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

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Chapter 1

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

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

2.

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

3.

Explain how politics and law are related.

4.

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

5.

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

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

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

[1]

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

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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 people or groups that
have military power can also command political power to make and enforce the laws. Revolutions are
difficult and contentious, but each year there are revolts against existing political-legal authority; an
aspiration for democratic rule, or greater “rights” for citizens, is a recurring theme in politics and law.

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

EXERCISES
1.

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

2.

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

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

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

2.

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

3.

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

4.

Differentiate critical legal studies and eco-feminist legal perspectives from both natural law and legal
positivist perspectives.

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

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

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

[1]

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

The Unanimous Declaration of the Thirteen United States of America
July 4, 1776
When in the Course of human events, it becomes necessary for one people to dissolve the political bands
which have connected them with another, and to assume among the powers of the earth, the separate and
equal station to which the Laws of Nature and of Nature’s God entitle them, a decent respect to the
opinions of mankind requires that they should declare the causes which impel them to the separation.
We hold these truths to be self-evident, that all men are created equal, that they are endowed by their
Creator with certain unalienable Rights that among these are Life, Liberty and the Pursuit of Happiness.
That to secure these rights, Governments are instituted among Men, deriving their just powers from the
consent of the governed.…

The natural-law school has been very influential in American legal thinking. The idea that certain rights,
for example, are “unalienable” (as expressed in the Declaration of Independence and in the writings of
John Locke) is consistent with this view of the law. Individuals may have “God-given” or “natural” rights
that government cannot legitimately take away. Government only by consent of the governed is a natural
outgrowth of this view.
Civil disobedience—in the tradition of Henry Thoreau, Mahatma Gandhi, or Martin Luther King Jr.—
becomes a matter of morality over “unnatural” law. For example, in his “Letter from Birmingham Jail,”
Martin Luther King Jr. claims that obeying an unjust law is not moral and that deliberately disobeying an
unjust law is in fact a moral act that expresses “the highest respect for law”: “An individual who breaks a
law that conscience tells him is unjust, and who willingly accepts the penalty of imprisonment in order to
arouse the conscience of the community over its injustice, is in reality expressing the highest respect for
law.…One who breaks an unjust law must do so openly, lovingly, and with a willingness to accept the
penalty.”

[2]

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

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

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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 Eco-feminist 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. Eco-feminists would say that the same social mentality that leads to exploitation of
women is at the root of man’s exploitation and degradation of the natural environment. They would say
that male ownership of land has led to a “dominator culture,” in which man is not so much a steward of
the existing environment or those “subordinate” to him but is charged with making all that he controls
economically “productive.” Wives, children, land, and animals are valued as economic resources, and legal
systems (until the nineteenth century) largely conferred rights only to men with land. Eco-feminists
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 (eco-feminist legal theory).

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EXERCISES
1.

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

2.

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

3.

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

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

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

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

2.

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

3.

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

4.

Know the difference between criminal cases and civil cases.

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

Law: The Moral Minimums in a Democratic Society
The law does not correct (or claim to correct) every wrong that occurs in society. At a minimum, it aims to
curb the worst kind of wrongs, the kinds of wrongs that violate what might be called the “moral
minimums” that a community demands of its members. These include not only violations of criminal law
(see Chapter 6 "Criminal Law") but also torts (see Chapter 7 "Introduction to Tort Law") and broken
promises (see Chapter 8 "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—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
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whatever I want on my own property may be limited by law; I can’t, without the public’s permission,
operate an incinerator on my property and burn heavy metals, as toxic ash may be deposited throughout
the neighborhood.

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

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

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

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

•

Torts

•

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

•

Corporations

•

Partnerships

•

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

•

Securities law

•

Environmental law

•

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

•

Banking

•

Insurance

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

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
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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
(sees Chapter 7 "Introduction to Tort Law").
Some of the basic differences between civil law and criminal law cases are illustrated in Table 1.1
"Differences between Civil and Criminal Cases".

Table 1.1 Differences between Civil and Criminal Cases

Civil Cases

Criminal Cases

Parties

Plaintiff brings case; defendant must answer or lose
by default

Prosecutor brings case; defendant may
remain silent

Proof

Preponderance of evidence

Beyond a reasonable doubt

Reason

To settle disputes peacefully, usually between
private parties

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

Remedies Money damages (legal remedy)

Fines, jail, and forfeitures

Injunctions (equitable remedy)
Specific performance (equity)

Regarding plaintiffs and prosecutors, you can often tell a civil case from a criminal case by looking at the
caption of a case going to trial. If the government appears first in the caption of the case (e.g., U.S. v.
Lieberman, it is likely that the United States is prosecuting on behalf of the people. The same is true of
cases prosecuted by state district attorneys (e.g., State v. Seidel). But this is not a foolproof formula.
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
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sued, as well; people occasionally sue their state or federal government, but they can only get a trial if the
government waives its sovereign immunity and allows such suits. Warner v. U.S., for example, could be a
claim for a tax refund wrongfully withheld or for damage caused to the Warner residence by a sonic boom
from a US Air Force jet flying overhead.

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

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

•

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

•

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

•

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

•

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

•

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

In contrast, procedural laws are the rules of courts and administrative agencies. They tell us how to
proceed if there is a substantive-law problem. For example, if you drive fifty-three miles per hour in a
forty mile-per-hour zone on Main Street on a Saturday night and get a ticket, you have broken a
substantive rule of law (the posted speed limit). Just how and what gets decided in court is a matter of
procedural law. Is the police officer’s word final, or do you get your say before a judge? If so, who goes
first, you or the officer? Do you have the right to be represented by legal counsel? Does the hearing or trial
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
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questions arise.) What if you unwisely bragged to a friend at a party recently that you went a hundred
miles an hour on Main Street five years ago at half past three on a Tuesday morning? (If the prosecutor
knows of this and the “friend” is willing to testify, is it relevant to the charge of fifty-three in a forty-mileper-hour zone?)
In the United States, all state procedural laws must be fair, since the due process clause of the Fourteenth
Amendment directs that no state shall deprive any citizen of “life, liberty, or property,” without due
process of law. (The $200 fine plus court cost is designed to deprive you of property, that is, money, if you
violate the speed limit.) Federal laws must also be fair, because the Fifth Amendment to the US
Constitution has the exact same due process language as the Fourteenth Amendment. This suggests that
some laws are more powerful or important than others, which is true. The next section looks at various
types of positive law and their relative importance.

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

EXERCISES
1.

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

2.

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

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1.4 Sources of Law and Their Priority
LEARNING OBJECTIVES
1.

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

2.

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

3.

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

4.

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

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

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

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

[1]

Statutes and Treaties in Congress
In Washington, DC, the federal legislature is known as Congress and has both a House of Representatives
and a Senate. The House is composed of representatives elected every two years from various districts in
each state. These districts are established by Congress according to population as determined every ten
years by the census, a process required by the Constitution. Each state has at least one district; the most
populous state (California) has fifty-two districts. In the Senate, there are two senators from each state,
regardless of the state’s population. Thus Delaware has two senators and California has two senators, even
though California has far more people. Effectively, less than 20 percent of the nation’s population can
send fifty senators to Washington.
Many consider this to be antidemocratic. The House of Representatives, on the other hand, is directly
proportioned by population, though no state can have less than one representative.
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
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a vote) or killed in committee. If a bill is reported out, it may be passed by majority vote. Because of the
procedural differences between the House and the Senate, bills that have the same language when
proposed in both houses are apt to be different after approval by each body. A conference committee will
then be held to try to match the two versions. If the two versions differ widely enough, reconciliation of
the two differing versions into one acceptable to both chambers (House and Senate) is more difficult.
If the House and Senate can agree on identical language, the reconciled bill will be sent to the president
for signature or veto. The Constitution prescribes that the president will have veto power over any
legislation. But the two bodies can override a presidential veto with a two-thirds vote in each chamber.
In the case of treaties, the Constitution specifies that only the Senate must ratify them. When the Senate
ratifies a treaty, it becomes part of federal law, with the same weight and effect as a statute passed by the
entire Congress. The statutes of Congress are collected in codified form in the US Code. The code is
available online at http://uscode.house.gov.

Delegating Legislative Powers: Rules by Administrative Agencies
Congress has found it necessary and useful to create government agencies to administer various laws
(see Chapter 5 "Administrative Law"). The Constitution does not expressly provide for administrative
agencies, but the US Supreme Court has upheld the delegation of power to create federal agencies.
Examples of administrative agencies would include the Occupational Safety and Health Administration
(OSHA), the Environmental Protection Agency (EPA), and the Federal Trade Commission (FTC).
It is important to note that Congress does not have unlimited authority to delegate its lawmaking powers
to an agency. It must delegate its authority with some guidelines for the agency and cannot altogether
avoid its constitutional responsibilities (see Chapter 5 "Administrative Law").
Agencies propose rules in the Federal Register, published each working day of the year. Rules that are
formally adopted are published in the Code of Federal Regulations, or CFR, available online
athttp://www.access.gpo.gov/nara/cfr/cfr-table-search.html.

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

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

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

Statutes and Cases
Statutes generally have priority, or take precedence, over case law (judicial decisions). Under commonlaw judicial decisions, employers could hire young children for difficult work, offer any wage they wanted,
and not pay overtime work at a higher rate. But various statutes changed that. For example, the federal
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

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on Tariffs and Trade (GATT) and obligations made later through the World Trade Organization (WTO)
would override previous federal or state statutes.
One example of treaty obligations overriding, or taking priority over, federal statutes was the tunadolphin dispute between the United States and Mexico. The Marine Mammal Protection Act amendments
in 1988 spelled out certain protections for dolphins in the Eastern Tropical Pacific, and the United States
began refusing to allow the importation of tuna that were caught using “dolphin-unfriendly” methods
(such as purse seining). This was challenged at a GATT dispute panel in Switzerland, and the United
States lost. The discussion continued at the WTO under its dispute resolution process. In short, US
environmental statutes can be ruled contrary to US treaty obligations.
Under most treaties, the United States can withdraw, or take back, any voluntary limitation on its
sovereignty; participation in treaties is entirely elective. That is, the United States may “unbind” itself
whenever it chooses. But for practical purposes, some limitations on sovereignty may be good for the
nation. The argument goes something like this: if free trade in general helps the United States, then it
makes some sense to be part of a system that promotes free trade; and despite some temporary setbacks,
the WTO decision process will (it is hoped) provide far more benefits than losses in the long run. This
argument invokes utilitarian theory (that the best policy does the greatest good overall for society) and
David Ricardo’s theory of comparative advantage.
Ultimately, whether the United States remains a supporter of free trade and continues to participate as a
leader in the WTO will depend upon citizens electing leaders who support the process. Had Ross Perot
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
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contract law. This case would give you a cause of action under the law of most states; unless Harold Hill
had some legal excuse recognized by the applicable state’s contract law—such as his legal incompetence,
his being less than eighteen years of age, his being drunk at the time the agreement was made, or his claim
that the instruments were trumpets rather than trombones or that they were delivered too late to be of use
to him—you could expect to recover some compensation for his breaching of your agreement with him.
An old saying in the law is that the law does not deal in trifles, or unimportant issues (in Latin, de minimis
non curat lex). Not every wrong you may suffer in life will be a cause to bring a court action. If you are
stood up for a Saturday night date and feel embarrassed or humiliated, you cannot recover anything in a
court of law in the United States, as there is no cause of action (no basis in the positive law) that you can
use in your complaint. If you are engaged to be married and your spouse-to-be bolts from the wedding
ceremony, there are some states that do provide a legal basis on which to bring a lawsuit. “Breach of
promise to marry” is recognized in several states, but most states have abolished this cause of action,
either by judicial decision or by legislation. Whether a runaway bride or groom gives rise to a valid cause
of action in the courts depends on whether the state courts still recognize and enforce this nowdisappearing cause of action.
Your cause of action is thus based on existing laws, including decided cases. How closely your case “fits”
with a prior decided case raises the question of precedent.
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
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person was replacing him. The court, with no past guidelines, would have to decide whether the employee
had stated a “cause of action” against the employer. If the court decided that the case was not legally
actionable, it would dismiss the action. Future courts would then treat similar cases in a similar way. In
the process, the court might make a holding that employers could fire employees for any reason or for no
reason. This rule could be applied in the future should similar cases come up.
But suppose that an employer fired an employee for not committing perjury (lying on the witness stand in
a court proceeding); the employer wanted the employee to cover up the company's criminal or unethical
act. Suppose that, as in earlier cases, there were no applicable statutes and no contract of employment.
Courts relying on a holding or precedent that “employers may fire employees for any reason or no reason”
might rule against an employee seeking compensation for being fired for telling the truth on the witness
stand. Or it might make an exception to the general rule, such as, “Employers may generally discharge
employees for any reason or for no reason without incurring legal liability; however, employers will incur
legal liability for firing an employee who refuses to lie on behalf of the employer in a court proceeding.”
In each case (the general rule and its exception), the common-law tradition calls for the court to explain
the reasons for its ruling. In the case of the general rule, “freedom of choice” might be the major reason.
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)
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each trial or appellate judge believes in. Because judges do not always agree on first principles (i.e., they
subscribe to different schools of legal thought), there are many divided opinions in appellate opinions and
in each US Supreme Court term.

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

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disappointed and angry and wants to sue the sorority. What are her prospects of recovery in the legal
system? Explain.
[1] Rulon-Miller v. International Business Machines Corp., 162 Cal. App.3d 241, 255 (1984).

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

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

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

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

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

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

EXERCISE
1.

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

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1.6 A Sample Case
Preliminary Note to Students
Title VII of the Civil Rights Act of 1964 is a federal statute that applies to all employers whose workforce
exceeds fifteen people. The text of Title VII says that
(a) it shall be an unlawful employment practice for an employer—
(1) to fail or refuse to hire or to discharge any individual, or otherwise to discriminate against any
individual with respect to his compensation, terms, conditions, or privileges of employment, because of
such individual’s race, color, religion, sex, or natural origin.
At common law—where judges decide cases without reference to statutory guidance—employers were
generally free to hire and fire on any basis they might choose, and employees were generally free to work
for an employer or quit an employer on any basis they might choose (unless the employer and the
employee had a contract). This rule has been called “employment at will.” State and federal statutes that
prohibit discrimination on any basis (such as the prohibitions on discrimination because of race, color,
religion, sex, or national origin in Title VII) are essentially legislative exceptions to the common-law
employment-at-will rule.
In the 1970s, many female employees began to claim a certain kind of sex discrimination: sexual
harassment. Some women were being asked to give sexual favors in exchange for continued employment
or promotion (quid pro quo sexual harassment) or found themselves in a working environment that put
their chances for continued employment or promotion at risk. This form of sexual discrimination came to
be called “hostile working environment” sexual harassment.
Notice that the statute itself says nothing about sexual harassment but speaks only in broad terms about
discrimination “because of” sex (and four other factors). Having set the broad policy, Congress left it to
employees, employers, and the courts to fashion more specific rules through the process of civil litigation.
This is a case from our federal court system, which has a trial or hearing in the federal district court, an
appeal to the Sixth Circuit Court of Appeals, and a final appeal to the US Supreme Court. Teresa Harris,
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
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carefully. Here, the court wanted to resolve a difference of opinion among the various circuit courts of
appeal as to whether or not a plaintiff in a hostile-working-environment claim could recover damages
without showing “severe psychological injury.”
Harris v. Forklift Systems
510 U.S. 17 (U.S. Supreme Court 1992)
JUDGES: O’CONNOR, J., delivered the opinion for a unanimous Court. SCALIA, J., and GINSBURG, J.,
filed concurring opinions.
JUSTICE O’CONNOR delivered the opinion of the Court.
In this case we consider the definition of a discriminatorily “abusive work environment” (also known as a
“hostile work environment”) under Title VII of the Civil Rights Act of 1964, 78 Stat. 253, as amended, 42
U.S.C. § 2000e et seq. (1988 ed., Supp. III).
I
Teresa Harris worked as a manager at Forklift Systems, Inc., an equipment rental company, from April
1985 until October 1987. Charles Hardy was Forklift’s president.
The Magistrate found that, throughout Harris’ time at Forklift, Hardy often insulted her because of her
gender and often made her the target of unwanted sexual innuendoes. Hardy told Harris on several
occasions, in the presence of other employees, “You’re a woman, what do you know” and “We need a man
as the rental manager”; at least once, he told her she was “a dumbass woman.” Again in front of others, he
suggested that the two of them “go to the Holiday Inn to negotiate [Harris’s] raise.” Hardy occasionally
asked Harris and other female employees to get coins from his front pants pocket. He threw objects on the
ground in front of Harris and other women, and asked them to pick the objects up. He made sexual
innuendoes about Harris’ and other women’s clothing.
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.

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Harris then sued Forklift, claiming that Hardy’s conduct had created an abusive work environment for her
because of her gender. The United States District Court for the Middle District of Tennessee, adopting the
report and recommendation of the Magistrate, found this to be “a close case,” but held that Hardy’s
conduct did not create an abusive environment. The court found that some of Hardy’s comments
“offended [Harris], and would offend the reasonable woman,” but that they were not “so severe as to be
expected to seriously affect [Harris’s] psychological well-being. A reasonable woman manager under like
circumstances would have been offended by Hardy, but his conduct would not have risen to the level of
interfering with that person’s work performance.
“Neither do I believe that [Harris] was subjectively so offended that she suffered injury.…Although Hardy
may at times have genuinely offended [Harris], I do not believe that he created a working environment so
poisoned as to be intimidating or abusive to [Harris].”
In focusing on the employee’s psychological well-being, the District Court was following Circuit precedent.
See Rabidue v. Osceola Refining Co., 805 F.2d 611, 620 (CA6 1986), cert. denied, 481 U.S. 1041, 95 L. Ed.
2d 823, 107 S. Ct. 1983 (1987). The United States Court of Appeals for the Sixth Circuit affirmed in a brief
unpublished decision…reported at 976 F.2d 733 (1992).
We granted certiorari, 507 U.S. 959 (1993), to resolve a conflict among the Circuits on whether conduct,
to be actionable as “abusive work environment” harassment (no quid pro quo harassment issue is present
here), must “seriously affect [an employee’s] psychological well-being” or lead the plaintiff to “suffer
injury.” Compare Rabidue (requiring serious effect on psychological well-being); Vance v. Southern Bell
Telephone & Telegraph Co., 863 F.2d 1503, 1510 (CA11 1989) (same); and Downes v. FAA, 775 F.2d 288,
292 (CA Fed. 1985) (same), with Ellison v. Brady, 924 F.2d 872, 877–878 (CA9 1991) (rejecting such a
requirement).
II
Title VII of the Civil Rights Act of 1964 makes it “an unlawful employment practice for an employer…to
discriminate against any individual with respect to his compensation, terms, conditions, or privileges of
employment, because of such individual’s race, color, religion, sex, or national origin.” 42 U.S.C. § 2000e2(a) (1). As we made clear in Meritor Savings Bank, FSB v. Vinson, 477 U.S. 57 (1986), this language “is
not limited to ‘economic’ or ‘tangible’ discrimination. The phrase ‘terms, conditions, or privileges of
employment’ evinces a congressional intent ‘to strike at the entire spectrum of disparate treatment of men
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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 makings 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 a…epithet which engenders offensive feelings in an employee,” does not
sufficiently affect the conditions of employment to implicate Title VII. Conduct that is not severe or
pervasive enough to create an objectively hostile or abusive work environment—an environment that a
reasonable person would find hostile or abusive—is beyond Title VII’s purview. Likewise, if the victim
does not subjectively perceive the environment to be abusive, the conduct has not actually altered the
conditions of the victim’s employment, and there is no Title VII violation.
But Title VII comes into play before the harassing conduct leads to a nervous breakdown. A
discriminatorily abusive work environment, even one that does not seriously affect employees’
psychological well-being, can and often will detract from employees’ job performance, discourage
employees from remaining on the job, or keep them from advancing in their careers. Moreover, even
without regard to these tangible effects, the very fact that the discriminatory conduct was so severe or
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
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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, or specifically address the Equal Employment Opportunity Commission’s
new regulations on this subject, see 58 Fed. Reg. 51266 (1993) (proposed 29 CFR §§ 1609.1, 1609.2); see
also 29 CFR § 1604.11 (1993). But we can say that whether an environment is “hostile” or “abusive” can be
determined only by looking at all the circumstances. These may include the frequency of the
discriminatory conduct; its severity; whether it is physically threatening or humiliating, or a mere
offensive utterance; and whether it unreasonably interferes with an employee’s work performance. The
effect on the employee’s psychological well-being is, of course, relevant to determining whether the
plaintiff actually found the environment abusive. But while psychological harm, like any other relevant
factor, may be taken into account, no single factor is required.
III
Forklift, while conceding that a requirement that the conduct seriously affect psychological well-being is
unfounded, argues that the District Court nonetheless correctly applied the Meritor standard. We
disagree. Though the District Court did conclude that the work environment was not “intimidating or
abusive to [Harris],” it did so only after finding that the conduct was not “so severe as to be expected to
seriously affect plaintiff’s psychological well-being,” and that Harris was not “subjectively so offended that
she suffered injury,” ibid. The District Court’s application of these incorrect standards may well have
influenced its ultimate conclusion, especially given that the court found this to be a “close case.”
We therefore reverse the judgment of the Court of Appeals, and remand the case for further proceedings
consistent with this opinion.
So ordered.

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

CASE QUESTIONS
1.

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

2.

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

3.

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

4.

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

5.

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

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

EXERCISES
1.

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

2.

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

3.

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

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

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

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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.

eco-feminist 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
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

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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.

SELF-TEST ANSWERS
1.

c

2.

e

3.

a

4.

c

5.

d

6.

d

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

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

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

2.

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

3.

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

4.

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

5.

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

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

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2.1 What Is Ethics?
LEARNING OBJECTIVES
1.

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

2.

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

Most of those who write about ethics do not make a clear distinction between ethics and morality. The
question of what is “right” or “morally correct” or “ethically correct” or “morally desirable” in any
situation is variously phrased, but all of the words and phrases are after the same thing: what act is
“better” in a moral or ethical sense than some other act? People sometimes speak of morality as
something personal but view ethics as having wider social implications. Others see morality as the subject
of a field of study, that field being ethics. Ethics would be morality as applied to any number of subjects,
including journalistic ethics, business ethics, or the ethics of professionals such as doctors, attorneys, and
accountants. We will venture a definition of ethics, but for our purposes, ethics and morality will be used
as equivalent terms.
People often speak about the ethics or morality of individuals and also about the morality or ethics of
corporations and nations. There are clearly differences in the kind of moral responsibility that we can
fairly ascribe to corporations and nations; we tend to see individuals as having a soul, or at least a
conscience, but there is no general agreement that nations or corporations have either. Still, our ordinary
use of language does point to something significant: if we say that some nations are “evil” and others are
“corrupt,” then we make moral judgments about the quality of actions undertaken by the governments or
people of that nation. For example, if North Korea is characterized by the US president as part of an “axis
of evil,” or if we conclude that WorldCom or Enron acted “unethically” in certain respects, then we are
making judgments that their collective actions are morally deficient.
In talking about morality, we often use the word good; but that word can be confusing. If we say that
Microsoft is a “good company,” we may be making a statement about the investment potential of
Microsoft stock, or their preeminence in the market, or their ability to win lawsuits or appeals or to
influence administrative agencies. Less likely, though possibly, we may be making a statement about the
civic virtue and corporate social responsibility of Microsoft. In the first set of judgments, we use the
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word good but mean something other than ethical or moral; only in the second instance are we using the
word good in its ethical or moral sense.
A word such as good can embrace ethical or moral values but also non-ethical 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? Welloff? Fun to be with? Humorous? Athletic? Smart? I could answer all of those questions with a yes, yet you
would still not know any of his moral qualities. But if I said that he was honest, caring, forthright, and
diligent, volunteered in local soup kitchens, or tithed to the church, many people would see Daniel as
having certain ethical or moral qualities. If I said that he keeps the Golden Rule as well as anyone I know,
you could conclude that he is an ethical person. But if I said that he is “always in control” or “always at the
top of his game,” you would probably not make inferences or assumptions about his character or ethics.
There are three key points here:
1.

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

2. As humans, we need and value ethical people and want to be around them.
3. Saying that someone or some organization is law-abiding does not mean the same as saying a person
or company is ethical.
Here is a cautionary note: for individuals, it is far from easy to recognize an ethical problem, have a clear
and usable decision-making process to deal it, and then have the moral courage to do what’s right. All of
that is even more difficult within a business organization, where corporate employees vary in their
motivations, loyalties, commitments, and character. There is no universally accepted way for developing
an organization where employees feel valued, respected, and free to openly disagree; where the actions of
top management are crystal clear; and where all the employees feel loyal and accountable to one another.
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
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following the letter of the law. There are many professional ethics codes, primarily because people realize
that law prescribes only a minimum of morality and does not provide purpose or goals that can mean
excellent service to customers, clients, or patients.
Business ethicists have talked for years about the intersection of law and ethics. Simply put, what is legal
is not necessarily ethical. Conversely, what is ethical is not necessarily legal. There are lots of legal
maneuvers that are not all that ethical; the well-used phrase “legal loophole” suggests as much.
Here are two propositions about business and ethics. Consider whether they strike you as true or whether
you would need to know more in order to make a judgment.
•

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

•

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

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The Arthur Andersen story is even more dramatic. A major accounting firm, Andersen worked closely
with Enron in hiding its various losses through creative accounting measures. Suspiciously, Andersen’s
Houston office also did some shredding around the clock, appearing to cover up what it was doing for
Enron. A criminal case based on this shredding resulted in a conviction, later overturned by the Supreme
Court. But it was too late. Even before the conviction, many clients had found other accounting firms that
were not under suspicion, and the Supreme Court’s reversal came too late to save the company. Even
without the conviction, Andersen would have lost significant market share.
The irony of Andersen as a poster child for overly aggressive accounting practices is that the man who
founded the firm built it on integrity and straightforward practices. “Think straight, talk straight” was the
company’s motto. Andersen established the company’s reputation for integrity over a hundred years ago
by refusing to play numbers games for a potentially lucrative client.
Maximizing profits while being legally compliant is not a very inspiring goal for a business. People in an
organization need some quality or excellence to strive for. By focusing on pushing the edge of what is
legal, by looking for loopholes in the law that would help create short-term financial gain, companies have
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

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was it? Explain to a friend of yours—or a classmate—why you think it was right. Does your friend
agree? Why or why not? What is the basic principle that forms the basis for your judgment that it was
right?
3.

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

4.

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

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2.2 Major Ethical Perspectives
LEARNING OBJECTIVES
1.

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

2.

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

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

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

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This statement describes “act utilitarianism”—which action among various options will deliver the
greatest good to society? “Rule utilitarianism” is a slightly different version; it asks, what rule or principle,
if followed regularly, will create the greatest good?
Notice that the emphasis is on finding the best possible results and that the assumption is that we can
measure the utilities involved. (This turns out to be more difficult that you might think.) Notice also that
“the sum total of utilities” clearly implies that in doing utilitarian analysis, we cannot be satisfied if an act
or set of acts provides the greatest utility to us as individuals or to a particular corporation; the test is,
instead, whether it provides the greatest utility to society as a whole. Notice that the theory does not tell us
what kinds of utilities may be better than others or how much better a good today is compared with a
good a year from today.
Whatever its difficulties, utilitarian thinking is alive and well in US law and business. It is found in such
diverse places as cost-benefit analysis in administrative and regulatory rules and calculations,
environmental impact studies, the majority vote, and 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
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not correcting a feature on their Pinto models that they knew could cause death or injury. General
Motors was often taken to task by juries that came to understand that the company would not recall
or repair known and dangerous defects because it seemed more profitable not to. In 2010, Toyota
learned the same lesson.
4. Underestimating the cost or harm of a certain decision to someone else or some other group of
people.
5.

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

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

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

Social Justice Theory and Social Contract Theory
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
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Governance") also reject the notion that a corporation has a duty to give to unmet needs in society,
believing that the government should play that role. Even the most dedicated free-market capitalist will
often admit the need for some government and some forms of welfare—Social Security, Medicare,
assistance to flood-stricken areas, help for AIDs patients—along with some public goods (such as defense,
education, highways, parks, and support of key industries affecting national security).
People who do not see the need for public goods (including laws, court systems, and the government
goods and services just cited) often question why there needs to be a government at all. One response
might be, “Without government, there would be no corporations.” Thomas Hobbes believed that people in
a “state of nature” would rationally choose to have some form of government. He called this
the social contract, where people give up certain rights to government in exchange for security and
common benefits. In your own lives and in this course, you will see an ongoing balancing act between
human desires for freedom and human desires for order; it is an ancient tension. Some commentators
also see a kind of social contract between corporations and society; in exchange for perpetual duration
and limited liability, the corporation has some corresponding duties toward society. Also, if a corporation
is legally a “person,” as the Supreme Court reaffirmed in 2010, then some would argue that if this
corporate person commits three felonies, it should be locked up for life and its corporate charter revoked!
Modern social contract theorists, such as Thomas Donaldson and Thomas Dunfee (Ties that Bind, 1999),
observe that various communities, not just nations, make rules for the common good. Your college or
school is a community, and there are communities within the school (fraternities, sororities, the folks
behind the counter at the circulation desk, the people who work together at the university radio station,
the sports teams, the faculty, the students generally, the gay and lesbian alliance) that have rules, norms,
or standards that people can buy into or not. If not, they can exit from that community, just as we are free
(though not without cost) to reject US citizenship and take up residence in another country.
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
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organic changes. Ideally, the social contract struck by citizens and the government allows for certain
fundamental rights such as those we enjoy in the United States, but it need not. People can give up
freedom-oriented rights (such as the right of free speech or the right to be free of unreasonable searches
and seizures) to secure order (freedom from fear, freedom from terrorism). For example, many citizens in
Russia now miss the days when the Kremlin was all powerful; there was less crime and more equality and
predictability to life in the Soviet Union, even if there was less freedom.
Thus the rights that people have—in positive law—come from whatever social contract exists in the
society. This view differs from that of the deontologists and that of the natural-law thinkers such as
Gandhi, Jesus, or Martin Luther King Jr., who believed that rights come from God or, in less religious
terms, from some transcendent moral order.
Another important movement in ethics and society is the communitarian outlook. Communitarians
emphasize that rights carry with them corresponding duties; that is, there cannot be a right without a
duty. Interested students may wish to explore the work of Amitai Etzioni. Etzioni was a founder of the
Communitarian Network, which is a group of individuals who have come together to bolster the moral,
social, and political environment. It claims to be nonsectarian, nonpartisan, and international in scope.
The relationship between rights and duties—in both law and ethics—calls for some explanations:
1.

If you have a right of free expression, the government has a duty to respect that right but can put
reasonable limits on it. For example, you can legally say whatever you want about the US president,
but you can’t get away with threatening the president’s life. Even if your criticisms are strong and
insistent, you have the right (and our government has the duty to protect your right) to 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 non-basic 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) modesty, or pleasure in personal conduct; (13)
righteous indignation, or getting angry at the right things and in the right amounts; and (14) justice.
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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 values has been
identified and that the values can be meaningfully applied to a variety of personal and corporate
decisions.
To simplify, let’s say that there are ethical and non-ethical qualities among people in the United States.
When you ask people what kinds of qualities they admire in others or in themselves, they may say wealth,
power, fitness, sense of humor, good looks, intelligence, musical ability, or some other quality. They may
also value honesty, caring, fairness, courage, perseverance, diligence, trustworthiness, or integrity. The
qualities on the second list have something in common—they are distinctively ethical characteristics. That
is, they are commonly seen as moral or ethical qualities, unlike the qualities on the first list. You can be,
like the Athenian Alcibiades, brilliant but unprincipled, or, like some political leaders today, powerful but
dishonest, or wealthy but uncaring. You can, in short, have a number of admirable qualities (brilliance,
power, wealth) that are not per se virtuous. Just because Harold is rich or good-looking or has a good
sense of humor does not mean that he is ethical. But if Harold is honest and caring (whether he is rich or
poor, humorous or humorless), people are likely to see him as ethical.
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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, 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.
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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

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a selective recall, still not notifying NHTSA, which has its own experts and the authority to order XYZ to
do a full recall of all affected models.
Experts have advised XYZ that standard failure-analysis methodology requires that the company obtain
absolutely every XYZ vehicle that has experienced sudden acceleration, using microscopic analysis of all
critical components of the electronic system. The company does not wish to take that advice, as it would
be—as one top executive put it—“too time-consuming and expensive.”
1.

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

2.

What would Kant advise XYZ to do? Explain.

3.

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

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

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2.3 An Ethical Decision Model
LEARNING OBJECTIVE
1.

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

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

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

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

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

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

The Core Values
Here are the core values and their subcomponents as developed by the Josephson Institute of Ethics.
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
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trust. Demonstrate integrity—stand up for what you believe, walk the walk as well as talking the talk; be
what you seem to be; show commitment and courage. Be loyal—stand by your family, friends, co-workers,
community, and nation; be discreet with information that comes into your hands; don’t spread rumors or
engage in harmful gossip; don’t violate your principles just to win friendship or approval; don’t ask a
friend to do something that is wrong. Keep promises—keep your word, honor your commitments, and pay
your debts; return what you borrow.
Respect: Judge people on their merits, not their appearance; be courteous, polite, appreciative, and
accepting of differences; respect others’ right to make decisions about their own lives; don’t abuse,
demean, mistreat anyone; don’t use, manipulate, exploit, or take advantage of others.
Responsibility: Be accountable—think about the consequences on yourself and others likely to be
affected before you act; be reliable; perform your duties; take responsibility for the consequences of your
choices; set a good example and don’t make excuses or take credit for other people’s work. Pursue
excellence: Do your best, don’t quit easily, persevere, be diligent, make all you do worthy of pride.
Exercise self-restraint—be disciplined, know the difference between what you have a right to do and what
is right to do.
Fairness: Treat all people fairly, be open-minded; listen; consider opposing viewpoints; be consistent;
use only appropriate considerations; don’t let personal feelings improperly interfere with decisions; don’t
take unfair advantage of mistakes; don’t take more than your fair share.
Caring: Show you care about others through kindness, caring, sharing, compassion, and empathy; treat
others the way you want to be treated; don’t be selfish, mean, cruel, or insensitive to others’ feelings.
Citizenship: Play by the rules, obey laws; do your share, respect authority, stay informed, vote, protect
your neighbors, pay your taxes; be charitable, help your community; protect the environment, conserve
resources.
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.

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That said, it does not follow that students (or managers) would necessarily act in accord with the results of
the core values decision process. There are many psychological pressures and organizational constraints
that place limits on people both individually and in organizations. These pressures and constraints tend to
compromise ideal or the most ethical solutions for individuals and for organizations. For a business, one
essential problem is that ethics can cost the organization money or resources, at least in the short term.
Doing the most ethical thing will often appear to be something that fails to maximize profits in the short
term or that may seem pointless because if you or your organization acts ethically, others will not, and
society will be no better off, anyway.

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

EXERCISE
1.

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

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2.4 Corporations and Corporate Governance
LEARNING OBJECTIVES
1.

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

2.

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

3.

Discern and describe the ethical challenges for corporate cultures.

4.

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

Legal Organization of the Corporation
Figure 2.1 Corporate Legal Structures

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

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

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same 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 mean 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

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charity, his church, his clubs, his city, his country. He may feel impelled by these responsibilities to devote
part of his income to causes he regards as worthy, to refuse to work for particular corporations, even to
leave his job…But in these respects he is acting as a principal, not an agent; he is spending his own money
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 non-shareholder interests.

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

Table 2.1 The Stakes of Various Stakeholders

Managers

Ownership

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

Directors who
own stock
Shareholders
Salaried
managers
Creditors
Suppliers

Economic
Dependence

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

Employees
Local
communities
Communities

Social Interests

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

Government
Media

Corporate Culture and Codes of Ethics
A corporation is a “person” capable of suing, being sued, and having rights and duties in our legal system.
(It is a legal or juridical person, not a natural person, according to our Supreme Court.) Moreover, many
corporations have distinct cultures and beliefs that are lived and breathed by its members. Often, the
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.
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Ethical Leadership Is Top-Down
People in an organization tend to watch closely what the top managers do and say. Regardless of
managers’ talk about ethics, employees quickly learn what speech or actions are in fact rewarded. If the
CEO is firm about acting ethically, others in the organization will take their cues from him or her. People
at the top tend to set the target, the climate, the beliefs, and the expectations that fuel behavior.

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

[1]

Again, we see that the manager is

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

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

[2]

When Sherron Watkins sent Ken Lay a

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

[3]

Ethics Codes
Without strong leadership and a willingness to listen to bad news as well as good news, managers do not
have the feedback necessary to keep the organization healthy. Ethics codes have been put in place—partly
in response to federal sentencing guidelines and partly to encourage feedback loops to top management.
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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 is 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 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.
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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 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.

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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 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.

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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 make right,” or that power is the ultimate measure of right and wrong.

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

[7]

The “conscious business” has a purpose that goes beyond maximizing profits. It is designed to maximize
profits but is focused more on its higher purpose and does not fixate solely on the bottom line. To do so, it
focuses on delivering value to all its stakeholders, harmonizing as best it can the interests of consumers,
partners, investors, the community, and the environment. This requires that company managers take a
“servant leadership” role, serving as stewards to the company’s deeper purpose and to the company’s
stakeholders.
Conscious business leaders serve as such stewards, focusing on fulfilling the company’s purpose,
delivering value to its stakeholders, and facilitating a harmony of interests, rather than on personal gain
and self-aggrandizement. Why is this refocusing needed? Within the standard profit-maximizing model,
corporations have long had to deal with the “agency problem.” Actions by top-level managers—acting on
behalf of the company—should align with the shareholders, but in a culture all about winning and money,
managers sometimes act in ways that are self-aggrandizing and that do not serve the interests of
shareholders. Laws exist to limit such self-aggrandizing, but the remedies are often too little and too late
and often catch only the most egregious overreaching. Having a culture of servant leadership is a much
better way to see that a company’s top management works to ensure a harmony of interests.
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[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] Find Law, Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron
Corp., February 1, 2002, accessed April 5, 2011,http://news.findlaw.com/wsj/docs/enron/sicreport.
[6] Steven Pearlstein, “Debating the Enron Effect,” Washington Post, February 17, 2002.
[7] Milton Friedman, John Mackey, and T. J. Rodgers, “Rethinking the Social Responsibility of Business,”
Reason.com, October 2005,http://reason.com/archives/2005/10/01/rethinking-the-social-responsi.

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

EXERCISES
1.

Consider again Milton Friedman’s article.

a.

What does Friedman mean by “ethical custom”?

b.

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

c.

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

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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.
b.

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

If Kant were his second-in-command and advising him on ethical matters, would he have
approved of Mr. Hardy’s behavior? Why or why not?
Consider the behaviors alleged by Ms. Harris and assume for a moment that they are all true. In

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

SELF-TEST QUESTIONS
1.

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

a.

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

careful attention to key stakeholders.

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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.
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.

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b.

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

c.

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

d.

Kantian duties take precedence over cost-benefit analyses.

SELF-TEST ANSWERS
1.

c

2.

d

3.

d

4.

c

5.

c

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Chapter 3
Courts and the Legal Process
LEARNING OBJECTIVES
After reading this chapter, you should be able to do the following:
1.

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

2.

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

3.

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

4.

Describe two alternatives to litigation: mediation and arbitration.

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

Robinson v. Audi
Harry and Kay Robinson purchased a new Audi automobile from Seaway Volkswagen, Inc. (Seaway), in
Massena, New York, in 1976. The following year the Robinson family, who resided in New York, left that
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state for a new home in Arizona. As they passed through Oklahoma, another car struck their Audi in the
rear, causing a fire that severely burned Kay Robinson and her two children. Later on, the Robinsons
brought a products-liability action in the District Court for Creek County, Oklahoma, claiming that their
injuries resulted from the defective design and placement of the Audi’s gas tank and fuel system. They
sued numerous defendants, including the automobile’s manufacturer, Audi NSU Auto Union
Aktiengesellschaft (Audi); its importer, Volkswagen of America, Inc. (Volkswagen); its regional
distributor, World-Wide Volkswagen Corp. (World-Wide); and its retail dealer, Seaway.
Should the Robinsons bring their action in state court or in federal court? Over which of the defendants
will the court have personal jurisdiction?

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

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

2.

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

3.

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

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

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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-called diversity of citizenship jurisdiction (or diversity jurisdiction). A citizen of New
Jersey may sue a citizen of New York over a contract dispute in federal court, but if both were citizens of
New Jersey, the plaintiff would be limited to the state courts. The Constitution established diversity
jurisdiction because it was feared that local courts would be hostile toward people from other states and
that they would need separate courts. In 2009, nearly a third of all lawsuits filed in federal court were
based on diversity of citizenship. In these cases, the federal courts were applying state law, rather than
taking federal question jurisdiction, where federal law provided the basis for the lawsuit or where the
United States was a party (as plaintiff or defendant).
Why are there so many diversity cases in federal courts? Defense lawyers believe that there is sometimes a
“home-court advantage” for an in-state plaintiff who brings a lawsuit against a nonresident in his local
state court. The defense attorney is entitled to ask for removal to a federal court where there is diversity.
This fits with the original reason for diversity jurisdiction in the Constitution—the concern that judges in
one state court would favor the in-state plaintiff rather than a nonresident defendant. Another reason
there are so many diversity cases is that plaintiffs’ attorneys know that removal is common and that it will
move the case along faster by filing in federal court to begin with. Some plaintiffs’ attorneys also find
advantages in pursuing a lawsuit in federal court. Federal court procedures are often more efficient than
state court procedures, so that federal dockets are often less crowded. This means a case will get to trial
faster, and many lawyers enjoy the higher status that comes in practicing before the federal bench. In
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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 18,000plus limited jurisdiction courts, which are estimated to hear more than 80 percent of all cases.
One familiar limited jurisdiction court is the small claims court, with jurisdiction to hear civil cases
involving claims for amounts ranging between $1,000 and $5,000 in about half the states and for
considerably less in the other states ($500 to $1,000). The advantage of the small claims court is that its
procedures are informal, it is often located in a neighborhood outside the business district, it is usually
open after business hours, and it is speedy. Lawyers are not necessary to present the case and in some
states are not allowed to appear in court.

General Jurisdiction Courts
All other civil and criminal cases are heard in the general trial courts, or courts of general jurisdiction.
These go by a variety of names: superior, circuit, district, or common pleas court (New York calls its
general trial court the supreme court). These are the courts in which people seek redress for incidents
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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 was commercial cases, and slightly
over 10 percent were devoted to car accident cases and other torts (as discussed in Chapter 7
"Introduction to Tort Law").
Most states have specialized courts that hear only a certain type of case, such as landlord-tenant disputes
or probate of wills. Decisions by judges in specialized courts are usually final, although any party
dissatisfied with the outcome may be able to get a new trial in a court of general jurisdiction. Because
there has been one trial already, this is known as a trial de novo. It is not an appeal, since the case
essentially starts over.

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

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

Courts of Appeal
Cases from the district courts can then be appealed to the circuit courts of appeal, of which there are
thirteen (Figure 3.1 "The Federal Judicial Circuits"). Each circuit oversees the work of the district courts in
several states. For example, the US Court of Appeals for the Second Circuit hears appeals from district
courts in New York, Connecticut, and Vermont. The US Court of Appeals for the Ninth Circuit hears
appeals from district courts in California, Oregon, Nevada, Montana, Washington, Idaho, Arizona, Alaska,
Hawaii, and Guam. The US Court of Appeals for the District of Columbia Circuit hears appeals from the
district court in Washington, DC, as well as from numerous federal administrative agencies (see Chapter 5
"Administrative Law"). The US Court of Appeals for the Federal Circuit, also located in Washington, hears
appeals in patent and customs cases. Appeals are usually heard by three-judge panels, but sometimes
there will be a rehearing at the court of appeals level, in which case all judges sit to hear the case “en
banc.”
There are also several specialized courts in the federal judicial system. These include the US Tax Court,
the Court of Customs and Patent Appeals, and the Court of Claims.
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United States Supreme Court
Overseeing all federal courts is the US Supreme Court, in Washington, DC. It consists of nine justices—the
chief justice and eight associate justices. (This number is not constitutionally required; Congress can
establish any number. It has been set at nine since after the Civil War.) The Supreme Court has selective
control over most of its docket. By law, the cases it hears represent only a tiny fraction of the cases that are
submitted. In 2008, the Supreme Court had numerous petitions (over 7,000, not including thousands of
petitions from prisoners) but heard arguments in only 87 cases. The Supreme Court does not sit in panels.
All the justices hear and consider each case together, unless a justice has a conflict of interest and must
withdraw from hearing the case.

Figure 3.1 The Federal Judicial Circuits

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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?

3.

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

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3.2 The Problem of Jurisdiction
LEARNING OBJECTIVES
1.

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

2.

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

3.

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

4.

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

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

The Federal-State Balance: Federalism
State courts have their origins in colonial era courts. After the American Revolution, state courts
functioned (with some differences) much like they did in colonial times. The big difference after 1789 was
that state courts coexisted with federal courts. Federalism was the system devised by the nation’s founders
in whom power is shared between states and the federal government. This sharing requires a division of
labor between the states and the federal government. It is Article III of the US Constitution that spells out
the respective spheres of authority (jurisdiction) between state and federal courts.

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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 beginnings of a tort case, with negligence as a primary
element of the claim, and state courts have routinely dealt with this kind of claim, from British colonial
times through Independence and to the present. (See also 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
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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 re-file in the correct court system. Such cases will be
routinely dismissed, regardless of how deserving the plaintiff might be in his quest for justice. (The
plaintiff’s only remedy at that point would be to sue his lawyer for negligence for failing to mind the clock
and get to the right court in time!)

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

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.

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Other cases specified by federal statute. Any other cases specified by a federal statute where
Congress declares that federal courts will have exclusive jurisdiction.

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

Summary of Rules on Subject Matter Jurisdiction
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.

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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 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?

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(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 (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.
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But now change the facts only slightly: Acme is incorporated in Delaware but has its principal place of
business in Phoenix, Arizona. Unless Mr. Coyote has a federal law he is using as a basis for his claims
against Acme, his attempt to get a federal court to hear and decide the case will fail. It will fail because
there is not complete diversity of citizenship between the plaintiff and the defendant.

Robinson v. Audi

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

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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 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.

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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.”
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

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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 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

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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.
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
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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.
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.

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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 long-arm statutes). The
Supreme Court has long recognized various bases for judging whether such process is fair.
1.

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

2. Domicile. The defendant is a permanent resident of that state.
3. Event. The defendant did something in that state, related to the lawsuit, that makes it fair for the state
to say, “Come back and defend!”
4. Service of process within the state will effectively provide personal jurisdiction over the nonresident.

Again, let’s consider Mrs. Robinson and her children in the Audi accident. She could file a lawsuit
anywhere in the country. She could file a lawsuit in Arizona after she establishes residency there. But
while the Arizona court would have subject matter jurisdiction over any products-liability claim (or any
claim that was not required to be heard in a federal court), the Arizona court would face an issue of “in
personam jurisdiction,” or personal jurisdiction: under the due process clause of the Fourteenth
Amendment, each state must extend due process to citizens of all of the other states. Because fairness is

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essential to due process, the court must consider whether it is fair to require an out-of-state defendant to
appear and defend against a lawsuit that could result in a judgment against that defendant.
Almost every state in the United States has a statute regarding personal jurisdiction, instructing judges
when it is permissible to assert personal jurisdiction over an out-of-state resident. These are called longarm statutes. But no state can reach out beyond the limits of what is constitutionally permissible under
the Fourteenth Amendment, which binds the states with its proviso to guarantee the due process rights of
the citizens of every state in the union. The “minimum contacts” test in Burger King v.
Rudzewicz (Section 3.9 "Cases") tries to make the fairness mandate of the due process clause more
specific. So do other tests articulated in the case (such as “does not offend traditional notions of fair play
and substantial justice”). These tests are posed by the Supreme Court and heeded by all lower courts in
order to honor the provisions of the Fourteenth Amendment’s due process guarantees. These tests are in
addition to any state long-arm statute’s instructions to courts regarding the assertion of personal
jurisdiction over nonresidents.

Choice of Law and Choice of Forum Clauses
In a series of cases, the Supreme Court has made clear that it will honor contractual choices of parties in a
lawsuit. Suppose the parties to a contract wind up in court arguing over the application of the contract’s
terms. If the parties are from two different states, the judge may have difficulty determining which law to
apply (see Table 3.1 "Sample Conflict-of-Law Principles"). But if the contract says that a particular state’s
law will be applied if there is a dispute, then ordinarily the judge will apply that state’s law as a rule of
decision in the case. For example, Kumar Patel (a Missouri resident) opens a brokerage account with
Goldman, Sachs and Co., and the contractual agreement calls for “any disputes arising under this
agreement” to be determined “according to the laws of the state of New York.” When Kumar claims in a
Missouri court that his broker is “churning” his account, and, on the other hand, Goldman, Sachs claims
that Kumar has failed to meet his margin call and owes $38,568.25 (plus interest and attorney’s fees), the
judge in Missouri will apply New York law based on the contract between Kumar and Goldman, Sachs.
Ordinarily, a choice-of-law clause will be accompanied by a choice-of-forum clause. In a choice-of-forum
clause, the parties in the contract specify which court they will go to in the event of a dispute arising under
the terms of contract. For example, Harold (a resident of Virginia) rents a car from Alamo at the Denver
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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 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

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letter, which is required before a Title VII action can be brought to court. Can she file a complaint that
will be heard by a state court?
3.

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

4.

Suppose Mr. and Mrs. Robinson find in the original paperwork with Seaway Volkswagen that there is a
contractual agreement with a provision that says “all disputes arising between buyer and Seaway
Volkswagen will be litigated, if at all, in the county courts of Westchester County, New York.” Will the
Oklahoma court take personal jurisdiction over Seaway Volkswagen, or will it require the Robinsons to
litigate their claim in New York?

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3.3 Motions and Discovery
LEARNING OBJECTIVES
1.

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

2.

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

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

Initial Pleadings and Motions to Dismiss
The first papers filed in a lawsuit are called the pleadings. These include the plaintiff’s complaint and then
(usually after thirty or more days) the answer or response from the defendant. The answer may be
coupled with a counterclaim against the plaintiff. (In effect, the defendant becomes the plaintiff for the
claims she has against the original plaintiff.) The plaintiff may reply to any counterclaim by the defendant.
State and federal rules of civil procedure require that the complaint must state the nature of the plaintiff’s
claim, the jurisdiction of the court, and the nature of the relief that is being asked for (usually an award of
money, but sometimes an injunction, or a declaration of legal rights). In an answer, the defendant will
often deny all the allegations of the complaint or will admit to certain of its allegations and deny others.

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A complaint and subsequent pleadings are usually quite general and give little detail. Cases can be decided
on the pleadings alone in the following situations: (1) If the defendant fails to answer the complaint, the
court can enter a default judgment, awarding the plaintiff what he seeks. (2) The defendant can move to
dismiss the complaint on the grounds that the plaintiff failed to “state a claim on which relief can be
granted,” or on the basis that there is no subject matter jurisdiction for the court chosen by the plaintiff,
or on the basis that there is no personal jurisdiction over the defendant. The defendant is saying, in effect,
that even if all the plaintiff’s allegations are true, they do not amount to a legal claim that can be heard by
the court. For example, a claim that the defendant induced a woman to stop dating the plaintiff (a socalled alienation of affections cause of action) is no longer actionable in US state courts, and any court will
dismiss the complaint without any further proceedings. (This type of dismissal is occasionally still called a
demurrer.)
A third kind of dismissal can take place on a motion for summary judgment. If there is no triable question
of fact or law, there is no reason to have a trial. For example, the plaintiff sues on a promissory note and,
at deposition (an oral examination under oath), the defendant admits having made no payment on the
note and offers no excuse that would be recognizable as a reason not to pay. There is no reason to have a
trial, and the court should grant summary judgment.

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

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few drinks under my belt.” Also, Mrs. Ferlito admits that she never reads product instructions from
manufacturers. If the case is brought in a state where contributory negligence is the law, on what
basis can Johnson & Johnson have the case dismissed before trial?

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
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before this stage; perhaps 85 percent of all civil cases end before trial, and more than 90 percent of
criminal prosecutions end with a guilty plea.

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

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

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

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

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

EXERCISES
1.

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

2.

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

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3.5 Judgment, Appeal, and Execution
LEARNING OBJECTIVES
1.

Understand the post-trial process—how appellate courts process appeals.

2.

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

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

Appeal
If the loser’s motion for a new trial or a judgment n.o.v. is denied, the losing party may appeal but must
ordinarily post a bond sufficient to ensure that there are funds to pay the amount awarded to the winning
party. In an appeal, the appellant aims to show that there was some prejudicial error committed by the
trial judge. There will be errors, of course, but the errors must be significant (i.e., not harmless). The basic
idea is for an appellate court to ensure that a reasonably fair trial was provided to both sides. Enforcement

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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. 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.

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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 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

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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 Goldberg’s.
(Barr was an especially good candidate for surrogate motherhood: she had borne two perfect
children and at age 28 drinks no wine, does not smoke or use drugs of any kind, practices yoga,
and maintains a largely vegetarian diet with just enough meat to meet the needs of the fetus
within.)
The Goldberg’s have asked the judge for an order compelling Penelope to give up the baby, who
was five days old when the lawsuit was filed. The baby is now a month old as the judge looks in
vain for guidance from any Nevada statute, federal statute, or any prior case in Nevada that
addressed the issue of surrogate motherhood. He does find several well-reasoned cases, one
from New Jersey, one from Michigan, and one from Oregon. Are any of these “precedent” that
he must follow? May he adopt the reasoning of any of these courts, if he should find that
reasoning persuasive?

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

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

2.

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

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

Case or Controversy: Standing to Sue
Article III of the US Constitution provides limits to federal judicial power. For some cases, the Supreme
Court has decided that it has no power to adjudicate because there is no “case or controversy.” For
example, perhaps the case has settled or the “real parties in interest” are not before the court. In such a
case, a court might dismiss the case on the grounds that the plaintiff does not have “standing” to sue.
For example, suppose you see a sixteen-wheel moving van drives 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

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to sue, because she has made the decision to never deal with lawyers if at all possible. Incensed, you
decide to sue on her behalf. But you will not have standing to sue because your person or property was not
directly injured by the moving van. Standing means that only the person whose interests are directly
affected has the legal right to sue.
The standing doctrine is easy to understand in straightforward cases such as this but is often a fairly
complicated matter. For example, can fifteen or more state attorneys general bring a lawsuit for a
declaratory judgment that the health care legislation passed in 2010 is unconstitutional? What particular
injury have they (or the states) suffered? Are they the best set of plaintiffs to raise this issue? Time—and
the Supreme Court—will tell.

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
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the Federal Rules of Civil Procedure (Rule 23) and in the separate codes of civil procedure in the states.
These rules differ among themselves and are often complex, but in general anyone can file a class action in
an appropriate case, subject to approval of the court. Once the class is “certified,” or judged to be a legally
adequate group with common injuries, the lawyers for the named plaintiffs become, in effect, lawyers for
the entire class.
Usually a person who doesn’t want to be in the class can decide to leave. If she does, she will not be
included in an eventual judgment or settlement. But a potential plaintiff who is included in the class
cannot, after a final judgment is awarded, seek to re-litigate 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.

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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?

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.,
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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.

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

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

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3.8 Alternative Means of Resolving Disputes
LEARNING OBJECTIVES
1.

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

2.

Describe the differences between arbitration and mediation.

3.

Explain why arbitration is final and binding.

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

Arbitration
Beginning around 1980, a movement toward alternative dispute resolution began to gain force throughout
the United States. Bar associations, other private groups, and the courts themselves wanted to find
quicker and cheaper ways for litigants and potential litigants to settle certain types of quarrels than
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through the courts. As a result, neighborhood justice centers or dispute resolution centers have sprung up
in communities. These are where people can come for help in settling disputes, of both civil and criminal
nature, that should not consume the time and money of the parties or courts in lengthy proceedings.
These alternative forums use a variety of methods, including arbitration, mediation, and conciliation, to
bring about agreement or at least closure of the dispute. These methods are not all alike, and their
differences are worth noting.
Arbitration is a type of adjudication. The parties use a private decision maker, the arbitrator, and the rules
of procedure are considerably more relaxed than those that apply in the courtroom. Arbitrators might be
retired judges, lawyers, or anyone with the kind of specialized knowledge and training that would be
useful in making a final, binding decision on the dispute. In a contractual relationship, the parties can
decide even before a dispute arises to use arbitration when the time comes. Or parties can decide after a
dispute arises to use arbitration instead of litigation. In a pre-dispute 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.
Much arbitration 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.
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Under both federal and state law, arbitration is favored, and a decision rendered by an arbitrator is
binding by law and may be enforced by the courts. The arbitrator’s decision is final and binding, with very
few exceptions (such as fraud or manifest disregard of the law by the arbitrator or panel of arbitrators).
Saying that arbitration is favored means that if you have agreed to arbitration, you can’t go to court if the
other party wants you to arbitrate. Under the Federal Arbitration Act, the other party can go to court and
get a stay against your litigation and also get an order compelling you to go to arbitration.

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

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?

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2.

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

3.

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

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.

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Rudzewicz and MacShara bought $165,000 worth of restaurant equipment from Burger King’s Davmor
Industries division in Miami. But before the final agreements were signed, the parties began to disagree
over site-development fees, building design, computation of monthly rent, and whether Rudzewicz and
MacShara could assign their liabilities to a corporation they had formed. Negotiations took place between
Rudzewicz, MacShara, and the Birmingham regional office; but Rudzewicz and MacShara learned that the
regional office had limited decision-making power and turned directly to Miami headquarters for their
concerns. The final agreement was signed by June 1979 and provided that the franchise relationship was
governed by Florida law, and called for payment of all required fees and forwarding of all relevant notices
to Miami headquarters.
The Drayton Plains restaurant did fairly well at first, but a recession in late 1979 caused the franchisees to
fall far behind in their monthly payments to Miami. Notice of default was sent from Miami to Rudzewicz,
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
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activities at residents of the forum, and the litigation results from alleged injuries that “arise out of or
relate to” those activities, Thus “[t]he forum State does not exceed its powers under the Due Process
Clause if it asserts personal jurisdiction over a corporation that delivers its products into the stream of
commerce with the expectation that they will be purchased by consumers in the forum State” and those
products subsequently injure forum consumers. Similarly, a publisher who distributes magazines in a
distant State may fairly be held accountable in that forum for damages resulting there from an allegedly
defamatory story.…
…[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
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communications across state lines, thus obviating the need for physical presence within a State in which
business is conducted. So long as a commercial actor’s efforts are “purposefully directed” toward residents
of another State, we have consistently rejected the notion that an absence of physical contacts can defeat
personal jurisdiction there.
Once it has been decided that a defendant purposefully established minimum contacts within the forum
State, these contacts may be considered in light of other factors to determine whether the assertion of
personal jurisdiction would comport with “fair play and substantial justice.” International Shoe Co. v.
Washington, 326 U.S., at 320. Thus courts in “appropriate case[s]” may evaluate “the burden on the
defendant,” “the forum State’s interest in adjudicating the dispute,” “the plaintiff’s interest in obtaining
convenient and effective relief,” “the interstate judicial system’s interest in obtaining the most efficient
resolution of controversies,” and the “shared interest of the several States in furthering fundamental
substantive social policies.” These considerations sometimes serve to establish the reasonableness of
jurisdiction upon a lesser showing of minimum contacts than would otherwise be required. [Citations]
Applying these principles to the case at hand, we believe there is substantial record evidence supporting
the District Court’s conclusion that the assertion of personal jurisdiction over Rudzewicz in Florida for the
alleged breach of his franchise agreement did not offend due process.…
In this case, no physical ties to Florida can be attributed to Rudzewicz other than MacShara’s brief
training course in Miami. Rudzewicz did not maintain offices in Florida and, for all that appears from the
record, has never even visited there. Yet this franchise dispute grew directly out of “a contract which had a
substantial connection with that State.” Eschewing the option of operating an independent local
enterprise, Rudzewicz deliberately “reach[ed] out beyond” Michigan and negotiated with a Florida
corporation for the purchase of a long-term franchise and the manifold benefits that would derive from
affiliation with a nationwide organization. Upon approval, he entered into a carefully structured 20-year
relationship that envisioned continuing and wide-reaching contacts with Burger King in Florida. In light
of Rudzewicz’ voluntary acceptance of the long-term and exacting regulation of his business from Burger
King’s Miami headquarters, the “quality and nature” of his relationship to the company in Florida can in
no sense be viewed as “random,” “fortuitous,” or “attenuated.” Rudzewicz’ refusal to make the
contractually required payments in Miami, and his continued use of Burger King’s trademarks and
confidential business information after his termination caused foreseeable injuries to the corporation in
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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
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blackened with Halloween paint. At the party Mr. Ferlito attempted to light his cigarette by using butane
lighter. The flame passed close to 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. Allis-Chalmers Corp., 414 Mich. 413, 425, 326 N.W.2d 372
(1982). Whether a plaintiff’s use of a product is foreseeable is a legal question to be resolved by the court.
Trotter, supra. Whether the resulting injury is foreseeable is a question of fact for the jury.

[2]

Thomas v.

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

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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.

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6.

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

7.

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

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

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;
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the fear of communism (as antithetical to American values and principles) was paramount. As you look at
the Constitution and how it affects the legal environment of business, please consider what basic values it
may impart to us and what makes it uniquely American and worth defending “against all enemies, foreign
and domestic.”
In Article I, the Constitution places the legislature first and prescribes the ways in which representatives
are elected to public office. Article I balances influence in the federal legislature between large states and
small states by creating a Senate in which the smaller states (by population) as well as the larger states
have two votes. In Article II, the Constitution sets forth the powers and responsibilities of the branch—the
presidency—and makes it clear that the president should be the commander in chief of the armed forces.
Article II also gives states rather than individuals (through the Electoral College) a clear role in the
election process. Article III creates the federal judiciary, and the Bill of Rights, adopted in 1791, makes
clear that individual rights must be preserved against activities of the federal government. In general, the
idea of rights is particularly strong.
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 the separation 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 much-debated concept in US constitutional law: substantive
due process (see Section 4.5.3 "Fifth Amendment"). The problem of judicial review and its proper scope is
brought into sharp focus in the abortion controversy. Abortion became a lucrative service business
after Roe v. Wade was decided in 1973. That has gradually changed, with state laws that have limited
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rather than overruled Roe v. Wade and with persistent antiabortion protests, killings of abortion doctors,
and efforts to publicize the human nature of the fetuses being aborted. The key here is to understand that
there is no explicit mention in the Constitution of any right of privacy. As Justice Harry Blackmun argued
in his majority opinion in Roe v. Wade,
The Constitution does not explicitly mention any right of privacy. In a line of decisions, however, the
Court has recognized that a right of personal privacy or a guarantee of certain areas or zones of privacy do
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 civilian. Suppose also
that the people of the United States favor such indefinite detention and that Congress wants to pass a

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

4.2 The Commerce Clause
LEARNING OBJECTIVES
1.

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

2.

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

3.

Describe both the wider use of the commerce clause from World War II through the 1990s and the
limitations the Supreme Court imposed in 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
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to make certain laws, then it acts unconstitutionally and its actions may be ruled unconstitutional by the
Supreme Court. Lately, the Supreme Court has not been shy about ruling acts of Congress
unconstitutional.
Here are the first five parts of Article I, Section 8, which sets forth the powers of the federal legislature.
The commerce clause is in boldface. It is short, but most federal legislation affecting business depends on
this very clause:

Section 8
[Clause 1] The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises, to pay the
Debts and provide for the common Defense 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, In Hammer v. Dagenhart, decided in 1918, a 1916 federal statute
had barred transportation in interstate commerce of goods produced in mines or factories employing
children under fourteen or employing children fourteen and above for more than eight hours a day. A
complaint was filed in the US District Court for the Western District of North Carolina by a father in his
own behalf and on behalf of his two minor sons, one under the age of fourteen years and the other
between fourteen and sixteen years, who were employees in cotton mill in Charlotte, North Carolina. The

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father’s lawsuit asked the court to enjoin (block) the enforcement of the act of Congress intended to
prevent interstate commerce in the products of child labor.
The Supreme Court saw the issue as whether Congress had the power under the commerce clause to
control interstate shipment of goods made by children under the age of fourteen. The court found that
Congress did not. The court cited several cases that had considered what interstate commerce could be
constitutionally regulated by Congress. In Hipolite Egg Co. v. United States, the Supreme Court had
sustained the power of Congress to pass the Pure Food and Drug Act, which prohibited the introduction
into the states by means of interstate commerce impure foods and drugs.

[1]

In Hoke v. United States, the

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

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appeals; the application of the federal law was enjoined. Goods produced by children under the age of
fourteen could be shipped anywhere in the United States without violating the federal law.

From the New Deal to the New Frontier and the Great Society: 1930s–1970
During the global depression of the 1930s, the US economy saw jobless rates of a third of all workers, and
President Roosevelt’s New Deal program required more active federal legislation. Included in the New
Deal program was the recognition of a “right” to form labor unions without undue interference from
employers. Congress created the National Labor Relations Board (NLRB) in 1935 to investigate and to
enjoin employer practices that violated this right.
In NLRB v. Jones & Laughlin Steel Corporation, a union dispute with management at a large steelproducing facility near Pittsburgh, Pennsylvania, became a court case. In this case, the NLRB had charged
the Jones & Laughlin Steel Corporation with discriminating against employees who were union members.
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
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challenged on the ground that Congress lacked the power under the commerce clause to regulate what
was otherwise fairly local conduct. For example, Title II of the act prohibited racial discrimination in
public accommodations (such as hotels, motels, and restaurants), leading to the famous case
of Katzenbach v. McClung (1964).
Ollie McClung’s barbeque place in Birmingham, Alabama, allowed “colored” people to buy takeout at the
back of the restaurant but not to sit down with “white” folks inside. The US attorney sought a court order
to require Ollie to serve all races and colors, but Ollie resisted on commerce clause grounds: the federal
government had no business regulating a purely local establishment. Indeed, Ollie did not advertise
nationally, or even regionally, and had customers only from the local area. But the court found that some
42 percent of the supplies for Ollie’s restaurant had moved in the channels of interstate commerce. This
was enough to sustain federal regulation based on the commerce clause.

[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 Polytechnic Institute (Virginia Tech), Christy
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Brzonkala alleged that Antonio Morrison and James Crawford, both students and varsity football players
at Virginia Tech, had raped her. In 1995, Brzonkala filed a complaint against Morrison and Crawford
under Virginia Tech’s sexual assault policy. After a hearing, Morrison was found guilty of sexual assault
and sentenced to immediate suspension for two semesters. Crawford was not punished. A second hearing
again found Morrison guilty. After an appeal through the university’s administrative system, Morrison’s
punishment was set aside, as it was found to be “excessive.” Ultimately, Brzonkala dropped out of the
university. Brzonkala then sued Morrison, Crawford, and Virginia Tech in federal district court, alleging
that Morrison’s and Crawford’s attack violated 42 USC Section 13981, part of the VAWA), which provides
a federal civil remedy for the victims of gender-motivated violence. Morrison and Crawford moved to
dismiss Brzonkala’s suit on the ground that Section 13981’s civil remedy was unconstitutional. In
dismissing the complaint, the district court found that that Congress lacked authority to enact Section
13981 under either the commerce clause or the Fourteenth Amendment, which Congress had explicitly
identified as the sources of federal authority for the VAWA. Ultimately, the court of appeals affirmed, as
did the Supreme Court.
The Supreme Court held that Congress lacked the authority to enact a statute under the commerce clause
or the Fourteenth Amendment because the statute did not regulate an activity that substantially affected
interstate commerce nor did it redress harm caused by the state. Chief Justice William H. Rehnquist
wrote for the court that “under our federal system that remedy must be provided by the Commonwealth of
Virginia, and not by the United States.” Dissenting, Justice Stephen G. Breyer argued that the majority
opinion “illustrates the difficulty of finding a workable judicial Commerce Clause touchstone.” Justice
David H. Souter, dissenting, noted that VAWA contained a “mountain of data assembled by
Congress…showing the effects of violence against women on interstate commerce.”
The absence of a workable judicial commerce clause touchstone remains. In 1996, California voters
passed the Compassionate Use Act, legalizing marijuana for medical use. California’s law conflicted with
the federal Controlled Substances Act (CSA), which banned possession of marijuana. After the Drug
Enforcement Administration (DEA) seized doctor-prescribed marijuana from a patient’s home, a group of
medical marijuana users sued the DEA and US Attorney General John Ashcroft in federal district court.
The medical marijuana users argued that the CSA—which Congress passed using its constitutional power
to regulate interstate commerce—exceeded Congress’s commerce clause power. The district court ruled
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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 matters that are essentially local or intrastate,
but the range of federal involvement in local matters is still considerable.

EXERCISES

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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? “Obama care”? 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” dormantcommerce-clause cases.

Congress has the power to legislate under the commerce clause and often does legislate. For example,
Congress might say that trucks moving on interstate highways must not be more than seventy feet in

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length. But if Congress does not exercise its powers and regulate in certain areas (such as the size and
length of trucks on interstate highways), states may make their own rules. States may do so under the socalled historic police powers of states those 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.
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
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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 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.

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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 Trans boundary 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, and road deterioration resulting from increased vehicular traffic and public health and the
environment.
Our bill would require the EPA to consider these factors in determining whether to accept imports of trash
from Canada. It is my strong view that such a review should lead the EPA to say “no” to the status quo of
trash imports.

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

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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 appliedfor 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).

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

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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 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

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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.

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
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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 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.

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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 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
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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.”

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
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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 over flight 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
The Fifth Amendment states, “No person shall be…deprived of life, liberty, or property, without due
process of law; nor shall private property be taken for public use, without just compensation.”
The Fifth Amendment has three principal aspects: procedural due process, the takings clause,
and substantive due process. In terms of procedural due process, the amendment prevents government
from arbitrarily taking the life of a criminal defendant. In civil lawsuits, it is also constitutionally essential
that the proceedings be fair. This is why, for example, the defendant in Burger King v. Rudzewicz had a
serious constitutional argument, even though he lost.
The takings clause of the Fifth Amendment ensures that the government does not take private property
without just compensation. In the international setting, governments that take private property engage in
what is called expropriation. The standard under customary international law is that when governments
do that, they must provide prompt, adequate, and effective compensation. This does not always happen,
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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.
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.”
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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, common law, moral philosophy,
and deeply rooted traditions of US legal history. The Supreme Court has stressed that he
word liberty cannot be defined by a definitive list of rights; rather, it must be viewed as a rational
continuum of freedom through which every aspect of human behavior is protected from arbitrary
impositions and random restraints. In this regard, as the Supreme Court has observed, the due process
clause protects abstract liberty interests, including the right to personal autonomy, bodily integrity, selfdignity, and self-determination.
These liberty interests often are grouped to form a general right to privacy, which was first recognized
in Griswold v. Connecticut (Section 4.6.1), where the Supreme Court struck down a state statute
forbidding married adults from using, possessing, or distributing contraceptives on the ground that the
law violated the sanctity of the marital relationship. According to Justice Douglas’s plurality opinion, this
penumbra of privacy, though not expressly mentioned in the Bill of Rights, must be protected to establish
a buffer zone or breathing space for those freedoms that are constitutionally enumerated.
But substantive due process has seen fairly limited use since the 1930s. During the 1990s, the Supreme
Court was asked to recognize a general right to die under the doctrine of substantive due process.
Although the court stopped short of establishing such a far-reaching right, certain patients may exercise a
constitutional liberty to hasten their deaths under a narrow set of circumstances. In Cruzan v. Missouri
Department of Health, the Supreme Court ruled that the due process clause guarantees the right of
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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]

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
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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 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
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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 refused to award
[8]

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

[9]

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

EXERCISES
1.

John Hanks works at ProLogis. The company decides to institute a drug-testing policy. John is a good
and longtime employee but enjoys smoking marijuana on the weekends. The drug testing will involve
urine samples and, semiannually, a hair sample. It is nearly certain that the drug-testing protocol that
ProLogis proposes will find that Hanks is a marijuana user. The company has made it clear that it will
have zero tolerance for any kind of non-prescribed 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?

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

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bedrooms for telltale signs of the use of contraceptives? The very idea is repulsive to the notions of privacy
surrounding the marital relationship.
We deal with a right of privacy older than the Bill of Rights—older than our political parties, older than
our school system. Marriage is a coming together for better or for worse, hopefully enduring, and intimate
to the degree of being sacred. It is an association that promotes a way of life, not causes; a harmony in
living, not political faiths; a bilateral loyalty, not commercial or social projects. Yet it is an association for
as noble a purpose as any involved in our prior decisions.
Mr. Justice Stewart, whom Mr. Justice Black joins, is 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.

1.

CASE QUESTIONS

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

2.

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

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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.
Kassel v. Consolidated Freightways Corp.
450 U.S. 662 (U.S. Supreme Court 1981)

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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 40-foot twoaxle trailer. This unit, commonly called a single, or “semi,” is 55 feet in length overall. Such trucks have
long been used on the Nation’s highways. Consolidated also uses a two-axle tractor pulling a single-axle
trailer which, in turn, pulls a single-axle dolly and a second single-axle trailer. This combination, known
as a double, or twin, is 65 feet long overall. Many trucking companies, including Consolidated,
increasingly prefer to use doubles to ship certain kinds of commodities. Doubles have larger capacities,
and the trailers can be detached and routed separately if necessary. Consolidated would like to use 65-foot
doubles on many of its trips through Iowa.
The State of Iowa, however, by statute, restricts the length of vehicles that may use its highways. Unlike all
other States in the West and Midwest, Iowa generally prohibits the use of 65-foot doubles within its
borders.
…
Because of Iowa’s statutory scheme, Consolidated cannot use its 65-foot doubles to move commodities
through the State. Instead, the company must do one of four things: (i) use 55-foot singles; (ii) use 60-foot
doubles; (iii) detach the trailers of a 65-foot double and shuttle each through the State separately; or (iv)
divert 65-foot doubles around Iowa. Dissatisfied with these options, Consolidated filed this suit in the
District Court averring that Iowa’s statutory scheme unconstitutionally burdens interstate commerce.
Iowa defended the law as a reasonable safety measure enacted pursuant to its police power. The State

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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 fewer splashes and spray. However, they are more likely than semis to jackknife or upset. They
can be backed only for a short distance. The negative characteristics are not such that they render the twin
less safe than semis overall. Semis are more stable, but are more likely to ‘rear-end’ another vehicle.”
In light of these findings, the District Court applied the standard we enunciated in Raymond Motor
Transportation, Inc. v. Rice, 434 U.S. 429 (1978), and concluded that the state law impermissibly
burdened interstate commerce: “[T]he balance here must be struck in favor of the federal interests.
The total effect of the law as a safety measure in reducing accidents and casualties is so slight and
problematical that it does not outweigh the national interest in keeping interstate commerce free from
interferences that seriously impede it.”
The Court of Appeals for the Eighth Circuit affirmed. 612 F.2d 1064 (1979). It accepted the District Court’s
finding that 65-foot doubles were as safe as 55-foot singles. Id. at 1069. Thus, the only apparent safety
benefit to Iowa was that resulting from forcing large trucks to detour around the State, thereby reducing
overall truck traffic on Iowa’s highways. The Court of Appeals noted that this was not a constitutionally
permissible interest. It also commented that the several statutory exemptions identified above, such as
those applicable to border cities and the shipment of livestock, suggested that the law, in effect, benefited
Iowa residents at the expense of interstate traffic. Id. at 1070-1071. The combination of these exemptions
weakened the presumption of validity normally accorded a state safety regulation. For these reasons, the
Court of Appeals agreed with the District Court that the Iowa statute unconstitutionally burdened
interstate commerce.
Iowa appealed, and we noted probable jurisdiction. 446 U.S. 950 (1980). We now affirm.
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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 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
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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 55foot singles. Moreover, Iowa’s law is now out of step with the laws of all other Midwestern and Western
States. Iowa thus substantially burdens the interstate flow of goods by truck. In the absence of
congressional action to set uniform standards, some burdens associated with state safety regulations must
be tolerated. But where, as here, the State’s safety interest has been found to be illusory, and its
regulations impair significantly the federal interest in efficient and safe interstate transportation, the state
law cannot be harmonized with the Commerce Clause.

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

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

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

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

CASE QUESTIONS
1.

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

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2.

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

3.

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

Hunt v. Washington Apple Advertising Commission
Hunt v. Washington Apple Advertising Commission
432 U.S. 33 (U.S. Supreme Court 1977)
MR. CHIEF JUSTICE BURGER delivered the opinion of the Court.
In 1973, North Carolina enacted a statute which required, inter alia, all closed containers of apples sold,
offered for sale, or shipped into the State to bear “no grade other than the applicable U.S. grade or
standard.”…Washington State is the Nation’s largest producer of apples, its crops accounting for
approximately 30% of all apples grown domestically and nearly half of all apples shipped in closed
containers in interstate commerce. [Because] of the importance of the apple industry to the State, its
legislature has undertaken to protect and enhance the reputation of Washington apples by establishing a
stringent, mandatory inspection program [that] requires all apples shipped in interstate commerce to be
tested under strict quality standards and graded accordingly. In all cases, the Washington State grades
[are] the equivalent of, or superior to, the comparable grades and standards adopted by the [U.S. Dept. of]
Agriculture (USDA).
[In] 1972, the North Carolina Board of Agriculture adopted an administrative regulation, unique in the 50
States, which in effect required all closed containers of apples shipped into or sold in the State to display
either the applicable USDA grade or a notice indicating no classification. State grades were expressly
prohibited. In addition to its obvious consequence—prohibiting the display of Washington State apple
grades on containers of apples shipped into North Carolina—the regulation presented the Washington
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
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variety and grade. [Compliance] with North Carolina’s unique regulation would have required
Washington growers to obliterate the printed labels on containers shipped to North Carolina, thus giving
their product a damaged appearance. Alternatively, they could have changed their marketing practices to
accommodate the needs of the North Carolina market, i.e., repack apples to be shipped to North Carolina
in containers bearing only the USDA grade, and/or store the estimated portion of the harvest destined for
that market in such special containers. As a last resort, they could discontinue the use of the preprinted
containers entirely. None of these costly and less efficient options was very attractive to the industry.
Moreover, in the event a number of other States followed North Carolina’s lead, the resultant inability to
display the Washington grades could force the Washington growers to abandon the State’s expensive
inspection and grading system which their customers had come to know and rely on over the 60-odd
years of its existence.…
Unsuccessful in its attempts to secure administrative relief [with North Carolina], the Commission
instituted this action challenging the constitutionality of the statute. [The] District Court found that the
North Carolina statute, while neutral on its face, actually discriminated against Washington State growers
and dealers in favor of their local counterparts [and] concluded that this discrimination [was] not justified
by the asserted local interest—the elimination of deception and confusion from the marketplace—arguably
furthered by the [statute].
…
[North Carolina] maintains that [the] burdens on the interstate sale of Washington apples were far
outweighed by the local benefits flowing from what they contend was a valid exercise of North Carolina’s
[police powers]. Prior to the statute’s enactment,…apples from 13 different States were shipped into North
Carolina for sale. Seven of those States, including [Washington], had their own grading systems which,
while differing in their standards, used similar descriptive labels (e.g., fancy, extra fancy, etc.). This
multiplicity of inconsistent state grades [posed] dangers of deception and confusion not only in the North
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.

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[As] the appellants properly point out, not every exercise of state authority imposing some burden on the
free flow of commerce is invalid, [especially] when the State acts to protect its citizenry in matters
pertaining to the sale of foodstuffs. By the same token, however, a finding that state legislation furthers
matters of legitimate local concern, even in the health and consumer protection areas, does not end the
inquiry. Rather, when such state legislation comes into conflict with the Commerce Clause’s overriding
requirement of a national “common market,” we are confronted with the task of effecting an
accommodation of the competing national and local interests. We turn to that task.
As the District Court correctly found, the challenged statute has the practical effect of not only burdening
interstate sales of Washington apples, but also discriminating against them. This discrimination takes
various forms. The first, and most obvious, is the statute’s consequence of raising the costs of doing
business in the North Carolina market for Washington apple growers and dealers, while leaving those of
their North Carolina counterparts unaffected. [This] disparate effect results from the fact that North
Carolina apple producers, unlike their Washington competitors, were not forced to alter their marketing
practices in order to comply with the statute. They were still free to market their wares under the USDA
grade or none at all as they had done prior to the statute’s enactment. Obviously, the increased costs
imposed by the statute would tend to shield the local apple industry from the competition of Washington
apple growers and dealers who are already at a competitive disadvantage because of their great distance
from the North Carolina market.
Second, the statute has the effect of stripping away from the Washington apple industry the competitive
and economic advantages it has earned for itself through its expensive inspection and grading system. The
record demonstrates that the Washington apple-grading system has gained nationwide acceptance in the
apple trade. [The record] contains numerous affidavits [stating a] preference [for] apples graded under
the Washington, as opposed to the USDA, system because of the former’s greater consistency, its
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
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the statute’s operation, Washington apples which would otherwise qualify for and be sold under the
superior Washington grades will now have to be marketed under their inferior USDA counterparts. Such
“downgrading” offers the North Carolina apple industry the very sort of protection against competing outof-state products that the Commerce Clause was designed to prohibit. At worst, it will have the effect of an
embargo against those Washington apples in the superior grades as Washington dealers withhold them
from the North Carolina market. At best, it will deprive Washington sellers of the market premium that
such apples would otherwise command.
Despite the statute’s facial neutrality, the Commission suggests that its discriminatory impact on
interstate commerce was not an unintended by-product, and there are some indications in the record to
that effect. The most glaring is the response of the North Carolina Agriculture Commissioner to the
Commission’s request for an exemption following the statute’s passage in which he indicated that before
he could support such an exemption, he would “want to have the sentiment from our apple
producers since they were mainly responsible for this legislation being passed.” [Moreover], we find it
somewhat suspect that North Carolina singled out only closed containers of apples, the very means by
which apples are transported in commerce, to effectuate the statute’s ostensible consumer protection
purpose when apples are not generally sold at retail in their shipping containers. However, we need not
ascribe an economic protection motive to the North Carolina Legislature to resolve this case; we conclude
that the challenged statute cannot stand insofar as it prohibits the display of Washington State grades
even if enacted for the declared purpose of protecting consumers from deception and fraud in the
marketplace.
…
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

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that case, the USDA grade would serve as a benchmark against which the consumer could evaluate the
quality of the various state grades.…
[The court affirmed the lower court’s holding that the North Carolina statute was unconstitutional.]

CASE QUESTIONS
1.

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

2.

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

Citizens United v. Federal Election Commission
Citizens United v. Federal Election Commission
588 U.S. ____; 130 S.Ct. 876 (U.S. Supreme Court 2010)
Justice Kennedy delivered the opinion of the Court.
Federal law prohibits corporations and unions from using their general treasury funds to make
independent expenditures for speech defined as an “electioneering communication” or for speech
expressly advocating the election or defeat of a candidate. 2 U.S.C. §441b. Limits on electioneering
communications were upheld in McConnell v. Federal Election Comm’n, 540 U.S. 93, 203–209 (2003).
The holding of McConnell rested to a large extent on an earlier case, Austin v. Michigan Chamber of
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.
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I
A
Citizens United is a nonprofit corporation. It has an annual budget of about $12 million. Most of its funds
are from donations by individuals; but, in addition, it accepts a small portion of its funds from for-profit
corporations.
In January 2008, Citizens United released a film entitled Hillary: The Movie. We refer to the film
as Hillary. It is a 90-minute documentary about then-Senator Hillary Clinton, who was a candidate in the
Democratic Party’s 2008 Presidential primary elections. Hillary mentions Senator Clinton by name and
depicts interviews with political commentators and other persons, most of them quite critical of Senator
Clinton.…
In December 2007, a cable company offered, for a payment of $1.2 million, to make Hillary available on a
video-on-demand channel called “Elections ’08.”…Citizens United was prepared to pay for the video-ondemand; and to promote the film; it produced two 10-second ads and one 30-second ad for Hillary. Each
ad includes a short (and, in our view, pejorative) statement about Senator Clinton, followed by the name
of the movie and the movie’s Website address. Citizens United desired to promote the video-on-demand
offering by running advertisements on broadcast and cable television.

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
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funds for express advocacy or electioneering communications. They may establish, however, a “separate
segregated fund” (known as a political action committee, or PAC) for these purposes. 2 U.S.C. §441b (b)
(2). The moneys received by the segregated fund are limited to donations from stockholders and
employees of the corporation or, in the case of unions, members of the union. Ibid.

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

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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.
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)…
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Speech is an essential mechanism of democracy, for it is the means to hold officials accountable to the
people. See Buckley, supra, at 14–15 (“In a republic where the people are sovereign, the ability of the
citizenry to make informed choices among candidates for office is essential.”) The right of citizens to
inquire, to hear, to speak, and to use information to reach consensus is a precondition to enlightened selfgovernment and a necessary means to protect it. The First Amendment “‘has its fullest and most urgent
application’ to speech uttered during a campaign for political office.”
For these reasons, political speech must prevail against laws that would suppress it, whether by design or
inadvertence. Laws that burden political speech are “subject to strict scrutiny,” which requires the
Government to prove that the restriction “furthers a compelling interest and is narrowly tailored to
achieve that interest.”
…
The Court has recognized that First Amendment protection extends to corporations. This protection has
been extended by explicit holdings to the context of political speech. Under the rationale of these
precedents, political speech does not lose First Amendment protection “simply because its source is a
corporation.” Bellotti, supra, at 784. The Court has thus rejected the argument that political speech of
corporations or other associations should be treated differently under the First Amendment simply
because such associations are not “natural persons.”
The purpose and effect of this law is to prevent corporations, including small and nonprofit corporations,
from presenting both facts and opinions to the public. This makes Austin’s anti-distortion 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.

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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 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 pre-election period is
not a permissible remedy. Here Congress has created categorical bans on speech that are asymmetrical to
preventing quid pro quo-corruption.
Our precedent is to be respected unless the most convincing of reasons demonstrates that adherence to it
puts us on a course that is sure error. “Beyond workability, the relevant factors in deciding whether to
adhere to the principle of stare decisis include the antiquity of the precedent, the reliance interests at
stake, and of course whether the decision was well reasoned.” [citing prior cases]
These considerations counsel in favor of rejecting Austin, which itself contravened this Court’s earlier
precedents in Buckley and Bellotti. “This Court has not hesitated to overrule decisions offensive to the
First Amendment.”WRTL, 551 U.S., at 500 (opinion of Scalia, J.). “[S]tare decisis is a principle of policy
and not a mechanical formula of adherence to the latest decision. Helvering v. Hallock, 309 U.S. 106 at
119 (1940).
Austin is undermined by experience since its announcement. Political speech is so ingrained in our
culture that speakers find ways to circumvent campaign finance laws. See, e.g., McConnell, 540 U.S., at
176–177 (“Given BCRA’s tighter restrictions on the raising and spending of soft money, the incentives…to
exploit [26 U.S.C. §527] organizations will only increase”). Our Nation’s speech dynamic is changing, and
informative voices should not have to circumvent onerous restrictions to exercise their First Amendment
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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 political message. Soon,
however, it may be that Internet sources, such as blogs and social networking Web sites, will provide
citizens with significant information about political candidates and issues. Yet, §441b would seem to ban a
blog post expressly advocating the election or defeat of a candidate if that blog were created with
corporate funds. The First Amendment does not permit Congress to make these categorical distinctions
based on the corporate identity of the speaker and the content of the political speech.
Due consideration leads to this conclusion: Austin should be and now is overruled. We return to the
principle established in Buckley and Bellotti that the Government may not suppress political speech on
the basis of the speaker’s corporate identity. No sufficient governmental interest justifies limits on the
political speech of nonprofit or for-profit corporations.

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

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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 U.S. 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 U.S 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 remove the signs because they violated the
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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. Does either of them have a winning case based on the equal protection clause of the Fourteenth
Amendment?

3.

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

4.

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

5.

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

6.

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

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South Carolina legislation had effectively “taken” his property. At trial, South Carolina conceded that
because of the legislation, Lucas’s property was effectively worth zero. Has there been a taking under
the Fifth Amendment (as incorporated through the Fourteenth Amendment), and if so, what should the
state owe to Lucas? Suppose that Lucas could have made an additional $1 million by building a house on
each of his parcels. Is he entitled to recover his original purchase price or his potential profits?

SELF-TEST QUESTIONS
1.

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

a.

places an undue burden on interstate commerce

b.

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

c.

regulates economic activities within the state’s borders

d.

a and b

e.

b and c
The state legislature in Maine enacts a law that directly conflicts with a federal law. Mapco
Industries, located in Portland, Maine, cannot comply with both the state and the federal law.

a.

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

powers.
b.

Because there’s a conflict, both laws are invalid; the state and the federal government will have
to work out a compromise of some sort.

c.

The federal law preempts the state law.

d.

Both laws govern concurrently.
Hannah, who lives in Ada, is the owner of Superior Enterprises, Inc. She believes that certain
actions in the state of Ohio infringe on her federal constitutional rights, especially those found in
the Bill of Rights. Most of these rights apply to the states under

a.

the supremacy clause
b.

the protection clause

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c.

the due process clause of the Fourteenth Amendment

d.

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

a.

a violation of the Tenth Amendment
b.

a violation of the First Amendment

c.

a violation of the Calloways’ right to equal protection of the laws

d.

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

a.

The partners could be arrested in North Carolina and may well be convicted.
b.

The materials in Raleigh may be the basis for a criminal conviction.

c.

The materials are protected under the First Amendment’s right of free speech.

d.

The materials are protected under state law.

e.

a and b

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SELF-TEST ANSWERS
1.

a

2.

c

3.

c

4.

b

5.

e

Chapter 5
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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
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LEARNING OBJECTIVES
1.

Explain the reasons why we have federal administrative agencies.

2.

Explain the difference between executive branch agencies and independent agencies.

3.

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

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

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

Ideal Conditions for a Free Market
1.

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

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

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

6. All buyers and sellers are utility maximizes; 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.

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In short, some forms of legislation and regulation are needed to counter a tendency toward consolidation
of economic power (Chapter 16 "Antitrust Law") and discriminatory attitudes toward certain individuals
and groups (Chapter 18 "Employment Law") and to insist that people and companies clean up their own
messes and not hide information that would empower voluntary choices in the free market.
But there are additional reasons to regulate. For example, in economic systems, it is likely for natural
monopolies to occur. These are where one firm can most efficiently supply all of the good or service.
Having duplicate (or triplicate) systems for supplying electricity, for example, would be inefficient, so
most states have a public utilities commission to determine both price and quality of service. This is direct
regulation.
Sometimes destructive competition can result if there is no regulation. Banking and insurance are good
examples of this. Without government regulation of banks (setting standards and methods), open and
fierce competition would result in widespread bank failures. That would erode public confidence in banks
and business generally. The current situation (circa 2011) of six major banks that are “too big to fail” is,
however, an example of destructive noncompetition.
Other market imperfections can yield a demand for regulation. For example, there is a need to regulate
frequencies for public broadcast on radio, television, and other wireless transmissions (for police, fire,
national defense, etc.). Many economists would also list an adequate supply of public goods as something
that must be created by government. On its own, for example, the market would not provide public goods
such as education, a highway system, lighthouses, and 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, and 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
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unsafe work environments, preserving environmental quality and resources, and protecting consumers
from unsafe products. Sometimes these objectives are met by giving individuals statutory rights that can
be used in bringing a complaint (e.g., Title VII of the Civil Rights Act of 1964, for employment
discrimination), and sometimes they are met by creating agencies with the right to investigate and
monitor and enforce statutory law and regulations created to enforce such law (e.g., the Environmental
Protection Agency, for bringing a lawsuit against a polluting company).

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

Classification of Agencies
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
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removed except for “good cause.” This means that most presidents will not get to appoint all the
commissioners of a given independent agency. Most independent agencies have a statutory requirement
of bipartisan membership on the commission, so the president cannot simply fill vacancies with members
of his own political party.
In addition to the ICC and the FTC, the major independent agencies are the Federal Communications
Commission (1934), Securities and Exchange Commission (1934), National Labor Relations Board (1935),
and Environmental Protection Agency (1970). See Note 5.4 "Ideal Conditions for a Free Market" in the
sidebar.
By contrast, members of executive branch agencies serve at the pleasure of the president and are therefore
far more amenable to political control. One consequence of this distinction is that the rules that
independent agencies promulgate may not be reviewed by the president or his staff—only Congress may
directly overrule them—whereas the White House or officials in the various cabinet departments may
oversee the work of the agencies contained within them (unless specifically denied the power by
Congress).

Powers of Agencies
Agencies have a variety of powers. Many of the original statutes that created them, like the Federal
Communications Act, gave them licensing power. No party can enter into the productive activity covered
by the act without prior license from the agency—for example; no utility can start up a nuclear power
plant unless first approved by the Nuclear Regulatory Commission. In recent years, the move toward
deregulation of the economy has led to diminution of some licensing power. Many agencies also have the
authority to set the rates charged by companies subject to the agency’s jurisdiction. Finally, the agencies
can regulate business practices. The FTC has general jurisdiction over all business in interstate commerce
to monitor and root out “unfair acts” and “deceptive practices.” The Securities and Exchange Commission
(SEC) oversees the issuance of corporate securities and other investments and monitors the practices of
the stock exchanges.
Unlike courts, administrative agencies are charged with the responsibility of carrying out a specific
assignment or reaching a goal or set of goals. They are not to remain neutral on the various issues of the
day; they must act. They have been given legislative powers because in a society growing ever more
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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

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to an agency. In later decisions, it was made clear that Congress could delegate some of its legislative
powers, but only if the delegation of authority was not overly broad.
Still, some congressional enabling acts are very broad, such as the enabling legislation for the
Occupational Safety and Health Administration (OSHA), which is given the authority to make rules to
provide for safe and healthful working conditions in US workplaces. Such a broad initiative power gives
OSHA considerable discretion. But, as noted in Section 5.2 "Controlling Administrative Agencies", there
are both executive and judicial controls over administrative agency activities, as well as ongoing control by
Congress through funding and the continuing oversight of agencies, both in hearings and through
subsequent statutory amendments.

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

EXERCISES
1.

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

2.

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

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

5.2 Controlling Administrative Agencies
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LEARNING OBJECTIVES
1.

Understand how the president controls administrative agencies.

2.

Understand how Congress controls administrative agencies.

3.

Understand how the courts can control administrative agencies.

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

Figure 5.1 Major Administrative Agencies of the United States

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

Executive Control
The president (or a governor, for state agencies) can exercise considerable control over agencies that are
part of his cabinet departments and that are not statutorily defined as independent. Federal agencies,
moreover, are subject to the fiscal scrutiny of the Office of Management and Budget (OMB), subject to the
direct control of the president. Agencies are not permitted to go directly to Congress for increases in
budget; these requests must be submitted through the OMB, giving the president indirect leverage over
the continuation of administrators’ programs and policies.
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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
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LEARNING OBJECTIVES
1.

Understand why the Administrative Procedure Act was needed.

2.

Understand how hearings are conducted under the act.

3.

Understand how the act affects rulemaking by agencies.

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

Trial-Type Hearings
Deciding cases is a major task of many agencies. For example, the Federal Trade Commission (FTC) is
empowered to charge a company with having violated the Federal Trade Commission Act. Perhaps a seller
is accused of making deceptive claims in its advertising. Proceeding in a manner similar to a court, staff
counsel will prepare a case against the company, which can defend itself through its lawyers. The case is
tried before an administrative law judge (ALJ), formerly known as an administrative hearing examiner.
The change in nomenclature was made in 1972 to enhance the prestige of ALJs and more accurately
reflect their duties. Although not appointed for life as federal judges are, the ALJ must be free of
assignments inconsistent with the judicial function and is not subject to supervision by anyone in the
agency who carries on an investigative or prosecutorial function.
The accused parties are entitled to receive notice of the issues to be raised, to present evidence, to argue,
to cross-examine, and to appear with their lawyers. Ex parte (eks PAR-tay) communications—contacts
between the ALJ and outsiders or one party when both parties are not present—are prohibited. However,
the usual burden-of-proof standard followed in a civil proceeding in court does not apply: the ALJ is not
bound to decide in favor of that party producing the more persuasive evidence. The rule in most
administrative proceedings is “substantial evidence,” evidence that is not flimsy or weak, but is not
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necessarily overwhelming evidence, either. The ALJ in most cases will write an opinion. That opinion is
not the decision of the agency, which can be made only by the commissioners or agency head. In effect,
the ALJ’s opinion is appealed to the commission itself.
Certain types of agency actions that have a direct impact on individuals need not be filtered through a fullscale hearing. Safety and quality inspections (grading of food, inspection of airplanes) can be made on the
spot by skilled inspectors. Certain licenses can be administered through tests without a hearing (a test for
a driver’s license), and some decisions can be made by election of those affected (labor union elections).

Rulemaking
Trial-type hearings generally impose on particular parties liabilities based on past or present facts.
Because these cases will serve as precedents, they are a partial guide to future conduct by others. But they
do not directly apply to nonparties, who may argue in a subsequent case that their conduct does not fit
within the holding announced in the case. Agencies can affect future conduct far more directly by
announcing rules that apply to all who come within the agency’s jurisdiction.
The acts creating most of the major federal agencies expressly grant them authority to engage in
rulemaking. This means, in essence, authority to legislate. The outpouring of federal regulations has been
immense. The APA directs agencies about to engage in rulemaking to give notice in
the <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.

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Administrative regulations are not legally binding unless they are published. Agencies must publish in
the Federal Register the text of final regulations, which ordinarily do not become effective until thirty
days later. Every year the annual output of regulations is collected and reprinted in
the<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
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1.

Describe the paperwork burden imposed by administrative agencies.

2.

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

3.

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

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

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

[2]

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

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

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

•

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

•

records exempted from disclosure by another statute

•

interagency memos or decisions reflecting the deliberative process

•

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

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disclose it. Most agencies notify a company whose data they are about to disclose. But these practices are
not legally required under the FOIA.

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

EXERCISES
1.

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

2.

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

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

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2.

Detail various strategies for obtaining judicial review of agency rules.

3.

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

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

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

Strategies for Obtaining Judicial Review
Once these obstacles are cleared, the court may look at one of a series of claims. The appellant might
assert that the agency’s action was ultra vires (UL-truh VI-reez)—beyond the scope of its authority as set
down in the statute. This attack is rarely successful. A somewhat more successful claim is that the agency
did not abide by its own procedures or those imposed upon it by the Administrative Procedure Act.
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.
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Nevertheless, regulations cannot exceed the scope of the authority conferred by Congress on the agency.
In an important 1981 case before the Supreme Court, the issue was whether the secretary of labor, acting
through the Occupational Health and Safety Administration (OSHA), could lawfully issue a standard
limiting exposure to cotton dust in the workplace without first undertaking a cost-benefit analysis. A
dozen cotton textile manufacturers and the American Textile Manufacturers Institute, representing 175
companies, asserted that the cotton dust standard was unlawful because it did not rationally relate the
benefits to be derived from the standard to the costs that the standard would impose. See Section 5.6
"Cases", American Textile Manufacturers Institute v. Donovan.
In summary, then, an individual or a company may (after exhaustion of administrative remedies)
challenge agency action where such action is the following:
•

not in accordance with the agency’s scope of authority

•

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

•

not in accordance with the substantial evidence test

•

unwarranted by the facts

•

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

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

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

[2]

In recent years, the Supreme Court has been stripping away the traditional immunity enjoyed by many
government officials against personal suits. Some government employees—judges, prosecutors,
legislators, and the president, for example—have absolute immunity against suit for official actions. But
many public administrators and government employees have at best a qualified immunity. Under a
provision of the Civil Rights Act of 1871 (so-called Section 1983 actions), state officials can be sued in
federal court for money damages whenever “under color of any state law” they deprive anyone of his
rights under the Constitution or federal law. In Bivens v. Six Unknown Federal Narcotics Agents, the
Supreme Court held that federal agents may be sued for violating the plaintiff’s Fourth Amendment rights
[3]

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

[4]

The appropriations

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

KEY TAKEAWAY
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

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1.

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

2.

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

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

5.6 Cases
Marshall v. Barlow’s, Inc.
Marshall v. Barlow’s, Inc.

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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., and 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 asserted permit 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.
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
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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 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.
***

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The clear import of our cases is that the closely regulated industry of the type involved
in Colonnade and Biswell is the exception. The Secretary would make it the rule. Invoking the WalshHealey Act of 1936, 41 U.S.C. § 35 et seq., the Secretary attempts to support a conclusion that all
businesses involved in interstate commerce have long been subjected to close supervision of employee
safety and health conditions. But…it is quite unconvincing to argue that the imposition of minimum
wages and maximum hours on employers who contracted with the Government under the Walsh-Healey
Act prepared the entirety of American interstate commerce for regulation of working conditions to the
minutest detail. Nor can any but the most fictional sense of voluntary consent to later searches be found in
the single fact that one conducts a business affecting interstate commerce. Under current practice and
law, few businesses can be conducted without having some effect on interstate commerce.
***
The critical fact in this case is that entry over Mr. Barlow’s objection is being sought by a Government
agent. Employees are not being prohibited from reporting OSHA violations. What they observe in their
daily functions is undoubtedly beyond the employer’s reasonable expectation of privacy. The Government
inspector, however, is not an employee. Without a warrant he stands in no better position than a member
of the public. What is observable by the public is observable, without a warrant, by the Government
inspector as well. The owner of a business has not, by the necessary utilization of employees in his
operation, thrown open the areas where employees alone are permitted to the warrantless scrutiny of
Government agents. That an employee is free to report, and the Government is free to use, any evidence of
noncompliance with OSHA that the employee observes furnishes no justification for federal agents to
enter a place of business from which the public is restricted and to conduct their own warrantless search.
***
[The District Court judgment is affirmed.]

CASE QUESTIONS
1.

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

2.

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

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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 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.

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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 as high as 0.2 mg lint-free
cotton dust/cu m,” or 200 g/m3. of lint-free reparable 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
Workers 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 reparable
cotton dust for all segments of the cotton industry. Ibid. It also suggested an implementation strategy for

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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 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

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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 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 the entire burden be on the manufacturer?

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

EXERCISES
1.

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

2.

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

3.

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

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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 authorize four warrantless
inspections per year. Is the provision for warrantless inspections by this agency constitutional?

5.

[1]

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

[2]

SELF-TEST QUESTIONS
1.

Most federal administrative agencies are created by

a.

an executive order by the president

b.

a Supreme Court decision

c.

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

d.

a and c
The Federal Trade Commission, like most administrative agencies of the federal government, is
part of

a.

the executive branch of government

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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

c.

prosecute firms that have violated FTC regulations

d.

none of the above

e.

all of the above

SELF-TEST ANSWERS

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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
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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.

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

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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; intent to inflict great bodily harm
can be murder if the result is the death of another person. A killing that takes place while a felony (such as
armed robbery) is being committed is also murder, whether or not the killer intended any harm. This is
the so-called felony murder rule. Examples are the accidental discharge of a gun that kills an innocent
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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 result 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 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.
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.
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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 “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.
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
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because the thief in these cases already had possession; his crime was in assuming ownership. Today,
such wrongful conversion, known as embezzlement, has been made a statutory offense in all states.
Statutes against larceny and embezzlement did not cover all the gaps in the law. A conceptual problem
arises in the case of one who is tricked into giving up his title to property. In larceny and embezzlement,
the thief gains possession or ownership without any consent of the owner or custodian of the property.
Suppose, however, that an automobile dealer agrees to take his customer’s present car as a trade-in. The
customer says that he has full title to the car. In fact, the customer is still paying off an installment loan
and the finance company has an interest in the old car. If the finance company repossesses the car, the
customer—who got a new car at a discount because of his false representation—cannot be said to have
taken the new car by larceny or embezzlement. Nevertheless, he tricked the dealer into selling, and the
dealer will have lost the value of the repossessed car. Obviously, the customer is guilty of a criminal act;
the statutes outlawing it refer to this trickery as the crime of false pretenses, defined as obtaining
ownership of the property of another by making untrue representations of fact with intent to defraud.
A number of problems have arisen in the judicial interpretation of false-pretense statutes. One concerns
whether the taking is permanent or only temporary. The case of State v. Mills (Section 6.7 "Cases") shows
the subtle questions that can be presented and the dangers inherent in committing “a little fraud.”
In the Mills case, the claim was that a mortgage instrument dealing with one parcel of land was used
instead for another. This is a false representation of fact. Suppose, by contrast, that a person
misrepresents his state of mind: “I will pay you back tomorrow,” he says, knowing full well that he does
not intend to. Can such a misrepresentation amount to false pretenses punishable as a criminal offense?
In most jurisdictions it cannot. A false-pretense violation relates to a past event or existing fact, not to a
statement of intention. If it were otherwise, anyone failing to pay a debt might find himself facing criminal
prosecution, and business would be less prone to take risks.
The problem of proving intent is especially difficult when a person has availed himself of the services of
another without paying. A common example is someone leaving a restaurant without paying for the meal.
In most states, this is specifically defined in the statutes as theft of services.

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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, 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 permit tee 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
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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 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.

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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 white-collar crimes include tax fraud;
price fixing; violations of food, drug, and environmental laws; corporate bribery of foreign companies;
and—the newest form—computer fraud. Some of these are discussed here; others are covered in later
chapters.

Mail and Wire Fraud
Federal law prohibits the use of the mails or any interstate electronic communications medium for the
purpose of furthering a “scheme or artifice to defraud.” The statute is broad, and it is relatively easy for
prosecutors to prove a violation. The law also bans attempts to defraud, so the prosecutor need not show
that the scheme worked or that anyone suffered any losses. “Fraud” is broadly construed: anyone who
uses the mails or telephone to defraud anyone else of virtually anything, not just of money, can be
convicted under the law. In one case, a state governor was convicted of mail fraud when he took bribes to
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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 Antitrust Law
In Chapter 16 "Antitrust Law" we consider the fundamentals of antitrust law, which for the most part
affects the business enterprise civilly. But violations of Section 1 of the Sherman Act, which condemns
activities in “restraint of trade” (including price fixing), are also crimes.

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 payer (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

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Sec. (a)(1)

10 years maximum (20 years second
offense)

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Trespassing in a government computer

Sec. (a)(3)

1 year (5)

Compromising the confidentiality of a computer

Sec. (a)(2)

1 year (10)

Accessing a computer to defraud and obtain
value

Sec. (a)4

5 years (10)

Intentional access and reckless damage

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

Trafficking in passwords

(a)(6)

1 year (10)

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

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6.3 The Nature of a Criminal Act
LEARNING OBJECTIVES
1.

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

2.

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

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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
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reasonably believes that the officer is entitled to the bag. Unbeknownst to the employee, the bag contains
money that belongs to the company, and the officer wishes to keep it. This is not a conspiracy. The
employee is not guilty of larceny, but the officer is, because the agent’s act is imputed to him.
Since intent is a necessary component of crime, an agent’s intent cannot be imputed to his principal if the
principal did not share the intent. The company president tells her sales manager, “Go make sure our
biggest customer renews his contract for next year”—by which she meant, “Don’t ignore our biggest
customer.” Standing before the customer’s purchasing agent, the sales manager threatens to tell the
purchasing agent’s boss that the purchasing agent has been cheating on his expense account, unless he
signs a new contract. The sales manager could be convicted of blackmail, but the company president could
not.
Can a corporation be guilty of a crime? For many types of crimes, the guilt of individual employees may be
imputed to the corporation. Thus the antitrust statutes explicitly state that the corporation may be
convicted and fined for violations by employees. This is so even though the shareholders are the ones who
ultimately must pay the price—and who may have had nothing to do with the crime or 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 men’s 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

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1.

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

2.

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

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

Excuses That Limit or Overcome Responsibility
Mistake of Fact and Mistake of Law
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
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violating the statute cannot stand. In rare cases, a lawyer’s advice, contrary to the statute, will be held to
excuse the client, but usually the client is responsible for his attorney’s mistakes. Otherwise, as it is said,
the lawyer would be superior to the law.
Ignorance or mistake of fact more frequently will serve as an excuse. If you take a coat from a restaurant,
believing it to be yours, you cannot be convicted of larceny if it is not. Your honest mistake of fact negates
the requisite intent. In general, the rule is that a mistaken belief of fact will excuse criminal responsibility
if (1) the belief is honestly held, (2) it is reasonable to hold it, and (3) the act would not have been criminal
if the facts were as the accused supposed them to have been.

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

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
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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?

6.5 Procedure
LEARNING OBJECTIVES

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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 post-trial 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 information (a document stating the
crime of which the person being held is accused) or ask the grand jury for an indictment. The grand jury
consists of twenty-three people who sit to determine whether there is sufficient evidence to warrant a
prosecution. It does not sit to determine guilt or innocence. The indictment is the grand jury’s formal
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
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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 through plea bargaining with the prosecution. In return for the plea, the prosecutor promises to
recommend to the judge that the sentence be limited. The judge most often, but not always, goes along
with the prosecutor’s recommendation.
The defendant is also permitted to file a plea of nolo contendere (no contest) in prosecutions for certain
crimes. In so doing, he neither affirms nor denies his guilt. He may be sentenced as though he had
pleaded guilty, although usually a nolo plea is the result of a plea bargain. Why plead nolo? In some
offenses, such as violations of the antitrust laws, the statutes provide that private plaintiffs may use a
conviction or a guilty plea as proof that the defendant violated the law. This enables a plaintiff to prove
liability without putting on witnesses or evidence and reduces the civil trial to a hearing about the
damages to plaintiff. The nolo plea permits the defendant to avoid this, so that any plaintiff will have to
not only prove damages but also establish civil liability.
Following a guilty plea or a verdict of guilt, the judge will impose a sentence after presentencing reports
are written by various court officials (often, probation officers). Permissible sentences are spelled out in
statutes, though these frequently give the judge a range within which to work (e.g., twenty years to life).
The judge may sentence the defendant to imprisonment, a fine, or both, or may decide to suspend
sentence (i.e., the defendant will not have to serve the sentence as long as he stays out of trouble).
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.
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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

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1.

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

2.

Explain the Exclusionary rule and the reason for its existence.

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

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

[1]

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

that have made this branch of jurisprudence especially complex.

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

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

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

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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 is defendants put in stocks for public display and
humiliation. In pre-Revolutionary America, an unlucky defendant who found himself convicted could face
brutal torture before death.
The Eighth Amendment banned these actions with the words that “cruel and unusual punishments [shall
not be] inflicted.” Virtually all such punishments either never were enacted or have been eliminated from
the statute books in the United States. Nevertheless, the Eighth Amendment has become a source of
controversy, first with the Supreme Court’s ruling in 1976 that the death penalty, as haphazardly applied
in the various states, amounted to cruel and unusual punishment. Later Supreme Court opinions have
made it easier for states to administer the death penalty. As of 2010, there were 3,300 defendants on
death row in the United States. Of course, no corporation is on death row, and no corporation’s charter
has ever been revoked by a US state, even though some corporations have repeatedly been indicted and
convicted of criminal offenses.

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

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

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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
presumptions 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).

6.7 Cases
False Pretenses
State v. Mills
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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 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
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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 him 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 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 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
1.

False pretense 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
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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 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
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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 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

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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 Appeals reversed the conviction on the ground that only the drug dealer, whether
corporation or individual, was subject to the criminal provisions of the Act, and that where the dealer was
a corporation, an individual connected therewith might be held personally only if he was operating the
corporation as his ‘alter ego.’
In reversing the judgment of the Court of Appeals and reinstating Dotterweich’s conviction, this Court
looked to the purposes of the Act and noted that they “touch phases of the lives and health of people
which, in the circumstances of modern industrialism, are largely beyond self-protection. It observed that
the Act is of “a now familiar type” which “dispenses with the conventional requirement for criminal
conduct-awareness of some wrongdoing: In the interest of the larger good it puts the burden of acting at
hazard upon a person otherwise innocent but standing in responsible relation to a public danger. Central
to the Court’s conclusion that individuals other than proprietors are subject to the criminal provisions of
the Act was the reality that the only way in which a corporation can act is through the individuals, who act
on its behalf.
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***
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.
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.

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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?

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
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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 does so.

EXERCISES
1.

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

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and shove him bodily out the door. He calls the police to have you arrested for assault. Should the
police arrest you? Assuming that they do, how would you defend yourself in court?
3.

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

4.

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

5.

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

6.

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

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officer to seize any items that were “evidence of violations of federal criminal law.” The warrants did
not describe the specific crime suspected, nor did the warrants limit the seizure of items solely to Dali
artwork or suspected Dali forgeries. Are these search warrants valid?

[1]

SELF-TEST QUESTIONS
1.

Jared has made several loans to debtors who have declared bankruptcy. These are unsecured
claims. Jared “doctors” the documentation to show amounts owed that are higher than the
debtors actually owe. Later, Jared is charged with the federal criminal offense of filing false
claims. The standard (or “burden”) of proof that the US attorney must meet in the prosecution is

a.

beyond all doubt

b.

beyond a reasonable doubt

c.

clear and convincing evidence

d.

a preponderance of the evidence
Jethro, a businessman who resides in Atlanta, creates a disturbance at a local steakhouse and
is arrested for being drunk and disorderly. Drunk and disorderly is a misdemeanor under Georgia
law. A misdemeanor is a crime punishable by imprisonment for up to

a.

one year
b.

two years

c.

five years

d.

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

a.

actus reus and mens rea
b.

mens rea only

c.

the performance of a prohibited act

d.

none of the above
Kira works for Data Systems Ltd. and may be liable for larceny if she steals

a.

a competitor’s trade secrets

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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).

Chapter 7
Introduction to Tort Law
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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
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LEARNING OBJECTIVES
1.

Explain why a sound market system requires tort law.

2.

Define a tort and give two examples.

3.

Explain the moral basis of tort liability.

4.

Understand the purposes of damage awards in tort.

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

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

Dimensions of Tort Liability
There is a clear moral basis for recovery through the legal system where the defendant has been careless
(negligent) or has intentionally caused harm. Using the concepts that we are free and autonomous beings
with basic rights, we can see that when others interfere with either our freedom or our autonomy, we will
usually react negatively. As the old saying goes, “Your right to swing your arm ends at the tip of my nose.”
The law takes this even one step further: under intentional tort law, if you frighten someone by swinging
your arms toward the tip of her nose, you may have committed the tort of assault, even if there is no actual
touching (battery).
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 the tort feasor—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.
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
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the moral sense. The defendant may have observed all possible precautions and yet still be held liable.
This is called strict liability. An example is that incurred by the manufacturer of a defective product that is
placed on the market despite all possible precautions, including quality-control inspection. In many
states, if the product causes injury, the manufacturer will be held liable.

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

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

Damages

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

EXERCISES
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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 re-impose the victim’s costs onto the tortfeasor? What would a totally non-litigious
society be like?

7.2 Intentional Torts
LEARNING OBJECTIVES
1.

Distinguish intentional torts from other kinds of torts.

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2.

Give three examples of an intentional tort—one that causes injury to a person, one that causes injury to
property, and one that causes injury to a reputation.

The analysis of most intentional torts is straightforward and parallels the substantive crimes already
discussed in Chapter 6 "Criminal Law". When physical injury or damage to property is caused, there is
rarely debate over liability if the plaintiff deliberately undertook to produce the harm. Certain other
intentional torts are worth noting for their relevance to business.

Assault and Battery
One of the most obvious intentional torts is assault and battery. Both criminal law and tort law serve to
restrain individuals from using physical force on others. Assault is (1) the threat of immediate harm or
offense of contact or (2) any act that would arouse reasonable apprehension of imminent harm. Battery is
unauthorized and harmful or offensive physical contact with another person that causes injury.
Often an assault results in battery, but not always. In Western Union Telegraph Co. v. Hill, for example,
the defendant did not touch the plaintiff’s wife, but the case presented an issue of possible assault even
without an actual battery; the defendant employee attempted to kiss a customer across the countertop,
couldn't quite reach her, but nonetheless created actionable fear (or, as the court put it, “apprehension”)
on the part of the plaintiff's wife. It is also possible to have a battery without an assault. For example, if
someone hits you on the back of the head with an iron skillet and you didn’t see it coming, there is a
battery but no assault. Likewise, if Andrea passes out from drinking too much at the fraternity party and a
stranger (Andre) kisses her on the lips while she is passed out, she would not be aware of any threat of
offensive contact and would have no apprehension of any harm. Thus there has been no tort of assault,
but she could allege the tort of battery. (The question of what damages, if any, would be an interesting
argument.)
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
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The tort of false imprisonment originally implied a locking up, as in a prison, but today it can occur if a
person is restrained in a room or a car or even if his or her movements are restricted while walking down
the street. People have a right to be free to go as they please, and anyone who without cause deprives
another of personal freedom has committed a tort. Damages are allowed for time lost, discomfort and
resulting ill health, mental suffering, humiliation, loss of reputation or business, and expenses such as
attorneys’ fees incurred as a result of the restraint (such as a false arrest). But as the case of Lester v.
Albers Super Markets, Inc. (Section 7.5 "Cases") shows, the defendant must be shown to have restrained
the plaintiff in order for damages to be allowed.

Intentional Infliction of Emotional Distress
Until recently, the common-law rule was that there could be no recovery for acts, even though
intentionally undertaken, that caused purely mental or emotional distress. For a case to go to the jury, the
courts required that the mental distress result from some physical injury. In recent years, many courts
have overthrown the older rule and now recognize the so-called new tort. In an employment context,
however, it is rare to find a case where a plaintiff is able to recover. The most difficult hurdle is proving
that the conduct was “extreme” or “outrageous.”
In an early California case, bill collectors came to the debtor’s home repeatedly and threatened the
debtor’s pregnant wife. Among other things, they claimed that the wife would have to deliver her child in
prison. The wife miscarried and had emotional and physical complications. The court found that the
behavior of the collection company’s two agents was sufficiently outrageous to prove the tort of
intentional infliction of emotional distress. In Roche v. Stern (New York), the famous cable television talk
show host Howard Stern had tastelessly discussed the remains of Deborah Roche, a topless dancer and
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
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pregnant wife, a miscarriage. Other states have not required physical symptoms, finding that shame,
embarrassment, fear, and anger constitute severe mental distress.

Trespass and Nuisance
Trespass is intentionally going on land that belongs to someone else or putting something on someone
else’s property and refusing to remove it. This part of tort law shows how strongly the law values the rights
of property owners. The right to enjoy your property without interference from others is also found in
common law of nuisance. There are limits to property owners’ rights, however. In Katko v. Briney, for
example, the plaintiff was injured by a spring gun while trespassing on the defendant’s property.

[2]

The

defendant had set up No Trespassing signs after ten years of trespassing and housebreaking events, with
the loss of some household items. Windows had been broken, and there was “messing up of the property
in general.” The defendants had boarded up the windows and doors in order to stop the intrusions and
finally had set up a shotgun trap in the north bedroom of the house. One defendant had cleaned and oiled
his 20-gauge shotgun and taken it to the old house where it was secured to an iron bed with the barrel
pointed at the bedroom door. “It was rigged with wire from the doorknob to the gun’s trigger so would fire
when the door was opened.” The angle of the shotgun was adjusted to hit an intruder in the legs. The
spring could not be seen from the outside, and no warning of its presence was posted.
The plaintiff, Katko, had been hunting in the area for several years and considered the property
abandoned. He knew it had long been uninhabited. He and a friend had been to the house and found
several old bottles and fruit jars that they took and added to their collection of antiques. When they made
a second trip to the property, they entered by removing a board from a porch window. When the plaintiff
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
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example, may have a case against the homeowner unless the courts or legislature of that state have made
it clear that trespassers are owed the limited duty to avoid gross negligence. Or a very small child may
wander off his own property and fall into a gravel pit on a nearby property and suffer death or serious
injury; if the pit should (in the exercise of due care) have been filled in or some barrier erected around it,
then there was negligence. But if the state law holds that the duty to trespassers is only to avoid gross
negligence, the child’s family would lose, unless the state law makes an exception for very young
trespassers. In general, guests, licensees, and invitees are owed a duty of due care; a trespasser may not be
owed such a duty, but states have different rules on this.

Intentional Interference with Contractual Relations
Tortious interference with a contract can be established by proving four elements:
1.

There was a contract between the plaintiff and a third party.

2. The defendant knew of the contract.
3. The defendant improperly induced the third party to breach the contract or made performance of the
contract impossible.
4. There was injury to the plaintiff.
In a famous case of contract interference, Texaco was sued by Pennzoil for interfering with an agreement
that Pennzoil had with Getty Oil. After complicated negotiations between Pennzoil and Getty, a takeover
share price was struck, a memorandum of understanding was signed, and a press release announced the
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
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been completed. If there was no contract, Texaco could not have legally interfered with one. After the SEC
filed a brief that supported Texaco’s interpretation of the law, Texaco agreed to pay $3 billion to Pennzoil
to dismiss its claim of tortious interference with a contract.

Malicious Prosecution
Malicious prosecution is the tort of causing someone to be prosecuted for a criminal act, knowing that
there was no probable cause to believe that the plaintiff committed the crime. The plaintiff must show that
the defendant acted with malice or with some purpose other than bringing the guilty to justice. A mere
complaint to the authorities is insufficient to establish the tort, but any official proceeding will support the
claim—for example, a warrant for the plaintiff’s arrest. The criminal proceeding must terminate in the
plaintiff’s favor in order for his suit to be sustained.
A majority of US courts, though by no means all, permit a suit for wrongful civil proceedings. Civil
litigation is usually costly and burdensome, and one who forces another to defend himself against baseless
accusations should not be permitted to saddle the one he sues with the costs of defense. However,
because, as a matter of public policy, litigation is favored as the means by which legal rights can be
vindicated—indeed, the Supreme Court has even ruled that individuals have a constitutional right to
litigate—the plaintiff must meet a heavy burden in proving his case. The mere dismissal of the original
lawsuit against the plaintiff is not sufficient proof that the suit was unwarranted. The plaintiff in a suit for
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.
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The Restatement (Second) of Torts defines a defamatory communication as one that “so tends to harm the
reputation of another as to lower him in the estimation of the community or to deter third persons from
associating or dealing with him.”

[3]

A statement is not defamatory unless it is false. Truth is an absolute defense to a charge of libel or slander.
Moreover, the statement must be “published”—that is, communicated to a third person. You cannot be
libeled by one who sends you a letter full of false accusations and scurrilous statements about you unless a
third person opens it first (your roommate, perhaps). Any living person is capable of being defamed, but
the dead are not. Corporations, partnerships, and other forms of associations can also be defamed, if the
statements tend to injure their ability to do business or to garner contributions.
The statement must have reference to a particular person, but he or she need not be identified by name. A
statement that “the company president is a crook” is defamatory, as is a statement that “the major
network weathermen are imposters.” The company president and the network weathermen could show
that the words were aimed at them. But statements about large groups will not support an action for
defamation (e.g., “all doctors are butchers” is not defamatory of any particular doctor).
The law of defamation is largely built on strict liability. That a person did not intend to defame is
ordinarily no excuse; a typographical error that converts a true statement into a false one in a newspaper,
magazine, or corporate brochure can be sufficient to make out a case of libel. Even the exercise of due care
is usually no excuse if the statement is in fact communicated. Repeating a libel is itself a libel; a libel
cannot be justified by showing that you were quoting someone else. Though a plaintiff may be able to
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
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court. “Judicial” is broadly construed to include most proceedings of administrative bodies of the
government. The Constitution exempts members of Congress from suits for libel or slander for any
statements made in connection with legislative business. The courts have constructed a similar privilege
for many executive branch officials.

Qualified Privilege
Absolute privileges pertain to those in the public sector. A narrower privilege exists for private citizens. In
general, a statement that would otherwise be actionable is held to be justified if made in a reasonable
manner and for a reasonable purpose. Thus you may warn a friend to beware of dealing with a third
person, and if you had reason to believe that what you said was true, you are privileged to issue the
warning, even though false. Likewise, an employee may warn an employer about the conduct or character
of a fellow or prospective employee, and a parent may complain to a school board about the competence
or conduct of a child’s teacher. There is a line to be drawn, however, and a defendant with nothing but an
idle interest in the matter (an “officious intermeddler”) must take the risk that his information is wrong.
In 1964, the Supreme Court handed down its historic decision in New York Times v. Sullivan, holding
that under the First Amendment a libel judgment brought by a public official against a newspaper cannot
stand unless the plaintiff has shown “actual malice,” which in turn was defined as “knowledge that [the
[4]

statement] was false or with a reckless disregard of whether it was false or not.” In subsequent cases, the
court extended the constitutional doctrine further, applying it not merely to government officials but
to public figures, people who voluntarily place themselves in the public eye or who involuntarily find
themselves the objects of public scrutiny. Whether a private person is or is not a public figure is a difficult
question that has so far eluded rigorous definition and has been answered only from case to case. A CEO
of a private corporation ordinarily will be considered a private figure unless he puts himself in the public
eye—for example, by starring in the company’s television commercials.

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

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

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

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

KEY TAKEAWAY
There are many kinds of intentional torts. Some of them involve harm to the physical person or to his or
her property, reputation or feelings, or economic interests. In each case of intentional tort, the plaintiff
must show 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).
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[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.

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3.

Explain the primary defenses to a claim of negligence.

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

Standard of Care
Not every unintentional act that causes injury is negligent. If you brake to a stop when you see a child dart
out in front of your car, and if the noise from your tires gives someone in a nearby house a heart attack,
you have not acted negligently toward the person in the house. The purpose of the negligence standard is
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
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standard of “the reasonable man.” This fictitious person “of ordinary prudence” is the model that juries
are instructed to compare defendants with in assessing whether those defendants have acted negligently.
Analysis of this mythical personage has baffled several generations of commentators. How much
knowledge must he have of events in the community, of technology, of cause and effect? With what
physical attributes, courage, or wisdom is this nonexistent person supposedly endowed? If the defendant
is a person with specialized knowledge, like a doctor or an automobile designer, must the jury also treat
the “reasonable man” as having this knowledge, even though the average person in the community will
not? (Answer: in most cases, yes.)
Despite the many difficulties, the concept of the reasonable man is one on which most negligence cases
ultimately turn. If a defendant has acted “unreasonably under the circumstances” and his conduct posed
an unreasonable risk of injury, then he is liable for injury caused by his conduct. Perhaps in most
instances, it is not difficult to divine what the reasonable man would do. The reasonable man stops for
traffic lights and always drives at reasonable speeds, does not throw baseballs through windows, performs
surgical operations according to the average standards of the medical profession, ensures that the floors of
his grocery store are kept free of fluids that would cause a patron to slip and fall, takes proper precautions
to avoid spillage of oil from his supertanker, and so on. The "reasonable man" standard imposes hindsight
on the decisions and actions of people in society; the circumstances of life are such that courts may
sometimes impose a standard of due care that many people might not find reasonable.

Duty of Care and Its Breach
The law does not impose on us a duty to care for every person. If the rule were otherwise, we would all, in
this interdependent world, be our brothers’ keepers, constantly unsure whether any action we took might
subject us to liability for its effect on someone else. The law copes with this difficulty by limiting the
number of people toward whom we owe a duty to be careful.
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 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
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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 unforeseeable.
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
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issues are for the jury to resolve. Since it is frequently difficult to make out the requisite proof, the law
allows certain presumptions and rules of evidence that ease the plaintiff’s task, on the ground that without
them substantial injustice would be done. One important rule goes by the Latin phrase res ipsa loquitur,
meaning “the thing speaks for itself.” The best evidence is always the most direct evidence: an eyewitness
account of the acts in question. But eyewitnesses are often unavailable, and in any event they frequently
cannot testify directly to the reasonableness of someone’s conduct, which inevitably can only be inferred
from the circumstances.
In many cases, therefore, circumstantial evidence (evidence that is indirect) will be the only evidence or
will constitute the bulk of the evidence. Circumstantial evidence can often be quite telling: though no one
saw anyone leave the building, muddy footprints tracing a path along the sidewalk are fairly conclusive.
Res ipsa loquitur is a rule of circumstantial evidence that permits the jury to draw an inference of
negligence. A common statement of the rule is the following: “There must be reasonable evidence of
negligence but where the thing is shown to be under the management of the defendant or his servants,
and the accident is such as in the ordinary course of things does not happen if those who have the
management use proper care, it affords reasonable evidence, in the absence of explanation by the
defendants, that the accident arose from want of care.”

[2]

If a barrel of flour rolls out of a factory window and hits someone, or a soda bottle explodes, or an airplane
crashes, courts in every state permit juries to conclude, in the absence of contrary explanations by the
defendants, that there was negligence. The plaintiff is not put to the impossible task of explaining
precisely how the accident occurred. A defendant can always offer evidence that he acted reasonably—for
example, that the flour barrel was securely fastened and that a bolt of lightning, for which he was not
responsible, broke its bands, causing it to roll out the window. But testimony by the factory employees
that they secured the barrel, in the absence of any further explanation, will not usually serve to rebut the
inference. That the defendant was negligent does not conclude the inquiry or automatically entitle the
plaintiff to a judgment. Tort law provides the defendant with several excuses, some of which are discussed
briefly in the next section.

Excuses

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

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

Assumption of Risk
Risk of injury pervades the modern world, and plaintiffs should not win a lawsuit simply because they
took a risk and lost. The law provides, therefore, that when a person knowingly takes a risk, he or she
must suffer the consequences.
The assumption of risk doctrine comes up in three ways. The plaintiff may have formally agreed with the
defendant before entering a risky situation that he will relieve the defendant of liability should injury
occur. (“You can borrow my car if you agree not to sue me if the brakes fail, because they’re worn and I
haven’t had a chance to replace them.”) Or the plaintiff may have entered into a relationship with the
defendant knowing that the defendant is not in a position to protect him from known risks (the fan who is
hit by a line drive in a ballpark). Or the plaintiff may act in the face of a risky situation known in advance
to have been created by the defendant’s negligence (failure to leave, while there was an opportunity to do
so, such as getting into an automobile when the driver is known to be drunk).
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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 responde at superior, meaning that the higher authority must respond to claims brought
against one of its agents. Responde at superior is not limited to the employment relationship but extends
to a number of other agency relationships as well.

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

KEY TAKEAWAY
The most common tort claim is based on the negligence of the defendant. In each negligence claim, the
plaintiff must establish by a preponderance of the evidence that (1) the defendant had a duty of due
care, (2) the defendant breached that duty, (3) that the breach of duty both actually and approximately
has caused harm to the plaintiff, and (4) that the harm is measurable in money damages.
It is also possible for the negligence of one person to be imputed to another, as in the case of responde
at 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?

[1] Tarasoff v. Regents of University of California, 551 P.2d 334 (Calif. 1976).
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[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
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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 Ultra-hazardous 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 ultra-hazardous (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 court invokes 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
Products liability is extremely important. Strict liability may also apply as a legal standard for products,
even those that are not ultra-hazardous. 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.
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In Greenman, the plaintiff had used a home power saw and bench, the Shop smith, designed and
manufactured by the defendant. He was experienced in using power tools and was injured while using the
approved lathe attachment to the Shop smith to fashion a wooden chalice. The case was decided on the
premise that Greenman had done nothing wrong in using the machine but that the machine had a defect
that was “latent” (not easily discoverable by the consumer). Rather than decide the case based on
warranties, or requiring that Greenman prove how the defendant had been negligent, Justice Traynor
found for the plaintiff based on the overall social utility of strict liability in cases of defective products.
According to his decision, the purpose of such liability is to ensure that the “cost of injuries resulting from
defective products is borne by the manufacturers…rather than by the injured persons who are powerless
to protect themselves.”
Today, the majority of US states recognize strict liability for defective products, although some states limit
strict liability actions to damages for personal injuries rather than property damage. Injured plaintiffs
have to prove the product caused the harm but do not have to prove exactly how the manufacturer was
careless. Purchasers of the product, as well as injured guests, bystanders, and others with no direct
relationship with the product may sue for damages caused by the product.
The Restatement of the Law of Torts, Section 402(a), was originally issued in 1964. It is a widely accepted
statement of the liabilities of sellers of goods for defective products. The Restatement specifies six
requirements, all of which must be met for a plaintiff to recover using strict liability for a product that the
plaintiff claims is defective:
1.

The product must be in a defective condition when the defendant sells it.

2. The defendant must normally be engaged in the business of selling or otherwise distributing the
product.
3. The product must be unreasonably dangerous to the user or consumer because of its defective
condition.
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.

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Section 402(a) also explicitly makes clear that a defendant can be held liable even though the defendant
has exercised “all possible care.” Thus in a strict liability case, the plaintiff does not need to show “fault”
(or negligence).
For defendants, who can include manufacturers, distributors, processors, assemblers, packagers, bottlers,
retailers, and wholesalers, there are a number of defenses that are available, including assumption of risk,
product misuse and comparative negligence, commonly known dangers, and the knowledgeable-user
defense. We have already seen assumption of risk and comparative negligence in terms of negligence
actions; the application of these is similar in products-liability actions.
Under product misuse, a plaintiff who uses a product in an unexpected and unusual way will not recover
for injuries caused by such misuse. For example, suppose that someone uses a rotary lawn mower to trim
a hedge and that after twenty minutes of such use loses control because of its weight and suffers serious
cuts to his abdomen after dropping it. Here, there would be a defense of product misuse, as well as
contributory negligence. Consider the urban (or Internet) legend of Mervin Gratz, who supposedly put his
Winnebago on autopilot to go back and make coffee in the kitchen, then recovered millions after his
Winnebago turned over and he suffered serious injuries. There are multiple defenses to this alleged
action; these would include the defenses of contributory negligence, comparative negligence, and product
misuse. (There was never any such case, and certainly no such recovery; it is not known who started this
legend, or why.)
Another defense against strict liability as a cause of action is the knowledgeable user defense. If the
parents of obese teenagers bring a lawsuit against McDonald’s, claiming that its fast-food products are
defective and that McDonald’s should have warned customers of the adverse health effects of eating its
products, a defense based on the knowledgeable user is available. In one case, the court found that the
high levels of cholesterol, fat, salt, and sugar in McDonald’s food is well known to users. The court stated,
“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]

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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?

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

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

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…She does not say that she went unwillingly…Evidence is wholly lacking to show that she was detained by
force or threats. It was probably a disagreeable experience, a humiliating one to her, but she came out
victorious and was allowed to go when she desired with the assurance of Mr. Krause that it was all right.
The demurrer to the evidence on both counts was properly sustained.
The result of the cases is epitomized in 22 Am.Jur. 368, as follows:
A customer or patron who apparently has not paid for what he has received may be detained for a
reasonable time to investigate the circumstances, but upon payment of the demand, he has the
unqualified right to leave the premises without restraint, so far as the proprietor is concerned, and it is
false imprisonment for a private individual to detain one for an unreasonable time, or under unreasonable
circumstances, for the purpose of investigating a dispute over the payment of a bill alleged to be owed by
the person detained for cash services.
***
For these reasons, the judgment is reversed and final judgment entered for the defendant-appellant.

CASE QUESTIONS
1.

The court begins by saying what false imprisonment is not. What is the legal definition of false
imprisonment?

2.

What kinds of detention are permissible for a store to use in accosting those that may have been
shoplifting?

3.

Jody broke up with Jeremy and refused to talk to him. Jeremy saw Jody get into her car near the
business school and parked right behind her so she could not move. He then stood next to the driver’s
window for fifteen minutes, begging Jody to talk to him. She kept saying, “No, let me leave!” Has
Jeremy committed the tort of false imprisonment?

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Negligence: Duty of Due Care
Whitlock v. University of Denver
744 P.2d 54 (Supreme Court of Colorado1987)
On June 19, 1978, at approximately 10:00 p.m., plaintiff Oscar Whitlock suffered a paralyzing injury while
attempting to complete a one-and-three-quarters front flip on a trampoline. The injury rendered him a
quadriplegic. The trampoline was owned by the Beta Theta Pi fraternity (the Beta house) and was situated
on the front yard of the fraternity premises, located on the University campus. At the time of his injury,
Whitlock was twenty years old, attended the University of Denver, and was a member of the Beta house,
where he held the office of acting house manager. The property on which the Beta house was located was
leased to the local chapter house association of the Beta Theta Pi fraternity by the defendant University of
Denver.
Whitlock had extensive experience jumping on trampolines. He began using trampolines in junior high
school and continued to do so during his brief tenure as a cadet at the United States Military Academy at
West Point, where he learned to execute the one-and-three-quarters front flip. Whitlock testified that he
utilized the trampoline at West Point every other day for a period of two months. He began jumping on
the trampoline owned by the Beta house in September of 1977. Whitlock recounted that in the fall and
spring prior to the date of his injury, he jumped on the trampoline almost daily. He testified further that
prior to the date of his injury; he had successfully executed the one-and-three-quarters front flip between
seventy-five and one hundred times.
During the evening of June 18 and early morning of June 19, 1978, Whitlock attended a party at the Beta
house, where he drank beer, vodka and scotch until 2:00 a.m. Whitlock then retired and did not awaken
until 2:00 p.m. on June 19. He testified that he jumped on the trampoline between 2:00 p.m. and 4:00
p.m., and again at 7:00 p.m. At 10:00 p.m., the time of the injury, there again was a party in progress at
the Beta house, and Whitlock was using the trampoline with only the illumination from the windows of
the fraternity house, the outside light above the front door of the house, and two street lights in the area.
As Whitlock attempted to perform the one-and-three-quarters front flip, he landed on the back of his
head, causing his neck to break.
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
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the Beta Theta Pi organizations. Whitlock reached settlements with all of the named defendants except
the University, so only the negligence action against the University proceeded to trial. The jury returned a
verdict in favor of Whitlock, assessing his total damages at $ 7,300,000. The jury attributed twenty-eight
percent of causal negligence to the conduct of Whitlock and seventy-two percent of causal negligence to
the conduct of the University. The trial court accordingly reduced the amount of the award against the
University to $ 5,256,000.
The University moved for judgment notwithstanding the verdict, or, in the alternative, a new trial. The
trial court granted the motion for judgment notwithstanding the verdict, holding that as a matter of law,
no reasonable jury could have found that the University was more negligent than Whitlock, and that the
jury’s monetary award was the result of sympathy, passion or prejudice.
A panel of the court of appeals reversed…by a divided vote. Whitlock v. University of Denver, 712 P.2d
1072 (Colo. App. 1985). The court of appeals held that the University owed Whitlock a duty of due care to
remove the trampoline from the fraternity premises or to supervise its use.…The case was remanded to
the trial court with orders to reinstate the verdict and damages as determined by the jury. The University
then petitioned for certiorari review, and we granted that petition.

II.
A negligence claim must fail if based on circumstances for which the law imposes no duty of care upon the
defendant for the benefit of the plaintiff. [Citations] Therefore, if Whitlock’s judgment against the
University is to be upheld, it must first be determined that the University owed a duty of care to take
reasonable measures to protect him against the injury that he sustained.
Whether a particular defendant owes a legal duty to a particular plaintiff is a question of law. [Citations]
“The court determines, as a matter of law, the existence and scope of the duty—that is, whether the
plaintiff’s interest that has been infringed by the conduct of the defendant is entitled to legal protection.”
[Citations] In Smith v. City & County of Denver, 726 P.2d 1125 (Colo. 1986), we set forth several factors to
be considered in determining the existence of duty in a particular case:
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.
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…A court’s conclusion that a duty does or does not exist is “an expression of the sum total of those
considerations of policy which lead the law to say that the plaintiff is [or is not] entitled to protection.”
…
We believe that the fact that the University is charged with negligent failure to act rather than negligent
affirmative action is a critical factor that strongly militates against imposition of a duty on the University
under the facts of this case. In determining whether a defendant owes a duty to a particular plaintiff, the
law has long recognized a distinction between action and a failure to act—“that is to say, between active
misconduct working positive injury to others [misfeasance] and passive inaction or a failure to take steps
to protect them from harm [nonfeasance].” W. Keeton, § 56, at 373. Liability for nonfeasance was slow to
receive recognition in the law. “The reason for the distinction may be said to lie in the fact that by
‘misfeasance’ the defendant has created a new risk of harm to the plaintiff, while by ‘nonfeasance’ he has
at least made his situation no worse, and has merely failed to benefit him by interfering in his
affairs.” Id. 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 purposes of imposition of a duty of care include common carrier/passenger,
innkeeper/guest, and possessor of land/invited entrant, employer/employee, parent/child, and
hospital/patient. See Restatement (Second) of Torts § 314 A (1965); 3 Harper and James, § 18.6, at 722–
23. The authors of the Restatement (Second) of Torts § 314 A, comment b (1965), state that “the law
appears…to be working slowly toward 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 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
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inhospitable environment, largely inconsistent with the objectives of a modern college
education.” Beach, 726 P.2d at 419.
The evidence demonstrates that only in limited instances has the University attempted to impose
regulations or restraints on the private recreational pursuits of its students, and the students have not
looked to the University to assure the safety of their recreational choices. Nothing in the University’s
student handbook, which contains certain regulations concerning student conduct, reflects an effort by
the University to control the risk-taking decisions of its students in their private recreation. Indeed,
fraternity and sorority self-governance with minimal supervision appears to have been fostered by the
University.
…
Aside from advising the Beta house on one occasion to put the trampoline up when not in use, there is no
evidence that the University officials attempted to assert control over trampoline use by the fraternity
members. We conclude from this record that the University’s very limited actions concerning safety of
student recreation did not give Whitlock or the other members of campus fraternities or sororities any
reason to depend upon the University for evaluation of the safety of trampoline use.…Therefore, we
conclude that the student-university relationship is not a special relationship of the type giving rise to a
duty of the University to take reasonable measures to protect the members of fraternities and sororities
from risks of engaging in extra-curricular trampoline jumping.
The plaintiff asserts, however, that we should recognize a duty of the University to take affirmative action
to protect fraternity members because of the foreseeability of the injury, the extent of the risks involved in
trampoline use, the seriousness of potential injuries, and the University’s superior knowledge concerning
these matters. The argument in essence is that a duty should spring from the University’s natural interest
in the welfare and safety of its students, its superior knowledge of the nature and degree of risk involved
in trampoline use, and its knowledge of the use of trampolines on the University campus. The evidence
amply supports a conclusion that trampoline use involves risks of serious injuries and that the potential
for an injury such as that experienced by Whitlock was foreseeable. It shows further that prior injuries
resulting from trampoline accidents had been reported to campus security and to the student clinic, and
that University administrators were aware of the number and severity of trampoline injuries nationwide.

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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.
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

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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 contributory 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 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.
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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 truck man 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; 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.

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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?

Klein v. Pyrodyne Corporation
Klein v. Pyrodyne Corporation
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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 ultra-hazardous or abnormally dangerous so that strict liability
is imposed?

2.

If the activities are known to be abnormally dangerous, did Klein assume the risk?

3.

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

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

EXERCISES
1.

What is the difference in objectives between tort law and criminal law?

2.

A woman fell ill in a store. An employee put the woman in an infirmary but provided no medical care for
six hours, and she died. The woman’s family sued the store for wrongful death. What arguments could

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the store make that it was not liable? What arguments could the family make? Which seem the stronger
arguments? Why?
3.

The signals on a railroad crossing are defective. Although the railroad company was notified of the
problem a month earlier, the railroad inspector has failed to come by and repair them. Seeing the all-clear
signal, a car drives up and stalls on the tracks as a train rounds the bend. For the past two weeks the car
had been stalling, and the driver kept putting off taking the car to the shop for a tune-up. As the train
rounds the bend, the engineer is distracted by a conductor and does not see the car until it is too late to
stop. Who is negligent? Who must bear the liability for the damage to the car and to the train?

4.

Suppose in the Katko v. Briney case (Section 7.2 "Intentional Torts") that instead of setting such a device,
the defendants had simply let the floor immediately inside the front door rot until it was so weak that
anybody who came in and took two steps straight ahead would fall through the floor and to the cellar.
Will the defendant be liable in this case? What if they invited a realtor to appraise the place and did not
warn her of the floor? Does it matter whether the injured person is a trespasser or an invitee?

5.

Plaintiff’s husband died in an accident, leaving her with several children and no money except a valid
insurance policy by which she was entitled to $5,000. Insurance Company refused to pay, delaying and
refusing payment and meanwhile “inviting” Plaintiff to accept less than $5,000, hinting that it had a
defense. Plaintiff was reduced to accepting housing and charity from relatives. She sued the insurance
company for bad-faith refusal to settle the claim and for the intentional infliction of emotional distress.
The lower court dismissed the case. Should the court of appeals allow the matter to proceed to trial?

SELF-TEST QUESTIONS
1.

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

a third party hears it

b.

Nick suffers severe emotional distress as a result

c.

the statement is the actual and proximate cause of his distress

d.

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

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a.
b.

malice
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

1.

a

2.

d

3.

c

SELF-TEST ANSWERS

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4.

c

5.

a

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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 contract duties 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.

Next

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8.1 General Perspectives on Contracts
LEARNING OBJECTIVES
1.

Understand the role of contract in society: it moves society from status to contract.

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
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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 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

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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
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 law and 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, and 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
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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
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)

•

Bank Deposits and Collections (Article 4)

•

Letters of Credit (Article 5)

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•

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 are 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 Newark 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.
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.
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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 non-sales 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” 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.

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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, 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
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.

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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. A quasi-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
promise; 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 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 offered, but
if she looks for the dog and finds it, she is entitled to the $50.

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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.)

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
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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 executor contract before either promise is carried
out. Most executor 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?

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

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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 an acceptance. Note, however, that not
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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. The Restatement (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
offered 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 must be
communicated and must be definite; that is, they must spell out terms to which the offeree can assent.

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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 was once sufficient to make a contract binding
without any other consideration. In most states, the seal is no longer a substitute for consideration,

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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
a legal detriment—an act, forbearance, or a promise of such from the promisee. The detriment need not be
an actual detriment; it may in fact be a benefit to the promisee, or at least not a loss. 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 legal concept, and it centers on the giving up of a legal right or
benefit.
Consideration has two elements. The first, as just outlined, is whether the promisee has incurred a legal
detriment. (Some courts—although a minority—takes 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.
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
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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 fewer than twenty-one remain ambiguous, however. Although eighteenyear-olds may assent to binding contracts, not all creditors and landlords believe it, and they may require
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.

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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 or disaffirm it. She may
ratify explicitly; no further consideration is necessary. She may also do so by implication—for instance, by
continuing to make payments or retaining goods for an unreasonable period of time. (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 executor, the minor can simply disaffirm. If the
contract has been executed, however, the minor must face more onerous consequences. Although he will
not be required to perform under the contract, he will be liable under a theory of “quasi-contract” for the
reasonable value of the necessity.

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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 highfashion 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 the Statute 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 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.
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[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 Contracts Chapter 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.

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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?

[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).

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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
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 are the general category of damages awarded to make the non-breaching
party whole.
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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]

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
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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
contract for a loan sells the collateral to a good-faith purchaser for value even though the debtor was not
in default, he has breached the contract and committed the tort of conversion. Punitive damages may be
awarded, assuming the behavior was willful and not merely mistaken.
Punitive damages are not fixed by law. The judge or jury may award at its discretion whatever sum is
believed necessary to redress the wrong or deter like conduct in the future. This means that a richer
person may be slapped with much heavier punitive damages than a poorer one in the appropriate case.
But the judge in all cases may remit (lower) some or all of a punitive damage award if he or she considers
it excessive.
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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
executor. 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
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
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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.
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 subcategories of incidental and nominal damages; punitive damages (to punish the breaching party) are
sometimes allowed where the breach is egregious and intentional.
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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.

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8.4 Cases
Objective Intention
Lucy v. Zehmer
84 S.E.2d 516 (Va. 1954)
Buchanan, J.
This suit was instituted by W. O. Lucy and J. C. Lucy, complainants, against A. H. Zehmer and Ida S.
Zehmer, his wife, defendants, to have specific performance of a contract by which it was alleged the
Zehmers had sold to W. O. Lucy a tract of land owned by A. H. Zehmer in Dinwiddie county containing
471.6 acres, more or less, known as the Ferguson farm, for $50,000. J. C. Lucy, the other complainant, is
a brother of W. O. Lucy, to whom W. O. Lucy transferred a half interest in his alleged purchase.
The instrument sought to be enforced was written by A. H. Zehmer on December 20, 1952, in these words:
“We hereby agree to sell to W. O. Lucy the Ferguson farm complete for $50,000.00, title satisfactory to
buyer,” and signed by the defendants, A. H. Zehmer and Ida S. Zehmer.
The answer of A. H. Zehmer admitted that at the time mentioned W. O. Lucy offered him $50,000 cash
for the farm, but that he, Zehmer, considered that the offer was made in jest; that so thinking, and both he
and Lucy having had several drinks, he wrote out “the memorandum” quoted above and induced his wife
to sign it; that he did not deliver the memorandum to Lucy, but that Lucy picked it up, read it, put it in his
pocket, attempted to offer Zehmer $5 to bind the bargain, which Zehmer refused to accept, and realizing
for the first time that Lucy was serious, Zehmer assured him that he had no intention of selling the farm
and that the whole matter was a joke. Lucy left the premises insisting that he had purchased the farm.…
In his testimony Zehmer claimed that he “was high as a Georgia pine,” and that the transaction “was just a
bunch of two doggoned drunks bluffing to see who could talk the biggest and say the most.” That claim is
inconsistent with his attempt to testify in great detail as to what was said and what was done.…
If it be assumed, contrary to what we think the evidence shows, that Zehmer was jesting about selling his
farm to Lucy and that the transaction was intended by him to be a joke, nevertheless the evidence shows
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
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examine the title. The next night, Tuesday, he was back at Zehmer’s place and there Zehmer told him for
the first time, Lucy said, that he wasn’t going to sell and he told Zehmer, “You know you sold that place
fair and square.” After receiving the report from his attorney that the title was good he wrote to Zehmer
that he was ready to close the deal.
Not only did Lucy actually believe, but the evidence shows he was warranted in believing, that the contract
represented a serious business transaction and a good faith sale and purchase of the farm.
In the field of contracts, as generally elsewhere, “We must look to the outward expression of a person as
manifesting his intention rather than to his secret and unexpressed intention. The law imputes to a person
an intention corresponding to the reasonable meaning of his words and acts.”
At no time prior to the execution of the contract had Zehmer indicated to Lucy by word or act that he was
not in earnest about selling the farm. They had argued about it and discussed its terms, as Zehmer
admitted, for a long time. Lucy testified that if there was any jesting it was about paying $50,000 that
night. The contract and the evidence show that he was not expected to pay the money that night. Zehmer
said that after the writing was signed he laid it down on the counter in front of Lucy. Lucy said Zehmer
handed it to him. In any event there had been what appeared to be a good faith offer and a good faith
acceptance, followed by the execution and apparent delivery of a written contract. Both said that Lucy put
the writing in his pocket and then offered Zehmer $5 to seal the bargain. Not until then, even under the
defendants’ evidence, was anything said or done to indicate that the matter was a joke. Both of the
Zehmers testified that when Zehmer asked his wife to sign he whispered that it was a joke so Lucy
wouldn’t hear and that it was not intended that he should hear.
The mental assent of the parties is not requisite for the formation of a contract. If the words or other acts
of one of the parties have but one reasonable meaning, his undisclosed intention is immaterial except
when an unreasonable meaning which he attaches to his manifestations is known to the other party.
“* * * The law, therefore, judges of an agreement between two persons exclusively from those expressions
of their intentions which are communicated between them. * * *.” [Citation]
An agreement or mutual assent is of course essential to a valid contract but the law imputes to a person an
intention corresponding to the reasonable meaning of his words and acts. If his words and acts, judged by
a reasonable standard, manifest an intention to agree, it is immaterial what may be the real but
unexpressed state of his mind.
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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.

Its 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.…
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
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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. * * *.’…
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
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danger. The community and the county have recompensed them in commendation, admiration and high
praise, and the world looks on them as heroes. But in making known the robbery and assisting in
acquainting the public and the officers with details of the crime and with identification of the robbers,
they performed a duty to the bank and the public, for which they cannot claim a reward.
The claims of Corbin Reynolds, Julia Reynolds, Alvie Reynolds and Gene Reynolds also must fail.
According to their statements they gave valuable information to the arresting officers. However, they did
not follow the procedure as set forth in the offer of reward in that they never filed a claim with the
Kentucky Bankers Association. It is well established that a claimant of a reward must comply with the
terms and conditions of the offer of reward. [Citation]
State Policemen Garret Godby, Johnny Simms and Tilford Reppert made the arrest of the bank robbers
and captured the stolen money. All participated in the prosecution. At the time of the arrest, it was the
duty of the state policemen to apprehend the criminals. Under the law they cannot claim or share in the
reward and they are interposing no claim to it.
This leaves the defendant, Tilford Reppert the sole eligible claimant. The record shows that at the time of
the arrest he was a deputy sheriff in Rockcastle County, but the arrest and recovery of the stolen money
took place in Pulaski County. He was out of his jurisdiction, and was thus under no legal duty to make the
arrest, and is thus eligible to claim and receive the reward. In [Citation] it was said:
‘It is * * * well established that a public officer with the authority of the law to make an arrest may accept
an offer of reward or compensation for acts or services performed outside of his bailiwick or not within
the scope of his official duties. * * *.’…
It is manifest from the record that Tilford Reppert is the only claimant qualified and eligible to receive the
reward. Therefore, it is the judgment of the circuit court that he is entitled to receive payment of the
$1,500.00 reward now deposited with the Clerk of this Court.
The judgment is affirmed.

CASE QUESTIONS
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?

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Consequential Damages
EBWS, LLC v. Britly Corp.
928 A.2d 497 (Vt. 2007)
Reiber, C.J.
The Ransom family owns Rock Bottom Farm in Strafford, Vermont, where Earl Ransom owns a dairy
herd and operates an organic dairy farm. In 2000, the Ransoms decided to build a creamery on-site to
process their milk and formed EBWS, LLC to operate the dairy-processing plant and to market the plant’s
products. In July 2000, Earl Ransom, on behalf of EBWS, met with Britly’s president to discuss building
the creamery…In January 2001, EBWS and Britly entered into a contract requiring Britly to construct a
creamery building for EBWS in exchange for $160,318.…The creamery was substantially completed by
April 15, 2001, and EBWS moved in soon afterward. On June 5, 2001, EBWS notified Britly of alleged
defects in construction. [EBWS continued to use the creamery pending the necessity to vacate it for three
weeks when repairs were commenced].
On September 12, 2001, EBWS filed suit against Britly for damages resulting from defective design and
construction.…
Following a three-day trial, the jury found Britly had breached the contract and its express warranty, and
awarded EBWS: (1) $38,020 in direct damages, and (2) $35,711 in consequential damages.…
…The jury’s award to EBWS included compensation for both direct and consequential damages that
EBWS claimed it would incur while the facility closed for repairs. Direct damages [i.e., compensatory
damages] are for “losses that naturally and usually flow from the breach itself,” and it is not necessary that
the parties actually considered these damages. [Citation]. In comparison, special or consequential
damages “must pass the tests of causation, certainty and foreseeability, and, in addition, be reasonably
supposed to have been in the contemplation of both parties at the time they made the contract.”
…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
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admitted that such a requirement was self-imposed as there was no written output contract between
EBWS and the farm to buy milk. In addition, Huyffer testified that EBWS would pay its employees during
the closure even though EBWS has no written contract to pay its employees when they are not working.
The trial court allowed these elements of damages to be submitted to the jury, and the jury awarded
EBWS consequential damages for unused milk and staff wages.
On appeal, Britly contends that because there is no contractual or legal obligation for EBWS to purchase
milk or pay its employees, these are not foreseeable damages. EBWS counters that it is common
knowledge that cows continue to produce milk, even if the processing plant is not working, and thus it is
foreseeable that this loss would occur. We conclude that these damages are not the foreseeable result of
Britly’s breach of the construction contract and reverse the award.…
[W]e conclude that…it is not reasonable to expect Britly to foresee that its failure to perform under the
contract would result in this type of damages. While we are sympathetic to EBWS’s contention that the
cows continue to produce milk, even when the plant is closed down, this fact alone is not enough to
demonstrate that buying and dumping milk is a foreseeable result of Britly’s breach of the construction
contract. Here, the milk was produced by a separate and distinct entity, Rock Bottom Farm, which sold
the milk to EBWS…
Similarly, EBWS maintained no employment agreements with its employees obligating it to pay wages
during periods of closure for repairs, dips in market demand, or for any other reason. Any losses EBWS
might suffer in the future because it chooses to pay its employees during a plant closure for repairs would
be a voluntary expense and not in Britly’s contemplation at the time it entered the construction contract.
It is not reasonable to expect Britly to foresee losses incurred as a result of agreements that are informal in
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.…

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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 EBWS was
then not entitled to those damages which it will certainly suffer when the creamery is down for repairs?

3.

Britly (the contractor) must have known EBWS had employees that would be idled when the creamery
shut down for repairs. Why was it not liable for their lost wages?

4.

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

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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 the Restatement (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 quasicontracts implied by law; (2) bilateral and unilateral; (3) enforceable and unenforceable; and (4)
completed (executed) and uncompleted (executor). 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 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

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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.

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

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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.

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?

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

a.

true

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b.

false

SELF-TEST ANSWERS
1.

c

2.

d

3.

c

4.

b

5.

false

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Chapter 9
Consumer Credit Transactions
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

How consumers enter into credit transactions and what protections they are afforded when they do

2.

What rights consumers have after they have entered into a consumer transaction

3.

What debt collection practices third-party collectors may pursue

This chapter and the three that follow are devoted to debtor-creditor relations. In this chapter, we focus
on the consumer credit transaction. Chapter 10 "Secured Transactions and Suretyship" and Chapter 11
"Mortgages and Nonconsensual Liens" explore different types of security that a creditor might
require. Chapter 12 "Bankruptcy" examines debtors’ and creditors’ rights under bankruptcy law.
The amount of consumer debt, or household debt, owed by Americans to mortgage lenders, stores,
automobile dealers, and other merchants who sell on credit is difficult to ascertain. One reads that the
average household credit card debt (not including mortgages, auto loans, and student loans) in 2009 was
almost $16,000.

[1]

Or maybe it was $10,000.

[2]

[3]

Or maybe it was $7,300. But probably focusing on

the average household debt is not very helpful: 55 percent of households have no credit card debt at all,
and the median debt is $1,900.

[4]

In 2007, the total household debt owed by Americans was $13.3 trillion, according to the Federal Reserve
Board. That is really an incomprehensible number: suffice it to say, then, that the availability of credit is
an important factor in the US economy, and not surprisingly, a number of statutes have been enacted over
the years to protect consumers both before and after signing credit agreements.
The statutes tend to fall within three broad categories. First, several statutes are especially important
when a consumer enters into a credit transaction. These include laws that regulate credit costs, the credit
application, and the applicant’s right to check a credit record. Second, after a consumer has contracted for
credit, certain statutes give a consumer the right to cancel the contract and correct billing mistakes. Third,
if the consumer fails to pay a debt, the creditor has several traditional debt collection remedies that today
are tightly regulated by the government.

Next

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[1] Ben Woolsey and Matt Schulz, Credit Card Statistics, Industry Statistics, Debt Statistics, August 24,
2010, http://www.creditcards.com/credit-card-news/credit-card-industry-facts-personal-debt-statistics-1276.php.
This is “calculated by dividing the total revolving debt in the U.S. ($852.6 billion as of March 2010 data, as listed in
the Federal Reserve’s May 2010 report on consumer credit) by the estimated number of households carrying
credit card debt (54 million).”
[2] Deborah Fowles, “Your Monthly Credit Card Minimum Payments May Double,” About.com Financial
Planning,http://financialplan.about.com/od/creditcarddebt/a/CCMinimums.htm.
[3] Index Credit Cards, Credit Card Debt, February 9, 2010,http://www.indexcreditcards.com/creditcarddebt.
[4] Liz Pulliam Weston, “The Big Lie about Credit Card Debt,” MSN Money, July 30, 2007.

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9.1 Entering into a Credit Transaction
LEARNING OBJECTIVES
1.

Understand what statutes regulate the cost of credit, and the exceptions.

2.

Know how the cost of credit is expressed in the Truth in Lending Act.

3.

Recognize that there are laws prohibiting discrimination in credit granting.

4.

Understand how consumers’ credit records are maintained and may be corrected.

The Cost of Credit
Lenders, whether banks or retailers, are not free to charge whatever they wish for credit. Usury laws
establish a maximum rate of lawful interest. The penalties for violating usury laws vary from state to state.
The heaviest penalties are loss of both principal and interest, or loss of a multiple of the interest the
creditor charged. The courts often interpret these laws stringently, so that even if the impetus for a
usurious loan comes from the borrower, the contract can be avoided, as demonstrated in Matter of Dane’s
Estate (Section 9.3 "Cases").
Some states have eliminated interest rate limits altogether. In other states, usury law is riddled with
exceptions, and indeed, in many cases, the exceptions have pretty much eaten up the general rule. Here
are some common exceptions:
•

Business loans. In many states, businesses may be charged any interest rate, although some states
limit this exception to incorporated businesses.

•

Mortgage loans. Mortgage loans are often subject to special usury laws. The allowable interest rates
vary, depending on whether a first mortgage or a subordinate mortgage is given, or whether the loan
is insured or provided by a federal agency, among other variables.

•

Second mortgages and home equity loans by licensed consumer loan companies.

•

Credit card and other retail installment debt. The interest rate for these is governed by the law of the
state where the credit card company does business. (That’s why the giant Citibank, otherwise
headquartered in New York City, runs its credit card division out of South Dakota, which has no usury
laws for credit cards.)

•

Consumer leasing.

•

“Small loans” such as payday loans and pawnshop loans.

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•

Lease-purchases on personal property. This is the lease-to-own concept.

•

Certain financing of mobile homes that have become real property or where financing is insured by
the federal government.

•

Loans a person takes from her tax-qualified retirement plan.

•

Certain loans from stockbrokers and dealers.

•

Interest and penalties on delinquent property taxes.

•

Deferred payment of purchase price (layaway loans).

•

Statutory interest on judgments.

And there are others. Moreover, certain charges are not considered interest, such as fees to record
documents in a public office and charges for services such as title examinations, deed preparation, credit
reports, appraisals, and loan processing. But a creditor may not use these devices to cloak what is in fact a
usurious bargain; it is not the form but the substance of the agreement that controls.
As suggested, part of the difficulty here is that governments at all levels have for a generation attempted to
promote consumption to promote production; production is required to maintain politically acceptable
levels of employment. If consumers can get what they want on credit, consumerism increases. Also,
certainly, tight limits on interest rates cause creditors to deny credit to the less creditworthy, which may
not be helpful to the lower classes. That’s the rationale for the usury exceptions related to pawnshop and
payday loans.

Disclosure of Credit Costs
Setting limits on what credit costs—as usury laws do—is one thing. Disclosing the cost of credit is another.

The Truth in Lending Act
Until 1969, lenders were generally free to disclose the cost of money loaned or credit extended in any way
they saw fit—and they did. Financing and credit terms varied widely, and it was difficult and sometimes
impossible to understand what the true cost was of a particular loan, much less to comparison shop. After
years of failure, consumer interests finally persuaded Congress to pass a national law requiring disclosure
of credit costs in 1968. Officially called the Consumer Credit Protection Act, Title I of the law is more
popularly known as the Truth in Lending Act (TILA). The act only applies to consumer credit

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transactions, and it only protects natural-person debtors—it does not protect business organization
debtors.
The act provides what its name implies: lenders must inform borrowers about significant terms of the
credit transaction. The TILA does not establish maximum interest rates; these continue to be governed by
state law. The two key terms that must be disclosed are the finance charge and the annual percentage rate.
To see why, consider two simple loans of $1,000, each carrying interest of 10 percent, one payable at the
end of twelve months and the other in twelve equal installments. Although the actual charge in each is the
same—$100—the interest rate is not. Why? Because with the first loan you will have the use of the full
$1,000 for the entire year; with the second, for much less than the year because you must begin repaying
part of the principal within a month. In fact, with the second loan you will have use of only about half the
money for the entire year, and so the actual rate of interest is closer to 15 percent. Things become more
complex when interest is compounded and stated as a monthly figure, when different rates apply to
various portions of the loan, and when processing charges and other fees are stated separately. The act
regulates open-end credit (revolving credit, like charge cards) and closed-end credit (like a car loan—
extending for a specific period), and—as amended later—it regulates consumer leases and credit card
transactions, too.
Figure 9.1 Credit Disclosure Form

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By requiring that the finance charge and the annual percentage rate be disclosed on a uniform basis, the
TILA makes understanding and comparison of loans much easier. The finance charge is the total of all
money paid for credit; it includes the interest paid over the life of the loan and all processing charges. The
annual percentage rate is the true rate of interest for money or credit actually available to the borrower.
The annual percentage rate must be calculated using the total finance charge (including all extra fees).
See Figure 9.1 "Credit Disclosure Form" for an example of a disclosure form used by creditors.

Consumer Leasing Act of 1988
The Consumer Leasing Act (CLA) amends the TILA to provide similar full disclosure for consumers who
lease automobiles or other goods from firms whose business it is to lease such goods, if the goods are
valued at $25,000 or less and the lease is for four months or more. All material terms of the lease must be
disclosed in writing.

Fair Credit and Charge Card Disclosure

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In 1989, the Fair Credit and Charge Card Disclosure Act went into effect. This amends the TILA by
requiring credit card issuers to disclose in a uniform manner the annual percentage rate, annual fees,
grace period, and other information on credit card applications.

Credit Card Accountability, Responsibility, and Disclosure Act of 2009
The 1989 act did make it possible for consumers to know the costs associated with credit card use, but the
card companies’ behavior over 20 years convinced Congress that more regulation was required. In 2009,
Congress passed and President Obama signed the Credit Card Accountability, Responsibility, and
Disclosure Act of 2009 (the Credit Card Act). It is a further amendment of the TILA. Some of the salient
parts of the act are as follows:
•

Restricts all interest rate increases during the first year, with some exceptions. The purpose is to
abolish “teaser” rates.

•

Increases notice for rate increase on future purchases to 45 days.

•

Preserves the ability to pay off on the old terms, with some exceptions.

•

Limits fees and penalty interest and requires statements to clearly state the required due date and late
payment penalty.

•

Requires fair application of payments. Amounts in excess of the minimum payment must be applied
to the highest interest rate (with some exceptions).

•

Provides sensible due dates and time to pay.

•

Protects young consumers. Before issuing a card to a person under the age of twenty-one, the card
issuer must obtain an application that contains either the signature of a cosigner over the age of
twenty-one or information indicating an independent means of repaying any credit extended.

•

Restricts card issuers from providing tangible gifts to students on college campuses in exchange for
filling out a credit card application.

•

Requires colleges to publicly disclose any marketing contracts made with a card issuer.

•

Requires enhanced disclosures.

•

Requires issuers to disclose the period of time and the total interest it will take to pay off the card
balance if only minimum monthly payments are made.

•

Establishes gift card protections.

[1]

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The Federal Reserve Board is to issue implementing rules.
Creditors who violate the TILA are subject to both criminal and civil sanctions. Of these, the most
important are the civil remedies open to consumers. If a creditor fails to disclose the required
information, a customer may sue to recover twice the finance charge, plus court costs and reasonable
attorneys’ fees, with some limitations. As to the Credit Card Act of 2009, the issuing companies were not
happy with the reforms. Before the law went into effect, the companies—as one commentator put it—
[2]

unleashed a “frenzy of retaliation,” by re-pricing customer accounts, changing fixed rates to variable
rates, lowering credit limits, and increasing fees.

State Credit Disclosure Laws
The federal TILA is not the only statute dealing with credit disclosures. A uniform state act, the Uniform
Consumer Credit Code, as amended in 1974, is now on the books in twelve US jurisdictions,

[3]

though its

effect on the development of modern consumer credit law has been significant beyond the number of
states adopting it. It is designed to protect consumers who buy goods and services on credit by
simplifying, clarifying, and updating legislation governing consumer credit and usury.

Getting Credit
Disclosure of credit costs is a good thing. After discovering how much credit will cost, a person might
decide to go for it: get a loan or a credit card. The potential creditor, of course, should want to know if the
applicant is a good risk; that requires a credit check. And somebody who knows another person’s
creditworthiness has what is usually considered confidential information, the possession of which is
subject to abuse, and thus regulation.

Equal Credit Opportunity Act
Through the 1960s, banks and other lending and credit-granting institutions regularly discriminated
against women. Banks told single women to find a cosigner for loans. Divorced women discovered that
they could not open store charge accounts because they lacked a prior credit history, even though they had
contributed to the family income on which previous accounts had been based. Married couples found that
the wife’s earnings were not counted when they sought credit; indeed, families planning to buy homes
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were occasionally even told that the bank would grant a mortgage if the wife would submit to a
hysterectomy! In all these cases, the premise of the refusal to treat women equally was the unstated—and
usually false—belief that women would quit work to have children or simply to stay home.
By the 1970s, as women became a major factor in the labor force, Congress reacted to the manifest
unfairness of the discrimination by enacting (as part of the Consumer Credit Protection Act) the Equal
Credit Opportunity Act (ECOA) of 1974. The act prohibits any creditor from discriminating “against any
applicant on the basis of sex or marital status with respect to any aspect of a credit transaction.” In 1976,
Congress broadened the law to bar discrimination (1) on the basis of race, color, religion, national origin,
and age; (2) because all or a part of an applicant’s income is from a public assistance program; or (3)
because an applicant has exercised his or her rights under the Consumer Credit Protection Act.
Under the ECOA, a creditor may not ask a credit applicant to state sex, race, national origin, or religion.
And unless the applicant is seeking a joint loan or account or lives in a community-property state, the
creditor may not ask for a statement of marital status or, if you have voluntarily disclosed that you are
married, for information about your spouse, nor may one spouse be required to cosign if the other is
deemed independently creditworthy. All questions concerning plans for children are improper. In
assessing the creditworthiness of an applicant, the creditor must consider all sources of income, including
regularly received alimony and child support payments. And if credit is refused, the creditor must, on
demand, tell you the specific reasons for rejection. See Rosa v. Park West Bank & Trust Co. in Section 9.3
"Cases" for a case involving the ECOA.
The Home Mortgage Disclosure Act, 1975, and the Community Reinvestment Act (CRA), 1977, get at
another type of discrimination: redlining. This is the practice by a financial institution of refusing to grant
home loans or home-improvement loans to people living in low-income neighborhoods. The act requires
that financial institutions within its purview report annually by transmitting information from their Loan
Application Registers to a federal agency. From these reports it is possible to determine what is happening
to home prices in a particular area, whether investment in one neighborhood lags compared with that in
others, if the racial or economic composition of borrowers changed over time, whether minorities or
women had trouble accessing mortgage credit, in what kinds of neighborhoods subprime loans are
concentrated, and what types of borrowers are most likely to receive subprime loans, among others.
“Armed with hard facts, users of all types can better execute their work: Advocates can launch consumer
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education campaigns in neighborhoods being targeted by subprime lenders, planners can better tailor
housing policy to market conditions, affordable housing developers can identify gentrifying
neighborhoods, and activists can confront banks with poor lending records in low income
communities.”

[4]

Under the CRA, 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.

Fair Credit Reporting Act of 1970: Checking the Applicant’s Credit Record
It is in the interests of all consumers that people who would be bad credit risks not get credit: if they do
and they default (fail to pay their debts), the rest of us end up paying for their improvidence. Because
credit is such a big business, a number of support industries have grown up around it. One of the most
important is the credit-reporting industry, which addresses this issue of checking creditworthiness.
Certain companies—credit bureaus—collect information about borrowers, holders of credit cards, store
accounts, and installment purchasers. For a fee, this information—currently held on tens of millions of
Americans—is sold to companies anxious to know whether applicants are creditworthy. If the information
is inaccurate, it can lead to rejection of a credit application that should be approved, and it can wind up in
other files where it can live to do more damage. In 1970, Congress enacted, as part of the Consumer Credit
Protection Act, the Fair Credit Reporting Act (FCRA) to give consumers access to their credit files in order
to correct errors.
Under this statute, an applicant denied credit has the right to be told the name and address of the credit
bureau (called “consumer reporting agency” in the act) that prepared the report on which the denial was
based. (The law covers reports used to screen insurance and job applicants as well as to determine
creditworthiness.) The agency must list the nature and substance of the information (except medical
information) and its sources (unless they contributed to an investigative-type report). A credit report lists
such information as name, address, employer, salary history, loans outstanding, and the like. An
investigative-type report is one that results from personal interviews and may contain nonfinancial
information, like drinking and other personal habits, character, or participation in dangerous sports.
Since the investigators rely on talks with neighbors and coworkers, their reports are usually subjective and
can often be misleading and inaccurate.
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The agency must furnish the consumer the information free if requested within thirty days of rejection
and must also specify the name and address of anyone who has received the report within the preceding
six months (two years if furnished for employment purposes).
If the information turns out to be inaccurate, the agency must correct its records; if investigative material
cannot be verified, it must be removed from the file. Those to whom it was distributed must be notified of
the changes. When the agency and the consumer disagree about the validity of the information, the
consumer’s version must be placed in the file and included in future distributions of the report. After
seven years, any adverse information must be removed (ten years in the case of bankruptcy). A person is
entitled to one free copy of his or her credit report from each of the three main national credit bureaus
every twelve months. If a reporting agency fails to correct inaccurate information in a reasonable time, it
is liable to the consumer for $1,000 plus attorneys’ fees.
Under the FCRA, any person who obtains information from a credit agency under false pretenses is
subject to criminal and civil penalties. The act is enforced by the Federal Trade Commission. See Rodgers
v. McCullough in Section 9.3 "Cases" for a case involving use of information from a credit report.

KEY TAKEAWAY
Credit is an important part of the US economy, and there are various laws regulating its availability and
disclosure. Usury laws prohibit charging excessive interest rates, though the laws are riddled with
exceptions. The disclosure of credit costs is regulated by the Truth in Lending Act of 1969, the Consumer
Leasing Act of 1988, the Fair Credit and Charge Card Disclosure Act of 1989, and the Credit Card
Accountability, Responsibility, and Disclosure Act of 2009 (these latter three are amendments to the
TILA). Some states have adopted the Uniform Consumer Credit Code as well. Two major laws prohibit
invidious discrimination in the granting of credit: the Equal Credit Opportunity Act of 1974 and the Home
Mortgage Disclosure Act of 1975 (addressing the problem of redlining). The Fair Credit Reporting Act of
1970 governs the collection and use of consumer credit information held by credit bureaus.

EXERCISES
1.

The penalty for usury varies from state to state. What are the two typical penalties?

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2.

What has the TILA done to the use of interest as a term to describe how much credit costs, and why?

3.

What is redlining?

4.

What does the Fair Credit Reporting Act do, in general?

[1] Consumers Union, “Upcoming Credit Card Protections,”http://www.creditcardreform.org/pdf/dodd-summary509.pdf.
[2] Liz Pulliam Weston, “Credit Card Lenders Go on a Rampage,” MSN Money, November 25, 2009.
[3] States adopting the Uniform Consumer Credit Code are the following: Colorado, Idaho, Indiana, Iowa, Kansas,
Maine, Oklahoma, South Carolina, Utah, Wisconsin, Wyoming, and Guam. Cornell University Law School, “Uniform
Laws.”http://www.law.cornell.edu/uniform/vol7.html#concc.
[4] Kathryn L.S. Pettit and Audrey E. Droesch, “A Guide to Home Mortgage Disclosure Act Data,” The Urban
Institute, December 2008,http://www.urban.org/uploadedpdf/1001247_hdma.pdf.

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9.2 Consumer Protection Laws and Debt Collection Practices
LEARNING OBJECTIVES
1.

Understand that consumers have the right to cancel some purchases made on credit.

2.

Know how billing mistakes may be corrected.

3.

Recognize that professional debt collectors are governed by some laws restricting certain practices.

Cancellation Rights
Ordinarily, a contract is binding when signed. But consumer protection laws sometimes provide an escape
valve. For example, a Federal Trade Commission (FTC) regulation gives consumers three days to cancel
contracts made with door-to-door salespersons. Under this cooling-off provision, the cancellation is
effective if made by midnight of the third business day after the date of the purchase agreement. The
salesperson must notify consumers of this right and supply them with two copies of a cancellation form,
and the sales agreement must contain a statement explaining the right. The purchaser cancels by
returning one copy of the cancellation form to the seller, who is obligated either to pick up the goods or to
pay shipping costs. The three-day cancellation privilege applies only to sales of twenty-five dollars or more
made either in the home or away from the seller’s place of business; it does not apply to sales made by

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mail or telephone, to emergency repairs and certain other home repairs, or to real estate, insurance, or
securities sales.
The Truth in Lending Act (TILA) protects consumers in a similar way. For certain big-ticket purchases
(such as installations made in the course of major home improvements), sellers sometimes require a
mortgage (which is subordinate to any preexisting mortgages) on the home. The law gives such customers
three days to rescind the contract. Many states have laws similar to the FTC’s three-day cooling-off period,
and these may apply to transactions not covered by the federal rule (e.g., to purchases of less than twentyfive dollars and even to certain contracts made at the seller’s place of business).

Correcting Billing Mistakes
Billing Mistakes
In 1975, Congress enacted the Fair Credit Billing Act as an amendment to the Consumer Credit Protection
Act. It was intended to put to an end the phenomenon, by then a standard part of any comedian’s
repertoire, of the many ways a computer could insist that you pay a bill, despite errors and despite letters
you might have written to complain. The act, which applies only to open-end credit and not to installment
sales, sets out a procedure that creditors and customers must follow to rectify claimed errors. The
customer has sixty days to notify the creditor of the nature of the error and the amount. Errors can
include charges not incurred or those billed with the wrong description, charges for goods never delivered,
accounting or arithmetic errors, failure to credit payments or returns, and even charges for which you
simply request additional information, including proof of sale. During the time the creditor is replying,
you need not pay the questioned item or any finance charge on the disputed amount.
The creditor has thirty days to respond and ninety days to correct your account or explain why your belief
that an error has been committed is incorrect. If you do turn out to be wrong, the creditor is entitled to all
back finance charges and to prompt payment of the disputed amount. If you persist in disagreeing and
notify the creditor within ten days, it is obligated to tell all credit bureaus to whom it sends notices of
delinquency that the bill continues to be disputed and to tell you to whom such reports have been sent;
when the dispute has been settled, the creditor must notify the credit bureaus of this fact. Failure of the
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creditor to follow the rules, an explanation of which must be provided to each customer every six months
and when a dispute arises, bars it from collecting the first fifty dollars in dispute, plus finance charges,
even if the creditor turns out to be correct.

Disputes about the Quality of Goods or Services Purchased
While disputes over the quality of goods are not “billing errors,” the act does apply to unsatisfactory goods
or services purchased by credit card (except for store credit cards); the customer may assert against the
credit card company any claims or defenses he or she may have against the seller. This means that under
certain circumstances, the customer may withhold payments without incurring additional finance
charges. However, this right is subject to three limitations: (1) the value of the goods or services charged
must be in excess of fifty dollars, (2) the goods or services must have been purchased either in the home
state or within one hundred miles of the customer’s current mailing address, and (3) the consumer must
make a good-faith effort to resolve the dispute before refusing to pay. If the consumer does refuse to pay,
the credit card company would acquiesce: it would credit her account for the disputed amount, pass the
loss down to the merchant’s bank, and that bank would debit the merchant’s account. The merchant
would then have to deal with the consumer directly.

Debt Collection Practices
Banks, financial institutions, and retailers have different incentives for extending credit—for some, a loan
is simply a means of making money, and for others, it is an inducement to buyers. But in either case,
credit is a risk because the consumer may default; the creditor needs a means of collecting when the
customer fails to pay. Open-end credit is usually given without collateral. The creditor can, of course, sue,
but if the consumer has no assets, collection can be troublesome. Historically, three different means of
recovering the debt have evolved: garnishment, wage assignment, and confession of judgment.

Garnishment
Garnishment is a legal process by which a creditor obtains a court order directing the debtor’s employer
(or any party who owes money to the debtor) to pay directly to the creditor a certain portion of the
employee’s wages until the debt is paid. Until 1970, garnishment was regulated by state law, and its effects
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could be devastating—in some cases, even leading to suicide. In 1970, Title III of the Consumer Credit
Protection Act asserted federal control over garnishment proceedings for the first time. The federal wagegarnishment law limits the amount of employee earnings that may be withheld in any one pay date to the
lesser of 25 percent of disposable (after-tax) earnings or the amount by which disposable weekly earnings
exceed thirty times the highest current federal minimum wage. The federal law covers everyone who
receives personal earnings, including wages, salaries, commissions, bonuses, and retirement income
(though not tips), but it allows courts to garnish above the federal maximum in cases involving support
payments (e.g., alimony), in personal bankruptcy cases, and in cases where the debt owed is for state or
federal tax.
The federal wage-garnishment law also prohibits an employer from firing any worker solely because the
worker’s pay has been garnished for one debt (multiple garnishments may be grounds for discharge). The
penalty for violating this provision is a $1,000 fine, one-year imprisonment, or both. But the law does not
say that an employee fired for having one debt garnished may sue the employer for damages. In a 1980
case, the Fifth Circuit Court of Appeals denied an employee the right to sue, holding that the statute places
enforcement exclusively in the hands of the federal secretary of labor.

[1]

The l970 federal statute is not the only limitation on the garnishment process. Note that the states can
also still regulate garnishment so long as the state regulation is not in conflict with federal law: North
Carolina, Pennsylvania, South Carolina, and Texas prohibit most garnishments, unless it is the
government doing the garnishment. And there is an important constitutional limitation as well. Many
states once permitted a creditor to garnish the employee’s wage even before the case came to court: a
simple form from the clerk of the court was enough to freeze a debtor’s wages, often before the debtor
knew a suit had been brought. In 1969, the US Supreme Court held that this prejudgment garnishment
procedure was unconstitutional.

[2]

Wage Assignment
A wage assignment is an agreement by an employee that a creditor may take future wages as security for a
loan or to pay an existing debt. With a wage assignment, the creditor can collect directly from the
employer. However, in some states, wage assignments are unlawful, and an employer need not honor the
agreement (indeed, it would be liable to the employee if it did). Other states regulate wage assignments in
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various ways—for example, by requiring that the assignment be a separate instrument, not part of the
loan agreement, and by specifying that no wage assignment is valid beyond a certain period of time (two
or three years).

Confession of Judgment
Because suing is at best nettlesome, many creditors have developed forms that allow them to sidestep the
courthouse when debtors have defaulted. As part of the original credit agreement, the consumer or
borrower waives his right to defend himself in court by signing a confession of judgment. This written
instrument recites the debtor’s agreement that a court order be automatically entered against him in the
event of default. The creditor’s lawyer simply takes the confession of judgment to the clerk of the court,
who enters it in the judgment book of the court without ever consulting a judge. Entry of the judgment
entitles the creditor to attach the debtor’s assets to satisfy the debt. Like prejudgment garnishment, a
confession of judgment gives the consumer no right to be heard, and it has been banned by statute or
court decisions in many states.

Fair Debt Collection Practices Act of 1977
Many stores, hospitals, and other organizations attempt on their own to collect unpaid bills, but
thousands of merchants, professionals, and small businesses rely on collection agencies to recover
accounts receivable. The debt collection business employed some 216,000 people in 2007 and collected
over $40 billion in debt.

[3]

For decades, some of these collectors used harassing tactics: posing as

government agents or attorneys, calling at the debtor’s workplace, threatening physical harm or loss of
property or imprisonment, using abusive language, publishing a deadbeats list, misrepresenting the size
of the debt, and telling friends and neighbors about the debt. To provide a remedy for these abuses,
Congress enacted, as part of the Consumer Credit Protection Act, the Fair Debt Collection Practices Act
(FDCPA) in 1977.
This law regulates the manner by which third-party collection agencies conduct their business. It covers
collection of all personal, family, and household debts by collection agencies. It does not deal with
collection by creditors themselves; the consumer’s remedy for abusive debt collection by the creditor is in
tort law.
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Under the FDCPA, the third-party collector may contact the debtor only during reasonable hours and not
at work if the debtor’s employer prohibits it. The debtor may write the collector to cease contact, in which
case the agency is prohibited from further contact (except to confirm that there will be no further contact).
A written denial that money is owed stops the bill collector for thirty days, and he can resume again only
after the debtor is sent proof of the debt. Collectors may no longer file suit in remote places, hoping for
default judgments; any suit must be filed in a court where the debtor lives or where the underlying
contract was signed. The use of harassing and abusive tactics, including false and misleading
representations to the debtor and others (e.g., claiming that the collector is an attorney or that the debtor
is about to be sued when that is not true), is prohibited. Unless the debtor has given the creditor her cell
phone number, calls to cell phones (but not to landlines) are not allowed.

[4]

In any mailings sent to the

debtor, the return address cannot indicate that it is from a debt collection agency (so as to avoid
embarrassment from a conspicuous name on the envelope that might be read by third parties).
Communication with third parties about the debt is not allowed, except when the collector may need to
talk to others to trace the debtor’s whereabouts (though the collector may not tell them that the inquiry
concerns a debt) or when the collector contacts a debtor’s attorney, if the debtor has an attorney. The
federal statute gives debtors the right to sue the collector for damages for violating the statute and for
causing such injuries as job loss or harm to reputation.

KEY TAKEAWAY
Several laws regulate practices after consumer credit transactions. The FTC provides consumers with a
three-day cooling-off period for some in-home sales, during which time the consumer-purchaser may
cancel the sale. The TILA and some state laws also have some cancellation provisions. Billing errors are
addressed by the Fair Credit Billing Act, which gives consumers certain rights. Debt collection practices
such as garnishment, wage assignments, and confessions of judgment are regulated (and in some states
prohibited) by federal and state law. Debt collection practices for third-party debt collectors are
constrained by the Fair Debt Collection Practices Act.

EXERCISES
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1.

Under what circumstances may a consumer have three days to avoid a contract?

2.

How does the Fair Credit Billing Act resolve the problem that occurs when a consumer disputes a bill
and “argues” with a computer about it?

3.

What is the constitutional problem with garnishment as it was often practiced before 1969?

4.

If Joe of Joe’s Garage wants to collect on his own the debts he is owed, he is not constrained by the
FDCPA. What limits are there on his debt collection practices?

[1] Smith v. Cotton Brothers Baking Co., Inc., 609 F.2d 738 (5th Cir. 1980).
[2] Sniadach v. Family Finance Corp., 395 U.S. 337 (1969).
[3] PricewaterhouseCoopers LLP, Value of Third-Party Debt Collection to the U.S. Economy in 2007: Survey And
Analysis, June 2008, http://www.acainternational.org/files.aspx?p=/images/12546/pwc2007-final.pdf.
[4] Federal Communications Commission, “In the Matter of Rules and Regulations Implementing the Telephone
Consumer Protection Act of 1991,”http://fjallfoss.fcc.gov/edocs_public/attachmatch/FCC-07-232A1.txt. (This
document shows up best with Adobe Acrobat.)

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9.3 Cases
Usury
Matter of Dane’s Estate
390 N.Y.S.2d 249 (N.Y.A.D. 1976)
MAHONEY, J.
On December 17, 1968, after repeated requests by decedent [Leland Dane] that appellant [James Rossi]
loan him $10,500 [about $64,000 in 2010 dollars] the latter drew a demand note in that amount and with
decedent’s consent fixed the interest rate at 7 1/2% Per annum, the then maximum annual interest
permitted being 7 1/4%. Decedent executed the note and appellant gave him the full amount of the note in
cash.…[The estate] moved for summary judgment voiding the note on the ground that it was a usurious
loan, the note having been previously rejected as a claim against the estate. The [lower court] granted the
motion, voided the note and enjoined any prosecution on it thereafter. Appellant’s cross motion to enforce
the claim was denied.
New York’s usury laws are harsh, and courts have been reluctant to extend them beyond cases that fall
squarely under the statutes [Citation]. [New York law] makes any note for which more than the legal rate
of interests is ‘reserved or taken’ or ‘agreed to be reserved or taken’ void. [The law] commands
cancellation of a note in violation of [its provisions]. Here, since both sides concede that the note
evidences the complete agreement between the parties, we cannot aid appellant by reliance upon the
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presumption that he did not make the loan at a usurious rate [Citation]. The terms of the loan are not in
dispute. Thus, the note itself establishes, on its face, clear evidence of usury. There is no requirement of a
specific intent to violate the usury statute. A general intent to charge more than the legal rate as evidenced
by the note is all that is needed. If the lender intends to take and receive a rate in excess of the legal
percentage at the time the note is made, the statute condemns the act and mandates its cancellation
[Citation]. The showing, as here, that the note reserves to the lender an illegal rate of interest satisfies
respondents’ burden of proving a usurious loan.
Next, where the rate of interest on the face of a note is in excess of the legal rate, it cannot be argued that
such a loan may be saved because the borrower prompted the loan or even set the rate. The usury statutes
are for the protection of the borrower and [their] purpose would be thwarted if the lender could avoid its
consequences by asking the borrower to set the rate. Since the respondents herein asserted the defense of
usury, it cannot be said that the decedent waived the defense by setting or agreeing to the 7 1/2% Rate of
interest.
Finally, equitable considerations cannot be indulged when, as here, a statute specifically condemns an act.
The statute fixes the law, and it must be followed.
The order should be affirmed, without costs.

CASE QUESTIONS
1.

What is the consequence to the lender of charging usurious rates in New York?

2.

The rate charged here was one-half of one percent in excess of the allowable limit. Who made the note,
the borrower or the lender? That makes no difference, but should it?

3.

What “equitable considerations” were apparently raised by the creditor?

Discrimination under the ECOA
Rosa v. Park West Bank & Trust Co.
214 F.3d 213, C.A.1 (Mass. 2000)
Lynch, J.

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Lucas Rosa sued the Park West Bank & Trust Co. under the Equal Credit Opportunity Act (ECOA), 15
U.S.C. §§ 1691–1691f, and various state laws. He alleged that the Bank refused to provide him with a loan
application because he did not come dressed in masculine attire and that the Bank’s refusal amounted to
sex discrimination under the Act. The district court granted the Bank’s motion to dismiss the ECOA
claim…

I.
According to the complaint, which we take to be true for the purpose of this appeal, on July 21, 1998, Mr.
Lucas Rosa came to the Bank to apply for a loan. A biological male, he was dressed in traditionally
feminine attire. He requested a loan application from Norma Brunelle, a bank employee. Brunelle asked
Rosa for identification. Rosa produced three forms of photo identification: (1) a Massachusetts
Department of Public Welfare Card; (2) a Massachusetts Identification Card; and (3) a Money Stop Check
Cashing ID Card. Brunelle looked at the identification cards and told Rosa that she would not provide him
with a loan application until he “went home and changed.” She said that he had to be dressed like one of
the identification cards in which he appeared in more traditionally male attire before she would provide
him with a loan application and process his loan request.

II.
Rosa sued the Bank for violations of the ECOA and various Massachusetts antidiscrimination statutes.
Rosa charged that “[b]y requiring [him] to conform to sex stereotypes before proceeding with the credit
transaction, [the Bank] unlawfully discriminated against [him] with respect to an aspect of a credit
transaction on the basis of sex.” He claims to have suffered emotional distress, including anxiety,
depression, humiliation, and extreme embarrassment. Rosa seeks damages, attorney’s fees, and injunctive
relief.
Without filing an answer to the complaint, the Bank moved to dismiss…The district court granted the
Bank’s motion. The court stated:
[T]he issue in this case is not [Rosa’s] sex, but rather how he chose to dress when applying for a loan.
Because the Act does not prohibit discrimination based on the manner in which someone dresses, Park
West’s requirement that Rosa change his clothes does not give rise to claims of illegal discrimination.
Further, even if Park West’s statement or action were based upon Rosa’s sexual orientation or perceived
sexual orientation, the Act does not prohibit such discrimination.
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Price Waterhouse v. Hopkins (U.S. Supreme Court, 1988), which Rosa relied on, was not to the contrary,
according to the district court, because that case “neither holds, nor even suggests, that discrimination
based merely on a person’s attire is impermissible.”
On appeal, Rosa says that the district court “fundamentally misconceived the law as applicable to the
Plaintiff’s claim by concluding that there may be no relationship, as a matter of law, between telling a
bank customer what to wear and sex discrimination.” …The Bank says that Rosa loses for two reasons.
First, citing cases pertaining to gays and transsexuals, it says that the ECOA does not apply to cross
dressers. Second, the Bank says that its employee genuinely could not identify Rosa, which is why she
asked him to go home and change.

III.
…In interpreting the ECOA, this court looks to Title VII case law, that is, to federal employment
discrimination law…The Bank itself refers us to Title VII case law to interpret the ECOA.
The ECOA prohibits discrimination, “with respect to any aspect of a credit transaction [,] on the basis of
race, color, religion, national origin, sex or marital status, or age.” 15 U.S.C. § 1691(a). Thus to prevail, the
alleged discrimination against Rosa must have been “on the basis of…sex.” See [Citation.] The ECOA’s sex
discrimination prohibition “protects men as well as women.”
While the district court was correct in saying that the prohibited bases of discrimination under the ECOA
do not include style of dress or sexual orientation that is not the discrimination alleged. It is alleged that
the Bank’s actions were taken, in whole or in part, “on the basis of… [the appellant’s] sex.” The Bank, by
seeking dismissal under Rule 12(b)(6), subjected itself to rigorous standards. We may affirm dismissal
“only if it is clear that no relief could be granted under any set of facts that could be proved consistent with
the allegations.” [Citations] Whatever facts emerge, and they may turn out to have nothing to do with sexbased discrimination, we cannot say at this point that the plaintiff has no viable theory of sex
discrimination consistent with the facts alleged.
The evidence is not yet developed, and thus it is not yet clear why Brunelle told Rosa to go home and
change. It may be that this case involves an instance of disparate treatment based on sex in the denial of
credit. See [Citation]; (“‘Disparate treatment’…is the most easily understood type of discrimination. The
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employer simply treats some people less favorably than others because of their…sex.”); [Citation]
(invalidating airline’s policy of weight limitations for female “flight hostesses” but not for similarly
situated male “directors of passenger services” as impermissible disparate treatment); [Citation]
(invalidating policy that female employees wear uniforms but that similarly situated male employees need
wear only business dress as impermissible disparate treatment); [Citation] (invalidating rule requiring
abandonment upon marriage of surname that was applied to women, but not to men). It is reasonable to
infer that Brunelle told Rosa to go home and change because she thought that Rosa’s attire did not accord
with his male gender: in other words, that Rosa did not receive the loan application because he was a
man, whereas a similarly situated woman would have received the loan application. That is, the Bank may
treat, for credit purposes, a woman who dresses like a man differently than a man who dresses like a
woman. If so, the Bank concedes, Rosa may have a claim. Indeed, under Price Waterhouse, “stereotyped
remarks [including statements about dressing more ‘femininely’] can certainly be evidence that gender
played a part.” [Citation.] It is also reasonable to infer, though, that Brunelle refused to give Rosa the loan
application because she thought he was gay, confusing sexual orientation with cross-dressing. If so, Rosa
concedes, our precedents dictate that he would have no recourse under the federal Act. See [Citation]. It is
reasonable to infer, as well, that Brunelle simply could not ascertain whether the person shown in the
identification card photographs was the same person that appeared before her that day. If this were the
case, Rosa again would be out of luck. It is reasonable to infer, finally, that Brunelle may have had mixed
motives, some of which fall into the prohibited category.
It is too early to say what the facts will show; it is apparent, however, that, under some set of facts within
the bounds of the allegations and non-conclusory facts in the complaint, Rosa may be able to prove a
claim under the ECOA…
We reverse and remand for further proceedings in accordance with this opinion.

CASE QUESTIONS
1.

Could the bank have denied Mr. Rosa a loan because he was gay?

2.

If a woman had applied for loan materials dressed in traditionally masculine attire, could the bank have
denied her the materials?

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3.

The Court offers up at least three possible reasons why Rosa was denied the loan application. What
were those possible reasons, and which of them would have been valid reasons to deny him the
application?

4.

To what federal law does the court look in interpreting the application of the ECOA?

5.

Why did the court rule in Mr. Rosa’s favor when the facts as to why he was denied the loan application
could have been interpreted in several different ways?

Uses of Credit Reports under the FCRA
Rodgers v. McCullough
296 F.Supp.2d 895 (W.D. Tenn. 2003)

Background
This case concerns Defendants’ receipt and use of Christine Rodgers’ consumer report. The material facts
do not seem to be disputed. The parties agree that Ms. Rodgers gave birth to a daughter, Meghan, on May
4, 2001. Meghan’s father is Raymond Anthony. Barbara McCullough, an attorney, represented Mr.
Anthony in a child custody suit against Ms. Rodgers in which Mr. Anthony sought to obtain custody and
child support from Ms. Rodgers. Ms. McCullough received, reviewed, and used Ms. Rodgers’ consumer
report in connection with the child custody case.
On September 25, 2001, Ms. McCullough instructed Gloria Christian, her secretary, to obtain Ms.
Rodgers’ consumer report. Ms. McCullough received the report on September 27 or 28 of 2001. She
reviewed the report in preparation for her examination of Ms. Rodgers during a hearing to be held in

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juvenile court on October 23, 2001. She also used the report during the hearing, including attempting to
move the document into evidence and possibly handing it to the presiding judge.
The dispute in this case centers on whether Ms. McCullough obtained and used Ms. Rodgers’ consumer
report for a purpose permitted under the Fair Credit Reporting Act (the “FCRA”). Plaintiff contends that
Ms. McCullough, as well as her law firm, Wilkes, McCullough & Wagner, a partnership, and her partners,
Calvin J. McCullough and John C. Wagner, are liable for the unlawful receipt and use of Ms. Rodgers’
consumer report in violation 15 U.S.C. §§ 1681 o(negligent failure to comply with the FCRA) and 1681n
(willful failure to comply with the FCRA or obtaining a consumer report under false pretenses). Plaintiff
has also sued Defendants for the state law tort of unlawful invasion of privacy.…

Analysis
Plaintiff has moved for summary judgment on the questions of whether Defendants failed to comply with
the FCRA (i.e. whether Defendants had a permissible purpose to obtain Ms. Rodgers’ credit report),
whether Defendants’ alleged failure to comply was willful, and whether Defendants’ actions constituted
unlawful invasion of privacy. The Court will address the FCRA claims followed by the state law claim for
unlawful invasion of privacy.

A. Permissible Purpose under the FCRA
Pursuant to the FCRA, “A person shall not use or obtain a consumer report for any purpose unless (1) the
consumer report is obtained for a purpose for which the consumer report is authorized to be furnished
under this section.…” [Citation.] Defendants do not dispute that Ms. McCullough obtained and used Ms.
Rodgers’ consumer report.
[The act] provides a list of permissible purposes for the receipt and use of a consumer report, of which the
following subsection is at issue in this case:
[A]ny consumer reporting agency may furnish a consumer report under the following circumstances and
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(A) Intends to use the information in connection with a credit transaction involving the consumer on
whom the information is to be furnished and involving the extension of credit to, or review or collection of
an account of, the consumer…
[Citation.] Defendants concede that Ms. McCullough’s receipt and use of Ms. Rodgers’ consumer report
does not fall within any of the other permissible purposes enumerated in [the act].
Ms. Rodgers does not request summary judgment in her favor on this point, relying on the plain text of
the statute, because she was not in arrears on any child support obligation at the time Ms. McCullough did
not request the consumer report, nor did she owe Ms. McCullough’s client any debt. She notes that Mr.
Anthony did not have custody of Meghan Rodgers and that an award of child support had not even been
set at the time Ms. McCullough obtained her consumer report.
Defendants maintain that Ms. McCullough obtained Ms. Rodgers’ consumer report for a permissible
purpose, namely to locate Ms. Rodgers’ residence and set and collect child support obligations.
Defendants argue that 15 U.S.C. § 1681b(a)(3)(A) permits the use of a credit report in connection with
“collection of an account” and, therefore, Ms. McCullough was permitted to use Ms. Rodgers’ credit report
in connection with the collection of child support.

[1]

The cases Defendants have cited in response to the motion for summary judgment are inapplicable to the
present facts. In each case cited by Defendants, the person who obtained a credit report did so in order to
collect on an outstanding judgment or an outstanding debt. See, e.g., [Citation] (finding that collection of
a judgment of arrears in child support is a permissible purpose under [the act]; [Citation] (holding that
defendant had a permissible purpose for obtaining a consumer report where plaintiff owed an
outstanding debt to the company).
However, no such outstanding debt or judgment existed in this case. At the time Ms. McCullough
obtained Ms. Rodgers’ consumer report, Ms. Rodgers’ did not owe money to either Ms. McCullough or her
client, Mr. Anthony. Defendants have provided no evidence showing that Ms. McCullough believed Ms.
Rodgers owed money to Mr. Anthony at the time she requested the credit report. Indeed, Mr. Anthony
had not even been awarded custody of Meghan Rodgers at the time Ms. McCullough obtained and used
the credit report. Ms. McCullough acknowledged each of the facts during her deposition. Moreover, in
response to Plaintiff’s request for admissions, Ms. McCullough admitted that she did not receive the credit
report for the purpose of collecting on an account from Ms. Rodgers.
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The evidence before the Court makes clear that Ms. McCullough was actually attempting, on behalf of Mr.
Anthony, to secure custody of Meghan Rodgers and obtain a future award of child support payments from
Ms. Rodgers by portraying Ms. Rodgers as irresponsible to the court. These are not listed as permissible
purposes under [FCRA]. Defendants have offered the Court no reason to depart from the plain language
of the statute, which clearly does not permit an individual to obtain a consumer report for the purposes of
obtaining child custody and instituting child support payments. Moreover, the fact that the Juvenile Court
later awarded custody and child support to Mr. Anthony does not retroactively provide Ms. McCullough
with a permissible purpose for obtaining Ms. Rodgers’ consumer report. Therefore, the Court GRANTS
Plaintiff’s motion for partial summary judgment on the question of whether Defendants had a permissible
purpose to obtain Ms. Rodgers’ credit report.

B. Willful Failure to Comply with the FCRA
Pursuant to [the FCRA], “Any person who willfully fails to comply with any requirement imposed under
this subchapter with respect to any consumer is liable to that consumer” for the specified damages.
“To show willful noncompliance with the FCRA, [the plaintiff] must show that [the defendant] ‘knowingly
and intentionally committed an act in conscious disregard for the rights of others,’ but need not show
‘malice or evil motive.’” [Citation.] “Under this formulation the defendant must commit the act that
violates the Fair Credit Reporting Act with knowledge that he is committing the act and with intent to do
so, and he must also be conscious that his act impinges on the rights of others.” “The statute’s use of the
word ‘willfully’ imports the requirement that the defendant know his or her conduct is unlawful.”
[Citation.] A defendant cannot be held civilly liable under [the act] if he or she obtained the plaintiff’s
credit report “under what is believed to be a proper purpose under the statute but which a court…later
rules to be impermissible legally under [Citation].
Ms. McCullough is an attorney who signed multiple service contracts with Memphis Consumer Credit
Association indicating that the primary purpose for which credit information would be ordered was “to
collect judgments.” Ms. McCullough also agreed in these service contracts to comply with the FCRA. Her
deposition testimony indicates that she had never previously ordered a consumer report for purposes of
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calculating child support. This evidence may give rise to an inference that Ms. McCullough was aware that
she did not order Ms. Rodgers’ consumer report for a purpose permitted under the FCRA.
Defendants argue in their responsive memorandum that if Ms. McCullough had suspected that she had
obtained Ms. Rodgers’ credit report in violation of the FCRA, it is unlikely that she would have attempted
to present the report to the Juvenile Court as evidence during the custody hearing for Meghan Rodgers.
Ms. McCullough also testified that she believed she had a permissible purpose for obtaining Ms. Rodgers’
consumer report (i.e. to set and collect child support obligations).
Viewing the evidence in the light most favorable to the nonmoving party, Defendants have made a
sufficient showing that Ms. McCullough may not have understood that she lacked a permissible purpose
under the FCRA to obtain and use Ms. Rodgers’ credit report.
If Ms. McCullough was not aware that her actions might violate the FCRA at the time she obtained and
used Ms. Rodgers’ credit report, she would not have willfully failed to comply with the FCRA. The
question of Ms. McCullough’s state of mind at the time she obtained and used Ms. Rodgers’ credit report
is an issue best left to a jury. [Citation] (“state of mind is typically not a proper issue for resolution on
summary judgment”). The Court DENIES Plaintiff’s motion for summary judgment on the question of
willfulness under [the act].

C. Obtaining a Consumer Report under False Pretenses or Knowingly without a Permissible
Purpose
…For the same reasons the Court denied Plaintiff’s motion for summary judgment on the question of
willfulness, the Court also DENIES Plaintiff’s motion for summary judgment on the question of whether
Ms. McCullough obtained and used Ms. Rodgers’ credit report under false pretenses or knowingly without
a permissible purpose.
[Discussion of the invasion of privacy claim omitted.]
Conclusion
For the foregoing reasons, the Court GRANTS Plaintiff’s Motion for Partial Summary Judgment
Regarding Defendants’ Failure to Comply with the Fair Credit Reporting Act [having no permissible
purpose]. The Court DENIES Plaintiff’s remaining motions for partial summary judgment.

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CASE QUESTIONS
1.

Why did the defendant, McCullough, order her secretary to obtain Ms. Rodgers’s credit report? If Ms.
McCullough is found liable, why would her law firm partners also be liable?

2.

What “permissible purpose” did the defendants contend they had for obtaining the credit report? Why
did the court determine that purpose was not permissible?

3.

Why did the court deny the plaintiff’s motion for summary judgment on the question of whether the
defendant “willfully” failed to comply with the act? Is the plaintiff out of luck on that question, or can it
be litigated further?

[1] Defendants also admit that Ms. McCullough used the credit report to portray Ms. Rodgers as irresponsible,
financially unstable, and untruthful about her residence and employment history to the Juvenile Court. Defendants
do not allege that these constitute permissible purposes under the FCRA.

9.4 Summary and Exercises
Summary

Consumers who are granted credit have long received protection through usury laws (laws that establish a
maximum interest rate). The rise in consumer debt in recent years has been matched by an increase in
federal regulation of consumer credit transactions. The Truth in Lending Act requires disclosure of credit
terms; the Equal Credit Opportunity Act prohibits certain types of discrimination in the granting of credit;
the Fair Credit Reporting Act gives consumers access to their credit dossiers and prohibits unapproved
use of credit-rating information. After entering into a credit transaction, a consumer has certain
cancellation rights and may use a procedure prescribed by the Fair Credit Billing Act to correct billing
errors. Traditional debt collection practices—garnishment, wage assignments, and confession of judgment
clauses—are now subject to federal regulation, as are the practices of collection agencies under the Fair
Debt Collection Practices Act.

EXERCISES
1.

Carlene Consumer entered into an agreement with Rent to Buy, Inc., to rent a computer for $20 per
week. The agreement also provided that if Carlene chose to rent the computer for fifty consecutive

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weeks, she would own it. She then asserted that the agreement was not a lease but a sale on credit
subject to the Truth in Lending Act, and that Rent to Buy, Inc., violated the act by failing to state the
annual percentage rate. Is Carlene correct?
2.

Carlos, a resident of Chicago, was on a road trip to California when he heard a noise under the hood of his
car. He took the car to a mechanic for repair. The mechanic overhauled the power steering unit and billed
Carlos $600, which he charged on his credit card. Later that day—Carlos having driven about fifty miles—
the car made the same noise, and Carlos took it to another mechanic, who diagnosed the problem as a
loose exhaust pipe connection at the manifold. Carlos was billed $300 for this repair, with which he was
satisfied. Carlos returned to Chicago and examined his credit card statement. What rights has he as to the
$600 charge on his card?

3.

Ken was the owner of Scrimshaw, a company that manufactured and sold carvings made on fossilized
ivory. He applied for a loan from Bank. Bank found him creditworthy, but seeking additional security for
repayment, it required his wife, Linda, to sign a guaranty as well. During a subsequent recession, demand
for scrimshaw fell, and Ken’s business went under. Bank filed suit against both Ken and Linda. What
defense has Linda?

4.

The FCRA requires that credit-reporting agencies “follow reasonable procedures to assure maximum
possible accuracy of the information.” In October of 1989, Renie Guimond became aware of, and notified
the credit bureau Trans Union about, inaccuracies in her credit report: that she was married (and it listed
a Social Security number for this nonexistent spouse), that she was also known as Ruth Guimond, and that
she had a Saks Fifth Avenue credit card. About a month later, Trans Union responded to Guimond’s letter,
stating that the erroneous information had been removed. But in March of 1990, Trans Union again
published the erroneous information it purportedly had removed. Guimond then requested the source of
the erroneous information, to which Trans Union responded that it could not disclose the identity of the
source because it did not know its source. The disputed information was eventually removed from
Guimond’s file in October 1990. When Guimond sued, Trans Union defended that she had no claim
because no credit was denied to her as a result of the inaccuracies in her credit file. The lower court
dismissed her case; she appealed. To what damages, if any, is Guimond entitled?

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5.

Plaintiff incurred a medical debt of $160. She received two or three telephone calls from
Defendant, the collection agency; each time she denied any money owing. Subsequently she
received this letter:
You have shown that you are unwilling to work out a friendly settlement with us to clear the
above debt. Our field investigator has now been instructed to make an investigation in your
neighborhood and to personally call on your employer.
The immediate payment of the full amount, or a personal visit to this office, will spare you this
embarrassment.
The top of the letter notes the creditor’s name and the amount of the alleged debt. The letter was
signed by a “collection agent.” The envelope containing that letter presented a return address
that included Defendant’s full name: “Collection Accounts Terminal, Inc.” What violations of the
Fair Debt Collection Practices Act are here presented?

6.

Eric and Sharaveen Rush filed a claim alleging violations of the Fair Credit Reporting Act arising out of an
allegedly erroneous credit report prepared by a credit bureau from information, in part, from Macy’s, the
department store. The error causes the Rushes to be denied credit. Macy’s filed a motion to dismiss. Is
Macy’s liable? Discuss.

SELF-TEST QUESTIONS
1.

An example of a loan that is a common exception to usury law is
a.

a business loan

b.

a mortgage loan

c.

an installment loan

d.

all of the above
Under the Fair Credit Reporting Act, an applicant denied credit

a.

has a right to a hearing
b.

has the right to be told the name and address of the credit bureau that prepared the credit report
upon which denial was based

c.

always must pay a fee for information regarding credit denial

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d.

none of the above
Garnishment of wages

a.

is limited by federal law
b.

involves special rules for support cases

c.

is a legal process where a creditor obtains a court order directing the debtor’s employer to pay a
portion of the debtor’s wages directly to the creditor

d.

involves all of the above
A wage assignment is

a.

an example of garnishment
b.

an example of confession of judgment

c.

an exception to usury law

d.

an agreement that a creditor may take future wages as security for a loan
The Truth-in-Truth in Lending Act requires disclosure of

a.

the annual percentage rate
b.

the borrower’s race

c.

both of the above

d.

neither of the above

SELF-TEST ANSWERS
1.

d

2.

b

3.

d

4.

d

5.

a

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Chapter 10
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

7.

The relationship between surety and principal

8.

Rights among cosureties

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10.1 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

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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.

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 10.1
"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.
Figure 10.1 The Grasping Hand

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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 1-201(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 9-103(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.”
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
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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.
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,
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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 9-102(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
Tangible property as collateral is goods. Goods mean “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.”
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Inventory
“Goods, other than farm products, held by a person for sale or lease or consisting of raw materials, work
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 good nor in-dispensable 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-care-insurance
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-ofcredit 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 warehouse and is
entitled to take the chairs and sell them to satisfy the obligation. The warehouse 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
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purchase-money security agreement; the note and security agreement is chattel paper). The chattel paper
is not yet collateral; the automobile is. 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 endorsement 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]

certificate).

Securities may be certified (represented by a certificate) or uncertified (not represented by a

[20]

Other Types of Collateral
Among possible other types of collateral that may be used as security is the floating 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:
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•

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.

•

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 inventory-picking 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 10.2 "Tangibles and Intangibles as Collateral".
Figure 10.2 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 10.1 "The Grasping Hand",”Attachment” is the outreached hand
that is prepared, if the debtor defaults, to grasp the collateral.

[21]

Requirements for Attachment
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.

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Creditor Gives Value
The creditor, or secured party, must give “value” for the security interest to attach. The UCC, in Section 1204, 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 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
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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 10.1 "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
“Except as otherwise provided…a financing statement must be filed to perfect all security agreements.”

[25]

The Financing Statement

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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 10.3 "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 10.3 UCC-1 Financing Statements

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Duration of the Financing Statement
Generally, the financing statement is effective for five years; a continuation 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 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
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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
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.
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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
“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,
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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 10.4 Attachments 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 one-third 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/32302EC3-81D5-47DFA9CBA32FAE38B22A.
[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-Ended-SecurityAgreement.
[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.

10.2 Priorities

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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.

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 first with the most.” 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
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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 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]

[2]

If both parties have perfected, the first to have perfected wins.

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 repossess 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 purchase-money 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.”
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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 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 non-inventory 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
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acquired property clause). In accord with the general 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 laterperfected 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 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

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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 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 10.5 "Cases").

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•

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
[11]

the collateral.

If it was perfected, the trustee can’t take it, 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—
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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 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
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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).
[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.
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10.3 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 timeconsuming 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, inhouse 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 360degree video cameras that record every aspect of the repossession. They have “skip chasers”—people
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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 10.5 "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
[2]

expensive.…Of course…all aspects of the disposition must be commercially reasonable.” 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 10.5 "Disposition after Repossession").
Figure 10.5 Dispositions 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
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 as strict 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
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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 10.5 "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
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?

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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.

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10.4 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.

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 the principal 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 engages 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

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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 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 10.6 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
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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 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
[1]

(absent application of the doctrine of promissory estoppel ). 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 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.
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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
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 10.5 "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.

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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 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 ascosureties. 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, and 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 wants 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
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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:
•

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

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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 10.6 "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

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

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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 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.

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10.5 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.
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
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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
semantically 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 science question.
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.
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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.…
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
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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 instituted civil action is the
appropriate remedy.” [Citation] (Interpreting the term “breach of the peace” in the context of section 9503 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
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
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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.
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).…

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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 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 locked garage.’”…This is so
because “public policy favors peaceful, non-trespassers 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.” Davenport held 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].

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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 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 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 2A-108.…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
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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?

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

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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 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
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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”?

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.

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10.6 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 after-acquired 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, 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

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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 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 after-acquired
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;

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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, 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

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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.
a.

Creditors may obtain security
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?

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

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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

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Chapter 11
Mortgages and Nonconsensual Liens
LEARNING OBJECTIVES
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

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11.1 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 10 "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 11.1 "Security Arrangements").
Figure 11.1 Security Arrangements

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
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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 10 "Secured
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
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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 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 11.2 "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.

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Creation of the Mortgage
Statutory Regulation
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 (as discussed in Chapter 9 "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.
Red-lining. 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,
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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 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 11.4 "Cases"), the equitable powers of
the court were invoked to prevent acceleration.

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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, insurance, and repairs. A sample mortgage
form is presented in Figure 11.2 "Sample Mortgage Form".
Figure 11.2 Sample Mortgage Form

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 back or at least be reimbursed for

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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?

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11.2 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 10 "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
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.

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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 10 "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 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.
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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 11.4
"Cases"), the bank mistakenly filed 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
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 11.3 "“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.

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Figure 11.3 “Subject to” Sales versus Assumption

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 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
[1]

Depository Institutions Act in 1982. 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

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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 11.4 "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 11.4 Foreclosure

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.

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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 non-judicial means.
Alpha Imperial Building, LLC v. Schnitzer Family Investment, LLC, Section 11.4 "Cases", discusses
several issues involving deeds of trust.

Installment or Land Contract
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
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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
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.

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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.

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11.3 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.

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
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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 in Section 11.3.3 "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 11.5 "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.
Figure 11.5Subcontractors’ 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
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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 11.4 "Cases".

Mechanic’s Liens Priorities
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 the possessory 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 non-possessory 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.

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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, 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?

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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?

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11.4 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
[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],

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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
…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 neither 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

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payments from the escrow account or make deposits with the court is more than just a “technical breach”
of the mortgage and note. [Citation.]
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 sent the acceleration letter to Cherry and a request for
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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 Chases’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 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.

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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
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
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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 material man’s performance of work on its property as required by
[the S.C. statute]?

Law/Analysis
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,
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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 material man
(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 material
man, as the Court of Appeals’ opinion indicates. A determination that the required consent must come
from the owner to the material man means the material man 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.…"
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 material man 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 material man. 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

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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 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 material man, 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
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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.

•

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.

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•

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 up fit, 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 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.
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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 material man 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 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 reopen the sale, [and] no duty to the junior lienholder…We affirm.

Facts
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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 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
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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 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

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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 re-opened 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:
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
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$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.
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 In Steward [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

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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.
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
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…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?

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?

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11.5 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, 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.

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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 counter argues 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

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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 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

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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

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

d.

b.

an attachment lien

c.

a possessory lien

none of the above

SELF-TEST ANSWERS
1.

b

2.

d

3.

d

4.

d

5.

b

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Chapter 12
Bankruptcy
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

A short history of US bankruptcy law

2.

An overview of key provisions of the 2005 bankruptcy act

3.

The basic operation of Chapter 7 bankruptcy

4.

The basic operation of Chapter 11 bankruptcy

5.

The basic operation of Chapter 13 bankruptcy

6.

What debtor’s relief is available outside of bankruptcy

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12.1 Introduction to Bankruptcy and Overview of the 2005
Bankruptcy Act
LEARNING OBJECTIVES
1.

Understand what law governs bankruptcy in the United States.

2.

Know the key provisions of the law.

The Purpose of Bankruptcy Law
Bankruptcy law governs the rights of creditors and insolvent debtors who cannot pay their debts. In
broadest terms, bankruptcy deals with the seizure of the debtor’s assets and their distribution to the
debtor’s various creditors. The term derives from the Renaissance custom of Italian traders, who did their
trading from benches in town marketplaces. Creditors literally “broke the bench” of a merchant who failed
to pay his debts. The term banco rotta (broken bench) thus came to apply to business failures.
In the Victorian era, many people in both England and the United States viewed someone who became
bankrupt as a wicked person. In part, this attitude was prompted by the law itself, which to a greater
degree in England and to a lesser degree in the United States treated the insolvent debtor as a sort of
felon. Until the second half of the nineteenth century, British insolvents could be imprisoned; jail for
insolvent debtors was abolished earlier in the United States. And the entire administration of bankruptcy
law favored the creditor, who could with a mere filing throw the financial affairs of the alleged insolvent
into complete disarray.
Today a different attitude prevails. Bankruptcy is understood as an aspect of financing, a system that
permits creditors to receive an equitable distribution of the bankrupt person’s assets and promises new
hope to debtors facing impossible financial burdens. Without such a law, we may reasonably suppose that
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the level of economic activity would be far less than it is, for few would be willing to risk being personally
burdened forever by crushing debt. Bankruptcy gives the honest debtor a fresh start and resolves disputes
among creditors.

History of the Bankruptcy System; Bankruptcy Courts and Judges
Constitutional Basis
The US Constitution prohibits the states from impairing the “obligation of a contract.” This means that no
state can directly provide a means for discharging a debtor unless the debt has been entirely paid. But the
Constitution in Article I, Section 8, does give the federal government such a power by providing that
Congress may enact a uniform bankruptcy law.

Bankruptcy Statutes
Congress passed bankruptcy laws in 1800, 1841, and 1867. These lasted only a few years each. In 1898,
Congress enacted the Bankruptcy Act, which together with the Chandler Act amendments in 1938, lasted
until 1978. In 1978, Congress passed the Bankruptcy Reform Act, and in 2005, it adopted the current law,
the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). This law is the subject of our
chapter.
At the beginning of the twentieth century, bankruptcies averaged fewer than 20,000 per year. Even in
1935, at the height of the Great Depression, bankruptcy filings in federal court climbed only to 69,000. At
the end of World War II, in 1945, they stood at 13,000. From 1950 on, the statistics show a steep increase.
During the decade before the 1978 changes, bankruptcy filings in court averaged 181,000 a year—reaching
a high of 254,000 in 1975. They soared to over 450,000 filings per year in the 1980s and mostly
maintained that pace until just before the 2005 law took effect (see Figure 12.1 "US Bankruptcies, 1980–
[1]

2009"). The 2005 act—preceded by “massive lobbying largely by banks and credit card companies” —
was intended by its promoters to restore personal responsibility and integrity in the bankruptcy system.
The law’s critics said it was simply a way for the credit card industry to extract more money from
consumers before their debts were wiped away.
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Figure 12.1 US Bankruptcies, 1980–2009

Bankruptcy Action.com, http://www.bankruptcyaction.com/USbankstats.htm, statistics from
Administrative Office of the Courts.

Bankruptcy Courts, Judges, and Costs
Each federal judicial district has a US Bankruptcy Court, whose judges are appointed by US Courts of
Appeal. Unless both sides agree otherwise, bankruptcy judges are to hear only bankruptcy matters (called
core proceedings). Bankruptcy trustees are government lawyers appointed by the US Attorney General.
They have administrative responsibilities in overseeing the proceedings.
The filing fee for a bankruptcy is about $200, depending upon the type of bankruptcy, and the typical
lawyer’s fee for uncomplicated cases is about $1,200–$1,400.

Overview of Bankruptcy Provisions
The BAPCPA provides for six different kinds of bankruptcy proceedings. Each is covered by its own
chapter in the act and is usually referred to by its chapter number (see Figure 12.2 "Bankruptcy Options").

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Figure 12.2 Bankruptcy Options

The bankruptcy statute (as opposed to case law interpreting it) is usually referred to as the
bankruptcy code. The types of bankruptcies are as follows:
•

Chapter 7, Liquidation: applies to all debtors except railroads, insurance companies, most banks and
credit unions, and homestead associations.

[2]

A liquidation is a “straight” bankruptcy proceeding. It

entails selling the debtor’s nonexempt assets for cash and distributing the cash to the creditors,
thereby discharging the insolvent person or business from any further liability for the debt. About 70
percent of all bankruptcy filings are Chapter 7.
•

Chapter 9, Adjustment of debts of a municipality: applies to municipalities that are insolvent and
want to adjust their debts.

[3]

(The law does not suppose that a town, city, or county will go out of

existence in the wake of insolvency.)
•

Chapter 11, Reorganization: applies to anybody who could file Chapter 7, plus railroads. It is the
means by which a financially troubled company can continue to operate while its financial affairs are
put on a sounder basis. A business might liquidate following reorganization but will probably take on
new life after negotiations with creditors on how the old debt is to be paid off. A company may

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voluntarily decide to seek Chapter 11 protection in court, or it may be forced involuntarily into a
Chapter 11 proceeding.
•

Chapter 12, Adjustment of debts of a family farmer or fisherman with regular annual income.

[4]

Many

family farmers cannot qualify for reorganization under Chapter 13 because of the low debt ceiling, and
under Chapter 11, the proceeding is often complicated and expensive. As a result, Congress created
Chapter 12, which applies only to farmers whose total debts do not exceed $1.5 million.
•

Chapter 13, Adjustment of debts of an individual with regular income: applies only to individuals (no
corporations or partnerships) with debt not exceeding about $1.3 million.

[5]

This chapter permits an

individual with regular income to establish a repayment plan, usually either a composition (an
agreement among creditors, discussed in Section 12.5 "Alternatives to Bankruptcy", “Alternatives to
Bankruptcy”) or an extension (a stretch-out of the time for paying the entire debt).
•

Chapter 15, Ancillary and other cross-border cases: incorporates the United Nations’ Model Law on
Cross-Border Insolvency to promote cooperation among nations involved in cross-border cases and is
intended to create legal certainty for trade and investment. “Ancillary” refers to the possibility that a
US debtor might have assets or obligations in a foreign country; those non-US aspects of the case are
“ancillary” to the US bankruptcy case.

The BAPCPA includes three chapters that set forth the procedures to be applied to the various
proceedings. Chapter 1, “General Provisions,” establishes who is eligible for relief under the act. Chapter
3, “Case Administration,” spells out the powers of the various officials involved in the bankruptcy
proceedings and establishes the methods for instituting bankruptcy cases. Chapter 5, “Creditors, the
Debtor, and the Estate,” deals with the debtor’s “estate”—his or her assets. It lays down ground rules for
determining which property is to be included in the estate, sets out the powers of the bankruptcy trustee
to “avoid” (invalidate) transactions by which the debtor sought to remove property from the estate, orders
the distribution of property to creditors, and sets forth the duties and benefits that accrue to the debtor
under the act.
To illustrate how these procedural chapters (especially Chapter 3 and Chapter 5) apply, we focus on the
most common proceeding: liquidation (Chapter 7). Most of the principles of bankruptcy law discussed in
connection with liquidation apply to the other types of proceedings as well. However, some principles

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vary, and we conclude the chapter by noting special features of two other important proceedings—Chapter
13 and Chapter 11.

KEY TAKEAWAY
Bankruptcy law’s purpose is to give the honest debtor a fresh start and to resolve disputes among
creditors. The most recent amendments to the law were effective in 2005. Bankruptcy law provides
relief to six kinds of debtors: (1) Chapter 7, straight bankruptcy—liquidation—applies to most debtors
(except banks and railroads); (2) Chapter 9 applies to municipalities; (3) Chapter 11 is business
reorganization; (4) Chapter 12 applies to farmers; (5) Chapter 13 is for wage earners; and (6) Chapter
15 applies to cross-border bankruptcies. The bankruptcy statutes also have several chapters that cover
procedures of bankruptcy proceedings.

EXERCISES
1.

Why is bankruptcy law required in a modern capitalistic society?

2.

Who does the bankruptcy trustee represent?

3.

The three most commonly filed bankruptcies are Chapter 7, 11, and 13. Who gets relief under those
chapters?

[1] CCH Bankruptcy Reform Act Briefing, “Bankruptcy Abuse Prevention and Consumer Protection Act of 2005,”
April 2005, http://www.cch.com/bankruptcy/bankruptcy_04-21.pdf.
[2] 11 United States Code, Section 109(b).
[3] 11 United States Code, Section 109(c).
[4] 11 United States Code, Section 109(f).
[5] 11 United States Code, Section 109(e).

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12.2 Case Administration; Creditors’ Claims; Debtors’
Exemptions and Dischargeable Debts; Debtor’s Estate
LEARNING OBJECTIVES
1.

Understand the basic procedures involved in administering a bankruptcy case.

2.

Recognize the basic elements of creditors’ rights under the bankruptcy code.

3.

Understand the fundamentals of what property is included in the debtor’s estate.

4.

Identify some of the debtor’s exemptions—what property can be kept by the debtor.

5.

Know some of the debts that cannot be discharged in bankruptcy.

6.

Know how an estate is liquidated under Chapter 7.

Case Administration (Chapter 3 of the Bankruptcy Code)
Recall that the purpose of liquidation is to convert the debtor’s assets—except those exempt under the
law—into cash for distribution to the creditors and thereafter to discharge the debtor from further
liability. With certain exceptions, any person may voluntarily file a petition to liquidate under Chapter 7. A
“person” is defined as any individual, partnership, or corporation. The exceptions are railroads and
insurance companies, banks, savings and loan associations, credit unions, and the like.
For a Chapter 7 liquidation proceeding, as for bankruptcy proceedings in general, the various aspects of
case administration are covered by the bankruptcy code’s Chapter 3. These include the rules governing

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commencement of the proceedings, the effect of the petition in bankruptcy, the first meeting of the
creditors, and the duties and powers of trustees.

Commencement
The bankruptcy begins with the filing of a petition in bankruptcy with the bankruptcy court.

Voluntary and Involuntary Petitions
The individual, partnership, or corporation may file a voluntary petition in bankruptcy; 99 percent of
bankruptcies are voluntary petitions filed by the debtor. But involuntary bankruptcy is possible, too,
under Chapter 7 or Chapter 11. To put anyone into bankruptcy involuntarily, the petitioning creditors
must meet three conditions: (1) they must have claims for unsecured debt amounting to at least $13,475;
(2) three creditors must join in the petition whenever twelve or more creditors have claims against the
particular debtor—otherwise, one creditor may file an involuntary petition, as long as his claim is for at
least $13,475; (3) there must be no bona fide dispute about the debt owing. If there is a dispute, the debtor
can resist the involuntary filing, and if she wins the dispute, the creditors who pushed for the involuntary
petition have to pay the associated costs. Persons owing less than $13,475, farmers, and charitable
organizations cannot be forced into bankruptcy.

The Automatic Stay
The petition—voluntary or otherwise—operates as a stay against suits or other actions against the debtor
to recover claims, enforce judgments, or create liens (but not alimony collection). In other words, once the
petition is filed, the debtor is freed from worry over other proceedings affecting her finances or property.
No more debt collection calls! Anyone with a claim, secured or unsecured, must seek relief in the
bankruptcy court. This provision in the act can have dramatic consequences. Beset by tens of thousands of
products-liability suits for damages caused by asbestos, UNR Industries and Manville Corporation, the
nation’s largest asbestos producers, filed (separate) voluntary bankruptcy petitions in 1982; those filings
automatically stayed all pending lawsuits.
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First Meeting of Creditors
Once a petition in bankruptcy is filed, the courts issue an order of relief, which determines that the
debtor’s property is subject to bankruptcy court control and creates the stay. The Chapter 7 case may be
dismissed by the court if, after a notice and hearing, it finds that among other things (e.g., delay,
nonpayment of required bankruptcy fees), the debts are primarily consumer debts and the debtor could
pay them off—that’s the 2005 act’s famous “means test,” discussed in Section 12.3 "Chapter 7
Liquidation".
Assuming that the order of relief has been properly issued, the creditors must meet within a reasonable
time. The debtor is obligated to appear at the meeting and submit to examination under oath. The judge
does not preside and, indeed, is not even entitled to attend the meeting.
When the judge issues an order for relief, an interim trustee is appointed who is authorized initially to
take control of the debtor’s assets. The trustee is required to collect the property, liquidate the debtor’s
estate, and distribute the proceeds to the creditors. The trustee may sue and be sued in the name of the
estate. Under every chapter except Chapter 7, the court has sole discretion to name the trustee. Under
Chapter 7, the creditors may select their own trustee as long as they do it at the first meeting of creditors
and follow the procedures laid down in the act.

Trustee’s Powers and Duties
The act empowers the trustee to use, sell, or lease the debtor’s property in the ordinary course of business
or, after notice and a hearing, even if not in the ordinary course of business. In all cases, the trustee must
protect any security interests in the property. As long as the court has authorized the debtor’s business to
continue, the trustee may also obtain credit in the ordinary course of business. She may invest money in
the estate to yield the maximum, but reasonably safe, return. Subject to the court’s approval, she may
employ various professionals, such as attorneys, accountants, and appraisers, and may, with some
exceptions, assume or reject executor contracts and unexpired leases that the debtor has made. The
trustee also has the power to avoid many pre-bankruptcy transactions in order to recover property of the
debtor to be included in the liquidation.

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Creditors’ Claims, the Debtor, and the Estate (Chapter 5 of the Bankruptcy Code)
We now turn to the major matters covered in Chapter 5 of the bankruptcy act: creditors’ claims, debtors’
exemptions and discharge, and the property to be included in the estate. We begin with the rules
governing proof of claims by creditors and the priority of their claims.

Claims and Creditors
A claim is defined as a right to payment, whether or not it is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, un-matured, disputed, undisputed, legal, equitable, secured, or
unsecured. A creditor is defined as a person or entity with a claim that arose no later than when the court
issues the order for relief. These are very broad definitions, intended to give the debtor the broadest
possible relief when finally discharged.

Proof of Claims
Before the trustee can distribute proceeds of the estate, unsecured creditors must file a proof of claim,
prima facie evidence that they are owed some amount of money. They must do so within six months after
the first date set for the first meeting of creditors. A creditor’s claim is disallowed, even though it is valid,
if it is not filed in a timely manner. A party in interest, such as the trustee or creditor, may object to a
proof of claim, in which case the court must determine whether to allow it. In the absence of objection, the
claim is “deemed allowed.” The court will not allow some claims. These include unenforceable claims,
claims for un-matured interest, claims that may be offset by debts the creditor owes the debtor, and
unreasonable charges by an insider or an attorney. If it’s a “no asset” bankruptcy—most are—creditors are
in effect told by the court not to waste their time filing proof of claim.

Claims with Priority
The bankruptcy act sets out categories of claimants and establishes priorities among them. The law is
complex because it sets up different orders of priorities.
First, secured creditors get their security interests before anyone else is satisfied, because the security
interest is not part of the property that the trustee is entitled to bring into the estate. This is why being a
secured creditor is important (as discussed in Suretyship “and Chapter 11 "Mortgages and Nonconsensual
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Liens"). To the extent that secured creditors have claims in excess of their collateral, they are considered
unsecured or general creditors and are lumped in with general creditors of the appropriate class.
Second, of the six classes of claimants (see Figure 12.3 "Distribution of the Estate"), the first is known as
that of “priority claims.” It is subdivided into ten categories ranked in order of priority. The highestpriority class within the general class of priority claims must be paid off in full before the next class can
share in a distribution from the estate, and so on. Within each class, members will share pro rata if there
are not enough assets to satisfy everyone fully. The priority classes, from highest to lowest, are set out in
the bankruptcy code (11 USC Section 507) as follows:
(1) Domestic support obligations (“DSO”), which are claims for support due to the spouse, former spouse,
child, or child’s representative, and at a lower priority within this class are any claims by a governmental
unit that has rendered support assistance to the debtor’s family obligations.
(2) Administrative expenses that are required to administer the bankruptcy case itself. Under former law,
administrative expenses had the highest priority, but Congress elevated domestic support obligations
above administrative expenses with the passage of the BAPCPA. Actually, though, administrative
expenses have a de facto priority over domestic support obligations, because such expenses are deducted
before they are paid to DSO recipients. Since trustees are paid from the bankruptcy estate, the courts have
allowed de facto top priority for administrative expenses because no trustee is going to administer a
bankruptcy case for nothing (and no lawyer will work for long without getting paid, either).
(3) Gap creditors. Claims made by gap creditors in an involuntary bankruptcy petition under Chapter 7 or
Chapter 11 are those that arise between the filing of an involuntary bankruptcy petition and the order for
relief issued by the court. These claims are given priority because otherwise creditors would not deal with
the debtor, usually a business, when the business has declared bankruptcy but no trustee has been
appointed and no order of relief issued.
(4) Employee wages up to $10,950 for each worker, for the 180 days previous to either the bankruptcy
filing or when the business ceased operations, whichever is earlier (180-day period).
(5) Unpaid contributions to employee benefit plans during the 180-day period, but limited by what was
already paid by the employer under subsection (4) above plus what was paid on behalf of the employees
by the bankruptcy estate for any employment benefit plan.

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(6) Any claims for grain from a grain producer or fish from a fisherman for up to $5,400 each against a
storage or processing facility.
(7) Consumer layaway deposits of up to $2,425 each.
(8) Taxes owing to federal, state, and local governments for income, property, employment and excise
taxes. Outside of bankruptcy, taxes usually have a higher priority than this, which is why many times
creditors—not tax creditors—file an involuntary bankruptcy petition against the debtor so that they have a
higher priority in bankruptcy than they would outside it.
(9) Allowed claims based on any commitment by the debtor to a federal depository institution to
maintain the capital of an insured depository institution.
(10) Claims for death or personal injury from a motor vehicle or vessel that occurred while the debtor
was legally intoxicated.
Third through sixth (after secured creditors and priority claimants), other claimants are attended to, but
not immediately. The bankruptcy code (perhaps somewhat awkwardly) deals with who gets paid when in
more than one place. Chapter 5 sets out priority claims as just noted; that order applies to all
bankruptcies. Chapter 7, dealing with liquidation (as opposed to Chapter 11 and Chapter 13, wherein the
debtor pays most of her debt), then lists the order of distribution. Section 726 of 11 United States Code
provides: “Distribution of property of the estate. (1) First, in payment of claims of the kind specified in,
and in the order specified in section 507…” (again, the priority of claims just set out). Following the order
specified in the bankruptcy code, our discussion of the order of distribution is taken up in Section 12.3
"Chapter 7 Liquidation".

Debtor's Duties and Exemptions
The act imposes certain duties on the debtor, and it exempts some property that the trustee can
accumulate and distribute from the estate.

Debtor’s Duties
The debtor, reasonably enough, is supposed to file a list of creditors, assets, liabilities, and current income
and a statement of financial affairs. The debtor must cooperate with the trustee and be an “honest debtor”
in general; the failure to abide by these duties is grounds for a denial of discharge.
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The individual debtor (not including partnerships or corporations) also must show evidence that he or she
attended an approved nonprofit budget and counseling agency within 180 days before the filing. The
counseling may be “an individual or group briefing (including a briefing conducted by telephone or on the
Internet) that outline[s] the opportunities for available credit counseling and assisted such individual in
performing a related budget analysis.”

[1]

In Section 111, the 2005 act describes who can perform this

counseling, and a host of regulations and enforcement mechanisms are instituted, generally applying to
persons who provide goods or services related to bankruptcy work for consumer debtors whose
nonexempt assets are less than $150,000, in order to improve the professionalism of attorneys and others
who work with debtors in, or contemplating, bankruptcy. A debtor who is incapacitated, disabled, or on
active duty in a military zone doesn’t have to go through the counseling.

Debtor’s Exemptions
The bankruptcy act exempts certain property of the estate of an individual debtor so that he or she will not
be impoverished upon discharge. Exactly what is exempt depends on state law.
Notwithstanding the Constitution’s mandate that Congress establish “uniform laws on the subject of
bankruptcies,” bankruptcy law is in fact not uniform because the states persuaded Congress to allow nonuniform exemptions. The concept makes sense: what is necessary for a debtor in Maine to live a nonimpoverished post-bankruptcy life might not be the same as what is necessary in southern California. The
bankruptcy code describes how a person’s residence is determined for claiming state exemptions:
basically, where the debtor lived for 730 days immediately before filing or where she lived for 180 days
immediately preceding the 730-day period. For example, if the debtor resided in the same state, without
interruption, in the two years leading up to the bankruptcy, he can use that state’s exemptions. If not, the
location where he resided for a majority of the half-year preceding the initial two years will be used. The
point here is to reduce “exemption shopping”—to reduce the incidences in which a person moves to a
generous exemption state only to declare bankruptcy there.
Unless the state has opted out of the federal exemptions (a majority have), a debtor can choose which
exemptions to claim.

[2]

There are also some exemptions not included in the bankruptcy code: veteran’s,

Social Security, unemployment, and disability benefits are outside the code, and alimony payments are
also exempt under federal law. The federal exemptions can be doubled by a married couple filing together.
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Here are the federal exemptions:

[3]

Homestead:
•

Real property, including mobile homes and co-ops, or burial plots up to $20,200. Unused portion of
homestead, up to $10,125, may be used for other property.

Personal Property:
•

Motor vehicle up to $3,225.

•

Animals, crops, clothing, appliances and furnishings, books, household goods, and musical
instruments up to $525 per item, and up to $10,775 total.

•

Jewelry up to $1,350.

•

$1,075 of any property, and unused portion of homestead up to $10,125.

•

Health aids.

•

Wrongful death recovery for person you depended upon.

•

Personal injury recovery up to $20,200 except for pain and suffering or for pecuniary loss.

•

Lost earnings payments.

Pensions:
•

Tax exempt retirement accounts; IRAs and Roth IRAs up to $1,095,000 per person.

Public Benefits:
•

Public assistance, Social Security, Veteran’s benefits, Unemployment Compensation.

•

Crime victim’s compensation.

Tools of Trade:
•

Implements, books, and tools of trade, up to $2,025.

Alimony and Child Support:
•

Alimony and child support needed for support.

Insurance:
•

Un-matured life insurance policy except credit insurance.

•

Life insurance policy with loan value up to $10,775.

•

Disability, unemployment, or illness benefits.

•

Life insurance payments for a person you depended on, which you need for support.

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In the run-up to the 2005 changes in the bankruptcy law, there was concern that some states—especially
[4]

Florida —had gone too far in giving debtors’ exemptions. The BAPCPA amended Section 522 to limit the
amount of equity a debtor can exempt, even in a state with unlimited homestead exemptions, in certain
circumstances. (Section 522(o) and (p) set out the law’s changes.)

Secured Property
As already noted, secured creditors generally have priority, even above the priority claims. That’s why
banks and lending institutions almost always secure the debtor’s obligations. But despite the general rule,
the debtor can avoid certain types of security interests. Liens that attach to assets that the debtor is
entitled to claim as exempt can be avoided to the extent the lien impairs the value of the exemption in
both Chapter 13 and Chapter 7. To be avoidable, the lien must be a judicial lien (like a judgment or a
garnishment), or a non-possessory, non-purchase-money security interest in household goods or tools of
the trade.
Tax liens (which are statutory liens, not judicial liens) aren’t avoidable in Chapter 7 even if they impair
exemptions; tax liens can be avoided in Chapter 13 to the extent the lien is greater than the asset’s value.

Dischargeable and Non-dischargeable Debts
The whole point of bankruptcy, of course, is for debtors to get relief from the press of debt that they
cannot reasonably pay.

Dischargeable Debts
Once discharged, the debtor is no longer legally liable to pay any remaining unpaid debts (except nondischargeable debts) that arose before the court issued the order of relief. The discharge operates to void
any money judgments already rendered against the debtor and to bar the judgment creditor from seeking
to recover the judgment.

Non-dischargeable Debts

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Some debts are not dischargeable in bankruptcy. A bankruptcy discharge varies, depending on the type of
bankruptcy the debtor files (Chapter 7, 11, 12, or 13). The most common non-dischargeable debts listed in
Section 523 include the following:
•

All debts not listed in the bankruptcy petition

•

Student loans—unless it would be an undue hardship to repay them (see Section 12.6 "Cases", In re
Zygarewicz)

•

Taxes—federal, state, and municipal

•

Fines for violating the law, including criminal fines and traffic tickets

•

Alimony and child support, divorce, and other property settlements

•

Debts for personal injury caused by driving, boating, or operating an aircraft while intoxicated

•

Consumer debts owed to a single creditor and aggregating more than $550 for luxury goods or
services incurred within ninety days before the order of relief

•

Cash advances aggregating more than $825 obtained by an individual debtor within ninety days
before the order for relief

•

Debts incurred because of fraud or securities law violations

•

Debts for willful injury to another’s person or his or her property

•

Debts from embezzlement

This is not an exhaustive list, and as noted in Section 12.3 "Chapter 7 Liquidation", there are some
circumstances in which it is not just certain debts that aren’t dischargeable: sometimes a discharge is
denied entirely.

Reaffirmation
A debtor may reaffirm a debt that was discharged. Section 524 of the bankruptcy code provides important
protection to the debtor intent on doing so. No reaffirmation is binding unless the reaffirmation was
made prior to the granting of the discharge; the reaffirmation agreement must contain a clear and
conspicuous statement that advises the debtor that the agreement is not required by bankruptcy or nonbankruptcy law and that the agreement may be rescinded by giving notice of rescission to the holder of
such claim at any time prior to discharge or within sixty days after the agreement is filed with the court,
whichever is later.
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A written agreement to reaffirm a debt must be filed with the bankruptcy court. The attorney for the
debtor must file an affidavit certifying that the agreement represents a fully informed and voluntary
agreement, that the agreement does not impose an undue hardship on the debtor or a dependent of the
debtor, and that the attorney has fully advised the debtor of the legal consequences of the agreement and
of a default under the agreement. Where the debtor is an individual who was not represented by an
attorney during the course of negotiating the agreement, the reaffirmation agreement must be approved
by the court, after disclosures to the debtor, and after the court finds that it is in the best interest of the
debtor and does not cause an undue hardship on the debtor or a dependent.

Property Included in the Estate
When a bankruptcy petition is filed, a debtor’s estate is created consisting of all the debtor’s then-existing
property interests, whether legal or equitable. In addition, the estate includes any bequests, inheritances,
and certain other distributions of property that the debtor receives within the next 180 days. It also
includes property recovered by the trustee under certain powers granted by the law. What is not exempt
property will be distributed to the creditors.
The bankruptcy code confers on the trustee certain powers to recover property for the estate that the
debtor transferred before bankruptcy.
One such power (in Section 544) is to act as a hypothetical lien creditor. This power is best explained by
an example. Suppose Dennis Debtor purchases equipment on credit from Acme Supply Company. Acme
fails to perfect its security interest, and a few weeks later Debtor files a bankruptcy petition. By virtue of
the section conferring on the trustee the status of a hypothetical lien creditor, the trustee can act as
though she had a lien on the equipment, with priority over Acme’s unperfected security interest. Thus the
trustee can avoid Acme’s security interest, with the result that Acme would be treated as an unsecured
creditor.
Another power is to avoid transactions known as voidable preferences—transactions highly favorable to
particular creditors.

[5]

A transfer of property is voidable if it was made (1) to a creditor or for his benefit,

(2) on account of a debt owed before the transfer was made, (3) while the debtor was insolvent, (4) on or
within ninety days before the filing of the petition, and (5) to enable a creditor to receive more than he
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would have under Chapter 7. If the creditor was an “insider”—one who had a special relationship with the
debtor, such as a relative or general partner of the debtor or a corporation that the debtor controls or
serves in as director or officer—then the trustee may void the transaction if it was made within one year of
the filing of the petition, assuming that the debtor was insolvent at the time the transaction was made.
Some pre-bankruptcy transfers that seem to fall within these provisions do not. The most important
exceptions are (1) transfers made for new value (the debtor buys a refrigerator for cash one week before
filing a petition; this is an exchange for new value and the trustee may not void it); (2) a transfer that
creates a purchase-money security interest securing new value if the secured party perfects within ten
days after the debtor receives the goods; (3) payment of a debt incurred in the ordinary course of
business, on ordinary business terms; (4) transfers totaling less than $600 by an individual whose debts
are primarily consumer debts; (5) transfers totaling less than $5,475 by a debtor whose debts are not
primarily consumer debts; and (6) transfers to the extent the transfer was a bona fide domestic support
obligation.
A third power of the trustee is to avoid fraudulent transfers made within two years before the date that the
bankruptcy petition was filed.

[6]

This provision contemplates various types of fraud. For example, while

insolvent, the debtor might transfer property to a relative for less than it was worth, intending to recover
it after discharge. This situation should be distinguished from the voidable preference just discussed, in
which the debtor pays a favored creditor what he actually owes but in so doing cannot then pay other
creditors.

KEY TAKEAWAY
A bankruptcy commences with the filing of a petition of bankruptcy. Creditors file proofs of claim and
are entitled to certain priorities: domestic support obligations and the costs of administration are first.
The debtor has an obligation to file full and truthful schedules and to attend a credit counseling
session, if applicable. The debtor has a right to claim exemptions, federal or state, that leave her with
assets sufficient to make a fresh start: some home equity, an automobile, and clothing and personal
effects, among others. The honest debtor is discharged of many debts, but some are nondischargeable, among them taxes, debt from illegal behavior (embezzlement, drunk driving), fines,
student loans, and certain consumer debt. A debtor may, after proper counseling, reaffirm debt, but
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only before filing. The bankruptcy trustee takes over the nonexempt property of the debtor; he may
act as a hypothetical lien creditor (avoiding unperfected security interests) and avoid preferential and
fraudulent transfers that unfairly diminish the property of the estate.

EXERCISES
1.

What is the automatic stay, and when does it arise?

2.

Why are the expenses of claimants administering the bankruptcy given top priority (notwithstanding
the nominal top priority of domestic support obligations)?

3.

Why are debtor’s exemptions not uniform? What sorts of things are exempt from being taken by the
bankruptcy trustee, and why are such exemptions allowed?

4.

Some debts are non-dischargeable; give three examples. What is the rationale for disallowing some
debts from discharge?

5.

How does the law take care that the debtor is fully informed of the right not to reaffirm debts, and
why is such care taken?

6.

What is a hypothetical lien creditor? What is the difference between a preferential transfer and a
fraudulent one? Why is it relevant to discuss these three things in the same paragraph?

[1] 11 United States Code, Section 109(h).
[2] These are the states that allow residents to choose either federal or state exemptions (the other states
mandate the use of state exemptions only): Arkansas, Connecticut, District of Columbia, Hawaii, Kentucky,
Massachusetts, Michigan, Minnesota, New Hampshire, New Jersey, New Mexico, Pennsylvania, Rhode Island,
Texas, Vermont, Washington, and Wisconsin.
[3] 11 United States Code, Section 522.
[4] The Florida homestead exemption is “[r]eal or personal property, including mobile or modular home and
condominium, to unlimited value. Property cannot exceed: 1/2 acre in a municipality, or 160 acres elsewhere.” The
2005 act limits the state homestead exemptions, as noted.
[5] 11 United States Code, Section 547.
[6] 11 United States Code, Section 548.

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12.3 Chapter 7 Liquidation
LEARNING OBJECTIVES
1.

Recognize the grounds for a Chapter 7 case to be dismissed.

2.

Be familiar with the BAPCPA’s means-testing requirements before Chapter 7 discharge is granted.

3.

Know under what circumstances a debtor will be denied discharge.

4.

Understand the order of distribution of the debtor’s estate under Chapter 7.

Trustee’s Duties under Chapter 7; Grounds for Dismissal: The Means Test
Except as noted, the provisions discussed up until now apply to each type of bankruptcy proceeding. The
following discussion is limited to certain provisions under Chapter 7.

Trustee’s Duties
In addition to the duties already noted, the trustee has other duties under Chapter 7. He must sell the
property for money, close up the estate “as expeditiously as is compatible with the best interests of parties
in interest,” investigate the debtor’s financial affairs, examine proofs of claims, reject improper ones,
oppose the discharge of the debtor where doing so is advisable in the trustee’s opinion, furnish a creditor

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with information about the estate and his administration (unless the court orders otherwise), file tax
reports if the business continues to be operated, and make a final report and file it with the court.

Conversion
Under Section 706 of the bankruptcy code, the debtor may convert a Chapter 7 case to Chapter 11, 12, or
13 at any time. The court may order a conversion to Chapter 11 at any time upon request of a party in
interest and after notice and hearing. And, as discussed next, a case may be converted from Chapter 7 to
Chapter 13 if the debtor agrees, or be dismissed if he does not, in those cases where the debtor makes too
much money to be discharged without it being an “abuse” under the 2005 act.

Dismissal
The court may dismiss a case for three general reasons.
The first reason is “for cause,” after notice and a hearing for cause, including (1) unreasonable delay by the
debtor that prejudices creditors, (2) nonpayment of any fees required, (3) failure to file required
documents and schedules.
The second reason for dismissal (or, with the debtor’s permission, conversion to Chapter 11 or 13) applies
to debtors whose debt is primarily consumer debt: the court may—after notice and a hearing—dismiss a
case if granting relief would be “an abuse of the provisions” of the bankruptcy code.
The third reason for dismissal is really the crux of the 2005 law: under it, the court will find that granting
relief under Chapter 7 to a debtor whose debt is primarily consumer debt is “an abuse” if the debtor makes
too much money. The debtor must pass a means test: If he’s poor enough, he can go Chapter 7. If he is not
poor enough (or if they are not, in case of a married couple), Chapter 13—making payments to creditors—
is the way to go. Here is one practitioner’s explanation of the means test:
To apply the means test, the courts will look at the debtor’s average income for the 6 months prior to filing
[not the debtor’s income at the time of filing, when—say—she just lost her job] and compare it to the
median income for that state. For example, the median annual income for a single wage-earner in
California is $42,012. If the income is below the median, then Chapter 7 remains open as an option. If the
income exceeds the median, the remaining parts of the means test will be applied.
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The next step in the calculation takes monthly income less reasonable living expenses [“reasonable living
expenses” are strictly calculated based on IRS standards; the figure excludes payments on the debts
included in the bankruptcy], and multiplies that figure times 60. This represents the amount of income
available over a 5-year period for repayment of the debt obligations.
If the income available for debt repayment over that 5-year period is $10,000 or more, then Chapter 13
will be required. In other words, anyone earning above the state median, and with at least $166.67 per
month ($10,000 divided by 60) of available income, will automatically be denied Chapter 7. So for
example, if the court determines that you have $200 per month income above living expenses, $200 times
60 is $12,000. Since $12,000 is above $10,000, you’re stuck with Chapter 13.
What happens if you are above the median income but do NOT have at least $166.67 per month to pay
toward your debts? Then the final part of the means test is applied. If the available income is less than
$100 per month, then Chapter 7 again becomes an option. If the available income is between $100 and
$166.66, then it is measured against the debt as a percentage, with 25% being the benchmark.
In other words, let’s say your income is above the median, your debt is $50,000, and you only have $125
of available monthly income. We take $125 times 60 months (5 years), which equals $7,500 total. Since
$7,500 is less than 25% of your $50,000 debt, Chapter 7 is still a possible option for you. If your debt was
only $25,000, then your $7,500 of available income would exceed 25% of your debt and you would be
required to file under Chapter 13.
To sum up, first figure out whether you are above or below the median income for your state—median
income figures are available at http://www.new-bankruptcy-law-info.com. Be sure to account for your
spouse’s income if you are a two-income family. Next, deduct your average monthly living expenses from
your monthly income and multiply by 60. If the result is above $10,000, you’re stuck with Chapter 13. If
the result is below $6,000, you may still be able to file Chapter 7. If the result is between $6,000 and
$10,000, compare it to 25% of your debt. Above 25%, you’re looking at Chapter 13 for sure.

[1]

The law also requires that attorneys sign the petition (as well as the debtor); the attorney’s signature
certifies that the petition is well-grounded in fact and that the attorney has no knowledge after reasonable
inquiry that the schedules and calculations are incorrect. Attorneys thus have an incentive to err in favor
of filing Chapter 13 instead of Chapter 7 (perhaps that was part of Congress’s purpose in this section of the
law).
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If there’s been a dismissal, the debtor and creditors have the same rights and remedies as they had prior
to the case being commenced—as if the case had never been filed (almost). The debtor can re-file
immediately, unless the court orders a 120-day penalty (for failure to appear). In most cases, a debtor can
file instantly for a Chapter 13 following a Chapter 7 dismissal.

Distribution of the Estate and Discharge; Denying Discharge
Distribution of the Estate
The estate includes all his or her assets or all their assets (in the case of a married couple) broadly defined.
From the estate, the debtor removes property claimed exempt; the trustee may recapture some assets
improperly removed from the estate (preferential and fraudulent transfers), and what’s left is the
distributable estate. It is important to note that the vast majority of Chapter 7 bankruptcies are noasset cases—90–95 percent of them, according to one longtime bankruptcy trustee.

[2]

That means

creditors get nothing. But in those cases where there are assets, the trustee must distribute the estate to
the remaining classes of claimants in this order:
1.

Secured creditors, paid on their security interests

2. Claims with priority
3. Unsecured creditors who filed their claims on time
4. Unsecured creditors who were tardy in filing, if they had no notice of the bankruptcy
5.

Unsecured creditors who were tardy and had notice, real or constructive

6. Claims by creditors for fines, penalties, and exemplary or punitive damages
7.

Interest for all creditors at the legal rate

8. The debtor
Figure 12.3 Distribution of the Estate

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Discharge
Once the estate is distributed, the court will order the debtor discharged (except for non-dischargeable
debts) unless one of the following overall exceptions applies for denying discharge (i.e., relief from the
debt). This list is not exhaustive:
1.

The debtor is not an individual. In a Chapter 7 case, a corporation or partnership does not receive a
bankruptcy discharge; instead, the entity is dissolved and its assets liquidated. The debts remain
theoretically valid but uncollectible until the statute of limitations on them has run. Only an
individual can receive a Chapter 7 discharge.

[3]

2. The debtor has concealed or destroyed property with intent to defraud, hinder, or delay within twelve
months preceding filing of the petition.
3. The debtor has concealed, destroyed, or falsified books and records
4. The debtor has lied under oath, knowingly given a false account, presented or used a false claim, given
or received bribes, refused to obey court orders.
5.

The debtor has failed to explain satisfactorily any loss of assets.

6. The debtor has declared Chapter 7 or Chapter 11 bankruptcy within eight years, or Chapter 13 within
six years (with some exceptions).
7.

The debtor failed to participate in “an instructional course concerns personal financial management”
(unless that’s excused).

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8. An individual debtor has “abused” the bankruptcy process. A preferential transfer is not an “abuse,”
but it will be set aside. Making too much money to file Chapter 7 is “an abuse” that will deny
discharge.
A discharge may be revoked if the debtor committed fraud during the bankruptcy proceedings, but the
trustee or a creditor must apply for revocation within one year of the discharge.
Having the discharge denied does not affect the administration of the bankruptcy case. The trustee can
(and will) continue to liquidate any nonexempt assets of the debtor and pay the creditors, but the debtor
still has to pay the debts left over.
As to any consequence of discharge, bankruptcy law prohibits governmental units from discriminating
against a person who has gone through bankruptcy. Debtors are also protected from discrimination by
private employers; for example, a private employer may not fire a debtor because of the bankruptcy.
Certainly, however, the debtor’s credit rating will be affected by the bankruptcy.

KEY TAKEAWAY
A Chapter 7 bankruptcy case may be dismissed for cause or because the debtor has abused the system.
The debtor is automatically considered to have abused the system if he makes too much money. With
the debtor’s permission, the Chapter 7 may be converted to Chapter 11, 12, or 13. The law requires
that the debtor pass a means test to qualify for Chapter 7. Assuming the debtor does qualify for
Chapter 7, her nonexempt assets (if there are any) are sold by the trustee and distributed to creditors
according to a priority set out in the law. A discharge may be denied, in general because the debtor has
behaved dishonestly or—again—has abused the system.

EXERCISES
1.

What is the difference between denial of a discharge for cause and denial for abuse?

2.

What is the difference between a dismissal and a denial of discharge?

3.

Which creditors get satisfied first in a Chapter 7 bankruptcy?

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[1] Charles Phelan, “The New Bankruptcy Means Test Explained in Plain
English,”Buzzle.com, http://www.buzzle.com/editorials/1-10-2006-85999.asp.
[2] Eugene Crane, Hearing before the Subcommittee on Commercial and Administrative Law of the Committee on
the Judiciary, House of Representatives, One Hundred Tenth Congress, Second Session, Statement to the House
Judiciary Sub-Committee, September 16, 2008;http://judiciary.house.gov/hearings/printers/110th/44493.PDF.
[3] 11 United States Code, Section 727(a) (1).

12.4 Chapter 11 and Chapter 13 Bankruptcies
LEARNING OBJECTIVES
1.

Understand the basic concepts of Chapter 11 bankruptcies.

2.

Understand the basic concepts of Chapter 13 bankruptcies.

Reorganization: Chapter 11 Bankruptcy
Overview

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Chapters 11 provides a means by which corporations, partnerships, and other businesses, including sole
proprietorships, can rehabilitate themselves and continue to operate free from the burden of debts that
they cannot pay.
It is simple enough to apply for the protection of the court in Chapter 11 proceeding, and for many years,
large financially ailing companies have sought shelter in Chapter 11. Well-known examples include
General Motors, Texaco, K-Mart, Delta Airlines, and Northwest Airlines. An increasing number of
corporations have turned to Chapter 11 even though, by conventional terms, they were solvent. Doing so
enables them to negotiate with creditors to reduce debt. It also may even permit courts to snuff out
lawsuits that have not yet been filed. Chapters 3 and 5, discussed in Section 12.2 "Case Administration;
Creditors’ Claims; Debtors’ Exemptions and Dischargeable Debts; Debtor’s Estate", apply to Chapter 11
proceedings also. Our discussion, therefore, is limited to special features of Chapter 11.

How It Works
Eligibility
Any person eligible for discharge in Chapter 7 proceeding (plus railroads) is eligible for a Chapter 11
proceeding, except stockbrokers and commodity brokers. Individuals filing Chapter 11 must take credit
counseling; businesses do not. A company may voluntarily enter Chapter 11 or may be put there
involuntarily by creditors. Individuals can file Chapter 11 particularly if they have too much debt to qualify
for Chapter 13 and make too much money to qualify for Chapter 7; under the 2005 act, individuals must
commit future wages to creditors, just as in Chapter 13.

[1]

Operation of Business
Unless a trustee is appointed, the debtor will retain possession of the business and may continue to
operate with its own management. The court may appoint a trustee on request of any party in interest
after notice and a hearing. The appointment may be made for cause—such as dishonesty, incompetence,
or gross mismanagement—or if it is otherwise in the best interests of the creditors. Frequently, the same
incompetent management that got the business into bankruptcy is left running it—that’s a criticism of
Chapter 11.

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Creditors’ Committee
The court must appoint a committee of unsecured creditors as soon as practicable after issuing the order
for relief. The committee must consist of creditors willing to serve who have the seven largest claims,
unless the court decides to continue a committee formed before the filing, if the committee was fairly
chosen and adequately represents the various claims. The committee has several duties, including these:
(1) to investigate the debtor’s financial affairs, (2) to determine whether to seek appointment of a trustee
or to let the business continue to operate, and (3) to consult with the debtor or trustee throughout the
case.

The Reorganization Plan
The debtor may always file its own plan, whether in a voluntary or involuntary case. If the court leaves the
debtor in possession without appointing a trustee, the debtor has the exclusive right to file a
reorganization plan during the first 120 days. If it does file, it will then have another 60 days to obtain the
creditors’ acceptances. Although its exclusivity expires at the end of 180 days, the court may lengthen or
shorten the period for good cause. At the end of the exclusive period, the creditors’ committee, a single
creditor, or a holder of equity in the debtor’s property may file a plan. If the court does appoint a trustee,
any party in interest may file a plan at any time.
The Bankruptcy Reform Act specifies certain features of the plan and permits others to be included.
Among other things, the plan must (1) designate classes of claims and ownership interests; (2) specify
which classes or interests are impaired—a claim or ownership interest is impaired if the creditor’s legal,
equitable, contractual rights are altered under the plan; (3) specify the treatment of any class of claims or
interests that is impaired under the plan; (4) provide the same treatment of each claim or interests of a
particular class, unless the holder of a particular claim or interest agrees to a less favorable treatment; and
(5) provide adequate means for carrying out the plan. Basically, what the plan does is provide a process
for rehabilitating the company’s faltering business by relieving it from repaying part of its debt and
initiating reforms so that the company can try to get back on its feet.

Acceptance of the Plan

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The act requires the plan to be accepted by certain proportions of each impaired class of claims and
interests. A class of claims accepts the plan if creditors representing at least two-thirds of the dollar
amount of claims and more than one-half the number of allowed claims vote in favor. A class of property
interests accepts the plan if creditors representing two-thirds of the dollar amount of the allowed
ownership interests vote in favor. Unimpaired classes of claims and interest are deemed to have accepted
the plan; it is unnecessary to solicit their acceptance.

Confirmation of the Plan
The final act necessary under Chapter 11 is confirmation by the court. Once the court confirms the plan,
the plan is binding on all creditors. The rules governing confirmation are complex, but in essence, they
include the following requirements:
1.

The plan must have been proposed in good faith. Companies must also make a good-faith attempt to
negotiate modifications in their collective bargaining agreements (labor union contracts).

2. All provisions of the act must have been complied with.
3. The court must have determined that the reorganized business will be likely to succeed and be
unlikely to require further financial reorganization in the foreseeable future.
4. Impaired classes of claims and interests must have accepted the plan, unless the plan treats them in a
“fair and equitable” manner, in which case consent is not required. This is sometimes referred to as
the cram-down provision.
5.

All members of every class must have received no less value than they would have in Chapter 7
liquidation.

Discharge, Conversion
The debtor gets discharged when all payments under the plan are completed. A Chapter 11 bankruptcy
may be converted to Chapter 7, with some restrictions, if it turns out the debtor cannot make the plan
work.

Adjustment of Debts of an Individual with Regular Income: Chapter 13
Bankruptcy
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In General
Anyone with a steady income who is having difficulty paying off accumulated debts may seek the
protection of a bankruptcy court in Chapter 13 proceeding (often called the wage earner’s plan). Under
this chapter, the individual debtor presents a payment plan to creditors, and the court appoints a trustee.
If the creditors wind up with more under the plan presented than they would receive in Chapter 7
proceeding, then the court is likely to approve it. In general, a Chapter 13 repayment plan extends the
time to pay the debt and may reduce it so that the debtor need not pay it all. Typically, the debtor will pay
a fixed sum monthly to the trustee, who will distribute it to the creditors. The previously discussed
provisions of Chapters 3 and 5 apply also to this chapter; therefore, the discussion that follows focuses on
some unique features of Chapter 13.
People seek Chapter 13 discharges instead of Chapter 7 for various reasons: they make too much money to
pass the Chapter 7 means test; they are behind on their mortgage or car payments and want to make them
up over time and reinstate the original agreement; they have debts that can’t be discharged in Chapter 7;
they have nonexempt property they want to keep; they have co-debtors on a personal debt who would be
liable if the debtor went Chapter 7; they have a real desire to pay their debts but cannot do so without
getting the creditors to give them some breathing room. Chapter 7 cases may always be converted to
Chapter 13.

How It Works
Eligibility
Chapter 13 is voluntary only. Anyone—sole proprietorships included—who has a regular income,
unsecured debts of less than $336,000, and secured debts of less than $1,010,650 is eligible to seek its
protection. The debts must be unpaid and owing at the time the debtor applies for relief. If the person has
more debt than that, she will have to file Chapter 11. The debtor must attend a credit-counseling class, as
in Chapter 7.
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The Plan
Plans are typically extensions or compositions—that is, they extend the time to pay what is owing, or they
are agreements among creditors each to accept something less than the full amount owed (so that all get
something). Under Chapter 13, the stretch-out period is three to five three years. The plan must provide
for payments of all future income or a sufficient portion of it to the trustee. Priority creditors are entitled
to be paid in full, although they may be paid later than required under the original indebtedness. As long
as the plan is being carried out, the debtor may enjoin any creditors from suing to collect the original debt.

Confirmation
Under Section 1325 of the bankruptcy code, the court must approve the plan if it meets certain
requirements. These include (1) distribution of property to unsecured creditors whose claims are allowed
in an amount no less than that which they would have received had the estate been liquidated under
Chapter 7; (2) acceptance by secured creditors, with some exceptions, such as when the debtor surrenders
the secured property to the creditor; and (3) proposal of the plan “in good faith.” If the trustee or an
unsecured creditor objects to confirmation, the plan must meet additional tests. For example, a plan will
be approved if all of the debtor’s disposable income (as defined in Section 1325) over the commitment
period (three to five years) will be used to make payments under the plan.

Discharge
Once a debtor has made all payments called for in the plan, the court will discharge him from all
remaining debts except certain long-term debts and obligations to pay alimony, maintenance, and
support. Under former law, Chapter 13 was so broad that it permitted the court to discharge the debtor
from many debts considered non-dischargeable under Chapter 7, but 1994 amendments and the 2005 act
made Chapter 13 less expansive. Debts dischargeable in Chapter 13, but not in Chapter 7, include debts for
willful and malicious injury to property, debts incurred to pay non-dischargeable tax obligations, and
debts arising from property settlements in divorce or separation proceedings. (See Section 12.6
"Cases", In re Ryan, for a discussion of what debts are dischargeable under Chapter 13 as compared with
Chapter 7.)
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Although a Chapter 13 debtor generally receives a discharge only after completing all payments required
by the court-approved (i.e., “confirmed”) repayment plan, there are some limited circumstances under
which the debtor may request the court to grant a “hardship discharge” even though the debtor has failed
to complete plan payments. Such a discharge is available only to a debtor whose failure to complete plan
payments is due to circumstances beyond the debtor’s control. A Chapter 13 discharge stays on the credit
record for up to ten years.
A discharge may be denied if the debtor previously went through a bankruptcy too soon before filing
Chapter 13, failed to act in good faith, or—with some exceptions—failed to complete a personal financial
management course.

KEY TAKEAWAY
Chapter 11—frequently referred to as “corporate reorganization”—is most often used by businesses
whose value as a going concern is greater than it would be if liquidated, but, with some exceptions,
anyone eligible to file Chapter 7 can file Chapter 11. The business owners, or in some cases the trustee
or creditors, develop a plan to pay the firm’s debts over a three- to five-year period; the plan must be
approved by creditors and the court. Chapter 13—frequently called the wage-earner’s plan—is a
similar mechanism by which a person can discharge some debt and have longer to pay debts off than
originally scheduled. Under Chapter 13, people can get certain relief from creditors that they cannot
get in Chapter 7.

EXERCISES
1.

David Debtor is a freelance artist with significant debt that he feels a moral obligation to pay. Why is
Chapter 11 his best choice of bankruptcy chapters to file under?

2.

What is the practical difference between debts arising from property settlements in divorce or
separation proceedings—which can be discharged under Chapter 13—and debts owing for alimony
(maintenance) and child support—which cannot be discharged under Chapter 13?

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3.

Why would a person want to go through the long grind of Chapter 13 instead of just declaring straight
bankruptcy (Chapter 7) and being done with it?

[1] 11 United States Code, Sections 1115, 1123(a) (8), and 1129(a)(15).

12.5 Alternatives to Bankruptcy
LEARNING OBJECTIVES
1.

Understand that there are non-bankruptcy alternatives for debtors who cannot pay their bills in a timely
way: assignment for benefit of creditors, compositions, and receiverships.

2.

Recognize the reasons why these alternatives might not work.

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Alternatives to Bankruptcy: Overview
Bankruptcy is a necessary thing in a capitalist economic system. As already noted, without it, few people
would be willing to take business risks, and the economy would necessarily operate at a lower level
(something some people might not think so bad overall). But bankruptcy, however “enlightened” society
may have become about it since Victorian days, still carries a stigma. Bankruptcy filings are public
information; the lists of people and businesses who declare bankruptcy are regularly published in monthly
business journals. Bankruptcy is expensive, too, and both debtors and creditors become enmeshed in
significantly complex federal law. For these reasons, among others, both parties frequently determine it is
in their best interest to find an alternative to bankruptcy. Here we take up briefly three common
alternatives.
In other parts of this book, other non-bankruptcy creditors’ rights are discussed: under the Uniform
Commercial Code (UCC), creditors have rights to reclaim goods sold and delivered but not paid for; under
the UCC, too, creditors have a right to repossess personal property that has been put up as collateral for
the debtor’s loan or extension of credit; and mortgagees have the right to repossess real estate without
judicial assistance in many circumstances. These non-bankruptcy remedies are governed mostly by state
law.
The non-bankruptcy alternatives discussed here are governed by state law also.

Assignment for Benefit of Creditors; Compositions; Receivership
Assignment for Benefit of Creditors
Under a common-law assignment for the benefit of creditors, the debtor transfers some or all of his assets
to a trustee—usually someone appointed by the adjustment bureau of a local credit managers’
association—who sells the assets and apportions the proceeds in some agreed manner, usually pro rata, to
the creditors. Of course, not every creditor need agree with such a distribution. Strictly speaking, the
common-law assignment does not discharge the balance of the debt. Many state statutes attempt to
address this problem either by prohibiting creditors who accept a partial payment of debt under an
assignment from claiming the balance or by permitting debtors to demand a release from creditors who
accept partial payment.
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Composition
A composition is simply an agreement by creditors to accept less than the full amount of the debt and to
discharge the debtor from further liability. As a contract, composition requires consideration; the mutual
agreement among creditors to accept a pro rata share of the proceeds is held to be sufficient consideration
to support the discharge. The essential difference between assignment and composition lies in the
creditors’ agreement: an assignment implies no agreement among the creditors, whereas a composition
does. Not all creditors of the particular debtor need agree to the composition for it to be valid. A creditor
who does not agree to the composition remains free to attempt to collect the full sum owed; in particular,
a creditor not inclined to compose the debt could attach the debtor’s assets while other creditors are
bargaining over the details of the composition agreement.
One advantage of the assignment over the composition is that in the former the debtor’s assets—having
been assigned—are protected from attachment by hungry creditors. Also, the assignment does not require
creditors’ consent. However, an advantage to the debtor of the assignment (compared with the
composition) is that in the composition creditors cannot go after the debtor for any deficiency (because
they agreed not to).

Receivership
A creditor may petition the court to appoint a receiver; receivership is a long-established procedure in
equity whereby the receiver takes over the debtor’s property under instructions from the court. The
receiver may liquidate the property, continue to operate the business, or preserve the assets without
operating the business until the court finally determines how to dispose of the debtor’s property.
The difficulty with most of the alternatives to bankruptcy lies in their voluntary character: a creditor who
refuses to go along with an agreement to discharge the debtor can usually manage to thwart the debtor
and her fellow creditors because, at the end of the day, the US Constitution forbids the states from
impairing private citizens’ contractual obligations. The only final protection, therefore, is to be found in
the federal bankruptcy law.

KEY TAKEAWAY
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Bankruptcy is expensive and frequently convoluted. Non-bankruptcy alternatives include assignment for
the benefit of creditors (the debtor’s assets are assigned to a trustee who manages or disposes of them for
creditors), compositions (agreements by creditors to accept less than they are owed and to discharge the
debtor from further liability), and receivership (a type of court-supervised assignment).

EXERCISES
1.

What is an assignment for benefit of creditors?

2.

What is a composition?

3.

What is a receivership?

4.

Why are these alternatives to bankruptcy often unsatisfactory?

12.6 Cases
Discharge ability of Student Loans under Chapter 7
In re Zygarewicz
423 B.R. 909 (Bkrtcy.E.D.Cal. 2010)
MCMANUS, BANKRUPTCY JUDGE.

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Angela Zygarewicz, a chapter 7 debtors and the plaintiff in this adversary proceeding, borrowed 16
government-guaranteed student [sic] loans totaling $81,429. The loans have been assigned to Educational
Credit Management Corporation (“ECMC”). By September 2009, the accrual of interest on these student
loans had caused the debt to balloon to more than $146,000. The debtor asks the court to declare that
these student loans were discharged in bankruptcy.
The Bankruptcy Code provides financially distressed debtors with a fresh start by discharging most of
their pre-petition debts.…However, under 11 U.S.C. § 523(a)(8), there is a presumption that educational
loans extended by or with the aid of a governmental unit or nonprofit institution are non-dischargeable
unless the debtor can demonstrate that their repayment would be an undue hardship. See [Citation]. This
exception to a bankruptcy discharge ensures that student loans, which are typically extended solely on the
basis of the student’s future earnings potential, cannot be discharged by recent graduates who then pocket
all of the future benefits derived from their education. See [Citation].
The debtor bears the burden of proving by a preponderance of the evidence that she is entitled to a
discharge of the student loan. See [Citation]. That is, the debtor must prove that repayment of student
loans will cause an undue hardship.
The Bankruptcy Code does not define “the undue hardship.” Courts interpreting section 523(a)(8),
however, have concluded that undue hardship [and] is something more than “garden-variety hardship.”
[Citation.] Only cases involving “real and substantial” hardship merit discharges. See [Citation.]
The Ninth Circuit has adopted a three-part test to guide courts in their attempts to determine whether a
debtor will suffer an undue hardship is required to repay a student loan:
•

First, the debtor must establish “that she cannot maintain, based on current income and expenses, a
‘minimal’ standard of living for herself and her dependents if forced to repay the loans.”…

•

Second, the debtor must show “that additional circumstances exist indicating that this state of affairs
is likely to persist for a significant portion of the repayment period of the student loans.”…

•

The third prong requires “that the debtor has made good faith efforts to repay the loans.…”

(Pena, citing Brunner v. N.Y. State Higher Educ. Servs. Corp., [Citation]).
Debtor must satisfy all three parts of the Brunner test before her student loans can be discharged. Failure
to prove any of the three prongs will defeat a debtor’s case.

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When this bankruptcy case was filed in September 2005, the debtor was a single woman and had no
dependents. She is 39 years old.
Schedule I reported that the debtor was unemployed. The debtor’s responses to the Statement of Financial
Affairs revealed that she had received $5,500 in income during 2005 prior to the filing of the petition.
Evidence at trial indicated that after the petition was filed, the debtor found work and earned a total of
$9,424 in 2005. In 2004 and 2003, she earned $13,994 and $17,339, respectively.
Despite this modest income, the debtor did not immediately file an adversary proceeding to determine the
discharge ability of her student loans. It was almost three years after the entry of her chapter 7 discharge
‘on January 3, 2006 that the debtor reopened her chapter 7 cases in order to pursue this adversary
proceeding.’
In her complaint, the debtor admits that after she received a discharge, she found part-time work with a
church and later took a full-time job as a speech therapist. During 2006, the debtor earned $20,009 and
in 2007 she earned $37,314. Hence, while it is clear the debtor’s income was very modest in the time
period immediately prior to her bankruptcy petition, her financial situation improved during her
bankruptcy case.
The court cannot conclude based on the evidence of the debtor’s financial circumstances up to the date of
the discharge that she was unable to maintain a minimal standard of living if she was required to repay
her students [sic] loans.
However, in January 2007, the debtor was injured in an automobile accident. Her injuries eventually
halted the financial progress she had been making and eventually prevented her from working. She now
subsists on social security disability payments.
The circumstance creating the debtor’s hardship, the automobile accident, occurred after her chapter 7
petitions was filed, indeed; approximately one year after her discharge was entered. The debtor is
maintaining that this post-petition, post-discharge circumstance warrants a declaration that her student
loans were discharged effective from the petition date.
When must the circumstances creating a debtor’s hardship arise: before the bankruptcy case is filed; after
the case if filed but prior to the entry of a discharge; or at any time, including after the entry of a
discharge?

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The court concludes that the circumstances causing a chapter 7 debtor’s financial hardship must arise
prior to the entry of the discharge. If the circumstances causing a debtor’s hardship arise after the entry of
a discharge, those circumstances cannot form the basis of a determination that repayment of a student
loan will be an undue hardship.…
[T]here is nothing in the Bankruptcy Code requiring that a complaint under section 523(a) (8) [to
discharge student loans] be filed at any particular point in a bankruptcy case, whether it is filed under
chapter 7 or 13. [Relevant Federal Rules of Bankruptcy Procedure] permits such discharge ability
complaints to be brought at any time, including after the entry of a discharge and the closing of the
bankruptcy case.…
While a debtor’s decision to file an action to determine the discharge ability of a student loan is not
temporally constrained, this does not mean that a debtor’s financial hardship may arise after a discharge
has been entered.
[The] Coleman [case, cited by debtor] deals with the ripeness of a dispute concerning the discharge ability
of a student loan. [The Ninth Circuit held that it] is ripe for adjudication at any point during the case. The
Ninth Circuit did not conclude, however, that a debtor could rely upon post-discharge circumstances to
establish undue hardship. In fact, the court in Coleman made clear that the debtor could take a snapshot
of the hardship warranting a discharge of a student loan any time prior to discharge. [Coleman was a
Chapter 13 case.]
Here, the debtor was injured in an automobile accident on January 17, 2007, almost exactly one year after
her January 3, 2006 chapter 7 discharges. Because the accident had no causal link to the misfortune
prompting the debtor to seek bankruptcy relief in the first instance, the accident cannot be relied on to
justify the discharge of the student loans because repayment would be an undue hardship.
To hold otherwise would mean that a bankruptcy discharge is a perpetual license to discharge student
loans based on events that occur years after the bankruptcy discharge is granted. If a discharged debtor
suffers later financial misfortune, that debtor must consider seeking another discharge subject to the
limitations imposed by [the sections of the code stipulating how often a person can petition for
bankruptcy]. In the context of a second case, the debtor could then ask that the student loan be declared
dischargeable under section 523(a) (8).

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In this instance, the debtor is now eligible for a discharge in a chapter 13 case. Her chapter 7 petition was
filed on September 19, 2005. Section 1328(f) (1) bars a chapter 13 discharge when the debtor has received
a chapter 7 discharge in a case commenced in the prior four years. She would not be eligible for a chapter
7 discharge until September 19, 2013.
This is not to say that post-discharge events are irrelevant. The second and third prongs of the Pena test
require the court to consider whether the circumstances preventing a debtor from repaying a student loan
are likely to persist, and whether the debtor has made good faith efforts to repay the student loan. Postdischarge events are relevant to these determinations because they require the court to look into the
debtor’s financial future.
Unfortunately for the debtor, it is unnecessary to consider the second and third prongs because she
cannot satisfy the first prong.

CASE QUESTIONS
1.

What is the rationale for making the bankruptcy discharge of student loans very difficult?

2.

Petitioner argued that she should be able to use a post discharge event (the auto accident) as a basis
for establishing that she could not maintain a “minimal” standard of living, and thus she should get a
retroactive discharge of her student loans. What benefit is there to her if she could successfully make
the argument, given that she could—as the court noted—file for Chapter 13?
3.

The court cites the Coleman case. That was a Chapter 13 proceeding. Here were the facts:
Debtor had not yet completed her payments under her five-year repayment plan, and no
discharge order had yet been entered; one year into the plan, she was laid off work. She had
been trying to repay her student loans for several years, and she claimed she would suffer
hardship in committing to the five-year repayment plan without any guarantee that her
student loan obligations would be discharged, since she was required to commit all of her
disposable income to payments under the plan and would likely be forced to pursue undue
hardship issue pro se upon completion of the plan.” In Coleman, the court held that Debtor
could, post filing but pre-discharge—one year into the five-year plan—bring up the hardship
issue.

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Now, in the case here, after the auto accident, the petitioner “subsists” on Social Security
disability payments, and she has almost $150,000 in debt, yet the court prohibited her from
claiming a hardship discharge of student loans. Does this result really make sense? Is the
court’s concern that allowing this post discharge relief would mean “that a bankruptcy
discharge is a perpetual license to discharge student loans based on events that occur years
after the bankruptcy discharge is granted” well founded? Suppose it is scheduled to take thirty
years to pay off student loans; in year 4, the student-borrower, now Debtor, declares Chapter
7 bankruptcy, student loans not being discharged; in year 6, the person is rendered disabled.
What public policy is offended if the person is allowed to “reopen” the bankruptcy and use the
post-bankruptcy event as a basis for claiming a hardship discharge of student loans?
4.

The court suggests she file for Chapter 13. What if—because of timing—the petitioner was not eligible
for Chapter 13? What would happen then?

Chapter 11 Bankruptcy
In re Johns-Manville Corp.
36 B.R. 727 (Bkrtcy. N.Y. 1984)
Lifland, Bankruptcy Judge.
Whether an industrial enterprise in the United States is highly successful is often gauged by its
“membership” in what has come to be known as the “Fortune 500”. Having attained this measure of
financial achievement, Johns-Manville Corp. and its affiliated companies (collectively referred to as
“Manville”) were deemed a paradigm of success in corporate America by the financial community. Thus,
Manville’s filing for protection under Chapter 11 of Title 11 of the United States Code (“the Code or the
Bankruptcy Code”) on August 26, 1982 (“the filing date”) was greeted with great surprise and
consternation on the part of some of its creditors and other corporations that were being sued along with
Manville for injuries caused by asbestos exposure. As discussed at length herein, Manville submits that
the sole factor necessitating its filing is the mammoth problem of uncontrolled proliferation of asbestos
health suits brought against it because of its substantial use for many years of products containing
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asbestos which injured those who came into contact with the dust of this lethal substance. According to
Manville, this current problem of approximately 16,000 lawsuits pending as of the filing date is
compounded by the crushing economic burden to be suffered by Manville over the next 20–30 years by
the filing of an even more staggering number of suits by those who had been exposed but who will not
manifest the asbestos-related diseases until sometime during this future period (“the future asbestos
claimants”). Indeed, approximately 6,000 asbestos health claims are estimated to have arisen in only the
first 16 months since the filing date. This burden is further compounded by the insurance industry’s
general disavowal of liability to Manville on policies written for this very purpose.
It is the propriety of the filing by Manville which is the subject of the instant decision. Four separate
motions to dismiss the petition pursuant to Section 1112(b) of the Code have been lodged before this
Court.…
Preliminarily, it must be stated that there is no question that Manville is eligible to be a debtor under the
Code’s statutory requirements. Moreover, it should also be noted that neither Section 109 nor any other
provision relating to voluntary petitions by companies contains any insolvency
requirement.…Accordingly, it is abundantly clear that Manville has met all of the threshold eligibility
requirements for filing a voluntary petition under the Code.…
A “principal goal” of the Bankruptcy Code is to provide “open access” to the “bankruptcy process.”
[Citation.] The rationale behind this “open access” policy is to provide access to bankruptcy relief which is
as “open” as “access to the credit economy.” Thus, Congress intended that “there should be no legal
barrier to voluntary petitions.” Another major goal of the Code that of “rehabilitation of debtors,” requires
that relief for debtors must be “timely.” Congress declared that it is essential to both the “open access” and
“rehabilitation” goals that
[i]nitiating relief should not be a death knell. The process should encourage resort to it, by debtors and
creditors, that cuts short the dissipation of assets and the accumulation of debts. Belated commencement
of a case may kill an opportunity for reorganization or arrangement.
Accordingly, the drafters of the Code envisioned that a financially beleaguered debtor with real debt and
real creditors should not be required to wait until the economic situation is beyond repair in order to file a
reorganization petition. The “Congressional purpose” in enacting the Code was to encourage resort to the
bankruptcy process. This philosophy not only comports with the elimination of an insolvency
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requirement, but also is a corollary of the key aim of Chapter 11 of the Code, that of avoidance of
liquidation. The drafters of the Code announced this goal, declaring that reorganization is more efficient
than liquidation because “assets that are used for production in the industry for which they were designed
are more valuable than those same assets sold for scrap.” [Citation.] Moreover, reorganization also fosters
the goals of preservation of jobs in the threatened entity. [Citation.]
In the instant case, not only would liquidation be wasteful and inefficient in destroying the utility of
valuable assets of the companies as well as jobs, but, more importantly, liquidation would preclude just
compensation of some present asbestos victims and all future asbestos claimants. This unassailable reality
represents all the more reason for this Court to adhere to this basic potential liquidation avoidance aim of
Chapter 11 and deny the motions to dismiss. Manville must not be required to wait until its economic
picture has deteriorated beyond salvation to file for reorganization.
Clearly, none of the justifications for declaring an abuse of the jurisdiction of the bankruptcy court
announced by these courts [in various cases cited] are present in the Manville case. In Manville, it is
undeniable that there has been no sham or hoax perpetrated on the Court in that Manville is a real
business with real creditors in pressing need of economic reorganization. Indeed, the Asbestos Committee
has belied its own contention that Manville has no debt and no real creditors by quantifying a benchmark
settlement demand approaching one billion dollars for compensation of approximately 15,500 prepetition asbestos claimants, during the course of negotiations pitched toward achieving a consensual plan.
This huge asserted liability does not even take into account the estimated 6,000 new asbestos health
claims which have arisen in only the first 16 months since the filing date. The number of post-filing claims
increases each day as “future claims back into the present.” …
In short, Manville’s filing did not in the appropriate sense abuse the jurisdiction of this Court and it is
indeed, like the debtor in [Citation], a “once viable business supporting employees and unsecured
creditors [that] has more recently been burdened with judgments [and suits] that threaten to put it out of
existence.” Thus, its petition must be sustained.…
In sum, Manville is a financially besieged enterprise in desperate need of reorganization of its crushing
real debt, both present and future. The reorganization provisions of the Code were drafted with the aim of
liquidation avoidance by great access to Chapter 11. Accordingly, Manville’s filing does not abuse the
jurisdictional integrity of this Court, but rather presents the same kinds of reasons that were present in
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[Citation], for awaiting the determination of Manville’s good faith until it is considered…as a prerequisite
to confirmation or as a part of the cadre of motions before me which are scheduled to be heard
subsequently.
[A]ll four of the motions to dismiss the Manville petition are denied in their entirety.

CASE QUESTIONS
1.

What did Manville want to do here, and why?

2.

How does this case demonstrate the fundamental purpose of Chapter 11 as opposed to Chapter 7
filings?

3.

The historical background here is that Manville knew from at least 1930 that asbestos—used in many
industrial applications—was a deadly carcinogen, and it worked diligently for decades to conceal and
obfuscate the fact. What “good faith” argument was raised by the movants in this case?

Chapter 13: What Debts Are Dischargeable?
In re Ryan
389 B.R. 710 9th Cir. BAP, (Idaho, 2008)
On July 13, 1995, Ryan was convicted of possession of an unregistered firearm under 26 U.S.C. § 5861(d)
in the United States District Court for the District of Alaska. Ryan was sentenced to fifty-seven months in
prison followed by three years of supervised release. In addition, Ryan was ordered to pay a fine of
$7,500…, costs of prosecution in the amount of $83,420, and a special assessment of $50.00. Ryan served
his sentence. He also paid the $7,500 fine. The district court, following an appellate mandate, ultimately
eliminated the restitution obligation.
On April 25, 2003, Ryan filed a petition for bankruptcy relief under chapter 7 in the District of Idaho. He
received his chapter 7 discharge on August 11, 2003. Shortly thereafter, Ryan filed a case under chapter
13, listing as his only obligation the amount of unpaid costs of prosecution owed to the United States
(“Government”).…
Ryan completed payments under the plan, and an “Order of Discharge” was entered on October 5, 2006.
The chapter 13 trustee’s final report reflected that the Government received $2,774.89 from payments
made by Ryan under his plan, but a balance of $77,088.34 on the Government’s costs of prosecution
claim remained unpaid. Ryan then renewed his request for determination of discharge ability. The
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bankruptcy court held that the unpaid portion of the Government’s claim for costs of prosecution was
excepted from discharge by § 1328(a)(3). Ryan appealed.
Section 1328(a) (3) provides an exception to discharge in chapter 13 for “restitution, or a criminal fine.” It
states, in pertinent part:
[A]s soon as practicable after the completion by the debtor of all payments under the plan, the court shall
grant the debtor a discharge of all debts provided for by the plan or disallowed under section 502 of this
title except any debt…
(3) for restitution, or a criminal fine, included in a sentence on the debtor’s conviction of a crime [.]
[emphasis added].
The essential question, then, is whether these costs of prosecution constitute a “criminal fine.”
Statutory interpretation begins with a review of the particular language used by Congress in the relevant
version of the law. [Citation.]
The term “criminal fine” is not defined in [Chapter 13] or anywhere else in the Bankruptcy Code.
However, its use in § 1328(a)(3) implicates two important policies embedded in the Bankruptcy Code.
First, in light of the objective to provide a fresh start for debtors overburdened by debts that they cannot
pay, exceptions to discharge are interpreted strictly against objecting creditors and in favor of
debtors. See, e.g. [Citations]. In chapter 13, this principle is particularly important because Congress
adopted the liberal “super discharge” provisions of § 1328 as an incentive to debtors to commit to a plan
to pay their creditors all of their disposable income over a period of years rather than simply discharging
their debts in a chapter 7 liquidation.
“[T]he discharge ability of debts in chapter 13 that are not dischargeable in chapter 7 represents a policy
judgment that [it] is preferable for debtors to attempt to pay such debts to the best of their abilities over
three years rather than for those debtors to have those debts hanging over their heads indefinitely,
perhaps for the rest of their lives.” [Citations.]
A second, countervailing policy consideration is a historic deference, both in the Bankruptcy Code and in
the administration of prior bankruptcy law, to accepting criminal sanctions from discharge in bankruptcy.
Application of this policy is consistent with a general recognition that, “[t]he principal purpose of the
Bankruptcy Code is to grant a ‘fresh start’ to the ‘honest but unfortunate debtor.’” [Citation] (emphasis
added [in original]).
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The legislative history is clear that [in its 1994 amendments to the bankruptcy law] Congress intended to
overrule the result in [of a 1990 Supreme Court case so that]…“[N]o debtor with criminal restitution
obligations will be able to discharge them through any bankruptcy proceeding.”…
The imposition on a defendant of the costs of a special prosecutor is different from ordering a defendant
to pay criminal fines. Costs are paid to the entity incurring the costs; criminal fines are generally paid to a
special fund for victims’ compensation and assistance in the U.S. Treasury…
To honor the principle that exceptions to discharge are to be construed narrowly in favor of debtors,
particularly in chapter 13, where a broad discharge was provided by Congress as an incentive for debtors
to opt for relief under that chapter rather than under chapter 7, it is not appropriate to expand the scope
of the [Chapter 13] exception beyond the terms of the statute. Congress could have adopted an exception
to discharge in chapter 13 that mirrored [the one in Chapter 7]. It did not do so. In contrast, under [the
2005] BAPCPA, when Congress wanted to limit the chapter 13 “super discharge,” it incorporated
exceptions to discharge from [Chapter 7] wholesale.…
As a bottom line matter, Ryan served his time and paid in full the criminal fine that was imposed as part
of his sentence for conviction of possession of an unregistered firearm. The restitution obligation that was
included as part of his sentence was voided. Ryan paid the Government a total of $6,331.66 to be applied
to the costs of prosecution awarded as part of his criminal judgment, including $2,774.89 paid under his
chapter 13 plan, leaving a balance of $77,088.34. We determine that the unpaid balance of the costs of
prosecution award was covered by Ryan’s chapter 13 discharges.
Based on the foregoing analysis, we conclude that the exception to discharge included in [Chapter 13] for
“restitution, or a criminal fine, included in a sentence on the debtor’s conviction of a crime” does not cover
costs of prosecution included in such a sentence, and we REVERSE.

CASE QUESTIONS
1.

What is the rationale for making some things dischargeable under Chapter 13 that are not
dischargeable under Chapter 7?

2.

What is the difference between “criminal restitution” (which in 1994 Congress said could not get
discharged at all) and “the costs of prosecution”?

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3.

Why did the court decide that Ryan’s obligation to pay “costs of prosecution” was not precluded by
the limits on Chapter 13 bankruptcies imposed by Congress?

12.7 Summary and Exercises
Summary
The Constitution gives Congress the power to legislate on bankruptcy. The current law is the Bankruptcy
Abuse Prevention and Consumer Protection Act of 2005, which provides for six types of proceedings: (1)

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liquidation, Chapter 7; (2) adjustment of debts of a municipality, Chapter 9; (3) reorganization, Chapter
11; (4) family farmers with regular income, Chapter 12; (5) individuals with regular income, Chapter 13;
and (6) cross-border bankruptcies, Chapter 15.
With some exceptions, any individual, partnership, or corporation seeking liquidation may file a voluntary
petition in bankruptcy. An involuntary petition is also possible; creditors petitioning for that must meet
certain criteria.
A petition operates as a stay against the debtor for lawsuits to recover claims or enforce judgments or
liens. A judge will issue an order of relief and appoint a trustee, who takes over the debtor’s property and
preserves security interests. To recover monies owed, creditors must file proof of claims. The trustee has
certain powers to recover property for the estate that the debtor transferred before bankruptcy. These
include the power to act as a hypothetical lien creditor, to avoid fraudulent transfers and voidable
preferences.
The bankruptcy act sets out categories of claimants and establishes priority among them. After secured
parties take their security, the priorities are (1) domestic support obligations, (2) administrative expenses,
(3) gap creditor claims, (4) employees’ wages, salaries, commissions, (5) contributions to employee
benefit plans, (6) grain or fish producers’ claims against a storage facility, (7) consumer deposits, (8) taxes
owed to governments, (9) allowed claims for personal injury or death resulting from debtor’s driving or
operating a vessel while intoxicated. After these priority claims are paid, the trustee must distribute the
estate in this order: (a) unsecured creditors who filed timely, (b) unsecured creditors who filed late, (c)
persons claiming fines and the like, (d) all other creditors, (e) the debtor. Most bankruptcies are no-asset,
so creditors get nothing.
Under Chapter 7’s 2005 amendments, debtors must pass a means test to be eligible for relief; if they make
too much money, they must file Chapter 13.
Certain property is exempt from the estate of an individual debtor. States may opt out of the federal list of
exemptions and substitute their own; most have.
Once discharged, the debtor is no longer legally liable for most debts. However, some debts are not
dischargeable, and bad faith by the debtor may preclude discharge. Under some circumstances, a debtor
may reaffirm a discharged debt. A Chapter 7 case may be converted to Chapter 11 or 13 voluntarily, or to
Chapter 11 involuntarily.
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Chapter 11 provides for reorganization. Any person eligible for discharge in Chapter 7 is eligible for
Chapter 11, except stockbrokers and commodity brokers; those who have too much debt to file Chapter 13
and surpass the means test for Chapter 7 file Chapter 11. Under Chapter 11, the debtor retains possession
of the business and may continue to operate it with its own management unless the court appoints a
trustee. The court may do so either for cause or if it is in the best interests of the creditors. The court must
appoint a committee of unsecured creditors, who remain active throughout the proceeding. The debtor
may file its own reorganization plan and has the exclusive right to do so within 120 days if it remains in
possession. The plan must be accepted by certain proportions of each impaired class of claims and
interests. It is binding on all creditors, and the debtor is discharged from all debts once the court confirms
the plan.
Chapter 13 is for any individual with regular income who has difficulty paying debts; it is voluntary only;
the debtor must get credit counseling. The debtor presents a payment plan to creditors, and the court
appoints a trustee. The plan extends the time to pay and may reduce the size of the debt. If the creditors
wind up with more in this proceeding than they would have in Chapter 7, the court is likely to approve the
plan. The court may approve a stretch-out of five years. Some debts not dischargeable under Chapter 7
may be under Chapter 13.
Alternatives to bankruptcy are (1) composition (agreement by creditors to accept less than the face
amount of the debt), (2) assignment for benefit of creditors (transfer of debtor’s property to a trustee, who
uses it to pay debts), and (3) receivership (a disinterested person is appointed by the court to preserve
assets and distribute them at the court’s direction). Because these are voluntary procedures, they are
ineffective if all parties do not agree to them.

EXERCISES
1.

David has debts of $18,000 and few assets. Because his debts are less than $25,000, he decides to file
for bankruptcy using the state court system rather than the federal system. Briefly describe the
procedure he should follow to file for bankruptcy at the state level.

2.

Assume that David in Exercise 1 is irregularly employed and has developed a plan for paying off his
creditors. What type of bankruptcy should he use, Chapter 7, 11, or 13? Why?

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3.

Assume that David owns the following unsecured property: a $3,000 oboe, a $1,000 piano, a $2,000
car, and a life insurance policy with a cash surrender value of $8,000. How much of this property is
available for distribution to his creditors in a bankruptcy? Explain.

4.

If David owes his ex-wife alimony (maintenance) payments and is obligated to pay $12,000 for an
educational loan, what effect will his discharge have on these obligations?

5.

Assume that David owns a corporation that he wants to liquidate under Chapter 7. After the corporate
assets are distributed to creditors, there is still money owing to many of them. What obstacle does
David face in obtaining a discharge for the corporation?

6.

The famous retired professional football player—with a pension from the NFL—Orenthal James “O.J.”
Simpson was convicted of wrongful death in a celebrated Santa Monica, California, trial in 1997 and
ordered to pay $33.5 million in damages to the families of the deceased. Mr. Simpson sold his
California house, moved to Florida, and, from occasional appearances in the press, seemed to be living
a high-style life with a big house, nice cars, and sharp clothing. He has never declared bankruptcy.
Why hasn’t he been forced into an involuntary Chapter 7 bankruptcy by his creditors?

7.
a.

A debtor has an automobile worth $5,000. The federal exemption applicable to her is $3,225.
The trustee sells the car and gives the debtor the amount of the exemption. The debtor,
exhausted by the bankruptcy proceedings, takes the $3,225 and spends it on a six-week
vacation in Baja California. Is this an “abuse” of the bankruptcy system?

b.

A debtor has $500 in cash beyond what is exempt in bankruptcy. She takes the cash and buys
new tires for her car, which is worth about $2,000. Is this an “abuse” of the bankruptcy
system?

SELF-TEST QUESTIONS
1.

Alternatives to bankruptcy include

a.

an assignment

b.

a composition

c.

receivership

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d.

all of the above
A composition is

a.

a procedure where a receiver takes over the debtor’s property
b.

an agreement by creditors to take less than the face value of their debt

c.

basically the same as an assignment

d.

none of these
The highest-priority class set out by the 2005 act is for

a.

employees’ wages
b.

administrative expenses

c.

property settlements arising from divorce

d.

domestic support obligations
Darlene Debtor did the following within ninety days of filing for bankruptcy. Which could be
set aside as a preferential payment?
a.

paid water and electricity bills

b.

made a gift to the Humane Society

c.

prepaid an installment loan on inventory

d.

borrowed money from a bank secured by a mortgage on business property
Donald Debtor sold his 1957 Chevrolet to his brother for one-fifth its value sixty days before
filing for bankruptcy. The trustee wishes to avoid the transaction on the basis that it was

a.

a hypothetical lien
b.

a lease disguised as a sale

c.

a preferential payment

d.

avoidable preference
Acme Co. filed for bankruptcy with the following debts; which is their correct priority from
highest to lowest?
i. wages of $15,000 owed to employees
ii. unpaid federal taxes

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iii. balance owed to a creditor who claimed its security with a $5,000 deficiency owing
a.

i, ii, iii
b.

ii, iii, i

c.

iii, ii, i

d.

i, iii, ii

SELF-TEST ANSWERS
1.

d

2.

b

3.

d

4.

c

5.

d

6.

a

Chapter 13
Intellectual Property
LEARNING OBJECTIVES

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After reading this chapter, you should understand the following:
1.

The principal kinds of intellectual property

2.

The difference between patents and trade secrets, and why a company might choose to rely on trade
secrets rather than obtain a patent

3.

What copyrights are, how to obtain them, and how they differ from trademarks

4.

Why some “marks” may not be eligible for trademark protection, and how to obtain trademark
protection for those that are

Few businesses of any size could operate without being able to protect their rights to a particular type of
intangible personal property: intellectual property. The major forms of intellectual property are patents,
copyrights, and trademarks. Unlike tangible personal property (machines, inventory) or real property
(land, office buildings), intellectual property is formless. It is the product of the human intellect that is
embodied in the goods and services a company offers and by which the company is known.
A patent is a grant from government that gives an inventor the exclusive right to make, use, and sell an
invention for a period of twenty years from the date of filing the application for a patent. A copyright is the
right to exclude others from using or marketing forms of expression. A trademark is the right to prevent
others from using a company’s product name, slogan, or identifying design. Other forms of intellectual
property are trade secrets (particular kinds of information of commercial use to a company that created it)
and right of publicity (the right to exploit a person’s name or image). Note that the property interest
protected in each case is not the tangible copy of the invention or writing—not the machine with a
particular serial number or the book lying on someone’s shelf—but the invention or words themselves.
That is why intellectual property is said to be intangible: it is a right to exclude any others from gaining
economic benefit from your own 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.

13.1 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.

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3.

Explain the procedures for obtaining a patent, and how patent rights may be an issue where the
invention is created by an employee.

4.

Understand who can sue for patent infringement, on what basis, and with what potential remedies.

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

Patentability
What May Be Patented
The patent law says that “any new and useful process, machine, manufacture, or composition of matter, or
any new and useful improvement thereof” may be patented.

[1]

A process is a “process, art or method, and
[2]

includes a new use of a known process, machine, manufacture, composition of matter, or material.” A
process for making rolled steel, for example, qualifies as a patentable process under the statute.
A machine is a particular apparatus for achieving a certain result or carrying out a distinct process—
lathes, printing presses, motors, and the cotton gin are all examples of the hundreds of thousands of
machines that have received US patents since the first Patent Act in 1790. A manufacture is an article or a
product, such as a television, an automobile, a telephone, or a light bulb. 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
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them. Gene patenting, always controversial, generated new controversy when the PTO issued a patent to
Human Genome Sciences, Inc. for a gene found to serve as a platform from which the AIDS virus can
infect cells of the body. Critics faulted the PTO for allowing “ownership” of a naturally occurring human
gene and for issuing patents without requiring a showing of the gene’s utility. New guidelines from the
PTO followed in 2000; these focused on requiring the applicant to make a strong showing on the utility
aspect of patentability and somewhat diminished the rush of biotech patent requests.
There are still other categories of patentable subjects. An improvement is an alteration of a process,
machine, manufacture, or composition of matter that satisfies one of the tests for patentability given later
in this section. New, original ornamental designs for articles of manufacture are patentable (e.g., the
shape of a lamp); works of art are not patentable but are protected under the copyright law. New varieties
of cultivated or hybridized plants are also patentable, as are genetically modified strains of soybean, corn,
or other crops.

What May Not Be Patented
Many things can be patented, but not (1) the laws of nature, (2) natural phenomena, and (3) abstract
ideas, including algorithms (step-by-step formulas for accomplishing a specific task).
One frequently asked question is whether patents can be issued for computer software. The PTO was
reluctant to do so at first, based on the notion that computer programs were not “novel”—the software
program either incorporated automation of manual processes or used mathematical equations (which
were not patentable). But in 1998, the Supreme Court held in Diamond v. Diehr

[4]

that patents could be

obtained for a process that incorporated a computer program if the process itself was patentable.
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
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processing credit-card orders securely. (But see Amazon.com v. Barnesandnoble.com,

[6]

in which the

court of appeals rejected Amazon’s challenge to Barnesandnoble.com using its Express Land one-click
ordering system.)

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

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

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
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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 a contractual
agreement with employees about who owns the invention and what royalties will be paid.

Infringement and Invalidity Suits
Suits for patent infringement can arise in three ways: (1) the patent holder may seek damages and an
injunction against the infringer in federal court, requesting damages for royalties and lost profits as well;
(2) even before being sued, the accused party may take the patent holder to court under the federal
Declaratory Judgment Act, seeking a court declaration that the patent is invalid; (3) the patent holder may
sue a licensee for royalties claimed to be due, and the licensee may counterclaim that the patent is invalid.
Such a suit, if begun in state court, may be removed to federal court.
In a federal patent infringement lawsuit, the court may grant the winning party reimbursement for
attorneys’ fees and costs. If the infringement is adjudged to be intentional, the court can triple the amount
of damages awarded. Prior to 2006, courts were typically granting permanent injunctions to prevent
future infringement. Citing eBay, Inc. v. Merc Exchange, LLC,

[7]

the Supreme Court ruled that patent

holders are not automatically entitled to a permanent injunction against infringement during the life of
the patent. Courts have the discretion to determine whether justice requires a permanent injunction, and
they may conclude that the public interest and equitable principles may be better satisfied with
compensatory damages only.
Proving infringement can be a difficult task. Many companies employ engineers to “design around” a
patent product—that is, to seek ways to alter the product to such an extent that the substitute product no
longer consists of enough of the elements of the invention safeguarded by the patent. However, infringing
products, processes, or machines need not be identical; as the Supreme Court said in Sanitary
Refrigerator Co. v. Winers,

[8]

“one device is an infringement of another…if two devices do the same work

in substantially the same way, and accomplish substantially the same result…even though they differ in
name, form, or shape.” This is known as the doctrine of equivalents. In an infringement suit, the court
must choose between these two extremes: legitimate “design around” and infringement through some
equivalent product.

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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 13.1.2 "Patentability" and rule on these independently of the
conclusions drawn by the PTO.

Patent Misuse
Although a patent is a monopoly granted to the inventor or his assignee or licensee, the monopoly power
is legally limited. An owner who misuses the patent may find that he will lose an infringement suit. One
common form of misuse is to tie the patented good to some unpatented one—for example, a patented
movie projector that will not be sold unless the buyer agrees to rent films supplied only by the
manufacturer of the movie projector, or a copier manufacturer that requires buyers to purchase plain
paper from it. As we will see in Chapter 16 "Antitrust Law", 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.

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EXERCISES
1.

Calera, Inc. discovers a way to capture carbon dioxide emissions at a California power plant and use
them to make cement. This is a win for the power company, which needs to reduce its carbon dioxide
emissions and a win for Calera. Calera decides to patent this invention. What kind of patent would this
be? A machine? A composition of matter? A manufacture?

2.

In your opinion, what is the benefit of allowing companies to isolate genetic material and claim a
patent? What kind of patent would this be? A machine? A composition of matter? A manufacture?

3.

How could a “garage inventor,” working on her own, protect a patentable invention while yet
demonstrating it to a large company that could bring the invention to market?

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

13.2 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.

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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 non-obviousness. A patent can be
designed around; but if the trade secret is kept, its owner will be the exclusive user of it. Patents are
expensive to obtain, and the process is extremely time consuming. Patent protection expires in twenty
years, after which anyone is free to use the invention, but a trade secret can be maintained for as long as
the secret is kept.
However, a trade secret is valuable only so long as it is kept secret. Once it is publicly revealed, by
whatever means, anyone is free to use it. The critical distinction between a patent and a trade secret is
this: a patent gives its owner the right to enjoin anyone who infringes it from making use of it, whereas a
trade secret gives its “owner” the right to sue only the person who improperly took it or revealed it.
According to the Restatement of Torts, Section 757, Comment b, a trade secret may consist of
any formula, pattern, device or compilation of information which is used in one’s business, and which
gives him an opportunity to obtain an advantage over competitors who do not know or use it. It may be a
formula for a chemical compound, a process of manufacturing, treating or preserving materials, a pattern
for a machine or other device, or a list of customers…A trade secret is a process or device for continuous
use in the operation of a business. Generally it relates to the production of goods, as, for example, a
machine or formula for the production of an article.
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.

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

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

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
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will benefit a foreign power. Penalties for violation are fines of up to US$500,000 per offense and
imprisonment of up to fifteen years for individuals, and fines of up to US$10 million for organizations.
The second section

[2]

criminalizes the misappropriation of trade secrets related to or included in a

product that is produced for or placed in interstate (including international) commerce, with the
knowledge or intent that the misappropriation will injure the owner of the trade secret. Penalties for
violation are imprisonment for up to ten years for individuals (no fines) and fines of up to US$5 million
for organizations.
In addition to these specific penalties, the fourth section of the EEA

[3]

also requires criminal forfeiture of

(1) any proceeds of the crime and property derived from proceeds of the crime and (2) any property used,
or intended to be used, in commission of the crime.
The EEA authorizes civil proceedings by the Department of Justice to enjoin violations of the act but does
not create a private cause of action. This means that anyone believing they have been victimized must go
through the US attorney general in order to obtain an injunction.
The EEA is limited to the United States and has no extraterritorial application unless (1) the offender is a
US company or a citizen operating from abroad against a US company or (2) an act in furtherance of the
espionage takes place in the United States. Other nations lack such legislation, and some may actively
support industrial espionage using both their national intelligence services. The US Office of the National
Counterintelligence Executive publishes an annual report, mandated by the US Congress, on foreign
economic collection and industrial espionage, which outlines these espionage activities of many foreign
nations.

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
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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 knowhow 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 cyber-attacks.

EXERCISES
1.

Wu Dang, based in Hong Kong, hacks into the Hewlett-Packard database and “steals” plans and
specifications for HP’s latest products. The HP server is located in the United States. He sells this
information to a Chinese company in Shanghai. Has he violated the US Economic Espionage Act?

2.

What are the advantages of keeping a formula as a trade secret rather than getting patent protection?

[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).

13.3 Copyright
LEARNING OBJECTIVES
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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.
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.

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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 phono records or by any
other means specified by section 106 of the copyright, for purposes such as criticism, comment, news
reporting, teaching (including multiple copies for classroom use), scholarship, or research, is not an
infringement of copyright. In determining whether the use made of a work in any particular case is a fair
use, the factors to be considered shall include–
(1) the purpose and character of the use, including whether such use is of a commercial nature or is for
nonprofit educational purposes;
(2) the nature of the copyrighted work;
(3) the amount and substantiality of the portion used in relation to the copyrighted work as a whole; and
(4) the effect of the use upon the potential market for or value of the copyrighted work.

[1]

These are broad guidelines. Accordingly, any copying could be infringement, and fair use could become a
question of fact on a case-by-case basis. In determining fair use, however, courts have often considered
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
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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.

Copy-right ability Standards
To be subject to copyright, the writing must be “fixed” in some “tangible medium of expression.” A
novelist who composes a chapter of her next book in her mind and tells it to a friend before putting it on
paper could not stop the friend from rushing home, writing it down, and selling it (at least the federal
copyright law would offer no protection; some states might independently offer a legal remedy, however).
The work also must be creative, at least to a minimal degree. Words and phrases, such as names, titles,
and slogans, are not copyrightable; nor are symbols or designs familiar to the public. But an author who
contributes her own creativity—like taking a photograph of nature—may copyright the resulting work,
even if the basic elements of the composition were not of her making.
Finally, the work must be “original,” which means simply that it must have originated with the author.
The law does not require that it be novel or unique. This requirement was summarized pithily by Judge
Learned Hand: “If by some magic a man who had never known it were to compose anew Keats’s Ode on a
Grecian Urn, he would be an author, and, if he copyrighted it, others might not copy that poem, though
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.

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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 copy-right
ability of computer programs.

[5]

Now the courts are wrestling with the more difficult question of the scope

of protection: what constitutes an “idea” and what constitutes its mere “expression” in a program.
How far the copyright law will protect particular software products is a hotly debated topic, sparked by a
federal district court’s ruling in 1990 that the “look and feel” of Lotus 1-2-3’s menu system is
copyrightable and was in fact infringed by Paperback Software’s VP-Planner, a competing
spreadsheet.

[6]

The case has led some analysts to “fear that legal code, rather than software code, is

emerging as the factor that will determine which companies and products will dominate the 1990s.”

[7]

Who May Obtain a Copyright?
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
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in fact an “independent contractor” and the work in question involves any one of nine types (book,
movies, etc.) spelled out in the Copyright Act, the employer and the creator must spell out their
entitlement to the copyright in a written agreement.

[8]

Obtaining a Copyright
Until 1978, a work could not be copyrighted unless it was registered in the Copyright Office or was
published and unless each copy of the work carried a copyright notice, consisting of the word Copyright,
the abbreviation Copr., or the common symbol ©, together with the date of first publication and the name
of the copyright owner. Under the 1976 act, copyright became automatic whenever the work was fixed in a
tangible medium of expression (e.g., words on paper, images on film or videotape, sound on tape or
compact disc), even if the work remained unpublished or undistributed. However, to retain copyright
protection, the notice had to be affixed once the work was “published” and copies circulated to the public.
After the United States entered the Berne Convention, an international treaty governing copyrights,
Congress enacted the Berne Implementation Act, declaring that, effective in 1989, notice, even after
publication, was no longer required.
Notice does, however, confer certain benefits. In the absence of notice, a copyright holder loses the right
to receive statutory damages (an amount stated in the Copyright Act and not required to be proved) if
someone infringes the work. Also, although it is no longer required, an application and two copies of the
work (for deposit in the Library of Congress) filed with the Copyright Office, in Washington, DC, will
enable the copyright holder to file suit should the copyright be infringed. Unlike patent registration, which
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
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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 super-nodes” that acted as music hubs
for the company and was not directly involved in controlling any specific music-file downloads.)
Grokster had argued, based on Sony v. Universal Studios,

[10]

that the sale of its copying equipment (like

the Betamax videocassette recorders at issue in that case) did not constitute contributory infringement “if
the product is widely used for legitimate, unobjectionable purposes.” Plaintiffs successfully argued that
the Sony safe-harbor concept requires proof that the non-infringing 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.

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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’ permission?
Does it matter that he uses the word Times in his proposed title?

4.

What kind of file sharing of music is now entirely legal? Shaunese Collins buys a Yonder Mountain
String Band CD at a concert at Red Rocks in Morrison, Colorado. With her iMac, she makes a series of
CDs for her friends. She does this six times. Has she committed six copyright violations?

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

13.4 Trademarks
LEARNING OBJECTIVES
1.

Understand what a trademark is and why it deserves protection.

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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. A service 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. 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
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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 un-protectable?
These tests do not have mechanical answers; they call for judgment. Some marks are wholly fanciful,
clearly identify origin of goods, and distinguish them from others—Kodak, for example. Other marks may
not be so arbitrary but may nevertheless be distinctive, either when adopted or as a result of advertising—
for example, Crest, as the name of a toothpaste.
Marks that are merely descriptive of the product are entitled to protection only if it can be shown that the
mark has acquired secondary meaning. This term reflects a process of identification on the mark in the
public mind with the originator of the product. Holiday Inn was initially deemed too descriptive: an inn
where people might go on holiday. But over time, travelers came to identify the source of the Great Sign
and the name Holiday Inn as the Holiday Inn Corporation in Memphis, and secondary meaning was
granted. Holiday Inn could thus protect its mark against other innkeepers, hoteliers, and such; however,
the trademark protection for the words Holiday Inn was limited to the corporation’s hotel and motel
business, and no other.
Certain words and phrases may not qualify at all for trademark protection. These include generic terms
like “straw broom” (for a broom made of straw) and ordinary words like “fast food.” In one case, a federal
appeals court held that the word “Lite” is generic and cannot be protected by a beer manufacturer to
describe a low-calorie brew.

[2]

Donald Trump’s effort to trademark “You’re fired!” and Paris Hilton’s

desire to trademark “That’s hot!” were also dismissed as being generic.
Deceptive words will not be accepted for registration. Thus the US Patent and Trademark Office (PTO)
denied registration to the word Vynahyde because it suggested that the plastic material to which it was
applied came from animal skin. Geographic terms are descriptive words and may not be used as protected
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
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living person without consent, or of a deceased US president during the lifetime of his widow; and
immoral, deceptive, or scandalous matter (in an earlier era, the phrase “Bubby Trap” for brassieres was
denied registration).

Dilution, Tarnishment, and Blurring
Under the federal Trademark Dilution Act of 1995, companies with marks that dilute the value of a senior
mark may be liable for damages. The act provides that owners of marks of significant value have property
rights that should not be eroded, blurred, tarnished, or diluted in any way by another. But as a plaintiff,
the holder of the mark must show (1) that it is a famous mark, (2) that the use of a similar mark is
commercial, and (3) that such use causes dilution of the distinctive quality of the mark. Thus a T-shirt
maker who promotes a red-and-white shirt bearing the mark Budweiser may be liable to Anheuser-Busch,
or a pornographic site called Candy land 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 Candy land 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
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trademark will be protected for ten years (before the 1988 revision, a federal trademark remained valid
for twenty years); if after that time the mark is still being used, the registration can be renewed. Obtaining
a trademark registration lies between obtaining patents and obtaining copyrights in difficulty. The PTO
will not routinely register a trademark; it searches its records to ensure that the mark meets several
statutory tests and does not infringe another mark. Those who feel that their own marks would be hurt by
registration of a proposed mark may file an opposition proceeding with the PTO. Until 1990, the office
received about 77,000 applications each year. With the change in procedure, some experts predicted that
applications would rise by 30 percent.
In many foreign countries, use need not be shown to obtain trademark registration. It is common for
some people in these countries to register marks that they expect to be valuable so that they can sell the
right to use the mark to the company that established the mark’s value. Companies that expect to market
abroad should register their marks early.

Loss of Rights
Trademark owners may lose their rights if they abandon the mark, if a patent or copyright expires on
which the mark is based, or if the mark becomes generic. A mark is abandoned if a company goes out of
business and ceases selling the product. Some marks are based on design patents; when the patent
expires, the patent holder will not be allowed to extend the patent’s duration by arguing that the design or
name linked with the design is a registrable trademark.
The most widespread difficulty that a trademark holder faces is the prospect of too much success: if a
trademark comes to stand generically for the product itself, it may lose exclusivity in the mark. Famous
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.

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

EXERCISES
1.

How will Google protect its trademark, assuming that people begin using “Google” as a verb substitute
for “Internet search,” just like people began using the word “cellophane” for all brands of plastic
wrap?

2.

Do a small amount of web searching and find out what “trade dress” protection is, and how it differs
from trademark protection.

3.

LexisNexis is a brand for a database collection offered by Mead Data Central. Lexus is a high-end
automobile. Can Lexus succeed in getting Mead Data Central to stop using “Lexis” as a mark?

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

13.5 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)
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TALLMAN, CIRCUIT JUDGE:
Plaintiffs are a group of companies and individuals holding copyrights in various materials relating to
Elvis Presley. For example, plaintiff SOFA Entertainment, Inc., is the registered owner of several Elvis
appearances on The Ed Sullivan Show. Plaintiff Promenade Trust owns the copyright to two television
specials featuring Elvis: The Elvis 1968 Comeback Special and Elvis Aloha from Hawaii…Many Plaintiffs
are in the business of licensing their copyrights. For example, SOFA Entertainment charges $10,000 per
minute for use of Elvis’ appearances on The Ed Sullivan Show.
Passport Entertainment and its related entities (collectively “Passport”) produced and sold The Definitive
Elvis, a 16-hour video documentary about the life of Elvis Presley. The Definitive Elvis sold for $99 at
retail. Plaintiffs allege that thousands of copies were sent to retail outlets and other distributors. On its
box, The Definitive Elvis describes itself as an all-encompassing, in-depth look at the life and career of a
man whose popularity is unrivaled in the history of show business and who continues to attract millions
of new fans each year.…
The Definitive Elvis uses Plaintiffs’ copyrighted materials in a variety of ways. With the video footage, the
documentary often uses shots of Elvis appearing on television while a narrator or interviewee talks over
the film. These clips range from only a few seconds in length to portions running as long as 30 seconds. In
some instances, the clips are the subject of audio commentary, while in other instances they would more
properly be characterized as video “filler” because the commentator is discussing a subject different from
or more general than Elvis’ performance on a particular television show. But also significant is the
frequency with which the copyrighted video footage is used. The Definitive 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

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Plaintiffs’ copyrighted materials was likely not fair use. The court enjoined Passport from selling or
distributing The Definitive Elvis. Passport timely appeals.
***
We first address the purpose and character of Passport’s use of Plaintiffs’ copyrighted materials. Although
not controlling, the fact that a new use is commercial as opposed to non-profit weighs against a finding of
fair use. Harper & Row Publishers, Inc. v. Nation Enters, 471 U.S. 539, 562, 85 L. Ed. 2d 588, 105 S.Ct.
2218 (1985). And the degree to which the new user exploits the copyright for commercial gain—as
opposed to incidental use as part of a commercial enterprise—affects the weight we afford commercial
nature as a factor. More importantly for the first fair-use factor, however, is the “transformative” nature of
the new work. Specifically, we ask “whether the new work…merely supersedes the objects of the original
creation, or instead adds something new, with a further purpose or different character, altering the first
with new expression, meaning, or message.…” The more transformative new works, the less significant
other inquiries, such as commercialism, become.
***
The district court below found that the purpose and character of The Definitive Elvis will likely weigh
against a finding of fair use. We cannot say, based on this record, that the district court abused its
discretion.
First, Passport’s use, while a biography, is clearly commercial in nature. But more significantly, Passport
seeks to profit directly from the copyrights it uses without a license. One of the most salient selling points
on the box of The Definitive Elvis is that “Every Film and Television Appearance is represented.” Passport
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.…

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It would be impossible to produce a biography of Elvis without showing some of his most famous
television appearances for reference purposes. But some of the clips are played without much
interruption, if any. The purpose of showing these clips likely goes beyond merely making a reference for
a biography, but instead serves the same intrinsic entertainment value that is protected by Plaintiffs’
copyrights.
***
The third factor is the amount and substantiality of the portion used in relation to the copyrighted work as
a whole. This factor evaluates both the quantity of the work taken and the quality and importance of the
portion taken. Regarding the quantity, copying “may not be excused merely because it is insubstantial
with respect to the infringing work.” Harper & Row, 471 U.S. at 565 (emphasis in original). But if the
amount used is substantial with respect to the infringing work, it is evidence of the value of the copyrighted work.
Passport’s uses 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
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in a substantially adverse impact on the potential market for the original.” Campbell, 510 U.S. at 590. The
more transformative the new work, the less likely the new work’s use of copyrighted materials will affect
the market for the materials. Finally, if the purpose of the new work is commercial in nature, “the
likelihood [of market harm] may be presumed.” A&M Records, 239 F.3d at 1016 (quoting Sony, 464 U.S.
at 451).
The district court found that Passport’s use of Plaintiffs’ copyrighted materials likely does affect the
market for those materials. This conclusion was not clearly erroneous.
First, Passport’s use is commercial in nature, and thus we can assume market harm. Second, Passport has
expressly advertised that The Definitive 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?

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3.

What is the significance of the discussion on “transformative” aspects of the defendant’s product?

Trademark Infringement and Dilution
Playboy Enterprises v. Welles
279 F.3d 796 (9th Circuit Court of Appeals, 2001)
T. G. NELSON, Circuit Judge:
Terri Welles was on the cover of Playboy in 1981 and was chosen to be the Playboy Playmate of the Year
for 1981. Her use of the title “Playboy Playmate of the Year 1981,” and her use of other trademarked terms
on her website are at issue in this suit. During the relevant time period, Welles’ website offered
information about and free photos of Welles, advertised photos for sale, advertised memberships in her
photo club, and promoted her services as a spokesperson. A biographical section described Welles’
selection as Playmate of the Year in 1981 and her years modeling for PEI. The site included a disclaimer
that read as follows: “This site is neither endorsed, nor sponsored, nor affiliated with Playboy Enterprises,
Inc. PLAYBOY tm PLAYMATE OF THE YEAR tm AND PLAYMATE OF THE MONTH tm are registered
trademarks of Playboy Enterprises, Inc.”
Wells used (1) the terms “Playboy ”and “Playmate” in the meta tags 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.”

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We articulated the test for a permissible, nominative use in New Kids On The Block v. New America
Publishing, Inc. The band, New Kids On The Block, claimed trademark infringement arising from the use
of their trademarked name by several newspapers. The newspapers had conducted polls asking which
member of the band New Kids On The Block was the best and most popular. The papers’ use of the
trademarked term did not fall within the traditional fair use doctrine. Unlike a traditional fair use
scenario, the defendant newspaper was using the trademarked term to describe not its own product, but
the plaintiff’s. Thus, the factors used to evaluate fair use were inapplicable. The use was nonetheless
permissible, we concluded, based on its nominative nature.
We adopted the following test for nominative use:
First, the product or service in question must be one not readily identifiable without use of the trademark;
second, only so much of the mark or marks may be used as is reasonably necessary to identify the product
or service; and third, the user must do nothing that would, in conjunction with the mark, suggest
sponsorship or endorsement by the trademark holder.
We group the uses of PEI’s trademarked terms into three for the purpose of applying the test for
nominative use.
1. Headlines and banner advertisements.
...
The district court properly identified Welles’ situation as one which must… be accepted. 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

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element because they use only the trademarked words, not the font or symbols associated with the
trademarks.
The third element requires that the user do “nothing that would, in conjunction with the mark, suggest
sponsorship or endorsement by the trademark holder.” As to this element, we conclude that aside from
the wallpaper, which we address separately, Welles does nothing in conjunction with her use of the marks
to suggest sponsorship or endorsement by PEI. The marks are clearly used to describe the title she
received from PEI in 1981, a title that helps describe who she is. It would be unreasonable to assume that
the Chicago Bulls sponsored a website of Michael Jordan’s simply because his name appeared with the
appellation “former Chicago Bull.” Similarly, in this case, it would be unreasonable to assume that PEI
currently sponsors or endorses someone who describes herself as a “Playboy Playmate of the Year in
1981.” The designation of the year, in our case, serves the same function as the “former” in our example. It
shows that any sponsorship or endorsement occurred in the past.
For the foregoing reasons, we conclude that Welles’ use of PEI’s marks in her headlines and banner
advertisements is a nominative use excepted from the law of trademark infringement.
2. Meta tags
Welles includes the terms “playboy” and “playmate” in her Meta tags. Meta tags describe the contents of a
website using keywords. Some search engines search Meta tags to identify websites relevant to a search.
Thus, when an internet searcher enters “playboy” or “playmate” into a search engine that uses Meta tags,
the results will include Welles’ site. Because Welles ’Meta tags 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’ Meta tags 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 Meta tags, 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 Meta tags meets the first part of the test for nominative use…We conclude that the Meta tags
satisfy the second and third elements of the test as well. The Meta tags use only so much of the marks as
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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 Meta tags listed the
trademarked term so repeatedly that Welles’ site would regularly appear above PEI’s in searches for one
of the trademarked terms.
3. Wallpaper/watermark.
The background, or wallpaper, of Welles’ site consists of the repeated abbreviation “PMOY ’81,” which
stands for “Playmate of the Year 1981.” Welles’ name or likeness does not appear before or after “PMOY
’81.” The pattern created by the repeated abbreviation appears as the background of the various pages of
the website. Accepting, for the purposes of this appeal, that the abbreviation “PMOY” is indeed entitled to
protection, we conclude that the repeated, stylized use of this abbreviation fails the nominative use test.
The repeated depiction of “PMOY ‘81” is not necessary to describe Welles. “Playboy Playmate of the Year
1981” is quite adequate. Moreover, the term does not even appear to describe Welles—her name or
likeness does 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?

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2.

If PMOY is not a registered trademark, why does the court discuss it?

3.

What does “nominative use” mean in the context of this case?

4.

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

13.6 Summary and Exercises

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

EXERCISES
1.

Samuel Morse filed claims in the US Patent Office for his invention of the telegraph and also for the
“use of the motive power of the electric or galvanic current…however developed, for marking or
printing intelligible characters, signs or letters at any distances.” For which claim, if any, was he
entitled to a patent? Why?

2.

In 1957, an inventor dreamed up and constructed a certain new kind of computer. He kept his
invention a secret. Two years later, another inventor who conceived the same machine filed a patent
application. The first inventor, learning of the patent application, filed for his own patent in 1963. Who
is entitled to the patent, assuming that the invention was truly novel and not obvious? Why?

3.

A large company discovered that a small company was infringing one of its patents. It wrote the small
company and asked it to stop. The small company denied that it was infringing. Because of personnel
changes in the large company, the correspondence file was lost and only rediscovered eight years
later. The large company sued. What would be the result? Why?

4.

Clifford Witter was a dance instructor at the Arthur Murray Dance Studios in Cleveland. As a condition
of employment, he signed a contract not to work for a competitor. Subsequently, he was hired by the

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Fred Astaire Dancing Studios, where he taught the method that he had learned at Arthur Murray.
Arthur Murray sued to enforce the non-compete contract. What would be result? What additional
information, if any, would you need to know to decide the case?
5.

Greenberg worked for Buckingham Wax as its chief chemist, developing chemical formulas for
products by testing other companies’ formulas and modifying them. Brite Products bought
Buckingham’s goods and resold them under its own name. Greenberg went to work for Brite, where
he helped Brite make chemicals substantially similar to the ones it had been buying from Buckingham.
Greenberg had never made any written or oral commitment to Buckingham restricting his use of the
chemical formulas he developed. May Buckingham stop Greenberg from working for Brite? May it
stop him from working on formulas learned while working at Buckingham? Why?

SELF-TEST QUESTIONS
1.

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

a.

a synthesized molecule

b.

a one-line book title

c.

a one-line advertising jingle

d.

a one-word company name
Which of the following does not expire by law?

a.

a closely guarded trade secret not released to the public
b.

a patent granted by the US Patent and Trademark Office

c.

a copyright registered in the US Copyright Office

d.

a federal trademark registered under the Lanham Act
A sculptor casts a marble statue of a three-winged bird. To protect against copying, the
sculptor can obtain which of the following?

a.

a patent
b.

a trademark

c.

a copyright

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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 14
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The Nature and Regulation of Real Estate and the
Environment
LEARNING OBJECTIVES
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 we focus on regulation of land use and the environment (see Figure 14.1 "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.

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14.1 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 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 14.1 Chapter Overview

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

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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 consider both present
and future freehold interests.

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
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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
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
remainder man—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 remainder man 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

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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.

Reversion
A reversion arises whenever the estate transferred has 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
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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.

EXERCISES
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?

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14.2 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 trespasses 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
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.

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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
14.2 "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. Riparianrefers 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, (see Section 14.6.1 "Reasonable Use Doctrine".

[2]

Figure 14.2 Water Rights

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
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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
Hannaford’s, 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 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 oneand 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).

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14.3 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 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 the dominant tenement, and the burdened land—that is, the
land subject to the easement—is called the servient tenement (see Figure 14.3 "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 14.3 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
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
him 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.

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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 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.
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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?

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14.4 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
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-law nuisance 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 commonlaw cause of action is a primary means for landowners to obtain damages for invasive environmental
harms.

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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 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
of attractive 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):
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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 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 non-trespasser 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 a licensee. 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
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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. 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.
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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 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

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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 seventy-two 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 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 of Kelo 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.

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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 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 multiplefamily 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
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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 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?

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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).

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14.5 Environmental Law
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
an environmental impact statement in every recommendation or report on proposals for legislation and
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whenever undertaking a major federal action that significantly affects environmental quality. The
statement must (1) detail the environmental impact of the proposed 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
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biological integrity of the Nation’s waters.”

[3]

It operates on the states, requiring them to designate the

uses of every significant 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 fill. 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

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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 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.
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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.
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.

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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 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., (see Section 14.6.2 "Criminal Liability of
Employees under RCRA").

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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 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 cleanup 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
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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, 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 thirty-five 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.
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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, 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;
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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 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.

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[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).

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14.6 Cases
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. Seventy-five cottages and several farms,
including defendants, 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:

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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.
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
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use is for; its extent, duration, necessity, and its application; the nature 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 Mills v. 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 has 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 trichloroethylene, 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 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).
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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, 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
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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 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
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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 self-protection.” 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. What is the moral
justification for applying criminal penalties to such employees (such as Hopkins and Angel)?

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14.7 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.
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

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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 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

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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
The prior appropriation doctrine

a.

tends to be applied by eastern states

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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

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Chapter 15
Securities Regulation
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

The nature of securities regulation

2.

The Securities Act of 1933 and the Securities Exchange Act of 1934

3.

Liability under securities laws

4.

What insider trading is and why it’s unlawful

5.

Civil and criminal penalties for violations of securities laws

This chapter examines government regulation of securities and insider trading. Both the registration and
the trading of securities are highly regulated by the Securities and Exchange Commission (SEC). A
violation of a securities law can lead to severe criminal and civil penalties. But first we examine the
question, Why is there a need for securities regulation?

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15.1 The Nature of Securities Regulation
LEARNING OBJECTIVES
1.

Recognize that the definition of security encompasses a broad range of interests.

2.

Understand the functions of the Securities and Exchange Commission and the penalties for violations
of the securities laws.

3.

Understand which companies the Securities Exchange Act of 1934 covers.

4.

Explore the purpose of state Blue Sky Laws.

5.

Know the basic provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

What we commonly refer to as “securities” are essentially worthless pieces of paper. Their inherent
value lies in the interest in property or an ongoing enterprise that they represent. This disparity between
the tangible property—the stock certificate, for example—and the intangible interest it represents gives
rise to several reasons for regulation. First, there is need for a mechanism to inform the buyer accurately
what it is he is buying. Second, laws are necessary to prevent and provide remedies for deceptive and
manipulative acts designed to defraud buyers and sellers. Third, the evolution of stock trading on a
massive scale has led to the development of numerous types of specialists and professionals, in dealings
with who the public can be at a severe disadvantage, and so the law undertakes to ensure that they do not
take unfair advantage of their customers.
The Securities Act of 1933 and the Securities Exchange Act of 1934 are two federal statutes that
are vitally important, having virtually refashioned the law governing corporations during the past half
century. In fact, it is not too much to say that although they deal with securities, they have become the
general federal law of corporations. This body of federal law has assumed special importance in recent
years as the states have engaged in a race to the bottom in attempting to compete with Delaware’s
permissive corporation law.

What Is a Security?
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Securities law questions are technical and complex and usually require professional counsel. For the nonlawyer, the critical question on which all else turns is whether the particular investment or document is
a security. If it is, anyone attempting any transaction beyond the routine purchase or sale through a
broker should consult legal counsel to avoid the various civil and criminal minefields that the law has
strewn about.
The definition of security, which is set forth in the Securities Act of 1933, is comprehensive, but it does
not on its face answer all questions that financiers in a dynamic market can raise. Under Section 2(1) of
the act, “security” includes “any note, stock, treasury stock, bond, debenture, evidence of indebtedness,
certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate,
preorganization certificate or subscription, transferable share, investment contract, voting-trust
certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral
rights, or, in general, any interest or instrument commonly known as a ‘security,’ or any certificate of
interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or
right to subscribe to or purchase, any of the foregoing.”
Under this definition, an investment may not be a security even though it is so labeled, and it may actually
be a security even though it is called something else. For example, does a service contract that obligates
someone who has sold individual rows in an orange orchard to cultivate, harvest, and markets an orange
crop involve a security subject to regulation under federal law? Yes, said the Supreme Court in Securities
& Exchange Commission v. W. J. Howey Co.

[1]

The Court said the test is whether “the person invests his

money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a
third party.” Under this test, courts have liberally interpreted “investment contract” and “certificate of
interest or participation in any profit-sharing agreement” to be securities interests in such property as real
estate condominiums and cooperatives, commodity option contracts, and farm animals.
The Supreme Court ruled that notes that are not “investment contracts” under the Howey test can still be
considered securities if certain factors are present, as discussed in Reves v. Ernst & Young, (see Section
15.3.1 "What Is a Security?"). These factors include (1) the motivations prompting a reasonable seller and
buyer to enter into the transaction, (2) the plan of distribution and whether the instruments are
commonly traded for speculation or investment, (3) the reasonable expectations of the investing public,

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and (4) the presence of other factors that significantly reduce risk so as to render the application of the
Securities Act unnecessary.

The Securities and Exchange Commission
Functions
The Securities and Exchange Commission (SEC) is over half a century old, having been created by
Congress in the Securities Exchange Act of 1934. It is an independent regulatory agency, subject to the
rules of the Administrative Procedure Act (see Chapter 5 "Administrative Law"). The commission is
composed of five members, who have staggered five-year terms. Every June 5, the term of one of the
commissioners expires. Although the president cannot remove commissioners during their terms of
office, he does have the power to designate the chairman from among the sitting members. The SEC is
bipartisan: not more than three commissioners may be from the same political party.
The SEC’s primary task is to investigate complaints or other possible violations of the law in securities
transactions and to bring enforcement proceedings when it believes that violations have occurred. It is
empowered to conduct information inquiries, interview witnesses, examine brokerage records, and review
trading data. If its requests are refused, it can issue subpoenas and seek compliance in federal court. Its
usual leads come from complaints of investors and the general public, but it has authority to conduct
surprise inspections of the books and records of brokers and dealers. Another source of leads is price
fluctuations that seem to have been caused by manipulation rather than regular market forces.
Among the violations the commission searches out are these: (1) unregistered sale of securities subject to
the registration requirement of the Securities Act of 1933, (2) fraudulent acts and practices, (3)
manipulation of market prices, (4) carrying out of a securities business while insolvent, (5)
misappropriation of customers’ funds by brokers and dealers, and (4) other unfair dealings by brokers
and dealers.
When the commission believes that a violation has occurred, it can take one of three courses. First, it can
refer the case to the Justice Department with a recommendation for criminal prosecution in cases of fraud
or other willful violation of law.

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Second, the SEC can seek a civil injunction in federal court against further violations. As a result of
amendments to the securities laws in 1990 (the Securities Enforcement Remedies and Penny Stock
Reform Act), the commission can also ask the court to impose civil penalties. The maximum penalty is
$100,000 for each violation by a natural person and $500,000 for each violation by an entity other than a
natural person. Alternatively, the defendant is liable for the gain that resulted from violating securities law
if the gain exceeds the statutory penalty. The court is also authorized to bar an individual who has
committed securities fraud from serving as an officer or a director of a company registered under the
securities law.
Third, the SEC can proceed administratively—that is, hold its own hearing, with the usual due process
rights, before an administrative law judge. If the commissioners by majority vote accept the findings of
the administrative law judge after reading briefs and hearing oral argument, they can impose a variety of
sanctions: suspend or expel members of exchanges; deny, suspend, or revoke the registrations of brokerdealers; censure individuals for misconduct; and bar censured individuals (temporarily or permanently)
from employment with a registered firm. The 1990 securities law amendments allow the SEC to impose
civil fines similar to the court-imposed fines described. The amendments also authorize the SEC to order
individuals to cease and desist from violating securities law.

Fundamental Mission
The SEC’s fundamental mission is to ensure adequate disclosure in order to facilitate informed
investment decisions by the public. However, whether a particular security offering is worthwhile or
worthless is a decision for the public, not for the SEC, which has no legal authority to pass on the merits of
an offering or to bar the sale of securities if proper disclosures are made.
One example of SEC’s regulatory mandate with respect to disclosures involved the 1981 sale of $274
million in limited partnership interests in a company called Petrogene Oil & Gas Associates, New York.
The Petrogene offering was designed as a tax shelter. The company’s filing with the SEC stated that the
offering involved “a high degree of risk” and that only those “who can afford the complete loss of their
investment” should contemplate investing. Other disclosures included one member of the controlling
group having spent four months in prison for conspiracy to commit securities fraud; that he and another
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sheltered securities; that the general partner, brother-in-law of one of the principals, had no experience in
the company’s proposed oil and gas operations (Petrogene planned to extract oil from plants by using
radio frequencies); that one of the oils to be produced was potentially carcinogenic; and that the
principals “stand to benefit substantially” whether or not the company fails and whether or not
purchasers of shares recovered any of their investment. The prospectus went on to list specific risks.
Despite this daunting compilation of troublesome details, the SEC permitted the offering because all
disclosures were made (Wall Street Journal, December 29, 1981). It is the business of the marketplace,
not the SEC, to determine whether the risk is worth taking.
The SEC enforces securities laws through two primary federal acts: The Securities Act of 1933 and The
Securities Exchange Act of 1934.

Securities Act of 1933
Goals
The Securities Act of 1933 is the fundamental “truth in securities” law. Its two basic objectives, which are
written in its preamble, are “to provide full and fair disclosure of the character of securities sold in
interstate and foreign commerce and through the mails, and to prevent frauds in the sale thereof.”

Registration
The primary means for realizing these goals is the requirement of registration. Before securities subject to
the act can be offered to the public, the issuer must file a registration statement and prospectus with the
SEC, laying out in detail relevant and material information about the offering as set forth in various
schedules to the act. If the SEC approves the registration statement, the issuer must then provide any
prospective purchaser with the prospectus. Since the SEC does not pass on the fairness of price or other
terms of the offering, it is unlawful to state or imply in the prospectus that the commission has the power
to disapprove securities for lack of merit, thereby suggesting that the offering is meritorious.
The SEC has prepared special forms for registering different types of issuing companies. All call for a
description of the registrant’s business and properties and of the significant provisions of the security to
be offered, facts about how the issuing company is managed, and detailed financial statements certified by
independent public accountants.
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Once filed, the registration and prospectus become public and are open for public inspection. Ordinarily,
the effective date of the registration statement is twenty days after filing. Until then, the offering may not
be made to the public. Section 2(10) of the act defines prospectus as any “notice, circular, advertisement,
letter, or communication, written or by radio or television, which offers any security for sale or confirms
the sale of any security.” (An exception: brief notes advising the public of the availability of the formal
prospectus.) The import of this definition is that any communication to the public about the offering of a
security is unlawful unless it contains the requisite information.
The SEC staff examines the registration statement and prospectus, and if they appear to be materially
incomplete or inaccurate, the commission may suspend or refuse the effectiveness of the registration
statement until the deficiencies are corrected. Even after the securities have gone on sale, the agency has
the power to issue a stop order that halts trading in the stock.
Section 5(c) of the act bars any person from making any sale of any security unless it is first registered.
Nevertheless, there are certain classes of exemptions from the registration requirement. Perhaps the most
important of these is Section 4(3), which exempts “transactions by any person other than an issuer,
underwriter or dealer.” Section 4(3) also exempts most transactions of dealers. So the net is that trading
in outstanding securities (the secondary market) is exempt from registration under the Securities Act of
1933: you need not file a registration statement with the SEC every time you buy or sell securities through
a broker or dealer, for example. Other exemptions include the following: (1) private offerings to a limited
number of persons or institutions who have access to the kind of information registration would disclose
and who do not propose to redistribute the securities; (2) offerings restricted to the residents of the state
in which the issuing company is organized and doing business; (3) securities of municipal, state, federal
and other government instrumentalities, of charitable institutions, of banks, and of carriers subject to the
Interstate Commerce Act; (4) offerings not in excess of certain specified amounts made in compliance
with regulations of the Commission…: and (5) offerings of “small business investment companies” made
in accordance with rules and regulations of the Commission.

Penalties
Section 24 of the Securities Act of 1933 provides for fines not to exceed $10,000 and a prison term not to
exceed five years, or both, for willful violations of any provisions of the act. This section makes these
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criminal penalties specifically applicable to anyone who “willfully, in a registration statement filed under
this title, makes any untrue statement of a material fact or omits to state any material fact required to be
stated therein or necessary to make the statements therein not misleading.”
Sections 11 and 12 provide that anyone injured by false declarations in registration statements,
prospectuses, or oral communications concerning the sale of the security—as well as anyone injured by
the unlawful failure of an issuer to register—may file a civil suit to recover the net consideration paid for
the security or for damages if the security has been sold.
Although these civil penalty provisions apply only to false statements in connection with the registration
statement, prospectus, or oral communication, the Supreme Court held, in Case v. Borak,

[2]

that there is

an “implied private right of action” for damages resulting from a violation of SEC rules under the act. The
Court’s ruling in Borak opened the courthouse doors to many who had been defrauded but were
previously without a practical remedy.

Securities Exchange Act of 1934
Companies Covered
The Securities Act of 1933 is limited, as we have just seen, to new securities issues—that is
the primary market. The trading that takes place in the secondary market is far more significant, however.
In a normal year, trading in outstanding stock totals some twenty times the value of new stock issues.
To regulate the secondary market, Congress enacted the Securities Exchange Act of 1934. This law, which
created the SEC, extended the disclosure rationale to securities listed and registered for public trading on
the national securities exchanges. Amendments to the act have brought within its ambit every corporation
whose equity securities are traded over the counter if the company has at least $10 million in assets and
five hundred or more shareholders.

Reporting Proxy Solicitation
Any company seeking listing and registration of its stock for public trading on a national exchange—or
over the counter, if the company meets the size test—must first submit a registration application to both
the exchange and the SEC. The registration statement is akin to that filed by companies under the
Securities Act of 1933, although the Securities Exchange Act of 1934 calls for somewhat fewer disclosures.
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Thereafter, companies must file annual and certain other periodic reports to update information in the
original filing.
The Securities Exchange Act of 1934 also covers proxy solicitation. Whenever management, or a dissident
minority, seeks votes of holders of registered securities for any corporate purpose, disclosures must be
made to the stockholders to permit them to vote yes or no intelligently.

Penalties
The logic of the Borak case (discussed in Section 15.1.3 "Securities Act of 1933") also applies to this act, so
that private investors may bring suit in federal court for violations of the statute that led to financial
injury. Violations of any provision and the making of false statements in any of the required disclosures
subject the defendant to a maximum fine of $5 million and a maximum twenty-year prison sentence, but a
defendant who can show that he had no knowledge of the particular rule he was convicted of violating
may not be imprisoned. The maximum fine for a violation of the act by a person other than a natural
person is $25 million. Any issuer omitting to file requisite documents and reports is liable to pay a fine of
$100 for each day the failure continues.

Blue Sky Laws
Long before congressional enactment of the securities laws in the 1930s, the states had legislated
securities regulations. Today, every state has enacted a blue sky law, so called because its purpose is to
prevent “speculative schemes which have no more basis than so many feet of ‘blue sky.’”

[3]

The federal

Securities Act of 1933, discussed in Section 15.1.3 "Securities Act of 1933", specifically preserves the
jurisdiction of states over securities.
Blue sky laws are divided into three basic types of regulation. The simplest is that which prohibits fraud in
the sale of securities. Thus at a minimum, issuers cannot mislead investors about the purpose of the
investment. All blue sky laws have antifraud provisions; some have no other provisions. The second type
calls for registration of broker-dealers, and the third type for registration of securities. Some state laws
parallel the federal laws in intent and form of proceeding, so that they overlap; other blue sky laws
empower state officials (unlike the SEC) to judge the merits of the offerings, often referred to as
merit review laws. As part of a movement toward deregulation, several states have recently modified or
eliminated merit provisions.
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Many of the blue sky laws are inconsistent with each other, making national uniformity difficult. In 1956,
the National Conference of Commissioners on Uniform State Laws approved the Uniform Securities Act.
It has not been designed to reconcile the conflicting philosophies of state regulation but to take them into
account and to make the various forms of regulation as consistent as possible. States adopt various
portions of the law, depending on their regulatory philosophies. The Uniform Securities Act has antifraud,
broker-dealer registration, and securities registration provisions. More recent acts have further increased
uniformity. These include the National Securities Markets Improvement Act of 1996, which preempted
differing state philosophies with regard to registration of securities and regulation of brokers and
advisors, and the Securities Litigation Uniform Standards Act of 1998, which preempted state law
securities fraud claims from being raised in class action lawsuits by investors.

Dodd-Frank Wall Street Reform and Consumer Protection Act
In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which is the
largest amendment to financial regulation in the United States since the Great Depression. This
amendment was enacted in response to the economic recession of the late 2000s for the following
purposes: (1) to promote the financial stability of the United States by improving accountability and
transparency in the financial system, (2) to end “too big to fail” institutions, (3) to protect the American
taxpayer by ending bailouts, and (4) to protect consumers from abusive financial services practices. The
institutions most affected by the regulatory changes include those involved in monitoring the financial
system, such as the Federal Deposit Insurance Corporation (FDIC) and the SEC. Importantly, the
amendment ended the exemption for investment advisors who previously were not required to register
with the SEC because they had fewer than fifteen clients during the previous twelve months and did not
hold out to the public as investment advisors. This means that in practice, numerous investment advisors,
as well as hedge funds and private equity firms, are now subject to registration requirements.

[4]

KEY TAKEAWAY
The SEC administers securities laws to prevent the fraudulent practices in the sales of securities. The
definition of security is intentionally broad to protect the public from fraudulent investments that
otherwise would escape regulation. The Securities Act of 1933 focuses on the issuance of securities,
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and the Securities Exchange Act of 1934 deals predominantly with trading in issued securities.
Numerous federal and state securities laws are continuously created to combat securities fraud, with
penalties becoming increasingly severe.

EXERCISES
1.

What differentiates an ordinary investment from a security? List all the factors.

2.

What is the main objective of the SEC?

3.

What are the three courses of action that the SEC may take against one who violates a securities law?

4.

What is the difference between the Securities Act of 1933 and the Securities Exchange Act of 1934?

5.

What do blue sky laws seek to protect?

[1] Securities & Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946).
[2] Case v. Borak, 377 U.S. 426 (1964).
[3] Hall v. Geiger-Jones Co., 242 U.S. 539 (1917).
[4] For more information on the Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub.L. 111-203,
H.R. 4173), see Thomas, “Major Actions,” Bill Summary & Status 111th Congress (2009–2010)
H.R.4173, http://thomas.loc.gov/cgi-bin/bdquery/z?d111:HR04173:@@@L&summ2=m&#major%20actions.

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15.2 Liability under Securities Law
LEARNING OBJECTIVES
1.

Understand how the Foreign Corrupt Practices Act prevents American companies from using bribes to
enter into contracts or gain licenses from foreign governments.

2.

Understand the liability for insider trading for corporate insiders, “tippees,” and secondary actors
under Sections 16(b) and 10(b) of the 1934 Securities Exchange Act.

3.

Recognize how the Sarbanes-Oxley Act has amended the 1934 act to increase corporate regulation,
transparency, and penalties.

Corporations may be found liable if they engage in certain unlawful practices, several of which we explore
in this section.

The Foreign Corrupt Practices Act
Investigations by the Securities and Exchange Commission (SEC) and the Watergate Special Prosecutor in
the early 1970s turned up evidence that hundreds of companies had misused corporate funds, mainly by
bribing foreign officials to induce them to enter into contracts with or grant licenses to US companies.
Because revealing the bribes would normally be self-defeating and, in any event, could be expected to stir
up immense criticism, companies paying bribes routinely hid the payments in various accounts. As a
result, one of many statutes enacted in the aftermath of Watergate, the
Foreign Corrupt Practices Act (FCPA) of 1977, was incorporated into the 1934 Securities Exchange Act.
The SEC’s legal interest in the matter is not premised on the morality of bribery but rather on the falsity of
the financial statements that are being filed.

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Congress’s response to abuses of financial reporting, the FCPA, was much broader than necessary to treat
the violations that were uncovered. The FCPA prohibits an issuer (i.e., any US business enterprise), a
stockholder acting on behalf of an issuer, and “any officer, director, employee, or agent” of an issuer from
using either the mails or interstate commerce corruptly to offer, pay, or promise to pay anything of value
to foreign officials, foreign political parties, or candidates if the purpose is to gain business by inducing
the foreign official to influence an act of the government to render a decision favorable to the US
corporation.
But not all payments are illegal. Fewer than 1988 amendments to the FCPA, payments may be made to
expedite routine governmental actions, such as obtaining a visa. And payments are allowed if they are
lawful under the written law of a foreign country. More important than the foreign-bribe provisions, the
act includes accounting provisions, which broaden considerably the authority of the SEC. These
provisions are discussed in SEC v. World-Wide Coin Investments, Ltd.,

[1]

the first accounting provisions

case brought to trial.

Insider Trading
Corporate insiders—directors, officers, or important shareholders—can have a substantial trading
advantage if they are privy to important confidential information. Learning bad news (such as financial
loss or cancellation of key contracts) in advance of all other stockholders will permit the privileged few to
sell shares before the price falls. Conversely, discovering good news (a major oil find or unexpected
profits) in advance gives the insider a decided incentive to purchase shares before the price rises.
Because of the unfairness to those who are ignorant of inside information, federal law
prohibits insider trading. Two provisions of the 1934 Securities Exchange Act are
paramount: Section 16(b) and 10(b).

Recapture of Short-Swing Profits: Section 16(b)
The Securities Exchange Act assumes that any director, officer, or shareholder owning 10 percent or more
of the stock in a corporation is using inside information if he or any family member makes a profit from
trading activities, either buying and selling or selling and buying, during a six-month period. Section 16(b)
penalizes any such person by permitting the corporation or a shareholder suing on its behalf to recover
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the short-swing profits. The law applies to any company with more than $10 million in assets and at least
five hundred or more shareholders of any class of stock.
Suppose that on January 1, Bob (a company officer) purchases one hundred shares of stock in BCT
Bookstore, Inc., for $60 a share. On September 1, he sells them for $100 a share. What is the result? Bob
is in the clear, because his $4,000 profit was not realized during a six-month period. Now suppose that
the price falls, and one month later, on October 1, he repurchases one hundred shares at $30 a share and
holds them for two years. What is the result? He will be forced to pay back $7,000 in profits even if he had
no inside information. Why? In August, Bob held one hundred shares of stock, and he did again on
October 1—within a six-month period. His net gain on these transactions was $7,000 ($10,000 realized
on the sale less the $3,000 cost of the purchase).
As a consequence of Section 16(b) and certain other provisions, trading in securities by directors, officers,
and large stockholders presents numerous complexities. For instance, the law requires people in this
position to make periodic reports to the SEC about their trades. As a practical matter, directors, officers,
and large shareholders should not trade in their own company stock in the short run without legal advice.

Insider Trading: Section 10(b) and Rule 10b-5
Section 10(b) of the Securities Exchange Act of 1934 prohibits any person from using the mails or facilities
of interstate commerce “to use or employ, in connection with the purchase or sale of any security…any
manipulative or deceptive device or contrivance in contravention of such rules and regulations as the
Commission may prescribe as necessary or appropriate in the public interest or for the protection of
investors.” In 1942, the SEC learned of a company president who misrepresented the company’s financial
condition in order to buy shares at a low price from current stockholders. So the commission adopted a
rule under the authority of Section 10(b). Rule 10b-5, as it was dubbed, has remained unchanged for more
than forty years and has spawned thousands of lawsuits and SEC proceedings. It reads as follows:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of
interstate commerce, or of the mails, or of any facility of any national securities exchange,
(1) to employ any device, scheme, or artifice to defraud,
(2) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to
make the statements made, in the light of circumstances under which they were made, not misleading, or
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(3) to engage in any act, practice, or course of business which operates or would operate as a fraud or
deceit upon any person, in connection with the purchase or sale of any security.
Rule 10b-5 applies to any person who purchases or sells any security. It is not limited to securities
registered under the 1934 Securities Exchange Act. It is not limited to publicly held companies. It applies
to any security issued by any company, including the smallest closely held company. In substance, it is an
antifraud rule, enforcement of which seems, on its face, to be limited to action by the SEC. But over the
years, the courts have permitted people injured by those who violate the statute to file private damage
suits. This sweeping rule has at times been referred to as the “federal law of corporations” or the “catch
everybody” rule.
Insider trading ran headlong into Rule 10b-5 beginning in 1964 in a series of cases involving Texas Gulf
Sulphur Company (TGS). On November 12, 1963, the company discovered a rich deposit of copper and
zinc while drilling for oil near Timmins, Ontario. Keeping the discovery quiet, it proceeded to acquire
mineral rights in adjacent lands. By April 1964, word began to circulate about TGS’s find.
Newspapers printed rumors, and the Toronto Stock Exchange experienced a wild speculative spree. On
April 12, an executive vice president of TGS issued a press release downplaying the discovery, asserting
that the rumors greatly exaggerated the find and stating that more drilling would be necessary before
coming to any conclusions. Four days later, on April 16, TGS publicly announced that it had uncovered a
strike of 25 million tons of ore. In the months following this announcement, TGS stock doubled in value.
The SEC charged several TGS officers and directors with having purchased or told their friends, socalled tippees, to purchase TGS stock from November 12, 1963, through April 16, 1964, on the basis of
material inside information. The SEC also alleged that the April 12, 1964, press release was deceptive. The
US Court of Appeals, in SEC v. Texas Gulf Sulphur Co.,

[2]

decided that the defendants who purchased the

stock before the public announcement had violated Rule 10b-5. According to the court, “anyone in
possession of material inside information must either disclose it to the investing public, or, if he is
disabled from disclosing to protect a corporate confidence, or he chooses not to do so, must abstain from
trading in or recommending the securities concerned while such inside information remains undisclosed.”
On remand, the district court ordered certain defendants to pay $148,000 into an escrow account to be
used to compensate parties injured by the insider trading.

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The court of appeals also concluded that the press release violated Rule 10b-5 if “misleading to the
reasonable investor.” On remand, the district court held that TGS failed to exercise “due diligence” in
issuing the release. Sixty-nine private damage actions were subsequently filed against TGS by
shareholders who claimed they sold their stock in reliance on the release. The company settled most of
these suits in late 1971 for $2.7 million.
Following the TGS episode, the Supreme Court refined Rule 10b-5 on several fronts. First, in Ernst &
Ernst v. Hochfelder,

[3]

the Court decided that proof of scienter—defined as “mental state embracing

intent to deceive, manipulate, or defraud”—is required in private damage actions under Rule 10b-5. In
other words, negligence alone will not result in Rule 10b-5 liability. The Court also held that scienter,
which is an intentional act, must be established in SEC injunctive actions.

[4]

The Supreme Court has placed limitations on the liability of tippees under Rule 10b-5. In 1980, the Court
reversed the conviction of an employee of a company that printed tender offer and merger prospectuses.
Using information obtained at work, the employee had purchased stock in target companies and later sold
it for a profit when takeover attempts were publicly announced. In Chiarella v. United States, the Court
held that the employee was not an insider or a fiduciary and that “a duty to disclose under Section 10(b)
does not arise from the mere possession of nonpublic market information.”

[5]

Following Chiarella, the

Court ruled in Dirks v. Securities and Exchange Commission (see Section 15.3.2 "Tippee Liability"), that
tippees are liable if they had reason to believe that the tipper breached a fiduciary duty in disclosing
confidential information and the tipper received a personal benefit from the disclosure.
The Supreme Court has also refined Rule 10b-5 as it relates to the duty of a company to
disclose material information, as discussed in Basic, Inc. v. Levinson (see Section 15.3.3 "Duty to Disclose
Material Information"). This case is also important in its discussion of the degree of reliance investors
must prove to support a Rule 10b-5 action.
In 2000, the SEC enacted Rule 10b5-1, which defines trading “on the basis of” inside information as any
time a person trades while aware of material nonpublic information. Therefore, a defendant is not saved
by arguing that the trade was made independent of knowledge of the nonpublic information. However,
the rule also creates an affirmative defense for trades that were planned prior to the person’s receiving
inside information.

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In addition to its decisions relating to intent (Ernst & Ernst), tippees (Dirks), materiality (Basic), and
awareness of nonpublic information (10b5-1), the Supreme Court has considered
the misappropriation theory, under which a person who misappropriates information from an employer
faces insider trading liability. In a leading misappropriation theory case, the Second Circuit Court of
Appeals reinstated an indictment against employees who traded on the basis of inside information
obtained through their work at investment banking firms. The court concluded that the employees’
violation of their fiduciary duty to the firms violated securities law.
misappropriation theory in United States v. O’Hagan,

[7]

[6]

The US Supreme Court upheld the

and the SEC adopted the theory as

new Rule 10b5-2. Under this new rule, the duty of trust or confidence exists when (1) a person agrees to
maintain information in confidence; (2) the recipient knows or should have known through history,
pattern, or practice of sharing confidences that the person communicating the information expects
confidentiality; and (3) a person received material nonpublic information from his or her spouse, parent,
child, or sibling.
In 1987, in Carpenter v. United States,

[8]

the Supreme Court affirmed the conviction of a Wall Street

Journal reporter who leaked advanced information about the contents of his “Heard on the Street”
column. The reporter, who was sentenced to eighteen months in prison, had been convicted on both mail
and wire fraud and securities law charges for misappropriating information. The Court upheld the mail
and wire fraud conviction by an 8–0 vote and the securities law conviction by a 4–4 vote. (In effect, the tie
vote affirmed the conviction.)

[9]

Beyond these judge-made theories of liability, Congress had been concerned about insider trading, and in
1984 and 1988, it substantially increased the penalties. A person convicted of insider trading now faces a
maximum criminal fine of $1 million and a possible ten-year prison term. A civil penalty of up to three
times the profit made (or loss avoided) by insider trading can also be imposed. This penalty is in addition
to liability for profits made through insider trading. For example, financier Ivan Boesky, who was
sentenced in 1987 to a three-year prison term for insider trading, was required to disgorge $50 million of
profits and was liable for another $50 million as a civil penalty. In 2003, Martha Stewart was indicted on
charges of insider trading but was convicted for obstruction of justice, serving only five months. More
recently, in 2009, billionaire founder of the Galleon Group, Raj Rajaratnam, was arrested for insider

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trading; he was convicted in May 2011 of all 14 counts of insider trading. For the SEC release on the
Martha Stewart case, seehttp://www.sec.gov/news/press/2003-69.htm.
Companies that knowingly and recklessly fail to prevent insider trading by their employees are subject to
a civil penalty of up to three times the profit gained or loss avoided by insider trading or $1 million,
whichever is greater. Corporations are also subject to a criminal fine of up to $2.5 million.

Secondary Actor
In Stoneridge Investment Partners v. Scientific-Atlanta,

[10]

the US Supreme Court held that “aiders and

abettors” of fraud cannot be held secondarily liable under 10(b) for a private cause of action. This means
that secondary actors, such as lawyers and accountants, cannot be held liable unless their conduct
satisfies all the elements for 10(b) liability.
For an overview of insider trading, go tohttp://www.sec.gov/answers/insider.htm.

Sarbanes-Oxley Act
Congress enacted the Sarbanes-Oxley Act in 2002 in response to major corporate and accounting
scandals, most notably those involving Enron, Tyco International, Adelphia, and WorldCom. The act
created the Public Company Accounting Oversight Board, which oversees, inspects, and regulates
accounting firms in their capacity as auditors of public companies. As a result of the act, the SEC may
include civil penalties to a disgorgement fund for the benefit of victims of the violations of the Securities
Act of 1933 and the Securities Exchange Act of 1934.

KEY TAKEAWAY
Corrupt practices, misuse of corporate funds, and insider trading unfairly benefit the minority and cost
the public billions. Numerous federal laws have been enacted to create liability for these bad actors in
order to prevent fraudulent trading activities. Both civil and criminal penalties are available to punish
those actors who bribe officials or use inside information unlawfully.

EXERCISES
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1.

Why is the SEC so concerned with bribery? What does the SEC really aim to prevent through the
FCPA?

2.

What are short-swing profits?

3.

To whom does Section 16(b) apply?

4.

Explain how Rule 10b-5 has been amended “on the basis of” insider information.

5.

Can a secondary actor (attorney, accountant) be liable for insider trading? What factors must be
present?

[1] SEC v. World-Wide Coin Investments, Ltd., 567 F.Supp. 724 (N.D. Ga. 1983).
[2] SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968).
[3] Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976).
[4] Aaron v. SEC, 446 U.S. 680 (1980).
[5] Chiarella v. United States, 445 U.S. 222 (1980).
[6] United States v. Newman, 664 F.2d 12 (2d Cir. 1981).
[7] United States v. O’Hagan, 521 U.S. 642 (1997).
[8] Carpenter v. United States, 484 U.S. 19 (1987).
[9] Carpenter v. United States, 484 U.S. 19 (1987).
[10] Stoneridge Investment Partners v. Scientific-Atlanta, 552 U.S. 148 (2008).

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15.3 Cases
What Is a Security?
Reves v. Ernst & Young
494 U.S. 56, 110 S.Ct. 945 (1990)
JUSTICE MARSHALL delivered the opinion of the Court.
This case presents the question whether certain demand notes issued by the Farmer’s Cooperative of
Arkansas and Oklahoma are “securities” within the meaning of § 3(a)(10) of the Securities and Exchange
Act of 1934. We conclude that they are.
The Co-Op is an agricultural cooperative that, at the same time relevant here, had approximately 23,000
members. In order to raise money to support its general business operations, the Co-Op sold promissory
notes payable on demand by the holder. Although the notes were uncollateralized and uninsured, they
paid a variable rate of interest that was adjusted monthly to keep it higher than the rate paid by local
financial institutions. The Co-Op offered the notes to both members and nonmembers, marketing the
scheme as an “Investment Program.” Advertisements for the notes, which appeared in each Co-Op
newsletter, read in part: “YOUR CO-OP has more than $11,000,000 in assets to stand behind your
investments. The Investment is not Federal [sic] insured but it is…Safe…Secure…and available when you
need it.” App. 5 (ellipses in original). Despite these assurances, the Co-Op filed for bankruptcy in 1984. At
the time of the filing, over 1,600 people held notes worth a total of $10 million.
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After the Co-Op filed for bankruptcy, petitioners, a class of holders of the notes, filed suit against Arthur
Young & Co., the firm that had audited the Co-Op’s financial statements (and the predecessor to
respondent Ernst & Young). Petitioners alleged, inter alia, that Arthur Young had intentionally failed to
follow generally accepted accounting principles in its audit, specifically with respect to the valuation of
one of the Co-Op’s major assets, a gasohol plant. Petitioners claimed that Arthur Young violated these
principles in an effort to inflate the assets and net worth of the Co-Op. Petitioners maintained that, had
Arthur Young properly treated the plant in its audits, they would not have purchased demand notes
because the Co-Op’s insolvency would have been apparent. On the basis of these allegations, petitioners
claimed that Arthur Young had violated the antifraud provisions of the 1934 Act as well as Arkansas’
securities laws.
Petitioners prevailed at trial on both their federal and state claims, receiving a $6.1 million judgment.
Arthur Young appealed, claiming that the demand notes were not “securities” under either the 1934 Act or
Arkansas law, and that the statutes’ antifraud provisions therefore did not apply. A panel of the Eighth
Circuit, agreeing with Arthur Young on both the state and federal issues, reversed. Arthur Young & Co. v.
Reves, 856 F.2d 52 (1988). We granted certiorari to address the federal issue, 490 U.S. 1105, 109 S.Ct.
3154, 104 L.Ed.2d 1018 (1989), and now reverse the judgment of the Court of Appeals.
***
The fundamental purpose undergirding the Securities Acts is “to eliminate serious abuses in a largely
unregulated securities market.” United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 849, 95 S.Ct.
2051, 2059, 44 L.Ed.2d 621 (1975). In defining the scope of the market that it wished to regulate, Congress
painted with a broad brush. It recognized the virtually limitless scope of human ingenuity, especially in
the creation of “countless and variable schemes devised by those who seek the use of the money of others
on the promise of profits,” SEC v. W.J. Howey Co., 328 U.S. 293, 299, 66 S.Ct. 1100, 1103, 90 L.Ed. 1244
(1946), and determined that the best way to achieve its goal of protecting investors was “to define ‘the
term “security” in sufficiently broad and general terms so as to include within that definition the many
types of instruments that in our commercial world fall within the ordinary concept of a security.’” Forman,
supra, 421 U.S., at 847-848, 95 S.Ct, at 2058-2059 (quoting H.R.Rep. No. 85, 73d Cong., 1st Sess., 11
(1933)). Congress therefore did not attempt precisely to cabin the scope of the Securities Acts. Rather, it

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enacted a definition of “security” sufficiently broad to encompass virtually any instrument that might be
sold as an investment.
***
[In deciding whether this transaction involves a “security,” four factors are important.] First, we examine
the transaction to assess the motivations that would prompt a reasonable seller and buyer to enter into it.
If the seller’s purpose is to raise money for the general use of a business enterprise or to finance
substantial investments and the buyer is interested primarily in the profit the note is expected to generate,
the instrument is likely to be a “security.” If the note is exchanged to facilitate the purchase and sale of a
minor asset or consumer good, to correct for the seller’s cash-flow difficulties, or to advance some other
commercial or consumer purpose, on the other hand, the note is less sensibly described as a “security.”
Second, we examine the “plan of distribution” of the instrument to determine whether it is an instrument
in which there is “common trading for speculation or investment.” Third, we examine the reasonable
expectations of the investing public: The Court will consider instruments to be “securities” on the basis of
such public expectations, even where an economic analysis of the circumstances of the particular
transaction might suggest that the instruments are not “securities” as used in that transaction. Finally, we
examine whether some factor such as the existence of another regulatory scheme significantly reduces the
risk of the instrument, thereby rendering application of the Securities Acts unnecessary.
***
[We] have little difficulty in concluding that the notes at issue here are “securities.”

CASE QUESTIONS
1.

What are the four factors the court uses to determine whether or not the transaction involves a
security?

2.

How does the definition of security in this case differ from the definition in Securities & Exchange
Commission v. W. J. Howey?

Tippee Liability
Dirks v. Securities and Exchange Commission
463 U.S. 646 (1983)

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[A] tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material
nonpublic information only when the insider has breached his fiduciary duty to the shareholders by
disclosing the information to the tippee and the tippee knows or should know that there has been a
breach.
***
Whether disclosure is a breach of duty therefore depends in large part on the purpose of the disclosure.
This standard was identified by the SEC itself in Cady, Roberts: a purpose of the securities laws was to
eliminate “use of inside information for personal advantage.” Thus, the test is whether the insider
personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has
been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach.
***
Under the inside-trading and tipping rules set forth above, we find that there was no actionable violation
by Dirks. It is undisputed that Dirks himself was a stranger to Equity Funding, with no preexisting
fiduciary duty to its shareholders. He took no action, directly, or indirectly, that induced the shareholders
or officers of Equity Funding to repose trust or confidence in him. There was no expectation by Dirk’s
sources that he would keep their information in confidence. Nor did Dirks misappropriate or illegally
obtain the information about Equity Funding. Unless the insiders breached their Cady, Roberts’s duty to
shareholders in disclosing the nonpublic information to Dirks, he breached no duty when he passed it on
to investors as well as to the Wall Street Journal.
***
It is clear that neither Secrist nor the other Equity Funding employees violated their Cady, Roberts’s duty
to the corporation’s shareholders by providing information to Dirks. The tippers received no monetary or
personal benefit for revealing Equity Funding’s secrets, nor were their purpose to make a gift of valuable
information to Dirks. As the facts of this case clearly indicate, the tippers were motivated by a desire to
expose the fraud. In the absence of a breach of duty to shareholders by the insiders, there was no
derivative breach by Dirks. Dirks therefore could not have been “a participant after the fact in [an]
insider’s breach of a fiduciary duty.” Chiarella, 445 U.S., at 230, n. 12.
***

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We conclude that Dirks, in the circumstances of this case, had no duty to abstain from the use of the
inside information that he obtained. The judgment of the Court of Appeals therefore is reversed.

CASE QUESTIONS
1.

When does a tippee assume a fiduciary duty to shareholders of a corporation?

2.

Did Dirks violate any insider trading laws? Why or why not?

3.

How does this case refine Rule 10b-5?

Duty to Disclose Material Information
Basic Inc. v. Levinson
485 U.S. 224 (1988)
[In December 1978, Basic Incorporated agreed to merge with Consolidated Engineering. Prior to the
merger, Basic made three public statements denying it was involved in merger negotiations. Shareholders
who sold their stock after the first of these statements and before the merger was announced sued Basic
and its directors under Rule 10b-5, claiming that they sold their shares at depressed prices as a result of
Basic’s misleading statements. The district court decided in favor of Basic on the grounds that Basic’s
statements were not material and therefore was not misleading. The court of appeals reversed, and the
Supreme Court granted certiorari.]
JUSTICE BLACKMUN.
We granted certiorari to resolve the split among the Courts of Appeals as to the standard of materiality
applicable to preliminary merger discussions, and to determine whether the courts below properly applied
a presumption of reliance in certifying the class, rather than requiring each class member to show direct
reliance on Basic’s statements.
***

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The Court previously has addressed various positive and common-law requirements for a violation of §
10(b) or of Rule 10b-5. The Court also explicitly has defined a standard of materiality under the securities
laws, see TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976), concluding in the proxy-solicitation
context that “[a]n omitted fact is material if there is a substantial likelihood that a reasonable shareholder
would consider it important in deciding how to vote.”…We now expressly adopt the TSC Industries
standard of materiality for the 5 10(b) and Rule 10b-5 context.
The application of this materiality standard to preliminary merger discussions is not self-evident. Where
the impact of the corporate development on the target’s fortune is certain and clear, the TSC Industries
materiality definition admits straight-forward application. Where, on the other hand, the event is
contingent or speculative in nature, it is difficult to ascertain whether the “reasonable investor” would
have considered the omitted information significant at the time. Merger negotiations, because of the everpresent possibility that the contemplated transaction will not be effectuated, fall into the latter category.
***
Even before this Court’s decision in TSC Industries, the Second Circuit had explained the role of the
materiality requirement of Rule 10b-5, with respect to contingent or speculative information or events, in
a manner that gave that term meaning that is independent of the other provisions of the Rule. Under such
circumstances, materiality “will depend at any given time upon a balancing of both the indicated
probability that the event will occur and the anticipated magnitude of the event in light of the totality of
the company activity.” SEC v. Texas Gulf Sulphur Co., 401 F.2d, at 849.
***
Whether merger discussions in any particular case are material therefore depends on the facts. Generally,
in order to assess the probability that the event will occur, a fact finder will need to look to indicia of
interest in the transactions at the highest corporate levels. Without attempting to catalog all such possible
factors, we note by way of example that board resolutions, instructions to investment bankers, and actual
negotiations between principals or their intermediaries may serve as indicia of interest. To assess the
magnitude of the transaction to the issuer of the securities allegedly manipulated, a fact finder will need to
consider such facts as the size of the two corporate entities and of the potential premiums over market
value. No particular event or factor short of closing the transaction need to be either necessary or
sufficient by itself to render merger discussions material.
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As we clarify today, materiality depends on the significance the reasonable investor would place on the
withheld or misrepresented information. The fact-specific inquiry we endorse here is consistent with the
approach a number of courts have taken in assessing the materiality of merger negotiations. Because the
standard of materiality we have adopted differs from that used by both courts below, we remand the case
for reconsideration of the question whether a grant of summary judgment is appropriate on this record.
We turn to the question of reliance and the fraud on-the-market theory. Succinctly put:
The fraud on the market theory is based on the hypothesis that, in an open and developed securities
market, the price of a company’s stock is determined by the available information regarding the company
and its business.…Misleading statements will therefore defraud purchasers of stock even if the purchasers
do not directly rely on the misstatements.…The causal connection between the defendants’ fraud and the
plaintiff’s purchase of stock in such a case is no less significant than in a case of direct reliance on
misrepresentations. Peil v. Speiser, 806 F.2d 1154, 1160-1161 (CA3 1986).
***
We agree that reliance is an element of a Rule 10b-5 cause of action. Reliance provides the requisite causal
connection between a defendant’s misrepresentation and a plaintiff’s misrepresentation and a plaintiff’s
injury. There is, however, more than one way to demonstrate the causal connection.
***
Presumptions typically serve to assist courts in managing circumstances in which direct proof, for one
reason or another, is rendered difficult. The courts below accepted a presumption, created by the fraudon-the-market theory and subject to rebuttal by petitioners, that persons who had traded Basic shares had
done so in reliance on the integrity of the price set by the market, but because of petitioners’ material
misrepresentations that price had been fraudulently depressed. Requiring a plaintiff to show a speculative
state of facts, i.e., how he would have acted if omitted material information had been disclosed, or if the
misrepresentation had not been made, would place an unnecessarily unrealistic evidentiary burden on the
Rule 10b-5 plaintiff who has traded on an impersonal market.
Arising out of considerations of fairness, public policy, and probability, as well as judicial economy,
presumptions are also useful devices for allocating the burdens of proof between parties. The presumption
of reliance employed in this case is consistent with, and, by facilitating Rule 10b-5 litigation, supports, the
congressional policy embodied in the 1934 Act…
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The presumption is also supported by common sense and probability. Recent empirical studies have
tended to confirm Congress’ premise that the market price of shares traded on well-developed markets
reflects all publicly available information, and, hence, any material misrepresentations. It has been noted
that “it is hard to imagine that there ever is a buyer or seller who does not rely on market integrity. Who
would knowingly roll the dice in a crooked crap game?” Schlanger v. Four-Phase Systems, Inc., 555
F.Supp. 535, 538 (SDNY 1982)…An investor who buys or sells stock at the price set by the market does so
in reliance on the integrity of that price. Because most publicly available information is reflected in
market price, an investor’s reliance on any public material misrepresentations, therefore, may be
presumed for purposes of a Rule 10b-5 action.
***
The judgment of the Court of Appeals is vacated and the case is remanded to that court for further
proceedings consistent with this opinion.

CASE QUESTIONS
1.

How does the court determine what is or is not material information? How does this differ from its
previous rulings?

2.

What is the fraud-on-the-market theory?

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15.4 Summary and Exercises
Summary
Beyond state corporation laws, federal statutes—most importantly, the Securities Act of 1933 and the
Securities Exchange Act of 1934—regulate the issuance and trading of corporate securities. The federal
definition of security is broad, encompassing most investments, even those called by other names.
The law does not prohibit risky stock offerings; it bans only those lacking adequate disclosure of risks. The
primary means for realizing this goal is the registration requirement: registration statements,
prospectuses, and proxy solicitations must be filed with the Securities and Exchange Commission (SEC).
Penalties for violation of securities law include criminal fines and jail terms, and damages may be
awarded in civil suits by both the SEC and private individuals injured by the violation of SEC rules. A 1977
amendment to the 1934 act is the Foreign Corrupt Practices Act, which prohibits an issuer from paying a
bribe or making any other payment to foreign officials in order to gain business by inducing the foreign
official to influence his government in favor of the US company. This law requires issuers to keep accurate
sets of books reflecting the dispositions of their assets and to maintain internal accounting controls to
ensure that transactions comport with management’s authorization.

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The Securities Exchange Act of 1934 presents special hazards to those trading in public stock on the basis
of inside information. One provision requires the reimbursement to the company of any profits made
from selling and buying stock during a six-month period by directors, officers, and shareholders owning
10 percent or more of the company’s stock. Under Rule 10b-5, the SEC and private parties may sue
insiders who traded on information not available to the general public, thus gaining an advantage in
either selling or buying the stock. Insiders include company employees.
The Sarbanes-Oxley Act amended the 1934 act, creating more stringent penalties, increasing corporate
regulation, and requiring greater transparency.

EXERCISES
1.

Anne operated a clothing store called Anne’s Rags, Inc. She owned all of the stock in the company.
After several years in the clothing business, Anne sold her stock to Louise, who personally managed
the business. Is the sale governed by the antifraud provisions of federal securities law? Why?

2.

While waiting tables at a campus-area restaurant, you overhear a conversation between two
corporate executives who indicate that their company has developed a new product that will
revolutionize the computer industry. The product is to be announced in three weeks. If you purchase
stock in the company before the announcement, will you be liable under federal securities law? Why?

3.

Eric was hired as a management consultant by a major corporation to conduct a study, which took him
three months to complete. While working on the study, Eric learned that someone working in
research and development for the company had recently made an important discovery. Before the
discovery was announced publicly, Eric purchased stock in the company. Did he violate federal
securities law? Why?

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4.

While working for the company, Eric also learned that it was planning a takeover of another
corporation. Before announcement of a tender offer, Eric purchased stock in the target company. Did
he violate securities law? Why?

5.

The commercial lending department of First Bank made a substantial loan to Alpha Company after
obtaining a favorable confidential earnings report from Alpha. Over lunch, Heidi, the loan officer who
handled the loan, mentioned the earnings report to a friend who worked in the bank’s trust
department. The friend proceeded to purchase stock in Alpha for several of the bank’s trusts. Discuss
the legal implications.

6.

In Exercise 5, assume that a week after the loan to Alpha, First Bank financed Beta Company’s
takeover of Alpha. During the financing negotiations, Heidi mentioned the Alpha earnings report to
Beta officials; furthermore, the report was an important factor in Heidi’s decision to finance the
takeover. Discuss the legal implications.

7.

In Exercise 6, assume that after work one day, Heidi told her friend in the trust department that Alpha
was Beta’s takeover target. The friend proceeded to purchase additional stock in Alpha for a bank
trust he administered. Discuss the legal implications.

SELF-TEST QUESTIONS
1.

The issuance of corporate securities is governed by

a.

various federal statutes

b.

state law

c.

both of the above

d.

neither of the above
The law that prohibits the payment of a bribe to foreign officials to gain business is called

a.

the Insider Trading Act
b.

the blue sky law

c.

the Foreign Corrupt Practices Act

d.

none of the above
The primary means for banning stock offerings that inadequately disclose risks is

a.

the registration requirement

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b.

SEC prohibition of risky stock offerings

c.

both of the above

d.

neither of the above
To enforce its prohibition under insider trading, the SEC requires reimbursement to the
company of any profits made from selling and buying stock during any six-month period by
directors owing
a.

60 percent or more of company stock

b.

40 percent or more of company stock

c.

10 percent or more of company stock

d.

none of the above
Under Rule 10b-5, insiders include

a.

all company employees
b.

any person who possesses nonpublic information

c.

all tippees

d.

none of the above
The purpose of the Dodd-Frank Act is to

a.

promote financial stability
b.

end “too big to fail”

c.

end bailouts

d.

protect against abusive financial services practices

e.

all of the above

SELF-TEST ANSWERS
1.

c

2.

c

3.

a

4.

d

5.

a

6.

e

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Chapter 16
Antitrust Law
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

The history and basic framework of antitrust laws on horizontal restraints of trade

2.

The distinction between vertical restraints of trade and horizontal restraints of trade

3.

The various exemptions from antitrust law that Congress has created

4.

Why monopolies pose a threat to competitive markets, and what kinds of monopolies are proscribed by
the Sherman Act and the Clayton Act

This chapter will describe the history and current status of federal laws to safeguard the US market from
anticompetitive practices, especially those of very large companies that may have a monopoly. Companies
that have a monopoly in any market segment have the potential to exercise monopoly power in ways that
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are harmful to consumers and competitors. Economic theory assures us that for the most part,
competition is good: that sound markets will offer buyers lots of choices and good information about
products and services being sold and will present few barriers to entry for buyers and sellers. By
encouraging more, rather than fewer, competitors in a given segment of the market, US antitrust law
attempts to preserve consumer choice and to limit barriers to entry, yet it does allow some businesses to
achieve considerable size and market share on the belief that size can create efficiencies and pass along
the benefits to consumers.

16.1 History and Basic Framework of Antitrust Laws in the
United States
LEARNING OBJECTIVES
1.

Know the history and basic framework of antitrust laws in the United States.

2.

Understand how US antitrust laws may have international application.

3.

Explain how US antitrust laws are enforced and what kinds of criminal and civil penalties may apply.

In this chapter, we take up the origins of the federal antitrust laws and the basic rules governing restraints
of trade.

[1]

We also look at concentrations of market power: monopoly and acquisitions and

mergers.

[2]

In, we explore the law of deceptive acts and unfair trade practices, both as administered by the

Federal Trade Commission (FTC) and as regulated at common law.
Figure 16.1 An Antitrust Schematic

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The antitrust laws are aimed at maintaining competition as the driving force of the US economy. The very
word antitrust implies opposition to the giant trusts that began to develop after the Civil War. Until then,
the economy was largely local; manufacturers, distributors, and retailers were generally small. The Civil
War demonstrated the utility of large-scale enterprise in meeting the military’s ferocious production
demands, and business owners were quick to understand the advantage of size in attracting capital. For
the first time, immense fortunes could be made in industry, and adventurous entrepreneurs were quick to
do so in an age that lauded the acquisitive spirit.
The first great business combinations were the railroads. To avoid ruinous price wars, railroad owners
made private agreements, known as “pools,” through which they divided markets and offered discounts to
favored shippers who agreed to ship goods on certain lines. The pools discriminated against particular
shippers and certain geographic regions, and public resentment grew.
Farmers felt the effects first and hardest, and they organized politically to express their opposition. In
time, they persuaded many state legislatures to pass laws regulating railroads. In Munn v. Illinois, the
Supreme Court rejected a constitutional attack on a state law regulating the transportation and
warehousing of grain; the court declared that the “police powers” of the states permit the regulation of
property put to public uses.

[3]

But over time, many state railroad laws were struck down because they

interfered with interstate commerce, which only Congress may regulate constitutionally. The consequence

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was federal legislation: the Interstate Commerce Act of 1887, establishing the first federal administrative
agency, the Interstate Commerce Commission.
In the meantime, the railroads had discovered that their pools lacked enforcement power. Those who
nominally agreed to be bound by the pooling arrangement could and often did cheat. The corporate form
of business enterprise allowed for potentially immense accumulations of capital to be under the control of
a small number of managers; but in the 1870s and 1880s, the corporation was not yet established as the
dominant legal form of operation. To overcome these disadvantages, clever lawyers for John D.
Rockefeller organized his Standard Oil of Ohio as a common-law trust. Trustees were given corporate
stock certificates of various companies; by combining numerous corporations into the trust, the trustees
could effectively manage and control an entire industry. Within a decade, the Cotton Trust, Lead Trust,
Sugar Trust, and Whiskey Trust, along with oil, telephone, steel, and tobacco trusts, had become, or were
in the process of becoming, monopolies.
Consumers howled in protest. The political parties got the message: In 1888, both Republicans and
Democrats put an antitrust plank in their platforms. In 1889, the new president, Republican Benjamin
Harrison, condemned monopolies as “dangerous conspiracies” and called for legislation to remedy the
tendency of monopolies that would “crush out” competition.
The result was the Sherman Antitrust Act of 1890, sponsored by Senator John Sherman of Ohio. Its two
key sections forbade combinations in restraint of trade and monopolizing. Senator Sherman and other
sponsors declared that the act had roots in a common-law policy that frowned on monopolies. To an
extent, it did, but it added something quite important for the future of business and the US economy: the
power of the federal government to enforce a national policy against monopoly and restraints of trade.
Nevertheless, passage of the Sherman Act did not end the public clamor, because fifteen years passed
before a national administration began to enforce the act, when President Theodore Roosevelt—”the
Trustbuster”—sent his attorney general after the Northern Securities Corporation, a transportation
holding company.
During its seven years, the Roosevelt administration initiated fifty-four antitrust suits. The pace picked up
under the Taft administration, which in only four years filed ninety antitrust suits. But the pressure for
further reform did not abate, especially when the Supreme Court, in the Standard Oil case of
1911,

[4]

declared that the Sherman Act forbids only “unreasonable” restraints of trade. A congressional

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investigation of US Steel Corporation brought to light several practices that had gone unrestrained by the
Sherman Act. It also sparked an important debate, one that has echoes in our own time, about the nature
of national economic policy: should it enforce competition or regulate business in a partnership kind of
arrangement?
Big business was firmly on the side of regulation, but Congress opted for the policy followed waveringly to
the present: competition enforced by government, not a partnership of government and industry, must be
the engine of the economy. Accordingly, in 1914, at the urging of President Woodrow Wilson, Congress
enacted two more antitrust laws, the Clayton Act and the Federal Trade Commission Act. The Clayton Act
outlawed price discrimination, exclusive dealing and tying contracts, acquisition of a company’s
competitors, and interlocking directorates. The FTC Act outlawed “unfair methods” of competition,
established the FTC as an independent administrative agency, and gave it power to enforce the antitrust
laws alongside the Department of Justice.
The Sherman, Clayton, and FTC Acts remain the basic texts of antitrust law. Over the years, many states
have enacted antitrust laws as well; these laws govern intrastate competition and are largely modeled on
the federal laws. The various state antitrust laws are beyond the scope of this textbook.
Two additional federal statutes were adopted during the next third of a century as amendments to the
Clayton Act. Enacted in the midst of the Depression in 1936, the Robinson-Patman Act prohibits various
forms of price discrimination. The Celler-Kefauver Act, strengthening the Clayton Act’s prohibition
against the acquisition of competing companies, was enacted in 1950 in the hopes of stemming what
seemed to be a tide of corporate mergers and acquisitions. We will examine these laws in turn.

The Sherman Act
Section 1 of the Sherman Act declares, “Every contract, combination in the form of trust or otherwise, or
conspiracy, in restraint of trade or commerce among the several states, or with foreign nations, is declared
to be illegal.” This is sweeping language. What it embraces seems to depend entirely on the meaning of the
words “restraint of trade or commerce.” Whatever they might mean, every such restraint is declared
unlawful. But in fact, as we will see, the proposition cannot be stated quite so categorically, for in 1911 the
Supreme Court limited the reach of this section to unreasonable restraints of trade.

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What does “restraint of trade” mean? The Sherman Act’s drafters based the act on a common-law policy
against monopolies and other infringements on competition. But common law regarding restraints of
trade had been developed in only rudimentary form, and the words have come to mean whatever the
courts say they mean. In short, the antitrust laws, and the Sherman Act in particular, authorize the courts
to create a federal “common law” of competition.
Section 2 of the Sherman Act prohibits monopolization: “Every person who shall monopolize, or attempt
to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the
trade or commerce among the several states, or with foreign nations, shall be deemed guilty of a
misdemeanor.” In 1976, Congress upped the ante: violations of the Sherman Act are now felonies. Unlike
Section 1, Section 2 does not require a combination between two or more people. A single company acting
on its own can be guilty of monopolizing or attempting to monopolize.

The Clayton Act
The Clayton Act was enacted in 1914 to plug what many in Congress saw as loopholes in the Sherman Act.
Passage of the Clayton Act was closely linked to that of the FTC Act. Unlike the Sherman Act, the Clayton
Act is not a criminal statute; it merely declares certain defined practices as unlawful and leaves it to the
government or to private litigants to seek to enjoin those practices. But unlike the FTC Act, the Clayton
Act does spell out four undesirable practices. Violations of the Sherman Act require an actual adverse
impact on competition, whereas violations of the Clayton Act require merely a probable adverse impact.
Thus the enforcement of the Clayton Act involves a prediction that the defendant must rebut in order to
avoid an adverse judgment.
The four types of proscribed behavior are these:
1.

Discrimination in prices charged different purchasers of the same commodities.

2. Conditioning the sale of one commodity on the purchaser’s refraining from using or dealing in
commodities of the seller’s competitors.

[5]

3. Acquiring the stock of a competing corporation.

[6]

Because the original language did not prohibit

various types of acquisitions and mergers that had grown up with modem corporate law and finance,
Congress amended this section in 1950 (the Celler-Kefauver Act) to extend its prohibition to a wide
variety of acquisitions and mergers.
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4. Membership by a single person on more than one corporate board of directors if the companies are or
were competitors.

[7]

The Federal Trade Commission Act
Like the Clayton Act, the FTC Act is a civil statute, involving no criminal penalties. Unlike the Clayton Act,
its prohibitions are broadly worded. Its centerpiece is Section 5, which forbids “unfair methods of
competition in commerce, and unfair or deceptive acts or practices in commerce.” We examine Section 5
in .

Enforcement of Antitrust Laws
General Enforcement
There are four different means of enforcing the antitrust laws.
First, the US Department of Justice may bring civil actions to enjoin violations of any section of the
Sherman and Clayton Acts and may institute criminal prosecutions for violations of the Sherman Act.
Both civil and criminal actions are filed by the offices of the US attorney in the appropriate federal district,
under the direction of the US attorney general. In practice, the Justice Department’s guidance comes
through its Antitrust Division in Washington, headed by an assistant attorney general. With several
hundred lawyers and dozens of economists and other professionals, the Antitrust Division annually files
fewer than one hundred civil and criminal actions combined. On average, far more criminal cases are filed
than civil cases. In 2006, thirty-four criminal cases and twelve civil cases were filed; in 2007, forty
criminal cases and six civil cases; in 2008, fifty-four criminal cases and nineteen civil cases; and in 2009,
seventy-two criminal cases and nine civil cases.
The number of cases can be less important than the complexity and size of a particular case. For
example, U.S. v. American Telephone & Telegraph and U.S. v. IBM were both immensely complicated,
took years to dispose of, and consumed tens of thousands of hours of staff time and tens of millions of
dollars in government and defense costs.
Second, the FTC hears cases under the Administrative Procedure Act, as described in . The commission’s
decisions may be appealed to the US courts of appeals. The FTC may also promulgate “trade regulation
rules,” which define fair practices in specific industries. The agency has some five hundred lawyers in
Washington and a dozen field offices, but only about half the lawyers is directly involved in antitrust
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enforcement. The government’s case against Microsoft was, like the cases against AT&T and IBM, a very
complex case that took a large share of time and resources from both the government and Microsoft.
Third, in the Antitrust Improvements Act of 1976, Congress authorized state attorneys general to file
antitrust suits in federal court for damages on behalf of their citizens; such a suit is known as a parens
patriae claim. Any citizen of the state who might have been injured by the defendant’s actions may opt out
of the suit and bring his or her own private action. The states have long had the authority to file antitrust
suits seeking injunctive relief on behalf of their citizens.
Fourth, private individuals and companies may file suits for damages or injunctions if they have been
directly injured by a violation of the Sherman or Clayton Act. Private individuals or companies may not
sue under the FTC Act, no matter how unfair or deceptive the behavior complained of; only the FTC may
do so. In the 1980s, more than 1,500 private antitrust suits were filed in the federal courts each year,
compared with fewer than 100 suits filed by the Department of Justice. More recently, from 2006 to
2008, private antitrust suits numbered above 1,000 but dropped significantly, to 770, in 2009. The pace
was even slower for the first half of 2010. Meanwhile, the Department of Justice filed 40 or fewer criminal
antitrust cases from 2006 to 2008; that pace has quickened under the Obama administration (72 cases in
2009).

Enforcement in International Trade
The Sherman and Clayton Acts apply when a company’s activities affect US commerce. This means that
these laws apply to US companies that agree to fix the price of goods to be shipped abroad and to the acts
of a US subsidiary of a foreign company. It also means that non–US citizens and business entities can be
prosecuted for violations of antitrust laws, even if they never set foot in the United States, as long as their
anticompetitive activities are aimed at the US market. For example, in November of 2010, a federal grand
jury in San Francisco returned an indictment against three former executives in Taiwan. They had
conspired to fix prices on color display tubes (CDTs), a type of cathode-ray tube used in computer
monitors and other specialized applications.
The indictment charged Seung-Kyu “Simon” Lee, Yeong-Ug “Albert” Yang, and Jae-Sik “J. S.” Kim with
conspiring with unnamed coconspirators to suppress and eliminate competition by fixing prices, reducing
output, and allocating market shares of CDTs to be sold in the United States and elsewhere. Lee, Yang,
and Kim allegedly participated in the conspiracy during various time periods between at least as early as
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January 2000 and as late as March 2006. The conspirators met in Taiwan, Korea, Malaysia, China, and
elsewhere, but not in the United States. They allegedly met for the purpose of exchanging CDT sales,
production, market share, and pricing information for the purpose of implementing, monitoring, and
enforcing their agreements. Because the intended effects of their actions were to be felt in the United
States, the US antitrust laws could apply.

Criminal Sanctions
Until 1976, violations of the Sherman Act were misdemeanors. The maximum fine was $50,000 for each
count on which the defendant was convicted (only $5,000 until 1955), and the maximum jail sentence was
one year. But in the CDT case just described, each of the three conspirators was charged with violating the
Sherman Act, which carries a maximum penalty of ten years in prison and a $1 million fine for
individuals. The maximum fine may be increased to twice the gain derived from the crime or twice the
loss suffered by the victims if either of those amounts is greater than the statutory maximum fine of $1
million.

Forfeitures
One provision in the Sherman Act, not much used, permits the government to seize any property in
transit in either interstate or foreign commerce if it was the subject of a contract, combination, or
conspiracy outlawed under Section 1.

Injunctions and Consent Decrees
The Justice Department may enforce violations of the Sherman and Clayton Acts by seeking injunctions in
federal district court. The injunction can be a complex set of instructions, listing in some detail the
practices that a defendant is to avoid and even the way in which it will be required to conduct its business
thereafter. Once an injunction is issued and affirmed on appeal, or the time for appeal has passed, it
confers continuing jurisdiction on the court to hear complaints by those who say the defendant is violating
it. In a few instances, the injunction or a consent decree is in effect the basic “statute” by which an
industry operates. A 1956 decree against American Telephone & Telegraph Company (AT&T) kept the
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company out of the computer business for a quarter-century, until the government’s monopoly suit
against AT&T was settled and a new decree issued in 1983. The federal courts also have the power to
break up a company convicted of monopolizing or to order divestiture when the violation consists of
unlawful mergers and acquisitions.
The FTC may issue cease and desist orders against practices condemned under Section 5 of the FTC Act—
which includes violations of the Sherman and Clayton Acts—and these orders may be appealed to the
courts.
Rather than litigate a case fully, defendants may agree to consent decrees, in which, without admitting
guilt, they agree not to carry on the activity complained of. Violations of injunctions cease and desist
orders, and consent decrees subject companies to a fine of $10,000 a day for every day the violation
continues. Companies frequently enter into consent decrees—and not just because they wish to avoid the
expense and trouble of trial. Section 5 of the Clayton Act says that whenever an antitrust case brought by
the federal government under either the Clayton Act or the Sherman Act goes to final judgment, the
judgment can be used, in a private suit in which the same facts are at issue, as prima facie evidence that
the violation was committed. This is a powerful provision, because it means that a private plaintiff need
prove only that the violation in fact injured him. He need not prove that the defendant committed the acts
that amount to antitrust violations. Since this provision makes it relatively easy for private plaintiffs to
prevail in subsequent suits, defendants in government suits have a strong inducement to enter into
consent decrees, because these are not considered judgments. Likewise, a guilty plea in a criminal case
gives the plaintiff in a later private civil suit prima facie evidence of the defendant’s liability. However, a
plea of nolo contendere will avoid this result. Section 5 has been the spur for a considerable proportion of
all private antitrust suits. For example, the government’s price-fixing case against the electric equipment
industry that sent certain executives of General Electric to jail in the 1950s led to more than 2,200 private
suits.

Treble Damages
The crux of the private suit is its unique damage award: any successful plaintiff is entitled to collect three
times the amount of damages actually suffered—treble damages, as they are known—and to be paid the
cost of his attorneys. These fees can be huge: defendants have had to pay out millions of dollars for
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attorneys’ fees alone in single cases. The theory of treble damages is that they will serve as an incentive to
private parties to police industry for antitrust violations, thus saving the federal government the immense
expense of maintaining an adequate staff for that job.

Class Actions
One of the most important developments in antitrust law during the 1970s was the rise of the class action.
Under liberalized rules of federal procedure, a single plaintiff may sue on behalf of the entire class of
people injured by an antitrust violation. This device makes it possible to bring numerous suits that would
otherwise never have been contemplated. A single individual who has paid one dollar more than he would
have been charged in a competitive market obviously will not file suit. But if there are ten million
consumers like him, then in a class action he may seek—on behalf of the entire class, of course—$30
million ($10 million trebled), plus attorneys’ fees. Critics charge that the class action is a device that in the
antitrust field benefits only the lawyers, who have a large incentive to find a few plaintiffs willing to have
their names used in a suit run entirely by the lawyers. Nevertheless, it is true that the class action permits
antitrust violations to be rooted out that could not otherwise be attacked privately. During the 1970s, suits
against drug companies and the wallboard manufacturing industry were among the many large-scale
antitrust class actions.

Interpreting the Laws
Vagueness
The antitrust laws, and especially Section 1 of the Sherman Act, are exceedingly vague. As Chief Justice
Charles Evans Hughes once put it, “The Sherman Act, as a charter of freedom, has a generality and
adaptability comparable to that found to be desirable in constitutional provisions.”

[8]

Without the

sweeping but vague language, the antitrust laws might quickly have become outdated. As written, they
permit courts to adapt the law to changing circumstances. But the vagueness can lead to uncertainty and
uneven applications of the law.

The “Rule of Reason”

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Section 1 of the Sherman Act says that “every” restraint of trade is illegal. But is a literal interpretation
really possible? No, for as Justice Louis Brandeis noted in 1918 in one of the early price-fixing cases,
“Every agreement concerning trade, every regulation of trade restrains. To bind, to restrain, is of their
[9]

very essence.” When a manufacturing company contracts to buy raw materials, trade in those goods is
restrained: no one else will have access to them. But to interpret the Sherman Act to include such a
contract is an absurdity. Common sense says that “every” cannot really mean every restraint.
Throughout this century, the courts have been occupied with this question. With the hindsight of
thousands of cases, the broad outlines of the answer can be confidently stated. Beginning with Standard
Oil Co. of New Jersey v. United States, the Supreme Court has held that only unreasonable restraints of
trade are unlawful.

[10]

Often called the rule of reason, the interpretation of Section 1 made in Standard Oil itself has two possible
meanings, and they have been confused over the years. The rule of reason could mean that a restraint is
permissible only if it is ancillary to a legitimate business purpose. The standard example is a covenant not
to compete. Suppose you decide to purchase a well-regarded bookstore in town. The proprietor is well
liked and has developed loyal patrons. He says he is going to retire in another state. You realize that if he
changed his mind and stayed in town to open another bookstore; your new business would suffer
considerably. So you negotiate as a condition of sale that he agrees not to open another bookstore within
ten miles of the town for the next three years. Since your intent is not to prevent him from going into
business—as it would be if he had agreed never to open a bookstore anywhere—but merely to protect the
value of your purchase, this restraint of trade is ancillary to your business purpose. The rule of reason
holds that this is not an unlawful restraint of trade.
Another interpretation of the rule of reason is even broader. It holds that agreements that might directly
impair competition are not unlawful unless the particular impairment itself is unreasonable. For example,
several retailers of computer software are distraught at a burgeoning price war that will possibly reduce
prices so low that they will not be able to offer their customers proper service. To avert this “cutthroat
competition,” the retailers agree to set a price floor—a floor that, under the circumstances, is reasonable.
Chief Justice Edward White, who wrote the Standard Oil opinion, might have found that such an
agreement was reasonable because, in view of its purposes, it was not unduly restrictive and did not
unduly restrain trade.
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But this latter view is not the law. Almost any business agreement could enhance the market power of one
or more parties to the agreement, and thus restrain trade. “The true test of legality,” Justice Brandeis
wrote in 1918 in Chicago Board of Trade, “is whether the restraint imposed is such as merely regulates
and perhaps thereby promotes competition or whether it is such as may suppress or even destroy
competition.”

[11]

Section 1 violation analyzed under the rule of reason will look at several factors,

including the purpose of the agreement, the parties’ power to implement the agreement to achieve that
purpose, and the effect or potential effect of the agreement on competition. If the parties could have used
less restrictive means to achieve their purpose, the Court would more likely have seen the agreement as
unreasonable.

[12]

“Per Se” Rules
Not every act or commercial practice needs to be weighed by the rule of reason. Some acts have come to
be regarded as intrinsically or necessarily impairing competition, so that no further analysis need be made
if the plaintiff can prove that the defendant carried them out or attempted or conspired to do so. Pricefixing is an example. Price-fixing is said to be per se illegal under the Sherman Act—that is, unlawful on its
face. The question in a case alleging price-fixing is not whether the price was reasonable or whether it
impaired or enhanced competition, but whether the price in fact was fixed by two sellers in a market
segment. Only that question can be at issue.

Under the Clayton Act
The rule of reason and the per se rules apply to the Sherman Act. The Clayton Act has a different
standard. It speaks in terms of acts that may tend substantially to lessen competition. The courts must
construe these terms too, and in the sections that follow, we will see how they have done so.

KEY TAKEAWAY
The preservation of competition is an important part of public policy in the United States. The various
antitrust laws were crafted in response to clear abuses by companies that sought to claim easier profits
by avoiding competition through the exercise of monopoly power, price-fixing, or territorial

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agreements. The Department of Justice and the Federal Trade Commission have substantial criminal
and civil penalties to wield in their enforcement of the various antitrust laws.

EXERCISES
1.

Why did industries become so much larger after the US Civil War, and how did this lead to abusive
practices? What role did politics play in creating US laws fostering competition?

2.

Go to the Department of Justice website and see how many antitrust enforcement actions have taken
place since 2008.

3.

Consider whether the US government should break up the biggest US banks. Why or why not? If the
United States does so, and other nations have very large government banks, or have very large private
banks, can US banks remain competitive?

[1] Sherman Act, Section 1; Clayton Act, Section 3.
[2] Sherman Act, Section 2; Clayton Act, Section 7.
[3] Munn v. Illinois, 94 U.S. 113 (1877).
[4] Standard Oil Co. of New Jersey v. United States, 221 U.S. 1 (1911).
[5] Clayton Act, Section 3.
[6] Clayton Act, Section 7.
[7] Clayton Act, Section 8.
[8] Appalachian Coals v. United States, 288 U.S. 344, 359 (1933).
[9] Chicago Board of Trade v. United States, 246 U.S. 231 (1918).
[10] Standard Oil Co. of New Jersey v. United States, 221 U.S. 1 (1911).
[11] Chicago Board of Trade v. United States, 246 U.S. 231 (1918).
[12] Chicago Board of Trade v. United States, 246 U.S. 231 (1918).

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16.2 Horizontal Restraints of Trade
LEARNING OBJECTIVES
1.

Know why competitors are the likely actors in horizontal restraints of trade.

2.

Explain what it means when the Supreme Court declares a certain practice to be a per se violation of
the antitrust laws.

3.

Describe at least three ways in which otherwise competing parties can fix prices.

4.

Recognize why dividing territories is a horizontal restraint of trade.

Classification of antitrust cases and principles is not self-evident because so many cases turn on complex
factual circumstances. One convenient way to group the cases is to look to the relationship of those who
have agreed or conspired. If the parties are competitors—whether competing manufacturers, wholesalers,
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retailers, or others—there could be a horizontal restraint of trade. If the parties are at different levels of
the distribution chain—for example, manufacturer and retailer—their agreement is said to involve
a vertical restraint of trade. These categories are not airtight: a retailer might get competing
manufacturers to agree not to supply a competitor of the retailer. This is a vertical restraint with
horizontal effects.

Price-Fixing
Direct Price-Fixing Agreements
Price-fixing agreements are per se violations of Section 1 of the Sherman Act. The per se rule was
[1]

announced explicitly in United States v. Trenton Potteries. In that case, twenty individuals and twentythree corporations, makers and distributors of 82 percent of the vitreous pottery bathroom fixtures used
in the United States, were found guilty of having agreed to establish and adhere to a price schedule. On
appeal, they did not dispute that they had combined to fix prices. They did argue that the jury should have
been permitted to decide whether what they had done was reasonable. The Supreme Court disagreed,
holding that any fixing of prices is a clear violation of the Sherman Act.
Twenty-four years later, the Court underscored this categorical per se rule in Kiefer-Stewart Co. v. Joseph
E. Seagram & Sons.

[2]

The defendants were distillers who had agreed to sell liquor only to those

wholesalers who agreed to resell it for no more than a maximum price set by the distillers. The defendants
argued that setting maximum prices did not violate the Sherman Act because such prices promoted rather
than restrained competition. Again, the Supreme Court disagreed: “[S]uch agreements, no less than those
to fix minimum prices, cripple the freedom of traders and thereby restrain their ability to sell in
accordance with their own judgment.”
The per se prohibition against price-fixing is not limited to agreements that directly fix prices. Hundreds
of schemes that have the effect of controlling prices have been tested in court and found wanting, some
because they were per se restraints of trade, others because their effects were unreasonable—that is,
because they impaired competition—under the circumstances. In the following sections, we examine some
of these cases briefly.

Exchanging Price Information
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Knowledge of competitors’ prices can be an effective means of controlling prices throughout an industry.
Members of a trade association of hardwood manufacturers adopted a voluntary “open competition” plan.
About 90 percent of the members adhered to the plan. They accounted for one-third of the production of
hardwood in the United States. Under the plan, members reported daily on sales and deliveries and
monthly on production, inventory, and prices. The association, in turn, sent out price, sales, and
production reports to the participating members. Additionally, members met from time to time to discuss
these matters, and they were exhorted to refrain from excessive production in order to keep prices at
profitable levels. In American Column and Lumber Company v. United States, the Supreme Court
condemned this plan as a per se violation of Section 1 of the Sherman Act.

[3]

Not every exchange of information is necessarily a violation, however. A few years after American Column
and Lumber, in Maple Flooring Manufacturers’ Association v. United States, the Court refused to find a
violation in the practice of an association of twenty-two hardwood-floor manufacturers in circulating a list
to all members of average costs and freight rates, as well as summaries of sales, prices, and
inventories.

[4]

The apparent difference between American Column and Lumber and Maple Flooring was

that in the latter, the members did not discuss prices at their meetings, and their rules permitted them to
charge individually whatever they wished. It is not unlawful, therefore, for members of an industry to
meet to discuss common problems or to develop statistical information about the industry through a
common association, as long as the discussions do not border on price or on techniques of controlling
prices, such as by restricting output. Usually, it takes evidence of collusion to condemn the exchange of
prices or other data.

Controlling Output
Competitors also fix prices by controlling an industry’s output. For example, competitors could agree to
limit the amount of goods each company makes or by otherwise limiting the amount that comes to
market. This latter technique was condemned in United States v. Socony-Vacuum Oil Co.

[5]

To prevent oil

prices from dropping, dominant oil companies agreed to and did purchase from independent refiners
surplus gasoline that the market was forcing them to sell at distress prices. By buying up this gasoline, the
large companies created a price floor for their own product. This conduct, said the Court, is a per se
violation.
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Regulating Competitive Methods
Many companies may wish to eliminate certain business practices—for example, offering discounts or
premiums such as trading stamps on purchase of goods—but are afraid or powerless to do so unless their
competitors also stop. The temptation is strong to agree with one’s competitors to jointly end these
practices; in most instances, doing so is unlawful when the result would be to affect the price at which the
product is sold. But not every agreed-on restraint or standard is necessarily unlawful. Companies might
decide that it would serve their customers’ interests as well as their own if the product could be
standardized, so that certain names or marks signify a grade or quality of product. When no restriction is
placed on what grades are to be sold or at what prices, no restraint of trade has occurred.
In National Society of Professional Engineers v. United States, , a canon of ethics of the National Society
of Professional Engineers prohibited members from making competitive bids. This type of prohibition has
been common in the codes of ethics of all kinds of occupational groups that claim professional status.
These groups justify the ban by citing public benefits; though not necessarily price benefits, that flow from
observance of the “ethical” rule.

Non-price Restraints of Trade
Allocating Territories
Suppose four ice-cream manufacturers decided one day that their efforts to compete in all four corners of
the city were costly and destructive. Why not simply strike a bargain: each will sell ice cream to retail
shops in only one quadrant of the city. This is not a pricing arrangement; each is free to sell at whatever
price it desires. But it is a restraint of trade, for in carving up the territory in which each may sell, they
make it impossible for grocery stores to obtain a choice among all four manufacturers. The point becomes
obvious when the same kind of agreement is put on a national scale: suppose Ford and Toyota agreed that
Ford would not sell its cars in New York and Toyota would not sell Toyotas in California.
Most cases of territorial allocation are examples of vertical restraints in which manufacturers and
distributors strike a bargain. But some cases deal with horizontal allocation of territories. In United States
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v. Sealy, the defendant company licensed manufacturers to use the Sealy trademark on beds and
[6]

mattresses and restricted the territories in which the manufacturers could sell. The evidence showed
that the licensees, some thirty small bedding manufacturers, actually owned the licensor and were using
the arrangement to allocate the territory. It was held to be unlawful per se.

Exclusionary Agreements
We said earlier that it might be permissible for manufacturers, through a trade association, to establish
certain quality standards for the convenience of the public. As long as these standards are not
exclusionary and do not reflect any control over price, they might not inhibit competition. The UL mark
on electrical and other equipment—a mark to show that the product conforms to specifications of the
private Underwriters Laboratory—is an example. But suppose that certain widget producers establish the
Scientific Safety Council, a membership association whose staff ostensibly assigns quality labels, marked
SSC, to those manufacturers who meet certain engineering and safety standards. In fact, however, the
manufacturers are using the widespread public acceptance of the SSC mark to keep the market to
themselves by refusing to let nonmembers join and by refusing to let nonmembers use the SSC mark, even
if their widgets conform to the announced standards. This subterfuge would be a violation of Section 1 of
the Sherman Act.

Boycotts
Agreements by competitors to boycott (refuse to deal with) those who engage in undesirable practices are
unlawful. In an early case, a retailers’ trade association circulated a list of wholesale distributors who sold
directly to the public. The intent was to warn member retailers not to buy from those wholesalers.
Although each member was free to act however it wanted, the Court saw in this blacklist a plan to promote
a boycott.

[7]

This policy remains true even if the objective of the boycott is to prevent unethical or even illegal
activities. Members of a garment manufacturers association agreed with a textile manufacturers
association not to use any textiles that had been “pirated” from designs made by members of the textile
association. The garment manufacturers also pledged, among other things, not to sell their goods to any
retailer who did not refrain from using pirated designs. The argument that this was the only way to
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prevent unscrupulous design pirates from operating fell on deaf judicial ears; the Supreme Court held the
policy unlawful under Section 5 of the Federal Trade Commission (FTC) Act, the case having been brought
by the FTC.

[8]

Proof of Agreement
It is vital for business managers to realize that once an agreement or a conspiracy is shown to have
existed, they or their companies can be convicted of violating the law even if neither agreement nor
conspiracy led to concrete results. Suppose the sales manager of Extremis Widget Company sits down
over lunch with the sales manager of De Minimis Widget Company and says, “Why are we working so
hard? I have a plan that will let us both relax.” He explains that their companies can put into operation a
data exchange program that will stabilize prices. The other sales manager does not immediately commit
himself, but after lunch, he goes to the stationery store and purchases a notebook in which to record the
information he will get from a telephone test of the plan. That action is probably enough to establish a
conspiracy to fix prices, and the government could file criminal charges at that point. Discussion with
your competitors of prices, discounts, production quotas, rebates, bid rigging, trade-in allowances,
commission rates, salaries, advertising, and the like is exceedingly dangerous. It can lead to criminal
conduct and potential jail terms.

Proof of Harm
It is unnecessary to show that the public is substantially harmed by a restraint of trade as long as the
plaintiff can show that the restraint injured him. In Klor’s, Inc. v. Broadway-Hale Stores, the plaintiff
was a small retail appliance shop in San Francisco.

[9]

Next door to the shop was a competing appliance

store, one of a chain of stores run by Broadway-Hale. Klor’s alleged that Broadway-Hale, using its
“monopolistic buying power,” persuaded ten national manufacturers and their distributors, including GE,
RCA, Admiral, Zenith, and Emerson, to cease selling to Klor’s or to sell at discriminatory prices. The
defendants did not dispute the allegations. Instead, they moved for summary judgment on the ground
that even if true, the allegations did not give rise to a legal claim because the public could not conceivably
have been injured as a result of their concerted refusal to deal. As evidence, they cited the un-contradicted
fact that within blocks of Klor’s, hundreds of household appliance retailers stood ready to sell the public
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the very brands Klor’s was unable to stock as a result of the boycott. The district court granted the motion
and dismissed Klor’s complaint. The court of appeals affirmed. But the Supreme Court reversed, saying as
follows:
This combination takes from Klor’s its freedom to buy appliances in an open competitive market and
drives it out of business as a dealer in the defendants’ products. It deprives the manufacturers and
distributors of their freedom to sell to Klor’s.…It interferes with the natural flow of interstate commerce.
It clearly has, by its “nature” and “character,” a “monopolistic tendency.” As such it is not to be tolerated
merely because the victim is just one merchant whose business is so small that his destruction makes little
difference to the economy. Monopoly can surely thrive by the elimination of such small businessmen, one
at a time, as it can by driving them out in large groups.
We have been exploring the Sherman Act as it applies to horizontal restraints of trade—that is, restraints
of trade between competitors. We now turn our attention to vertical restraints—those that are the result of
agreements or conspiracies between different levels of the chain of distribution, such as manufacturer and
wholesaler or wholesaler and retailer.

KEY TAKEAWAY
Competitors can engage in horizontal restraints of trade by various means of price-fixing. They can also
engage in horizontal price restraints of trade by allocating territories or by joint boycotts (refusals to
deal). These restraints need not be substantial in order to be actionable as a violation of US antitrust
laws.

EXERCISES
1.

Suppose that BMW of North America tells its dealers that the prestigious M100 cannot be sold for
more than $230,000. Explain why this could be a violation of antitrust law.

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2.

Suppose that JPMorgan Chase, the Bank of England, and the Bank of China agree that they will not
compete for investment services, and that JPMorgan Chase is given an exclusive right to North and
South America, Bank of England is given access rights to Europe, and Bank of China is given exclusive
rights to Asia, India, and Australia. Is there a violation of US antitrust law here? If not, why not? If so,
what act does it violate, and how?

3.

“It’s a free country.” Why are agreements by competitors to boycott (to refuse to deal with) certain
others considered a problem that needs to be dealt with by law?

[1] United States v. Trenton Potteries, 273 U.S. 392 (1927).
[2] Kiefer-Stewart Co. v. Joseph E. Seagram & Sons, 340 U.S. 211 (1951).
[3] American Column and Lumber Company v. United States, 257 U.S. 377 (1921).
[4] Maple Flooring Manufacturers’ Association v. United States, 268 U.S. 563 (1925).
[5] United States v. Socony-Vacuum Oil Co., 310 U.S. 150 (1940).
[6] United States v. Sealy, 388 U.S. 350 (1967).
[7] Eastern State Lumber Dealers’ Association v. United States, 234 U.S. 600 (1914).
[8] Fashion Originators’ Guild of America v. Federal Trade Commission, 312 U.S. 457 (1941).
[9] Klor’s, Inc. v. Broadway-Hale Stores, 359 U.S. 207 (1959).

16.3 Vertical Restraints of Trade
LEARNING OBJECTIVES
1.

Distinguish vertical restraints of trade from horizontal restraints of trade.

2.

Describe exclusive dealing, and explain why exclusive dealing is anticompetitive in any way.

3.

Explain how tying one product’s sale to that of another could be anticompetitive.

We have been exploring the Sherman Act as it applies to horizontal restraints of trade, restraints that are
created between competitors. We now turn to vertical restraints—those that result from agreements

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between different levels of the chain of distribution, such as manufacturer and wholesaler or wholesaler
and retailer.

Resale Price Maintenance
Is it permissible for manufacturers to require distributors or retailers to sell products at a set price?
Generally, the answer is no, but the strict per se rule against any kind of resale price maintenance has
been somewhat relaxed.
But why would a manufacturer want to fix the price at which the retailer sells its goods? There are several
possibilities. For instance, sustained, long-term sales of many branded appliances and other goods
depend on reliable servicing by the retailer. Unless the retailer can get a fair price, it will not provide good
service. Anything less than good service will ultimately hurt the brand name and lead to fewer sales.
Another possible argument for resale price maintenance is that unless all retailers must abide by a certain
price, some goods will not be stocked at all. For instance, the argument runs, bookstores will not stock
slow-selling books if they cannot be guaranteed a good price on best sellers. Stores free to discount best
sellers will not have the profit margin to stock other types of books. To guarantee sales of best sellers to
bookstores carrying many lines of books, it is necessary to put a floor under the price of books. Still
another argument is that brand-name goods are inviting targets for loss-leader sales; if one merchant
drastically discounts Extremis Widgets, other merchants may not want to carry the line, and the
manufacturer may experience unwanted fluctuations in sales.
None of these reasons has completely appeased the critics of price-fixing, including the most important
critics—the US federal judges. As long ago as 1910, in Dr. Miles Medical Co. v. John D. Park & Sons Co.,
the Supreme Court declared vertical price-fixing (what has come to be called resale price maintenance)
unlawful under the Sherman Act. Dr. Miles Medical Company required wholesalers that bought its
proprietary medicines to sign an agreement in which they agreed not to sell below a certain price and not
to sell to retailers who did not have a “retail agency contract” with Dr. Miles. The retail agency contract
similarly contained a price floor. Dr. Miles argued that since it was free to make or not make the
medicines, it should be free to dictate the prices at which purchasers could sell them. The Court said that
Dr. Miles’s arrangement with more than four hundred jobbers (wholesale distributors) and twenty-five
thousand retailers was no different than if the wholesalers or retailers agreed among themselves to fix the
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price. Dr. Miles “having sold its product at prices satisfactory to itself, the public is entitled to whatever
advantage may be derived from a competition in the subsequent traffic.”

[1]

In Dr. Miles, the company’s restrictions impermissibly limited the freedom of choice of other drug
distributors and retailers. Society was therefore deprived of various benefits it would have received from
unrestricted distribution of the drugs. But academics and some judges argue that most vertical price
restraints do not limit competition among competitors, and manufacturers retain the power to restrict
output, and the power to raise prices. Arguably, vertical price restraints help to ensure economic
efficiencies and maximize consumer welfare. Some of the same arguments noted in this section—such as
the need to ensure good service for retail items—continue to be made in support of a rule of reason.
The Supreme Court has not accepted these arguments with regard to minimum prices but has increased
the plaintiff’s burden of proof by requiring evidence of an agreement on specific price levels. Where a
discounter is terminated by a manufacturer, it will probably not be told exactly why, and very few
manufacturers would be leaving evidence in writing that insists on dealers agreeing to minimum prices.
Moreover, in State Oil Company v. Khan, the Supreme Court held that “vertical maximum price fixing,
like the majority of commercial arrangements subject to the antitrust laws, should be evaluated under the
rule of reason.”

[2]

Vertical maximum price-fixing is not legal per se but should be analyzed under a rule of

reason “to identify the situations in which it amounts to anti-competitive conduct.” The Khan case is at
the end of this chapter, in Section 16.8.2 "Vertical Maximum Price Fixing and the Rule of Reason".

Exclusive Dealing and Tying
We move now to a non-price vertical form of restraint. Suppose you went to the grocery store intent on
purchasing a bag of potato chips to satisfy a late-night craving. Imagine your surprise—and indignation—
if the store manager waved a paper in your face and said, “I’ll sell you this bag only on the condition that
you sign this agreement to buy all of your potato chips in the next five years from me.” Or if he said, “I’ll
sell only if you promise never to buy potato chips from my rival across the street.” This is
an exclusive dealing agreement, and if the effect may be to lessen competition substantially, it is unlawful
under Section 3 of the Clayton Act. It also may be unlawful under Section 1 of the Sherman Act and
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Section 5 of the Federal Trade Commission (FTC) Act. Another form of exclusive dealing, known as
a tying contract, is also prohibited under Section 3 of the Clayton Act and under the other statutes. A tying
contract results when you are forced to take a certain product in order to get the product you are really
after: “I’ll sell you the potato chips you crave, but only if you purchase five pounds of my Grade B liver.”
Section 3 of the Clayton Act declares it unlawful for any person engaged in commerce
to lease or make a sale or contract for sale of goods, wares, merchandise, machinery, supplies or other
commodities, whether patented or unpatented, for use, consumption or resale…or fix a price charged
therefore, or discount from or rebate upon, such price, on the condition…that the lessee or
purchaser…shall not use or deal in the goods, wares, merchandise, machinery, supplies, or
other commodities of a competitor or competitors of the lessor or seller, where the effect of
such lease, sale, or contract for sale or such condition…may be to substantially lessen competition or tend
to erect a monopoly in any line of commerce. (emphasis added)
Under Section 3, the potato chip example is not unlawful, for you would not have much of an effect on
competition nor tend to create a monopoly if you signed with your corner grocery. But the Clayton Act has
serious ramifications for a producer who might wish to require a dealer to sell only its products—such as a
fast-food franchise that can carry cooking ingredients bought only from the franchisor (Chapter 17 "Unfair
Trade Practices and the Federal Trade Commission"), an appliance store that can carry only one national
brand of refrigerators, or an ice-cream parlor that must buy ice-cream supplies from the supplier of its
machinery.
A situation like the one in the ice-cream example came under review in International Salt Co. v. United
States.

[3]

International Salt was the largest US producer of salt for industrial uses. It held patents on two

machines necessary for using salt products; one injected salt into foodstuffs during canning. It leased
most of these machines to canners, and the lease required the lessees to purchase from International Salt
all salt to be used in the machines. The case was decided on summary judgment; the company did not
have the chance to prove the reasonableness of its conduct. The Court held that it was not entitled to.
International Salt’s valid patent on the machines did not confer on it the right to restrain trade in
unpatented salt. Justice Tom Clark said that doing so was a violation of both Section 1 of the Sherman Act
and Section 3 of the Clayton Act:

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Not only is price-fixing unreasonable, per se, but also it is unreasonable, per se, to foreclose competitors
from any substantial market. The volume of business affected by these contracts cannot be said to be
insignificant or insubstantial, and the tendency of the arrangement to accomplishment of monopoly
seems obvious. Under the law, agreements are forbidden which “tend to create a monopoly,” and it is
immaterial that the tendency is a creeping one rather than one that proceeds at full gallop; nor does the
law await arrival at the goal before condemning the direction of the movement.
In a case involving the sale of newspaper advertising space (to purchase space in the morning paper, an
advertiser would have to take space in the company’s afternoon paper), the government lost because it
could not use the narrower standards of Section 3 and could not prove that the defendant had monopoly
power over the sale of advertising space. (Another afternoon newspaper carried advertisements, and its
sales did not suffer.) In the course of his opinion, Justice Clark set forth the rule for determining legality
of tying arrangements under both the Clayton and Sherman Acts:
When the seller enjoys a monopolistic position in the market for the “tying” product [i.e., the product that
the buyer wants] or if a substantial volume of commerce in the “tied” product [i.e., the product that the
buyer does not want] is restrained, a tying arrangement violates the narrower standards expressed in
section 3 of the Clayton Act because from either factor the requisite potential lessening of competition is
inferred. And because for even a lawful monopolist it is “unreasonable per se to foreclose competitors
from any substantial market” a tying arrangement is banned by section 1 of the Sherman Act wherever
both conditions are met.

[4]

This rule was broadened in 1958 in a Sherman Act case involving the Northern Pacific Railroad Company,
which had received forty million acres of land from Congress in the late nineteenth century in return for
building a rail line from the Great Lakes to the Pacific. For decades, Northern Pacific leased or sold the
land on condition that the buyer or lessee use Northern Pacific to ship any crops grown on the land or
goods manufactured there. To no avail, the railroad argued that unlike International Salt’s machines, the
railroad’s “tying product” (its land) was not patented, and that the land users were free to ship on other
lines if they could find cheaper rates. Wrote Justice Hugo Black,
[A] tying arrangement may be defined as an agreement by a party to sell one product but only on the
condition that the buyer also purchases a different (or tied) product, or at least agrees that he will not
purchase that product from any other supplier. Where such conditions are successfully exacted
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competition on the merits with respect to the tied product is inevitably curbed…They deny competitors
free access to the market for the tied product, not because the party imposing the tying requirements has a
better product or a lower price but because of his power or leverage in another market. At the same time
buyers are forced to forego their free choice between competing products…They are unreasonable in
and of them whenever a party has sufficient economic power with respect to the tying
product to appreciably restrain free competition in the market for the tied product and a
“not insubstantial” amount of interstate commerce is affected. In this case…the undisputed
facts established beyond any genuine question that the defendant possessed substantial economic power
by virtue of its extensive landholdings which it used as leverage to induce large numbers of purchasers
and lessees to give it preference.

[5]

(emphasis in original)

Taken together, the tying cases suggest that anyone with certain market power over a commodity or other
valuable item (such as a trademark) runs a serious risk of violating the Clayton Act or Sherman Act or
both if he insists that the buyer must also take some other product as part of the bargain. Microsoft
learned about the perils of “tying” in a case brought by the United States, nineteen individual states, and
the District of Columbia. The allegation was that Microsoft had tied together various software programs
on its operating system, Microsoft Windows. Windows came prepackaged with Microsoft’s Internet
Explorer (IE), its Windows Media Player, Outlook Express, and Microsoft Office. The United States
claimed that Microsoft had bundled (or “tied”) IE to sales of Windows 98, making IE difficult to remove
from Windows 98 by not putting it on the Remove Programs list.
The government alleged that Microsoft had designed Windows 98 to work “unpleasantly” with Netscape
Navigator and that this constituted an illegal tying of Windows 98 and IE. Microsoft argued that its web
browser and mail reader were just parts of the operating system, included with other personal computer
operating systems, and that the integration of the products was technologically justified. The United
States Court of Appeals for the District of Columbia Circuit rejected Microsoft’s claim that IE was simply
one facet of its operating system, but the court held that the tie between Windows and IE should be
analyzed deferentially under the rule of reason. The case settled before reaching final judicial resolution.
[6]

(See United States v. Microsoft. )

Non-price Vertical Restraints: Allocating Territory and Customers
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With horizontal restraints of trade, we have already seen that it is a per se violation of Section 1 of the
Sherman Act for competitors to allocate customers and territory. But a vertical allocation of customers or
territory is only illegal if competition to the markets as a whole is adversely affected. The key here is
distinguishing intra-brand competition from inter-brand competition. Suppose that Samsung electronics
has relationships with ten different retailers in Gotham City. If Samsung decides to limit its contractual
relationships to only six retailers, the market for consumer electronics in Gotham City is still competitive
in terms of inter-brand competition. Intra-brand competition, however, is now limited. It could be that
consumers will pay slightly higher prices for Samsung electronics with only six different retailers selling
those products in Gotham City. That is, intra-brand competition is lowered, but inter-brand competition
remains strong.
Notice that it is unlikely that the six remaining retailers will raise their prices substantially, since there is
still strong inter-brand competition. If the retailer only deals in Samsung electronics, it is unlikely to raise
prices that much, given the strength of inter-brand competition.
If the retailer carries Samsung and other brands, it will also not want to raise prices too much, for then its
inventory of Samsung electronics will pile up, while its inventory of other electronics products will move
off the shelves.
Why would Samsung want to limit its retail outlets in Gotham City at all? It may be that Samsung has
decided that by firming up its dealer network, it can enhance service, offer a wider range of products at
each of the remaining retailers, ensure improved technical and service support, increase a sense of
commitment among the remaining retail outlets, or other good business reasons. Where the retailer deals
in other electronic consumer brands as well, making sure that well-trained sales and service support is
available for Samsung products can promote inter-brand competition in Gotham City. Thus vertical
allocation of retailers within the territory is not a per se violation of the Sherman Act. It is instead a rule of
reason violation, or the law will intervene only if Samsung’s activities have an anticompetitive effect on
the market as a whole. Notice here that the only likely objections to the new allocation would come from
those dealers who were contractually terminated and who are then effectively restricted from selling
Samsung electronics.
There are other potentially legitimate territorial restrictions, and limits on what kind of customer the
retailer can sell to will prevent a dealer or distributor from selling outside a certain territory or to a certain
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class of customers. Samsung may reduce its outlets in Iowa from four to two, and it may also impose
limits on those retail outlets from marketing beyond certain areas in and near Iowa.
Suppose that a Monsanto representative selling various kinds of fertilizers and pesticides was permitted to
sell only to individual farmers and not to co-ops or retail distributors, or was limited to the state of Iowa.
The Supreme Court has held that such vertical territorial or customer searches are not per se violations of
Section 1 of the Sherman Act, as the situations often increase “inter-brand competition.” Thus the rule of
reason will apply to vertical allocation of customers and territory.

Non-price Vertical Restraints: Exclusive Dealing Agreements
Often, a distributor or retailer agrees with the manufacturer or supplier not to carry the products of any
other supplier. This is not in itself (per se) illegal under Section 1 of the Sherman Act or Section 3 of the
Clayton Act. Only if these exclusive dealing contracts have an anticompetitive effect will there be an
antitrust violation. Ideally, in a competitive market, there are no significant barriers to entry. In the real
world, however, various deals are made that can and do restrict entry. Suppose that on his farm in
Greeley, Colorado, Richard Tucker keeps goats, and he creates a fine, handcrafted goat cheese for the
markets in Denver, Fort Collins, and Boulder, Colorado, and Cheyenne, Wyoming. In these markets, if
Safeway, Whole Foods, Albertsons, and King Soopers already have suppliers, and the suppliers have
gained exclusive dealing agreements, Tucker will be effectively barred from the market.
Suppose that Billy Goat Cheese is a nationally distributed brand of goat cheese and has created exclusive
dealing arrangements with the four food chains in the four cities. Tucker could sue Billy Goat for violating
antitrust laws if he finds out about the arrangements. But the courts will not assume a per se violation has
taken place. Instead, the courts will look at the number of other distributors available, the portion of the
market foreclosed by the exclusive dealing arrangements, the ease with which new distributors could
enter the market, the possibility that Tucker could distribute the product himself, and legitimate business
reasons that led the distributors to accept exclusive dealing contracts from Billy Goat Cheese.

KEY TAKEAWAY

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Vertical restraints of trade can be related to price, can be in the form of tying arrangements, and can
be in the form of allocating customers and territories. Vertical restraints can also come in the form of
exclusive dealing agreements.

EXERCISES
1.

Explain how a seller with a monopoly in one product and tying the sale of that product to a new
product that has no such monopoly is in any way hurting competition. How “free” is the buyer to
choose a product different from the seller’s?

2.

If your company wants to maintain its image as a high-end product provider, is it legal to create a floor
for your product’s prices? If so, under what circumstances?

[1] Dr. Miles Medical Co. v. John D. Park & Sons Co., 220 U.S. 373 (1910).
[2] State Oil Company v. Khan, 522 U.S. 3 (1997).
[3] International Salt Co. v. United States, 332 U.S. 392 (1947).
[4] Times-Picayune Publishing Co. v. United States, 345 U.S. 594 (1953).
[5] Northern Pacific Railway Co. v. United States, 356 U.S. 1 (1958).
[6] United States v. Microsoft, 253 F.3d 34 (D.C. Cir. 2001).

16.4 Price Discrimination: The Robinson-Patman Act
LEARNING OBJECTIVES
1.

Understand why Congress legislated against price-cutting by large companies.

2.

Recognize why price discrimination is not per se illegal.

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3.

Identify and explain the defenses to a Robinson-Patman price discrimination charge.

If the relatively simple and straightforward language of the Sherman Act can provide litigants and courts
with interpretive headaches, the law against price discrimination—the Robinson-Patman Act—can strike
the student with a crippling migraine. Technically, Section 2 of the Clayton Act, the Robinson-Patman
Act, has been verbally abused almost since its enactment in 1936. It has been called the “Typhoid Mary of
Antitrust,” a “grotesque manifestation of the scissors and paste-pot method” of draftsmanship. Critics
carp at more than its language; many have asserted over the years that the act is anticompetitive because
it prevents many firms from lowering their prices to attract more customers.
Despite this rhetoric, the Robinson-Patman Act has withstood numerous attempts to modify or repeal it,
and it can come into play in many everyday situations. Although in recent years the Justice Department
has declined to enforce it, leaving government enforcement efforts to the Federal Trade Commission
(FTC), private plaintiffs are actively seeking treble damages in numerous cases. So whether it makes
economic sense or not, the act is a living reality for marketers. This section introduces certain problems
that lurk in deciding how to price goods and how to respond to competitors’ prices.
The Clayton Act’s original Section 2, enacted in 1914, was aimed at the price-cutting practice of the large
trusts, which would reduce the price of products below cost where necessary in a particular location to
wipe out smaller competitors who could not long sustain such losses. But the original Clayton Act
exempted from its terms any “discrimination in price…on account of differences in the quantity of the
commodity sold.” This was a gaping loophole that made it exceedingly difficult to prove a case of price
discrimination.
Not until the Depression in the 1930s did sufficient cries of alarm over price discrimination force
Congress to act. The alarm was centered on the practices of large grocery chains. Their immense buying
power was used as a lever to pry out price discounts from food processors and wholesalers. Unable to
extract similar price concessions, the small mom-and-pop grocery stores found that they could not offer
the retail customer the lower food prices set by the chains. The small shops began to fail. In 1936,
Congress strengthened Section 2 by enacting the Robinson-Patman Act. Although prompted by concern
about how large buyers could use their purchasing power, the act in fact places most of its restrictions on
the pricing decisions of sellers.

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The Statutory Framework
The heart of the act is Section 2(a), which reads in pertinent part as follows: “[I]t shall be unlawful for any
person engaged in commerce…to discriminate in price between different purchasers of commodities of
like grade and quality…where the effect of such discrimination may be substantially to lessen competition
or tend to create a monopoly in any line of commerce, or to injure, destroy or prevent competition with
any person who either grants or knowingly receives the benefit of such discrimination, or with customers
of either of them.”
This section provides certain defenses to a charge of price discrimination. For example, differentials in
price are permissible whenever they “make only due allowances for differences in the cost of manufacture,
sale, or delivery resulting from the differing methods or quantities in which such commodities are to such
purchasers sold or delivered.” This section also permits sellers to change prices in response to changing
marketing conditions or the marketability of the goods—for example, if perishable goods begin to
deteriorate, the seller may drop the price in order to move the goods quickly.
Section 2(b) provides the major defense to price discrimination: any price is lawful if made in good faith
to meet competition.

Discrimination by the Seller
Preliminary Matters
Simultaneous Sales
To be discriminatory, the different prices must have been charged in sales made at the same time or
reasonably close in time. What constitutes a reasonably close time depends on the industry and the
circumstances of the marketplace. The time span for dairy sales would be considerably shorter than that
for sales of mainframe computers, given the nature of the product, the frequency of sales, the unit cost,
and the volatility of the markets.

Identity of Purchaser
Another preliminary issue is the identity of the actual purchaser. A supplier who deals through a dummy
wholesaler might be charged with price discrimination even though on paper only one sale appears to
have been made. Under the “indirect purchaser” doctrine, a seller who deals with two or more retail
customers but passes their orders on to a single wholesaler and sells the total quantity to the wholesaler in
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one transaction can be held to have violated the act. The retailers are treated as indirect purchasers of the
supplier.

Sales of Commodities
The act applies only to sales of commodities. A lease, a rental, or a license to use a product does not
constitute a sale; hence price differentials under one of those arrangements cannot be unlawful under
Robinson-Patman. Likewise, since the act applies only to commodities—tangible things—the courts have
held that it does not apply to the sale of intangibles, such as rights to license or use patents, shares in a
mutual fund, newspaper or television advertising, or title insurance.

Goods of Like Grade and Quality
Only those sales involving goods of “like grade and quality” can be tested under the act for discriminatory
pricing. What do these terms mean? The leading case is FTC v. Borden Co., in which the Supreme Court
ruled that trademarks and labels do not, for Robinson-Patman purposes, distinguish products that are
otherwise the same.

[1]

Grade and quality must be determined “by the characteristics of the product itself.”

When the products are physically or chemically identical, they are of like grade and quality, regardless of
how imaginative marketing executives attempt to distinguish them. But physical differences that affect
marketability can serve to denote products as being of different grade and quality, even if the differences
are slight and do not affect the seller’s cost in manufacturing or marketing.

Competitive Injury
To violate the Robinson-Patman Act, the seller’s price discrimination must have an anticompetitive effect.
The usual Clayton Act standard for measuring injury applies to Robinson-Patman violations—that is, a
violation occurs when the effect may be substantially to lessen competition or tend to create a monopoly
in any line of commerce. But because the Robinson-Patman Act has a more specific test of competitive
injury, the general standard is rarely cited.
The more specific test measures the impact on particular persons affected. Section 2(a) says that it is
unlawful to discriminate in price where the effect is “to injure, destroy, or prevent competition with any
person who grants or knowingly receives the benefit of such discrimination or to customers of either of
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them.” The effect—injury, destruction, or prevention of competition—is measured against three types of
those suffering it: (1) competitors of the seller or supplier (i.e., competitors of the person who “grants” the
price discrimination), (2) competitors of the buyer (i.e., competitors of the buyer who “knowingly receives
the benefit” of the price differential), and (3) customers of either of the two types of competitors. As we
will see, the third category presents many difficulties.
For purposes of our discussion, assume the following scenario: Ace Brothers Widget Company
manufactures the usual sizes and styles of American domestic widgets. It competes primarily with
National Widget Corporation, although several smaller companies make widgets in various parts of the
country. Ace Brothers is the largest manufacturer and sells throughout the United States. National sells
primarily in the western states. The industry has several forms of distribution. Many retailers buy directly
from Ace and National, but several regional and national wholesalers also operate, including Widget
Jobbers, Ltd. and Widget Pushers, LLC. The retailers in any particular city compete directly against each
other to sell to the general public. Jobbers and Pushers are in direct competition. Jobbers also sells
directly to the public, so that it is in direct competition with retailers as well as Widget Pushers. As
everyone knows, widgets are extremely price sensitive, being virtually identical in physical appearance
and form.

Primary-Line Injury
Now consider the situation in California, Oregon, and Wisconsin. The competing manufacturers, Ace
Brothers and National Widgets, both sell to wholesalers in California and Oregon, but only Ace have a
sales arm in Wisconsin. Seeing an opportunity, Ace drops its prices to wholesalers in California and
Oregon and raises them in Wisconsin, putting National at a competitive disadvantage. This situation,
illustrated in Figure 16.2 "Primary-Line Injury", is an example of primary-line injury—the injury is done
directly to a competitor of the company that differentiates its prices. This is price discrimination, and it is
prohibited under Section 2(a).

Figure 16.2 Primary-Line Injury

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Most forms of primary-line injury have a geographical basis, but they need not. Suppose National sells
exclusively to Jobbers in northern California, and Ace Brothers sells both to Jobbers and several other
wholesalers. If Ace cuts its prices to Jobbers while charging higher prices to the other wholesalers, the
effect is also primary-line injury to National. Jobbers will obviously want to buy more from Ace at lower
prices, and National’s reduced business is therefore a direct injury. If Ace intends to drive National out of
business, this violation of Section 2(a) could also be an attempt to monopolize in violation of Section 2 of
the Sherman Act.

Secondary-Line Injury
Next, we consider injury done to competing buyers. Suppose that Ace Brothers favors Jobbers—or those
Jobbers, a powerful and giant wholesaler induces Ace to act favorably by threatening not to carry Ace’s
line of widgets otherwise. Although Ace continues to supply both Jobbers and Widget Pushers, it cuts its
prices to Jobbers. As a result, Jobbers can charge its retail customers lower prices than can Pushers, so
that Pusher’s business begins to slack off. This is secondary-line injury at the buyer’s level. Jobbers and
Pushers are in direct competition, and by impairing Pusher’s ability to compete, the requisite injury has
been committed. This situation is illustrated in Figure 16.3 "Secondary-Line Injury".

Figure 16.3Secondary-Line Injury

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Variations on this secondary-line injury are possible. Assume Ace Brothers sells directly to Fast Widgets, a
retail shop, and also to Jobbers. Jobbers sell to retail shops that compete with Fast Widgets and also
directly to consumers. The situation is illustrated in Figure 16.4 "Variation on Secondary-Line Injury").

Figure 16.4 Variations on Secondary-Line Injury

If Ace favors Jobbers by cutting its prices, discriminating against Fast Widgets, the transaction is
unlawful, even though Jobbers and Fast Widgets do not compete for sales to other retailers. Their
competition for the business of ultimate consumers is sufficient to establish the illegality of the
discrimination. A variation on this situation was at issue in the first important case to test Section 2(a) as
it affects buyers. Morton Salt sold to both wholesalers and retailers, offering quantity discounts. Its
pricing policy was structured to give large buyers great savings, computed on a yearly total, not on
shipments made at any one time. Only five retail chains could take advantage of the higher discounts, and
as a result, these chains could sell salt to grocery shoppers at a price below that at which the chains’ retail
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competitors could buy it from their wholesalers. See Figure 16.5 "Variation: Morton Salt Co." for a
schematic illustration. In this case, FTC v. Morton Salt Co., the Supreme Court for the first time declared
that the impact of the discrimination does not have to be actual; it is enough if there is a “reasonable
possibility” of competitive injury.

[2]

Figure 16.5 Variation: Morton Salt Co.

In order to make out a case of secondary-line injury, it is necessary to show that the buyers purchasing at
different prices are in fact competitors. Suppose that Ace Brothers sells to Fast Widgets, the retailer, and
also to Boron Enterprises, a manufacturer that incorporates widgets in most of its products. Boron does
not compete against Fast Widgets, and therefore Ace Brothers may charge different prices to Boron and
Fast without fearing Robinson-Patman repercussions. Figure 16.6 "Variation: Boron-Fast
Schematic" shows the Boron-Fast schematic.

Figure 16.6 Variation: Boron-Fast Schematic

Third-Line Injury
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Second-line injury to buyers does not exhaust the possibilities. Robinson-Patman also works against socalled third-line or tertiary-line injury. At stake here is injury another rung down the chain of distribution.
Ace Brothers sells to Pushers, which processes unfinished widgets in its own factory and sells them in turn
directly to retail customers. Ace also sells to Jobbers, a wholesaler without processing facilities. Jobbers
sell to retail shops that can process the goods and sell directly to consumers, thus competing with Pushers
for the retail business. This distribution chain is shown schematically in Figure 16.7 "Third-Line Injury".

Figure 16.7 Third-Line Injury

If Ace’s price differs between Pushers and Jobbers so that Jobbers is able to sell at a lower price to the
ultimate consumers than Pushers, a Robinson-Patman violation has occurred.

Fourth-Line Injury
In a complex economy, the distribution chain can go on and on. So far, we have examined discrimination
on the level of competing supplier-sellers, on the level of competing customers of the supplier-seller, and
on the level of competing customers of customers of the supplier-seller. Does the vigilant spotlight of
Robinson-Patman penetrate below this level? The Supreme Court has said yes. In Perkins v. Standard Oil
Co., the Court said that “customer” in Section 2(a) means any person who distributes the supplier-seller’s
product, regardless of how many intermediaries are involved in getting the product to him.

[3]

Seller’s Defenses
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Price discrimination is not per se unlawful. The Robinson-Patman Act allows the seller two general
defenses: (1) cost justification and (2) meeting competition. If the seller can demonstrate that sales to one
particular buyer are cheaper than sales to others, a price differential is permitted if it is based entirely on
the cost differences. For example, if one buyer is willing to have the goods packed in cheaper containers or
larger crates that save money that savings can be passed along to the buyer. Similarly, a buyer who takes
over a warehousing function formerly undertaken by the seller is entitled to have the cost saving reflected
in the selling price. Suppose the buyer orders its entire requirements for the year from the manufacturer,
a quantity many times greater than that taken by any other customer. This large order permits the
manufacturer to make the goods at a considerably reduced unit cost. May the manufacturer pass those
savings along to the quantity buyer? It may, as long as it does not pass along the entire savings but only
that attributable to the particular buyer, for other buyers add to its total production run and thus
contribute to the final unit production cost. The marketing manager should be aware that the courts
strictly construe cost-justification claims, and few companies have succeeded with this defense.

Meeting Competition
Lowering a price to meet competition is a complete defense to a charge of price discrimination. Assume
Ace Brothers is selling widgets to retailers in Indiana and Kentucky at $100 per dozen. National Widgets
suddenly enters the Kentucky market and, because it has lower manufacturing costs than Ace, sells
widgets to the four Kentucky widget retailers at $85 per dozen. Ace may lower its price to that amount in
Kentucky without lowering its Indiana price. However, if National’s price violated the Robinson-Patman
Act and Ace knew or should have known that it did, Ace may not reduce its price.
The defense of meeting competition has certain limitations. For example, the seller may not use this
defense as an excuse to charge different customers a price differential over the long run. Moreover, if
National’s lower prices result from quantity orders, Ace may reduce its prices only for like quantities. Ace
may not reduce its price for lesser quantities if National charges more for smaller orders. And although
Ace may meet National’s price to a given customer, Ace may not legally charge less.
Section 2(c) prohibits payment of commissions by one party in a transaction to the opposite party (or to
the opposite party’s agent) in a sale of goods unless services are actually rendered for them. Suppose the
buyer’s broker warehouses the goods. May the seller pass along this cost to the broker in the form of a
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rebate? Isn’t that “services rendered”? Although it might seem so, the courts have said no, because they
refuse to concede that a buyer’s broker or agent can perform services for the seller. Because Section 2(c) of
the Robinson-Patman Act stands on its own, the plaintiff need prove only that a single payment was
made. Further proof of competitive impact is unnecessary. Hence Section 2(c) cases are relatively easy to
win once the fact of a brokerage commission is uncovered.

Allowances for Merchandising and Other Services
Sections 2(d) and 2(e) of the Robinson-Patman Act prohibit sellers from granting discriminatory
allowances for merchandising and from performing other services for buyers on a discriminatory basis.
These sections are necessary because price alone is far from the only way to offer discounts to favored
buyers. Allowances and services covered by these sections include advertising allowances, floor and
window displays, warehousing, return privileges, and special packaging.

KEY TAKEAWAY
Under the Robinson-Patman Act, it is illegal to charge different prices to different purchasers if the
items are the same and the price discrimination lessens competition. It is legal, however, to charge a
lower price to a specific buyer if the cost of serving that buyer is lower or if the seller is simply
“meeting competition.”

EXERCISES
1.

Nikon sells its cameras to retailers at 5 percent less in the state of California than in Nevada or
Arizona. Without knowing more, can you say that this is illegal?

2.

Tysons Foods sells its chicken wings to GFS and other very large distributors at a price per wing that is
10 percent less than it sells to most grocery store chains. The difference is attributable to
transportation costs, since GFS and others accept shipments in very large containers, which cost less
to deliver than smaller containers. Is the price differential legal?

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3.

Your best customer, who has high volume with your company, asks you for a volume discount.
Actually, he demands this, rather than just asking. Under what circumstances, if any, can you grant
this request without violating antitrust laws?

[1] FTC v. Borden Co., 383 U.S. 637 (1966).
[2] FTC v. Morton Salt Co., 334 U.S. 37 (1948).
[3] Perkins v. Standard Oil Co., 395 U.S. 642 (1969).

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16.5 Exemptions
LEARNING OBJECTIVE
1.

Know and describe the various exemptions from US antitrust law.

Regulated Industries
Congress has subjected several industries to oversight by specific regulatory agencies. These include
banking, securities and commodities exchanges, communications, transportation, and fuel and energy.
The question often arises whether companies within those industries are immune to antitrust attack. No
simple answer can be given. As a general rule, activities that fall directly within the authority of the
regulatory agency are immune. The agency is said to have exclusive jurisdiction over the conduct—for
example, the rate structure of the national stock exchanges, which are supervised by the Securities and
Exchange Commission. But determining whether a particular case falls within a specific power of an
agency is still up to the courts, and judges tend to read the antitrust laws broadly and the regulatory laws
narrowly when they seem to clash. A doctrine known as primary jurisdiction often dictates that the
question of regulatory propriety must first be submitted to the agency before the courts will rule on an
antitrust question. If the agency decides the activity complained of is otherwise impermissible, the
antitrust question becomes moot.

Organized Labor
In the Clayton Act, Congress explicitly exempted labor unions from the antitrust laws in order to permit
workers to band together. Section 6 says that “the labor of a human being is not a commodity or article of
commerce. Nothing contained in the antitrust laws shall be construed to forbid the existence and
operation of labor…organizations…nor shall such organizations or the members thereof, be held or
construed to be illegal combinations or conspiracies in restraint of trade, under the antitrust laws.” This
provision was included to reverse earlier decisions of the courts that had applied the Sherman Act more
against labor than business. Nevertheless, the immunity is not total, and unions have run afoul of the laws
when they have combined with non-labor groups to achieve a purpose unlawful under the antitrust laws.
Thus a union could not bargain with an employer to sell its products above a certain price floor.

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Insurance Companies
Under the McCarran-Ferguson Act of 1945, insurance companies are not covered by the antitrust laws to
the extent that the states regulate the business of insurance. Whether or not the states adequately regulate
insurance and the degree to which the exemption applies are complex questions, and there has been some
political pressure to repeal the insurance exemption.

State Action
In 1943, the Supreme Court ruled in Parker v. Brown that when a valid state law regulates a particular
industry practice and the industry members are bound to follow that law, then they are exempt from the
federal antitrust laws.

[1]

Such laws include regulation of public power and licensing and regulation of the

professions. This exemption for “state action” has proved troublesome and, like the other exemptions, a
complex matter to apply. But it is clear that the state law must require or compel the action and not
merely permit it. No state law would be valid if it simply said, “Bakers in the state may jointly establish
tariffs for the sale of cookies.”
The recent trend of Supreme Court decisions is to construe the exemption as narrowly as possible. A city,
county, or other subordinate unit of a state is not immune under the Parker doctrine. A municipality can
escape the consequences of antitrust violations—for example, in its operation of utilities—only if it is
carrying out express policy of the state. Even then, a state-mandated price-fixing scheme may not survive
a federal antitrust attack. New York law required liquor retailers to charge a certain minimum price, but
because the state itself did not actively supervise the policy it had established, it fell to the Supreme
Court’s antitrust axe.

Group Solicitation of Government
Suppose representatives of the railroad industry lobby extensively and eventually successfully for state
legislation that hampers truckers, the railroads’ deadly enemies. Is this a combination or conspiracy to
restrain trade? In Eastern Railroad President’s Conference v. Noerr Motor Freight, Inc., the Supreme
Court said no.

[2]

What has come to be known as the Noerr doctrine holds that applying the antitrust laws

to such activities would violate First Amendment rights to petition the government. One exception to this
rule of immunity for soliciting action by the government comes when certain groups seek to harass
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competitors by instituting state or federal proceedings against them if the claims are baseless or known to
be false. Nor does the Noerr doctrine apply to horizontal boycotts even if the object is to force the
government to take action. In FTC v. Superior Court Trial Lawyers Assn., the Supreme Court held that a
group of criminal defense lawyers had clearly violated the Sherman Act when they agreed among
themselves to stop handling cases on behalf of indigent defendants to force the local government to raise
the lawyers’ fees.

[3]

The Court rejected their claim that they had a First Amendment right to influence the

government through a boycott to pay a living wage so that indigent defendants could be adequately
represented.

Baseball
Baseball, the Supreme Court said back in 1923, is not “in commerce.” Congress has never seen fit to
overturn this doctrine. Although some inroads have been made in the way that the leagues and clubs may
exercise their power, the basic decision stands. Some things are sacred.

KEY TAKEAWAY
For various reasons over time, certain industries and organized groups have been exempted from the
operation of US antitrust laws. These include organized labor, insurance companies, and baseball. In
addition, First Amendment concerns allow trade groups to solicit both state and federal governments,
and state law may sometimes provide a “state action” exemption.

EXERCISE
1.

Do a little Internet research. Find out why Curt Flood brought an antitrust lawsuit against Major
League Baseball and what the Supreme Court did with his case.

[1] Parker v. Brown, 317 U.S. 341 (1943).
[2] Eastern Railroad President’s Conference v. Noerr Motor Freight, Inc., 365 U.S. 127 (1961).
[3] FTC v. Superior Court Trial Lawyers Assn., 493 U.S. 411 (1990).

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16.6 Sherman Act, Section 2: Concentrations of Market Power
LEARNING OBJECTIVES
1.

Understand the ways in which monopoly power can be injurious to competition.

2.

Explain why not all monopolies are illegal under the Sherman Act.

3.

Recognize the importance of defining the relevant market in terms of both geography and product.

4.

Describe the remedies for Sherman Act Section 2 violations.

Introduction
Large companies, or any company that occupies a large portion of any market segment, can thwart
competition through the exercise of monopoly power. Indeed, monopoly means the lack of
competition, or at least of effective competition. As the Supreme Court has long defined it, monopoly is
“the power to control market prices or exclude competition.”

[1]

Public concern about the economic and

political power of the large trusts, which tended to become monopolies in the late nineteenth century, led
to Section 2 of the Sherman Act in 1890 and to Section 7 of the Clayton Act in 1914. These statutes are not
limited to the giants of American industry, such as ExxonMobil, Microsoft, Google, or AT&T. A far smaller
company that dominates a relatively small geographic area or that merges with another company in an
area where few others compete can be in for trouble under Sections 2 or 7. These laws should therefore be
of concern to all businesses, not just those on the Fortune500 list. In this section, we will consider how
the courts have interpreted both the Section 2 prohibition against monopolizing and the Section 7
prohibition against mergers and acquisitions that tend to lessen competition or to create monopolies.
Section 2 of the Sherman Act reads as follows: “Every person who shall monopolize, or attempt to
monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade
or commerce among the several states, or with foreign nations, shall be deemed guilty of a [felony].”
We begin the analysis of Section 2 with the basic proposition that a monopoly is not per se unlawful.
Section 2 itself makes this proposition inescapable: it forbids the act of monopolizing, not the condition or
attribute of monopoly. Why should that be so? If monopoly power is detrimental to a functioning
competitive market system, why shouldn’t the law ban the very existence of a monopoly?
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The answer is that we cannot hope to have “perfect competition” but only “workable competition.” Any
number of circumstances might lead to monopolies that we would not want to eliminate. Demand for a
product might be limited to what one company could produce, there thus being no incentive for any
competitor to come into the market. A small town may be able to support only one supermarket,
newspaper, or computer outlet. If a company is operating efficiently through economies of scale, we would
not want to split it apart and watch the resulting companies fail. An innovator may have a field all to him,
yet we would not want to penalize the inventor for his very act of invention. Or a company might simply
be smarter and more efficient, finally coming to stand alone through the very operation of competitive
pressures. It would be an irony indeed if the law were to condemn a company that was forged in the fires
of competition itself. As the Supreme Court has said, the Sherman Act was designed to protect
competition, not competitors.
A company that has had a monopoly position “thrust upon it” is perfectly lawful. The law penalizes not the
monopolist as such but the competitor who gains his monopoly power through illegitimate means with
intent to become a monopolist, or who after having become a monopolist acts illegitimately to maintain
his power.
A Section 2 case involves three essential factors:
1.

What is the relevant market for determining dominance? The question of relevant market has two
aspects: a geographic market dimension and a relevant product market dimension. It makes a
considerable difference whether the company is thought to be a competitor in ten states or only one. A
large company in one state may appear tiny matched against competitors operating in many states.
Likewise, if the product itself has real substitutes, it makes little sense to brand its maker a
monopolist. For instance, Coca-Cola is made by only one company, but that does not make the CocaCola Company a monopoly, for its soft drink competes with many in the marketplace.

2. How much monopoly power is too much? What share of the market must a company have to be
labeled a monopoly? Is a company with 50 percent of the market a monopoly? 75 percent? 90
percent?
3. What constitutes an illegitimate means of gaining or maintaining monopoly power?
These factors are often closely intertwined, especially the first two. This makes it difficult to examine each
separately, but to the extent possible, we will address each factor in the order given.
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Relevant Markets: Product Market and Geographic Market
Product Market
The monopolist never exercises power in the abstract. When exercised, monopoly power is used to set
prices or exclude competition in the market for a particular product or products. Therefore it is essential
in any Section 2 case to determine what products to include in the relevant market.
The Supreme Court looks at “cross-elasticity of demand” to determine the relevant market. That is, to
what degree can a substitute be found for the product in question if the producer sets the price too high?
If consumers stay with the product as its price rises, moving to a substitute only at a very high price, then
the product is probably in a market by itself. If consumers shift to another product with slight rises in
price, then the product market is “elastic” and must include all such substitutes.

Geographic Market
A company doesn’t have to dominate the world market for a particular product or service in order to be
held to be a monopolist. The Sherman Act speaks of “any part” of the trade or commerce. The Supreme
Court defines this as the “area of effective competition.” Ordinarily, the smaller the part the government
can point to, the greater its chances of prevailing, since a company usually will have greater control over a
single marketplace than a regional or national market. Because of this, alleged monopolists will usually
argue for a broad geographic market, while the government tries to narrow it by pointing to such factors
as transportation costs and the degree to which consumers will shop outside the defined area.

Monopoly Power
After the relevant product and geographic markets are defined, the next question is whether the
defendant has sufficient power within them to constitute a monopoly. The usual test is the market share
the alleged monopolist enjoys, although no rigid rule or mathematical formula is possible. In United
States v. Aluminum Company of America, presented in Section 16.8.3 "Acquiring and Maintaining a
Monopoly" of this chapter, Judge Learned Hand said that Alcoa’s 90 percent share of the ingot market
was enough to constitute a monopoly but that 64 percent would have been doubtful.

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[2]

In a case against

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DuPont many years ago, the court looked at a 75 percent market share in cellophane but found that the
relevant market (considering the cross-elasticity of demand) was not restricted to cellophane.

Monopolization: Acquiring and Maintaining a Monopoly
Possessing a monopoly is not per se unlawful. Once a company has been found to have monopoly power
in a relevant market, the final question is whether it either acquired its monopoly power in an unlawful
way or has acted unlawfully to maintain it. This additional element of “deliberateness” does not mean that
the government must prove that the defendant intended monopolization, in the sense that what
it desired was the complete exclusion of all competitors. It is enough to show that the monopoly would
probably result from its actions, for as Judge Hand put it, “No monopolist monopolizes unconscious of
what he is doing.”
What constitutes proof of unlawful acquisition or maintenance of a monopoly? In general, proof is made
by showing that the defendant’s acts were aimed at or had the probable effect of excluding competitors
from the market. Violations of Section 1 or other provisions of the antitrust laws are examples. “Predatory
pricing”—charging less than cost—can be evidence that the defendant’s purpose was monopolistic, for
small companies cannot compete with large manufacturers capable of sustaining continued losses until
the competition folds up and ceases operations.
In United States v. Lorain Journal Company, the town of Lorain, Ohio, could support only one
newspaper.

[3]

With a circulation of twenty thousand, the Lorain Journal reached more than 99 percent of

the town’s families. The Journal had thus lawfully become a monopoly. But when a radio station was set
up, the paper found itself competing directly for local and national advertising. To retaliate,
the Journal refused to accept advertisements unless the advertiser agreed not to advertise on the local
station. The Court agreed that this was an unlawful attempt to boycott and hence was a violation of
Section 2 because the paper was using its monopoly power to exclude a competitor. (Where was the
interstate commerce that would bring the activity under federal law? The Court said that the radio station
was in interstate commerce because it broadcast national news supported by national advertising.)
Practices that help a company acquire or maintain its monopoly position need not be unlawful in them. In
the Aluminum Company case, Alcoa claimed its monopoly power was the result of superior business skills
and techniques. These superior skills led it to constantly build plant capacity and expand output at every
opportunity. But Judge Hand thought otherwise, given that for a quarter of a century other producers
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could not break into the market because Alcoa acted at every turn to make it impossible for them to
compete, even as Alcoa increased its output by some 800 percent. Judge Hand’s explanation remains the
classic exposition.

Innovation as Evidence of Intent to Monopolize
During the 1970s, several monopolization cases seeking huge damages were filed against a number of
well-known companies, including Xerox, International Business Machines (IBM), and Eastman Kodak. In
particular, IBM was hit with several suits as an outgrowth of the Justice Department’s lawsuit against the
computer maker. (United States v. IBM was filed in 1969 and did not terminate until 1982, when the
government agreed to drop all charges, a complete victory for the company.) The plaintiffs in many of
these suits—SCM Corporation against Xerox, California Computer Products Incorporated against IBM
(the Calcomp case), Berkey Photo Incorporated against Kodak—charged that the defendants had
maintained their alleged monopolies by strategically introducing key product innovations that rendered
competitive products obsolete. For example, hundreds of computer companies manufacture peripheral
equipment “plug-compatible” with IBM computers. Likewise, Berkey manufactured film usable in Kodak
cameras. When the underlying products are changed—mainframe computers, new types of cameras—the
existing manufacturers are left with unusable inventory and face a considerable time lag in designing new
peripheral equipment. In some of these cases, the plaintiffs managed to obtain sizable treble damage
awards—SCM won more than $110 million, IBM initially lost one case in the amount of $260 million, and
Berkey bested Kodak to the tune of $87 million. Had these cases been sustained on appeal, a radical new
doctrine would have been imported into the antitrust laws—that innovation for the sake of competing is
unlawful.
None of these cases withstood appellate scrutiny. The Supreme Court has not heard cases in this area, so
the law that has emerged is from decisions of the federal courts of appeals. A typical case is ILC
Peripherals Leasing Corp. v. International Business Machines (the Memorex case).

[4]

Memorex argued

that among other things, IBM’s tactic of introducing a new generation of computer technology at lower
prices constituted monopolization. The court disagreed, noting that other companies could “reverse
engineer” IBM equipment much more cheaply than IBM could originally design it and that IBM
computers and related products were subject to intense competition to the benefit of plug-compatible
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equipment users. The actions of IBM undoubtedly hurt Memorex, but they were part and parcel of the
competitive system, the very essence of competition. “This kind of conduct by IBM,” the court said, “is
precisely what the antitrust laws were meant to encourage. Memorex sought to use the antitrust laws to
make time stand still and preserve its very profitable position. This court will not assist it and the others
who would follow after in this endeavor.”
The various strands of the innovation debate are perhaps best summed up in Berkey Photo, Inc. v.
Eastman Kodak Company, Section 16.8.4 "Innovation and Intent to Monopolize".

Attempts to Monopolize
Section 2 prohibits not only actual monopolization but also attempts to monopolize. An attempt need not
succeed to be unlawful; a defendant who tries to exercise sway over a relevant market can take no legal
comfort from failure. In any event, the plaintiff must show a specific intent to monopolize, not merely
intent to commit the act or acts that constitute the attempt.

Remedies
Since many of the defendant’s acts that constitute Sherman Act Section 2 monopolizing are also violations
of Section 1 of the Clayton Act, why should plaintiffs resort to Section 2 at all? What practical difference
does Section 2 make? One answer is that not every act of monopolizing is a violation of another law.
Leasing and pricing practices that are perfectly lawful for an ordinary competitor may be unlawful only
because of Section 2. But the more important reason is the remedy provided by the Sherman Act:
divestiture. In the right case, the courts may order the company broken up.
In the Standard Oil decision of 1911, the Supreme Court held that the Standard Oil Company constituted a
monopoly and ordered it split apart into separate companies. Several other trusts were similarly dealt
with. In many of the early cases, doing so posed no insuperable difficulties, because the companies
themselves essentially consisted of separate manufacturing plants knit together by financial controls. But
not every company is a loose confederation of potentially separate operating companies.
The Alcoa case (Section 16.8.3 "Acquiring and Maintaining a Monopoly") was fraught with difficult
remedial issues. Judge Hand’s opinion came down in 1945, but the remedial side of the case did not come
up until 1950. By then the industry had changed radically, with the entrance of Reynolds and Kaiser as
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effective competitors, reducing Alcoa’s share of the market to 50 percent. Because any aluminum
producer needs considerable resources to succeed and because aluminum production is crucial to national
security, the later court refused to order the company broken apart. The court ordered Alcoa to take a
series of measures that would boost competition in the industry. For example, Alcoa stockholders had to
divest themselves of the stock of a closely related Canadian producer in order to remove Alcoa’s control of
that company; and the court rendered unenforceable a patent-licensing agreement with Reynolds and
Kaiser that required them to share their inventions with Alcoa, even though neither the Canadian tie nor
the patent agreements were in themselves unlawful.
Although the trend has been away from breaking up the monopolist, it is still employed as a potent
remedy. In perhaps the largest monopolization case ever brought—United States v. American Telephone
& Telegraph Company—the government sought divestiture of several of AT&T’s constituent companies,
including Western Electric and the various local operating companies. To avoid prolonged litigation,
AT&T agreed in 1982 to a consent decree that required it to spin off all its operating companies,
companies that had been central to AT&T’s decades-long monopoly.

KEY TAKEAWAY
Aggressive competition is good for consumers and for the market, but if the company has enough
power to control a market, the benefits to society decrease. Under Section 2 of the Sherman Act, it is
illegal to monopolize or attempt to monopolize the market. If the company acquires a monopoly in the
wrong way, using wrongful tactics, it is illegal under Section 2. Courts will look at three questions to see
if a company has illegally monopolized a market: (1) What is the relevant market? (2) Does the
company control the market? and (3) How did the company acquire or maintain its control?

EXERCISES
1.

Mammoth Company, through three subsidiaries, controls 87 percent of the equipment to operate
central station hazard-detecting devices; these devices are used to prevent burglary and detect fires
and to provide electronic notification to police and fire departments at a central location. In an
antitrust lawsuit, Mammoth Company claims that there are other means of protecting against

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burglary and it therefore does not have monopoly power. Explain how the Justice Department may be
able to prove its claim that Mammoth Company is operating an illegal monopoly.
2.

Name the sanctions used to enforce Section 2 of the Sherman Act.

3.

Look at any news database or the Department of Justice antitrust website for the past three years and
describe a case involving a challenge to the exercise of a US company’s monopoly power.

[1] United States v. Grinnell Corp., 384 U.S. 563, 571 (1966).
[2] United States v. Aluminum Co. of America, 148 F.2d 416 (2d Cir. 1945).
[3] United States v. Lorain Journal Company, 342 U.S. 143 (1951).
[4] ILC Peripherals Leasing Corp. v. International Business Machines, 458 F.Supp. 423 (N.D. Cal. 1978).

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16.7 Acquisitions and Mergers under Section 7 of the Clayton
Act
LEARNING OBJECTIVES
1.

Distinguish the three kinds of mergers.

2.

Describe how the courts will define the relevant market in gauging the potential anticompetitive
effects of mergers and acquisitions.

Neither Section 1 nor Section 2 of the Sherman Act proved particularly useful in barring mergers between
companies or acquisition by one company of another. As originally written, neither did the Clayton Act,
which prohibited only mergers accomplished through the sale of stock, not mergers or acquisitions
carried out through acquisition of assets. In 1950, Congress amended the Clayton Act to cover the
loophole concerning acquisition of assets. It also narrowed the search for relevant market; henceforth, if
competition might be lessened in any line of commerce in any section of the country, the merger is
unlawful.
As amended, the pertinent part of Section 7 of the Clayton Act reads as follows:
[N]o corporation engaged in commerce shall acquire, directly or indirectly, the whole or any part of the
stock or other share capital and no corporation subject to the jurisdiction of the Federal Trade
Commission shall acquire the whole or any part of the assets of another corporation engaged also in
commerce, where in any line of commerce in any section of the country, the effect of such acquisition may
be substantially to lessen competition, or to tend to create a monopoly.
No corporation shall acquire, directly or indirectly, the whole or any part of the stock or other share
capital and no corporation subject to the jurisdiction of the Federal Trade Commission shall acquire the
whole or any part of the assets of one or more corporations engaged in commerce, where in any line of
commerce in any section of the country, the effect of such acquisition, of such stock or assets, or of the use
of such stock by the voting or granting of proxies or otherwise, may be substantially to lessen competition,
or to tend to create a monopoly.

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Definitions
Mergers and Acquisitions
For the sake of brevity, we will refer to both mergers and acquisitions as mergers. Mergers are usually
classified into three types: horizontal, vertical, and conglomerate.

Horizontal
A horizontal merger is one between competitors—for example, between two bread manufacturers or two
grocery chains competing in the same locale.

Vertical
A vertical merger is that of a supplier and a customer. If the customer acquires the supplier, it is known as
backward vertical integration; if the supplier acquires the customer, it is forward vertical integration. For
example, a book publisher that buys a paper manufacturer has engaged in backward vertical integration.
Its purchase of a bookstore chain would be forward vertical integration.

Conglomerate Mergers
Conglomerate mergers do not have a standard definition but generally are taken to be mergers between
companies whose businesses are not directly related. Many commentators have subdivided this category
into three types. In a “pure” conglomerate merger, the businesses are not related, as when a steel
manufacturer acquires a movie distributor. In a product-extension merger, the manufacturer of one
product acquires the manufacturer of a related product—for instance, a producer of household cleansers,
but not of liquid bleach, acquires a producer of liquid bleach. In a market-extension merger, a company in
one geographic market acquires a company in the same business in a different location. For example,
suppose a bakery operating only in San Francisco buys a bakery operating only in Palo Alto. Since they
had not completed before the merger, this would not be a horizontal merger.

General Principles
As in monopolization cases, a relevant product market and geographic market must first be marked out to
test the effect of the merger. But Section 7 of the Clayton Act has a market definition different from that of
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Section 2. Section 7 speaks of “any line of commerce in any section of the country” (emphasis added). And
its test for the effect of the merger is the same as that which we have already seen for exclusive dealing
cases governed by Section 3: “may be substantially to lessen competition or to tend to create a monopoly.”
Taken together, this language makes it easier to condemn an unlawful merger than an unlawful
monopoly. The relevant product market is any line of commerce, and the courts have taken this language
to permit the plaintiff to prove the existence of “submarkets” in which the relative effect of the merger is
greater. The relevant geographic market is any section of the country, which means that the plaintiff can
show the appropriate effect in a city or a particular region and not worry about having to show the effect
in a national market. Moreover, as we have seen, the effect is one of probability, not actuality. Thus the
question is, Might competition be substantially lessened? Rather than, was competition in fact
substantially lessened? Likewise, the question is, did the merger tend to create a monopoly? rather than,
Did the merger in fact create a monopoly?
In United States v. du Pont, the government charged that du Pont’s “commanding position as General
Motors’ supplier of automotive finishes and fabrics” was not achieved on competitive merit alone but
because du Pont had acquired a sizable block of GM stock, and the “consequent close intercompany
relationship led to the insulation of most of the General Motors’ market from free competition,” in
violation of Section 7.

[1]

Between 1917 and 1919, du Pont took a 23 percent stock interest in GM. The

district court dismissed the complaint, partly on the grounds that at least before the 1950 amendment to
Section 7, the Clayton Act did not condemn vertical mergers and partly on the grounds that du Pont had
not dominated GM’s decision to purchase millions of dollars’ worth of automotive finishes and fabrics.
The Supreme Court disagreed with this analysis and sent the case back to trial. The Court specifically held
that even though the stock acquisition had occurred some thirty-five years earlier, the government can
resort to Section 7 whenever it appears that the result of the acquisition will violate the competitive tests
set forth in the section.

Defining the Market
In the seminal Brown Shoe case, the Supreme Court said that the outer boundaries of broad markets “are
determined by the reasonable interchangeability of use or the cross elasticity of demand between the
product itself and substitutes for it” but that narrower “well defined submarkets” might also be
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appropriate lines of commerce.

[2]

In drawing market boundaries, the Court said, courts should

realistically reflect “[c]ompetition where, in fact, it exists.” Among the factors to consider are “industry or
public recognition of the submarket as a separate economic entity, the product’s peculiar characteristics
and uses, unique production facilities, distinct customers, distinct prices, sensitivity to price changes and
specialized vendors.” To select the geographic market, courts must consider both “the commercial
realities” of the industry and the economic significance of the market.

The Failing Company Doctrine
One defense to a Section 7 case is that one of the merging companies is a failing company. In Citizen
Publishing Company v. United States, the Supreme Court said that the defense is applicable if two
conditions are satisfied.

[3]

First, a company must be staring bankruptcy in the face; it must have virtually

no chance of being resuscitated without the merger. Second, the acquiring company must be the only
available purchaser, and the failing company must have made bona fide efforts to search for another
purchaser.

Beneficial Effects
That a merger might produce beneficial effects is not a defense to a Section 7 case. As the Supreme Court
said in United States v. Philadelphia National Bank, “[A] merger, the effect of which ‘may be substantially
to lessen competition’ is not saved because, on some ultimate reckoning of social or economic debits or
credits, it may be deemed beneficial.”

[4]

And in FTC v. Procter & Gamble Co., the Court said, “Possible
[5]

economies cannot be used as a defense to illegality.” Congress was also aware that some mergers which
lessen competition may also result in economies but it struck the balance in favor of protecting
competition.

Tests of Competitive Effect
Horizontal Mergers
Three factors are critical in assessing whether a horizontal merger may substantially lessen competition:
(1) the market shares of the merging companies, (2) the concentration ratios, and (3) the trends in the
industry toward concentration.
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The first factor is self-evident. A company with 10 percent or even 5 percent of the market is in a different
position from one with less than 1 percent. A concentration ratio indicates the number of firms that
constitute an industry. An industry with only four firms is obviously much more concentrated than one
with ten or seventy firms. Concentration trends indicate the frequency with which firms in the relevant
market have been merging. The first merger in an industry with a low concentration ratio might be
predicted to have no likely effect on competition, but a merger of two firms in a four-firm industry would
obviously have a pronounced effect.
In the Philadelphia National Bank case, the court announced this test in assessing the legality of a
horizontal merger: “[A] merger which produces a firm controlling an undue percentage share of the
relevant market, and results in a significant increase in the concentration of firms in that market is so
inherently likely to lessen competition substantially that it must be enjoined in the absence of evidence
clearly showing that the merger is not likely to have such anticompetitive effects.” In this case, the merger
led to a 30 percent share of the commercial banking market in a four-county region around Philadelphia
and an increase in concentration by more than one-third, and the court held that those numbers
amounted to a violation of Section 7. The court also said that “if concentration is already great, the
importance of preventing even slight increases in concentration and so preserving the possibility of
eventual de-concentration is correspondingly great.”
The Hart-Scott-Rodino Antitrust Improvements Act of 1976 requires certain companies to notify the
Justice Department before actually completing mergers or acquisitions, whether by private negotiation or
by public tender offer. When one of the companies has sales or assets of $100 million or more and the
other company $10 million or more, premerger notification must be provided at least thirty days prior to
completion of the deal—or fifteen days in the case of a tender offer of cash for publicly traded shares if the
resulting merger would give the acquiring company $50 million worth or 15 percent of assets or voting
securities in the acquired company. The rules are complex, but they are designed to give the department
time to react to a merger before it has been secretly accomplished and then announced. The 1976 act gives
the department the authority to seek an injunction against the completion of any such merger, which of
course greatly simplifies the remedial phase of the case should the courts ultimately hold that the merger
would be unlawful. (Note: Section 7 is one of the “tools” in the kit of the lawyer who defends companies

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against unwelcomed takeover attempts: if the target company can point to lines of its business in which it
competes with the acquiring company, it can threaten antitrust action in order to block the merger.)

Vertical Mergers
To prove a Section 7 case involving a vertical merger, the plaintiff must show that the merger forecloses
competition “in a substantial share of” a substantial market. But statistical factors alone do not govern in
a vertical merger. To illustrate, we see that in Ford Motor Co. v. United States, the merger between Ford
and Autolite (a manufacturer of spark plugs) was held unlawful because it eliminated Ford’s potential
entry into the market as an independent manufacturer of spark plugs and because it foreclosed Ford “as a
purchaser of about ten percent of total industry output” of spark plugs.

[6]

This decision underscores the

principle that a company may serve to enhance competition simply by waiting in the wings as a potential
entrant to a market. If other companies feel threatened by a company the size of Ford undertaking to
compete where it had not done so before, the existing manufacturers will likely keep their prices low so as
not to tempt the giant in. Of course, had Ford entered the market on its own by independently
manufacturing spark plugs, it might ultimately have caused weak competitors to fold. As the Court said,
“Had Ford taken the internal-expansion route, there would have been no illegality; not, however, because
the result necessarily would have been commendable, but simply because that course has not been
proscribed.”

Conglomerate Mergers
Recall the definition of a conglomerate merger given in Section 16.7.1 "Definitions". None of the three
types listed has a direct impact on competition, so the test for illegality is more difficult to state and apply
than for horizontal or vertical mergers. But they are nonetheless within the reach of Section 7. In the late
1960s and early 1970s, the government filed a number of divestiture suits against conglomerate mergers.
It did not win them all, and none reached the Supreme Court; most were settled by consent decree,
leading in several instances to divestiture either of the acquired company or of another division of the
acquiring company. Thus International Telephone & Telegraph Company agreed to divest itself of
Canteen Corporation and either of the following two groups: (1) Avis, Levin & Sons, and Hamilton Life
Insurance Company; or (2) Hartford Fire Insurance Company. Ling-Temco-Vought agreed to divest itself
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of either Jones & Laughlin Steel or Braniff Airways and Okonite Corporation. In these and other cases, the
courts have looked to specific potential effects, such as raising the barriers to entry into a market and
eliminating potential competition, but they have rejected the more general claim of “the rising tide of
economic concentration in American industry.”

Entrenching Oligopoly
One way to attack conglomerate mergers is to demonstrate that by taking over a dominant company in an
oligopolistic industry, a large and strong acquiring company will further entrench the oligopoly. In an
oligopolistic industry, just a few major competitors so dominate the industry that competition is quelled.
In FTC v. Procter & Gamble Co., the government challenged Procter & Gamble’s (P&G’s) acquisition of
Clorox. P&G was the leading seller of household cleansers, with annual sales of more than $1 billion.

[7]

In

addition, it was the “nation’s largest advertiser,” promoting its products so heavily that it was able to take
advantage of substantial advertising discounts from the media. Clorox had more than 48 percent of
national sales for liquid bleach in a heavily concentrated industry. Since all liquid bleach is chemically
identical, advertising and promotion plays the dominant role in selling the product. Prior to the merger,
P&G did not make or sell liquid bleach; hence it was a product-extension merger rather than a horizontal
one.
The Supreme Court concluded that smaller firms would fear retaliation from P&G if they tried to compete
in the liquid bleach market and that “a new entrant would be much more reluctant to face the giant
Procter than it would have been to face the smaller Clorox.” Hence “the substitution of the powerful
acquiring firm for the smaller, but already dominant firm may substantially reduce the competitive
structure of the industry by raising entry barriers and by dissuading the smaller firms from aggressively
competing.” The entrenchment theory probably applies only to highly concentrated industries and
dominant firms, however. Many subsequent cases have come out in favor of the defendants on a variety of
grounds—that the merger led simply to a more efficient acquired firm, that the existing competitors were
strong and able to compete, or even that the acquiring firm merely gives the acquired company a deep
pocket to better finance its operations.

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Eliminating Potential Competition
This theory holds that but for the merger, the acquiring company might have competed in the acquired
company’s market. In Procter & Gamble, for example, P&G might have entered the liquid bleach market
itself and thus given Clorox a run for its money. An additional strong company would then have been in
the market. When P&G bought Clorox, however, it foreclosed that possibility. This theory depends on
proof of some probability that the acquiring company would have entered the market. When the acquired
company is small, however, a Section 7 violation is unlikely; these so-called toehold mergers permit the
acquiring company to become a competitive force in an industry without necessarily sacrificing any
preexisting competition.

Reciprocity
Many companies are both heavy buyers and heavy sellers of products. A company may buy from its
customers as well as sell to them. This practice is known in antitrust jargon as reciprocity. Reciprocity is
the practice of a seller who uses his volume of purchases from the buyer to induce the buyer to purchase
from him. The clearest example arose in FTC v. Consolidated Foods Corp.

[8]

Consolidated owned

wholesale grocery outlets and retail food stores. It wanted to merge with Gentry, which made dehydrated
onions and garlic. The Supreme Court agreed that the merger violated Section 7 because of the possibility
of reciprocity: Consolidated made bulk purchases from several food processors, which were purchasers of
dehydrated onions and garlic from Gentry and others. Processors who did not buy from Gentry might feel
pressured to do so in order to keep Consolidated as a customer for their food supplies. If so, other onion
and garlic processors would be foreclosed from competing for sales. A merger that raises the mere
possibility of reciprocity is not per se unlawful, however. The plaintiff must demonstrate that it was
probable the acquiring company would adopt the practice—for example, by conditioning future orders for
supplies on the receipt of orders for onions and garlic—and that doing so would have an anticompetitive
effect given the size of the reciprocating companies and their positions in the market.

Joint Ventures
Section 7 can also apply to joint ventures, a rule first announced in 1964. Two companies, Hooker and
American Potash, dominated sales of sodium chlorate in the Southeast, with 90 percent of the market.
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Pennsalt Chemicals Corporation produced the rest in the West and sold it in the Southeast through Olin
Mathieson Chemical Corporation. The latter two decided to team up, the better to compete with the
giants, and so they formed Penn-Olin, which they jointly owned. The district court dismissed the
government’s suit, but the Supreme Court reinstated it, saying that a joint venture can serve to blunt
competition, or at least potential competition, between the parent companies. The Court said that the
lower court must look to a number of factors to determine whether the joint venture was likely to lessen
competition substantially:
The number and power of the competitors in the relevant market; the background of their growth; the
power of the joint ventures; the relationship of their lines of commerce; competition existing between
them and the power of each in dealing with the competitors of the other; the setting in which the joint
venture was created; the reasons and necessities for its existence; the joint venture’s line of commerce and
the relationship thereof to that of its parents; the adaptability of its line of commerce to non-competitive
practices; the potential power of the joint venture in the relevant market; and appraisal of what the
competition in the relevant market would have been if one of the joint ventures had entered it alone
instead of through Penn-Olin; the effect, in the event of this occurrence, of the other joint venture’s
potential competition; and such other factors as might indicate potential risk to competition in the
relevant market.

[9]

These numerous factors illustrate how the entire economic environment surrounding the joint venture
and mergers in general must be assessed to determine the legalities.

Remedies
The Clayton Act provides that the government may seek divestiture when an acquisition or a merger
violates the act. Until relatively recently, however, it was unresolved whether a private plaintiff could seek
divestiture after proving a Clayton Act violation. In 1990, the Supreme Court unanimously agreed that
divestiture is an available remedy in private suits, even in suits filed by a state’s attorney general on behalf
of consumers.

[10]

This ruling makes it more likely that anti-merger litigation will increase in the future.

During the years of the Reagan administration in the 1980s, the federal government became far less active
in prosecuting antitrust cases, especially merger cases, than it had been in previous decades. Many giant
mergers went unchallenged, like the merger between two oil behemoths, Texaco and Getty, resulting in a
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company with nearly $50 billion in assets in 1984. With the arrival of the first Bush administration in
1989, the talk in Washington antitrust circles was of a renewed interest in antitrust enforcement. The
arrival of the second Bush administration in 2000 brought about an era of less antitrust enforcement than
had been undertaken during the Clinton administration. Whether the Obama administration
reinvigorates antitrust enforcement remains to be seen.

KEY TAKEAWAY
Section 7 prohibits mergers or acquisitions that might tend to lessen competition in any line of
commerce in any section of the country. Mergers and acquisitions are usually classified in one of three
ways: horizontal (between competitors), vertical (between different levels of the distribution chain), or
conglomerate (between businesses that are not directly related). The latter may be divided into
product-extension and market-expansion mergers. The relevant market test is different than in
monopolization cases; in a Section 7 action, relevance of market may be proved.
In assessing horizontal mergers, the courts will look to the market shares of emerging companies,
industry concentration ratios, and trends toward concentration in the industry. To prove a Section 7
case, the plaintiff must show that the merger forecloses competition “in a substantial share of” a
substantial market. Conglomerate merger cases are harder to prove and require a showing of specific
potential effects, such as raising barriers to entry into an industry and thus entrenching monopoly, or
eliminating potential competition. Joint ventures may also be condemned by Section 7. The Hart-ScottRodino Antitrust Improvements Act of 1976 requires certain companies to get premerger notice to the
Justice Department.

EXERCISES
1.

Sirius Satellite radio and XM satellite radio proposed to merge. Was this a horizontal merger, a vertical
merger, or a conglomerate merger? How is the market defined, in terms of both product or service
and geographic area?

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2.

In 2010, Live Nation and Ticketmaster proposed to merge. Was this a horizontal merger, a vertical
merger, or a conglomerate merger? How should the market be defined, in terms of both product or
service and geographic area? Should the US government approve the merger?

[1] United States v. du Pont, 353 U.S. 586 (1957).
[2] Brown Shoe Co., Inc. v. United States, 370 U.S. 294 (1962).
[3] Citizen Publishing Company v. United States, 394 U.S. 131 (1969).
[4] United States v. Philadelphia National Bank, 374 U.S. 321, 371 (1963).
[5] FTC v. Procter & Gamble Co., 386 U.S. 568, 580 (1967).
[6] Ford Motor Co. v. United States, 405 U.S. 562 (1972).
[7] FTC v. Procter & Gamble Co., 386 U.S. 568 (1967).
[8] FTC v. Consolidated Foods Corp., 380 U.S. 592 (1965).
[9] United States v. Penn-Olin Chemical Co., 378 U.S. 158 (1964).
[10] California v. American Stores, 58 U.S.L.W. 4529 (1990).

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16.8 Cases
Horizontal Restraints of Trade
National Society of Professional Engineers v. United States
435 U.S. 679 (1978)
MR. JUSTICE STEVENS delivered the opinion of the Court.
This is a civil antitrust case brought by the United States to nullify an association’s canon of ethics
prohibiting competitive bidding by its members. The question is whether the canon may be justified
under the Sherman Act, 15 U.S. c. § 1 et seq. (1976 ed.), because it was adopted by members of a learned
profession for the purpose of minimizing the risk that competition would produce inferior engineering
work endangering the public safety. The District Court rejected this justification without making any
findings on the likelihood that competition would produce the dire consequences foreseen by the
association. The Court of Appeals affirmed. We granted certiorari to decide whether the District Court
should have considered the factual basis for the proffered justification before rejecting it. Because we are
satisfied that the asserted defense rests on a fundamental misunderstanding of the Rule of Reason
frequently applied in antitrust litigation, we affirm.
Engineering is an important and learned profession. There are over 750,000 graduate engineers in the
United States, of whom about 325,000 are registered as professional engineers. Registration
requirements vary from State to State, but usually require the applicant to be a graduate engineer with at
least four years of practical experience and to pass a written examination. About half of those who are
registered engage in consulting engineering on a fee basis. They perform services in connection with the
study, design, and construction of all types of improvements to real property—bridges, office buildings,
airports, and factories are examples. Engineering fees, amounting to well over $2 billion each year,
constitute about 5% of total construction costs. In any given facility, approximately 50% to 80% of the
cost of construction is the direct result of work performed by an engineer concerning the systems and
equipment to be incorporated in the structure.
The National Society of Professional Engineers (Society) was organized in 1935 to deal with the
nontechnical aspects of engineering practice, including the promotion of the professional, social, and
economic interests of its members. Its present membership of 69,000 resides throughout the United
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States and in some foreign countries. Approximately 12,000 members are consulting engineers who offer
their services to governmental, industrial, and private clients. Some Society members are principals or
chief executive officers of some of the largest engineering firms in the country.
The charges of a consulting engineer may be computed in different ways. He may charge the client a
percentage of the cost of the project, may charge fixed rates per hour for different types of work, may
perform an assignment for a specific sum, or he may combine one or more of these approaches.…This
case…involves a charge that the members of the Society have unlawfully agreed to refuse to negotiate or
even to discuss the question of fees until after a prospective client has selected the engineer for a
particular project. Evidence of this agreement is found in § II(c) of the Society’s Code of Ethics, adopted in
July 1964.
The District Court found that the Society’s Board of Ethical Review has uniformly interpreted the “ethical
rules against competitive bidding for engineering services as prohibiting the submission of any form of
price information to a prospective customer which would enable that customer to make a price
comparison on engineering services.” If the client requires that such information be provided, then § II(c)
imposes an obligation upon the engineering firm to withdraw from consideration for that job.
[P]etitioner argues that its attempt to preserve the profession’s traditional method of setting fees for
engineering services is a reasonable method of forestalling the public harm which might be produced by
unrestrained competitive bidding. To evaluate this argument it is necessary to identify the contours of the
Rule of Reason and to discuss its application to the kind of justification asserted by petitioner.
***
The test prescribed in Standard Oil is whether the challenged contracts or acts “were unreasonably
restrictive of competitive conditions.” Unreasonableness under that test could be based either (I) on the
nature or character of the contracts, or (2) on surrounding circumstances giving rise to the inference or
presumption that they were intended to restrain trade and enhance prices. Under either branch of the
test, the inquiry is confined to a consideration of impact on competitive conditions.
***
Price is the “central nervous system of the economy,” United States v. Socony-Vacuum Oil Co., 310 U.S.
150, 226 n. 59, and an agreement that “interfere[s] with the setting of price by free market forces” is illegal
on its face, United States v. Container Corp., 393 U.S. 333,337. In this case we are presented with an
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agreement among competitors to refuse to discuss prices with potential customers until after negotiations
have resulted in the initial selection of an engineer. While this is not price fixing as such, no elaborate
industry analysis is required to demonstrate the anticompetitive character of such an agreement. It
operates as an absolute ban on competitive bidding, applying with equal force to both complicated and
simple projects and to both inexperienced and sophisticated customers. As the District Court found, the
ban “impedes the ordinary give and take of the market place,” and substantially deprives the customer of
“the ability to utilize and compare prices in selecting engineering services.” On its face, this agreement
restrains trade within the meaning of § 1 of the Sherman Act.
The Society’s affirmative defense confirms rather than refutes the anticompetitive purpose and effect of its
agreement. The Society argues that the restraint is justified because bidding on engineering services is
inherently imprecise, would lead to deceptively low bids, and would thereby tempt individual engineers to
do inferior work with consequent risk to public safety and health. The logic of this argument rests on the
assumption that the agreement will tend to maintain the price level; if it had no such effect, it would not
serve its intended purpose. The Society nonetheless invokes the Rule of Reason, arguing that its restraint
on price competition ultimately inures to the public benefit by preventing the production of inferior work
and by insuring ethical behavior. As the preceding discussion of the Rule of Reason reveals, this Court has
never accepted such an argument.
It may be, as petitioner argues that competition tends to force prices down and that an inexpensive item
may be inferior to one that is more costly. There is some risk, therefore, that competition will cause some
suppliers to market a defective product. Similarly, competitive bidding for engineering projects may be
inherently imprecise and incapable of taking into account all the variables which will be involved in the
actual performance of the project. Based on these considerations, a purchaser might conclude that his
interest in quality—which may embrace the safety of the end product—outweighs the advantages of
achieving cost savings by pitting one competitor against another. Or an individual vendor might
independently refrain from price negotiation until he has satisfied himself that he fully understands the
scope of his customers’ needs. These decisions might be reasonable; indeed, petitioner has provided
ample documentation for that thesis. But these are not reasons that satisfy the Rule; nor are such
individual decisions subject to antitrust attack.

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The Sherman Act does not require competitive bidding; it prohibits unreasonable restraints on
competition. Petitioner’s ban on competitive bidding prevents all customers from making price
comparisons in the initial selection of an engineer, and imposes the Society’s views of the costs and
benefits of competition on the entire marketplace. It is this restraint that must be justified under the Rule
of Reason, and petitioner’s attempt to do so on the basis of the potential threat that competition poses to
the public safety and the ethics of its profession is nothing less than a frontal assault on the basic policy of
the Sherman Act.
The Sherman Act reflects a legislative judgment that ultimately competition will produce not only lower
prices, but also better goods and services. “The heart of our national economic policy long has been faith
in the value of competition.” Standard Oil Co. v. FTC, 340 U.S. 231, 248. The assumption that competition
is the best method of allocating resources in a free market recognizes that all elements of a bargain—
quality, service, safety, and durability—and not just the immediate cost, are favorably affected by the free
opportunity to select among alternative offers. Even assuming occasional exceptions to the presumed
consequences of competition, the statutory policy precludes inquiry into the question whether
competition is good or bad.
***
In sum, the Rule of Reason does not support a defense based on the assumption that competition itself is
unreasonable. Such a view of the Rule would create the “sea of doubt” on which Judge Taft refused to
embark in Addyston, 85 F. 271 (1898), at 284, and which this Court has firmly avoided ever since.
***
The judgment of the Court of Appeals is affirmed.

CASE QUESTIONS
1.

What kinds of harms are likely if there is unrestrained competitive bidding among engineering firms?

2.

By what other means (i.e., not including deliberate nondisclosure of price information up to the time
of contracting) could the National Society of Professional Engineers protect the public from harm?

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Vertical Maximum Price Fixing and the Rule of Reason
State Oil Company v. Barkat U Khan and Khan & Associates
522 U.S. 3 (1997)
Barkat U. Khan and his corporation entered into an agreement with State Oil Company to lease and
operate a gas station and convenience store owned by State Oil. The agreement provided that Khan would
obtain the station’s gasoline supply from State Oil at a price equal to a suggested retail price set by State
Oil, less a margin of 3.25 cents per gallon. Under the agreement, respondents could charge any amount
for gasoline sold to the station’s customers, but if the price charged was higher than State Oil’s suggested
retail price, the excess was to be rebated to State Oil. Respondents could sell gasoline for less than State
Oil’s suggested retail price, but any such decrease would reduce their 3.25 cents-per-gallon margin.
About a year after respondents began operating the gas station, they fell behind in lease payments. State
Oil then gave notice of its intent to terminate the agreement and commenced a state court proceeding to
evict respondents. At State Oil’s request, the state court appointed a receiver to operate the gas station.
The receiver operated the station for several months without being subject to the price restraints in
respondents’ agreement with State Oil. According to respondents, the receiver obtained an overall profit
margin in excess of 3.25 cents per gallon by lowering the price of regular-grade gasoline and raising the
price of premium grades.
Respondents sued State Oil in the United States District Court for the Northern District of Illinois,
alleging in part that State Oil had engaged in price fixing in violation of § 1 of the Sherman Act by
preventing respondents from raising or lowering retail gas prices. According to the complaint, but for the
agreement with State Oil, respondents could have charged different prices based on the grades of
gasoline, in the same way that the receiver had, thereby achieving increased sales and profits. State Oil
responded that the agreement did not actually prevent respondents from setting gasoline prices, and that,
in substance, respondents did not allege a violation of antitrust laws by their claim that State Oil’s
suggested retail price was not optimal.
The District Court entered summary judgment for State Oil on this claim, [finding] that [Khan’s
allegations, if true]…did not establish the sort of “manifestly anticompetitive implications or pernicious
effect on competition” that would justify per se prohibition of State Oil’s conduct. The Seventh Circuit
reversed. The Court of Appeals for the Seventh Circuit reversed the District Court’s grant of summary
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judgment for State Oil on the basis of Albrecht v. Herald Co., 390 U.S. 14 (1968). 93 F.3d 1358 (1996). The
court first noted that the agreement between respondents and State Oil did indeed fix maximum gasoline
prices by making it “worthless” for respondents to exceed the suggested retail prices. After reviewing legal
and economic aspects of price fixing, the court concluded that State Oil’s pricing scheme was a per se
antitrust violation under Albrecht v. Herald Co., supra. Although the Court of Appeals characterized
Albrecht as “unsound when decided” and “inconsistent with later decisions” of this Court, it felt
constrained to follow that decision. The Supreme Court granted certiorari.
Justice Sandra Day O’Connor
We granted certiorari to consider two questions, whether State Oil’s conduct constitutes a per se violation
of the Sherman Act and whether respondents are entitled to recover damages based on that conduct.
****
Although the Sherman Act, by its terms, prohibits every agreement “in restraint of trade,” this Court has
long recognized that Congress intended to outlaw only unreasonable restraints. See, e.g., Arizona v.
Maricopa County Medical Soc., U.S. Supreme Court (1982). As a consequence, most antitrust claims are
analyzed under a “rule of reason,” according to which the finder of fact must decide whether the
questioned practice imposes an unreasonable restraint on competition, taking into account a variety of
factors, including specific information about the relevant business, its condition before and after the
restraint was imposed, and the restraint’s history, nature, and effect.
Some types of restraints, however, have such predictable and pernicious anticompetitive effect, and such
limited potential for pro-competitive benefit, that they are deemed unlawful per se. Northern Pacific R.
Co. v. United States, U.S. Supreme Court (1958). Per se treatment is appropriate “once experience with a
particular kind of restraint enables the Court to predict with confidence that the rule of reason will
condemn it.” Maricopa County (1982). Thus, we have expressed reluctance to adopt per se rules with
regard to “restraints imposed in the context of business relationships where the economic impact of
certain practices is not immediately obvious.” FTC v. Indiana Federation of Dentists, U.S. Supreme Court
(1986).
A review of this Court’s decisions leading up to and beyond Albrecht is relevant to our assessment of the
continuing validity of the per se rule established in Albrecht. Beginning with Dr. Miles Medical Co. v.
John D. Park & Sons Co., U.S. Supreme Court (1911), the Court recognized the illegality of agreements
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under which manufacturers or suppliers set the minimum resale prices to be charged by their distributors.
By 1940, the Court broadly declared all business combinations “formed for the purpose and with the effect
of raising, depressing, fixing, pegging, or stabilizing the price of a commodity in interstate or foreign
commerce” illegal per se. United States v. Socony-Vacuum Oil Co., U.S. Supreme Court (1940).
Accordingly, the Court condemned an agreement between two affiliated liquor distillers to limit the
maximum price charged by retailers in Kiefer-Stewart Co. v. Joseph E. Seagram & Sons, Inc., U.S.
Supreme Court (1951), noting that agreements to fix maximum prices, “no less than those to fix minimum
prices, cripple the freedom of traders and thereby restrain their ability to sell in accordance with their own
judgment.”
In subsequent cases, the Court’s attention turned to arrangements through which suppliers imposed
restrictions on dealers with respect to matters other than resale price. In White Motor Co. v. United
States, U.S. Supreme Court (1963), the Court considered the validity of a manufacturer’s assignment of
exclusive territories to its distributors and dealers. The Court determined that too little was known about
the competitive impact of such vertical limitations to warrant treating them as per se unlawful. Four years
later, in United States v. Arnold, Schwinn & Co., U.S. Supreme Court (1967), the Court reconsidered the
status of exclusive dealer territories and held that, upon the transfer of title to goods to a distributor, a
supplier’s imposition of territorial restrictions on the distributor was “so obviously destructive of
competition” as to constitute a per se violation of the Sherman Act. In Schwinn, the Court acknowledged
that some vertical restrictions, such as the conferral of territorial rights or franchises, could have procompetitive benefits by allowing smaller enterprises to compete, and that such restrictions might avert
vertical integration in the distribution process. The Court drew the line, however, at permitting
manufacturers to control product marketing once dominion over the goods had passed to dealers.
Albrecht, decided [a year after Schwinn], involved a newspaper publisher who had granted exclusive
territories to independent carriers subject to their adherence to a maximum price on resale of the
newspapers to the public. Influenced by its decisions in Socony-Vacuum, Kiefer-Stewart, and Schwinn,
the Court concluded that it was per se unlawful for the publisher to fix the maximum resale price of its
newspapers. The Court acknowledged that “maximum and minimum price fixing may have different
consequences in many situations,” but nonetheless condemned maximum price fixing for “substituting
the perhaps erroneous judgment of a seller for the forces of the competitive market.”
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Nine years later, in Continental T. V., Inc. v. GTE Sylvania, Inc., 433 U.S. 36, 53 L. Ed. 2d 568, 97 S. Ct.
2549 (1977), the Court overruled Schwinn, thereby rejecting application of a per se rule in the context of
vertical non-price restrictions. The Court acknowledged the principle of stare decisis, but explained that
the need for clarification in the law justified reconsideration of Schwinn:
“Since its announcement, Schwinn has been the subject of continuing controversy and confusion, both in
the scholarly journals and in the federal courts. The great weight of scholarly opinion has been critical of
the decision, and a number of the federal courts confronted with analogous vertical restrictions have
sought to limit its reach. In our view, the experience of the past 10 years should be brought to bear on this
subject of considerable commercial importance.”
The Court then reviewed scholarly works supporting the economic utility of vertical non-price
restraints.…The Court concluded that, because “departure from the rule-of-reason standard must be
based upon demonstrable economic effect rather than—as in Schwinn—upon formalistic line drawing,”
the appropriate course would be “to return to the rule of reason that governed vertical restrictions prior
to Schwinn.” Sylvania (1977)
***
Subsequent decisions of the Court…have hinted that the analytical underpinnings of Albrecht were
substantially weakened by Sylvania. We noted in Maricopa County that vertical restraints are generally
more defensible than horizontal restraints…and that decisions such as Sylvania “recognize the possibility
that a vertical restraint imposed by a single manufacturer or wholesaler may stimulate inter-brand
competition even as it reduces intra-brand competition.”
[I]n Atlantic Richfield Co. v. USA Petroleum Co. (ARCO), U.S. Supreme Court (1990),
although Albrecht’s continuing validity was not squarely before the Court, some disfavor with that
decision was signaled by our statement that we would “assume, arguendo, that Albrecht correctly held
that vertical, maximum price fixing is subject to the per se rule.” More significantly, we specifically
acknowledged that vertical maximum price fixing “may have procompetitive inter-brand effects,” and
pointed out that, in the wake of GTE Sylvania, “the procompetitive potential of a vertical maximum price
restraint is more evident…than it was when Albrecht was decided, because exclusive territorial
arrangements and other non-price restrictions were unlawful per se in 1968.”

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Thus, our reconsideration of Albrecht’s continuing validity is informed by several of our decisions, as well
as a considerable body of scholarship discussing the effects of vertical restraints. Our analysis is also
guided by our general view that the primary purpose of the antitrust laws is to protect inter-brand
competition. See, e.g., Business Electronics Corp. v. Sharp Electronics Corp., 485 U.S. 717, 726, 99 L. Ed.
2d 808, 108 S. Ct. 1515 (1988). “Low prices,” we have explained, “benefit consumers regardless of how
those prices are set, and so long as they are above predatory levels, they do not threaten competition.”
ARCO, supra, at 340. Our interpretation of the Sherman Act also incorporates the notion that
condemnation of practices resulting in lower prices to consumers is “especially costly” because “cutting
prices in order to increase business often is the very essence of competition.”
So informed, we find it difficult to maintain that vertically-imposed maximum prices could harm
consumers or competition to the extent necessary to justify their per se invalidation. As Chief Judge
Posner wrote for the Court of Appeals in this case:
As for maximum resale price fixing, unless the supplier is a monopolist he cannot squeeze his dealers’
margins below a competitive level; the attempt to do so would just drive the dealers into the arms of a
competing supplier. A supplier might, however, fix a maximum resale price in order to prevent his dealers
from exploiting a monopoly position.…Suppose that State Oil, perhaps to encourage…dealer services…has
spaced its dealers sufficiently far apart to limit competition among them (or even given each of them an
exclusive territory); and suppose further that Union 76 is a sufficiently distinctive and popular brand to
give the dealers in it at least a modicum of monopoly power. Then State Oil might want to place a ceiling
on the dealers’ resale prices in order to prevent them from exploiting that monopoly power fully. It would
do this not out of disinterested malice, but in its commercial self-interest. The higher the price at which
gasoline is resold, the smaller the volume sold, and so the lower the profit to the supplier if the higher
profit per gallon at the higher price is being snared by the dealer.” 93 F.3d at 1362.
We recognize that the Albrecht decision presented a number of theoretical justifications for a per se rule
against vertical maximum price fixing. But criticism of those premises abounds. The Albrecht decision
was grounded in the fear that maximum price fixing by suppliers could interfere with dealer freedom. 390
U.S. at 152. In response, as one commentator has pointed out, “the ban on maximum resale price
limitations declared in Albrecht in the name of ‘dealer freedom’ has actually prompted many suppliers to
integrate forward into distribution, thus eliminating the very independent trader for whom Albrecht
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professed solicitude.” 7 P. Areeda, Antitrust Law, P1635, p. 395 (1989). For example, integration in the
newspaper industry since Albrecht has given rise to litigation between independent distributors and
publishers.
The Albrecht Court also expressed the concern that maximum prices may be set too low for dealers to
offer consumers essential or desired services. 390 U.S. at 152-153. But such conduct, by driving away
customers, would seem likely to harm manufacturers as well as dealers and consumers, making it unlikely
that a supplier would set such a price as a matter of business judgment.… In addition, Albrecht noted that
vertical maximum price fixing could effectively channel distribution through large or specially-advantaged
dealers. 390 U.S. at 153. It is unclear, however, that a supplier would profit from limiting its market by
excluding potential dealers. See, e.g., Easterbrook, supra, at 905-908. Further, although vertical
maximum price fixing might limit the viability of inefficient dealers, that consequence is not necessarily
harmful to competition and consumers.
Finally, Albrecht reflected the Court’s fear that maximum price fixing could be used to disguise
arrangements to fix minimum prices, 390 U.S. at 153, which remain illegal per se. Although we have
acknowledged the possibility that maximum pricing might mask minimum pricing, see Maricopa County,
457 U.S. at 348, we believe that such conduct—as with the other concerns articulated in Albrecht—can be
appropriately recognized and punished under the rule of reason.…After reconsidering Albrecht’s rationale
and the substantial criticism the decision has received, however, we conclude that there is insufficient
economic justification for per se invalidation of vertical maximum price fixing.
***
Despite what Chief Judge Posner aptly described as Albrecht’s “infirmities, [and] its increasingly wobbly,
moth-eaten foundations,” there remains the question whether Albrecht deserves continuing respect under
the doctrine of stare decisis. The Court of Appeals was correct in applying that principle despite
disagreement with Albrecht, for it is this Court’s prerogative alone to overrule one of its precedents.…We
approach the reconsideration of decisions of this Court with the utmost caution. Stare decisis reflects “a
policy judgment that ‘in most matters it is more important that the applicable rule of law be settled than
that it be settled right.’” Agostini v. Felton, U.S. Supreme Court (1997).

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But “stare decisis is not an inexorable command.” Payne v. Tennessee, U.S. Supreme Court (1991). In the
area of antitrust law, there is a competing interest, well-represented in this Court’s decisions, in
recognizing and adapting to changed circumstances and the lessons of accumulated experience.
…With the views underlying Albrecht eroded by this Court’s precedent, there is not much of that decision
to salvage.… [W]e find its conceptual foundations gravely weakened. In overruling Albrecht, we of course
do not hold that all vertical maximum price fixing is per se lawful. Instead, vertical maximum price fixing,
like the majority of commercial arrangements subject to the antitrust laws, should be evaluated under the
rule of reason.

CASE QUESTIONS
1.

What does Judge Posner of the Seventh Circuit mean when he uses the termmonopsonist? Is he
referring to the respondent (Khan and Associates) or to the State Oil Company?

2.

Explain why State Oil Company would want to set a maximum price. What business benefit is it for
State Oil Company?

3.

The court clearly states that setting maximum price is no longer a per se violation of the Sherman Act
and is thus a rule of reason analysis in each case. What about setting minimum prices? Is setting
minimum prices per se illegal, illegal if it does not pass the rule of reason standard, or entirely legal?

Acquiring and Maintaining a Monopoly
United States v. Aluminum Company of America
148 F.2d 416 (2d Cir. 1945)
JUDGE LEARNED HAND
It does not follow because “Alcoa” had such a monopoly that it “monopolized” the ingot market: it may
not have achieved monopoly; monopoly may have been thrust upon it. If it had been a combination of
existing smelters which united the whole industry and controlled the production of all aluminum ingot, it
would certainly have “monopolized” the market.…We may start therefore with the premise that to have
combined ninety percent of the producers of ingot would have been to “monopolize” the ingot market;

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and, so far as concerns the public interest, it can make no difference whether an existing competition is
put an end to, or whether prospective competition is prevented.…
Nevertheless, it is unquestionably true that from the very outset the courts have at least kept in reserve
the possibility that the origin of a monopoly may be critical in determining its legality; and for this they
had warrant in some of the congressional debates which accompanied the passage of the Act.…This notion
has usua1ly been expressed by saying that size does not determine guilt; that there must be some
“exclusion” of competitors; that the growth must be something else than “natural” or “normal”; that there
must be a “wrongful intent,” or some other specific intent; or that some “unduly” coercive means must be
used. At times there has been emphasis upon the use of the active verb, “monopolize,” as the judge noted
in the case at bar.
A market may, for example, be so limited that it is impossible to produce at all and meet the cost of
production except by a plant large enough to supply the whole demand. Or there may be changes in taste
or in cost which drive out all but one purveyor. A single producer may be the survivor out of a group of
active competitors, merely by virtue of his superior skill, foresight, and industry. In such cases a strong
argument can be made that, although the result may expose the public to the evils of monopoly, the Act
does not mean to condemn the resultant of those very forces which it is its prime object to foster: finis
opus coronal. The successful competitor, having been urged to compete, must not be turned upon when
he wins.
***
[As] Cardozo, J., in United States v. Swift & Co., 286 U.S. 106, p. 116, 52 S. Ct. 460, 463, 76 L.Ed.
999,…said, “Mere size…is not an offense against the Sherman Act unless magnified to the point at which it
amounts to a monopoly…but size carries with it an opportunity for abuse that is not to be ignored when
the opportunity is proved to have been utilized in the past.” “Alcoa’s” size was “magnified” to make it a
“monopoly”; indeed, it has never been anything else; and its size not only offered it an “opportunity for
abuse,” but it “utilized” its size for “abuse,” as can easily be shown.
It would completely misconstrue “Alcoa’s” position in 1940 to hold that it was the passive beneficiary of a
monopoly, following upon an involuntary elimination of competitors by automatically
operative economic forces. Already in 1909, when its last lawful monopoly ended, it sought to strengthen
its position by unlawful practices, and these concededly continued until 1912. In that year it had two
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plants in New York, at which it produced less than 42 million pounds of ingot; in 1934 it had five plants
(the original two, enlarged; one in Tennessee; one in North Carolina; one in Washington), and its
production had risen to about 327 million pounds, an increase of almost eight-fold. Meanwhile not a
pound of ingot had been produced by anyone else in the United States. This increase and this continued
and undisturbed control did not fall un-designed into “Alcoa’s” lap; obviously it could not have done so. It
could only have resulted, as it did result, from a persistent determination to maintain the control, with
which it found itself vested in 1912. There were at least one or two abortive attempts to enter the industry,
but “Alcoa” effectively anticipated and forestalled all competition, and succeeded in holding the field
alone. True, it stimulated demand and opened new uses for the metal, but not without making sure that it
could supply what it had evoked. There is no dispute as to this; “Alcoa” avows it as evidence of the skill,
energy and initiative with which it has always conducted its business: as a reason why, having won its way
by fair means, it should be commended, and not dismembered. We need charge it with no moral
derelictions after 1912; we may assume that all its claims for itself are true. The only question is whether it
falls within the exception established in favor of those who do not seek, but cannot avoid, the control of a
market. It seems to us that that question scarcely survives its statement. It was not inevitable that it
should always anticipate increases in the demand for ingot and be prepared to supply them. Nothing
compelled it to keep doubling and redoubling its capacity before others entered the field. It insists that it
never excluded competitors; but we can think of no more effective exclusion than progressively to
embrace each new opportunity as it opened, and to face every newcomer with new capacity already geared
into a great organization, having the advantage of experience, trade connections and the elite of
personnel. Only in case we interpret “exclusion” as limited to maneuvers not honestly industrial, but
actuated solely by a desire to prevent competition, can such a course, indefatigably pursued, be deemed
not “exclusionary.” So to limit it would in our judgment emasculate the Act; would permit just such
consolidations as it was designed to prevent.
We disregard any question of “intent.” Relatively early in the history of the Act—1905—Holmes, J., in
Swift & Co. v. United States, explained this aspect of the Act in a passage often quoted. Although the
primary evil was monopoly, the Act also covered preliminary steps, which, if continued, would lead to it.
These may do no harm of themselves; but if they are initial moves in a plan or scheme which, carried out,
will result in monopoly, they are dangerous and the law will nip them in the bud.…In order to fall within §
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2, the monopolist must have both the power to monopolize, and the intent to monopolize. To read the
passage as demanding any “specific,” intent, makes nonsense of it, for no monopolist monopolizes
unconscious of what he is doing. So here, “Alcoa” meant to keep, and did keep, that complete and
exclusive hold upon the ingot market with which it started. That was to “monopolize” that market,
however innocently it otherwise proceeded. So far as the judgment held that it was not within § 2, it must
be reversed.

CASE QUESTIONS
1.

Judge Learned Hand claims there would be no violation of the Sherman Act in any case where
a company achieves monopoly through “natural” or “normal” operation of the market.

a.

What language in the Sherman Act requires the plaintiff to show something more than a
company’s monopoly status?

b.

What specifics, if any, does Judge Hand provide that indicate that Alcoa not only had market
dominance but sought to increase its dominance and to exclude competition?
Can you think of a single producer in a given product or geographic market that has achieved that

status because of “peer skill, foresight, and industry”? Is there anything wrong with Alcoa’s selling the
concept of aluminum products to an ever-increasing set of customers and then also ensuring that it
had the capacity to meet the increasing demand?
To stimulate inter-brand competition, would you recommend that Congress change Section 2 so
that any company that had over 80 percent of market share would be “broken up” to ensure
competition? Why is this a bad idea? Or why do you think it is a good idea?

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Innovation and Intent to Monopolize
Berkey Photo, Inc. v. Eastman Kodak Company
603 F.2d 263 (2d Cir. 1979)
IRVING R. KAUFMAN, CHIEF JUDGE
To millions of Americans, the name Kodak is virtually synonymous with photography.…It is one of the
giants of American enterprise, with international sales of nearly $6 billion in 1977 and pre-tax profits in
excess of $1.2 billion.
This action, one of the largest and most significant private antitrust suits in history, was brought by
Berkey Photo, Inc., a far smaller but still prominent participant in the industry. Berkey competes with
Kodak in providing photofinishing services—the conversion of exposed film into finished prints, slides, or
movies. Until 1978, Berkey sold cameras as well. It does not manufacture film, but it does purchase Kodak
film for resale to its customers, and it also buys photofinishing equipment and supplies, including color
print paper, from Kodak.
The two firms thus stand in a complex, multifaceted relationship, for Kodak have been Berkey’s
competitor in some markets and its supplier in others. In this action, Berkey claims that every aspect of
the association has been infected by Kodak’s monopoly power in the film, color print paper, and camera
markets, willfully acquired, maintained, and exercised in violation of § 2 of the Sherman Act, 15 U.S.C. §
2.…Berkey alleges that these violations caused it to lose sales in the camera and photofinishing markets
and to pay excessive prices to Kodak for film, color print paper, and photofinishing equipment.
***
[T]he jury found for Berkey on virtually every point, awarding damages totaling $37,620,130. Judge
Frankel upheld verdicts aggregating $27,154,700 for lost camera and photofinishing sales and for
excessive prices on film and photofinishing equipment.…Trebled and supplemented by attorneys’ fees and
costs pursuant to § 4 of the Clayton Act, 15 U.S.C. § 15, Berkey’s judgment reached a grand total of
$87,091,309.47, with interest, of course, continuing to accrue.
Kodak now appeals this judgment.
The principal markets relevant here, each nationwide in scope, are amateur conventional still cameras,
conventional photographic film, photofinishing services, photofinishing equipment, and color print paper.

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The “amateur conventional still camera” market now consists almost entirely of the so-called 110 and 126
instant-loading cameras. These are the direct descendants of the popular “box” cameras, the best-known
of which was Kodak’s so-called “Brownie.” Small, simple, and relatively inexpensive, cameras of this type
are designed for the mass market rather than for the serious photographer.
Kodak has long been the dominant firm in the market thus defined. Between 1954 and 1973 it never
enjoyed less than 61% of the annual unit sales, nor less than 64% of the dollar volume, and in the peak
year of 1964, Kodak cameras accounted for 90% of market revenues. Much of this success is no doubt due
to the firm’s history of innovation.
Berkey has been a camera manufacturer since its 1966 acquisition of the Keystone Camera Company, a
producer of movie cameras and equipment. In 1968 Berkey began to sell amateur still cameras made by
other firms, and the following year the Keystone Division commenced manufacturing such cameras itself.
From 1970 to 1977, Berkey accounted for 8.2% of the sales in the camera market in the United States,
reaching a peak of 10.2% in 1976. In 1978, Berkey sold its camera division and thus abandoned this
market.
***
One must comprehend the fundamental tension—one might almost say the paradox—that is near the
heart of § 2…
The conundrum was indicated in characteristically striking prose by Judge Hand, who was not able to
resolve it. Having stated that Congress “did not condone ‘good trusts’ and condemn ‘bad’ ones; it forbad
all,” he declared with equal force, “The successful competitor, having been urged to compete, must not be
turned upon when he wins.”…We must always be mindful lest the Sherman Act be invoked perversely in
favor of those who seek protection against the rigors of competition.
***
In sum, although the principles announced by the § 2 cases often appear to conflict, this much is clear.
The mere possession of monopoly power does notipso facto condemns a market participant. But, to avoid
the proscriptions of § 2, the firm must refrain at all times from conduct directed at smothering
competition. This doctrine has two branches. Unlawfully acquired power remains anathema even when
kept dormant. And it is no less true that a firm with a legitimately achieved monopoly may not wield the
resulting power to tighten its hold on the market.
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***
As Kodak had hoped, the 110 system proved to be a dramatic success. In 1972—the system’s first year—the
company sold 2,984,000 Pocket Instamatics, more than 50% of its sales in the amateur conventional still
camera market. The new camera thus accounted in large part for a sharp increase in total market sales,
from 6.2 million units in 1971 to 8.2 million in 1972…
Berkey’s Keystone division was a late entrant in the 110 sweepstakes, joining the competition only in late
1973. Moreover, because of hasty design, the original models suffered from latent defects, and sales that
year were a paltry 42,000. With interest in the 126 dwindling, Keystone thus suffered a net decline of
118,000 unit sales in 1973. The following year, however, it recovered strongly, in large part because
improvements in its pocket cameras helped it sell 406,000 units, 7% of all 110s sold that year.
Berkey contends that the introduction of the 110 system was both an attempt to monopolize and actual
monopolization of the camera market.
***
It will be useful at the outset to present the arguments on which Berkey asks us to uphold its verdict:
Kodak, a film and camera monopolist was in a position to set industry standards. Rivals could not
compete effectively without offering products similar to Kodak’s. Moreover, Kodak persistently refused to
make film available for most formats other than those in which it made cameras. Since cameras are
worthless without film, this policy effectively prevented other manufacturers from introducing cameras in
new formats. Because of its dominant position astride two markets, and by use of its film monopoly to
distort the camera market, Kodak forfeited its own right to reap profits from such innovations without
providing its rivals with sufficient advance information to enable them to enter the market with copies of
the new product on the day of Kodak’s introduction. This is one of several “predisclosure” arguments
Berkey has advanced in the course of this litigation.
***
Through the 1960s, Kodak followed a checkered pattern of predisclosing innovations to various segments
of the industry. Its purpose on these occasions evidently was to ensure that the industry would be able to
meet consumers’ demand for the complementary goods and services they would need to enjoy the new
Kodak products. But predisclosure would quite obviously also diminish Kodak’s share of the auxiliary
markets. It was therefore, in the words of Walter Fallon, Kodak’s chief executive officer, “a matter of
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judgment on each and every occasion” whether predisclosure would be for or against Kodak’s selfinterest. Kodak decided not to release advance information about the new film and format. The decision
was evidently based on the perception of Dr. Louis K. Eilers, Kodak’s chief executive officer at that time
that Kodak would gain more from being first on the market for the sale of all goods and services related to
the 110 system than it would lose from the inability of other photofinishers to process Kodacolor II.
Judge Frankel did not decide that Kodak should have disclosed the details of the 110 to other camera
manufacturers prior to introduction. Instead, he left the matter to the jury…We hold that this instruction
was in error and that, as a matter of law, Kodak did not have a duty to predisclose information about the
110 system to competing camera manufacturers.
As Judge Frankel indicated, and as Berkey concedes, a firm may normally keep its innovations secret from
its rivals as long as it wishes, forcing them to catch up on the strength of their own efforts after the new
product is introduced. It is the possibility of success in the marketplace, attributable to superior
performance that provides the incentives on which the proper functioning of our competitive economy
rests…
Withholding from others advance knowledge of one’s new products, therefore, ordinarily constitutes valid
competitive conduct. Because, as we have already indicated, a monopolist is permitted, and indeed
encouraged, by § 2 to compete aggressively on the merits, any success that it may achieve through “the
process of invention and innovation” is clearly tolerated by the antitrust laws.
***
Moreover, enforced predisclosure would cause undesirable consequences beyond merely encouraging the
sluggishness the Sherman Act was designed to prevent. A significant vice of the theory propounded by
Berkey lies in the uncertainty of its application. Berkey does not contend, in the colorful phrase of Judge
Frankel, that “Kodak has to live in a goldfish bowl,” disclosing every innovation to the world at large.
However predictable in its application, such an extreme rule would be insupportable. Rather, Berkey
postulates that Kodak had a duty to disclose limited types of information to certain competitors under
specific circumstances. But it is difficult to comprehend how a major corporation, accustomed though it is
to making business decisions with antitrust considerations in mind, could possess the omniscience to
anticipate all the instances in which a jury might one day in the future retrospectively conclude that
predisclosure was warranted. And it is equally difficult to discern workable guidelines that a court might
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set forth to aid the firm’s decision. For example, how detailed must the information conveyed be? And
how far must research have progressed before it is “ripe” for disclosure? These inherent uncertainties
would have an inevitable chilling effect on innovation. They go far, we believe, towards explaining why no
court has ever imposed the duty Berkey seeks to create here.
***
We do not perceive, however, how Kodak’s introduction of a new format was rendered an unlawful act of
monopolization in the camera market because the firm also manufactured film to fit the cameras. “The
110 system was in substantial part a camera development.…”
Clearly, then, the policy considerations militating against predisclosure requirements for monolithic
monopolists are equally applicable here. The first firm, even a monopolist, to design a new camera format
has a right to the lead time that follows from its success. The mere fact that Kodak manufactured film in
the new format as well, so that its customers would not be offered worthless cameras, could not deprive it
of that reward.
***
Conclusion We have held that Kodak did not have an obligation, merely because it introduced film and
camera in a new format, to make any predisclosure to its camera-making competitors. Nor did the earlier
use of its film monopoly to foreclose format innovation by those competitors create of its own force such a
duty where none had existed before. In awarding Berkey $15,250,000, just $828,000 short of the
maximum amount demanded, the jury clearly based its calculation of lost camera profits on Berkey’s
central argument that it had a right to be “at the starting line when the whistle blew” for the new system.
The verdict, therefore, cannot stand.

CASE QUESTIONS
1.

Consider patent law. Did Kodak have a legal monopoly on the 110 system (having invented it) for
seventeen years? Did it have any legal obligation to share the technology with others?

2.

Might it have been better business strategy to give predisclosure to Berkey and others about the
necessary changes in film that would come about with the introduction of the 110 camera? How so, or
why not? Is there any way that some sort of predisclosure to Berkey and others would maintain or
sustain good relations with competitors?

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16.9 Summary and Exercises
Summary
Four basic antitrust laws regulate the competitive activities of US business: the Sherman Act, the Clayton
Act, the Federal Trade Commission Act, and the Robinson-Patman Act. The Sherman Act prohibits
restraints of trade and monopolizing. The Clayton Act prohibits a variety of anticompetitive acts,
including mergers and acquisitions that might tend to lessen competition. The Federal Trade Commission
Act prohibits unfair methods of competition and unfair and deceptive acts or practices in commerce. The
Robinson-Patman Act prohibits a variety of price discriminations. (This act is actually an amendment to
the Clayton Act.) These laws are enforced in four ways: (1) by the US Department of Justice, Antitrust
Division; (2) by the Federal Trade Commission; (3) by state attorneys general; and (4) by private litigants.
The courts have interpreted Section 1 of the Sherman Act, prohibiting every contract, combination, or
conspiracy in restraint of trade, by using a rule of reason. Thus reasonable restraints that are ancillary to
legitimate business practices are lawful. But some acts are per se unreasonable, such as price-fixing, and
will violate Section 1. Section 1 restraints of trade include both horizontal and vertical restraints of trade.
Vertical restraints of trade include resale price maintenance, refusals to deal, and unreasonable territorial
restrictions on distributors. Horizontal restraints of trade include price-fixing, exchanging price
information when doing so permits industry members to control prices, controlling output, regulating
competitive methods, allocating territories, exclusionary agreements, and boycotts.
Exclusive dealing contracts and tying contracts whose effects may be to substantially lessen
competition violate Section 3 of the Clayton Act and may also violate both Section 1 of the Sherman Act
and Section 5 of the Federal Trade Commission Act. Requirements and supply contracts are unlawful if
they tie up so much of a commodity that they tend substantially to lessen competition or might tend to do
so.
The Robinson-Patman Act (Section 2 of the Clayton Act) prohibits price discrimination for different
purchasers of commodities of like grade and quality if the effect may be substantially to (1) lessen
competition or tend to create a monopoly in any line of commerce or (2) impair competition with (a) any
person who grants or (b) knowingly receives the benefit of the discrimination, or (c) with customers of
either of them.

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Some industries and groups are insulated from the direct reach of the antitrust laws. These include
industries separately regulated under federal law, organized labor, and insurance companies, activities
mandated under state law, group solicitation government action, and baseball.
Section 2 of the Sherman Act prohibits monopolizing or attempting to monopolize any part of interstate
or foreign trade or commerce. The law does not forbid monopoly as such but only acts or attempts or
conspiracies to monopolize. The prohibition includes the monopolist who has acquired his monopoly
through illegitimate means.
Three factors are essential in a Section 2 case: (1) relevant market for determining dominance, (2) the
degree of monopoly power, and (3) the particular acts claimed to be illegitimate.
Relevant market has two dimensions: product market and geographic market. Since many goods have
close substitutes, the courts look to the degree to which consumers will shift to other goods or suppliers if
the price of the commodity or service in question is priced in a monopolistic way. This test is known as
cross-elasticity of demand. If the cross-elasticity is high—meaning that consumers will readily shift—then
the other goods or services must be included in the product market definition, thus reducing the share of
the market that the defendant will be found to have. The geographic market is not the country as a whole,
because Section 2 speaks in terms of “any part” of trade or commerce. Usually the government or private
plaintiff will try to show that the geographic market is small, since that will tend to give the alleged
monopolist a larger share of it.
Market power in general means the share of the relevant market that the alleged monopolist enjoys. The
law does not lay down fixed percentages, though various decisions seem to suggest that two-thirds of the
market might be too low but three-quarters high enough to constitute monopoly power.
Acts that were aimed at or had the probable effect of excluding competitors from the market are acts of
monopolizing. Examples are predatory pricing and boycotts. Despite repeated claims during the 1970s
and 1980s by smaller competitors, large companies have prevailed in court against the argument that
innovation suddenly sprung on the market without notice is per se evidence of intent to monopolize.
Remedies for Sherman Act Section 2 violations include damages, injunction, and divestiture. These
remedies are also available in Clayton Act Section 7 cases.
Section 7 prohibits mergers or acquisitions that might tend to lessen competition in any line of commerce
in any section of the country. Mergers and acquisitions are usually classified in one of three ways:
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horizontal (between competitors), vertical (between different levels of the distribution chain), or
conglomerate (between businesses that are not directly related). The latter may be divided into productextension and market-expansion mergers. The relevant market test is different than in monopolization
cases; in a Section 7 action, relevance of market may be proved.
In assessing horizontal mergers, the courts will look to the market shares of emerging companies,
industry concentration ratios, and trends toward concentration in the industry. To prove a Section 7 case,
the plaintiff must show that the merger forecloses competition “in a substantial share of” a substantial
market. Conglomerate merger cases are harder to prove and require a showing of specific potential
effects, such as raising barriers to entry into an industry and thus entrenching monopoly, or eliminating
potential competition. Joint ventures may also be condemned by Section 7. The Hart-Scott-Rodino
Antitrust Improvements Act of 1976 requires certain companies to get premerger notice to the Justice
Department.

EXERCISES
1.

To protect its state’s businesses against ruinous price wars, a state legislature has passed a law
permitting manufacturers to set a “suggested resale price” on all goods that they make and sell direct
to retailers. Retailers are forbidden to undercut the resale price by more than 10 percent. A retailer
who violates the law may be sued by the manufacturer for treble damages: three times the difference
between the suggested resale price and the actual selling price. But out-of-state retailers are bound by
no such law and are regularly discounting the goods between 35 and 40 percent. As the general
manager of a large discount store located within a few miles of a city across the state line, you wish to
offer the public a price of only 60 percent of the suggested retail price on items covered by the law in
order to compete with the out-of-state retailers to which your customers have easy access. May you
lower your price in order to compete? How would you defend yourself if sued by a manufacturer
whose goods you discounted in violation of the law?

2.

The DiForio Motor Car Company is a small manufacturer of automobiles and sells to three distributors
in the city of Peoria. The largest distributor, Hugh’s Auras, tells DiForio that it is losing money on its
dealership and will quit selling the cars unless DiForio agrees to give it an exclusive contract. DiForio

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tells the other distributors, whose contracts were renewed from year to year, that it will no longer sell
them cars at the end of the contract year. Smith Autos, one of the other dealers, protests, but DiForio
refuses to resupply it. Smith Autos sues DiForio and Hugh’s. What is the result? Why?
3.

Twenty-five local supermarket chains banded together as Topco Associates Incorporated to sell
groceries under a private label. Topco was formed in 1940 to compete with the giant chains, which
had the economic clout to sell private-label merchandise unavailable to the smaller chains. Topco
acted as a purchasing agent for the members. By the late 1960s, Topco’s members were doing a
booming business: $1.3 billion in retail sales, with market share ranging from 1.5 percent to 16
percent in the markets that members served. Topco-brand groceries accounted for no more than 10
percent of any store’s total merchandise. Under Topco’s rules, members were assigned exclusive
territories in which to sell Topco-brand goods. A member chain with stores located in another
member’s exclusive territory could not sell Topco-brand goods in those stores. Topco argued that the
market division was necessary to give each chain the economic incentive to advertise and develop
brand consciousness and thus to be able to compete more effectively against the large nonmember
supermarkets’ private labels. If other stores in the locality could also carry the Topco brand, then it
would not be a truly “private” label and there would be no reason to tout it; it would be like any
national brand foodstuff, and Topco members did not have the funds to advertise the brand
nationally. Which, if any, antitrust laws have Topco violated? Why?

4.

In 1983, Panda Bears Incorporated, a small manufacturer, began to sell its patented panda bear robot
dolls (they walk, smile, and eat bamboo shoots) to retail toy shops. The public took an immediate
fancy to panda bears, and the company found it difficult to meet the demand. Retail shops sold out
even before their orders arrived. In order to allocate the limited supply fairly while it tooled up to
increase production runs, the company announced to its distributors that it would not sell to any
retailers that did not also purchase its trademarked Panda Bear’s Bambino Bamboo Shoots. It also
announced that it would refuse to supply any retailer that sold the robots for less than $59.95. Finally,
it said that it would refuse to sell to retailers unless they agreed to use the company’s repair services
exclusively when customers brought bears back to repair malfunctions in their delicate, patented
computerized nervous system. By the following year, with demand still rising, inferior competitive
panda robots and bamboo shoots began to appear. Some retailers began to lower the Panda Bear

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price to meet the competition. The company refused to resupply them. Panda Bears Incorporated also
decreed that it would refuse to sell to retailers who carried any other type of bamboo shoot. What
antitrust violations, if any, has Panda Bear Incorporated committed? What additional information
might be useful in helping you to decide?
5.

Elmer has invented a new battery-operated car. The battery, which Elmer has patented, functions for
five hundred miles before needing to be recharged. The car, which he has named The Elmer, is a
sensation when announced, and his factory can barely keep up with the orders. Worried about the
impact, all the other car manufacturers ask Elmer for a license to use the battery in their cars. Elmer
refuses because he wants the car market all to himself. Banks are eager to lend him the money to
expand his production, and within three years he has gained a 5 percent share of the national market
for automobiles. During these years, Elmer has kept the price of The Elmer high, to pay for his large
costs in tooling up a factory. But then it dawns on him that he can expand his market much more
rapidly if he drops his price, so he prices the car to yield the smallest profit margin of any car being
sold in the country. Its retail price is far lower than that of any other domestic car on the market.
Business begins to boom. Within three more years, he has garnered an additional 30 percent of the
market, and he announces at a press conference that he confidently expects to have the market “all to
myself” within the next five years. Fighting for their lives now, the Big Three auto manufacturers
consult their lawyers about suing Elmer for monopolizing. Do they have a case? What is Elmer’s
defense?

6.

National Widget Company is the dominant manufacturer of widgets in the United States, with 72
percent of the market for low-priced widgets and 89 percent of the market for high-priced widgets.
Dozens of companies compete with National in the manufacture and sale of compatible peripheral
equipment for use with National’s widgets, including countertops, holders, sprockets and gear
assemblies, instruction booklets, computer software, and several hundred replacements parts.
Revenues of these peripherals run upwards of $100 million annually. Beginning with the 1981 model
year, National Widget sprang a surprise: a completely redesigned widget that made most of the
peripheral equipment obsolete. Moreover, National set the price for its peripherals below that which
would make economic sense for competitors to invest in new plants to tool up for producing
redesigned peripherals. Five of the largest peripheral-equipment competitors sued National under

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Section 2 of the Sherman Act. One of these, American Widget Peripherals, Inc., had an additional
complaint: on making inquiries in early 1980, American was assured by National’s general manager
that it would not be redesigning any widgets until late 1985 at the earliest. On the basis of that
statement, American invested $50 million in a new plant to manufacture the now obsolescent
peripheral equipment, and as a result, it will probably be forced into bankruptcy. What is the result?
Why? How does this differ, if at all, from the Berkey Camera case?
7.

In 1959, The Aluminum Company of America (Alcoa) acquired the stock and assets of the
Rome Cable Corporation. Alcoa and Rome both manufactured bare and insulated aluminum
wire and cable, used for overhead electric power transmission lines. Rome, but not Alcoa,
manufactured copper conductor, used for underground transmissions. Insulated aluminum
wire and cable is quite inferior to copper, but it can be used effectively for overhead
transmission, and Alcoa increased its share of annual installations from 6.5 percent in 1950 to
77.2 percent in 1959. During that time, copper lost out to aluminum for overhead
transmission. Aluminum and copper conductor prices do not respond to one another; lower
copper conductor prices do not put great pressure on aluminum wire and cable prices. As the
Supreme Court summarized the facts in United States v. Aluminum Co. of America,

[1]

In 1958—the year prior to the merger—Alcoa was the leading producer of aluminum
conductor, with 27.8% of the market; in bare aluminum conductor, it also led the industry with
32.5%. Alcoa plus Kaiser controlled 50% of the aluminum conductor market and, with its three
leading competitors, more than 76%. Only nine concerns (including Rome with 1.3%)
accounted for 95.7% of the output of aluminum conductor, Alcoa was third with 11.6%, and
Rome was eighth with 4.7%. Five companies controlled 65.4% and four smaller ones, including
Rome, added another 22.8%.
The Justice Department sued Alcoa-Rome for violation of Section 7 of the Clayton Act. What is
the government’s argument? What is the result?
8.

Quality Graphics has been buying up the stock of companies that manufacture billboards. Quality now
owns or controls 23 of the 129 companies that make billboards, and its sales account for 3.2 percent
of the total national market of $72 million. In Texas, Quality has acquired 27 percent of the billboard

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market, and in the Dallas–Ft. Worth area alone, about 25 percent. Billboard advertising accounts for
only 0.001 percent of total national advertising sales; the majority goes to newspaper, magazine,
television, and radio advertising. What claims could the Justice Department assert in a suit against
Quality? What is Quality’s defense? What is the result?
9.

The widget industry consists of six large manufacturers who together account for 62 percent of
output, which in 1985 amounted to $2.1 billion in domestic US sales. The remaining 38 percent is
supplied by more than forty manufacturers. All six of the large manufacturers and thirty-one of the
forty small manufacturers belong to the Widget Manufacturers Trade Association (WMTA). An officer
from at least two of the six manufacturers always serves on the WMTA executive committee, which
consists of seven members. The full WMTA board of directors consists of one member from each
manufacturer. The executive committee meets once a month for dinner at the Widgeters Club; the full
board meets semiannually at the Widget Show. The executive committee, which always meets with
the association’s lawyer in attendance, discusses a wide range of matters, including industry
conditions, economic trends, customer relations, technological developments, and the like, but
scrupulously refrains from discussing price, territories, or output. However, after dinner at the bar,
five of the seven members meet for drinks and discuss prices in an informal manner. The chairman of
the executive committee concludes the discussion with the following statement: “If I had to guess, I’d
guess that the unit price will increase by 5 percent the first of next month.” On the first of the month,
his prediction is proven to be correct among the five companies whose officers had a drink, and within
a week, most of the other manufacturers likewise increase their prices. At the semiannual meeting of
the full board, the WMTA chairman notes that prices have been climbing steadily, and he ventures the
hope that they will not continue to do so because otherwise they will face stiff competition from the
widget industry. However, following the next several meetings of the executive committee, the price
continues to rise as before. The Justice Department gets wind of these discussions and sues the
companies whose officers are members of the board of directors and also sues individually the
members of the executive committee and the chairman of the full board. What laws have they
violated, if any, and who has violated them? What remedies or sanctions may the department seek?

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SELF-TEST QUESTIONS
1.

A company with 95 percent of the market for its product is

a.

a monopolist

b.

monopolizing

c.

violating Section 2 of the Sherman Act

d.

violating Section 1 of the Sherman Act
Which of the following may be evidence of intent to monopolize?

a.

innovative practices
b.

large market share

c.

pricing below cost of production

d.

low profit margins
A merger that lessens competition in any line of commerce is prohibited by

a.

Section 1 of the Sherman Act
b.

Section 2 of the Sherman Act

c.

Section 7 of the Clayton Act

d.

none of the above
Which of the following statements is true?

a.

A horizontal merger is always unlawful.
b.

A conglomerate merger between companies with unrelated products is always lawful.

c.

A vertical merger violates Section 2 of the Sherman Act.

d.

A horizontal merger that unduly increases the concentration of firms in a particular market is
always unlawful.
A line of commerce is a concept spelled out in

a.

Section 7 of the Clayton Act
b.

Section 2 of the Sherman Act

c.

Section 1 of the Sherman Act

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d.

none of the above

SELF-TEST ANSWERS
1.

a

2.

c

3.

c

4.

d

5.

d

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Chapter 17

Unfair Trade Practices and the Federal Trade
Commission
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

The general powers of the Federal Trade Commission

2.

The general principles of law that govern deceptive acts and practices

3.

Several categories of deceptive acts and practices, with examples

4.

The remedies that the Federal Trade Commission has at its disposal to police unfair trade practices

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17.1 The Federal Trade Commission: Powers and Law Governing
Deceptive Acts
LEARNING OBJECTIVES
1.

Describe the general powers of the Federal Trade Commission.

2.

Describe the general principles that guide laws and regulations against unfair and deceptive trade
practices.

General Powers of the Federal Trade Commission
Common law prohibited a variety of trade practices unfair either to competitors or to consumers. These
included passing off one’s products as though they were made by someone else, using a trade name
confusingly similar to that of another, stealing trade secrets, and various forms of misrepresentation. In
the Federal Trade Commission Act of 1912, Congress for the first time empowered a federal agency to
investigate and deter acts of unfair competition.
Section 5 of the act gave the Federal Trade Commission (FTC) power to enforce a law that said “unfair
methods of competition in commerce are hereby declared unlawful.” By “unfair methods of competition,”
Congress originally intended acts that constituted violations of the Sherman and Clayton Antitrust Acts.
But from the beginning, the commissioners of the FTC took a broader view of their mandate. Specifically,
they were concerned about the problem of false and deceptive advertising and promotional schemes. But
the original Section 5 was confining; it seemed to authorize FTC action only when the deceptive
advertising injured a competitor of the company. In 1931, the Supreme Court ruled that this was indeed
the case: an advertisement that deceived the public was not within the FTC’s jurisdiction unless a
competitor was injured by the misrepresentation also. Congress responded in 1938 with the Wheeler-Lea
Amendments to the FTC Act. To the words “unfair methods of competition” were added these words:
“unfair or deceptive acts or practices in commerce.” Now it became clear that the FTC had a broader role
to play than as a second agency enforcing the antitrust laws. Henceforth, the FTC would be the guardian
also of consumers.
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Deceptive practices that the FTC has prosecuted are also amenable to suit at common law. A tire
manufacturer who advertises that his “special tire” is “new” when it is actually a retread has committed a
common-law misrepresentation, and the buyer could sue for rescission of the contract or for damages. But
having a few buyers sue for misrepresentation does not stop the determined fraudster. Moreover, such
lawsuits are expensive to bring, and the amount of damages awarded is usually small; thus law actions
alone cannot adequately address deliberately fraudulent practices.
Through Section 5, however, the FTC can seek far-reaching remedies against the sham and the phony; it is
not limited to proving damages to individual customers case by case. The FTC can issue cease and desist
orders and has other sanctions to wield as well. So do its counterpart agencies at the state level.
As an administrative agency, the FTC has broader powers than those vested in the ordinary prosecutorial
authority, such as the Department of Justice. It can initiate administrative proceedings in accordance with
the Administrative Procedure Act to enforce the several statutes that it administers. In addition to issuing
cease and desist orders and getting them enforced in court, the FTC can seek temporary and permanent
injunctions, fines, and monetary damages and promulgate trade regulation rules (TRRs). Although the
FTC’s authority to issue TRRs had long been assumed (and was approved by the US court of appeals in
Washington in 1973), Congress formalized it in 1975 in the FTC Improvement Act (part of the MagnusonMoss Warranty Act), which gives the FTC explicit authority to prescribe rules defining unfair or deceptive
acts or practices.
A TRR is like a statute. It is a detailed statement of procedures and substantive dos and don’ts. Before
promulgating a TRR, the commission must publish its intention to do so in the Federal Register and must
hold open hearings on its proposals. Draft versions of a TRR must be published to allow the public to
comment. Once issued, the final version is published as part of the Code of Federal Regulations and
becomes a permanent part of the law unless modified or repealed by the FTC itself or by Congress—or
overturned by a court on grounds of arbitrariness, lack of procedural regularity, or the like. A violation of
a TRR is treated exactly like a violation of a federal statute. Once the FTC proves that a defendant violated
a TRR, no further proof is necessary that the defendant’s act was unfair or deceptive. Examples of TRRs
include the Retail Food Store Advertising and Marketing Practices Rule, Games of Chance in the Food
Retailing and Gasoline Industries Rule, Care Labeling of Textile Wearing Apparel Rule, Mail Order

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Merchandise Rule, Cooling-Off Period for Door-to-Door Sales Rule, and Use of Negative Option Plans by
Sellers in Commerce.

General Principles of Law Governing Deceptive Acts and Practices
With a staff of some sixteen hundred and ten regional offices, the FTC is, at least from time to time, an
active regulatory agency. The FTC’s enforcement vigor waxes and wanes with the economic climate.
Critics have often charged that what the FTC chooses to investigate defies common sense because so many
of the cases seem to involve trivial, or at least relatively unimportant, offenses: Does the nation really need
a federal agency to guard us against pronouncements by singer Pat Boone on the efficacy of acne
medication or to ensure the authenticity of certain crafts sold to tourists in Alaska as “native”? One
answer is that through such cases, important principles of law are declared and ratified.
To be sure, most readers of this book, unlikely to be gulled by false claims, may see a certain Alice-inWonderland quality to FTC enforcement. But the first principle of FTC action is that it gauges deceptive
acts and practices as interpreted by the general public, not by the more sophisticated. As a US court of
appeals once said, the FTC Act was not “made for the protection of experts, but for the public—that vast
multitude which includes the ignorant, the unthinking, and the credulous.” The deceptive statement or act
need not actually deceive. Before 1983, it was sufficient that the statement had a “capacity to deceive.”
According to a standard adopted in 1983, however, the FTC will take action against deceptive advertising
“if there is a representation, omission or practice that is likely to mislead the consumer acting reasonably
in the circumstances, to the consumer’s detriment.” Critics of the new standard have charged that it will
be harder to prove deception because an advertisement must be “likely to mislead” rather than merely
have a “capacity to deceive.” The FTC might also be put to the burden of showing that consumers
reasonably interpreted the ad and that they relied on the ad. Whether the standard will reduce the volume
of FTC actions against deceptive advertising remains to be seen.
The FTC also has the authority to proceed against “unfair…acts or practices.” These need not be deceptive
but, instead, of such a character that they offend a common sense of propriety or justice or of an honest
way of comporting oneself. See Figure 17.1 "Unfair and Deceptive Practices Laws" for a diagram of the
unfair and deceptive practices discussed in this chapter.

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Figure 17.1 Unfair and Deceptive Practices Laws

KEY TAKEAWAY
Although common law still serves to prohibit certain kinds of trade practices, the FTC has far more
extensive powers to police unfair and deceptive trade practices. The FTC’s rules, once passed through
the processes defined in the Administrative Procedure Act, have the same authority as a federal
statute. Trade regulation rules issued by the FTC, if violated, can trigger injunctions, fines, and other
remedial actions.

EXERCISE
1.

Go to the FTC website and look at its most recent annual report. Find a description of a loan
modification scam, and discuss with another student why a regulatory agency is needed. Ask
yourselves whether leaving it up to individual consumers to sue the scammers, using common law,
would create greater good for society.

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17.2 Deceptive Acts and Practices
LEARNING OBJECTIVE
1.

Name the categories of deceptive acts and practices that the Federal Trade Commission has found,
and give examples.

Failure to Disclose Pertinent Facts
Businesses are under no general obligation to disclose everything. Advertisers may put a bright face on
their products as long as they do not make a direct material misrepresentation or misstatement. But
under certain circumstances, a business may be required to disclose more than it did in order not to be
involved in unfair or deceptive acts and practices. For example, failure to state the cost of a service might
constitute deception. Thus a federal court has ruled that it is deceptive for a telephone service to fail to
disclose that it cost fifteen dollars per call for customers dialing a special 900 number listed in newspaper
advertisements offering jobs.

[1]

Likewise, if a fact not disclosed might have a material bearing on a

consumer’s decision whether to purchase the product, its omission might be tantamount to deception,
as J. B. Williams Co. v. FTC (see Section 17.5.1 "False and Misleading Representations"), suggests.

Descriptions of Products
Although certain words are considered mere puffery (greatest, best), other words, which have more
precise connotations, can cause trouble if they are misused. One example is the word new. In most cases,
the Federal Trade Commission (FTC) has held that if a product is more than six months old, it is not new
and may not lawfully be advertised as such.
The efficacy of products is perhaps their most often advertised aspect. An ad stating that a product will do
more than it can is almost always deceptive if the claim is specific. Common examples that the FTC
continues to do battle over are claims that a cream, pill, or other substance will “rejuvenate” the body;
“cure” baldness, “permanently remove” wrinkles, or “restore” the vitality of hair.

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The composition of goods is another common category of deceptive claims. For example, a product
advertised as “wool” had better be 100 percent wool; a mixture of wool and synthetic fabrics cannot be
advertised as wool. The FTC has lists of dozens of descriptive words with appropriate definitions.
Labeling of certain products is strictly regulated by specific statutes. Under the Food, Drug, and Cosmetic
Act, artificial colors and flavors must be disclosed. Other specific federal statutes include the Wool
Products Labeling Act, the Textile Fiber Products Identification Act, the Fur Products Labeling Act, and
the Flammable Fabrics Act; these acts are enforced by the FTC. In 1966, Congress enacted the Fair
Packaging and Labeling Act. It governs most consumer products and gives the FTC authority to issue
regulations for proper labeling of most of them. In particular, the statute is designed to help standardize
quantity descriptions (“small,” “medium,” and “large”) and enable shoppers to compare the value of
competing goods in the stores.

Misleading Price and Savings Claims
“Buy one, get another for half price.” “Suggested retail price: $25. Our price: $5.95.” “Yours for only $95.
You save $50.” Claims such as these assault the eye and ear daily. Unless these ads are strictly true, they
are violations of Section 5 of the FTC Act. To regulate deceptive price and savings claims, the FTC has
issued a series of Guides against Deceptive Pricing that set forth certain principles by which the
commission will judge the merits of price claims. These guides are not themselves law, but they are
important clues to how the FTC will act when faced with a price claim case and they may even provide
guidance to state courts hearing claims of deceptive pricing ads.
In general, the guides deal with five claims, as follows:
•

Comparisons of the sale price to a former price. The former price must have been offered for a
substantial period of time in the near past for a seller to be justified in referring to it. A product that
once had a price tag of $50, but that never actually sold for more than $40, cannot be hawked at “the
former price of $50.” Under the FTC guides, a reduction of at least 10 percent is necessary to make the
claim true.

•

Comparable products. “This same mattress and box spring would cost you $450 at retail.” The
advertisement is true only if the seller is in fact offering the same merchandise and if the price quoted
is genuine.

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•

“Suggested” retail price. The same rules apply as those just mentioned. But in the case of a
“manufacturer’s suggested” price, an additional wrinkle can occur: the manufacturer might help the
retailer deceive by listing a “suggested” price that is in fact considerably greater than the going price
in the retailer’s trading area. Whether it is the manufacturer who is doing his own selling or the
retailer who takes advantage of the “list price” ticket on the goods, the resulting claim of a bargain is
deceptive if the product does not sell for the list price in any market or in the market of the retailer.

•

Bargain based on the purchase of something else. The usual statement in these cases is “Buy
one, get one free” (or at some percentage of the usual selling price). Again, the watchwords are literal
accuracy. If the package of batteries normally sells in the advertiser’s store for ninety-nine cents, and
two packages are now selling for that price, then the advertisement is unexceptionable. But
advertisers are often tempted to raise the original selling price or reduce the size or quantity of the
bargain product; doing so is deceptive.

•

False claims to explain a “sale” price. “Giant clearance sale” or “going out of business” or
“limited offer” are common advertising gimmicks. If true, they are legitimate, but it takes very little to
make them deceptive. A “limited offer” that goes on forever (or a sale price charged beyond the date
on which a sale is said to end) is deceptive. Likewise, false claims that imply the manufacturer is
charging the customer a small price are illegitimate. These include claims like “wholesale price,”
“manufacturer’s close-outs,” “irregulars,” or “seconds.”

Bait-and-Switch Advertisements
A common sales pitch in retail is the bait and switch. The retailer “baits” the prospective customer by
dangling an alluring offer, but the offer either disappears or is disparaged once the customer arrives.
Suppose someone sees this advertisement: “Steinway Grand Piano—only $1,000.” But when the customer
arrives at the store, he finds that the advertised product has “sold out.” The retailer then tries to sell the
disappointed customer a higher priced product. Or the salesperson may have the product, but she will
disparage it—pointing out that it does not really live up to the advertised expectations—and will exhort the
customer to buy the “better,” more expensive model. These and related tactics are all violations of Section
5 of the FTC Act. In its Guides Against Bait Advertising, the FTC lists several such unfair practices,
including the following: (1) refusing to demonstrate the advertised product, (2) disparaging the product
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(e.g., by exhibiting a visibly inferior grade of product next to higher-priced merchandise), (3) failing to
stock enough of the advertised product to meet anticipated demand (although the advertiser may say
“supplies limited,” if that is the case), (4) stating that delivery of the advertised product will take an
inordinate amount of time, (5) demonstrating a defective product, and (6) deliberately discouraging the
would-be buyer from purchasing the advertised product.

Free Offers
Careless advertisers will discover that free, perhaps the most powerful word in advertising comes at a
cost. As just noted, a product is not free if it is conditional on buying another product and the price of the
“free” product is included in the purchased product (“Buy one tube and get another tube free”). Just how
far the commission is prepared to take this rule is clear from F.T.C. v. Mary Carter Paint Co.

[2]

In that

case, the company offered, from the time it began business, to sell on a two-for-one basis: “every second
can FREE, gallon or quart.” The problem was that it had never priced and sold single cans of paint, so the
FTC assumed that the price of the second can was included in the first, even though Mary Carter claimed
it had established single-can prices that were comparable to those for paint of comparable quality sold by
competing manufacturers. The Supreme Court sustained the commission’s finding of deception.

Product Comparisons and Disparagements
Product disparagement—saying defamatory things about a competitor’s product—is a common-law tort,
actionable under state law. It is also actionable under Section 5 of the FTC Act. The FTC brands as
disparagement the making of specific untrue statements about a competitor’s product. The agency labels
an indirect form of disparagement “comparative misrepresentation”—making false claims of superiority
of one’s own product. Again, the common-law puffing rule would permit the manufacturer of an over-thecounter pain reliever to make the general statement “Our pill is the best.” But the claim that a pill “works
three times as fast as the leading competitor’s” violates Section 5 if untrue.
Truth has always been a defense to claims of product disparagement, but even that common-law rule has
been eroded in recent years with the application of the significance doctrine. A statement may be
technically true but insignificant and made in such a way as to be misleading. For example, P. Lorillard
Co. v. Federal Trade Commission (Section 17.5.2 "Product Comparisons") concerned a comparative study
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published in Reader’s Digest of tar and nicotine in cigarettes. The article suggested that the differences
were inconsequential to health, but the company making the cigarette with the smallest amount of tar and
nicotine touted the fact anyway.
During the 1970s, to help enforce its rules against comparative misrepresentations, the FTC began to
insist that advertisers fully document any quantitative claims that their products were superior to others.
This meant that the advertiser should have proof of accuracy not only if the commission comes calling; the
advertiser should collect the information beforehand. If it does not, the claim will be held presumptively
deceptive.
The FTC Act and state laws against misleading advertising are not the only statutes aimed at product
comparisons. One important more recent federal law is the Trademark Law Revision Act of 1988,
amending the original Lanham Act that protects trademarks as intellectual property (see Chapter 13
"Intellectual Property"). For many years, the federal courts had ruled that a provision in the Lanham Act
prohibiting false statements in advertisements was limited to an advertiser’s false statements about its
own goods or services only. The 1988 amendments overturned that line of court cases, broadening the
rule to cover false statements about someone else’s goods or services as well. The amendments also
prohibit false or misleading claims about another company’s commercial activities, such as the nature of
its warranties. The revised Lanham Act now permits a company injured by a competitor’s false advertising
to sue directly in federal court.

Endorsements
How wonderful to have a superstar (or maybe yesterday’s superstar) appear on television drooling over
your product. Presumably, millions of people would buy a throat spray if Lady Gaga swore by it, or a pair
of jeans if Justin Bieber wore them, or a face cream if Paris Hilton blessed it. In more subtle ways,
numerous products are touted every day with one form of testimonial or another: “Three out of four
doctors recommend…” or “Drivers across the country use.…” In this area, there are endless opportunities
for deception.
It is not a deception for a well-known personality to endorse a product without disclosing that she is being
paid to do so. But the person giving the testimonial must in fact use the product; if she does not, the
endorsement is deceptive. Suppose an astronaut just returned to Earth is talked into endorsing
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suspenders (“They keep your pants from floating away”) that he was seen to be wearing on televised shots
of the orbital mission. If he has customarily worn them, he may properly endorse them. But if he stops
wearing them for another brand or because he has decided to go back to wearing belts, reruns of the TV
commercials must be pulled from the air.

Figure 17.2

Consent Decree: Pat Boone and Cooga Mooga, Inc.
That a particular consumer is in fact ecstatic about a product does not save a false statement: it is
deceptive to present this glowing testimonial to the public if there are no facts to back up the customer’s
claim. The assertion “I was cured by apricot pits” to market a cancer remedy would not pass FTC muster.
Nor may an endorser give a testimonial involving subjects known only to experts if the endorser is not
himself that kind of expert, as shown in the consent decree negotiated by the FTC with singer Pat Boone
(Figure 17.2).
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Pictorial and Television Advertising
Pictorial representations create special problems because the picture can belie the caption or the
announcer’s words. A picture showing an expensive car may be deceptive if the dealer does not stock
those cars or if the only readily available cars are different models. The ways of deceiving by creating false
inferences through pictures are limited only by imagination. White-coated “doctors,” seals of the British
monarchy, and plush offices can connote various things about a product, even if the advertisement never
says that the man in the white coat is a doctor, that the product is related to the British crown, or that the
company has its operations in the building depicted.
Television demonstrations may also suggest nonexistent properties or qualities in a product. In one case,
the commission ordered the manufacturer of a liquid cleaner to cease showing it in use near hot stoves
and candles, implying falsely that it was nonflammable. A commercial showing a knife cutting through
nails is deceptive if the nails were precut and different knives were used for the before and after shots.

KEY TAKEAWAY
A variety of fairly common acts and practices have been held by the FTC to be deceptive (and illegal).
These include the failure to disclose pertinent facts, misleading price and savings claims, bait and
switch advertisements, careless use of the word “free,” and comparative misrepresentation—making
misleading comparisons between your product and the product of another company.

EXERCISES
1.

Look around this week for an example of a merchant offering something for “free.” Do you think there
is anything deceptive about the merchant’s offer? If they offer “free shipping,” how do you know that
the shipping cost is not hidden in the price? In any case, why do consumers need protection from an
agency that polices merchant offerings that include the word free?

2.

Find the FTC’s guide against deceptive pricing (http://www.ftc.gov/bcp/guides/decptprc.htm). Can
you find any merchants locally that appear to be in violation of the FTC’s rules and principles?

[1] FTC v. Transworld Courier Services, Inc., 59 A&TR Rpt. 174 (N.D. Ga. 1990).
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17.3 Unfair Trade Practices
LEARNING OBJECTIVES
1.

Explain how unfair trade practices are different from deceptive trade practices.

2.

Name three categories of unfair trade practices, and give examples.

We turn now to certain practices that not only have deceptive elements but also operate unfairly in ways
beyond mere deception. In general, three types of unfair practices will be challenged: (1) failing to
substantiate material representations in advertisements before publishing them or putting them on the
air, (2) failing to disclose certain material information necessary for consumers to make rational
comparisons of price and quality of products, and (3) taking unconscionable advantage of certain
consumers or exploiting their weakness. The Federal Trade Commission (FTC) has enjoined many ads of
the first type. The second type of unfairness has led the commission to issue a number of trade regulation
rules (TRRs) setting forth what must be disclosed—for example, octane ratings of gasoline. In this section,
we focus briefly on the third type.

Contests and Sweepstakes
In 1971, the FTC obtained a consent order from Reader’s Digest barring it from promoting a mail-order
sweepstakes—a sweepstakes in which those responding had a chance to win large monetary or other
prizes by returning numbered tickets—unless the magazine expressly disclosed how many prizes would be
awarded and unless all such prizes were in fact awarded. Reader’s Digest had heavily promoted the size
and number of prizes, but few of the winning tickets were ever returned, and consequently few of the
prizes were ever actually awarded.

[1]

Beginning in the 1960s, the retail food and gasoline industries began to heavily promote games of chance.
Investigations by the FTC and a US House of Representatives small business subcommittee showed that
the games were rigged: winners were “picked” early by planting the winning cards early on in the
distribution, winning cards were sent to geographic areas most in need of the promotional benefits of
announcing winners, not all prizes were awarded before many games terminated, and local retailers could
spot winning cards and cash them in or give them to favored customers. As a result of these

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investigations, the FTC in 1969 issued its Trade Regulation Rule for Games of Chance in the Food
Retailing and Gasoline Industries, strictly regulating how the games may operate and be promoted.
Many marketers use contests, as opposed to sweepstakes, in merchandising their products. In a contest,
the consumer must actually do something other than return a ticket, such as fill in a bingo card or come
up with certain words. It is an unfair practice for the sponsoring company not to abide by its own rules in
determining winners.

Door-to-Door, Direct Mail and Unsolicited Merchandise
In 1974, the FTC promulgated a TRR requiring a three-day cooling-off period within which any door-todoor sales contract can be cancelled. The contract must state the buyer’s right to the cooling-off period.
For many years, certain unscrupulous distributors would mail unsolicited merchandise to consumers and
demand payment through a series of dunning letters and bills. In 1970, Congress enacted legislation that
declares any unsolicited mailing and subsequent dunning to be an unfair trade practice under Section 5 of
the FTC Act. Under this law, if you receive an unsolicited product in the mail, you may treat it as a gift and
use it; you are under no obligation to return it or pay for it.
Another regulation of mail-order sales is the FTC’s TRR concerning mail-order merchandise. Any directmail merchandiser must deliver the promised goods within thirty days or give the consumer an option to
accept delayed delivery or a prompt refund of his money or cancellation of the order if it has not been
prepaid.

Negative-Option Plans
The “negative option” was devised in the 1920s by the Book-of-the-Month Club. It is a marketing device
through which the consumer responds to the seller only if she wishes not to receive the product. As used
by book clubs and other distributors of goods that are sent out periodically, the customer agrees, when
“joining,” to accept and pay for all items unless she specifically indicates, before they arrive, that she
wishes to reject them. If she does nothing, she must pay. Difficulties arise when the negative-option notice
arrives late in the mail or when a member quits and continues to receive the monthly notices. Internet
users will recognize the negative option in current use as the “opt out” process, where you are “in” unless
you notice what’s going on and specifically opt out.
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In 1974, the FTC issued a TRR governing use of negative-option plans by sellers. The TRR laid down
specific notice requirements. Among other things, a subscriber is entitled to ten days in which to notify
sellers that she has rejected the particular item about to be sent. If a customer has cancelled hers
membership, the seller must take back and pay the former member’s mailing expenses for any
merchandise mailed after cancellation. The former member may treat any shipments beyond one after
cancellation as unsolicited merchandise and keep it without having to pay for it or return it.

Breach of Contract
Under certain circumstances, a company’s willful breach of contract can constitute an unfair trade
practice, thus violating section 5 of the FTC Act. In one recent case, a termite and pest exterminating
company signed contracts with its customers guaranteeing “lifetime” protection against termite damage
to structures that the company treated. The contract required a customer to renew the service each year
by paying an unchanging annual fee. Five years after signing these contracts, the company notified
207,000 customers that it was increasing the annual fee because of inflation. The FTC challenged the fee
hike on the ground that it was a breach of contract amounting to an unfair trade practice. The FTC’s
charges were sustained on appeal. The eleventh circuit approved the FTC’s three-part test for determining
unfairness: (1) the injury “must be substantial,” (2) “it must not be outweighed by countervailing benefits
to consumers,” and (3) “it must be an injury that consumers themselves could not reasonably have
avoided.” In the termite case, all three parts were met: consumers were forced to pay substantially higher
fees, they received no extra benefits, and they could not have anticipated or prevented the price hike, since
the contract specifically precluded them.

[2]

KEY TAKEAWAY
Market efficiency is premised on buyers being able to make rational choices about their purchases.
Where sellers fail to substantiate material representations or to disclose material information that is
necessary for buyers to act rationally, the FTC may find an unfair trade practice. In addition, some
sellers will take “unconscionable advantage” of certain buyers or exploit their weakness. This takes
place in various contests and sweepstakes, door-to-door and mail-order selling, and negative-option
plans. The FTC has issued a number of TRRs to combat some of these unfair practices.
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EXERCISES
1.

The FTC receives over ten thousand complaints every year about sweepstakes and prizes. Using the
Internet or conversations with people you know, name two ways that sweepstakes or contests can be
unfair to consumers.

2.

As economic hard times return, many scam artists have approached people in debt or people who are
in danger of losing their homes. Describe some of the current practices of such people and companies,
and explain why they are unfair.

3.

With regard to Exercise 2, discuss and decide whether government serves a useful public function by
protecting consumers against such scam artists or whether use of the common law—by the
individuals who have been taken advantage of—would create greater good for society.

[1] Reader’s Digest Assoc., 79 F.T.C. 599 (1971).
[2] Orkin Exterminating Co. v. FTC, 849 F.2d 1354 (11th Cir. 1988), cert. denied, 488 U.S. 1041 (1989).

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17.4 Remedies
LEARNING OBJECTIVES
1.

Describe the various remedies the Federal Trade Commission has used against unfair and deceptive
acts and practices.

2.

Understand that the states also have power to regulate unfair and deceptive trade practices and often
do.

The Federal Trade Commission (FTC) has a host of weapons in its remedial arsenal. It may issue cease
and desist orders against unfair and deceptive acts and practices and let the punishment fit the crime. For
instance, the FTC can order a company to remove or modify a deceptive trade name. It may order
companies to substantiate their advertising. Or if a company fails to disclose facts about a product, the
commission may order the company to affirmatively disclose the facts in future advertising. In the J.
B.Williams case (Section 17.5.2 "Product Comparisons"), the court upheld the commission’s order that the
company tell consumers in future advertising that the condition Geritol is supposed to treat—iron-poor
blood—is only rarely the cause of symptoms of tiredness that Geritol would help cure.
The FTC has often exercised its power to order affirmative disclosures during the past decade, but its
power to correct advertising deceptions is even broader. In Warner Lambert Co. v. Federal Trade
Commission, the US court of appeals in Washington, using corrective advertising, approved the
commission’s power to order a company to correct in future advertisements its former misleading and
deceptive statements regarding Listerine mouthwash should it choose to continue to advertise the
product.

[1]

The court also approved the FTC’s formula for determining how much the company must

spend: an amount equal to the average annual expenditure on advertising the mouthwash during the ten
years preceding the case.
In addition to its injunctive powers, the FTC may seek civil penalties of $10,000 for violation of final cease
and desist orders, and if the violation is a continuing one—an advertising campaign that lasts for weeks or
months—each day is considered a separate violation. The commission may also sue for up to $10,000 per
violation, as just described, for violations of its trade regulation rules (TRRs). Under the FTC
Improvement Act of 1975, the commission is authorized to seek injunctions and collect monetary damages
on behalf of injured consumers in cases involving violations of TRRs. It may also seek restitution for
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consumers in cases involving cease and desist orders if the party continuing to commit the unfair or
deceptive practice should have known that it would be dishonest or fraudulent to continue doing so. The
exact reach of this power to seek restitution, which generally had not been available before 1975, remains
to be tested in the courts. As for private parties, though they have rights under the antitrust statutes, they
have no right to sue under Section 5 of the FTC Act.

Little FTC Acts
Even when consumers have no direct remedy under federal law for unfair or deceptive acts and practices,
they may have recourse under state laws modeled on the FTC Act, known as little FTC acts. All states have
some sort of consumer protection act, and these acts are often more liberal than the federal unfair trade
rules; they permit consumers—and in several states, even aggrieved businesses—to sue when injured by a
host of “immoral, unethical, oppressive, or unscrupulous” commercial acts. Often, a successful plaintiff
can recover treble damages and attorneys’ fees.
The acts are helpful to consumers because common-law fraud is difficult to prove. Its elements are
rigorous and unyielding: an intentional misrepresentation of material facts, reliance by the recipient,
causation, and damages. Many of these elements are omitted from consumer fraud statutes. While most
statutes require some aspect of willfulness, some do not. In fact, many states relax or even eliminate the
element of reliance, and some states do not even require a showing of causation or injury.

KEY TAKEAWAY
The FTC has many weapons to remedy unfair and deceptive trade practices. These include civil
penalties, cease and desist orders, restitution for consumers, and corrective advertising. States have
supplemented common law with their own consumer protection acts, known as little FTC acts.
Remedies are similar for state statutes, and private parties may bring lawsuits directly.

EXERCISE
1.

Doan’s Pills are an over-the-counter medicine for low back pain. Using the Internet, find out what
claims Doan’s was making and why the FTC thought corrective advertising was necessary.

2.

[1] Warner Lambert Co. v. Federal Trade Commission, 562 F.2d 749 (D.C. Cir. 1977), cert. denied, 435
U.S. 950 (1978).

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17.5 Cases
False and Misleading Representations
J. B. Williams Co. v. FTC
381 F.2d 884 (6th Cir. 1967)
CELEBREEZE, CIRCUIT JUDGE
The question presented by this appeal is whether Petitioners’ advertising of a product, Geritol, for the
relief of iron deficiency anemia, is false and misleading so as to violate Sections 5 and 12 of the Federal
Trade Commission Act.
The J. B. Williams Company, Inc. is a New York corporation engaged in the sale and distribution of two
products known as Geritol liquid and Geritol tablets. Geritol liquid was first marketed in August, 1950;
Geritol tablets in February, 1952. Geritol is sold throughout the United States and advertisements for
Geritol have appeared in newspapers and on television in all the States of the United States.
Parkson Advertising Agency, Inc. has been the advertising agency for Williams since 1957. Most of the
advertising money for Geritol is spent on television advertising.…
The Commission’s Order requires that not only must the Geritol advertisements be expressly limited to
those persons whose symptoms are due to an existing deficiency of one or more of the vitamins contained
in the preparation, or due to an existing deficiency of iron, but also the Geritol advertisements must
affirmatively disclose the negative fact that a great majority of persons who experience these symptoms do
not experience them because they have a vitamin or iron deficiency; that for the great majority of people
experiencing these symptoms, Geritol will be of no benefit. Closely related to this requirement is the
further requirement of the Order that the Geritol advertisements refrain from representing that the
symptoms are generally reliable indications of iron deficiency.
***
The main thrust of the Commission’s Order is that the Geritol advertising must affirmatively disclose the
negative fact that a great majority of persons who experience these symptoms do not experience them
because there is a vitamin or iron deficiency.
The medical evidence on this issue is conflicting and the question is not one which is susceptible to precise
statistical analysis.
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***
While the advertising does not make the affirmative representation that the majority of people who are
tired and rundown are so because of iron deficiency anemia and the product Geritol will be an effective
cure, there is substantial evidence to support the finding of the Commission that most tired people are not
so because of iron deficiency anemia, and the failure to disclose this fact is false and misleading because
the advertisement creates the impression that the tired feeling is caused by something which Geritol can
cure.
***
Here the advertisements emphasize the fact that if you are often tired and run-down you will feel stronger
fast by taking Geritol. The Commission, in looking at the overall impression created by the advertisements
on the general public, could reasonably find these advertisements were false and misleading. The finding
that the advertisements link common, non-specific symptoms with iron deficiency anemia, and thereby
create a false impression because most people with these symptoms are not suffering from iron deficiency
anemia, is both reasonable and supported by substantial evidence. The Commission is not bound to the
literal meaning of the words, nor must the Commission take a random sample to determine the meaning
and impact of the advertisements.
Petitioners argue vigorously that the Commission does not have the legal power to require them to state
the negative fact that “in the great majority of persons who experience such symptoms, these symptoms
are not caused by a deficiency of one or more of the vitamins contained in the preparation or by iron
deficiency or iron deficiency anemia”; and “for such persons the preparation will be of no benefit.”
We believe the evidence is clear that Geritol is of no benefit in the treatment of tiredness except in those
cases where tiredness has been caused by a deficiency of the ingredients contained in Geritol. The fact that
the great majority of people who experience tiredness symptoms do not suffer from any deficiency of the
ingredients in Geritol is a “material fact” under the meaning of that term as used in Section 15 of the
Federal Trade Commission Act and Petitioners’ failure to reveal this fact in this day when the consumer is
influenced by mass advertising utilizing highly developed arts of persuasion, renders it difficult for the
typical consumer to know whether the product will in fact meet his needs unless he is told what the
product will or will not do.…
***
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The Commission forbids the Petitioners’ representation that the presence of iron deficiency anemia can be
self-diagnosed or can be determined without a medical test. The danger to be remedied here has been
fully and adequately taken care of in the other requirements of the Order. We can find no Congressional
policy against self-medication on a trial and error basis where the consumer is fully informed and the
product is safe as Geritol is conceded to be. In fact, Congressional policy is to encourage such self-help. In
effect the Commission’s Order l(f) tends to place Geritol in the prescription drug field. We do not consider
it within the power of the Federal Trade Commission to remove Geritol from the area of proprietary drugs
and place it in the area of prescription drugs. This requirement of the Order will not be enforced. We also
find this Order is not unduly vague and fairly apprises the Petitioners of what is required of them. Petition
denied and, except for l (f) of the Commission’s Order, enforcement of the Order will be granted

Video 49.1

Students may be interested in a Geritol ad from 1960.

CASE QUESTIONS
1.

Did the defendant actually make statements that were false? If so, what were they? Or, rather than
being clearly false, were the statements deceptive? If so, how so?

2.

Whether or not you feel that you have “tired blood” or “iron-poor blood,” you may be amused by a
Geritol ad from 1960. See Video 49.1. Do the disclaimers at the start of the ad that “the majority of
tired people don’t feel that way because of iron-poor blood” sound like corrective advertising? Is the
ad still deceptive in some way? If so, how? If not, why not?

Product Comparisons
P. Lorillard Co. v. Federal Trade Commission
186 F.2d 52 (4th Cir. 1950)
Parker, Chief Judge
This is a petition to set aside an order of the Federal Trade Commission which directed that the P.
Lorillard Company cease and desist from making certain representations found to be false in the

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advertising of its tobacco products. The Commission has filed an answer asking that its order be enforced.
The company was ordered to cease and desist “from representing by any means directly or indirectly”:
That Old Gold cigarettes or the smoke therefrom contains less nicotine, or less tars and resins, or is less
irritating to the throat than the cigarettes or the smoke therefrom of any of the six other leading brands of
cigarettes.
***
Laboratory tests introduced in evidence show that the difference in nicotine, tars and resins of the
different leading brands of cigarettes is insignificant in amount; and there is abundant testimony of
medical experts that such difference as there is could result in no difference in the physiological effect
upon the smoker. There is expert evidence, also, that the slight difference in the nicotine, tar and resin
content of cigarettes is not constant between different brands, but varies from place to place and from
time to time, and that it is a practical impossibility for the manufacturer of cigarettes to determine or to
remove or substantially reduce such content or to maintain constancy of such content in the finished
cigarette. This testimony given ample support to the Commission’s findings.
***
The company relies upon the truth of the advertisements complained of, saying that they merely state
what had been truthfully stated in an article in the Reader’s Digest. An examination of the advertisements,
however, shows a perversion of the meaning of the Reader’s Digest article which does little credit to the
company’s advertising department—a perversion which results in the use of the truth in such a way as to
cause the reader to believe the exact opposite of what was intended by the writer of the article. A
comparison of the advertisements with the article makes this very plain. The article, after referring to
laboratory tests that had been made on cigarettes of the leading brands, says:
“The laboratory’s general conclusion will be sad news for the advertising copy writers, but good news for
the smoker, who need no longer worry as to which cigarette can most effectively nail down his coffin. For
one nail is just about as good as another. Says the laboratory report: ‘The differences between brands are,
practically speaking, small, and no single brand is so superior to its competitors as to justify its selection
on the ground that it is less harmful.’ How small the variations are may be seen from the data tabulated
on page 7.”

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The table referred to in the article was inserted for the express purpose of showing the insignificance of
the difference in the nicotine and tar content of the smoke from the various brands of cigarettes. It
appears therefrom that the Old Gold cigarettes examined in the test contained less nicotine, tars and
resins than the others examined, although the difference, according to the un-contradicted expert
evidence, was so small as to be entirely insignificant and utterly without meaning so far as effect upon the
smoker is concerned. The company proceeded to advertise this difference as though it had received a
citation for public service instead of castigation from the Reader’s Digest. In the leading newspapers of the
country and over the radio it advertised that the Reader’s Digest had had experiments conducted and had
found that Old Gold cigarettes were lowest in nicotine and lowest in irritating tars and resins, just as
though a substantial difference in such content had been found. The following advertisement may be
taken as typical:
OLD GOLDS FOUND LOWEST IN NICOTINE
OLD GOLDS FOUND LOWEST IN
THROAT-IRRITATING TARS AND RESINS
“See Impartial Test by Reader’s Digest July Issue.” See How Your Brand Compares with Old Gold.
“Reader’s Digest assigned a scientific testing laboratory to find out about cigarettes. They tested seven
leading cigarettes and Reader’s Digest published the results.
“The cigarette whose smoke was lowest in nicotine was Old Gold. The cigarette with the least throatirritating tars and resins was Old Gold.
“On both these major counts Old Gold was best among all seven cigarettes tested.
“Get July Reader’s Digest. Turn to Page 5. See what this highly respected magazine reports.
“You’ll say, ‘From now on, my cigarette is Old Gold.’ Light one? Note the mild, interesting flavor. Easier
on the throat? Sure: And more smoking pleasure: Yes, it’s the new Old Gold—finer yet, since ‘something
new has been added’.”
The fault with this advertising was not that it did not print all that the Reader’s Digest article said, but that
it printed a small part thereof in such a way as to create an entirely false and misleading impression, not
only as to what was said in the article, but also as to the quality of the company’s cigarettes. Almost
anyone reading the advertisements or listening to the radio broadcasts would have gained the very
definite impression that Old Gold cigarettes were less irritating to the throat and less harmful than other
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leading brands of cigarettes because they contained substantially less nicotine, tars and resins, and that
the Reader’s Digest had established this fact in impartial laboratory tests; and few would have troubled to
look up the Reader’s Digest to see what it really had said. The truth was exactly the opposite. There was no
substantial difference in Old Gold cigarettes and the other leading brands with respect to their content of
nicotine, tars and resins and this was what the Reader’s Digest article plainly said. The table who’s
meaning the advertisements distorted for the purpose of misleading and deceiving the public was
intended to prove that there was no practical difference and did prove it when properly understood. To
tell less than the whole truth is a well-known method of deception; and he who deceives by resorting to
such method cannot excuse the deception by relying upon the truthfulness per se of the partial truth by
which it has been accomplished.
In determining whether or not advertising is false or misleading within the meaning of the statute regard
must be had, not to fine spun distinctions and arguments that may be made in excuse, but to the effect
which it might reasonably be expected to have upon the general public. “The important criterion is the net
impression which the advertisement is likely to make upon the general populace.” As was well said by
Judge Coxe in Florence Manufacturing Co. v. J. C Dowd & Co., with reference to the law relating to
trademarks: “The law is not made for the protection of experts, but for the public—that vast multitude
which includes the ignorant, the unthinking and the credulous, who, in making purchases, do not stop to
analyze, but are governed by appearances and general impressions.”
***
For the reasons stated, the petition to set aside the order will be denied and the order will be enforced.

CASE QUESTIONS
1.

From a practical perspective, what (if anything) is wrong with caveat emptor—”let the buyer
beware”? The careful consumer could have looked at the Reader’s Digest article; the magazine was
widely available in libraries and newsstands.

2.

Why isn’t this just an example of “puffing” the company’s wares? (Puffing presents opinions rather
than facts; statements like “This car is a real winner” and “Your wife will love this watch” constitute
puffing.)

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17.6 Summary and Exercises
Summary
Section 5 of the Federal Trade Commission (FTC) Act gives the FTC the power to enforce a provision
prohibiting “unfair methods of competition and unfair or deceptive acts or practices in commerce.” Under
this power, the FTC may bring enforcement proceedings against companies on a case-by-case basis or
may promulgate trade regulation rules.
A deceptive act or practice need not actually deceive as long as it is “likely to mislead.” An unfair act or
practice need not deceive at all but must offend a common sense of propriety or justice or of an honest
way of acting. Among the proscribed acts or practices are these: failure to disclose pertinent facts, false or
misleading description of products, misleading price and savings claims, bait-and-switch advertisements,
free-offer claims, false product comparisons and disparagements, and endorsements by those who do not
use the product or who have no reasonable basis for making the claims. Among the unfair trade practices
that the FTC has sought to deter are certain types of contests and sweepstakes, high-pressure door-todoor and mail-order selling, and certain types of negative-option plans.
The FTC has a number of remedial weapons: cease and desist orders tailored to the particular deception
or unfair act (including affirmative disclosure in advertising and corrections in future advertising), civil
monetary penalties, and injunctions, damages, and restitution on behalf of injured consumers. Only the
FTC may sue to correct violations of Section 5; private parties have no right to sue under Section 5, but
they can sue for certain kinds of false advertising under the federal trademark laws.

EXERCISES
1.

Icebox Ike, a well-known tackle for a professional football team, was recently signed to a multimilliondollar contract to appear in a series of nationally televised advertisements touting the pleasures of
going to the ballet and showing him in the audience watching a ballet. In fact, Icebox has never been
to a ballet, although he has told his friends that he “truly believes” ballet is a “wonderful thing.” The
FTC opens an investigation to determine whether there are grounds to take legal action against Icebox
and the ballet company ads. What advice can you give Icebox Ike? What remedies can the FTC seek?

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2.

Door-to-door salespersons of an encyclopedia company offer a complete set of encyclopedias to
“selected” customers. They tell customers that their only obligation is to pay for a ten-year updating
service. In fact, the price of the updating service includes the cost of the encyclopedias. The FTC sues,
charging deception under Section 5 of the FTC Act. The encyclopedia company defends itself on the
ground that no one could possibly have been misled because everyone must have understood that no
company could afford to give away a twenty-volume set of books for free. What is the result?

3.

Vanessa Cosmetics takes out full-page advertisements in the local newspaper stating that “this Sunday
only” the Vanessa Makeup Kit will be “reduced to only $25.” In fact, the regular price has been $25.50.
Does this constitute deceptive advertising? Why?

4.

Lilliputian Department Stores advertises a “special” on an electric carrot slicer, priced “this week only
at $10.” When customers come to the store, they find the carrot slicer in frayed boxes, and the
advertised special is clearly inferior to a higher-grade carrot slicer priced at $25. When customers ask
about the difference, the store clerk tells them, “You wouldn’t want to buy the cheaper one; it wears
out much too fast.” What grounds, if any, exist to charge Lilliputian with violations of the FTC Act?

5.

A toothpaste manufacturer advertises that special tests demonstrate that use of its toothpaste results
in fewer cavities than “regular toothpaste.” In fact, the “regular” toothpaste was not marketed but
was merely the advertiser’s brand stripped of its fluoride. Various studies over the years have
demonstrated, however, that fluoride in toothpaste will reduce the number of cavities a user will get.
Is this advertisement deceptive under Section 5 of the FTC Act?

6.

McDonald’s advertises a sweepstakes through a mailing that says prizes are to be reserved for 15,610
“lucky winners.” The mailing further states, “You may be [a winner] but you will never know if you
don’t claim your prize. All prizes not claimed will never be given away, so hurry.” The mailing does not
give the odds of winning. The FTC sues to enjoin the mailing as deceptive. What is the result?

SELF-TEST QUESTIONS
1.

Section 5 of the Federal Trade Commission Act is enforceable by

a.

a consumer in federal court

b.

a consumer in state court

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c.

the FTC in an administrative proceeding

d.

the FTC suing in federal court
The FTC

a.

is an independent federal agency
b.

is an arm of the Justice Department

c.

supersedes Congress in defining deceptive trade practices

d.

speaks for the president on consumer matters
A company falsely stated that its competitor’s product “won’t work.” Which of the following
statements is false?

a.

The competitor may sue the company under state law.
b.

The competitor may sue the company for violating the FTC Act.

c.

The competitor may sue the company for violating the Lanham Act.

d.

The FTC may sue the company for violating the FTC Act.
The FTC may order a company that violated Section 5 of the FTC Act by false advertising

a.

to go out of business
b.

to close down the division of the company that paid for false advertising

c.

to issue corrective advertising

d.

to buy back from its customers all the products sold by the advertising
The ingredients in a nationally advertised cupcake must be disclosed on the package under

a.

state common law
b.

a trade regulation rule promulgated by the FTC

c.

the federal Food, Drug, and Cosmetic Act

d.

an executive order of the president

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SELF-TEST ANSWERS
1.

c

2.

a

3.

b

4.

c

5.

b

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Chapter 18
Employment Law
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

How common-law employment at will is modified by common-law doctrine, federal statutes, and
state statutes

2.

Various kinds of prohibited discrimination under Title VII and examples of each kind

3.

The various other protections for employees imposed by federal statute, including the Age
Discrimination in Employment Act (ADEA) and the Americans with Disabilities Act (ADA)

In the next chapter, we will examine the laws that govern the relationship between the employer and the
employee who belongs, or wants to belong, to a union. Although federal labor law is confined to that
relationship, laws dealing with the employment relationship—both state and federal—are far broader than
that. Because most employees do not belong to unions, a host of laws dealing with the many faces of
discrimination shapes employers’ power over and duties to their employees. Beyond the issue of
discrimination, the law also governs a number of other issues, such as the extent to which an employer
may terminate the relationship itself. We examine these issues later in this chapter.
Even before statutes governing collective bargaining and various state and federal discrimination laws,
the common law set the boundaries for employer-employee relationships. The basic rule that evolved
prior to the twentieth century was “employment at will.” We will look at employment at will toward the
end of this chapter. But as we go through the key statutes on employment law and employment
discrimination, bear in mind that these statutes stand as an important set of exceptions to the basic
common-law rule of employment at will. That rule holds that in the absence of a contractual agreement
otherwise, an employee is free to leave employment at any time and for any reason; similarly, an employer
is free to fire employees at any time and for any reason.

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18.1 Federal Employment Discrimination Laws
LEARNING OBJECTIVES
1.

Know the various federal discrimination laws and how they are applied in various cases.

2.

Distinguish between disparate impact and disparate treatment cases.

3.

Understand the concept of affirmative action and its limits in employment law.

As we look at federal employment discrimination laws, bear in mind that most states also have laws that
prohibit various kinds of discriminatory practices in employment. Until the 1960s, Congress had intruded
but little in the affairs of employers except in union relationships. A company could refuse to hire
members of racial minorities, exclude women from promotions, or pay men more than women for the
same work. But with the rise of the civil rights movement in the early 1960s, Congress (and many states)
began to legislate away the employer’s frequently exercised power to discriminate. The most important
statutes are Title VII of the Civil Rights Act of 1964, the Equal Pay Act of 1963, the Age Discrimination in
Employment Act of 1967, and the Americans with Disabilities Act of 1990.

Title VII of the Civil Rights Act of 1964
The most basic antidiscrimination law in employment is in Title VII of the federal Civil Rights Act of 1964.
The key prohibited discrimination is that based on race, but Congress also included sex, religion, national
origin, and color as prohibited bases for hiring, promotion, layoff, and discharge decisions. To put the
Civil Rights Act in its proper context, a short history of racial discrimination in the United States follows.
The passage of the Civil Rights Act of 1964 was the culmination of a long history that dated back to
slavery, the founding of the US legal system, the Civil War, and many historical and political
developments over the ninety-nine years from the end of the Civil War to the passage of the act. The years
prior to 1964 had seen a remarkable rise of civil disobedience, led by many in the civil rights movement
but most prominently by Dr. Martin Luther King Jr. Peaceful civil disobedience was sometimes met with
violence, and television cameras were there to record most of it.
While the Civil War had addressed slavery and the secession of Southern states, the Thirteenth,
Fourteenth, and Fifteenth Amendments, ratified just after the war, provided for equal protection under

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the law, guaranteed citizenship, and protected the right to vote for African Americans. The amendments
also allowed Congress to enforce these provisions by enacting appropriate, specific legislation.
But during the Reconstruction Era, many of the Southern states resisted the laws that were passed in
Washington, DC, to bolster civil rights. To a significant extent, decisions rendered by the US Supreme
Court in this era—such as Plessy v. Ferguson, condoning “separate but equal” facilities for different
races—restricted the utility of these new federal laws. The states effectively controlled the public
treatment of African Americans, and a period of neglect set in that lasted until after World War II. The
state laws essentially mandated segregated facilities (restaurants, hotels, schools, water fountains, public
bathrooms) that were usually inferior for blacks.
Along with these Jim Crow laws in the South, the Ku Klux Klan was very strong, and lynching’s (hangings
without any sort of public due process) by the Klan and others were designed to limit the civil and
economic rights of the former slaves. The hatred of blacks from that era by many whites in America has
only gradually softened since 1964. Even as the civil rights bill was being debated in Congress in 1964,
some Young Americans for Freedom in the right wing of the GOP would clandestinely chant “Be a man,
join the Klan” and sing “We will hang Earl Warren from a sour apple tree,” to the tune of “Battle Hymn of
the Republic,” in anger over the Chief Justice’s presiding over Brown v. Board of Education, which
reversed Plessy v. Ferguson.
But just a few years earlier, the public service and heroism of many black military units and individuals in
World War II had created a perceptual shift in US society; men of many races who had served together in
the war against the Axis powers (fascism in Europe and the Japanese emperor’s rule in the Pacific) began
to understand their common humanity. Major migrations of blacks from the South to industrial cities of
the North also gave impetus to the civil rights movement.
Bills introduced in Congress regarding employment policy brought the issue of civil rights to the attention
of representatives and senators. In 1945, 1947, and 1949, the House of Representatives voted to abolish
the poll tax. The poll tax was a method used in many states to confine voting rights to those who could pay
a tax, and often, blacks could not. The Senate did not go along, but these bills signaled a growing interest
in protecting civil rights through federal action. The executive branch of government, by presidential
order, likewise became active by ending discrimination in the nation’s military forces and in federal
employment and work done under government contract.
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The Supreme Court gave impetus to the civil rights movement in its reversal of the “separate but equal”
doctrine in the Brown v. Board of Education decision. In its 1954 decision, the Court said, “To separate
black children from others of similar age and qualifications solely because of their race generates a feeling
of inferiority as to their status in the community that may affect their hearts and minds in a way never to
be undone.…We conclude that in the field of public education the doctrine of separate but equal has no
place. Separate educational facilities are inherently unequal.”
This decision meant that white and black children could not be forced to attend separate public schools.
By itself, however, this decision did not create immediate gains, either in public school desegregation or in
the desegregation of other public facilities. There were memorable standoffs between federal agents and
state officials in Little Rock, Arkansas, for example; the Democratic governor of Arkansas personally
blocked young black students from entering Little Rock’s Central High School, and it was only President
Eisenhower’s order to have federal marshals accompany the students that forced integration. The year
was 1957.
But resistance to public school integration was widespread, and other public facilities were not governed
by the Brown ruling. Restaurants, hotels, and other public facilities were still largely segregated.
Segregation kept blacks from using public city buses, park facilities, and restrooms on an equal basis with
whites. Along with inferior schools, workplace practices throughout the South and also in many Northern
cities sharply limited African Americans’ ability to advance economically. Civil disobedience began to
grow.
The bus protests in Montgomery, Alabama, were particularly effective. Planned by civil rights leaders,
Rosa Parks’ refusal to give up her seat to a white person and sit at the back of the public bus led to a
boycott of the Montgomery bus system by blacks and, later, a boycott of white businesses in Montgomery.
There was months of confrontation and some violence; finally, the city agreed to end its long-standing
rules on segregated seating on buses.
There were also protests at lunch counters and other protests on public buses, where groups of Northern
protesters—Freedom Riders—sometimes met with violence. In 1962, James Meredith’s attempt to enroll
as the first African American at the University of Mississippi generated extreme hostility; two people were
killed and 375 were injured as the state resisted Meredith’s admission. The murders of civil rights workers

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Medgar Evers and William L. Moore added to the inflamed sentiments, and whites in Birmingham,
Alabama, killed four young black girls who were attending Sunday school when their church was bombed.
These events were all covered by the nation’s news media, whose photos showed beatings of protesters
and the use of fire hoses on peaceful protesters. Social tensions were reaching a postwar high by 1964.
According to the government, there were nearly one thousand civil rights demonstrations in 209 cities in
a three-month period beginning May 1963. Representatives and senators could not ignore the impact of
social protest. But the complicated political history of the Civil Rights Act of 1964 also tells us that the
legislative result was anything but a foregone conclusion.

[1]

In Title VII of the Civil Rights Act of 1964, Congress for the first time outlawed discrimination in
employment based on race, religion, sex, or national origin:. Title VII declares: “It shall be an unlawful
employment practice for an employer 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 national origin.” Title VII applies to
(1) employers with fifteen or more employees whose business affects interstate commerce, (2) all
employment agencies, (3) labor unions with fifteen or more members, (4) state and local governments
and their agencies, and (5) most federal government employment.
In 1984, the Supreme Court said that Title VII applies to partnerships as well as corporations when ruling
that it is illegal to discriminatorily refuse to promote a female lawyer to partnership status in a law firm.
This applies, by implication, to other fields, such as accounting.

[2]

The remedy for unlawful discrimination

is back pay and hiring, reinstatement, or promotion.
Title VII established the Equal Employment Opportunity Commission (EEOC) to investigate violations of
the act. A victim of discrimination who wishes to file suit must first file a complaint with the EEOC to
permit that agency to attempt conciliation of the dispute. The EEOC has filed a number of lawsuits to
prove statistically that a company has systematically discriminated on one of the forbidden bases. The
EEOC has received perennial criticism for its extreme slowness in filing suits and for failure to handle the
huge backlog of complaints with which it has had to wrestle.
The courts have come to recognize two major types of Title VII cases:
1.

Cases of disparate treatment

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o

In this type of lawsuit, the plaintiff asserts that because of race, sex, religion, or national origin, he or
she has been treated less favorably than others within the organization. To prevail in a disparate
treatment suit, the plaintiff must show that the company intended to discriminate because of one of
the factors the law forbids to be considered. Thus in McDonnell Douglas Corp. v. Green, the Supreme
Court held that the plaintiff had shown that the company intended to discriminate by refusing to
rehire him because of his race.

[3]

In general, there are two types of disparate treatment cases: (1)

pattern-and-practice cases, in which the employee asserts that the employer systematically
discriminates on the grounds of race, religion, sex, or national origin; and (2) reprisal or retaliation
cases, in which the employee must show that the employer discriminated against him or her because
that employee asserted his or her Title VII rights.
2. Cases of disparate impact
o

In this second type of Title VII case, the employee need not show that the employer intended to
discriminate but only that the effect, or impact, of the employer’s action was discriminatory. Usually,
this impact will be upon an entire class of employees. The plaintiff must demonstrate that the reason
for the employer’s conduct (such as refusal to promote) was not job related. Disparate impact cases
often arise out of practices that appear to be neutral or nondiscriminatory on the surface, such as
educational requirements and tests administered to help the employer choose the most qualified
candidate. In the seminal case of Griggs v. Duke Power Co., the Supreme Court held that under Title
VII, an employer is not free to use any test it pleases; the test must bear a genuine relationship to job
performance.

[4]

Griggs stands for the proposition that Title VII “prohibits employment practices that

have discriminatory effects as well as those that are intended to discriminate.”

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Figure 18.1 A Checklist of Employment Law

Discrimination Based on Religion
An employer who systematically refuses to hire Catholics, Jews, Buddhists, or members of any other
religious group engages in unlawful disparate treatment under Title VII. But refusal to deal with someone
because of his or her religion is not the only type of violation under the law. Title VII defines religion as
including religious observances and practices as well as belief and requires the employer to “reasonably
accommodate to an employee’s or prospective employee’s religious observance or practice” unless the
employer can demonstrate that a reasonable accommodation would work an “undue hardship on the
conduct of the employer’s business.” Thus a company that refused even to consider permitting a devout
Sikh to wear his religiously prescribed turban on the job would violate Title VII.
But the company need not make an accommodation that would impose more than a minimal cost. For
example, an employee in an airline maintenance department, open twenty-four hours a day, wished to
avoid working on his Sabbath. The employee belonged to a union, and under the collective bargaining
agreement, a rotation system determined by seniority would have put the worker into a work shift that fell
on his Sabbath. The Supreme Court held that the employer was not required to pay premium wages to
someone whom the seniority system would not require to work on that day and could discharge the
employee if he refused the assignment.
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[5]

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Title VII permits religious organizations to give preference in employment to individuals of the same
religion. Obviously, a synagogue looking for a spiritual leader would hire a rabbi and not a priest.

Sex Discrimination
A refusal to hire or promote a woman simply because she is female is a clear violation of Title VII. Under
the Pregnancy Act of 1978, Congress declared that discrimination because of pregnancy is a form of sex
discrimination. Equal pay for equal or comparable work has also been an issue in sex (or gender)
discrimination. Barbano v. Madison County (see ), presents a straightforward case of sex discrimination.
In that case, notice how the plaintiff has the initial burden of proving discriminatory intent and how the
burden then shifts to the defendant to show a plausible, nondiscriminatory reason for its hiring decision.
The late 1970s brought another problem of sex discrimination to the fore: sexual harassment. There is
much fear and ignorance about sexual harassment among both employers and employees. Many men
think they cannot compliment a woman on her appearance without risking at least a warning by the
human resources department. Many employers have spent significant time and money trying to train
employees about sexual harassment, so as to avoid lawsuits. Put simply, sexual harassment involves
unwelcome sexual advances, requests for sexual favors, and other verbal or physical conduct of a sexual
nature.
There are two major categories of sexual harassment: (1) quid pro quo and (2) hostile work environment.
Quid pro quo comes from the Latin phrase “one thing in return for another.” If any part of a job is made
conditional on sexual activity, there is quid pro quo sexual harassment. Here, one person’s power over
another is essential; a coworker, for example, is not usually in a position to make sexual demands on
someone at his same level, unless he has special influence with a supervisor who has power to hire, fire,
promote, or change work assignments. A supervisor, on the other hand, typically has those powers or the
power to influence those kinds of changes. For example, when the male foreman says to the female line
worker, “I can get you off of the night shift if you’ll sleep with me,” there is quid pro quo sexual
harassment.
In Harris v. Forklift Systems, Inc.

[6]

and in Meritor v. Vinson,

[7]

we see examples of hostile work

environment. Hostile work environment claims are more frequent than quid pro quo claims and so are
more worrisome to management. An employee has a valid claim of sexual harassment if sexual talk,
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imagery, or behavior becomes so pervasive that it interferes with the employee’s ability to work to her best
capacity. On occasion, courts have found that offensive jokes, if sufficiently frequent and pervasive in the
workplace, can create a hostile work environment. Likewise, comments about body parts or public
displays of pornographic pictures can also create a hostile work environment. In short, the plaintiff can be
detrimentally offended and hindered in the workplace even if there are no measurable psychological
injuries.
In the landmark hostile work environment case of Meritor v. Vinson, the Supreme Court held that Title
VII’s ban on sexual harassment encompasses more than the trading of sexual favors for employment
benefits. Unlawful sexual harassment also includes the creation of a hostile or offensive working
environment, subjecting both the offending employee and the company to damage suits even if the victim
was in no danger of being fired or of losing a promotion or raise.
In recalling Harris v. Forklift Systems (, ), we see that the “reasonable person” standard is declared by the
court as follows: “So long as the environment would reasonably be perceived, and is perceived, as hostile
or abusive there is no need for it also to be psychologically injurious.” In Duncan v. General Motors
Corporation (see), Harris is used as a precedent to deny relief to a woman who was sexually harassed,
because the court believed the conditions were not severe or pervasive enough to unreasonably interfere
with her work.
Sex discrimination in terms of wages and benefits is common enough that a number of sizeable class
action lawsuits have been brought. A class action lawsuit is generally initiated by one or more people who
believe that they, along with a group of other people, have been wronged in similar ways. Class actions for
sexual harassment have been successful in the past. On June 11, 1998, the EEOC reached a $34 million
settlement with Mitsubishi over allegations of widespread sexual harassment at the Normal, Illinois, auto
plant. The settlement involved about five hundred women who split the $34 million, although only seven
received the maximum $300,000 allowed by law. The others received amounts ranging from $8,000 to
$225,000.
Class action lawsuits involve specific plaintiffs (called class plaintiffs or class representatives) who are
named in the class action lawsuit to assert the claims of the unnamed or absent members of the class; thus
all those with a common complaint need not file their own separate lawsuit. From the point of view of
plaintiffs who may have lost only a few thousand dollars annually as a result of the discrimination, a class
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action is advantageous: almost no lawyer would take a complicated civil case that had a potential gain of
only a few thousand dollars. But if there are thousands of plaintiffs with very similar claims, the judgment
could be well into the millions. Defendants can win the procedural battle by convincing a court that the
proposed class of plaintiffs does not present common questions of law or of fact.
In the Wal-Mart class action case decided by the Supreme Court in 2011, three named plaintiffs (Dukes,
Arana, and Kwapnoski) represented a proposed class of 1.5 million current or former Wal-Mart
employees. The plaintiffs’ attorneys asked the trial court in 2001 to certify as a class all women employed
at any Wal-Mart domestic retail store at any time since December of 1998. As the case progressed through
the judicial system, the class grew in size. If the class was certified, and discrimination proven, Wal-Mart
could have been liable for over $1 billion in back pay. So Wal-Mart argued that as plaintiffs, the cases of
the 1.5 million women did not present common questions of law or of fact—that is, that the claims were
different enough that the Court should not allow a single class action lawsuit to present such differing
kinds of claims. Initially, a federal judge disagreed, finding the class sufficiently coherent for purposes of
federal civil procedure. The US Court of Appeals for the Ninth Circuit upheld the trial judge on two
occasions.
But the US Supreme Court agreed with Wal-Mart. In the majority opinion, Justice Scalia discussed the
commonality condition for class actions.
Quite obviously, the mere claim by employees of the same company that they have suffered a Title VII
injury, or even a disparate impact Title VII injury, gives no cause to believe that all their claims can
productively be litigated at once. Their claims must depend upon a common contention—for example, the
assertion of discriminatory bias on the part of the same supervisor. That common contention, moreover,
must be of such a nature that it is capable of class-wide resolution—which means that determination of its
truth or falsity will resolve an issue that is central to the validity of each one of the claims in one stroke.

[8]

Finding that there was no common contention, the Supreme Court reversed the lower courts. Many
commentators, and four dissenting Justices, believed that the majority opinion has created an
unnecessarily high hurdle for class action plaintiffs in Title VII cases.

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Discrimination Based on Race, Color, and National Origin
Title VII was primarily enacted to prohibit employment discrimination based on race, color, and national
origin. Race refers to broad categories such as black, Caucasian, Asian, and Native American. Color simply
refers to the color of a person’s skin, and national origin refers to the country of the person’s ancestry.

Exceptions to Title VII
Merit
Employers are allowed to select on merit and promote on merit without offending title VII’s requirements.
Merit decisions are usually based on work, educational experience, and ability tests. All requirements,
however, must be job related. For example, the ability to lift heavy cartons of sixty pounds or more is
appropriate for certain warehouse jobs but is not appropriate for all office workers. The ability to do
routine maintenance (electrical, plumbing, construction) is an appropriate requirement for maintenance
work but not for a teaching position. Requiring someone to have a high school degree, as in Griggs vs.
Duke Power Co., is not appropriate as a qualification for common labor.

Seniority
Employers may also maintain seniority systems that reward workers who have been with the company for
a long time. Higher wages, benefits, and choice of working hours or vacation schedules are examples of
rewards that provide employees with an incentive to stay with the company. If they are not the result of
intentional discrimination, they are lawful. Where an employer is dealing with a union, it is typical to see
seniority systems in place.

Bona Fide Occupational Qualification (BFOQ)
For certain kinds of jobs, employers may impose bona fide occupational qualifications (BFOQs). Under
the express terms of Title VII, however, a bona fide (good faith) occupational qualification of race or color
is never allowed. In the area of religion, as noted earlier, a group of a certain religious faith that is
searching for a new spiritual leader can certainly limit its search to those of the same religion. With regard
to sex (gender), allowing women to be locker-room attendants only in a women’s gym is a valid BFOQ.

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One important test that the courts employ in evaluating an employer’s BFOQ claims is the “essence of the
business” test.
In Diaz v. Pan American World Airways, Inc., the airline maintained a policy of exclusively hiring
females for its flight attendant positions.

[9]

The essence of the business test was established with the

court’s finding that “discrimination based on sex is valid only when the essence of the business operation
would be undermined by not hiring members of one sex exclusively.” Although the court acknowledged
that females might be better suited to fulfill the required duties of the position, this was not enough to
fulfill the essence of the business test:
The primary function of an airline is to transport passengers safely from one point to another. While a
pleasant environment, enhanced by the obvious cosmetic effect that female stewardesses provide as well
as…their apparent ability to perform the non-mechanical functions of the job in a more effective manner
than most men, may all be important, they are tangential to the essence of the business involved. No one
has suggested that having male stewards will so seriously affect the operation of an airline as to jeopardize
or even minimize its ability to provide safe transportation from one place to another.

[10]

The reason that airlines now use the gender-neutral term flight attendant is a direct result of Title VII. In
the 1990s, Hooters had some difficulty convincing the EEOC and certain male plaintiffs that only women
could be hired as wait staff in its restaurants. With regard to national origin, directors of movies and
theatrical productions would be within their Title VII BFOQ rights to restrict the roles of fictional Asians
to those actors whose national origin was Asian, but could also permissibly hire Caucasian actors made up
in “yellow face.”

Defenses in Sexual Harassment Cases
In the 1977 term, the US Supreme Court issued two decisions that provide an affirmative defense in some
sexual harassment cases. In Faragher v. City of Boca Raton
Ellerth,

[12]

[11]

and in Burlington Industries, Inc. v.

female employees sued for sexual harassment. In each case, they proved that their supervisors

had engaged in unconsented-to touching as well as verbal sexual harassment. In both cases, the plaintiff
quit her job and, after going through the EEOC process, got a right-to-sue letter and in fact sued for sexual
harassment. In Faragher, the employer had never disseminated the policy against sexual harassment to
its employees. But in the second case, Burlington Industries, the employer had a policy that was made
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known to employees. Moreover, a complaints system had been established that was not used by the
female employee.
Both opinions rejected the notion of strict or automatic liability for employers when agents (employees)
engage in sexual harassment. But the employer can have a valid defense to liability if it can prove (1) that
it exercised reasonable care to prevent and correct any sexual harassment behaviors and (2) that the
plaintiff employee unreasonably failed to take advantage of any preventive or corrective opportunities
provided by the employer or to otherwise avoid harm. As with all affirmative defenses, the employer has
the burden of proving this defense.

Affirmative Action
Affirmative action is mentioned in the statutory language of Title VII, as courts have the power to order
affirmative action as a remedy for the effects of past discriminatory actions. In addition to court-ordered
affirmative action, employers may voluntarily use an affirmative action plan to remedy the effects of past
practices or to achieve diversity within the workforce to reflect the diversity in their community.
In Johnson v. Santa Clara County Transportation Agency,

[13]

the agency had an affirmative action plan.

A woman was promoted from within to the position of dispatcher, even though a male candidate had a
slightly higher score on a test that was designed to measure aptitude for the job. The man brought a
lawsuit alleging sex discrimination. The Court found that voluntary affirmative action was not reverse
discrimination in this case, but employers should be careful in hiring and firing and layoff decisions
versus promotion decisions. It is in the area of promotions that affirmative action is more likely to be
upheld.
In government contracts, President Lyndon Johnson’s Executive Order 11246 prohibits private
discrimination by federal contractors. This is important, because one-third of all US workers are
employed by companies that do business with the federal government. Because of this executive order,
many companies that do business with the government have adopted voluntary affirmative action
programs. In 1995, the Supreme Court limited the extent to which the government could require
contractors to establish affirmative action programs. The Court said that such programs are permissible
only if they serve a “compelling national interest” and are “narrowly tailored” so that they minimize the
harm to white males. To make a requirement for contractors, the government must show that the
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programs are needed to remedy past discrimination, that the programs have time limits, and that
nondiscriminatory alternatives are not available.

[14]

The Age Discrimination in Employment Act
The Age Discrimination in Employment Act (ADEA) of 1967 (amended in 1978 and again in 1986)
prohibits discrimination based on age, and recourse to this law has been growing at a faster rate than any
other federal anti-bias employment law. In particular, the act protects workers over forty years of age and
prohibits forced retirement in most jobs because of age. Until 1987, federal law had permitted mandatory
retirement at age seventy, but the 1986 amendments that took effect January 1, 1987, abolished the age
ceiling except for a few jobs, such as firefighters, police officers, tenured university professors, and
executives with annual pensions exceeding $44,000. Like Title VII, the law has a BFOQ exception—for
example, employers may set reasonable age limitations on certain high-stress jobs requiring peak physical
condition.
There are important differences between the ADEA and Title VII, as Gross v. FBL Financial Services,
Inc. () makes clear. It is now more difficult to prove an age discrimination claim than a claim under Title

VII.

Disabilities: Discrimination against the Handicapped
The 1990 Americans with Disabilities Act (ADA) prohibits employers from discriminating on the basis of
disability. A disabled person is someone with a physical or mental impairment that substantially limits a
major life activity or someone who is regarded as having such impairment. This definition includes people
with mental illness, epilepsy, visual impairment, dyslexia, and AIDS. It also covers anyone who has
recovered from alcoholism or drug addiction. It specifically does not cover people with sexual disorders,
pyromania, kleptomania, exhibitionism, or compulsive gambling.
Employers cannot disqualify an employee or job applicant because of disability as long as he or she can
perform the essential functions of the job, with reasonable accommodation. Reasonable accommodation
might include installing ramps for a wheelchair, establishing more flexible working hours, creating or
modifying job assignments, and the like.

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Reasonable accommodation means that there is no undue hardship for the employer. The law does not
offer uniform standards for identifying what may be an undue hardship other than the imposition on the
employer of a “significant difficulty or expense.” Cases will differ: the resources and situation of each
particular employer relative to the cost or difficulty of providing the accommodation will be considered;
relative cost, rather than some definite dollar amount, will be the issue.
As with other areas of employment discrimination, job interviewers cannot ask questions about an
applicant’s disabilities before making a job offer; the interviewer may only ask whether the applicant can
perform the work. Requirements for a medical exam are a violation of the ADA unless the exam is job
related and required of all applicants for similar jobs. Employers may, however, use drug testing, although
public employers are to some extent limited by the Fourth Amendment requirements of reasonableness.
The ADA’s definition of disability is very broad. However, the Supreme Court has issued several important
decisions that narrow the definition of what constitutes a disability under the act.
Two kinds of narrowing decisions stand out: one deals with “correctable conditions,” and the other deals
with repetitive stress injuries. In 1999, the Supreme Court reviewed a case that raised an issue of whether
severe nearsightedness (which can be corrected with lenses) qualifies as a disability under the
ADA.

[15]

The Supreme Court ruled that disability under the ADA will be measured according to how a

person functions with corrective drugs or devices and not how the person functions without them. In Orr
v. Wal-Mart Stores, Inc., a federal appellate court held that a pharmacist who suffered from diabetes did
not have a cause of action against Wal-Mart under the ADA as long as the condition could be corrected by
insulin.

[16]

The other narrowing decision deals with repetitive stress injuries. For example, carpal tunnel syndrome—
or any other repetitive stress injury—could constitute a disability under the ADA. By compressing a nerve
in the wrist through repetitive use, carpal tunnel syndrome causes pain and weakness in the hand. In
2002, the Supreme Court determined that while an employee with carpal tunnel syndrome could not
perform all the manual tasks assigned to her, her condition did not constitute a disability under the ADA
because it did not “extensively limit” her major life activities. (See.)

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Equal Pay Act
The Equal Pay Act of 1963 protects both men and women from pay discrimination based on sex. The act
covers all levels of private sector employees and state and local government employees but not federal
workers. The act prohibits disparity in pay for jobs that require equal skill and equal effort. Equal skill
means equal experience, and equal effort means comparable mental and/or physical exertion. The act
prohibits disparity in pay for jobs that require equal responsibility, such as equal supervision and
accountability, or similar working conditions.
In making their determinations, courts will look at the stated requirements of a job as well as the actual
requirements of the job. If two jobs are judged to be equal and similar, the employer cannot pay disparate
wages to members of different sexes. Along with the EEOC enforcement, employees can also bring private
causes of action against an employer for violating this act. There are four criteria that can be used as
defenses in justifying differentials in wages: seniority, merit, quantity or quality of product, and any factor
other than sex. The employer will bear the burden of proving any of these defenses.
A defense based on merit will require that there is some clearly measurable standard that justifies the
differential. In terms of quantity or quality of product, there may be a commission structure, piecework
structure, or quality-control-based payment system that will be permitted. Factors “other than sex” do not
include so-called market forces. In Glenn v. General Motors Corp., the US Court of Appeals for the
Eleventh Circuit rejected General Motor’s argument that it was justified in paying three women less than
their male counterparts on the basis of “the market force theory” that women will work for less than a
man.

[17]

KEY TAKEAWAY
Starting with employment at will as a common-law doctrine, we see many modifications by statute,
particularly after 1960. Title VII of the Civil Rights Act of 1964 is the most significant, for it prohibits
employers engaged in interstate commerce from discriminating on the basis of race, color, sex,
religion, or national origin.
Sex discrimination, especially sexual harassment, has been a particularly fertile source of litigation.
There are many defenses to Title VII claims: the employer may have a merit system or a seniority
system in place, or there may be bona fide occupational qualifications in religion, gender, or national
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origin. In addition to Title VII, federal statutes limiting employment discrimination are the ADEA, the
ADA, and the Equal Pay Act.

EXERCISES
1.

Go to the EEOC website. Describe the process by which an employee or ex-employee who wants to
make a Title VII claim obtains a right-to-sue letter from the EEOC.

2.

Again, looking at the EEOC website, find the statistical analysis of Title VII claims brought to the EEOC.
What kind of discrimination is most frequent?

3.

According to the EEOC website, what is “retaliation”? How frequent are retaliation claims relative to
other kinds of claims?

4.

Greg Connolly is a member of the Church of God and believes that premarital sex and abortion are
sinful. He works as a pharmacist for Wal-Mart, and at many times during the week, he is the only
pharmacist available to fill prescriptions. One product sold at his Wal-Mart is the morning-after pill
(RU 468). Based on his religious beliefs, he tells his employer that he will refuse to fill prescriptions for
the morning-after pill. Must Wal-Mart make a reasonable accommodation to his religious beliefs?

[1] See Congress Link, “Major Features of the Civil Rights Act of 1964,”
athttp://www.congresslink.org/print_basics_histmats_civilrights64text.htm.
[2] Hishon v. King & Spalding, 467 U.S. 69 (1984).
[3] McDonnell Douglas Corp. v. Green, 411 U.S. 792 (1973).
[4] Griggs v. Duke Power Co., 401 U.S. 424 (1971).
[5] Trans World Airlines v. Hardison, 432 U.S. 63 (1977).
[6] Harris v. Forklift Systems, Inc., 510 U.S. 17 (1993).
[7] Meritor v. Vinson, 477 U.S. 57 (1986).
[8] 564 U.S. ___ (2011).
[9] Diaz v. Pan American World Airways, Inc., 442 F.2d 385 (5th Cir. 1971).
[10] Diaz v. Pan American World Airways, Inc., 442 F.2d 385 (5th Cir. 1971).
[11] Faragher v. City of Boca Raton, 524 U.S. 775 (1998).
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[12] Burlington Industries v. Ellerth, 524 U.S. 742 (1988).
[13] Johnson v. Santa Clara County Transportation Agency, 480 U.S. 616 (1987).
[14] Adarand Constructors, Inc. v. Pena, 515 U.S. 200 (1995).
[15] Sutton v. United Airlines, Inc., 527 U.S. 471 (1999).
[16] Orr v. Wal-Mart Stores, Inc., 297 F.3d 720 (8th Cir. 2002).
[17] Glenn v. General Motors Corp., 841 F.2d 1567 (1988).

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18.2 Employment at Will
LEARNING OBJECTIVES
1.

Understand what is meant by employment at will under common law.

2.

Explain the kinds of common-law (judicially created) exceptions to the employment-at-will doctrine,
and provide examples.

At common law, an employee without a contract guaranteeing a job for a specific period was an employee
at will and could be fired at any time and for any reason, or even for no reason at all. The various federal
statutes we have just examined have made inroads on the at-will doctrine. Another federal statute, the
Occupational Safety and Health Act, prohibits employers from discharging employees who exercise their
rights under that law.
The courts and legislatures in more than forty states have made revolutionary changes in the at-will
doctrine. They have done so under three theories: tort, contract, and duty of good faith and fair dealing.
We will first consider the tort of wrongful discharge.
Courts have created a major exception to the employment-at-will rule by allowing the tort of wrongful
discharge. Wrongful discharge means firing a worker for a bad reason. What is a bad reason? A bad
reason can be (1) discharging an employee for refusing to violate a law, (2) discharging an employee for
exercising a legal right, (3) discharging an employee for performing a legal duty, and (4) discharging an
employee in a way that violates public policy.

Discharging an Employee for Refusing to Violate a Law
Some employers will not want employees to testify truthfully at trial. In one case, a nurse refused a
doctor’s order to administer a certain anesthetic when she believed it was wrong for that particular
patient; the doctor, angry at the nurse for refusing to obey him, then administered the anesthetic himself.
The patient soon stopped breathing. The doctor and others could not resuscitate him soon enough, and he
suffered permanent brain damage. When the patient’s family sued the hospital, the hospital told the nurse
she would be in trouble if she testified. She did testify according to her oath in the court of law (i.e.,
truthfully), and after several months of harassment, was finally fired on a pretext. The hospital was held

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liable for the tort of wrongful discharge. As a general rule, you should not fire an employee for refusing to
break the law.

Discharging an Employee for Exercising a Legal Right
Suppose Bob Berkowitz files a claim for workers’ compensation for an accident at Pacific Gas & Electric,
where he works and where the accident that injured him took place. He is fired for doing so, because the
employer does not want to have its workers’ comp premiums increased. In this case, the right exercised by
Berkowitz is supported by public policy: he has a legal right to file the claim, and if he can establish that
his discharge was caused by his filing the claim, he will prove the tort of wrongful discharge.

Discharging an Employee for Performing a Legal Duty
Courts have long held that an employee may not be fired for serving on a jury. This is so even though
courts do recognize that many employers have difficulty replacing employees called for jury duty. Jury
duty is an important civic obligation, and employers are not permitted to undermine it.

Discharging an Employee in a Way That Violates Public Policy
This is probably the most controversial basis for a tort of wrongful discharge. There is an inherent
vagueness in the phrase “basic social rights, duties, or responsibilities.” This is similar to the exception in
contract law: the courts will not enforce contract provisions that violate public policy. (For the most part,
public policy is found in statutes and in cases.) But what constitutes public policy is an important decision
for state courts. In Wagenseller v. Scottsdale Memorial Hospital,

[1]

for example, a nurse who refused to

“play along” with her coworkers on a rafting trip was discharged. The group of coworkers had socialized at
night, drinking alcohol; when the partying was near its peak, the plaintiff refused to be part of a group
that bared their buttocks to the tune of “Moon River” (a composition by Henry Mancini that was popular
in the 1970s). The court, at great length, considered that “mooning” was a misdemeanor under Arizona
law and that therefore her employer could not discharge her for refusing to violate a state law.
Other courts have gone so far as to include professional oaths and codes as part of public policy. In Rocky
Mountain Hospital and Medical Services v. Diane Mariani, the Colorado Supreme Court reviewed a trial
court decision to refuse relief to a certified public accountant who was discharged when she refused to
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violate her professional code.

[2]

(Her employer had repeatedly required her to come up with numbers and

results that did not reflect the true situation, using processes that were not in accord with her training and
the code.) The court of appeals had reversed the trial court, and the Supreme Court had to decide if the
professional code of Colorado accountants could be considered to be part of public policy. Given that
accountants were licensed by the state on behalf of the public, and that the Board of Accountancy had
published a code for accounting professionals and required an oath before licensing, the court noted the
following:
The Colorado State Board of Accountancy is established pursuant to section 12-2-103, 5A C.R.S. (1991).
The Board has responsibility for making appropriate rules of professional conduct, in order to establish
and maintain a high standard of integrity in the profession of public accounting. § 12-2-104, 5A C.R.S.
(1991). These rules of professional conduct govern every person practicing as a certified public
accountant. Id. Failure to abide by these rules may result in professional discipline. § 12-2-123, 5A C.R.S.
(1991). The rules of professional conduct for accountants have an important public purpose. They ensure
the accurate reporting of financial information to the public. They allow the public and the business
community to rely with confidence on financial reporting. Rule 7.1, 3 C.C.R. 705-1 (1991). In addition, they
ensure that financial information will be reported consistently across many businesses. The legislature
has endorsed these goals in section 12-2-101, 5A C.R.S.
The court went on to note that the stated purpose of the licensing and registration of certified public
accountants was to “provide for the maintenance of high standards of professional conduct by those so
licensed and registered as certified public accountants.” Further, the specific purpose of Rule 7.1 provided
a clear mandate to support an action for wrongful discharge. Rule 7.1 is entitled “Integrity and
Objectivity” and states, “A certificate holder shall not in the performance of professional services
knowingly misrepresent facts, nor subordinate his judgment to others.” The fact that Mariani’s employer
asked her to knowingly misrepresent facts was a sufficient basis in public policy to make her discharge
wrongful.

Contract Modification of Employment at Will
Contract law can modify employment at will. Oral promises made in the hiring process may be
enforceable even though the promises are not approved by top management. Employee handbooks may
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create implied contracts that specify personnel processes and statements that the employees can be fired
only for a “just cause” or only after various warnings, notice, hearing, or other procedures.

Good Faith and Fair Dealing Standard
A few states, among them Massachusetts and California, have modified the at-will doctrine in a farreaching way by holding that every employer has entered into an implied covenant of good faith and fair
dealing with its employees. That means, the courts in these states say, that it is “bad faith” and therefore
unlawful to discharge employees to avoid paying commissions or pensions due them. Under this implied
covenant of fair dealing, any discharge without good cause—such as incompetence, corruption, or habitual
tardiness—is actionable. This is not the majority view, as the case in Section 18.4.4 "Disability
Discrimination" makes clear.

KEY TAKEAWAY
Although employment at will is still the law, numerous exceptions have been established by judicial
decision. Employers can be liable for the tort of wrongful discharge if they discharge an employee for
refusing to violate a law, for exercising a legal right or performing a legal duty, or in a way that violates
basic public policy.

EXERCISES
1.

Richard Mudd, an employee of CompuServe, is called for jury duty in Wayne County, Michigan. His
immediate supervisor, Harvey Lorie, lets him know that he “must” avoid jury duty at all costs. Mudd
tells the judge of his circumstances and his need to be at work, but the judge refuses to let Mudd
avoid jury duty. Mudd spends the next two weeks at trial. He sends regular e-mails and texts to Lorie
during this time, but on the fourth day gets a text message from Lorie that says, “Don’t bother to
come back.” When he does return, Lorie tells him he is fired. Does Mudd have a cause of action for
the tort of wrongful discharge?

2.

Olga Monge was a schoolteacher in her native Costa Rica. She moved to New Hampshire and attended
college in the evenings to earn US teaching credentials. At night, she worked at the Beebe Rubber

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Company after caring for her husband and three children during the day. When she applied for a
better job at the plant, the foreman offered to promote her if she would be “nice” and go out on a
date with him. She refused, and he assigned her to a lower-wage job, took away her overtime, made
her clean the washrooms, and generally ridiculed her. She finally collapsed at work, and he fired her.
Does Monge have any cause of action?

[1] Wagenseller v. Scottsdale Memorial Hospital, 147 Ariz. 370; 710 P.2d 1025 (1085).
[2] Rocky Mountain Hospital and Medical Services v. Diane Mariani, 916 P.2d 519 (Colo. 1996).

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18.3 Other Employment-Related Laws
LEARNING OBJECTIVE
1.

Understand the various federal and state statutes that affect employers in the areas of plant closings,
pensions, workers’ compensation, use of polygraphs, and worker safety.

The Federal Plant-Closing Act
A prime source of new jobs across the United States is the opening of new industrial plants—which
accounted for millions of jobs a year during the 1970s and 1980s. But for every 110 jobs thus created,
nearly 100 were lost annually in plant closings during that period. In the mid-1980s alone, 2.2 million
plant jobs were lost each year. As serious as those losses were for the national economy, they were no less
serious for the individuals who were let go. Surveys in the 1980s showed that large numbers of companies
provided little or no notice to employees that their factories were to be shut down and their jobs
eliminated. Nearly a quarter of businesses with more than 100 employees provided no specific notice to
their employees that their particular work site would be closed or that they would suffer mass layoffs.
More than half provided two weeks’ notice or less.
Because programs to support dislocated workers depend heavily on the giving of advance notice, a
national debate on the issue in the late 1980s culminated in 1988 in Congress’s enactment of the Worker
Adjustment and Retraining Notification (WARN) Act, the formal name of the federal plant-closing act.
Under this law, businesses with 100 or more employees must give employees or their local bargaining
unit, along with the local city or county government, at least sixty days’ notice whenever (1) at least 50
employees in a single plant or office facility would lose their jobs or face long-term layoffs or a reduction
of more than half their working hours as the result of a shutdown and (2) a shutdown would require longterm layoffs of 500 employees or at least a third of the workforce. An employer who violates the act is
liable to employees for back pay that they would have received during the notice period and may be liable
to other fines and penalties.
An employer is exempted from having to give notice if the closing is caused by business circumstances
that were not reasonably foreseeable as of the time the notice would have been required. An employer is
also exempted if the business is actively seeking capital or business that if obtained, would avoid or

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postpone the shutdown and the employer, in good faith, believes that giving notice would preclude the
business from obtaining the needed capital or business.

The Employee Polygraph Protection Act
Studies calling into question the reliability of various forms of lie detectors have led at least half the states
and, in 1988, Congress to legislate against their use by private businesses. The Employee Polygraph
Protection Act forbids private employers from using lie detectors (including such devices as voice stress
analyzers) for any reason. Neither employees nor applicants for jobs may be required or even asked to
submit to them. (The act has some exceptions for public employers, defense and intelligence businesses,
private companies in the security business, and manufacturers of controlled substances.)
Use of polygraphs, machines that record changes in the subject’s blood pressure, pulse, and other
physiological phenomena, is strictly limited. They may be used in conjunction with an investigation into
such crimes as theft, embezzlement, and industrial espionage, but in order to require the employee to
submit to polygraph testing, the employer must have “reasonable suspicion” that the employee is involved
in the crime, and there must be supporting evidence for the employer to discipline or discharge the
employee either on the basis of the polygraph results or on the employee’s refusal to submit to testing.
The federal polygraph law does not preempt state laws, so if a state law absolutely bars an employer from
using one, the federal law’s limited authorization will be unavailable.

Occupational Safety and Health Act
In a heavily industrialized society, workplace safety is a major concern. Hundreds of studies for more than
a century have documented the gruesome toll taken by hazardous working conditions in mines, on
railroads, and in factories from tools, machines, treacherous surroundings, and toxic chemicals and other
substances. Studies in the late 1960s showed that more than 14,000 workers were killed and 2.2 million
were disabled annually—at a cost of more than $8 billion and a loss of more than 250 million worker days.
Congress responded in 1970 with the Occupational Safety and Health Act, the primary aim of which is “to
assure so far as possible every working man and woman in the Nation safe and healthful working
conditions.”

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The act imposes on each employer a general duty to furnish a place of employment free from recognized
hazards likely to cause death or serious physical harm to employees. It also gives the secretary of labor the
power to establish national health and safety standards. The standard-making power has been delegated
to the Occupational Safety and Health Administration (OSHA), an agency within the US Department of
Labor. The agency has the authority to inspect workplaces covered by the act whenever it receives
complaints from employees or reports about fatal or multiple injuries. The agency may assess penalties
and proceed administratively to enforce its standards. Criminal provisions of the act are enforced by the
Justice Department.
During its first two decades, OSHA was criticized for not issuing standards very quickly: fewer than thirty
national workplace safety standards were issued by 1990. But not all safety enforcement is in the hands of
the federal government: although OSHA standards preempt similar state standards, under the act the
secretary may permit the states to come up with standards equal to or better than federal standards and
may make grants to the states to cover half the costs of enforcement of the state safety standards.

Employee Retirement Income Security Act
More than half the US workforce is covered by private pension plans for retirement. One 1988 estimate
put the total held in pension funds at more than $1 trillion, costing the federal Treasury nearly $60 billion
annually in tax write-offs. As the size of the private pension funds increased dramatically in the 1960s,
Congress began to hear shocking stories of employees defrauded out of pension benefits, deprived of a
lifetime’s savings through various ruses (e.g., by long vesting provisions and by discharges just before
retirement). To put an end to such abuses, Congress, in 1974, enacted the Employee Retirement Income
Security Act (ERISA).
In general, ERISA governs the vesting of employees’ pension rights and the funding of pension plans.
Within five years of beginning employment, employees are entitled to vested interests in retirement
benefits contributed on their behalf by individual employers. Multiemployer pension plans must vest their
employees’ interests within ten years. A variety of pension plans must be insured through a federal
agency, the Pension Benefit Guaranty Corporation, to which employers must pay annual premiums. The
corporation may assume financial control of underfunded plans and may sue to require employers to
make up deficiencies. The act also requires pension funds to disclose financial information to
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beneficiaries, permits employees to sue for benefits, governs the standards of conduct of fund
administrators, and forbids employers from denying employees their rights to pensions. The act largely
preempts state law governing employee benefits.

Fair Labor Standards Act
In the midst of the Depression, Congress enacted at President Roosevelt’s urging a national minimum
wage law, the Fair Labor Standards Act of 1938 (FLSA). The act prohibits most forms of child labor and
established a scale of minimum wages for the regular workweek and a higher scale for overtime. (The
original hourly minimum was twenty-five cents, although the administrator of the Wage and Hour
Division of the US Department of Labor, a position created by the act, could raise the minimum rate
industry by industry.) The act originally was limited to certain types of work: that which was performed in
transporting goods in interstate commerce or in producing goods for shipment in interstate commerce.
Employers quickly learned that they could limit the minimum wage by, for example, separating the
interstate and intrastate components of their production. Within the next quarter century, the scope of
the FLSA was considerably broadened, so that it now covers all workers in businesses that do a particular
dollar-volume of goods that move in interstate commerce, regardless of whether a particular employee
actually works in the interstate component of the business. It now covers between 80 and 90 percent of all
persons privately employed outside of agriculture, and a lesser but substantial percentage of agricultural
workers and state and local government employees. Violations of the act are investigated by the
administrator of the Wage and Hour Division, who has authority to negotiate back pay on the employee’s
behalf. If no settlement is reached, the Labor Department may sue on the employee’s behalf, or the
employee, armed with a notice of the administrator’s calculations of back wages due, may sue in federal or
state court for back pay. Under the FLSA, a successful employee will receive double the amount of back
wages due.

Workers’ Compensation Laws
Since the beginning of the twentieth century, work-related injuries or illnesses have been covered under
state workers’ compensation laws that provide a set amount of weekly compensation for disabilities
caused by accidents and illnesses suffered on the job. The compensation plans also pay hospital and
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medical expenses necessary to treat workers who are injured by, or become ill from, their work. In
assuring workers of compensation, the plans eliminate the hazards and uncertainties of lawsuits by
eliminating the need to prove fault. Employers fund the compensation plans by paying into statewide
plans or purchasing insurance.

Other State Laws
Although it may appear that most employment law is federal, employment discrimination is largely
governed by state law because Congress has so declared it. The Civil Rights Act of 1964 tells federal courts
to defer to state agencies to enforce antidiscrimination provisions of parallel state statutes with remedies
similar to those of the federal law. Moreover, many states have gone beyond federal law in banning certain
forms of discrimination. Thus well before enactment of the Americans with Disabilities Act, more than
forty states prohibited such discrimination in private employment. More than a dozen states ban
employment discrimination based on marital status, a category not covered by federal law. Two states
have laws that protect those that may be considered “overweight.” Two states and more than seventy
counties or municipalities ban employment discrimination on the basis of sexual orientation; most large
companies have offices or plants in at least one of these jurisdictions. By contrast, federal law has no
statutory law dealing with sexual orientation.

KEY TAKEAWAY
There are a number of important federal employment laws collective bargaining or discrimination.
These include the federal plant-closing act, the Employee Polygraph Protection Act, the Occupational
Safety and Health Act, the Employee Retirement Income Security Act, and the Fair Labor Standards Act.
At the state level, workers’ compensation laws preempt common-law claims against employers for
work-related injuries, and state equal opportunity employment laws provide remedies for certain kinds
of workplace discrimination that have no parallel at the federal level.

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EXERCISES
1.

United Artists is a corporation doing business in Texas. United Pension Fund is a defined-contribution
employee pension benefit plan sponsored by United Artists for employees. Each employee has his or
her own individual pension account, but plan assets are pooled for investment purposes. The plan is
administered by the board of trustees. From 1977 to 1986, seven of the trustees made a series of
loans to themselves from the plan. These trustees did not (1) require the borrowers to submit a
written application for the loans, (2) assess the prospective borrower’s ability to repay loans, (3)
specify a period in which the loans were to be repaid, or (4) call the loans when they remained unpaid.
The trustees also charged less than fair-market-value interest for the loans. The secretary of labor
sued the trustees, alleging that they had breached their fiduciary duty in violation of ERISA. Who
won?

2.

[1]

Arrow Automotive Industries remanufactures and distributes automobile and truck parts. Its
operating plants produce identical product lines. The company is planning to open a new facility in
Santa Maria, California. The employees at the Arrow plant in Hudson, Massachusetts, are represented
by a union, the United Automobile, Aerospace, and Agricultural Implement Workers of America. The
Hudson plant has a history of unprofitable operations. The union called a strike when the existing
collective bargaining agreement expired and a new agreement could not be reached. After several
months, the board of directors of the company voted to close the striking plant. The closing would
give Arrow a 24 percent increase in gross profits and free capital and equipment for the new Santa
Maria plant. In addition, the existing customers of the Hudson plant could be serviced by the
Spartanburg, South Carolina, plant, which is currently being underutilized. What would have to be
done if the plant-closing act applied to the situation?

[2]

[1] Mc Laughlin v. Rowley, 69 F.Supp. 1333 (N.D. Tex. 1988).
[2] Arrow Automotive Industries, Inc. v. NLRB, 853 F.2d 233 (4th Cir. 1989).

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18.4 Cases
Disparate Treatment: Burdens of Proof
Barbano v. Madison County
922 F.2d 139 (2d Cir. 1990)

Factual Background
At the Madison County (New York State) Veterans Service Agency, the position of director became vacant.
The County Board of Supervisors created a committee of five men to hold interviews for the position. The
committee interviewed Maureen E. Barbano and four others. When she entered the interview room, she
heard someone say, “Oh, another woman.” At the beginning of the interview, Donald Greene said he
would not consider “some woman” for the position. Greene also asked Barbano some personal questions
about her family plans and whether her husband would mind if she transported male veterans. Ms.
Barbano answered that the questions were irrelevant and discriminatory. However, Greene replied that
the questions were relevant because he did not want to hire a woman who would get pregnant and quit.
Another committee member, Newbold, agreed that the questions were relevant, and no committee
member said the questions were not relevant.
None of the interviewers rebuked Greene or objected to the questions, and none of them told Barbano
that she need not answer them. Barbano did state that if she decided to have a family she would take no
more time off than medically necessary. Greene once again asked whether Barbano’s husband would
object to her “running around the country with men” and said he would not want his wife to do it.
Barbano said she was not his wife. The interview concluded after Barbano asked some questions about
insurance.
After interviewing several other candidates, the board hired a man. Barbano sued the county for sex
discrimination in violation of Title VII, and the district court held in her favor. She was awarded $55,000
in back pay, prejudgment interest, and attorney’s fees. Madison County appealed the judgment of Federal
District Judge McAvoy; Barbano cross-appealed, asking for additional damages.
The court then found that Barbano had established a prima facie case of discrimination under Title VII,
thus bringing into issue the appellants’ purported reasons for not hiring her. The appellants provided four
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reasons why they chose Wagner over Barbano, which the district court rejected either as unsupported by
the record or as a pretext for discrimination in light of Barbano’s interview. The district court then found
that because of Barbano’s education and experience in social services, the appellants had failed to prove
that absent the discrimination, they still would not have hired Barbano. Accordingly, the court awarded
Barbano back pay, prejudgment interest, and attorney’s fees. Subsequently, the court denied Barbano’s
request for front pay and a mandatory injunction ordering her appointment as director upon the next
vacancy. This appeal and cross-appeal followed.

From the Opinion of FEINBERG, CIRCUIT JUDGE
Appellants argue that the district court erred in finding that Greene’s statements during the interview
showed that the Board discriminated in making the hiring decision, and that there was no direct evidence
of discrimination by the Board, making it improper to require that appellants prove that they would not
have hired Barbano absent the discrimination. Barbano in turn challenges the adequacy of the relief
awarded to her by the district court.

A. Discrimination
At the outset, we note that Judge McAvoy’s opinion predated Price Waterhouse v. Hopkins, 490 U.S. 228,
109 S. Ct. 1775, 104 L. Ed. 2d 268 (1990), in which the Supreme Court made clear that a “pretext” case
should be analyzed differently from a “mixed motives” case. Id. 109 S. Ct. at 1788-89. Judge McAvoy, not
having the benefit of the Court’s opinion in Price Waterhouse, did not clearly distinguish between the two
types of cases in analyzing the alleged discrimination. For purposes of this appeal, we do not think it is
crucial how the district court categorized the case. Rather, we need only concern ourselves with whether
the district court’s findings of fact are supported by the record and whether the district court applied the
proper legal standards in light of its factual findings.
Whether the case is one of pretext or mixed motives, the plaintiff bears the burden of persuasion on the
issue of whether gender played a part in the employment decision. Price Waterhouse v. Hopkins, at 1788.
Appellants contend that Barbano did not sustain her burden of proving discrimination because the only
evidence of discrimination involved Greene’s statements during the interview, and Greene was an elected
official over whom the other members of the Board exercised no control. Thus, appellants maintain, since
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the hiring decision was made by the 19-member board, evidence of discrimination by one member does
not establish that the Board discriminated in making the hiring decision.
We agree that discrimination by one individual does not necessarily imply that a collective decisionmaking body of which the individual is a member also discriminated. However, the record before us
supports the district court’s finding that the Board discriminated in making the hiring decision.
First, there is little doubt that Greene’s statements during the interview were discriminatory. He said he
would not consider “some woman” for the position. His questioning Barbano about whether she would get
pregnant and quit was also discriminatory, since it was unrelated to a bona fide occupational
qualification. King v. Trans World Airlines, 738 F.2d 255, 258 n.2 (8th Cir. 1984). Similarly, Greene’s
questions about whether Barbano’s husband would mind if she had to “run around the country with men,”
and that he would not want his wife to do it, were discriminatory, since once again the questions were
unrelated to bona fide occupational qualifications. Hopkins, at 1786.
Moreover, the import of Greene’s discriminatory questions was substantial, since apart from one question
about her qualifications, none of the interviewers asked Barbano about other areas that allegedly formed
the basis for selecting a candidate. Thus, Greene’s questioning constituted virtually the entire interview,
and so the district court properly found that the interview itself was discriminatory.
Next, given the discriminatory tenor of the interview, and the acquiescence of the other Committee
members to Greene’s line of questioning, it follows that the judge could find that those present at the
interview, and not merely Greene, discriminated against Barbano. Judge McAvoy pointed out that the
Chairman of the Committee, Newbold, thought Greene’s discriminatory questions were relevant.
Significantly, Barbano protested that Greene’s questions were discriminatory, but no one agreed with her
or told her that she need not answer. Indeed, no one even attempted to steer the interview in another
direction. This knowing and informed toleration of discriminatory statements by those participating in
the interview constitutes evidence of discrimination by all those present. That each member was
independently elected to the Board does not mean that the Committee itself was unable to control the
course of the interview. The Committee had a choice of how to conduct the interview, and the court could
find that the Committee exercised that choice in a plainly discriminatory fashion.
This discrimination directly affected the hiring decision. At the end of the interviewing process, the
interviewers evaluated the candidates, and on that basis submitted a recommendation as to which
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candidate to hire for the position. “Evaluation does not occur in a vacuum. By definition, when evaluating
a candidate to fill a vacant position, one compares that candidate against other eligible candidates.” Berl v.
County of Westchester, 849 F.2d 712, 715 (2d Cir. 1988). Appellants stipulated that Barbano was qualified
for the position. Again, because Judge McAvoy could find that the evaluation of Barbano was biased by
gender discrimination, the judge could also find that the Committee’s recommendation to hire Wagner,
which was the result of a weighing of the relative merits of Barbano, Wagner and the other eligible
candidates, was necessarily tainted by discrimination.
The Board in turn unanimously accepted the Committee’s recommendation to hire Wagner, and so the
Board’s hiring decision was made in reliance upon a discriminatory recommendation. The Supreme Court
in Hopkins v. Price Waterhouse found that a collective decision-making body can discriminate by relying
upon discriminatory recommendations, and we are persuaded that the reasoning in that case applies here
as well.
In Hopkins’ case against Price Waterhouse, Ann Hopkins, a candidate for partnership at the accounting
firm of Price Waterhouse, alleged that she was refused admission as a partner because of sex
discrimination. Hopkins’s evidence of discrimination consisted largely of evaluations made by various
partners. Price Waterhouse argued that such evidence did not prove that its internal Policy Board, which
was the effective decision-maker as to partnership in that case, had discriminated. The Court rejected that
argument and found the evidence did establish discrimination:
Hopkins showed that the partnership solicited evaluations from all of the firm’s partners; that it generally
relied very heavily on such evaluations in making its decision; that some of the partners’ comments were
the product of [discrimination]; and that the firm in no way disclaimed reliance on those particular
comments, either in Hopkins’ case or in the past. Certainly, a plausible—and, one might say, inevitable—
conclusion to draw from this set of circumstances is that the Policy Board in making its decision did in
fact take into account all of the partners’ comments, including the comments that were motivated by
[discrimination].
Hopkins, at 1794.
In a very significant sense, Barbano presents an even stronger case of discrimination because the only
recommendation the Board relied upon here was discriminatory, whereas in Price Waterhouse, not all of
the evaluations used in the decision-making process were discriminatory. On the other hand, it is true
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that the discriminatory content of some of the evaluations in Price Waterhouse was apparent from
reading them, whereas here, the recommendation was embodied in a resolution to the Board and a
reading of the resolution would not reveal that it was tainted by discrimination. Nonetheless, the facts in
this case show that the Board was put on notice before making the appointment that the Committee’s
recommendation was biased by discrimination.
Barbano was a member of the public in attendance at the Board meeting in March 1980 when the Board
voted to appoint Wagner. Before the Board adopted the resolution appointing Wagner, Barbano objected
and asked the Board if male applicants were asked the questions she was asked during the interview. At
this point, the entire Board membership was alerted to the possibility that the Committee had
discriminated against Barbano during her interview. The Committee members did not answer the
question, except for Newbold, who evaded the issue by stating that he did not ask such questions. The
Board’s ability to claim ignorance at this point was even further undermined by the fact that the Chairman
of the Board, Callahan, was present at many of the interviews, including Barbano’s, in his role as
Chairman of the Board. Callahan did not refute Barbano’s allegations, implying that they were worthy of
credence, and none of the Board members even questioned Callahan on the matter.
It is clear that those present understood Barbano was alleging that she had been subjected to
discrimination during her interview. John Patane, a member of the Board who had not interviewed
Barbano, asked Barbano whether she was implying that Madison County was not an equal opportunity
employer. Barbano said yes. Patane said the County already had their “token woman.” Callahan
apologized to Barbano for “any improper remarks that may have been made,” but an apology for
discrimination does not constitute an attempt to eliminate the discrimination from the hiring decision.
Even though the Board was aware of possible improprieties, it made no investigation whatsoever into the
allegations and did not disclaim any reliance upon the discrimination. In short, the circumstances show
the Board was willing to rely on the Committee’s recommendation even if Barbano had been
discriminated against during her interview. On these facts, it was not clearly erroneous for the district
court to conclude that Barbano sustained her burden of proving discrimination by the Board.

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B. The Employer’s Burden
Having found that Barbano carried her burden of proving discrimination, the district court then placed
the burden on appellants to prove by a preponderance of the evidence that, absent the discrimination,
they would not have hired Barbano for the position. Appellants argue that this burden is only placed on an
employer if the plaintiff proves discrimination by direct evidence, and since Barbano’s evidence of
discrimination was merely circumstantial, the district court erred by placing the burden of proof on them.
Appellants, however, misapprehend the nature of Barbano’s proof and thus the governing legal standard.
The burden is properly placed on the defendant “once the plaintiff establishes by direct evidence that an
illegitimate factor played a motivating or substantial role in an employment decision.” Grant v. Hazelett
Strip-Casting Corp., 880 F.2d 1564, 1568 (2d Cir. 1989). Thus, the key inquiry on this aspect of the case is
whether the evidence is direct, that is, whether it shows that the impermissible criterion played some part
in the decision-making process. See Hopkins, at 1791; Grant, 880 F.2d at 1569. If plaintiff provides such
evidence, the fact-finder must then determine whether the evidence shows that the impermissible
criterion played a motivating or substantial part in the hiring decision. Grant, 880 F.2d at 1569.
As we found above, the evidence shows that Barbano’s gender was clearly a factor in the hiring decision.
That the discrimination played a substantial role in that decision is shown by the importance of the
recommendation to the Board. As Rafte testified, the Board utilizes a committee system, and so the Board
“usually accepts” a committee’s recommendation, as it did here when it unanimously voted to appoint
Wagner. Had the Board distanced itself from Barbano’s allegations of discrimination and attempted to
ensure that it was not relying upon illegitimate criteria in adopting the Committee’s recommendation, the
evidence that discrimination played a substantial role in the Board’s decision would be significantly
weakened. The Board showed no inclination to take such actions, however, and in adopting the
discriminatory recommendation allowed illegitimate criteria to play a substantial role in the hiring
decision.
The district court thus properly required appellants to show that the Board would not have hired Barbano
in the absence of discrimination. “The employer has not yet been shown to be a violator, but neither is it
entitled to the…presumption of good faith concerning its employment decisions. At this point the
employer may be required to convince the fact-finder that, despite the smoke, there is no fire.” Hopkins,
at 1798-99 (O’Connor, J., concurring).
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Judge McAvoy noted in his opinion that appellants claimed they chose Wagner over Barbano because he
was better qualified in the following areas: (1) interest in veterans’ affairs; (2) experience in the military;
(3) tactfulness; and (4) experience supervising an office. The judge found that the evidence before him
supported only appellants’ first and second reasons for refusing to hire Barbano, but acknowledged that
the Committee members “were enamored with Wagner’s military record and involvement with veterans’
organizations.” However, neither of these is listed as a job requirement in the job description, although
the district court found that membership in a veterans’ organization may indicate an interest in veterans’
affairs. Nonetheless, the district court found that given Barbano’s “education and experience in social
services,” appellants failed to carry their burden of proving by a preponderance of the evidence that,
absent discrimination, they would not have hired Barbano.
The district court properly held appellants to a preponderance of the evidence standard. Hopkins, 109 S.
Ct. at 1795…
At the time of the hiring decision in 1980, Barbano had been a Social Welfare Examiner for Madison
County for the three previous years. In this position, she determined the eligibility of individuals for
public assistance, Medicaid or food stamps, and would then issue or deny the individual’s application
based on all federal, state and local regulations pertaining to the program from which the individual was
seeking assistance. Barbano was thus familiar with the operation of public assistance programs, knew how
to fill out forms relating to benefits and had become familiar with a number of welfare agencies that could
be of use to veterans. Barbano was also working towards an Associate Degree in Human Services at the
time. Rafte testified that Barbano’s resume was “very impressive.” Moreover, Barbano, unlike Wagner,
was a resident of Madison County, and according to Rafte, a candidate’s residency in the county was
considered to be an advantage. Finally, Barbano had also enlisted in the United States Marine Corps in
1976, but during recruit training had been given a vaccine that affected her vision. She had received an
honorable discharge shortly thereafter.
Wagner had nine years’ experience as an Air Force Personnel Supervisor, maintaining personnel records,
had received a high school equivalency diploma and took several extension classes in management. He
had been honorably discharged from the Air Force in 1965 with the rank of Staff Sergeant. Wagner was a
member of the American Legion, and his application for the position included recommendations from two
American Legion members. However, for the six years prior to his appointment as Director, Wagner’s sole
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paid employment was as a school bus driver and part-time bartender at the American Legion. Wagner
admitted that before he was hired he had no knowledge of federal, state and local laws, rules and
regulations pertaining to veterans’ benefits and services, or knowledge of the forms, methods and
procedures used to process veteran benefits claims. Wagner also had not maintained liaison with welfare
agencies and was unfamiliar with the various welfare agencies that existed in the county.
To be sure, both candidates were qualified for the Director’s position, and it is not our job—nor was it the
district courts—to decide which one was preferable. However, there is nothing to indicate that Judge
McAvoy misconceived his function in this phase of the case, which was to decide whether appellants failed
to prove by a preponderance of the evidence that they would not have hired Barbano even if they had not
discriminated against her. The judge found that defendants had not met that burden. We must decide
whether that finding was clearly erroneous, and we cannot say that it was.

CASE QUESTIONS
1.

Madison County contended that Barbano needed to provide “direct evidence” of discrimination that
had played a motivating or substantial part in the decision. What would such evidence look like? Is it
likely that most plaintiffs who are discriminated against because of their gender would be able to get
“direct evidence” that gender was a motivating or substantial factor?

2.

The “clearly erroneous” standard is applied here, as it is in many cases where appellate courts review
trial court determinations. State the test, and say why the appellate court believed that the trial
judge’s ruling was not “clearly erroneous.”

Title VII and Hostile Work Environment
Duncan v. General Motors Corporation
300 F.3d 928 (8th Cir. 2002)
OPINION BY HANSEN, Circuit Judge.
The Junior College District of St. Louis (the College) arranged for Diana Duncan to provide in-house
technical training at General Motors Corporation’s (GMC) manufacturing facility in Wentzville, Missouri.
Throughout her tenure at GMC, Duncan was subjected to unwelcome attention by a GMC employee,
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James Booth, which culminated in Duncan’s resignation. Duncan subsequently filed this suit under Title
VII of the Civil Rights Act and the Missouri Human Rights Act, see 42 U.S.C. §§ 2000e-2000e-17; Mo.
Rev. Stat. §§ 213.010-213.137,2 alleging that she was sexually harassed and constructively discharged. A
jury found in favor of Duncan and awarded her $4600 in back pay, $700,000 in emotional distress
damages on her sexual harassment claim, and $300,000 in emotional distress damages on her
constructive discharge claim. GMC appeals from the district court’s denial of its post-trial motion for
judgment as a matter of law, and the district court’s award of attorneys’ fees attendant to the post-trial
motion. We reverse.

I.
Diana Duncan worked as a technical training clerk in the high-tech area at GMC as part of the College’s
Center for Business, Industry, and Labor program from August 1994 until May 1997. Duncan provided inhouse training support to GMC employees.
Duncan first learned about the College’s position at GMC from Booth, a United Auto Workers Union
technology training coordinator for GMC. Booth frequented the country club where Duncan worked as a
waitress and a bartender. Booth asked Duncan if she knew anyone who had computer and typing skills
and who might be interested in a position at GMC. Duncan expressed interest in the job. Booth brought
the pre-employment forms to Duncan at the country club, and he forwarded her completed forms to Jerry
Reese, the manager of operations, manufacturing, and training for the College. Reese arranged to
interview Duncan at GMC. Reese, Booth, and Ed Ish, who was Booth’s management counterpart in the
high-tech area of the GMC plant, participated in the interview. Duncan began work at GMC in August
1994.
Two weeks after Duncan began working at GMC, Booth requested an off-site meeting with her at a local
restaurant. Booth explained to Duncan that he was in love with a married coworker and that his own
marriage was troubled. Booth then propositioned Duncan by asking her if she would have a relationship
with him. Duncan rebuffed his advance and left the restaurant. The next day Duncan mentioned the
incident to the paint department supervisor Joe Rolen, who had no authority over Booth. Duncan did not
report Booth’s conduct to either Reese (her supervisor) at the College or Ish (Booth’s management
counterpart) at GMC. However, she did confront Booth, and he apologized for his behavior. He made no
further such “propositions.” Duncan stated that Booth’s manner toward her after she declined his advance
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became hostile, and he became more critical of her work. For example, whenever she made a
typographical error, he told her that she was incompetent and that he should hire a “Kelly Services”
person to replace her. Duncan admitted that Booth’s criticisms were often directed at other employees as
well, including male coworkers.
Duncan testified to numerous incidents of Booth’s inappropriate behavior. Booth directed Duncan to
create a training document for him on his computer because it was the only computer with the necessary
software. The screen saver that Booth had selected to use on his computer was a picture of a naked
woman. Duncan testified to four or five occasions when Booth would unnecessarily touch her hand when
she handed him the telephone. In addition, Booth had a planter in his office that was shaped like a
slouched man wearing a sombrero. The planter had a hole in the front of the man’s pants that allowed for
a cactus to protrude. The planter was in plain view to anyone entering Booth’s office. Booth also kept a
child’s pacifier that was shaped like a penis in his office that he occasionally showed to his coworkers and
specifically to Duncan on two occasions.
In 1995, Duncan requested a pay increase and told Booth that she would like to be considered for an
illustrator’s position. Booth said that she would have to prove her artistic ability by drawing his planter.
Duncan objected, particularly because previous applicants for the position were required to draw
automotive parts and not his planter. Ultimately, Duncan learned that she was not qualified for the
position because she did not possess a college degree.
Additionally in 1995, Booth and a College employee created a “recruitment” poster that was posted on a
bulletin board in the high-tech area. The poster portrayed Duncan as the president and CEO of the Man
Hater’s Club of America. It listed the club’s membership qualifications as: “Must always be in control of:
(1) Checking, Savings, all loose change, etc.; (2) (Ugh) Sex; (3) Raising children our way!; (4) Men must
always do household chores; (5) Consider T.V. Dinners a gourmet meal.”…
On May 5, 1997, Booth asked Duncan to type a draft of the beliefs of the “He-Men Women Hater’s Club.”
The beliefs included the following:
—Constitutional Amendment, the 19th, giving women [the] right to vote should be repealed. Real He-Men
indulge in a lifestyle of cursing, using tools, handling guns, driving trucks, and hunting and of course,
drinking beer.
—Women really do have coodies [sic] and they can spread.
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—Women [are] the cause of 99.9 per cent of stress in men.
—Sperm has a right to live.
—All great chiefs of the world are men.
—Prostitution should be legalized.
Duncan refused to type the beliefs and resigned two days later.
Duncan testified that she complained to anyone who would listen to her about Booth’s behavior,
beginning with paint department supervisor Joe Rolen after Booth propositioned her in 1994. Duncan
testified that between 1994 and 1997 she complained several times to Reese at the College about Booth’s
behavior, which would improve at least in the short term after she spoke with Reese.…
Duncan filed a charge of sex discrimination with the Equal Employment Opportunity Commission
(EEOC) on October 30, 1997. The EEOC issued Duncan a right to sue notice on April 17, 1998. Alleging
sexual harassment and constructive discharge, Duncan filed suit against the College and GMC under both
Title VII of the Civil Rights Act and the Missouri Human Rights Act. Duncan settled with the College prior
to trial. After the jury found in Duncan’s favor on both counts against GMC, GMC filed a post-trial motion
for judgment as a matter of law or, alternatively, for a new trial. The district court denied the motion. The
district court also awarded Duncan attorneys’ fees in conjunction with GMC’s post-trial motion. GMC
appeals.

II.
A. Hostile Work Environment
GMC argues that it was entitled to judgment as a matter of law on Duncan’s hostile work environment
claim because she failed to prove a prima facie case. We agree.…
It is undisputed that Duncan satisfies the first two elements of her prima facie case: she is a member of a
protected group and Booth’s attention was unwelcome. We also conclude that the harassment was based
on sex…Although there is some evidence in the record that indicates some of Booth’s behavior, and the
resulting offensive and disagreeable atmosphere, was directed at both male and female employees, GMC
points to ten incidents when Booth’s behavior was directed at Duncan alone. GMC concedes that five of
these ten incidents could arguably be based on sex: (1) Booth’s proposition for a “relationship”; (2)
Booth’s touching of Duncan’s hand; (3) Booth’s request that Duncan sketch his planter; (4) the Man
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Hater’s Club poster; and (5) Booth’s request that Duncan type the He-Men Women Haters beliefs. “A
plaintiff in this kind of case need not show…that only women were subjected to harassment, so long as she
shows that women were the primary target of such harassment.” We conclude that a jury could reasonably
find that Duncan and her gender were the overriding themes of these incidents. The evidence is sufficient
to support the jury finding that the harassment was based on sex.
We agree, however, with GMC’s assertion that the alleged harassment was not so severe or pervasive as to
alter a term, condition, or privilege of Duncan’s employment…To clear the high threshold of actionable
harm, Duncan has to show that “the workplace is permeated with discriminatory intimidation, ridicule,
and insult.” Harris v. Forklift Systems, Inc., 510 U.S. 17, 21, 126 L. Ed. 2d 295, 114 S. Ct. 367 (1993)
(internal quotations omitted). “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.” Oncale, 523 U.S. at 81 (internal quotation omitted). Thus, the
fourth part of a hostile environment claim includes both objective and subjective components: an
environment that a reasonable person would find hostile and one that the victim actually perceived as
abusive. Harris, 510 U.S. at 21-22. In determining whether the conduct is sufficiently severe or pervasive,
we look to the totality of the circumstances, including the “frequency of the discriminatory conduct; its
severity; whether it is physically threatening or humiliating, or a mere offensive utterance; and whether it
unreasonably interferes with an employee’s work performance.”…These standards are designed to “filter
out complaints attacking the ordinary tribulations of the workplace, such as the sporadic use of abusive
language, gender-related jokes, and occasional teasing.” Faragher v. City of Boca Raton, 524 U.S. 775, 788,
141 L. Ed. 2d 662, 118 S. Ct. 2275 (1998) (internal quotations omitted).
The evidence presented at trial illustrates that Duncan was upset and embarrassed by the posting of the
derogatory poster and was disturbed by Booth’s advances and his boorish behavior; but, as a matter of
law, she has failed to show that these occurrences in the aggregate were so severe and extreme that a
reasonable person would find that the terms or conditions of Duncan’s employment had been
altered.…Numerous cases have rejected hostile work environment claims premised upon facts equally or
more egregious than the conduct at issue here. See, e.g., Shepherd v. Comptroller of Pub. Accounts, 168
F.3d 871, 872, 874 (5th Cir.) (holding that several incidents over a two-year period, including the
comment “your elbows are the same color as your nipples,” another comment that plaintiff had big thighs,
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repeated touching of plaintiff’s arm, and attempts to look down the plaintiff’s dress, were insufficient to
support hostile work environment claim), cert. denied, 528 U.S. 963, 145 L. Ed. 2d 308, 120 S. Ct. 395
(1999); Adusumilli v. City of Chicago, 164 F.3d 353, 357, 361-62 (7th Cir. 1998) (holding conduct
insufficient to support hostile environment claim when employee teased plaintiff, made sexual jokes
aimed at her, told her not to wave at police officers “because people would think she was a prostitute,”
commented about low-necked tops, leered at her breasts, and touched her arm, fingers, or buttocks on
four occasions), cert. denied, 528 U.S. 988, 145 L. Ed. 2d 367, 120 S. Ct. 450 (1999); Black v. Zaring
Homes,, Inc., 104 F.3d 822, 823-24, 826 (6th Cir.) (reversing jury verdict and holding behavior merely
offensive and insufficient to support hostile environment claim when employee reached across plaintiff,
stating “nothing I like more in the morning than sticky buns” while staring at her suggestively; suggested
to plaintiff that parcel of land be named “Hootersville,” “Titusville,” or “Twin Peaks”; and asked “weren’t
you there Saturday night dancing on the tables?” while discussing property near a biker bar), cert. denied,
522 U.S. 865, 139 L. Ed. 2d 114, 118 S. Ct. 172 (1997); Weiss v. Coca-Cola Bottling Co., 990 F.2d 333, 337
(7th Cir. 1993) (holding no sexual harassment when plaintiff’s supervisor asked plaintiff for dates, asked
about her personal life, called her a “dumb blond,” put his hand on her shoulder several times, placed “I
love you” signs at her work station, and attempted to kiss her twice at work and once in a bar).
Booth’s actions were boorish, chauvinistic, and decidedly immature, but we cannot say they created an
objectively hostile work environment permeated with sexual harassment. Construing the evidence in the
light most favorable to Duncan, she presented evidence of four categories of harassing conduct based on
her sex: a single request for a relationship, which was not repeated when she rebuffed it, four or five
isolated incidents of Booth briefly touching her hand, a request to draw a planter, and teasing in the form
of a poster and beliefs for an imaginary club. It is apparent that these incidents made Duncan
uncomfortable, but they do not meet the standard necessary for actionable sexual harassment. It is worth
noting that Duncan fails to even address this component of her prima facie case in her brief. We conclude
as a matter of law that she did not show a sexually harassing hostile environment sufficiently severe or
pervasive so as to alter the conditions of her employment, a failure that dooms Duncan’s hostile work
environment claim. See Meritor Sav. Bank, FSB v. Vinson, 477 U.S. 57, 67, 91 L. Ed. 2d 49, 106 S. Ct. 2399
(1986).

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For the foregoing reasons, we reverse the district court’s denial of judgment as a matter of law. Because
GMC should have prevailed on its post-trial motion, the award of attorneys’ fees is likewise vacated.
RICHARD S. ARNOLD, Circuit Judge, dissenting.
The Court concludes that the harassment suffered by Ms. Duncan was not so severe or pervasive as to
alter a term, condition, or privilege of her employment, and that, therefore, GMC is entitled to judgment
as a matter of law on her hostile-work environment and constructive-discharge claims. I respectfully
disagree.
Ms. Duncan was subjected to a long series of incidents of sexual harassment in her workplace, going far
beyond “gender-related jokes and occasional teasing.” Faragher v. City of Boca Raton, 524 U.S. 775, 788
(1988). When the evidence is considered in the light most favorable to her, and she is given the benefit of
all reasonable inferences, there is “substantial evidence to sustain the cause of action.” Stockmen’s
Livestock Market, Inc. v. Norwest Bank of Sioux City, 135 F.3d 1236, 1240 (8th Cir. 1998) In Ms. Duncan’s
case, a jury reached the conclusion that Mr. Booth’s offensive behavior created a hostile work
environment. I believe this determination was reasonable and supported by ample evidence.
Ms. Duncan was subjected to a sexual advance by her supervisor within days of beginning her job. This
proposition occurred during work hours and was a direct request for a sexual relationship. The Court
characterizes this incident as a “single request,” (but) [t]his description minimizes the effect of the sexual
advance on Ms. Duncan’s working conditions. During the months immediately following this incident,
Mr. Booth became hostile to Ms. Duncan, increased his criticism of her work, and degraded her
professional capabilities in front of her peers. Significantly, there is no suggestion that this hostile
behavior occurred before Ms. Duncan refused his request for sex. From this evidence, a jury could easily
draw the inference that Mr. Booth changed his attitude about Ms. Duncan’s work because she rejected his
sexual advance.
Further, this sexual overture was not an isolated incident. It was only the beginning of a string of
degrading actions that Mr. Booth directed toward Ms. Duncan based on her sex. This inappropriate
behavior took many forms, from physical touching to social humiliation to emotional intimidation. For
example, Mr. Booth repeatedly touched Ms. Duncan inappropriately on her hand. He publicly singled her
out before her colleagues as a “Man Hater” who “must always be in control of” sex. He required her to
choose between drawing a vulgar planter displayed in his office or not being considered for a promotion,
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an unfair choice that would likely intimidate a reasonable person from seeking further career
advancement.
The Court cites cases in which our sister Circuits have rejected hostile-work environment claims premised
upon facts that the Court determines to be “equally or more egregious” than the conduct at issue here. I do
not agree that Ms. Duncan experienced less severe harassment than those plaintiffs. For example, in
Weiss v. Coca-Cola Bottling Co., 990 F.2d 333 (7th Cir. 1993), the plaintiff did not allege that her work
duties or evaluations were different because of her sex. This is not the situation Ms. Duncan faced. She
was given specific tasks of a sexually charged nature, such as typing up the minutes of the “He-Man
Women Hater’s Club.” Performing this “function” was presented to her as a required duty of her job.
Also Ms. Duncan was subjected to allegations that she was professionally “incompetent because of her
sex.”…She adduced evidence of this factor when she testified that after she rejected his sexual advance,
Mr. Booth became more critical of her work. With the request for her to draw the planter for a promotion,
Ms. Duncan also faced “conduct that would prevent her from succeeding in the workplace,” a fact that Ms.
Shepherd could not point to in her case. Additionally, Ms. Duncan was “propositioned” to sleep with her
employer…a claim not made by Ms. Shepherd.
Finally, we note that in Ms. Duncan’s case the harassing acts were directed specifically at her. The Court
in Black v. Zaring Homes, 104 F.3d 822, 826 (6th Cir.), cert. denied, 522 U.S. 865, 139 L. Ed. 2d 114, 118
S. Ct. 172 (1997), stated that the lack of specific comments to the plaintiff supported the conclusion that
the defendant’s conduct was not severe enough to create actionable harm. By contrast, in the present case,
a jury could reasonably conclude that Ms. Duncan felt particularly humiliated and degraded by Mr.
Booth’s behavior because she alone was singled out for this harassment.
Our own Court’s Title VII jurisprudence suggests that Ms. Duncan experienced enough offensive conduct
to constitute sexual harassment. For example, in Breeding v. Arthur J. Gallagher and Co. we reversed a
grant of summary judgment to an employer, stating that a supervisor who “fondled his genitals [**25] in
front of” a female employee and “used lewd and sexually inappropriate language” could create an
environment severe enough to be actionable under Title VII. 164 F.3d 1151, 1159 (8th Cir. 1999). In Rorie
v. United Parcel Service, we concluded that a work environment in which “a supervisor pats a female
employee on the back, brushes up against her, and tells her she smells good” could be found by a jury to

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be a hostile work environment. 151 F.3d 757, 762 (8th Cir. 1998). Is it clear that the women in these cases
suffered harassment greater than Ms. Duncan? I think not.
We have acknowledged that “there is no bright line between sexual harassment and merely unpleasant
conduct, so a jury’s decision must generally stand unless there is trial error.” Hathaway v. Runyon, 132
F.3d 1214, 1221 (8th Cir. 1998). We have also ruled that “once there is evidence of improper conduct and
subjective offense, the determination of whether the conduct rose to the level of abuse is largely in the
hands of the jury.” Howard v. Burns Bros., Inc., 149 F.3d 835, 840 (8th Cir. 1998). The Court admits that
Ms. Duncan took subjective offense to Mr. Booth’s behavior and characterizes Mr. Booth’s behavior as
“boorish, chauvinistic, and decidedly immature.” Thus, the Court appears to agree that Mr. Booth’s
behavior was “improper conduct.” I believe the Court errs in deciding as a matter of law that the jury did
not act reasonably in concluding that Ms. Duncan faced severe or pervasive harassment that created a
hostile work environment.
Therefore, I dissent from the Court’s conclusion that Ms. Duncan did not present sufficient evidence to
survive judgment as a matter of law on her hostile work-environment and constructive-discharge claims.

CASE QUESTIONS
1.

Which opinion is more persuasive to you—the majority opinion or the dissenting opinion?

2.

“Numerous cases have rejected hostile work environment claims premised upon facts equally or more
egregious than the conduct at issue here.” By what standard or criteria does the majority opinion
conclude that Duncan’s experiences were no worse than those mentioned in the other cases?

3.

Should the majority on the appeals court substitute its judgment for that of the jury?

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Age Discrimination: Burden of Persuasion
Gross v. FBL Financial Services, Inc.
557 U.S. ___ (2009)
JUSTICE CLARENCE THOMAS delivered the opinion of the court.

I
Petitioner Jack Gross began working for respondent FBL Financial Group, Inc. (FBL), in 1971. As of 2001,
Gross held the position of claims administration director. But in 2003, when he was 54 years old, Gross
was reassigned to the position of claims project coordinator. At that same time, FBL transferred many of
Gross’ job responsibilities to a newly created position—claims administration manager. That position was
given to Lisa Kneeskern, who had previously been supervised by Gross and who was then in her early
forties. Although Gross (in his new position) and Kneeskern received the same compensation, Gross
considered the reassignment a demotion because of FBL’s reallocation of his former job responsibilities to
Kneeskern.
In April 2004, Gross filed suit in District Court, alleging that his reassignment to the position of claims
project coordinator violated the ADEA, which makes it unlawful for an employer to take adverse action
against an employee “because of such individual’s age.” 29 U. S. C. §623(a). The case proceeded to trial,
where Gross introduced evidence suggesting that his reassignment was based at least in part on his age.
FBL defended its decision on the grounds that Gross’ reassignment was part of a corporate restructuring
and that Gross’ new position was better suited to his skills.
At the close of trial, and over FBL’s objections, the District Court instructed the jury that it must return a
verdict for Gross if he proved, by a preponderance of the evidence, that FBL “demoted [him] to claims
project[t] coordinator” and that his “age was a motivating factor” in FBL’s decision to demote him. The
jury was further instructed that Gross’ age would qualify as a “‘motivating factor,’ if [it] played a part or a
role in [FBL]’s decision to demote [him].” The jury was also instructed regarding FBL’s burden of proof.
According to the District Court, the “verdict must be for [FBL]…if it has been proved by the
preponderance of the evidence that [FBL] would have demoted [Gross] regardless of his age.” Ibid. The
jury returned a verdict for Gross, awarding him $46,945 in lost compensation. FBL challenged the jury
instructions on appeal. The United States Court of Appeals for the Eighth Circuit reversed and remanded
for a new trial, holding that the jury had been incorrectly instructed under the standard established in
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Price Waterhouse v. Hopkins, 490 U. S. 228 (1989). In Price Waterhouse, this Court addressed the
proper allocation of the burden of persuasion in cases brought under Title VII of the Civil Rights Act of
1964, when an employee alleges that he suffered an adverse employment action because of both
permissible and impermissible considerations—i.e., a “mixed-motives” case. 490 U. S., at 232, 244–247
(plurality opinion). The Price Waterhouse decision was splintered. Four Justices joined a plurality
opinion, and three Justices dissented. Six Justices ultimately agreed that if a Title VII plaintiff shows that
discrimination was a “motivating” or a “ ‘substantial’ “ factor in the employer’s action, the burden of
persuasion should shift to the employer to show that it would have taken the same action regardless of
that impermissible consideration. Justice O’Connor further found that to shift the burden of persuasion to
the employer, the employee must present “direct evidence that an illegitimate criterion was a substantial
factor in the [employment] decision.”…
Because Gross conceded that he had not presented direct evidence of discrimination, the Court of Appeals
held that the District Court should not have given the mixed-motives instruction. Ibid. Rather, Gross
should have been held to the burden of persuasion applicable to typical, non-mixed-motives claims; the
jury thus should have been instructed only to determine whether Gross had carried his burden of
“prov[ing] that age was the determining factor in FBL’s employment action.”
We granted certiorari, 555 U.S. ___ (2008), and now vacate the decision of the Court of Appeals.

II
The parties have asked us to decide whether a plaintiff must “present direct evidence of discrimination in
order to obtain a mixed-motive instruction in a non-Title VII discrimination case.” Before reaching this
question, however, we must first determine whether the burden of persuasion ever shifts to the party
defending an alleged mixed-motives discrimination claim brought under the ADEA. We hold that it does
not.

A
Petitioner relies on this Court’s decisions construing Title VII for his interpretation of the ADEA. Because
Title VII is materially different with respect to the relevant burden of persuasion, however, these decisions
do not control our construction of the ADEA.
In Price Waterhouse, a plurality of the Court and two Justices concurring in the judgment determined
that once a “plaintiff in a Title VII case proves that [the plaintiff’s membership in a protected class] played
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a motivating part in an employment decision, the defendant may avoid a finding of liability only by
proving by a preponderance of the evidence that it would have made the same decision even if it had not
taken [that factor] into account.” 490 U. S., at 258; see also id., at 259–260 (opinion of White, J.); id., at
276 (opinion of O’Connor, J.). But as we explained in Desert Palace, Inc. v. Costa, 539 U. S. 90, 94–95
(2003), Congress has since amended Title VII by explicitly authorizing discrimination claims in which an
improper consideration was “a motivating factor” for an adverse employment decision. See 42 U. S. C.
§2000e–2(m) (providing that “an unlawful employment practice is established when the complaining
party demonstrates that race, color, religion, sex, or national origin was a motivating factor for any
employment practice, even though other factors also motivated the practice” (emphasis added))…
This Court has never held that this burden-shifting framework applies to ADEA claims. And, we decline to
do so now. When conducting statutory interpretation, we “must be careful not to apply rules applicable
under one statute to a different statute without careful and critical examination.” Unlike Title VII, the
ADEA’s text does not provide that a plaintiff may establish discrimination by showing that age was simply
a motivating factor. Moreover, Congress neglected to add such a provision to the ADEA when it amended
Title VII to add §§2000e–2(m) and 2000e–5(g)(2)(B), even though it contemporaneously amended the
ADEA in several ways.…
We cannot ignore Congress’ decision to amend Title VII’s relevant provisions but not make similar
changes to the ADEA. When Congress amends one statutory provision but not another, it is presumed to
have acted intentionally.…As a result, the Court’s interpretation of the ADEA is not governed by Title VII
decisions such as Desert Palace and Price Waterhouse.

B
Our inquiry therefore must focus on the text of the ADEA to decide whether it authorizes a mixed-motives
age discrimination claim. It does not. “Statutory construction must begin with the language employed by
Congress and the assumption that the ordinary meaning of that language accurately expresses the
legislative purpose.”…The ADEA provides, in relevant part, that “[i]t shall be unlawful for an employer…to
fail or refuse to hire or to discharge any individual or otherwise discriminate against any individual with
respect to his compensation, terms, conditions, or privileges of employment, because of such individual’s
age.” 29 U. S. C. §623(a)(1) (emphasis added).

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The words “because of” mean “by reason of: on account of.” Webster’s Third New International Dictionary
194 (1966); see also Oxford English Dictionary 746 (1933) (defining “because of” to mean “By reason of,
on account of” (italics in original)); The Random House Dictionary of the English Language 132 (1966)
(defining “because” to mean “by reason; on account”). Thus, the ordinary meaning of the ADEA’s
requirement that an employer took adverse action “because of” age is that age was the “reason” that the
employer decided to act.…To establish a disparate-treatment claim under the plain language of the ADEA,
therefore, a plaintiff must prove that age was the “but-for” cause of the employer’s adverse decision.…
It follows, then, that under §623(a)(1), the plaintiff retains the burden of persuasion to establish that age
was the “but-for” cause of the employer’s adverse action. Indeed, we have previously held that the burden
is allocated in this manner in ADEA cases. See Kentucky Retirement Systems v. EEOC, 554 U. S. ____.
And nothing in the statute’s text indicates that Congress has carved out an exception to that rule for a
subset of ADEA cases. Where the statutory text is “silent on the allocation of the burden of persuasion,”
we “begin with the ordinary default rule that plaintiffs bear the risk of failing to prove their claims.
”Schaffer v. Weast, 546 U. S. 49, 56 (2005)…
Hence, the burden of persuasion necessary to establish employer liability is the same in alleged mixedmotives cases as in any other ADEA disparate-treatment action. A plaintiff must prove by a
preponderance of the evidence (which may be direct or circumstantial), that age was the “but-for” cause of
the challenged employer decision.

III
Finally, we reject petitioner’s contention that our interpretation of the ADEA is controlled by Price
Waterhouse, which initially established that the burden of persuasion shifted in alleged mixed-motives
Title VII claims. In any event, it is far from clear that the Court would have the same approach were it to
consider the question today in the first instance.
Whatever the deficiencies of Price Waterhouse in retrospect, it has become evident in the years since that
case was decided that its burden-shifting framework is difficult to apply. For example, in cases tried to a
jury, courts have found it particularly difficult to craft an instruction to explain its burden-shifting
framework.…Thus, even if Price Waterhouse was doctrinally sound, the problems associated with its
application have eliminated any perceivable benefit to extending its framework to ADEA claims.

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IV
We hold that a plaintiff bringing a disparate-treatment claim pursuant to the ADEA must prove, by a
preponderance of the evidence, that age was the “but-for” cause of the challenged adverse employment
action. The burden of persuasion does not shift to the employer to show that it would have taken the
action regardless of age, even when a plaintiff has produced some evidence that age was one motivating
factor in that decision. Accordingly, we vacate the judgment of the Court of Appeals and remand the case
for further proceedings consistent with this opinion.
It is so ordered.

CASE QUESTIONS
1.

What is the practical effect of this decision? Will plaintiffs with age-discrimination cases find it harder
to win after Gross?

2.

As Justice Thomas writes about it, does “but-for” cause here mean the “sole cause”? Must plaintiffs
now eliminate any other possible cause in order to prevail in an ADEA lawsuit?

3.

Based on this opinion, if the employer provides a nondiscriminatory reason for the change in the
employee’s status (such as “corporate restructuring” or “better alignment of skills”), does the
employer bear any burden of showing that those are not just words but that, for example, the
restructuring really does make sense or that the “skills” really do line up better in the new
arrangement?

4.

If the plaintiff was retained at the same salary as before, how could he have a “discrimination”
complaint, since he still made the same amount of money?

5.

The case was decided by a 5-4 majority. A dissent was filed by Justice Stevens, and a separate dissent
by Justice Breyer, joined by Justices Ginsburg and Souter. You can access those
at http://www.law.cornell.edu/supct/pdf/08-441P.ZD1.

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Disability Discrimination
Toyota v. Williams
534 U.S. 184 (2000)

Factual Background
Ella Williams’s job at the Toyota manufacturing plant involved using pneumatic tools. When her hands
and arms began to hurt, she consulted a physician and was diagnosed with carpal tunnel syndrome. The
doctor advised her not to work with any pneumatic tools or lift more than twenty pounds. Toyota shifted
her to a different position in the quality control inspection operations (QCIO) department, where
employees typically performed four different tasks. Initially, Williams was given two tasks, but Toyota
changed its policy to require all QCIO employees to rotate through all four tasks. When she performed the
“shell body audit,” she had to hold her hands and arms up around shoulder height for several hours at a
time.
She soon began to experience pain in her neck and shoulders. When she asked permission to do only the
two tasks that she could perform without difficulty, she was refused. According to Toyota, Williams then
began missing work regularly.
In 1997, Toyota Motor Manufacturing, Kentucky, Inc. terminated Ella Williams, citing her poor
attendance record. Subsequently, claiming to be disabled from performing her automobile assembly line
job by carpal tunnel syndrome and related impairments, Williams sued Toyota for failing to provide her
with a reasonable accommodation as required by the Americans with Disabilities Act (ADA) of 1990.
Granting Toyota summary judgment, the district court held that Williams’s impairment did not qualify as
a disability under the ADA because it had not substantially limited any major life activity and that there
was no evidence that Williams had had a record of a substantially limiting impairment. In reversing, the
court of appeals found that the impairments substantially limited Williams in the major life activity of
performing manual tasks. Because her ailments prevented her from doing the tasks associated with
certain types of manual jobs that require the gripping of tools and repetitive work with hands and arms
extended at or above shoulder levels for extended periods of time, the appellate court concluded that
Williams demonstrated that her manual disability involved a class of manual activities affecting the ability
to perform tasks at work.
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JUSTICE SANDRA DAY O’CONNOR delivered the unanimous opinion of the court.
When it enacted the ADA in 1990, Congress found that some 43 million Americans have one or more
physical or mental disabilities. If Congress intended everyone with a physical impairment that precluded
the performance of some isolated, unimportant, or particularly difficult manual task to qualify as
disabled, the number of disabled Americans would surely have been much higher. We therefore hold that
to be substantially limited in performing manual tasks, an individual must have an impairment that
prevents or severely restricts the individual from doing activities that are of central importance to most
people’s daily lives. The impairments impact must also be permanent or long-term.
When addressing the major life activity of performing manual tasks, the central inquiry must be whether
the claimant is unable to perform the variety of tasks central to most people’s daily lives, not whether the
claimant is unable to perform the tasks associated with her specific job. In this case, repetitive work with
hands and arms extended at or above shoulder levels for extended periods of time is not an important part
of most people’s daily lives. The court, therefore, should not have considered respondent’s inability to do
such manual work in or specialized assembly line job as sufficient proof that she was substantially limited
in performing manual tasks.
At the same time, the Court of Appeals appears to have disregarded the very type of evidence that it
should have focused upon. It treated as irrelevant “[t]he fact that [respondent] can…ten[d] to her personal
hygiene [and] carr[y]out personal or household chores.” Yet household chores, bathing, and brushing
one’s teeth are among the types of manual tasks of central importance to people’s daily lives, and should
have been part of the assessment of whether respondent was substantially limited in performing manual
tasks.
The District Court noted that at the time respondent sought an accommodation from petitioner, she
admitted that she was able to do the manual tasks required by her original two jobs in QCIO. In addition,
according to respondent’s deposition testimony, even after her condition worsened, she could still brush
her teeth, wash her face, bathe, tend her flower garden, fix breakfast, do laundry, and pick up around the
house. The record also indicates that her medical conditions caused her to avoid sweeping, to quit
dancing, to occasionally seek help dressing, and to reduce how often she plays with her children, gardens,
and drives long distances. But these changes in her life did not amount to such severe restrictions in the
activities that are of central importance to most people’s daily lives that they establish a manual task
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disability as a matter of law. On this record, it was therefore inappropriate for the Court of Appeals to
grant partial summary judgment to respondent on the issue of whether she was substantially limited in
performing manual tasks, and its decision to do so must be reversed.
Accordingly, we reverse the Court of Appeals’ judgment granting partial summary judgment to
respondent and remand the case for further proceedings consistent with this opinion.

CASE QUESTIONS
1.

What is the court’s most important “finding of fact” relative to hands and arms? How does this relate
to the statutory language that Congress created in the ADA?

2.

The case is remanded to the lower courts “for further proceedings consistent with this opinion.” In
practical terms, what does that mean for this case?

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18.5 Summary and Exercises
Summary
For the past forty-eight years, Title VII of the Civil Rights Act of 1964 has prohibited employment
discrimination based on race, religion, sex, or national origin. Any employment decision, including hiring,
promotion, and discharge, based on one of these factors is unlawful and subjects the employer to an
award of back pay, promotion, or reinstatement. The Equal Employment Opportunity Commission
(EEOC) may file suits, as may the employee—after the commission screens the complaint.
Two major types of discrimination suits are those for disparate treatment (in which the employer
intended to discriminate) and disparate impact (in which, regardless of intent, the impact of a particular
non-job-related practice has a discriminatory effect). In matters of religion, the employer is bound not
only to refrain from discrimination based on an employee’s religious beliefs or preferences but also to
accommodate the employee’s religious practices to the extent that the accommodation does not impose an
undue hardship on the business.
Sex discrimination, besides refusal to hire a person solely on the basis of sex, includes discrimination
based on pregnancy. Sexual harassment is a form of sex discrimination, and it includes the creation of a
hostile or offensive working environment. A separate statute, the Equal Pay Act, mandates equal pay for
men and women assigned to the same job.
One major exception to Title VII permits hiring people of a particular religion, sex, or nationality if that
feature is a bona fide occupational qualification. There is no bona fide occupational qualification (BFOQ)
exception for race, nor is a public stereotype a legitimate basis for a BFOQ.
Affirmative action plans, permitting or requiring employers to hire on the basis of race to make up for
past discrimination or to bring up the level of minority workers, have been approved, even though the
plans may seem to conflict with Title VII. But affirmative action plans have not been permitted to
overcome bona fide seniority or merit systems.

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The Age Discrimination in Employment Act protects workers over forty from discharge solely on the basis
of age. Amendments to the law have abolished the age ceiling for retirement, so that most people working
for employers covered by the law cannot be forced to retire.
The Americans with Disabilities Act of 1990 prohibits discrimination based on disability and applies to
most jobs in the private sector.
At common law, an employer was free to fire an employee for any reason or for no reason at all. In recent
years, the employment-at-will doctrine has been seriously eroded. Many state courts have found against
employers on the basis of implied contracts, tortious violation of public policy, or violations of an implied
covenant of good faith and fair dealing.
Beyond antidiscrimination law, several other statutes have an impact on the employment relationship.
These include the plant-closing law, the Employee Polygraph Protection Act, the Occupational Safety and
Health Act, the Employee Retirement Income Security Act, and the Fair Labor Standards Act.

EXERCISES
1.

Rainbow Airlines, a new air carrier headquartered in Chicago with routes from Rome to Canberra,
extensively studied the psychology of passengers and determined that more than 93 percent of its
passengers felt most comfortable with female flight attendants between the ages of twenty-one and
thirty-four. To increase its profitability, the company issued a policy of hiring only such people for jobs
in the air but opened all ground jobs to anyone who could otherwise qualify. The policy made no racial
distinction, and, in fact, nearly 30 percent of the flight attendants hired were black. What violations of
federal law has Rainbow committed, if any?

2.

Tex Olafson worked for five years as a messenger for Pressure Sell Advertising Agency, a company
without a unionized workforce. On his fifth anniversary with the company, Tex was called in to the
president’s office, was given a 10 percent raise, and was complimented on his diligence. The following
week, a new head of the messenger department was hired. He wanted to appoint his nephew to a
messenger job but discovered that a company-wide hiring freeze prevented him from adding another
employee to the messenger ranks. So he fired Tex and hired his nephew. What remedy, if any, does
Tex have? What additional facts might change the result?

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3.

Ernest lost both his legs in combat in Vietnam. He has applied for a job with Excelsior Products in the
company’s quality control lab. The job requires inspectors to randomly check products coming off the
assembly line for defects. Historically, all inspectors have stood two-hour shifts. Ernest proposes to sit
in his wheelchair. The company refuses to hire him because it says he will be less efficient. Ernest’s
previous employment record shows him to be a diligent, serious worker. Does Ernest have a legal right
to be hired? What additional facts might you want to know in deciding?

4.

Marlene works for Frenzied Traders, a stockbrokerage with a seat on the New York Stock Exchange.
For several years, Marlene has been a floor trader, spending all day in the hurly-burly of stock trading,
yelling herself hoarse. Each year, she has received a large bonus from the company. She has just told
the company that she is pregnant. Citing a company policy, she is told she can no longer engage in
trading because it is too tiring for pregnant women. Instead, she may take a backroom job, though the
company cannot guarantee that the floor job will be open after she delivers. Marlene also wants to
take six months off after her child is born. The company says it cannot afford to give her that time. It
has a policy of granting paid leave to anyone recuperating from a stay in the hospital and unpaid leave
for four months thereafter. What legal rights does Marlene have, and what remedies is she entitled
to?

5.

Charlie Goodfellow works for Yum-burger and has always commanded respect at the local franchise
for being the fastest server. One day, he undergoes a profound religious experience, converts to
Sikhism, and changes his name to Sanjay Singh. The tenets of his religion require him to wear a beard
and a turban. He lets his beard grow, puts on a turban, and his fellow workers tease him. When a
regional vice president sees that Sanjay is not wearing the prescribed Yum-Burger uniform, he fires
him. What rights of Sanjay, if any, has Yum-burger violated? What remedies are available to him?

SELF-TEST QUESTIONS
1.

Affirmative action in employment

a.

is a requirement of Title VII of the Civil Rights Act of 1964

b.

is prohibited by Title VII of the Civil Rights Act of 1964

c.

is a federal statute enacted by Congress

d.

depends on the circumstances of each case for validity

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The Age Discrimination in Employment Act protects
a.

all workers of any age
b.

all workers up to age seventy

c.

most workers over forty

d.

no workers over seventy
Federal laws barring discrimination against the handicapped and disabled

a.

apply to all disabilities
b.

apply to most disabilities in private employment

c.

apply to all disabilities in public employment

d.

apply to most disabilities in public employment
Under Title VII, a bona fide occupational qualification exception may never apply to cases
involving

a.

racial discrimination
b.

religious discrimination

c.

sex discrimination

d.

age discrimination
The employment-at-will doctrine derives from

a.

Title VII of the Civil Rights Act of 1964
b.

employment contracts

c.

the common law

d.

liberty of contract under the Constitution

SELF-TEST ANSWERS
1.

d

2.

c

3.

b

4.

a

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5.

c

Chapter 19
Labor-Management Relations
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

How collective bargaining was resisted for many years in the United States, and how political and
economic changes resulted in legalization of labor unions

2.

The four major federal labor laws in the United States

3.

The process by which bargaining units are recognized by the National Labor Relations Board

4.

The various kinds of unfair labor practices that employers might engage in, and those that unions and
their members might engage in

Over half a century, the federal law of labor relations has developed out of four basic statutes into an
immense body of cases and precedent regulating the formation and governance of labor unions and the
relationships among employers, unions, and union members. Like antitrust law, labor law is a complex
subject that has spawned a large class of specialized practitioners. Though specialized, it is a subject that
no employer of any size can ignore, for labor law has a pervasive influence on how business is conducted
throughout the United States. In this chapter, we examine the basic statutory framework and the activities
that it regulates.
It is important to note at the outset that legal rights for laborers in the United States came about through
physical and political struggles. The right of collective bargaining and the right to strike (and
corresponding rights for employers, such as the lockout) were hard-won and incremental. The legislation
described in this chapter began only after many years of labor-management strife, including judicial
opposition to unions and violent and deadly confrontations between pro-union workers and management.
In 1806, the union of Philadelphia Journeymen Cordwainers was convicted of and bankrupted by charges
of criminal conspiracy after a strike for higher wages, setting a precedent by which the US government
would combat unions for years to come. Andrew Jackson became a strikebreaker in 1834 when he sent
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troops to the construction sites of the Chesapeake and Ohio Canal. In 1877, a general strike halted the
movement of US railroads. In the following days, strike riots spread across the United States. The next
week, federal troops were called out to force an end to the nationwide strike. At the Battle of the Viaduct
in Chicago, federal troops (recently returned from an Indian massacre) killed thirty workers and wounded
over one hundred. Numerous other violent confrontations marked the post–Civil War period in America,
including the violent rail strikes of 1877, when President Rutherford B. Hayes sent troops to prevent
obstruction of the mails. President Grover Cleveland used soldiers to break the Pullman strike of 1894.
Not until the anthracite coal strikes in Pennsylvania in 1902 did the US governments become a mediator
between labor and management rather than an enforcer for industry.
Many US labor historians see the first phase of the labor movement in terms of the struggles in the private
sector that led to the labor legislation of the New Deal, described in . The second phase of the movement,
post–World War II, saw less violent confrontation and more peaceful resolution of labor issues in
collective bargaining. Yet right-to-work states in the southern part of the United States and globalization
weakened the attractiveness of unions in the private sector. Right-to-work states provided a haven for
certain kinds of manufacturing operations that wanted no part of bargaining with unions. Globalization
meant that companies could (realistically) threaten to relocate outside the United States entirely. Unions
in the public sector of the United States began to grow stronger relative to unions in the private sector:
governments could not relocate as companies could, and over the last half century, there has been a
gradual decline in private sector unionism and growth in public sector unionism.

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19.1 A Brief History of Labor Legislation
LEARNING OBJECTIVES
1.

Understand and explain the rise of labor unions in the United States.

2.

Explain what common-law principles were used by employers and courts to resist legalized collective
bargaining.

3.

Be able to put US labor law in its historical context.

Labor and the Common Law in the Nineteenth Century
Labor unions appeared in modern form in the United States in the 1790s in Boston, New York, and
Philadelphia. Early in the nineteenth century, employers began to seek injunctions against union
organizing and other activities. Two doctrines were employed: (1) common-law conspiracy and
(2) common-law restraint of trade. The first doctrine held that workers who joined together were acting
criminally as conspirators, regardless of the means chosen or the objectives sought.
The second doctrine—common-law restraint of trade—was also a favorite theory used by the courts to
enjoin unionizing and other joint employee activities. Workers who banded together to seek better wages
or working conditions were, according to this theory, engaged in concerted activity that restrained trade in
their labor. This theory made sense in a day in which conventional wisdom held that an employer was
entitled to buy labor as cheaply as possible—the price would obviously rise if workers were allowed to
bargain jointly rather than if they were required to offer their services individually on the open market.

Labor under the Antitrust Laws
The Sherman Act did nothing to change this basic judicial attitude. A number of cases decided early in the
act’s history condemned labor activities as violations of the antitrust law. In particular, in the Danbury
Hatters’ case (Loewe v. Lawlor) the Supreme Court held that a “secondary boycott” against a
nonunionized company violated the Sherman Act. The hatters instigated a boycott of retail stores that

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sold hats manufactured by a company whose workers had struck. The union was held liable for treble
damages.

[1]

By 1912, labor had organized widely, and it played a pivotal role in electing Woodrow Wilson and giving
him a Democratic Congress, which responded in 1914 with the Clayton Act’s “labor exemption.” Section 6
of the Clayton Act says that labor unions are not “illegal combinations or conspiracies in restraint of trade,
under the antitrust laws.” Section 20 forbids courts from issuing injunctions in cases involving strikes,
boycotts, and other concerted union activities (which were declared to be lawful) as long as they arose out
of disputes between employer and employees over the terms of employment.
But even the Clayton Act proved of little lasting value to the unions. In 1921, the Supreme Court again
struck out against a secondary boycott that crippled the significance of the Clayton Act provisions. In the
case, a machinists’ union staged a boycott against an employer (by whom the members were not
employed) in order to pressure the employer into permitting one of its factories to be unionized. The
Court ruled that the Clayton Act exemptions applied only in cases involving an employer and its own
employees.

[2]

Without the ability to boycott under those circumstances, and with the threat of antitrust

prosecutions or treble-damage actions, labor would be hard-pressed to unionize many companies. More
antiunion decisions followed.

Moves toward Modern Labor Legislation
Collective bargaining appeared on the national scene for the first time in 1918 with the creation of the War
Labor Conference Board. The National War Labor Board was empowered to mediate or reconcile labor
disputes that affected industries essential to the war, but after the war, the board was abolished.
In 1926, Congress enacted the Railway Labor Act. This statute imposed a duty on railroads to bargain in
good faith with their employees’ elected representatives. The act also established the National Mediation
Board to mediate disputes that were not resolved in contract negotiations. The stage was set for more
comprehensive national labor laws. These would come with the Great Depression.

The Norris–La Guardia Act
The first labor law of the Great Depression was the Norris–La Guardia Act of 1932. It dealt with the
propensity of federal courts to issue preliminary injunctions, often ex parte (i.e., after hearing only the
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plaintiff’s argument), against union activities. Even though the permanent injunction might later have
been denied, the effect of the vaguely worded preliminary injunction would have been sufficient to destroy
the attempt to unionize. The Norris–La Guardia Act forbids federal courts from temporarily or
permanently enjoining certain union activities, such as peaceful picketing and strikes. The act is
applicable is any “labor dispute,” defined as embracing “any controversy concerning terms or conditions
of employment, or concerning the association or representation of persons in negotiating, fixing,
maintaining, changing, or seeking to arrange terms or conditions of employment, regardless of whether or
not the disputants stand in the proximate relation of employer and employee.” This language thus
permitted the secondary boycott that had been held a violation of the antitrust laws in Duplex Printing
Press v. Deering. The act also bars the courts from enforcing so-called yellow-dog contracts—agreements
that employees made with their employer not to join unions.

The National Labor Relations Act (the Wagner Act)
In 1935, Congress finally enacted a comprehensive labor statute. The National Labor Relations Act
(NLRA), often called the Wagner Act after its sponsor, Senator Robert F. Wagner, declared in Section 7
that workers in interstate commerce “have the right to self-organization, to form, join or assist labor
organizations, to bargain collectively through representatives of their own choosing, and to engage in
concerted activities for the purpose of collective bargaining or other mutual aid or protection.” Section 8
sets out five key unfair labor practices:
1.

Interference with the rights guaranteed by Section 7

2. Interference with the organization of unions, or dominance by the employer of union administration
(this section thus outlaws “company unions”)
3. Discrimination against employees who belong to unions
4. Discharging or otherwise discriminating against employees who seek relief under the act
5.

Refusing to bargain collectively with union representatives

The procedures for forming a union to represent employees in an appropriate “bargaining unit” are set
out in Section 9. Finally, the Wagner Act established the National Labor Relations Board (NLRB) as an
independent federal administrative agency, with power to investigate and remedy unfair labor practices.

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The Supreme Court upheld the constitutionality of the act in 1937 in a series of five cases. In the
first, NLRB v. Jones & Laughlin Steel Corp., the Court ruled that congressional power under the
Commerce Clause extends to activities that might affect the flow of interstate commerce, as labor relations
[3]

certainly did. Through its elaborate mechanisms for establishing collective bargaining as a basic national
policy, the Wagner Act has had a profound effect on interstate commerce during the last half-century.

The Taft-Hartley Act (Labor-Management Relations Act)
The Wagner Act did not attempt to restrict union activities in any way. For a dozen years, opponents of
unions sought some means of curtailing the breadth of opportunity opened up to unions by the Wagner
Act. After failing to obtain relief in the Supreme Court, they took their case to Congress and finally
succeeded after World War II when, in 1947, Congress, for the first time since 1930, had Republican
majorities in both houses. Congress responded to critics of “big labor” with the Taft-Hartley Act, passed
over President Truman’s veto. Taft-Hartley—known formally as the Labor-Management Relations Act—
did not repeal the protections given employees and unions under the NLRA. Instead, it balanced union
power with a declaration of rights of employers. In particular, Taft-Hartley lists six unfair labor practices
of unions, including secondary boycotts, strikes aimed at coercing an employer to fire an employee who
refuses to join a union, and so-called jurisdictional strikes over which union should be entitled to do a
specified jobs at the work site.
In addition to these provisions, Taft-Hartley contains several others that balance the rights of unions and
employers. For example, the act guarantees both employers and unions the right to present their views on
unionization and collective bargaining. Like employers, unions became obligated to bargain in good faith.
The act outlaws the closed shop (a firm in which a worker must belong to a union), gives federal courts the
power to enforce collective bargaining agreements, and permits private parties to sue for damages arising
out of a secondary boycott. The act also created the Federal Mediation and Conciliation Service to cope
with strikes that create national emergencies, and it declared strikes by federal employees to be unlawful.
It was this provision that President Reagan invoked in 1981 to fire air traffic controllers who walked off
the job for higher pay.

The Landrum-Griffin Act
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Congressional hearings in the 1950s brought to light union corruption and abuses and led in 1959 to the
last of the major federal labor statutes, the Landrum-Griffin Act (Labor-Management Reporting and
Disclosure Act). It established a series of controls on internal union procedures, including the method of
electing union officers and the financial controls necessary to avoid the problems of corruption that had
been encountered. Landrum-Griffin also restricted union picketing under various circumstances,
narrowed the loopholes in Taft-Hartley’s prohibitions against secondary boycotts, and banned “hot cargo”
agreements (see Section 19.3.6 "Hot Cargo Agreement").

KEY TAKEAWAY
Common-law doctrines were used in the early history of the labor movement to enjoin unionizing and
other joint employee activities. These were deemed to be restraints of trade that violated antitrust
laws. In addition, common-law conspiracy charges provided criminal enforcement against joint
employee actions and agreements. Politically, the labor movement gained some traction in 1912 and
got an antitrust-law exemption in the Clayton Act. But it was not until the Great Depression and the
New Deal that the right of collective bargaining was recognized by federal statute in the National Labor
Relations Act. Subsequent legislation (Taft-Hartley and Landrum-Griffin) added limits to union activities
and controls over unions in their internal functions.

EXERCISES
1.

Use the Internet to find stories of government-sponsored violence against union activities in the late
1900s and early part of the twentieth century. What were some of the most violent confrontations,
and what caused them? Discuss why business and government were so opposed to collective
bargaining.

2.

Use the Internet to find out which countries in the world have legal systems that support collective
bargaining. What do these countries have in common with the United States? Does the People’s
Republic of China support collective bargaining?

[1] Loewe v. Lawlor, 208 U.S. 274 (1908).
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[2] Duplex Printing Press Co. v. Deering, 254 U.S. 443 (1921).
[3] NLRB v. Jones & Laughlin Steel Corp., 301 U.S. 1 (1937).

19.2 The National Labor Relations Board: Organization and
Functions
LEARNING OBJECTIVE
1.

Explain the process that leads to recognition of bargaining units by the National Labor Relations
Board.

The National Labor Relations Board (NLRB) consists of five board members, appointed by the president
and confirmed by the Senate, who serve for five-year, staggered terms. The president designates one of
the members as chairman. The president also appoints the general counsel, who is in charge of the board’s
investigatory and prosecutorial functions and who represents the NLRB when it goes (or is taken) to
court. The general counsel also oversees the thirty-three regional offices scattered throughout the country,
each of which is headed by a regional director.
The NLRB serves two primary functions: (1) it investigates allegations of unfair labor practices and
provides remedies in appropriate cases, and (2) it decides in contested cases which union should serve as
the exclusive bargaining agent for a particular group of employees.

Unfair Labor Practice Cases
Unfair labor practice cases are fairly common; some twenty-two thousand unfair labor practice claims
were filed in 2008. Volume was considerably higher thirty years ago; about forty thousand a year was
typical in the early 1980s. A charge of an unfair labor practice must be presented to the board, which has
no authority to initiate cases on its own. Charges are investigated at the regional level and may result in a
complaint by the regional office. A regional director’s failure to issue a complaint may be appealed to the
general counsel, whose word is final (there is no possible appeal).
A substantial number of charges are dismissed or withdrawn each year—sometimes as many as 70
percent. Once issued, the complaint is handled by an attorney from the regional office. Most cases, usually
around 80 percent, are settled at this level. If not settled, the case will be tried before an administrative
law judge, who will take evidence and recommend a decision and an order. If no one objects, the decision
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and order become final as the board’s opinion and order. Any party may appeal the decision to the board
in Washington. The board acts on written briefs, rarely on oral argument. The board’s order may be
appealed to the US court of appeals, although its findings of fact are not reviewable “if supported by
substantial evidence on the record considered as a whole.” The board may also go to the court of appeals
to seek enforcement of its orders.

Representation Cases
The NLRB is empowered to oversee representative elections—that is, elections by employees to determine
whether or not to be represented by a union. The board becomes involved if at least 30 percent of the
members of a potential bargaining unit petition it to do so or if an employer petitions on being faced with
a claim by a union that it exclusively represents the employees. The board determines which bargaining
unit is appropriate and which employees are eligible to vote. A representative of the regional office will
conduct the election itself, which is by secret ballot. The regional director may hear challenges to the
election procedure to determine whether the election was valid.

KEY TAKEAWAY
The NLRB has two primary functions: (1) it investigates allegations of unfair labor practices and
provides remedies in appropriate cases, and (2) it decides in contested cases which union should serve
as the exclusive bargaining agent for a particular group of employees.

EXERCISES
1.

Go to the website for the NLRB. Find out how many unfair labor practice charges are filed each year.
Also find out how many “have merit” according to the NLRB.

2.

How many of these unfair labor practice charges that “have merit” are settled through the auspices of
the NLRB?

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19.3 Labor and Management Rights under the Federal Labor
Laws
LEARNING OBJECTIVES
1.

Describe and explain the process for the National Labor Relations Board to choose a particular union
as the exclusive bargaining representative.

2.

Describe and explain the various duties that employers have in bargaining.

3.

Indicate the ways in which employers may commit unfair labor practice by interfering with union
activity.

4.

Explain the union’s right to strike and the difference between an economic strike and a strike over an
unfair labor practice.

5.

Explain secondary boycotts and hot cargo agreements and why they are controversial.

6.

Choosing the Union as the Exclusive Bargaining Representative
Determining the Appropriate Union
As long as a union has a valid contract with the employer, no rival union may seek an election to oust it
except within sixty to ninety days before the contract expires. Nor may an election be held if an election
has already been held in the bargaining unit during the preceding twelve months.
Whom does the union represent? In companies of even moderate size, employees work at different tasks
and have different interests. Must the secretaries, punch press operators, drivers, and clerical help all
belong to the same union in a small factory? The National Labor Relations Board (NLRB) has the
authority to determine which group of employees will constitute the appropriate bargaining unit. To make
its determination, the board must look at the history of collective bargaining among similar workers in the

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industry; the employees’ duties, wages, skills, and working conditions; the relationship between the
proposed unit and the structure of the employer’s organization; and the desires of the employees
themselves.
Two groups must be excluded from any bargaining unit—supervisory employees and independent
contractors. Determining whether or not a particular employee is a supervisor is left to the discretion of
the board.

Interfering with Employee Communication
To conduct an organizing drive, a union must be able to communicate with the employees. But the
employer has valid interests in seeing that employees and organizers do not interfere with company
operations. Several different problems arise from the need to balance these interests.
One problem is the protection of the employer’s property rights. May nonemployee union organizers come
onto the employer’s property to distribute union literature—for example, by standing in the company’s
parking lots to hand out leaflets when employees go to and from work? May organizers, whether
employees or not, picket or hand out literature in private shopping centers in order to reach the public—
for example, to protest a company’s policies toward its nonunion employees? The interests of both
employees and employers under the NLRB are twofold: (1) the right of the employees (a) to communicate
with each other or the public and (b) to hear what union organizers have to say, and (2) the employers’ (a)
property rights and (b) their interest in managing the business efficiently and profitably.
The rules that govern in these situations are complex, but in general they appear to provide these answers:
(1) If the persons doing the soliciting are not employees, the employer may bar them from entering its
private property, even if they are attempting to reach employees—assuming that the employer does not
[1]

discriminate and applies a rule against use of its property equally to everyone. (2) If the solicitors are not
employees and they are trying to reach the public, they have no right to enter the employer’s private
property. (3) If the solicitors are employees who are seeking to reach the public, they have the right to
distribute on the employer’s property—in a common case, in a shopping center—unless they have a
convenient way to reach their audience on public property off the employer’s premises.

[2]

(4) If the

solicitors are employees seeking to reach employees, the employer is permitted to limit the distribution of

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literature or other solicitations to avoid litter or the interruption of work, but it cannot prohibit
solicitation on company property altogether.
In the leading case of Republic Aviation Corp. v. NLRB, the employer, a nonunion plant, had a standing
rule against any kind of solicitation on the premises.

[3]

Thereafter, certain employees attempted to

organize the plant. The employer fired one employee for soliciting on behalf of the union and three others
for wearing union buttons. The Supreme Court upheld the board’s determination that the discharges
constituted an unfair labor practice under Section 8(a) of the NLRA. It does not matter, the Court said,
whether the employees had other means of communicating with each other or that the employer’s rule
against solicitation may have no effect on the union’s attempt to organize the workers. In other words, the
employer’s intent or motive is irrelevant. The only question is whether the employer’s actions might tend
to interfere with the employees’ exercise of their rights under the NLRB.

Regulating Campaign Statements
A union election drive is not like a polite conversation over coffee; it is, like political campaigns, full of
charges and countercharges. Employers who do not want their employees unionized may warn darkly of
the effect of the union on profitability; organizers may exaggerate the company’s financial position. In a
1982 NLRB case, NLRB v. Midland National Life Ins. Co., the board said it would not set aside an election
if the parties misrepresented the issues or facts but that it would do so if the statements were made in a
deceptive manner—for example, through forged documents.

[4]

The board also watches for threats and

promises of rewards; for example, the employer might threaten to close the plant if the union succeeds.
In NLRB v. Gissel Packing Co., the employer stated his worries throughout the campaign that a union
would prompt a strike and forces the plant to close.

[5]

The board ruled that the employer’s statements

were an impermissible threat. To the employer’s claim that he was simply exercising his First Amendment
rights, the Supreme Court held that although employers do enjoy freedom of speech, it is an unfair labor
practice to threaten consequences that are not rooted in economic realities.
A union campaign has become an intricate legal duel, heavily dependent on strategic considerations of law
and public relations. Neither management nor labor can afford to wage a union campaign without
specialized advisers who can guide the thrust and parry of the antagonists. Labor usually has such
advisers because very few organizational drives are begun without outside organizers who have access to
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union lawyers. A business person who attempts to fight a union, like a labor organizer or an employee,
who attempts to organize one, takes a sizeable risk when acting alone, without competent advice. For
example, an employer’s simple statement like “We will get the heating fixed” in response to a seemingly
innocent question about the “drafty old building” at a meeting with employees can lead to an NLRB
decision to set aside an election if the union loses, because the answer can easily be construed as a
promise, and under Section 8(c) of the National Labor Relations Act (NLRA), a promise of reward or
benefit during an organization campaign is an unfair labor practice by management. Few union election
campaigns occur without questions, meetings, and pamphleteering carefully worked out in advance.
The results of all the electioneering are worth noting. In the 1980s, some 20 percent of the total US
workforce was unionized. As of 2009, the union membership rate was 12.3 percent, and more union
members were public employees than private sector employees. Fairly or unfairly, public employee unions
were under attack as of 2010, as their wages generally exceeded the average wages of other categories of
workers.

Exclusivity
Once selected as the bargaining representative for an appropriate group of employees, the union has
the exclusive right to bargain. Thereafter, individual employees may not enter into separate contracts with
the employer, even if they voted against the particular union or against having a union at all. The principle
of exclusivity is fundamental to the collective bargaining process. Just how basic it is can be seen
in Emporium Capwell Co. v. Western Addition Community Organization (Section 19.4.1 "Exclusivity"),
in which one group of employees protested what they thought were racially discriminatory work
assignments, barred under the collective bargaining agreement (the contract between the union and the
employer). Certain of the employees filed grievances with the union, which looked into the problem more
slowly than the employees thought necessary. They urged that the union permit them to picket, but the
union refused. They picketed anyway, calling for a consumer boycott. The employer warned them to
desist, but they continued and were fired. The question was whether they were discharged for engaging in
concerted activity protected under Section 7 of the NLRA.

The Duty to Bargain
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The Duty to Bargain in Good Faith
The NLRA holds both employer and union to a duty to “bargain in good faith.” What these words mean
has long been the subject of controversy. Suppose Mr. Mardian, a company’s chief negotiator, announces
to Mr. Ulasewicz, the company’s chief union negotiator, “I will sit down and talk with you, but be damned
if I will agree to a penny more an hour than the people are getting now.” That is not a refusal to bargain: it
is a statement of the company’s position, and only Mardian’s actual conduct during the negotiations will
determine whether he was bargaining in good faith. Of course, if he refused to talk to Ulasewicz, he would
have been guilty of a failure to bargain in good faith.
Suppose Mardian has steadily insisted during the bargaining sessions that the company must have
complete control over every aspect of the labor relationship, including the right to hire and fire exactly as
it saw fit, the right to raise or lower wages whenever it wanted, and the right to determine which employee
was to do which job. The Supreme Court has said that an employer is not obligated to accept any
particular term in a proposed collective bargaining agreement and that the NLRB may not second-guess
any agreement eventually reached.

[6]

However, the employer must actually engage in bargaining, and a

stubborn insistence on leaving everything entirely to the discretion of management has been construed as
a failure to bargain.

[7]

Suppose Mardian had responded to Ulasewicz’s request for a ten-cent-an-hour raise: “If we do that, we’ll
go broke.” Suppose further that Ulasewicz then demanded, on behalf of the union, that Mardian prove his
contention but that Mardian refused. Under these circumstances, the Supreme Court has ruled, the NLRB
is entitled to hold that management has failed to bargain in good faith, for once having raised the issue;
the employer must in good faith demonstrate veracity.

[8]

Mandatory Subjects of Bargaining
The NLRB requires employers and unions to bargain over “terms and condition of employment.” Wages,
hours, and working conditions—whether workers must wear uniforms, when the lunch hour begins, the
type of safety equipment on hand—are well-understood terms and conditions of employment. But the
statutory phrase is vague, and the cases abound with debates over whether a term insisted on by union or
management is within the statutory phrase. No simple rule can be stated for determining whether a desire
of union or management is mandatory or non-mandatory. The cases do suggest that management retains
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the right to determine the scope and direction of the enterprise, so that, for example, the decision to invest
in labor-saving machinery is a non-mandatory subject—meaning that a union could not insist that an
employer bargain over it, although the employer may negotiate if it desires. Once a subject is incorporated
in a collective bargaining agreement, neither side may demand that it be renegotiated during the term of
the agreement.

The Board’s Power to Compel an Agreement
A mere refusal to agree, without more, is not evidence of bad-faith bargaining. That may seem a difficult
conclusion to reach in view of what has just been said. Nevertheless, the law is clear that a company may
refuse to accede to a union’s demand for any reason other than unwillingness to consider the matter in the
first place. If a union negotiator cannot talk management into accepting his demand, then the union may
take other actions—including strikes to try to force management to bow. It follows from this conclusion
that the NLRB has no power to compel agreement—even if management is guilty of negotiating in bad
faith. The federal labor laws are premised on the fundamental principle that the parties are free to
bargain.

Interference and Discrimination by the Employer
Union Activity on Company Property
The employer may not issue a rule flatly prohibiting solicitation or distribution of literature during
“working time” or “working hours”—a valid rule against solicitation or distribution must permit these
activities during employees’ free time, such as on breaks and at meals. A rule that barred solicitation on
the plant floor during actual work would be presumptively valid. However, the NLRB has the power to
enjoin its enforcement if the employer used the rule to stop union soliciting but permitted employees
during the forbidden times to solicit for charitable and other causes.

“Runaway Shop”
A business may lawfully decide to move a factory for economic reasons, but it may not do so to discourage
a union or break it apart. The removal of a plant from one location to another is known as a runaway
shop. An employer’s representative who conceals from union representatives that a move is contemplated
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commits an unfair labor practice because the union is deprived of the opportunity to negotiate over an
important part of its members’ working conditions. If a company moves a plant and it is later determined
that the move was to interfere with union activity, the board may order the employer to offer affected
workers employment at the new site and the cost of transportation.

Other Types of Interference
Since “interference” is not a precise term but descriptive of a purpose embodied in the law, many activities
lie within its scope. These include hiring professional strikebreakers to disrupt a strike, showing
favoritism toward a particular union to discourage another one, awarding or withholding benefits to
encourage or discourage unionization, engaging in misrepresentations and other acts during election
campaigns, spying on workers, making employment contracts with individual members of a union,
blacklisting workers, attacking union activists physically or verbally, and disseminating various forms of
antiunion propaganda.

Discrimination against Union Members
Under Section 8(a) (3) of the NLRA, an employer may not discriminate against employees in hiring or
tenure to encourage or discourage membership in a labor organization. Thus an employer may not refuse
to hire a union activist and may not fire an employee who is actively supporting the union or an
organizational effort if the employee is otherwise performing adequately on the job. Nor may an employer
discriminate among employees seeking reinstatement after a strike or discriminatory layoff or lockout (a
closing of the job site to prevent employees from coming to work), hiring only those who were less vocal in
their support of the union.
The provision against employer discrimination in hiring prohibits certain types of compulsory unionism.
Four basic types of compulsory unionism are possible: the closed shop, the union shop, maintenance-ofmembership agreements, and preferential hiring agreements. In addition, a fifth arrangement—the
agency shop—while not strictly compulsory unionism, has characteristics similar to it. Section 8(a)(3)
prohibits the closed shop and preferential hiring. But Section 14 permits states to enact more stringent
standards and thus to outlaw the union shop, the agency shop, and maintenance of membership as well.

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1.

Closed shop. This type of agreement requires a potential employee to belong to the union before
being hired and to remain a member during employment. It is unlawful, because it would require an
employer to discriminate on the basis of membership in deciding whether to hire.

2. Union shop. An employer who enters into a union shop agreement with the union may hire a
nonunion employee, but all employees who are hired must then become members of the union and
remain members so long as they work at the job. Because the employer may hire anyone, a union or
nonunion member, the union shop is lawful unless barred by state law.
3. Maintenance-of-membership agreements. These agreements require employees who are
members of the union before being hired to remain as members once they are hired unless they take
advantage of an “escape clause” to resign within a time fixed in the collective bargaining agreement.
Workers who were not members of the union before being hired are not required to join once they are
on the job. This type of agreement is lawful unless barred by state law.
4. Preferential hiring. An employer who accepts a preferential hiring clause agrees to hire only union
members as long as the union can supply him with a sufficient number of qualified workers. These
clauses are unlawful.
5.

Agency shop. The agency shop is not true compulsory unionism, for it specifically permits an
employee not to belong to the union. However, it does require the employee to pay into the union the
same amount required as dues of union members. The legality of an agency shop is determined by
state law. If permissible under state law, it is permissible under federal law.

The Right to Strike
Section 13 of the NLRA says that “nothing in this Act, except as specifically provided for herein, shall be
construed so as either to interfere with or impede or diminish in any way the right to strike, or to affect
the limitations or qualifications on that right.” The labor statutes distinguish between two types of strikes:
the economic strike and the strike over an unfair labor practice. In the former, employees go on strike to
try to force the employer to give in to the workers’ demands. In the latter, the strikers are protesting the
employer’s committing an unfair labor practice. The importance of the distinction lies in whether the
employees are entitled to regain their jobs after the strike is over. In either type of strike, an employer may
hire substitute employees during the strike. When it concludes, however, a difference arises. In NLRB v.
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International Van Lines, the Supreme Court said that an employer may hire permanent employees to take
over during an economic strike and need not discharge the substitute employees when it is done.

[9]

That is

not true for a strike over an unfair labor practice: an employee who makes an unconditional offer to
return to his job is entitled to it, even though in the meantime the employer may have replaced him.
These rules do not apply to unlawful strikes. Not every walkout by workers is permissible. Their collective
bargaining agreement may contain a no-strike clause barring strikes during the life of the contract. Most
public employees—that is, those who work for the government—are prohibited from striking. Sit-down
strikes, in which the employees stay on the work site, precluding the employer from using the facility, are
unlawful. So are wildcat strikes, when a faction within the union walks out without authorization. Also
unlawful are violent strikes, jurisdictional strikes, secondary strikes and boycotts, and strikes intended to
force the employer to sign “hot cargo” agreements (see Section 19.3.6 "Hot Cargo Agreement").
To combat strikes, especially when many employers are involved with a single union trying to bargain for
better conditions throughout an industry, an employer may resort to a lockout. Typically, the union will
call a whipsaw strike, striking some of the employers but not all. The whipsaw strike puts pressure on the
struck employers because their competitors are still in business. The employers who are not struck may
lawfully respond by locking out all employees who belong to the multiemployer union. This is known as a
defensive lockout. In several cases, the Supreme Court has ruled that an offensive lockout, which occurs
when the employer, anticipating a strike, locks the employees out, is also permissible.

Secondary Boycotts
Section 8(b)(4), added to the NLRA by the Taft-Hartley Act, prohibits workers from engaging
in secondary boycotts—strikes, refusals to handle goods, threats, coercion, restraints, and other actions
aimed at forcing any person to refrain from performing services for or handling products of any producer
other than the employer, or to stop doing business with any other person. Like the Robinson-Patman Act
(Chapter 16 "Antitrust Law"), this section of the NLRA is extremely difficult to parse and has led to many
convoluted interpretations. However, its essence is to prevent workers from picketing employers not
involved in the primary labor dispute.
Suppose that the Amalgamated Widget Workers of America puts up a picket line around the Ace Widget
Company to force the company to recognize the union as the exclusive bargaining agent for Ace’s
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employees. The employees themselves do not join in the picketing, but when a delivery truck shows up at
the plant gates and discovers the pickets, it turns back because the driver’s policy is never to cross a picket
line. This activity falls within the literal terms of Section (8) (b) (4): it seeks to prevent the employees of
Ace’s suppliers from doing business with Ace. But in NLRB v. International Rice Milling Co., the Supreme
Court declared that this sort of primary activity—aimed directly at the employer involved in the primary
dispute—is not unlawful.

[10]

So it is permissible to throw up a picket line to attempt to stop anyone from

doing business with the employer—whether suppliers, customers, or even the employer’s other employees
(e.g., those belonging to other unions). That is why a single striking union is so often successful in closing
down an entire plant: when the striking union goes out, the other unions “honor the picket line” by
refusing to cross it and thus stay out of work as well. The employer might have been able to replace the
striking workers if they were only a small part of the plant’s labor force, but it becomes nearly impossible
to replace all the workers within a dozen or more unions.
Suppose the United Sanders Union strikes the Ace Widget Company. Nonunion sanders refuse to cross
the picket line. So Ace sends out its un-sanded widgets to Acme Sanders, a job shop across town, to do the
sanding job. When the strikers learn what Ace has done, they begin to picket Acme, at which point Acme’s
sanders honor the picket line and refuse to enter the premises. Acme goes to court to enjoin the pickets—
an exception to the Norris–La Guardia Act permits the federal courts to enjoin picketing in cases of
unlawful secondary boycotts. Should the court grant the injunction? It might seem so, but under the socalled ally doctrine, the court will not. Since Acme is joined with Ace to help it finish the work, the courts
deem the second employer an ally (or extension) of the first. The second picket line, therefore, is not
secondary.
Suppose that despite the strike, Ace manages to ship its finished product to the Dime Store, which sells a
variety of goods, including widgets. The union puts up a picket around the store; the picketers bear signs
that urge shoppers to refrain from buying any Ace widgets at the Dime Store. Is this an unlawful
secondary boycott? Again, the answer is no. A proviso to Section 8(b)(4) permits publicity aimed at
truthfully advising the public that products of a primary employer with whom the union is on strike are
being distributed by a secondary employer.
Now suppose that the picketers carried signs and orally urged shoppers not to enter the Dime Store at all
until it stopped carrying Ace’s widgets. That would be unlawful: a union may not picket a secondary site to
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persuade consumers to refrain from purchasing any of the secondary employer’s products. Likewise, the
union may not picket in order to cause the secondary employees (the salesclerks at the Dime Store) to
refuse to go to work at the secondary employer. The latter is a classic example of inducing a secondary
work stoppage, and it is barred by Section 8(b)(4). However, in DeBartolo Corp. v. Florida Gulf Coast
Building and Construction Trades Council, the Supreme Court opened what may prove to be a significant
loophole in the prohibition against secondary boycotts.

[11]

Instead of picketing, the union distributed

handbills at the entrance to a shopping mall, asking customers not to patronize any stores in the mall
until the mall owner, in building new stores, promised to deal only with contractors paying “fair wages.”
The Court approved the hand-billing, calling it “only an attempt to persuade customers not to shop in the
mall,” distinguishing it from picketing, which the Court said would constitute a secondary boycott.

Hot Cargo Agreement
A union might find it advantageous to include in a collective bargaining agreement a provision under
which the employer agrees to refrain from dealing with certain people or from purchasing their products.
For example, suppose the Teamsters Union negotiates a contract with its employers that permit truckers
to refuse to carry goods to an employer being struck by the Teamsters or any other union. The struck
employer is the primary employer; the employer who has agreed to the clause—known as a hot cargo
clause—is the secondary employer. The Supreme Court upheld these clauses in United Brotherhood of
Carpenters and Joiners, Local 1976 v. NLRB, but the following year, Congress outlawed them in Section
8(e), with a partial exemption for the construction industry and a full exemption for garment and apparel
workers.

[12]

Discrimination by Unions
A union certified as the exclusive bargaining representative in the appropriate bargaining unit is obligated
to represent employees within that unit, even those who are not members of the union. Various provisions
of the labor statutes prohibit unions from entering into agreements with employers to discriminate
against nonmembers. The laws also prohibit unions from treating employees unfairly on the basis of race,
creed, color, or national origin.

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Jurisdictional Disputes
Ace Widget, a peaceful employer, has a distinguished labor history. It did not resist the first union, which
came calling in 1936, just after the NLRA was enacted; by 1987, it had twenty-three different unions
representing 7,200 workers at forty-eight sites throughout the United States. Then, because of
increasingly more powerful and efficient machinery, United Widget Workers realized that it was losing
jobs throughout the industry. It decided to attempt to bring within its purview jobs currently performed
by members of other unions. United Widget Workers asked Ace to assign all sanding work to its members.
Since sanding work was already being done by members of the United Sanders, Ace management refused.
United Widget Workers decided to go on strike over the issue. Is the strike lawful? Under Section 8(b) (4)
(D), regulating jurisdictional disputes, it is not. It is an unfair labor practice for a union to strike or engage
in other concerted actions to pressure an employer to assign or reassign work to one union rather than
another.

Bankruptcy and the Collective Bargaining Agreement
An employer is bound by a collective bargaining agreement to pay the wages of unionized workers
specified in the agreement. But obviously, no paper agreement can guarantee wages when an insolvent
company goes out of business. Suppose a company files for reorganization under the bankruptcy laws
(see Chapter 12 "Bankruptcy"). May it then ignore its contractual obligation to pay wages previously
bargained for? In the early 1980s, several major companies—for example, Continental Airlines and
Oklahoma-based Wilson Foods Corporation—sought the protection of federal bankruptcy law in part to
cut union wages. Alarmed, Congress, in 1984, amended the bankruptcy code to require companies to
attempt to negotiate a modification of their contracts in good faith. In Bankruptcy Code Section 1113,
Congress set forth several requirements for a debtor to extinguish its obligations under a collective
bargaining agreement (CBA). Among other requirements, the debtor must make a proposal to the union
modifying the CBA based on accurate and complete information, and meet with union leaders and confer
in good faith after making the proposal and before the bankruptcy judge would rule.

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If negotiations fail, a bankruptcy judge may approve the modification if it is necessary to allow the debtor
to reorganize, and if all creditors, the debtor, and affected parties are treated fairly and equitably. If the
union rejects the proposal without good cause, and the debtor has met its obligations of fairness and
consultation from section 1113, the bankruptcy judge can accept the proposed modification to the CBA. In
1986, the US court of appeals in Philadelphia ruled that Wheeling-Pittsburgh Steel Corporation could not
modify its contract with the United Steelworkers simply because it was financially distressed. The court
pointed to the company’s failure to provide a “snap-back” clause in its new agreement. Such a clause
would restore wages to the higher levels of the original contract if the company made a comeback faster
than anticipated.

[13]

But in the 2006 case involving Northwest Airlines Chapter 11 reorganization,

[14]

the

court found that Northwest had to reduce labor costs if it were going to successfully reorganize, that it had
made an equitable proposal and consulted in good faith with the union, but that the union had rejected
the proposed modification without good cause. Section 1113 was satisfied, and Northwest was allowed to
modify its CBA with the union.

KEY TAKEAWAY
The NLRB determines the appropriate bargaining unit and also supervises union organizing drives. It
must balance protecting the employer’s rights, including property rights and the right to manage the
business efficiently, with the right of employees to communicate with each other. The NLRB will select
a union and give it the exclusive right to bargain and the result will usually be a collective bargaining
unit. The employer should not interfere with the unionizing process or interfere once the union is in
place. The union has the right to strike, subject to certain very important restrictions.

EXERCISES
1.

Suppose that employees of the Shop Rite chain elect the Allied Food Workers Union as their exclusive
bargaining agent. Negotiations for an initial collective bargaining agreement begin, but after six
months, no agreement has been reached. The company finds excess damage to merchandise in its
warehouse and believes that this was intentional sabotage by dissident employees. The company
notifies the union representative that any employees doing such acts will be terminated, and the

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union, in turn, notifies the employees. Soon thereafter, a Shop Rite manager notices an employee in
the flour section—where he has no right to be—making quick motions with his hands. The manager
then finds several bags of flour that have been cut. The employee is fired, whereupon a fellow
employee and union member lead more than two dozen employees in an immediate walkout. The
company discharges these employees and refuses to rehire them. The employees file a grievance with
the NLRB. Are they entitled to get their jobs back?
2.

[15]

American Shipbuilding Company has a shipyard in Chicago, Illinois. During winter months, it repairs
ships operating on the Great Lakes, and the workers at the shipyard are represented by several
different unions. In 1961, the unions notified the company of their intention to seek a modification of
the current collective bargaining agreement. On five previous occasions, agreements had been
preceded by strikes (including illegal strikes) that were called just after ships arrived in the shipyard for
repairs. In this way, the unions had greatly increased their leverage in bargaining with the company.
Because of this history, the company was anxious about the unions’ strike plans. In August 1961, after
extended negotiations, the company and the unions reached an impasse. The company then decided
to lay off most of the workers and sent the following notice: “Because of the labor dispute which has
been unresolved since August of 1961, you are laid off until further notice.” The unions filed unfair
labor practice charges with the NLRB. Did the company engage in an unfair labor practice?

[16]

[1] NLRB v. Babcock Wilcox Co., 351 U.S. 105 (1956).
[2] Hudgens v. NLRB, 424 U.S. 507 (1976).
[3] Republic Aviation Corp. v. NLRB, 324 U.S. 793 (1945).
[4] Midland National Life Ins. Co., 263 N.L.R.B. 130 (1982).
[5] NLRB v. Gissel Packing Co., 395 U.S. 575 (1969).
[6] NLRB v. American National Insurance Co., 343 U.S. 395 (1962).
[7] NLRB v. Reed St Prince Manufacturing Co., 205 F.2d 131 (1st Cir. 1953).
[8] NLRB v. Truitt Manufacturer Co., 351 U.S. 149 (1956).
[9] NLRB v. International Van Lines, 409 U.S. 48 (1972).
[10] NLRB v. International Rice Milling Co., 341 U.S. 665 (1951).

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[11] DeBartolo Corp. v. Florida Gulf Coast Building and Construction Trades Council, 485 U.S. 568 (1988).
[12] United Brotherhood of Carpenters and Joiners, Local 1976 v. NLRB, 357 U.S. 93 (1958).
[13] Wheeling-Pittsburgh Steel Corp. v. United Steelworkers of America, 791 F.2d 1071 (3d Cir. 1986).
[14] In re Northwest Airlines Corp., 2006 Bank. LEXIS 1159 (So. District N.Y.).
[15] NLRB v. Shop Rite Foods, 430 F.2d 786 (5th Cir. 1970).
[16] American Shipbuilding Company v. NLRB, 380 U.S. 300 (1965).

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19.4 Case
Exclusivity
Emporium Capwell Co. v. Western Addition Community Organization
420 U.S. 50 (1975)
The Emporium Capwell Company (Company) operates a department store in San Francisco. At all times
relevant to this litigation it was a party to the collective-bargaining agreement negotiated by the San
Francisco Retailer’s Council, of which it was a member, and the Department Store Employees Union
(Union), which represented all stock and marketing area employees of the Company. The agreement, in
which the Union was recognized as the sole collective-bargaining agency for all covered employees,
prohibited employment discrimination by reason of race, color, creed, national origin, age, or sex, as well
as union activity. It had a no-strike or lockout clause, and it established grievance and arbitration
machinery for processing any claimed violation of the contract, including a violation of the antidiscrimination clause.
On April 3, 1968, a group of Company employees covered by the agreement met with the secretarytreasurer of the Union, Walter Johnson, to present a list of grievances including a claim that the Company
was discriminating on the basis of race in making assignments and promotions. The Union official agreed
to certain of the grievances and to investigate the charge of racial discrimination. He appointed an
investigating committee and prepared a report on the employees’ grievances, which he submitted to the
Retailer’s Council and which the Council in turn referred to the Company. The report described “the
possibility of racial discrimination” as perhaps the most important issue raised by the employees and
termed the situation at the Company as potentially explosive if corrective action were not taken. It offers
as an example of the problem the Company’s failure to promote a Negro stock employee regarded by other
employees as an outstanding candidate but a victim of racial discrimination.
Shortly after receiving the report, the Company’s labor relations director met representatives and agreed
to “look into the matter” of discrimination, and see what needed to be done. Apparently unsatisfied with
these representations, the Union held a meeting in September attended by Union officials, Company
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employees, and representatives of the California Fair Employment Practices Committee (FEPC) and the
local anti-poverty agency. The secretary-treasurer of the Union announced that the Union had concluded
that the Company was discriminating, and that it would process every such grievance through to
arbitration if necessary. Testimony about the Company’s practices was taken and transcribed by a court
reporter, and the next day the Union notified the Company of its formal charge and demanded that the
union-management Adjustment Board be convened “to hear the entire case.”
At the September meeting some of the Company’s employees had expressed their view that the contract
procedures were inadequate to handle a systemic grievance of this sort; they suggested that the Union
instead begin picketing the store in protest. Johnson explained that the collective agreement bound the
Union to its processes and expressed his view that successful grievant would be helping not only
themselves but all others who might be the victims of invidious discrimination as well. The FEPC and
anti-poverty agency representatives offered the same advice. Nonetheless, when the Adjustment Board
meeting convened on October 16, James Joseph Hollins, Torn Hawkins, and two other employees whose
testimony the Union had intended to elicit refused to participate in the grievance procedure. Instead,
Hollins read a statement objecting to reliance on correction of individual inequities as an approach to the
problem of discrimination at the store and demanding that the president of the Company meet with the
four Protestants to work out a broader agreement for dealing with the issue as they saw it. The four
employees then walked out of the hearing.
…On Saturday, November 2, Hollins, Hawkins, and at least two other employees picketed the store
throughout the day and distributed at the entrance handbills urging consumers not to patronize the store.
Johnson encountered the picketing employees, again urged them to rely on the grievance process, and
warned that they might be fired for their activities. The pickets, however, were not dissuaded, and they
continued to press their demand to deal directly with the Company president.
On November 7, Hollins and Hawkins were given written warnings that a repetition of the picketing or
public statements about the Company could lead to their discharge. When the conduct was repeated the
following Saturday, the two employees were fired.
[T]he NLRB Trial Examiner found that the discharged employees had believed in good faith that the
Company was discriminating against minority employees, and that they had resorted to concerted activity

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on the basis of that belief. He concluded, however, that their activity was not protected by § 7 of the Act
and that their discharges did not, therefore, violate S 8(a) (1).
The Board, after oral argument, adopted the findings and conclusions of its Trial Examiner and dismissed
the complaint. Among the findings adopted by the Board was that the discharged employees’ course of
conduct was no mere presentation of a grievance but nothing short of a demand that the [Company]
bargain with the picketing employees for the entire group of minority employees.
The Board concluded that protection of such an attempt to bargain would undermine the statutory system
of bargaining through an exclusive, elected representative, impede elected unions’ efforts at bettering the
working conditions of minority employees, “and place on the Employer an unreasonable burden of
attempting to placate self-designated representatives of minority groups while abiding by the terms of a
valid bargaining agreement and attempting in good faith to meet whatever demands the bargaining
representative put forth under that agreement.”
On respondent’s petition for review the Court of Appeals reversed and remanded. The court was of the
view that concerted activity directed against racial discrimination enjoys a “unique status” by virtue of the
national labor policy against discrimination.…The issue, then, is whether such attempts to engage in
separate bargaining are protected by 7 of the Act or proscribed by § 9(a).
Central to the policy of fostering collective bargaining, where the employees elect that course, is the
principle of majority rule. If the majority of a unit chooses union representation, the NLRB permits it to
bargain with its employer to make union membership a condition of employment, thus, imposing its
choice upon the minority.
In vesting the representatives of the majority with this broad power, Congress did not, of course,
authorize a tyranny of the majority over minority interests. First, it confined the exercise of these powers
to the context of a “unit appropriate” for the purposes of collective bargaining, i.e., a group of employees
with a sufficient commonality of circumstances to ensure against the submergence of a minority with
distinctively different interests in the terms and conditions of their employment. Second, it undertook in
the 1959 Landrum-Griffin amendments to assure that minority voices are heard as they are in the
functioning of a democratic institution. Third, we have held, by the very nature of the exclusive bargaining
representative’s status as representative of all unit employees, Congress implicitly imposed upon it a duty
fairly and in good faith to represent the interests of minorities within the unit. And the Board has taken
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the position that a union’s refusal to process grievances against racial discrimination in violation of that
duty is an unfair labor practice.…
***
The decision by a handful of employees to bypass a grievance procedure in favor of attempting to bargain
with their employer…may or may not be predicated upon the actual existence of discrimination. An
employer confronted with bargaining demands from each of several minority groups who would not
necessarily, or even probably, be able to agree to remain real steps satisfactory to all at once. Competing
claims on the employer’s ability to accommodate each group’s demands, e.g., for reassignments and
promotions to a limited number of positions, could only set one group against the other even if it is not
the employer’s intention to divide and overcome them.…In this instance we do not know precisely what
form the demands advanced by Hollins, Hawkins, et al, would take, but the nature of the grievance that
motivated them indicates that the demands would have included the transfer of some minority employees
to sales areas in which higher commissions were paid. Yet the collective-bargaining agreement provided
that no employee would be transferred from a higher-paying to a lower-paying classification except by
consent or in the course of a layoff or reduction in force. The potential for conflict between the minority
and other employees in this situation is manifest. With each group able to enforce its conflicting
demands—the incumbent employees by resort to contractual processes and minority employees by
economic coercion—the probability of strife and deadlock is high; the making headway against
discriminatory practices would be minimal.
***
Accordingly, we think neither aspect of respondent’s contention in support of a right to short-circuit
orderly, established processes eliminating discrimination in employment is well-founded. The policy of
industrial self-determination as expressed in § 7 does not require fragmentation of the bargaining unit
along racial or other lines in order to consist with the national labor policy against discrimination. And in
the face of such fragmentation, whatever its effect on discriminatory practices, the bargaining process that
the principle of exclusive representation is meant to lubricate could not endure unhampered.
***
Reversed.

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CASE QUESTIONS
1.

Why did the picketers think that the union’s response had been inadequate?

2.

In becoming members of the union, which had a contract that included an antidiscrimination clause along
with a no-strike clause and a no-lockout clause, did the protesting employees waive all right to pursue
discrimination claims in court?

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19.5 Summary and Exercises
Summary
Federal labor law is grounded in the National Labor Relations Act, which permits unions to organize and
prohibits employers from engaging in unfair labor practices. Amendments to the National Labor
Relations Act (NLRA), such as the Taft-Hartley Act and the Landrum-Griffin Act, declare certain acts of
unions and employees also to be unfair labor practices.
The National Labor Relations Board supervises union elections and decides in contested cases which
union should serve as the exclusive bargaining unit, and it also investigates allegations of unfair labor
practices and provides remedies in appropriate cases.
Once elected or certified, the union is the exclusive bargaining unit for the employees it represents.
Because the employer is barred from interfering with employee communications when the union is
organizing for an election, he may not prohibit employees from soliciting fellow employees on company
property but may limit the hours or spaces in which this may be done. The election campaign itself is an
intricate legal duel; rewards, threats, and misrepresentations that affect the election are unfair labor
practices.
The basic policy of the labor laws is to foster good-faith collective bargaining over wages, hours, and
working conditions. The National Labor Relations Board (NLRB) may not compel agreement: it may not
order the employer or the union to adopt particular provisions, but it may compel a recalcitrant company
or union to bargain in the first place.
Among the unfair labor practices committed by employers are these:
1.

Discrimination against workers or prospective workers for belonging to or joining unions. Under
federal law, the closed shop and preferential hiring are unlawful. Some states outlaw the union shop,
the agency shop, and maintenance-of-membership agreements.

2. Interference with strikes. Employers may hire replacement workers during a strike, but in a strike
over an unfair labor practice, as opposed to an economic strike, the replacement workers may be
temporary only; workers are entitled to their jobs back at the strike’s end.
Among the unfair labor practices committed by unions are these:
1.

Secondary boycotts. Workers may not picket employers not involved in the primary labor dispute.

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2. Hot cargo agreements. An employer’s agreement, under union pressure, to refrain from dealing with
certain people or purchasing their products is unlawful.
3.

EXERCISES
1.

After years of working without a union, employees of Argenta Associates began organizing for a
representation election. Management did not try to prevent the employees from passing out leaflets
or making speeches on company property, but the company president did send out a notice to all
employees stating that in his opinion, they would be better off without a union. A week before the
election, he sent another notice, stating that effective immediately; each employee would be entitled
to a twenty-five-cents-an-hour raise. The employees voted the union down. The following day, several
employees began agitating for another election. This time management threatened to fire anyone
who continued talking about an election on the ground that the union had lost and the employees
would have to wait a year. The employees’ organizing committee filed an unfair labor practice
complaint with the NLRB. What was the result?

2.

Palooka Industries sat down with Local 308, which represented its telephone operators, to discuss
renewal of the collective bargaining agreement. Palooka pressed its case for a no-strike clause in the
next contract, but Local 308 refused to discuss it at all. Exasperated, Palooka finally filed an unfair
labor practice claim with the NLRB. What was the result?

3.

Union organizers sought to organize the punch press operators at Dan’s Machine Shop. The shop was
located on a lot surrounded by heavily forested land from which access to employees was impossible.
The only practical method of reaching employees on the site was in the company parking lot. When
the organizers arrived to distribute handbills, the shop foreman, under instructions from Dan, ordered
them to leave. At a hearing before the NLRB, the company said that it was not antiunion but that its
policy, which it had always strictly adhered to, forbade nonemployees from being on the property if
not on company business. Moreover, company policy barred any activities that would lead to littering.
The company noted that the organizers could reach the employees in many other ways—meeting the
employees personally in town after hours, calling them at home, writing them letters, or advertising a

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public meeting. The organizers responded that these methods were far less effective means of
reaching the employees. What was the result? Why?

SELF-TEST QUESTIONS
1.

Which of the following is not a subject of mandatory bargaining?

a.

rate of pay per hour

b.

length of the workweek

c.

safety equipment

d.

new products to manufacture
Under a union shop agreement,

a.

an employer may not hire a nonunion member
b.

an employer must hire a nonunion member

c.

an employee must join the union after being hired

d.

an employee must belong to the union before being hired
Which of the following is always unlawful under federal law?

a.

union shop
b.

agency shop

c.

closed shop

d.

runaway shop
An employer’s agreement with its union to refrain from dealing with companies being struck
by other unions is a

a.

secondary boycott agreement
b.

hot cargo agreement

c.

lockout agreement

d.

maintenance-of-membership agreement
Striking employees are entitled to their jobs back when they are engaged in

a.

economic strikes

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b.

jurisdictional strikes

c.

both economic and jurisdictional strikes

d.

neither economic nor jurisdictional strikes

SELF-TEST ANSWERS
1.

d

2.

c

3.

c

4.

b

5.

a

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Chapter 20
International Law
LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1.

The concepts of sovereignty, self-determination, failed states, and failing states

2.

The sources of international law, and examples of treaties, conventions, and customary international
law

3.

How civil-law disputes between the parties from different nation-states can be resolved through
national court systems or arbitration

4.

The well-recognized bases for national jurisdiction over various parties from different nation-states

5.

The doctrines of forum non convenient, sovereign immunity, and act of state

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20.1 Introduction to International Law
J. L. Austin, the legal realist, famously defined law as “the command of a sovereign.” He had in mind the
fact that legal enforcement goes beyond negotiation and goodwill, and may ultimately have to be enforced
by some agent of the government. For example, if you fail to answer a summons and complaint, a default
judgment will be entered against you; if you fail to pay the judgment, the sheriff (or US marshal) will
actually seize assets to pay the judgment, and will come armed with force, if necessary.
The force and authority of a government in any given territory is fundamental to sovereignty. Historically,
that was understood to mean a nation’s “right” to issue its own currency, make and enforce laws within its
borders without interference from other nations (the “right of self-determination” that is noted in the
Charter of the United Nations), and to defend its territory with military force, if necessary. In a nation at
relative peace, sovereignty can be exercised without great difficulty. But many countries are in civil war,
and others experience “breakaway” areas where force must be used to assert continued sovereignty. In
some countries, civil war may lead to the formation of new nation-states, such as in Sudan in 2011.
In the United States, there was a Civil War from 1860 to 1864, and even now, there are separatist
movements, groups who refuse to recognize the authority of the local, state, or national governments.
From time to time, these groups will declare their independence of the sovereign, raise their own flag,
refuse to pay taxes, and resist government authority with arms. In the United States, the federal
government typically responds to these “mini-secessionist” movements with force.
In Canada, the province of Quebec has considered separating from Canada, and this came close to reality
in 1995 on a referendum vote for secession that gained 49.4 percent of the votes. Away from North
America, claims to exclusive political and legal authority within some geographic area are often the stuff
of civil and regional wars. Consider Kosovo’s violent secession from Yugoslavia, or Chechnya’s attempted
secession from Russia. At stake in all these struggles is the uncontested right to make and enforce laws
within a certain territory. In some nation-states, government control has failed to achieve effective control
over substantial areas, leaving factions, tribal groups, or armed groups in control. For such nations, the
phrase “failed states” or “failing states” has sometimes been used. A failing state usually has some
combination of lack of control over much of its territory, failure to provide public services, widespread
corruption and criminality, and sharp economic decline. Somalia, Chad, and Afghanistan, among others,
head the list as of 2011.
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In a functioning state, the right to make and enforce law is not contested or in doubt. But in the
international arena, there is no sovereign lawgiver and law enforcer. If a criminal burglarizes your house
and is caught, the legal authorities in your state have little difficulty bringing him to justice. But suppose a
dictator or military-run government oppresses some of the citizenry, depriving these citizens of the
chance to speak freely, to carry on a trade or profession, to own property, to be educated, or to have access
to water and a livable environment, or routinely commits various atrocities against ethnic groups (forced
labor, rape, pillage, murder, torture). Who will bring the dictator or government to justice, and before
what tribunal?
There is still no forum (court or tribunal) that is universally accepted as a place to try to punish such
people. The International Criminal Court has wide support and has prosecuted several individuals for
crimes, but the United States has still not agreed to its jurisdiction.
During the 1990s, the United States selectively “policed” certain conflicts (Kosovo, Haiti, Somalia), but it
cannot consistently serve over a long period of time as the world’s policeman. The United States has often
allowed human rights to be violated in many nations without much protest, particularly during the Cold
War with the Union of Soviet Socialist Republics (USSR), where alliances with dictatorships and
nondemocratic regimes were routinely made for strategic reasons.
Still, international law is no myth. As we shall see, there are enforceable treaties and laws that most
nations abide by, even as they are free to defect from these treaties. Yet the recent retreat by the United
States from pending international agreements (the Kyoto Protocol, the International Criminal Court, and
others) may be a sign that multilateralism is on the wane or that other nations and regional groupings (the
European Union, China) will take a more prominent role in developing binding multilateral agreements
among nations.

KEY TAKEAWAY
International law is based on the idea of the nation-state that has sovereignty over a population of
citizens within a given geographical territory. In theory, at least, this sovereignty means that nationstates should not interfere with legal and political matters within the borders of other nation-states.

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EXERCISES
1.

Using news sources, find at least one nation in the world where other nations are officially
commenting on or objecting to what goes on within that nation’s borders. Are such objections or
comments amounting to an infringement of the other nation’s sovereignty?

2.

Using news sources, find at least one nation in the world that is engaged in trying to change the
political and legal landscape of another nation. What is it doing, and why? Is this an infringement of
the other nation’s sovereignty?

3.

What is a failed state? What is a failing state? What is the difference? Is either one a candidate for
diplomatic recognition of its sovereignty? Discuss.

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20.2 Sources and Practice of International Law
LEARNING OBJECTIVES
1.

Explain what a treaty is and how it differs from a convention.

2.

Understand that a treaty can be a voluntary relinquishment of some aspects of sovereignty.

3.

Describe customary international law, and explain how it is different from treaties as a source of
international law.

4.

Describe some of the difficulties in enforcing one nation’s judicial judgments in another nation.

In this section, we shall be looking at a number of different sources of international law. These sources
include treaties and conventions, decisions of courts in various countries (including decisions in your own
state and nation), decisions of regional courts (such as the European Court of Justice), the World Trade
Organization (WTO), resolutions of the United Nations (UN), and decisions by regional trade
organizations such as the North American Free Trade Agreement (NAFTA). These sources are different
from most of the cases in your textbook, either because they involve parties from different nations or
because the rule makers or decision makers affect entities beyond their own borders.
In brief, the sources of international law include everything that an international tribunal might rely on to
decide international disputes. International disputes include arguments between nations, arguments
between individuals or companies from different nations, and disputes between individuals or companies
and a foreign nation-state. Article 38(1) of the Statute of the International Court of Justice (ICJ) lists four
sources of international law: treaties and conventions, custom, general principles of law, and judicial
decisions and teachings.
The ICJ only hears lawsuits between nation-states. Its jurisdiction is not compulsory, meaning that both
nations in a dispute must agree to have the ICJ hear the dispute.

Treaties and Conventions
Even after signing a treaty or convention, a nation is always free to go it alone and repudiate all regional
or international bodies, or refuse to obey the dictates of the United Nations or, more broadly and
ambiguously, “the community of nations.” The United States could repudiate NAFTA, could withdraw
from the UN, and could let the WTO know that it would no longer abide by the post–World War II rules of
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free trade embodied in the General Agreement on Tariffs and Trade (GATT). The United States would be
within its rights as a sovereign to do so, since it owes allegiance to no global or international sovereign.
Why, however, does it not do so? Why is the United States so involved with the “entangling alliances” that
George Washington warned about? Simply put, nations will give away part of their sovereignty if they
think it’s in their self-interest to do so. For example, if Latvia joins the European Union (EU), it gives up
its right to have its own currency but believes it has more to gain.
A treaty is nothing more than an agreement between two sovereign nations. In international law, a nation
is usually called a state or nation-state. This can be confusing, since there are fifty US states, none of
which has power to make treaties with other countries. It may be helpful to recall that the thirteen original
states under the Articles of Confederation were in fact able to have direct relations with foreign states.
Thus New Jersey (for a few brief years) could have had an ambassador to France or made treaties with
Spain. Such a decentralized confederation did not last long. Under the present Constitution, states gave
up their right to deal directly with other countries and vested that power in the federal government.
There are many treaties to which the United States is a party. Some of these are conventions, which are
treaties on matters of common concern, usually negotiated on a regional or global basis, sponsored by an
international organization, and open to adoption by many nations. For example, as of 2011, there were
192 parties (nation-states) that had signed on to the Charter of the UN, including the United States,
Uzbekistan, Ukraine, Uganda, United Arab Emirates, United Kingdom of Great Britain and Northern
Ireland, and Uruguay (just to name a few of the nation’s starting with U).
The most basic kind of treaty is an agreement between two nation-states on matters of trade and friendly
relations. Treaties of friendship, commerce, and navigation (FCN treaties) are fairly common and provide
for mutual respect for each nation-state’s citizens in (1) rights of entry, (2) practice of professions, (3)
right of navigation, (4) acquisition of property, (5) matters of expropriation or nationalization, (6) access
to courts, and (7) protection of patent rights. Bilateral investment treaties (BITs) are similar but are more
focused on commerce and investment. The commercial treaties may deal with a specific product or
product group, investment, tariffs, or taxation.
Nation-states customarily enter not only into FCN treaties and BITs but also into peace treaties or
weapons limitations treaties, such as the US-Russia Strategic Arms Reduction Talks (START) treaty.
Again, treaties are only binding as long as each party continues to recognize their binding effect. In the
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United States, the procedure for ratifying a treaty is that the Senate must approve it by a two-thirds vote
(politically, an especially difficult number to achieve). Once ratified, a treaty has the same force of law
within the United States as any statute that Congress might pass.

Custom
Custom between nations is another source of international law. Custom is practice followed by two or
more nations in the course of dealing with each other. These practices can be found in diplomatic
correspondence, policy statements, or official government statements. To become custom, a consistent
and recurring practice must go on over a significant period of time, and nations must recognize that the
practice or custom is binding and must follow it because of legal obligation and not mere courtesy.
Customs may become codified in treaties.

General Principles of Law, or Customary International Law
Even without treaties, there would be some international law, since not all disputes are confined to the
territory of one nation-state. For example, in In re the Bremen, a US company’s disagreement with a
German company was heard in US courts. The US courts had to decide where the dispute would properly
be heard. In giving full effect to a forum-selection clause, the US Supreme Court set out a principle that it
hoped would be honored by courts of other nations—namely, that companies from different states should
honor any forum-selection clause in their contract to settle disputes at a specific place or court. (See
the Bremen case, Section 20.5.1 "Forum-selection clauses"). If that principle is followed by enough
national court systems, it could become a principle of customary international law. As an example,
consider that for many years, courts in many nations believed that sovereign immunity was an established
principle of international law.

Judicial Decisions in International Tribunals; Scholarly Teachings
The Statute of the International Court of Justice recognizes that international tribunals may also refer to
the teachings of preeminent scholars on international law. The ICJ, for example, often referred to the
scholarly writings of Sir Hersh Lauterpacht in its early decisions. Generally, international tribunals are

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not bound by stare decisis (i.e., they may decide each case on its merits). However, courts such as the ICJ
do refer to their own past decisions for guidance.
There are many international tribunals, including the European Court of Justice, the ICJ, and the
International Criminal Court. Typically, however, disputes between corporations or between individuals
that cross national boundaries must be resolved in national court systems or in arbitration. In other
words, there is no international civil court, and much complexity in international law derives from the fact
that national court systems must often choose from different sources of law, using different legal
traditions in order to resolve international disputes. For example, a court in one nation may have some
difficulty accepting the judgment of a foreign nation’s court system, as we see in Koster v.
Automark (see Section 20.5.2 "Due process in the enforcement of judgments").

Due Process and Recognition of Foreign Judgments
Issues surrounding recognition of foreign judgments arise when one nation’s courts have questions about
the fairness of procedures used in foreign courts to acquire the judgment. Perhaps the defendant was not
notified or did not have ample time in which to prepare a defense, or perhaps some measure of damages
was assessed that seemed distinctly unfair. If a foreign state makes a judgment against a US company, the
judgment will not be recognized and enforced in the United States unless the US court believes that the
foreign judgment provided the US company with due process. But skepticism about a foreign judgment
works the other way, as well. For example, if a US court were to assess punitive damages against a Belgian
company, and the successful plaintiff were to ask for enforcement of the US judgment in Belgium, the
Belgian court would reject that portion of the award based on punitive damages. Compensatory damages
would be allowed, but as Belgian law does not recognize punitive damages, it might not recognize that
portion of the US court’s award.
Concerns about notice, service of process, and the ability to present certain defenses are evident in Koster
v. Automark. Many such concerns are eliminated with the use of forum-selection clauses. The classic case
in US jurisprudence is the Bremen case, which resolves difficult questions of where the case should be
tried between a US and German company by approving the use of a forum-selection clause indicating that
a court in the United Kingdom would be the only forum that could hear the dispute.

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Part of what is going on in Bremen is the Supreme Court’s concern that due process should be provided to
the US company. What is fair (procedurally) is the dominant question in this case. One clear lesson is that
issues of fairness regarding personal jurisdiction can be resolved with a forum-selection clause—if both
parties agree to a forum that would have subject matter jurisdiction, at least minimal fairness is evident,
because both parties have “consented” to have the forum decide the case.

Arbitration
The idea that a forum-selection clause could, by agreement of the parties, take a dispute out of one
national court system and into another court system is just one step removed from the idea that the
parties can select a fair resolution process that does not directly involve national court systems. In
international arbitration, parties can select, either before or after a dispute arises, an arbitrator or arbitral
panel that will hear the dispute. As in all arbitration, the parties agree that the arbitrator’s decision will be
final and binding. Arbitration is generally faster, can be less expensive, and is always private, being a
proceeding not open to media scrutiny.
Typically, an arbitration clause in the contract will specify the arbitrator or the means of selecting the
arbitrator. For that purpose, there are many organizations that conduct international arbitrations,
including the American Arbitration Association, the International Chamber of Commerce, the
International Centre for Settlement of Investment Disputes, and the United Nations Commission on
International Trade Law. Arbitrators need not be judges or lawyers; they are usually business people,
lawyers, or judges who are experienced in global commercial transactions. The arbitration clause is thus
in essence a forum-selection clause and usually includes a choice of law for the arbitrator or arbitral panel
to follow.
An arbitral award is not a judgment. If the losing party refuses to pay the award, the winning party must
petition a court somewhere to enforce it. Fortunately, almost every country that is engaged in
international commerce has ratified the United Nations Convention on the Recognition and Enforcement
of Arbitral Awards, sometimes known as the New York Convention. The United States adopted this
convention in 1970 and has amended the Federal Arbitration Act accordingly. Anyone who has an arbitral
award subject to the convention can attach property of the loser located in any country that has signed the
convention.
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KEY TAKEAWAY
Treaties and conventions, along with customary international law, are the primary sources of what we
call international law. Disputes involving parties from different nation-states are resolved in national
(federal) court systems, and one nation’s recognition and enforcement of another nation’s judicial
orders or judgments will require reciprocal treaties or some review that the order or judgment was
fairly obtained (that there was due process in the determination of the order or judgment).

EXERCISES
1.

At the US Senate website, read about the history of treaties in the United States. What is an
“executive agreement,” and why has the use of executive agreements grown so fast since World War
II?

2.

Is NAFTA a treaty or an executive agreement? What practical difference does it make if it is one rather
than the other?

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20.3 Important Doctrines of Nation-State Judicial Decisions
LEARNING OBJECTIVES
1.

Define and describe the three traditional bases for a nation’s jurisdiction over those individuals and
entities from other nation-states.

2.

Explain forum non convenient and be able to apply that in a case involving citizens from two different
nation-states.

3.

Describe and explain the origins of both sovereign immunity and the act-of-state doctrine, and be able
to distinguish between the two.

Bases for National Jurisdiction under International Law
A nation-state has jurisdiction to make and enforce laws (1) within its own borders, (2) with respect to its
citizens (nationals”) wherever they might be, and (3) with respect to actions taking place outside the
territory but having an objective or direct impact within the territory. In the Restatement (Third) of
Foreign Relations Law, these three jurisdictional bases are known as (1) the territorial principle, (2) the
nationality principle, and (3) the objective territoriality principle.
As we have already seen, many difficult legal issues involve jurisdictional problems. When can a court
assert authority over a person? (That’s the personal jurisdiction question.) When can a court apply its own
law rather than the law of another state? When is it obligated to respect the legal decisions of other states?
All these problems have been noted in the context of US domestic law, with its state-federal system; the
resolution of similar problems on a global scale are only slightly more complicated.
The territorial principle is fairly simple. Anything that happens within a nation’s borders is subject to its
laws. A German company that makes direct investment in a plant in Spartanburg, South Carolina, is
subject to South Carolina law and US law as well.
Nationality jurisdiction often raises problems. The citizens of a nation-state are subject to its laws while
within the nation and beyond. The United States has passed several laws that govern the conduct of US
nationals abroad. United States companies may not, for example, bribe public officials of foreign countries

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in order to get contracts (Foreign Corrupt Practices Act of 1976). Title VII of the Civil Rights Act also
applies extraterritorially—where a US citizen is employed abroad by a US company.
For example, suppose Jennifer Stanley (a US citizen) is discriminated against on the basis of gender by
Aramco (a US-based company) in Saudi Arabia, and she seeks to sue under Title VII of the Civil rights Act
of 1964. The extraterritorial reach of US law seems odd, especially if Saudi Arabian law or custom conflicts
with US law. Indeed, in EEOC v. Arabian American Oil Co., the Supreme Court was hesitant to say that
US law would “reach” across the globe to dictate proper corporate conduct.

[1]

Later that year, Congress

made it clear by amending Title VII so that its rules would in fact reach that far, at least where US citizens
were the parties to a dispute. But if Saudi Arabian law directly conflicted with US law, principles of
customary international law would require that territorial jurisdiction would trump nationality
jurisdiction.
Note that where the US laws conflict with local or host country laws, we have potential conflict in the
extraterritorial application of US law to activities in a foreign land. See, for example, Kern v.
Dynalectron.

[2]

In Kern, a Baptist pilot (US citizen) wanted to work for a company that provided

emergency services to those Muslims who were on a pilgrimage to Mecca. The job required helicopter
pilots to occasionally land to provide emergency services. However, Saudi law required that all who set
foot in Mecca must be Muslim. Saudi law provided for death to violators. Kern (wanting the job) tried to
convert but couldn’t give up his Baptist roots. He sued Dynalectron (a US company) for discrimination
under Title VII, claiming that he was denied the job because of his religion. Dynalectron did not deny that
they had discriminated on the basis of his religion but argued that because of the Saudi law, they had no
viable choice. Kern lost on the Title VII claim (his religion was a bona fide occupational qualification). The
court understood that US law would apply extraterritorially because of his nationality and the US
nationality of his employer.
The principle of objective territoriality is fairly simple: acts taking place within the borders of one nation
can have a direct and foreseeable impact in another nation. International law recognizes that nationstates act appropriately when they make and enforce law against actors whose conduct has such direct
effects. A lawsuit in the United States against Osama bin Laden and his relatives in the Middle East was
based on objective territoriality. (Based in Afghanistan, the Al Qaeda leader who claimed credit for attacks
on the United States on September 11, 2001.)
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Where a defendant is not a US national or is not located in the United States when prosecution or a civil
complaint is filed, there may be conflicts between the United States and the country of the defendant’s
nationality. One of the functions of treaties is to map out areas of agreement between nation-states so that
when these kinds of conflicts arise, there is a clear choice of which law will govern. For example, in an
extradition treaty, two nation-states will set forth rules to apply when one country wants to prosecute
someone who is present in the other country. In general, these treaties will try to give priority to
whichever country has the greater interest in taking jurisdiction over the person to be prosecuted.
Once jurisdiction is established in US courts in cases involving parties from two different nations, there
are some important limiting doctrines that business leaders should be aware of. These
are forum non convenient, sovereign immunity, and the act-of-state doctrine. Just as conflicts arise over
the proper venue in US court cases where two states’ courts may claim jurisdiction, so do conflicts occur
over the proper forum when the court systems of two nation-states have the right to hear the case.

Forum Non Convenient; Forum-Selection Clauses
Forum non convenient is a judicial doctrine that tries to determine the proper forum when the courts of
two different nation-states can claim jurisdiction. For example, when Union Carbide’s plant in Bhopal,
India, exploded and killed or injured thousands of workers and local citizens, the injured Indian plaintiffs
could sue Union Carbide in India (since Indian negligence law had territorial effect in Bhopal and Union
Carbide was doing business in India) or Union Carbide in the United States (since Union Carbide was
organized and incorporated in the United States, which would thus have both territorial and nationality
bases for jurisdiction over Union Carbide). Which nation’s courts should take a primary role? Note
that forum non convenient comes into play when courts in two different nation-states both have subject
matter and personal jurisdiction over the matter. Which nation’s court system should take the case? That,
in essence, is the question that the forum non convenient doctrine tries to answer.
In the Bremen case (), the German contractor (Unterweser) had agreed to tow a drilling rig owned by
Zapata from Galveston, Texas, to the Adriatic Sea. The drilling rig was towed by Unterweser’s vessel, The
Bremen. An accident in the Gulf damaged the drilling rig, and Zapata sued in US district court in Florida.
Unterweser argued that London was a “better,” or more convenient, forum for the resolution of Zapata’s
claim against Unterweser, but the district court rejected that claim. Had it not been for the forumselection clause, the claim would have been resolved in Tampa, Florida. The Bremen case, although it
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does have a forum non convenient analysis, is better known for its holding that in cases where
sophisticated parties engage in arms-length bargaining and select a forum in which to settle their
disputes, the courts will not second-guess that selection unless there is fraud or unless one party has
overwhelming bargaining power over the other.
In short, parties to an international contract can select a forum (a national court system and even a
specific court within that system, or an arbitral forum) to resolve any disputes that might arise. In
the Bremen case, Zapata was held to its choice; this tells you that international contracting requires
careful attention to the forum-selection clause. Since the Bremen case, the use of arbitration clauses in
international contracting has grown exponentially. The arbitration clause is just like a forum-selection
clause; instead of the party’s selecting a judicial forum, the arbitration clause points to resolution of the
dispute by an arbitrator or an arbitral panel.
Where there is no forum-selection clause, as in most tort cases, corporate defendants often find it useful
to invoke forum non convenient to avoid a lawsuit in the United States, knowing that the lawsuit
elsewhere cannot as easily result in a dollar-value judgment. Consider the case of Gonzalez v. Chrysler
Corporation (see).

Sovereign Immunity
For many years, sovereigns enjoyed complete immunity for their own acts. A king who established courts
for citizens (subjects) to resolve their disputes would generally not approve of judges who allowed subjects
to sue the king (the sovereign) and collect money from the treasury of the realm. If a subject sued a
foreign sovereign, any judgment would have to be collectible in the foreign realm, and no king would
allow another king’s subjects to collect on his treasury, either. In effect, claims against sovereigns,
domestic or foreign (at home or abroad), just didn’t get very far. Judges, seeing a case against a sovereign,
would generally dismiss it on the basis of “sovereign immunity.” This became customary international
law.
In the twentieth century, the rise of communism led to state-owned companies that began trading across
national borders. But when a state-owned company failed to deliver the quantity or quality of goods
agreed upon, could the disappointed buyer sue? Many tried, but sovereign immunity was often invoked as
a reason why the court should dismiss the lawsuit. Indeed, most lawsuits were dismissed on this basis.
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Gradually, however, a few courts began distinguishing between governmental acts and commercial acts:
where a state-owned company was acting like a private, commercial entity, the court would not grant
immunity. This became known as the “restrictive” version of sovereign immunity, in contrast to “absolute”
sovereign immunity. In US courts, decisions as to sovereign immunity after World War II were often
political in nature, with the US State Department giving advisory letters on a case-by-case basis,
recommending (or not recommending) that the court grant immunity to the foreign state. Congress
moved to clarify matters in 1976 by passing the Foreign Sovereign Immunities Act, which legislatively
recognized the restrictive theory. Note, especially, Section 1605(a) (2).

Jurisdictional Immunities of Foreign States
28 USCS § 1602 (1998)
§ 1602. Findings and declaration of purpose
The Congress finds that the determination by United States courts of the claims of foreign states to
immunity from the jurisdiction of such courts would serve the interests of justice and would protect the
rights of both foreign states and litigants in United States courts. Under international law, states are not
immune from the jurisdiction of foreign courts insofar as their commercial activities are concerned, and
their commercial property may be levied upon for the satisfaction of judgments rendered against them in
connection with their commercial activities. Claims of foreign states to immunity should henceforth be
decided by courts of the United States and of the States in conformity with the principles set forth in this
chapter [28 USCS §§ 1602 et seq.].
§ 1603. Definitions
For purposes of this chapter [28 USCS §§ 1602 et seq.]—
(a) A “foreign state”, except as used in section 1608 of this title, includes a political subdivision of a
foreign state or an agency or instrumentality of a foreign state as defined in subsection (b).
(b) An “agency or instrumentality of a foreign state” means any entity—
(1) which is a separate legal person, corporate or otherwise, and
(2) which is an organ of a foreign state or political subdivision thereof, or a majority of whose shares or
other ownership interest is owned by a foreign state or political subdivision thereof, and

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(3) which is neither a citizen of a State of the United States as defined in section 1332(c) and (d) of this
title nor created under the laws of any third country.
(c) The “United States” includes all territory and waters, continental or insular, subject to the jurisdiction
of the United States.
(d) A “commercial activity” means either a regular course of commercial conduct or a particular
commercial transaction or act. The commercial character of an activity shall be determined by reference
to the nature of the course of conduct or particular transaction or act, rather than by reference to its
purpose.
(e) A “commercial activity carried on in the United States by a foreign state” means commercial activity
carried on by such state and having substantial contact with the United States.

§ 1604. Immunity of a foreign state from jurisdiction
Subject to existing international agreements to which the United States is a party at the time of enactment
of this Act [enacted Oct. 21, 1976] a foreign state shall be immune from the jurisdiction of the courts of the
United States and of the States except as provided in sections 1605 to 1607 of this chapter.
§ 1605. General exceptions to the jurisdictional immunity of a foreign state
(a) A foreign state shall not be immune from the jurisdiction of courts of the United States or of the States
in any case—
(1) in which the foreign state has waived its immunity either explicitly or by implication, notwithstanding
any withdrawal of the waiver which the foreign state may purport to effect except in accordance with the
terms of the waiver;
(2) in which the action is based upon a commercial activity carried on in the United States by the foreign
state; or upon an act performed in the United States in connection with a commercial activity of the
foreign state elsewhere; or upon an act outside the territory of the United States in connection with a
commercial activity of the foreign state elsewhere and that act causes a direct effect in the United States;
(3) in which rights in property taken in violation of international law are in issue and that property or any
property exchanged for such property is present in the United States in connection with a commercial
activity carried on in the United States by the foreign state; or that property or any property exchanged for

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such property is owned or operated by an agency or instrumentality of the foreign state and that agency or
instrumentality is engaged in a commercial activity in the United States;
(4) in which rights in property in the United States acquired by succession or gift or rights in immovable
property situated in the United States are in issue;
(5) not otherwise encompassed in paragraph (2) above, in which money damages are sought against a
foreign state for personal injury or death, or damage to or loss of property, occurring in the United States
and caused by the tortious act or omission of that foreign state or of any official or employee of that
foreign state while acting within the scope of his office or employment; except this paragraph shall not
apply to—
(A) any claim based upon the exercise or performance or the failure to exercise or perform a discretionary
function regardless of whether the discretion be abused, or
(B) any claim arising out of malicious prosecution, abuse of process, libel, slander, misrepresentation,
deceit, or interference with contract rights;

Act of State
A foreign country may expropriate private property and be immune from suit in the United States by the
former owners, who might wish to sue the country directly or seek an order of attachment against
property in the United States owned by the foreign country. In the United States, the government may
constitutionally seize private property under certain circumstances, but under the Fifth Amendment, it
must pay “just compensation” for any property so taken. Frequently, however, foreign governments have
seized the assets of US corporations without recompensing them for the loss. Sometimes the foreign
government seizes all private property in a certain industry, sometimes only the property of US citizens. If
the seizure violates the standards of international law—as, for example, by failing to pay just
compensation—the question arises whether the former owners may sue in US courts. One problem with
permitting the courts to hear such claims is that by time of suit, the property may have passed into the
hands of bona fide purchasers, perhaps even in other countries.
The Supreme Court has enunciated a doctrine governing claims to recover for acts of expropriation. This
is known as the act-of-state doctrine. As the Supreme Court put it in 1897, “Every sovereign State is bound
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to respect the independence of every other sovereign State, and the courts of one country will not sit in
judgment on…[and thereby adjudicate the legal validity of] the acts of the government of another done
within its own territory.”

[3]

This means that US courts will “reject private claims based on the contention

that the damaging act of another nation violates either US or international law.”

[4]

Sovereign immunity

and the act-of-state doctrine rest on different legal principles and have different legal consequences. The
doctrine of sovereign immunity bars a suit altogether: once a foreign-government defendant shows that
sovereign immunity applies to the claims the plaintiff has raised, the court has no jurisdiction even to
consider them and must dismiss the case. By contrast, the act-of-state doctrine does not require dismissal
in a case properly before a court; indeed, the doctrine may be invoked by plaintiffs as well as defendants.
Instead, it precludes anyone from arguing against the legal validity of an act of a foreign government. In a
simple example, suppose a widow living in the United States is sued by her late husband’s family to
prevent her from inheriting his estate. They claim she was never married to the deceased. She shows that
while citizens of another country; they were married by proclamation of that country’s legislature.
Although legislatures do not marry people in the United States, the act-of-state doctrine would bar a court
from denying the legal validity of the marriage entered into in their home country.
The Supreme Court’s clearest statement came in a case growing out of the 1960 expropriation of US sugar
companies operating in Cuba. A sugar broker had entered into contracts with a wholly owned subsidiary
of Compania Azucarera Vertientes-Camaguey de Cuba (C.A.V.), whose stock was principally owned by US
residents. When the company was nationalized, sugar sold pursuant to these contracts had been loaded
onto a German vessel still in Cuban waters. To sail, the skipper needed the consent of the Cuban
government. That was forthcoming when the broker agreed to sign contracts with the government that
provided for payment to a Cuban bank rather than to C.A.V. The Cuban bank assigned the contracts to
Banco Nacional de Cuba, an arm of the Cuban government. However, when C.A.V. notified the broker that
in its opinion, C.A.V. still owned the sugar, the broker agreed to turn the process of the sale over to
Sabbatino, appointed under New York law as receiver of C.A.V.’s assets in the state. Banco Nacional de
Cuba then sued Sabbatino, alleging that the broker’s refusal to pay Banco the proceeds amounted to
common-law conversion.
The federal district court held for Sabbatino, ruling that if Cuba had simply failed to abide by its own law,
C.A.V.’s stockholders would have been entitled to no relief. But because Cuba had violated international
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law, the federal courts did not need to respect its act of appropriation. The violation of international law,
the court said, lay in Cuba’s motive for the expropriation, which was retaliation for President
Eisenhower’s decision to lower the quota of sugar that could be imported into the United States, and not
for any public purpose that would benefit the Cuban people; moreover, the expropriation did not provide
for adequate compensation and was aimed at US interests only, not those of other foreign nationals
operating in Cuba. The US court of appeals affirmed the lower court’s decision, holding that federal courts
may always examine the validity of a foreign country’s acts.
But in Banco Nacional de Cuba v. Sabbatino, the Supreme Court reversed, relying on the act-of-state
doctrine.

[5]

This doctrine refers, in the words of the Court, to the “validity of the public acts a recognized

foreign sovereign power commit[s] within its own territory.” If the foreign state exercises its own
jurisdiction to give effect to its public interests, however the government defines them, the expropriated
property will be held to belong to that country or to bona fide purchasers. For the act-of-state doctrine to
be invoked, the act of the foreign government must have been completely executed within the country—
for example, by having enacted legislation expropriating the property. The Supreme Court said that the
act-of-state doctrine applies even though the United States had severed diplomatic relations with Cuba
and even though Cuba would not reciprocally apply the act-of-state doctrine in its own courts.
Despite its consequences in cases of expropriations, the act-of-state doctrine is relatively narrow. As W. S.
Kirkpatrick Co., Inc. v. Environmental Tectonics Co.() shows, it does not apply merely because a judicial
inquiry in the United States might embarrass a foreign country or even interfere politically in the conduct
of US foreign policy.

KEY TAKEAWAY
Each nation-state has several bases of jurisdiction to make and enforce laws, including the territorial
principle, nationality jurisdiction, and objective territoriality. However, nation-states will not always
choose to exercise their jurisdiction: the doctrines of forum non convenient, sovereign immunity, and
act of state limit the amount and nature of judicial activity in one nation that would affect nonresident
parties and foreign sovereigns.

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EXERCISES
1.

Argentina sells bonds on the open market, and buyers all around the world buy them. Five years later,
Argentina declares that it will default on paying interest or principal on these bonds. Assume that
Argentina has assets in the United States. Is it likely that a bondholder in the United States can bring
an action in US courts that will not be dismissed for lack of subject matter jurisdiction?

2.

During the Falkland Island war between Argentina and Great Britain, neutral tanker traffic was at risk
of being involved in hostilities. Despite diplomatic cables from the United States assuring Argentina of
the vessels’ neutrality, an oil tanker leased by Amerada Hess, traveling from Puerto Rico to Valdez,
Alaska, was repeatedly bombed by the Argentine air force. The ship had to be scuttled, along with its
contents. Will a claim by Amerada Hess be recognized in US courts?

[1] EEOC v. Arabian American Oil Co. 499 U.S. 244 (1991).
[2] Kern v. Dynalectron, 746 F.2d 810 (1984).
[3] Underhill v. Hernandez, 168 U.S. 250, 252 (1897).
[4] Mannington Mills, Inc. v. Congoleum Corp., 595 F.2d 1287 (3d Cir. 1979).
[5] Banco Nacional de Cuba v. Sabbatino, 376 U.S. 398 (1964).

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20.4 Regulating Trade
LEARNING OBJECTIVES
1.

Understand why nation-states have sometimes limited imports but not exports.

2.

Explain why nation-states have given up some of their sovereignty by lowering tariffs in agreement
with other nation-states.

Before globalization, nation-states traded with one another, but they did so with a significant degree of
protectiveness. For example, one nation might have imposed very high tariffs (taxes on imports from
other countries) while not taxing exports in order to encourage a favorable “balance of trade.” The balance
of trade is an important statistic for many countries; for many years, the US balance of trade has been
negative because it imports far more than it exports (even though the United States, with its very large
farms, is the world’s largest exporter of agricultural products). This section will explore import and export
controls in the context of the global agreement to reduce import controls in the name of free trade.

Export Controls
The United States maintains restrictions on certain kinds of products being sold to other nations and to
individuals and firms within those nations. For example, the Export Administration Act of 1985 has
controlled certain exports that would endanger national security, drain scarce materials from the US
economy, or harm foreign policy goals. The US secretary of commerce has a list of controlled commodities
that meet any of these criteria.
More specifically, the Arms Export Control Act permits the president to create a list of controlled goods
related to military weaponry, and no person or firm subject to US law can export any listed item without a
license. When the United States has imposed sanctions, the International Emergency Economic Powers
Act (IEEPA) has often been the legislative basis; and the act gives the president considerable power to
impose limitations on trade. For example, in 1979, President Carter, using IEEPA, was able to impose

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sanctions on Iran after the diplomatic hostage crisis. The United States still imposes travel restrictions
and other sanctions on Cuba, North Korea, and many other countries.

Import Controls and Free Trade
Nation-states naturally wish to protect their domestic industries. Historically, protectionism has come in
the form of import taxes, or tariffs, also called duties. The tariff is simply a tax imposed on goods when
they enter a country. Tariffs change often and vary from one nation-state to another. Efforts to implement
free trade began with the General Agreement on Tariffs and Trade (GATT) and are now enforced through
the World Trade Organization (WTO); the GATT and the WTO have sought, through successive rounds of
trade talks, to decrease the number and extent of tariffs that would hinder the free flow of commerce from
one nation-state to another. The theory of comparative advantage espoused by David Ricardo is the basis
for the gradual but steady of tariffs, from early rounds of talks under the GATT to the Uruguay Round,
which established the WTO.
The GATT was a huge multilateral treaty negotiated after World War II and signed in 1947. After various
“rounds” of re-negotiation, the Uruguay Round ended in 1994 with the United States and 125 other
nation-states signing the treaty that established the WTO. In 1948, the worldwide average tariff on
industrial goods was around 40 percent. That number is now more like 4 percent as globalization has
taken root. Free-trade proponents claim that globalization has increased general well-being, while
opponents claim that free trade has brought outsourcing, industrial decline, and the hollowing-out of the
US manufacturing base. The same kinds of criticisms have been directed at the North American Free
Trade Agreement (NAFTA).
The Uruguay Round was to be succeeded by the Doha Round. But that round has not concluded because
developing countries have not been satisfied with the proposed reductions in agricultural tariffs imposed
by the more developed economies; developing countries have been resistant to further agreements unless
and until the United States and the European Union lower their agricultural tariffs.
There are a number of regional trade agreements other than NAFTA. The European Union, formerly the
Common Market, provides for the free movement of member nations’ citizens throughout the European
Union (EU) and sets union-wide standards for tariffs, subsidies, transportation, human rights, and many
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other issues. Another regional trade agreement is Mercosur—an organization formed by Brazil, Argentina,
Uruguay, and Paraguay to improve trade and commerce among those South American nations. Almost all
trade barriers between the four nations have been eliminated, and the organization has also established a
broad social agenda focusing on education, culture, the environment, and consumer protection.

KEY TAKEAWAY

Historically, import controls were more common than export controls; nation-states would typically
impose tariffs (taxes) on goods imported from other nation-states. Some nation-states, such as the
United States, nevertheless maintain certain export controls for national security and military
purposes. Most nation-states have voluntarily given up some of their sovereignty in order to gain the
advantages of bilateral and multilateral trade and investment treaties. The most prominent example of
a multilateral trade treaty is the GATT, now administered by the WTO. There are also regional freetrade agreements, such as NAFTA and Mercosur that provide additional relaxation of tariffs beyond
those agreed to under the WTO.

EXERCISES
1.

Look at various sources and describe, in one hundred or fewer words, why the Doha Round of WTO
negotiation has not been concluded.

2.

What is the most recent bilateral investment treaty (BIT) that has been concluded between the United
States and another nation-state? What are its key provisions? Which US businesses are most helped
by this treaty?

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20.5 Cases
Forum-selection clauses
In re the Bremen
407 U.S. 1 (1972)
MR. CHIEF JUSTICE BURGER delivered the opinion of the Court.
We granted certiorari to review a judgment of the United States Court of Appeals for the Fifth Circuit
declining to enforce a forum-selection clause governing disputes arising under an international towage
contract between petitioners and respondent. The circuits have differed in their approach to such clauses.
For the reasons stated hereafter, we vacate the judgment of the Court of Appeals.
In November 1967, respondent Zapata, a Houston-based American corporation, contracted with
petitioner Unterweser, a German corporation, to tow Zapata’s ocean-going, self-elevating drilling rig
Chaparral from Louisiana to a point off Ravenna, Italy, in the Adriatic Sea, where Zapata had agreed to
drill certain wells.
Zapata had solicited bids for the towage, and several companies including Unterweser had responded.
Unterweser was the low bidder and Zapata requested it to submit a contract, which it did. The contract
submitted by Unterweser contained the following provision, which is at issue in this case:
Any dispute arising must be treated before the London Court of Justice.
In addition the contract contained two clauses purporting to exculpate Unterweser from liability for
damages to the towed barge. After reviewing the contract and making several changes, but without any
alteration in the forum-selection or exculpatory clauses, a Zapata vice president executed the contract and
forwarded it to Unterweser in Germany, where Unterweser accepted the changes, and the contract
became effective.
On January 5, 1968, Unterweser’s deep sea tug Bremen departed Venice, Louisiana, with the Chaparral in
tow bound for Italy. On January 9, while the flotilla was in international waters in the middle of the Gulf
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of Mexico, a severe storm arose. The sharp roll of the Chaparral in Gulf waters caused its elevator legs,
which had been raised for the voyage, to break off and fall into the sea, seriously damaging the Chaparral.
In this emergency situation Zapata instructed the Bremen to tow its damaged rig to Tampa, Florida, the
nearest port of refuge.
On January 12, Zapata, ignoring its contract promise to litigate “any dispute arising” in the English courts,
commenced a suit in admiralty in the United States District Court at Tampa, seeking $3,500,000
damages against Unterweser in personam and the Bremen in rem, alleging negligent towage and breach
of contract. Unterweser responded by invoking the forum clause of the towage contract, and moved to
dismiss for lack of jurisdiction or on forum non conveniens grounds, or in the alternative to stay the
action pending submission of the dispute to the “London Court of Justice.” Shortly thereafter, in
February, before the District Court had ruled on its motion to stay or dismiss the United States action,
Unterweser commenced an action against Zapata seeking damages for breach of the towage contract in
the High Court of Justice in London, as the contract provided. Zapata appeared in that court to contest
jurisdiction, but its challenge was rejected, the English courts holding that the contractual forum
provision conferred jurisdiction.
In the meantime, Unterweser was faced with a dilemma in the pending action in the United States court at
Tampa. The six-month period for filing action to limit its liability to Zapata and other potential claimants
was about to expire, but the United States District Court in Tampa had not yet ruled on Unterweser’s
motion to dismiss or stay Zapata’s action. On July 2, 1968, confronted with difficult alternatives,
Unterweser filed an action to limit its liability in the District Court in Tampa. That court entered the
customary injunction against proceedings outside the limitation court, and Zapata re-filed its initial claim
in the limitation action.
It was only at this juncture, on July 29, after the six-month period for filing the limitation action had run,
that the District Court denied Unterweser’s January motion to dismiss or stay Zapata’s initial action. In
denying the motion that court relied on the prior decision of the Court of Appeals in Carbon Black Export,
Inc. In that case the Court of Appeals had held a forum-selection clause unenforceable, reiterating the
traditional view of many American courts that “agreements in advance of controversy whose object is to
oust the jurisdiction of the courts are contrary to public policy and will not be enforced.”
***
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Thereafter, on January 21, 1969, the District Court denied another motion by Unterweser to stay the
limitation action pending determination of the controversy in the High Court of Justice in London and
granted Zapata’s motion to restrain Unterweser from litigating further in the London court. The District
Judge ruled that, having taken jurisdiction in the limitation proceeding, he had jurisdiction to determine
all matters relating to the controversy. He ruled that Unterweser should be required to “do equity” by
refraining from also litigating the controversy in the London court, not only for the reasons he had
previously stated for denying Unterweser’s first motion to stay Zapata’s action, but also because
Unterweser had invoked the United States court’s jurisdiction to obtain the benefit of the Limitation Act.
On appeal, a divided panel of the Court of Appeals affirmed, and on rehearing en banc the panel opinion
was adopted, with six of the 14 en banc judges dissenting.

[1]

As had the District Court, the majority rested

on the Carbon Black decision, concluding that “at the very least” that case stood for the proposition that a
forum-selection clause “will not be enforced unless the selected state would provide a more convenient
forum than the state in which suit is brought.” From that premise the Court of Appeals proceeded to
conclude that, apart from the forum-selection clause, the District Court did not abuse its discretion in
refusing to decline jurisdiction on the basis of forum non conveniens. It noted that (1) the flotilla never
“escaped the Fifth Circuit’s mare nostrum, and the casualty occurred in close proximity to the district
court”; (2) a considerable number of potential witnesses, including Zapata crewmen, resided in the Gulf
Coast area; (3) preparation for the voyage and inspection and repair work had been performed in the Gulf
area; (4) the testimony of the Bremen crew was available by way of deposition; (5) England had no
interest in or contact with the controversy other than the forum-selection clause. The Court of Appeals
majority further noted that Zapata was a United States citizen and “[t]he discretion of the district court to
remand the case to a foreign forum was consequently limited”—especially since it appeared likely that the
English courts would enforce the exculpatory clauses. In the Court of Appeals’ view, enforcement of such
clauses would be contrary to public policy in American courts under Bisso v. Inland Waterways Corp., 349
U.S. 85 (1955), and Dixilyn Drilling Corp. v. Crescent Towing & Salvage Co., 372 U.S. 697 (1963).
Therefore, “[t]he district court was entitled to consider that remanding Zapata to a foreign forum, with no
practical contact with the controversy, could raise a bar to recovery by a United States citizen which its
own convenient courts would not countenance.”

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We hold, with the six dissenting members of the Court of Appeals, that far too little weight and effect were
given to the forum clause in resolving this controversy. For at least two decades we have witnessed an
expansion of overseas commercial activities by business enterprises based in the United States. The
barrier of distance that once tended to confine a business concern to a modest territory no longer does so.
Here we see an American company with special expertise contracting with a foreign company to tow a
complex machine thousands of miles across seas and oceans. The expansion of American business and
industry will hardly be encouraged if, not-withstanding solemn contracts, we insist on a parochial concept
that all disputes must be resolved under our laws and in our courts. Absent a contract forum, the
considerations relied on by the Court of Appeals would be persuasive reasons for holding an American
forum convenient in the traditional sense, but in an era of expanding world trade and commerce, the
absolute aspects of the doctrine of the Carbon Black case have little place and would be a heavy hand
indeed on the future development of international commercial dealings by Americans. We cannot have
trade and commerce in world markets and international waters exclusively on our terms, governed by our
laws, and resolved in our courts.
Forum-selection clauses have historically not been favored by American courts. Many courts, federal and
state, have declined to enforce such clauses on the ground that they were “contrary to public policy,” or
that their effect was to “oust the jurisdiction” of the court. Although this view apparently still has
considerable acceptance, other courts are tending to adopt a more hospitable attitude toward forumselection clauses. This view…is that such clauses are prima facie valid and should be enforced unless
enforcement is shown by the resisting party to be “unreasonable” under the circumstances.
We believe this is the correct doctrine to be followed by federal district courts sitting in admiralty. It is
merely the other side of the proposition recognized by this Court in National Equipment Rental, Ltd. v.
Szukhent, 375 U.S. 311 (1964), holding that in federal courts a party may validly consent to be sued in a
jurisdiction where he cannot be found for service of process through contractual designation of an “agent”
for receipt of process in that jurisdiction. In so holding, the Court stated: “[I]t is settled…that parties to a
contract may agree in advance to submit to the jurisdiction of a given court, to permit notice to be served
by the opposing party, or even to waive notice altogether.”
This approach is substantially that followed in other common-law countries including England. It is the
view advanced by noted scholars and that adopted by the Restatement of the Conflict of Laws. It accords
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with ancient concepts of freedom of contract and reflects an appreciation of the expanding horizons of
American contractors who seek business in all parts of the world. Not surprisingly, foreign businessmen
prefer, as do we, to have disputes resolved in their own courts, but if that choice is not available, then in a
neutral forum with expertise in the subject matter. Plainly, the courts of England meet the standards of
neutrality and long experience in admiralty litigation. The choice of that forum was made in an arm’slength negotiation by experienced and sophisticated businessmen, and absent some compelling and
countervailing reason it should be honored by the parties and enforced by the courts.
***
The judgment of the Court of Appeals is vacated and the case is remanded for further proceedings
consistent with this opinion.
Vacated and remanded.
MR. JUSTICE DOUGLAS, dissenting.
***
The Limitation Court is a court of equity and traditionally an equity court may enjoin litigation in another
court where equitable considerations indicate that the other litigation might prejudice the proceedings in
the Limitation Court. Petitioners’ petition for limitation [407 U.S. 1, 23] subjects them to the full equitable
powers of the Limitation Court.
Respondent is a citizen of this country. Moreover, if it were remitted to the English court, its substantive
rights would be adversely affected. Exculpatory provisions in the towage control provide (1) that
petitioners, the masters and the crews “are not responsible for defaults and/or errors in the navigation of
the tow” and (2) that “[d]amages suffered by the towed object are in any case for account of its Owners.”
Under our decision in Dixilyn Drilling Corp v. Crescent Towing & Salvage Co., 372 U.S. 697, 698, “a
contract which exempts the tower from liability for its own negligence” is not enforceable, though there is
evidence in the present record that it is enforceable in England. That policy was first announced in Bisso
v. Inland Waterways Corp., 349 U.S. 85; and followed in Boston Metals Co. v. The Winding Gulf, 349 U.S.
122.
***
Moreover, the casualty occurred close to the District Court, a number of potential witnesses, including
respondent’s crewmen, reside in that area, and the inspection and repair work were done there. The
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testimony of the tower’s crewmen, residing in Germany, is already available by way of depositions taken
in the proceedings. [407 U.S. 1, 24]
All in all, the District Court judge exercised his discretion wisely in enjoining petitioners from pursuing
the litigation in England.
I would affirm the judgment below.

1.

CASE QUESTIONS

Without a forum-selection clause, would the court in England have personal jurisdiction over either
party?

2.

Under forum non conveniens, there will be two courts, both of which have subject matter and
personal jurisdiction—and the court will defer jurisdiction to the more “convenient” forum. If there
were no forum-selection clause here, could the US court defer jurisdiction to the court in London?

3.

Will Zapata recover anything if the case is heard in London?

4.

Is it “fair” to let Unterweser excuse itself from liability? If not, under what ethical perspective does it
“make sense” or “seem reasonable” for the court to allow Zapata to go to London and recover very
little or nothing?

Due process in the enforcement of judgments
Koster v. Automark
640 F.2d 77 (N.D. Ill. 1980)
MARVIN E. ASPEN, District Judge:
On November 23, 1970, plaintiff Koster and defendant Automark Industries Incorporated (“Automark”)
consummated a five-month course of negotiation by entering into an agreement whereby Automark
promised to purchase 600,000 valve cap gauges during 1971. As a result of Automark’s alleged breach of
this agreement, plaintiff brought an action for damages in the District Court in Amsterdam, 3rd Lower
Chamber A. On October 16, 1974, plaintiff obtained a default judgment in the amount of Dutch Florins
214,747,50—$66,000 in American currency at the rate of exchange prevailing on December 31, 1971—plus
costs and interest. Plaintiff filed this diversity action on January 27, 1978, to enforce that foreign
judgment.
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The case now is before the Court on plaintiff’s motion for summary judgment pursuant to Federal Rules of
Civil Procedure (Fed.R.Civ.P) 56(a). Defendant contests this motion on three grounds: (1) that service was
inadequate, (2) that defendant lacked the minimum contacts necessary to render it subject to in personam
jurisdiction in Amsterdam, and (3) that defendant has meritorious defenses to the action which it could
not present in the foreign proceeding. For the reasons that follow, however, the Court finds defendant’s
contentions unavailing.
[Note: The discussion on inadequate service has been omitted from what follows.]
As the court noted in Walters…service of process cannot confer personal jurisdiction upon a court in the
absence of minimum contacts. The requirement of minimum contacts is designed to ensure that it is
reasonable to compel a party to appear in a particular forum to defend against an action. Shaffer v.
Heitner, 433 U.S. 186 (1977); International Shoe Co. v. Washington, 326 U.S. 317 (1945). Here, it is
undisputed that Automark initiated the negotiations by a letter to plaintiff dated June 25, 1970. The fivemonth period of negotiations, during which time defendant sent several letters and telegrams to plaintiff
in Amsterdam, led to the agreement of November 23, 1970. Moreover, although there is no evidence as to
the contemplated place of performance, plaintiff attests—without contradiction—that the payment was to
be made in Amsterdam.
On facts not dissimilar from these, the Illinois courts have found the existence of minimum contacts
sufficient to justify long-arm personal jurisdiction under the Illinois statute. Ill.Rev.Stat. Ch. 110, §
17(a)(1). In Colony Press, Inc. v. Fleeman, 17 Ill.App.3d 14, 308 N.E.2d 78 (1st Dist. 1974), the court found
that minimum contacts existed where the defendant had initiated the negotiations by submitting a
purchase order to an Illinois company and the contract was to be performed in Illinois. And in Cook
Associates, Inc. v. Colonial Broach & Machine Co., 14 Ill.App.3d 965, 304 N.E.2d 27 (1st Dist. 1973), the
court found that a single telephone call into Illinois initiating a business transaction that was to be
performed in Illinois by an Illinois agency was enough to establish personal jurisdiction in Illinois. Thus,
the Court finds that the Amsterdam court had personal jurisdiction over Automark.
Finally, defendant suggests that it has meritorious defenses which it could not present because of its
absence at the judicial proceeding in Amsterdam; specifically, that there was no binding agreement and,
alternatively, that its breach was justified by plaintiff’s failure to perform his end of the bargain. It is
established beyond question, however, that a default judgment is a conclusive and final determination
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that is accorded the same res judicata effect as a judgment after a trial on the merits. Such a judgment
may be attacked collaterally only on jurisdictional grounds, or upon a showing that the judgment was
obtained by fraud or collusion. Thus, defendant is foreclosed from challenging the underlying merits of
the judgment obtained in Amsterdam.
[In a footnote, the court says:] “Again, even assuming that defendant could attack the judgment on the
merits, it has failed to raise any genuine issue of material fact…An affidavit by defendant’s secretary
states only that “to the best of [his] knowledge” there was no contract with anyone in Amsterdam. Yet,
there is no affidavit from the party who negotiated and allegedly contracted with plaintiff; nor is there
any explanation why such an affidavit was not filed. In the face of the copy of a letter of agreement
provided by plaintiff, this allegation is insufficient to create a factual question. Moreover, defendant
offers no extrinsic material in support of its allegation of non-performance by plaintiff. Thus, even were
the Court to consider defendant’s alleged defenses to the contract action, it would grant summary
judgment for plaintiff on the merits.”
Accordingly, the Court finds that plaintiff is entitled to enforcement of the foreign judgment. Thus,
plaintiff’s motion for summary judgment is granted. It is so ordered.

CASE QUESTIONS
1.

Why do you think Automark did not go to Amsterdam to contest this claim by Koster?

2.

Why does the Illinois court engage in a due process analysis of personal jurisdiction?

3.

What if the letter of agreement had an arbitration clause? Would the court in Amsterdam have
personal jurisdiction over Automark?

Forum non conveniens
Gonzalez v. Chrysler Corporation
301 F.3d 377 (5th Cir. 2002)
[Note: Although the court’s opinion was appealed to the Supreme Court, no writ of certiorari was issued,
so the following decision stands as good precedent in forum non conveniens cases.]
Opinion by E. GRADY JOLLY, Circuit Judge.
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In this forum non conveniens case, we first consider whether the cap imposed by Mexican law on the
recovery of tort damages renders Mexico an inadequate forum for resolving a tort suit by a Mexican
citizen against an American manufacturer and an American designer of an air bag. Holding that Mexico—
despite its cap on damages—represents an adequate alternative forum, we next consider whether the
district court committed reversible error when it concluded that the private and public interest factors so
strongly pointed to Mexico that Mexico, instead of Texas, was the appropriate forum in which to try this
case. Finding no reversible error, we affirm the district court’s judgment dismissing this case on the
ground of forum non conveniens.
In 1995, while in Houston, the plaintiff, Jorge Luis Machuca Gonzalez (“Gonzalez”) saw several magazine
and television advertisements for the Chrysler LHS. The advertisements sparked his interest. So, Gonzalez
decided to visit a couple of Houston car dealerships. Convinced by these visits that the Chrysler LHS was a
high quality and safe car, Gonzalez purchased a Chrysler LHS upon returning to Mexico.
On May 21, 1996, the wife of the plaintiff was involved in a collision with another moving vehicle while
driving the Chrysler LHS in Atizapan de Zaragoza, Mexico. The accident triggered the passenger-side air
bag. The force of the air bag’s deployment instantaneously killed Gonzalez’s three-year-old son, Pablo.
Seeking redress, Gonzalez brought suit in Texas district court against (1) Chrysler, as the manufacturer of
the automobile; (2) TRW,, Inc. and TRW Vehicle Safety Systems, Inc., as the designers of the front sensor
for the air bag; and (3) Morton International, Inc., as designer of the air bag module. Gonzalez asserted
claims based on products liability, negligence, gross negligence, and breach of warranty. As noted,
Gonzalez chose to file his suit in Texas. Texas, however, has a tenuous connection to the underlying
dispute. Neither the car nor the air bag module was designed or manufactured in Texas. The accident took
place in Mexico, involved Mexican citizens, and only Mexican citizens witnessed the accident. Moreover,
Gonzalez purchased the Chrysler LHS in Mexico (although he shopped for the car in Houston, Texas).
Because of these factors, the district court granted the defendants’ identical motions for dismissal on the
ground of forum non conveniens. Gonzalez now appeals.
II. A
The primary question we address today involves the threshold inquiry in the forum non conveniens
analysis: Whether the limitation imposed by Mexican law on the award of damages renders Mexico an

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inadequate alternative forum for resolving a tort suit brought by a Mexican citizen against a United States
manufacturer.
We should note at the outset that we may reverse the grant or denial of a motion to dismiss on the ground
of forum non conveniens only “where there has been a clear abuse of discretion.” Baumgart v. Fairchild
Aircraft Corp., 981 F.2d 824, 835 (5th Cir. 1993).
The forum non conveniens inquiry consists of four considerations. First, the district court must assess
whether an alternative forum is available. See Alpine View Co. Ltd. v. Atlas Copco AB, 205 F.3d 208, 221
(5th Cir. 2000). An alternative forum is available if “the entire case and all parties can come within the
jurisdiction of that forum.” In re Air Crash Disaster Near New Orleans, La. on July 9, 1982, 821 F.2d 1147,
1165 (5th Cir. 1987) (en banc), vacated on other grounds sub nom., Pan Am. World Airways, Inc. v. Lopez,
490 U.S. 1032, 104 L. Ed. 2d 400, 109 S. Ct. 1928 (1989). Second, the district court must decide if the
alternative forum is adequate. See Alpine View, 205 F.3d at 221. An alternative forum is adequate if “the
parties will not be deprived of all remedies or treated unfairly, even though they may not enjoy the same
benefits as they might receive in an American court.” In re Air Crash, 821 F.2d at 1165 (internal citation
omitted).
If the district court decides that an alternative forum is both available and adequate, it next must weigh
various private interest factors. See Baumgart, 981 F.2d at 835-36. If consideration of these private
interest factors counsels against dismissal, the district court moves to the fourth consideration in the
analysis. At this stage, the district court must weigh numerous public interest factors. If these factors
weigh in the moving party’s favor, the district court may dismiss the case. Id. at 837.
B. 1
The heart of this appeal is whether the alternative forum, Mexico, is adequate. (The court here explains
that Mexico is an amenable forum because the defendants have agreed to submit to the jurisdiction of the
Mexican courts.) The jurisprudential root of the adequacy requirement is the Supreme Court’s decision in
Piper Aircraft Co. v. Reyno, 454 U.S. 235, 70 L. Ed. 2d 419, 102 S. Ct. 252 (1981). The dispute in Piper
Aircraft arose after several Scottish citizens were killed in a plane crash in Scotland. A representative for
the decedents filed a wrongful death suit against two American aircraft manufacturers. The Court noted
that the plaintiff filed suit in the United States because “[US] laws regarding liability, capacity to sue, and
damages are more favorable to her position than are those of Scotland.” Id. The Court further noted that
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“Scottish law does not recognize strict liability in tort.” Id. This fact, however, did not deter the Court from
reversing the Third Circuit. In so doing, the Court held that “although the relatives of the decedent may
not be able to rely on a strict liability theory, and although their potential damage award may be smaller,
there is no danger that they will be deprived of any remedy or treated unfairly [in Scotland].” Thus, the
Court held that Scotland provided an adequate alternative forum for resolving the dispute, even though its
forum provided a significantly lesser remedy. In a footnote, however, Justice Marshall observed that on
rare occasions this may not be true:
At the outset of any forum non conveniens inquiry, the court must determine whether there exists an
alternative forum. Ordinarily, this requirement will be satisfied when the defendant is “amenable to
process” in the other jurisdiction. In rare circumstances, however, where the remedy offered by the other
forum is clearly unsatisfactory, the other forum may not be an adequate alternative, and the initial
requirement may not be satisfied. Thus, for example, dismissal would not be appropriate where the
alternative forum does not permit litigation of the subject matter of the dispute.
.…
Citing the language from this footnote, Gonzalez contends that a Mexican forum would provide a clearly
unsatisfactory remedy because (1) Mexican tort law does not provide for a strict liability theory of recovery
for the manufacture or design of an unreasonably dangerous product and (2) Mexican law caps the
maximum award for the loss of a child’s life at approximately $ 2,500 (730 days’ worth of wages at the
Mexican minimum wage rate). Thus, according to Gonzalez, Mexico provides an inadequate alternative
forum for this dispute.
B.2
(a) Gonzalez’s first contention may be quickly dismissed based on the explicit principle stated in Piper
Aircraft. As noted, there the Supreme Court held that Scotland’s failure to recognize strict liability did not
render Scotland an inadequate alternative forum. Id. at 255. There is no basis to distinguish the absence
of a strict products liability cause of action under Mexican law from that of Scotland. Piper Aircraft
therefore controls. Accordingly, we hold that the failure of Mexican law to allow for strict liability on the
facts of this case does not render Mexico an inadequate forum.
(b) Gonzalez’s second contention—that the damage cap renders the remedy available in a Mexican forum
“clearly unsatisfactory”—is slightly more problematic. Underlying this contention are two distinct
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arguments: First, Gonzalez argues that if he brings suit in Mexico, the cap on damages will entitle him to
a de minimis recovery only—a clearly unsatisfactory award for the loss of a child. Second, Gonzalez argues
that because of the damage cap, the cost of litigating this case in Mexico will exceed the potential recovery.
As a consequence, the lawsuit will never be brought in Mexico. Stated differently, the lawsuit is not
economically viable in Mexico. It follows, therefore, that Mexico offers no forum (much less an adequate
forum) through which Gonzalez can (or will) seek redress. We address each argument in turn.
(b)(i)
In addressing Gonzalez’s first argument, we start from basic principles of comity. Mexico, as a sovereign
nation, has made a deliberate choice in providing a specific remedy for this tort cause of action. In making
this policy choice, the Mexican government has resolved a trade-off among the competing objectives and
costs of tort law, involving interests of victims, of consumers, of manufacturers, and of various other
economic and cultural values. In resolving this trade-off, the Mexican people, through their duly-elected
lawmakers, have decided to limit tort damages with respect to a child’s death. It would be inappropriate—
even patronizing—for us to denounce this legitimate policy choice by holding that Mexico provides an
inadequate forum for Mexican tort victims. In another forum non conveniens case, the District Court for
the Southern District of New York made this same point observing (perhaps in a hyperbolic choice of
words) that “to retain the litigation in this forum, as plaintiffs request, would be yet another example of
imperialism, another situation in which an established sovereign inflicted its rules, its standards and
values on a developing nation.” In re Union Carbide Corp. Gas Plant Disaster at Bhopal, India in
December, 1984, 634 F. Supp. 842, 867 (S.D.N.Y. 1986), aff’d as modified, 809 F.2d 195 (2d Cir. 1987). In
short, we see no warrant for us, a United States court, to replace the policy preference of the Mexican
government with our own view of what is a good policy for the citizens of Mexico.
Based on the considerations mentioned above, we hold that the district court did not err when it found
that the cap on damages did not render the remedy available in the Mexican forum clearly unsatisfactory.
(b) (ii) We now turn our attention to Gonzalez’s “economic viability” argument—that is, because there is
no economic incentive to file suit in the alternative forum, there is effectively no alternative forum.
The practical and economic realities lying at the base of this dispute are clear. At oral argument, the
parties agreed that this case would never be filed in Mexico. In short, a dismissal on the ground of forum
non conveniens will determine the outcome of this litigation in Chrysler’s favor. We nevertheless are
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unwilling to hold as a legal principle that Mexico offers an inadequate forum simply because it does not
make economic sense for Gonzalez to file this lawsuit in Mexico. Our reluctance arises out of two practical
considerations.
First, the plaintiff’s willingness to maintain suit in the alternative (foreign) forum will usually depend
on, inter alia, (1) whether the plaintiff’s particular injuries are compensable (and to what extent) in that
forum; (2) not whether the forum recognizes some cause of action among those applicable to the
plaintiff’s case, but whether it recognizes his most provable and compensable action; (3) similarly,
whether the alternative forum recognizes defenses that might bar or diminish recovery; and (4) the
litigation costs (i.e., the number of experts, the amount of discovery, geographic distances, attorney’s fees,
etc.) associated with bringing that particular case to trial. These factors will vary from plaintiff to plaintiff,
from case to case. Thus, the forum of a foreign country might be deemed inadequate in one case but not
another, even though the only difference between the two cases might be the cost of litigation or the
recovery for the plaintiff’s particular type of injuries. In sum, we find troublesome and lacking in guiding
principle the fact that the adequacy determination could hinge on constantly varying and arbitrary
differences underlying the “economic viability” of a lawsuit.
Second, if we allow the economic viability of a lawsuit to decide the adequacy of an alternative forum, we
are further forced to engage in a rudderless exercise of line drawing with respect to a cap on damages: At
what point does a cap on damages transform a forum from adequate to inadequate? Is it, as here, $2,500?
Is it $50,000? Or is it $100,000? Any recovery cap may, in a given case, make the lawsuit economically
unviable. We therefore hold that the adequacy inquiry under Piper Aircraft does not include an evaluation
of whether it makes economic sense for Gonzalez to file this lawsuit in Mexico.
C.
Having concluded that Mexico provides an adequate forum, we now consider whether the private and
public interest factors nonetheless weigh in favor of maintaining this suit in Texas. As noted, the district
court concluded that the public and the private interest factors weighed in favor of Mexico and dismissed
the case on the ground of forum non conveniens. Our review of this conclusion is restricted to abuse of
discretion. See Alpine View, 205 F.3d at 220.
The district court found that almost all of the private and public interest factors pointed away from Texas
and toward Mexico as the appropriate forum. It is clear to us that this finding does not represent an abuse
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of discretion. After all, the tort victim was a Mexican citizen, the driver of the Chrysler LHS (Gonzalez’s
wife) is a Mexican citizen, and the plaintiff is a Mexican citizen. The accident took place in Mexico.
Gonzalez purchased the car in Mexico. Neither the car nor the air bag was designed or manufactured in
Texas. In short, there are no public or private interest factors that would suggest that Texas is the
appropriate forum for the trial of this case.
III.
For the foregoing reasons, the district court’s dismissal of this case on the ground of forum non
conveniens is
AFFIRMED.

CASE QUESTIONS
1.

How can an alternative forum be “adequate” if no rational lawyer would take Gonzalez’s case to file in
a Mexican state court?

2.

To what extent does it strike you as “imperialism” for a US court to make a judgment that a Mexican
court is not “adequate”?

Act of State
W. S. Kirkpatrick Co., Inc. v. Environmental Tectonics Co.
493 U.S. 400 (1990)
Justice Scalia delivered the Court’s opinion.
In 1981, Harry Carpenter, who was then Chairman of the Board and Chief Executive Officer of petitioner
W. S. Kirkpatrick & Co., Inc. (Kirkpatrick) learned that the Republic of Nigeria was interested in
contracting for the construction and equipment of an aeromedical center at Kaduna Air Force Base in
Nigeria. He made arrangements with Benson “Tunde” Akindele, a Nigerian Citizen, whereby Akindele
would endeavor to secure the contract for Kirkpatrick. It was agreed that in the event the contract was
awarded to Kirkpatrick, Kirkpatrick would pay to two Panamanian entities controlled by Akindele an
amount equal to 20% of the contract price, which would in turn be given as a bribe to officials of the
Nigerian government. In accordance with this plan, the contract was awarded to petitioner W. S.
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Kirkpatrick & Co., International (Kirkpatrick International), a wholly owned subsidiary of Kirkpatrick;
Kirkpatrick paid the promised “commission” to the appointed Panamanian entities; and those funds were
disbursed as bribes. All parties agree that Nigerian law prohibits both the payment and the receipt of
bribes in connection with the award of a government contract.
Respondent Environmental Tectonics Corporation, International, an unsuccessful bidder for the Kaduna
contract, learned of the 20% “commission” and brought the matter to the attention of the Nigerian Air
Force and the United States Embassy in Lagos. Following an investigation by the Federal Bureau of
Investigation, the United States Attorney for the District of New Jersey brought charges against both
Kirkpatrick and Carpenter for violations of the Foreign Corrupt Practices Act of 1977 and both pleaded
guilty.
Respondent then brought this civil action in the United States District Court of the District of New Jersey
against Carpenter, Akindele, petitioners, and others, seeking damages under the Racketeer Influenced
and Corrupt Organizations Act, the Robinson-Patman Act, and the New Jersey Anti-Racketeering Act.
The defendants moved to dismiss the complaint under Rule 12(b)(6) of the Federal Rules of Civil
Procedure on the ground that the action was barred by the act of state doctrine.
The District Court concluded that the act of state doctrine applies “if the inquiry presented for judicial
determination includes the motivation of a sovereign act which would result in embarrassment to the
sovereign or constitute interference in the conduct of foreign policy of the United States.” Applying that
principle to the facts at hand, the court held that respondents suit had to be dismissed because in order to
prevail respondents would have to show that “the defendants or certain other than intended to wrongfully
influenced the decision to award the Nigerian contract by payment of a bribe, that the government of
Nigeria, its officials or other representatives knew of the offered consideration forewarning the Nigerian
contract to Kirkpatrick, that the bribe was actually received or anticipated and that but for the payment or
anticipation of the payment of the bribed, ETC would have been awarded the Nigerian contract.”
The Court of Appeals for the Third Circuit reversed.
…
This Courts’ description of the jurisprudential foundation for the act of state doctrine has undergone some
evolution over the years. We once viewed the doctrine as an expression of international law, resting upon
“the highest considerations of international comity and expediency,” Oetjen v. Central Leather Co., 246
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U.S. 297, 303-304 (1918). We have more recently described it, however, as a consequence of domestic
separation of powers, reflecting “the strong sense of the Judicial Branch that its engagement in the task of
passing on the validity of foreign acts of state may hinder” the conduct of foreign affairs, Banco Nacional
de Cuba v. Sabbatino, 376 U.S. 398, 423 (1964). Some Justices have suggested possible exceptions to
application of the doctrine, where one or both of the foregoing policies would seemingly not be served: an
exception, for example, for acts of state that consist of commercial transactions, since neither modern
international comity nor the current position of our Executive Branch accorded sovereign immunity to
such acts…or an exception for cases in which the executive branch has represented that it has no objection
to denying validity to the foreign sovereign act, since then the court should be impeding no foreign-policy
goals.
We find it unnecessary, however, to pursue those inquiries, since the factual predicate for application of
the act of state doctrine does not exist. Nothing in the present suit requires the court to declare invalid,
and thus ineffective as “a rule of decision for the courts of this country,” the official act of a foreign
sovereign.
In every case in which we have held the act of state doctrine applicable, the relief sought or the defense
interposed would have required a court in the United States to declare invalid the official acts of a foreign
sovereign performed within its own territory.…In Sabbatino, upholding the defendant’s claim to the funds
would have required a holding that Cuba’s expropriation of goods located in Havana was null and void. In
the present case, by contrast, neither the claim nor any asserted defense requires a determination that
Nigeria’s contract with Kirkpatrick International was, or, was not effective.
Petitioners point out, however, that the facts necessary to establish respondent’s claim will also establish
that the contract was unlawful. Specifically, they note that in order to prevail respondent must prove that
petitioner Kirkpatrick made, and Nigerian officials received, payments that violate Nigerian law, which
would, they assert, support a finding that the contract is invalid under Nigerian law. Assuming that to be
true, it still does not suffice. The act of state doctrine is not some vague doctrine of abstention but a
“principle of decision binding on federal and state courts alike.” As we said in Ricaud, “the act within its
own boundaries of one sovereign State…becomes a rule of decision for the courts of this country.” Act of
state issues only arise when a court must decide—that is, when the outcome of the case turns upon—the
effect of official action by a foreign sovereign. When that question is not in the case, neither is the act of
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state doctrine. This is the situation here. Regardless of what the court’s factual findings may suggest as to
the legality of the Nigerian contract, its legality is simply not a question to be decided in the present suit,
and there is thus no occasion to apply the rule of decision that the act of state doctrine requires.
***
The short of the matter is this: Courts in the United States have the Power, and ordinarily the obligation,
to decide cases and controversies properly presented to them. The act of state doctrine does not establish
an exception for cases and controversies that may embarrass foreign governments, but merely requires
that; in the process of deciding, the acts of foreign sovereigns taken within their own jurisdictions shall be
deemed valid: That doctrine has no application to the present case because the validity of no foreign
sovereign act is at issue.
The judgment of the Court for the Third Circuit is affirmed.

CASE QUESTIONS
1.

Why is this case not about sovereign immunity?

2.

On what basis does the US court take jurisdiction over an event or series of events that takes place in
Nigeria?

3.

If the court goes on to the merits of the case and determines that an unlawful bribe took place in
Nigeria, is it likely that diplomatic relations between the United States and Nigeria will be adversely
affected?

[1] The term en banc means that all the judges of a circuit court of appeals heard oral arguments and voted to
decide the outcome of the case.

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20.6 Summary and Exercises
Summary
International law is not like the domestic law of any one country. The sovereign, or lawgiver, in any
particular nation-state has the power to make and enforce laws within its territory. But globally, there is
no single source of law or law enforcement. Thus international law is a collection of agreements between
nation-states (treaties and conventions), customary international law (primarily based on decisions of
national court systems), and customary practice between nation-states. There is an international court of
justice, but it only hears cases between nation-states. There is no international court for the resolution of
civil disputes, and no regional courts for that purpose, either.
The lack of unified law and prevalence of global commerce means that local and national court systems
have had to devise ways of forcing judgments from one national court system or another to deal with
claims against sovereigns and to factor in diplomatic considerations as national judicial systems
encounter disputes that involve (directly or indirectly) the political and diplomatic prerogatives of
sovereigns. Three doctrines that have been devised are sovereign immunity, act of state, and forum non
conveniens. The recognition of forum-selection clauses in national contracting has also aided the use of
arbitration clauses, making international commercial-dispute resolution more efficient. Arbitral awards
against any individual or company in most nations engaged in global commerce are more easily
enforceable than judgments from national court systems.
In terms of regulating trade, the traditional practice of imposing taxes (tariffs) on imports from other
countries (and not taxing exports to other countries) has been substantially modified by the emergence of
the General Agreement on Tariffs and Trade (GATT) rules as now enforced by the World Trade
Organization (WTO). The United States has a practice of regulating exports, however, to take into account
national security and other foreign policy considerations. For example, the Export Administration Act of
1985 has controlled certain exports that would endanger national security, drain scarce materials from the
US economy, or harm foreign policy goals. The US secretary of commerce has a list of controlled
commodities that meet any of these criteria.

EXERCISES
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1.

Assume that the United States enters into a multilateral treaty with several third-world countries
under which then-existing private claims to molybdenum and certain other minerals in the United
States are assigned to an international agency for exploitation. When the owner of a US mine
continues to dig for ore covered by the treaty, the Justice Department sues to enjoin further mining.
What is the result? Why?

2.

A foreign government enters into a contract with a US company to provide computer equipment and
services for the intelligence arm of its military forces. After the equipment has been supplied, the
foreign government refuses to pay. The US company files suit in federal court in the United States,
seeking to attach a US bank account owned by the foreign government. The foreign government
claims that the US court has no jurisdiction and that even if it does; the government is immune from
suit. What is the result?

3.

Would the result in Exercise 2 be any different if the US company had maintained its own equipment
on a lease basis abroad and the foreign government had then expropriated the equipment and
refused to pay the US company it’s just value?

4.

The Concentrated Phosphate Export Association consists of the five largest phosphate producers. The
Agency for International Development (AID) undertook to sell fertilizer to Korea and solicited bids. The
association set prices and submitted a single bid on 300,000 tons. A paid the contract price,
determined the amounts to be purchased, coordinated the procedure for buying, and undertook to
resell to Korea. The Justice Department sued the association and its members, claiming that their
actions violated Section 1 of the Sherman Act. What defense might the defendants have? What is the
result?

5.

Canada and Russia have competing claims over fishing and mining rights in parts of the Arctic Ocean.
Assuming they cannot settle their competing claims through diplomatic negotiation, where might they
have their dispute settled?

SELF-TEST QUESTIONS
1.

International law derives from

a.

the US Constitution

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b.

the common law

c.

treaties

d.

customary international law

e.

c and d
Foreign nations are immune from suit in US courts for governmental acts because of

a.

the international sovereign immunity treaty
b.

a United Nations law forbidding suits against foreign sovereigns

c.

the Foreign Sovereign Immunities Act

d.

precedent created by the US Supreme Court
A foreign government’s expropriation of private assets belonging to a nonresident is
a.

a violation of international law

b.

a violation of the US Constitution

c.

permitted by the domestic law of most nation-states

d.

in violation of the act-of-state doctrine
Arbitration of business disputes is

a.

frowned upon by courts for replacing public dispute resolution with private dispute

resolution
b.

permissible when a country’s laws permit it

c.

permissible if the parties agree to it

d.

a and b

e.

b and c

SELF-TEST ANSWERS
1.

d

2.

a

3.

c

4.

e

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