified national defense information. Two sorts of activities are criminalized. The first section
of the act [1] criminalizes the misappropriation of trade secrets (including conspiracy to
misappropriate trade secrets and the subsequent acquisition of such misappropriated trade
secrets) with the knowledge or intent that the theft will benefit a foreign power. Penalties for
violation are fines of up to US$500,000 per offense and imprisonment of up to fifteen years for
individuals, and fines of up to US$10 million for organizations.
The second section [2] criminalizes the misappropriation of trade secrets related to or included in
a product that is produced for or placed in interstate (including international) commerce, with
the knowledge or intent that the misappropriation will injure the owner of the trade secret.
Penalties for violation are imprisonment for up to ten years for individuals (no fines) and fines
of up to US$5 million for organizations.
In addition to these specific penalties, the fourth section of the EEA [3] also requires criminal
forfeiture of (1) any proceeds of the crime and property derived from proceeds of the crime and
(2) any property used, or intended to be used, in commission of the crime.
The EEA authorizes civil proceedings by the Department of Justice to enjoin violations of the act
but does not create a private cause of action. This means that anyone believing they have been
victimized must go through the US attorney general in order to obtain an injunction.
The EEA is limited to the United States and has no extraterritorial application unless (1) the
offender is a US company or a citizen operating from abroad against a US company or (2) an act
in furtherance of the espionage takes place in the United States. Other nations lack such
legislation, and some may actively support industrial espionage using both their national
intelligence services. The US Office of the National Counterintelligence Executive publishes an

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annual report, mandated by the US Congress, on foreign economic collection and industrial
espionage, which outlines these espionage activities of many foreign nations.

Right of Employees to Use Trade Secrets
A perennial source of lawsuits in the trade secrets arena is the employee who is hired away by a
competitor, allegedly taking trade secrets along with him. Companies frequently seek to prevent
piracy by requiring employees to sign confidentiality agreements. An agreement not to disclose
particular trade secrets learned or developed on the job is generally enforceable. Even without
an agreement, an employer can often prevent disclosure under principles of agency law. Sections
395 and 396 of the Restatement (Second) of Agency suggest that it is an actionable breach of
duty to disclose to third persons information given confidentially during the course of the
agency. However, every person is held to have a right to earn a living. If the rule were strictly
applied, a highly skilled person who went to another company might be barred from using his
knowledge and skills. The courts do not prohibit people from using elsewhere the general
knowledge and skills they developed on the job. Only specific trade secrets are protected.
To get around this difficulty, some companies require their employees to sign agreements not to
compete. But unless the agreements are limited in scope and duration to protect a company
against only specific misuse of trade secrets, they are unenforceable.

KEY TAKEAWAY

Trade secrets, if they can be kept, have indefinite duration and thus greater potential value
than patents. Trade secrets can be any formula, pattern, device, process, or compilation of
information to be used in a business. Customer information, pricing data, marketing
methods, sources of supply, and technical know-how could all be trade secrets. State law has
protected trade secrets, and federal law has provided criminal sanctions for theft of trade
secrets. With the importance of digitized information, methods of theft now include
computer hacking; theft of corporate secrets is a burgeoning global business that often
involves cyberattacks.

EXERCISES

1. Wu Dang, based in Hong Kong, hacks into the Hewlett-Packard database and “steals” plans
and specifications for HP’s latest products. The HP server is located in the United States. He

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sells this information to a Chinese company in Shanghai. Has he violated the US Economic
Espionage Act?
2. What are the advantages of keeping a formula as a trade secret rather than getting patent
protection?

[1] Economic Espionage Act, 18 United States Code, Section 1831(a) (1996)
[2] Economic Espionage Act, 18 United States Code, Section 1832 (1996).
[3] Economic Espionage Act, 18 United States Code, Section 1834 (1996).

10.3 Copyright

LEARNING OBJECTIVES

1. Describe and explain copyrights, how to obtain one, and how they differ from trademarks.
2. Explain the concept of fair use and describe its limits.

Definition and Duration
Copyright is the legal protection given to “authors” for their “writings.” Copyright law is federal;
like patent law, its source lies in the Constitution. Copyright protects the expression of ideas in
some tangible form, but it does not protect the ideas themselves. Under the 1976 Copyright Act
as amended, a copyright in any work created after January 1, 1978, begins when the work is
fixed in tangible form—for example, when a book is written down or a picture is painted—and
generally lasts for the life of the author plus 70 years after his or her death. This is similar to
copyright protection in many countries, but in some countries, the length of copyright
protection is the life of the author plus 50 years. For copyrights owned by publishing houses,
done as works for hire, common copyright expires 95 years from the date of publication or 120
years from the date of creation, whichever is first. For works created before 1978, such as many
of Walt Disney’s movies and cartoons, the US Sonny Bono Copyright Term Extension Act of
1998 provided additional protection of up to 95 years from publication date. Thus works created
in 1923 by Disney would not enter the public domain until 2019 or after, unless the copyright
had expired prior to 1998 or unless the Disney company released the work into the public
domain. In general, after expiration of the copyright, the work enters the public domain.
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In 1989, the United States signed the Berne Convention, an international copyright treaty. This
law eliminated the need to place the symbol © or the word Copyright or the
abbreviation Copr. on the work itself. Copyrights can be registered with the US Copyright Office
in Washington, DC.

Protected Expression
The Copyright Act protects a variety of “writings,” some of which may not seem written at all.
These include literary works (books, newspapers, and magazines), music, drama, choreography,
films, art, sculpture, and sound recordings. Since copyright covers the expression and not the
material or physical object, a book may be copyrighted whether it is on paper, microfilm, tape,
or computer disk.

Rights Protected by the Copyright Act
Preventing Copying
A copyright gives its holder the right to prevent others from copying his or her work. The
copyright holder has the exclusive right to reproduce the work in any medium (paper, film,
sound recording), to perform it (e.g., in the case of a play), or to display it (a painting or film). A
copyright also gives its holder the exclusive right to prepare derivative works based on the
copyrighted work. Thus a playwright could not adapt to the stage a novelist’s book without the
latter’s permission.

Fair Use
One major exception to the exclusivity of copyrights is the fair use doctrine. Section 107 of the
Copyright Act provides as follows:
Fair use of a copyrighted work, including such use by reproduction in copies or phonorecords or
by any other means specified by section 106 of the copyright, for purposes such as criticism,
comment, news reporting, teaching (including multiple copies for classroom use), scholarship,
or research, is not an infringement of copyright. In determining whether the use made of a work
in any particular case is a fair use, the factors to be considered shall include–
(1) the purpose and character of the use, including whether such use is of a commercial nature
or is for nonprofit educational purposes;
(2) the nature of the copyrighted work;
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(3) the amount and substantiality of the portion used in relation to the copyrighted work as a
whole; and
(4) the effect of the use upon the potential market for or value of the copyrighted work.[1]
These are broad guidelines. Accordingly, any copying could be infringement, and fair use could
become a question of fact on a case-by-case basis. In determining fair use, however, courts have
often considered the fourth factor (effect of the use upon the potential market for the
copyrighted work) to be the most important.
Clear examples of fair use would be when book reviewers or writers quote passages from
copyrighted books. Without fair use, most writing would be useless because it could not readily
be discussed. But the doctrine of fair use grew more troublesome with the advent of plain-paper
copiers and is now even more troublesome with electronic versions of copyrighted materials that
are easily copied and distributed. The 1976 act took note of the new copier technology, listing
“teaching (including multiple copies for classroom use)” as one application of fair use. The
Copyright Office follows guidelines specifying just how far the copying may go—for example,
multiple copies of certain works may be made for classroom use, but copies may not be used to
substitute for copyrighted anthologies.

Infringement
Verbatim use of a copyrighted work is easily provable. The more difficult question arises when
the copyrighted work is altered in some way. As in patent law, the standard is one of substantial
similarity.

Copyrightability Standards
To be subject to copyright, the writing must be “fixed” in some “tangible medium of expression.”
A novelist who composes a chapter of her next book in her mind and tells it to a friend before
putting it on paper could not stop the friend from rushing home, writing it down, and selling it
(at least the federal copyright law would offer no protection; some states might independently
offer a legal remedy, however).
The work also must be creative, at least to a minimal degree. Words and phrases, such as names,
titles, and slogans, are not copyrightable; nor are symbols or designs familiar to the public. But
an author who contributes her own creativity—like taking a photograph of nature—may
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copyright the resulting work, even if the basic elements of the composition were not of her
making.
Finally, the work must be “original,” which means simply that it must have originated with the
author. The law does not require that it be novel or unique. This requirement was summarized
pithily by Judge Learned Hand: “If by some magic a man who had never known it were to
compose anew Keats’s Ode on a Grecian Urn, he would be an author, and, if he copyrighted it,
others might not copy that poem, though they might of course copy Keats’s.” [2] Sometimes the
claim is made that a composer, for example, just happened to compose a tune identical or
strikingly similar to a copyrighted song; rather than assume the unlikely coincidence that Judge
Hand hypothesized, the courts will look for evidence that the alleged copier had access to the
copyrighted song. If he did—for example, the song was frequently played on the air—he cannot
defend the copying with the claim that it was unconscious, because the work would not then
have been original.
Section 102 of the Copyright Act excludes copyright protection for any “idea, procedure, process,
system, method of operation, concept, principle, or discovery, regardless of the form in which it
is described, explained, illustrated, or embodied.” [3]
Einstein copyrighted books and monographs he wrote on the theory of relativity, but he could
not copyright the famous formula E = mc2, nor could he prevent others from writing about the
theory. But he could protect the particular way in which his ideas were expressed. In general,
facts widely known by the public are not copyrightable, and mathematical calculations are not
copyrightable. Compilations of facts may be copyrightable, if the way that they are coordinated
or arranged results in a work that shows some originality. For example, compiled information
about yachts listed for sale may qualify for copyright protection. [4]
One of the most troublesome recent questions concerning expression versus ideas is whether a
computer program may be copyrighted. After some years of uncertainty, the courts have
accepted the copyrightability of computer programs. [5] Now the courts are wrestling with the
more difficult question of the scope of protection: what constitutes an “idea” and what
constitutes its mere “expression” in a program.

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How far the copyright law will protect particular software products is a hotly debated topic,
sparked by a federal district court’s ruling in 1990 that the “look and feel” of Lotus 1-2-3’s menu
system is copyrightable and was in fact infringed by Paperback Software’s VP-Planner, a
competing spreadsheet. [6] The case has led some analysts to “fear that legal code, rather than
software code, is emerging as the factor that will determine which companies and products will
dominate the 1990s.” [7]

Who May Obtain a Copyright?
With one important exception, only the author may hold the initial copyright, although the
author may assign it or license any one or more of the rights conveyed by the copyright. This is a
simple principle when the author has written a book or painted a picture. But the law is unclear
in the case of a motion picture or a sound recording. Is the author the script writer, the
producer, the performer, the director, the engineer, or someone else? As a practical matter, all
parties involved spell out their rights by contract.
The exception, which frequently covers the difficulties just enumerated, is for works for hire.
Any person employed to write—a journalist or an advertising jingle writer, for example—is not
the “author.” For purposes of the statute, the employer is the author and may take out the
copyright. When the employee is in fact an “independent contractor” and the work in question
involves any one of nine types (book, movies, etc.) spelled out in the Copyright Act, the employer
and the creator must spell out their entitlement to the copyright in a written agreement. [8]

Obtaining a Copyright
Until 1978, a work could not be copyrighted unless it was registered in the Copyright Office or
was published and unless each copy of the work carried a copyright notice, consisting of the
word Copyright, the abbreviation Copr., or the common symbol ©, together with the date of
first publication and the name of the copyright owner. Under the 1976 act, copyright became
automatic whenever the work was fixed in a tangible medium of expression (e.g., words on
paper, images on film or videotape, sound on tape or compact disc), even if the work remained
unpublished or undistributed. However, to retain copyright protection, the notice had to be
affixed once the work was “published” and copies circulated to the public. After the United
States entered the Berne Convention, an international treaty governing copyrights, Congress
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enacted the Berne Implementation Act, declaring that, effective in 1989, notice, even after
publication, was no longer required.
Notice does, however, confer certain benefits. In the absence of notice, a copyright holder loses
the right to receive statutory damages (an amount stated in the Copyright Act and not required
to be proved) if someone infringes the work. Also, although it is no longer required, an
application and two copies of the work (for deposit in the Library of Congress) filed with the
Copyright Office, in Washington, DC, will enable the copyright holder to file suit should the
copyright be infringed. Unlike patent registration, which requires elaborate searching of Patent
and Trademark Office (PTO) records, copyright registration does not require a reading of the
work to determine whether it is an original creation or an infringement of someone else’s prior
work. But copyright registration does not immunize the holder from an infringement suit. If a
second work has been unlawfully copied from an earlier work, the second author’s copyright will
not bar the infringed author from collecting damages and obtaining an injunction.

Computer Downloads and the Digital Millennium Copyright Act
The ubiquity of the Internet and the availability of personal computers with large capacities have
greatly impacted the music business. Sharing of music files took off in the late 1990s with
Napster, which lost a legal battle on copyright and had to cease doing business. By providing the
means by which individuals could copy music that had been purchased, major record labels
were losing substantial profits. Grokster, a privately owned software company based in the West
Indies, provided peer-to-peer file sharing from 2001 to 2005 until the US Supreme Court’s
decision in MGM Studios, Inc. v. Grokster, Ltd. [9]
For computers with the Microsoft operating system, the Court disallowed the peer-to-peer file
sharing, even though Grokster claimed it did not violate any copyright laws because no files
passed through its computers. (Grokster had assigned certain user computers as “root
supernodes” that acted as music hubs for the company and was not directly involved in
controlling any specific music-file downloads.)
Grokster had argued, based on Sony v. Universal Studios, [10] that the sale of its copying
equipment (like the Betamax videocassette recorders at issue in that case) did not constitute
contributory infringement “if the product is widely used for legitimate, unobjectionable
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purposes.” Plaintiffs successfully argued that the Sony safe-harbor concept requires proof that
the noninfringing use is the primary use in terms of the product’s utility.
The Digital Millennium Copyright Act (DMCA), passed into law in 1998, implements two 1996
treaties of the World Intellectual Property Organization. It criminalizes production and sale of
devices or services intended to get around protective measures that control access to
copyrighted works. In addition, the DMCA heightens the penalties for copyright infringement on
the Internet. The DMCA amended Title 17 of the United States Code to extend the reach of
copyright, while limiting the liability of the providers of online services for copyright
infringement by their users.

KEY TAKEAWAY

Copyright is the legal protection given to “authors” for their “writings.” It protects ideas in
fixed, tangible form, not ideas themselves. Copyright protection can extend as long as 120
years from the date of creation or publication. Expression found in literary works, music,
drama, film, art, sculpture, sound recordings, and the like may be copyrighted. The fair use
doctrine limits the exclusivity of copyright in cases where scholars, critics, or teachers use
only selected portions of the copyrighted material in a way that is unlikely to affect the
potential market for or value of the copyrighted work.

EXERCISES

1. Explain how a list could be copyrightable.
2. An author wrote a novel, Brunch at Bruno’s, in 1961. She died in 1989, and her heirs now
own the copyright. When do the rights of the heirs come to an end? That is, when
does Brunch at Bruno’s enter the public domain?
3. Keith Bradsher writes a series of articles on China for the New York Times and is paid for
doing so. Suppose he wants to leave the employ of the Times and be a freelance writer. Can
he compile his best articles into a book, Changing Times in China, and publish it without
the New York Times’s permission? Does it matter that he uses the word Times in his
proposed title?
4. What kind of file sharing of music is now entirely legal? Shaunese Collins buys a Yonder
Mountain String Band CD at a concert at Red Rocks in Morrison, Colorado. With her iMac, she

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makes a series of CDs for her friends. She does this six times. Has she committed six
copyright violations?

[1] 17 United States Code, Section 107.
[2] Sheldon v. Metro-Goldwyn Pictures Corp., 81 F.2d 49 (2d Cir. 1936).
[3] 17 United States Code, Section 102.
[4] BUC International Corp. v. International Yacht Council, Ltd., 489 F.3d 1129 (11th Cir. 2007).
[5] Apple Computer, Inc. v. Franklin Computer Corp., 714 F.2d 1240 (3d Cir. 1983).
[6] Lotus Development Corp. v. Paperback Software International, 740 F.Supp. 37 (D. Mass. 1990).
[7] Peter H. Lewis, “When Computing Power Is Generated by the Lawyers,” New York Times, July 22
1990.
[8] Community for Creative Non-Violence v. Reid, 109 S.Ct. 2166 (1989).
[9] MGM Studios, Inc. v. Grokster, Ltd., 545 U.S. 913 (2005).
[10] Sony v. Universal Studios, 464 U.S. 417 (1984).

10.4 Trademarks

LEARNING OBJECTIVES

1. Understand what a trademark is and why it deserves protection.
2. Know why some “marks” may not be eligible for trademark protection, and how to obtain
trademark protection for those that are.
3. Explain what “blurring” and “tarnishment” are and what remedies are available to the holder
of the mark.

Definitions of Trademarks
A trademark is defined in the federal Lanham Act of 1946 as “any word, name, symbol, or device
or any combination thereof adopted and used by a manufacturer or merchant to identify his
goods and distinguish them from goods manufactured or sold by others.”[1]
Examples of well-known trademarks are Coca-Cola, Xerox, and Apple. Aservice mark is used in
the sale or advertising of services to identify the services of one person and distinguish them
from the services of others. Examples of service marks are McDonald’s, BP, and Hilton.
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A certification mark is used in connection with many products “to certify regional or other
origin, material, mode of manufacture, quality, accuracy or other characteristics of such goods
or services or that the work or labor on the goods or services was performed by members of a
union or other organization.” Examples are the Good Housekeeping Seal of Approval and UL
(Underwriters Laboratories, Inc., approval mark). Unlike other forms of trademark, the owner
of the certification mark (e.g., Good Housekeeping, or the Forest Stewardship Council’s FSC
mark) is not the owner of the underlying product.

Extent of Trademark Protection
Kinds of Marks
Trademarks and other kinds of marks may consist of words and phrases, pictures, symbols,
shapes, numerals, letters, slogans, and sounds. Trademarks are a part of our everyday world: the
sounds of a radio or television network announcing itself (NBC, BBC), the shape of a whiskey
bottle (Haig & Haig’s Pinch Bottle), a series of initials (GE, KPMG, IBM), or an animal’s warning
growl (MGM’s lion).

Limitations on Marks
Although trademarks abound, the law limits the subjects that may fall into one of the defined
categories. Not every word or shape or symbol will be protected in an infringement action. To
qualify for protection, a trademark must be used to identify and distinguish. The courts employ
a four-part test: (1) Is the mark so arbitrary and fanciful that it merits the widest protection? (2)
Is it “suggestive” enough to warrant protection without proof of secondary meaning? (3) Is it
“descriptive,” warranting protection if secondary meaning is proved? (4) Is the mark generic and
thus unprotectable?
These tests do not have mechanical answers; they call for judgment. Some marks are wholly
fanciful, clearly identify origin of goods, and distinguish them from others—Kodak, for example.
Other marks may not be so arbitrary but may nevertheless be distinctive, either when adopted
or as a result of advertising—for example, Crest, as the name of a toothpaste.
Marks that are merely descriptive of the product are entitled to protection only if it can be
shown that the mark has acquired secondary meaning. This term reflects a process of
identification on the mark in the public mind with the originator of the product. Holiday Inn
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was initially deemed too descriptive: an inn where people might go on holiday. But over time,
travelers came to identify the source of the Great Sign and the name Holiday Inn as the Holiday
Inn Corporation in Memphis, and secondary meaning was granted. Holiday Inn could thus
protect its mark against other innkeepers, hoteliers, and such; however, the trademark
protection for the words Holiday Inn was limited to the corporation’s hotel and motel business,
and no other.
Certain words and phrases may not qualify at all for trademark protection. These include
generic terms like “straw broom” (for a broom made of straw) and ordinary words like “fast
food.” In one case, a federal appeals court held that the word “Lite” is generic and cannot be
protected by a beer manufacturer to describe a low-calorie brew.[2] Donald Trump’s effort to
trademark “You’re fired!” and Paris Hilton’s desire to trademark “That’s hot!” were also
dismissed as being generic.
Deceptive words will not be accepted for registration. Thus the US Patent and Trademark Office
(PTO) denied registration to the word Vynahyde because it suggested that the plastic material to
which it was applied came from animal skin. Geographic terms are descriptive words and may
not be used as protected trademarks unless they have acquired a secondary meaning, such as
Hershey when used for chocolates. (Hershey’s chocolates are made in Hershey, Pennsylvania.) A
design that reflects a common style cannot be protected in a trademark to exclude other similar
designs in the same tradition. Thus the courts have ruled that a silverware pattern that is a
“functional feature” of the “baroque style” does not qualify for trademark protection. Finally, the
Lanham Act denies federal registration to certain marks that fall within categories of words and
shapes, including the following: the flag; the name, portrait, or signature of any living person
without consent, or of a deceased US president during the lifetime of his widow; and immoral,
deceptive, or scandalous matter (in an earlier era, the phrase “Bubby Trap” for brassieres was
denied registration).

Dilution, Tarnishment, and Blurring
Under the federal Trademark Dilution Act of 1995, companies with marks that dilute the value
of a senior mark may be liable for damages. The act provides that owners of marks of significant
value have property rights that should not be eroded, blurred, tarnished, or diluted in any way
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by another. But as a plaintiff, the holder of the mark must show (1) that it is a famous mark, (2)
that the use of a similar mark is commercial, and (3) that such use causes dilution of the
distinctive quality of the mark. Thus a T-shirt maker who promotes a red-and-white shirt
bearing the mark Buttweiser may be liable to Anheuser-Busch, or a pornographic site called
Candyland could be liable to Parker Brothers, the board game company. Interesting cases have
already been brought under this act, including a case brought by Victoria’s Secret against a small
adult store in Kentucky called Victor’s Little Secret. Notice that unlike most prior trademark law,
the purpose is not to protect the consumer from confusion as to the source or origin of the goods
or services being sold; for example, no one going to the Candyland site would think that Parker
Brothers was the source.

Acquiring Trademark Rights
For the first time in more than forty years, Congress, in 1988, changed the way in which
trademarks can be secured. Under the Lanham Act, the fundamental means of obtaining a
trademark was through use. The manufacturer or distributor actually must have placed the
mark on its product—or on related displays, labels, shipping containers, advertisements, and the
like—and then have begun selling the product. If the product was sold in interstate commerce,
the trademark was entitled to protection under the Lanham Act (or if not, to protection under
the common law of the state in which the product was sold).
Under the Trademark Law Revision Act of 1988, which went into effect in 1989, trademarks can
be obtained in advance by registering with the PTO an intention to use the mark within six
months (the applicant can gain extensions of up to thirty more months to put the mark into
use). Once obtained, the trademark will be protected for ten years (before the 1988 revision, a
federal trademark remained valid for twenty years); if after that time the mark is still being
used, the registration can be renewed. Obtaining a trademark registration lies between
obtaining patents and obtaining copyrights in difficulty. The PTO will not routinely register a
trademark; it searches its records to ensure that the mark meets several statutory tests and does
not infringe another mark. Those who feel that their own marks would be hurt by registration of
a proposed mark may file an opposition proceeding with the PTO. Until 1990, the office received

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about 77,000 applications each year. With the change in procedure, some experts predicted that
applications would rise by 30 percent.
In many foreign countries, use need not be shown to obtain trademark registration. It is
common for some people in these countries to register marks that they expect to be valuable so
that they can sell the right to use the mark to the company that established the mark’s value.
Companies that expect to market abroad should register their marks early.

Loss of Rights
Trademark owners may lose their rights if they abandon the mark, if a patent or copyright
expires on which the mark is based, or if the mark becomes generic. A mark is abandoned if a
company goes out of business and ceases selling the product. Some marks are based on design
patents; when the patent expires, the patent holder will not be allowed to extend the patent’s
duration by arguing that the design or name linked with the design is a registrable trademark.
The most widespread difficulty that a trademark holder faces is the prospect of too much
success: if a trademark comes to stand generically for the product itself, it may lose exclusivity in
the mark. Famous examples are aspirin, escalator, and cellophane. The threat is a continual one.
Trademark holders can protect themselves from their marks’ becoming generic in several ways.
1. Use a descriptive term along with the trademark. Look on a jar of Vaseline and you will see that
the label refers to the contents as Vaseline petroleum jelly.
2. Protest generic use of the mark in all publications by writing letters and taking out
advertisements.
3. Always put the words Trademark, Registered Trademark, or the symbol ® (meaning
“registered”) next to the mark itself, which should be capitalized.

KEY TAKEAWAY

Trademark protection is federal, under the Lanham Act. Branding of corporate logos, names,
and products is essential to business success, and understanding trademarks is pivotal to
branding. A “mark” must be distinctive, arbitrary, or fanciful to merit protection: this means
that it must not be generic or descriptive. Marks can be words, symbols, pictures, slogans,
sounds, phrases, and even shapes. In the United States, rights to marks are obtained by
registration and intent to use in commerce and must be renewed every ten years.

EXERCISES

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1. How will Google protect its trademark, assuming that people begin using “google” as a verb
substitute for “Internet search,” just like people began using the word “cellophane” for all
brands of plastic wrap?
2. Do a small amount of web searching and find out what “trade dress” protection is, and how it
differs from trademark protection.
3. LexisNexis is a brand for a database collection offered by Mead Data Central. Lexus is a highend automobile. Can Lexus succeed in getting Mead Data Central to stop using “Lexis” as a
mark?

[1] 15 United States Code, Section 1127.
[2] Miller Brewing Co. v. Falstaff Brewing Corp., 655 F.2d 5 (1st Cir. 1981).

10.5 Cases
Fair Use in Copyright
Elvis Presley Enterprises et al. v. Passport Video et al.
349 F.3d 622 (9th Circuit Court of Appeals, 2003)
TALLMAN, CIRCUIT JUDGE:
Plaintiffs are a group of companies and individuals holding copyrights in various materials
relating to Elvis Presley. For example, plaintiff SOFA Entertainment, Inc., is the registered
owner of several Elvis appearances on The Ed Sullivan Show. Plaintiff Promenade Trust owns
the copyright to two television specials featuring Elvis: The Elvis 1968 Comeback
Special and Elvis Aloha from Hawaii.…Many Plaintiffs are in the business of licensing their
copyrights. For example, SOFA Entertainment charges $10,000 per minute for use of Elvis’
appearances on The Ed Sullivan Show.
Passport Entertainment and its related entities (collectively “Passport”) produced and sold The
Definitive Elvis, a 16-hour video documentary about the life of Elvis Presley.The Definitive Elvis
sold for $99 at retail. Plaintiffs allege that thousands of copies were sent to retail outlets and
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depth look at the life and career of a man whose popularity is unrivaled in the history of show
business and who continues to attract millions of new fans each year.…
The Definitive Elvis uses Plaintiffs’ copyrighted materials in a variety of ways. With the video
footage, the documentary often uses shots of Elvis appearing on television while a narrator or
interviewee talks over the film. These clips range from only a few seconds in length to portions
running as long as 30 seconds. In some instances, the clips are the subject of audio commentary,
while in other instances they would more properly be characterized as video “filler” because the
commentator is discussing a subject different from or more general than Elvis’ performance on a
particular television show. But also significant is the frequency with which the copyrighted video
footage is used. The Definitive Elvis employs these clips, in many instances, repeatedly. In total,
at least 5% to 10% of The Definitive Elvis uses Plaintiffs’ copyrighted materials.
Use of the video footage, however, is not limited to brief clips.…Thirty-five percent of his
appearances on The Ed Sullivan Show is replayed, as well as three minutes from The 1968
Comeback Special.
***
Plaintiffs sued Passport for copyright infringement.…Passport, however, asserts that its use of
the copyrighted materials was “fair use” under 17 U.S.C. § 107. Plaintiffs moved for a
preliminary injunction, which was granted by the district court after a hearing. The district court
found that Passport’s use of Plaintiffs’ copyrighted materials was likely not fair use. The court
enjoined Passport from selling or distributing The Definitive Elvis. Passport timely appeals.
***
We first address the purpose and character of Passport’s use of Plaintiffs’ copyrighted materials.
Although not controlling, the fact that a new use is commercial as opposed to non-profit weighs
against a finding of fair use. Harper & Row Publishers, Inc. v. Nation Enters., 471 U.S. 539, 562,
85 L. Ed. 2d 588, 105 S.Ct. 2218 (1985). And the degree to which the new user exploits the
copyright for commercial gain—as opposed to incidental use as part of a commercial
enterprise—affects the weight we afford commercial nature as a factor. More importantly for the
first fair-use factor, however, is the “transformative” nature of the new work. Specifically, we ask
“whether the new work…merely supersedes the objects of the original creation, or instead adds
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something new, with a further purpose or different character, altering the first with new
expression, meaning, or message.…” The more transformative a new work, the less significant
other inquiries, such as commercialism, become.
***
The district court below found that the purpose and character of The Definitive Elviswill likely
weigh against a finding of fair use. We cannot say, based on this record, that the district court
abused its discretion.
First, Passport’s use, while a biography, is clearly commercial in nature. But more significantly,
Passport seeks to profit directly from the copyrights it uses without a license. One of the most
salient selling points on the box of The Definitive Elvis is that “Every Film and Television
Appearance is represented.” Passport is not advertising a scholarly critique or historical
analysis, but instead seeks to profit at least in part from the inherent entertainment value of
Elvis’ appearances on such shows as The Steve Allen Show, The Ed Sullivan Show, and The 1968
Comeback Special. Passport’s claim that this is scholarly research containing biographical
comments on the life of Elvis is not dispositive of the fair use inquiry.
Second, Passport’s use of Plaintiffs’ copyrights is not consistently transformative. True,
Passport’s use of many of the television clips is transformative because the clips play for only a
few seconds and are used for reference purposes while a narrator talks over them or
interviewees explain their context in Elvis’ career. But voice-overs do not necessarily transform a
work.…
It would be impossible to produce a biography of Elvis without showing some of his most
famous television appearances for reference purposes. But some of the clips are played without
much interruption, if any. The purpose of showing these clips likely goes beyond merely making
a reference for a biography, but instead serves the same intrinsic entertainment value that is
protected by Plaintiffs’ copyrights.
***
The third factor is the amount and substantiality of the portion used in relation to the
copyrighted work as a whole. This factor evaluates both the quantity of the work taken and the
quality and importance of the portion taken. Regarding the quantity, copying “may not be
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excused merely because it is insubstantial with respect to the infringingwork.” Harper & Row,
471 U.S. at 565 (emphasis in original). But if the amount used is substantial with respect to the
infringing work, it is evidence of the value of the copy-righted work.
Passport’s use of clips from television appearances, although in most cases of short duration,
were repeated numerous times throughout the tapes. While using a small number of clips to
reference an event for biographical purposes seems fair, using a clip over and over will likely no
longer serve a biographical purpose. Additionally, some of the clips were not short in length.
Passport’s use of Elvis’ appearance on The Steve Allen Show plays for over a minute and many
more clips play for more than just a few seconds.
Additionally, although the clips are relatively short when compared to the entire shows that are
copyrighted, they are in many instances the heart of the work. What makes these copyrighted
works valuable is Elvis’ appearance on the shows, in many cases singing the most familiar
passages of his most popular songs. Plaintiffs are in the business of licensing these copyrights.
Taking key portions extracts the most valuable part of Plaintiffs’ copyrighted works. With
respect to the photographs, the entire picture is often used. The music, admittedly, is usually
played only for a few seconds.
***
The last, and “undoubtedly the single most important” of all the factors, is the effect the use will
have on the potential market for and value of the copyrighted works. Harper & Row, 471 U.S. at
566. We must “consider not only the extent of market harm caused by the particular actions of
the alleged infringer, but also whether unrestricted and widespread conduct of the sort engaged
in by the defendant…would result in a substantially adverse impact on the potential market for
the original.” Campbell, 510 U.S. at 590. The more transformative the new work, the less likely
the new work’s use of copyrighted materials will affect the market for the materials. Finally, if
the purpose of the new work is commercial in nature, “the likelihood [of market harm] may be
presumed.” A&M Records, 239 F.3d at 1016 (quoting Sony, 464 U.S. at 451).
The district court found that Passport’s use of Plaintiffs’ copyrighted materials likely does affect
the market for those materials. This conclusion was not clearly erroneous.

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First, Passport’s use is commercial in nature, and thus we can assume market harm. Second,
Passport has expressly advertised that The Definitive Elvis contains the television appearances
for which Plaintiffs normally charge a licensing fee. If this type of use became wide-spread, it
would likely undermine the market for selling Plaintiffs’ copyrighted material. This conclusion,
however, does not apply to the music and still photographs. It seems unlikely that someone in
the market for these materials would purchase The Definitive Elvis instead of a properly
licensed product. Third, Passport’s use of the television appearances was, in some instances, not
transformative, and therefore these uses are likely to affect the market because they serve the
same purpose as Plaintiffs’ original works.
***
We emphasize that our holding today is not intended to express how we would rule were we
examining the case ab initio as district judges. Instead, we confine our review to whether the
district court abused its discretion when it weighed the four statutory fair-use factors together
and determined that Plaintiffs would likely succeed on the merits. Although we might view this
case as closer than the district court saw it, we hold there was no abuse of discretion in the
court’s decision to grant Plaintiffs’ requested relief.
AFFIRMED.

CASE QUESTIONS

1. How would you weigh the four factors in this case? If the trial court had found fair use, would
the appeals court have overturned its ruling?
2. Why do you think that the fourth factor is especially important?
3. What is the significance of the discussion on “transformative” aspects of the defendant’s
product?

Trademark Infringement and Dilution
Playboy Enterprises v. Welles
279 F.3d 796 (9th Circuit Court of Appeals, 2001)
T. G. NELSON, Circuit Judge:
Terri Welles was on the cover of Playboy in 1981 and was chosen to be the Playboy Playmate of
the Year for 1981. Her use of the title “Playboy Playmate of the Year 1981,” and her use of other

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trademarked terms on her website are at issue in this suit. During the relevant time period,
Welles’ website offered information about and free photos of Welles, advertised photos for sale,
advertised memberships in her photo club, and promoted her services as a spokesperson. A
biographical section described Welles’ selection as Playmate of the Year in 1981 and her years
modeling for PEI. The site included a disclaimer that read as follows: “This site is neither
endorsed, nor sponsored, nor affiliated with Playboy Enterprises, Inc. PLAYBOY tm PLAYMATE
OF THE YEAR tm AND PLAYMATE OF THE MONTH tm are registered trademarks of Playboy
Enterprises, Inc.”
Wells used (1) the terms “Playboy ”and “Playmate” in the metatags of the website; (2) the phrase
“Playmate of the Year 1981” on the masthead of the website; (3) the phrases “Playboy Playmate
of the Year 1981” and “Playmate of the Year 1981” on various banner ads, which may be
transferred to other websites; and (4) the repeated use of the abbreviation “PMOY ’81” as the
watermark on the pages of the website. PEI claimed that these uses of its marks constituted
trademark infringement, dilution, false designation of origin, and unfair competition. The
district court granted defendants’ motion for summary judgment. PEI appeals the grant of
summary judgment on its infringement and dilution claims. We affirm in part and reverse in
part.
A. Trademark Infringement
Except for the use of PEI’s protected terms in the wallpaper of Welles’ website, we conclude that
Welles’ uses of PEI’s trademarks are permissible, nominative uses. They imply no current
sponsorship or endorsement by PEI. Instead, they serve to identify Welles as a past PEI
“Playmate of the Year.”
We articulated the test for a permissible, nominative use in New Kids On The Block v. New
America Publishing, Inc. The band, New Kids On The Block, claimed trademark infringement
arising from the use of their trademarked name by several newspapers. The newspapers had
conducted polls asking which member of the band New Kids On The Block was the best and
most popular. The papers’ use of the trademarked term did not fall within the traditional fair use
doctrine. Unlike a traditional fair use scenario, the defendant newspaper was using the
trademarked term to describe not its own product, but the plaintiff’s. Thus, the factors used to
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evaluate fair use were inapplicable. The use was nonetheless permissible, we concluded, based
on its nominative nature.
We adopted the following test for nominative use:
First, the product or service in question must be one not readily identifiable without use of the
trademark; second, only so much of the mark or marks may be used as is reasonably necessary
to identify the product or service; and third, the user must do nothing that would, in conjunction
with the mark, suggest sponsorship or endorsement by the trademark holder.
We group the uses of PEI’s trademarked terms into three for the purpose of applying the test for
nominative use.
1. Headlines and banner advertisements.
...
The district court properly identified Welles’ situation as one which must… be excepted. No
descriptive substitute exists for PEI’s trademarks in this context.…Just as the newspapers
in New Kids could only identify the band clearly by using its trademarked name, so can Welles
only identify herself clearly by using PEI’s trademarked title.
The second part of the nominative use test requires that “only so much of the mark or marks
may be used as is reasonably necessary to identify the product or service[.]” New Kids provided
the following examples to explain this element: “[A] soft drink competitor would be entitled to
compare its product to Coca-Cola or Coke, but would not be entitled to use Coca-Cola’s
distinctive lettering.” Similarly, in a past case, an auto shop was allowed to use the trademarked
term “Volkswagen” on a sign describing the cars it repaired, in part because the shop “did not
use Volkswagen’s distinctive lettering style or color scheme, nor did he display the encircled
‘VW’ emblem.” Welles’ banner advertisements and headlines satisfy this element because they
use only the trademarked words, not the font or symbols associated with the trademarks.
The third element requires that the user do “nothing that would, in conjunction with the mark,
suggest sponsorship or endorsement by the trademark holder.” As to this element, we conclude
that aside from the wallpaper, which we address separately, Welles does nothing in conjunction
with her use of the marks to suggest sponsorship or endorsement by PEI. The marks are clearly
used to describe the title she received from PEI in 1981, a title that helps describe who she is. It
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would be unreasonable to assume that the Chicago Bulls sponsored a website of Michael
Jordan’s simply because his name appeared with the appellation “former Chicago Bull.”
Similarly, in this case, it would be unreasonable to assume that PEI currently sponsors or
endorses someone who describes herself as a “Playboy Playmate of the Year in 1981.” The
designation of the year, in our case, serves the same function as the “former” in our example. It
shows that any sponsorship or endorsement occurred in the past.
For the foregoing reasons, we conclude that Welles’ use of PEI’s marks in her headlines and
banner advertisements is a nominative use excepted from the law of trademark infringement.
2. Metatags
Welles includes the terms “playboy” and “playmate” in her metatags. Metatags describe the
contents of a website using keywords. Some search engines search metatags to identify websites
relevant to a search. Thus, when an internet searcher enters “playboy” or “playmate” into a
search engine that uses metatags, the results will include Welles’ site. Because Welles’ metatags
do not repeat the terms extensively, her site will not be at the top of the list of search results.
Applying the three-factor test for nominative use, we conclude that the use of the trademarked
terms in Welles’ metatags is nominative.
As we discussed above with regard to the headlines and banner advertisements, Welles has no
practical way of describing herself without using trademarked terms. In the context of metatags,
we conclude that she has no practical way of identifying the content of her website without
referring to PEI’s trademarks.
...
Precluding their use would have the unwanted effect of hindering the free flow of information on
the internet, something which is certainly not a goal of trademark law. Accordingly, the use of
trademarked terms in the metatags meets the first part of the test for nominative use.…We
conclude that the metatags satisfy the second and third elements of the test as well. The
metatags use only so much of the marks as reasonably necessary and nothing is done in
conjunction with them to suggest sponsorship or endorsement by the trademark holder. We
note that our decision might differ if the metatags listed the trademarked term so repeatedly

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that Welles’ site would regularly appear above PEI’s in searches for one of the trademarked
terms.
3. Wallpaper/watermark.
The background, or wallpaper, of Welles’ site consists of the repeated abbreviation “PMOY ’81,”
which stands for “Playmate of the Year 1981.” Welles’ name or likeness does not appear before
or after “PMOY ’81.” The pattern created by the repeated abbreviation appears as the
background of the various pages of the website. Accepting, for the purposes of this appeal, that
the abbreviation “PMOY” is indeed entitled to protection, we conclude that the repeated, stylized
use of this abbreviation fails the nominative use test.
The repeated depiction of “PMOY ‘81” is not necessary to describe Welles. “Playboy Playmate of
the Year 1981” is quite adequate. Moreover, the term does not even appear to describe Welles—
her name or likeness do not appear before or after each “PMOY ’81.” Because the use of the
abbreviation fails the first prong of the nominative use test, we need not apply the next two
prongs of the test.
Because the defense of nominative use fails here, and we have already determined that the
doctrine of fair use does not apply, we remand to the district court. The court must determine
whether trademark law protects the abbreviation “PMOY,” as used in the wallpaper.
B. Trademark Dilution [At this point, the court considers and rejects PEI’s claim for trademark
dilution.]
Conclusion
For the foregoing reasons, we affirm the district court’s grant of summary judgment as to PEI’s
claims for trademark infringement and trademark dilution, with the sole exception of the use of
the abbreviation “PMOY.” We reverse as to the abbreviation and remand for consideration of
whether it merits protection under either an infringement or a dilution theory.

CASE QUESTIONS

1. Do you agree with the court’s decision that there is no dilution here?
2. If PMOY is not a registered trademark, why does the court discuss it?
3. What does “nominative use” mean in the context of this case?

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4. In business terms, why would PEI even think that it was losing money, or could lose money,
based on Welles’s use of its identifying marks?

10.6 Summary and Exercises
Summary

The products of the human mind are at the root of all business, but they are legally protectable
only to a certain degree. Inventions that are truly novel may qualify for a twenty-year patent; the
inventor may then prohibit anyone from using the art (machine, process, manufacture, and the
like) or license it on his own terms. A business may sue a person who improperly gives away its
legitimate trade secrets, but it may not prevent others from using the unpatented trade secret
once publicly disclosed. Writers or painters, sculptors, composers, and other creative artists may
generally protect the expression of their ideas for the duration of their lives plus seventy years,
as long as the ideas are fixed in some tangible medium. That means that they may prevent
others from copying their words (or painting, etc.), but they may not prevent anyone from
talking about or using their ideas. Finally, one who markets a product or service may protect its
trademark or service or other mark that is distinctive or has taken on a secondary meaning, but
may lose it if the mark becomes the generic term for the goods or services.

EXERCISES

1. Samuel Morse filed claims in the US Patent Office for his invention of the telegraph and also
for the “use of the motive power of the electric or galvanic current…however developed, for
marking or printing intelligible characters, signs or letters at any distances.” For which claim,
if any, was he entitled to a patent? Why?
2. In 1957, an inventor dreamed up and constructed a certain new kind of computer. He kept
his invention a secret. Two years later, another inventor who conceived the same machine
filed a patent application. The first inventor, learning of the patent application, filed for his
own patent in 1963. Who is entitled to the patent, assuming that the invention was truly
novel and not obvious? Why?
3. A large company discovered that a small company was infringing one of its patents. It wrote
the small company and asked it to stop. The small company denied that it was infringing.
Because of personnel changes in the large company, the correspondence file was lost and
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only rediscovered eight years later. The large company sued. What would be the result?
Why?
4. Clifford Witter was a dance instructor at the Arthur Murray Dance Studios in Cleveland. As a
condition of employment, he signed a contract not to work for a competitor. Subsequently,
he was hired by the Fred Astaire Dancing Studios, where he taught the method that he had
learned at Arthur Murray. Arthur Murray sued to enforce the noncompete contract. What
would be result? What additional information, if any, would you need to know to decide the
case?
5. Greenberg worked for Buckingham Wax as its chief chemist, developing chemical formulas
for products by testing other companies’ formulas and modifying them. Brite Products
bought Buckingham’s goods and resold them under its own name. Greenberg went to work
for Brite, where he helped Brite make chemicals substantially similar to the ones it had been
buying from Buckingham. Greenberg had never made any written or oral commitment to
Buckingham restricting his use of the chemical formulas he developed. May Buckingham stop
Greenberg from working for Brite? May it stop him from working on formulas learned while
working at Buckingham? Why?

SELF-TEST QUESTIONS

1. Which of the following cannot be protected under patent, copyright, or trademark
law?
a.

a synthesized molecule
b. a one-line book title
c. a one-line advertising jingle
d. a one-word company name
Which of the following does not expire by law?

a.

a closely guarded trade secret not released to the public
b. a patent granted by the US Patent and Trademark Office
c. a copyright registered in the US Copyright Office
d. a federal trademark registered under the Lanham Act

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A sculptor casts a marble statue of a three-winged bird. To protect against
copying, the sculptor can obtain which of the following?
a.

a patent
b. a trademark
c. a copyright
d. none of the above
A stock analyst discovers a new system for increasing the value of a stock
portfolio. He may protect against use of his system by other people by securing
a.

a patent

b. a copyright
c. a trademark
d. none of the above
A company prints up its customer list for use by its sales staff. The cover
page carries a notice that says “confidential.” A rival salesman gets a copy of the
list. The company can sue to recover the list because the list is
a.

patented

b. copyrighted
c. a trade secret
d. none of the above

SELF-TEST ANSWERS

1. b
2. a
3. c
4. d
5. c

Chapter 11
The Nature and Regulation of Real Estate and the
Environment
LEARNING OBJECTIVES

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After reading this chapter, you should understand the following:
1. The various kinds of interests (or “estates”) in real property
2. The various rights that come with ownership of real property
3. What easements are, how they are created, and how they function
4. How ownership of real property is regulated by tort law, by agreement, and by the public
interest (through eminent domain)
5. The various ways in which environmental laws affect the ownership and use of real property
Real property is an important part of corporate as well as individual wealth. As a consequence,
the role of the corporate real estate manager has become critically important within the
corporation. The real estate manager must be aware not only of the value of land for purchase
and sale but also of proper lease negotiation, tax policies and assessments, zoning and land
development, and environmental laws.
In this chapter and in Chapter 12 "The Transfer of Real Estate by Sale" and Chapter 13
"Landlord and Tenant Law", we focus on regulation of land use and the environment (see Figure
11.1 "Chapter Overview"). We divide our discussion of the nature of real estate into three major
categories: (1) estates; (2) rights that are incidental to the possession and ownership of land—for
example, the right to air, water, and minerals; and (3) easements—the rights in lands of others.

11.1 Estates

LEARNING OBJECTIVE

1. Distinguish between the various kinds of estates, or interests, in real property that the law
recognizes.
In property law, an estate is an interest in real property, ranging from absolute dominion and
control to bare possession. Ordinarily when we think of property, we think of only one kind:
absolute ownership. The owner of a car has the right to drive it where and when she wants,
rebuild it, repaint it, and sell it or scrap it. The notion that the owner might lose her property
when a particular event happens is foreign to our concept of personal property. Not so with real
property. You would doubtless think it odd if you were sold a used car subject to the condition
that you not paint it a different color—and that if you did, you would automatically be stripped
of ownership. But land can be sold that way. Land and other real property can be divided into
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many categories of interests, as we will see. (Be careful not to confuse the various types of
interests in real property with the forms of ownership, such as joint tenancy. An interest in real
property that amounts to an estate is a measure of the degree to which a thing is owned; the
form of ownership deals with the particular person or persons who own it.)

Figure 11.1 Chapter Overview

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The common law distinguishes estates along two main axes: (1) freeholds versus leaseholds and
(2) present versus future interests. A freehold estate is an interest in land that has an uncertain
duration. The freehold can be outright ownership—called the fee simple absolute—or it can be
an interest in the land for the life of the possessor; in either case, it is impossible to say exactly
how long the estate will last. In the case of one who owns property outright, her estate will last
until she sells or transfers it; in the case of a life estate, it will last until the death of the owner or
another specified individual. A leasehold estate is one whose termination date is usually known.
A one-year lease, for example, will expire precisely at the time stated in the lease agreement.
A present estate is one that is currently owned and enjoyed; a future estate is one that will come
into the owner’s possession upon the occurrence of a particular event. In this chapter, we

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consider both present and future freehold interests; leasehold interests we save for Chapter 13
"Landlord and Tenant Law".

Present Estates (Freeholds)
Fee Simple Absolute
The strongest form of ownership is known as the fee simple absolute (or fee simple, or merely
fee). This is what we think of when we say that someone “owns” the land. As one court put it,
“The grant of a fee in land conveys to the grantee complete ownership, immediately and forever,
with the right of possession from boundary to boundary and from the center of the earth to the
sky, together with all the lawful uses thereof.” [1]Although the fee simple may be encumbered by
a mortgage (you may borrow money against the equity in your home) or an easement (you may
grant someone the right to walk across your backyard), the underlying control is in the hands of
the owner. Though it was once a complex matter in determining whether a person had been
given a fee simple interest, today the law presumes that the estate being transferred is a fee
simple, unless the conveyance expressly states to the contrary. (In her will, Lady Gaga grants her
five-thousand-acre ranch “to my screen idol, Tilda Swinton.” On the death of Lady Gaga,
Swinton takes ownership of the ranch outright in fee simple absolute.)

Fee Simple Defeasible
Not every transfer of real property creates a fee simple absolute. Some transfers may limit the
estate. Any transfer specifying that the ownership will terminate upon a particular happening is
known as a fee simple defeasible. Suppose, for example, that Mr. Warbucks conveys a tract of
land “to Miss Florence Nightingale, for the purpose of operating her hospital and for no other
purpose. Conveyance to be good as long as hospital remains on the property.” This grant of land
will remain the property of Miss Nightingale and her heirs as long as she and they maintain a
hospital. When they stop doing so, the land will automatically revert to Mr. Warbucks or his
heirs, without their having to do anything to regain title. Note that the conveyance of land could
be perpetual but is not absolute, because it will remain the property of Miss Nightingale only so
long as she observes the conditions in the grant.

Life Estates

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An estate measured by the life of a particular person is called a life estate. A conventional life
estate is created privately by the parties themselves. The simplest form is that conveyed by the
following words: “to Scarlett for life.” Scarlett becomes a life tenant; as such, she is the owner of
the property and may occupy it for life or lease it or even sell it, but the new tenant or buyer can
acquire only as much as Scarlett has to give, which is ownership for her life (i.e., all she can sell
is a life estate in the land, not a fee simple absolute). If Scarlett sells the house and dies a month
later, the buyer’s interest would terminate. A life estate may be based on the life of someone
other than the life tenant: “to Scarlett for the life of Rhett.”
The life tenant may use the property as though he were the owner in fee simple absolute with
this exception: he may not act so as to diminish the value of the property that will ultimately go
to the remainderman—the person who will become owner when the life estate terminates. The
life tenant must pay the life estate for ordinary upkeep of the property, but the remainderman is
responsible for extraordinary repairs.
Some life estates are created by operation of law and are known as legal life estates. The most
common form is a widow’s interest in the real property of her husband. In about one-third of the
states, a woman is entitled to dower, a right to a percentage (often one-third) of the property of
her husband when he dies. Most of these states give a widower a similar interest in the property
of his deceased wife. Dower is an alternative to whatever is bequeathed in the will; the widow
has the right to elect the share stated in the will or the share available under dower. To prevent
the dower right from upsetting the interests of remote purchasers, the right may be waived on
sale by having the spouse sign the deed.

Future Estates
To this point, we have been considering present estates. But people also can have future
interests in real property. Despite the implications of its name, the future interest is owned now
but is not available to be used or enjoyed now. For the most part, future interests may be bought
and sold, just as land held in fee simple absolute may be bought and sold. There are several
classes of future interests, but in general there are two major types: reversion and remainder.

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Reversion
A reversion arises whenever the estate transferred has a duration less than that originally owned
by the transferor. A typical example of a simple reversion is that which arises when a life estate
is conveyed. The ownership conveyed is only for the life; when the life tenant dies, the
ownership interest reverts to the grantor. Suppose the grantor has died in the meantime. Who
gets the reversion interest? Since the reversion is a class of property that is owned now, it can be
inherited, and the grantor’s heirs would take the reversion at the subsequent death of the life
tenant.

Remainder
The transferor need not keep the reversion interest for himself. He can give that interest to
someone else, in which case it is known as a remainder interest, because the remainder of the
property is being transferred. Suppose the transferor conveys land with these words: “to Scarlett
for life and then to Rhett.” Scarlett has a life estate; the remainder goes to Rhett in fee simple
absolute. Rhett is said to have a vested remainder interest, because on Scarlett’s death, he or his
heirs will automatically become owners of the property. Some remainder interests are
contingent—and are therefore known as contingent remainder interests—on the happening of a
certain event: “to my mother for her life, then to my sister if she marries Harold before my
mother dies.” The transferor’s sister will become the owner of the property in fee simple only if
she marries Harold while her mother is alive; otherwise, the property will revert to the
transferor or his heirs. The number of permutations of reversions and remainders can become
quite complex, far more than we have space to discuss in this text.

KEY TAKEAWAY

An estate is an interest in real property. Estates are of many kinds, but one generic difference
is between ownership estates and possessory estates. Fee simple estates and life estates are
ownership estates, while leasehold interests are possessory. Among ownership estates, the
principal division is between present estates and future estates. An owner of a future estate
has an interest that can be bought and sold and that will ripen into present possession at the
end of a period of time, at the end of the life of another, or with the happening of some
contingent event.

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EXERCISES
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1. Jessa owns a house and lot on 9th Avenue. She sells the house to the Hartley family, who
wish to have a conveyance from her that says, “to Harriet Hartley for life, remainder to her
son, Alexander Sandridge.” Alexander is married to Chloe, and they have three children,
Carmen, Sarah, and Michael. Who has a future interest, and who has a present interest?
What is the correct legal term for Harriet’s estate? Does Alexander, Carmen, Sarah, or
Michael have any part of the estate at the time Jessa conveys to Harriet using the stated
language?
2. After Harriet dies, Alexander wants to sell the property. Alexander and Chloe’s children are
all eighteen years of age or older. Can he convey the property by his signature alone? Who
else needs to sign?

[1] Magnolia Petroleum Co. v. Thompson, 106 F.2d 217 (8th Cir. 1939).

11.2 Rights Incident to Possession and Ownership of
Real Estate
LEARNING OBJECTIVE

1. Understand that property owners have certain rights in the airspace above their land, in the
minerals beneath their land, and even in water that adjoins their land.

Rights to Airspace
The traditional rule was stated by Lord Coke: “Whoever owns the soil owns up to the sky.” This
traditional rule remains valid today, but its application can cause problems. A simple example
would be a person who builds an extension to the upper story of his house so that it hangs out
over the edge of his property line and thrusts into the airspace of his neighbor. That would
clearly be an encroachment on the neighbor’s property. But is it trespass when an airplane—or
an earth satellite—flies over your backyard? Obviously, the courts must balance the right to
travel against landowners’ rights. In U.S. v. Causby, [1] the Court determined that flights over
private land may constitute a diminution in the property value if they are so low and so frequent
as to be a direct and immediate interference with the enjoyment and use of land.

Rights to the Depths
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Lord Coke’s dictum applies to the depths as well as the sky. The owner of the surface has the
right to the oil, gas, and minerals below it, although this right can be severed and sold
separately. Perplexing questions may arise in the case of oil and gas, which can flow under the
surface. Some states say that oil and gas can be owned by the owner of the surface land; others
say that they are not owned until actually extracted—although the property owner may sell the
exclusive right to extract them from his land. But states with either rule recognize that oil and
gas are capable of being “captured” by drilling that causes oil or gas from under another plot of
land to run toward the drilled hole. Since the possibility of capture can lead to wasteful drilling
practices as everyone nearby rushes to capture the precious commodities, many states have
enacted statutes requiring landowners to share the resources.

Rights to Water
The right to determine how bodies of water will be used depends on basic property rules. Two
different approaches to water use in the United States—eastern and western—have developed
over time (see Figure 11.2 "Water Rights"). Eastern states, where water has historically been
more plentiful, have adopted the so-called riparian rights theory, which itself can take two
forms. Riparian refers to land that includes a part of the bed of a waterway or that borders on a
public watercourse. A riparian owner is one who owns such land. What are the rights of
upstream and downstream owners of riparian land regarding use of the waters? One approach is
the “natural flow” doctrine: Each riparian owner is entitled to have the river or other waterway
maintained in its natural state. The upstream owner may use the river for drinking water or for
washing but may not divert it to irrigate his crops or to operate his mill if doing so would
materially change the amount of the flow or the quality of the water. Virtually all eastern states
today are not so restrictive and rely instead on a “reasonable use” doctrine, which permits the
benefit to be derived from use of the waterway to be weighed against the gravity of the harm.
This approach is illustrated in Hoover v. Crane, (seeSection 11.6.1 "Reasonable Use Doctrine". [2]
Figure 11.2 Water Rights

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In contrast to riparian rights doctrines, western states have adopted the prior appropriation
doctrine. This rule looks not to equality of interests but to priority in time: first in time is first in
right. The first person to use the water for a beneficial purpose has a right superior to
latecomers. This rule applies even if the first user takes all the water for his own needs and even
if other users are riparian owners. This rule developed in water-scarce states in which
development depended on incentives to use rather than hoard water. Today, the prior
appropriation doctrine has come under criticism because it gives incentives to those who already
have the right to the water to continue to use it profligately, rather than to those who might
develop more efficient means of using it.

KEY TAKEAWAY

Property owners have certain rights in the airspace above their land. They also have rights in
subsurface minerals, which include oil and gas. Those property owners who have bodies of
water adjacent to their land will also have certain rights to withdraw or impound water for
their own use. Regarding US water law, the reasonable use doctrine in the eastern states is
distinctly different from the prior appropriation doctrine in western states.

EXERCISES

1. Steve Hannaford farms in western Nebraska. The farm has passed to succeeding generations
of Hannafords, who use water from the North Platte River for irrigation purposes. The
headlands of the North Platte are in Colorado, but use of the water from the North Platte by
Nebraskans preceded use of the water by settlers in Colorado. What theory of water rights
governs Nebraska and Colorado residents? Can the state of Colorado divert and use water in

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such a way that less of it reaches western Nebraska and the Hannaford farm? Why or why
not?
2. Jamie Stoner decides to put solar panels on the south face of his roof. Jamie lives on a block
of one- and two-bedroom bungalows in South Miami, Florida. In 2009, someone purchases
the house next door and within two years decides to add a second and third story. This
proposed addition will significantly decrease the utility of Jamie’s solar array. Does Jamie
have any rights that would limit what his new neighbors can do on their own land?

[1] U.S. v. Causby, 328 U.S. 256 (1946).
[2] Hoover v. Crane, 362 Mich. 36, 106 N.W.2d 563 (1960).

11.3 Easements: Rights in the Lands of Others
LEARNING OBJECTIVES

1. Explain the difference between an easement and a license.
2. Describe the ways in which easements can be created.

Definition
An easement is an interest in land created by agreement that permits one person to make use of
another’s estate. This interest can extend to a profit, the taking of something from the other’s
land. Though the common law once distinguished between an easement and profit, today the
distinction has faded, and profits are treated as a type of easement. An easement must be
distinguished from a mere license, which is permission, revocable at the will of the owner, to
make use of the owner’s land. An easement is an estate; a license is personal to the grantee and
is not assignable.
The two main types of easements are affirmative and negative. An affirmative easement gives a
landowner the right to use the land of another (e.g., crossing it or using water from it), while
a negative easement, by contrast, prohibits the landowner from using his land in ways that
would affect the holder of the easement. For example, the builder of a solar home would want to
obtain negative easements from neighbors barring them from building structures on their land
that would block sunlight from falling on the solar home. With the growth of solar energy, some
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states have begun to provide stronger protection by enacting laws that regulate one’s ability to
interfere with the enjoyment of sunlight. These laws range from a relatively weak statute in
Colorado, which sets forth rules for obtaining easements, to the much stronger statute in
California, which says in effect that the owner of a solar device has a vested right to continue to
receive the sunlight.
Another important distinction is made between easements appurtenant and easements in gross.
An easement appurtenant benefits the owner of adjacent land. The easement is thus
appurtenant to the holder’s land. The benefited land is called thedominant tenement, and the
burdened land—that is, the land subject to the easement—is called
the servient tenement (see Figure 11.3 "Easement Appurtenant"). An easement in gross is
granted independent of the easement holder’s ownership or possession of land. It is simply an
independent right—for example, the right granted to a local delivery service to drive its trucks
across a private roadway to gain access to homes at the other end.

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Figure 11.3 Easement Appurtenant

Unless it is explicitly limited to the grantee, an easement appurtenant “runs with the land.” That
is, when the dominant tenement is sold or otherwise conveyed, the new owner automatically
owns the easement. A commercial easement in gross may be transferred—for instance,
easements to construct pipelines, telegraph and telephone lines, and railroad rights of way.
However, most noncommercial easements in gross are not transferable, being deemed personal
to the original owner of the easement. Rochelle sells her friend Mrs. Nanette—who does not own
land adjacent to Rochelle—an easement across her country farm to operate skimobiles during
the winter. The easement is personal to Mrs. Nanette; she could not sell the easement to anyone
else.

Creation
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Easements may be created by express agreement, either in deeds or in wills. The owner of the
dominant tenement may buy the easement from the owner of the servient tenement or may
reserve the easement for himself when selling part of his land. But courts will sometimes allow
implied easements under certain circumstances. For instance, if the deed refers to an easement
that bounds the premises—without describing it in any detail—a court could conclude that an
easement was intended to pass with the sale of the property.
An easement can also be implied from prior use. Suppose a seller of land has two lots, with a
driveway connecting both lots to the street. The only way to gain access to the street from the
back lot is to use the driveway, and the seller has always done so. If the seller now sells the back
lot, the buyer can establish an easement in the driveway through the front lot if the prior use was
(1) apparent at the time of sale, (2) continuous, and (3) reasonably necessary for the enjoyment
of the back lot. The rule of implied easements through prior use operates only when the
ownership of the dominant and servient tenements was originally in the same person.

Use of the Easement
The servient owner may use the easement—remember, it is on or under or above his land—as
long as his use does not interfere with the rights of the easement owner. Suppose you have an
easement to walk along a path in the woods owned by your neighbor and to swim in a private
lake that adjoins the woods. At the time you purchased the easement, your neighbor did not use
the lake. Now he proposes to swim in it himself, and you protest. You would not have a sound
case, because his swimming in the lake would not interfere with your right to do so. But if he
proposed to clear the woods and build a mill on it, obliterating the path you took to the lake and
polluting the lake with chemical discharges, then you could obtain an injunction to bar him from
interfering with your easement.
The owner of the dominant tenement is not restricted to using his land as he was at the time he
became the owner of the easement. The courts will permit him to develop the land in some
“normal” manner. For example, an easement on a private roadway for the benefit of a large
estate up in the hills would not be lost if the large estate were ultimately subdivided and many
new owners wished to use the roadway; the easement applies to the entire portion of the original
dominant tenement, not merely to the part that abuts the easement itself. However, the owner
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of an easement appurtenant to one tract of land cannot use the easement on another tract of
land, even if the two tracts are adjacent.

KEY TAKEAWAY

An easement appurtenant runs with the land and benefits the dominant tenement,
burdening the servient tenement. An easement, generally, has a specific location or
description within or over the servient tenement. Easements can be created by deed, by will,
or by implication.

EXERCISE

1. Beth Delaney owns property next to Kerry Plemmons. The deed to Delaney’s property notes
that she has access to a well on the Plemmons property “to obtain water for household use.”
The well has been dry for many generations and has not been used by anyone on the
Plemmons property or the Delaney property for as many generations. The well predated
Plemmons’s ownership of the property; as the servient tenement, the Plemmons property
was burdened by this easement dating back to 1898. Plemmons hires a company to dig a
very deep well near one of his outbuildings to provide water for his horses. The location is
one hundred yards from the old well. Does the Delaney property have any easement to use
water from the new well?

11.4 Regulation of Land Use

LEARNING OBJECTIVES

1. Compare the various ways in which law limits or restricts the right to use your land in any
way that you decide is best for you.
2. Distinguish between regulation by common law and regulation by public acts such as zoning
or eminent domain.
3. Understand that property owners may restrict the uses of land by voluntary agreement,
subject to important public policy considerations.
Land use regulation falls into three broad categories: (1) restriction on the use of land through
tort law, (2) private regulation by agreement, and (3) public ownership or regulation through
the powers of eminent domain and zoning.

Regulation of Land Use by Tort Law
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Tort law is used to regulate land use in two ways: (1) The owner may become liable for certain
activities carried out on the real estate that affect others beyond the real estate. (2) The owner
may be liable to persons who, upon entering the real estate, are injured.

Landowner’s Activities
The two most common torts in this area are nuisance and trespass. A common-lawnuisance is
an interference with the use and enjoyment of one’s land. Examples of nuisances are excessive
noise (especially late at night), polluting activities, and emissions of noxious odors. But the
activity must produce substantial harm, not fleeting, minor injury, and it must produce those
effects on the reasonable person, not on someone who is peculiarly allergic to the complained-of
activity. A person who suffered migraine headaches at the sight of croquet being played on a
neighbor’s lawn would not likely win a nuisance lawsuit. While the meaning of nuisance is
difficult to define with any precision, this common-law cause of action is a primary means for
landowners to obtain damages for invasive environmental harms.
A trespass is the wrongful physical invasion of or entry upon land possessed by another. Loud
noise blaring out of speakers in the house next door might be a nuisance but could not be a
trespass, because noise is not a physical invasion. But spraying pesticides on your gladiolas
could constitute a trespass on your neighbor’s property if the pesticide drifts across the
boundary.
Nuisance and trespass are complex theories, a full explanation of which would consume far
more space than we have. What is important to remember is that these torts are two-edged
swords. In some situations, the landowner himself will want to use these theories to sue
trespassers or persons creating a nuisance, but in other situations, the landowner will be liable
under these theories for his own activities.

Injury to Persons Entering the Real Estate
Traditionally, liability for injury has depended on the status of the person who enters the real
estate.

Trespassers
If the person is an intruder without permission—a trespasser—the landowner owes him no duty
of care unless he knows of the intruder’s presence, in which case the owner must exercise
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reasonable care in his activities and warn of hidden dangers on his land of which he is aware. A
known trespasser is someone whom the landowner actually sees on the property or whom he
knows frequently intrudes on the property, as in the case of someone who habitually walks
across the land. If a landowner knows that people frequently walk across his property and one
day he puts a poisonous chemical on the ground to eliminate certain insects, he is obligated to
warn those who continue to walk on the grounds. Intentional injury to known trespassers is not
allowed, even if the trespasser is a criminal intent on robbery, for the law values human life
above property rights.

Children
If the trespasser is a child, a different rule applies in most states. This is the doctrine
ofattractive nuisance. Originally this rule was enunciated to deal with cases in which something
on the land attracted the child to it, like a swimming pool. In recent years, most courts have
dropped the requirement that the child must have been attracted to the danger. Instead, the
following elements of proof are necessary to make out a case of attractive nuisance (Restatement
of Torts, Section 339):
1. The child must have been injured by a structure or other artificial condition.
2. The possessor of the land (not necessarily the owner) must have known or should have known
that young children would be likely to trespass.
3. The possessor must have known or should have known that the artificial condition exists and
that it posed an unreasonable risk of serious injury.
4. The child must have been too young to appreciate the danger that the artificial condition posed.
5. The risk to the child must have far outweighed the utility of the artificial condition to the
possessor.
6. The possessor did not exercise reasonable care in protecting the child or eliminating the danger.
Old refrigerators, open gravel pits, or mechanisms that a curious child would find inviting are all
examples of attractive nuisance. Suppose Farmer Brown keeps an old buggy on his front lawn,
accessible from the street. A five-year-old boy clambers up the buggy one day, falls through a
rotted floorboard, and breaks his leg. Is Farmer Brown liable? Probably so. The child was too
young to appreciate the danger posed by the buggy, a structure. The farmer should have
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appreciated that young children would be likely to come onto the land when they saw the buggy
and that they would be likely to climb up onto the buggy. Moreover, he should have known, if he
did not know in fact, that the buggy, left outside for years without being tended, would pose an
unreasonable risk. The buggy’s utility as a decoration was far overbalanced by the risk that it
posed to children, and the farmer failed to exercise reasonable care.

Licensees
A nontrespasser who comes onto the land without being invited, or if invited, comes for
purposes unconnected with any business conducted on the premises, is known as alicensee. This
class of visitors to the land consists of (1) social guests (people you invite to your home for a
party); (2) a salesman, not invited by the owner, who wishes to sell something to the owner or
occupier of the property; and (3) persons visiting a building for a purpose not connected with
the business on the land (e.g., students who visit a factory to see how it works). The landowner
owes the same duty of care to licensees that he owes to known trespassers. That is, he must warn
them against hidden dangers of which he is aware, and he must exercise reasonable care in his
activities to ensure that they are not injured.

Invitees
A final category of persons entering land is that of invitee. This is one who has been invited onto
the land, usually, though not necessarily, for a business purpose of potential economic benefit to
the owner or occupier of the premises. This category is confusing because it sounds as though it
should include social guests (who clearly are invited onto the premises), but traditionally social
guests are said to be licensees.
Invitees include customers of stores, users of athletic and other clubs, customers of repair shops,
strollers through public parks, restaurant and theater patrons, hotel guests, and the like. From
the owner’s perspective, the major difference between licensees and invitees is that he is liable
for injuries resulting to the latter from hidden dangers that he should have been aware of, even
if he is not actually aware of the dangers. How hidden the dangers are and how broad the
owner’s liability is depends on the circumstances, but liability sometimes can be quite broad.
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Difficult questions arise in lawsuits brought by invitees (or business invitees, as they are
sometimes called) when the actions of persons other than the landowner contribute to the
injury.
The foregoing rules dealing with liability for persons entering the land are the traditional rules
at common law. In recent years, some courts have moved away from the rigidities and
sometimes perplexing differences between trespassers, licensees, and invitees. By court
decision, several states have now abolished such distinctions and hold the proprietor, owner, or
occupier liable for failing to maintain the premises in a reasonably safe condition. According to
the California Supreme Court,
A man’s life or limb does not become less worthy of protection by the law nor a loss less worthy
of compensation under the law because he has come upon the land of another without
permission or with permission but without a business purpose. Reasonable people do not
ordinarily vary their conduct depending upon such matters, and to focus upon the status of the
injured party as a trespasser, licensee, or invitee in order to determine the question whether the
landowner has a duty of care, is contrary to our modern social mores and humanitarian values.
Where the occupier of land is aware of a concealed condition involving in the absence of
precautions an unreasonable risk of harm to those coming in contact with it and is aware that a
person on the premises is about to come in contact with it, the trier of fact can reasonably
conclude that a failure to warn or to repair the condition constitutes negligence. Whether or not
a guest has a right to expect that his host will remedy dangerous conditions on his account, he
should reasonably be entitled to rely upon a warning of the dangerous condition so that he, like
the host, will be in a position to take special precautions when he comes in contact with it. [1]

Private Regulation of Land Use by Agreement
A restrictive covenant is an agreement regarding the use of land that “runs with the land.” In
effect, it is a contractual promise that becomes part of the property and that binds future
owners. Violations of covenants can be redressed in court in suits for damages or injunctions but
will not result in reversion of the land to the seller.
Usually, courts construe restrictive covenants narrowly—that is, in a manner most conducive to
free use of the land by the ultimate owner (the person against whom enforcement of the
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covenant is being sought). Sometimes, even when the meaning of the covenant is clear, the
courts will not enforce it. For example, when the character of a neighborhood changes, the
courts may declare the covenant a nullity. Thus a restriction on a one-acre parcel to residential
purposes was voided when in the intervening thirty years a host of businesses grew up around it,
including a bowling alley, restaurant, poolroom, and sewage disposal plant. [2]
An important nullification of restrictive covenants came in 1947 when the US Supreme Court
struck down as unconstitutional racially restrictive covenants, which barred blacks and other
minorities from living on land so burdened. The Supreme Court reasoned that when a court
enforces such a covenant, it acts in a discriminatory manner (barring blacks but not whites from
living in a home burdened with the covenant) and thus violates the Fourteenth Amendment’s
guarantee of equal protection of the laws. [3]

Public Control of Land Use through Eminent Domain
The government may take private property for public purposes. Its power to do so is known as
eminent domain. The power of eminent domain is subject to constitutional limitations. Under
the Fifth Amendment, the property must be put to public use, and the owner is entitled to “just
compensation” for his loss. These requirements are sometimes difficult to apply.

Public Use
The requirement of public use normally means that the property will be useful to the public once
the state has taken possession—for example, private property might be condemned to construct
a highway. Although not allowed in most circumstances, the government could even condemn
someone’s property in order to turn around and sell it to another individual, if a legitimate
public purpose could be shown. For example, a state survey in the mid-1960s showed that the
government owned 49 percent of Hawaii’s land. Another 47 percent was controlled by seventytwo private landowners. Because this concentration of land ownership (which dated back to
feudal times) resulted in a critical shortage of residential land, the Hawaiian legislature enacted
a law allowing the government to take land from large private estates and resell it in smaller
parcels to homeowners. In 1984, the US Supreme Court upheld the law, deciding that the land
was being taken for a public use because the purpose was “to attack certain perceived evils of
concentrated property ownership.” [4] Although the use must be public, the courts will not
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inquire into the necessity of the use or whether other property might have been better suited. It
is up to government authorities to determine whether and where to build a road, not the courts.
The limits of public use were amply illustrated in the Supreme Court’s 2002 decision ofKelo v.
New London, [5] in which Mrs. Kelo’s house was condemned so that the city of New London, in
Connecticut, could create a marina and industrial park to lease to Pfizer Corporation. The city’s
motives were to create a higher tax base for property taxes. The Court, following precedent
in Midkiff and other cases, refused to invalidate the city’s taking on constitutional grounds.
Reaction from states was swift; many states passed new laws restricting the bases for state and
municipal governments to use powers of eminent domain, and many of these laws also provided
additional compensation to property owners whose land was taken.

Just Compensation
The owner is ordinarily entitled to the fair market value of land condemned under eminent
domain. This value is determined by calculating the most profitable use of the land at the time of
the taking, even though it was being put to a different use. The owner will have a difficult time
collecting lost profits; for instance, a grocery store will not usually be entitled to collect for the
profits it might have made during the next several years, in part because it can presumably move
elsewhere and continue to make profits and in part because calculating future profits is
inherently speculative.

Taking
The most difficult question in most modern cases is whether the government has in fact “taken”
the property. This is easy to answer when the government acquires title to the property through
condemnation proceedings. But more often, a government action is challenged when a law or
regulation inhibits the use of private land. Suppose a town promulgates a setback ordinance,
requiring owners along city sidewalks to build no closer to the sidewalk than twenty feet. If the
owner of a small store had only twenty-five feet of land from the sidewalk line, the ordinance
would effectively prevent him from housing his enterprise, and the ordinance would be a taking.
Challenging such ordinances can sometimes be difficult under traditional tort theories because
the government is immune from suit in some of these cases. Instead, a theory of inverse
condemnation has developed, in which the plaintiff private property owner asserts that the
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government has condemned the property, though not through the traditional mechanism of a
condemnation proceeding.

Public Control of Land Use through Zoning
Zoning is a technique by which a city or other municipality regulates the type of activity to be
permitted in geographical areas within its boundaries. Though originally limited to residential,
commercial, and industrial uses, today’s zoning ordinances are complex sets of regulations. A
typical municipality might have the following zones: residential with a host of subcategories
(such as for single-family and multiple-family dwellings), office, commercial, industrial,
agricultural, and public lands. Zones may be exclusive, in which case office buildings would not
be permitted in commercial zones, or they may be cumulative, so that a more restricted use
would be allowed in a less restrictive zone. Zoning regulations do more than specify the type of
use: they often also dictate minimum requirements for parking, open usable space, setbacks, lot
sizes, and the like, and maximum requirements for height, length of side lots, and so on.

Nonconforming Uses
When a zoning ordinance is enacted, it will almost always affect existing property owners, many
of whom will be using their land in ways no longer permitted under the ordinance. To avoid the
charge that they have thereby “taken” the property, most ordinances permit previous
nonconforming uses to continue, though some ordinances limit the nonconforming uses to a
specified time after becoming effective. But this permission to continue a nonconforming use is
narrow; it extends only to the specific use to which the property was put before the ordinance
was enacted. A manufacturer of dresses that suddenly finds itself in an area zoned residential
may continue to use its sewing machines, but it could not develop a sideline in woodworking.

Variances
Sometimes an owner may desire to use his property in ways not permitted under an existing
zoning scheme and will ask the zoning board for a variance—authority to carry on a
nonconforming use. The board is not free to grant a variance at its whim. The courts apply three
general tests to determine the validity of a variance: (1) The land must be unable to yield a
reasonable return on the uses allowed by the zoning regulation. (2) The hardship must be

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unique to the property, not to property generally in the area. (3) If granted, the variance must
not change the essential character of the neighborhood.

KEY TAKEAWAY

Land use regulation can mean (1) restrictions on the use of land through tort law, (2) private
regulation—by agreement, or (3) regulation through powers of eminent domain or zoning.

EXERCISES

1. Give one example of the exercise of eminent domain. In order to exercise its power under
eminent domain, must the government actually take eventual ownership of the property
that is “taken”?
2. Felix Unger is an adult, trespassing for the first time on Alan Spillborghs’s property. Alan has
been digging a deep grave in his backyard for his beloved Saint Bernard, Maximilian, who has
just died. Alan stops working on the grave when it gets dark, intending to return to the task
in the morning. He seldom sees trespassers cutting through his backyard. Felix, in the dark,
after visiting the local pub, decides to take a shortcut through Alan’s yard and falls into the
grave. He breaks his leg. What is the standard of care for Alan toward Felix or other
infrequent trespassers? If Alan has no insurance for this accident, would the law make Alan
responsible?
3. Atlantic Cement owns and operates a cement plant in New York State. Nearby residents are
exposed to noise, soot, and dust and have experienced lowered property values as a result of
Atlantic Cement’s operations. Is there a common-law remedy for nearby property owners for
losses occasioned by Atlantic’s operations? If so, what is it called?

[1] Rowland v. Christian, 443 P.2d 561 (Cal. 1968).
[2] Norris v. Williams, 54 A.2d 331 (Md. 1947).
[3] Shelley v. Kraemer, 334 U.S. 1 (1947).
[4] Hawaii Housing Authority v. Midkiff, 467 U.S. 229 (1984).
[5] Kelo v. New London, 545 U.S. 469 (2005).

11.5 Environmental Law
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LEARNING OBJECTIVES
1. Describe the major federal laws that govern business activities that may adversely affect air
quality and water quality.
2. Describe the major federal laws that govern waste disposal and chemical hazards including
pesticides.
In one sense, environmental law is very old. Medieval England had smoke control laws that
established the seasons when soft coal could be burned. Nuisance laws give private individuals a
limited control over polluting activities of adjacent landowners. But a comprehensive set of US
laws directed toward general protection of the environment is largely a product of the past
quarter-century, with most of the legislative activity stemming from the late 1960s and later,
when people began to perceive that the environment was systematically deteriorating from
assaults by rapid population growth and greatly increased automobile driving, vast proliferation
of factories that generate waste products, and a sharp rise in the production of toxic materials.
Two of the most significant developments in environmental law came in 1970, when the
National Environmental Policy Act took effect and the Environmental Protection Agency
became the first of a number of new federal administrative agencies to be established during the
decade.

National Environmental Policy Act
Signed into law by President Nixon on January 1, 1970, the National Environmental Policy Act
(NEPA) declared that it shall be the policy of the federal government, in cooperation with state
and local governments, “to create and maintain conditions under which man and nature can
exist in productive harmony, and fulfill the social, economic, and other requirements of present
and future generations of Americans.…The Congress recognizes that each person should enjoy a
healthful environment and that each person has a responsibility to contribute to the
preservation and enhancement of the environment.” [1]
The most significant aspect of NEPA is its requirement that federal agencies prepare
anenvironmental impact statement in every recommendation or report on proposals for
legislation and whenever undertaking a major federal action that significantly affects
environmental quality. The statement must (1) detail the environmental impact of the proposed

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action, (2) list any unavoidable adverse impacts should the action be taken, (3) consider
alternatives to the proposed action, (4) compare short-term and long-term consequences, and
(5) describe irreversible commitments of resources. Unless the impact statement is prepared,
the project can be enjoined from proceeding. Note that NEPA does not apply to purely private
activities but only to those proposed to be carried out in some manner by federal agencies.

Environmental Protection Agency
The Environmental Protection Agency (EPA) has been in the forefront of the news since its
creation in 1970. Charged with monitoring environmental practices of industry, assisting the
government and private business to halt environmental deterioration, promulgating regulations
consistent with federal environmental policy, and policing industry for violations of the various
federal environmental statutes and regulations, the EPA has had a pervasive influence on
American business. Business Week noted the following in 1977: “Cars rolling off Detroit’s
assembly line now have antipollution devices as standard equipment. The dense black
smokestack emissions that used to symbolize industrial prosperity are rare, and illegal, sights.
Plants that once blithely ran discharge water out of a pipe and into a river must apply for
permits that are almost impossible to get unless the plants install expensive water treatment
equipment. All told, the EPA has made a sizable dent in man-made environmental filth.” [2]
The EPA is especially active in regulating water and air pollution and in overseeing the
disposition of toxic wastes and chemicals. To these problems we now turn.

Water Pollution
Clean Water Act
Legislation governing the nation’s waterways goes back a long time. The first federal water
pollution statute was the Rivers and Harbors Act of 1899. Congress enacted new laws in 1948,
1956, 1965, 1966, and 1970. But the centerpiece of water pollution enforcement is the Clean
Water Act of 1972 (technically, the Federal Water Pollution Control Act Amendments of 1972),
as amended in 1977 and by the Water Quality Act of 1987. The Clean Water Act is designed to
restore and maintain the “chemical, physical, and biological integrity of the Nation’s
waters.” [3] It operates on the states, requiring them to designate the uses of every significant

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body of water within their borders (e.g., for drinking water, recreation, commercial fishing) and
to set water quality standards to reduce pollution to levels appropriate for each use.
Congress only has power to regulate interstate commerce, and so the Clean Water Act is
applicable only to “navigable waters” of the United States. This has led to disputes over whether
the act can apply, say, to an abandoned gravel pit that has no visible connection to navigable
waterways, even if the gravel pit provides habitat for migratory birds. In Solid Waste Agency of
Northern Cook County v. Army Corps of Engineers, the US Supreme Court said no. [4]

Private Industry
The Clean Water Act also governs private industry and imposes stringent standards on the
discharge of pollutants into waterways and publicly owned sewage systems. The act created an
effluent permit system known as the National Pollutant Discharge Elimination System. To
discharge any pollutants into navigable waters from a “point source” like a pipe, ditch, ship, or
container, a company must obtain a certification that it meets specified standards, which are
continually being tightened. For example, until 1983, industry had to use the “best practicable
technology” currently available, but after July 1, 1984, it had to use the “best available
technology” economically achievable. Companies must limit certain kinds of “conventional
pollutants” (such as suspended solids and acidity) by “best conventional control technology.”

Other EPA Water Activities
Federal law governs, and the EPA regulates, a number of other water control measures. Ocean
dumping, for example, is the subject of the Marine Protection, Research, and Sanctuaries Act of
1972, which gives the EPA jurisdiction over wastes discharged into the oceans. The Clean Water
Act gives the EPA and the US Army Corps of Engineers authority to protect waters, marshlands,
and other wetlands against degradation caused by dredging and fills. The EPA also oversees
state and local plans for restoring general water quality to acceptable levels in the face of a host
of non-point-source pollution. The Clean Water Act controls municipal sewage systems, which
must ensure that wastewater is chemically treated before being discharged from the sewage
system.
Obviously, of critical importance to the nation’s health is the supply of drinking water. To ensure
its continuing purity, Congress enacted the Safe Drinking Water Act of 1974, with amendments
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passed in 1986 and 1996. This act aims to protect water at its sources: rivers, lakes, reservoirs,
springs, and groundwater wells. (The act does not regulate private wells that serve fewer than
twenty-five individuals.) This law has two strategies for combating pollution of drinking water.
It establishes national standards for drinking water derived from both surface reservoirs and
underground aquifers. It also authorizes the EPA to regulate the injection of solid wastes into
deep wells (as happens, for instance, by leakage from underground storage tanks).

Air Pollution
The centerpiece of the legislative effort to clean the atmosphere is the Clean Air Act of 1970
(amended in 1975, 1977, and 1990). Under this act, the EPA has set two levels of National
Ambient Air Quality Standards (NAAQS). The primary standards limit the ambient (i.e.,
circulating) pollution that affects human health; secondary standards limit pollution that affects
animals, plants, and property. The heart of the Clean Air Act is the requirement that subject to
EPA approval, the states implement the standards that the EPA establishes. The setting of these
pollutant standards was coupled with directing the states to develop state implementation plans
(SIPs), applicable to appropriate industrial sources in the state, in order to achieve these
standards. The act was amended in 1977 and 1990 primarily to set new goals (dates) for
achieving attainment of NAAQS since many areas of the country had failed to meet the
deadlines.
Beyond the NAAQS, the EPA has established several specific standards to control different types
of air pollution. One major type is pollution that mobile sources, mainly automobiles, emit. The
EPA requires new cars to be equipped with catalytic converters and to use unleaded gasoline to
eliminate the most noxious fumes and to keep them from escaping into the atmosphere. To
minimize pollution from stationary sources, the EPA also imposes uniform standards on new
industrial plants and those that have been substantially modernized. And to safeguard against
emissions from older plants, states must promulgate and enforce SIPs.
The Clean Air Act is even more solicitous of air quality in certain parts of the nation, such as
designated wilderness areas and national parks. For these areas, the EPA has set standards to
prevent significant deterioration in order to keep the air as pristine and clear as it was centuries
ago.
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The EPA also worries about chemicals so toxic that the tiniest quantities could prove fatal or
extremely hazardous to health. To control emission of substances like asbestos, beryllium,
mercury, vinyl chloride, benzene, and arsenic, the EPA has established or proposed various
National Emissions Standards for Hazardous Air Pollutants.
Concern over acid rain and other types of air pollution prompted Congress to add almost eight
hundred pages of amendments to the Clean Air Act in 1990. (The original act was fifty pages
long.) As a result of these amendments, the act was modernized in a manner that parallels other
environmental laws. For instance, the amendments established a permit system that is modeled
after the Clean Water Act. And the amendments provide for felony convictions for willful
violations, similar to penalties incorporated into other statutes.
The amendments include certain defenses for industry. Most important, companies are
protected from allegations that they are violating the law by showing that they were acting in
accordance with a permit. In addition to this “permit shield,” the law also contains protection
for workers who unintentionally violate the law while following their employers’ instructions.

Waste Disposal
Though pollution of the air by highly toxic substances like benzene or vinyl chloride may seem a
problem removed from that of the ordinary person, we are all in fact polluters. Every year, the
United States generates approximately 230 million tons of “trash”—about 4.6 pounds per
person per day. Less than one-quarter of it is recycled; the rest is incinerated or buried in
landfills. But many of the country’s landfills have been closed, either because they were full or
because they were contaminating groundwater. Once groundwater is contaminated, it is
extremely expensive and difficult to clean it up. In the 1965 Solid Waste Disposal Act and the
1970 Resource Recovery Act, Congress sought to regulate the discharge of garbage by
encouraging waste management and recycling. Federal grants were available for research and
training, but the major regulatory effort was expected to come from the states and
municipalities.
But shocking news prompted Congress to get tough in 1976. The plight of homeowners near
Love Canal in upstate New York became a major national story as the discovery of massive
underground leaks of toxic chemicals buried during the previous quarter century led to
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evacuation of hundreds of homes. Next came the revelation that Kepone, an exceedingly toxic
pesticide, had been dumped into the James River in Virginia, causing a major human health
hazard and severe damage to fisheries in the James and downstream in the Chesapeake Bay.
The rarely discussed industrial dumping of hazardous wastes now became an open controversy,
and Congress responded in 1976 with the Resource Conservation and Recovery Act (RCRA) and
the Toxic Substances Control Act (TSCA) and in 1980 with the Comprehensive Environmental
Response, Compensation, and Liability Act (CERCLA).

Resource Conservation and Recovery Act
The RCRA expresses a “cradle-to-grave” philosophy: hazardous wastes must be regulated at
every stage. The act gives the EPA power to govern their creation, storage, transport, treatment,
and disposal. Any person or company that generates hazardous waste must obtain a permit
(known as a “manifest”) either to store it on its own site or ship it to an EPA-approved
treatment, storage, or disposal facility. No longer can hazardous substances simply be dumped
at a convenient landfill. Owners and operators of such sites must show that they can pay for
damage growing out of their operations, and even after the sites are closed to further dumping,
they must set aside funds to monitor and maintain the sites safely.
This philosophy can be severe. In 1986, the Supreme Court ruled that bankruptcy is not a
sufficient reason for a company to abandon toxic waste dumps if state regulations reasonably
require protection in the interest of public health or safety. The practical effect of the ruling is
that trustees of the bankrupt company must first devote assets to cleaning up a dump site, and
only from remaining assets may they satisfy creditors. [5]Another severity is RCRA’s imposition
of criminal liability, including fines of up to $25,000 a day and one-year prison sentences, which
can be extended beyond owners to individual employees, as discussed in U.S. v. Johnson &
Towers, Inc., et al., (seeSection 11.6.2 "Criminal Liability of Employees under RCRA").

Comprehensive Environmental Response, Compensation, and Liability Act
The CERCLA, also known as the Superfund, gives the EPA emergency powers to respond to
public health or environmental dangers from faulty hazardous waste disposal, currently
estimated to occur at more than seventeen thousand sites around the country. The EPA can
direct immediate removal of wastes presenting imminent danger (e.g., from train wrecks, oil
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spills, leaking barrels, and fires). Injuries can be sudden and devastating; in 1979, for example,
when a freight train derailed in Florida, ninety thousand pounds of chlorine gas escaped from a
punctured tank car, leaving 8 motorists dead and 183 others injured and forcing 3,500 residents
within a 7-mile radius to be evacuated. The EPA may also carry out “planned removals” when
the danger is substantial, even if immediate removal is not necessary.
The EPA prods owners who can be located to voluntarily clean up sites they have abandoned.
But if the owners refuse, the EPA and the states will undertake the task, drawing on a federal
trust fund financed mainly by taxes on the manufacture or import of certain chemicals and
petroleum (the balance of the fund comes from general revenues). States must finance 10
percent of the cost of cleaning up private sites and 50 percent of the cost of cleaning up public
facilities. The EPA and the states can then assess unwilling owners’ punitive damages up to
triple the cleanup costs.
Cleanup requirements are especially controversial when applied to landowners who innocently
purchased contaminated property. To deal with this problem, Congress enacted the Superfund
Amendment and Reauthorization Act in 1986, which protects innocent landowners who—at the
time of purchase—made an “appropriate inquiry” into the prior uses of the property. The act
also requires companies to publicly disclose information about hazardous chemicals they use.
We now turn to other laws regulating chemical hazards.

Chemical Hazards
Toxic Substances Control Act
Chemical substances that decades ago promised to improve the quality of life have lately shown
their negative side—they have serious adverse side effects. For example, asbestos, in use for half
a century, causes cancer and asbestosis, a debilitating lung disease, in workers who breathed in
fibers decades ago. The result has been crippling disease and death and more than thirty
thousand asbestos-related lawsuits filed nationwide. Other substances, such as polychlorinated
biphenyls (PCBs) and dioxin, have caused similar tragedy. Together, the devastating effects of
chemicals led to enactment of the TSCA, designed to control the manufacture, processing,
commercial distribution, use, and disposal of chemicals that pose unreasonable health or
environmental risks. (The TSCA does not apply to pesticides, tobacco, nuclear materials,
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firearms and ammunition, food, food additives, drugs, and cosmetics—all are regulated by other
federal laws.)
The TSCA gives the EPA authority to screen for health and environmental risks by requiring
companies to notify the EPA ninety days before manufacturing or importing new chemicals. The
EPA may demand that the companies test the substances before marketing them and may
regulate them in a number of ways, such as requiring the manufacturer to label its products, to
keep records on its manufacturing and disposal processes, and to document all significant
adverse reactions in people exposed to the chemicals. The EPA also has authority to ban certain
especially hazardous substances, and it has banned the further production of PCBs and many
uses of asbestos.
Both industry groups and consumer groups have attacked the TSCA. Industry groups criticize
the act because the enforcement mechanism requires mountainous paperwork and leads to
widespread delay. Consumer groups complain because the EPA has been slow to act against
numerous chemical substances. The debate continues.

Pesticide Regulation
The United States is a major user of pesticides, substances that eliminate troublesome insects,
rodents, fungi, and bacteria, consuming more than a billion pounds a year in the form of thirtyfive thousand separate chemicals. As useful as they can be, like many chemical substances,
pesticides can have serious side effects on humans and plant and animal life. Beginning in the
early 1970s, Congress enacted major amendments to the Federal Insecticide, Fungicide, and
Rodenticide Act of 1947 and the Federal Food, Drug, and Cosmetic Act (FFDCA) of 1906.
These laws direct the EPA to determine whether pesticides properly balance effectiveness
against safety. If the pesticide can carry out its intended function without causing unreasonable
adverse effects on human health or the environment, it may remain on the market. Otherwise,
the EPA has authority to regulate or even ban its distribution and use. To enable the EPA to
carry out its functions, the laws require manufacturers to provide a wealth of data about the way
individual pesticides work and their side effects. The EPA is required to inspect pesticides to
ensure that they conform to their labeled purposes, content, and safety, and the agency is
empowered to certify pesticides for either general or restricted use. If a pesticide is restricted,
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only those persons certified in approved training programs may use it. Likewise, under the
Pesticide Amendment to the FFDCA, the EPA must establish specific tolerances for the residue
of pesticides on feed crops and both raw and processed foods. The Food and Drug
Administration (for agricultural commodities) and the US Department of Agriculture (for meat,
poultry, and fish products) enforce these provisions.

Other Types of Environmental Controls
Noise Regulation
Under the Noise Regulation Act of 1972, Congress has attempted to combat a growing menace to
US workers, residents, and consumers. People who live close to airports and major highways,
workers who use certain kinds of machinery (e.g., air compressors, rock drills, bulldozers), and
consumers who use certain products, such as power mowers and air conditioners, often suffer
from a variety of ailments. The Noise Regulation Act delegates to the EPA power to limit “noise
emissions” from these major sources of noise. Under the act, manufacturers may not sell new
products that fail to conform to the noise standards the EPA sets, and users are forbidden from
dismantling noise control devices installed on these products. Moreover, manufacturers must
label noisy products properly. Private suits may be filed against violators, and the act also
permits fines of up to $25,000 per day and a year in jail for those who seek to avoid its terms.

Radiation Controls
The terrifying effects of a nuclear disaster became frighteningly clear when the Soviet Union’s
nuclear power plant at Chernobyl exploded in early 1986, discharging vast quantities of
radiation into the world’s airstream and affecting people thousands of miles away. In the United
States, the most notorious nuclear accident occurred at the Three Mile Island nuclear utility in
Pennsylvania in 1979, crippling the facility for years because of the extreme danger and long life
of the radiation. Primary responsibility for overseeing nuclear safety rests with the Nuclear
Regulatory Commission, but many other agencies and several federal laws (including the Clean
Air Act; the Federal Water Pollution Control Act; the Safe Drinking Water Act; the Uranium Mill
Tailings Radiation Control Act; the Marine Protection, Research, and Sanctuaries Act; the
Nuclear Waste Policy Act of 1982; the CERCLA; and the Ocean Dumping Act) govern the use of
nuclear materials and the storage of radioactive wastes (some of which will remain severely
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dangerous for thousands of years). Through many of these laws, the EPA has been assigned the
responsibility of setting radiation guidelines, assessing new technology, monitoring radiation in
the environment, setting limits on release of radiation from nuclear utilities, developing
guidance for use of X-rays in medicine, and helping to plan for radiation emergencies.

KEY TAKEAWAY

Laws limiting the use of one’s property have been around for many years; common-law
restraints (e.g., the law of nuisance) exist as causes of action against those who would use
their property to adversely affect the life or health of others or the value of their neighbors’
property. Since the 1960s, extensive federal laws governing the environment have been
enacted. These include laws governing air, water, chemicals, pesticides, solid waste, and
nuclear activities. Some laws include criminal penalties for noncompliance.

EXERCISES

1. Who is responsible for funding CERCLA? That is, what is the source of funds for cleanups of
hazardous waste?
2. Why is it necessary to have criminal penalties for noncompliance with environmental laws?
3. What is the role of states in setting standards for clean air and clean water?
4. Which federal act sets up a “cradle-to-grave” system for handling waste?
5. Why are federal environmental laws necessary? Why not let the states exclusively govern in
the area of environmental protection?

[1] 42 United States Code, Section 4321 et seq.
[2] “The Tricks of the Trade-off,” Business Week, April 4, 1977, 72.
[3] 33 United States Code, Section 1251.
[4] Solid Waste Agency of Northern Cook County v. Army Corps of Engineers, 531 U.S. 159 (2001).
[5] Midlantic National Bank v. New Jersey, 474 U.S. 494 (1986).

11.6 Cases
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Reasonable Use Doctrine
Hoover v. Crane
362 Mich. 36, 106 N.W.2d 563 (1960)
EDWARDS, JUSTICE
This appeal represents a controversy between plaintiff cottage and resort owners on an inland
Michigan lake and defendant, a farmer with a fruit orchard, who was using the lake water for
irrigation. The chancellor who heard the matter ruled that defendant had a right to reasonable
use of lake water. The decree defined such reasonable use in terms which were unsatisfactory to
plaintiffs who have appealed.
The testimony taken before the chancellor pertained to the situation at Hutchins Lake, in
Allegan county, during the summer of 1958. Defendant is a fruit farmer who owns a 180-acre
farm abutting on the lake. Hutchins Lake has an area of 350 acres in a normal season. Seventyfive cottages and several farms, including defendant’s, abut on it. Defendant’s frontage is
approximately 1/4 mile, or about 10% of the frontage of the lake.
Hutchins Lake is spring fed. It has no inlet but does have an outlet which drains south.
Frequently in the summertime the water level falls so that the flow at the outlet ceases.
All witnesses agreed that the summer of 1958 was exceedingly dry and plaintiffs’ witnesses
testified that Hutchins Lake’s level was the lowest it had ever been in their memory. Early in
August, defendant began irrigation of his 50-acre pear orchard by pumping water out of
Hutchins Lake. During that month the lake level fell 6 to 8 inches—the water line receded 50 to
60 feet and cottagers experienced severe difficulties with boating and swimming.
***
The tenor of plaintiffs’ testimony was to attribute the 6- to 8-inch drop in the Hutchins Lake
level in that summer to defendant’s irrigation activities. Defendant contended that the decrease
was due to natural causes, that the irrigation was of great benefit to him and contributed only
slightly to plaintiff’s discomfiture. He suggests to us:
One could fairly say that because plaintiffs couldn’t grapple with the unknown causes that
admittedly occasioned a greater part of the injury complained of, they chose to grapple mightily
with the defendant because he is known and visible.
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The circuit judge found it impossible to determine a normal lake level from the testimony,
except that the normal summer level of the lake is lower than the level at which the lake ceases
to drain into the outlet. He apparently felt that plaintiffs’ problems were due much more to the
abnormal weather conditions of the summer of 1958 than to defendant’s irrigation activities.
His opinion concluded:
Accepting the reasonable use theory advanced by plaintiffs it appears to the court that the most
equitable disposition of this case would be to allow defendant to use water from the lake until
such time when his use interferes with the normal use of his neighbors. One quarter inch of
water from the lake ought not to interfere with the rights and uses of defendant’s neighbors and
this quantity of water ought to be sufficient in time of need to service 45 acres of pears. A meter
at the pump, sealed if need be, ought to be a sufficient safeguard. Pumping should not be
permitted between the hours of 11 p.m. and 7 a.m. Water need be metered only at such times as
there is no drainage into the outlet.
The decree in this suit may provide that the case be kept open for the submission of future
petitions and proofs as the conditions permit or require.
***
Michigan has adopted the reasonable-use rule in determining the conflicting rights of riparian
owners to the use of lake water.
In 1874, Justice COOLEY said:
It is therefore not a diminution in the quantity of the water alone, or an alteration in its flow, or
either or both of these circumstances combined with injury, that will give a right of action, if in
view of all the circumstances, and having regard to equality of right in others, that which has
been done and which causes the injury is not unreasonable. In other words, the injury that is
incidental to a reasonable enjoyment of the common right can demand no
redress. Dumont v. Kellogg, 29 Mich 420, 425.
And in People v. Hulbert, the Court said:
No statement can be made as to what is such reasonable use which will, without variation or
qualification, apply to the facts of every case. But in determining whether a use is reasonable we
must consider what the use is for; its extent, duration, necessity, and its application; the nature
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and size of the stream, and the several uses to which it is put; the extent of the injury to the one
proprietor and of the benefit to the other; and all other facts which may bear upon the
reasonableness of the use. Red River Roller Millsv. Wright, 30 Minn 249, 15 NW 167, and cases
cited.
The Michigan view is in general accord with 4 Restatement, Torts, §§ 851–853.
***
We interpret the circuit judge’s decree as affording defendant the total metered equivalent in
pumpage of 1/4 inch of the content of Hutchins Lake to be used in any dry period in between the
cessation of flow from the outlet and the date when such flow recommences. Where the decree
also provides for the case to be kept open for future petitions based on changed conditions, it
would seem to afford as much protection for plaintiffs as to the future as this record warrants.
Both resort use and agricultural use of the lake are entirely legitimate purposes. Neither serves
to remove water from the watershed. There is, however, no doubt that the irrigation use does
occasion some water loss due to increased evaporation and absorption. Indeed, extensive
irrigation might constitute a threat to the very existence of the lake in which all riparian owners
have a stake; and at some point the use of the water which causes loss must yield to the common
good.
The question on this appeal is, of course, whether the chancellor’s determination of this point
was unreasonable as to plaintiffs. On this record, we cannot overrule the circuit judge’s view that
most of plaintiffs’ 1958 plight was due to natural causes. Nor can we say, if this be the only
irrigation use intended and the only water diversion sought, that use of the amount provided in
the decree during the dry season is unreasonable in respect to other riparian owners.
Affirmed.

CASE QUESTIONS

1. If the defendant has caused a diminution in water flow, an alteration of the water flow, and
the plaintiff is adversely affected, why would the Supreme Court of Michigan not provide
some remedy?
2. Is it possible to define an injury that is “not unreasonable”?
3. Would the case even have been brought if there had not been a drought?

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Criminal Liability of Employees under RCRA
U.S. v. Johnson & Towers, Inc., Jack W. Hopkins, and Peter Angel
741 F.2d 662 (1984)
SLOVITER, Circuit Judge
Before us is the government’s appeal from the dismissal of three counts of an indictment
charging unlawful disposal of hazardous wastes under the Resource Conservation and Recovery
Act. In a question of first impression regarding the statutory definition of “person,” the district
court concluded that the Act’s criminal penalty provision imposing fines and imprisonment
could not apply to the individual defendants. We will reverse.
The criminal prosecution in this case arose from the disposal of chemicals at a plant owned by
Johnson & Towers in Mount Laurel, New Jersey. In its operations the company, which repairs
and overhauls large motor vehicles, uses degreasers and other industrial chemicals that contain
chemicals such as methylene chloride and trichlorethylene, classified as “hazardous wastes”
under the Resource Conservation and Recovery Act (RCRA), 42 U.S.C. §§ 6901–6987 (1982)
and “pollutants” under the Clean Water Act, 33 U.S.C. §§ 1251–1376 (1982). During the period
relevant here, the waste chemicals from cleaning operations were drained into a holding tank
and, when the tank was full, pumped into a trench. The trench flowed from the plant property
into Parker’s Creek, a tributary of the Delaware River. Under RCRA, generators of such wastes
must obtain a permit for disposal from the Environmental Protection Agency (E.P.A.). The
E.P.A. had neither issued nor received an application for a permit for Johnson & Towers’
operations.
The indictment named as defendants Johnson & Towers and two of its employees, Jack
Hopkins, a foreman, and Peter Angel, the service manager in the trucking department.
According to the indictment, over a three-day period federal agents saw workers pump waste
from the tank into the trench, and on the third day observed toxic chemicals flowing into the
creek.
Count 1 of the indictment charged all three defendants with conspiracy under 18 U.S.C. § 371
(1982). Counts 2, 3, and 4 alleged violations under the RCRA criminal provision, 42 U.S.C. §
6928(d) (1982). Count 5 alleged a violation of the criminal provision of the Clean Water Act, 33
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U.S.C. § 1319(c) (1982). Each substantive count also charged the individual defendants as aiders
and abettors under 18 U.S.C. § 2 (1982).
The counts under RCRA charged that the defendants “did knowingly treat, store, and dispose of,
and did cause to be treated, stored and disposed of hazardous wastes without having obtained a
permit…in that the defendants discharged, deposited, injected, dumped, spilled, leaked and
placed degreasers…into the trench.…” The indictment alleged that both Angel and Hopkins
“managed, supervised and directed a substantial portion of Johnson & Towers’
operations…including those related to the treatment, storage and disposal of the hazardous
wastes and pollutants” and that the chemicals were discharged by “the defendants and others at
their direction.” The indictment did not otherwise detail Hopkins’ and Angel’s activities or
responsibilities.
Johnson & Towers pled guilty to the RCRA counts. Hopkins and Angel pled not guilty, and then
moved to dismiss counts 2, 3, and 4. The court concluded that the RCRA criminal provision
applies only to “owners and operators,” i.e., those obligated under the statute to obtain a permit.
Since neither Hopkins nor Angel was an “owner” or “operator,” the district court granted the
motion as to the RCRA charges but held that the individuals could be liable on these three
counts under 18 U.S.C. § 2 for aiding and abetting. The court denied the government’s motion
for reconsideration, and the government appealed to this court under 18 U.S.C. § 3731 (1982).
***
The single issue in this appeal is whether the individual defendants are subject to prosecution
under RCRA’s criminal provision, which applies to:
any person who—
.…
(2) knowingly treats, stores, or disposes of any hazardous waste identified or listed under this
subchapter either—
(A) without having obtained a permit under section 6925 of this title…or
(B) in knowing violation of any material condition or requirement of such permit.
42 U.S.C. § 6928(d) (emphasis added). The permit provision in section 6925, referred to in
section 6928(d), requires “each person owning or operating a facility for the treatment, storage,
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or disposal of hazardous waste identified or listed under this subchapter to have a permit” from
the E.P.A.
The parties offer contrary interpretations of section 6928(d)(2)(A). Defendants consider it an
administrative enforcement mechanism, applying only to those who come within section 6925
and fail to comply; the government reads it as penalizing anyone who handles hazardous waste
without a permit or in violation of a permit. Neither party has cited another case, nor have we
found one, considering the application of this criminal provision to an individual other than an
owner or operator.
As in any statutory analysis, we are obliged first to look to the language and then, if needed,
attempt to divine Congress’ specific intent with respect to the issue.
First, “person” is defined in the statute as “an individual, trust, firm, joint stock company,
corporation (including a government corporation), partnership, association, State, municipality,
commission, political subdivision of a State, or any interstate body.” 42 U.S.C. § 6903(15)
(1982). Had Congress meant in section 6928(d)(2)(A) to take aim more narrowly, it could have
used more narrow language. Since it did not, we attribute to “any person” the definition given
the term in section 6903(15).
Second, under the plain language of the statute the only explicit basis for exoneration is the
existence of a permit covering the action. Nothing in the language of the statute suggests that we
should infer another provision exonerating persons who knowingly treat, store or dispose of
hazardous waste but are not owners or operators.
Finally, though the result may appear harsh, it is well established that criminal penalties
attached to regulatory statutes intended to protect public health, in contrast to statutes based on
common law crimes, are to be construed to effectuate the regulatory purpose.
***
Congress enacted RCRA in 1976 as a “cradle-to-grave” regulatory scheme for toxic materials,
providing “nationwide protection against the dangers of improper hazardous waste disposal.”
H.R. Rep. No. 1491, 94th Cong., 2d Sess. 11, reprinted in 1976 U.S. Code Cong. & Ad. News
6238, 6249. RCRA was enacted to provide “a multifaceted approach toward solving the
problems associated with the 3–4 billion tons of discarded materials generated each year, and
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the problems resulting from the anticipated 8% annual increase in the volume of such
waste.” Id. at 2, 1976 U.S. Code Cong. & Ad. News at 6239. The committee reports
accompanying legislative consideration of RCRA contain numerous statements evincing the
Congressional view that improper disposal of toxic materials was a serious national problem.
The original statute made knowing disposal (but not treatment or storage) of such waste without
a permit a misdemeanor. Amendments in 1978 and 1980 expanded the criminal provision to
cover treatment and storage and made violation of section 6928 a felony. The fact that Congress
amended the statute twice to broaden the scope of its substantive provisions and enhance the
penalty is a strong indication of Congress’ increasing concern about the seriousness of the
prohibited conduct.
We conclude that in RCRA, no less than in the Food and Drugs Act, Congress endeavored to
control hazards that, “in the circumstances of modern industrialism, are largely beyond selfprotection.” United States v. Dotterweich, 320 U.S. at 280. It would undercut the purposes of
the legislation to limit the class of potential defendants to owners and operators when others
also bear responsibility for handling regulated materials. The phrase “without having obtained a
permit under section 6925” (emphasis added) merely references the section under which the
permit is required and exempts from prosecution under section 6928(d)(2)(A) anyone who has
obtained a permit; we conclude that it has no other limiting effect. Therefore we reject the
district court’s construction limiting the substantive criminal provision by confining “any
person” in section 6928(d)(2)(A) to owners and operators of facilities that store, treat or dispose
of hazardous waste, as an unduly narrow view of both the statutory language and the
congressional intent.

CASE QUESTIONS

1. The district court (trial court) accepted the individual defendants’ argument. What was that
argument?
2. On what reasoning did the appellate court reject that argument?
3. If employees of a company that is violating the RCRA carry out disposal of hazardous
substances in violation of the RCRA, they would presumably lose their jobs if they didn’t.

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What is the moral justification for applying criminal penalties to such employees (such as
Hopkins and Angel)?

11.7 Summary and Exercises
Summary

An estate is an interest in real property; it is the degree to which a thing is owned. Freehold
estates are those with an uncertain duration; leaseholds are estates due to expire at a definite
time. A present estate is one that is currently owned; a future estate is one that is owned now but
not yet available for use.
Present estates are (1) the fee simple absolute; (2) the fee simple defeasible, which itself may be
divided into three types, and (3) the life estate.
Future estates are generally of two types: reversion and remainder. A reversion arises whenever
a transferred estate will endure for a shorter time than that originally owned by the transferor. A
remainder interest arises when the transferor gives the reversion interest to someone else.
Use of air, earth, and water are the major rights incident to ownership of real property.
Traditionally, the owner held “up to the sky” and “down to the depths,” but these rules have
been modified to balance competing rights in a modern economy. The law governing water
rights varies with the states; in general, the eastern states with more plentiful water have
adopted either the natural flow doctrine or the reasonable use doctrine of riparian rights, giving
those who live along a waterway certain rights to use the water. By contrast, western states have
tended to apply the prior appropriation doctrine, which holds that first in time is first in right,
even if those downstream are disadvantaged.
An easement is an interest in land—created by express agreement, prior use, or necessity—that
permits one person to make use of another’s estate. An affirmative easement gives one person
the right to use another’s land; a negative easement prevents the owner from using his land in a
way that will affect another person’s land. In understanding easement law, the important
distinctions are between easements appurtenant and in gross, and between dominant and
servient owners.
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The law not only defines the nature of the property interest but also regulates land use. Tort law
regulates land use by imposing liability for (1) activities that affect those off the land and (2)
injuries caused to people who enter it. The two most important theories relating to the former
are nuisance and trespass. With respect to the latter, the common law confusingly distinguishes
among trespassers, licensees, and invitees. Some states are moving away from the perplexing
and rigid rules of the past and simply require owners to maintain their property in a reasonably
safe condition.
Land use may also be regulated by private agreement through the restrictive covenant, an
agreement that “runs with the land” and that will be binding on any subsequent owner. Land use
is also regulated by the government’s power under eminent domain to take private land for
public purposes (upon payment of just compensation), through zoning laws, and through
recently enacted environmental statutes, including the National Environmental Policy Act and
laws governing air, water, treatment of hazardous wastes, and chemicals.

EXERCISES

1. Dorothy deeded an acre of real estate that she owns to George for the life of Benny and then
to Ernie. Describe the property interests of George, Benny, Ernie, and Dorothy.
2. In Exercise 1, assume that George moves into a house on the property. During a tornado, the
roof is destroyed and a window is smashed. Who is responsible for repairing the roof and
window? Why?
3. Dennis likes to spend his weekends in his backyard, shooting his rifle across his neighbor’s
yard. If Dennis never sets foot on his neighbor’s property, and if the bullets strike neither
persons nor property, has he violated the legal rights of the neighbor? Explain.
4. Dennis also drills an oil well in his backyard. He “slant drills” the well; that is, the well slants
from a point on the surface in his yard to a point four hundred feet beneath the surface of his
neighbor’s yard. Dennis has slanted the drilling in order to capture his neighbor’s oil. Can he
do this legally? Explain.
5. Wanda is in charge of acquisitions for her company. Realizing that water is important to
company operations, Wanda buys a plant site on a river, and the company builds a plant that

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uses all of the river water. Downstream owners bring suit to stop the company from using
any water. What is the result? Why?
6. Sunny decides to build a solar home. Before beginning construction, she wants to establish
the legal right to prevent her neighbors from constructing buildings that will block the
sunlight. She has heard that the law distinguishes between licenses and easements,
easements appurtenant and in gross, and affirmative and negative easements. Which of
these interests would you recommend for Sunny? Why?

SELF-TEST QUESTIONS

1. A freehold estate is defined as an estate
a.

with an uncertain duration
b. due to expire at a definite time
c. owned now but not yet available for use
d. that is leased or rented
A fee simple defeasible is a type of

a.

present estate
b. future estate
c. life estate
d. leasehold estate
A reversion is

a.

a present estate that prevents transfer of land out of the family
b. a form of life estate
c. a future estate that arises when the estate transferred has a duration less than
that originally owned by the transferor
d. identical to a remainder interest
An easement is an interest in land that may be created by
a.

express agreement

b. prior use
c. necessity
d. all of the above

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The prior appropriation doctrine
a.

tends to be applied by eastern states

b. holds that first in time is first in right
c. gives those that live along a waterway special rights to use the water
d. all of the above

SELF-TEST ANSWERS

1. a
2. a
3. c
4. d
5. b

Chapter 12
The Transfer of Real Estate by Sale
LEARNING OBJECTIVES

After reading this chapter, you should understand the following:
1. The various forms of real estate ownership, including fee simple, tenancy in common, and
joint tenancy
2. The mechanics of finding, financing, and closing a real estate transaction
3. How adverse possession may sometimes vest title in real property despite the nonconsent of
the owner
This chapter follows the steps taken when real estate is transferred by sale.
1. The buyer selects a form of ownership.
2. The buyer searches for the real estate to be purchased. In doing so, the buyer will usually deal
with real estate brokers.
3. After a parcel is selected, the seller and buyer will negotiate and sign a sales agreement.
4. The seller will normally be required to provide proof of title.
5. The buyer will acquire property insurance.
6. The buyer will arrange financing.
7. The sale and purchase will be completed at a closing.
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During this process, the buyer and seller enter into a series of contracts with each other and with
third parties such as brokers, lenders, and insurance companies. In this chapter, we focus on the
unique features of these contracts, with the exception of mortgages (Chapter 17 "Mortgages and
Nonconsensual Liens") and property insurance (Chapter 15 "Insurance"). We conclude by briefly
examining adverse possession—a method of acquiring property for free.

12.1 Forms of Ownership

LEARNING OBJECTIVES

1. Be familiar with the various kinds of interest in real property.
2. Know the ways that two or more people can own property together.
3. Understand the effect of marriage, divorce, and death on various forms of property
ownership.

Overview
The transfer of property begins with the buyer’s selection of a form of ownership. Our emphasis
here is not on what is being acquired (the type of property interest) but on how the property is
owned.
One form of ownership of real property is legally quite simple, although lawyers refer to it with a
complicated-sounding name. This is ownership by one individual, known as ownership
in severalty. In purchasing real estate, however, buyers frequently complicate matters by
grouping together—because of marriage, close friendship, or simply in order to finance the
purchase more easily
When purchasers group together for investment purposes, they often use various forms of
organization—corporations, partnerships, limited partnerships, joint ventures, and business
trusts. The most popular of these forms of organization for owning real estate is the limited
partnership. A real estate limited partnership is designed to allow investors to take substantial
deductions that offset current income from the partnership and other similar investments, while
at the same time protecting the investor from personal liability if the venture fails.

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But you do not have to form a limited partnership or other type of business in order to acquire
property with others; many other forms are available for personal or investment purposes. To
these we now turn.

Joint Tenancy
Joint tenancy is an estate in land owned by two or more persons. It is distinguished chiefly by
the right of survivorship. If two people own land as joint tenants, then either becomes the sole
owner when the other dies. For land to be owned jointly, four unities must coexist:
1. Unity of time. The interests of the joint owners must begin at the same time.
2. Unity of title. The joint tenants must acquire their title in the same conveyance—that is, the
same will or deed.
3. Unity of interest. Each owner must have the same interest in the property; for example, one may
not hold a life estate and the other the remainder interest.
4. Unity of possession. All parties must have an equal right to possession of the property
(see Figure 12.1 "Forms of Ownership and Unities").

Figure 12.1 Forms of Ownership and Unities

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Suppose a woman owns some property and upon marriage wishes to own it jointly with her
husband. She deeds it to herself and her husband “as joint tenants and not tenants in common.”
Strictly speaking, the common law would deny that the resulting form of ownership was joint
because the unities of title and time were missing. The wife owned the property first and
originally acquired title under a different conveyance. But the modern view in most states is that
an owner may convey directly to herself and another in order to create a joint estate.
When one or more of the unities is destroyed, however, the joint tenancy lapses. Fritz and Gary
own a farm as joint tenants. Fritz decides to sell his interest to Jesse (or, because Fritz has gone
bankrupt, the sheriff auctions off his interest at a foreclosure sale). Jesse and Gary would hold as
tenants in common and not as joint tenants. Suppose Fritz had made out his will, leaving his
interest in the farm to Reuben. On Fritz’s death, would the unities be destroyed, leaving Gary
and Reuben as tenants in common? No, because Gary, as joint tenant, would own the entire
farm on Fritz’s death, leaving nothing behind for Reuben to inherit.

Tenancy by the Entirety
About half the states permit husbands and wives to hold property astenants by the entirety. This
form of ownership is similar to joint tenancy, except that it is restricted to husbands and wives.
This is sometimes described as the unity of person. In most of the states permitting tenancy by
the entirety, acquisition by husband and wife of property as joint tenants automatically becomes
a tenancy by the entirety. The fundamental importance of tenancy by the entirety is that neither
spouse individually can terminate it; only a joint decision to do so will be effective. One spouse
alone cannot sell or lease an interest in such property without consent of the other, and in many
states a creditor of one spouse cannot seize the individual’s separate interest in the property,
because the interest is indivisible.

Tenancy in Common
Two or more people can hold property as tenants in common when the unity of possession is
present, that is, when each is entitled to occupy the property. None of the other unities—of time,
title, or interest—is necessary, though their existence does not impair the common ownership.
Note that the tenants in common do not own a specific portion of the real estate; each has an
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undivided share in the whole, and each is entitled to occupy the whole estate. One tenant in
common may sell, lease, or mortgage his undivided interest. When a tenant in common dies, his
interest in the property passes to his heirs, not to the surviving tenants in common.
Because tenancy in common does not require a unity of interest, it has become a popular form of
“mingling,” by which unrelated people pool their resources to purchase a home. If they were
joint tenants, each would be entitled to an equal share in the home, regardless of how much each
contributed, and the survivor would become sole owner when the other owner dies. But with a
tenancy-in-common arrangement, each can own a share in proportion to the amount invested.

Community Property
In ten states—Alaska, Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas,
Washington, and Wisconsin—property acquired during a marriage is said to
becommunity property. There are differences among these states, but the general theory is that
with certain exceptions, each spouse has an undivided equal interest in property acquired while
the husband and wife are married to each other. The major exception is for property acquired by
gift or inheritance during the marriage. (By definition, property owned by either spouse before
the marriage is not community property.) Property acquired by gift of inheritance or owned
before the marriage is known as separate property. Community property states recognize other
forms of ownership; specifically, husbands and wives may hold property as joint tenants,
permitting the survivor to own the whole.
The consequence of community property laws is that either the husband or the wife may manage
the community property, borrow against it, and dispose of community personal property.
Community real estate may only be sold or encumbered by both jointly. Each spouse may
bequeath only half the community property in his or her will. In the absence of a will, the onehalf property interest will pass in accordance with the laws of intestate succession. If the couple
divorces, the states generally provide for an equal or near-equal division of the community
property, although a few permit the court in its discretion to divide in a different proportion.

Condominiums
In popular parlance, a condominium is a kind of apartment building, but that is not its technical
legal meaning. Condominium is a form of ownership, not a form of structure, and it can even
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apply to space—for example, to parking spaces in a garage. The wordcondominium means joint
ownership or control, and it has long been used whenever land has been particularly scarce or
expensive. Condominiums were popular in ancient Rome (especially near the Forum) and in the
walled cities of medieval Europe.
In its modern usage, condominium refers to a form of housing involving two elements of
ownership. The first is the living space itself, which may be held in common, in joint tenancy, or
in any other form of ownership. The second is the common space in the building, including the
roof, land under the structure, hallways, swimming pool, and the like. The common space is held
by all purchasers as tenants in common. The living space may not be sold apart from the interest
in the common space.
Two documents are necessary in a condominium sale—the master deed and the bylaws. The
master deed (1) describes the condominium units, the common areas, and any restrictions that
apply to them; (2) establishes the unit owner’s interest in the common area, his number of votes
at owners’ association meetings, and his share of maintenance and operating expenses
(sometimes unit owners have equal shares, and sometimes their share is determined by
computing the ratio of living area or market price or original price of a single unit to the whole);
and (3) creates a board of directors to administer the affairs of the whole condominium. The
bylaws usually establish the owners’ association, set out voting procedures, list the powers and
duties of the officers, and state the obligations of the owners for the use of the units and the
common areas.

Cooperatives
Another popular form of owning living quarters with common areas is the cooperative. Unlike
the person who lives in a condominium, the tenant of a cooperative does not own a particular
unit. Instead, he owns a share of the entire building. Since the building is usually owned by a
corporation (a cooperative corporation, hence the name), this means that the tenant owns stock
in the corporation. A tenant occupies a unit under a lease from the corporation. Together, the
lease and stock in the building corporation are considered personal, not real, property.
In a condominium, an owner of a unit who defaults in paying monthly mortgage bills can face
foreclosure on the unit, but neighbors in the building suffer no direct financial impact, except
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that the defaulter probably has not paid monthly maintenance charges either. In a cooperative,
however, a tenant who fails to pay monthly charges can jeopardize the entire building, because
the mortgage is on the building as a whole; consequently, the others will be required to make
good the payments or face foreclosure.

Time-Shares
A time-share is an arrangement by which several people can own the same property while being
entitled to occupy the premises exclusively at different times on a recurring basis. In the typical
vacation property, each owner has the exclusive right to use the apartment unit or cottage for a
specified period of time each year—for example, Mr. and Mrs. Smith may have possession from
December 15 through December 22, Mr. and Mrs. Jones from December 23 through December
30, and so on. The property is usually owned as a condominium but need not be. The sharers
may own the property in fee simple, hold a joint lease, or even belong to a vacation club that
sells time in the unit.
Time-share resorts have become popular in recent years. But the lure of big money has brought
unscrupulous contractors and salespersons into the market. Sales practices can be unusually
coercive, and as a result, most states have sets of laws specifically to regulate time-share sales.
Almost all states provide a cooling-off period, or rescission period; these periods vary from state
to state and provide a window where buyers can change their minds without forfeiting payments
or deposits already made.

KEY TAKEAWAY

Property is sometimes owned by one person or one entity, but more often two or more
persons will share in the ownership. Various forms of joint ownership are possible, including
joint tenancies, tenancy by the entirety, and tenancy in common. Married persons should be
aware of whether the state they live in is a community property state; if it is, the spouse will
take some interest in any property acquired during the marriage. Beyond traditional
landholdings, modern real estate ownership may include interests in condominiums,
cooperatives, or time-shares.

EXERCISES

1. Miguel and Maria Ramirez own property in Albuquerque, New Mexico, as tenants by the
entirety. Miguel is a named defendant in a lawsuit that alleges defamation, and an award is
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made for $245,000 against Miguel. The property he owns with Maria is worth $320,000 and
is owned free of any mortgage interest. To what extent can the successful plaintiff recover
damages by forcing a sale of the property?
2. Miguel and Maria Ramirez own property in Albuquerque, New Mexico, as tenants by the
entirety. They divorce. At the time of the divorce, there are no new deeds signed or
recorded. Are they now tenants in common or joint tenants?

12.2 Brokers, Contracts, Proof of Title, and Closing
LEARNING OBJECTIVES

1. Know the duties of the real estate broker and how brokers are licensed.
2. Be able to discuss the impact of constitutonal and statutory law on real estate sellers and
brokers.
3. Describe the various kinds of listing contracts and their import.
4. Know the elements of a sales agreement and the various types of deeds to real estate.
5. Understand the closing process and how “good title” is obtained through the title search and
insurance process.
Once the buyer (or buyers) knows what form of ownership is most desirable, the search for a
suitable property can begin. This search often involves contact with a broker hired by the seller.
The seller’s contract with the broker, known as the listing agreement, is the first of the series of
contracts in a typical real estate transaction. As you consider these contracts, it is important to
keep in mind that despite the size of the transaction and the dire financial consequences should
anything go awry, the typical person (buyer or seller) usually acts as his or her own attorney. An
American Bar Association committee has noted the following:
It is probably safe to say that in a high percentage of cases the seller is unrepresented and signs
the contracts of brokerage and sale on the basis of his faith in the broker. The buyer does not
employ a lawyer. He signs the contract of sale without reading it and, once financing has been
obtained, leaves all the details of title search and closing to the lender or broker. The lender or
broker may employ an attorney but, where title insurance is furnished by a company
maintaining its own title plant, it is possible that no lawyer, not even house counsel, will appear.
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This being so, the material that follows is especially important for buyers and sellers who are not
represented in the process of buying or selling real estate.

Regulation of the Real Estate Business
State Licensing
Real estate brokers, and the search for real estate generally, are subject to state and federal
government regulation. Every state requires real estate brokers to be licensed. To obtain a
license, the broker must pass an examination covering the principles of real estate practice,
transactions, and instruments. Many states additionally insist that the broker take several
courses in finance, appraisal, law, and real estate practice and apprentice for two years as a
salesperson in a real estate broker’s office.

Civil Rights Act
Two federal civil rights laws also play an important role in the modern real estate transaction.
These are the Civil Rights Act of 1866 and the Civil Rights Act of 1968 (Fair Housing Act).
In Jones v. Alfred H. Mayer Co., [1] the Supreme Court upheld the constitutionality of the 1866
law, which expressly gives all citizens of the United States the same rights to inherit, purchase,
lease, sell, hold, and convey real and personal property. A minority buyer or renter who is
discriminated against may sue for relief in federal court, which may award damages, stop the
sale of the house, or even direct the seller to convey the property to the plaintiff.
The 1968 Fair Housing Act prohibits discrimination on the grounds of race, color, religion, sex,
national origin, handicap, or family status (i.e., no discrimination against families with children)
by any one of several means, including the following:
1. Refusing to sell or rent to or negotiate with any person
2. Discriminating in the terms of sale or renting
3. Discriminating in advertising
4. Denying that the housing is available when in fact it is
5. “Blockbusting” (panicking owners into selling or renting by telling them that minority groups
are moving into the neighborhood)
6. Creating different terms for granting or denying home loans by commercial lenders
7. Denying anyone the use of real estate services
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However, the 1968 act contains several exemptions:
1. Sale or rental of a single-family house if the seller
a.

owns less than four such houses,

b. does not use a broker,
c. does not use discriminatory advertising,
d. within two years sells no more than one house in which the seller was not the most recent
occupant.
e. Rentals in a building occupied by the owner as long as it houses fewer than five families and the
owner did not use discriminatory advertising
f.

Sale or rental of space in buildings or land restricted by religious organization owners to people
of the same religion (assuming that the religion does not discriminate on the basis of race, color,
or national origin)

g. Private clubs, if they limit their noncommercial rentals to members
The net impact of these laws is that discrimination based on color or race is flatly prohibited and
that other types of discrimination are also barred unless one of the enumerated exemptions
applies.

Hiring the Broker: The Listing Agreement
When the seller hires a real estate broker, he will sign a listing agreement. (In several states, the
Statute of Frauds says that the seller must sign a written agreement; however, he should do so in
all states in order to provide evidence in the event of a later dispute.) This listing agreement sets
forth the broker’s commission, her duties, the length of time she will serve as broker, and other
terms of her agency relationship. Whether the seller will owe a commission if he or someone
other than the broker finds a buyer depends on which of three types of listing agreements has
been signed.

Exclusive Right to Sell
If the seller agrees to an exclusive-right-to-sell agency, he will owe the broker the stated
commission regardless of who finds the buyer. Language such as the following gives the broker
an exclusive right to sell: “Should the seller or anyone acting for the seller (including his heirs)
sell, lease, transfer, or otherwise dispose of the property within the time fixed for the
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continuance of the agency, the broker shall be entitled nevertheless to the commission as set out
herein.”

Exclusive Agency
Somewhat less onerous from the seller’s perspective (and less generous from the broker’s
perspective) is the exclusive agency. The broker has the exclusive right to sell and will be entitled
to the commission if anyone other than the seller finds the buyer (i.e., the seller will owe no
commission if he finds a buyer). Here is language that creates an exclusive agency: “A
commission is to be paid the broker whether the purchaser is secured by the broker or by any
person other than the seller.”

Open Listing
The third type of listing, relatively rarely used, is the open listing, which authorizes “the broker
to act as agent in securing a purchaser for my property.” The open listing calls for payment to
the broker only if the broker was instrumental in finding the buyer; the broker is not entitled to
her commission if anyone else, seller or otherwise, locates the buyer.
Suppose the broker finds a buyer, but the seller refuses at that point to sell. May the seller
simply change his mind and avoid having to pay the broker’s commission? The usual rule is that
when a broker finds a buyer who is “ready, willing, and able” to purchase or lease the property,
she has earned her commission. Many courts have interpreted this to mean that even if the
buyers are unable to obtain financing, the commission is owed nevertheless once the prospective
buyers have signed a purchase agreement. To avoid this result, the seller should insist on either
a “no deal, no commission” clause in the listing agreement (entitling the broker to payment only
if the sale is actually consummated) or a clause in the purchase agreement making the purchase
itself contingent on the buyer’s finding financing.

Broker’s Duties
Once the listing agreement has been signed, the broker becomes the seller’s agent—or, as
occasionally happens, the buyer’s agent, if hired by the buyer. A broker is not a general agent
with broad authority. Rather, a broker is a special agent with authority only to show the property
to potential buyers. Unless expressly authorized, a broker may not accept money on behalf of the
seller from a prospective buyer. Suppose Eunice hires Pete’s Realty to sell her house. They sign a
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standard exclusive agency listing, and Pete cajoles Frank into buying the house. Frank writes out
a check for $10,000 as a down payment and offers it to Pete, who absconds with the money.
Who must bear the loss? Ordinarily, Frank would have to bear the loss, because Pete was given
no authority to accept money. If the listing agreement explicitly said that Pete could accept the
down payment from a buyer, then the loss would fall on Eunice.
Although the broker is but a special agent, she owes the seller, her principal, afiduciary duty. A
fiduciary duty is a duty of the highest loyalty and trust. It means that the broker cannot buy the
property for herself through an intermediary without full disclosure to the seller of her
intentions. Nor may the broker secretly receive a commission from the buyer or suggest to a
prospective buyer that the property can be purchased for less than the asking price.

The Sales Agreement
Once the buyer has selected the real estate to be acquired, an agreement of sale will be
negotiated and signed. Contract law in general is discussed in Chapter 8 "Contracts"; our
discussion here will focus on specific aspects of the real estate contract. The Statute of Frauds
requires that contracts for sale of real estate must be in writing. The writing must contain
certain information.

Names of Buyers and Sellers
The agreement must contain the names of the buyers and sellers. As long as the parties sign the
agreement, however, it is not necessary for the names of buyers and sellers to be included within
the body of the agreement.

Real Estate Description
The property must be described sufficiently for a court to identify the property without having to
look for evidence outside the agreement. The proper address, including street, city, and state, is
usually sufficient.

Price
The price terms must be clear enough for a court to enforce. A specific cash price is always clear
enough. But a problem can arise when installment payments are to be made. To say “$50,000,
payable monthly for fifteen years at 12 percent” is not sufficiently detailed, because it is

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impossible to determine whether the installments are to be equal each month or are to be equal
principal payments with varying interest payments, declining monthly as the balance decreases.

Signature
As a matter of prudence, both buyer and seller should sign the purchase agreement. However,
the Statute of Frauds requires only the signature of the party against whom the agreement is to
be enforced. So if the seller has signed the agreement, he cannot avoid the agreement on the
grounds that the buyer has not signed it. However, if the buyer, not having signed, refuses to go
to closing and take title, the seller would be unable to enforce the agreement against him.

Easements and Restrictive Covenants
Unless the contract specifically states otherwise, the seller must delivermarketable title. A
marketable title is one that is clear of restrictions to which a reasonable buyer would object.
Most buyers would refuse to close the deal if there were potential third-party claims to all or part
of the title. But a buyer would be unreasonable if, at closing, he refused to consummate the
transaction on the basis that there were utility easements for the power company or a known
and visible driveway easement that served the neighboring property. As a precaution, a seller
must be sure to say in the contract for sale that the property is being sold “subject to easements
and restrictions of record.” A buyer who sees only such language should insist that the particular
easements and restrictive covenants be spelled out in the agreement before he signs.

Risk of Loss
Suppose the house burns down after the contract is signed but before the closing. Who bears the
loss? Once the contract is signed, most states apply the rule of equitable conversion, under
which the buyer’s interest (his executory right to enforce the contract to take title to the
property) is regarded as real property, and the seller’s interest is regarded as personal property.
The rule of equitable conversion stems from an old maxim of the equity courts: “That which
ought to be done is regarded as done.” That is, the buyer ought to have the property and the
seller ought to have the money. A practical consequence of this rule is that the loss of the
property falls on the buyer. Because most buyers do not purchase insurance until they take title,
eleven states have adopted the Uniform Vendor and Purchaser Risk Act, which reverses the
equitable conversion rule and places risk of loss on the seller. The parties may themselves
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reverse the application of the rule; the buyer should always insist on a clause in a contract
stating that risk of loss remains with the seller until a specified date, such as the closing.

Earnest Money
As protection against the buyer’s default, the seller usually insists on a down payment known as
earnest money. This is intended to cover such immediate expenses as proof of marketable title
and the broker’s commission. If the buyer defaults, he forfeits the earnest money, even if the
contract does not explicitly say so.

Contingencies
Performance of most real estate contracts is subject to various contingencies—that is, it is
conditioned on the happening of certain events. For example, the buyer might wish to condition
his agreement to buy the house on his ability to find a mortgage or to find one at a certain rate of
interest. Thus the contract for sale might read that the buyer “agrees to buy the premises for
$50,000, subject to his obtaining a $40,000 mortgage at 5 percent.” The person protected by
the contingency may waive it; if the lowest interest rate the buyer could find was 5.5 percent, he
could either refuse to buy the house or waive the condition and buy it anyway.

Times for Performance
A frequent difficulty in contracting to purchase real estate is the length of time it takes to receive
an acceptance to an offer. If the acceptance is not received in a reasonable time, the offeror may
treat the offer as rejected. To avoid the uncertainty, an offeror should always state in his offer
that it will be held open for a definite period of time (five working days, two weeks, or whatever).
The contract also ought to spell out the times by which the following should be done: (1) seller’s
proof that he has title, (2) buyer’s review of the evidence of title, (3) seller’s correction of title
defects, (4) closing date, and (5) possession by the buyer. The absence of explicit time provisions
will not render the contract unenforceable—the courts will infer a reasonable time—but their
absence creates the possibility of unnecessary disputes.

Types of Deeds
Most real estate transactions involve two kinds of deeds, the general warranty deed and the
quitclaim deed.

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1. General warranty deed. In a warranty deed, the seller warrants to the buyer that he
possesses certain types of legal rights in the property. In thegeneral warranty deed, the seller
warrants that (a) he has good title to convey, (b) the property is free from any encumbrance not
stated in the deed (the warranty against encumbrances), and (c) the property will not be taken
by someone with a better title (the warranty of quiet enjoyment). Breach of any of these
warranties exposes the seller to damages.
2. Quitclaim deed. The simplest form of deed is the quitclaim deed, in which the seller makes no
warranties. Instead, he simply transfers to the buyer whatever title he had, defects and all. A
quitclaim deed should not be used in the ordinary purchase and sale transaction. It is usually
reserved for removing a cloud on the title—for instance, a quitclaim deed by a widow who might
have a dower interest in the property.
If the purchase agreement is silent about the type of deed, courts in many states will require the
seller to give the buyer a quitclaim deed. In the contract, the buyer should therefore specify that
the seller is to provide a warranty deed at closing.
When buyers move in after the closing, they frequently discover defects (the boiler is broken, a
pipe leaks, the electrical power is inadequate). To obtain recourse against such an eventuality,
the buyer could attempt to negotiate a clause in the contract under which the seller gives a
warranty covering named defects. However, even without an express warranty, the law implies
two warranties when a buyer purchases a new house from a builder. These are warranties that
(1) the house is habitable and (2) the builder has completed the house in a workmanlike manner.
Most states have refused to extend these warranties to subsequent purchasers—for example, to
the buyer from a seller who had bought from the original builder. However, a few states have
begun to provide limited protection to subsequent purchasers—in particular, for defects that a
reasonable inspection will not reveal but that will show up only after purchase.

Proof of Title
Contracts are often formed and performed simultaneously, but in real estate transactions there
is more often a gap between contract formation and performance (the closing). The reason is
simple: the buyer must have time to obtain financing and to determine whether the seller has
marketable title. That is not always easy; at least, it is not as straightforward as looking at a piece
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of paper. To understand how title relates to the real estate transaction, some background on
recording statutes will be useful.

Recording Statutes
Suppose Slippery Sam owned Whispering Pines, a choice resort hotel on Torch Lake. On
October 1, Slippery deeded Whispering Pines to Lorna for $1,575,000. Realizing the profit
potential, Slippery decided to sell it again, and did so on November 1, without bothering to tell
Malvina, the new buyer to whom he gave a new deed, that he had already sold it to Lorna. He
then departed for a long sailing trip to the British Virgin Islands.
When Malvina arrives on the doorstep to find Lorna already tidying up, who should prevail? At
common law, the first deed prevailed over subsequent deeds. So in our simple example, if this
were a pure common-law state, Lorna would have title and Malvina would be out of luck, stuck
with a worthless piece of paper. Her only recourse, probably futile, would be to search out and
sue Slippery Sam for fraud. Most states, however, have enacted recording statutes, which award
title to the person who has complied with the requirement to place the deed in a publicly
available file in a public office in the county, often called the recorder’s office or the register of
deeds.

Notice Statute
Under the most common type of recording statute, called a notice statute, a deed must be
recorded in order for the owner to prevail against a subsequent purchaser. Assume in our
example that Lorna recorded her deed on November 2 and that Malvina recorded on November
4. In a notice-statute state, Malvina’s claim to title would prevail over Lorna’s because on the
day that Malvina received title (November 1), Lorna had not yet recorded. For this rule to apply,
Malvina must have been a bona fide purchaser, meaning that she must have (1) paid valuable
consideration, (2) bought in good faith, and (3) had no notice of the earlier sale. If Lorna had
recorded before Malvina took the deed, Lorna would prevail if Malvina did not in fact check the
public records; she should have checked, and the recorded deed is said to put subsequent
purchasers onconstructive notice.

Notice-Race Statute

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Another common type of recording statute is the notice-race statute. To gain priority under this
statute, the subsequent bona fide purchaser must also record—that is, win the race to the
recorder’s office before the earlier purchaser. So in our example, in a notice-race jurisdiction,
Lorna would prevail, since she recorded before Malvina did.

Race Statute
A third, more uncommon type is the race statute, which gives title to whoever records first, even
if the subsequent purchaser is not bona fide and has actual knowledge of the prior sale. Suppose
that when she received the deed, Malvina knew of the earlier sale to Lorna. Malvina got to the
recording office the day she got the deed, November 1, and Lorna came in the following day. In a
race-statute jurisdiction, Malvina would take title.

Chain of Title
Given the recording statutes, the buyer must check the deed on record to determine (1) whether
the seller ever acquired a valid deed to the property—that is, whether a chain of title can be
traced from earlier owners to the seller—and (2) whether the seller has already sold the property
to another purchaser, who has recorded a deed. There are any number of potential “clouds” on
the title that would defeat a fee simple conveyance: among others, there are potential
judgments, liens, mortgages, and easements that might affect the value of the property. There
are two ways to protect the buyer: the abstract of title and opinion, and title insurance.

Abstract and Opinion
An abstract of title is a summary of the chain of title, listing all previous deeds, mortgages, tax
liens, and other instruments recorded in the county land records office. The abstract is prepared
by either an attorney or a title company. Since the list itself says nothing about whether the
recorded instruments are legally valid, the buyer must also have the opinion of an attorney
reviewing the abstract, or must determine by doing his own search of the public records, that the
seller has valid title. The attorney’s opinion is known as a title opinion or certificate of title. The
problem with this method of proving title is that the public records do not reveal hidden defects.
One of the previous owners might have been a minor or an incompetent person who can still
void his sale, or a previous deed might have been forged, or a previous seller might have claimed

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to be single when in fact he was married and his wife failed to sign away her dower rights. A
search of the records would not detect these infirmities.

Title Insurance
To overcome these difficulties, the buyer should obtain title insurance. This is a one-premium
policy issued by a title insurance company after a search through the same public records. When
the title company is satisfied that title is valid, it will issue the insurance policy for a premium
that could be as high as 1 percent of the selling price. When the buyer is taking out a mortgage,
he will ordinarily purchase two policies, one to cover his investment in the property and the
other to cover the mortgagee lender’s loan. In general, a title policy protects the buyer against
losses that would occur if title (1) turns out to belong to someone else; (2) is subject to a lien,
encumbrance, or other defect; or (3) does not give the owner access to the land. A preferred type
of title policy will also insure the buyer against losses resulting from an unmarketable title.
Note that in determining whether to issue a policy, the title company goes through the process of
searching through the public records again. The title policy as such does not guarantee that title
is sound. A buyer could conceivably lose part or all of the property someday to a previous
rightful owner, but if he does, the title insurance company must reimburse him for his losses.
Although title insurance is usually a sound protection, most policies are subject to various
exclusions and exceptions. For example, they do not provide coverage for zoning laws that
restrict use of the property or for a government’s taking of the property under its power of
eminent domain. Nor do the policies insure against defects created by the insured or known by
the insured but unknown to the company. Some companies will not provide coverage for
mechanics’ liens, public utility easements, and unpaid taxes. (If the accrued taxes are known, the
insured will be presented with a list, and if he pays them on or before the closing, they will be
covered by the final policy.) Furthermore, as demonstrated in Title and Trust Co. of Florida v.
Barrows, (seeSection 12.4.1 "Title Insurance"), title insurance covers title defects only, not
physical defects in the property.

The Closing
Closing can be a confusing process because in most instances several contracts are being
performed simultaneously:
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1. The seller and purchaser are performing the sales contract.
2. The seller is paying off a mortgage, while the buyer is completing arrangements to borrow
money and mortgage the property.
3. Title and other insurance arrangements will be completed.
4. The seller will pay the broker.
5. If buyer and seller are represented, attorneys for each party will be paid.
Figure 12.2 Closing Process

Despite all these transactions, the critical players are the seller, the purchaser, and the bank. To
place the closing process in perspective, assume that one bank holds the existing (seller’s)
mortgage on the property and is also financing the buyer’s purchase. We can visualize the three
main players sitting at a table, ready to close the transaction. The key documents and the money
will flow as illustrated in Figure 12.2 "Closing Process".

Form of the Deed
The deed must satisfy two fundamental legal requirements: it must be in the proper form, and
there must be a valid delivery. Deeds are usually prepared by attorneys, who must include not
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only information necessary for a valid deed but also information required in order to be able to
record the deed. The following information is typically required either for a valid deed or by the
recording statutes.

Grantor
The grantor—the person who is conveying the property—must be designated in some manner.
Obviously, it is best to give the grantor’s full name, but it is sufficient that the person or persons
conveying the deed are identifiable from the document. Thus “the heirs of Lockewood Filmer” is
sufficient identification if each of the heirs signs the deed.

Grantee
Similarly, the deed should identify the grantee—the person to whom the property is being
conveyed. It does not void the deed to misspell a person’s name or to omit part of a name, or
even to omit the name of one of the grantees (as in “Lockewood Filmer and wife”). Although not
technically necessary, the deed ought to detail the interests being conveyed to each grantee in
order to avoid considerable legal difficulty later. “To Francis Lucas, a single man, and Joseph
Lucas and Matilda Lucas, his wife” was a deed of unusual ambiguity. Did each party have a onethird interest? Or did Joseph and Matilda hold half as tenants by the entirety and Francis have a
one-half interest as a tenant in common? Or perhaps Francis had a one-third interest as a tenant
in common and Joseph and Matilda held two-thirds as tenants by the entirety? Or was there
some other possible combination? The court chose the second interpretation, but considerable
time and money could have been saved had the deed contained a few simple words of
explanation. [2]

Addresses
Addresses of the parties should be included, although their absence will not usually invalidate
the deed. However, in some states, failure to note the addresses will bar the deed from being
recorded.

Words of Conveyance
The deed must indicate that the grantor presently intends to convey his interest in the property
to the grantee. The deed may recite that the grantor “conveys and warrants” the property

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(warranty deed) or “conveys and quitclaims” the property (quitclaim deed). Some deeds use the
words “bargain and sell” in place of convey.

Description
The deed must contain an accurate description of the land being conveyed, a description clear
enough that the land can be identified without resorting to other evidence. Four general
methods are used.
1. The US government survey. This is available west of the Mississippi (except in Texas) and in
Alabama, Florida, Illinois, Indiana, Michigan, Mississippi, Ohio, and Wisconsin. With this
survey, it is possible to specify with considerable exactitude any particular plot of land in any
township in these states.
2. Metes and bounds. The description of metes and bounds begins with a particular designated
point (called a monument)—for example, a drainpipe, an old oak tree, a persimmon stump—and
then defines the boundary with distances and angles until returning to the monument. As you
can tell, using monuments that are biological (like trees and stumps) will have a limited utility as
time goes on. Most surveyors put in stakes (iron pins), and the metes and bounds description
will go from points where stakes have been put in the ground.
3. Plats. Many land areas have been divided into numbered lots and placed on a map called a plat.
The plats are recorded. The deed, then, need only refer to the plat and lot number—for example,
“Lot 17, Appledale Subdivision, record in Liber 2 of Plats, page 62, Choctaw County Records.”
4. Informal description. If none of the preceding methods can be used, an informal description,
done precisely enough, might suffice. For instance, “my home at 31 Fernwood Street,
Maplewood, Idaho” would probably pass muster.

Statement of Consideration
Statutes usually require that some consideration be stated in the deed, even though a grantor
may convey property as a gift. When there is a selling price, it is easy enough to state it, although
the actual price need not be listed. When land is being transferred as a gift, a statement of
nominal consideration—for example, one dollar—is sufficient.

Date
Dates are customary, but deeds without dates will be enforced.
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Execution
The deed must be signed by the grantor and, in some states, witnesses, and these signatures
must be acknowledged by a notary public in order to make the deed eligible for recording. If
someone is signing for the grantor under a power of attorney, a written instrument authorizing
one person to sign for another, the instrument must be recorded along with the deed.

Delivery
To validly convey title to the property, the deed must not only be in proper form but also be
delivered. This technical legal requirement is sometimes misunderstood. Deliveryentails (1)
physical delivery to the grantee, (2) an intention by the grantor to convey title, and (3)
acceptance of title by the grantee. Because the grantor must intend to convey title, failure to
meet the other two elements during the grantor’s lifetime will void title on his death (since at
that point he of course cannot have an intention). Thus when a grantee is unaware of the
grantor’s intention to deed the property to him, an executed deed sitting in a safe-deposit box
will be invalid if discovered after the grantor’s death.

Delivery to Grantee
If the deed is physically delivered to the grantee or recorded, there is a rebuttable presumption
that legal delivery has been made. That is, the law presumes, in the absence of evidence to the
contrary, that all three conditions have been met if delivery or recording takes place. But this
presumption can be rebutted, as shown in Havens v. Schoen, (see Section 12.4.2 "Delivery of a
Deed").

Delivery to Third Party (Commercial Escrow)
The grantor may deliver the deed to a third party to hold until certain conditions have been met.
Thus to avoid the problem of the deed sitting in the grantor’s own safe-deposit box, he could
deliver it to a third party with instructions to hold it until his death and then to deliver it to the
grantee. This would be an effective delivery, even though the grantee could not use the property
until the grantor died. For this method to be effective, the grantor must lose all control over the
deed, and the third party must be instructed to deliver the deed when the specified conditions
occur.

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This method is most frequently used in the commercial escrow. Escrow is a method by which a
third party holds a document or money or both until specified conditions have been met. A
typical example would be a sale in which the buyer is afraid of liens that might be filed after the
closing. A contractor that has supplied materials for the building of a house, for example, might
file a lien against the property for any amounts due but unpaid under the contract. The
effectiveness of the lien would relate back to the time that the materials were furnished. Thus, at
closing, all potential liens might not have been filed. The buyer would prefer to pay the seller
after the time for filing materialmen’s liens has lapsed. But sellers ordinarily want to ensure that
they will receive their money before delivering a deed. The solution is for the buyer to pay the
money into escrow (e.g., to a bank) and for the seller to deliver the deed to the same escrow
agent. The bank would be instructed to hold both the money and the deed until the time for
filing mechanics’ liens has ended. If no materialmen’s liens have been filed, then the money is
paid out of escrow to the seller and the deed is released to the buyer. If a lien has been filed, then
the money will not be paid until the seller removes the lien (usually by paying it off).

KEY TAKEAWAY

Most real estate is bought and sold through real estate brokers, who must be licensed by the
state. Brokers have different kinds of agreements with clients, including exclusive right to
sell, exclusive agency, and open listing. Brokers will usually arrange a sales agreement that
includes standard provisions such as property description, earnest money, and various
contingencies. A deed, usually a warranty deed, will be exchanged at the closing, but not
before the buyer has obtained good proof of title, usually by getting an abstract and opinion
and paying for title insurance. The deed will typically be delivered to the buyer and recorded
at the county courthouse in the register of deeds’ office.

EXERCISES

1. Kitty Korniotis is a licensed real estate broker. Barney Woodard and his wife, Carol, sign an
exclusive agency listing with Kitty to sell their house on Woodvale Avenue. At a social
gathering, Carol mentions to a friend, Helen Nearing, that the house on Woodvale is for sale.
The next day, Helen drives by the property and calls the number on Kitty’s sign. Helen and
Scott Nearing sign a contract to buy the house from the Woodards. Is Kitty entitled to the
commission?
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2. Deepak Abhishek, a single man, lives in a race-notice state. He contracts to buy a
large parcel of land from his friend, Ron Khurana, for the sum of $280,000.
Subsequent to the contract, Khurana finds another buyer, who is willing to pay
$299,000. Khurana arranges for two closings on the same day, within two hours of
each other. At 10 a.m., he sells the property to Beverly Hanks and her husband,
John, for $299,000. The Hanks are not represented by an attorney. Khurana hands
them the deed at closing, but he takes it back from them and says, “I will record
this at the courthouse this afternoon.” The Hankses take a copy of the deed with
them and are satisfied that they have bought the property; moreover, Khurana
gives them a commitment from Lawyer’s Title Company that the company will
insure that they are receiving fee simple title from Khurana, subject to the deed’s
being recorded in the county register of deeds’ office.
At noon, Khurana has a closing with Abhishek, who is represented by an attorney.
The attorney went to the courthouse earlier, at 11:30 a.m., and saw nothing on
record that would prevent Khurana from conveying fee simple title. As the deal
closes, and as Khurana prepares to leave town, Abhishek’s attorney goes to the
courthouse and records the deed at 1:15 p.m. At 2:07 p.m., on his way out of
town, Abhishek records the deed to the Hankses.
a.

Who has better claim to the property—the Hankses or Deepak Abhishek?

b. Does it matter if the state is a notice jurisdiction or a notice-race jurisdiction?
c. A warranty deed is given in both closings. What would be the best remedy for
whichever buyer did not get the benefit of clear title from these two transactions?

[1] Jones v. Alfred H. Mayer Co., 392 U.S. 409 (1968).
[2] Heatter v. Lucas, 80 A.2d 749 (Pa. 1951).

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12.3 Adverse Possession

LEARNING OBJECTIVE

1. Explain how it is possible to own land without paying for it.
In some instances, real property can be acquired for free—or at least without paying the original
owner anything. (Considerable cost may be involved in meeting the requisite conditions.) This
method of acquisition—known as adverse possession—is effective when five conditions are met:
(1) the person claiming title by adverse possession must assert that he has a right to possession
hostile to the interest of the original owner, (2) he must actually possess the property, (3) his
possession must be “open and notorious,” (4) the possession must be continuous, and (5) the
possession must be exclusive.

Hostile Possession
Suppose Jean and Jacques are tenants in common of a farm. Jean announces that he no longer
intends to pursue agricultural habits and leaves for the city. Jacques continues to work on the
land, making improvements and paying taxes and the mortgage. Years later, Jacques files suit
for title, claiming that he now owns the land outright by adverse possession. He would lose,
since his possession was not hostile to Jacques. To be hostile, possession of the land must be
without permission and with the intention to claim ownership. Possession by one cotenant is
deemed permissive, since either or both are legally entitled to possession. Suppose, instead, that
Jean and Jacques are neighboring farmers, each with title to his own acreage, and that Jean
decides to fence in his property. Just to be on the safe side, he knowingly constructs the fence
twenty feet over on Jacques’s side. This is adverse possession, since it is clearly hostile to
Jacques’s possession of the land.

Actual Possession
Not only must the possession be hostile but it must also be actual. The possessor must enter
onto the land and make some use of it. Many state statutes define the permissible type of
possession—for example, substantial enclosure or cultivation and improvement. In other states,
the courts will look to the circumstances of each case to determine whether the claimant had in
fact possessed the land (e.g., by grazing cattle on the land each summer).

Open and Notorious Possession
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The possessor must use the land in an open way, so that the original owner could determine by
looking that his land was being claimed and so that people in the area would know that it was
being used by the adverse possessor. In the melodramatic words of one court, the adverse
possessor “must unfurl his flag on the land, and keep it flying so that the owner may see, if he
will, that an enemy has invaded his domains, and planted the standard of
conquest.” [1] Construction of a building on the owner’s property would be open and notorious;
development of a cave or tunnel under the owner’s property would not be.

Continuous Possession
The adverse possessor must use the land continuously, not intermittently. In most states, this
continuous period must last for at least twenty years. If the adverse possession is passed on to
heirs or the interest is sold, the successor adverse possessors may tack on the time they claim
possession to reach the twenty years. Should the original owner sell his land, the time needed to
prove continuous possession will not lapse. Of course, the original owner may interrupt the
period—indeed, may terminate it—by moving to eject the adverse possessor any time before the
twenty years has elapsed.

Exclusive Possession
The adverse possessor must claim exclusive possession of the land. Sharing the land with the
owner is insufficient to ground a claim of legal entitlement based on adverse possession, since
the sharing is not fully adverse or hostile. Jean finds a nice wooded lot to enjoy weekly picnics.
The lot belongs to Jacques, who also uses it for picnics. This use would be insufficient to claim
adverse possession because it is neither continuous nor exclusive.
If the five tests are met, then the adverse possessor is entitled to legal title. If any one of the tests
is missing, the adverse possession claim will fail.

KEY TAKEAWAY

Real property can be acquired without paying the lawful owner if five conditions of adverse
possession are met: (1) the person claiming title by adverse possession must assert that he
has a right to possession hostile to the interest of the original owner, (2) he must actually
possess the property, (3) his possession must be “open and notorious,” (4) the possession
must be continuous, and (5) the possession must be exclusive.

EXERCISE

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1. Tyler decides to camp out on a sandy beach lot near Isle of Palms, South Carolina. The owner,
who had hoped to build a large house there, lived out of state. Tyler made no secret of his
comings and goings, and after several weeks, when no one challenged his right to be there,
he built a sturdy lean-to. After a while, he built a “micro house” and put a propane tank next
to it. Although there was no running water, Tyler was plenty comfortable. His friends came
often, they partied on the beach, and life was good. Five years after he first started camping
out there, an agent of the owner came and told him to deconstruct his shelter and “move
on.” Does Tyler have any rights in the property? Why or why not?

[1] Robin v. Brown, 162 A. 161 (Pa. 1932).

12.4 Cases
Title Insurance
Title and Trust Co. of Florida v. Barrows
381 So.2d 1088 (Fla. App. 1979)
McCORD, ACTING CHIEF JUDGE.
This appeal is from a final judgment awarding money damages to appellees (Barrows) for breach
of title insurance policy. We reverse.
Through a realtor, the Barrowses purchased, for $ 12,500, a lot surrounded on three sides by
land owned by others, all of which is a part of a beach subdivision. The fourth side of their lot
borders on a platted street called Viejo Street, the right-of-way for which has been dedicated to
and accepted by St. Johns County. The right-of-way line opposite their lot abuts a Corps of
Engineers’ right-of-way in which there is a stone breakwater. The intracoastal waterway flows on
the other side of the breakwater.
The realtor who sold the lot to the Barrows represented to them that the county would build a
road in the right-of-way along Viejo Street when they began plans for building on their lot. There
have been no street improvements in the dedicated right-of-way, and St. Johns County has no

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present plans for making any improvements. The “road” is merely a continuation of a sandy
beach.
A year after purchasing the land the Barrowses procured a survey which disclosed that the
elevation of their lot is approximately one to three feet above the mean high water mark. They
later discovered that their lot, along with the Viejo Street right-of-way abutting it, is covered by
high tide water during the spring and fall of each year.
At the time appellees purchased their lot, they obtained title insurance coverage from appellant.
The title policy covered:
Any defect in or lien or encumbrance on the title to the estate or title covered hereby…or a lack
of a right of access to and from the land.…
Appellees’ complaint of lack of right of access was founded on the impassable condition of the
platted street. After trial without a jury, the trial court entered final judgment finding that
appellees did not have access to their property and, therefore, were entitled to recover $ 12,500
from appellant the face amount of the policy.
Appellant and Florida Land Title Association, appearing as amicus curiae, argue that appellant
cannot be held liable on grounds of “lack of right of access to and from the land” since there is
no defect shown by the public record as to their right of access; that the public record shows a
dedicated and accepted public right-of-way abutting the lot. They contend that title insurance
does not insure against defects in the physical condition of the land or against infirmities in legal
right of access not shown by the public record. See Pierson v. Bill, 138 Fla. 104, 189 So. 679
(1939). They argue that defects in the physical condition of the land such as are involved here
are not covered by title insurance. We agree. Title insurance only insures against title defects.
The Supreme Court of North Carolina in Marriott Financial Services, Inc. v. Capitol Funds,
Inc., 288 N.C. 122, 217 S.E.2d 551 (1975), construed “right of access” to mean the right to go to
and from the public right-of-way without unreasonable restrictions.Compare Hocking v. Title
Insurance & Trust Company, 37 Cal.2d 644, 234 P.2d 625 (1951), where, in ruling that the
plaintiff failed to state a cause of action in a suit brought under her title policy, the court said:

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She appears to possess fee simple title to the property for whatever it may be worth; if she has
been damaged by false representations in respect to the condition and value of the land her
remedy would seem to be against others than the insurers of the title she acquired.
In Mafetone, et al., v. Forest Manor Homes, Inc., et al., 34 A.D.2d 566, 310 N.Y.S.2d 17
(N.Y.1970), the plaintiff brought an action against a title insurance company for damages
allegedly flowing from a change in the grade of a street. There the court said:
The title company is not responsible to plaintiffs for the damages incurred by reason of the
change in elevating the abutting street to its legal grade, since the provisions of the standard title
insurance policy here in question are concerned with matters affecting title to property and do
not concern themselves with physical conditions of the abutting property absent a specific
request by the person ordering a title report and policy.…
In McDaniel v. Lawyers’ Title Guaranty Fund, 327 So.2d 852 (Fla. 2 D.C.A. 1976), our sister
court of the Second District said:
The man on the street buys a title insurance policy to insure against defects in the record title.
The title insurance company is in the business of guaranteeing the insured’s title to the extent it
is affected by the public records.
In the case here before us, there is no dispute that the public record shows a legal right of access
to appellant’s property via the platted Viejo Street. The title insurance policy only insured
against record title defects and not against physical infirmities of the platted street.
Reversed.

CASE QUESTIONS

1. Do you think that the seller (or the seller’s agent) actually took the Barrowses to see the
property when it was underwater? Why or why not?
2. Before buying, should the Barrowses have actually gone to the property to see for
themselves “the lay of the land” or made inquiries of neighboring lot owners?
3. Assuming that they did not make inspection of the property or make other inquiries, do you
think the seller or the seller’s agent made any misrepresentations about the property that
would give the Barrowses any remedies in law or equity?

Delivery of a Deed
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Havens v. Schoen
108 Mich. App. 758; 310 N.W.2d 870 (Mich. App. 1981)
[Norma Anderson Havens, the owner of certain farm property in Marlette, Michigan, in
contemplation of her death executed a quit-claim deed to the property to her only daughter,
Linda Karen Anderson. The deed was subsequently recorded. Subsequently, Linda Karen
Anderson married and became Linda Karen Adams and died. Thereafter, Norma Anderson
Havens and Norman William Scholz, a nephew of Havens who has an interest in the property as
the beneficiary of a trust, brought a suit in Sanilac Circuit Court against Ernest E. Schoen,
Administrator of the estate of Linda Karen Adams, deceased, and other heirs of James W.
Anderson, the ex-husband of Norma Anderson Havens, seeking to set aside the deed or to
impose a constructive trust on the farm property which was the subject of the deed. Arthur E.
Moore, J., found no cause of action and entered judgment for defendants. The plaintiffs appeal
alleging error because there never was a delivery of the deed or an intent by Havens to then
presently and unconditionally convey an interest in the property.]
PER CURIAM.
In 1962, plaintiff Dr. [Norma Anderson] Havens purchased the Scholz family farm from the
estate of her twin brother, Norman Scholz. She gave a deed of trust to her other brother Earl
Scholz in 1964, naming her daughter Linda Karen Adams as the principal beneficiary. In 1969,
she filed suit against Earl and Inez Scholz and, in settlement of that suit, the property was
conveyed to Dr. Havens and her daughter, now deceased. On August 13, 1969, Dr. Havens
executed a quit-claim deed to her daughter of her remaining interest in the farm. It is this deed
which Dr. Havens wishes to set aside.
The trial court found that plaintiffs failed to meet the burden of proving an invalid conveyance.
Plaintiffs claim that there was never a delivery or an intent to presently and unconditionally
convey an interest in the property to the daughter. The deed was recorded but defendants
presented no other evidence to prove delivery. The recording of a deed raises a presumption of
delivery. Hooker v Tucker, 335 Mich 429, 434; 56 NW2d 246 (1953). The only effect of this
presumption is to cast upon the opposite party the burden of moving forward with the
evidence. Hooker v Tucker, supra. The burden of proving delivery by a preponderance of the
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evidence remains with the party relying on the deed. Camp v Guaranty Trust Co, 262 Mich 223,
226; 247 NW 162 (1933). Acknowledging that the deed was recorded, plaintiffs presented
substantial evidence showing no delivery and no intent to presently and unconditionally convey
an interest in the property. The deed, after recording, was returned to Dr. Havens. She
continued to manage the farm and pay all expenses for it. When asked about renting the farm,
the daughter told a witness to ask her mother. Plaintiffs presented sufficient evidence to dispel
the presumption. We find that the trial court erred when it stated that plaintiffs had the burden
of proof on all issues. The defendants had the burden of proving delivery and requisite intent.
In Haasjes v Woldring, 10 Mich App 100; 158 NW2d 777 (1968), leave denied 381 Mich 756
(1968), two grandparents executed a deed to property to two grandchildren. The grandparents
continued to live on the property, pay taxes on it and subsequent to the execution of the deed
they made statements which this Court found inconsistent with a prior transfer of property.
These circumstances combined with the fact that the deed was not placed beyond the grantors’
control led the Haasjes Court to conclude that a valid transfer of title had not been effected.
The Haasjes Court, citing Wandel v Wandel, 336 Mich 126; 57 NW2d 468 (1953), and Resh v
Fox, 365 Mich 288, 112 NW2d 486 (1961), held that in considering whether there was a present
intent to pass title, courts may look to the subsequent acts of the grantor.
This Court reviews de novo the determinations of a trial court sitting in an equity case.Chapman
v Chapman, 31 Mich App 576, 579; 188 NW2d 21 (1971). Having reviewed the evidence
presented by the defendants to prove delivery, we find that the defendants failed to meet their
burden of proof. Under the circumstances, the recording itself and the language of the deed were
not persuasive proof of delivery or intent. Defendants presented no evidence of possession of the
deed by anyone but the grantor and presented no evidence showing knowledge of the deed by
the grantee. No evidence was presented showing that the daughter was ever aware that she
owned the property. The showing made by defendants was inadequate to carry their burden of
proof. The deed must be set aside.
Plaintiffs alleged none of the grounds which have traditionally been recognized as justifying the
imposition of a constructive trust. See Chapman v Chapman, supra. A constructive trust is
imposed only when it would be inequitable to do otherwise. Arndt v Vos, 83 Mich App 484; 268
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NW2d 693 (1978). Although plaintiffs claim relief for a mutual mistake, plaintiffs have
presented no facts suggesting a mistake on the part of the grantee. Creation of a constructive
trust is not warranted by the facts as found by the trial court. There has been no claim that those
findings are erroneous.
We remand to the trial court to enter an order setting aside the August 13, 1969, deed from
Norma Anderson Havens to Linda Karen Anderson Adams purporting to convey the interest of
Dr. Havens in the farm. The decision of the trial court finding no justification for imposing a
trust upon the property is affirmed.
Affirmed in part, reversed in part, and remanded.
DISSENT BY:
MacKenzie, J. (dissenting).
I respectfully dissent. The deed was recorded with the knowledge and assent of the grantor,
which creates a presumption of delivery. See Schmidt v Jennings, 359 Mich 376, 383; 102
NW2d 589 (1960), Reed v Mack, 344 Mich 391, 397; 73 NW2d 917 (1955). Crucial evidence was
conflicting and I would disagree that the trial court’s findings were clearly erroneous.
In Reed v Mack, the Court affirmed the trial court’s finding that there had been delivery where
the grantor defendant, who had owned the property with her husband, recorded a deed
conveying a property jointly to herself and the two other grantees, stating:
“We are in agreement with the trial court. The defendant-appellant, a grantor in the deed,
caused the recording of the deed, the delivery of which she attacks. The recording of a warranty
deed may, under some circumstances, be effectual to show delivery. A delivery to one of several
joint grantees, in absence of proof to the contrary, is delivery to all. Mayhew v Wilhelm, 249
Mich 640 [229 NW 459 (1930)]. While placing a deed on record does not in itself necessarily
establish delivery, the recording of a deed raises a presumption of delivery, and the whole object
of delivery is to indicate an intent by the grantor to give effect to the instrument.” [Citations]
In McMahon v Dorsey, 353 Mich 623, 626; 91 NW2d 893 (1958), the significance of delivery
was characterized as the manifestation of the grantor’s intent that the instrument be a
completed act.
***
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The evidence herein indicates that plaintiff Norma Anderson Havens, after she had been told
she was dying from cancer, executed a quit-claim deed on August 16, 1969, to her daughter,
Linda Karen Anderson. Plaintiff Havens testified that the reason she executed the deed was that
she felt “if something should happen to me, at least Karen would be protected”. The deed was
recorded the same day by plaintiff Havens’s attorney. Plaintiff Havens either knew that the deed
was recorded then or learned of the recording shortly thereafter. Although plaintiff Havens
testified that she intended only a testamentary disposition, she apparently realized that the deed
was effective to convey the property immediately because her testimony indicated an intention
to execute a trust agreement. Linda Karen lived on the farm for five years after the deed was
recorded until her death in 1974, yet plaintiff Havens did not attempt to have Linda Karen deed
the farm back to her so she could replace the deed with a trust agreement or a will. Plaintiff
Havens testified that she approached her attorneys regarding a trust agreement, but both
attorneys denied this. The trial judge specifically found the testimony of the attorneys was
convincing and he, of course, had the benefit of observing the witnesses.
Haasjes v Woldring, 10 Mich App 100; 158 NW2d 777 (1968), relied upon by the majority,
involved unrecorded deeds which remained in a strongbox under control of the grantors until
after their deaths. The grantors continued to live alone on the property and pay taxes thereon.
Based on the lack of recording, I find Haasjesdistinguishable from the present case.
In Hooker v Tucker, 335 Mich 429; 56 NW2d 246 (1953), delivery was held not to have occurred
where the grantor handed her attorney a copy of a deed containing a legal description of
property she wished included in a will to be drawn by him and he subsequently mailed the deed
to the grantee without the grantor’s knowledge or permission. The purported delivery by mailing
being unauthorized distinguishesHooker from this case where there was no indication the
recording was done without the grantor’s authorization.
The majority relies on the grantee’s purported lack of knowledge of the conveyance but the
record is not at all clear in this regard. Further, if a deed is beneficial to the grantee, its
acceptance is presumed. Tackaberry v Monteith, 295 Mich 487, 493; 295 NW 236 (1940), see
also Holmes v McDonald, 119 Mich 563; 78 NW 647 (1899). While the burden of proving
delivery is on the person relying upon the instrument, the burden shifts upon its recordation so
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that the grantor must go forward with the evidence of showing nondelivery, once recordation
and beneficial interest have been shown.Hooker v Tucker, supra, and Tackaberry, supra. The
trial court properly found that plaintiffs failed to go forward with the evidence and found that
the deed conveyed title to the farm.
Factually, this is a difficult case because plaintiff Havens executed a deed which she intended to
be a valid conveyance at the time it was executed and recorded. Subsequently, when her
daughter unexpectedly predeceased her, the deed created a result she had not foreseen. She
seeks to eradicate the unintended result by this litigation.
I am reluctant to set aside an unambiguous conveyance which was on record and unchallenged
for five years on the basis of the self-serving testimony of the grantor as to her intent at the time
she executed the deed and authorized its recordation.
I would affirm.

CASE QUESTION

1. Which opinion, the majority or the dissenting opinion, do you agree with, and why?

12.5 Summary and Exercises
Summary

Real property can be held in various forms of ownership. The most common forms are tenancy
in common, joint tenancy, and tenancy by the entirety. Ten states recognize the community
property form of ownership.
In selling real property, various common-law and statutory provisions come into play. Among
the more important statutory provisions are the Civil Rights Acts of 1866 and 1968. These laws
control the manner in which property may be listed and prohibit discrimination in sales. Sellers
and buyers must also be mindful of contract and agency principles governing the listing
agreement. Whether the real estate broker has an exclusive right to sell, an exclusive agency, or
an open listing will have an important bearing on the fee to which the broker will be entitled
when the property is sold.
The Statute of Frauds requires contracts for the sale of real property to be in writing. Such
contracts must include the names of buyers and sellers, a description of the property, the price,
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and signatures. Unless the contract states otherwise, the seller must deliver marketable title, and
the buyer will bear the loss if the property is damaged after the contract is signed but before the
closing. The seller will usually insist on being paid earnest money, and the buyer will usually
protect himself contractually against certain contingencies, such as failure to obtain financing.
The contract should also specify the type of deed to be given to the buyer.
To provide protection to subsequent buyers, most states have enacted recording statutes that
require buyers to record their purchases in a county office. The statutes vary: which of two
purchasers will prevail depends on whether the state has a notice, notice-race, or race statute.
To protect themselves, buyers usually purchase an abstract and opinion or title insurance.
Although sale is the usual method of acquiring real property, it is possible to take legal title
without the consent of the owner. That method is adverse possession, by which one who openly,
continuously, and exclusively possesses property and asserts his right to do so in a manner
hostile to the interest of the owner will take title in twenty years in most states.

EXERCISES

1. Rufus enters into a contract to purchase the Brooklyn Bridge from Sharpy. The contract
provides that Sharpy is to give Rufus a quitclaim deed at the closing. After the closing, Rufus
learns that Sharpy did not own the bridge and sues him for violating the terms of the deed.
What is the result? Why?
2. Pancho and Cisco decide to purchase ten acres of real estate. Pancho is to provide 75 percent
of the purchase price, Cisco the other 25 percent. They want to use either a joint tenancy or
tenancy in common form of ownership. What do you recommend? Why?
3. Suppose in Exercise 2 that a friend recommends that Pancho and Cisco use a tenancy by the
entirety. Would this form of ownership be appropriate? Why?
4. Richard and Elizabeth, a married couple, live in a community property state. During their
marriage, they save $500,000 from Elizabeth’s earnings. Richard does not work, but during
the marriage, he inherits $500,000. If Richard and Elizabeth are divorced, how will their
property be divided? Why?
5. Jack wants to sell his house. He hires Walter, a real estate broker, to sell the house and signs
an exclusive-right-to-sell listing agreement. Walter finds a buyer, who signs a sales contract

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with Jack. However, the buyer later refuses to perform the contract because he cannot
obtain financing. Does Jack owe a commission to Walter? Why?
6. Suppose in Exercise 5 that Jack found the buyer, the buyer obtained financing, and the sale
was completed. Does Jack owe a commission to Walter, who provided no assistance in
finding the buyer and closing the deal? Why?
7. Suppose in Exercise 5 that Jack’s house is destroyed by fire before the closing. Who bears the
loss—Jack or the buyer? Must Jack pay a commission to Walter? Why?
8. Suppose in Exercise 5 that the buyer paid $15,000 in earnest money when the contract was
signed. Must Jack return the earnest money when the buyer learns that financing is
unavailable? Why?

SELF-TEST QUESTIONS

1. A contract for a sale of property must include
a.

a description of the property
b. price
c. signatures of buyer and seller
d. all of the above
If real property is damaged after a contract for sale is signed but before
closing, it is generally true that the party bearing the loss is

a.

the seller
b. the buyer
c. both parties, who split the loss evenly
d. none of the above
The following deeds extend warranties to the buyer:

a.

quitclaim and special warranty
b. quitclaim and general warranty
c. general and special warranty
d. all of the above
Under a notice-race statute,

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a.

whoever records first is given title, regardless of the good faith of the

purchaser
b. whoever records first and is a bona fide purchaser is given title
c. either of the above may be acceptable
d. none of the above is acceptable
The elements of adverse possession do not include
a.

actual possession

b. open and notorious use
c. consent of the owner
d. continuous possession

SELF-TEST ANSWERS

1. d
2. b
3. c
4. b
5. c

Chapter 13
Landlord and Tenant Law
LEARNING OBJECTIVES

After reading this chapter, you should understand the following:
1. The various types of leasehold estates
2. How leasehold states are created and extended
3. The rights and duties of landlords
4. The rights and duties of tenants
5. The potential tort liability of landlords

13.1 Types and Creation of Leasehold Estates
LEARNING OBJECTIVES

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1. Distinguish between the different types of leasehold estates.
2. Describe how leasehold states can be created, both orally and in writing, and the
requirements for creating leases that last for more than one year.
In Chapter 11 "The Nature and Regulation of Real Estate and the Environment", we noted that
real property can be divided into types of interests: freehold estates and leasehold estates. The
freehold estate is characterized by indefinite duration, and the owner has title and the right to
possess. The leasehold estate, by contrast, lasts for a specific period. The owner of the leasehold
estate—the tenant—may take possession but does not have title to the underlying real property.
When the period of the leasehold ends, the right to possession reverts to the landlord—hence the
landlord’s interest during the tenant’s possession is known as a reversionary interest.
Although a leasehold estate is said to be an interest in real property, the leasehold itself is in fact
personal property. The law recognizes three types of leasehold estates: the estate for years, the
periodic tenancy, and the tenancy at will.

Types of Leasehold Estates
Estate for Years
The estate for years is characterized by a definite beginning and a definite end. When you rent
an apartment for two years, beginning September 1 and ending on the second August 31, you are
the owner of an estate for years. Virtually any period will do; although it is called an estate “for
years,” it can last but one day or extend one thousand years or more. Some statutes declare that
any estate for years longer than a specified period—one hundred years in Massachusetts, for
instance—is a fee simple estate.
Unless the lease—the agreement creating the leasehold interest—provides otherwise, the estate
for years terminates automatically at midnight of the last day specified in the lease. The lease
need not refer explicitly to calendar dates. It could provide that “the tenant may occupy the
premises for six months to commence one week from the date of signing.” Suppose the landlord
and tenant sign on June 23. Then the lease term begins at 12:00 a.m. on July 1 and ends just
before midnight of December 31. Unless a statute provides otherwise, the landlord is not
obligated to send the tenant a notice of termination. Should the tenant die before the lease term

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ends, her property interest can be inherited under her will along with her other personal
property or in accordance with the laws of intestate succession.

Periodic Tenancy
As its name implies, a periodic tenancy lasts for a period that is renewed automatically until
either landlord or tenant notifies the other that it will end. The periodic tenancy is sometimes
called an estate from year to year (or month to month, or week to week). The lease may provide
explicitly for the periodic tenancy by specifying that at the expiration of, say, a one-year lease, it
will be deemed renewed for another year unless one party notifies the other to the contrary
within six months prior to the expiration of the term. Or the periodic tenancy may be created by
implication, if the lease fails to state a term or is defective in some other way, but the tenant
takes possession and pays rent. The usual method of creating a periodic tenancy occurs when
the tenant remains on the premises (“holds over”) when an estate for years under a lease has
ended. The landlord may either reject or accept the implied offer by the tenant to rent under a
periodic tenancy. If he rejects the implied offer, the tenant may be ejected, and the landlord is
entitled to rent for the holdover period. If he accepts the offer, the original lease determines the
rent and length of the renewable period, except that no periodic tenancy may last longer than
from year to year—that is, the renewable period may never be any longer than twelve months.
At common law, a party was required to give notice at least six months prior to the end of a yearto-year tenancy, and notice equal to the term for any other periodic tenancy. In most states
today, the time period for giving notice is regulated by statute. In most instances, a year-to-year
tenancy requires a month’s notice, and shorter tenancies require notice equal to the term. To
illustrate the approach typically used, suppose Simone rents from Anita on a month-to-month
tenancy beginning September 15. On March 30, Simone passes the orals for her doctorate and
decides to leave town. How soon may she cancel her tenancy? If she calls Anita that afternoon,
she will be two weeks shy of a full month’s notice for the period ending April 15, so the earliest
she can finish her obligation to pay rent is May 15. Suppose her term had been from the first of
each month. On April 1, she notifies Anita of her intention to leave at the end of April, but she is
stuck until the end of May, because notice on the first of the month is not notice for a full month.
She would have had to notify Anita by March 31 to terminate the tenancy by April 30.
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Tenancy at Will
If the landlord and tenant agree that the lease will last only as long as both want it to, then they
have created a tenancy at will. Statutes in most states require some notice of intention to
terminate. Simone comes to the university to study, and Anita gives her a room to stay in for
free. The arrangement is a tenancy at will, and it will continue as long as both want it to. One
Friday night, after dinner with classmates, Simone decides she would rather move in with Bob.
She goes back to her apartment, packs her suitcase, and tells Anita she’s leaving. The tenancy at
will terminates that day.

Creation of Leasehold Estates
Oral Leases
Leases can be created orally, unless the term of the lease exceeds the period specified by the
Statute of Frauds. In most states, that period is one year. Any oral lease for a period longer than
the statutory period is invalid. Suppose that Simone, in a state with a one-year Statute of Frauds
period, orally agrees with Anita to rent Anita’s apartment for two years, at a monthly rent of
$250. The lease is invalid, and either could repudiate it.

Written Leases
A lease required to be in writing under the Statute of Frauds must contain the following items or
provisions: (1) it must identify the parties, (2) it must identify the premises, (3) it must specify
the duration of the lease, (4) it must state the rent to be paid, and (5) it must be signed by the
party against whom enforcement is sought (known as “the party to be charged”).
The provisions need not be perfectly stated. As long as they satisfy the five requirements, they
will be adequate to sustain the lease under the Statute of Frauds. For instance, the parties need
not necessarily be named in the lease itself. Suppose that the prospective tenant gives the
landlord a month’s rent in advance and that the landlord gives the tenant a receipt listing the
property and the terms of the lease but omitting the name of the tenant. The landlord
subsequently refuses to let the tenant move in. Who would prevail in court? Since the tenant had
the receipt in her possession, that would be sufficient to identify her as the tenant to whom the
terms of the lease were meant to apply. Likewise, the lease need not specify every aspect of the
premises to be enjoyed. Thus the tenant who rents an apartment in a building will be entitled to
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the use of the common stairway, the roof, and so on, even though the lease is silent on these
points. And as long as a specific amount is ascertainable, the rent may be stated in other than
absolute dollar terms. For example, it could be expressed in terms of a cost-of-living index or as
a percentage of the tenant’s dollar business volume.

KEY TAKEAWAY

A leasehold estate, unlike a freehold estate, has a definite duration. The landlord’s interest
during the term of a leasehold estate is a reversionary interest. Leasehold estates can last for
short terms or very long terms; in the case of long-term leases, a property right is created
that can be passed to heirs. The usual landlord-tenant relationship is a periodic tenancy,
which carries with it various common-law and statutory qualifications regarding renewal and
termination. In a tenancy at will, either landlord or tenant can end the leasehold estate as
soon as notice is provided by either party.

EXERCISES

1. What is the difference between a periodic tenancy and a tenancy at will?
2. What are the essential terms that must be in a written lease?

13.2 Rights and Duties of Landlords and Tenants
LEARNING OBJECTIVES

1. Itemize and explain the rights and duties of landlords.
2. List and describe the rights and duties of tenants.
3. Understand the available remedies for tenants when a landlord is in breach of his or her
duties.

Rights and Duties of Landlords
The law imposes a number of duties on the landlord and gives the tenant a number of
corresponding rights. These include (1) possession, (2) habitable condition, and (3)
noninterference with use.

Possession
The landlord must give the tenant the right of possession of the property. This duty is breached
if, at the time the tenant is entitled to take possession, a third party has paramount title to the
property and the assertion of this title would deprive the tenant of the use contemplated by the
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parties. Paramount title means any legal interest in the premises that is not terminable at the
will of the landlord or at the time the tenant is entitled to take possession.
If the tenant has already taken possession and then discovers the paramount title, or if the
paramount title only then comes into existence, the landlord is not automatically in breach.
However, if the tenant thereafter is evicted from the premises and thus deprived of the property,
then the landlord is in breach. Suppose the landlord rents a house to a doctor for ten years,
knowing that the doctor intends to open a medical office in part of the home and knowing also
that the lot is restricted to residential uses only. The doctor moves in. The landlord is not yet in
default. The landlord will be in default if a neighbor obtains an injunction against maintaining
the office. But if the landlord did not know (and could not reasonably have known) that the
doctor intended to use his home for an office, then the landlord would not be in default under
the lease, since the property could have been put to normal—that is, residential—use without
jeopardizing the tenant’s right to possession.

Warranty of Habitability
As applied to leases, the old common-law doctrine of caveat emptor said that once the tenant
has signed the lease, she must take the premises as she finds them. Since she could inspect them
before signing the lease, she should not complain later. Moreover, if hidden defects come to
light, they ought to be easy enough for the tenant herself to fix. Today this rule no longer applies,
at least to residential rentals. Unless the parties specifically agree otherwise, the landlord is in
breach of his lease if the conditions are unsuitable for residential use when the tenant is due to
move in. The landlord is held to an implied warranty of habitability.
The change in the rule is due in part to the conditions of the modern urban setting: tenants have
little or no power to walk away from an available apartment in areas where housing is scarce. It
is also due to modem construction and technology: few tenants are capable of fixing most types
of defects. A US court of appeals has said the following:
Today’s urban tenants, the vast majority of whom live in multiple dwelling houses, are
interested not in the land, but solely in “a house suitable for occupation.” Furthermore, today’s
city dweller usually has a single, specialized skill unrelated to maintenance work; he is unable to
make repairs like the “jack-of-all-trades” farmer who was the common law’s model of the lessee.
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Further, unlike his agrarian predecessor who often remained on one piece of land for his entire
life, urban tenants today are more mobile than ever before. A tenant’s tenure in a specific
apartment will often not be sufficient to justify efforts at repairs. In addition, the increasing
complexity of today’s dwellings renders them much more difficult to repair than the structures
of earlier times. In a multiple dwelling, repairs may require access to equipment and areas in
control of the landlord. Low and middle income tenants, even if they were interested in making
repairs, would be unable to obtain financing for major repairs since they have no long-term
interest in the property. [1]
At common law, the landlord was not responsible if the premises became unsuitable once the
tenant moved in. This rule was often harshly applied, even for unsuitable conditions caused by a
sudden act of God, such as a tornado. Even if the premises collapsed, the tenant would be liable
to pay the rent for the duration of the lease. Today, however, many states have statutorily
abolished the tenant’s obligation to pay the rent if a non-man-made force renders the premises
unsuitable. Moreover, most states today impose on the landlord, after the tenant has moved in,
the responsibility for maintaining the premises in a safe, livable condition, consistent with the
safety, health, and housing codes of the jurisdiction.
These rules apply only in the absence of an express agreement between the parties. The landlord
and tenant may allocate in the lease the responsibility for repairs and maintenance. But it is
unlikely that any court would enforce a lease provision waiving the landlord’s implied warranty
of habitability for residential apartments, especially in areas where housing is relatively scarce.

Noninterference with Use
In addition to maintaining the premises in a physically suitable manner, the landlord has an
obligation to the tenant not to interfere with a permissible use of the premises. Suppose Simone
moves into a building with several apartments. One of the other tenants consistently plays music
late in the evening, causing Simone to lose sleep. She complains to the landlord, who has a
provision in the lease permitting him to terminate the lease of any tenant who persists in
disturbing other tenants. If the landlord does nothing after Simone has notified him of the
disturbance, he will be in breach. This right to be free of interference with permissible uses is
sometimes said to arise from the landlord’s implied covenant of quiet enjoyment.
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Tenant’s Remedies
When the landlord breaches one of the foregoing duties, the tenant has a choice of three basic
remedies: termination, damages, or rent adjustment.
In virtually all cases where the landlord breaches, the tenant may terminate the lease, thus
ending her obligation to continue to pay rent. To terminate, the tenant must (1) actually vacate
the premises during the time that she is entitled to terminate and (2) either comply with lease
provisions governing the method of terminating or else take reasonable steps to ensure that the
landlord knows she has terminated and why.
When the landlord physically deprives the tenant of possession, he has evicted the tenant;
wrongful eviction permits the tenant to terminate the lease. Even if the landlord’s conduct falls
short of actual eviction, it may interfere substantially enough with the tenant’s permissible use
so that they are tantamount to eviction. This is known as constructive eviction, and it covers a
wide variety of actions by both the landlord and those whose conduct is attributable to him, as
illustrated by Fidelity Mutual Life Insurance Co. v Kaminsky, (see Section 13.5.1 "Constructive
Eviction").

Damages
Another traditional remedy is money damages, available whenever termination is an
appropriate remedy. Damages may be sought after termination or as an alternative to
termination. Suppose that after the landlord had refused Simone’s request to repair the
electrical system, Simone hired a contractor to do the job. The cost of the repair work would be
recoverable from the landlord. Other recoverable costs can include the expense of relocating if
the lease is terminated, moving costs, expenses connected with finding new premises, and any
increase in rent over the period of the terminated lease for comparable new space. A business
may recover the loss of anticipated business profits, but only if the extent of the loss is
established with reasonable certainty. In the case of most new businesses, it would be almost
impossible to prove loss of profits.
In all cases, the tenant’s recovery will be limited to damages that would have been incurred by a
tenant who took all reasonable steps to mitigate losses. That is, the tenant must take reasonable

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steps to prevent losses attributable to the landlord’s breach, to find new space if terminating, to
move efficiently, and so on.

Rent Remedies
Under an old common-law rule, the landlord’s obligation to provide the tenant with habitable
space and the tenant’s obligation to pay rent wereindependent covenants. If the landlord
breached, the tenant was still legally bound to pay the rent; her only remedies were termination
and suit for damages. But these are often difficult remedies for the tenant. Termination means
the aggravation of moving, assuming that new quarters can be found, and a suit for damages is
time consuming, uncertain, and expensive. The obvious solution is to permit the tenant to
withhold rent, or what we here call rent adjustment. The modern rule, adopted in several states
(but not yet in most), holds that the mutual obligations of landlord and tenant are dependent.
States following this approach have developed three types of remedies: rent withholding, rent
application, and rent abatement.
The simplest approach is for the tenant to withhold the rent until the landlord remedies the
defect. In some states, the tenant may keep the money. In other states, the rent must be paid
each month into an escrow account or to the court, and the money in the escrow account
becomes payable to the landlord when the default is cured.
Several state statutes permit the tenant to apply the rent money directly to remedy the defect or
otherwise satisfy the landlord’s performance. Thus Simone might have deducted from her rent
the reasonable cost of hiring an electrician to repair the electrical system.
In some states, the rent may be reduced or even eliminated if the landlord fails to cure specific
types of defects, such as violations of the housing code. The abatement will continue until the
default is eliminated or the lease is terminated.

Rights and Duties of Tenants
In addition to the duties of the tenant set forth in the lease itself, the common law imposes three
other obligations: (1) to pay the rent reserved (stated) in the lease, (2) to refrain from
committing waste (damage), and (3) not to use the premises for an illegal purpose.

Duty to Pay Rent

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What constitutes rent is not necessarily limited to the stated periodic payment usually
denominated “rent.” The tenant may also be responsible for such assessments as taxes and
utilities, payable to the landlord as rent. Simone’s lease calls for her to pay taxes of $500 per
year, payable in quarterly installments. She pays the rent on the first of each month and the first
tax bill on January 1. On April 1, she pays the rent but defaults on the next tax bill. She has failed
to pay the rent reserved in the lease.
The landlord in the majority of states is not obligated to mitigate his losses should the tenant
abandon the property and fail thereafter to pay the rent. As a practical matter, this means that
the landlord need not try to rent out the property but instead can let it sit vacant and sue the
defaulting tenant for the balance of the rent as it becomes due. However, the tenant might notify
the landlord that she has abandoned the property or is about to abandon it and offer to
surrender it. If the landlord accepts the surrender, the lease then terminates. Unless the lease
specifically provides for it, a landlord who accepts the surrender will not be able to recover from
the tenant the difference between the amount of her rent obligation and the new tenant’s rent
obligation.
Many leases require the tenant to make a security deposit—a payment of a specific sum of
money to secure the tenant’s performance of duties under the lease. If the tenant fails to pay the
rent or otherwise defaults, the landlord may use the money to make good the tenant’s
performance. Whatever portion of the money is not used to satisfy the tenant’s obligations must
be repaid to the tenant at the end of the lease. In the absence of an agreement to the contrary,
the landlord must pay interest on the security deposit when he returns the sum to the tenant at
the end of the lease.

Alteration and Restoration of the Premises
In the absence of a specific agreement in the lease, the tenant is entitled to physically change the
premises in order to make the best possible permissible use of the property, but she may not
make structural alterations or damage (waste) the property. A residential tenant may add
telephone lines, put up pictures, and affix bookshelves to the walls, but she may not remove a
wall in order to enlarge a room.

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The tenant must restore the property to its original condition when the lease ends, but this
requirement does not include normal wear and tear. Simone rents an apartment with newly
polished wooden floors. Because she likes the look of oak, she decides against covering the floors
with rugs. In a few months’ time, the floors lose their polish and become scuffed. Simone is not
obligated to refinish the floors, because the scuffing came from normal walking, which is
ordinary wear and tear.

Use of the Property for an Illegal Purpose
It is a breach of the tenant’s obligation to use the property for an illegal purpose. A landlord who
found a tenant running a numbers racket, for example, or making and selling moonshine whisky
could rightfully evict her.

Landlord’s Remedies
In general, when the tenant breaches any of the three duties imposed by the common law, the
landlord may terminate the lease and seek damages. One common situation deserves special
mention: the holdover tenant. When a tenant improperly overstays her lease, she is said to be
a tenant at sufferance, meaning that she is liable to eviction. Some cultures, like the Japanese,
exhibit a considerable bias toward the tenant, making it exceedingly difficult to move out
holdover tenants who decide to stay. But in the United States, landlords may remove tenants
through summary (speedy) proceedings available in every state or, in some cases, through selfhelp. Self-help is a statutory remedy for landlords or incoming tenants in some states and
involves the peaceful removal of a holdover tenant’s belongings. If a state has a statute providing
a summary procedure for removing a holdover tenant, neither the landlord nor the incoming
tenant may resort to self-help, unless the statute specifically allows it. A provision in the lease
permitting self-help in the absence of statutory authority is unenforceable. Self-help must be
peaceful, must not cause physical harm or even the expectation of harm to the tenant or anyone
on the premises with his permission, and must not result in unreasonable damage to the
tenant’s property. Any clause in the lease attempting to waive these conditions is void.
Self-help can be risky, because some summary proceeding statutes declare it to be a criminal act
and because it can subject the landlord to tort liability. Suppose that Simone improperly holds
over in her apartment. With a new tenant scheduled to arrive in two days, the landlord knocks
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on her door the evening after her lease expires. When Simone opens the door, she sees the
landlord standing between two 450-pound Sumo wrestlers with menacing expressions. He
demands that she leave immediately. Fearing for her safety, she departs instantly. Since she had
a reasonable expectation of harm had she not complied with the landlord’s demand, Simone
would be entitled to recover damages in a tort suit against her landlord, although she would not
be entitled to regain possession of the apartment.
Besides summary judicial proceedings and self-help, the landlord has another possible remedy
against the holdover tenant: to impose another rental term. In order to extend the lease in this
manner, the landlord need simply notify the holdover tenant that she is being held to another
term, usually measured by the periodic nature of the rent payment. For example, if rent was
paid each month, then imposition of a new term results in a month-to-month tenancy. One year
is the maximum tenancy that the landlord can create by electing to hold the tenant to another
term.

KEY TAKEAWAY

Both landlords and tenants have rights and duties. The primary duty of a landlord is to meet
the implied warranty of habitability: that the premises are in a safe, livable condition. The
tenant has various remedies available if the landlord fails to meet that duty, or if the landlord
fails to meet the implied covenant of quiet enjoyment. These include termination, damages,
and withholding of rent. The tenant has duties as well: to pay the rent, refrain from
committing waste, and not use the property for an illegal purpose.

EXERCISES

1. Consistent with the landlord’s implied warranty of habitability, can the landlord and tenant
agree in a lease that the tenant bear any and all expenses to repair the refrigerator, the
stove, and the microwave?
2. Under what conditions is it proper for a tenant to withhold rent from the landlord?
[1] Javins v. First National Realty Corp., 428 F.2d 1071, 1078-79 (D.C. Cir.), cert. denied, 400 U.S. 925
(1970).

13.3 Transfer of Landlord’s or Tenant’s Interest
LEARNING OBJECTIVES

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1. Explain how the landlord’s reversionary interest works and how it may be assigned.
2. Describe the two ways in which a tenant’s leasehold interest may be transferred to another
party.

General Rule
At common law, the interests of the landlord and tenant may be transferred freely unless (1) the
tenancy is at will; (2) the lease requires either party to perform significant personal services,
which would be substantially less likely to be performed if the interest was transferred; or (3)
the parties agree that the interest may not be transferred.

Landlord’s Interest
When the landlord sells his interest, the purchaser takes subject to the lease. If there are tenants
with leases in an apartment building, the new landlord may not evict them simply because he
has taken title. The landlord may divide his interest as he sees fit, transferring all or only part of
his entire interest in the property. He may assign his right to the rent or sell his reversionary
interest in the premises. For instance, Simone takes a three-year lease on an apartment near the
university. Simone’s landlord gives his aged uncle his reversionary interest for life. This means
that Simone’s landlord is now the uncle, and she must pay him rent and look to him for repairs
and other performances owed under the lease. When Simone’s lease terminates, the uncle will
be entitled to rent the premises. He does so, leasing to another student for three years. One year
later, the uncle dies. His nephew (Simone’s original landlord) has the reversionary interest and
so once again becomes the landlord. He must perform the lease that the uncle agreed to with the
new student, but when that lease expires, he will be free to rent the premises as he sees fit.

Tenant’s Interest
Why would a tenant be interested in transferring her leasehold interest? For at least two
reasons: she might need to move before her lease expired, or she might be able to make money
on the leasehold itself. In recent years, many companies in New York have discovered that their
present leases were worth far more to them by moving out than staying in. They had signed
long-term leases years ago when the real estate market was glutted and were paying far less than
current market prices. By subletting the premises and moving to cheaper quarters, they could
pocket the difference between their lease rate and the market rate they charged their subtenants.
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The tenant can transfer her interest in the lease by assigning or by subletting. In anassignment,
the tenant transfers all interest in the premises and all obligations. Thus the assignee-tenant is
duty bound to pay the landlord the periodic rental and to perform all other provisions in the
lease. If the assignee defaulted, however, the original tenant would remain liable to the landlord.
In short, with an assignment, both assignor and assignee are liable under the lease unless the
landlord releases the assignor. By contrast, a sublease is a transfer of something less than the
entire leasehold interest (see Figure 13.1 "Assignment vs. Sublease"). For instance, the tenant
might have five years remaining on her lease and sublet the premises for two years, or she might
sublet the ground floor of a four-story building. Unlike an assignee, the subtenant does not step
into the shoes of the tenant and is not liable to the landlord for performance of the tenant’s
duties. The subtenant’s only obligations are to the tenant. What distinguishes the assignment
from the sublease is not the name but whether or not the entire leasehold interest has been
transferred. If not, the transfer is a sublease.

Figure 13.1 Assignment vs. Sublease

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Many landlords include clauses in their leases prohibiting assignments or subleases, and these
clauses are generally upheld. But the courts construe them strictly, so that a provision barring
subleases will not be interpreted to bar assignments.

KEY TAKEAWAY

The interests of landlords and tenants can be freely transferred unless the parties agree
otherwise or unless there is a tenancy at will. If the tenant assigns her leasehold interest, she
remains liable under the lease unless the landlord releases her. If less than the entire
leasehold interest is transferred, it is a sublease rather than an assignment. But the original
lease may prohibit either or both.

EXERCISES

1. What is the difference between an assignment and a sublease?
2. Are the duties of the tenant any different if the reversionary interest is assigned? Suppose
that Simone is in year one of a three-year lease and that Harry is the landlord. If Harry assigns
his reversionary interest to Louise, can Louise raise the rent for the next two years beyond
what is stated in the original lease?

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13.4 Landlord’s Tort Liability

LEARNING OBJECTIVES

1. State the general common-law rule as to the liability of the landlord for injuries occurring on
the leased premises.
2. State the exceptions to the general rule, and explain the modern trend toward increased
liability of the landlord.
In Chapter 11 "The Nature and Regulation of Real Estate and the Environment", we discussed
the tort liability of the owner or occupier of real estate to persons injured on the property. As a
general rule, when injury occurs on premises rented to a tenant, it is the tenant—an occupier—
who is liable. The reason for this rule seems clear: The landlord has given up all but a
reversionary interest in the property; he has no further control over the premises. Indeed, he is
not even permitted on the property without the tenant’s permission. But over the years, certain
exceptions have developed to the rule that the landlord is not liable. The primary reason for this
change is the recognition that the landlord is better able to pay for repairs to his property than
his relatively poorer tenants and that he has ultimate control over the general conditions
surrounding the apartment or apartment complex.

Exceptions to the General Rule
Hidden Dangers Known to Landlord
The landlord is liable to the tenant, her family, or guests who are injured by hidden and
dangerous conditions that the landlord knew about or should have known about but failed to
disclose to the tenant.

Dangers to People off the Premises
The landlord is liable to people injured outside the property by defects that existed when the
lease was signed. Simone rents a dilapidated house and agrees with the landlord to keep the
building repaired. She neglects to hire contractors to repair the cracked and sagging wall on the
street. The building soon collapses, crushing several automobiles parked alongside. Simone can
be held responsible and so can the landlord; the tenant’s contractual agreement to maintain the
property is not sufficient to shift the liability away from the landlord. In a few cases, the landlord

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has even been held liable for activities carried on by the tenant, but only because he knew about
them when the lease was signed and should have known that the injuries were probable results.

Premises Leased for Admitting the Public
A landlord is responsible for injuries caused by dangerous conditions on property to be used by
the public if the danger existed when the lease was made. Thus an uneven floor that might cause
people to trip or a defective elevator that stops a few inches below the level of each floor would
be sufficiently dangerous to pin liability on the landlord.

Landlord Retaining Control of Premises
Frequently, a landlord will retain control over certain areas of the property—for example, the
common hallways and stairs in an apartment building. When injuries occur as a result of faulty
and careless maintenance of these areas, the landlord will be responsible. In more than half the
states, the landlord is liable for failure to remove ice and snow from a common walkway and
stairs at the entrance. In one case, the tenant even recovered damages for a broken hip caused
when she fell in fright from seeing a mouse that jumped out of her stove; she successfully
charged the landlord with negligence in failing to prevent mice from entering the dwelling in
areas under his control.

Faulty Repair of Premises
Landlords often have a duty to repair the premises. The duty may be statutory or may rest on an
agreement in the lease. In either case, the landlord will be liable to a tenant or others for injury
resulting from defects that should have been repaired. No less important, a landlord will be
liable even if he has no duty to repair but negligently makes repairs that themselves turn out to
be dangerous.

KEY TAKEAWAY

At common law, injuries taking place on leased premises were the responsibility of the
tenant. There were notable exceptions, including situations where hidden dangers were
known to the landlord but not the tenant, where the premises’ condition caused injury to
people off the premises, or where faulty repairs caused the injuries. The modern trend is to
adopt general negligence principles to determine landlord liability. Thus where the landlord

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does not use reasonable care and subjects others to an unreasonable risk of harm, there may
be liability for the landlord. This varies from state to state.

EXERCISES

1. What was the basic logic of the common law in having tenants be responsible for all injuries
that took place on leased premises?
2. Does the modern trend of applying general negligence principles to landlords make more
sense? Explain your answer.

13.5 Cases
Constructive Eviction
Fidelity Mutual Life Insurance Co. v. Kaminsky
768 S.W.2d 818 (Tx. Ct. App. 1989)
MURPHY, JUSTICE
The issue in this landlord-tenant case is whether sufficient evidence supports the jury’s findings
that the landlord and appellant, Fidelity Mutual Life Insurance Company [“Fidelity”],
constructively evicted the tenant, Robert P. Kaminsky, M.D., P.A. [“Dr. Kaminsky”] by breaching
the express covenant of quiet enjoyment contained in the parties’ lease. We affirm.
Dr. Kaminsky is a gynecologist whose practice includes performing elective abortions. In May
1983, he executed a lease contract for the rental of approximately 2,861 square feet in the Red
Oak Atrium Building for a two-year term which began on June 1, 1983. The terms of the lease
required Dr. Kaminsky to use the rented space solely as “an office for the practice of medicine.”
Fidelity owns the building and hires local companies to manage it. At some time during the lease
term, Shelter Commercial Properties [“Shelter”] replaced the Horne Company as managing
agents. Fidelity has not disputed either management company’s capacity to act as its agent.
The parties agree that: (1) they executed a valid lease agreement; (2) Paragraph 35 of the lease
contains an express covenant of quiet enjoyment conditioned on Dr. Kaminsky’s paying rent
when due, as he did through November 1984; Dr. Kaminsky abandoned the leased premises on
or about December 3, 1984 and refused to pay additional rent; anti-abortion protestors began

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picketing at the building in June of 1984 and repeated and increased their demonstrations
outside and inside the building until Dr. Kaminsky abandoned the premises.
When Fidelity sued for the balance due under the lease contract following Dr. Kaminsky’s
abandonment of the premises, he claimed that Fidelity constructively evicted him by breaching
Paragraph 35 of the lease. Fidelity apparently conceded during trial that sufficient proof of the
constructive eviction of Dr. Kaminsky would relieve him of his contractual liability for any
remaining rent payments. Accordingly, he assumed the burden of proof and the sole issue
submitted to the jury was whether Fidelity breached Paragraph 35 of the lease, which reads as
follows:

Quiet Enjoyment
Lessee, on paying the said Rent, and any Additional Rental, shall and may peaceably and quietly
have, hold and enjoy the Leased Premises for the said term.
A constructive eviction occurs when the tenant leaves the leased premises due to conduct by the
landlord which materially interferes with the tenant’s beneficial use of the premises. Texas law
relieves the tenant of contractual liability for any remaining rentals due under the lease if he can
establish a constructive eviction by the landlord.
The protests took place chiefly on Saturdays, the day Dr. Kaminsky generally scheduled
abortions. During the protests, the singing and chanting demonstrators picketed in the
building’s parking lot and inner lobby and atrium area. They approached patients to speak to
them, distributed literature, discouraged patients from entering the building and often accused
Dr. Kaminsky of “killing babies.” As the protests increased, the demonstrators often occupied
the stairs leading to Dr. Kaminsky’s office and prevented patients from entering the office by
blocking the doorway. Occasionally they succeeded in gaining access to the office waiting room
area.
Dr. Kaminsky complained to Fidelity through its managing agents and asked for help in keeping
the protestors away, but became increasingly frustrated by a lack of response to his requests.
The record shows that no security personnel were present on Saturdays to exclude protestors
from the building, although the lease required Fidelity to provide security service on Saturdays.
The record also shows that Fidelity’s attorneys prepared a written statement to be handed to the
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protestors soon after Fidelity hired Shelter as its managing agent. The statement tracked TEX.
PENAL CODE ANN. §30.05 (Vernon Supp. 1989) and generally served to inform trespassers
that they risked criminal prosecution by failing to leave if asked to do so. Fidelity’s attorneys
instructed Shelter’s representative to “have several of these letters printed up and be ready to
distribute them and verbally demand that these people move on and off the property.” The same
representative conceded at trial that she did not distribute these notices. Yet when Dr. Kaminsky
enlisted the aid of the Sheriff’s office, officers refused to ask the protestors to leave without a
directive from Fidelity or its agent. Indeed, an attorney had instructed the protestors to
remain unless the landlord or its representative ordered them to leave. It appears that Fidelity’s
only response to the demonstrators was to state, through its agents, that it was aware of Dr.
Kaminsky’s problems.
Both action and lack of action can constitute “conduct” by the landlord which amounts to a
constructive eviction.…
This case shows ample instances of Fidelity’s failure to act in the fact of repeated requests for
assistance despite its having expressly covenanted Dr. Kaminsky’s quiet enjoyment of the
premises. These instances provided a legally sufficient basis for the jury to conclude that Dr.
Kaminsky abandoned the leased premises, not because of the trespassing protestors, but
because of Fidelity’s lack of response to his complaints about the protestors. Under the
circumstances, while it is undisputed that Fidelity did not “encourage” the demonstrators, its
conduct essentially allowed them to continue to trespass.
[The trial court judgment is affirmed.]

CASE QUESTIONS

A constructive eviction occurs when the tenant leaves the leased premises because of
conduct by the landlord that materially interferes with the tenant’s beneficial use of the
premises.
1. At the trial, who concluded that Fidelity’s “conduct” constituted constructive eviction? Is this
a question of fact, an interpretation of the contract, or both?
2. How can failure to act constitute “conduct”? What could explain Fidelity’s apparent
reluctance to give notice to protestors that they might be arrested for trespass?

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Landlord’s Tort Liability
Stephens v. Stearns
106 Idaho 249; 678 P.2d 41 (Idaho Sup. Ct. 1984)
Donaldson, Chief Justice
Plaintiff-appellant Stephens filed this suit on October 2, 1978, for personal injuries she
sustained on July 15, 1977, from a fall on an interior stairway of her apartment. Plaintiff’s
apartment, located in a Boise apartment complex, was a “townhouse” consisting of two separate
floors connected by an internal stairway.
The apartments were built by defendant Koch and sold to defendant Stearns soon after
completion in 1973. Defendant Stearns was plaintiff’s landlord from the time she moved into the
apartment in 1973 through the time of plaintiff’s fall on July 15, 1977. Defendant Albanese was
the architect who designed and later inspected the apartment complex.
***
When viewed in the light most favorable to appellant, the facts are as follows: On the evening of
July 15, 1977, Mrs. Stephens went to visit friends. While there she had two drinks. She returned
to her apartment a little past 10:00 p.m. Mrs. Stephens turned on the television in the living
room and went upstairs to change clothes. After changing her clothes, she attempted to go
downstairs to watch television. As Mrs. Stephens reached the top of the stairway, she either
slipped or fell forward. She testified that she “grabbed” in order to catch herself. However, Mrs.
Stephens was unable to catch herself and she fell to the bottom of the stairs. As a result of the
fall, she suffered serious injury. The evidence further showed that the stairway was
approximately thirty-six inches wide and did not have a handrail although required by a Boise
ordinance.
***
In granting defendant Stearns’ motion for directed verdict, the trial judge concluded that there
was “an absolute lack of evidence” and that “to find a proximate cause between the absence of
the handrail and the fall suffered by the plaintiff would be absolutely conjecture and
speculation.” (Although the trial judge’s conclusion referred to “proximate cause,” it is apparent

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that he was referring to factual or actual cause. See Munson v. State, Department of Highways,
96 Idaho 529, 531 P.2d 1174 (1975).) We disagree with the conclusion of the trial judge.
We have considered the facts set out above in conjunction with the testimony of Chester
Shawver, a Boise architect called as an expert in the field of architecture, that the primary
purpose of a handrail is for user safety. We are left with the firm conviction that there is
sufficient evidence from which reasonable jurors could have concluded that the absence of a
handrail was the actual cause of plaintiff’s injuries; i.e., that plaintiff would not have fallen, or at
least would have been able to catch herself, had there been a handrail available for her to grab.
In addition, we do not believe that the jury would have had to rely on conjecture and speculation
to find that the absence of the handrail was the actual cause. To the contrary, we believe that
reasonable jurors could have drawn legitimate inferences from the evidence presented to
determine the issue. This comports with the general rule that the factual issue of causation is for
the jury to decide. McKinley v. Fanning, 100 Idaho 189, 595 P.2d 1084 (1979); Munson v. State,
Department of Highways, supra. In addition, courts in several other jurisdictions, when faced
with similar factual settings, have held that this issue is a question for the jury.
***
Rather than attempt to squeeze the facts of this case into one of the common-law exceptions,
plaintiff instead has brought to our attention the modern trend of the law in this area. Under the
modern trend, landlords are simply under a duty to exercise reasonable care under the
circumstances. The Tennessee Supreme Court had the foresight to grasp this concept many
years ago when it stated: “The ground of liability upon the part of a landlord when he demises
dangerous property has nothing special to do with the relation of landlord and tenant. It is the
ordinary case of liability for personal misfeasance, which runs through all the relations of
individuals to each other.” Wilcox v. Hines, 100 Tenn. 538, 46 S.W. 297, 299 (1898). Seventyfive years later, the Supreme Court of New Hampshire followed the lead of Wilcox. Sargent v.
Ross, 113 N.H. 388, 308 A.2d 528 (1973). The Sargent court abrogated the common-law rule
and its exceptions, and adopted the reasonable care standard by stating:
We thus bring up to date the other half of landlord-tenant law. Henceforth, landlords as other
persons must exercise reasonable care not to subject others to an unreasonable risk of harm.…A
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landlord must act as a reasonable person under all of the circumstances including the likelihood
of injury to others, the probable seriousness of such injuries, and the burden of reducing or
avoiding the risk.
Id. at 534 [Citations]
Tennessee and New Hampshire are not alone in adopting this rule. As of this date, several other
states have also judicially adopted a reasonable care standard for landlords.
***
In commenting on the common-law rule, A. James Casner, Reporter of Restatement (Second) of
Property—Landlord and Tenant, has stated: “While continuing to pay lip service to the general
rule, the courts have expended considerable energy and exercised great ingenuity in attempting
to fit various factual settings into the recognized exceptions.” Restatement (Second) of
Property—Landlord and Tenant ch. 17 Reporter’s Note to Introductory Note (1977). We believe
that the energies of the courts of Idaho should be used in a more productive manner. Therefore,
after examining both the common-law rule and the modern trend, we today decide to leave the
common-law rule and its exceptions behind, and we adopt the rule that a landlord is under a
duty to exercise reasonable care in light of all the circumstances.
We stress that adoption of this rule is not tantamount to making the landlord an insurer for all
injury occurring on the premises, but merely constitutes our removal of the landlord’s commonlaw cloak of immunity. Those questions of hidden danger, public use, control, and duty to
repair, which under the common-law were prerequisites to the consideration of the landlord’s
negligence, will now be relevant only inasmuch as they pertain to the elements of negligence,
such as foreseeability and unreasonableness of the risk. We hold that defendant Stearns did owe
a duty to plaintiff Stephens to exercise reasonable care in light of all the circumstances, and that
it is for a jury to decide whether that duty was breached. Therefore, we reverse the directed
verdict in favor of defendant Stearns and remand for a new trial of plaintiff’s negligence action
against defendant Stearns.

CASE QUESTIONS

1. Why should actual cause be a jury question rather than a question that the trial judge
decides on her own?

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2. Could this case have fit one of the standard exceptions to the common-law rule that injuries
on the premises are the responsibility of the tenant?
3. Does it mean anything at all to say, as the court does, that persons (including landlords) must
“exercise reasonable care not to subject others to an unreasonable risk of harm?” Is this a
rule that gives very much direction to landlords who may wonder what the limit of their
liabilities might be?

13.6 Summary and Exercises
Summary

A leasehold is an interest in real property that terminates on a certain date. The leasehold itself
is personal property and has three major forms: (1) the estate for years, (2) the periodic tenancy,
and (3) the tenancy at will. The estate for years has a definite beginning and end; it need not be
measured in years. A periodic tenancy—sometimes known as an estate from year to year or
month to month—is renewed automatically until either landlord or tenant notifies the other that
it will end. A tenancy at will lasts only as long as both landlord and tenant desire. Oral leases are
subject to the Statute of Frauds. In most states, leases to last longer than a year must be in
writing, and the lease must identify the parties and the premises, specify the duration, state the
rent, and be signed by the party to be charged.
The law imposes on the landlord certain duties toward the tenant and gives the tenant
corresponding rights, including the right of possession, habitable condition, and
noninterference with use. The right of possession is breached if a third party has paramount title
at the time the tenant is due to take possession. In most states, a landlord is obligated to provide
the tenant with habitable premises not only when the tenant moves in but also during the entire
period of the lease. The landlord must also refrain from interfering with a tenant’s permissible
use of the premises.
If the landlord breaches an obligation, the tenant has several remedies. He may terminate the
lease, recover damages, or (in several states) use a rent-related remedy (by withholding rent, by
applying it to remedy the defect, or by abatement).

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The tenant has duties also. The tenant must pay the rent. If she abandons the property and fails
to pay, most states do not require the landlord to mitigate damages, but several states are
moving away from this general rule. The tenant may physically change the property to use it to
her best advantage, but she may not make structural alterations or commit waste. The tenant
must restore the property to its original condition when the lease ends. This rule does not
include normal wear and tear.
Should the tenant breach any of her duties, the landlord may terminate the lease and seek
damages. In the case of a holdover tenant, the landlord may elect to hold the tenant to another
rental term.
The interest of either landlord or tenant may be transferred freely unless the tenancy is at will,
the lease requires either party to perform significant personal services that would be
substantially less likely to be performed, or the parties agree that the interest may not be
transferred.
Despite the general rule that the tenant is responsible for injuries caused on the premises to
outsiders, the landlord may have significant tort liability if (1) there are hidden dangers he
knows about, (2) defects that existed at the time the lease was signed injure people off the
premises, (3) the premises are rented for public purposes, (4) the landlord retains control of the
premises, or (5) the landlord repairs the premises in a faulty manner.

EXERCISES

1. Lanny orally agrees to rent his house to Tenny for fifteen months, at a monthly rent of
$1,000. Tenny moves in and pays the first month’s rent. Lanny now wants to cancel the lease.
May he? Why?
2. Suppose in Exercise 1 that Tenny had an option to cancel after one year. Could Lanny cancel
before the end of the year? Why?
3. Suppose in Exercise 1 that Lanny himself is a tenant and has leased the house for six months.
He subleases the house to Tenny for one year. The day before Tenny is to move into the
house, he learns of Lanny’s six-month lease and attempts to terminate his one-year lease.
May he? Why?

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4. Suppose in Exercise 3 that Tenny learned of Lanny’s lease the day after he moved into the
house. May he terminate? Why?
5. Simon owns a four-story building and rents the top floor to a college student. Simon is in the
habit of burning refuse in the backyard, and the smoke from the refuse is so noxious that it
causes the student’s eyes to water and his throat to become raw. Has Simon breached a duty
to the student? Explain.
6. In Exercise 5, if other tenants (but not Simon) were burning refuse in the backyard, would
Simon be in breach? Why?
7. Assume in Exercise 5 that Simon was in breach. Could the student move out of the apartment
and terminate the lease? What effect would this have on the student’s duty to pay rent?
Explain.

SELF-TEST QUESTIONS

1. An estate for years
a.

has a definite beginning and end
b. is a leasehold estate
c. usually terminates automatically at midnight of the last day specified in the lease
d. includes all of the above
Not included among the rights given to a tenant is

a.

paramount title
b. possession
c. habitable condition
d. noninterference with use
The interest of either landlord or tenant may be transferred freely

a.

unless the tenancy is at will
b. unless the lease requires significant personal services unlikely to be performed by
someone else
c. unless either of the above apply
d. under no circumstances
When injuries are caused on the premises to outsiders,

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a.

the tenant is always liable

b. the landlord is always liable
c. the landlord may be liable if there are hidden dangers the landlord knows about
d. they have no cause of action against the landlord or tenant since they have no
direct contractual relationship with either party
Legally a tenant may
a.

commit waste

b. make some structural alterations to the property
c. abandon the property at any time
d. physically change the property to suit it to her best advantage, as long as no
structural alterations are made

SELF-TEST ANSWERS

1. d
2. a
3. c
4. c
5. d

Chapter 14
Estate Planning: Wills, Estates, and Trusts
LEARNING OBJECTIVES

After reading this chapter, you should understand the following:
1. How property, both real and personal, can be devised and bequeathed to named heirs in a
will
2. What happens to property of a decedent when there is no will
3. The requirements for “testamentary capacity”—what it takes to make a valid will that can be
admitted to probate
4. The steps in the probate and administration of a will

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5. How a will is distinguished from a trust, and how a trust is created, how it functions, and how
it may come to an end
6. The various kinds of trusts, as well as factors that affect both estates and trusts
Broadly defined, estate planning is the process by which someone decides how his assets are to
be passed on to others at his death. Estate planning has two general objectives: to ensure that
the assets are transferred according to the owner’s wishes and to minimize state and federal
taxes.
People have at their disposal four basic estate planning tools: (1) wills, (2) trusts, (3) gifts, and
(4) joint ownership (see Figure 14.1 "Estate Planning"). The rules governing gifts are discussed
in Chapter 9 "Introduction to Property: Personal Property and Fixtures", and joint ownership is
treated in Chapter 11 "The Nature and Regulation of Real Estate and the Environment".
Consequently, we focus on the first two tools here. In addition to these tools, certain assets, such
as insurance (discussed in Chapter 15 "Insurance"), are useful in estate planning.

Figure 14.1 Estate Planning

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Estate planning not only provides for the spouses and children, other relatives and friends, the
children’s education, payoff of the mortgage, and so on, but also serves as the principal means
by which liquidity can be guaranteed for taxes, expenses for administering the estate, and the
like, while preserving the assets of the estate. And whenever a business is formed, estate
planning consequences should always be considered, because the form and structure of the
business can have important tax ramifications for the individual owners.

14.1 Wills and Estate Administration

LEARNING OBJECTIVES

1. Describe how property, both real and personal, can be devised and bequeathed to named
heirs in a will.
2. Understand what happens to property of a decedent when there is no will.
3. Explain the requirements for “testamentary capacity”—what it takes to make a valid will that
can be admitted to probate.
4. Describe the steps in the probate and administration of a will.

Definition
A will is the declaration of a person’s wishes about the disposition of his assets on his death.
Normally a written document, the will names the persons who are to receive specific items of
real and personal property. Unlike a contract or a deed, a will is not binding as long as the
person making the will lives. He may revoke it at any time. Wills have served their present
function for virtually all of recorded history. The earliest known will is from 1800 BC (see Figure
14.2 "An Ancient Will"). Even if somewhat different in form, it served the same basic function as
a modern will.

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Figure 14.2 An Ancient Will

Source: John H. Wigmore, A Panorama of the World’s Legal Systems, vol. 1, p. 22.

Although most wills are written in a standardized form, some special types of wills are
enforceable in many states.
1. A nuncupative will is one that is declared orally in front of witnesses. In states where allowed,
the statutes permit it to be used only when the testator is dying as he declares his will. (A
testator is one who dies with a will.)
2. A holographic will is one written entirely by the testator’s hand and not witnessed. At common
law, a holographic will was invalid if any part of the paper on which it was written contained

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printing. Modern statutes tend to validate holographic wills, even with printing, as long as the
testator who signs it puts down material provisions in his own hand.
3. Soldiers’ and sailors’ wills are usually enforceable, no matter how informal the document, if
made while the soldier is on service or the sailor is at sea (although they cannot usually transfer
real property without observing certain formalities).
4. A conditional will is one that will take effect only on the happening of a particular named event.
For example, a man intending to marry might write, “This will is contingent on my marrying
Alexa Jansey.” If he and Ms. Jansey do not marry, the will can have no operational effect.
5. A joint will is one in which two (or more) people use the same instrument to dispose of their
assets. It must be signed by each person whose assets it is to govern.
6. Mutual or reciprocal wills are two or more instruments with reciprocal terms, each written by a
person who intends to dispose of his or her assets in favor of the others.

The Uniform Probate Code
Probate is the process by which a deceased’s estate is managed under the supervision of a court.
In most states, the court supervising this process is a specialized one and is often called the
probate court. Probate practices vary widely from state to state, although they follow a general
pattern in which the assets of an estate are located, added up, and disbursed according to the
terms of the will or, if there is no will, according to the law of intestate succession. To attempt to
bring uniformity into the conflicting sets of state laws the National Conference of
Commissioners on Uniform State Laws issued the Uniform Probate Code (UPC) in 1969, and by
2011 it had been adopted in its entirety in sixteen states. Several other states have adopted
significant parts of the UPC, which was revised in 2006. Our discussion of wills and estate
administration is drawn primarily from the UPC, but you should note that there are variations
among the states in some of the procedures standardized in the UPC.

Will Requirements and Interpretation
Capacity
Any person who is over eighteen and of “sound mind” may make a will. One who is insane may
not make an enforceable will, although the degree of mental capacity necessary to sustain a will
is generally said to be a “modest level of competence” and is lower than the degree of capacity
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people must possess to manage their own affairs during their life. In other words, a court might
order a guardian to manage the affairs of one who is mentally deficient but will uphold a will
that the person has written. Insanity is not the only type of mental deficiency that will disqualify
a will; medication of a person for serious physical pain might lead to the conclusion that the
person’s mind was dulled and he did not understand what he was doing when writing his will.
The case Estate of Seymour M. Rosen, (see Section 14.4.1 "Testamentary Capacity"), considers
just such a situation.

Writing
Under the UPC, wills must be in writing. The will is not confined to the specific piece of paper
called “will” and signed by the testator. It may incorporate by reference any other writing in
existence when the will is made, as long as the will sufficiently identifies the other writing and
manifests an intent to incorporate it. Although lawyers prepare neatly typed wills, the document
can be written in pencil or pen and on any kind of paper or even on the back of an envelope.
Typically, the written will has the following provisions: (1) a “publication clause,” listing the
testator’s name and his or her intention to make a will; (2) a “revocation clause,” revoking all
previously made wills; (3) burial instructions; (4) debt payments, listing specific assets to be
used; (5)bequests, which are gifts of personal property by will; (6) devises, which are gifts of real
property by will; (7) a “residuary clause,” disposing of all property not covered by a specific
bequest or devise; (8) a “penalty clause,” stating a penalty for anyone named in the will who
contests the will; (9) the name of minor children’s guardian; and (10) the name of the executor.
The executor’s job is to bring in all the assets of an estate, pay all just claims, and make
distribution to beneficiaries in accord with the testator’s wishes. Beginning with California in
1983, several states have adopted statutory wills—simple fill-in-the-blank will forms that can be
completed without consulting an attorney.

Signature
The testator must sign the will, and the proper place for the signature is at the end of the entire
document. The testator need not sign his full name, although that is preferable; his initials or
some other mark in his own hand, intended as an execution of the document, will suffice. The

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UPC permits someone else to sign for the testator as long as the signing is done in the testator’s
presence and by his or her direction.

Witnesses
Most states require two or three witnesses to sign the will. The UPC requires two witnesses. The
witnesses should observe the testator sign the will and then sign it themselves in the presence of
each other. Since the witnesses might be asked to attest in court to the testator’s signature, it is
sound practice to avoid witnesses who are unduly elderly and to use an extra witness or two.
Most states forbid a person who has an interest in the will—that is, one who is a beneficiary
under the will—from witnessing.
In some states, a beneficiary who serves as a witness will lose his or her right to a bequest or
devise. The UPC differs from the usual rule: no will or any provision of a will is invalid because
an interested party witnesses it, nor does the interested witness forfeit a bequest or devise.

Revocation and Modification
Since wills are generally effective only at death, the testator may always revoke or amend a will
during his lifetime. He may do so by tearing, burning, obliterating, or otherwise destroying it. A
subsequent will has the effect of revoking an inconsistent prior will, and most wills expressly
state that they are intended to revoke all prior wills. A written modification of or supplement to
a prior will is called a codicil. The codicil is often necessary, because circumstances are
constantly changing. The testator may have moved to a new state where he must meet different
formal requirements for executing the will; one of his beneficiaries may have died; his property
may have changed. Or the law, especially the tax law, may have changed.
One exception to the rule that wills are effective only at death is the so-calledliving will.
Beginning with California in 1976, most states have adopted legislation permitting people to
declare that they refuse further treatment should they become terminally ill and unable to tell
physicians not to prolong their lives if they can survive only by being hooked up to lifepreserving machines. This living will takes effect during the patient’s life and must be honored
by physicians unless the patient has revoked it. The patient may revoke at any time, even as he
sees the doctor moving to disconnect the plug.

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In most states, a later marriage revokes a prior will, but divorce does not. Under the UPC,
however, a divorce or annulment revokes any disposition of property bequeathed or devised to
the former spouse under a will executed prior to the divorce or annulment. A will is at least
partially revoked if children are born after it is executed, unless it has either provided for
subsequently born children or stated the testator’s intention to disinherit such children.

Abatement
Specific bequests listed in a will might not be available in the estate when the testator or
testatrix dies. Abatement of a bequest happens when there are insufficient assets to pay the
bequest. Suppose the testatrix leaves $10,000 each to “my four roommates,” but when she dies,
her estate is worth only $20,000. The gift to each of the roommates is said to have abated, and
each will take only $5,000.
Abatement can pose a serious problem in wills not carefully drafted. Since circumstances can
always change, a general provision in a father’s will, providing “my dear daughter with all the
rest, residue, and remainder of my estate,” will do her little good if business reverses mean that
the $10,000 bequest to the local hospital exhausts the estate of its assets—even though at the
time the will was made, the testator had assets of $1 million and supposed his daughter would
be getting the bulk of it. Since specific gifts must be paid out ahead of general bequests or
devises, abatement can cause the residual legatee (the person taking all assets not specifically
distributed to named individuals) to suffer.

Ademption
Suppose that a testator bequeathed her 1923 Rolls Royce to “my faithful secretary,” but that the
car had been sold and she owned only a 1980 Volkswagen when she died. Since the Rolls was
not part of the estate, it is said to have adeemed (to have been taken away). Ademption of a gift
in a will means that the intended legatee (the person named in the will) forfeits the object
because it no longer exists. An object used as a substitute by the testator will not pass to the
legatee unless it is clear that she intended the legatee to have it.

Intestacy
Intestacy means dying without a will. Intestacy happens all too frequently; even those who know
the consequences for their heirs often put off making a will until it is too late—Abraham Lincoln,
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for one, who as an experienced lawyer knew very well the hazards to heirs of dying intestate. On
his death, Lincoln’s property was divided, with one-third going to his widow, one-third to a
grown son, and one-third to a twelve-year-old son. Statistics show that in New York, about onethird of the people who die with estates of $5,000 or more die without wills. In every state,
statutes provide for the disposition of property of decedents dying without wills. If you die
without a will, the state in effect has made one for you. Although the rules vary by statute from
state to state, a common distribution pattern prevails.

Unmarried Decedent
At common law, parents of an intestate decedent could not inherit his property. Today, however,
many states provide that parents will share in the property. If the parents have already died,
then the estate will pass to collateral heirs (siblings, nieces, nephews, aunts, and uncles). If there
are no collateral heirs, most state laws provide that the next surviving kin of equal degree will
share the property equally (e.g., first cousins). If there are no surviving kin, the
estate escheats (es CHEETS) to the state, which is then the sole owner of the assets of the estate.

Married with No Children
In some states, the surviving spouse without children will inherit the entire estate. In other
states, the spouse must share the property with the decedent’s parents or, if they are deceased,
with the collateral heirs.

Married with Children
In general, the surviving spouse will be entitled to one-third of the estate, and the remainder will
pass in equal shares to living children of the decedent. The share of any child who died before
the decedent will be divided equally among that child’s offspring. These grandchildren of the
decedent are said to take per stirpes (per STIR peas), meaning that they stand in the shoes of
their parent. Suppose that the decedent left a wife, three children, and eight grandchildren (two
children each of the three surviving children and two children of a fourth child who predeceased
the decedent), and that the estate was worth $300,000. Under a typical intestate succession law,
the widow would receive property worth $100,000. The balance of the property would be
divided into four equal parts, one for each of the four children. The three surviving children

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would each receive $50,000. The two children of the fourth child would each receive $25,000.
The other grandchildren would receive nothing.
A system of distribution in which all living descendants share equally, regardless of generation,
is said to be a distribution per capita. In the preceding example, after the widow took her share,
the remaining sum would be divided into eleven parts, three for the surviving children and eight
for the surviving grandchildren.

Unmarried with Children
If the decedent was a widow or widower with children, then the surviving children generally will
take the entire estate.

Estate Administration
To carry on the administration of an estate, a particular person must be responsible for locating
the estate property and carrying out the decedent’s instructions. If named in the will, this person
is called an executor. When a woman serves, she is still known in many jurisdictions as
an executrix. If the decedent died intestate, the court will appoint an administrator (or
administratrix, if a woman), usually a close member of the family. The UPC refers to the person
performing the function of executor or administrator as a personal representative. Unless
excused by the will from doing so, the personal representative must post a bond, usually in an
amount that exceeds the value of the decedent’s personal property.
The personal representative must immediately become familiar with the decedent’s business,
preserve the assets, examine the books and records, check on insurance, and notify the
appropriate banks.
When confirmed by the court (if necessary), the personal representative must offer the will in
probate—that is, file the will with the court, prove its authenticity through witnesses, and defend
it against any challenges. Once the court accepts the will, it will enter a formal decree admitting
the will to probate.
Traditionally, a widow could make certain elections against the will; for example, she could
choose dower and homestead rights. The right of dower entitled the widow to a life estate in
one-third of the husband’s inheritable land, while a homestead right is the right to the family
home as measured by an amount of land (e.g., 160 acres of rural land or 1 acre of urban land in
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Kansas) or a specific dollar amount. In some states, this amount is quite low (e.g., $4,000 in
Kansas) where the legislature has not upwardly adjusted the dollar amount for many years.
Today, most states have eliminated traditional dower rights. These states give the surviving
spouse (widow or widower) the right to reject provisions made in a will and to take a share of the
decedent’s estate instead.
Once the will is admitted to probate, the personal representative must assemble and inventory
all assets. This task requires the personal representative to collect debts and rent due, supervise
the decedent’s business, inspect the real estate, store personal and household effects, prove the
death and collect proceeds of life insurance policies, take securities into custody, and ascertain
whether the decedent held property in other states. Next, the assets must be appraised as of the
date of death. When inventory and appraisal are completed, the personal representative must
decide how and when to dispose of the assets by answering the following sorts of questions:
Should a business be liquidated, sold, or allowed to continue to operate? Should securities be
sold, and if so, when? Should the real estate be kept intact under the will or sold? To whom must
the personal effects be given?
The personal representative must also handle claims against the estate. If the decedent had
unpaid debts while alive, the estate will be responsible for paying them. In most states, the
personal representative is required to advertise that the estate is in probate. When all claims
have been gathered and authenticated, the personal representative must pay just claims in order
of priority. In general (though by no means in every state), the order of priority is as follows: (1)
funeral expenses, (2) administration expenses (cost of bond, advertising expenses, filing fees,
lawsuit costs, etc.), (3) family allowance, (4) claims of the federal government, (5) hospital and
other expenses associated with the decedent’s last illness, (6) claims of state and local
governments, (7) wage claims, (8) lien claims, (9) all other debts. If the estate is too small to
cover all these claims, every claim in the first category must be satisfied before the claims in the
second category may be paid, and so on.
Before the estate can be distributed, the personal representative must take care of all taxes owed
by the estate. She will have to file returns for both estate and income taxes and pay from assets
of the estate the taxes due. (She may have to sell some assets to obtain sufficient cash to do
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so.) Estate taxes—imposed by the federal government and based on the value of the estate—are
nearly as old as the Republic; they date back to 1797. They were instituted originally to raise
revenue, but in our time they serve also to break up large estates.
As of 2011, the first $1 million of an estate is exempt from taxation, lowering the threshold from
an earlier standard. The Tax Policy Institute of the Brookings Institution estimates that 108,200
estates of people dying in 2011 will file estate tax returns, and 44,200 of those estates will pay
taxes totaling $34.4 billion.
Although a unified tax is imposed on gifts during life and transfers at death, everyone is
permitted to give away $13,000 per donee each year without paying any tax on the gift. A tax on
sizable gifts is imposed to prevent people with large estates from giving away during their lives
portions of their estate in order to escape estate taxes. Thus two grandparents with two married
children and four grandchildren may give away $26,000 ($13,000 from each grandparent) to
their eight descendants (children, spouses, grandchildren) each year, for a total of $208,000,
without paying any tax.
State governments also impose taxes at death. In many states, these are known
asinheritance taxes and are taxes on the heir’s right to receive the property. The tax rate depends
on the relationship to the decedent: the closer the relation, the smaller the tax. Thus a child will
pay less than a nephew or niece, and either of them will pay less than an unrelated friend who is
named in the will.
Once the taxes are paid, a final accounting must be prepared, showing the remaining principal,
income, and disbursements. Only at this point may the personal representative actually
distribute the assets of the estate according to the will.

KEY TAKEAWAY

Any person with the requisite capacity may make a will and bequeath personal property to
named heirs. A will can also devise real property. Throughout the United States, there are
fairly common requirements to be met for a will to qualify for probate.
Intestacy statutes will govern where there is no will, and an administrator will be appointed
by the probate court. Intestacy statutes will dictate which relatives will get what portion of
the decedent’s estate, portions that are likely to differ from what the decedent would have

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done had he or she left a valid will. Where there are no heirs, the decedent’s property
escheats to the state.
An executor (or executrix) is the person named in the will to administer the estate and
render a final accounting. Estate and inheritance taxes may be owed if the estate is large
enough.

EXERCISES

1. Donald Trump is married to Ivanna Trump, but they divorce. Donald neglects to change his
will, which leaves everything to Ivanna. If he were to die before remarrying, would the will
still be valid?
2. Tom Tyler, married to Tina Tyler, dies without a will. If his legal state of residence is
California, how will his estate be distributed? (This will require a small amount of Internet
browsing.)
3. Suppose Tom Tyler is very wealthy. When he dies at age sixty-three, there are two wills: one
leaves everything to his wife and family, and the other leaves everything to his alma mater,
the University of Colorado. The family wishes to dispute the validity of the second (later in
time) will. What, in general, are the bases on which a will can be challenged so that it does
not enter into probate?

14.2 Trusts

LEARNING OBJECTIVES

1. Distinguish a will from a trust, and describe how a trust is created, how it functions, and how
it may come to an end.
2. Compare the various kinds of trusts, as well as factors that affect both estates and trusts.

Definitions
When the legal title to certain property is held by one person while another has the use and
benefit of it, a relationship known as a trust has been created. The trust developed centuries ago
to get around various nuances and complexities, including taxes, of English real property law.
The trustee has legal title and the beneficiary has “equitable title,” since the courts of equity
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would enforce the obligations of the trustee to honor the terms by which the property was
conveyed to him. A typical trust might provide for the trustee to manage an estate for the
grantor’s children, paying out income to the children until they are, say, twenty-one, at which
time they would become legal owners of the property.
Trusts may be created by bequest in a will, by agreement of the parties, or by a court decree.
However created, the trust is governed by a set of rules that grew out of the courts of equity.
Every trust involves specific property, known as the res (rees; Latin for “thing”), and three
parties, though the parties may be the same person.

Settlor or Grantor
Anyone who has legal capacity to make a contract may create a trust. The creator is known as
the settlor or grantor. Trusts are created for many reasons; for example, so that a minor can
have the use of assets without being able to dissipate them or so that a person can have a
professional manage his money.

Trustee
The trustee is the person or legal entity that holds the legal title to the res. Banks do
considerable business as trustees. If the settlor should neglect to name a trustee, the court may
name one. The trustee is a fiduciary of the trust beneficiary and will be held to the highest
standard of loyalty. Not even an appearance of impropriety toward the trust property will be
permitted. Thus a trustee may not loan trust property to friends, to a corporation of which he is
a principal, or to himself, even if he is scrupulous to account for every penny and pays the
principal back with interest. The trustee must act prudently in administering the trust.

Beneficiary
The beneficiary is the person, institution, or other thing for which the trust has been created.
Beneficiaries are not limited to one’s children or close friends; an institution, a corporation, or
some other organization, such as a charity, can be a beneficiary of a trust, as can one’s pet dogs,
cats, and the like. The beneficiary may usually sell or otherwise dispose of his interest in a trust,
and that interest likewise can usually be reached by creditors. Note that the settlor may create a
trust of which he is the beneficiary, just as he may create a trust of which he is the trustee.

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Continental Bank & Trust Co. v. Country Club Mobile Estates, Ltd., (see Section 14.4.2
"Settlor’s Limited Power over the Trust"), considers a basic element of trust law: the settlor’s
power over the property once he has created the trust.

Express Trusts
Trusts are divided into two main categories: express and implied. Express trusts
includetestamentary trusts and inter vivos (or living) trusts. The testamentary trust is one
created by will. It becomes effective on the testator’s death. The inter vivos trust is one created
during the lifetime of the grantor. It can be revocable or irrevocable (seeFigure 14.3 "Express
Trusts").
Figure 14.3 Express Trusts

A revocable trust is one that the settlor can terminate at his option. On termination, legal title to
the trust assets returns to the settlor. Because the settlor can reassert control over the assets
whenever he wishes, the income they generate is taxed to him.
By contrast, an irrevocable trust is permanent, and the settlor may not revoke or modify its
terms. All income to the trust must be accumulated in the trust or be paid to the beneficiaries in
accordance with the trust agreement. Because income does not go to the settlor, the irrevocable
trust has important income tax advantages, even though it means permanent loss of control over
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the assets (beyond the instructions for its use and disposition that the settlor may lay out in the
trust agreement). A hybrid form is the reversionary trust: until the end of a fixed period, the
trust is irrevocable and the settlor may not modify its terms, but thereafter the trust assets revert
to the settlor. The reversionary trust combines tax advantages with ultimate possession of the
assets.
Of the possible types of express trusts, five are worth examining briefly: (1) Totten trusts, (2),
blind trusts, (3) Clifford trusts, (4) charitable trusts, and (5) spendthrift trusts. The use of
express trusts in business will also be noted.

Totten Trust
The Totten trust, which gets its name from a New York case, In re Totten, [1] is a tentative trust
created when someone deposits funds in a bank as trustee for another person as beneficiary.
(Usually, the account will be named in the following form: “Mary, in trust for Ed.”) During the
beneficiary’s lifetime, the grantor-depositor may withdraw funds at his discretion or revoke the
trust altogether. But if the grantor-depositor dies before the beneficiary and had not revoked the
trust, then the beneficiary is entitled to whatever remains in the account at the time of the
depositor’s death.

Blind Trust
In a blind trust, the grantor transfers assets—usually stocks and bonds—to trustees who hold
and manage them for the grantor as beneficiary. The trustees are not permitted to tell the
grantor how they are managing the portfolio. The blind trust is used by high government
officials who are required by the Ethics in Government Act of 1978 to put their assets in blind
trusts or abstain from making decisions that affect any companies in which they have a financial
stake. Once the trust is created, the grantor-beneficiary is forbidden from discussing financial
matters with the trustees or even to give the trustees advice. All that the grantor-beneficiary sees
is a quarterly statement indicating by how much the trust net worth has increased or decreased.

Clifford Trust
The Clifford trust, named after the settlor in a Supreme Court case, Helvering v. Clifford, [2] is
reversionary: the grantor establishes a trust irrevocable for at least ten years and a day. By so
doing, the grantor shifts the tax burden to the beneficiary. So a person in a higher bracket can
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save considerable money by establishing a Clifford trust to benefit, say, his or her children. The
tax savings will apply as long as the income from the trust is not devoted to needs of the children
that the grantor is legally required to supply. At the expiration of the express period in the trust,
legal title to the res reverts to the grantor. However, the Tax Reform Act of 1986 removed the tax
advantages for Clifford trusts established after March 1986. As a result, all income from such
trusts is taxed to the grantor. Existing Clifford trusts were not affected by the 1986 tax law.

Charitable Trust
A charitable trust is one devoted to any public purpose. The definition is broad; it can
encompass funds for research to conquer disease, to aid battered wives, to add to museum
collections, or to permit a group to proselytize on behalf of a particular political or religious
doctrine. The law in all states recognizes the benefits to be derived from encouraging charitable
trusts, and states use the cy pres (see press; “as near as possible”) doctrine to further the intent
of the grantor. The most common type of trust is the charitable remainder trust. You would
donate property—usually intangible property such as stock—in trust to an approved charitable
organization, usually one that has tax-exempt 501(c)(3) status from the IRS. The organization
serves as trustee during your life and provides you or someone you designate with a specified
level of income from the property that you donated. This could be for a number of years or for
your lifetime. After your death or the period that you set, the trust ends and the charitable
organization owns the assets that were in the trust.
There are important tax reasons why people set up charitable trusts. The trustor gets five years'
worth of tax deductions for the value of the assets in the charitable trust. Capital gains are
treated favorably, as well: charitable trusts are irrevocable, which means that the person setting
up the trust (the “trustor”) permanently gives up control of the assets to the charitable
organization. Thus, the charitable organization could sell an asset in the trust that would
ordinarily incur significant capital gains taxes, but since the trustor no longer owns the asset,
there is no capital gains tax: as a tax-exempt organization, the charity will not pay capital gains,
either.

Spendthrift Trust

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A spendthrift trust is established when the settlor believes that the beneficiary is not to be
trusted with whatever rights she might possess to assign the income or assets of the trust. By
express provision in a trust instrument, the settlor may ensure that the trustees are legally
obligated to pay only income to the beneficiary; no assignment of the assets may be made, either
voluntarily by the beneficiary or involuntarily by operation of law. Hence the spendthrift
beneficiary cannot gamble away the trust assets nor can they be reached by creditors to pay her
gambling (or other) debts.

Express Trusts in Business
In addition to their use in estate planning, express trusts are also created for business purposes.
The business trust was popular late in the nineteenth century as a way of getting around state
limitations on the corporate form and is still used today. By giving their shares to a voting trust,
shareholders can ensure that their agreement to vote as a bloc will be carried out. But voting
trusts can be dangerous. Agreements that result in price fixing or other restraints of trade violate
the antitrust laws; for example, companies are in violation when they act collusively to fix prices
by pooling voting stock under a trust agreement, as happened frequently at the turn of the
century.

Implied Trusts
Trusts can be created by courts without any intent by a settlor to do so. For various reasons, a
court will declare that particular property is to be held by its owner in trust for someone else.
Such trusts are implied trusts and are usually divided into two
types:constructive trusts and resulting trusts. A constructive trust is one created usually to
redress a fraud or to prevent unjust enrichment. Suppose you give $1 to an agent to purchase a
lottery ticket for you, but the agent buys the ticket in his own name instead and wins
$1,000,000, payable into an account in amounts of $50,000 per year for twenty years. Since the
agent had violated his fiduciary obligation and unjustly enriched himself, the court would
impose a constructive trust on the account, and the agent would find himself holding the funds
as trustee for you as beneficiary. By contrast, a resulting trust is one imposed to carry out the
supposed intent of the parties. You give an agent $100,000 to purchase a house for you. Title is
put in your agent’s name at the closing, although it is clear that since she was paid for her
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services, you did not intend to give the house to her as a gift. The court would declare that the
house was to be held by the agent as trustee for you during the time that it takes to have the title
put in your name.

KEY TAKEAWAY

A trust can be created during the life of the settlor of the trust. A named trustee and
beneficiary are required, as well as some assets that the trustee will administer. The trustee
has a fiduciary duty to administer the trust with the utmost care. Inter vivos trusts can be
revocable or irrevocable. Testamentary trusts are, by definition, not revocable, as they take
effect on the death of the settlor.

EXERCISES

1. Karen Vreeland establishes a testamentary trust for her son, Brian, who has a gambling
addiction. What kind of trust should she have established?
2. A group of ten coworkers “invests” in the Colorado Lottery when the jackpot reaches $200
million. Each puts in $10 for five tickets. Dan Connelly purchases fifty Colorado Lottery tickets
on behalf of the group and holds them. As luck would have it, one of the tickets is a winner.
Dan takes the ticket, claims the $200 million, quits his job, and refuses to share. Do the
coworkers have any legal recourse? Was a trust created in this situation?
3. Laura Sarazen has two sisters, Lana and Linda. Laura deposits $50,000 at the Bank of America
and creates an account that names her sister, Linda, in the following form: “Laura Sarazen, in
trust for Linda Sarazen.” Laura dies two years later and has not withdrawn funds from the
bank. The executrix, Lana Sarazen, wants to include those funds in the estate. Linda wants to
claim the $50,000 plus accumulated interest in addition to whatever share she gets in the
will. Can she?

[1] In re Totten, 71 N.E. 748 (N.Y. 1904).
[2] Helvering v. Clifford, 309 U.S. 331 (1940).

14.3 Factors Affecting Estates and Trusts
LEARNING OBJECTIVES

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1. Know how principal and income are distinguished in administering a trust.
2. Explain how estates and trusts are taxed, and the utility of powers of appointment.

Principal and Income
Often, one person is to receive income from a trust or an estate and another person, the
remainderman, is to receive the remaining property when the trust or estate is terminated. In
thirty-six states, a uniform act, the Uniform Principal and Income Act (UPIA), defines principal
and income and specifies how expenses are to be paid. If the trust agreement expressly gives the
trustee power to determine what is income and what is principal, then his decision is usually
unreviewable. If the agreement is silent, the trustee is bound by the provisions of the UPIA.
The general rule is that ordinary receipts are income, whereas extraordinary receipts are
additions to principal. Ordinary receipts are defined as the return of money or property derived
from the use of the principal, including rent, interest, and cash dividends. Extraordinary
receipts include stock dividends, revenues or other proceeds from the sale or exchange of trust
assets, proceeds from insurance on assets, all income accrued at the testator’s death, proceeds
from the sale or redemption of bonds, and awards or judgments received in satisfaction of
injuries to the trust property. Expenses or obligations incurred in producing or preserving
income—including ordinary repairs and ordinary taxes—are chargeable to income. Expenses
incurred in making permanent improvements to the property, in investing the assets, and in
selling or purchasing trust property are chargeable to principal, as are all obligations incurred
before the decedent’s death.

Taxation
Estates and trusts are taxable entities under the federal income tax statute. The general rule is
that all income paid out to the beneficiaries is taxable to the beneficiaries and may be deducted
from the trust’s or estate’s gross income in arriving at its net taxable income. The trust or estate
is then taxed on the balance left over—that is, on any amounts accumulated. This is known as
the conduit rule, because the trust or estate is seen as a conduit for the income.

Power of Appointment
A power of appointment is the authority given by one person (the donor) to another (the donee)
to dispose of the donor’s property according to whatever instructions the donor provides. A
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power of appointment can be created in a will, in a trust, or in some other writing. The writing
may imply the power of appointment rather than specifically calling it a power of appointment.
For example, a devise or bequest of property to a person that allows that person to receive it or
transfer it gives that person a power of appointment. The person giving the power is the donor,
and the person receiving it is the donee.
There are three classes of powers of appointment. General powers of appointment give donees
the power to dispose of the property in any way they see fit. Limited powers of appointment,
also known as special powers of appointment, give donees the power to transfer the property to
a specified class of persons identified in the instrument creating the power. Testamentary
powers of appointment are powers of appointment that typically are created by wills.
If properly used, the power of appointment is an important tool, because it permits the donee to
react flexibly to circumstances that the donor could not have foreseen. Suppose you desire to
benefit your children when they are thirty-five or forty according to whether they are wealthy or
poor. The poorer children will be given more from the estate or trust than the wealthier ones.
Since you will not know when you write the will or establish the trust which children will be
poorer, a donee with a power of appointment will be able to make judgments impossible for the
donor to make years or decades before.

KEY TAKEAWAY

Administering either an estate or a trust requires knowing the distinction between principal
and income in a variety of situations. For example, knowing which receipts are ordinary and
which are extraordinary is essential to knowing whether to allocate the receipts as income or
as an addition to principal. Knowing which expenses are chargeable to principal and which
are chargeable to income is also important. Both estates and trusts are taxable entities,
subject to federal and state laws on estate and trust taxation. Powers of appointment can be
used in both trusts and estates in order to give flexibility to named donees.

EXERCISES

1. In his will, Hagrid leaves his pet dragon, Norberta, to Ron Weasley as donee with power of
appointment. He intends to restrict Ron’s power as donee to give or sell Norberta only to
wizards or witches. What kind of power of appointment should Hagrid use?

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2. In a testamentary trust, Baxter Black leaves Hilda Garde both real and personal property to
administer as she sees fit as trustee “for the benefit of the Michigan Militia.” Hilda intends to
sell the house, but meanwhile she rents it out at $1,200 a month and incurs repairs to the
property to prepare it for sale in the amount of $4,328.45. Is the expense chargeable to
income or principal? Is the rent to be characterized as ordinary receipts or extraordinary
receipts?

14.4 Cases
Testamentary Capacity
Estate of Seymour M. Rosen
Supreme Judicial Court of Maine
447 A.2d 1220 (1982)
GODFREY, JUSTICE
Phoebe Rosen and Jeffrey Rosen, widow and son of the decedent, Seymour M. Rosen, appeal
from an order of the Knox County Probate Court admitting the decedent’s will to probate.
Appellants argue that the decedent lacked the testamentary capacity necessary to execute a valid
will and that the Probate Court’s finding that he did have the necessary capacity is clearly
erroneous. On direct appeal from the Probate Court pursuant to section 1-308 of the Probate
Code (18-A M.R.S.A. § 1-308), this Court reviews for clear error the findings of fact by the
Probate Court. Estate of Mitchell, Me., 443 A.2d 961 (1982). We affirm the judgment.
Decedent, a certified public accountant, had an accounting practice in New York City, where he
had been married to Phoebe for about thirty years. Their son, Jeffrey, works in New York City.
In 1973, the decedent was diagnosed as having chronic lymphatic leukemia, a disease that, as it
progresses, seriously impairs the body’s ability to fight infection. From 1973 on, he understood
that he might die within six months. In June, 1978, he left his home and practice and moved to
Maine with his secretary of two months, Robin Gordon, the appellee. He set up an accounting
practice in Camden.
The leukemia progressed. The decedent was on medication and was periodically hospitalized for
infections, sometimes involving septic shock, a condition described by the treating physician as
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akin to blood poisoning. The infections were treated with antibiotics with varying degrees of
success. Despite his medical problems, the decedent continued his accounting practice, working
usually three days a week, until about two months before his death on December 4, 1980. Robin
Gordon lived with him and attended him until his death.
While living in New York, the decedent had executed a will leaving everything to his wife or, if
she should not survive him, to his son. In November, 1979, decedent employed the services of
Steven Peterson, a lawyer whose office was in the same building as decedent’s, to execute a
codicil to the New York will leaving all his Maine property to Robin. At about this time, decedent
negotiated a property settlement with his wife, who is now living in Florida. He executed the will
at issue in this proceeding on July 25, 1980, shortly after a stay in the hospital with a number of
infections, and shortly before a hospitalization that marked the beginning of the decedent’s final
decline. This will, which revoked all earlier wills and codicils, left all his property, wherever
located, to Robin, or to Jeffrey if Robin did not survive him.
The court admitted the 1980 will to probate over the objections of Phoebe and son, making
extensive findings to support its conclusion that “the decedent clearly had testamentary capacity
when he executed his Will.”
The Probate Court applied the standard heretofore declared by this Court for determining
whether a decedent had the mental competence necessary to execute a valid will:
A ‘disposing mind’ involves the exercise of so much mind and memory as would enable a person
to transact common and simple kinds of business with that intelligence which belongs to the
weakest class of sound minds; and a disposing memory exists when one can recall the general
nature, condition and extent of his property, and his relations to those to whom he gives, and
also to those from whom he excludes, his bounty. He must have active memory enough to bring
to his mind the nature and particulars of the business to be transacted, and mental power
enough to appreciate them, and act with sense and judgment in regard to them. He must have
sufficient capacity to comprehend the condition of his property, his relations to the persons who
were or should have been the objects of his bounty, and the scope and bearing of the provisions
of his will. He must have sufficient active memory to collect in his mind, without prompting, the
particulars or elements of the business to be transacted, and to hold them in his mind a
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sufficient length of time to perceive at least their obvious relations to each other, and be able to
form some rational judgment in relation to them.
In re Leonard, Me., 321 A.2d 486, 488-89 (1974), quoting Hall v. Perry, 87 Me. 569, 572, 33 A.
160, 161 (1895).
Appellants portray the decedent as “a man ravaged by cancer and dulled by medication,” and it
is true that some evidence in the record tends to support this characterization. However, the law
as set out in In re Leonard requires only a modest level of competence (“the weakest class of
sound minds”), and there is considerable evidence of record that the decedent had at least that
level of mental ability and probably more:
1. The three women who witnessed the will all testified that decedent was of sound mind. They
worked in the same building as the decedent, knew him, and saw him regularly. Such testimony
is admissible to show testamentary capacity. In re Leonard, 321 A.2d at 489.
2. Lawyer Peterson, who saw the decedent daily, testified that he was of sound mind. Peterson
used the decedent as a tax adviser, and the decedent did accounting work for Peterson’s clients.
Peterson had confidence in the decedent’s tax abilities and left the tax aspects of the will to the
decedent’s own consideration.
3. Dr. Weaver, the treating physician, testified that although the decedent would be mentally
deadened for a day or two while in shock in the hospital, he would then regain “normal mental
function.” Though on medication, the decedent was able to conduct his business until soon
before his death. Dr. Weaver testified without objection that on one occasion he had offered a
written opinion that the decedent was of sound mind.
Appellants’ principal objection to the will is that the decedent lacked the necessary knowledge of
“the general nature, condition and extent of his property.” In re Leonard, 321 A.2d at 488. The
record contains testimony of Robin Gordon and lawyer Peterson that decedent did not know
what his assets were or their value. However, there is other evidence, chiefly Peterson’s
testimony about his discussions with the decedent preliminary to the drafting of the 1980 will
and, earlier, when the 1979 codicil to the New York will was being prepared, that the decedent
did have knowledge of the contents of his estate. He knew that he had had a Florida
condominium, although he was unsure whether this had been turned over to his wife as part of
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the recent property settlement; he knew that he had an interest in an oil partnership, and,
although he was unable to place a value on that interest, he knew the name of an individual who
could supply further information about it; he knew he had stocks and bonds, two motor vehicles,
an account at the Camden National Bank, and accounts receivable from his accounting practice.
The law does not require that a testator’s knowledge of his estate be highly specific in order for
him to execute a valid will. It requires only that the decedent be able to recall “the general
nature, condition and extent of his property.” In re Leonard, 321 A.2d at 488. Such knowledge
of one’s property is an aspect of mental soundness, not an independent legal requirement as the
appellants seem to suggest. Here, there was competent evidence that the decedent had a general
knowledge of his estate. The Probate Court was justified in concluding that, in the
circumstances, the decedent’s ignorance of the precise extent of his property did not establish
his mental incompetence. The decedent’s uncertainty about his property was understandable in
view of the fact that some of his property had been transferred to his wife in the recent property
negotiations in circumstances rendering it possible that the decedent might have wanted to put
the matter out of his mind. Also, there was evidence from which the court could have inferred
that much of the property was of uncertain or changing value.
On the evidence of record, this Court cannot hold that the findings of the Probate Court were
clearly erroneous. Where, as here, there is a choice between two permissible views of the weight
of the evidence, the findings of the Probate Court must stand. Estate of Mitchell, Me., 443 A.2d
961 (1982).

CASE QUESTIONS

1. Based on what is written in this opinion, did the decedent’s widow get nothing as a result of
her husband’s death? What did she get, and how?
2. If Phoebe Rosen’s appeal had resulted in a reversal of the probate court, what would
happen?
3. Is it possible that Seymour Rosen lacked testamentary capacity? Could the probate court
have ruled that he did and refuse to admit the will to probate? If so, what would happen,
using the court’s language and cited opinions?

Settlor’s Limited Power over the Trust
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Continental Bank & Trust Co. v. Country Club Mobile Estates, Ltd.
632 P.2d 869 (Utah 1981)
Oaks, Justice
The issue in this appeal is whether a settlor who has created a trust by conveying property that is
subject to an option to sell can thereafter extend the period of the option without the
participation or consent of the trustee. We hold that he cannot. For ease of reference, this
opinion will refer to the plaintiff-appellant, Continental Bank & Trust Co., as the “trustee,” to
defendant-respondent, Country Club Mobile Estates, Ltd., as the “lessee-optionee,” and to
Marshall E. Huffaker, deceased, as the “settlor.”
The sequence of events is critical. On September 29, 1965, the settlor gave the lessee-optionee a
fifty-year lease and an option to purchase, during the sixth year of the lease, the 31 acres of land
at issue in this litigation. On March 1, 1971, the settlor granted the lessee-optionee a five-year
extension of its option, to September 29, 1976. On December 6, 1973, the settlor conveyed the
subject property to the trustee in trust for various members of his family, signing a trust
agreement and conveying the property to the trustee by a warranty deed, which was promptly
recorded. The lessee-optionee had actual as well as constructive notice of the creation of this
trust by at least April, 1975, when it began making its monthly lease payments directly to the
trustee. On March 1, 1976, the settlor signed an instrument purporting to grant the lesseeoptionee another five-year extension of its option, to September 29, 1981. The trustee was
unaware of this action and did not participate in it. On October 30, 1978, approximately one
week after the settlor’s death, the trustee learned of the March 1, 1976, attempted extension and
demanded and obtained a copy of the instrument.
On July 3, 1979, the trustee brought this action against the lessee-optionee and other interested
parties to quiet title to the 31 acres of trust property and to determine the validity of the
attempted extension of the option. Both parties moved for summary judgment on the issue of
the validity of the extended option. The district court denied the trustee’s motion and granted
the lessee-optionee’s motion, and the trustee appealed. We reverse.
A settlor admittedly could reserve power to extend the duration of an option on trust property,
and do so without the consent or involvement of the trustee. The question is whether this settlor
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did so. The issue turns on the terms of the trust instrument, which, in this case, gave the trustee
broad powers, including the power to grant options, but also reserved to the settlor the right to
revoke the trust or to direct the trustee to sell trust property. The relevant clauses are as follows:

ARTICLE IV.

To carry out the Trust purposes of the Trust created hereby…the Trustee is vested with the
following powers…:
B. To manage, control, sell, convey…; to grant options…
K.…The enumeration of certain powers of the Trustee herein shall not be construed as a
limitation of the Trustee’s power, it being intended that the Trustee shall have all rights, powers
and privileges that an absolute owner of the property would have.

ARTICLE V.

The Trustor by an instrument in writing filed with the Trustee may modify, alter or revoke this
Agreement in whole or in part, and may withdraw any property subject to the agreement;…
There is hereby reserved to the Trustor the power to direct the trustee, in writing, from time to
time, to retain, sell, exchange or lease any property of the trust estate.…Upon receipt of such
directions, the Trustee shall comply therewith. The lessee-optionee argues, and the district court
held, that in the foregoing provisions of the trust agreement the settlor reserved the power to
direct the trustee in regard to the leased property, and that the effect of his executing the
extension of the option on March 1, 1976, was to direct the trustee to sell the property to the
lessee-optionee upon its exercise of the option. We disagree. We are unable to find an exercise of
the “power to direct the trustee, in writing,” in an act that was not intended to communicate and
did not in fact communicate anything to the trustee. We are likewise unable to construe the
extension agreement signed by the settlor and the lessee-optionee as “an instrument in writing
filed with the Trustee” to “modify, alter or revoke this Agreement.…” Nor can we agree with the
dissent’s argument for “liberal construction…to the reserved powers of a settlor” in a trust
agreement which expressly vests the trustee with the power “to grant options” and explicitly
states its intention that the trustee “shall have all rights, powers and privileges that an
absolute owner of the property would have.” Article IV, quoted above. (emphases in original)

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A trust is a form of ownership in which the legal title to property is vested in a trustee, who has
equitable duties to hold and manage it for the benefit of the beneficiaries.Restatement of Trusts,
Second, § 2 (1959). It is therefore axiomatic in trust law that the trustee under a valid trust deed
has exclusive control of the trust property, subject only to the limitations imposed by law or the
trust instrument, and that once the settlor has created the trust he is no longer the owner of the
trust property and has only such ability to deal with it as is expressly reserved to him in the trust
instrument. Boone v. Davis, 64 Miss. 133, 8 So. 202 (1886); Marvin v. Smith, 46 N.Y. 571
(1871). As stated in Bogert,Trusts & Trustees, §42 (2d ed. 1965):
After a settlor has completed the creation of a trust he is, with small exceptions noted below, and
except as expressly provided otherwise by the trust instrument or by statute, not in any legal
relationship with the beneficiaries or the trustee, and has no liabilities or powers with regard to
the trust administration.
None of the exceptions identified by Bogert applies in this case.
This is a case where a settlor created a trust and then chose to ignore it. He could have modified
or revoked the trust, or directed the trustee in writing to sell or lease the trust property, but he
took neither of these actions. Instead, more than two years after the creation and recording of
the trust, and without any direction or notice to the trustee, the settlor gave the lessee-optionee
a signed instrument purporting to extend its option to buy the trust property for another five
years. The trustee did not learn of this instrument until two and one-half years later,
immediately following the death of the settlor.
An extension of the option to buy would obviously have a limiting effect on the value of the
reversion owned by the trust (and thus on the rights of the trust beneficiaries), which the trustee
has a duty to protect. Even a revocable trust clothes beneficiaries, for the duration of the trust,
with a legally enforceable right to insist that the terms of the trust be adhered to. If we gave legal
effect to the settlor’s extension of this option in contravention of the existence and terms of the
trust, we would prejudice the interests of the beneficiaries, blur some fundamental principles of
trust law, and cast doubt upon whether it is the trustee or the settlor who is empowered to
manage and dispose of the trust property in a valid revocable trust.

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The judgment of the district court is reversed and the cause is remanded with instructions to
enter judgment for the plaintiff. Costs to appellant.
HOWE, Justice: (Dissenting)
I dissent. The majority opinion has overlooked the cardinal principle of construction of a trust
agreement which is that the settlor’s intent should be followed. See Leggroan v. Zion’s Savings
Bank & Trust Co., 120 Utah 93, 232 P.2d 746 (1951). Instead, the majority places a strict and
rigid interpretation on the language of the trust agreement which defeats the settlor’s intent and
denies him an important power he specifically reserved to himself. All of this is done in a fact
situation where there is no adverse interest asserted and no one will be prejudiced in any way by
following the undisputed and obvious intent of the settlor.
Unlike the situation found with many trusts, Huffaker in establishing his trust reserved to
himself broad powers in Article V.:

ARTICLE V.

The Trustor by an instrument in writing filed with the Trustee may modify, alter or revoke this
Agreement in whole or in part, and may withdraw any property subject to the
Agreement; Provided, however, that the duties, powers and limitations of the Trustee shall not
be substantially changed without its written consent, except as to revocation or withdrawal.
(emphasis added)
****
There is hereby reserved to the Trustor the power to direct the trustee, in writing, from time to
time, to retain, sell, exchange or lease any property of the Trust estate, to invest Trust funds, or
to purchase for the Trust any property which they [sic] may designate and which is acceptable to
the Trustee. Upon receipt of such directions, the Trustee shall comply therewith. (emphasis
added)
Thus while Huffaker committed the property into the management and control of the trustee, he
retained the right in Article V. to direct the trustee from time to time with regard to the property,
and the trustee agreed that upon receipt of any such directions it would comply. It is significant
that the consent of the trustee was not required. These broad reserved powers in effect gave him
greater power over the property than the trustee possessed since he had the final word.
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The property in question was subject to defendant’s option when it was placed in trust. The
trustee took title subject to that option and subject to future directions from Huffaker. The
extension granted by Huffaker to the defendant was in effect a directive that the trustee sell the
property to the defendant if and when it elected to purchase the property. At that time, the
defendant could deliver the directive to the trustee which held legal title and the sale could be
consummated. Contrary to what is said in the majority opinion, the extension was intended to
communicate and did communicate to the trustee the settlor’s intention to sell to the defendant.
The trustee does not claim to have any doubt as to what the settlor intended.
There was no requirement in the trust agreement as to when the directive to sell had to be
delivered to the trustee nor was there any requirement that the settlor must himself deliver the
direction to sell to the trustee rather than the buyer deliver it. The majority opinion concedes
that Huffaker had the power to extend the option but denies him that power because he did not
communicate his intention to exercise that power to the trustee at the time he extended the
option. It ignores the fact that the lessee had five years to decide whether it wanted to buy the
property, at which time it could deliver the direction to sell to the trustee. The majority opinion
reads into the trust agreement rigidity and strictness which is unwarranted.
The majority opinion contains a quote from Bogert, Trust and Trustees, § 42, for authority that
after a settlor has completed the creation of a trust he is not in any legal relationship with the
beneficiaries or the trustee, and has no liabilities or power with regard to the trust
administration. However, as will be seen in that quote, it is there recognized that those rules do
not apply where it has been expressly provided otherwise by the trust instrument. Such is the
case here where the settlor reserved extensive powers and was himself the primary beneficiary.
Huffaker’s extension agreement apparently would not have been challenged by his trustee if he
had given written directions to the trustee to extend the option instead of executing the
extension with the defendant himself, and apparently would not have been challenged had he
not died. Yet, although the trustee did not itself extend the option nor receive a copy of the
agreement until after Huffaker’s death, it had not in the meantime dealt with third parties
concerning the property or made any commitments that were inconsistent with Huffaker’s
action. Since there were no intervening third-party rights and it is not unfair to the trust
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beneficiaries to require them to abide by the intention of their donor and benefactor, I see no
justification for the refusal of the trustee to accept the extension agreement as a valid direction
to sell the property as provided for by the terms of the trust. This is not a case where the trustee
in ignorance of the action of the settlor in granting an option had also granted an option or dealt
with the property in a manner inconsistent with the actions of the settlor so that there are
conflicting claims of innocent third-parties presented. In such a case there would be some
justification for applying a strict construction so that there can be orderliness in trust
administration. After all, the reason for the provisions of the trust agreement defining the
powers of the trustee and the reserved powers of the settlor was to provide for the exercise of
those powers in a manner that would be orderly and without collision between the trustee and
settlor. In the instant case the trustee has not even suggested how it will be prejudiced by
following Huffaker’s directions. The majority opinion makes reference to protecting the interest
of the contingent beneficiaries but overlooks that Huffaker was not only the settlor but also the
primary beneficiary both when the trust was established and when the option was extended.
The majority opinion treats the relationship between Huffaker and his trustee as an adversary
relationship instead of recognizing that the trustee was Huffaker’s fiduciary to assist him in
managing his property. Therefore, there is no reason to construe the trust agreement as if it
were meant to deal with a relationship between two adverse parties.
My view that a liberal construction should be given to the reserved powers of a settlor under
these circumstances finds support in a decision of the Supreme Judicial Court of
Massachusetts, Trager v. Schwartz, 345 Mass. 653, 189 N.E.2d 509 (1963). There the settlor on
July 15, 1942, executed as donor a declaration of trust. The property was 65 shares of stock and
4 lots of land. In that instrument he reserved the right to alter, amend or revoke the instrument
in whole or in part. However, it was specifically provided in the declaration of trust that “any
such alterations, amendments or revocations of this trust shall be by an instrument in writing
signed by the donor, and shall become effective only upon being recorded in the South District
Registry of Deeds for Middlesex County.”
Later, on February 4, 1954, the trustor executed a document entitled “Modification and
Amendment of Trust” whereby he withdrew the 65 shares of stock from the trust and sold them
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to his son and told him that he had arranged for the recording of that instrument by his lawyer.
However, he did not record the document nor instruct his attorney to do so. On August 25, 1960,
the settlor executed a document entitled “Revocation of Declaration of Trust,” in which he
revoked in whole the declaration of trust of July 15, 1942. This revocation was recorded on
August 26th. He thereupon directed the trustees to deliver to him the 65 shares of stock and the
4 lots of real estate. His son received notice of the revocation on August 30, 1960, and recorded
the following day the modification and amendment dated February 4, 1954, by which he had
obtained the 165 shares of stock.
In a suit brought by the settlor to regain ownership of the stock, he contended that the recording
of his complete revocation on August 26, 1960, rendered ineffective the recording of the partial
revocation on August 31, 1960. He relied upon the principle that “A valid trust once created
cannot be revoked or altered except by the exercise of a reserve power to do so, which must be
exercised in strict conformity to its terms.” The court upheld the earlier sale of stock stating:
The provision of the declaration of trust that amendments and revocations ‘shall become
effective only upon being recorded’ shall not be interpreted, where there are no intervening
rights of third-parties, as preventing the carrying out of the earlier amendment once it has been
recorded. This should be the result, particularly where there was an express undertaking by one
of the parties to see to the recording.
In the instant case, defendant will be greatly prejudiced, and the settlor’s intention thwarted, as
a result of following the majority opinion’s interpretation of the trust terms as they relate to a
written direction to the trustee to sell trust property. Defendant gave up the opportunity to
purchase the property within the original option period in reliance on Huffaker’s execution of
the extension agreement, a document prepared by his attorney. I am not persuaded that because
defendant was making its rental payments to the trustee it was unreasonable in obtaining the
extension of the option, which previously had been granted it by Huffaker, to again deal with
him and rely on him since he was the final power respecting his property, and since neither he
nor his attorney who had full and complete knowledge of the trust apparently raised any
question as to the propriety of what they were doing. Just as the settlor in Trager v. Schwartz,
supra, was not permitted to gain advantage by his failure to record as required by the trust
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agreement, I think the settlor’s beneficiaries in the instant case should not gain by Huffaker’s
omissions and to the extreme prejudice of defendant.
The trustee has based its arguments on cases and principles that are distinguishable or
inapplicable to the instant case. It regards the trust agreement as expressly allowing only it, as
trustee and holder of the legal title to the property, to sell, option, or otherwise dispose of it. But
the language of the trust regarding powers retained by Huffaker is inclusive enough to
encompass his action in this case, for he expressly retained the right to direct the plaintiff to sell
the property, a right that is compatible with his granting of the option extension.
The trustee also asserts that the written instrument received after Huffaker’s death was
ineffective as a directive to the trustee. Plaintiff cites authority for the principle that a revocable
trust can only be modified during the settlor’s lifetime, e.g., Chase National Bank of City of N.Y.
v. Tomagno, 172 Misc. 63, 14 N.Y.S.2d 759 (1939). We are not dealing with an attempted
testamentary disposition in this case, however. The option extension agreement was executed
during Huffaker’s lifetime, and the fact that it was received by plaintiff only after he died does
not deprive it of its effect.
I would affirm the judgment below.

CASE QUESTIONS

1. Does the decision effectively deprive Country Club Mobile Estates, Ltd. of anything? What?
2. Why would the trustee (Continental Bank & Trust Co.) object to giving Country Club Mobile
Estates, Ltd. another two and a half years on the lease?
3. Which opinion seems better reasoned—the majority or the dissent? Why do you think so?

14.5 Summary and Exercises
Summary

Estate planning is the process by which an owner decides how her property is to be passed on to
others. The four basic estate planning tools are wills, trusts, gifts, and joint ownership. In this
chapter, we examined wills and trusts. A will is the declaration of a person’s wishes about the
disposition of her assets on her death. The law of each state sets forth certain formalities, such
as the number of witnesses, to which written wills must adhere. Wills are managed through the
probate process, which varies from state to state, although many states have now adopted the
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Uniform Probate Code. In general, anyone over eighteen and of sound mind may make a will. It
must be signed by the testator, and two or three others must witness the signature. A will may
always be modified or revoked during the testator’s lifetime, either expressly through a codicil or
through certain actions, such as a subsequent marriage and the birth of children, not
contemplated by the will. Wills must be carefully drafted to avoid abatement and ademption.
The law provides for distribution in the case of intestacy. The rules vary from state to state and
depend on whether the decedent was married when she died, had children or parents who
survived her, or had collateral heirs.
Once a will is admitted to probate, the personal representative must assemble and inventory all
assets, have them appraised, handle claims against the estate, pay taxes, prepare a final
accounting, and only then distribute the assets according to the will.
A trust is a relationship in which one person holds legal title to certain property and another
person has the use and benefit of it. The settlor or grantor creates the trust, giving specific
property (the res) to the trustee for the benefit of the beneficiary. Trusts may be living or
testamentary, revocable or irrevocable. Express trusts come in many forms, including Totten
trusts, blind trusts, Clifford trusts, charitable trusts, and spendthrift trusts. Trusts may also be
imposed by law; constructive and resulting trusts are designed to redress frauds, prevent unjust
enrichment, or see to it that the intent of the parties is carried out.

EXERCISES

1. Seymour deposits $50,000 in a bank account, ownership of which is specified as “Seymour, in
trust for Fifi.” What type of trust is this? Who is the settlor? The beneficiary? The trustee?
May Seymour spend the money on himself? When Seymour dies, does the property pass
under the laws of intestacy, assuming he has no will?
2. Seymour, a resident of Rhode Island, signed a will in which he left all his property to his close
friend, Fifi. Seymour and Fifi then moved to Alabama, where Seymour eventually died.
Seymour’s wife Hildegarde, who stayed behind in Rhode Island and who was not named in
the will, claimed that the will was revoked when Seymour moved from one state to another.
Is she correct? Why?

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3. Assume in Exercise 2 that Seymour’s Rhode Island will is valid in Alabama. Is Hildegarde
entitled to a part of Seymour’s estate? Explain.
4. Assume in Exercise 2 that Seymour’s Rhode Island will is valid in Alabama. Seymour and
Hildegarde own, as tenants by the entirety, a cottage on the ocean. In the will, Seymour
specifically states that the cottage goes to Fifi on his death. Does Fifi or Hildegarde get the
cottage? Or do they share it? Explain?
5. Assume in Exercise 2 that Seymour’s Rhode Island will is not valid. Seymour’s only relative
besides Hildegarde is his nephew, Chauncey, whom Seymour detests. Who is entitled to
Seymour’s property when he dies—Fifi, Hildegarde, or Chauncey? Explain.
6. Scrooge is in a high tax bracket. He has set aside in a savings account $100,000, which he
eventually wants to use to pay the college expenses of his tiny son, Tim, who is three. The
account earns $10,000 a year, of which $5,000 goes to the government in taxes. How could
Scrooge lower the tax payments while retaining control of the $100,000?
7. Assume in Exercise 6 that Scrooge considers placing the $100,000 in trust for Tim. But he is
worried that when Tim comes of age, he might sell his interest in the trust. Could the trust be
structured to avoid this possibility? Explain.
8. Assume that Scrooge has a substantial estate and no relatives. Is there any reason for him to
consider a will or trust? Why? If he dies without a will, what will happen to his property?

SELF-TEST QUESTIONS

1. A will written by the testator’s hand and not witnessed is called
a.

a conditional will
b. a nuncupative will
c. a holographic will
d. a reciprocal will
A written modification or supplement to a prior will is called

a.

a revocation clause
b. an abatement
c. a codicil
d. none of the above

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A trust created by will is called
a.

an inter vivos trust
b. a reversionary trust
c. a Totten trust
d. a testamentary trust
Trustees are not permitted to tell the grantor how they are managing their
portfolio of assets in
a.

a Clifford trust

b. a spendthrift trust
c. a blind trust
d. a voting trust
An example of an implied trust is
a.

a spendthrift trust

b. a Clifford trust
c. a resulting trust
d. none of the above

SELF-TEST ANSWERS

1. c
2. c
3. d
4. c
5. c

Chapter 15
Insurance

LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1. The basic terms and distinctions in the law of insurance
2. The basic types of insurance for property, liability, and life
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3. The basic defenses to claims against insurance companies by the insured: representation,
concealment, and warranties
We conclude our discussions about property with a focus on insurance law, not only because
insurance is a means of compensating an owner for property losses but also because the
insurance contract itself represents a property right. In this chapter, we begin by examining
regulation of the insurance industry. We then look at legal issues relating to specific types of
insurance. Finally, we examine defenses that insurance companies might raise to avoid making
payments under insurance policies.

15.1 Definitions and Types of Insurance
LEARNING OBJECTIVES

1. Know the basic types of insurance for individuals.
2. Name and describe the various kinds of business insurance.
Certain terms are usefully defined at the outset. Insurance is a contract of reimbursement. For
example, it reimburses for losses from specified perils, such as fire, hurricane, and earthquake.
An insurer is the company or person who promises to reimburse. The insured (sometimes called
the assured) is the one who receives the payment, except in the case of life insurance, where
payment goes to the beneficiary named in the life insurance contract. The premium is the
consideration paid by the insured—usually annually or semiannually—for the insurer’s promise
to reimburse. The contract itself is called the policy. The events insured against are known
as risks orperils.
Regulation of insurance is left mainly in the hands of state, rather than federal, authorities.
Under the McCarran-Ferguson Act, Congress exempted state-regulated insurance companies
from the federal antitrust laws. Every state now has an insurance department that oversees
insurance rates, policy standards, reserves, and other aspects of the industry. Over the years,
these departments have come under fire in many states for being ineffective and “captives” of
the industry. Moreover, large insurers operate in all states, and both they and consumers must
contend with fifty different state regulatory schemes that provide very different degrees of
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protection. From time to time, attempts have been made to bring insurance under federal
regulation, but none have been successful.
We begin with an overview of the types of insurance, from both a consumer and a business
perspective. Then we examine in greater detail the three most important types of insurance:
property, liability, and life.

Public and Private Insurance
Sometimes a distinction is made between public and private insurance. Public (or social)
insurance includes Social Security, Medicare, temporary disability insurance, and the like,
funded through government plans. Private insurance plans, by contrast, are all types of coverage
offered by private corporations or organizations. The focus of this chapter is private insurance.

Types of Insurance for the Individual
Life Insurance
Life insurance provides for your family or some other named beneficiaries on your death. Two
general types are available: term insurance provides coverage only during the term of the policy
and pays off only on the insured’s death; whole-life insurance provides savings as well as
insurance and can let the insured collect before death.

Health Insurance
Health insurance covers the cost of hospitalization, visits to the doctor’s office, and prescription
medicines. The most useful policies, provided by many employers, are those that cover 100
percent of the costs of being hospitalized and 80 percent of the charges for medicine and a
doctor’s services. Usually, the policy will contain a deductible amount; the insurer will not make
payments until after the deductible amount has been reached. Twenty years ago, the deductible
might have been the first $100 or $250 of charges; today, it is often much higher.

Disability Insurance
A disability policy pays a certain percentage of an employee’s wages (or a fixed sum) weekly or
monthly if the employee becomes unable to work through illness or an accident. Premiums are
lower for policies with longer waiting periods before payments must be made: a policy that
begins to pay a disabled worker within thirty days might cost twice as much as one that defers
payment for six months.
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Homeowner’s Insurance
A homeowner’s policy provides insurance for damages or losses due to fire, theft, and other
named perils. No policy routinely covers all perils. The homeowner must assess his needs by
looking to the likely risks in his area—earthquake, hailstorm, flooding, and so on. Homeowner’s
policies provide for reduced coverage if the property is not insured for at least 80 percent of its
replacement costs. In inflationary times, this requirement means that the owner must adjust the
policy limits upward each year or purchase a rider that automatically adjusts for inflation.
Where property values have dropped substantially, the owner of a home (or a commercial
building) might find savings in lowering the policy’s insured amount.

Automobile Insurance
Automobile insurance is perhaps the most commonly held type of insurance. Automobile
policies are required in at least minimum amounts in all states. The typical automobile policy
covers liability for bodily injury and property damage, medical payments, damage to or loss of
the car itself, and attorneys’ fees in case of a lawsuit.

Other Liability Insurance
In this litigious society, a person can be sued for just about anything: a slip on the walk, a harsh
and untrue word spoken in anger, an accident on the ball field. A personal liability policy covers
many types of these risks and can give coverage in excess of that provided by homeowner’s and
automobile insurance. Such umbrella coverage is usually fairly inexpensive, perhaps $250 a year
for $1 million in liability.

Types of Business Insurance
Workers’ Compensation
Almost every business in every state must insure against injury to workers on the job. Some may
do this through self-insurance—that is, by setting aside certain reserves for this contingency.
Most smaller businesses purchase workers’ compensation policies, available through
commercial insurers, trade associations, or state funds.

Automobile Insurance

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Any business that uses motor vehicles should maintain at least a minimum automobile
insurance policy on the vehicles, covering personal injury, property damage, and general
liability.

Property Insurance
No business should take a chance of leaving unprotected its buildings, permanent fixtures,
machinery, inventory, and the like. Various property policies cover damage or loss to a
company’s own property or to property of others stored on the premises.

Malpractice Insurance
Professionals such as doctors, lawyers, and accountants will often purchase malpractice
insurance to protect against claims made by disgruntled patients or clients. For doctors, the cost
of such insurance has been rising over the past thirty years, largely because of larger jury awards
against physicians who are negligent in the practice of their profession.

Business Interruption Insurance
Depending on the size of the business and its vulnerability to losses resulting from damage to
essential operating equipment or other property, a company may wish to purchase insurance
that will cover loss of earnings if the business operations are interrupted in some way—by a
strike, loss of power, loss of raw material supply, and so on.

Liability Insurance
Businesses face a host of risks that could result in substantial liabilities. Many types of policies
are available, including policies for owners, landlords, and tenants (covering liability incurred
on the premises); for manufacturers and contractors (for liability incurred on all premises); for a
company’s products and completed operations (for liability that results from warranties on
products or injuries caused by products); for owners and contractors (protective liability for
damages caused by independent contractors engaged by the insured); and for contractual
liability (for failure to abide by performances required by specific contracts).
Some years ago, different types of individual and business coverage had to be purchased
separately and often from different companies. Today, most insurance is available on a package
basis, through single policies that cover the most important risks. These are often called
multiperil policies.
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KEY TAKEAWAY
Although insurance is a need for every US business, and many businesses operate in all fifty
states, regulation of insurance has remained at the state level. There are several forms of
public insurance (Social Security, disability, Medicare) and many forms of private insurance.
Both individuals and businesses have significant needs for various types of insurance, to
provide protection for health care, for their property, and for legal claims made against them
by others.

EXERCISES

1. Theresa Conley is joining the accounting firm of Hunter and Patton in Des Moines, Iowa. She
is a certified public accountant. What kind of insurance will she (or the firm, on her behalf)
need to buy because of her professional activities?
2. Nate Johnson has just signed a franchise agreement with Papa Luigi’s Pizza and will be
operating his own Papa Luigi’s store in Lubbock, Texas. The franchise agreement requires
that he personally contract for “all necessary insurance” for the successful operation of the
franchise. He expects to have twelve employees, five full-time and seven part-time (the
delivery people), at his location, which will be on a busy boulevard in Lubbock and will offer
take-out only. Pizza delivery employees will be using their own automobiles to deliver orders.
What kinds of insurance will be “necessary”?

15.2 Property Insurance, Liability Insurance, and Life
Insurance
LEARNING OBJECTIVES

1. Distinguish and define the basic types of insurance for property, liability, and life.
2. Explain the concepts of subrogation and assignment.
We turn now to a more detailed discussion of the law relating to the three most common types of
insurance: property, liability, and life insurance.

Property Insurance
It is sometimes said that property is the foundation for a system of free market capitalism. If so,
then protecting property is a necessary part of being part of that system, whether as an
individual or as a business entity.

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Coverage
As we have noted, property insurance provides coverage for real and personal property owned
by a business or an individual. Property insurance is also part of automobile policies covering
damage to the car caused by an accident (collision coverage) or by other events such as
vandalism or fire (comprehensive coverage). Different levels of coverage are available. For
example, many basic homeowners’ policies cover damage resulting from the following types of
perils only: fire and lightning, windstorm and hail, explosions, riots and civil commotions,
aircraft and vehicular accidents, smoke, vandalism and malicious mischief, theft, and breakage
of glass that is part of a building.
A broader policy, known as broad coverage, also includes these perils: falling objects; weight of
ice, snow, and sleet; collapse of buildings; sudden and accidental damage to heating systems;
accidental discharge from plumbing, heating, or air-conditioning systems; freezing of heating,
plumbing, and air conditioning systems; and sudden and accidental injury from excess currents
to electrical appliances and wiring. Even with the broadest form of coverage, known as
comprehensive, which covers all perils except for certain named exclusions, the homeowner can
be left without protection. For example, comprehensive policies do not usually cover damage
resulting from flooding, earthquakes, war, or nuclear radiation. The homeowner can purchase
separate coverage for these perils but usually at a steep premium.

Insurable Interest in Property
To purchase property insurance, the would-be insured must have aninsurable interest in the
property. Insurable interest is a real and substantial interest in specific property such that a loss
to the insured would ensue if the property were damaged. You could not, for instance, take out
an insurance policy on a motel down the block with which you have no connection. If a fire
destroyed it, you would suffer no economic loss. But if you helped finance the motel and had an
investment interest in it, you would be permitted to place an insurance policy on it. This
requirement of an insurable interest stems from the public policy against wagering. If you could
insure anything, you would in effect be betting on an accident.
To insure property, therefore, you must have a legal interest and run the risk of a pecuniary loss.
Any legal interest is sufficient: a contractual right to purchase, for instance, or the right of
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possession (a bailee may insure). This insurable interest must exist both at the time you take out
the policy and at the time the loss occurs. Moreover, coverage is limited to the extent of the
interest. As a mortgagee, you could ensure only for the amount still due.
Prior to the financial meltdown of 2008, many investment banks took insurance against
possible losses from collateralized debt obligations (CDOs) and other financial products based
on subprime loans. The principal insurer was American International Group, Inc. (AIG), which
needed a US government bailout when the risks covered by AIG turned out to be riskier than
AIG’s models had projected.

Subrogation
Figure 15.1 Subrogation

Subrogation is the substitution of one person for another in pursuit of a legal claim. When an
insured is entitled to recover under a policy for property damage, the insurer is said to be
subrogated to the insured’s right to sue any third party who caused the damage. For example, a
wrecking company negligently destroys an insured’s home, mistaking it for the building it was
hired to tear down. The insured has a cause of action against the wrecking company. If the
insured chooses instead to collect against a homeowner’s policy, the insurance company may
sue the wrecking company in the insured’s place to recover the sum it was obligated to pay out
under the policy (seeFigure 15.1 "Subrogation").

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Assignment
Assignment is the transfer of any property right to another. In property insurance, a distinction
is made between assignment of the coverage and assignment of the proceeds. Ordinarily, the
insured may not assign the policy itself without the insurer’s permission—that is, he may not
commit the insurer to insure someone else. But the insured may assign any claims against the
insurer—for example, the proceeds not yet paid out on a claim for a house that has already
burned down.

Intentional Losses
Insurance is a means of spreading risk. It is economically feasible because not every house burns
down and not every car is stolen. The number that do burn down or that are stolen can be
calculated and the premium set accordingly. Events that will certainly happen, like ordinary
wear and tear and the destruction of property through deliberate acts such as arson, must be
excluded from such calculations. The injury must result from accidental, not deliberate, causes.

Coinsurance Clause
Most commercial property policies contain a so-called coinsurance clause, which requires the
insured to maintain insurance equal to a specified percentage of the property value. It is often
80 percent but may be higher or lower. If the property owner insures for less than that
percentage, the recovery will be reduced. In effect, the owner becomes a coinsurer with the
insurance company. The usual formula establishes the proportion that the insurer must pay by
calculating the ratio of (1) the amount of insurance actually taken to (2) the coinsurance
percentage multiplied by the total dollar value of the property. Suppose a fire causes $160,000
damage to a plant worth $1,000,000. The plant should have been insured for 80 percent
($800,000), but the insured took out only a $500,000 policy. He will recover only $100,000. To
see why, multiply the total damages of $160,000 by the coinsurance proportion of five-eighths
($500,000 of insurance on the required minimum of $800,000). Five-eighths of $160,000
equals $100,000, which would be the insured’s recovery where the policy has a coinsurance
clause.

Liability Insurance

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Liability insurance has taken on great importance for both individuals and businesses in
contemporary society. Liability insurance covers specific types of legal liabilities that a
homeowner, driver, professional, business executive, or business itself might incur in the round
of daily activities. A business is always at risk in sending products into the marketplace. Doctors,
accountants, real estate brokers, insurance agents, and lawyers should obtain liability insurance
to cover the risk of being sued for malpractice. A prudent homeowner will acquire liability
insurance as part of homeowner’s policy and a supplemental umbrella policy that insures for
liability in excess of a limit of, say, $100,000 in the regular homeowner’s policy. And businesses,
professionals, and individuals typically acquire liability insurance for driving-related activities
as part of their automobile insurance. In all cases, liability policies cover not only any settlement
or award that might ultimately have to be paid but also the cost of lawyers and related expenses
in defending any claims.
Liability insurance is similar in several respects to property insurance and is often part of the
same package policy. As with property insurance, subrogation is allowed with liability insurance,
but assignment of the policy is not allowed (unless permission of the insurer is obtained), and
intentional losses are not covered. For example, an accountant who willfully helps a client
conceal fraud will not recover from his malpractice insurance policy if he is found guilty of
participating in the fraud.

No-Fault Trends
The major legal development of the century relating to liability insurance has been the
elimination of liability in the two areas of greatest exposure: in the workplace and on the
highway. In the next unit on agency law, we discuss the no-fault system of workers’
compensation, under which a worker receives automatic benefits for workplace injuries and
gives up the right to sue the employer under common-law theories of liability. Here we will look
briefly at the other major type of no-fault system: recovery for damages stemming from motor
vehicle accidents.
“No-fault” means that recovery for damages in an accident no longer depends on who was at
fault in causing it. A motorist will file a claim to recover his actual damages (medical expenses,
income loss) directly from his own insurer. The no-fault system dispenses with the costly and
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uncertain tort system of having to prove negligence in court. Many states have adopted one form
or another of no-fault automobile insurance, but even in these states the car owner must still
carry other insurance. Some no-fault systems have a dollar “threshold” above which a victim
may sue for medical expenses or other losses. Other states use a “verbal threshold,” which
permits suits for “serious” injury, defined variously as “disfigurement,” “fracture,” or
“permanent disability.” These thresholds have prevented no-fault from working as efficiently as
theory predicts. Inflation has reduced the power of dollar thresholds (in some states as low as
$200) to deter lawsuits, and the verbal thresholds have standards that can only be defined in
court, so much litigation continues.
No state has adopted a “pure” no-fault system. A pure no-fault system trades away entirely the
right to sue in return for the prompt payment of “first-party” insurance benefits—that is,
payment by the victim’s own insurance company instead of traditional “third-party” coverage, in
which the victim collects from the defendant’s insurance company.
Among the criticisms of no-fault insurance is the argument that it fails to strengthen the central
purpose of the tort system: to deter unsafe conduct that causes accidents. No-fault lessens, it is
said, the incentive to avoid accidents. In any event, no-fault automobile insurance has been a
major development in the insurance field since 1970 and seems destined to be a permanent
fixture of insurance law.

Life Insurance
Insurable Interest
The two types of life insurance mentioned in Section 15.1.2 "Types of Insurance for the
Individual", term and whole-life policies, are important both to individuals and to businesses
(insurance for key employees). As with property insurance, whoever takes out a life insurance
policy on a person’s life must have an insurable interest. Everyone has an insurable interest in
his own life and may name whomever he pleases as beneficiary; the beneficiary need not have an
insurable interest. But the requirement of insurable interest restricts those who may take out
insurance on someone else’s life. A spouse or children have an insurable interest in a spouse or
parent. Likewise, a parent has an insurable interest in any minor child. That means that a wife,
for example, may take out a life insurance policy on her husband without his consent. But she
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could not take out a policy on a friend or neighbor. As long as the insurable interest existed
when the policy was taken out, the owner may recover when the insured dies, even if the
insurable interest no longer exists. Thus a divorced wife who was married when the policy was
obtained may collect when her ex-husband dies as long as she maintained the payments.
Likewise, an employer has an insurable interest in his key employees and partners; such
insurance policies help to pay off claims of a partner’s estate and thus prevent liquidation of the
business.

Subrogation
Unlike property insurance, life insurance does not permit subrogation. The insurer must pay the
claim when the insured dies and may not step into the shoes of anyone entitled to file a wrongful
death claim against a person who caused the death. Of course, if the insured died of natural
causes, there would be no one to sue anyway.

Change of Beneficiary and Assignment
Unless the insured reserves the right to change beneficiaries, his or her initial designation is
irrevocable. These days, however, most policies do reserve the right if certain formalities are
observed, including written instructions to the insurer’s home office to make the change and
endorsement of the policy. The insured may assign the policy, but the beneficiary has priority to
collect over the assignee if the right to change beneficiaries has not been reserved. If the policy
permits beneficiaries to be changed, then the assignee will have priority over the original
beneficiary.

Intentional Losses
Two types of intentional losses are especially important in life insurance: suicide and murder of
the insured by the beneficiary.

Suicide
In a majority of states, in the absence of a suicide clause in the policy, when an insured commits
suicide, the insurer need not pay out if the policy is payable to the insured’s estate. However, if
the policy is payable to a third person (e.g., the insured’s company), payment will usually be
allowed. And if an insured kills himself while insane, all states require payment, whether to the
estate or a third party. Most life insurance policies today have a provision that explicitly excepts
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suicide from coverage for a limited period, such as two years, after the policy is issued. In other
words, if the insured commits suicide within the first two years, the insurer will refund the
premiums to his estate but will not pay the policy amount. After two years, suicide is treated as
any other death would be.

Murder
Under the law in every state, a beneficiary who kills the insured in order to collect the life
insurance is barred from receiving it. But the invocation of that rule does not absolve the insurer
of liability to pay the policy amount. An alternate beneficiary must be found. Sometimes the
policy will name contingent beneficiaries, and many, but not all, states require the insurer to pay
the contingent beneficiaries. When there are no contingent beneficiaries or the state law
prohibits paying them, the insurer will pay the insured’s estate. Not every killing is murder; the
critical question is whether the beneficiary intended his conduct to eliminate the insured in
order to collect the insurance.
The willful, unlawful, and felonious killing of the insured by the person named as beneficiary in
a life policy results in the forfeiture of all rights of such person therein. It is unnecessary that
there should be an express exception in the contract of insurance forbidding a recovery in favor
of such a person in such an event. On considerations of public policy, the death of the insured,
willfully and intentionally caused by the beneficiary of the policy, is an excepted risk so far as the
person thus causing the death is concerned.

KEY TAKEAWAY

Many kinds of insurance are available for individuals and businesses. For individuals, life
insurance, homeowner’s insurance, and automobile insurance are common, with health
insurance considered essential but often expensive. Businesses with sufficient employees will
obtain workers’ compensation insurance, property insurance, and liability insurance, and
auto insurance for any employees driving company vehicles. Insurance companies will often
pay a claim for their insured and take over the insured’s claim against a third party.
Liability insurance is important for individuals, companies, and licensed professionals. A trend
toward no-fault in liability insurance is seen in claims for work-related injuries (workers’

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compensation) and in automobile insurance. Life insurance is common for most families and
for businesses that want to protect against the loss of key employees.

EXERCISES

1. Helen Caldicott raises a family and then begins a career as a caterer. As her business grows,
she hires several employees and rents space near downtown that has a retail space, parking,
and a garage for the three vehicles that bear her business’s name. What kinds of insurance
does Helen need for her business?
2. One of Helen’s employees, Bob Zeek, is driving to a catered event when another car fails to
stop at a red light and severely injures Bob and nearly totals the van Bob was driving. The
police issue a ticket for careless and reckless driving to the other driver, who pleads guilty to
the offense. The other driver is insured, but Helen’s automobile insurance carrier goes ahead
and pays for the damages to the company vehicle. What will her insurance company likely do
next?
3. The health insurance provider for Helen’s employees pays over $345,000 of Bob’s medical
and hospitalization bills. What will Helen’s insurance company likely do next?
4. Many homeowners live on floodplains but have homeowner’s insurance nonetheless. Must
insurance companies write such policies? Do homeowners on floodplains pay more in
premiums? If insurance companies are convinced that global climate change is happening,
with rising sea levels and stronger storms, can they simply avoid writing policies for homes
and commercial buildings in coastal areas?

15.3 Insurer’s Defenses

LEARNING OBJECTIVES

1. Understand the principal defenses available to insurers when claims are made.
2. Recognize that despite these defenses, insurance companies must act in good faith.

Types of Defenses
It is a common perception that because insurance contracts are so complex, many insureds who
believe they are covered end up with uninsured losses. In other words, the large print giveth,
and the small print taketh away. This perception is founded, to some extent, on the use by
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insurance companies of three common defenses, all of which relate to a duty of good faith on the
part of the insured: (1) representation, (2) concealment, and (3) warranties.

Representation
A representation is a statement made by someone seeking an insurance policy—for example, a
statement that the applicant did (or did not) consult a doctor for any illness during the previous
five years. An insurer has grounds to avoid the contract if the applicant makes a false
representation. The misrepresentation must have been material; that is, a false description of a
person’s hair coloring should not defeat a claim under an automobile accident policy. But a false
statement, even if innocent, about a material fact—for instance, that no one in the family uses
the car to go to work, when unbeknownst to the applicant, his wife uses the car to commute to a
part-time job she hasn’t told him about—will at the insurer’s option defeat a claim by the
insured to collect under the policy. The accident need not have arisen out of the
misrepresentation to defeat the claim. In the example given, the insurance company could
refuse to pay a claim for any accident in the car, even one occurring when the car was driven by
the husband to go to the movies, if the insurer discovered that the car was used in a manner in
which the insured had declared it was not used. This chapter’s case, Mutual Benefit Life
Insurance Co. v. JMR Electronics Corp., (see Section 15.4.1 "Misrepresentation to Insurer"),
illustrates what happens when an insured misrepresents his smoking habits.

Concealment
An insured is obligated to volunteer to the insurer all material facts that bear on insurability.
The failure of an insured to set forth such information is a concealment, which is, in effect, the
mirror image of a false representation. But the insured must have had a fraudulent intent to
conceal the material facts. For example, if the insured did not know that gasoline was stored in
his basement, the insurer may not refuse to pay out on a fire insurance policy.

Warranties
Many insurance policies covering commercial property will contain warranties. For example, a
policy may have a warranty that the insured bank has installed or will install a particular type of
burglar alarm system. Until recently, the rule was strictly enforced: any breach of a warranty
voided the contract, even if the breach was not material. A nonmaterial breach might be, for
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example, that the bank obtained the alarm system from a manufacturer other than the one
specified, even though the alarm systems are identical. In recent years, courts or legislatures
have relaxed the application of this rule. But a material breach still remains absolute grounds for
the insurer to avoid the contract and refuse to pay.

Incontestable Clause
In life insurance cases, the three common defenses often are unavailable to the insurer because
of the so-called incontestable clause. This states that if the insured has not died during a
specified period of time in which the life insurance policy has been in effect (usually two years),
then the insurer may not refuse to pay even if it is later discovered that the insured committed
fraud in applying for the policy. Few nonlife policies contain an incontestable clause; it is used in
life insurance because the effect on many families would be catastrophic if the insurer claimed
misrepresentation or concealment that would be difficult to disprove years later when the
insured himself would no longer be available to give testimony about his intentions or
knowledge.

Requirement of Insurer’s Good Faith
Like the insured, the insurer must act in good faith. Thus defenses may be unavailable to an
insurer who has waived them or acted in such a manner as to create an estoppel. Suppose that
when an insured seeks to increase the amount on his life insurance policy, the insurance
company learns that he lied about his age on his original application. Nevertheless, the company
accepts his application for an increase. The insured then dies, and the insurer refuses to pay his
wife any sum. A court would hold that the insurer had waived its right to object, since it could
have cancelled the policy when it learned of the misrepresentation. Finally, an insurer that acts
in bad faith by denying a claim that it knows it should pay may find itself open to punitive
damage liability.

KEY TAKEAWAY

Some claims by insured parties can be legally denied by insurance companies where the
insured has made a material misrepresentation. Some claims can be legally denied if the
insured has deliberately concealed important matters in applying for insurance coverage.
Because insurance coverage is by contract, courts often strictly construe the contract

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language, and if the language does not cover the insured, the courts will typically not bend
the language of the contract to help the insured.

EXERCISES

1. Amir Labib gets a reduced rate from his auto insurance company because he represents in his
application that he commutes less than ten miles a day to work. Three years later, he and his
wife buy a new residence, farther away from work, and he begins a fifteen-mile-a-day
commute. The rate would be raised if he were to mention this to his insurance company. The
insurance company sees that he has a different address, because they are mailing invoices to
his new home. But the rate remains the same. Amir has a serious accident on a vacation to
Yellowstone National Park, and his automobile is totaled. His insurance policy is a no-fault
policy as it relates to coverage for vehicle damage. Is the insurance company within its rights
to deny any payment on his claim? How so, or why not?
2. In 2009, Peter Calhoun gets a life insurance policy from Northwest Mutual Life Insurance
Company, and the death benefit is listed as $250,000. The premiums are paid up when he
dies in 2011 after a getaway car being chased by the police slams into his car at fifty miles per
hour on a street in suburban Chicago. The life insurance company gets information that he
smoked two packs of cigarettes a day, whereas in his application in 2009, he said he smoked
only one pack a day. In fact, he had smoked about a pack and a half every day since 1992. Is
the insurance company within its rights to deny any payment on his claim? How so, or why
not?

15.4 Case
Misrepresentation to Insurer
Mutual Benefit Life Insurance Co. v. JMR Electronics Corp.
848 F.2d 30 (2nd Cir. 1988)
PER CURIAM
JMR Electronics Corporation (“JMR”) appeals from a judgment of the District Court for the
Southern District of New York (Robert W. Sweet, Judge) ordering rescission of a life insurance
policy issued by plaintiff-appellant The Mutual Benefit Life Insurance Company (“Mutual”) and
dismissing JMR’s counterclaim for the policy’s proceeds. Judge Sweet ruled that a
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misrepresentation made in the policy application concerning the insured’s history of cigarette
smoking was material as a matter of law. Appellant contends that the misrepresentation was not
material because Mutual would have provided insurance—albeit at a higher premium rate—even
if the insured’s smoking history had been disclosed. We agree with the District Court that
summary judgment was appropriate and therefore affirm.
The basic facts are not in dispute. On June 24, 1985, JMR submitted an application to Mutual
for a $ 250,000 “key man” life insurance policy on the life of its president, Joseph Gaon, at the
non-smoker’s discounted premium rate. Mutual’s 1985 Ratebook provides: “The Non-Smoker
rates are available when the proposed insured is at least 20 years old and has not smoked a
cigarette for at least twelve months prior to the date of the application.” Question 13 of the
application inquired about the proposed insured’s smoking history. Question 13(a) asked, “Do
you smoke cigarettes? How many a day?” Gaon answered this question, “No.” Question 13(b)
asked, “Did you ever smoke cigarettes? “ Gaon again answered, “No.” Based on these
representations, Mutual issued a policy on Gaon’s life at the non-smoker premium rate.
Gaon died on June 22, 1986, within the period of contestability contained in policy, seeN.Y. Ins.
Law § 3203 (a)(3) (McKinney 1985). Upon routine investigation of JMR’s claim for proceeds
under the policy, Mutual discovered that the representations made in the insurance application
concerning Gaon’s smoking history were untrue. JMR has stipulated that, at the time the
application was submitted, Gaon in fact “had been smoking one-half of a pack of cigarettes per
day for a continuous period of not less than 10 years.” Mutual brought this action seeking a
declaration that the policy is void. Judge Sweet granted Mutual’s motion for summary
judgment, dismissed JMR’s counterclaim for the proceeds of the policy, and ordered rescission
of the insurance policy and return of JMR’s premium payments, with interest.
Under New York law, which governs this diversity suit, “it is the rule that even an innocent
misrepresentation as to [the applicant’s medical history], if material, is sufficient to allow the
insurer to avoid the contract of insurance or defeat recovery thereunder.” Process Plants Corp.
v. Beneficial National Life Insurance Co., 366 N.E.2d 1361 (1977). A “misrepresentation” is
defined by statute as a false “statement as to past or present fact, made to the insurer…at or
before the making of the insurance contract as an inducement to the making thereof.” N.Y. Ins.
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Law § 3105(a) (McKinney 1985). A misrepresentation is “material” if “knowledge by the insurer
of the facts misrepresented would have led to a refusal by the insurer to make such
contract.” Id. § 3105(b).…
In the present case JMR has stipulated that Gaon’s smoking history was misrepresented in the
insurance application. However, JMR disputes that this misrepresentation is material as a
matter of law. JMR argues that under New York law a misrepresentation is not material unless
the insurer can demonstrate that, had the applicant provided complete and accurate
information, coverage either would have been refused or at the very least withheld pending a
more detailed underwriting examination. In JMR’s view summary judgment was inappropriate
on the facts of this case because a jury could reasonably have found that even “had appellee been
aware of Gaon’s smoking history, a policy at the smoker’s premium rate would have been
issued.” JMR takes the position that the appropriate remedy in this situation is to permit
recovery under the policy in the amount that the premium actually paid would have purchased
for a smoker.
We agree with Judge Sweet that this novel theory is without basis in New York law. The plain
language of the statutory definition of “materiality,” found in section 3105(b), permits avoidance
of liability under the policy where “knowledge by the insurer of the facts misrepresented would
have led to a refusal by the insurer to make such contract.” (emphasis added) Moreover,
numerous courts have observed that the materiality inquiry under New York law is made with
respect to the particular policy issued in reliance upon the misrepresentation.
***
There is no doubt that Mutual was induced to issue the non-smoker, discounted-premium policy
to JMR precisely as a result of the misrepresentations made by Gaon concerning his smoking
history. That Mutual might not have refused the risk on anyterms had it known the undisclosed
facts is irrelevant. Most risks are insurable at some price. The purpose of the materiality inquiry
is not to permit the jury to rewrite the terms of the insurance agreement to conform to the newly
disclosed facts but to make certain that the risk insured was the risk covered by the policy
agreed upon. If a fact is material to the risk, the insurer may avoid liability under a policy if that
fact was misrepresented in an application for that policy whether or not the parties might have
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agreed to some other contractual arrangement had the critical fact been disclosed. As observed
by Judge Sweet, a contrary result would reward the practice of misrepresenting facts critical to
the underwriter’s task because the unscrupulous (or merely negligent) applicant “would have
everything to gain and nothing to lose” from making material misrepresentations in his
application for insurance. Such a claimant could rest assured not only that he may demand full
coverage should he survive the contestability period, N.Y. Ins. Law § 3203 (a)(3), but that even
in the event of a contested claim, he would be entitled to the coverage that he might have
contracted for had the necessary information been accurately disclosed at the outset. New York
law does not permit this anomalous result. The judgment of the District Court is affirmed.

CASE QUESTIONS

1. When you read this case, did you assume that Gaon died from lung cancer or some other
smoking-related cause? Does the court actually say that?
2. Can you reasonably infer from the facts here that Gaon himself filled out the form and signed
it? That is, can you know with some degree of certainty that he lied to the insurance
company? Would it make any difference if he merely signed a form that his secretary filled
out? Why or why not?
3. What if Gaon died of causes unrelated to smoking (e.g., he was in a fatal automobile
accident), and the insurance company was looking for ways to deny the claim? Does the
court’s opinion and language still seem reasonable (e.g., the statement “there is no doubt
that Mutual was induced to issue the non-smoker, discounted-premium policy to JMR
precisely as a result of the misrepresentations made by Gaon concerning his smoking
history”)?
4. If Gaon had accurately disclosed his smoking history, is it clear that the insurance company
would have refused to write any policy at all? Why is this question important? Do you agree
with the court that the question is irrelevant?

15.5 Summary and Exercises
Summary

Insurance is an inescapable cost of doing business in a modern economy and an important
service for any individual with dependents or even a modest amount of property. Most readers
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of this book will someday purchase automobile, homeowner’s, and life insurance, and many
readers will deal with insurance in the course of a business career.
Most insurance questions are governed by contract law, since virtually all insurance is voluntary
and entered into through written agreements. This means that the insured must pay careful
attention to the wording of the policies to determine what is excluded from coverage and to
ensure that he makes no warranties that he cannot keep and no misrepresentations or
concealments that will void the contract. But beyond contract law, some insurance law
principles—such as insurable interest and subrogation rights—are important to bear in mind.
Defenses available to an insurance company may be based upon representation, concealment, or
warranties, but an insurer that is overzealous in denying coverage may find itself subject to
punitive damages.

EXERCISES

1. Martin and Williams, two business partners, agreed that each would insure his life for the
benefit of the other. On his application for insurance, Martin stated that he had never had
any heart trouble when in fact he had had a mild heart attack some years before. Martin’s
policy contained a two-year incontestable clause. Three years later, after the partnership had
been dissolved but while the policy was still in force, Martin’s car was struck by a car being
negligently driven by Peters. Although Martin’s injuries were superficial, he suffered a fatal
heart attack immediately after the accident—an attack, it was established, that was caused
by the excitement. The insurer has refused to pay the policy proceeds to Williams. Does the
insurer have a valid defense based on Martin’s misrepresentation? Explain.
2. In Exercise 1, was it necessary for Williams to have an insurable interest in Martin’s life to
recover under the policy? Why?
3. In Exercise 1, if Williams had taken out the policy rather than Martin, could the insurer
defend the claim on the ground that at the time of Martin’s death, Williams had no insurable
interest? Why?
4. If Williams had no insurable interest, would the incontestable clause prevent the company
from asserting this defense? Why?
5. If the insurer pays Williams’s claim, may it recover from Peters? Why?

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6. Skidmore Trucking Company decided to expand its operations into the warehousing field.
After examining several available properties, it decided to purchase a carbarn for $100,000
from a local bus company and to convert it into a warehouse. The standard contract for a
real estate purchase was signed by the parties. The contract obligated Skidmore to pay the
seller on an apportioned basis for the prepaid premiums on the existing fire insurance policy
($100,000 extended coverage). The policy expired two years and one month from the closing
date. At the closing, the seller duly assigned the fire insurance policy to Skidmore in return
for the payment of the apportioned amount of the prepaid premiums, but Skidmore failed to
notify the insurance company of the change in ownership. Skidmore took possession of the
premises and, after extensive renovation, began to use the building as a warehouse. Soon
afterward, one of Skidmore’s employees negligently dropped a lighted cigarette into a trash
basket and started a fire that totally destroyed the building. Was the assignment of the policy
to Skidmore valid? Why?
7. In Exercise 6, assuming the assignment is valid, would the insurer be obligated to pay for the
loss resulting from the employee’s negligence? Why?

SELF-TEST QUESTIONS

1. The substitution of one person for another in pursuit of a legal claim is called
a.

assignment
b. coinsurance
c. subrogation
d. none of the above
Most insurance questions are covered by

a.

tort law
b. criminal law
c. constitutional law
d. contract law
Common defenses used by insurance companies include

a.

concealment
b. false representation

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c. breach of warranty
d. all of the above
A coinsurance clause
a.

requires the insured to be insured by more than one policy

b. requires the insured to maintain insurance equal to a certain percentage of the
property’s value
c. allows another beneficiary to be substituted for the insured
d. is none of the above
Property insurance typically covers
a.

ordinary wear and tear

b. damage due to theft
c. intentional losses
d. damage due to earthquakes

SELF-TEST ANSWERS

1. c
2. d
3. d
4. b
5. b

Chapter 16
Secured Transactions and Suretyship
LEARNING OBJECTIVES

After reading this chapter, you should understand the following:
1. The basic concepts of secured transactions
2. The property subject to the security interest
3. Creation and perfection of the security interest
4. Priorities for claims on the security interest
5. Rights of creditors on default
6. The basic concepts of suretyship
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7. The relationship between surety and principal
8. Rights among cosureties

16.1 Introduction to Secured Transactions
LEARNING OBJECTIVES

1. Recognize, most generally, the two methods by which debtors’ obligations may be secured.
2. Know the source of law for personal property security.
3. Understand the meaning of security interest and other terminology necessary to discuss the
issues.
4. Know what property is subject to the security interest.
5. Understand how the security interest is created—”attached”—and perfected.

The Problem of Security
Creditors want assurances that they will be repaid by the debtor. An oral promise to pay is no
security at all, and—as it is oral—it is difficult to prove. A signature loan is merely a written
promise by the debtor to repay, but the creditor stuck holding a promissory note with a
signature loan only—while he may sue a defaulting debtor—will get nothing if the debtor is
insolvent. Again, that’s no security at all. Real security for the creditor comes in two forms: by
agreement with the debtor or by operation of law without an agreement.

By Agreement with the Debtor
Security obtained through agreement comes in three major types: (1) personal property security
(the most common form of security); (2) suretyship—the willingness of a third party to pay if the
primarily obligated party does not; and (3) mortgage of real estate.

By Operation of Law
Security obtained through operation of law is known as a lien. Derived from the French for
“string” or “tie,” a lien is the legal hold that a creditor has over the property of another in order
to secure payment or discharge an obligation.
In this chapter, we take up security interests in personal property and suretyship. In the next
chapter, we look at mortgages and nonconsensual liens.

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Basics of Secured Transactions
The law of secured transactions consists of five principal components: (1) the nature of property
that can be the subject of a security interest; (2) the methods of creating the security interest; (3)
the perfection of the security interest against claims of others; (4) priorities among secured and
unsecured creditors—that is, who will be entitled to the secured property if more than one
person asserts a legal right to it; and (5) the rights of creditors when the debtor defaults. After
considering the source of the law and some key terminology, we examine each of these
components in turn.
Here is the simplest (and most common) scenario: Debtor borrows money or obtains credit
from Creditor, signs a note and security agreement putting up collateral, and promises to pay
the debt or, upon Debtor’s default, let Creditor (secured party) take possession of (repossess) the
collateral and sell it. Figure 16.1 "The Grasping Hand"illustrates this scenario—the
grasping hand is Creditor’s reach for the collateral, but the hand will not close around the
collateral and take it (repossess) unless Debtor defaults.

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Figure 16.1 The Grasping Hand

Source of Law and Definitions
Source of Law
Article 9 of the Uniform Commercial Code (UCC) governs security interests in personal
property. The UCC defines the scope of the article (here slightly truncated): [1]
This chapter applies to the following:
1. A transaction, regardless of its form, that creates a security interest in personal property or
fixtures by contract;
2. An agricultural lien;
3. A sale of accounts, chattel paper, payment intangibles, or promissory notes;
4. A consignment…

Definitions

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As always, it is necessary to review some definitions so that communication on the topic at hand
is possible. The secured transaction always involves a debtor, a secured party, a security
agreement, a security interest, and collateral.
Article 9 applies to any transaction “that creates a security interest.” The UCC in Section 1201(35) defines security interest as “an interest in personal property or fixtures which secures
payment or performance of an obligation.”
Security agreement is “an agreement that creates or provides for a security interest.” It is the
contract that sets up the debtor’s duties and the creditor’s rights in event the debtor defaults. [2]
Collateral “means the property subject to a security interest or agricultural lien.” [3]
Purchase-money security interest (PMSI) is the simplest form of security interest. Section 9103(a) of the UCC defines “purchase-money collateral” as “goods or software that secures a
purchase-money obligation with respect to that collateral.” A PMSI arises where the debtor gets
credit to buy goods and the creditor takes a secured interest in those goods. Suppose you want to
buy a big hardbound textbook on credit at your college bookstore. The manager refuses to
extend you credit outright but says she will take back a PMSI. In other words, she will retain a
security interest in the book itself, and if you don’t pay, you’ll have to return the book; it will be
repossessed. Contrast this situation with a counteroffer you might make: because she tells you
not to mark up the book (in the event that she has to repossess it if you default), you would
rather give her some other collateral to hold—for example, your gold college signet ring. Her
security interest in the ring is not a PMSI but a pledge; a PMSI must be an interest in the
particular goods purchased. A PMSI would also be created if you borrowed money to buy the
book and gave the lender a security interest in the book.
Whether a transaction is a lease or a PMSI is an issue that frequently arises. The answer
depends on the facts of each case. However, a security interest is created if (1) the lessee is
obligated to continue payments for the term of the lease; (2) the lessee cannot terminate the
obligation; and (3) one of several economic tests, which are listed in UCC Section 1-201 (37), is
met. For example, one of the economic tests is that “the lessee has an option to become owner of
the goods for no additional consideration or nominal additional consideration upon compliance
with the lease agreement.”
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The issue of lease versus security interest gets litigated because of the requirements of Article 9
that a security interest be perfected in certain ways (as we will see). If the transaction turns out
to be a security interest, a lessor who fails to meet these requirements runs the risk of losing his
property to a third party. And consider this example. Ferrous Brothers Iron Works “leases” a
$25,000 punch press to Millie’s Machine Shop. Under the terms of the lease, Millie’s must pay a
yearly rental of $5,000 for five years, after which time Millie’s may take title to the machine
outright for the payment of $1. During the period of the rental, title remains in Ferrous
Brothers. Is this “lease” really a security interest? Since ownership comes at nominal charge
when the entire lease is satisfied, the transaction would be construed as one creating a security
interest. What difference does this make? Suppose Millie’s goes bankrupt in the third year of the
lease, and the trustee in bankruptcy wishes to sell the punch press to satisfy debts of the
machine shop. If it were a true lease, Ferrous Brothers would be entitled to reclaim the machine
(unless the trustee assumed the lease). But if the lease is really intended as a device to create a
security interest, then Ferrous Brothers can recover its collateral only if it has otherwise
complied with the obligations of Article 9—for example, by recording its security interest, as we
will see.
Now we return to definitions.
Debtor is “a person (1) having an interest in the collateral other than a security interest or a lien;
(2) a seller of accounts, chattel paper, payment intangibles, or promissory notes; or (3) a
consignee.” [4]
Obligor is “a person that, with respect to an obligation secured by a security interest in or an
agricultural lien on the collateral, (i) owes payment or other performance of the obligation, (ii)
has provided property other than the collateral to secure payment or other performance of the
obligation, or (iii) is otherwise accountable in whole or in part for payment or other performance
of the obligation.” [5] Here is example 1 from the Official Comment to UCC Section 9-102:
“Behnfeldt borrows money and grants a security interest in her Miata to secure the debt.
Behnfeldt is a debtor and an obligor.”
Behnfeldt is a debtor because she has an interest in the car—she owns it. She is an obligor
because she owes payment to the creditor. Usually the debtor is the obligor.
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A secondary obligor is “an obligor to the extent that: (A) [the] obligation is secondary; or (b)
[the person] has a right of recourse with respect to an obligation secured by collateral against
the debtor, another obligor, or property of either.” [6] The secondary obligor is a guarantor
(surety) of the debt, obligated to perform if the primary obligor defaults. Consider example 2
from the Official Comment to Section 9-102: “Behnfeldt borrows money and grants a security
interest in her Miata to secure the debt. Bruno cosigns a negotiable note as maker. As before,
Behnfeldt is the debtor and an obligor. As an accommodation party, Bruno is a secondary
obligor. Bruno has this status even if the note states that her obligation is a primary obligation
and that she waives all suretyship defenses.”
Again, usually the debtor is the obligor, but consider example 3 from the same Official
Comment: “Behnfeldt borrows money on an unsecured basis. Bruno cosigns the note and grants
a security interest in her Honda to secure her [Behnfeldt’s] obligation. Inasmuch as Behnfeldt
does not have a property interest in the Honda, Behnfeldt is not a debtor. Having granted the
security interest, Bruno is the debtor. Because Behnfeldt is a principal obligor, she is not a
secondary obligor. Whatever the outcome of enforcement of the security interest against the
Honda or Bruno’s secondary obligation, Bruno will look to Behnfeldt for her losses. The
enforcement will not affect Behnfeldt’s aggregate obligations.”
Secured party is “a person in whose favor a security interest is created or provided for under a
security agreement,” and it includes people to whom accounts, chattel paper, payment
intangibles, or promissory notes have been sold; consignors; and others under Section 9102(a)(72).
Chattel mortgage means “a debt secured against items of personal property rather than against
land, buildings and fixtures.” [7]

Property Subject to the Security Interest
Now we examine what property may be put up as security—collateral. Collateral is—again—
property that is subject to the security interest. It can be divided into four broad categories:
goods, intangible property, indispensable paper, and other types of collateral.

Goods

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Tangible property as collateral is goods. Goods means “all things that are movable when a
security interest attaches. The term includes (i) fixtures, (ii) standing timber that is to be cut and
removed under a conveyance or contract for sale, (iii) the unborn young of animals, (iv) crops
grown, growing, or to be grown, even if the crops are produced on trees, vines, or bushes, and
(v) manufactured homes. The term also includes a computer program embedded in
goods.” [8] Goods are divided into several subcategories; six are taken up here.

Consumer Goods
These are “goods used or bought primarily for personal, family, or household purposes.” [9]

Inventory
“Goods, other than farm products, held by a person for sale or lease or consisting of raw
materials, works in progress, or material consumed in a business.” [10]

Farm Products
“Crops, livestock, or other supplies produced or used in farming operations,” including aquatic
goods produced in aquaculture. [11]

Equipment
This is the residual category, defined as “goods other than inventory, farm products, or
consumer goods.” [12]

Fixtures
These are “goods that have become so related to particular real property that an interest in them
arises under real property law.” [13] Examples would be windows, furnaces, central air
conditioning, and plumbing fixtures—items that, if removed, would be a cause for significant
reconstruction.

Accession
These are “goods that are physically united with other goods in such a manner that the identity
of the original goods is lost.” [14] A new engine installed in an old automobile is an accession.

Intangible Property
Two types of collateral are neither goods nor indispensible paper: accounts and general
intangibles.

Accounts
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This type of intangible property includes accounts receivable (the right to payment of money),
insurance policy proceeds, energy provided or to be provided, winnings in a lottery, health-careinsurance receivables, promissory notes, securities, letters of credit, and interests in business
entities. [15] Often there is something in writing to show the existence of the right—such as a right
to receive the proceeds of somebody else’s insurance payout—but the writing is merely evidence
of the right. The paper itself doesn’t have to be delivered for the transfer of the right to be
effective; that’s done by assignment.

General Intangibles
General intangibles refers to “any personal property, including things in action, other than
accounts, commercial tort claims, deposit accounts, documents, goods, instruments, investment
property, letter-of-credit rights, letters of credit, money, and oil, gas, or other minerals before
extraction.” General intangibles include payment intangibles and software. [16]

Indispensable Paper
This oddly named category is the middle ground between goods—stuff you can touch—and
intangible property. It’s called “indispensable” because although the right to the value—such as a
warehouse receipt—is embodied in a written paper, the paper itself is indispensable for the
transferee to access the value. For example, suppose Deborah Debtor borrows $3,000 from Carl
Creditor, and Carl takes a security interest in four designer chairs Deborah owns that are being
stored in a warehouse. If Deborah defaults, Carl has the right to possession of the warehouse
receipt: he takes it to the warehouser and is entitled to take the chairs and sell them to satisfy
the obligation. The warehouser will not let Carl have the chairs without the warehouse receipt—
it’s indispensable paper. There are four kinds of indispensable paper.

Chattel Paper
Chattel is another word for goods. Chattel paper is a record (paper or electronic) that
demonstrates both “a monetary obligation and a security interest either in certain goods or in a
lease on certain goods.” [17] The paper represents a valuable asset and can itself be used as
collateral. For example, Creditor Car Company sells David Debtor an automobile and takes back
a note and security agreement (this is a purchase-money security agreement; the note and
security agreement is chattel paper). The chattel paper is not yet collateral; the automobile is.
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Now, though, Creditor Car Company buys a new hydraulic lift from Lift Co., and grants Lift Co. a
security interest in Debtor’s chattel paper to secure Creditor Car’s debt to Lift Co. The chattel
paper is now collateral. Chattel paper can be tangible (actual paper) or electronic.

Documents
This category includes documents of title—bills of lading and warehouse receipts are examples.

Instruments
An “instrument” here is “a negotiable instrument (checks, drafts, notes, certificates of deposit)
or any other writing that evidences a right to the payment of a monetary obligation, is not itself a
security agreement or lease, and is of a type that in the ordinary course of business is transferred
by delivery with any necessary indorsement or assignment.” “Instrument” does not include (i)
investment property, (ii) letters of credit, or (iii) writings that evidence a right to payment
arising out of the use of a credit or charge card or information contained on or for use with the
card. [18]

Investment Property
This includes securities (stock, bonds), security accounts, commodity accounts, and commodity
contracts. [19] Securities may be certified (represented by a certificate) or uncertified (not
represented by a certificate). [20]

Other Types of Collateral
Among possible other types of collateral that may be used as security is thefloating lien. This is a
security interest in property that was not in the possession of the debtor when the security
agreement was executed. The floating lien creates an interest that floats on the river of present
and future collateral and proceeds held by—most often—the business debtor. It is especially
useful in loans to businesses that sell their collateralized inventory. Without the floating lien, the
lender would find its collateral steadily depleted as the borrowing business sells its products to
its customers. Pretty soon, there’d be no security at all. The floating lien includes the following:
•

After-acquired property. This is property that the debtor acquires after the original deal was set
up. It allows the secured party to enhance his security as the debtor (obligor) acquires more
property subject to collateralization.

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•

Sale proceeds. These are proceeds from the disposition of the collateral. Carl Creditor takes a
secured interest in Deborah Debtor’s sailboat. She sells the boat and buys a garden tractor. The
secured interest attaches to the garden tractor.

•

Future advances. Here the security agreement calls for the collateral to stand for both present
and future advances of credit without any additional paperwork.
Here are examples of future advances:

o

Example 1: A debtor enters into a security agreement with a creditor that contains a future
advances clause. The agreement gives the creditor a security interest in a $700,000 inventorypicking robot to secure repayment of a loan made to the debtor. The parties contemplate that
the debtor will, from time to time, borrow more money, and when the debtor does, the machine
will stand as collateral to secure the further indebtedness, without new paperwork.

o

Example 2: A debtor signs a security agreement with a bank to buy a car. The security agreement
contains a future advances clause. A few years later, the bank sends the debtor a credit card.
Two years go by: the car is paid for, but the credit card is in default. The bank seizes the car.
“Whoa!” says the debtor. “I paid for the car.” “Yes,” says the bank, “but it was collateral for all
future indebtedness you ran up with us. Check out your loan agreement with us and UCC
Section 9-204(c), especially Comment 5.”
See Figure 16.2 "Tangibles and Intangibles as Collateral".
Figure 16.2 Tangibles and Intangibles as Collateral

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Attachment of the Security Interest
In General
Attachment is the term used to describe when a security interest becomes enforceable against
the debtor with respect to the collateral. In Figure 16.1 "The Grasping Hand", ”Attachment” is
the outreached hand that is prepared, if the debtor defaults, to grasp the collateral. [21]

Requirements for Attachment
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There are three requirements for attachment: (1) the secured party gives value; (2) the debtor
has rights in the collateral or the power to transfer rights in it to the secured party; (3) the
parties have a security agreement “authenticated” (signed) by the debtor, or the creditor has
possession of the collateral.

Creditor Gives Value
The creditor, or secured party, must give “value” for the security interest to attach. The UCC, in
Section 1-204, provides that
a person gives ‘value’ for rights if he acquires them
(1) in return for a binding commitment to extend credit or for the extension of immediately
available credit whether or not drawn upon and whether or not a charge-back is provided for in
the event of difficulties in collection; or
(2) as security for or in total or partial satisfaction of a pre-existing claim; or
(3) by accepting delivery pursuant to a pre-existing contract for purchase; or
(4) generally, in return for any consideration sufficient to support a simple contract.
Suppose Deborah owes Carl $3,000. She cannot repay the sum when due, so she agrees to give
Carl a security interest in her automobile to the extent of $3,000 in return for an extension of
the time to pay. That is sufficient value.

Debtor’s Rights in Collateral
The debtor must have rights in the collateral. Most commonly, the debtor owns the collateral (or
has some ownership interest in it). The rights need not necessarily be the immediate right to
possession, but they must be rights that can be conveyed. [22] A person can’t put up as collateral
property she doesn’t own.

Security Agreement (Contract) or Possession of Collateral by Creditor
The debtor most often signs the written security agreement, or contract. The UCC says that “the
debtor [must have] authenticated a security agreement that provides a description of the
collateral.…” “Authenticating” (or “signing,” “adopting,” or “accepting”) means to sign or, in
recognition of electronic commercial transactions, “to execute or otherwise adopt a symbol, or
encrypt or similarly process a record…with the present intent of the authenticating person to

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identify the person and adopt or accept a record.” The “record” is the modern UCC’s substitution
for the term “writing.” It includes information electronically stored or on paper. [23]
The “authenticating record” (the signed security agreement) is not required in some cases. It is
not required if the debtor makes a pledge of the collateral—that is, delivers it to the creditor for
the creditor to possess. For example, upon a creditor’s request of a debtor for collateral to secure
a loan of $3,000, the debtor offers up his stamp collection. The creditor says, “Fine, have it
appraised (at your expense) and show me the appraisal. If it comes in at $3,000 or more, I’ll
take your stamp collection and lock it in my safe until you’ve repaid me. If you don’t repay me,
I’ll sell it.” A creditor could take possession of any goods and various kinds of paper, tangible or
intangible. In commercial transactions, it would be common for the creditor to have possession
of—actually or virtually—certified securities, deposit accounts, electronic chattel paper,
investment property, or other such paper or electronic evidence of value. [24]
Again, Figure 16.1 "The Grasping Hand" diagrams the attachment, showing the necessary
elements: the creditor gives value, the debtor has rights in collateral, and there is a security
agreement signed (authenticated) by the debtor. If the debtor defaults, the creditor’s “hand” will
grab (repossess) the collateral.

Perfection of the Security Interest
As between the debtor and the creditor, attachment is fine: if the debtor defaults, the creditor
will repossess the goods and—usually—sell them to satisfy the outstanding obligation. But
unless an additional set of steps is taken, the rights of the secured party might be subordinated
to the rights of other secured parties, certain lien creditors, bankruptcy trustees, and buyers who
give value and who do not know of the security interest. Perfection is the secured party’s way of
announcing the security interest to the rest of the world. It is the secured party’s claim on the
collateral.
There are five ways a creditor may perfect a security interest: (1) by filing a financing statement,
(2) by taking or retaining possession of the collateral, (3) by taking control of the collateral, (4)
by taking control temporarily as specified by the UCC, or (5) by taking control automatically.

Perfection by Filing

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“Except as otherwise provided…a financing statement must be filed to perfect all security
agreements.” [25]

The Financing Statement
A financing statement is a simple notice showing the creditor’s general interest in the collateral.
It is what’s filed to establish the creditor’s “dibs.”

Contents of the Financing Statement
It may consist of the security agreement itself, as long as it contains the information required by
the UCC, but most commonly it is much less detailed than the security agreement: it “indicates
merely that a person may have a security interest in the collateral[.]…Further inquiry from the
parties concerned will be necessary to disclose the full state of affairs.” [26] The financing
statement must provide the following information:
•

The debtor’s name. Financing statements are indexed under the debtor’s name, so getting that
correct is important. Section 9-503 of the UCC describes what is meant by “name of debtor.”

•

The secured party’s name.

•

An “indication” of what collateral is covered by the financing statement. [27] It may describe the
collateral or it may “indicate that the financing statement covers all assets or all personal
property” (such generic references are not acceptable in the security agreement but are OK in
the financing statement). [28] If the collateral is real-property-related, covering timber to be cut
or fixtures, it must include a description of the real property to which the collateral is related. [29]
The form of the financing statement may vary from state to state, but see Figure 16.3 "UCC-1
Financing Statement" for a typical financing statement. Minor errors or omissions on the form
will not make it ineffective, but the debtor’s signature is required unless the creditor is
authorized by the debtor to make the filing without a signature, which facilitates paperless
filing. [30]
Figure 16.3 UCC-1 Financing Statement

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Duration of the Financing Statement
Generally, the financing statement is effective for five years; acontinuation statement may be
filed within six months before the five-year expiration date, and it is good for another five
years. [31] Manufactured-home filings are good for thirty years. When the debtor’s obligation is
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satisfied, the secured party files a termination statement if the collateral was consumer goods;
otherwise—upon demand—the secured party sends the debtor a termination statement. [32]

Debtor Moves out of State
The UCC also has rules for continued perfection of security interests when the debtor—whether
an individual or an association (corporation)—moves from one state to another. Generally, an
interest remains perfected until the earlier of when the perfection would have expired or for four
months after the debtor moves to a new jurisdiction. [33]

Where to File the Financing Statement
For most real-estate-related filings—ore to be extracted from mines, agricultural collateral, and
fixtures—the place to file is with the local office that files mortgages, typically the county
auditor’s office. [34] For other collateral, the filing place is as duly authorized by the state. In some
states, that is the office of the Secretary of State; in others, it is the Department of Licensing; or
it might be a private party that maintains the state’s filing system. [35] The filing should be made
in the state where the debtor has his or her primary residence for individuals, and in the state
where the debtor is organized if it is a registered organization. [36] The point is, creditors need to
know where to look to see if the collateral offered up is already encumbered. In any event, filing
the statement in more than one place can’t hurt. The filing office will provide instructions on
how to file; these are available online, and electronic filing is usually available for at least some
types of collateral.

Exemptions
Some transactions are exempt from the filing provision. The most important category of exempt
collateral is that covered by state certificate of title laws. For example, many states require
automobile owners to obtain a certificate of title from the state motor vehicle office. Most of
these states provide that it is not necessary to file a financing statement in order to perfect a
security interest in an automobile. The reason is that the motor vehicle regulations require any
security interests to be stated on the title, so that anyone attempting to buy a car in which a
security interest had been created would be on notice when he took the actual title certificate. [37]

Temporary Perfection

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The UCC provides that certain types of collateral are automatically perfected but only for a
while: “A security interest in certificated securities, or negotiable documents, or instruments is
perfected without filing or the taking of possession for a period of twenty days from the time it
attaches to the extent that it arises for new value given under an authenticated security
agreement.” [38] Similar temporary perfection covers negotiable documents or goods in
possession of a bailee, and when a security certificate or instrument is delivered to the debtor for
sale, exchange, presentation, collection, enforcement, renewal, or registration. [39] After the
twenty-day period, perfection would have to be by one of the other methods mentioned here.

Perfection by Possession
A secured party may perfect the security interest by possession where the collateral is negotiable
documents, goods, instruments, money, tangible chattel paper, or certified securities. [40] This is
a pledge of assets (mentioned in the example of the stamp collection). No security agreement is
required for perfection by possession.
A variation on the theme of pledge is field warehousing. When the pawnbroker lends money, he
takes possession of the goods—the watch, the ring, the camera. But when large manufacturing
concerns wish to borrow against their inventory, taking physical possession is not necessarily so
easy. The bank does not wish to have shipped to its Wall Street office several tons of copper
mined in Colorado. Bank employees perhaps could go west to the mine and take physical control
of the copper, but banks are unlikely to employ people and equipment necessary to build a
warehouse on the spot. Thus this so-called field pledge is rare.
More common is the field warehouse. The field warehouse can take one of two forms. An
independent company can go to the site and put up a temporary structure—for example, a fence
around the copper—thus establishing physical control of the collateral. Or the independent
company can lease the warehouse facilities of the debtor and post signs indicating that the goods
inside are within its sale custody. Either way, the goods are within the physical possession of the
field warehouse service. The field warehouse then segregates the goods secured to the particular
bank or finance company and issues a warehouse receipt to the lender for those goods. The
lender is thus assured of a security interest in the collateral.

Perfection by Control
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“A security interest in investment property, deposit accounts, letter-of-credit rights, or
electronic chattel paper may be perfected by control of the collateral.” [41] “Control” depends on
what the collateral is. If it’s a checking account, for example, the bank with which the deposit
account is maintained has “control”: the bank gets a security interest automatically because, as
Official Comment 3 to UCC Section 9-104 puts it, “all actual and potential creditors of the debtor
are always on notice that the bank with which the debtor’s deposit account is maintained may
assert a claim against the deposit account.” “Control” of electronic chattel paper of investment
property, and of letter-of-credit rights is detailed in Sections 9-105, 9-106, and 9-107. Obtaining
“control” means that the creditor has taken whatever steps are necessary, given the manner in
which the items are held, to place itself in a position where it can have the items sold, without
further action by the owner. [42]

Automatic Perfection
The fifth mechanism of perfection is addressed in Section 9-309 of the UCC: there are several
circumstances where a security interest is perfected upon mere attachment. The most important
here is automatic perfection of a purchase-money security interest given in consumer goods. If a
seller of consumer goods takes a PMSI in the goods sold, then perfection of the security interest
is automatic. But the seller may file a financial statement and faces a risk if he fails to file and
the consumer debtor sells the goods. Under Section 9-320(b), a buyer of consumer goods takes
free of a security interest, even though perfected, if he buys without knowledge of the interest,
pays value, and uses the goods for his personal, family, or household purposes—unless the
secured party had first filed a financing statement covering the goods.
Figure 16.4 Attachment and Perfection

KEY TAKEAWAY

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A creditor may be secured—allowed to take the debtor’s property upon debtor’s default—by
agreement between the parties or by operation of law. The law governing agreements for
personal property security is Article 9 of the UCC. The creditor’s first step is to attach the
security interest. This is usually accomplished when the debtor, in return for value (a loan or
credit) extended from the creditor, puts up as collateral some valuable asset in which she has
an interest and authenticates (signs) a security agreement (the contract) giving the creditor a
security interest in collateral and allowing that the creditor may take it if the debtor defaults.
The UCC lists various kinds of assets that can be collateralized, ranging from tangible
property (goods), to assets only able to be manifested by paper (indispensable paper), to
intangible assets (like patent rights). Sometimes no security agreement is necessary, mostly if
the creditor takes possession of the collateral. After attachment, the prudent creditor will
want to perfect the security interest to make sure no other creditors claim an interest in the
collateral. Perfection is most often accomplished by filing a financing statement in the
appropriate place to put the world on notice of the creditor’s interest. Perfection can also be
achieved by a pledge (possession by the secured creditor) or by “control” of certain assets
(having such control over them as to be able to sell them if the debtor defaults). Perfection is
automatic temporarily for some items (certified securities, instruments, and negotiable
documents) but also upon mere attachment to purchase-money security interests in
consumer goods.

EXERCISES

1. Why is a creditor ill-advised to be unsecured?
2. Elaine bought a computer for her use as a high school teacher, the school contributing onethird of its cost. Elaine was compelled to file for bankruptcy. The computer store claimed it
had perfected its interest by mere attachment, and the bankruptcy trustee claimed the
computer as an asset of Elaine’s bankruptcy estate. Who wins, and why?
3. What is the general rule governing where financing statements should be filed?
4. If the purpose of perfection is to alert the world to the creditor’s claim in the collateral, why
is perfection accomplishable by possession alone in some cases?

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5. Contractor pawned a power tool and got a $200 loan from Pawnbroker. Has there been a
perfection of a security interest?
[1] Uniform Commercial Code, Section 9-109.
[2] Uniform Commercial Code, Section 9-102(a)(73).
[3] Uniform Commercial Code, Section 9-102(12).
[4] Uniform Commercial Code, Section 9-102(a)(28).
[5] Uniform Commercial Code, Section 9-102 (59).
[6] Uniform Commercial Code, Section 9-102(a)(71).
[7] Commercial Brokers, Inc., “Glossary of Real Estate
Terms,”http://www.cbire.com/index.cfm/fuseaction/terms.list/letter/C/contentid/32302EC3-81D547DF-A9CBA32FAE38B22A.
[8] Uniform Commercial Code, Section 9-102(44).
[9] Uniform Commercial Code, Section 9-102(a)(48).
[10] Uniform Commercial Code, Section 9-102(a)(48).
[11] Uniform Commercial Code, Section 9-102(a)(34).
[12] Uniform Commercial Code, Section 9-102(a)(33).
[13] Uniform Commercial Code, Section 9-102(a)(41).
[14] Uniform Commercial Code, Section 9-102(a)(1).
[15] Uniform Commercial Code, Section 9-102(a)(2).
[16] Uniform Commercial Code, Section 9-102(42).
[17] Uniform Commercial Code, Section 9-102(11).
[18] Uniform Commercial Code, Section 9-102(a)(47).
[19] Uniform Commercial Code, Section 9-102(a)(49).
[20] Uniform Commercial Code, Section 8-102(a)(4) and (a)(18).
[21] Uniform Commercial Code, Section 9-203(a).
[22] Uniform Commercial Code, Section 9-203(b)(2).
[23] Uniform Commercial Code, Section 9-102, Official Comment 9. Here is a free example of a security
agreement online: Docstoc, “Free Business Templates—Sample Open-Ended Security

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Agreement,” http://www.docstoc.com/docs/271920/Free-Business-Templates—-Sample-Open-EndedSecurity-Agreement.
[24] Uniform Commercial Code, Section 9-203(b)(3)(B-D).
[25] Uniform Commercial Code, Section 9-310(a).
[26] Uniform Commercial Code, Section 9-502, Official Comment 2.
[27] Uniform Commercial Code, Section 9-502(a).
[28] Uniform Commercial Code, Section 9-504.
[29] Uniform Commercial Code, Section 9-502(b).
[30] Uniform Commercial Code, Section 9-506; Uniform Commercial Code, Section, 9-502, Comment 3.
[31] Uniform Commercial Code, Section 9-515.
[32] Uniform Commercial Code, Section 9-513.
[33] Uniform Commercial Code, Section 9-316.
[34] Uniform Commercial Code, Section 9-501.
[35] Uniform Commercial Code, Section 9-501(a)(2).
[36] Uniform Commercial Code, Section 9-307(b).
[37] Uniform Commercial Code, Section 9-303.
[38] Uniform Commercial Code, Section 9-312(e).
[39] Uniform Commercial Code, Section 9-312(f) and (g).
[40] Uniform Commercial Code, Section 9-313.
[41] Uniform Commercial Code, Section 9-314.
[42] Uniform Commercial Code, Section 8-106, Official Comment 1.

16.2 Priorities

LEARNING OBJECTIVES

1. Understand the general rule regarding who gets priority among competing secured parties.
2. Know the immediate exceptions to the general rule—all involving PMSIs.
3. Understand the basic ideas behind the other exceptions to the general rule.

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Priorities: this is the money question. Who gets what when a debtor defaults? Depending on
how the priorities in the collateral were established, even a secured creditor may walk away with
the collateral or with nothing. Here we take up the general rule and the exceptions.

General Rule
The general rule regarding priorities is, to use a quotation attributed to a Southern Civil War
general, the one who wins “gets there firstest with the mostest.” The first to do the best job of
perfecting wins. The Uniform Commercial Code (UCC) creates a race of diligence among
competitors.

Application of the Rule
If both parties have perfected, the first to perfect wins. If one has perfected and one attached,
the perfected party wins. If both have attached without perfection, the first to attach wins. If
neither has attached, they are unsecured creditors. Let’s test this general rule against the
following situations:
1. Rosemary, without having yet lent money, files a financing statement on February 1 covering
certain collateral owned by Susan—Susan’s fur coat. Under UCC Article 9, a filing may be made
before the security interest attaches. On March 1, Erika files a similar statement, also without
having lent any money. On April 1, Erika loans Susan $1,000, the loan being secured by the fur
coat described in the statement she filed on March 1. On May 1, Rosemary also loans Susan
$1,000, with the same fur coat as security. Who has priority? Rosemary does, since she filed
first, even though Erika actually first extended the loan, which was perfected when made
(because she had already filed). This result is dictated by the rule even though Rosemary may
have known of Erika’s interest when she subsequently made her loan.
2. Susan cajoles both Rosemary and Erika, each unknown to the other, to loan her $1,000 secured
by the fur coat, which she already owns and which hangs in her coat closet. Erika gives Susan
the money a week after Rosemary, but Rosemary has not perfected and Erika does not either. A
week later, they find out they have each made a loan against the same coat. Who has priority?
Whoever perfects first: the rule creates a race to the filing office or to Susan’s closet. Whoever
can submit the financing statement or actually take possession of the coat first will have priority,
and the outcome does not depend on knowledge or lack of knowledge that someone else is
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claiming a security interest in the same collateral. But what of the rule that in the absence of
perfection, whichever security interest first attached has priority? This is “thought to be of
merely theoretical interest,” says the UCC commentary, “since it is hard to imagine a situation
where the case would come into litigation without [either party] having perfected his interest.”
And if the debtor filed a petition in bankruptcy, neither unperfected security interest could
prevail against the bankruptcy trustee.
To rephrase: An attached security interest prevails over other unsecured creditors (unsecured
creditors lose to secured creditors, perfected or unperfected). If both parties are secured (have
attached the interest), the first to perfect wins. [1] If both parties have perfected, the first to have
perfected wins. [2]

Exceptions to the General Rule
There are three immediate exceptions to the general rule, and several other exceptions, all of
which—actually—make some straightforward sense even if it sounds a little complicated to
explain them.

Immediate Exceptions
We call the following three exceptions “immediate” ones because they allow junior filers
immediate priority to take their collateral before the debtor’s other creditors get it. They all
involve purchase-money security interests (PMSIs), so if the debtor defaults, the creditor
repossesses the very goods the creditor had sold the debtor.
(1) Purchase-money security interest in goods (other than inventory or livestock).The UCC
provides that “a perfected purchase-money security interest in goods other than inventory or
livestock has priority over a conflicting security interest in the same goods…if the purchasemoney security interest is perfected when debtor receives possession of the collateral or within
20 days thereafter.” [3] The Official Comment to this UCC section observes that “in most cases,
priority will be over a security interest asserted under an after-acquired property clause.”
Suppose Susan manufactures fur coats. On February 1, Rosemary advances her $10,000 under a
security agreement covering all Susan’s machinery and containing an after-acquired property
clause. Rosemary files a financing statement that same day. On March 1, Susan buys a new
machine from Erika for $5,000 and gives her a security interest in the machine; Erika files a
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financing statement within twenty days of the time that the machine is delivered to Susan. Who
has priority if Susan defaults on her loan payments? Under the PMSI rule, Erika has priority,
because she had a PMSI. Suppose, however, that Susan had not bought the machine from Erika
but had merely given her a security interest in it. Then Rosemary would have priority, because
her filing was prior to Erika’s.
What would happen if this kind of PMSI in noninventory goods (here, equipment) did not get
priority status? A prudent Erika would not extend credit to Susan at all, and if the new machine
is necessary for Susan’s business, she would soon be out of business. That certainly would not
inure to the benefit of Rosemary. It is, mostly, to Rosemary’s advantage that Susan gets the
machine: it enhances Susan’s ability to make money to pay Rosemary.
(2) Purchase-money security interest in inventory. The UCC provides that a perfected PMSI in
inventory has priority over conflicting interests in the same inventory, provided that the PMSI is
perfected when the debtor receives possession of the inventory, the PMSI-secured party sends
an authenticated notification to the holder of the conflicting interest and that person receives
the notice within five years before the debtor receives possession of the inventory, and the notice
states that the person sending it has or expects to acquire a PMSI in the inventory and describes
the inventory. [4] The notice requirement is aimed at protecting a secured party in the typical
situation in which incoming inventory is subject to a prior agreement to make advances against
it. If the original creditor gets notice that new inventory is subject to a PMSI, he will be
forewarned against making an advance on it; if he does not receive notice, he will have priority.
It is usually to the earlier creditor’s advantage that her debtor is able to get credit to “floor”
(provide) inventory, without selling which, of course, the debtor cannot pay back the earlier
creditor.
(3) Purchase-money security interest in fixtures. Under UCC Section 9-334(e), a perfected
security in fixtures has priority over a mortgage if the security interest is a PMSI and the security
interest is perfected by a fixture filing before the goods become fixtures or within twenty days
after. A mortgagee is usually a bank (the mortgagor is the owner of the real estate, subject to the
mortgagee’s interest). The bank’s mortgage covers the real estate and fixtures, even fixtures
added after the date of the mortgage (after-acquired property clause). In accord with the general
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rule, then, the mortgagee/bank would normally have priority if the mortgage is recorded first, as
would a fixture filing if made before the mortgage was recorded. But with the exception noted,
the bank’s interest is subordinate to the fixture-seller’s later-perfected PMSI. Example: Susan
buys a new furnace from Heating Co. to put in her house. Susan gave a bank a thirty-year
mortgage on the house ten years before. Heating Co. takes back a PMSI and files the appropriate
financing statement before or within twenty days of installation. If Susan defaults on her loan to
the bank, Heating Co. would take priority over the bank. And why not? The mortgagee has, in
the long run, benefited from the improvement and modernization of the real estate. (Again,
there are further nuances in Section 9-334 beyond our scope here.) A non-PMSI in fixtures or
PMSIs perfected more than twenty days after goods become a fixture loses out to prior recorded
interests in the realty.

Other Exceptions
We have noted the three immediate exceptions to the general rule that “the firstest with the
mostest” prevails. There are some other exceptions.
Think about how these other exceptions might arise: who might want to take property subject to
a security agreement (not including thieves)? That is, Debtor gives Creditor a security interest
in, say, goods, while retaining possession. First, buyers of various sorts might want the goods if
they paid for them; they usually win. Second, lien creditors might want the goods
(a lien creditor is one whose claim is based on operation of law—involuntarily against Debtor,
and including a trustee in bankruptcy—as opposed to one whose claim is based on agreement);
lien creditors may be statutory (landlords, mechanics, bailees) or judicial. Third, a bankruptcy
trustee representing Debtor’s creditors (independent of the trustee’s role as a lien creditor)
might want to take the goods to sell and satisfy Debtor’s obligations to the creditors. Fourth,
unsecured creditors; fifth, secured creditors; and sixth, secured and perfected creditors. We will
examine some of the possible permutations but are compelled to observe that this area of law
has many fine nuances, not all of which can be taken up here.
First we look at buyers who take priority over, or free of, unperfected security interests. Buyers
who take delivery of many types of collateral covered by an unperfected security interest win out
over the hapless secured party who failed to perfect if they give value and don’t know of the
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security interest or agricultural lien. [5] A buyer who doesn’t give value or who knows of the
security interest will not win out, nor will a buyer prevail if the seller’s creditor files a financing
statement before or within twenty days after the debtor receives delivery of the collateral.
Now we look at buyers who take priority over perfected security interests. Sometimes people
who buy things even covered by a perfected security interest win out (the perfected secured
party loses).
•

Buyers in the ordinary course of business. “A buyer in the ordinary course of business, other
than [one buying farm products from somebody engaged in farming] takes free of a security
interest created by the buyer’s seller, even if the security interest is perfected and the buyer
knows [it].” [6] Here the buyer is usually purchasing inventory collateral, and it’s OK if he knows
the inventory is covered by a security interest, but it’s not OK if he knows “that the sale violates a
term in an agreement with the secured party.” [7] It would not be conducive to faith in
commercial transactions if buyers of inventory generally had to worry whether their seller’s
creditors were going to repossess the things the buyers had purchased in good faith. For
example (based on example 1 to the same comment, UCC 9-320, Official Comment 3),
Manufacturer makes appliances and owns manufacturing equipment covered by a perfected
security agreement in favor of Lender. Manufacturer sells the equipment to Dealer, whose
business is buying and selling used equipment; Dealer, in turn, sells the stuff to Buyer, a buyer
in the ordinary course. Does Buyer take free of the security interest? No, because Dealer didn’t
create it; Manufacturer did.

•

Buyers of consumer goods purchased for personal, family, or household use take free of security
interests, even if perfected, so long as they buy without knowledge of the security interest, for
value, for their own consumer uses, and before the filing of a financing statement covering the
goods. This—again—is the rub when a seller of consumer goods perfects by “mere attachment”
(automatic perfection) and the buyer of the goods turns around and sells them. For example,
Tom buys a new refrigerator from Sears, which perfects by mere attachment. Tom has cash flow
problems and sells the fridge to Ned, his neighbor. Ned doesn’t know about Sears’s security
interest and pays a reasonable amount for it. He puts it in his kitchen for home use. Sears
cannot repossess the fridge from Ned. If it wanted to protect itself fully, Sears would have filed a
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financing statement; then Ned would be out the fridge when the repo men came. [8] The “value”
issue is interestingly presented in the Nicolosi case (Section 16.5 "Cases").
•

Buyers of farm products. The UCC itself does not protect buyers of farm products from security
interests created by “the person engaged in farming operations who is in the business of selling
farm products,” and the result was that sometimes the buyer had to pay twice: once to the
farmer and again to the lender whom the farmer didn’t pay. As a result, Congress included in its
1985 Farm Security Act, 7 USC 1631, Section 1324, this language: “A buyer who in the ordinary
course of business buys a farm product from a seller engaged in farming operations shall take
free of a security interest created by the seller, even though the security interest is perfected; and
the buyer knows of the existence of such interest.”
There are some other exceptions, beyond our scope here.

Lien Creditors
Persons (including bankruptcy trustees) who become lien creditors before the security interest is
perfected win out—the unperfected security interest is subordinate to lien creditors. Persons
who become lien creditors after the security interest is perfected lose (subject to some nuances
in situations where the lien arises between attachment by the creditor and the filing, and
depending upon the type of security interest and the type of collateral). [9] More
straightforwardly, perhaps, a lien securing payment or performance of an obligation for services
or materials furnished with respect to goods by a person in the ordinary course of business has
priority over other security interests (unless a statute provides otherwise). [10] This is the bailee
or “material man” (one who supplies materials, as to build a house) with a lien situation. Garage
Mechanic repairs a car in which Owner has previously given a perfected security interest to
Bank. Owner doesn’t pay Bank. Bank seeks to repossess the car from Mechanic. It will have to
pay the Mechanic first. And why not? If the car was not running, Bank would have to have it
repaired anyway.

Bankruptcy Trustee
To what extent can the bankruptcy trustee take property previously encumbered by a security
interest? It depends. If the security interest was not perfected at the time of filing for
bankruptcy, the trustee can take the collateral. [11] If it was perfected, the trustee can’t take it,
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subject to rules on preferential transfers: the Bankruptcy Act provides that the trustee can avoid
a transfer of an interest of the debtor in property—including a security interest—(1) to or for the
benefit of a creditor, (2) on or account of an antecedent debt, (3) made while the debtor was
insolvent, (4) within ninety days of the bankruptcy petition date (or one year, for “insiders”—like
relatives or business partners), (5) which enables the creditor to receive more than it would have
in the bankruptcy. [12] There are further bankruptcy details beyond our scope here, but the short
of it is that sometimes creditors who think they have a valid, enforceable security interest find
out that the bankruptcy trustee has snatched the collateral away from them.
Deposit accounts perfected by control. A security interest in a deposit account (checking
account, savings account, money-market account, certificate of deposit) takes priority over
security interests in the account perfected by other means, and under UCC Section 9-327(3), a
bank with which the deposit is made takes priority over all other conflicting security
agreements. [13] For example, a debtor enters into a security agreement with his sailboat as
collateral. The creditor perfects. The debtor sells the sailboat and deposits the proceeds in his
account with a bank; normally, the creditor’s interest would attach to the proceeds. The debtor
next borrows money from the bank, and the bank takes a security interest in the debtor’s
account by control. The debtor defaults. Who gets the money representing the sailboat’s
proceeds? The bank does. The rationale: “this…enables banks to extend credit to their
depositors without the need to examine [records] to determine whether another party might
have a security interest in the deposit account.” [14]

KEY TAKEAWAY

Who among competing creditors gets the collateral if the debtor defaults? The general rule
on priorities is that the first to secure most completely wins: if all competitors have
perfected, the first to do so wins. If one has perfected and the others have not, the one who
perfects wins. If all have attached, the first to attach wins. If none have attached, they’re all
unsecured creditors. To this general rule there are a number of exceptions. Purchase-money
security interests in goods and inventory prevail over previously perfected secured parties in
the same goods and inventory (subject to some requirements); fixture financers who file
properly have priority over previously perfected mortgagees. Buyers in the ordinary course of

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business take free of a security interest created by their seller, so long as they don’t know
their purchase violates a security agreement. Buyers of consumer goods perfected by mere
attachment win out over the creditor who declined to file. Buyers in the ordinary course of
business of farm products prevail over the farmer’s creditors (under federal law, not the
UCC). Lien creditors who become such before perfection win out; those who become such
after perfection usually lose. Bailees in possession and material men have priority over
previous perfected claimants. Bankruptcy trustees win out over unperfected security
interests and over perfected ones if they are considered voidable transfers from the debtor
to the secured party. Deposit accounts perfected by control prevail over previously perfected
secured parties in the same deposit accounts.

EXERCISES

1. What is the general rule regarding priorities for the right to repossess goods encumbered by
a security interest when there are competing creditors clamoring for that right?
2. Why does it make good sense to allow purchase-money security creditors in (1) inventory, (2)
equipment, and (3) fixtures priority over creditors who perfected before the PMSI was
perfected?
3. A buyer in the ordinary course of business is usually one buying inventory. Why does it make
sense that such a buyer should take free of a security interest created by his seller?
[1] Uniform Commercial Code, Section 9-322(a)(2).
[2] Uniform Commercial Code, Section 9-322(a)(1).
[3] Uniform Commercial Code, Section 9-324(a).
[4] Uniform Commercial Code, Section 9-324(b).
[5] Uniform Commercial Code, Section 9-317(b).
[6] Uniform Commercial Code, Section 9-320(a).
[7] Uniform Commercial Code, Section 9-320, Comment 3.
[8] Uniform Commercial Code, Section 9-320(b).
[9] Uniform Commercial Code, Section 9-317(a)(2)(B) and 9-317(e).
[10] Uniform Commercial Code, Section 9-333.
[11] 11 United States Code, Section 544 (Bankruptcy Act).
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[12] United States Code, Section 547.
[13] Uniform Commercial Code, Section 9-327(1).
[14] Uniform Commercial Code, Section 9-328, Official Comment 3 and 4.

16.3 Rights of Creditor on Default and Disposition after
Repossession
LEARNING OBJECTIVES

1. Understand that the creditor may sue to collect the debt.
2. Recognize that more commonly the creditor will realize on the collateral—repossess it.
3. Know how collateral may be disposed of upon repossession: by sale or by strict foreclosure.

Rights of Creditor on Default
Upon default, the creditor must make an election: to sue, or to repossess.

Resort to Judicial Process
After a debtor’s default (e.g., by missing payments on the debt), the creditor could ignore the
security interest and bring suit on the underlying debt. But creditors rarely resort to this remedy
because it is time-consuming and costly. Most creditors prefer to repossess the collateral and
sell it or retain possession in satisfaction of the debt.

Repossession
Section 9-609 of the Uniform Commercial Code (UCC) permits the secured party to take
possession of the collateral on default (unless the agreement specifies otherwise):
(a) After default, a secured party may (1) take possession of the collateral; and (2) without
removal, may render equipment unusable and dispose of collateral on a debtor’s premises.
(b) A secured party may proceed under subsection (a): (1) pursuant to judicial process; or (2)
without judicial process, if it proceeds without breach of the peace.
This language has given rise to the flourishing business of professional “repo men” (and
women). “Repo” companies are firms that specialize in repossession collateral. They have
trained car-lock pickers, in-house locksmiths, experienced repossession teams, damage-free
towing equipment, and the capacity to deliver repossessed collateral to the client’s desired
destination. Some firms advertise that they have 360-degree video cameras that record every
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aspect of the repossession. They have “skip chasers”—people whose business it is to track down
those who skip out on their obligations, and they are trained not to breach the
peace. [1] See Pantoja-Cahue v. Ford Motor Credit Co., a case discussing repossession, in Section
16.5 "Cases".
The reference in Section 9-609(a)(2) to “render equipment unusable and dispose of collateral on
a debtor’s premises” gets to situations involving “heavy equipment [when] the physical removal
from the debtor’s plant and the storage of collateral pending disposition may be impractical or
unduly expensive.…Of course…all aspects of the disposition must be commercially
reasonable.” [2] Rendering the equipment unusable would mean disassembling some critical part
of the machine—letting it sit there until an auction is set up on the premises.
The creditor’s agents—the repo people—charge for their service, of course, and if possible the
cost of repossession comes out of the collateral when it’s sold. A debtor would be better off
voluntarily delivering the collateral according to the creditor’s instructions, but if that doesn’t
happen, “self-help”—repossession—is allowed because, of course, the debtor said it would be
allowed in the security agreement, so long as the repossession can be accomplished without
breach of peace. “Breach of peace” is language that can cover a wide variety of situations over
which courts do not always agree. For example, some courts interpret a creditor’s taking of the
collateral despite the debtor’s clear oral protest as a breach of the peace; other courts do not.

Disposition after Repossession
After repossession, the creditor has two options: sell the collateral or accept it in satisfaction of
the debt (see Figure 16.5 "Disposition after Repossession").
Figure 16.5 Disposition after Repossession

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Sale
Sale is the usual method of recovering the debt. Section 9-610 of the UCC permits the secured
creditor to “sell, lease, license, or otherwise dispose of any or all of the collateral in its present
condition or following any commercially reasonable preparation or processing.” The collateral
may be sold as a whole or in parcels, at one time or at different times. Two requirements limit
the creditor’s power to resell: (1) it must send notice to the debtor and secondary obligor, and
(unless consumer goods are sold) to other secured parties; and (2) all aspects of the sale must be
“commercially reasonable.” [3] Most frequently the collateral is auctioned off.
Section 9-615 of the UCC describes how the proceeds are applied: first, to the costs of the
repossession, including reasonable attorney’s fees and legal expenses as provided for in the
security agreement (and it will provide for that!); second, to the satisfaction of the obligation
owed; and third, to junior creditors. This again emphasizes the importance of promptly
perfecting the security interest: failure to do so frequently subordinates the tardy creditor’s
interest to junior status. If there is money left over from disposing of the collateral—a surplus—
the debtor gets that back. If there is still money owing—a deficiency—the debtor is liable for that.
In Section 9-616, the UCC carefully explains how the surplus or deficiency is calculated; the
explanation is required in a consumer goods transaction, and it has to be sent to the debtor after
the disposition.

Strict Foreclosure
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Because resale can be a bother (or the collateral is appreciating in value), the secured creditor
may wish simply to accept the collateral in full satisfaction or partial satisfaction of the debt, as
permitted in UCC Section 9-620(a). This is known asstrict foreclosure. The debtor must consent
to letting the creditor take the collateral without a sale in a “record authenticated after default,”
or after default the creditor can send the debtor a proposal for the creditor to accept the
collateral, and the proposal is effective if not objected to within twenty days after it’s sent.
The strict foreclosure provisions contain a safety feature for consumer goods debtors. If the
debtor has paid at least 60 percent of the debt, then the creditor may not use strict foreclosure—
unless the debtor signs a statement after default renouncing his right to bar strict foreclosure
and to force a sale. [4] A consumer who refuses to sign such a statement thus forces the secured
creditor to sell the collateral under Section 9-610. Should the creditor fail to sell the goods
within ninety days after taking possession of the goods, he is liable to the debtor for the value of
the goods in a conversion suit or may incur the liabilities set forth in Section 9-625, which
provides for minimum damages for the consumer debtor. Recall that the UCC imposes a duty to
act in good faith and in a commercially reasonable manner, and in most cases with reasonable
notification. [5] See Figure 16.5 "Disposition after Repossession".

Foreclosure on Intangible Collateral
A secured party’s repossession of inventory or equipment can disrupt or even close a debtor’s
business. However, when the collateral is intangible—such as accounts receivable, general
intangibles, chattel paper, or instruments—collection by a secured party after the debtor’s
default may proceed without interrupting the business. Section 9-607 of the UCC provides that
on default, the secured party is entitled to notify the third party—for example, a person who
owes money on an account—that payment should be made to him. The secured party is
accountable to the debtor for any surplus, and the debtor is liable for any deficiency unless the
parties have agreed otherwise.
As always in parsing the UCC here, some of the details and nuances are necessarily omitted
because of lack of space or because a more detailed analysis is beyond this book’s scope.

KEY TAKEAWAY

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Upon default, the creditor may bring a lawsuit against the debtor to collect a judgment. But
the whole purpose of secured transactions is to avoid this costly and time-consuming
litigation. The more typical situation is that the creditor repossesses the collateral and then
either auctions it off (sale) or keeps it in satisfaction of the debt (strict foreclosure). In the
former situation, the creditor may then proceed against the debtor for the deficiency. In
consumer cases, the creditor cannot use strict foreclosure if 60 percent of the purchase price
has been paid.

EXERCISES

1. Although a creditor could sue the debtor, get a judgment against it, and collect on the
judgment, usually the creditor repossesses the collateral. Why is repossession the preferred
method of realizing on the security?
2. Why is repossession allowed so long as it can be done without a breach of the peace?
3. Under what circumstances is strict foreclosure not allowed?
[1] Here is an example of sophisticated online advertising for a repossession firm: SSR, “Southern &
Central Coast California Repossession Services,”http://www.simonsrecovery.com/index.htm.
[2] Uniform Commercial Code, Section 9-609(a)(2), Official Comment 6.
[3] Uniform Commercial Code, Section 9-611; Uniform Commercial Code, Section 9-610.
[4] Uniform Commercial Code, 9-620(e); Uniform Commercial Code, Section 9-624.
[5] Uniform Commercial Code, Section 1-203.

16.4 Suretyship

LEARNING OBJECTIVES

1. Understand what a surety is and why sureties are used in commercial transactions.
2. Know how suretyships are created.
3. Recognize the general duty owed by the surety to the creditor, and the surety’s defenses.
4. Recognize the principal obligor’s duty to the surety, and the surety’s rights against the surety.
5. Understand the rights among cosureties.
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Definition, Types of Sureties, and Creation of the Suretyship
Definition
Suretyship is the second of the three major types of consensual security arrangements noted at
the beginning of this chapter (personal property security, suretyship, real property security)—
and a common one. Creditors frequently ask the owners of small, closely held companies to
guarantee their loans to the company, and parent corporations also frequently are guarantors of
their subsidiaries’ debts. The earliest sureties were friends or relatives of the principal debtor
who agreed—for free—to lend their guarantee. Today most sureties in commercial transaction
are insurance companies (but insurance is not the same as suretyship).
A surety is one who promises to pay or perform an obligation owed by theprincipal debtor, and,
strictly speaking, the surety is primarily liable on the debt: the creditor can demand payment
from the surety when the debt is due. The creditor is the person to whom the principal debtor
(and the surety, strictly speaking) owes an obligation. Very frequently, the creditor requires first
that the debtor put up collateral to secure indebtedness, and—in addition—that the debtor
engage a surety to make extra certain the creditor is paid or performance is made. For example,
David Debtor wants Bank to loan his corporation, David Debtor, Inc., $100,000. Bank says,
“Okay, Mr. Debtor, we’ll loan the corporation money, but we want its computer equipment as
security, and we want you personally to guarantee the debt if the corporation can’t pay.”
Sometimes, though, the surety and the principal debtor may have no agreement between each
other; the surety might have struck a deal with the creditor to act as surety without the consent
or knowledge of the principal debtor.
A guarantor also is one who guarantees an obligation of another, and for practical purposes,
therefore, guarantor is usually synonymous with surety—the terms are used pretty much
interchangeably. But here’s the technical difference: a surety is usually a party to the original
contract and signs her (or his, or its) name to the original agreement along with the surety; the
consideration for the principal’s contract is the same as the surety’s consideration—she is bound
on the contract from the very start, and she is also expected to know of the principal debtor’s
default so that the creditor’s failure to inform her of it does not discharge her of any liability. On
the other hand, a guarantor usually does not make his agreement with the creditor at the same
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time the principal debtor does: it’s a separate contract requiring separate consideration, and if
the guarantor is not informed of the principal debtor’s default, the guarantor can claim
discharge on the obligation to the extent any failure to inform him prejudices him. But, again, as
the terms are mostly synonymous, surety is used here to encompass both.

Figure 16.6 Defenses of Principal Debtor and Surety

Types of Suretyship
Where there is an interest, public or private, that requires protection from the possibility of a
default, sureties are engaged. For example, a landlord might require that a commercial tenant
not only put up a security deposit but also show evidence that it has a surety on line ready to
stand for three months’ rent if the tenant defaults. Often, a municipal government will want its
road contractor to show it has a surety available in case, for some reason, the contractor cannot
complete the project. Many states require general contractors to have bonds, purchased from
insurance companies, as a condition of getting a contractor’s license; the insurance company is
the surety—it will pay out if the contractor fails to complete work on the client’s house. These are
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types of a performance bond. A judge will often require that a criminal defendant put up a bond
guaranteeing his appearance in court—that’s a type of suretyship where the bail-bonder is the
surety—or that a plaintiff put up a bond indemnifying the defendant for the costs of delays
caused by the lawsuit—a judicial bond. A bank will take out a bond on its employees in case they
steal money from the bank—the bank teller, in this case, is the principal debtor (a fidelity bond).
However, as we will see, sureties do not anticipate financial loss like insurance companies do:
the surety expects, mostly, to be repaid if it has to perform. The principal debtor goes to an
insurance company and buys the bond—the suretyship policy. The cost of the premium depends
on the surety company, the type of bond applied for, and the applicant’s financial history. A
sound estimate of premium costs is 1 percent to 4 percent, but if a surety company classifies an
applicant as high risk, the premium falls between 5 percent and 20 percent of the bond amount.
When the purchaser of real estate agrees to assume the seller’s mortgage (promises to pay the
mortgage debt), the seller then becomes a surety: unless the mortgagee releases the seller (not
likely), the seller has to pay if the buyer defaults.

Creation of the Suretyship
Suretyship can arise only through contract. The general principles of contract law apply to
suretyship. Thus a person with the general capacity to contract has the power to become a
surety. Consideration is required for a suretyship contract: if Debtor asks a friend to act as a
surety to induce Creditor to make Debtor a loan, the consideration Debtor gives Creditor also
acts as the consideration Friend gives. Where the suretyship arises after Creditor has already
extended credit, new consideration would be required (absent application of the doctrine of
promissory estoppel [1]). You may recall from the chapters on contracts that the promise by one
person to pay or perform for the debts or defaults of another must be evidenced by a writing
under the statute of frauds (subject to the “main purpose” exception).
Suretyship contracts are affected to some extent by government regulation. Under a 1985
Federal Trade Commission Credit Practices Rule, creditors are prohibited from misrepresenting
a surety’s liability. Creditors must also give the surety a notice that explains the nature of the
obligation and the potential liability that can arise if a person cosigns on another’s debt. [2]

Duties and Rights of the Surety
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Duties of the Surety
Upon the principal debtor’s default, the surety is contractually obligated to perform unless the
principal herself or someone on her behalf discharges the obligation. When the surety performs,
it must do so in good faith. Because the principal debtor’s defenses are generally limited, and
because—as will be noted—the surety has the right to be reimbursed by the debtor, debtors not
infrequently claim the surety acted in bad faith by doing things like failing to make an adequate
investigation (to determine if the debtor really defaulted), overpaying claims, interfering with
the contact between the surety and the debtor, and making unreasonable refusals to let the
debtor complete the project. The case Fidelity and Deposit Co. of Maryland v. Douglas Asphalt
Co., in Section 16.5 "Cases", is typical.

Rights of the Surety
The surety has four main rights stemming from its obligation to answer for the debt or default of
the principal debtor.

Exoneration
If, at the time a surety’s obligation has matured, the principal can satisfy the obligation but
refuses to do so, the surety is entitled to exoneration—a court order requiring the principal to
perform. It would be inequitable to force the surety to perform and then to have to
seek reimbursement from the principal if all along the principal is able to perform.

Reimbursement
If the surety must pay the creditor because the principal has defaulted, the principal is obligated
to reimburse the surety. The amount required to be reimbursed includes the surety’s reasonable,
good-faith outlays, including interest and legal fees.

Subrogation
Suppose the principal’s duty to the creditor is fully satisfied and that the surety has contributed
to this satisfaction. Then the surety is entitled to be subrogated to the rights of the creditor
against the principal. In other words, the surety stands in the creditor’s shoes and may assert
against the principal whatever rights the creditor could have asserted had the duty not been
discharged. The right of subrogation includes the right to take secured interests that the creditor
obtained from the principal to cover the duty. Sarah’s Pizzeria owes Martha $5,000, and Martha
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has taken a security interest in Sarah’s Chevrolet. Eva is surety for the debt. Sarah defaults, and
Eva pays Martha the $5,000. Eva is entitled to have the security interest in the car transferred to
her.

Contribution
Two or more sureties who are bound to answer for the principal’s default and who should share
between them the loss caused by the default are known as cosureties. A surety who in
performing its own obligation to the creditor winds up paying more than its proportionate share
is entitled to contribution from the cosureties.

Defenses of the Parties
The principal and the surety may have defenses to paying.

Defenses of the Principal
The principal debtor may avail itself of any standard contract defenses as against the creditor,
including impossibility, illegality, incapacity, fraud, duress, insolvency, or bankruptcy discharge.
However, the surety may contract with the creditor to be liable despite the principal’s defenses,
and a surety who has undertaken the suretyship with knowledge of the creditor’s fraud or duress
remains obligated, even though the principal debtor will be discharged. When the surety turns
to the principal debtor and demands reimbursement, the latter may have defenses against the
surety—as noted—for acting in bad faith.
One of the main reasons creditors want the promise of a surety is to avoid the risk that the
principal debtor will go bankrupt: the debtor’s bankruptcy is a defense to the debtor’s liability,
certainly, but that defense cannot be used by the surety. The same is true of the debtor’s
incapacity: it is a defense available to the principal debtor but not to the surety.

Defenses of the Surety
Generally, the surety may exercise defenses on a contract that would have been available to the
principal debtor (e.g., creditor’s breach; impossibility or illegality of performance; fraud, duress,
or misrepresentation by creditor; statute of limitations; refusal of creditor to accept tender or
performance from either debtor or surety.) Beyond that, the surety has some defenses of its own.
Common defenses raised by sureties include the following:

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•

Release of the principal. Whenever a creditor releases the principal, the surety is discharged,
unless the surety consents to remain liable or the creditor expressly reserves her rights against
the surety. The creditor’s release of the surety, though, does not release the principal debtor
because the debtor is liable without regard to the surety’s liability.

•

Modification of the contract. If the creditor alters the instrument sufficiently to discharge the
principal, the surety is discharged as well. Likewise, when the creditor and principal modify
their contract, a surety who has not consented to the modification is discharged if the surety’s
risk is materially increased (but not if it is decreased). Modifications include extension of the
time of payment, release of collateral (this releases the surety to the extent of the impairment),
change in principal debtor’s duties, and assignment or delegation of the debtor’s obligations to a
third party. The surety may consent to modifications.

•

Creditor’s failure to perfect. A creditor who fails to file a financing statement or record a
mortgage risks losing the security for the loan and might also inadvertently release a surety, but
the failure of the creditor to resort first to collateral is no defense.

•

Statute of frauds. Suretyship contracts are among those required to be evidenced by some
writing under the statute of frauds, and failure to do so may discharge the surety from liability.

•

Creditor’s failure to inform surety of material facts within creditor’s knowledge affecting
debtor’s ability to perform (e.g., that debtor has defaulted several times before).

•

General contract defenses. The surety may raise common defenses like incapacity (infancy), lack
of consideration (unless promissory estoppel can be substituted or unless no separate
consideration is necessary because the surety’s and debtor’s obligations arise at the same time),
and creditor’s fraud or duress on surety. However, fraud by the principal debtor on the surety to
induce the suretyship will not release the surety if the creditor extended credit in good faith; if
the creditor knows of the fraud perpetrated by the debtor on the surety, the surety may avoid
liability. See Figure 16.6 "Defenses of Principal Debtor and Surety".
The following are defenses of principal debtor only:

•

Death or incapacity of principal debtor

•

Bankruptcy of principal debtor

•

Principal debtor’s setoffs against creditor
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The following are defenses of both principal debtor and surety:
•

Material breach by creditor

•

Lack of mutual assent, failure of consideration

•

Creditor’s fraud, duress, or misrepresentation of debtor

•

Impossibility or illegality of performance

•

Material and fraudulent alteration of the contract

•

Statute of limitations
The following are defenses of surety only:

•

Fraud or duress by creditor on surety

o

Illegality of suretyship contract

o

Surety’s incapacity

o

Failure of consideration for surety contract (unless excused)

o

Statute of frauds

o

Acts of creditor or debtor materially affecting surety’s obligations:



Refusal by creditor to accept tender of performance



Release of principal debtor without surety’s consent



Release of surety



Release, surrender, destruction, or impairment of collateral



Extension of time on principal debtor’s obligation



Modification of debtor’s duties, place, amount, or manner of debtor’s obligations

KEY TAKEAWAY

Creditors often require not only the security of collateral from the debtor but also that the
debtor engage a surety. A contract of suretyship is a type of insurance policy, where the
surety (insurance company) promises the creditor that if the principal debtor fails to perform,
the surety will undertake good-faith performance instead. A difference between insurance
and suretyship, though, is that the surety is entitled to reimbursement by the principal
debtor if the surety pays out. The surety is also entitled, where appropriate, to exoneration,
subrogation, and contribution. The principal debtor and the surety both have some defenses

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available: some are personal to the debtor, some are joint defenses, and some are personal
to the surety.

EXERCISES

1. Why isn’t collateral put up by the debtor sufficient security for the creditor—why is a surety
often required?
2. How can it be said that sureties do not anticipate financial losses like insurance companies
do? What’s the difference, and how does the surety avoid losses?
3. Why does the creditor’s failure to perfect a security interest discharge the surety from
liability? Why doesn’t failure of the creditor to resort first to perfected collateral discharge
the surety?
4. What is the difference between a guarantor and a surety?
[1] American Druggists’ Ins. Co. v. Shoppe, 448 N.W.2d 103, Minn. App. (1989).
[2] Here is an example of the required notice: Federal Trade Commission, “Facts for Consumers: The
Credit Practices Rule,”http://www.ftc.gov/bcp/edu/pubs/consumer/credit/cre12.shtm.

16.5 Cases
Perfection by Mere Attachment; Priorities
In re NICOLOSI
4 UCC Rep. 111 (Ohio 1966)

Preliminary Statement and Issues
This matter is before the court upon a petition by the trustee to sell a diamond ring in his
possession free of liens.…Even though no pleadings were filed by Rike-Kumler Company, the
issue from the briefs is whether or not a valid security interest was perfected in this chattel as
consumer goods, superior to the statutory title and lien of the trustee in bankruptcy.

Findings of Fact
The [debtor] purchased from the Rike-Kumler Company, on July 7, 1964, the diamond ring in
question, for $1237.35 [about $8,500 in 2010 dollars], as an engagement ring for his fiancée. He
executed a purchase money security agreement, which was not filed. Also, no financing
statement was filed. The chattel was adequately described in the security agreement.
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The controversy is between the trustee in bankruptcy and the party claiming a perfected security
interest in the property. The recipient of the property has terminated her relationship with the
[debtor], and delivered the property to the trustee.

Conclusion of Law, Decision, and Order
If the diamond ring, purchased as an engagement ring by the bankrupt, cannot be categorized as
consumer goods, and therefore exempted from the notice filing requirements of the Uniform
Commercial Code as adopted in Ohio, a perfected security interest does not exist.
No judicial precedents have been cited in the briefs.
Under the commercial code, collateral is divided into tangible, intangible, and documentary
categories. Certainly, a diamond ring falls into the tangible category. The classes of tangible
goods are distinguished by the primary use intended. Under [the UCC] the four classes [include]
“consumer goods,” “equipment,” “farm products” and “inventory.”
The difficulty is that the code provisions use terms arising in commercial circles which have
different semantical values from legal precedents. Does the fact that the purchaser bought the
goods as a special gift to another person signify that it was not for his own “personal, family or
household purposes”? The trustee urges that these special facts control under the express
provisions of the commercial code.
By a process of exclusion, a diamond engagement ring purchased for one’s fiancée is not
“equipment” bought or used in business, “farm products” used in farming operations, or
“inventory” held for sale, lease or service contracts. When the [debtor] purchased the ring,
therefore, it could only have been “consumer goods” bought “primarily for personal use.” There
could be no judicial purpose to create a special class of property in derogation of the statutory
principles.
Another problem is implicit, although not covered by the briefs.
By the foregoing summary analysis, it is apparent that the diamond ring, when the interest of
the debtor attached, was consumer goods since it could have been no other class of goods.
Unless the fiancée had a special status under the code provision protecting a bona fide buyer,
without knowledge, for value, of consumer goods, the failure to file a financing statement is not
crucial. No evidence has been adduced pertinent to the scienter question.
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Is a promise, as valid contractual consideration, included under the term “value”? In other
words, was the ring given to his betrothed in consideration of marriage (promise for a promise)?
If so, and “value” has been given, the transferee is a “buyer” under traditional concepts.
The Uniform Commercial Code definition of “value”…very definitely covers a promise for a
promise. The definition reads that “a person gives ‘value’ for rights if he acquires
them…generally in return for any consideration sufficient to support a simple contract.”
It would seem unrealistic, nevertheless, to apply contract law concepts historically developed
into the law of marriage relations in the context of new concepts developed for uniform
commercial practices. They are not, in reality, the same juristic manifold. The purpose of
uniformity of the code should not be defeated by the obsessions of the code drafters to be all
inclusive for secured creditors.
Even if the trustee, in behalf of the unsecured creditors, would feel inclined to insert love,
romance and morals into commercial law, he is appearing in the wrong era, and possibly the
wrong court.
Ordered, that the Rike-Kumler Company holds a perfected security interest in the diamond
engagement ring, and the security interest attached to the proceeds realized from the sale of the
goods by the trustee in bankruptcy.

CASE QUESTIONS

1. Why didn’t the jewelry store, Rike-Kumler, file a financing statement to protect its security
interest in the ring?
2. How did the bankruptcy trustee get the ring?
3. What argument did the trustee make as to why he should be able to take the ring as an asset
belonging to the estate of the debtor? What did the court determine on this issue?

Repossession and Breach of the Peace
Pantoja-Cahue v. Ford Motor Credit Co.
872 N.E.2d 1039 (Ill. App. 2007)
Plaintiff Mario Pantoja-Cahue filed a six-count complaint seeking damages from defendant Ford
Motor Credit Company for Ford’s alleged breach of the peace and “illegal activities” in
repossessing plaintiff’s automobile from his locked garage.…

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In August 2000, plaintiff purchased a 2000 Ford Explorer from auto dealer Webb Ford.
Plaintiff, a native Spanish speaker, negotiated the purchase with a Spanish-speaking salesperson
at Webb. Plaintiff signed what he thought was a contract for the purchase and financing of the
vehicle, with monthly installment payments to be made to Ford. The contract was in English.
Some years later, plaintiff discovered the contract was actually a lease, not a purchase
agreement. Plaintiff brought suit against Ford and Webb on August 22, 2003, alleging fraud.
Ford brought a replevin action against plaintiff asserting plaintiff was in default on his
obligations under the lease. In the late night/early morning hours of March 11–12, 2004,
repossession agents [from Doe Repossession Services] entered plaintiff’s locked garage and
removed the car…
Plaintiff sought damages for Ford and Doe’s “unlawful activities surrounding the wrongful
repossession of Plaintiff’s vehicle.” He alleged Ford and Doe’s breaking into plaintiff’s locked
garage to effectuate the repossession and Ford’s repossession of the vehicle knowing that title to
the car was the subject of ongoing litigation variously violated section 2A-525(3) of the [Uniform
Commercial] Code (count I against Ford), the [federal] Fair Debt Collection Practices Act (count
II against Doe),…Ford’s contract with plaintiff (count V against Ford) and section 2A-108 of the
Code (count VI against Ford and Doe).…

Uniform Commercial Code Section 2A-525(3)
In count I, plaintiff alleged “a breach of the peace occurred as [Ford]’s repossession agent broke
into Plaintiff’s locked garage in order to take the vehicle” and Ford’s agent “repossessed the
subject vehicle by, among other things, breaking into Plaintiff’s locked garage and causing
substantial damage to Plaintiff’s personal property in violation of [section 2A-525(3)]”:
“After a default by the lessee under the lease contract * * * or, if agreed, after other default by the
lessee, the lessor has the right to take possession of the goods. * * *
The lessor may proceed under subsection (2) without judicial process if it can be done without
breach of the peace or the lessor may proceed by action.” [emphasis added.]
[U]pon a lessee’s default, a lessor has the right to repossess the leased goods in one of two ways:
by using the judicial process or, if repossession could be accomplished without a breach of the
peace, by self-help [UCC Section 2A-525(3)]. “If a breach of the peace is likely, a properly
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instituted civil action is the appropriate remedy.” [Citation] (interpreting the term “breach of the
peace” in the context of section 9-503 of the Code, which provides for the same self-help
repossession as section 2A-525 but for secured creditors rather than lessors).
Taking plaintiff’s well-pleaded allegations as true, Ford resorted to self-help, by employing an
agent to repossess the car and Ford’s agent broke into plaintiff’s locked garage to effectuate the
repossession. Although plaintiff’s count I allegations are minimal, they are sufficient to plead a
cause of action for a violation of section 2A-525(3) if breaking into a garage to repossess a car is,
as plaintiff alleged, a breach of the peace. Accordingly, the question here is whether breaking
into a locked garage to effectuate a repossession is a breach of the peace in violation of section
2A-525(3).
There are no Illinois cases analyzing the meaning of the term “breach of the peace” as used in
the lessor repossession context in section 2A-525(3). However, there are a few Illinois cases
analyzing the term as used in section 9-503 of the Code, which contains a similar provision
providing that a secured creditor may, upon default by a debtor, repossess its collateral either
“(1) pursuant to judicial process; or (2) without judicial process, if it proceeds without breach of
the peace.” The seminal case, and the only one of any use in resolving the issue, is Chrysler
Credit Corp. v. Koontz, 277 Ill.App.3d 1078, 214 Ill.Dec. 726, 661 N.E.2d 1171 (1996).
In Koontz, Chrysler, the defendant creditor, sent repossession agents to repossess the plaintiff’s
car after the plaintiff defaulted on his payments. The car was parked in the plaintiff’s front yard.
The plaintiff heard the repossession in progress and ran outside in his underwear shouting
“Don’t take it” to the agents. The agents did not respond and proceeded to take the car. The
plaintiff argued the repossession breached the peace and he was entitled to the statutory remedy
for violation of section 9-503, denial of a deficiency judgment to the secured party, Chrysler.…
After a thorough analysis of the term “breach of the peace,” the court concluded the term
“connotes conduct which incites or is likely to incite immediate public turbulence, or which
leads to or is likely to lead to an immediate loss of public order and tranquility. Violent conduct
is not a necessary element. The probability of violence at the time of or immediately prior to the
repossession is sufficient.”…[The Koontz court] held the circumstances of the repossession did
not amount to a breach the peace.
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The court then considered the plaintiff’s argument that Chrysler breached the peace by
repossessing the car under circumstances constituting criminal trespass to property. Looking to
cases in other jurisdictions, the court determined that, “in general, a mere trespass, standing
alone, does not automatically constitute a breach of the peace.” [Citation] (taking possession of
car from private driveway does not, without more, constitute breach of the peace), [Citation] (no
breach of the peace occurred where car repossessed from debtor’s driveway without entering
“any gates, doors, or other barricades to reach” car), [Citation] (no breach of the peace occurred
where car was parked partially under carport and undisputed that no door, “not even one to a
garage,” on the debtor’s premises was opened, much less broken, to repossess the car),
[Citation] (although secured party may not break into or enter homes or buildings or enclosed
spaces to effectuate a repossession, repossession of vehicle from parking lot of debtor’s
apartment building was not breach of the peace), [Citation] (repossession of car from debtor’s
driveway without entering any gates, doors or other barricades was accomplished without
breach of the peace).…
Although the evidence showed the plaintiff notified Chrysler prior to the repossession that it was
not permitted onto his property, the court held Chrysler’s entry onto the property to take the car
did not constitute a breach of the peace because there was no evidence Chrysler entered through
a barricade or did anything other than drive the car away. [Citation] “Chrysler enjoyed a limited
privilege to enter [the plaintiff’s] property for the sole and exclusive purpose of effectuating the
repossession. So long as the entry was limited in purpose (repossession), and so long as no
gates, barricades, doors, enclosures, buildings, or chains were breached or cut, no breach of the
peace occurred by virtue of the entry onto his property.”
…[W]e come to essentially the same conclusion: where a repossession is effectuated by an actual
breaking into the lessee/debtor’s premises or breaching or cutting of chains, gates, barricades,
doors or other barriers designed to exclude trespassers, the likelihood that a breach of the peace
occurred is high.
Davenport v. Chrysler Credit Corp., [Citation] (Tenn.App.1991), a case analyzing Tennessee’s
version of section 9-503 is particularly helpful, holding that “‘[a] breach of the peace is almost
certain to be found if the repossession is accompanied by the unauthorized entry into a closed or
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locked garage.’”…This is so because “public policy favors peaceful, non-trespassory
repossessions when the secured party has a free right of entry” and “forced entries onto the
debtor’s property or into the debtor’s premises are viewed as seriously detrimental to the
ordinary conduct of human affairs.” Davenportheld that the creditor’s repossession of a car by
entering a closed garage and cutting a chain that would have prevented it from removing the car
amounted to a breach of the peace, “[d]espite the absence of violence or physical confrontation”
(because the debtor was not at home when the repossession occurred). Davenport recognized
that the secured creditors’ legitimate interest in obtaining possession of collateral without
having to resort to expensive and cumbersome judicial procedures must be balanced against the
debtors’ legitimate interest in being free from unwarranted invasions of their property and
privacy interests.
“Repossession is a harsh procedure and is, essentially, a delegation of the State’s exclusive
prerogative to resolve disputes. Accordingly, the statutes governing the repossession of collateral
should be construed in a way that prevents abuse and discourages illegal conduct which might
otherwise go unchallenged because of the debtor’s lack of knowledge of legally proper
repossession techniques” [Citation].
We agree with [this] analysis of the term “breach of the peace” in the context of repossession
and hold, with regard to section 2A-525(3) of the Code, that breaking into a locked garage to
effectuate a repossession may constitute a breach of the peace.
Here, plaintiff alleges more than simply a trespass. He alleges Ford, through Doe, broke into his
garage to repossess the car. Given our determination that breaking into a locked garage to
repossess a car may constitute a breach of the peace, plaintiff’s allegation is sufficient to state a
cause of action under section 2A-525(3) of the Code. The court erred in dismissing count I of
plaintiff’s second amended complaint and we remand for further proceedings.

Uniform Commercial Code Section 2A-108
In count VI, plaintiff alleged the lease agreement was unconscionable because it was formed in
violation of [the Illinois Consumer Fraud Statute, requiring that the customer verify that the
negotiations were conducted in the consumer’s native language and that the document was

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translated so the customer understood it.]…Plaintiff does not quote [this] or explain how the
agreement violates [it]. Instead, he quotes UCC section 2A-108 of the Code, as follows:
“With respect to a consumer lease, if the court as a matter of law finds that a lease contract or
any clause of a lease contract has been induced by unconscionable conduct or that
unconscionable conduct has occurred in the collection of a claim arising from a lease contract,
the court may grant appropriate relief.
Before making a finding of unconscionability under subsection (1) or (2), the court, on its own
motion or that of a party, shall afford the parties a reasonable opportunity to present evidence as
to the setting, purpose, and effect of the lease contract or clause thereof, or of the conduct.”
He then, in “violation one” under count VI, alleges the lease was made in violation of [the
Illinois Consumer Fraud Statute] because it was negotiated in Spanish but he was only given a
copy of the contract in English; he could not read the contract and, as a result, Webb Ford was
able to trick him into signing a lease, rather than a purchase agreement; such contract was
induced by unconscionable conduct; and, because it was illegal, the contract was unenforceable.
This allegation is insufficient to state a cause of action against Ford under section 2A108.…First, Ford is an entirely different entity than Webb Ford and plaintiff does not assert
otherwise. Nor does plaintiff assert that Webb Ford was acting as Ford’s agent in inducing
plaintiff to sign the lease. Plaintiff asserts no basis on which Ford can be found liable for
something Webb Ford did. Second, there is no allegation as to how the contract violates [the
statute], merely the legal conclusion that it does, as well as the unsupported legal conclusion
that a violation of [it] is necessarily unconscionable.…[Further discussion omitted.]
For the reasons stated above, we affirm the trial court’s dismissal of counts IV, V and VI of
plaintiff’s second amended complaint. We reverse the court’s dismissal of count I and remand
for further proceedings. Affirmed in part and reversed in part; cause remanded.

CASE QUESTIONS

1. Under what circumstances, if any, would breaking into a locked garage to repossess a
car not be considered a breach of the peace?
2. The court did not decide that a breach of the peace had occurred. What would determine
that such a breach had occurred?

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3. Why did the court dismiss the plaintiff’s claim (under UCC Article 2A) that it was
unconscionable of Ford to trick him into signing a lease when he thought he was signing a
purchase contract? Would that section of Article 2A make breaking into his garage
unconscionable?
4. What alternatives had Ford besides taking the car from the plaintiff’s locked garage?
5. If it was determined on remand that a breach of the peace had occurred, what happens to
Ford?

Defenses of the Principal Debtor as against Reimbursement to Surety
Fidelity and Deposit Co. of Maryland v. Douglas Asphalt Co.
338 Fed.Appx. 886, 11th Cir. Ct. (2009)

Per Curium: [1]
The Georgia Department of Transportation (“GDOT”) contracted with Douglas Asphalt
Company to perform work on an interstate highway. After Douglas Asphalt allegedly failed to
pay its suppliers and subcontractors and failed to perform under the contract, GDOT defaulted
and terminated Douglas Asphalt. Fidelity and Deposit Company of Maryland and Zurich
American Insurance Company had executed payment and performance bonds in connection
with Douglas Asphalt’s work on the interstate, and after Douglas Asphalt’s default, Fidelity and
Zurich spent $15,424,798 remedying the default.
Fidelity and Zurich, seeking to recover their losses related to their remedy of the default,
brought this suit against Douglas Asphalt, Joel Spivey, and Ronnie Spivey. The Spiveys and
Douglas Asphalt had executed a General Indemnity Agreement in favor of Fidelity and Zurich. [2]
After a bench trial, the district court entered judgment in favor of Fidelity and Zurich for
$16,524,798. Douglas Asphalt and the Spiveys now appeal.
Douglas Asphalt and the Spiveys argue that the district court erred in entering judgment in favor
of Fidelity and Zurich because Fidelity and Zurich acted in bad faith in three ways.
First, Douglas Asphalt and the Spiveys argue that the district court erred in not finding that
Fidelity and Zurich acted in bad faith because they claimed excessive costs to remedy the
default. Specifically, Douglas Asphalt and the Spiveys argue that they introduced evidence that
the interstate project was 98% complete, and that only approximately $3.6 million was needed
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to remedy any default. But, the district court found that the interstate project was only 90%–
92% complete and that approximately $2 million needed to be spent to correct defective work
already done by Douglas Asphalt. Douglas Asphalt and the Spiveys have not shown that the
district court’s finding was clearly erroneous, and accordingly, their argument that Fidelity and
Zurich showed bad faith in claiming that the project was only 90% complete and therefore
required over $15 million to remedy the default fails.
Second, Douglas Asphalt and the Spiveys argue that Fidelity and Zurich acted in bad faith by
failing to contest the default. However, the district court concluded that the indemnity
agreement required Douglas Asphalt and the Spiveys to request a contest of the default, and to
post collateral security to pay any judgment rendered in the course of contesting the default. The
court’s finding that Douglas Asphalt and the Spiveys made no such request and posted no
collateral security was not clearly erroneous, and the sureties had no independent duty to
investigate a default. Accordingly, Fidelity and Zurich’s failure to contest the default does not
show bad faith.
Finally, Douglas Asphalt and the Spiveys argue that Fidelity and Zurich’s refusal to permit them
to remain involved with the interstate project, either as a contractor or consultant, was evidence
of bad faith. Yet, Douglas Asphalt and the Spiveys did not direct the district court or this court to
any case law that holds that the refusal to permit a defaulting contractor to continue working on
a project is bad faith. As the district court concluded, Fidelity and Zurich had a contractual right
to take possession of all the work under the contract and arrange for its completion. Fidelity and
Zurich exercised that contractual right, and, as the district court noted, the exercise of a
contractual right is not evidence of bad faith.
Finding no error, we affirm the judgment of the district court.

CASE QUESTIONS

1. Why were Douglas Asphalt and the Spiveys supposed to pay the sureties nearly $15.5
million?
2. What did the plaintiffs claim the defendant sureties did wrong as relates to how much money
they spent to cure the default?
3. What is a “contest of the default”?

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4. Why would the sureties probably not want the principal involved in the project?
[1] Latin for “by the court.” A decision of an appeals court as a whole in which no judge is identified as
the specific author.
[2] They promised to reimburse the surety for its expenses and hold it harmless for further liability.

16.6 Summary and Exercises
Summary

The law governing security interests in personal property is Article 9 of the UCC, which defines a
security interest as an interest in personal property or fixtures that secures payment or
performance of an obligation. Article 9 lumps together all the former types of security devices,
including the pledge, chattel mortgage, and conditional sale.
Five types of tangible property may serve as collateral: (1) consumer goods, (2) equipment, (3)
farm products, (4) inventory, and (5) fixtures. Five types of intangibles may serve as collateral:
(1) accounts, (2) general intangibles (e.g., patents), (3) documents of title, (4) chattel paper, and
(5) instruments. Article 9 expressly permits the debtor to give a security interest in afteracquired collateral.
To create an enforceable security interest, the lender and borrower must enter into an
agreement establishing the interest, and the lender must follow steps to ensure that the security
interest first attaches and then is perfected. There are three general requirements for
attachment: (1) there must be an authenticated agreement (or the collateral must physically be
in the lender’s possession), (2) the lender must have given value, and (3) the debtor must have
some rights in the collateral. Once the interest attaches, the lender has rights in the collateral
superior to those of unsecured creditors. But others may defeat his interest unless he perfects
the security interest. The three common ways of doing so are (1) filing a financing statement, (2)
pledging collateral, and (3) taking a purchase-money security interest (PMSI) in consumer
goods.
A financing statement is a simple notice, showing the parties’ names and addresses, the
signature of the debtor, and an adequate description of the collateral. The financing statement,

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effective for five years, must be filed in a public office; the location of the office varies among the
states.
Security interests in instruments and negotiable documents can be perfected only by the secured
party’s taking possession, with twenty-one-day grace periods applicable under certain
circumstances. Goods may also be secured through pledging, which is often done through field
warehousing. If a seller of consumer goods takes a PMSI in the goods sold, then perfection is
automatic and no filing is required, although the lender may file and probably should, to avoid
losing seniority to a bona fide purchaser of consumer goods without knowledge of the security
interest, if the goods are used for personal, family, or household purposes.
The general priority rule is “first in time, first in right.” Priority dates from the earlier of two
events: (1) filing a financing statement covering the collateral or (2) other perfection of the
security interest. Several exceptions to this rule arise when creditors take a PMSI, among them,
when a buyer in the ordinary course of business takes free of a security interest created by the
seller.
On default, a creditor may repossess the collateral. For the most part, self-help private
repossession continues to be lawful but risky. After repossession, the lender may sell the
collateral or accept it in satisfaction of the debt. Any excess in the selling price above the debt
amount must go to the debtor.
Suretyship is a legal relationship that is created when one person contracts to be responsible for
the proper fulfillment of another’s obligation, in case the latter (the principal debtor) fails to
fulfill it. The surety may avail itself of the principal’s contract defenses, but under various
circumstances, defenses may be available to the one that are not available to the other. One
general defense often raised by sureties is alteration of the contract. If the surety is required to
perform, it has rights for reimbursement against the principal, including interest and legal fees;
and if there is more than one surety, each standing for part of the obligation, one who pays a
disproportionate part may seek contribution from the others.

EXERCISES

1. Kathy Knittle borrowed $20,000 from Bank to buy inventory to sell in her knit shop and
signed a security agreement listing as collateral the entire present and future inventory in the

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shop, including proceeds from the sale of inventory. Bank filed no financing statement. A
month later, Knittle borrowed $5,000 from Creditor, who was aware of Bank’s security
interest. Knittle then declared bankruptcy. Who has priority, Bank or Creditor?
2. Assume the same facts as in Exercise 1, except Creditor—again, aware of Bank’s security
interest—filed a financing statement to perfect its interest. Who has priority, Bank or
Creditor?
3. Harold and Wilma are married. First Bank has a mortgage on their house, and it covers afteracquired property. Because Harold has a new job requiring travel to neighboring cities, they
purchase a second car for Wilma’s normal household use, financed by Second Bank. They
sign a security agreement; Second Bank files nothing. If they were to default on their house
payments, First Bank could repossess the house; could it repossess the car, too?
4.
a. Kathy Knittle borrowed $20,000 from Bank to buy inventory to sell in her knit
shop and signed a security agreement listing her collateral—present and future—
as security for the loan. Carlene Customer bought yarn and a tabletop loom from
Knittle. Shortly thereafter, Knittle declared bankruptcy. Can Bank get the loom
from Customer?
b. Assume that the facts are similar to those in Exercise 4a, except that the loom
that Knittle sold had been purchased from Larry Loomaker, who had himself given
a secured interest in it (and the other looms he manufactured) from Fine Lumber
Company (FLC) to finance the purchase of the lumber to make the looms.
Customer bought the loom from Knittle (unaware of Loomaker’s situation);
Loomaker failed to pay FLC. Why can FLC repossess the loom from Customer?
c. What recourse does Customer have now?
Creditor loaned Debtor $30,000 with the provision that the loan was callable by Creditor
with sixty days’ notice to Debtor. Debtor, having been called for repayment, asked for a
ninety-day extension, which Creditor assented to, provided that Debtor would put up a
surety to secure repayment. Surety agreed to serve as surety. When Debtor defaulted,

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Creditor turned to Surety for payment. Surety asserted that Creditor had given no
consideration for Surety’s promise, and therefore Surety was not bound. Is Surety correct?

a. Mrs. Ace said to University Bookstore: “Sell the books to my daughter. I’ll
pay for them.” When University Bookstore presented Mrs. Ace a statement
for $900, she refused to pay, denying she’d ever promised to do so, and she
raised the statute of frauds as a defense. Is this a good defense?
b. Defendant ran a stop sign and crashed into Plaintiff’s car, causing $8,000 damage.
Plaintiff’s attorney orally negotiated with Defendant’s insurance company,
Goodhands Insurance, to settle the case. Subsequently, Goodhands denied
liability and refused to pay, and it raised the statute of frauds as a defense,
asserting that any promise by it to pay for its insured’s negligence would have to
be in writing to be enforceable under the statute’s suretyship clause. Is
Goodhands’s defense valid?

a. First Bank has a security interest in equipment owned by Kathy Knittle in her Knit Shop.
If Kathy defaults on her loan and First Bank lawfully repossesses, what are the bank’s
options? Explain.
b. Suppose, instead, that First Bank had a security interest in Kathy’s home knitting
machine, worth $10,000. She paid $6,200 on the machine and then defaulted.
Now what are the bank’s options?

SELF-TEST QUESTIONS

1. Creditors may obtain security
a.

by agreement with the debtor

b. through operation of law
c. through both of the above
d. through neither of the above
Under UCC Article 9, when the debtor has pledged collateral to the creditor,
what other condition is required for attachment of the security interest?

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a.

A written security agreement must be authenticated by the debtor.

b. There must be a financing statement filed by or for the creditor.
c. The secured party received consideration.
d. The debtor must have rights in the collateral.
To perfect a security interest, one may
a.

file a financing statement

b. pledge collateral
c. take a purchase-money security interest in consumer goods
d. do any of the above
Perfection benefits the secured party by
a.

keeping the collateral out of the debtor’s reach

b. preventing another creditor from getting a secured interest in the collateral
c. obviating the need to file a financing statement
d. establishing who gets priority if the debtor defaults
Creditor filed a security interest in inventory on June 1, 2012. Creditor’s
interest takes priority over which of the following?
a.

a purchaser in the ordinary course of business who bought on June 5

b. mechanic’s lien filed on May 10
c. purchase-money security interest in after-acquired property who filed on May 15
d. judgment lien creditor who filed the judgment on June 10

SELF-TEST ANSWERS

1. c
2. d
3. d
4. d
5. d

Chapter 17
Mortgages and Nonconsensual Liens
LEARNING OBJECTIVES

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After reading this chapter, you should understand the following:
1. The basic concepts of mortgages
2. How the mortgage is created
3. Priorities with mortgages as security devices
4. Termination of the mortgage
5. Other methods of using real estate as security
6. Nonconsensual liens

17.1 Uses, History, and Creation of Mortgages
LEARNING OBJECTIVES

1. Understand the terminology used in mortgage transactions, and how mortgages are used as
security devices.
2. Know a bit about the history of mortgages.
3. Understand how the mortgage is created.
Having discussed in Chapter 16 "Secured Transactions and Suretyship" security interests in
personal property and suretyship—two of the three common types of consensual security
arrangements—we turn now to the third type of consensual security arrangement, the mortgage.
We also discuss briefly various forms of nonconsensual liens (see Figure 17.1 "Security
Arrangements").

Figure 17.1 Security Arrangements

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Definitions
A mortgage is a means of securing a debt with real estate. A long time ago, the mortgage was
considered an actual transfer of title, to become void if the debt was paid off. The modern view,
held in most states, is that the mortgage is but a lien, giving the holder, in the event of default,
the right to sell the property and repay the debt from the proceeds. The person giving the
mortgage is the mortgagor, or borrower. In the typical home purchase, that’s the buyer. The
buyer needs to borrow to finance the purchase; in exchange for the money with which to pay the
seller, the buyer “takes out a mortgage” with, say, a bank. The lender is the mortgagee, the
person or institution holding the mortgage, with the right to foreclose on the property if the debt
is not timely paid. Although the law of real estate mortgages is different from the set of rules in
Article 9 of the Uniform Commercial Code (UCC) that we examined in Chapter 16 "Secured
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Transactions and Suretyship", the circumstances are the same, except that the security is real
estate rather than personal property (secured transactions) or the promise of another
(suretyship).

The Uses of Mortgages
Most frequently, we think of a mortgage as a device to fund a real estate purchase: for a
homeowner to buy her house, or for a commercial entity to buy real estate (e.g., an office
building), or for a person to purchase farmland. But the value in real estate can be mortgaged for
almost any purpose (a home equity loan): a person can take out a mortgage on land to fund a
vacation. Indeed, during the period leading up to the recession in 2007–08, a lot of people
borrowed money on their houses to buy things: boats, new cars, furniture, and so on.
Unfortunately, it turned out that some of the real estate used as collateral was overvalued: when
the economy weakened and people lost income or their jobs, they couldn’t make the mortgage
payments. And, to make things worse, the value of the real estate sometimes sank too, so that
the debtors owed more on the property than it was worth (that’s called being underwater). They
couldn’t sell without taking a loss, and they couldn’t make the payments. Some debtors just
walked away, leaving the banks with a large number of houses, commercial buildings, and even
shopping centers on their hands.

Short History of Mortgage Law
The mortgage has ancient roots, but the form we know evolved from the English land law in the
Middle Ages. Understanding that law helps to understand modern mortgage law. In the
fourteenth century, the mortgage was a deed that actually transferred title to the mortgagee. If
desired, the mortgagee could move into the house, occupy the property, or rent it out. But
because the mortgage obligated him to apply to the mortgage debt whatever rents he collected,
he seldom ousted the mortgagor. Moreover, the mortgage set a specific date (the “law day”) on
which the debt was to be repaid. If the mortgagor did so, the mortgage became void and the
mortgagor was entitled to recover the property. If the mortgagor failed to pay the debt, the
property automatically vested in the mortgagee. No further proceedings were necessary.
This law was severe. A day’s delay in paying the debt, for any reason, forfeited the land, and the
courts strictly enforced the mortgage. The only possible relief was a petition to the king, who
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over time referred these and other kinds of petitions to the courts of equity. At first fitfully, and
then as a matter of course (by the seventeenth century), the equity courts would order the
mortgagee to return the land when the mortgagor stood ready to pay the debt plus interest. Thus
a new right developed: the equitable right of redemption, known for short as the equity of
redemption. In time, the courts held that this equity of redemption was a form of property right;
it could be sold and inherited. This was a powerful right: no matter how many years later, the
mortgagor could always recover his land by proffering a sum of money.
Understandably, mortgagees did not warm to this interpretation of the law, because their
property rights were rendered insecure. They tried to defeat the equity of redemption by having
mortgagors waive and surrender it to the mortgagees, but the courts voided waiver clauses as a
violation of public policy. Hence a mortgage, once a transfer of title, became a security for debt.
A mortgage as such can never be converted into a deed of title.
The law did not rest there. Mortgagees won a measure of relief in the development of
the foreclosure. On default, the mortgagee would seek a court order giving the mortgagor a fixed
time—perhaps six months or a year—within which to pay off the debt; under the court decree,
failure meant that the mortgagor was forever foreclosed from asserting his right of redemption.
This strict foreclosure gave the mortgagee outright title at the end of the time period.
In the United States today, most jurisdictions follow a somewhat different approach: the
mortgagee forecloses by forcing a public sale at auction. Proceeds up to the amount of the debt
are the mortgagee’s to keep; surplus is paid over to the mortgagor.Foreclosure by sale is the
usual procedure in the United States. At bottom, its theory is that a mortgage is a lien on land.
(Foreclosure issues are further discussed in Section 17.2 "Priority, Termination of the Mortgage,
and Other Methods of Using Real Estate as Security".)
Under statutes enacted in many states, the mortgagor has one last chance to recover his
property, even after foreclosure. This statutory right of redemption extends the period to repay,
often by one year.

Creation of the Mortgage
Statutory Regulation

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The decision whether to lend money and take a mortgage is affected by several federal and state
regulations.

Consumer Credit Statutes Apply
Statutes dealing with consumer credit transactions have a bearing on the mortgage, including
state usury statutes, and the federal Truth in Lending Act and Equal Credit Opportunity Act.

Real Estate Settlement Procedures Act
Other federal statutes are directed more specifically at mortgage lending. One, enacted in 1974,
is the Real Estate Settlement Procedures Act (RESPA), aimed at abuses in the settlement
process—the process of obtaining the mortgage and purchasing a residence. The act covers all
federally related first mortgage loans secured by residential properties for one to four families. It
requires the lender to disclose information about settlement costs in advance of the closing day:
it prohibits the lender from “springing” unexpected or hidden costs onto the borrower. The
RESPA is a US Department of Housing and Urban Development (HUD) consumer protection
statute designed to help home buyers be better shoppers in the home-buying process, and it is
enforced by HUD. It also outlaws what had been a common practice of giving and accepting
kickbacks and referral fees. The act prohibits lenders from requiring mortgagors to use a
particular company to obtain insurance, and it limits add-on fees the lender can demand to
cover future insurance and tax charges.
Redlining. Several statutes are directed to the practice of redlining—the refusal of lenders to
make loans on property in low-income neighborhoods or impose stricter mortgage terms when
they do make loans there. (The term derives from the supposition that lenders draw red lines on
maps around ostensibly marginal neighborhoods.) The most important of these is the
Community Reinvestment Act (CRA) of 1977. [1] The act requires the appropriate federal
financial supervisory agencies to encourage regulated financial institutions to meet the credit
needs of the local communities in which they are chartered, consistent with safe and sound
operation. To enforce the statute, federal regulatory agencies examine banking institutions for
CRA compliance and take this information into consideration when approving applications for
new bank branches or for mergers or acquisitions. The information is compiled under the
authority of the Home Mortgage Disclosure Act of 1975, which requires financial institutions
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within its purview to report annually by transmitting information from their loan application
registers to a federal agency.

The Note and the Mortgage Documents
The note and the mortgage documents are the contracts that set up the deal: the mortgagor gets
credit, and the mortgagee gets the right to repossess the property in case of default.

The Note
If the lender decides to grant a mortgage, the mortgagor signs two critical documents at the
closing: the note and the mortgage. It is enough here to recall that in a note (really a type of
IOU), the mortgagor promises to pay a specified principal sum, plus interest, by a certain date or
dates. The note is the underlying obligation for which the mortgage serves as security. Without
the note, the mortgagee would have an empty document, since the mortgage would secure
nothing. Without a mortgage, a note is still quite valid, evidencing the debtor’s personal
obligation.
One particular provision that usually appears in both mortgages and the underlying notes is
the acceleration clause. This provides that if a debtor should default on any particular payment,
the entire principal and interest will become due immediately at the lender’s option. Why an
acceleration clause? Without it, the lender would be powerless to foreclose the entire mortgage
when the mortgagor defaulted but would have to wait until the expiration of the note’s term.
Although the acceleration clause is routine, it will not be enforced unless the mortgagee acts in
an equitable and fair manner. The problem arises where the mortgagor’s default was the result
of some unconscionable conduct of the mortgagee, such as representing to the mortgagee that
she might take a sixty-day “holiday” from having to make payments. In Paul H. Cherry v. Chase
Manhattan Mortgage Group (Section 17.4 "Cases"), the equitable powers of the court were
invoked to prevent acceleration.

The Mortgage
Under the statute of frauds, the mortgage itself must be evidenced by some writing to be
enforceable. The mortgagor will usually make certain promises and warranties to the mortgagee
and state the amount and terms of the debt and the mortgagor’s duties concerning taxes,

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insurance, and repairs. A sample mortgage form is presented inFigure 17.2 "Sample Mortgage
Form".

Figure 17.2 Sample Mortgage Form

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KEY TAKEAWAY
As a mechanism of security, a mortgage is a promise by the debtor (mortgagor) to repay the
creditor (mortgagee) for the amount borrowed or credit extended, with real estate put up as
security. If the mortgagor doesn’t pay as promised, the mortgagee may repossess the real
estate. Mortgage law has ancient roots and brings with it various permutations on the theme
that even if the mortgagor defaults, she may nevertheless have the right to get the property

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back or at least be reimbursed for any value above that necessary to pay the debt and the
expenses of foreclosure. Mortgage law is regulated by state and federal statute.

EXERCISES

1. What role did the right of redemption play in courts of equity changing the substance of a
mortgage from an actual transfer of title to the mortgagee to a mere lien on the property?
2. What abuses did the federal RESPA address?
3. What are the two documents most commonly associated with mortgage transactions?
[1] 12 United States Code, Section 2901.

17.2 Priority, Termination of the Mortgage, and Other
Methods of Using Real Estate as Security
LEARNING OBJECTIVES

1. Understand why it is important that the mortgagee (creditor) record her interest in the
debtor’s real estate.
2. Know the basic rule of priority—who gets an interest in the property first in case of default—
and the exceptions to the rule.
3. Recognize the three ways mortgages can be terminated: payment, assumption, and
foreclosure.
4. Be familiar with other methods (besides mortgages) by which real property can be used as
security for a creditor.

Priorities in Real Property Security
You may recall from Chapter 16 "Secured Transactions and Suretyship" how important it is for a
creditor to perfect its secured interest in the goods put up as collateral. Absent perfection, the
creditor stands a chance of losing out to another creditor who took its interest in the goods
subsequent to the first creditor. The same problem is presented in real property security: the
mortgagee wants to make sure it has first claim on the property in case the mortgagor (debtor)
defaults.

The General Rule of Priorities

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The general rule of priority is the same for real property security as for personal property
security: the first in time to give notice of the secured interest is first in right. For real property,
the notice is by recording the mortgage. Recording is the act of giving public notice of changes in
interests in real estate. Recording was created by statute; it did not exist at common law. The
typical recording statute calls for a transfer of title or mortgage to be placed in a particular
county office, usually the auditor, recorder, or register of deeds.
A mortgage is valid between the parties whether or not it is recorded, but a mortgagee might
lose to a third party—another mortgagee or a good-faith purchaser of the property—unless the
mortgage is recorded.

Exceptions to the General Rule
There are exceptions to the general rule; two are taken up here.

Fixture Filing
The fixture-filing provision in Article 9 of the UCC is one exception to the general rule. As noted
in Chapter 16 "Secured Transactions and Suretyship", the UCC gives priority to purchase-money
security interests in fixtures if certain requirements are met.

Future Advances
A bank might make advances to the debtor after accepting the mortgage. If the future advances
are obligatory, then the first-in-time rule applies. For example: Bank accepts Debtor’s mortgage
(and records it) and extends a line of credit on which Debtor draws, up to a certain limit. (Or, as
in the construction industry, Bank might make periodic advances to the contractors as work
progresses, backed by the mortgage.) Second Creditor loans Debtor money—secured by the
same property—before Debtor began to draw against the first line of credit. Bank has priority: by
searching the mortgage records, Second Creditor should have been on notice that the first
mortgage was intended as security for the entire line of credit, although the line was doled out
over time.
However, if the future advances are not obligatory, then priority is determined by notice. For
example, a bank might take a mortgage as security for an original loan and for any future loans
that the bank chooses to make. A later creditor can achieve priority by notifying the bank with
the first mortgage that it is making an advance. Suppose Jimmy mortgages his property to a
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wealthy dowager, Mrs. Calabash, in return for an immediate loan of $20,000 and they agree
that the mortgage will serve as security for future loans to be arranged. The mortgage is
recorded. A month later, before Mrs. Calabash loans him any more money, Jimmy gives a
second mortgage to Louella in return for a loan of $10,000. Louella notifies Mrs. Calabash that
she is loaning Jimmy the money. A month later, Mrs. Calabash loans Jimmy another $20,000.
Jimmy then defaults, and the property turns out to be worth only $40,000. Whose claims will
be honored and in what order? Mrs. Calabash will collect her original $20,000, because it was
recited in the mortgage and the mortgage was recorded. Louella will collect her $10,000 next,
because she notified the first mortgage holder of the advance. That leaves Mrs. Calabash in third
position to collect what she can of her second advance. Mrs. Calabash could have protected
herself by refusing the second loan.

Termination of the Mortgage
The mortgagor’s liability can terminate in three ways: payment, assumption (with a novation),
or foreclosure.

Payment
Unless they live in the home for twenty-five or thirty years, the mortgagors usually pay off the
mortgage when the property is sold. Occasionally, mortgages are paid off in order to refinance. If
the mortgage was taken out at a time of high interest rates and rates later drop, the homeowner
might want to obtain a new mortgage at the lower rates. In many mortgages, however, this
entails extra closing costs and penalties for prepaying the original mortgage. Whatever the
reason, when a mortgage is paid off, the discharge should be recorded. This is accomplished by
giving the mortgagor a copy of, and filing a copy of, a Satisfaction of Mortgage document. In
the Paul H. Cherry v. Chase Manhattan Mortgage Group case (Section 17.4 "Cases"), the
bank mistakenlyfiled the Satisfaction of Mortgage document, later discovered its mistake,
retracted the satisfaction, accelerated the loan because the mortgagor stopped making payments
(the bank, seeing no record of an outstanding mortgage, refused to accept payments), and then
tried to foreclose on the mortgage, meanwhile having lost the note and mortgage besides.

Assumption

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The property can be sold without paying off the mortgage if the mortgage is assumed by the new
buyer, who agrees to pay the seller’s (the original mortgagor’s) debt. This is a novation if, in
approving the assumption, the bank releases the old mortgagor and substitutes the buyer as the
new debtor.
The buyer need not assume the mortgage. If the buyer purchases the property without agreeing
to be personally liable, this is a sale “subject to” the mortgage (see Figure 17.3 "“Subject to” Sales
versus Assumption"). In the event of the seller’s subsequent default, the bank can foreclose the
mortgage and sell the property that the buyer has purchased, but the buyer is not liable for any
deficiency.

Figure 17.3 “Subject to” Sales versus Assumption

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What if mortgage rates are high? Can buyers assume an existing low-rate mortgage from the
seller rather than be forced to obtain a new mortgage at substantially higher rates? Banks, of
course, would prefer not to allow that when interest rates are rising, so they often include in the
mortgage a due-on-sale clause, by which the entire principal and interest become due when the
property is sold, thus forcing the purchaser to get financing at the higher rates. The clause is a
device for preventing subsequent purchasers from assuming loans with lower-than-market
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interest rates. Although many state courts at one time refused to enforce the due-on-sale clause,
Congress reversed this trend when it enacted the Garn–St. Germain Depository Institutions Act
in 1982. [1] The act preempts state laws and upholds the validity of due-on-sale clauses. When
interest rates are low, banks have no interest in enforcing such clauses, and there are ways to
work around the due-on-sale clause.

Foreclosure
The third method of terminating the mortgage is by foreclosure when a mortgagor defaults.
Even after default, the mortgagor has the right to exercise his equity of redemption—that is, to
redeem the property by paying the principal and interest in full. If he does not, the mortgagee
may foreclose the equity of redemption. Although strict foreclosure is used occasionally, in most
cases the mortgagee forecloses by one of two types of sale (see Figure 17.4 "Foreclosure").
The first type is judicial sale. The mortgagee seeks a court order authorizing the sale to be
conducted by a public official, usually the sheriff. The mortgagor is entitled to be notified of the
proceeding and to a hearing. The second type of sale is that conducted under a clause called
a power of sale, which many lenders insist be contained in the mortgage. This clause permits the
mortgagee to sell the property at public auction without first going to court—although by custom
or law, the sale must be advertised, and typically a sheriff or other public official conducts the
public sale or auction.
Figure 17.4 Foreclosure

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Once the property has been sold, it is deeded to the new purchaser. In about half the states, the
mortgagor still has the right to redeem the property by paying up within six months or a year—
the statutory redemption period. Thereafter, the mortgagor has no further right to redeem. If
the sale proceeds exceed the debt, the mortgagor is entitled to the excess unless he has given
second and third mortgages, in which case the junior mortgagees are entitled to recover their
claims before the mortgagor. If the proceeds are less than the debt, the mortgagee is entitled to
recover the deficiency from the mortgagor. However, some states have statutorily abolished
deficiency judgments.

Other Methods of Using Real Estate as Security
Besides the mortgage, there are other ways to use real estate as security. Here we take up two:
the deed of trust and the installment or land contract.

Deed of Trust
The deed of trust is a device for securing a debt with real property; unlike the mortgage, it
requires three parties: the borrower, the trustee, and the lender. Otherwise, it is at base identical
to a mortgage. The borrower conveys the land to a third party, the trustee, to hold in trust for the
lender until the borrower pays the debt. (The trustee’s interest is really a kind of legal fiction:
that person is expected to have no interest in the property.) The primary benefit to the deed of
trust is that it simplifies the foreclosure process by containing a provision empowering the
trustee to sell the property on default, thus doing away with the need for any court filings. The
disinterested third party making sure things are done properly becomes the trustee, not a judge.
In thirty states and the District of Columbia—more than half of US jurisdictions—the deed of
trust is usually used in lieu of mortgages. [2]
But the deed of trust may have certain disadvantages as well. For example, when the debt has
been fully paid, the trustee will not release the deed of trust until she sees that all notes secured
by it have been marked canceled. Should the borrower have misplaced the canceled notes or
failed to keep good records, he will need to procure a surety bond to protect the trustee in case of
a mistake. This can be an expensive procedure. In many jurisdictions, the mortgage holder is
prohibited from seeking a deficiency judgment if the holder chooses to sell the property through
nonjudicial means.
Alpha Imperial Building, LLC v. Schnitzer Family Investment, LLC, Section 17.4 "Cases",
discusses several issues involving deeds of trust.

Installment or Land Contract

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Under the installment contract or land contract, the purchaser takes possession and agrees to
pay the seller over a period of years. Until the final payment, title belongs to the seller. The
contract will specify the type of deed to be conveyed at closing, the terms of payment, the buyer’s
duty to pay taxes and insure the premises, and the seller’s right to accelerate on default. The
buyer’s particular concern in this type of sale is whether the seller in fact has title. The buyers
can protect themselves by requiring proof of title and title insurance when the contract is signed.
Moreover, the buyer should record the installment contract to protect against the seller’s
attempt to convey title to an innocent third-party purchaser while the contract is in effect.
The benefit to the land contract is that the borrower need not bank-qualify, so the pool of
available buyers is larger, and buyers who have inadequate resources at the time of contracting
but who have the expectation of a rising income in the future are good candidates for the land
contract. Also, the seller gets all the interest paid by the buyer, instead of the bank getting it in
the usual mortgage. The obvious disadvantage from the seller’s point is that she will not get a big
lump sum immediately: the payments trickle in over years (unless she can sell the contract to a
third party, but that would be at a discount).

KEY TAKEAWAY

The general rule on priority in real property security is that the first creditor to record its
interest prevails over subsequent creditors. There are some exceptions; the most familiar is
that the seller of a fixture on a purchase-money security interest has priority over a
previously recorded mortgagee. The mortgage will terminate by payment, assumption by a
new buyer (with a novation releasing the old buyer), and foreclosure. In a judicial-sale
foreclosure, a court authorizes the property’s sale; in a power-of-sale foreclosure, no court
approval is required. In most states, the mortgagor whose property was foreclosed is given
some period of time—six months or a year—to redeem the property; otherwise, the sale is
done, but the debtor may be liable for the deficiency, if any. The deed of trust avoids any
judicial involvement by having the borrower convey the land to a disinterested trustee for
the benefit of the lender; the trustee sells it upon default, with the proceeds (after expenses)
going to the lender. Another method of real property security is a land contract: title shifts to
the buyer only at the end of the term of payments.

EXERCISES

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1. A debtor borrowed $350,000 to finance the purchase of a house, and the bank recorded its
interest on July 1. On July 15, the debtor bought $10,000 worth of replacement windows
from Window Co.; Window Co. recorded its purchase-money security interest that day, and
the windows were installed. Four years later, the debtor, in hard financial times, declared
bankruptcy. As between the bank and Windows Co., who will get paid first?
2. Under what interest rate circumstances would banks insist on a due-on-sale clause? Under
what interest rate circumstance would banks not object to a new person assuming the
mortgage?
3. What is the primary advantage of the deed of trust? What is the primary advantage of the
land contract?
4. A debtor defaulted on her house payments. Under what circumstances might a
court not allow the bank’s foreclosure on the property?
[1] 12 United States Code, Section 1701-j.
[2] The states using the deed of trust system are as follows: Alabama, Alaska, Arkansas, Arizona,
California, Colorado, District of Columbia, Georgia, Hawaii, Idaho, Iowa, Michigan, Minnesota,
Mississippi, Missouri, Montana, Nevada, New Hampshire, North Carolina, Oklahoma, Oregon, Rhode
Island, South Dakota, Tennessee, Texas, Utah, Virginia, Washington, West Virginia, Wisconsin, and
Wyoming.

17.3 Nonconsensual Lien

LEARNING OBJECTIVES

1. Understand the nonconsensual liens issued by courts—attachment liens and judgment
liens—and how they are created.
2. Recognize other types of nonconsensual liens: mechanic’s lien, possessory lien, and tax lien.
The security arrangements discussed so far—security interests, suretyship, mortgages—are all
obtained by the creditor with the debtor’s consent. A creditor may obtain certain liens without
the debtor’s consent.

Court-Decreed Liens
Some nonconsensual liens are issued by courts.
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Attachment Lien
An attachment lien is ordered against a person’s property—real or personal—to prevent him
from disposing of it during a lawsuit. To obtain an attachment lien, the plaintiff must show that
the defendant likely will dispose of or hide his property; if the court agrees with the plaintiff, she
must post a bond and the court will issue a writ of attachment to the sheriff, directing the sheriff
to seize the property. Attachments of real property should be recorded. Should the plaintiff win
her suit, the court issues a writ of execution, directing the sheriff to sell the property to satisfy
the judgment.

Judgment Lien
A judgment lien may be issued when a plaintiff wins a judgment in court if an attachment lien
has not already been issued. Like the attachment lien, it provides a method by which the
defendant’s property may be seized and sold.

Mechanic’s Lien
Overview
The most common nonconsensual lien on real estate is the mechanic’s lien. A mechanic’s lien
can be obtained by one who furnishes labor, services, or materials to improve real estate: this is
statutory, and the statute must be carefully followed. The “mechanic” here is one who works
with his or her hands, not specifically one who works on machines. An automobile mechanic
could not obtain a mechanic’s lien on a customer’s house to secure payment of work he did on
her car. (The lien to which the automobile mechanic is entitled is a “possessory lien” or
“artisan’s lien,” considered inSection 17.3.3 "Possessory Lien") To qualify for a mechanic’s lien,
the claimant must file a sworn statement describing the work done, the contract made, or the
materials furnished that permanently improved the real estate.
A particularly difficult problem crops up when the owner has paid the contractor, who in turn
fails to pay his subcontractors. In many states, the subcontractors can file a lien on the owner’s
property, thus forcing the owner to pay them (see Figure 17.5 "Subcontractors’ Lien")—and
maybe twice. To protect themselves, owners can demand a sworn statement from general
contractors listing the subcontractors used on the job, and from them, owners can obtain a
waiver of lien rights before paying the general contractor.
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Figure 17.5Subcontractors’ Lien

Procedure for Obtaining a Mechanic’s Lien
Anyone claiming a lien against real estate must record a lien statement stating the amount due
and the nature of the improvement. The lienor has a specified period of time (e.g., ninety days)
to file from the time the work is finished. Recording as such does not give the lienor an
automatic right to the property if the debt remains unpaid. All states specify a limited period of
time, usually one year, within which the claimant must file suit to enforce the lien. Only if the
court decides the lien is valid may the property be sold to satisfy the debt. Difficult questions
sometimes arise when a lien is filed against a landlord’s property as a result of improvements
and services provided to a tenant, as discussed in F & D Elec. Contractors, Inc. v. Powder
Coaters, Inc.,Section 17.4 "Cases".

Mechanic’s Liens Priorities

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A mechanic’s lien represents a special risk to the purchaser of real estate or to lenders who wish
to take a mortgage. In most states, the mechanic’s lien is given priority not from the date when
the lien is recorded but from an earlier date—either the date the contractor was hired or the date
construction began. Thus a purchaser or lender might lose priority to a creditor with a
mechanic’s lien who filed after the sale or mortgage. A practical solution to this problem is to
hold back part of the funds (purchase price or loan) or place them in escrow until the period for
recording liens has expired.

Possessory Lien
The most common nonconsensual lien on personal property (not real estate) is
thepossessory lien. This is the right to continue to keep the goods on which work has been
performed or for which materials have been supplied until the owner pays for the labor or
materials. The possessory lien arises both under common law and under a variety of statutes.
Because it is nonconsensual, the possessory lien is not covered by Article 9 of the UCC, which is
restricted to consensual security interests. Nor is it governed by the law of mechanic’s liens,
which are nonpossessory and relate only to work done to improve real property.
The common-law rule is that anyone who, under an express or implied contract, adds value to
another’s chattel (personal property) by labor, skill, or materials has a possessory lien for the
value of the services. Moreover, the lienholder may keep the chattel until her services are paid.
For example, the dry cleaner shop is not going to release the wool jacket that you took in for
cleaning unless you make satisfactory arrangements to pay for it, and the chain saw store won’t
let you take the chain saw that you brought in for a tune-up until you pay for the labor and
materials for the tune-up.

Tax Lien
An important statutory lien is the federal tax lien. Once the government assesses a tax, the
amount due constitutes a lien on the owner’s property, whether real or personal. Until it is filed
in the appropriate state office, others take priority, including purchasers, mechanics’ lienors,
judgment lien creditors, and holders of security interests. But once filed, the tax lien takes
priority over all subsequently arising liens. Federal law exempts some property from the tax
lien; for example, unemployment benefits, books and tools of a trade, workers’ compensation,
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judgments for support of minor children, minimum amounts of wages and salary, personal
effects, furniture, fuel, and provisions are exempt.
Local governments also can assess liens against real estate for failure to pay real estate taxes.
After some period of time, the real estate may be sold to satisfy the tax amounts owing.

KEY TAKEAWAY

There are four types of nonconsensual liens: (1) court-decreed liens are attachment liens,
which prevent a person from disposing of assets pending a lawsuit, and judgment liens,
which allow the prevailing party in a lawsuit to take property belonging to the debtor to
satisfy the judgment; (2) mechanics’ liens are authorized by statute, giving a person who has
provided labor or material to a landowner the right to sell the property to get paid; (3)
possessory liens on personal property allow one in possession of goods to keep them to
satisfy a claim for work done or storage of them; and (4) tax liens are enforced by the
government to satisfy outstanding tax liabilities and may be assessed against real or personal
property.

EXERCISES

1. The mortgagor’s interests are protected in a judicial foreclosure by a court’s oversight of the
process; how is the mortgagor’s interest protected when a deed of trust is used?
2. Why is the deed of trust becoming increasingly popular?
3. What is the rationale for the common-law possessory lien?
4. Mike Mechanic repaired Alice Ace’s automobile in his shop, but Alice didn’t have enough
money to pay for the repairs. May Mike have a mechanic’s lien on the car? A possessory lien?
5. Why does federal law exempt unemployment benefits, books and tools of a trade, workers’
compensation, minimum amounts of wages and salary, personal effects, furniture, fuel, and
other such items from the sweep of a tax lien?

17.4 Cases
Denial of Mortgagee’s Right to Foreclose; Erroneous Filings; Lost Instruments
Paul H. Cherry v. Chase Manhattan Mortgage Group
190 F.Supp.2d 1330 (Fed. Dist. Ct. FL 2002)
Background
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[Paul Cherry filed a complaint suing Chase for Fair Debt Collection Practices Act violations and
slander of credit.]…Chase counter-claimed for foreclosure and reestablishment of the lost
note.…
…Chase held a mortgage on Cherry’s home to which Cherry made timely payments until August
2000. Cherry stopped making payments on the mortgage after he received a letter from Chase
acknowledging his satisfaction of the mortgage. Cherry notified Chase of the error through a
customer service representative. Cherry, however, received a check dated August 15, 2000, as an
escrow refund on the mortgage. Chase subsequently recorded a Satisfaction of Mortgage into the
Pinellas County public records on October 19, 2000. On November 14, 2000, Chase sent Cherry
a “Loan Reactivation” letter with a new loan number upon which to make the payments. During
this time, Cherry was placing his mortgage payments into a bank account, which subsequently
were put into an escrow account maintained by his attorney. These payments were not, and have
not, been tendered to Chase. As a result of the failure to tender, Chase sent Cherry an
acceleration warning on November 17, 2000, and again on March 16, 2001. Chase notified the
credit bureaus as to Cherry’s default status and moved for foreclosure. In a letter addressed to
Cherry’s attorney, dated April 24, 2001, Chase’s attorney advised Cherry to make the mortgage
payments to Chase. Chase recorded a “vacatur, revocation, and cancellation of satisfaction of
mortgage” (vacatur) [vacatur: an announcement filed in court that something is cancelled or set
aside; an annulment] in the Pinellas County public records on May 3, 2001. Chase signed the
vacatur on March 21, 2001, and had it notarized on March 27, 2001. Chase has also been unable
to locate the original note, dated October 15, 1997, and deems it to be lost.…
Foreclosure
Chase accelerated Cherry’s mortgage debt after determining he was in a default status under the
mortgage provisions. Chase claims that the right to foreclose under the note and mortgage is
“absolute,” [Citation], and that this Court should enforce the security interest in the mortgage
though Chase made an administrative error in entering a Satisfaction of Mortgage into the
public records.…
Mortgage

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…Chase relies on the Florida Supreme Court decision in United Service Corp. v. Vi-An Const.
Corp., [Citation] (Fla.1955), which held that a Satisfaction of Mortgage “made through a mistake
may be canceled” and a mortgage reestablished as long as no other innocent third parties have
“acquired an interest in the property.” Generally the court looks to the rights of any innocent
third parties, and if none exist, equity will grant relief to a mortgagee who has mistakenly
satisfied a mortgage before fully paid. [Citation]. Both parties agree that the mortgage was
released before the debt was fully paid. Neither party has presented any facts to this Court that
implies the possibility nor existence of a third party interest. Although Cherry argues
under Biggs v. Smith, 184 So. 106, 107 (1938), that a recorded satisfaction of mortgage is “prima
facie evidence of extinguishment of a mortgage lien,” Biggs does not apply this standard to
mortgage rights affected by a mistake in the satisfaction.
Therefore, on these facts, this Court acknowledges that a vacatur is a proper remedy for Chase to
correct its unilateral mistake since “equity will grant relief to those who have through mistake
released a mortgage.” [Citation.] Accordingly, this Court holds that an equity action is required
to make a vacatur enforceable unless the parties consent to the vacatur or a similar remedy
during the mortgage negotiation.…
Tender
Cherry has not made a mortgage payment to Chase since August 2000, but claims to have made
these payments into an escrow account, which he claims were paid to the escrow account
because Chase recorded a satisfaction of his mortgage and, therefore, no mortgage existed.
Cherry also claims that representatives of Chase rejected his initial attempts to make payments
because of a lack of a valid loan number. Chase, however, correctly argues that payments made
to an escrow account are not a proper tender of payment. Matthews v. Lindsay, [Citation]
(1884) (requiring tender to be made to the court). Nor did Cherry make the required mortgage
payments to the court as provided by [relevant court rules], allowing for a “deposit with the
court all or any part of such sum or thing, whether that party claims all or any part of the sum or
thing.” Further, Chase also correctly argues that Cherry’s failure to tender the payments from
the escrow account or make deposits with the court is more than just a “technical breach” of the
mortgage and note. [Citation.]
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Chase may, therefore, recover the entire amount of the mortgage indebtedness, unless the court
finds a “limited circumstance” upon which the request may be denied. [Citation.] Although not
presented by Chase in its discussion of this case, the Court may refuse foreclosure,
notwithstanding that the defendant established a foreclosure action, if the acceleration was
unconscionable and the “result would be inequitable and unjust.” This Court will analyze the
inequitable result test and the limited circumstances by which the court may deny foreclosure.
First, this Court does not find the mortgage acceleration unconscionable by assuming arguendo
[for the purposes of argument] that the mortgage was valid during the period that the
Satisfaction of Mortgage was entered into the public records. Chase did not send the first
acceleration warning until November 14, 2000, the fourth month of non-payment, followed by
the second acceleration letter on March 16, 2001, the eighth month of non-payment. Although
Cherry could have argued that a foreclosure action was an “inequitable” and “unjust” result after
the Satisfaction of Mortgage was entered on his behalf, the result does not rise to an
unconscionable level since Cherry could have properly tendered the mortgage payments to the
court.
Second, the following “limited circumstances” will justify a court’s denial of foreclosure: 1)
waiver of right to accelerate; 2) mortgagee estopped from asserting foreclosure because
mortgagor reasonably assumed the mortgagee would not foreclose; 3) mortgagee failed to
perform a condition precedent for acceleration; 4) payment made after default but prior to
receiving intent to foreclose; or, 5) where there was intent to make to make timely payment, and
it was attempted, or steps taken to accomplish it, but nevertheless the payment was not made
due to a misunderstanding or excusable neglect, coupled with some conduct of the mortgagee
which in a measure contributed to the failure to pay when due or within the grace period.
[Citations.]
Chase fails to address this fifth circumstance in its motion, an apparent obfuscation of the case
law before the court. This Court acknowledges that Cherry’s facts do not satisfy the first four
limited circumstances. Chase at no time advised Cherry that the acceleration right was being
waived; nor is Chase estopped from asserting foreclosure on the mortgage because of the
administrative error, and Cherry has not relied on this error to his detriment; and since Chase
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sent the acceleration letter to Cherry and a request for payment to his attorney, there can be no
argument that Cherry believed Chase would not foreclose. Chase has performed all conditions
precedent required by the mortgage provisions prior to notice of the acceleration; sending
acceleration warnings on November 17, 2000, and March 16, 2001. Cherry also has no argument
for lack of notice of intent to accelerate after default since he has not tendered a payment since
July 2000, thus placing him in default of the mortgage provisions, and he admits receiving the
acceleration notices.
This Court finds, however, that this claim fails squarely into the final limited circumstance
regarding intent to make timely payments. Significant factual issues exist as to the intent of
Cherry to make or attempt to make timely mortgage payments to Chase. Cherry claims that he
attempted to make the payments, but was told by a representative of Chase that there was no
mortgage loan number upon which to apply the payments. As a result, the mortgage payments
were placed into an account and later into his counsel’s trust account as a mortgage escrow.
Although these payments should have, at a minimum, been placed with the court to ensure
tender during the resolution of the mortgage dispute, Cherry did take steps to accomplish timely
mortgage payments. Although Cherry, through excusable neglect or a misunderstanding as to
what his rights were after the Satisfaction of Mortgage was entered, failed to tender the
payments, Chase is also not without fault; its conduct in entering a Satisfaction of Mortgage into
the Pinellas County public records directly contributed to Cherry’s failure to tender timely
payments. Cherry’s attempt at making the mortgage payments, coupled with Chase’s improper
satisfaction of mortgage fits squarely within the limited circumstance created to justify a court’s
denial of a foreclosure. Equity here requires a balancing between Chase’s right to the security
interest encumbered by the mortgage and Cherry’s attempts to make timely payments. As such,
these limited circumstances exist to ensure that a foreclosure remains an action in equity. In
applying this analysis, this Court finds that equity requires that Chase’s request for foreclosure
be denied at this juncture.…
Reestablishment of the Lost Note and Mortgage
Chase also requests, as part of the foreclosure counterclaim, the reestablishment of the note
initially associated with the mortgage, as it is unable to produce the original note and provide by
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affidavit evidence of its loss. Chase has complied with the [necessary statutory]
requirements[.]…This Court holds the note to be reestablished and that Chase has the lawful
right to enforce the note upon the issuance of this order.
This Court also agrees that Chase may reestablish the mortgage through a vacatur, revocation,
and cancellation of satisfaction of mortgage. [Citation] (allowing the Equity Court to reestablish
a mortgage that was improperly canceled due to a mistake). However, this Court will deem the
vacatur effective as of the date of this order. This Court leaves the status of the vacatur during
the disputed period, and specifically since May 3, 2001, to be resolved in subsequent
proceedings.…Accordingly, it is:
ORDERED that [Chase cannot foreclose and] the request to reestablish the note and mortgage is
hereby granted and effective as of the date of this order. Cherry will tender all previously
escrowed mortgage payments to the Court, unless the parties agree otherwise, within ten days of
this order and shall henceforth, tender future monthly payments to Chase as set out in the
reestablished note and mortgage.

CASE QUESTIONS

1. When Chase figured out that it had issued a Satisfaction of Mortgage erroneously, what did it
file to rectify the error?
2. Cherry had not made any mortgage payments between the time Chase sent the erroneous
Satisfaction of Mortgage notice to him and the time of the court’s decision in this case. The
court listed five circumstances in which a mortgagee (Chase here) might be denied the right
to foreclose on a delinquent account: which one applied here? The court said Chase had
engaged in “an apparent obfuscation of the case law before the court”? What obfuscation
did it engage in?
3. What did Cherry do with the mortgage payments after Chase erroneously told him the
mortgage was satisfied? What did the court say he should have done with the payments?

Mechanic’s Lien Filed against Landlord for Payment of Tenant’s Improvements
F & D Elec. Contractors, Inc. v. Powder Coaters, Inc.
567 S.E.2d 842 (S.C. 2002)
Factual/ Procedural Background

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BG Holding f/k/a Colite Industries, Inc. (“BG Holding”) is a one-third owner of about thirty
acres of real estate in West Columbia, South Carolina. A warehouse facility is located on the
property. In September 1996, Powder Coaters, Inc. (“Powder Coaters”) agreed to lease a portion
of the warehouse to operate its business. Powder Coaters was engaged in the business of
electrostatically painting machinery parts and equipment and then placing them in an oven to
cure. A signed lease was executed between Powder Coaters and BG Holding. Prior to signing the
lease, Powder Coaters negotiated the terms with Mark Taylor, (“Taylor”) who was the property
manager for the warehouse facility and an agent of BG Holding.
The warehouse facility did not have a sufficient power supply to support Powder Coaters’
machinery. Therefore, Powder Coaters contracted with F & D Electrical (“F & D”) to perform
electrical work which included installing two eight foot strip light fixtures and a two hundred
amp load center. Powder Coaters never paid F & D for the services. Powder Coaters was also
unable to pay rent to BG Holding and was evicted in February 1997. Powder Coaters is no longer
a viable company.
In January 1997, F & D filed a Notice and Certificate of Mechanic’s Lien and Affidavit of
Mechanic’s Lien. In February 1997, F & D filed this action against BG Holding foreclosing on its
mechanic’s lien pursuant to S.C. [statute].…
A jury trial was held on September 2nd and 3rd, 1998. At the close of F & D’s evidence, and at
the close of all evidence, BG Holding made motions for directed verdicts, which were denied.
The jury returned a verdict for F & D in the amount of $8,264.00. The court also awarded F & D
attorneys’ fees and cost in the amount of $8,264.00, for a total award of $16,528.00.
BG Holding appealed. The Court of Appeals, in a two to one decision, reversed the trial court,
holding a directed verdict should have been granted to BG Holding on the grounds BG Holding
did not consent to the electrical upgrade, as is required by the Mechanic’s Lien Statute. This
Court granted F & D’s petition for certiorari, and the issue before this Court is:
Did the trial court err in denying BG Holding’s motion for directed verdict because the record
was devoid of any evidence of owner’s consent to materialman’s performance of work on its
property as required by [the S.C. statute]?

Law/Analysis
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F & D argues the majority of the Court of Appeals erred in holding the facts of the case failed to
establish that BG Holding consented to the work performed by F & D, as is required by the
[South Carolina] Mechanic’s Lien Statute. We agree.…
South Carolina’s Mechanic’s Lien Statute provides:
A person to whom a debt is due for labor performed or furnished or for materials furnished and
actually used in the erection, alteration, or repair of a building…by virtue of an agreement with,
or by consent of, the owner of the building or structure, or a person having authority from, or
rightfully acting for, the owner in procuring or furnishing the labor or materials shall have a
lien upon the building or structure and upon the interest of the owner of the building or
structure …to secure the payment of the debt due. [emphasis added.]
Both parties in this case concede there was no express “agreement” between F & D and BG
Holding. Therefore, the issue in this appeal turns on the meaning of the word “consent” in the
statute, as applied in the landlord-tenant context. This is a novel issue in South Carolina.
This Court must decide who must give the consent, who must receive consent, and what type of
consent (general, specific, oral, written) must be given in order to satisfy the statute. Finally, the
Court must decide whether the evidence in this case shows BG Holding gave the requisite
consent.

A. Who Must Receive the Consent.
The Court of Appeals’ opinion in this case contemplates the consent must be between the
materialman (lien claimant) and the landlord (owner). “It is only logical…that consent under
[the relevant section] must…be between the owner and the entity seeking the lien…” [Citation
from Court of Appeals]. As stated previously, applying the Mechanic’s Lien Statute in the
landlord-tenant context presents a novel issue. We find the consent required by the statute does
not have to be between the landlord/owner and the materialman, as the Court of Appeals’
opinion indicates. A determination that the required consent must come from the owner to the
materialman means the materialman can only succeed if he can prove an agreement with the
owner. Such an interpretation would render meaningless the language of the statute that
provides: “…by virtue of an agreement with, or by consent of the owner.…"

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Therefore, it is sufficient for the landlord/owner or his agent to give consent to his tenant. The
landlord/owner should be able to delegate to his tenant the responsibility for making the
requested improvements. The landlord/owner may not want to have direct involvement with the
materialman or sub-contractors, but instead may wish to allow the tenant to handle any
improvements or upgrades himself. In addition, the landlord/owner may be located far away
and may own many properties, making it impractical for him to have direct involvement with
the materialman. We find the landlord/owner or his agent is free to enter into a lease or
agreement with a tenant which allows the tenant to direct the modifications to the property
which have been specifically consented to by the landlord/owner or his agent.
We hold a landlord/owner or his agent can give his consent to the lessee/tenant, as well as
directly to the lien claimant, to make modifications to the leased premises.

B. What Kind of Consent Is Necessary.
This Court has already clearly held the consent required by [the relevant section] is “something
more than a mere acquiescence in a state of things already in existence. It implies an agreement
to that which, but for the consent, could not exist, and which the party consenting has a right to
forbid.” [Citations.] However, our Mechanics Lien Statute has never been applied in the
landlord-tenant context where a third party is involved.
Other jurisdictions have addressed this issue. The Court of Appeals cited [a Connecticut case,
1987] in support of its holding. We agree with the Court of Appeals that the Connecticut court’s
reasoning is persuasive, especially since Connecticut has a similar mechanics lien statute.…
The Connecticut courts have stated “the consent required from the owner or one acting under
the owner’s authority is more than the mere granting of permission for work to be conducted on
one’s property; or the mere knowledge that work was being performed on one’s land.”
Furthermore, although the Connecticut courts have stated the statute does not require an
express contract, the courts have required “consent that indicates an agreement that the owner
of…the land shall be, or may be, liable for the materials or labor.”…
The reasoning of [Connecticut and other states that have decided this issue] is persuasive. F &
D’s brief appears to argue that mere knowledge by the landowner that the work needed to be
done, coupled with the landlord’s general “permission” to perform the work, is enough to
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establish consent under the statute. Under this interpretation, a landlord who knew a tenant
needed to improve, upgrade, or add to the leased premises would be liable to any contractor
and/or subcontractor who performed work on his land. Under F & D’s interpretation the
landlord would not be required to know the scope, cost, etc. of the work, but would only need to
give the tenant general permission to perform upgrades or improvements.
Clearly, if the landlord/owner or his agent gives consent directly to the materialman, a lien can
be established. Consent can also be given to the tenant, but the consent needs to be specific. The
landlord/owner or his agent must know the scope of the project (for instance, as the lease
provided in the instant case, the landlord could approve written plans submitted by the tenant).
The consent needs to be more than “mere knowledge” that the tenant will perform work on the
property. There must be some kind of express or implied agreement that the landlord may be
held liable for the work or material. The landlord/owner or his agent may delegate the project or
work to his tenant, but there must be an express or implied agreement about the specific work to
be done. A general provision in a lease which allows tenant to make repairs or improvements is
not enough.

C. Evidence There Was No Consent
•

The record is clear that no contract, express or implied, existed between BG Holding and F & G.
BG Holding had no knowledge F & G would be performing the work.

•

F & G’s supervisor, David Weatherington, and Ray Dutton, the owner of F & D, both testified
they never had a conversation with anyone from BG Holding. In fact, until Powder Coaters failed
to pay under the contract, F & D did not know BG Holding was the owner of the building.

•

Mark Taylor, BG Holding’s agent, testified he never authorized any work by F & D, nor did he
see any work being performed by them on the site.

•

The lease specifically provided that all work on the property was to be approved in writing by BG
Holding.

•

David Weatherington of F & D testified he was looking to Powder Coaters, not BG Holding, for
payment.

•

Powder Coaters acknowledged it was not authorized to bind BG Holding to pay for the
modifications.
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•

The lease states, “[i]f the Lessee should make any [alterations, modification, additions, or
installations], the Lessee hereby agrees to indemnify, defend, and save harmless the Lessor from
any liability…”

D. Evidence There Was Consent
•

Bruce Houston, owner of Powder Coaters testified that during the lease negotiations, he
informed Mark Taylor, BG Holding’s property manager and agent, that electrical and gas
upgrading would be necessary for Powder Coaters to perform their work.

•

Houston testified Mark Taylor was present at the warehouse while F & D performed their work.
[However, Taylor testified he did not see F & D performing any work on the premises.]

•

Houston testified he would not have entered into the lease if he was not authorized to upgrade
the electrical since the existing power source was insufficient to run the machinery needed for
Powder Coaters to operate.

•

Houston testified Mark Taylor, BG Holding’s agent, showed him the power source for the
building so Taylor could understand the extent of the work that was going to be required.

•

Houston testified Paragraph 5 of the addendum to the lease was specifically negotiated. He
testified the following language granted him the authority to perform the electrical upfit, so that
he was not required to submit the plans to BG Holding as required by a provision in the lease:
“Lessor shall allow Lessee to put Office Trailer in Building. All Utilities necessary to handle
Lessee’s equipment shall be paid for by the Lessee including, but not limited to electricity, water,
sewer, and gas.” (We note that BG Holding denies this interpretation, but insists it just requires
the Lessee to pay for all utility bills.)

•

Powder Coaters no longer occupies the property, and BG Holding possibly benefits from the
work done.
In the instant case, there is some evidence of consent. However, it does not rise to the level
required under the statute.…
Viewing the evidence in the light most favorable to F & D, whether BG Holding gave their
consent is a close question. However, we agree with the Court of Appeals, that F & D has not
presented enough evidence to show: (1) BG Holding gave anything more than general consent to
make improvements (as the lease could be interpreted to allow); or (2) BG Holding had anything
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more that “mere knowledge” that the work was to be done. Powder Coaters asserted the lease’s
addendum evidenced BG Holding’s consent to perform the modifications; however, there is no
evidence BG Holding expressly or implicitly agreed that it might be liable for the work. In fact,
the lease between Powder Coaters and BG Holding expressly provided Powder Coaters was
responsible for any alterations made to the property. Even Powder Coaters acknowledged it was
not authorized to bind BG Holding.…Therefore, it is impossible to see how the very general
provision requiring Powder Coaters to pay for water, sewer, and gas can be interpreted to
authorize Powder Coaters to perform an electrical upgrade. Furthermore, we agree with the
Court of Appeals that the mere presence of BG Holding’s agent at the work site is not enough to
establish consent.

Conclusion
We hold consent, as required by the Mechanic’s Lien Statute, is something more than mere
knowledge work will be or could be done on the property. The landlord/owner must do more
than grant the tenant general permission to make repairs or improvements to the leased
premises. The landlord/owner or his agent must give either his tenant or the materialman
express or implied consent acknowledging he may be held liable for the work.
The Court of Appeals’ opinion is affirmed as modified.

CASE QUESTIONS

1. Why did the lienor want to go after the landlord instead of the tenant?
2. Did the landlord here know that there were electrical upgrades needed by the tenant?
3. What kind of knowledge or acceptance did the court determine the landlord-owner needed
to have or give before a material man could have a lien on the real estate?
4. What remedy has F & D (the material man) now?

Deeds of Trust; Duties of Trustee
Alpha Imperial Building, LLC v. Schnitzer Family Investment, LLC, II (SFI).
2005 WL 715940, (Wash. Ct. App. 2005)
Applewick, J.
Alpha Imperial LLC challenges the validity of a non-judicial foreclosure sale on multiple
grounds. Alpha was the holder of a third deed of trust on the building sold, and contests the

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location of the sale and the adequacy of the sale price. Alpha also claims that the trustee had a
duty to re-open the sale, had a duty to the junior lienholder, chilled the bidding, and had a
conflict of interest. We find that the location of the sale was proper, the price was adequate,
bidding was not chilled, and that the trustee had no duty to re-open the sale, [and] no duty to
the junior lienholder.…We affirm.

Facts
Mayur Sheth and another individual formed Alpha Imperial Building, LLC in 1998 for the
purpose of investing in commercial real estate. In February 2000 Alpha sold the property at
1406 Fourth Avenue in Seattle (the Property) to Pioneer Northwest, LLC (Pioneer). Pioneer
financed this purchase with two loans from [defendant Schnitzer Family Investment, LLC, II
(SFI)]. Pioneer also took a third loan from Alpha at the time of the sale for $1.3 million. This
loan from Alpha was junior to the two [other] loans[.]
Pioneer defaulted and filed for bankruptcy in 2002.…In October 2002 defendant Blackstone
Corporation, an entity created to act as a non-judicial foreclosure trustee, issued a Trustee’s
Notice of Sale. Blackstone is wholly owned by defendant Witherspoon, Kelley, Davenport &
Toole (Witherspoon). Defendant Michael Currin, a shareholder at Witherspoon, was to conduct
the sale on January 10, 2003. Currin and Witherspoon represented SFI and 4th Avenue LLC.
Sheth received a copy of the Notice of Sale through his attorney.
On January 10, 2003, Sheth and his son Abhi arrived at the Third Avenue entrance to the King
County courthouse between 9:30 and 9:45 a.m. They waited for about ten minutes. They noticed
two signs posted above the Third Avenue entrance. One sign said that construction work was
occurring at the courthouse and ‘all property auctions by the legal and banking communities will
be moved to the 4th Avenue entrance of the King County Administration Building.’ The other
sign indicated that the Third Avenue entrance would remain open during construction. Sheth
and Abhi asked a courthouse employee about the sign, and were told that all sales were
conducted at the Administration Building.
Sheth and Abhi then walked to the Administration Building, and asked around about the sale of
the Property. [He was told Michael Currin, one of the shareholders of Blackstone—the trustee—
was holding the sale, and was advised] to call Currin’s office in Spokane. Sheth did so, and was
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told that the sale was at the Third Avenue entrance. Sheth and Abhi went back to the Third
Avenue entrance.
In the meantime, Currin had arrived at the Third Avenue entrance between 9:35 and 9:40 a.m.
The head of SFI, Danny Schnitzer (Schnitzer), and his son were also present. Currin was
surprised to notice that no other foreclosure sales were taking place, but did not ask at the
information desk about it. Currin did not see the signs directing auctions to occur at the
Administration Building. Currin conducted the auction, Schnitzer made the only bid, for $2.1
million, and the sale was complete. At this time, the debt owed on the first two deeds of trust
totaled approximately $4.1 million. Currin then left the courthouse, but when he received a call
from his assistant telling him about Sheth, he arranged to meet Sheth back at the Third Avenue
entrance. When they met, Sheth told Currin that the sales were conducted at the Administration
Building. Currin responded that the sale had already been conducted, and he was not required
to go to the Administration Building. Currin told Sheth that the notice indicated the sale was to
be at the Third Avenue entrance, and that the sale had been held at the correct location. Sheth
did not ask to re-open the bidding.…
Sheth filed the current lawsuit, with Alpha as the sole plaintiff, on February 14, 2003. The
lawsuit asked for declaratory relief, restitution, and other damages. The trial court granted the
defendants’ summary judgment motion on August 8, 2003. Alpha appeals.
Location of the Sale
Alpha argues that the sale was improper because it was at the Third Avenue entrance, not the
Administration Building. Alpha points to a letter from a King County employee stating that
auctions are held at the Administration Building. The letter also stated that personnel were
instructed to direct bidders and trustees to that location if asked. In addition, Alpha argues that
the Third Avenue entrance was not a ‘public’ place, as required by [the statute], since auction
sales were forbidden there. We disagree. Alpha has not shown that the Third Avenue entrance
was an improper location. The evidence shows that the county had changed its policy as to
where auctions would be held and had posted signs to that effect. However, the county did not
exclude people from the Third Avenue entrance or prevent auctions from being held there.
Street, who frequented sales, stated that auctions were being held in both locations. The sale was
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held where the Notice of Sale indicated it would be. In addition, Alpha has not introduced any
evidence to show that the Third Avenue entrance was not a public place at the time of the sale.
The public was free to come and go at that location, and the area was ‘open and available for all
to use.’ Alpha relies on Morton v. Resolution Trust(S.D. Miss. 1995) to support its contention
that the venue of the sale was improper. [But] Morton is not on point.

Duty to Re-Open Sale
Alpha argues that Currin should have re-opened the sale. However, it is undisputed that Sheth
did not request that Currin re-open it. The evidence indicates that Currin may have known
about Sheth’s interest in bidding prior to the day of the sale, due to a conversation with Sheth’s
attorney about Sheth’s desire to protect his interest in the Property. But, this knowledge did not
create in Currin any affirmative duty to offer to re-open the sale.
In addition, Alpha cites no Washington authority to support the contention that Currin would
have been obligated to re-open the sale if Sheth had asked him to. The decision to continue a
sale appears to be fully within the discretion of the trustee: “[t]he trustee may for any cause the
trustee deems advantageous, continue the sale.” [Citation.] Alpha’s citation to Peterson v.
Kansas City Life Ins. Co., Missouri (1936) to support its contention that Currin should have reopened the sale is unavailing. In Peterson, the Notice of Sale indicated that the sale would be
held at the ‘front’ door of the courthouse. But, the courthouse had four doors, and the customary
door for sales was the east door. The sheriff, acting as the trustee, conducted the sale at the east
door, and then re-opened the sale at the south door, as there had been some sales at the south
door. Alpha contends this shows that Currin should have re-opened the sale when learning of
the Administration Building location, akin to what the sheriff did in Peterson. However,
Peterson does not indicate that the sheriff had an affirmative duty to re-sell the property at the
south door. This case is not on point.

Chilled Bidding
Alpha contends that Currin chilled the bidding on the Property by telling bidders that he
expected a full credit sale price and by holding the sale at the courthouse. Chilled bidding can be
grounds for setting aside a sale. Country Express Stores, Inc. v. Sims,[Washington Court of
Appeals] (1997). The Country Express court explained the two types of chilled bidding:
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The first is intentional, occurring where there is collusion for the purpose of holding down the
bids. The second consists of inadvertent and unintentional acts by the trustee that have the
effect of suppressing the bidding. To establish chilled bidding, the challenger must establish the
bidding was actually suppressed, which can sometimes be shown by an inadequate sale price.
We hold that there was no chilling. Alpha has not shown that Currin engaged in intentional
chilling. There is no evidence that Currin knew about the signs indicating auctions were
occurring at the Administration Building when he prepared the Notice of Sale, such that he
intentionally held the sale at a location from which he knew bidders would be absent.
Additionally, Currin’s statement to [an interested person who might bid on the property] that a
full credit sale price was expected and that the opening bid would be $4.1 million did not
constitute intentional chilling. SFI was owed $4.1 million on the Property. SFI could thus bid up
to that amount at no cost to itself, as the proceeds would go back to SFI. Currin confirmed that
SFI was prepared to make a full-credit bid. [It is common for trustees to] disclose the full-credit
bid amount to potential third party bidders, and for investors to lose interest when they learn of
the amount of indebtedness on property. It was therefore not a misrepresentation for Currin to
state $4.1 million as the opening bid, due to the indebtedness on the Property. Currin’s
statements had no chilling effect—they merely informed [interested persons] of the minimum
amount necessary to prevail against SFI. Thus, Currin did not intentionally chill the bidding by
giving Street that information.
Alpha also argues that the chilled bidding could have been unintended by Currin.… [But the
evidence is that] Currin’s actions did not intentionally or unintentionally chill the bidding, and
the sale will not be set aside.

Adequacy of the Sale Price
Alpha claims that the sale price was ‘greatly inadequate’ and that the sale should thus be set
aside. Alpha submitted evidence that the property had an ‘as is’ value of $4.35 million in
December 2002, and an estimated 2004 value of $5.2 million. The debt owed to SFI on the
property was $4.1 million. SFI bought the property for $2.1 million. These facts do not suggest
that the sale must be set aside.

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Washington case law suggests that the price the property is sold for must be ‘grossly inadequate’
for a trustee’s sale to be set aside on those grounds alone. In Cox [Citation, 1985], the property
was worth between $200,000 and $300,000, and was sold to the beneficiary for $11,873. The
Court held that amount to be grossly inadequate InSteward [Citation, 1988] the property had
been purchased for approximately $64,000, and then was sold to a third party at a foreclosure
sale for $4,870. This court held that $4,870 was not grossly inadequate. In Miebach [Citation]
(1984), the Court noted that a sale for less than two percent of the property’s fair market value
was grossly inadequate. The Court in Miebach also noted prior cases where the sale had been
voided due to grossly inadequate purchase price; the properties in those cases had been sold for
less than four percent of the value and less than three percent of the value. In addition, the
Restatement indicates that gross inadequacy only exists when the sale price is less than 20
percent of the fair market value—without other defects, sale prices over 20 percent will not be
set aside. [Citation.] The Property was sold for between 40 and 48 percent of its value. These
facts do not support a grossly inadequate purchase price.
Alpha cites Miebach for the proposition that ‘where the inadequacy of price is great the sale will
be set aside with slight indications of fraud or unfairness,’ arguing that such indications existed
here. However, the cases cited by the Court in Miebach to support this proposition involved
properties sold for less than three and four percent of their value. Alpha has not demonstrated
the slightest indication of fraud, nor shown that a property that sold for 40 to 48 percent of its
value sold for a greatly inadequate price.

Duty to a Junior Lienholder
Alpha claims that Currin owed a duty to Alpha, the junior lienholder. Alpha cites no case law for
this proposition, and, indeed, there is none—Division Two specifically declined to decide this
issue in Country Express [Citation]. Alpha acknowledges the lack of language in RCW 61.24 (the
deed of trust statute) regarding fiduciary duties of trustees to junior lienholders. But Alpha
argues that since RCW 61.24 requires that the trustee follow certain procedures in conducting
the sale, and allows for sales to be restrained by anyone with an interest, a substantive duty from
the trustee to a junior lienholder can be inferred.

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Alpha’s arguments are unavailing. The procedural requirements in RCW 61.24 do not create
implied substantive duties. The structure of the deed of trust sale illustrates that no duty is owed
to the junior lienholder. The trustee and the junior lienholder have no relationship with each
other. The sale is pursuant to a contract between the grantor, the beneficiary and the trustee.
The junior lienholder is not a party to that contract. The case law indicates only that the trustee
owes a fiduciary duty to the debtor and beneficiary: “a trustee of a deed of trust is a fiduciary for
both the mortgagee and mortgagor and must act impartially between them.” Cox [Citation]. The
fact that a sale in accordance with that contract can extinguish the junior lienholder’s interest
further shows that the grantor’s and beneficiary’s interest in the deed of trust being foreclosed is
adverse to the junior lienholder. We conclude the trustee, while having duties as fiduciary for
the grantor and beneficiary, does not have duties to another whose interest is adverse to the
grantor or beneficiary. Thus, Alpha’s claim of a special duty to a junior lienholder fails.…

Attorney Fees
…Defendants claim they are entitled to attorney fees for opposing a frivolous claim, pursuant to
[the Washington statute]. An appeal is frivolous ‘if there are no debatable issues upon which
reasonable minds might differ and it is so totally devoid of merit that there was no reasonable
possibility of reversal.’ [Citation] Alpha has presented several issues not so clearly resolved by
case law as to be frivolous, although Alpha’s arguments ultimately fail. Thus, Respondents’
request for attorney fees under [state law] is denied.
Affirmed.

CASE QUESTIONS

1. Why did the plaintiff (Alpha) think the sale should have been set aside because of the
location problems?
2. Why did the court decide the trustee had no duty to reopen bidding?
3. What is meant by “chilling bidding”? What argument did the plaintiff make to support its
contention that bidding was chilled?
4. The court notes precedent to the effect that a “grossly inadequate” bid price has some
definition. What is the definition? What percentage of the real estate’s value in this case was
the winning bid?

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5. A trustee is one who owes a fiduciary duty of the utmost loyalty and good faith to another,
the beneficiary. Who was the beneficiary here? What duty is owed to the junior lienholder
(Alpha here)—any duty?
6. Why did the defendants not get the attorneys’ fee award they wanted?

17.5 Summary and Exercises
Summary

A mortgage is a means of securing a debt with real estate. The mortgagor, or borrower, gives the
mortgage. The lender is the mortgagee, who holds the mortgage. On default, the mortgagee may
foreclose the mortgage, convening the security interest into title. In many states, the mortgagor
has a statutory right of redemption after foreclosure.
Various statutes regulate the mortgage business, including the Truth in Lending Act, the Equal
Credit Opportunity Act, the Real Estate Settlement Procedures Act, and the Home Mortgage
Disclosure Act, which together prescribe a code of fair practices and require various disclosures
to be made before the mortgage is created.
The mortgagor signs both a note and the mortgage at the closing. Without the note, the
mortgage would secure nothing. Most notes and mortgages contain an acceleration clause,
which calls for the entire principal and interest to be due, at the mortgagee’s option, if the debtor
defaults on any payment.
In most states, mortgages must be recorded for the mortgagee to be entitled to priority over
third parties who might also claim an interest in the land. The general rule is “First in time, first
in right,” although there are exceptions for fixture filings and nonobligatory future advances.
Mortgages are terminated by repayment, novation, or foreclosure, either through judicial sale or
under a power-of-sale clause.
Real estate may also be used as security under a deed of trust, which permits a trustee to sell the
land automatically on default, without recourse to a court of law.
Nonconsensual liens are security interests created by law. These include court-decreed liens,
such as attachment liens and judgment liens. Other liens are mechanic’s liens (for labor,

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services, or materials furnished in connection with someone’s real property), possessory liens
(for artisans working with someone else’s personal properly), and tax liens.

EXERCISES

1. Able bought a duplex from Carr, who had borrowed from First Bank for its purchase.
Able took title subject to Carr’s mortgage. Able did not make mortgage payments
to First Bank; the bank foreclosed and sold the property, leaving a deficiency.
Which is correct?
a.

Carr alone is liable for the deficiency.

b. Able alone is liable for the deficiency because he assumed the mortgage.
c. First Bank may pursue either Able or Carr.
d. Only if Carr fails to pay will Able be liable.
Harry borrowed $175,000 from Judith, giving her a note for that amount and a mortgage
on his condo. Judith did not record the mortgage. After Harry defaulted on his payments,
Judith began foreclosure proceedings. Harry argued that the mortgage was invalid because
Judith had failed to record it. Judith counterargues that because a mortgage is not an interest
in real estate, recording is not necessary. Who is correct? Explain.
Assume in Exercise 2 that the documents did not contain an acceleration clause and that
Harry missed three consecutive payments. Could Judith foreclose? Explain.
Rupert, an automobile mechanic, does carpentry work on weekends. He built a detached
garage for Clyde for $20,000. While he was constructing the garage, he agreed to tune up
Clyde’s car for an additional $200. When the work was completed, Clyde failed to pay him
the $20,200, and Rupert claimed a mechanic’s lien on the garage and car. What problems, if
any, might Rupert encounter in enforcing his lien? Explain.
In Exercise 4, assume that Clyde had borrowed $50,000 from First Bank and had given the
bank a mortgage on the property two weeks after Rupert commenced work on the garage
but several weeks before he filed the lien. Assuming that the bank immediately recorded its
mortgage and that Rupert’s lien is valid, does the mortgage take priority over the lien? Why?
Defendant purchased a house from Seller and assumed the mortgage indebtedness to
Plaintiff. All monthly payments were made on time until March 25, 1948, when no more

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were made. On October 8, 1948, Plaintiff sued to foreclose and accelerate the note. In
February of 1948, Plaintiff asked to obtain a loan elsewhere and pay him off; he offered a
discount if she would do so, three times, increasing the amount offered each time. Plaintiff
understood that Defendant was getting a loan from the Federal Housing Administration
(FHA), but she was confronted with a number of requirements, including significant property
improvements, which—because they were neighbors—Plaintiff knew were ongoing. While
the improvements were being made, in June or July, he said to her, “Just let the payments go
and we’ll settle everything up at the same time,” meaning she need not make monthly
payments until the FHA was consummated, and he’d be paid from the proceeds. But then
“he changed his tune” and sought foreclosure. Should the court order it?

SELF-TEST QUESTIONS

1. The person or institution holding a mortgage is called
a.

the mortgagor
b. the mortgagee
c. the debtor
d. none of the above
Mortgages are regulated by

a.

the Truth in Lending Act
b. the Equal Credit Opportunity Act
c. the Real Estate Settlement Procedures Act
d. all of the above
At the closing, a mortgagor signs
a.

only a mortgage

b. only a note
c. either a note or the mortgage
d. both a note and the mortgage
Mortgages are terminated by
a.

repayment

b. novation

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c. foreclosure
d. any of the above
A lien ordered against a person’s property to prevent its disposal during a
lawsuit is called
a.

a judgment lien

b. an attachment lien
c. a possessory lien
d. none of the above

SELF-TEST ANSWERS

1. b
2. d
3. d
4. d
5. b

Chapter 18
Bailments and the Storage, Shipment, and Leasing
of Goods
LEARNING OBJECTIVES

After reading this chapter, you should understand the following:
1. What the elements of a bailment are
2. What the bailee’s liability is
3. What the bailor’s liability is
4. What other rights and duties—compensation, bailee’s liens, casualty to goods—arise
5. What special types of bailments are recognized: innkeepers, warehousing
6. What rules govern the shipment of goods
7. How commodity paper is negotiated and transferred

18.1 Introduction to Bailment Law

LEARNING OBJECTIVES

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1. Understand what a bailment is, and why the law of bailment is important.
2. Recognize how bailments compare with sales.
3. Point out the elements required to create a bailment.
Finally, we turn to the legal relationships that buyers and sellers have with warehousers and
carriers—the parties responsible for physically transferring goods from seller to buyer. This
topic introduces a new branch of law—that of bailments; we’ll examine it before turning directly
to warehousers and carriers.

Overview of Bailments
A bailment is the relationship established when someone entrusts his property temporarily to
someone else without intending to give up title. Although bailment has often been said to arise
only through a contract, the modern definition does not require that there be an agreement. One
widely quoted definition holds that a bailment is “the rightful possession of goods by one who is
not the owner. It is the element of lawful possession, however created, and the duty to account
for the thing as the property of another, that creates the bailment, regardless of whether such
possession is based upon contract in the ordinary sense or not.” [1]
The word bailment derives from a Latin verb, bajulare, meaning “to bear a burden,” and then
from French, bailler, which means “to deliver” (i.e., into the hands or possession of someone).
The one who bails out a boat, filling a bucket and emptying it overboard, is a water-bearer. The
one who bails someone out of jail takes on the burden of ensuring that the one sprung appears
in court to stand trial; he also takes on the risk of loss of bond money if the jailed party does not
appear in court. The one who is abailee takes on the burden of being responsible to return the
goods to their owner.
The law of bailments is important to virtually everyone in modern society: anyone who has ever
delivered a car to a parking lot attendant, checked a coat in a restaurant, deposited property in a
safe-deposit box, rented tools, or taken items clothes or appliance in to a shop for repair. In
commercial transactions, bailment law governs the responsibilities of warehousers and the
carriers, such as UPS and FedEx, that are critical links in the movement of goods from
manufacturer to the consumer. Bailment law is an admixture of common law (property and

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tort), state statutory law (in the Uniform Commercial Code; UCC), federal statutory law, and—
for international issues—treaty. [2]

Bailments Compared with Sales
Bailment versus Sales
In a sale, the buyer acquires title and must pay for the goods. In a bailment, the bailee acquires
possession and must return the identical object. In most cases the distinction is clear, but
difficult borderline cases can arise. Consider the sad case of the leased cows: Carpenter v.
Griffen (N.Y. 1841). Carpenter leased a farm for five years to Spencer. The lease included thirty
cows. At the end of the term, Spencer was to give Carpenter, the owner, “cows of equal age and
quality.” Unfortunately, Spencer fell into hard times and had to borrow money from one Griffin.
When the time came to pay the debt, Spencer had no money, so Griffin went to court to levy
against the cows (i.e., he sought a court order giving him the cows in lieu of the money owed).
Needless to say, this threatened transfer of the cows upset Carpenter, who went to court to stop
Griffin from taking the cows. The question was whether Spencer was a bailee, in which case the
cows would still belong to Carpenter (and Griffin could not levy against them), or a purchaser, in
which case Spencer would own the cows and Griffin could levy against them. The court ruled
that title had passed to Spencer—the cows were his. Why? The court reasoned that Spencer was
not obligated to return the identical cows to Carpenter, hence Spencer was not a
bailee. [3] Section 2-304(1) of the UCC confirms this position, declaring that whenever the price
of a sale is payable in goods, each party is a seller of the goods that he is to transfer.
Note the implications that flow from calling this transaction a sale. Creditors of the purchaser
can seize the goods. The risk of loss is on the purchaser. The seller cannot recover the goods (to
make up for the buyer’s failure to pay him) or sell them to a third party.

Fungible Goods
Fungible goods (goods that are identical, like grain in a silo) present an especially troublesome
problem. In many instances the goods of several owners are mingled, and the identical items are
not intended to be returned. For example, the operator of a grain elevator agrees to return an
equal quantity of like-quality grain but not the actual kernels deposited there. Following the rule
in Carpenter’s cow case, this might seem to be a sale, but it is not. Under the UCC, Section 2Saylor URL: http://www.saylor.org/books

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207, the depositors of fungible goods are “tenants in common” of the goods; in other words, the
goods are owned by all. This distinction between a sale and a bailment is important. When there
is a loss through natural causes—for example, if the grain elevator burns—the depositors must
share the loss on a pro rata basis (meaning that no single depositor is entitled to take all his
grain out; if 20 percent of the grain was destroyed, then each depositor can take out no more
than 80 percent of what he deposited).

Elements of a Bailment
As noted, bailment is defined as “the rightful possession of goods by one who is not the owner.”
For the most part, this definition is clear (and note that it does not dictate that a bailment be
created by contract). Bailment law applies to the delivery of goods—that is, to the delivery
personal property. Personal property is usually defined as anything that can be owned other
than real estate. As we have just seen in comparing bailments to sales, the definition implies a
duty to return the identical goods when the bailment ends.
But one word in the definition is both critical and troublesome: possession. Possession requires
both a physical and a mental element. We examine these in turn.

Possession: Physical Control
In most cases, physical control is proven easily enough. A car delivered to a parking garage is
obviously within the physical control of the garage. But in some instances, physical control is
difficult to conceptualize. For example, you can rent a safe-deposit box in a bank to store
valuable papers, stock certificates, jewelry, and the like. The box is usually housed in the bank’s
vault. To gain access, you sign a register and insert your key after a bank employee inserts the
bank’s key. You may then inspect, add to, or remove contents of the box in the privacy of a small
room maintained in the vault for the purpose. Because the bank cannot gain access to the box
without your key and does not know what is in the box, it might be said to have no physical
control. Nevertheless, the rental of a safe-deposit box is a bailment. In so holding, a New York
court pointed out that if the bank was not in possession of the box renter’s property “it is
difficult to know who was. Certainly [the renter] was not, because she could not obtain access to
the property without the consent and active participation of the defendant. She could not go into
her safe unless the defendant used its key first, and then allowed her to open the box with her
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own key; thus absolutely controlling [her] access to that which she had deposited within the
safe. The vault was the [company’s] and was in its custody, and its contents were under the same
conditions.” [4] Statutes in some states, however, provide that the relationship is not a bailment
but that of a landlord and tenant, and many of these statutes limit the bank’s liability for losses.

Possession: Intent to Possess
In addition to physical control, the bailee must have had an intent to possess the goods; that is,
to exercise control over them. This mental condition is difficult to prove; it almost always turns
on the specific circumstances and, as a fact question, is left to the jury to determine. To illustrate
the difficulty, suppose that one crisp fall day, Mimi goes to Sally Jane’s Boutique to try on a
jacket. The sales clerk hands Mimi a jacket and watches while Mimi takes off her coat and places
it on a nearby table. A few minutes later, when Mimi is finished inspecting herself in the mirror,
she goes to retrieve her coat, only to discover it is missing. Who is responsible for the loss? The
answer depends on whether the store is a bailee. In some sense the boutique had physical
control, but did it intend to exercise that control? In a leading case, the court held that it did,
even though no one said anything about guarding the coat, because a store invites its patrons to
come in. Implicit in the act of trying on a garment is the removal of the garment being worn.
When the customer places it in a logical place, with the knowledge of and without objection from
the salesperson, the store must exercise some care in its safekeeping. [5]
Now suppose that when Mimi walked in, the salesperson told her to look around, to try on some
clothes, and to put her coat on the table. When the salesperson was finished with her present
customer, she said, she would be glad to help Mimi. So Mimi tried on a jacket and minutes later
discovered her coat gone. Is this a bailment? Many courts, including the New York courts, would
say no. The difference? The salesperson was helping another customer. Therefore, Mimi had a
better opportunity to watch over her own coat and knew that the salesperson would not be
looking out for it. This is a subtle distinction, but it has been sufficient in many cases to change
the ruling. [6]
Questions of intent and control frequently arise in parking lot cases. As someone once said, “The
key to the problem is the key itself.” The key is symbolic of possession and intent to possess. If
you give the attendant your key, you are a bailor and he (or the company he works for) is the
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bailee. If you do not give him the key, no bailment arises. Many parking lot cases do not fall
neatly within this rule, however. Especially common are cases involving self-service airport
parking lots. The customer drives through a gate, takes a ticket dispensed by a machine, parks
his car, locks it, and takes his key. When he leaves, he retrieves the car himself and pays at an
exit gate. As a general rule, no bailment is created under these circumstances. The lot operator
does not accept the vehicle nor intend to watch over it as bailee. In effect, the operator is simply
renting out space. [7] But a slight change of facts can alter this legal conclusion. Suppose, for
instance, that the lot had an attendant at the single point of entrance and exit, that the attendant
jotted down the license number on the ticket, one portion of which he retained, and that the car
owner must surrender the ticket when leaving or prove that he owns the car. These facts have
been held to add up to an intention to exercise custody and control over the cars in the lot, and
hence to have created a bailment. [8]
For a bailment to exist, the bailee must know or have reason to know that the property exists.
When property is hidden within the main object entrusted to the bailee, lack of notice can defeat
the bailment in the hidden property. For instance, a parking lot is not responsible for the
disappearance of valuable golf clubs stored in the trunk of a car, nor is a dance hall cloak room
responsible for the disappearance of a fur wrap inside a coat, if they did not know of their
existence. [9] This result is usually justified by observing that when a person is unaware that
goods exist or does not know their value, it is inequitable to hold him responsible for their loss
since he cannot take steps to prevent it. This rule has been criticized: trunks are meant to hold
things, and if the car was within the garage’s control, surely its contents were too. Some courts
soften the impact of the rule by holding that a bailee is responsible for goods that he might
reasonably expect to be present, like gloves in a coat checked at a restaurant or ordinary baggage
in a car checked at a hotel.

KEY TAKEAWAY

A bailment arises when one person (a bailee) rightfully holds property belonging to another
(a bailor). The law of bailments addresses the critical links in the movement of goods from
the manufacturer to the end user in a consumer society: to the storage and transportation of
goods. Bailments only apply to personal property; a bailment requires that the bailor deliver

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physical control of the goods to the bailee, who has an intention to possess the goods and a
duty to return them.

EXERCISES

1. Dennis takes his Mercedes to have the GPS system repaired. In the trunk of his car is a
briefcase containing $5,000 in cash. Is the cash bailed goods?
2. Marilyn wraps up ten family-heirloom crystal goblets, packages them carefully in a cardboard
box, and drops the box off at the local UPS store. Are the goblets bailed goods?
3. Bob agrees to help his friend Roger build a deck at Roger’s house. Bob leaves some of his
tools—without Bob’s noticing—around the corner of the garage at the foot of a
rhododendron bush. The tools are partly hidden. Are they bailed goods?
[1] Zuppa v. Hertz, 268 A.2d 364 (N.J. 1970).
[2] Here is a link to a history of bailment law: Globusz Publishing, “Lecture v. the Bailee at Common
Law,” accessed March 1, 2011,http://www.globusz.com/ebooks/CommonLaw/00000015.htm.
[3] Carpenter v. Spencer & Griffin, 37 Am. Dec. 396 (N.Y. 1841).
[4] Lockwood v. Manhattan Storage & Warehouse Co., 50 N.Y.S. 974 (N.Y. 1898).
[5] Bunnell v. Stern, 25 N.E. 910 (N.Y. 1890).
[6] Wamser v. Browning, King & Co., 79 N.E. 861 (N.Y. 1907).
[7] Wall v. Airport Parking Co. of Chicago, 244 N.E.2d 190 (Ill. 1969).
[8] Continental Insurance Co. v. Meyers Bros. Operations, Inc., 288 N.Y.S.2d 756 (Civ. Ct. N.Y. 1968).
[9] Samples v. Geary, 292 S.W. 1066 (Mo. App. 1927).

18.2 Liability of the Parties to a Bailment
LEARNING OBJECTIVES

1. Understand how the bailee’s liability arises and operates.
2. Recognize the cases in which the bailee can disclaim liability, and what limits are put on such
disclaimers.
3. Understand what duty and liability the bailor has.
4. Know other rights and duties that arise in a bailment.

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5. Understand the extent to which innkeepers—hotel and motels—are liable for their guests’
property.

Liability of the Bailee
Duty of Care
The basic rule is that the bailee is expected to return to its owner the bailed goods when the
bailee’s time for possession of them is over, and he is presumed liable if the goods are not
returned. But that a bailee has accepted delivery of goods does not mean that he is responsible
for their safekeeping no matter what. The law of bailments does not apply a standard of absolute
liability: the bailee is not an insurer of the goods’ safety; her liability depends on the
circumstances.

The Ordinary Care Rule
Some courts say that the bailee’s liability is the straightforward standard of “ordinary care under
the circumstances.” The question becomes whether the bailee exercised such care. If she did, she
is not liable for the loss.

The Benefit-of-the-Bargain Rule
Most courts use a complex (some say annoying) tripartite division of responsibility. If the
bailment is for the sole benefit of the owner (the bailor), the bailee is answerable only for gross
neglect or fraud: the duty of care is slight. For example, imagine that your car breaks down on a
dark night and you beg a passing motorist to tow it to a gas station; or you ask your neighbor if
you can store your utility trailer in her garage.
On the other hand, if the goods are entrusted to the bailee for his sole benefit, then he owes the
bailor extraordinary care. For example, imagine that your neighbor asks you to let him borrow
your car to go to the grocery store downtown because his car is in the shop; or a friend asks if
she can borrow your party canopy.
If the bailment is for the mutual benefit of bailee and bailor, then the ordinary negligence
standard of care will govern. For example, imagine you park your car in a commercial parking
lot, or you take your suit jacket to a dry cleaner (see Figure 18.1 "Duty of Care").
Figure 18.1 Duty of Care

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One problem with using the majority approach is the inherent ambiguity in the standards of
care. What constitutes “gross” negligence as opposed to “ordinary” negligence? The degree-ofcare approach is further complicated by the tendency of the courts to take into account the value
of the goods; the lesser the value of the goods, the lesser the obligation of the bailee to watch out
for them. To some degree, this approach makes sense, because it obviously behooves a person
guarding diamonds to take greater precautions against theft than one holding three paperback
books. But the value of the goods ought not to be the whole story: some goods obviously have
great value to the owner, regardless of any lack of intrinsic value.
Another problem in using the majority approach to the standard of care is determining whether
or not a benefit has been conferred on the bailee when the bailor did not expressly agree to pay
compensation. For example, a bank gives its customers free access to safe-deposit boxes. Is the
bank a “gratuitous bailee” that owes its bailor only a slight degree of care, or has it made the
boxes available as a commercial matter to hold onto its customers? Some courts cling to one
theory, some to the other, suggesting the difficulty with the tripartite division of the standard of
care. However, in many cases, whatever the formal theory, the courts look to the actual benefits
to be derived. Thus when a customer comes to an automobile showroom and leaves her car in
the lot while she test-drives the new car, most courts would hold that two bailments for mutual
benefit have been created: (1) the bailment to hold the old car in the lot, with the customer as
the bailor; and (2) the bailment to try out the new car, with the customer as the bailee.

Burden of Proof
In a bailment case, the plaintiff bailor has the burden of proving that a loss was caused by the
defendant bailee’s failure to exercise due care. However, the bailor establishes a prima facie (“at
first sight”—on first appearance, but subject to further investigation) case by showing that he
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delivered the goods into the bailee’s hands and that the bailee did not return them or returned
them damaged. At that point, a presumption of negligence arises, and to avoid liability the
defendant must rebut that presumption by showing affirmatively that he was not negligent. The
reason for this rule is that the bailee usually has a much better opportunity to explain why the
goods were not returned or were returned damaged. To put this burden on the bailor might
make it impossible for him to win a meritorious case.

Liability of the Bailor
As might be expected, most bailment cases involve the legal liability of bailees. However, a body
of law on the liability of bailors has emerged.

Negligence of Bailor
A bailor may be held liable for negligence. If the bailor receives a benefit from the bailment, then
he has a duty to inform the bailee of known defects and to make a reasonable inspection for
other defects. Suppose the Tranquil Chemical Manufacturing Company produces an insecticide
that it wants the Plattsville Chemical Storage Company to keep in tanks until it is sold. One of
the batches is defectively acidic and oozes out of the tanks. This acidity could have been
discovered through a routine inspection, but Tranquil neglects to inspect the batch. The tanks
leak and the chemical builds up on the floor until it explodes. Since Tranquil, the bailor, received
a benefit from the storage, it had a duty to warn Plattsville, and its failure to do so makes it liable
for all damages caused by the explosion.
If the bailor does not receive any benefit, however, then his only duty is to inform the bailee of
known defects. Your neighbor asks to borrow your car. You have a duty to tell her that the
brakes are weak, but you do not need to inspect the car beforehand for unknown defects.

Other Types of Liability
The theory of products liability extends to bailors. Both warranty and strict liability theories
apply. The rationale for extending liability in the absence of sale is that in modern commerce,
damage can be done equally by sellers or lessors of equipment. A rented car can inflict
substantial injury no less than a purchased one.
In several states, when an automobile owner (bailor) lends a vehicle to a friend (bailee) who
causes an accident, the owner is liable to third persons injured in the accident.
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Disclaimers of Liability
Bailee’s Disclaimer
Bailees frequently attempt to disclaim their liability for loss or damage. But courts often refuse
to honor the disclaimers, usually looking to one of two justifications for invalidating them.

Lack of Notice
The disclaimer must be brought to the attention of the bailor and must be unambiguous. Thus
posted notices and receipts disclaiming or limiting liability must set forth clearly and legibly the
legal effects intended. Most American courts follow the rule that the defendant bailee must show
that the bailor in fact knew about the disclaimer. Language printed on the back side of a receipt
will not do.

Public Policy Exception
Even if the bailor reads the disclaimer, some courts will nevertheless hold the bailee liable on
public policy grounds, especially when the bailee is a “business bailee,” such as a warehouse or
carrier. Indeed, to the extent that a business bailee attempts to totally disclaim liability, he will
probably fail in every American jurisdiction. But the Restatement (Second) of Contracts, Section
195(2)(b), does not go quite this far for most nonbusiness bailees. They may disclaim liability as
long as the disclaimer is read and does not relieve the bailee from wanton carelessness.

Bailor’s Disclaimer
Bailors most frequently attempt to disclaim liability in rental situations. For example,
in Zimmer v. Mitchell and Ness, the plaintiff went to the defendant’s rental shop at the
Camelback ski area to rent skis, boots, and poles. [1] He signed a rental agreement before
accepting the ski equipment. He was a lessee and a bailee. Later, while descending the
beginners’ slope, he fell. The bindings on his skis did not release, thereby causing him to sustain
numerous injuries. The plaintiff sued the defendant and Camelback Ski Corporation, alleging
negligence, violation of Section 402A of the Restatement (Second) of Torts, and breach of
warranty. The defendant filed an answer and claimed that the plaintiff signed a rental
agreement that fully released the defendant from liability. In his reply, the plaintiff admitted
signing the agreement but generally denied that it released the defendant from liability. The
defendant won on summary judgment.
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On appeal, the Pennsylvania Supreme Court held for the defendant and set out the law: “The
test for determining the validity of exculpatory clauses, admittedly not favored in the law, is set
out in [Citation]. The contract must not contravene any policy of the law. It must be a contract
between individuals relating to their private affairs. Each party must be a free bargaining agent,
not simply one drawn into an adhesion contract, with no recourse but to reject the entire
transaction.…We must construe the agreement strictly and against the party asserting it [and],
the agreement must spell out the intent of the parties with the utmost particularity.” The court
here was satisfied with the disclaimer.

Other Rights and Duties
Compensation
If the bailor hires the bailee to perform services for the bailed property, then the bailee is
entitled to compensation. Remember, however, that not every bailment is necessarily for
compensation. The difficult question is whether the bailee is entitled to compensation when
nothing explicit has been said about incidental expenses he has incurred to care for the bailed
property—as, for example, if he were to repair a piece of machinery to keep it running. No firm
rule can be given. Perhaps the best generalization that can be made is that, in the absence of an
express agreement, ordinary repairs fall to the bailee to pay, but extraordinary repairs are the
bailor’s responsibility. An express agreement between the parties detailing the responsibilities
would solve the problem, of course.

Bailee’s Lien
Lien is from the French, originally meaning “line,” “string,” or “tie.” In law a lien is the hold that
someone has over the property of another. It is akin, in effect, to a security interest. A common
type is the mechanic’s lien (“mechanic” here means one who works with his hands). For
example, a carpenter builds a room on your house and you fail to pay him; he can secure a lien
on your house, meaning that he has a property interest in the house and can start foreclosure
proceedings if you still fail to pay. Similarly, a bailee is said to have a lien on the bailed property
in his possession and need not redeliver it to the bailor until he has been paid. Try to take your
car out of a parking lot without paying and see what happens. The attendant’s refusal to give you
the car is entirely lawful under a common-law rule now more than a century and a half old. As
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the rule is usually stated, the common law confers the lien on the bailee if he has added value to
the property through his labor, skill, or materials. But that statement of the rule is somewhat
deceptive, since the person who has simply housed the goods is entitled to a lien, as is a person
who has altered or repaired the goods without measurably adding value to them. Perhaps a
better way of stating the rule is this: a lien is created when the bailee performs some special
benefit to the goods (e.g., preserving them or repairing them).
Many states have enacted statutes governing various types of liens. In many instances, these
have broadened the bailee’s common-law rights. This book discusses two types of liens in great
detail: the liens of warehousemen and those of common carriers. Recall that a lease creates a
type of bailment: the lessor is the bailor and the lessee is the bailee. This book references the
UCC’s take on leasing in its discussion of the sale of goods. [2]

Rights When Goods Are Taken or Damaged by a Third Party
The general rule is that the bailee can recover damages in full if the bailed property is damaged
or taken by a third party, but he must account in turn to the bailor. A delivery service is carrying
parcels—bailed goods entrusted to the trucker for delivery—when the truck is struck from
behind and blows up. The carrier may sue the third person who caused the accident and recover
for the total loss, including the value of the packages. The bailor may also recover for damages to
the parcels, but not if the bailee has already recovered a judgment. Suppose the bailee has sued
and lost. Does the bailor have a right to sue independently on the same grounds? Ordinarily, the
principle of res judicata would prevent a second suit, but if the bailor did not know of and
cooperate in the bailee’s suit, he probably has the right to proceed on his own suit.

Innkeepers’ Liability
The liability of an innkeeper—a type of bailor—is thought to have derived from the warlike
conditions that prevailed in medieval England, where brigands and bandits roamed the
countryside and the innkeeper himself might not have been above stealing from his guests. The
innkeeper’s liability extended not merely to loss of goods through negligence. His was an
insurer’s liability, extending to any loss, no matter how occasioned, and even to losses that
occurred in the guest’s room, a place where the guest had the primary right of possession. The
only exception was for losses due to the guest’s own negligence.
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Most states have enacted statutes providing exceptions to this extraordinarily broad commonlaw duty. Typically, the statutes exempt the hotel keeper from insurer’s liability if the hotelier
furnishes a safe in which the guests can leave their jewels, money, and other valuables and if a
notice is posted a notice advising the guests of the safe’s availability. The hotelier might face
liability for valuables lost or stolen from the safe but not from the rooms.

KEY TAKEAWAY

If the bailee fails to redeliver the goods to the bailor, a presumption of negligence arises, but
the bailee can rebut the presumption by showing that she exercised appropriate care. What
is “appropriate care” depends on the test used in the jurisdiction: some courts use the
“ordinary care under the circumstances,” and some determine how much care the bailee
should have exercised based on the extent to which she was benefited from the transaction
compared to the bailor. The bailor can be liable too for negligently delivering goods likely to
cause damage to the bailee. In either case reasonable disclaimers of liability are allowed. If
the bailed goods need repair while in the bailee’s possession, the usual rule is that ordinary
repairs are the bailee’s responsibility, extraordinary ones the bailor’s. Bailees are entitled to
liens to enforce payment owing to them. In common law, innkeepers were insurers of their
guests’ property, but hotels and motels today are governed mostly by statute: they are to
provide a safe for their guests’ valuables and are not liable for losses from the room.

EXERCISES

1. What is the “ordinary care under the circumstances” test for a bailee’s liability when the
bailed goods are not returned?
2. What is the tripartite test?
3. What liability does a bailor have for delivering defective goods to a bailee?
4. Under what circumstances are disclaimers of liability by the bailee or bailor acceptable?
5. Jason takes his Ford Mustang to a repair shop but fails to pay for the repairs. On what theory
can the shop keep and eventually sell the car to secure payment?
[1] Zimmer v. Mitchell and Ness, 385 A.2d 437 (Penn. 1978).
[2] Uniform Commercial Code, Section 2A.

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18.3 The Storage and Shipping of Goods
LEARNING OBJECTIVES

1. Understand a warehouser’s liability for losing goods, what types of losses a warehouser is
liable for, and what rights the warehouser has concerning the goods.
2. Know the duties, liabilities, and exceptions to liability a carrier of freight has, and what rights
the carrier has.
3. Understand the liability that is imposed on entities whose business it is to carry passengers.

Storage of Goods
Warehousing has been called the “second oldest profession,” stemming from the biblical story of
Joseph, who stored grain during the seven good years against the famine of the seven bad years.
Whatever its origins, warehousing is today a big business, taking in billions of dollars to
stockpile foods and other goods. As noted previously, the source of law governing warehousing
is Article 7 of the UCC, but noncode law also can apply. Section 7-103 of the Uniform
Commercial Code (UCC) specifically provides that any federal statute or treaty and any state
regulation or tariff supersedes the provisions of Article 7. A federal example is the United States
Warehouse Act, which governs receipts for stored agricultural products. Here we take up, after
some definitions, the warehouser’s liabilities and rights. A warehouser is a special type of bailee.

Definitions
A warehouser is defined in UCC, Section 7-102(h), as “a person engaged in the business of
storing goods for hire,” and under Section 1-201(45) awarehouse receipt is any receipt issued by
a warehouser. The warehouse receipt is an important document because it can be used to
transfer title to the goods, even while they remain in storage: it is worth money. No form is
prescribed for the warehouse receipt, but unless it lists in its terms the following nine items, the
warehouser is liable to anyone who is injured by the omission of any of them:
1. Location of the warehouse
2. Date receipt was issued
3. Consecutive number of the receipt
4. Statement whether the goods will be delivered to bearer, to a specified person, or “to a specified
person or his order”
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5. The rate of storage and handling charges
6. Description of the goods or the packages containing them
7. Signature of the warehouser, which his or her authorized agent may make
8. The warehouser’s ownership of the goods, if he or she has a sole or part ownership in them
9. The amount (if known, otherwise the fact) of advances made and liabilities incurred for which
the warehouser claims a lien or security interest

General Duty of Care
The warehouser’s general duty of care is embodied in the tort standard for measuring
negligence: he is liable for any losses or injury to the goods caused by his failure to exercise
“such care in regard to them as a reasonably careful man would exercise under like
circumstances.” [1] However, subsection 4 declares that this section does not repeal or dilute any
other state statute that imposes a higher responsibility on a warehouser. Nor does the section
invalidate contractual limitations otherwise permissible under Article 7. The warehouser’s duty
of care under this section is considerably weaker than the carrier’s duty. Determining when a
warehouser becomes a carrier, if the warehouser is to act as shipper, can become an important
issue.

Limitation of Liability
The warehouser may limit the amount of damages she will pay by so stating in the warehouse
receipt, but she must strictly observe that section’s requirements, under which the limitation
must be stated “per article or item, or value per unit of weight.” [2]Moreover, the warehouser
cannot force the bailor to accept this limitation: the bailor may demand in writing increased
liability, in which event the warehouser may charge more for the storage. If the warehouser
converts the goods to her own UCC, the limitation of liability does not apply.

Specific Types of Liability and Duties
Several problems recur in warehousing, and the law addresses them.

Nonreceipt or Misdescription
Under UCC Section 7-203, a warehouser is responsible for goods listed in a warehouse receipt
that were not in fact delivered to the warehouse (or were misdescribed) and must pay damages
to a good-faith purchaser of or party to a document of title. To avoid this liability, the issuer
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must conspicuously note on the document that he does not know whether the goods were
delivered or are correctly described. One simple way is to mark on the receipt that “contents,
condition, and quality are unknown.”

Delivery to the Wrong Party
The bailee is obligated to deliver the goods to any person with documents that entitle him to
possession, as long as the claimant pays any outstanding liens and surrenders the document so
that it can be marked “cancelled” (or can be partially cancelled in the case of partial delivery).
The bailee can avoid liability for no delivery by showing that he delivered the goods to someone
with a claim to possession superior to that of the claimant, that the goods were lost or destroyed
through no fault of the bailee, or that certain other lawful excuses apply. [3] Suppose a thief
deposits goods he has stolen with a warehouse. Discovering the theft, the warehouser turns the
goods over to the rightful owner. A day later the thief arrives with a receipt and demands
delivery. Because the rightful owner had the superior claim, the warehouser is not liable in
damages to the thief.
Now suppose you are moving and have placed your goods with a local storage company. A few
weeks later, you accidentally drop your wallet, which contains the receipt for the goods and all
your identification. A thief picks up the wallet and immediately heads for the warehouse,
pretending to be you. Having no suspicion that anything is amiss—it’s a large place and no one
can be expected to remember what you look like—the warehouse releases the goods to the thief.
This time you are probably out of luck. Section 7-404 says that “a bailee who in good faith
including observance of reasonable commercial standards has received goods and
delivered…them according to the terms of the document of title…is not liable.” This rule is true
even though the person to whom he made delivery had no authority to receive them, as in the
case of the thief. However, if the warehouser had a suspicion and failed to take precautions, then
he might be liable to the true owner.

Duty to Keep Goods Separate
Except for fungible goods, like grain, the warehouse must keep separate goods covered by each
warehouse receipt. The purpose of this rule, which may be negated by explicit language in the
receipt, is to permit the bailor to identify and take delivery of his goods at any time.
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Rights of the Warehouser
The warehouser has certain rights concerning the bailed goods.

Termination
A warehouser is not obligated to store goods indefinitely. Many warehouse receipts will specify
the period of storage. At the termination of the period, the warehouser may notify the bailor to
pay and to recover her goods. If no period is fixed in the receipt or other document of title, the
warehouser may give notice to pay and remove within no less than thirty days. The bailor’s
failure to pay and remove permits the warehouser to sell the goods for her fee. Suppose the
goods begin to deteriorate. Sections 7-207(2) and 7-207(3) of the UCC permit the warehouser to
sell the goods early if necessary to recover the full amount of her lien or if the goods present a
hazard. But if the rightful owner demands delivery before such a sale, the warehouser is
obligated to do so.

Liens
Section 7-209(1) of the UCC provides that a warehouser has a lien on goods covered by a
warehouse receipt to recover the following charges and expenses: charges for storage or
transportation, insurance, labor, and expenses necessary to preserve the goods. The lien is not
discharged if the bailor transfers his property interest in the goods by negotiating a warehouse
receipt to a purchaser in good faith, although the warehouser is limited then to an amount or a
rate fixed in the receipt or to a reasonable amount or rate if none was stated. The lien attaches
automatically and need not be spelled out in the warehouse receipt.
The warehouser may enforce the lien by selling the goods at a public or private sale, as long as
she does so in a commercially reasonable manner, as defined in Section 7-210. All parties known
to be claiming an interest in the goods must be notified of the sale and told the amount due, the
nature of the sale, and its time and place. Any person who in good faith purchases the goods
takes them free of any claim by the bailor, even if the warehouser failed to comply with the
requirements of Section 7-210. However, her failure to comply subjects her to damages, and if
she has willfully violated the provisions of this section she is liable to the bailor for conversion.

Shipment of Goods
Introduction and Terminology
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The shipment of goods throughout the United States and abroad is a very big business, and
many specialized companies have been established to undertake it, including railways, air cargo
operations, trucking companies, and ocean carriers. Article 7 of the UCC applies to carriage of
goods as it does to warehousing, but federal law is more important. The Federal Bill of Lading
Act (FBLA) covers bills of lading issued by common carriers for transportation of goods in
interstate or foreign commerce (i.e., from one state to another; in federal territory; or to foreign
countries). The Carmack Amendment was enacted in 1906 as an amendment to the Interstate
Commerce Act of 1887, and it is now part of the Interstate Commerce Commission Termination
Act of 1995; it covers liability of interstate carriers for loss, destruction, and damage to goods.
The shipper is the entity hiring the one who transports the goods: if you send your sister crystal
goblets for her birthday, you are the shipper.
Two terms are particularly important in discussing shipment of goods. One is common carrier;
the common carrier is “one who undertakes for hire or reward to transport the goods of such as
chooses to employ him, from place to place.” [4] This definition contains three elements: (1) the
carrier must hold itself out for all in common for hire—the business is not restricted to
particular customers but is open to all who apply for its services; (2) it must charge for his
services—it is for hire; (3) the service in question must be carriage. Included within this
tripartite definition are numerous types of carriers: household moving companies, taxicabs,
towing companies, and even oil and gas pipelines. Note that to be a common carrier it is not
necessary to be in the business of carrying every type of good to every possible point; common
carriers may limit the types of goods or the places to which they will transport them.
A bill of lading is any document that evidences “the receipt of goods for shipment issued by a
person engaged in the business of transporting or forwarding goods.” [5]This is a comprehensive
definition and includes documents used by contract carriers—that is, carriers who are not
common carriers. An example of a bill of lading is depicted in Figure 18.2 "A Bill of Lading
Form".

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Figure 18.2 A Bill of Lading Form

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Duties and Liabilities
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The transportation of goods has been an important part of all evolved economic systems for a
long time, and certainly it is critical to the development and operation of any capitalistic system.
The law regarding it is well developed.

Absolute Liability
Damage, destruction, and loss are major hazards of transportation for which the carrier will be
liable. Who will assert the claim against the carrier depends on who bears the risk of loss. The
rules governing risk of loss determine whether the buyer or seller will be the plaintiff. But
whoever is the plaintiff, the common carrier defendant faces absolute liability. With five
exceptions explored two paragraphs on, the common carrier is an insurer of goods, and
regardless of the cause of damage or loss—that is, whether or not the carrier was negligent—it
must make the owner whole. This ancient common-law rule is codified in state law, in the
federal Carmack Amendment, and in the UCC, Section 7-309(1), all of which hold the common
carrier to absolute liability to the extent that the common law of the state had previously done
so.
Absolute liability was imposed in the early cases because the judges believed such a rule was
necessary to prevent carriers from conspiring with thieves. Since it is difficult for the owner, who
was not on the scene, to prove exactly what happened, the judges reasoned that putting the
burden of loss on the carrier would prompt him to take extraordinary precautions against loss
(and would certainly preclude him from colluding with thieves). Note that the rules in this
section govern only common carriers; contract carriers that do not hold themselves out for
transport for hire are liable as ordinary bailees.

Exceptions to Absolute Liability
In general, the burden or proof rests on the carrier in favor of the shipper. The shipper (or
consignee of the shipper) can make out a prima facie case by showing that it delivered the goods
to the carrier in good condition and that the goods either did not arrive or arrived damaged in a
specified amount. Thereafter the carrier has the burden of proving that it was not negligent and
that the loss or damage was caused by one of the five following recognized exceptions to the rule
of absolute liability.

Act of God
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No one has ever succeeded in defining precisely what constitutes an act of God, but the courts
seem generally agreed that it encompasses acts that are of sudden and extraordinary natural, as
opposed to human, origin. Examples of acts of God are earthquakes, hurricanes, and fires
caused by lightning against which the carrier could not have protected itself. Rapid River
Carriers contracts to transport a refrigerated cargo of beef down the Mississippi River on the
SS Rapid. When the ship is en route, it is hit by a tornado and sinks. This is an act of God. But a
contributing act of negligence by a carrier overcomes the act of God exception. If it could be
shown that the captain was negligent to set sail when the weather warned of imminent tornados,
the carrier might be liable.

Act of Public Enemy
This is a narrow exception that applies only to acts committed by pirates at high sea or by the
armed forces of enemies of the state to which the carrier owes allegiance. American ships at sea
that are sunk during wartime by enemy torpedoes would not be liable for losses to the owners of
cargo. Moreover, public enemies do not include lawless mobs or criminals listed on the FBI’s
Ten Most Wanted list, even if federal troops are required, as in the Pullman Strike of 1894, to
put down the violence. After the Pullman Strike, carriers were held liable for property destroyed
by violent strikers.

Act of Public Authority
When a public authority—a sheriff or federal marshal, for example—through lawful process
seizes goods in the carrier’s possession, the carrier is excused from liability. Imagine that federal
agents board the SS Rapid in New Orleans and, as she is about to sail, show the captain a search
warrant and seize several boxes of cargo marked “beef” that turn out to hold cocaine. The owner
or consignee of this illegal cargo will not prevail in a suit against the carrier to recover damages.
Likewise, if the rightful owner of the goods obtains a lawful court order permitting him to attach
them, the carrier is obligated to permit the goods to be taken. It is not the carrier’s responsibility
to contest a judicial writ or to face the consequences of resisting a court order. The courts
generally agree that the carrier must notify the owner whenever goods are seized.

Act of Shipper

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When goods are lost or damaged because of the shipper’s negligence, the shipper is liable, not
the carrier. The usual situation under this exception arises from defective packing. The shipper
who packs the goods defectively is responsible for breakage unless the defect is apparent and the
carrier accepts the goods anyway. For example, if you ship your sister crystal goblets packed
loosely in the box, they will inevitably be broken when driven in trucks along the highways. The
trucker who knowingly accepts boxes in this condition is liable for the damage. Likewise, the
carrier’s negligence will overcome the exception and make him absolutely liable. A paper
supplier ships several bales of fine stationery in thin cardboard boxes susceptible to moisture.
Knowing their content, SS Rapid accepts the bales and exposes them to the elements on the
upper deck. A rainstorm curdles the stationery. The carrier is liable.

Inherent Nature of the Goods
The fifth exception to the rule of absolute liability is rooted in the nature of the goods
themselves. If they are inherently subject to deterioration or their inherent characteristics are
such that they might be destroyed, then the loss must lie on the owner. Common examples are
chemicals that can explode spontaneously and perishable fruits and vegetables. Of course, the
carrier is responsible for seeing that foodstuffs are properly stored and cared for, but if they
deteriorate naturally and not through the carrier’s negligence, he is not liable.

Which Carrier Is Liable?
The transportation system is complex, and few goods travel from portal to portal under the care
of one carrier only. In the nineteenth century, the shipper whose goods were lost had a difficult
time recovering their value. Initial carriers blamed the loss on subsequent carriers, and even if
the shipper could determine which carrier actually had possession of the goods when the
damage or loss occurred, diverse state laws made proof burdensome. The Carmack Amendment
ended the considerable confusion by placing the burden on the initial carrier; connecting
carriers are deemed agents of the initial carrier. So the plaintiff, whether seller or buyer, need
sue only the initial carrier, no matter where the loss occurred. Likewise, Section 7-302 of the
UCC fastens liability on an initial carrier for damages or loss caused by connecting carriers.

When Does Carrier Liability Begin and End?

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When a carrier’s liability begins and ends is an important issue because the same company can
act both to store the goods and to carry them. The carrier’s liability is more stringent than the
warehouser’s. So the question is, when does a warehouser become a carrier and vice versa?
The basic test for the beginning of carrier liability is whether the shipper must take further
action or give further instructions to the carrier before its duty to transport arises. Suppose that
Cotton Picking Associates delivers fifty bales of cotton to Rapid River Carriers for transport on
the SS Rapid. The SS Rapid is not due back to port for two more days, so Rapid River Carrier
stores the cotton in its warehouse, and on the following day the warehouse is struck by lightning
and burns to the ground. Is Rapid River Carriers liable in its capacity as a carrier or warehouse?
Since nothing was left for the owner to do, and Rapid River was storing the cotton for its own
convenience awaiting the ship’s arrival, it was acting as a carrier and is liable for the loss. Now
suppose that when Cotton Picking Associates delivered the fifty bales it said that another fifty
bales would be coming in a week and the entire lot was to be shipped together. Rapid River
stores the first fifty bales and lightning strikes. Since more remained for Cotton Picking to do
before Rapid River was obligated to ship, the carrier was acting in its warehousing capacity and
is not liable.
The carrier’s absolute liability ends when it has delivered the goods to the consignee’s residence
or place of business, unless the agreement states otherwise (as it often does). By custom, certain
carriers—notably rail carriers and carriers by water—are not required to deliver the goods to the
consignee (since rail lines and oceans do not take the carrier to the consignee’s door). Instead,
consignees must take delivery at the dock or some other place mutually agreed on or established
by custom.
When the carrier must make personal delivery to the consignee, carrier liability continues until
the carrier has made reasonable efforts to deliver. An express trucking company cannot call on a
corporate customer on Sunday or late at night, for instance. If reasonable efforts to deliver fail, it
may store the goods in its own warehouse, in which case its liability reverts to that of a
warehouser.
If personal delivery is not required (e.g., as in shipment by rail), the states use different
approaches for determining when the carrier’s liability terminates. The most popular intrastate
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approach provides that the carrier continues to be absolutely responsible for the goods until the
consignee has been notified of their arrival and has had a reasonable opportunity to take
possession of them.
Interstate shipments are governed by the Carmack Amendment, which generally provides that
liability will be determined by language in the bill of lading. The typical bill of lading (or “BOL”
and “B/L”) provides that if the consignee does not take the goods within a stated period of time
after receiving notice of their arrival, the carrier will be liable as warehouser only.

Disclaimers
The apparently draconian liability of the carrier—as an insurer of the goods—is in practice easily
minimized. Under neither federal nor state law may the carrier disclaim its absolute liability, but
at least as to commercial transactions it may limit the damages payable under certain
circumstances. Both the Carmack Amendment and Section 7-309 of the UCC permit the carrier
to set alternate tariffs, one costing the shipper more and paying full value, the other costing less
and limited to a dollar per pound or some other rate less than full value. The shipper must have
a choice; the carrier may not impose a lesser tariff unilaterally on the shipper, and the loss must
not be occasioned by the carrier’s own negligence.

Specific Types of Liability
The rules just discussed relate to the general liability of the carrier for damages to the goods.
There are two specific types of liability worth noting.

Nonreceipt or Misdescription
Under the UCC, Section 7-301(1), the owner of the goods (e.g., a consignee) described in a bill of
lading may recover damages from the issuer of the bill (the carrier) if the issuer did not actually
receive the goods from the shipper, if the goods were misdescribed, or if the bill was misdated.
The issuer may avoid liability by reciting in the bill of lading that she does not know whether the
goods were received or if they conform to the description; the issuer may avoid liability also by
marking the goods with such words as “contents or condition of contents unknown.” Even this
qualifying language may be ineffective. For instance, a common carrier may not hide behind
language indicating that the description was given by the shipper; the carrier must actually
count the packages of goods or ascertain the kind and quantity of bulk freight. Just because the
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carrier is liable to the consignee for errors in description does not mean that the shipper is free
from blame. Section 7-301(5) requires the shipper to indemnify the carrier if the shipper has
inaccurately described the goods in any way (including marks, labels, number, kind, quantity,
condition, and weight).

Delivery to the Wrong Party
The rule just discussed for warehouser applies to carriers under both state and federal law:
carriers are absolutely liable for delivering the goods to the wrong party. In the classic case
of Southern Express Co. v. C. L. Ruth & Son, a clever imposter posed as the representative of a
reputable firm and tricked the carrier into delivering a diamond ring.[6] The court held the
carrier liable, even though the carrier was not negligent and there was no collusion. The UCC
contains certain exceptions; under Section 7-303(1), the carrier is immune from liability if the
holder, the consignor, or (under certain circumstances) the consignee gives instructions to
deliver the goods to someone other than a person named in the bill of lading.

Carrier’s Right to Lien and Enforcement of Lien
Just as the warehouser can have a lien, so too can the carrier. The lien can cover charges for
storage, transportation, and preservation of goods. When someone has purchased a negotiable
bill of lading, the lien is limited to charges stated in the bill, allowed under applicable tariffs, or,
if none are stated, to a reasonable charge. A carrier who voluntarily delivers or unjustifiably
refuses to deliver the goods loses its lien. The carrier has rights paralleling those of the
warehouser to enforce the lien.

Passengers
In addition to shipping goods, common carriers also transport passengers and their baggage.
The carrier owes passengers a high degree of care; in 1880 the Supreme Court described the
standard as “the utmost caution characteristic of very careful prudent men.” [7] This duty implies
liability for a host of injuries, including mental distress occasioned by insults (“lunatic,”
“whore,” “cheap, common scalawag”) and by profane or indecent language. In Werndli v.
Greyhound, [8] Mrs. Werndli deboarded the bus at her destination at 2:30 a.m.; finding the bus
station closed, she walked some distance to find a bathroom. While doing so, she became the
victim of an assault. The court held Greyhound liable: it should have known the station was
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closed at 2:30 a.m. and that it was located in a area that became dangerous after hours. The case
illustrates the degree to which a carrier is responsible for its passengers’ safety and comfort.
The baggage carrier is liable as an insurer unless the baggage is not in fact delivered to the
carrier. A passenger who retains control over his hand luggage by taking it with him to his seat
has not delivered the baggage to the carrier, and hence the carrier has no absolute liability for its
loss or destruction. The carrier remains liable for negligence, however. When the passenger does
deliver his luggage to the carrier, the question often arises whether the property so delivered is
“baggage.” If it is not, the carrier does not have an insurer’s liability toward it. Thus a person
who transports household goods in a suitcase would not have given the carrier “baggage,” as that
term is usually defined (i.e., something transported for the passenger’s personal use or
convenience). At most, the carrier would be responsible for the goods as a gratuitous bailee.

KEY TAKEAWAY

The storage of goods is a special type of bailment. People who store goods can retrieve them
or transfer ownership of them by transferring possession of the warehouse receipt: whoever
has rightful possession of the receipt can take the goods, and the warehouser is liable for
misdelivery or for mixing up goods. The warehouser has a right to a lien to secure his fee,
enforceable by selling the goods in a commercially reasonable way. The shipping of goods is
of course an important business. Common carriers (those firms that hire out their trucks,
airplanes, ships, or trains to carry cargo) are strictly liable to ensure the proper arrival of the
goods to their destination, with five exceptions (act of God, public enemy, public authority,
shipper; inherent nature of the goods); the first carrier to receive them is liable—others who
subsequently carry are that carrier’s agents. The carrier may also store goods: if it does so for
its own convenience it is liable as a carrier; if it does so for the shipper’s convenience, it is
liable as a warehouser. As with warehousers, the carrier is liable for misdelivery and is
entitled to a lien to enforce payment. Carriers also carry people, and the standard of care
they owe to passengers is very high. Carrying passengers’ baggage, the carrier is liable as an
insurer—it is strictly liable.

EXERCISES

1. How are warehousers any different from the more generic bailees?
2. How do the duties and liabilities of warehousers differ from those of carriers?
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3. What rights do warehousers and carriers have to ensure their payment?
4. May a carrier limit its liability for losses not its fault?
[1] Uniform Commercial Code, Section 7-204(1).
[2] Uniform Commercial Code, Section 7-204(2).
[3] Uniform Commercial Code, Section 7-403(1).
[4] Ace High Dresses v. J. C. Trucking Co., 191 A. 536 (Conn. 1937).
[5] Uniform Commercial Code, Section 1-206(6).
[6] Southern Express Co. v. C. L. Ruth & Son, 59 So. 538 (Ala. Ct. App. 1912).
[7] Pennsylvania Co. v. Roy, 102 US 451 (1880).
[8] Werndli v. Greyhound Corp., 365 So.2d 177 (Fla. Ct. App., 1978)

18.4 Negotiation and Transfer of Documents of Title (or
Commodity Paper)
LEARNING OBJECTIVES

1. Understand how commodity paper operates in the sale of goods.
2. Recognize when the transferee of a properly negotiated document of title gets better rights
than her transferor had and the exceptions to this principle.

Overview of Negotiability
We have discussed in several places the concept of a document of title (also
calledcommodity paper). That is a written description, identification, or declaration of goods
authorizing the holder—usually a bailee—to receive, hold, and dispose of the document and the
goods it covers. Examples of documents of title are warehouse receipts, bills of lading, and
delivery orders. The document of title, properly negotiated (delivered), gives its holder
ownership of the goods it represents. It is much easier to pass around a piece of paper
representing the ownership interest in goods than it is to pass around the goods themselves.
It is a basic feature of our legal system that a person cannot transfer more rights to property
than he owns. It would follow here that no holder of a document of title has greater rights in the
goods than the holder’s transferor—the one from whom she got the document (and thus the
goods). But there are certain exceptions to this rule; for example, the power of a merchant in
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certain circumstances to transfer title to goods, even though the merchant himself did not have
title to them. A critically important exception to the general rule arises when certain types of
paper are sold; for example, commercial paper such as checks and notes. To conclude this
chapter, we discuss the rule as it applies to documents of title, sometimes known as commodity
paper.

The Elements and Effect of Negotiation
If a document of title is “negotiable” and is “duly negotiated,” the purchaser can obtain rights
greater than those of the storer or shipper. In the following discussion, we refer only to the
Uniform Commercial Code (UCC), although federal law also distinguishes between negotiable
and nonnegotiable documents of title (some of the technical details in the federal law may differ,
but these are beyond the scope of this book).

Negotiable Defined
Any document of title, including a warehouse receipt and a bill of lading, is negotiable or
becomes negotiable if by its terms the goods are to be delivered “to bearer or to the order of” a
named person. [1] All other documents of title are nonnegotiable. Suppose a bill of lading says
that the goods are consigned to Tom Thumb but that they may not be delivered unless Tom
signs a written order that they be delivered. Under Section 7-104(2), that is not a negotiable
document of title. A negotiable document of title must bear words such as “Deliver to the bearer”
or “deliver to the order of Tom Thumb.” These are the “magic words” that create a negotiable
document.

Duly Negotiated
To transfer title effectively through negotiation of the document of title, it must be “duly
negotiated.” In general terms, under Section 7-501 of the UCC, a negotiable document of title
is duly negotiated when the person named in it indorses (signs it over—literally “on the back of”)
and delivers it to a holder who purchases it in good faith and for value, without any notice that
someone else might have a claim against the goods, assuming the transaction is in the regular
course of business or financing. Note that last part: assuming the transaction is in the regular
course of business. If you gave your roommate a negotiable document of title in payment for a
car you bought from her, your roommate would have something of value, but it would not have
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been duly negotiated. Paper made out “to bearer” (bearer paper) is negotiated by delivery alone;
no indorsement is needed. A holder is anyone who possesses a document of title that is drawn to
his order, indorsed to him, or made out “to bearer.”

Effect
As a general rule, if these requirements are not met, the transferee acquires only those rights
that the transferor had and nothing more. And if a nonnegotiable document is sold, the buyer’s
rights may be defeated. For example, a creditor of the transferor might be entitled to treat the
sale as void.
Under Section 7-502 of the UCC, however, if the document is duly negotiated, then the holder
acquires (1) title to the document, (2) title to the goods, (3) certain rights to the goods delivered
to the bailee after the document itself was issued, and (4) the right to have the issuer of the
document of title hold the goods or deliver the goods free of any defense or claim by the issuer.
To contrast the difference between sale of goods and negotiation of the document of title,
consider the plight of Lucy, the owner of presidential campaign pins and other political
memorabilia. Lucy plans to hold them for ten years and then sell them for many times their
present value. She does not have the room in her cramped apartment to keep them, so she crates
them up and takes them to a friend for safekeeping. The friend gives her a receipt that says
simply: “Received from Lucy, five cartons; to be stored for ten years at $25 per year.” Although a
document of title, the receipt is not negotiable. Two years later, a browser happens on Lucy’s
crates, discovers their contents, and offers the friend $1,000 for them. Figuring Lucy will forget
all about them, the friend sells them. As it happens, Lucy comes by a week later to check on her
memorabilia, discovers what her former friend has done, and sues the browser for their return.
Lucy would prevail. Now suppose instead that the friend, who has authority from Lucy to store
the goods, takes the cartons to the Trusty Storage Company, receives a negotiable warehouse
receipt (“deliver to bearer five cartons”), and then negotiates the receipt. This time Lucy would
be out of luck. The bona fide purchaser from her friend would cut off Lucy’s right to recover the
goods, even though the friend never had good title to them.

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A major purpose of the concept is to allow banks and other creditors to loan money with the
right to the goods as represented on the paper as collateral. They can, in effect, accept the paper
as collateral without fear that third parties will make some claim on the goods.
But even if the requirements of negotiability are met, the document of title still will confer no
rights in certain cases. For example, when a thief forges the indorsement of the owner, who held
negotiable warehouse receipts, the bona fide purchaser from the thief does not obtain good title.
Only if the receipts were in bearer form would the purchaser prevail in a suit by the owner.
Likewise, if the owner brought his goods to a repair shop that warehoused them without any
authority and then sold the negotiable receipts received for them, the owner would prevail over
the subsequent purchaser.
Another instance in which an apparent negotiation of a document of title will not give the bona
fide purchaser superior rights occurs when a term in the document is altered without
authorization. But if blanks are filled in without authority, the rule states different consequences
for bills of lading and warehouse receipts. Under Section 7-306 of the UCC, any unauthorized
filling in of a blank in a bill of lading leaves the bill enforceable only as it was originally.
However, under Section 7-208, an unauthorized filling in of a blank in a warehouse receipt
permits the good-faith purchaser with no notice that authority was lacking to treat the insertion
as authorized, thus giving him good title. This section makes it dangerous for a warehouser to
issue a receipt with blanks in it, because he will be liable for any losses to the owner if a goodfaith purchaser takes the goods.
Finally, note that a purchaser of a document of title who is unable to get his hands on the
goods—perhaps the document was forged—might have a breach of warranty action against the
seller of the document. Under Section 7-507 of the UCC, a person who negotiates a document of
title warrants to his immediate purchaser that the document is genuine, that he has no
knowledge of any facts that would impair its validity, and that the negotiation is rightful and
effective. Thus the purchaser of a forged warehouse receipt would not be entitled to recover the
goods but could sue his transferor for breach of the warranty.

KEY TAKEAWAY

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It is a lot easier to move pieces of paper around than goods in warehouses. Therefore
commercial paper, or commodity paper, was invented: the paper represents the goods, and
the paper is transferred from one person to another by negotiation. The holder signs on the
back of the paper and indicates who its next holder should be (or foolishly leaves that blank);
that person then has rights to the goods and, indeed, better rights. On due negotiation the
transferee does not merely stand in the transferor’s shoes: the transferee takes free of
defects and defenses that could have been available against the transferor. For a document
of title to be a negotiable one, it must indicate that the intention of it is that it should be
passed on through commerce, with the words “to bearer” or “to the order of [somebody],”
and it must be duly negotiated: signed off on by its previous holder (or without any signature
needed if it was bearer paper).

EXERCISES

1. “George Baker deposited five cardboard boxes in my barn’s loft, and he can pick them up
when he wants.” Is this statement a negotiable document of title?
2. “George Baker deposited five cardboard boxes in my barn’s loft, and he or anybody to his
order can pick them up.” Is this statement a negotiable document of title?
3. Why is the concept of being a holder of duly negotiated documents of title important?
[1] Uniform Commercial Code, Section 7-104(1)(a).

18.5 Cases
Bailments and Disclaimers of Bailee’s Liability
Carr v. Hoosier Photo Supplies, Inc.
441 N.E.2d 450 (Ind. 1982)
Givan, J.
Litigation in this cause began with the filing of a complaint in Marion Municipal Court by John
R. Carr, Jr. (hereinafter “Carr”), seeking damages in the amount of $10,000 from defendants
Hoosier Photo Supplies, Inc. (hereinafter “Hoosier”) and Eastman Kodak Company (hereinafter
“Kodak”). Carr was the beneficiary of a judgment in the amount of $1,013.60. Both sides
appealed. The Court of Appeals affirmed the trial court in its entirety.
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The facts were established by stipulation agreement between the parties and thus are not in
dispute. In the late spring or early summer of 1970, Carr purchased some Kodak film from a
retailer not a party to this action, including four rolls of Kodak Ektachrome-X 135 slide film that
are the subject matter of this dispute. During the month of August, 1970, Carr and his family
vacationed in Europe. Using his own camera Carr took a great many photographs of the sites
they saw, using among others the four rolls of film referred to earlier. Upon their return to the
United States, Carr took a total of eighteen [18] rolls of exposed film to Hoosier to be developed.
Only fourteen [14] of the rolls were returned to Carr after processing. All efforts to find the
missing rolls or the pictures developed from them were unsuccessful. Litigation commenced
when the parties were unable to negotiate a settlement.
The film Carr purchased, manufactured by Kodak, is distributed in boxes on which there is
printed the following legend:

READ THIS NOTICE

This film will be replaced if defective in manufacture, labeling, or packaging, or if damaged or
lost by us or any subsidiary company even though by negligence or other fault. Except for such
replacement, the sale, processing, or other handling of this film for any purpose is without other
warranty of liability.
In the stipulation of facts it was agreed though Carr never read this notice on the packages of
film he bought, he knew there was printed on such packages “a limitation of liability similar or
identical to the Eastman Kodak limitation of liability.” The source of Carr’s knowledge was
agreed to be his years of experience as an attorney and as an amateur photographer.
When Carr took all eighteen [18] rolls of exposed film to Hoosier for processing, he was given a
receipt for each roll. Each receipt contained the following language printed on the back side:
Although film price does not include processing by Kodak, the return of any film or print to us
for processing or any other purpose, will constitute an agreement by you that if any such film or
print is damaged or lost by us or any subsidiary company, even though by negligence or other
fault, it will be replaced with an equivalent amount of Kodak film and processing and, except for
such replacement, the handling of such film or prints by us for any purpose is without other
warranty or liability.
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Again, it was agreed though Carr did not read this notice he was aware Hoosier “[gave] to their
customers at the time of accepting film for processing, receipts on which there are printed
limitations of liability similar or identical to the limitation of liability printed on each receipt
received by Carr from Hoosier Photo.”
It was stipulated upon receipt of the eighteen [18] rolls of exposed film only fourteen [14] were
returned to Hoosier by Kodak after processing. Finally, it was stipulated the four rolls of film
were lost by either Hoosier or Kodak.…
That either Kodak or Hoosier breached the bailment contract, by negligently losing the four rolls
of film, was established in the stipulated agreement of facts. Therefore, the next issue raised is
whether either or both, Hoosier or Kodak, may limit their liability as reflected on the film
packages and receipts.…
[A] prerequisite to finding a limitation of liability clause in a contract unconscionable and
therefore void is a showing of disparity in bargaining power in favor of the party whose liability
is thus limited.…In the case at bar the stipulated facts foreclose a finding of disparate bargaining
power between the parties or lack of knowledge or understanding of the liability clause by Carr.
The facts show Carr is an experienced attorney who practices in the field of business law. He is
hardly in a position comparable to that of the plaintiff in Weaver, supra. Moreover, it was
stipulated he was aware of the limitation of liability on both the film packages and the receipts.
We believe these crucial facts belie a finding of disparate bargaining power working to Carr’s
disadvantage.
Contrary to Carr’s assertions, he was not in a “take it or leave it position” in that he had no
choice but to accept the limitation of liability terms of the contract. As cross-appellants Hoosier
and Kodak correctly point out, Carr and other photographers like him do have some choice in
the matter of film processing. They can, for one, undertake to develop their film themselves.
They can also go to independent film laboratories not a part of the Kodak Company. We do not
see the availability of processing as limited to Kodak.…
We hold the limitation of liability clauses operating in favor of Hoosier and Kodak were assented
to by Carr; they were not unconscionable or void. Carr is, therefore, bound by such terms and is

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limited in his remedy to recovery of the cost of four boxes of unexposed Kodak Ektachrome-X
135 slide film.
The Court of Appeals’ opinion in this case is hereby vacated. The cause is remanded to the trial
court with instructions to enter a judgment in favor of appellant, John R. Carr, Jr., in the
amount of $13.60, plus interest. Each party is to bear its own costs.
Hunter and Pivarnik, JJ., concur. Prentice, J., concurs in result without opinion.
DeBruler, J., dissenting.
…As a general rule the law does not permit professional bailees to escape or diminish liability for
their own negligence by posting signs or handing out receipts. [Citations] The statements on the
film box and claim check used by Kodak and Hoosier Photo are in all respects like the printed
forms of similar import which commonly appear on packages, signs, chits, tickets, tokens and
receipts with which we are all bombarded daily. No one does, or can reasonably be expected, to
take the time to carefully read the front, back, and sides of such things. We all know their gist
anyway.
The distinguished trial judge below characterizes these statements before us as “mere notices”
and concludes that plaintiff below did not “assent” to them so as to render them a binding part
of the bailment contract. Implicit here is the recognition of the exception to the general rule
regarding such notices, namely, that they may attain the dignity of a special contract limiting
liability where the bailor overtly assents to their terms. [Citations] To assent to provisions of this
sort requires more than simply placing the goods into the hands of the bailee and taking back a
receipt or claim check. Such acts are as probative of ignorance as they are of knowledge.
However, according to the agreed statement of facts, plaintiff Carr “knew” by past experience
that the claim checks carried the limitation of liability statements, but he did not read them and
was unaware of the specific language in them. There is nothing in this agreed statement that
Carr recalled this knowledge to present consciousness at the time of these transactions.
Obviously we all know many things which we do not recall or remember at any given time. The
assent required by law is more than this; it is, I believe, to perform an act of understanding.
There is no evidence of that here.

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The evidence presented tending to support the award of damages included an actual
uncontroverted amount of $13.60 thereby precluding mere nominal damages. There was further
evidence that 150 exposures were lost. The actual award of $1,014.60 amounted to between
$6.00 and $7.00 per picture. Carr provided evidence that the pictures were of exceptional value
to him, having been taken in a once-in-a-lifetime European trip costing $6000 [about $33,000
in 2110 dollars], including visits arranged there before hand with relatives. The award was fair
and just compensation for the loss of value to the owner and does not include sentimental or
fanciful value.
The trial court judgment should be affirmed.

CASE QUESTIONS

1. Four out of eighteen rolls of film were not returned to the bailor, Mr. Carr. The court here
affirmed a judgment for about $6 per lost image. How could an image taken by an amateur
photographer be worth $6 a piece?
2. The European trip cost him $6,000 in 1970; he asked for $10,000 (about $55,000 in 2010
dollars). Upon what basis could such damages be arrived? What did he apparently want?
3. What argument did the plaintiff make as to why the limitation of liability should not be
enforced? What response did the court have to that?
4. Would it have made a difference if the plaintiff were not himself a business attorney? Why or
why not?
5. Why did the dissent think the court of appeals’ decision to award the plaintiff $1,000 was
correct and the majority’s opinion incorrect?

Bailed Goods of Sentimental Value
Mieske v. Bartell Drug Co.
593 P.2d 1308 (Wash. 1979)
Brachtenbach, J.
This case determines the measure of damages for personal property, developed movie film,
which is destroyed, and which cannot be replaced or reproduced. It also decides the legal effect
of a clause which purports to limit the responsibility of a film processor to replacement of film.…

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The facts are that over a period of years the plaintiffs had taken movie films of their family
activities. The films started with the plaintiffs’ wedding and honeymoon and continued through
vacations in Mexico, Hawaii and other places, Christmas gatherings, birthdays, Little League
participation by their son, family pets, building of their home and irreplaceable pictures of
members of their family, such as the husband’s brother, who are now deceased.
Plaintiffs had 32 50-foot reels of such developed film which they wanted spliced together into
four reels for convenience of viewing. Plaintiff wife visited defendant Bartell’s camera
department, with which she had dealt as a customer for at least 10 years. She was told that such
service could be performed.
The films were put in the order which plaintiffs desired them to be spliced and so marked. They
were then placed in four separate paper bags which in turn were placed in one large bag and
delivered to the manager of Bartell. The plaintiff wife explained the desired service and the
manner in which the films were assembled in the various bags. The manager placed a film
processing packet on the bag and gave plaintiff wife a receipt which contained this language:
“We assume no responsibility beyond retail cost of film unless otherwise agreed to in writing.”
There was no discussion about the language on the receipt. Rather, plaintiff wife told the
manager, “Don’t lose these. They are my life.”
Bartell sent the film package to defendant GAF Corporation, which intended to send them to
another processing lab for splicing. Plaintiffs assumed that Bartell did this service and were
unaware of the involvement of two other firms.
The bag of films arrived at the processing lab of GAF. The manager of the GAF lab described the
service ordered and the packaging as very unusual. Yet it is undisputed that the film was in the
GAF lab at the end of one day and gone the next morning. The manager immediately searched
the garbage disposal dumpster which already had been emptied. The best guess is that the
plaintiffs’ film went from GAF’s lab to the garbage dumpster to a truck to a barge to an upSound landfill where it may yet repose.
After several inquiries to Bartell, plaintiff wife was advised to call GAF. Not surprisingly, after
being advised of the complete absence and apparent fatality of plaintiffs’ films, this lawsuit
ensued.…
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Two main issues are raised: (1) the measure of damages and (2) the effect of the exclusionary
clause appearing on the film receipt.
On damages, the defendants assign error to (a) the court’s damages instruction and (b) the
court’s failure to give their proposed damages instruction.
The standard of recovery for destruction of personal property was summarized in [McCurdy].
We recognized in McCurdy that (1) personal property which is destroyed may have a market
value, in which case that market value is the measure of damages; (2) if destroyed property has
no market value but can be replaced or reproduced, then the measure is the cost of replacement
or reproduction; (3) if the destroyed property has no market value and cannot be replaced or
reproduced, then the value to the owner is to be the proper measure of damages. However, while
not stated in McCurdy, we have held that in the third McCurdy situation, damages are not
recoverable for the sentimental value which the owner places on the property. [Citations]
The defendants argue that plaintiffs’ property comes within the second rule of McCurdy, i.e., the
film could be replaced and that their liability is limited to the cost of replacement film. Their
position is not well taken. Defendants’ proposal would award the plaintiffs the cost of acquiring
film without pictures imposed thereon. That is not what plaintiffs lost. Plaintiffs lost not merely
film able to capture images by exposure but rather film upon which was recorded a multitude of
frames depicting many significant events in their lives. Awarding plaintiffs the funds to purchase
32 rolls of blank film is hardly a replacement of the 32 rolls of images which they had recorded
over the years. Therefore the third rule of McCurdy is the appropriate measure of damages, i.e.,
the property has no market value and cannot be replaced or reproduced.
The law, in those circumstances, decrees that the measure of damages is to be determined by the
value to the owner, often referred to as the intrinsic value of the property. Restatement of Torts
s. 911 (1939).
Necessarily the measure of damages in these circumstances is the most imprecise of the three
categories. Yet difficulty of assessment is not cause to deny damages to a plaintiff whose
property has no market value and cannot be replaced or reproduced. [Citations]
The fact that damages are difficult to ascertain and measure does not diminish the loss to the
person whose property has been destroyed. Indeed, the very statement of the rule suggests the
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opposite. If one’s destroyed property has a market value, presumably its equivalent is available
on the market and the owner can acquire that equivalent property. However, if the owner cannot
acquire the property in the market or by replacement or reproduction, then he simply cannot be
made whole.
The problem is to establish the value to the owner. Market and replacement values are relatively
ascertainable by appropriate proof. Recognizing that value to the owner encompasses a
subjective element, the rule has been established that compensation for sentimental or fanciful
values will not be allowed. [Citations] That restriction was placed upon the jury in this case by
the court’s damages instruction.…
Under these rules, the court’s damages instruction was correct. In essence it allowed recovery
for the actual or intrinsic value to the plaintiffs but denied recovery for any unusual sentimental
value of the film to the plaintiffs or a fanciful price which plaintiffs, for their own special
reasons, might place thereon.…
The next issue is to determine the legal effect of the exclusionary clause which was on the film
receipt given plaintiff wife by Bartell. As noted above, it read: “We assume no responsibility
beyond retail cost of film unless otherwise agreed to in writing.”
Is the exclusionary clause valid? Defendants rely upon 2-719(3), a section of the Uniform
Commercial Code, which authorizes a limitation or exclusion of consequential damages unless
the limitation is unconscionable.
Plaintiffs, on the other hand, argue that the Uniform Commercial Code is not applicable to this
transaction.…It is now clearly established that the reach of Article 2 goes considerably beyond
the confines of that type transaction which the Code itself defines to be a “sale”; namely, the
passing of title from a party called the seller to one denominated a buyer for a price. Chief
opportunity for this expansion is found in Section 2-102, which states that the article applies to
“transactions in goods.” “Article 2 sections are finding their way into more and more decisions
involving transactions which are not sales, but which are used as substitutes for a sale or which
to a court appear to have attributes to which sales principles or at least some of them seem
appropriate for application.…Most important of these is the application of the Article’s warranty
provisions to leases, bailments, or construction contracts. Of growing importance is the
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tendency of courts to find the Section on unconscionability, Section 2-302, appropriate to
nonsales deals.”
Application of the Uniform Commercial Code to this transaction leads to defendants’ next two
contentions. First, they urge that the code’s recognition of course of dealings and trade usage
validates the exclusionary clause. Second, defendants assign error to the grounds upon which
the court found the clause to be unconscionable and therefore invalid.
Defendants contend that it is the uniform trade practice of film processors to impose an
exclusionary clause similar to that contained in Bartell’s film receipt. However, the existence of a
trade usage is to be established as a fact [Citation]. It was proved as a usage among film
processors, but not as between commercial film processors and their retail
customers.…Consequently, defendants’ reliance on trade usage to uphold the exclusionary
clause is not well founded.
As to course of dealings, the record is clear that Mrs. Mieske and the Bartell manager never
discussed the exclusionary clause. Mrs. Mieske had never read it, she viewed the numbered slip
as merely a receipt. The manager was not “too clear on what it said.” There was no showing what
was the language on any other receipt given in prior dealings between the parties. In summary,
defendants’ proof fell short of that required by the express language of 1-205(3). Defendants
contend we should apply a course of dealing standard as a matter of law, but cite no authority
for such proposition. We decline the invitation.
Defendants next assert that the trial court held the exclusionary clause to be unconscionable
without considering the rules laid down in Schroeder v. Fageol Motors, Inc., 544 P.2d 20
(1975). In Schroeder, we recognized that the term unconscionable is not defined in the Uniform
Commercial Code. We acknowledge that the code mandates the court to determine
unconscionability as a matter of law, 2-302(1). Schroeder held that numerous factors enter into
a determination of unconscionability. No one element is controlling. The court must examine all
the circumstances surrounding the transaction, including conspicuousness of the clause, prior
course of dealings between the parties, negotiations about the clause, the commercial setting
and usage of the trade. Not each element will be applicable factually to every transaction.…

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The real question is whether the court considered the necessary elements of Schroeder. A review
of the record convinces us that it did. The court had the facts, the Schroeder case was argued,
the criteria set forth therein were discussed by defendants’ counsel both on objections and on
exceptions. There was no error. Judgment affirmed.

CASE QUESTIONS

1. This case presents pretty much the same fact situation as the previous one, but it comes out
the other way. Why? What’s the difference?
2. The court said there could be “recovery for the actual or intrinsic value to the plaintiffs but
[not for] for any unusual sentimental value of the film to the plaintiffs or a fanciful price
which plaintiffs, for their own special reasons, might place thereon.” What actual value does
a role of film have if not sentimental value, and if the court were not concerned about the
sentimental value, why did it mention all the irreplaceable memories recorded on the film—
what difference would it make what was on the film if it had an ascertainable “actual value”?
3. Determining that this bailment was governed by the UCC opened up three lines of argument
for the defendant. What were they?
4. Why did the court here say the disclaimer was unconscionable?

Liability of Carrier; Limitations on Liability
Calvin Klein Ltd. v. Trylon Trucking Corp.
892 F.2d 191C.A.2 (N.Y. 1989)
Miner, J.
Defendant-appellant Trylon Trucking Corp. (“Trylon”) appeals from a judgment…in favor of
plaintiff-appellee Calvin Klein Ltd. (“Calvin Klein”) for the full value of a lost shipment of
clothing. The appeal presents a novel issue under New York law: whether a limitation of liability
agreement between a shipper and a carrier is enforceable when the shipment is lost as a result of
the carrier’s gross negligence.
The district court held that the parties’ customary limitation of liability agreement did not
extend to the shipment at issue, due to the absence of assent and consideration. The court
observed that, had there been such an agreement, the liability of the carrier for its gross
negligence would be limited. For the reasons that follow, we reverse the judgment of the district

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court, find that the parties agreed to the limitation of liability, and determine that the agreement
limits Trylon’s liability for its gross negligence.…
Trylon is a New Jersey trucking firm which engaged in the business of transporting goods from
New York City’s airports for delivery to its customers’ facilities. Calvin Klein, a New York
clothing company, had used the services of Trylon for at least three years, involving hundreds of
shipments, prior to the lost shipment at issue. In past deliveries Calvin Klein, through its
customs broker, would contact Trylon to pick up the shipment from the airport for delivery to
Calvin Klein’s facility. After completing the carriage, Trylon would forward to Calvin Klein an
invoice, which contained a limitation of liability provision as follows:
In consideration of the rate charged, the shipper agrees that the carrier shall not be liable for
more than $50.00 on any shipment accepted for delivery to one consignee unless a greater value
is declared, in writing, upon receipt at time of shipment and charge for such greater value paid,
or agreed to be paid, by the shipper.
A shipment of 2,833 blouses from Hong Kong arrived at John F. Kennedy International Airport
for Calvin Klein on March 27, 1986. Calvin Klein arranged for Trylon to pick up the shipment
and deliver it to Calvin Klein’s New Jersey warehouse. On April 2, Trylon dispatched its driver,
Jamahl Jefferson, to pick up this shipment. Jefferson signed a receipt for the shipment from
Calvin Klein’s broker. By April 2, the parties discovered that Jefferson had stolen Trylon’s truck
and its shipment. The shipment never was recovered. Calvin Klein sent a claim letter to Trylon
for the full value of the lost blouses. In the absence of any response by Trylon, Calvin Klein filed
this action…to recover $150,000, allegedly the value of the lost shipment.…
In their stipulation in lieu of a jury trial, the parties agreed that Trylon is liable to Calvin Klein
for the loss of the shipment and that Trylon was grossly negligent in the hiring and supervision
of Jefferson. They also agreed that “[t]he terms and conditions of [Trylon]’s carriage [were] that
liability for loss or damage to cargo is limited to $50 in accordance with the legend on Trylon’s
invoice forms.” Calvin Klein conceded that it was aware of this limitation of liability, and that it
did not declare a value on the blouses at the time of shipment.
The parties left at issue whether the limitation of liability clause was valid and enforceable.
Calvin Klein argued in the district court, as it does here, that the limitation clause was not
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enforceable for two reasons: no agreement existed between Calvin Klein and Trylon as to the
limitation of liability; and, if such an agreement existed, public policy would prevent its
enforcement because of Trylon’s gross negligence.
The district court applied New York law, finding that the carriage was exempt from the
Interstate Commerce Commission’s jurisdiction, being entirely within the New York City
commercial zone.…
A common carrier…under New York law is strictly liable for the loss of goods in its custody.
“Where the loss is not due to the excepted causes [that is, act of God or public enemy, inherent
nature of goods, or shipper’s fault], it is immaterial whether the carrier was negligent or not.…”
[Citations] Even in the case of loss from theft by third parties, liability may be imposed up on a
negligent common carrier. [Citation]
A shipper and a common carrier may contract to limit the carrier’s liability in cases of loss to an
amount agreed to by the parties [Citations], so long as the language of the limitation is clear, the
shipper is aware of the terms of the limitation, and the shipper can change the terms by
indicating the true value of the goods being shipped. [Citations]…(similar scheme under
Interstate Commerce Act). Such a limitation agreement is generally valid and enforceable
despite carrier negligence. The limitation of liability provision involved here clearly provides
that, at the time of delivery, the shipper may increase the limitation by written notice of the
value of the goods to be delivered and by payment of a commensurately higher fee.
The parties stipulated to the fact that the $50 limitation of liability was a term and condition of
carriage and that Calvin Klein was aware of that limitation. This stipulated fact removes the first
issue, namely whether an agreement existed as to a liability limitation between the parties, from
this case. Calvin Klein’s argument that it never previously acknowledged this limitation by
accepting only $50 in settlement of a larger loss does not alter this explicit stipulation. “[A]
stipulation of fact that is fairly entered into is controlling on the parties and the court is bound
to enforce it.” [Citations] Neither party here has argued that the stipulation was unfairly entered
into.…
The remaining issue concerns the enforceability of the limitation clause in light of Trylon’s
conceded gross negligence. The district court considered that, assuming an agreement between
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the parties as to Trylon’s liability, Trylon’s gross negligence would not avoid the enforcement of
a limitation clause.
The district court found that New York law, as opposed to federal interstate commerce law,
applies in this case. The parties do not seriously contest this choice of law. With the choice thus
unchallenged, we must apply both established New York law as well as our belief of how the New
York Court of Appeals would rule if this case were before it.…
Although the New York Court of Appeals has addressed a limitation of liability provision in the
context of a contract between an airline and a passenger, [Citation] (refusing to enforce
unilateral limitation provision for death of passenger due to defendant’s negligence), that court
has never been called upon to enforce a limitation provision in the case of a grossly negligent
common carrier of goods. The various departments of the Appellate Division of the New York
State Supreme Court have addressed whether gross negligence bars enforcement of limitations
of liability in the context of contracts for the installation, maintenance and monitoring of
burglar alarm systems and are divided on the issue. Compare [Citation] (enforcing limitation
despite gross negligence) and [Citation] (even if gross negligence were established, plaintiff’s
recovery would be limited by limitation clause) with [Citation] (limitation clause cannot limit
liability for gross negligence) and [Citation] (finding “no significant distinction” between
complete exculpation and limitation “to a nominal sum,” therefore limitation is ineffective). The
First Department distinguished between exculpatory provisions and limitation provisions,
indicating that the latter would be effective even if the former are unenforceable due to the
contracting party’s gross negligence. [Citations].…The other departments which have considered
the question applied the holding of [Citation], that “[a]greements which purport to exempt a
party from liability for willful or grossly negligent acts are contrary to public policy and are
void.”…
Absent a rule of decision formulated by the New York Court of Appeals, we are not bound by the
opinions issued by the state’s lower courts.…
In the absence of direct New York authority, we must make our best estimate as to how New
York’s highest court would rule in this case. In making that determination, we are free to
consider all the resources the highest court of the state could use, including decisions reached in
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other jurisdictions.…We believe that the New York Court of Appeals would not differentiate
between gross negligence and ordinary negligence in recognizing the validity of the limitation of
liability in this case.
Since carriers are strictly liable for loss of shipments in their custody and are insurers of these
goods, the degree of carrier negligence is immaterial. [Citation] The common carrier must
exercise reasonable care in relation to the shipment in its custody. U.C.C. § 7-309(1). Carriers
can contract with their shipping customers on the amount of liability each party will bear for the
loss of a shipment, regardless of the degree of carrier negligence. See U.C.C. § 7-309(2)
(allowing limitation of liability for losses from any cause save carrier conversion). Unlike the
parachute school student, see [Citation], or the merchant acquiring a burglar alarm, the shipper
can calculate the specific amount of its potential damages in advance, declare the value of the
shipment based on that calculation, and pay a commensurately higher rate to carry the goods, in
effect buying additional insurance from the common carrier.
In this case, Calvin Klein and Trylon were business entities with an on-going commercial
relationship involving numerous carriages of Calvin Klein’s goods by Trylon. Where such
entities deal with each other in a commercial setting, and no special relationship exists between
the parties, clear limitations between them will be enforced. [Citation]. Here, each carriage was
under the same terms and conditions as the last, including a limitation of Trylon’s liability. See
[Citation] (court enforced limitation on shipper who possessed over five years of the carrier’s
manifests which included the $50 limitation). This is not a case in which the shipper was dealing
with the common carrier for the first time or contracting under new or changed terms. Calvin
Klein was aware of the terms and was free to adjust the limitation upon a written declaration of
the value of a given shipment, but failed to do so with the shipment at issue here. Since Calvin
Klein failed to adjust the limitation, the limitation applies here, and no public policy that
dictates otherwise can be identified.
Calvin Klein now argues that the limitation is so low as to be void.…This amount is immaterial
because Calvin Klein had the opportunity to negotiate the amount of coverage by declaring the
value of the shipment.…Commercial entities can easily negotiate the degree of risk each party
will bear and which party will bear the cost of insurance. That this dispute actually involves who
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will bear the cost of insurance is illustrated by the fact that this case has been litigated not by the
principal parties, but by their insurers. Calvin Klein could have increased Trylon’s coverage by
declaring the value of its shipment, but did not do so. Calvin Klein had the opportunity to
declare a higher value and we find all of its arguments relating to the unreasonableness of the
limitation to be without merit.
We reverse and remand to the district court with instructions to enter judgment against
defendant in the sum of $50.

CASE QUESTIONS

1. Why is the federal court here trying to figure out what the New York high court would do if it
had this case in front of it?
2. Did the federal court find direct New York State law to apply?
3. What is the legal issue here?
4. What argument did Calvin Klein make as to why the $50 limitation should not be valid?
5. The common-law rule was that carriers were strictly liable. Why didn’t the court apply that
rule?
6. Would this case have come out differently if the shipper (a) were an unsophisticated in
matters of relevant business or (b) if it had never done business with Trylon before?

18.6 Summary and Exercises
Summary

Ownership and sale of goods are not the only important legal relationships involving goods. In a
modern economy, possession of goods is often temporarily surrendered without surrendering
title. This creates a bailment, which is defined as the lawful possession of goods by one who is
not the owner.
To create a bailment, the goods must be in the possession of the bailee. Possession requires
physical control and intent. Whether the owner or someone else must bear a loss often hinges on
whether the other person is or is not a bailee.
The bailee’s liability for loss depends on the circumstances. Some courts use a straightforward
standard of ordinary care. Others use a tripartite test, depending on whether the bailment was

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for the benefit of the owner (the standard then is gross negligence), for the bailee (extraordinary
care), or for both (ordinary care). Bailees may disclaim liability unless they have failed to give
adequate notice or unless public policy prohibits disclaimers. A bailee who converts the property
will be held liable as an insurer.
A bailor may have liability toward the bailee—for example, for negligent failure to warn of
hazards in the bailed property and for strict liability if the injury was caused by a dangerous
object in a defective condition.
Special bailments arise in the cases of innkeepers (who have an insurer’s liability toward their
guests, although many state statutes provide exceptions to this general rule), warehouses,
carriers, and leases.
A warehouser is defined as a person engaged in the business of storing goods for hire. The
general standard of care is the same as that of ordinary negligence. Many states have statutes
imposing a higher standard.
A common carrier—one who holds himself out to all for hire to transport goods—has an
insurer’s liability toward the goods in his possession, with five exceptions: act of God, act of
public enemy, act of public authority, negligence of shipper, and inherent nature of the goods.
Because many carriers are involved in most commercial shipments of goods, the law places
liability on the initial carrier. The carrier’s liability begins once the shipper has given all
instructions and taken all action required of it. The carrier’s absolute liability ends when it has
delivered the goods to the consignee’s place of business or residence (unless the agreement
states otherwise) or, if no delivery is required, when the consignee has been notified of the
arrival of the goods and has had a reasonable opportunity to take possession.
Commodity paper—any document of title—may be negotiated; that is, through proper
indorsements on the paper, title may be transferred without physically touching the goods. A
duly negotiated document gives the holder title to the document and to the goods, certain rights
to the goods delivered to the bailee after the document was issued, and the right to take
possession free of any defense or claim by the issuer of the document of title. Certain rules limit
the seemingly absolute right of the holder to take title better than that held by the transferor.

EXERCISES

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1. Joe Andrews delivered his quarter horse I’ll Call Ya (worth about $319,000 in 2010 dollars) to
Harold Stone for boarding and stabling. Later he asked Stone if Stone could arrange for the
horse’s transportation some distance, and Stone engaged the services of the Allen brothers
for that purpose. Andrews did not know the Allens, but Stone had previously done business
with them. On the highway the trailer with I’ll Call Ya in it became disengaged from the
Allens’ truck and rolled over. The mare, severely injured, “apparently lingered for several
hours on the side of the road before she died without veterinary treatment.” The evidence
was that the Allens had properly secured the horse’s head at the front of the trailer and used
all other equipment that a reasonably prudent person would use to secure and haul the
horse; that the ball was the proper size and in good condition; that the ball was used without
incident to haul other trailers after the accident; that Ronny Allen was driving at a safe speed
and in a safe manner immediately before the accident; that after the accident the sleeve of
the trailer hitch was still in the secured position; and that they made a reasonable effort to
obtain veterinary treatment for the animal after the accident. The court determined this was
a mutual-benefit bailment. Are the Allens liable? [1]
2. Fisher Corporation, a manufacturer of electronic equipment, delivered VCRs to Consolidated
Freightways’ warehouse in California for shipment to World Radio Inc., an electronics retailer
in Council Bluffs, Iowa. World Radio rejected the shipments as duplicative, and they were
returned to Consolidated’s terminal in Sarpy County, Nebraska, pending Fisher’s instructions.
The VCRs were loaded onto a trailer; the doors of the trailer were sealed but not padlocked,
and the trailer was parked at the south end of the terminal. Padlocks were not used on any
trailers so as not to call attention to a trailer containing expensive cargo. The doors of the
trailer faced away from the terminal toward a cyclone fence that encircled the yard. Two
weeks later, on Sunday, July 15, a supervisor checked the grounds and found nothing amiss.
On Tuesday, July 17, Consolidated’s employees discovered a 3 × 5 foot hole had been cut in
the fence near the trailer, and half the VCRs were gone; they were never recovered.
Consolidated received Fisher’s return authorization after the theft occurred. If Consolidated
is considered a carrier, it would be strictly liable for the loss; if it is considered a bailee, it is
not liable unless negligent. Which is it?
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3. Plaintiff purchased a Greyhound bus ticket in St. Petersburg, Florida, for a trip to Fort
Meyers. The bus left at 11:30 p.m. and arrived at 4:15 a.m. When Plaintiff got off the bus, she
noticed that the station and restrooms were darkened, closed, and locked. She left the
terminal to cross at a lighted service station to use the bathroom. As she walked away from
the terminal, she was attacked by an unknown person and injured. The terminal was located
in a high-crime area of Fort Meyers. Is Greyhound liable?
4. Mrs. Carter, Plaintiff, took her fur coat to Reichlin Furriers for cleaning, glazing, and storage
until the next winter season. She was given a printed receipt form on the front of which
Furrier’s employee had written “$100” as the coat’s value, though Mrs. Carter did not discuss
its value with the employee, did not know that such a value had been noted, and didn’t read
the receipt. A space for the customer’s signature on the front of the receipt was blank; below
this in prominent type was this notice: “see reverse side for terms and conditions.” On the
back was a statement that this was a storage contract and the customer would be bound by
the terms unless contrary notice was given within ten days. There were fifteen conditions,
one of which was the following: “Storage charges are based upon valuation herein declared
by the depositor and amount recoverable for loss or damage shall not exceed…the
depositor’s valuation appearing in this receipt.” Six months later, when Mrs. Carter sought to
retrieve her coat, she was informed by Furrier that it was lost. Carter sued Furrier for $450
(about $2,200 in 2010 dollars); Furrier claimed its liability was limited to $100. Who wins and
why?
5. Michael Capezzaro (Plaintiff) reported to the police that he had been robbed of $30,000 (in
2010 dollars) at gunpoint by a woman. The next day police arrested a woman with $9,800 in
her possession. Plaintiff identified her as the woman who had robbed him, and the money
was impounded as evidence. Two years later the case against her was dismissed because she
was determined to have been insane when she committed the crime, and the money in the
police property room was released to her. Plaintiff then sued the police department, which
claimed it was “obligated to return the money to [the woman] as bailor.” Who wins and
why?

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6. Harley Hightower delivered his Cadillac to Auto Auction, where it was damaged. Auto Auction
defended itself against Hightower’s claim that it was a negligent bailee by asserting (1) that
he had not met the required burden of proof that a proximate cause of the injury was Auto
Auction’s negligence because it introduced evidence that negligence of a third party was a
proximate cause of the damage to his car and (2) that it was entitled to judgment in the
absence of evidence of specific acts of negligence of the bailee. There was evidence that a
Mrs. Tune drove her automobile onto the lot to sell it and parked it where she was directed
to; that the automobiles on said lot for sale were ordinarily lined up and numbered by Auto
Auction; that Plaintiff’s Cadillac was not so parked by the auction company but was parked so
that if Mrs. Tune’s automobile continued forward it would strike Hightower’s Cadillac
broadside; that when Mrs. Tune stopped her Buick and alighted, her car rolled down the
incline on the lot toward Hightower’s car; that she attempted to stop her car but it knocked
her down and continued rolling toward appellee’s Cadillac and, finally, struck and damaged
it. Who wins and why?
7. Several student radicals led by Richard Doctor, ranked number three on the FBI’s Ten Most
Wanted list, destroyed a shipment of military cargo en route from Colorado to a military
shipping facility in Washington State. Should the carrier be liable for the loss?
8. Everlena Mitchell contracted in writing with All American Van & Storage to transport and
store her household goods and furnishings, and she was to pay all charges incurred on a
monthly basis. As security she granted All American a warehouser’s lien giving it the right to
sell the property if the charges remained unpaid for three months and if, in the opinion of
the company, such action would be necessary to protect accrued charges. Everlena fell eight
months in arrears and on October 20 she received notice that the amount owed was to be
paid by October 31, 1975. The notice also stated that if payment was not made, her goods
and furnishings would be sold on November 7, 1975. Everlena had a pending claim with the
Social Security Administration, and advised All American that she would be receiving a
substantial sum of money soon from the Social Services Administration; this was confirmed
by two government agents. However, All American would not postpone the sale. Everlena’s
property was sold on November 7, 1975, for $925.50. Near the end of November 1975,
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Everlena received approximately $5,500 (about $22,000 in 2010 dollars) from the United
States as a disability payment under the Social Security Act, and she sued All American for
improperly selling her goods. The trial court ruled for All American on summary judgment.
What result should Everlena obtain on appeal?
9. Roland delivered a shipment of desks to Security Warehousers and received from Security a
negotiable receipt. Peter broke into Roland’s office, stole the document, and forged Roland’s
signature as an indorsement, making Peter himself the holder. Peter then indorsed the
document over to Billings, who knew nothing of the theft. Does Billings get good title to the
desks?
10. Baker’s Transfer & Storage Company, Defendant, hauled household goods and personal
effects by trucks “anywhere for hire.” Its trucks did not travel on regular routes or between
established terminals; it hauled household goods and personal effects on private contracts
with the owners as and when the opportunity presented itself. Baker contracted to haul the
Klein family’s household goods from Bakersfield, California, to Hollywood. En route the goods
were destroyed by fire without Baker’s negligence. Baker’s contract provided it would
redeliver the property “damage by the elements excepted.” If Baker were a common carrier,
its liability would be statutorily limited to less than the amount ordered by the trial court; if it
were a private carrier, its liability would be either based on ordinary negligence or as the
parties’ contract provided. Working with both points, what result obtains here?

SELF-TEST QUESTIONS

1. In a bailment, the bailee
a.

must return similar goods
b. must return identical goods
c. acquires title to the goods
d. must pay for the goods
In a bailment for the benefit of a bailee, the bailee’s duty of care is

a.

slight
b. extraordinary
c. ordinary

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A disclaimer of liability by a bailee is
a.

never allowed
b. sometimes allowed
c. always allowed
d. unheard of in business
A bailor may be held liable to the bailee on
a.

a negligence theory

b. a warranty theory
c. a strict liability theory
d. all of the above
The highest duty of care is imposed on which of the following?
a.

a common carrier

b. a lessee
c. a warehouser
d. an innkeeper

SELF-TEST ANSWERS

1. b
2. b
3. b
4. d
5. a
[1] Andrews v. Allen, 724 S.W.2d 893 (Tex. Ct. App., 1987).

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