This text was adapted by The Saylor Foundation under a Creative
Commons Attribution-NonCommercial-ShareAlike 3.0 License without
attribution as requested by the work’s original creator or licensee.

Saylor URL: http://www.saylor.org/books

Saylor.org
1

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.

Saylor URL: http://www.saylor.org/books

Saylor.org
2

Chapter 1
Introduction to Law and Legal Systems
LEARNING OBJECTIVES

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

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

Functions of the Law
In a nation, the law can serve to (1) keep the peace, (2) maintain the status quo, (3) preserve
individual rights, (4) protect minorities against majorities, (5) promote social justice, and (6)
provide for orderly social change. Some legal systems serve these purposes better than others.
Although a nation ruled by an authoritarian government may keep the peace and maintain the
status quo, it may also oppress minorities or political opponents (e.g., Burma, Zimbabwe, or
Saylor URL: http://www.saylor.org/books

Saylor.org
3

Iraq under Saddam Hussein). Under colonialism, European nations often imposed peace in
countries whose borders were somewhat arbitrarily created by those same European nations.
Over several centuries prior to the twentieth century, empires were built by Spain, Portugal,
Britain, Holland, France, Germany, Belgium, and Italy. With regard to the functions of the law,
the empire may have kept the peace—largely with force—but it changed the status quo and
seldom promoted the native peoples’ rights or social justice within the colonized nation.
In nations that were former colonies of European nations, various ethnic and tribal factions
have frequently made it difficult for a single, united government to rule effectively. In Rwanda,
for example, power struggles between Hutus and Tutsis resulted in genocide of the Tutsi
minority. (Genocide is the deliberate and systematic killing or displacement of one group of
people by another group. In 1948, the international community formally condemned the crime
of genocide.) In nations of the former Soviet Union, the withdrawal of a central power created
power vacuums that were exploited by ethnic leaders. When Yugoslavia broke up, the different
ethnic groups—Croats, Bosnians, and Serbians—fought bitterly for home turf rather than share
power. In Iraq and Afghanistan, the effective blending of different groups of families, tribes,
sects, and ethnic groups into a national governing body that shares power remains to be seen.

Law and Politics
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.

Saylor URL: http://www.saylor.org/books

Saylor.org
4

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.”

1.2 Schools of Legal Thought

LEARNING OBJECTIVES

1. Distinguish different philosophies of law—schools of legal thought—and explain their
relevance.
2. Explain why natural law relates to the rights that the founders of the US political-legal system
found important.
3. Describe legal positivism and explain how it differs from natural law.
4. Differentiate critical legal studies and ecofeminist legal perspectives from both natural law
and legal positivist perspectives.

Saylor URL: http://www.saylor.org/books

Saylor.org
5

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

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

Saylor.org
6

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 naturallaw outlook, as it emphasizes certain objective norms and rights of individuals and nations. The
US Declaration of Independence embodies a natural-law philosophy. The following short extract
should provide some sense of the deep beliefs in natural law held by those who signed the
document.

The Unanimous Declaration of the Thirteen United States of America
July 4, 1776
When in the Course of human events, it becomes necessary for one people to dissolve
the political bands which have connected them with another, and to assume among
Saylor URL: http://www.saylor.org/books

Saylor.org
7

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]
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
Saylor URL: http://www.saylor.org/books

Saylor.org
8

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.
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

Saylor URL: http://www.saylor.org/books

Saylor.org
9

not neutral or value-free. The CLS movement would use the law to overturn the hierarchical
structures of domination in the modern society.
Related to the CLS school, yet different, is the ecofeminist school of legal thought. This school
emphasizes—and would modify—the long-standing domination of men over both women and
the rest of the natural world. Ecofeminists would say that the same social mentality that leads to
exploitation of women is at the root of man’s exploitation and degradation of the natural
environment. They would say that male ownership of land has led to a “dominator culture,” in
which man is not so much a steward of the existing environment or those “subordinate” to him
but is charged with making all that he controls economically “productive.” Wives, children, land,
and animals are valued as economic resources, and legal systems (until the nineteenth century)
largely conferred rights only to men with land. Ecofeminists would say that even with increasing
civil and political rights for women (such as the right to vote) and with some nations’
recognizing the rights of children and animals and caring for the environment, the legacy of the
past for most nations still confirms the preeminence of “man” and his dominance of both nature
and women.

KEY TAKEAWAY

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

EXERCISES

1. Vandana Shiva draws a picture of a stream in a forest. She says that in our society the stream
is seen as unproductive if it is simply there, fulfilling the need for water of women’s families
and communities, until engineers come along and tinker with it, perhaps damming it and
using it for generating hydropower. The same is true of a forest, unless it is replaced with a
monoculture plantation of a commercial species. A forest may very well be productive—
protecting groundwater; creating oxygen; providing fruit, fuel, and craft materials for nearby
inhabitants; and creating a habitat for animals that are also a valuable resource. She criticizes
Saylor URL: http://www.saylor.org/books

Saylor.org
10

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.”

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
Saylor URL: http://www.saylor.org/books

Saylor.org
11

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

The Common Law: Property, Torts, and Contracts
Even before legislatures met to make rules for society, disputes happened and judges decided
them. In England, judges began writing down the facts of a case and the reasons for their
decision. They often resorted to deciding cases on the basis of prior written decisions. In relying
on those prior decisions, the judge would reason that since a current case was pretty much like a
prior case, it ought to be decided the same way. This is essentially reasoning by analogy. Thus
the use of precedent in common-law cases came into being, and a doctrine
of stare decisis (pronounced STAR-ay-de-SIGH-sus) became accepted in English courts. Stare
decisis means, in Latin, “let the decision stand.”
Most judicial decisions that don’t apply legislative acts (known as statutes) will involve one of
three areas of law—property, contract, or tort. Property law deals with the rights and duties of
Saylor URL: http://www.saylor.org/books

Saylor.org
12

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

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

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

•

Torts

Saylor URL: http://www.saylor.org/books

Saylor.org
13

•

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

Table 1.1 Differences between Civil and Criminal Cases
Civil Cases
Saylor URL: http://www.saylor.org/books

Criminal Cases
Saylor.org
14

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 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:
Saylor URL: http://www.saylor.org/books

Saylor.org
15

•

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
questions arise.) What if you unwisely bragged to a friend at a party recently that you went a
hundred miles an hour on Main Street five years ago at half past three on a Tuesday morning?
(If the prosecutor knows of this and the “friend” is willing to testify, is it relevant to the charge of
fifty-three in a forty-mile-per-hour zone?)
In the United States, all state procedural laws must be fair, since the due process clause of the
Fourteenth Amendment directs that no state shall deprive any citizen of “life, liberty, or
property,” without due process of law. (The $200 fine plus court costs is designed to deprive you
of property, that is, money, if you violate the speed limit.) Federal laws must also be fair,
because the Fifth Amendment to the US Constitution has the exact same due process language
as the Fourteenth Amendment. This suggests that some laws are more powerful or important
Saylor URL: http://www.saylor.org/books

Saylor.org
16

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?

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.
Saylor URL: http://www.saylor.org/books

Saylor.org
17

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 following the first ten in 1789; two-thirds of the House and Senate must
pass amendments, and three-fourths of the states must approve them.
The nation’s states also have constitutions. Along with providing for legislative, executive, and
judicial functions, state constitutions prescribe various rights of citizens. These rights may be
different from, and in addition to, rights granted by the US Constitution. Like statutes and
judicial decisions, a constitution’s specific provisions can provide people with a “cause of action”
on which to base a lawsuit (see Section 1.4.3 "Causes of Action, Precedent, and " on “causes of
action”). For example, California’s constitution provides that the citizens of that state have a
right of privacy. This has been used to assert claims against businesses that invade an
employee’s right of privacy. In the case of Virginia Rulon-Miller, her employer, International
Business Machines (IBM), told her to stop dating a former colleague who went to work for a
competitor. When she refused, IBM terminated her, and a jury fined the company for $300,000
in damages. As the California court noted, “While an employee sacrifices some privacy rights
when he enters the workplace, the employee’s privacy expectations must be balanced against the
employer’s interests.…[T]he point here is that privacy, like the other unalienable rights listed
first in our Constitution…is unquestionably a fundamental interest of our society.” [1]

Statutes and Treaties in Congress
Saylor URL: http://www.saylor.org/books

Saylor.org
18

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

Delegating Legislative Powers: Rules by Administrative Agencies

Saylor URL: http://www.saylor.org/books

Saylor.org
19

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 at http://www.access.gpo.gov/nara/cfr/cfr-table-search.html.

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

Saylor.org
20

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 ability—to modify or change common law into judicial law—
points to an important phenomenon: the priority of statutory law over common law. As we will
see in the next section, constitutional law will have priority over statutory law.

Priority of Laws
The Constitution as Preemptive Force in US Law
The US Constitution takes precedence over all statutes and judicial decisions that are
inconsistent. For example, if Michigan were to decide legislatively that students cannot speak ill
of professors in state-sponsored universities, that law would be void, since it is inconsistent with
the state’s obligation under the First Amendment to protect free speech. Or if the Michigan
courts were to allow a professor to bring a lawsuit against a student who had said something
about him that was derogatory but not defamatory, the state’s judicial system would not be
acting according to the First Amendment. (As we will see in Chapter 7 "Introduction to Tort
Saylor URL: http://www.saylor.org/books

Saylor.org
21

Law", free speech has its limits; defamation was a cause of action at the time the First
Amendment was added to the Constitution, and it has been understood that the free speech
rights in the First Amendment did not negate existing common law.)

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

Treaties as Statutes: The “Last in Time” Rule
A treaty or convention is considered of equal standing to a statute. Thus when Congress ratified
the North American Free Trade Agreement (NAFTA), any judicial decisions or previous statutes
that were inconsistent—such as quotas or limitations on imports from Mexico that were
opposite to NAFTA commitments—would no longer be valid. Similarly, US treaty obligations
under the General Agreement on Tariffs and Trade (GATT) and obligations made later through
the World Trade Organization (WTO) would override previous federal or state statutes.
One example of treaty obligations overriding, or taking priority over, federal statutes was the
tuna-dolphin dispute between the United States and Mexico. The Marine Mammal Protection
Act amendments in 1988 spelled out certain protections for dolphins in the Eastern Tropical
Pacific, and the United States began refusing to allow the importation of tuna that were caught
using “dolphin-unfriendly” methods (such as purse seining). This was challenged at a GATT
dispute panel in Switzerland, and the United States lost. The discussion continued at the WTO
under its dispute resolution process. In short, US environmental statutes can be ruled contrary
to US treaty obligations.
Under most treaties, the United States can withdraw, or take back, any voluntary limitation on
its sovereignty; participation in treaties is entirely elective. That is, the United States may
“unbind” itself whenever it chooses. But for practical purposes, some limitations on sovereignty
may be good for the nation. The argument goes something like this: if free trade in general helps
the United States, then it makes some sense to be part of a system that promotes free trade; and
Saylor URL: http://www.saylor.org/books

Saylor.org
22

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 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
Saylor URL: http://www.saylor.org/books

Saylor.org
23

several states, but most states have abolished this cause of action, either by judicial decision or
by legislation. Whether a runaway bride or groom gives rise to a valid cause of action in the
courts depends on whether the state courts still recognize and enforce this now-disappearing
cause of action.
Your cause of action is thus based on existing laws, including decided cases. How closely your
case “fits” with a prior decided case raises the question of precedent.
As noted earlier in this chapter, the English common-law tradition placed great emphasis on
precedent and what is called stare decisis. A court considering one case would feel obliged to
decide that case in a way similar to previously decided cases. Written decisions of the most
important cases had been spread throughout England (the common “realm”), and judges hoped
to establish a somewhat predictable, consistent group of decisions.
The English legislature (Parliament) was not in the practice of establishing detailed statutes on
crimes, torts, contracts, or property. Thus definitions and rules were left primarily to the courts.
By their nature, courts could only decide one case at a time, but in doing so they would articulate
holdings, or general rules, that would apply to later cases.
Suppose that one court had to decide whether an employer could fire an employee for no reason
at all. Suppose that there were no statutes that applied to the facts: there was no contract
between the employer and the employee, but the employee had worked for the employer for
many years, and now a younger person was replacing him. The court, with no past guidelines,
would have to decide whether the employee had stated a “cause of action” against the employer.
If the court decided that the case was not legally actionable, it would dismiss the action. Future
courts would then treat similar cases in a similar way. In the process, the court might make a
holding that employers could fire employees for any reason or for no reason. This rule could be
applied in the future should similar cases come up.
But suppose that an employer fired an employee for not committing perjury (lying on the
witness stand in a court proceeding); the employer wanted the employee to cover up the
company's criminal or unethical act. Suppose that, as in earlier cases, there were no applicable
statutes and no contract of employment. Courts relying on a holding or precedent that
“employers may fire employees for any reason or no reason” might rule against an employee
Saylor URL: http://www.saylor.org/books

Saylor.org
24

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) 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

Saylor URL: http://www.saylor.org/books

Saylor.org
25

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 disappointed and angry and wants to sue the sorority. What are her prospects of
recovery in the legal system? Explain.

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

1.5 Legal and Political Systems of the World
LEARNING OBJECTIVE

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

Saylor URL: http://www.saylor.org/books

Saylor.org
26

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 ofjurisprudence
constante. The major agency for growth and change, however, is the legislature, not the courts.”
Civil-law systems are used throughout Europe as well as in Central and South America. Some
nations in Asia and Africa have also adopted codes based on European civil law. Germany,
Holland, Spain, France, and Portugal all had colonies outside of Europe, and many of these
colonies adopted the legal practices that were imposed on them by colonial rule, much like the
original thirteen states of the United States, which adopted English common-law practices.

Saylor URL: http://www.saylor.org/books

Saylor.org
27

One source of possible confusion at this point is that we have already referred to US civil law in
contrast to criminal law. But the European civil law covers both civil and criminal law.
There are also legal systems that differ significantly from the common-law and civil-law
systems. The communist and socialist legal systems that remain (e.g., in Cuba and North Korea)
operate on very different assumptions than those of either English common law or European
civil law. Islamic and other religion-based systems of law bring different values and assumptions
to social and commercial relations.

KEY TAKEAWAY

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

EXERCISE

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

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
Saylor URL: http://www.saylor.org/books

Saylor.org
28

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 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
Saylor URL: http://www.saylor.org/books

Saylor.org
29

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.
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].”
Saylor URL: http://www.saylor.org/books

Saylor.org
30

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 wellbeing” or lead the plaintiff to “suffer injury.” Compare Rabidue (requiring serious effect on
psychological well-being); Vance v. Southern Bell Telephone & Telegraph Co., 863 F.2d 1503,
1510 (CA11 1989) (same); and Downes v. FAA, 775 F.2d 288, 292 (CA Fed. 1985) (same), with
Ellison v. Brady, 924 F.2d 872, 877–878 (CA9 1991) (rejecting such a requirement).
II
Title VII of the Civil Rights Act of 1964 makes it “an unlawful employment practice for an
employer…to discriminate against any individual with respect to his compensation, terms,
conditions, or privileges of employment, because of such individual’s race, color, religion, sex, or
national origin.” 42 U.S.C. § 2000e-2(a)(1). As we made clear in Meritor Savings Bank, FSB v.
Vinson, 477 U.S. 57 (1986), this language “is not limited to ‘economic’ or ‘tangible’
discrimination. The phrase ‘terms, conditions, or privileges of employment’ evinces a
congressional intent ‘to strike at the entire spectrum of disparate treatment of men and women’
in employment,” which includes requiring people to work in a discriminatorily hostile or abusive
environment. Id., at 64, quoting Los Angeles Dept. of Water and Power v. Manhart, 435 U.S.
702, 707, n.13, 55 L. Ed. 2d 657, 98 S. Ct. 1370 (1978). When the workplace is permeated with
“discriminatory intimidation, ridicule, and insult,” 477 U.S. at 65, that is “sufficiently severe or
pervasive to alter the conditions of the victim’s employment and create an abusive working
environment,” Title VII is violated.
This standard, which we reaffirm today, takes a middle path between making actionable any
conduct that is merely offensive and requiring the conduct to cause a tangible psychological
injury. As we pointed out in Meritor, “mere utterance of an…epithet which engenders offensive
feelings in an employee,” does not sufficiently affect the conditions of employment to implicate
Saylor URL: http://www.saylor.org/books

Saylor.org
31

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 statute is not limited to such conduct. So long as the
environment would reasonably be perceived, and is perceived, as hostile or abusive, Meritor,
supra, at 67, there is no need for it also to be psychologically injurious.
This is not, and by its nature cannot be, a mathematically precise test. We need not answer
today all the potential questions it raises, nor specifically address the Equal Employment
Opportunity Commission’s new regulations on this subject, see 58 Fed. Reg. 51266 (1993)
(proposed 29 CFR §§ 1609.1, 1609.2); see also 29 CFR § 1604.11 (1993). But we can say that
Saylor URL: http://www.saylor.org/books

Saylor.org
32

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 wellbeing is unfounded, argues that the District Court nonetheless correctly applied the Meritor
standard. We disagree. Though the District Court did conclude that the work environment was
not “intimidating or abusive to [Harris],” it did so only after finding that the conduct was not “so
severe as to be expected to seriously affect plaintiff’s psychological well-being,” and that Harris
was not “subjectively so offended that she suffered injury,” ibid. The District Court’s application
of these incorrect standards may well have influenced its ultimate conclusion, especially given
that the court found this to be a “close case.”
We therefore reverse the judgment of the Court of Appeals, and remand the case for further
proceedings consistent with this opinion.
So ordered.
Note to Students
This was only the second time that the Supreme Court had decided a sexual harassment case.
Many feminist legal studies scholars feared that the court would raise the bar and make hostileworking-environment claims under Title VII more difficult to win. That did not happen. When
the question to be decided is combined with the court’s decision, we get the holding of the case.
Here, the question that the court poses, plus its answer, yields a holding that “An employee need
not prove severe psychological injury in order to win a Title VII sexual harassment claim.” This
holding will be true until such time as the court revisits a similar question and answers it
differently. This does happen, but happens rarely.

CASE QUESTIONS

Saylor URL: http://www.saylor.org/books

Saylor.org
33

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?

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

Saylor URL: http://www.saylor.org/books

Saylor.org
34

provisions. The basic differences between the common law and civil law (continental, or
European) systems of law are also discussed.

EXERCISES

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

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

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

SELF-TEST QUESTIONS

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

the common law

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

civil law

b. constitutional law
c. natural law
d. ecofeminist law
e. positive law
Which of the following kinds of law are most often found in state law rather
than federal law?
Saylor URL: http://www.saylor.org/books

Saylor.org
35

a.

torts and contracts

b. bankruptcy
c. maritime law
d. international law
Where was natural law discovered?
a.

in nature

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

deductive reasoning

b. faulty reasoning
c. linear reasoning
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.
Saylor URL: http://www.saylor.org/books

Saylor.org
36

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

Saylor URL: http://www.saylor.org/books

Saylor.org
37

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.

Saylor URL: http://www.saylor.org/books

Saylor.org
38

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
Saylor URL: http://www.saylor.org/books

Saylor.org
39

making a statement about the civic virtue and corporate social responsibility of Microsoft. In the
first set of judgments, we use the word goodbut mean something other than ethical or moral;
only in the second instance are we using the word good in its ethical or moral sense.
A word such as good can embrace ethical or moral values but also nonethical values. If I like
Daniel and try to convince you what a “good guy” he is, you may ask all sorts of questions: Is he
good-looking? Well-off? Fun to be with? Humorous? Athletic? Smart? I could answer all of
those questions with a yes, yet you would still not know any of his moral qualities. But if I said
that he was honest, caring, forthright, and diligent, volunteered in local soup kitchens, or tithed
to the church, many people would see Daniel as having certain ethical or moral qualities. If I
said that he keeps the Golden Rule as well as anyone I know, you could conclude that he is an
ethical person. But if I said that he is “always in control” or “always at the top of his game,” you
would probably not make inferences or assumptions about his character or ethics.
There are three key points here:
1. Although morals and ethics are not precisely measurable, people generally have similar
reactions about what actions or conduct can rightly be called ethical or moral.
2. As humans, we need and value ethical people and want to be around them.
3. Saying that someone or some organization is law-abiding does not mean the same as saying a
person or company is ethical.
Here is a cautionary note: for individuals, it is far from easy to recognize an ethical problem,
have a clear and usable decision-making process to deal it, and then have the moral courage to
do what’s right. All of that is even more difficult within a business organization, where corporate
employees vary in their motivations, loyalties, commitments, and character. There is no
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?
Saylor URL: http://www.saylor.org/books

Saylor.org
40

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

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

•

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

Saylor.org
41

is because there has been a group decision that doing so is immoral. Thus the law provides some
important cues as to what society regards as right or wrong.
Finally, important policy issues that face society are often resolved through law, but it is
important to understand the moral perspectives that underlie public debate—as, for example, in
the continuing controversies over stem-cell research, medical use of marijuana, and abortion.
Some ethical perspectives focus on rights, some on social utility, some on virtue or character,
and some on social justice. People consciously (or, more often, unconsciously) adopt one or
more of these perspectives, and even if they completely agree on the facts with an opponent,
they will not change their views. Fundamentally, the difference comes down to incompatible
moral perspectives, a clash of basic values. These are hot-button issues because society is
divided, not so much over facts, but over basic values. Understanding the varied moral
perspectives and values in public policy debates is a clarifying benefit in following or
participating in these important discussions.

Why Should an Individual or a Business Entity Be Ethical?
The usual answer is that good ethics is good business. In the long run, businesses that pay
attention to ethics as well as law do better; they are viewed more favorably by customers. But
this is a difficult claim to measure scientifically, because “the long run” is an indistinct period of
time and because there are as yet no generally accepted criteria by which ethical excellence can
be measured. In addition, life is still lived in the short run, and there are many occasions when
something short of perfect conduct is a lot more profitable.
Some years ago, Royal Dutch/Shell (one of the world’s largest companies) found that it was in
deep trouble with the public for its apparent carelessness with the environment and human
rights. Consumers were boycotting and investors were getting frightened, so the company took a
long, hard look at its ethic of short-term profit maximization. Since then, changes have been
made. The CEO told one group of business ethicists that the uproar had taken them by surprise;
they thought they had done everything right, but it seemed there was a “ghost in the machine.”
That ghost was consumers, NGOs, and the media, all of whom objected to the company’s
seeming lack of moral sensitivity.

Saylor URL: http://www.saylor.org/books

Saylor.org
42

The market does respond to unethical behavior. In Section 2.4 "Corporations and Corporate
Governance", you will read about the Sears Auto Centers case. The loss of goodwill toward Sears
Auto Centers was real, even though the total amount of money lost cannot be clearly accounted
for. Years later, there are people who will not go near a Sears Auto Center; the customers who
lost trust in the company will never return, and many of their children may avoid Sears Auto
Centers as well.
The Arthur Andersen story is even more dramatic. A major accounting firm, Andersen worked
closely with Enron in hiding its various losses through creative accounting measures.
Suspiciously, Andersen’s Houston office also did some shredding around the clock, appearing to
cover up what it was doing for Enron. A criminal case based on this shredding resulted in a
conviction, later overturned by the Supreme Court. But it was too late. Even before the
conviction, many clients had found other accounting firms that were not under suspicion, and
the Supreme Court’s reversal came too late to save the company. Even without the conviction,
Andersen would have lost significant market share.
The irony of Andersen as a poster child for overly aggressive accounting practices is that the
man who founded the firm built it on integrity and straightforward practices. “Think straight,
talk straight” was the company’s motto. Andersen established the company’s reputation for
integrity over a hundred years ago by refusing to play numbers games for a potentially lucrative
client.
Maximizing profits while being legally compliant is not a very inspiring goal for a business.
People in an organization need some quality or excellence to strive for. By focusing on pushing
the edge of what is legal, by looking for loopholes in the law that would help create short-term
financial gain, companies have 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

Saylor URL: http://www.saylor.org/books

Saylor.org
43

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

2.2 Major Ethical Perspectives

LEARNING OBJECTIVES

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

Utilitarianism
Utilitarianism is a prominent perspective on ethics, one that is well aligned with economics and
the free-market outlook that has come to dominate much current thinking about business,
Saylor URL: http://www.saylor.org/books

Saylor.org
44

management, and economics. Jeremy Bentham is often considered the founder of utilitarianism,
though John Stuart Mill (who wrote On Liberty and Utilitarianism) and others promoted it as a
guide to what is good. Utilitarianism emphasizes not rules but results. An action (or set of
actions) is generally deemed good or right if it maximizes happiness or pleasure throughout
society. Originally intended as a guide for legislators charged with seeking the greatest good for
society, the utilitarian outlook may also be practiced individually and by corporations.
Bentham believed that the most promising way to obtain agreement on the best policies for a
society would be to look at the various policies a legislature could pass and compare the good
and bad consequences of each. The right course of action from an ethical point of view would be
to choose the policy that would produce the greatest amount of utility, or usefulness. In brief,
the utilitarian principle holds that an action is right if and only if the sum of utilities produced
by that action is greater than the sum of utilities from any other possible act.
This statement describes “act utilitarianism”—which action among various options will deliver
the greatest good to society? “Rule utilitarianism” is a slightly different version; it asks, what
rule or principle, if followed regularly, will create the greatest good?
Notice that the emphasis is on finding the best possible results and that the assumption is that
we can measure the utilities involved. (This turns out to be more difficult that you might think.)
Notice also that “the sum total of utilities” clearly implies that in doing utilitarian analysis, we
cannot be satisfied if an act or set of acts provides the greatest utility to us as individuals or to a
particular corporation; the test is, instead, whether it provides the greatest utility to society as a
whole. Notice that the theory does not tell us what kinds of utilities may be better than others or
how much better a good today is compared with a good a year from today.
Whatever its difficulties, utilitarian thinking is alive and well in US law and business. It is found
in such diverse places as cost-benefit analysis in administrative and regulatory rules and
calculations, environmental impact studies, the majority vote, product comparisons for
consumer information, marketing studies, tax laws, and strategic planning. In management,
people will often employ a form of utility reasoning by projecting costs and benefits for plan X
versus plan Y. But the issue in most of these cost-benefit analyses is usually (1) put exclusively in

Saylor URL: http://www.saylor.org/books

Saylor.org
45

terms of money and (2) directed to the benefit of the person or organization doing the analysis
and not to the benefit of society as a whole.
An individual or a company that consistently uses the test “What’s the greatest good for me or
the company?” is not following the utilitarian test of the greatest good overall. Another common
failing is to see only one or two options that seem reasonable. The following are some frequent
mistakes that people make in applying what they think are utilitarian principles in justifying
their chosen course of action:
1. Failing to come up with lots of options that seem reasonable and then choosing the one that has
the greatest benefit for the greatest number. Often, a decision maker seizes on one or two
alternatives without thinking carefully about other courses of action. If the alternative does
more good than harm, the decision maker assumes it’s ethically okay.
2. Assuming that the greatest good for you or your company is in fact the greatest good for all—that
is, looking at situations subjectively or with your own interests primarily in mind.
3. Underestimating the costs of a certain decision to you or your company. The now-classic Ford
Pinto case demonstrates how Ford Motor Company executives drastically underestimated the
legal costs of not correcting a feature on their Pinto models that they knew could cause death or
injury. General Motors was often taken to task by juries that came to understand that the
company would not recall or repair known and dangerous defects because it seemed more
profitable not to. In 2010, Toyota learned the same lesson.
4. Underestimating the cost or harm of a certain decision to someone else or some other group of
people.
5. Favoring short-term benefits, even though the long-term costs are greater.
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
Saylor URL: http://www.saylor.org/books

Saylor.org
46

that ethical action arises from doing one’s duty and that duties are defined by rational thought.
Duties, according to Kant, are not specific to particular kinds of human beings but are owed
universally to all human beings. Kant therefore uses “universalizing“ as a form of rational
thought that assumes the inherent equality of all human beings. It considers all humans as
equal, not in the physical, social, or economic sense, but equal before God, whether they are
male, female, Pygmy, Eskimoan, Islamic, Christian, gay, straight, healthy, sick, young, or old.
For Kantian thinkers, this basic principle of equality means that we should be able to
universalize any particular law or action to determine whether it is ethical. For example, if you
were to consider misrepresenting yourself on a resume for a particular job you really wanted and
you were convinced that doing so would get you that job, you might be very tempted to do so.
(What harm would it be? you might ask yourself. When I have the job, I can prove that I was
perfect for it, and no one is hurt, while both the employer and I are clearly better off as a result!)
Kantian ethicists would answer that your chosen course of action should be a universal one—a
course of action that would be good for all persons at all times. There are two requirements for a
rule of action to be universal: consistency and reversibility. Consider reversibility: if you make a
decision as though you didn’t know what role or position you would have after the decision, you
would more likely make an impartial one—you would more likely choose a course of action that
would be most fair to all concerned, not just you. Again, deontologyrequires that we put duty
first, act rationally, and give moral weight to the inherent equality of all human beings.
In considering whether to lie on your resume, reversibility requires you to actively imagine both
that you were the employer in this situation and that you were another well-qualified applicant
who lost the job because someone else padded his resume with false accomplishments. If the
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

Saylor URL: http://www.saylor.org/books

Saylor.org
47

works well for society as a whole and is generally practiced that lying even becomes possible!
That is, lying cannot be universalized, for it depends on the preexistence of honesty.
Similar demonstrations can be made for actions such as polluting, breaking promises, and
committing most crimes, including rape, murder, and theft. But these are the easy cases for
Kantian thinkers. In the gray areas of life as it is lived, the consistency test is often difficult to
apply. If breaking a promise would save a life, then Kantian thought becomes difficult to apply.
If some amount of pollution can allow employment and the harm is minimal or distant, Kantian
thinking is not all that helpful. Finally, we should note that the well-known Golden Rule, “Do
unto others as you would have them do unto you,” emphasizes the easier of the two
universalizing requirements: practicing reversibility (“How would I like it if someone did this to
me?”).

Social Justice Theory and Social Contract Theory
Social justice theorists worry about “distributive justice”—that is, what is the fair way to
distribute goods among a group of people? Marxist thought emphasizes that members of society
should be given goods to according to their needs. But this redistribution would require a
governing power to decide who gets what and when. Capitalist thought takes a different
approach, rejecting any giving that is not voluntary. Certain economists, such as the late Milton
Friedman (see the sidebar in Section 2.4 "Corporations and Corporate Governance") also reject
the notion that a corporation has a duty to give to unmet needs in society, believing that the
government should play that role. Even the most dedicated free-market capitalist will often
admit the need for some government and some forms of welfare—Social Security, Medicare,
assistance to flood-stricken areas, help for AIDs patients—along with some public goods (such as
defense, education, highways, parks, and support of key industries affecting national security).
People who do not see the need for public goods (including laws, court systems, and the
government goods and services just cited) often question why there needs to be a government at
all. One response might be, “Without government, there would be no corporations.” Thomas
Hobbes believed that people in a “state of nature” would rationally choose to have some form of
government. He called this thesocial contract, where people give up certain rights to government
in exchange for security and common benefits. In your own lives and in this course, you will see
Saylor URL: http://www.saylor.org/books

Saylor.org
48

an ongoing balancing act between human desires for freedom and human desires for order; it is
an ancient tension. Some commentators also see a kind of social contract between corporations
and society; in exchange for perpetual duration and limited liability, the corporation has some
corresponding duties toward society. Also, if a corporation is legally a “person,” as the Supreme
Court reaffirmed in 2010, then some would argue that if this corporate person commits three
felonies, it should be locked up for life and its corporate charter revoked!
Modern social contract theorists, such as Thomas Donaldson and Thomas Dunfee (Ties that
Bind, 1999), observe that various communities, not just nations, make rules for the common
good. Your college or school is a community, and there are communities within the school
(fraternities, sororities, the folks behind the counter at the circulation desk, the people who work
together at the university radio station, the sports teams, the faculty, the students generally, the
gay and lesbian alliance) that have rules, norms, or standards that people can buy into or not. If
not, they can exit from that community, just as we are free (though not without cost) to reject US
citizenship and take up residence in another country.
Donaldson and Dunfee’s integrative social contracts theory stresses the importance of studying
the rules of smaller communities along with the larger social contracts made in states (such as
Colorado or California) and nation-states (such as the United States or Germany). Our
Constitution can be seen as a fundamental social contract.
It is important to realize that a social contract can be changed by the participants in a
community, just as the US Constitution can be amended. Social contract theory is thus
dynamic—it allows for structural and organic changes. Ideally, the social contract struck by
citizens and the government allows for certain fundamental rights such as those we enjoy in the
United States, but it need not. People can give up freedom-oriented rights (such as the right of
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
Saylor URL: http://www.saylor.org/books

Saylor.org
49

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

Saylor.org
50

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.
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?
Saylor URL: http://www.saylor.org/books

Saylor.org
51

As to the third question, whether corporations can “have” virtues or values is a matter of lively
debate. A corporation is obviously not the same as an individual. But there seems to be growing
agreement that organizations do differ in their practices and that these practices are value
driven. If all a company cares about is the bottom line, other values will diminish or disappear.
Quite a few books have been written in the past twenty years that emphasize the need for
businesses to define their values in order to be competitive in today’s global economy. [2]
As to the first two questions regarding virtues, a look at Michael Josephson’s core values may
prove helpful.

Josephson’s Core Values Analysis and Decision Process
Michael Josephson, a noted American ethicist, believes that a current set of core valueshas been
identified and that the values can be meaningfully applied to a variety of personal and corporate
decisions.
To simplify, let’s say that there are ethical and nonethical qualities among people in the United
States. When you ask people what kinds of qualities they admire in others or in themselves, they
may say wealth, power, fitness, sense of humor, good looks, intelligence, musical ability, or some
other quality. They may also value honesty, caring, fairness, courage, perseverance, diligence,
trustworthiness, or integrity. The qualities on the second list have something in common—they
are distinctively ethical characteristics. That is, they are commonly seen as moral or ethical
qualities, unlike the qualities on the first list. You can be, like the Athenian Alcibiades, brilliant
but unprincipled, or, like some political leaders today, powerful but dishonest, or wealthy but
uncaring. You can, in short, have a number of admirable qualities (brilliance, power, wealth)
that are not per se virtuous. Just because Harold is rich or good-looking or has a good sense of
humor does not mean that he is ethical. But if Harold is honest and caring (whether he is rich or
poor, humorous or humorless), people are likely to see him as ethical.
Among the virtues, are any especially important? Studies from the Josephson Institute of Ethics
in Marina del Rey, California, have identified six core values in our society, values that almost
everyone agrees are important to them. When asked what values people hold dear, what values
they wish to be known by, and what values they wish others would exhibit in their actions, six

Saylor URL: http://www.saylor.org/books

Saylor.org
52

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.
Saylor URL: http://www.saylor.org/books

Saylor.org
53

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

EXERCISES

XYZ Motor Corporation begins to get customer complaints about two models of its
automobiles. Customers have had near-death experiences from sudden acceleration; they
would be driving along a highway at normal speed when suddenly the car would begin to
accelerate, and efforts to stop the acceleration by braking fail to work. Drivers could turn off
the ignition and come to a safe stop, but XYZ does not instruct buyers of its cars to do so, nor
is this a common reaction among drivers who experience sudden acceleration.
Internal investigations of half a dozen accidents in US locations come to the conclusion that
the accidents are not being caused by drivers who mistake the gas pedal for the brake pedal.
In fact, there appears to be a possible flaw in both models, perhaps in a semiconductor chip,
that makes sudden acceleration happen. Interference by floor mats and poorly designed gas
pedals do not seem to be the problem.
It is voluntary to report these incidents to the National Highway Traffic and Safety
Administration (NHTSA), but the company decides that it will wait awhile and see if there are
more complaints. Recalling the two models so that local dealers and their mechanics could
examine them is also an option, but it would be extremely costly. Company executives are
aware that quarterly and annual profit-and-loss statements, on which their bonuses depend,
could be decisively worse with a recall. They decide that on a cost-benefit basis, it makes
more sense to wait until there are more accidents and more data. After a hundred or more
accidents and nearly fifteen fatalities, the company institutes a selective recall, still not
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

Saylor URL: http://www.saylor.org/books

Saylor.org
54

does not wish to take that advice, as it would be—as one top executive put it—“too timeconsuming and expensive.”
1. Can XYZ’s approach to this problem be justified under utilitarian theory? If so, how? If not,
why not?
2. What would Kant advise XYZ to do? Explain.
3. What would the “virtuous” approach be for XYZ in this situation?

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

2.3 An Ethical Decision Model

LEARNING OBJECTIVE

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

Josephson’s Core Values Model
Once you recognize that there is a decision that involves ethical judgment, Michael Josephson
would first have you ask as many questions as are necessary to get a full background on the
relevant facts. Then, assuming you have all the needed information, the decision process is as
follows:
1. Identify the stakeholders. That is, who are the potential gainers and losers in the various
decisions that might be made here?
2. Identify several likely or reasonable decisions that could be made.
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.

Saylor URL: http://www.saylor.org/books

Saylor.org
55

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

The Core Values

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

Saylor.org
56

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

KEY TAKEAWAY

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

Saylor URL: http://www.saylor.org/books

EXERCISE

Saylor.org
57

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

2.4 Corporations and Corporate Governance
LEARNING OBJECTIVES

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

Legal Organization of the Corporation
Figure 2.1 Corporate Legal Structure

Saylor URL: http://www.saylor.org/books

Saylor.org
58

Figure 2.1 "Corporate Legal Structure", though somewhat oversimplified, shows the basic legal
structure of a corporation under Delaware law and the laws of most other states in the United
States. Shareholders elect directors, who then hire officers to manage the company. From this
structure, some very basic realities follow. Because the directors of a corporation do not meet
that often, it’s possible for the officers hired (top management, or the “C-suite”) to be selective of
what the board knows about, and directors are not always ready and able to provide the
oversight that the shareholders would like. Nor does the law require officers to be shareholders,
so that officers’ motivations may not align with the best interests of the company. This is the
“agency problem” often discussed in corporate governance: how to get officers and other top
management to align their own interests with those of the shareholders. For example, a CEO
might trade insider information to the detriment of the company’s shareholders. Even board
members are susceptible to misalignment of interets; for example, board members might resist
hostile takeover bids because they would likely lose their perks (short for perquisites) as
directors, even though the tender offer would benefit stockholders. Among other attempted
realignments, the use of stock options was an attempt to make managers more attentive to the
value of company stock, but the law of unintended consequences was in full force; managers
tweaked and managed earnings in the bubble of the 1990s bull market, and “managing by
numbers” became an epidemic in corporations organized under US corporate law. The rights of
shareholders can be bolstered by changes in state and federal law, and there have been some
attempts to do that since the late 1990s. But as owners, shareholders have the ultimate power to
replace nonperforming or underperforming directors, which usually results in changes at the Csuite level as well.

Shareholders and Stakeholders
There are two main views about what the corporation’s duties are. The first view—maximizing
profits—is the prevailing view among business managers and in business schools. This view
largely follows the idea of Milton Friedman that the duty of a manager is to maximize return on
investment to the owners. In essence, managers’ legally prescribed duties are those that make
their employment possible. In terms of the legal organization of the corporation, the
shareholders elect directors who hire managers, who have legally prescribed duties toward both
Saylor URL: http://www.saylor.org/books

Saylor.org
59

directors and shareholders. Those legally prescribed duties are a reflection of the fact that
managers are managing other people’s money and have a moral duty to act as a responsible
agent for the owners. In law, this is called the manager’s fiduciary duty. Directors have the same
duties toward shareholders. Friedman emphasized the primacy of this duty in his writings about
corporations and social responsibility.

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

“The Social Responsibility of Business Is to Increase Its Profits”
Milton Friedman, New York Times Magazine, September 13, 1970
What does it mean to say that “business” has responsibilities? Only people can have
responsibilities. A corporation is an artificial person and in this sense may have
artificial responsibilities, but “business” as a whole cannot be said to have
responsibilities, even in this vague sense.…
Presumably, the individuals who are to be responsible are businessmen, which means
individual proprietors or corporate executives.…In a free enterprise, privateproperty 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…
Saylor URL: http://www.saylor.org/books

Saylor.org
60

Of course, the corporate executive is also a person in his own right. As a person, he
may have other responsibilities that he recognizes or assumes voluntarily—to his
family, his conscience, his feeling of charity, his church, his clubs, his city, his country.
He may feel impelled by these responsibilities to devote part of his income to causes he
regards as worthy, to refuse to work for particular corporations, even to leave his
job…But in these respects he is acting as a principal, not an agent; he is spending his
own money 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
Saylor URL: http://www.saylor.org/books

Saylor.org
61

are imposed so far as possible in accordance with the preferences and desires of the
public.…
Others have challenged the notion that corporate managers have no real duties except toward
the owners (shareholders). By changing two letters in shareholder, stakeholder theorists
widened the range of people and institutions that a corporation should pay moral consideration
to. Thus they contend that a corporation, through its management, has a set of responsibilities
toward nonshareholder interests.

Stakeholder Theory
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
Saylor URL: http://www.saylor.org/books

Saylor.org
62

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

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

Shareholders
Salaried
managers
Creditors
Suppliers
Employees

Economic
Dependence

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

Saylor URL: http://www.saylor.org/books

Local
communities

Saylor.org
63

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.

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

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

Killing the Messenger
Where organizations no longer function, inevitably some employees are unhappy. If they call
attention to problems that are being covered up by coworkers or supervisors, they bring bad
news. Managers like to hear good news and discourage bad news. Intentionally or not, those
who told on others, or blew the whistle, have rocked the boat and become unpopular with those
whose defalcations they report on and with the managers who don’t really want to hear the bad
news. In many organizations, “killing the messenger” solves the problem. Consider James
Saylor URL: http://www.saylor.org/books

Saylor.org
64

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. The best ethics codes are aspirational, or having
an ideal to be pursued, not legalistic or compliance driven. The Johnson & Johnson ethics code
predated the Tylenol scare and the company’s oft-celebrated corporate response. [4] The
corporate response was consistent with that code, which was lived and modeled by the top of the
organization.
It’s often noted that a code of ethics is only as important as top management is willing to make
it. If the code is just a document that goes into a drawer or onto a shelf, it will not effectively
encourage good conduct within the corporation. The same is true of any kind of training that the
company undertakes, whether it be in racial sensitivity or sexual harassment. If the message is
not continuously reinforced, or (worse yet) if the message is undermined by management’s
actions, the real message to employees is that violations of the ethics code will not be taken
seriously, or that efforts to stop racial discrimination or sexual harassment are merely token
efforts, and that the important things are profits and performance. The ethics code at Enron
seems to have been one of those “3-P” codes that wind up sitting on shelves—“Print, Post, and
Pray.” Worse, the Enron board twice suspended the code in 1999 to allow outside partnerships
to be led by a top Enron executive who stood to gain financially from them. [5]

Ethics Hotlines and Federal Sentencing Guidelines
The federal sentencing guidelines were enacted in 1991. The original idea behind these
guidelines was for Congress to correct the lenient treatment often given to white-collar, or
corporate, criminals. The guidelines require judges to consider “aggravating and mitigating”
factors in determining sentences and fines. (While corporations cannot go to jail, its officers and
managers certainly can, and the corporation itself can be fined. Many companies will claim that
Saylor URL: http://www.saylor.org/books

Saylor.org
65

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.

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
Saylor URL: http://www.saylor.org/books

Saylor.org
66

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.
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.

Saylor URL: http://www.saylor.org/books

Saylor.org
67

•

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

Conscious Capitalism
One effort to integrate the two viewpoints of stakeholder theory and shareholder primacy is the
conscious capitalism movement. Companies that practiceconscious capitalism embrace the idea
that profit and prosperity can and must go hand in hand with social justice and environmental
stewardship. They operate with a holistic or systems view. This means that they understand that
all stakeholders are connected and interdependent. They reject false trade-offs between
stakeholder interests and strive for creative ways to achieve win-win-win outcomes for all. [7]
The “conscious business” has a purpose that goes beyond maximizing profits. It is designed to
maximize profits but is focused more on its higher purpose and does not fixate solely on the
Saylor URL: http://www.saylor.org/books

Saylor.org
68

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 selfaggrandizing and that do not serve the interests of shareholders. Laws exist to limit such selfaggrandizing, but the remedies are often too little and too late and often catch only the most
egregious overreaching. Having a culture of servant leadership is a much better way to see that a
company’s top management works to ensure a harmony of interests.

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

Saylor URL: http://www.saylor.org/books

Saylor.org
69

2.5 Summary and Exercises
Summary

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

EXERCISES

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

What does Friedman mean by “ethical custom”?

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

Saylor URL: http://www.saylor.org/books

Saylor.org
70

a.

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

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

SELF-TEST QUESTIONS

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

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

profits by paying careful attention to key stakeholders.
b. The business of business is business.

Saylor URL: http://www.saylor.org/books

Saylor.org
71

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.

Saylor URL: http://www.saylor.org/books

Saylor.org
72

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

Saylor URL: http://www.saylor.org/books

Saylor.org
73

Chapter 3
Courts and the Legal Process
LEARNING OBJECTIVES

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

Robinson v. Audi

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

Saylor.org
74

importer, Volkswagen of America, Inc. (Volkswagen); its regional distributor, World-Wide
Volkswagen Corp. (World-Wide); and its retail dealer, Seaway.
Should the Robinsons bring their action in state court or in federal court? Over which of the
defendants will the court have personal jurisdiction?

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

1. Understand the different but complementary roles of state and federal court systems.
2. Explain why it makes sense for some courts to hear and decide only certain kinds of cases.
3. Describe the difference between a trial court and an appellate court.
Although it is sometimes said that there are two separate court systems, the reality is more
complex. There are, in fact, fifty-two court systems: those of the fifty states, the local court
system in the District of Columbia, and the federal court system. At the same time, these are not
entirely separate; they all have several points of contact.
State and local courts must honor both federal law and the laws of the other states. First, state
courts must honor federal law where state laws are in conflict with federal laws (under the
supremacy clause of the Constitution; see Chapter 4 "Constitutional Law and US Commerce").
Second, claims arising under federal statutes can often be tried in the state courts, where the
Constitution or Congress has not explicitly required that only federal courts can hear that kind
of claim. Third, under the full faith and credit clause, each state court is obligated to respect the
final judgments of courts in other states. Thus a contract dispute resolved by an Arkansas court
cannot be relitigated in North Dakota when the plaintiff wants to collect on the Arkansas
judgment in North Dakota. Fourth, state courts often must consider the laws of other states in
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").

Saylor URL: http://www.saylor.org/books

Saylor.org
75

As state courts are concerned with federal law, so federal courts are often concerned with state
law and with what happens in state courts. Federal courts will consider state-law-based claims
when a case involves claims using both state and federal law. Claims based on federal laws will
permit the federal court to take jurisdiction over the whole case, including any state issues
raised. In those cases, the federal court is said to exercise “pendent jurisdiction” over the state
claims. Also, the Supreme Court will occasionally take appeals from a state supreme court where
state law raises an important issue of federal law to be decided. For example, a convict on death
row may claim that the state’s chosen method of execution using the injection of drugs is
unusually painful and involves “cruel and unusual punishment,” raising an Eighth Amendment
issue.
There is also a broad category of cases heard in federal courts that concern only state legal
issues—namely, cases that arise between citizens of different states. The federal courts are
permitted to hear these cases under their so-calleddiversity of citizenship jurisdiction (or
diversity jurisdiction). A citizen of New Jersey may sue a citizen of New York over a contract
dispute in federal court, but if both were citizens of New Jersey, the plaintiff would be limited to
the state courts. The Constitution established diversity jurisdiction because it was feared that
local courts would be hostile toward people from other states and that they would need separate
courts. In 2009, nearly a third of all lawsuits filed in federal court were based on diversity of
citizenship. In these cases, the federal courts were applying state law, rather than
taking federal question jurisdiction, where federal law provided the basis for the lawsuit or
where the United States was a party (as plaintiff or defendant).
Why are there so many diversity cases in federal courts? Defense lawyers believe that there is
sometimes a “home-court advantage” for an in-state plaintiff who brings a lawsuit against a
nonresident in his local state court. The defense attorney is entitled to ask for removal to a
federal court where there is diversity. This fits with the original reason for diversity jurisdiction
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
Saylor URL: http://www.saylor.org/books

Saylor.org
76

lawsuit in federal court. Federal court procedures are often more efficient than state court
procedures, so that federal dockets are often less crowded. This means a case will get to trial
faster, and many lawyers enjoy the higher status that comes in practicing before the federal
bench. In some federal districts, judgments for plaintiffs may be higher, on average, than in the
local state court. In short, not only law but also legal strategy factor into the popularity of
diversity cases in federal courts.

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

Limited Jurisdiction Courts
In most large urban states and many smaller states, there are four and sometimes five levels of
courts. The lowest level is that of the limited jurisdiction courts. These are usually county or
municipal courts with original jurisdiction to hear minor criminal cases (petty assaults, traffic
offenses, and breach of peace, among others) and civil cases involving monetary amounts up to a
fixed ceiling (no more than $10,000 in most states and far less in many states). Most disputes
that wind up in court are handled in the 18,000-plus limited jurisdiction courts, which are
estimated to hear more than 80 percent of all cases.
One familiar limited jurisdiction court is the small claims court, with jurisdiction to hear civil
cases involving claims for amounts ranging between $1,000 and $5,000 in about half the states
and for considerably less in the other states ($500 to $1,000). The advantage of the small claims
court is that its procedures are informal, it is often located in a neighborhood outside the
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

Saylor URL: http://www.saylor.org/books

Saylor.org
77

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

Appellate Courts
The losing party in a general jurisdiction court can almost always appeal to either one or two
higher courts. These intermediate appellate courts—usually called courts of appeal—have been
established in forty states. They do not retry the evidence, but rather determine whether the trial
was conducted in a procedurally correct manner and whether the appropriate law was applied.
For example, the appellant (the losing party who appeals) might complain that the judge
wrongly instructed the jury on the meaning of the law, or improperly allowed testimony of a
particular witness, or misconstrued the law in question. The appellee (who won in the lower
court) will ask that the appellant be denied—usually this means that the appellee wants the
lower-court judgment affirmed. The appellate court has quite a few choices: it can affirm,
modify, reverse, or reverse and remand the lower court (return the case to the lower court for
retrial).

Saylor URL: http://www.saylor.org/books

Saylor.org
78

The last type of appeal within the state courts system is to the highest court, the state supreme
court, which is composed of a single panel of between five and nine judges and is usually located
in the state capital. (The intermediate appellate courts are usually composed of panels of three
judges and are situated in various locations around the state.) In a few states, the highest court
goes by a different name: in New York, it is known as the court of appeals. In certain cases,
appellants to the highest court in a state have the right to have their appeals heard, but more
often the supreme court selects the cases it wishes to hear. For most litigants, the ruling of the
state supreme court is final. In a relatively small class of cases—those in which federal
constitutional claims are made—appeal to the US Supreme Court to issue
a writ of certiorariremains a possibility.

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

Courts of Appeal
Cases from the district courts can then be appealed to the circuit courts of appeal, of which there
are thirteen (Figure 3.1 "The Federal Judicial Circuits"). Each circuit oversees the work of the
district courts in several states. For example, the US Court of Appeals for the Second Circuit
hears appeals from district courts in New York, Connecticut, and Vermont. The US Court of
Appeals for the Ninth Circuit hears appeals from district courts in California, Oregon, Nevada,
Montana, Washington, Idaho, Arizona, Alaska, Hawaii, and Guam. The US Court of Appeals for
the District of Columbia Circuit hears appeals from the district court in Washington, DC, as well
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
Saylor URL: http://www.saylor.org/books

Saylor.org
79

customs cases. Appeals are usually heard by three-judge panels, but sometimes there will be a
rehearing at the court of appeals level, in which case all judges sit to hear the case “en banc.”
There are also several specialized courts in the federal judicial system. These include the US Tax
Court, the Court of Customs and Patent Appeals, and the Court of Claims.

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

Figure 3.1 The Federal Judicial Circuits

Saylor URL: http://www.saylor.org/books

Saylor.org
80

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?

Saylor URL: http://www.saylor.org/books

Saylor.org
81

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

3.2 The Problem of Jurisdiction

LEARNING OBJECTIVES

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

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

Saylor URL: http://www.saylor.org/books

Saylor.org
82

III of the US Constitution that spells out the respective spheres of authority (jurisdiction)
between state and federal courts.
Take a close look at Article III of the Constitution. (You can find a printable copy of the
Constitution at http://www.findlaw.com.) Article III makes clear that federal courts are courts
of limited power or jurisdiction. Notice that the only kinds of cases federal courts are authorized
to deal with have strong federal connections. For example, federal courts have jurisdiction when
a federal law is being used by the plaintiff or prosecutor (a “federal question” case) or the case
arises “in admiralty” (meaning that the problem arose not on land but on sea, beyond the
territorial jurisdiction of any state, or in navigable waters within the United States). Implied in
this list is the clear notion that states would continue to have their own laws, interpreted by their
own courts, and that federal courts were needed only where the issues raised by the parties had
a clear federal connection. The exception to this is diversity jurisdiction, discussed later.
The Constitution was constructed with the idea that state courts would continue to deal with
basic kinds of claims such as tort, contract, or property claims. Since states sanction marriages
and divorce, state courts would deal with “domestic” (family) issues. Since states deal with birth
and death records, it stands to reason that paternity suits, probate disputes, and the like usually
wind up in state courts. You wouldn’t go to the federal building or courthouse to get a marriage
license, ask for a divorce, or probate a will: these matters have traditionally been dealt with by
the states (and the thirteen original colonies before them). Matters that historically get raised
and settled in state court under state law include not only domestic and probate matters but also
law relating to corporations, partnerships, agency, contracts, property, torts, and commercial
dealings generally. You cannot get married or divorced in federal court, because federal courts
have no jurisdiction over matters that are historically (and are still) exclusively within the
domain of state law.
In terms of subject matter jurisdiction, then, state courts will typically deal with the kinds of
disputes just cited. Thus if you are Michigan resident and have an auto accident in Toledo with
an Ohio resident and you each blame each other for the accident, the state courts would
ordinarily resolve the matter if the dispute cannot otherwise be settled. Why state courts?
Because when you blame one another and allege that it’s the other person’s fault, you have the
Saylor URL: http://www.saylor.org/books

Saylor.org
83

beginnings of a tort case, with negligence as a primary element of the claim, and state courts
have routinely dealt with this kind of claim, from British colonial times through Independence
and to the present. (See alsoChapter 7 "Introduction to Tort Law" of this text.) People have had a
need to resolve this kind of dispute long before our federal courts were created, and you can tell
from Article III that the founders did not specify that tort or negligence claims should be
handled by the federal courts. Again, federal courts are courts of limited jurisdiction, limited to
the kinds of cases specified in Article III. If the case before the federal court does not fall within
one of those categories, the federal court cannot constitutionally hear the case because it does
not have subject matter jurisdiction.
Always remember: a court must have subject matter jurisdiction to hear and decide a case.
Without it, a court cannot address the merits of the controversy or even take the next
jurisdictional step of figuring out which of the defendants can be sued in that court. The
question of which defendants are appropriately before the court is a question
of personal jurisdiction.
Because there are two court systems, it is important for a plaintiff to file in the right court to
begin with. The right court is the one that has subject matter jurisdiction over the case—that is,
the power to hear and decide the kind of case that is filed. Not only is it a waste of time to file in
the wrong court system and be dismissed, but if the dismissal comes after the filing period
imposed by the applicable statute of limitations, it will be too late to refile in the correct court
system. Such cases will be routinely dismissed, regardless of how deserving the plaintiff might
be in his quest for justice. (The plaintiff’s only remedy at that point would be to sue his lawyer
for negligence for failing to mind the clock and get to the right court in time!)

Exclusive Jurisdiction in Federal Courts
With two court systems, a plaintiff (or the plaintiff’s attorney, most likely) must decide whether
to file a case in the state court system or the federal court system. Federal courts have exclusive
jurisdiction over certain kinds of cases. The reason for this comes directly from the Constitution.
Article III of the US Constitution provides the following:
The judicial Power shall extend to all Cases, in Law and Equity, arising under this
Constitution, the Laws of the United States, and Treaties made, or which shall be
Saylor URL: http://www.saylor.org/books

Saylor.org
84

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.
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.
Saylor URL: http://www.saylor.org/books

Saylor.org
85

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

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

Summary of Rules on Subject Matter Jurisdiction
Saylor URL: http://www.saylor.org/books

Saylor.org
86

1. A court must always have subject matter jurisdiction, and personal jurisdiction over at least one
defendant, to hear and decide a case.
2. A state court will have subject matter jurisdiction over any case that is not required to be
brought in a federal court.
Some cases can only be brought in federal court, such as bankruptcy cases, cases involving
federal crimes, patent cases, and Internal Revenue Service tax court claims. The list of cases for
exclusive federal jurisdiction is fairly short. That means that almost any state court will have
subject matter jurisdiction over almost any kind of case. If it’s a case based on state law, a state
court will always have subject matter jurisdiction.
3. A federal court will have subject matter jurisdiction over any case that is either based on a
federal law (statute, case, or US Constitution)
OR
A federal court will have subject matter jurisdiction over any case based on state law where the
parties are (1) from different states and (2) the amount in controversy is at least $75,000.
(1) The different states requirement means that no plaintiff can have permanent residence in a
state where any defendant has permanent residence—there must be complete diversity of
citizenship as between all plaintiffs and defendants.
(2) The amount in controversy requirement means that a good-faith estimate of the amount the
plaintiff may recover is at least $75,000.
NOTE: For purposes of permanent residence, a corporation is considered a resident where it is
incorporated AND where it has a principal place of business.
4. In diversity cases, the following rules apply.
(1) Federal civil procedure rules apply to how the case is conducted before and during trial and
any appeals, but
(2) State law will be used as the basis for a determination of legal rights and responsibilities.
(a) This “choice of law” process is interesting but complicated. Basically, each state has its own
set of judicial decisions that resolve conflict of laws. For example, just because A sues B in a
Texas court, the Texas court will not necessarily apply Texas law. Anna and Bobby collide and
suffer serious physical injuries while driving their cars in Roswell, New Mexico. Both live in
Saylor URL: http://www.saylor.org/books

Saylor.org
87

Austin, and Bobby files a lawsuit in Austin. The court there could hear it (having subject matter
jurisdiction and personal jurisdiction over Bobby) but would apply New Mexico law, which
governs motor vehicle laws and accidents in New Mexico. Why would the Texas judge do that?
(b) The Texas judge knows that which state’s law is chosen to apply to the case can make a
decisive difference in the case, as different states have different substantive law standards. For
example, in a breach of contract case, one state’s version of the Uniform Commercial Code may
be different from another’s, and which one the court decides to apply is often exceedingly good
for one side and dismal for the other. In Anna v. Bobby, if Texas has one kind of comparative
negligence statute and New Mexico has a different kind of comparative negligence statute, who
wins or loses, or how much is awarded, could well depend on which law applies. Because both
were under the jurisdiction of New Mexico’s laws at the time, it makes sense to apply New
Mexico law.
(3) Why do some nonresident defendants prefer to be in federal court?
(a) In the state court, the judge is elected, and the jury may be familiar with or sympathetic to
the “local” plaintiff.
(b) The federal court provides a more neutral forum, with an appointed, life-tenured judge and a
wider pool of potential jurors (drawn from a wider geographical area).
(4) If a defendant does not want to be in state court and there is diversity, what is to be done?
(a) Make a motion for removal to the federal court.
(b) The federal court will not want to add to its caseload, or docket, but must take the case
unless there is not complete diversity of citizenship or the amount in controversy is less
than $75,000.
To better understand subject matter jurisdiction in action, let’s take an example. Wile E. Coyote
wants a federal judge to hear his products-liability action against Acme, Inc., even though the
action is based on state law. Mr. Coyote’s attorney wants to “make a federal case” out of it,
thinking that the jurors in the federal district court’s jury pool will understand the case better
and be more likely to deliver a “high value” verdict for Mr. Coyote. Mr. Coyote resides in
Arizona, and Acme is incorporated in the state of Delaware and has its principal place of
business in Chicago, Illinois. The federal court in Arizona can hear and decide Mr. Coyote’s case
Saylor URL: http://www.saylor.org/books

Saylor.org
88

(i.e., it has subject matter jurisdiction over the case) because of diversity of citizenship. If Mr.
Coyote was injured by one of Acme’s defective products while chasing a roadrunner in Arizona,
the federal district court judge would hear his action—using federal procedural law—and decide
the case based on the substantive law of Arizona on product liability.
But now change the facts only slightly: Acme is incorporated in Delaware but has its principal
place of business in Phoenix, Arizona. Unless Mr. Coyote has a federal law he is using as a basis
for his claims against Acme, his attempt to get a federal court to hear and decide the case will
fail. It will fail because there is not complete diversity of citizenship between the plaintiff and the
defendant.

Robinson v. Audi
Now consider Mr. and Mrs. Robinson and their products-liability claim against Seaway
Volkswagen and the other three defendants. There is no federal products-liability law that could
be used as a cause of action. They are most likely suing the defendants using products-liability
law based on common-law negligence or common-law strict liability law, as found in state court
cases. They were not yet Arizona residents at the time of the accident, and their accident does
not establish them as Oklahoma residents, either. They bought the vehicle in New York from a
New York–based retailer. None of the other defendants is from Oklahoma.
They file in an Oklahoma state court, but how will they (their attorney or the court) know if the
state court has subject matter jurisdiction? Unless the case is requiredto be in a federal court
(i.e., unless the federal courts have exclusive jurisdiction over this kind of case), any state court
system will have subject matter jurisdiction, including Oklahoma’s state court system. But if
their claim is for a significant amount of money, they cannot file in small claims court, probate
court, or any court in Oklahoma that does not have statutory jurisdiction over their claim. They
will need to file in a court of general jurisdiction. In short, even filing in the right court system
(state versus federal), the plaintiff must be careful to find the court that has subject matter
jurisdiction.
If they wish to go to federal court, can they? There is no federal question presented here (the
claim is based on state common law), and the United States is not a party, so the only basis for
federal court jurisdiction would be diversity jurisdiction. If enough time has elapsed since the
Saylor URL: http://www.saylor.org/books

Saylor.org
89

accident and they have established themselves as Arizona residents, they could sue in federal
court in Oklahoma (or elsewhere), but only if none of the defendants—the retailer, the regional
Volkswagen company, Volkswagen of North America, or Audi (in Germany) are incorporated in
or have a principal place of business in Arizona. The federal judge would decide the case using
federal civil procedure but would have to make the appropriate choice of state law. In this case,
the choice of conflicting laws would most likely be Oklahoma, where the accident happened, or
New York, where the defective product was sold.
Table 3.1 Sample Conflict-of-Law Principles
Substantive Law Issue

Law to be Applied

Liability for injury caused by tortious conduct

State in which the injury was inflicted

Real property

State where the property is located

Personal Property: inheritance

Domicile of deceased (not location of property)

Contract: validity

State in which contract was made

Contract: breach

State in which contract was to be performed*

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

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

Saylor URL: http://www.saylor.org/books

Saylor.org
90

procedures in a state or in the federal system. (Most US states’ procedural laws are similar to the
federal procedural code.)
Once at the court, the case will proceed through various motions (motions to dismiss for lack of
jurisdiction, for example, or insufficient service of process), the proofs (submission of evidence),
and the arguments (debate about the meaning of the evidence and the law) of contesting parties.
This is at the heart of the adversary system, in which those who oppose each other may attack
the other’s case through proofs and cross-examination. Every person in the United States who
wishes to take a case to court is entitled to hire a lawyer. The lawyer works for his client, not the
court, and serves him as an advocate, or supporter. The client’s goal is to persuade the court of
the accuracy and justness of his position. The lawyer’s duty is to shape the evidence and the
argument—the line of reasoning about the evidence—to advance his client’s cause and persuade
the court of its rightness. The lawyer for the opposing party will be doing the same thing, of
course, for her client. The judge (or, if one is sitting, the jury) must sort out the facts and reach a
decision from this cross-fire of evidence and argument.
The method of adjudication—the act of making an order or judgment—has several important
features. First, it focuses the conflicting issues. Other, secondary concerns are minimized or
excluded altogether. Relevance is a key concept in any trial. The judge is required to decide the
questions presented at the trial, not to talk about related matters. Second, adjudication requires
that the judge’s decision be reasoned, and that is why judges write opinions explaining their
decisions (an opinion may be omitted when the verdict comes from a jury). Third, the judge’s
decision must not only be reasoned but also be responsive to the case presented: the judge is not
free to say that the case is unimportant and that he therefore will ignore it. Unlike other
branches of government that are free to ignore problems pressing upon them,
judges must decide cases. (For example, a legislature need not enact a law, no matter how many
people petition it to do so.) Fourth, the court must respond in a certain way. The judge must pay
attention to the parties’ arguments and his decision must result from their proofs and
arguments. Evidence that is not presented and legal arguments that are not made cannot be the
basis for what the judge decides. Also, judges are bound by standards of weighing evidence: the
burden of proof in a civil case is generally a “preponderance of the evidence.”
Saylor URL: http://www.saylor.org/books

Saylor.org
91

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

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

Saylor URL: http://www.saylor.org/books

Saylor.org
92

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

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

Service of Process and Personal Jurisdiction
The defendant must be “served”—that is, must receive notice that he has been sued. Service can
be done by physically presenting the defendant with a copy of the summons and complaint. But
sometimes the defendant is difficult to find (or deliberately avoids the marshal or other process
server). The rules spell out a variety of ways by which individuals and corporations can be
served. These include using US Postal Service certified mail or serving someone already
designated to receive service of process. A corporation or partnership, for example, is often
required by state law to designate a “registered agent” for purposes of getting public notices or
receiving a summons and complaint.

Saylor URL: http://www.saylor.org/books

Saylor.org
93

One of the most troublesome problems is service on an out-of-state defendant. The personal
jurisdiction of a state court over persons is clear for those defendants found within the state. If
the plaintiff claims that an out-of-state defendant injured him in some way, must the plaintiff go
to the defendant’s home state to serve him? Unless the defendant had some significant contact
with the plaintiff’s state, the plaintiff may indeed have to. For instance, suppose a traveler from
Maine stopped at a roadside diner in Montana and ordered a slice of homemade pie that was
tainted and caused him to be sick. The traveler may not simply return home and mail the diner a
notice that he is suing it in a Maine court. But if out-of-state defendants have some contact with
the plaintiff’s state of residence, there might be grounds to bring them within the jurisdiction of
the plaintiff’s state courts. In Burger King v. Rudzewicz, Section 3.9 "Cases", the federal court in
Florida had to consider whether it was constitutionally permissible to exercise personal
jurisdiction over a Michigan franchisee.
Again, recall that even if a court has subject matter jurisdiction, it must also have personal
jurisdiction over each defendant against whom an enforceable judgment can be made. Often this
is not a problem; you might be suing a person who lives in your state or regularly does business
in your state. Or a nonresident may answer your complaint without objecting to the court’s “in
personam” (personal) jurisdiction. But many defendants who do not reside in the state where
the lawsuit is filed would rather not be put to the inconvenience of contesting a lawsuit in a
distant forum. Fairness—and the due process clause of the Fourteenth Amendment—dictates
that nonresidents should not be required to defend lawsuits far from their home base, especially
where there is little or no contact or connection between the nonresident and the state where a
lawsuit is brought.

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

Saylor URL: http://www.saylor.org/books

Saylor.org
94

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

The process server personally serves a complaint on the defendant.



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



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



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

4. In addition to successfully serving the defendant with process, a plaintiff must convince the
court that exercising personal jurisdiction over the defendant is consistent with due process and
any statutes in that state that prescribe the jurisdictional reach of that state (the so-called longarm statutes). The Supreme Court has long recognized various bases for judging whether such
process is fair.
1. Consent. The defendant agrees to the court’s jurisdiction by coming to court, answering the
complaint, and having the matter litigated there.
Saylor URL: http://www.saylor.org/books

Saylor.org
95

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

Choice of Law and Choice of Forum Clauses
In a series of cases, the Supreme Court has made clear that it will honor contractual choices of
parties in a lawsuit. Suppose the parties to a contract wind up in court arguing over the
Saylor URL: http://www.saylor.org/books

Saylor.org
96

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

KEY TAKEAWAY

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

Saylor URL: http://www.saylor.org/books

Saylor.org
97

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

3.3 Motions and Discovery

LEARNING OBJECTIVES

Saylor URL: http://www.saylor.org/books

Saylor.org
98

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

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

Saylor.org
99

example, a claim that the defendant induced a woman to stop dating the plaintiff (a so-called
alienation of affections cause of action) is no longer actionable in US state courts, and any court
will dismiss the complaint without any further proceedings. (This type of dismissal is
occasionally still called a demurrer.)
A third kind of dismissal can take place on a motion for summary judgment. If there is no triable
question of fact or law, there is no reason to have a trial. For example, the plaintiff sues on a
promissory note and, at deposition (an oral examination under oath), the defendant admits
having made no payment on the note and offers no excuse that would be recognizable as a
reason not to pay. There is no reason to have a trial, and the court should grant summary
judgment.

Discovery
If there is a factual dispute, the case will usually involve some degree of discovery, where each
party tries to get as much information out of the other party as the rules allow. Until the 1940s,
when discovery became part of civil procedure rules, a lawsuit was frequently a game in which
each party hid as much information as possible and tried to surprise the other party in court.
Beginning with a change in the Federal Rules of Civil Procedure adopted by the Supreme Court
in 1938 and subsequently followed by many of the states, the parties are entitled to learn the
facts of the case before trial. The basic idea is to help the parties determine what the evidence
might be, who the potential witnesses are, and what specific issues are relevant. Discovery can
proceed by several methods. A party may serve an interrogatory on his adversary—a written
request for answers to specific questions. Or a party may depose the other party or a witness. A
deposition is a live question-and-answer session at which the witness answers questions put to
him by one of the parties’ lawyers. His answers are recorded verbatim and may be used at trial.
Each party is also entitled to inspect books, documents, records, and other physical items in the
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.

Saylor URL: http://www.saylor.org/books

Saylor.org
100

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

KEY TAKEAWAY

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

EXERCISES

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

3.4 The Pretrial and Trial Phase
Saylor URL: http://www.saylor.org/books

Saylor.org
101

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

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

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

Saylor URL: http://www.saylor.org/books

Saylor.org
102

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

Saylor.org
103

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

Saylor.org
104

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

Saylor.org
105

hung jury, and the case will have to be retried. When a jury does reach a verdict, it delivers it in
court with both parties and their lawyers present. The jury is then discharged, and control over
the case returns to the judge. (If there is no jury, the judge will usually announce in a written
opinion his findings of fact and how the law applies to those facts. Juries just announce their
verdicts and do not state their reasons for reaching them.)

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

Saylor.org
106

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

EXERCISES

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

3.5 Judgment, Appeal, and Execution
LEARNING OBJECTIVES

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

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

Saylor.org
107

prejudicial error committed by the trial judge. There will be errors, of course, but the errors
must be significant (i.e., not harmless). The basic idea is for an appellate court to ensure that a
reasonably fair trial was provided to both sides. Enforcement of the court’s judgment—an award
of money, an injunction—is usually stayed (postponed) until the appellate court has ruled. As
noted earlier, the party making the appeal is called the appellant, and the party defending the
judgment is the appellee (or in some courts, the petitioner and the respondent).
During the trial, the losing party may have objected to certain procedural decisions by the judge.
In compiling a record on appeal, the appellant needs to show the appellate court some examples
of mistakes made by the judge—for example, having erroneously admitted evidence, having
failed to admit proper evidence that should have been admitted, or having wrongly instructed
the jury. The appellate court must determine if those mistakes were serious enough to amount
to prejudicial error.
Appellate and trial procedures are different. The appellate court does not hear witnesses or
accept evidence. It reviews the record of the case—the transcript of the witnesses’ testimony and
the documents received into evidence at trial—to try to find a legal error on a specific request of
one or both of the parties. The parties’ lawyers prepare briefs (written statements containing the
facts in the case), the procedural steps taken, and the argument or discussion of the meaning of
the law and how it applies to the facts. After reading the briefs on appeal, the appellate court
may dispose of the appeal without argument, issuing a written opinion that may be very short or
many pages. Often, though, the appellate court will hear oral argument. (This can be months, or
even more than a year after the briefs are filed.) Each lawyer is given a short period of time,
usually no more than thirty minutes, to present his client’s case. The lawyer rarely gets a chance
for an extended statement because he is usually interrupted by questions from the judges.
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
Saylor URL: http://www.saylor.org/books

Saylor.org
108

case. As we have already seen, there is the possibility of appealing from an intermediate
appellate court to the state supreme court in twenty-nine states and to the US Supreme Court
from a ruling from a federal circuit court of appeal. In cases raising constitutional issues, there is
also the possibility of appeal to the Supreme Court from the state courts.
Like trial judges, appellate judges must follow previous decisions, or precedent. But not every
previous case is a precedent for every court. Lower courts must respect appellate court
decisions, and courts in one state are not bound by decisions of courts in other states. State
courts are not bound by decisions of federal courts, except on points of federal law that come
from federal courts within the state or from a federal circuit in which the state court sits. A state
supreme court is not bound by case law in any other state. But a supreme court in one state with
a type of case it has not previously dealt with may find persuasive reasoning in decisions of other
state supreme courts.
Federal district courts are bound by the decisions of the court of appeals in their circuit, but
decisions by one circuit court are not precedents for courts in other circuits. Federal courts are
also bound by decisions of the state supreme courts within their geographic territory in diversity
jurisdiction cases. All courts are bound by decisions of the US Supreme Court, except the
Supreme Court itself, which seldom reverses itself but on occasion has overturned its own
precedents.
Not everything a court says in an opinion is a precedent. Strictly speaking, only the exact holding
is binding on the lower courts. A holding is the theory of the law that applies to the particular
circumstances presented in a case. The courts may sometimes declare what they believe to be
the law with regard to points that are not central to the case being decided. These declarations
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.
Saylor URL: http://www.saylor.org/books

Saylor.org
109

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

EXERCISES

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

Saylor URL: http://www.saylor.org/books

Saylor.org
110

follow? May he adopt the reasoning of any of these courts, if he should find that
reasoning persuasive?

3.6 When Can Someone Bring a Lawsuit?
LEARNING OBJECTIVES

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

Case or Controversy: Standing to Sue
Article III of the US Constitution provides limits to federal judicial power. For some cases, the
Supreme Court has decided that it has no power to adjudicate because there is no “case or
controversy.” For example, perhaps the case has settled or the “real parties in interest” are not
before the court. In such a case, a court might dismiss the case on the grounds that the plaintiff
does not have “standing” to sue.
For example, suppose you see a sixteen-wheel moving van drive across your neighbor’s flower
bed, destroying her beloved roses. You have enjoyed seeing her roses every summer, for years.
She is forlorn and tells you that she is not going to raise roses there anymore. She also tells you
that she has decided not to sue, because she has made the decision to never deal with lawyers if
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.
Saylor URL: http://www.saylor.org/books

Saylor.org
111

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

KEY TAKEAWAY

Saylor URL: http://www.saylor.org/books

Saylor.org
112

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

EXERCISE

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

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
Saylor URL: http://www.saylor.org/books

Saylor.org
113

Lawyers charge for their services in one of three different ways: flat rate, hourly rate, and
contingent fee. A flat rate is used usually when the work is relatively routine and the lawyer
knows in advance approximately how long it will take her to do the job. Drawing a will or doing
a real estate closing are examples of legal work that is often paid a flat rate. The rate itself may
be based on a percentage of the worth of the matter—say, 1 percent of a home’s selling price.
Lawyers generally charge by the hour for courtroom time and for ongoing representation in
commercial matters. Virtually every sizable law firm bills its clients by hourly rates, which in
large cities can range from $300 for an associate’s time to $500 and more for a senior partner’s
time.
A contingent fee is one that is paid only if the lawyer wins—that is, it is contingent, or depends
upon, the success of the case. This type of fee arrangement is used most often in personal injury
cases (e.g., automobile accidents, products liability, and professional malpractice). Although
used quite often, the contingent fee is controversial. Trial lawyers justify it by pointing to the
high cost of preparing for such lawsuits. A typical automobile accident case can cost at least ten
thousand dollars to prepare, and a complicated products-liability case can cost tens of
thousands of dollars. Few people have that kind of money or would be willing to spend it on the
chance that they might win a lawsuit. Corporate and professional defendants complain that the
contingent fee gives lawyers a license to go big game hunting, or to file suits against those with
deep pockets in the hopes of forcing them to settle.
Trial lawyers respond that the contingent fee arrangement forces them to screen cases and weed
out cases that are weak, because it is not worth their time to spend the hundreds of hours
necessary on such cases if their chances of winning are slim or nonexistent.

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).
Saylor URL: http://www.saylor.org/books

Saylor.org
114

There are two types of exceptions to the American rule. By statute, Congress and the state
legislatures have provided that the winning party in particular classes of cases may recover its
full legal costs from the loser—for example, the federal antitrust laws so provide and so does the
federal Equal Access to Justice Act. The other exception applies to litigants who either initiate
lawsuits in bad faith, with no expectation of winning, or who defend them in bad faith, in order
to cause the plaintiff great expense. Under these circumstances, a court has the discretion to
award attorneys’ fees to the winner. But this rule is not infinitely flexible, and courts do not have
complete freedom to award attorneys’ fees in any amount, but only "reasonable" attorney's fees.

KEY TAKEAWAY

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

EXERCISES

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

3.8 Alternative Means of Resolving Disputes
LEARNING OBJECTIVES

1. Understand how arbitration and mediation are frequently used alternatives to litigation.
2. Describe the differences between arbitration and mediation.
3. Explain why arbitration is final and binding.
Saylor URL: http://www.saylor.org/books

Saylor.org
115

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

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

Saylor URL: http://www.saylor.org/books

Saylor.org
116

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

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

KEY TAKEAWAY

Saylor URL: http://www.saylor.org/books

Saylor.org
117

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

EXERCISES

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

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

Summary

Saylor URL: http://www.saylor.org/books

Saylor.org
118

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

Saylor.org
119

Plains facility. Franchisees appealed to the 11th Circuit Court of Appeals and won a reversal
based on lack of personal jurisdiction. Burger King petitioned the Supreme Ct. for a writ of
certiorari.
Justice Brennan delivered the opinion of the court.
The Due Process Clause protects an individual’s liberty interest in not being subject to the
binding judgments of a forum with which he has established no meaningful “contacts, ties, or
relations.” International Shoe Co. v. Washington. By requiring that individuals have “fair
warning that a particular activity may subject [them] to the jurisdiction of a foreign sovereign,”
the Due Process Clause “gives a degree of predictability to the legal system that allows potential
defendants to structure their primary conduct with some minimum assurance as to where that
conduct will and will not render them liable to suit.”…
Where a forum seeks to assert specific jurisdiction over an out-of-state defendant who has not
consented to suit there, this “fair warning” requirement is satisfied if the defendant has
“purposefully directed” his activities at residents of the forum, and the litigation results from
alleged injuries that “arise out of or relate to” those activities, Thus “[t]he forum State does not
exceed its powers under the Due Process Clause if it asserts personal jurisdiction over a
corporation that delivers its products into the stream of commerce with the expectation that
they will be purchased by consumers in the forum State” and those products subsequently injure
forum consumers. Similarly, a publisher who distributes magazines in a distant State may fairly
be held accountable in that forum for damages resulting there from an allegedly defamatory
story.…
…[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
Saylor URL: http://www.saylor.org/books

Saylor.org
120

purposefully avails itself of the privilege of conducting activities within the forum
State, thus invoking the benefits and protections of its laws.
This “purposeful availment” requirement ensures that a defendant will not be haled into a
jurisdiction solely as a result of “random,” “fortuitous,” or “attenuated” contacts, or of the
“unilateral activity of another party or a third person,” [Citations] Jurisdiction is proper,
however, where the contacts proximately result from actions by the defendant himself that
create a “substantial connection” with the forum State. [Citations] Thus where the defendant
“deliberately” has engaged in significant activities within a State, or has created “continuing
obligations” between himself and residents of the forum, he manifestly has availed himself of
the privilege of conducting business there, and because his activities are shielded by “the
benefits and protections” of the forum’s laws it is presumptively not unreasonable to require
him to submit to the burdens of litigation in that forum as well.
Jurisdiction in these circumstances may not be avoided merely because the defendant did not
physically enter the forum State. Although territorial presence frequently will enhance a
potential defendant’s affiliation with a State and reinforce the reasonable foreseeability of suit
there, it is an inescapable fact of modern commercial life that a substantial amount of business
is transacted solely by mail and wire communications across state lines, thus obviating the need
for physical presence within a State in which business is conducted. So long as a commercial
actor’s efforts are “purposefully directed” toward residents of another State, we have
consistently rejected the notion that an absence of physical contacts can defeat personal
jurisdiction there.
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.”
Saylor URL: http://www.saylor.org/books

Saylor.org
121

These considerations sometimes serve to establish the reasonableness of jurisdiction upon a
lesser showing of minimum contacts than would otherwise be required. [Citations] Applying
these principles to the case at hand, we believe there is substantial record evidence supporting
the District Court’s conclusion that the assertion of personal jurisdiction over Rudzewicz in
Florida for the alleged breach of his franchise agreement did not offend due process.…
In this case, no physical ties to Florida can be attributed to Rudzewicz other than MacShara’s
brief training course in Miami. Rudzewicz did not maintain offices in Florida and, for all that
appears from the record, has never even visited there. Yet this franchise dispute grew directly
out of “a contract which had a substantial connection with that State.” Eschewing the option of
operating an independent local enterprise, Rudzewicz deliberately “reach[ed] out beyond”
Michigan and negotiated with a Florida corporation for the purchase of a long-term franchise
and the manifold benefits that would derive from affiliation with a nationwide organization.
Upon approval, he entered into a carefully structured 20-year relationship that envisioned
continuing and wide-reaching contacts with Burger King in Florida. In light of Rudzewicz’
voluntary acceptance of the long-term and exacting regulation of his business from Burger
King’s Miami headquarters, the “quality and nature” of his relationship to the company in
Florida can in no sense be viewed as “random,” “fortuitous,” or “attenuated.” Rudzewicz’ refusal
to make the contractually required payments in Miami, and his continued use of Burger King’s
trademarks and confidential business information after his termination, caused foreseeable
injuries to the corporation in Florida. For these reasons it was, at the very least, presumptively
reasonable for Rudzewicz to be called to account there for such injuries.
…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.
Saylor URL: http://www.saylor.org/books

Saylor.org
122

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

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

Saylor URL: http://www.saylor.org/books

Saylor.org
123

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.
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
Saylor URL: http://www.saylor.org/books

Saylor.org
124

has a duty to warn depends on whether the use of the product and the injury sustained by it are
foreseeable. Gootee v. Colt Industries Inc., 712 F.2d 1057, 1065 (6th Cir. 1983); Owens v. AllisChalmers Corp., 414 Mich. 413, 425, 326 N.W.2d 372 (1982). Whether a plaintiff’s use of a
product is foreseeable is a legal question to be resolved by the court. Trotter, supra. Whether the
resulting injury is foreseeable is a question of fact for the jury. [2] Thomas v. International
Harvester Co., 57 Mich. App. 79, 225 N.W.2d 175 (1974).
In the instant action no reasonable jury could find that JJP’s failure to warn of the flammability
of cotton batting was a proximate cause of plaintiffs’ injuries because plaintiffs failed to offer any
evidence to establish that a flammability warning on JJP’s cotton batting would have dissuaded
them from using the product in the manner that they did.
Plaintiffs repeatedly stated in their response brief that plaintiff Susan Ferlito testified that “she
would never again use cotton batting to make a costume…However, a review of the trial
transcript reveals that plaintiff Susan Ferlito never testified that she would never again use
cotton batting to make a costume. More importantly, the transcript contains no statement by
plaintiff Susan Ferlito that a flammability warning on defendant JJP’s product would have
dissuaded her from using the cotton batting to construct the costume in the first place. At oral
argument counsel for plaintiffs conceded that there was no testimony during the trial that either
plaintiff Susan Ferlito or her husband, plaintiff Frank J. Ferlito, would have acted any different
if there had been a flammability warning on the product’s package. The absence of such
testimony is fatal to plaintiffs’ case; for without it, plaintiffs have failed to prove proximate
cause, one of the essential elements of their negligence claim.
In addition, both plaintiffs testified that they knew that cotton batting burns when it is exposed
to flame. Susan Ferlito testified that she knew at the time she purchased the cotton batting that
it would burn if exposed to an open flame. Frank Ferlito testified that he knew at the time he
appeared at the Halloween party that cotton batting would burn if exposed to an open flame. His
additional testimony that he would not have intentionally put a flame to the cotton batting
shows that he recognized the risk of injury of which he claims JJP should have warned. Because
both plaintiffs were already aware of the danger, a warning by JJP would have been superfluous.

Saylor URL: http://www.saylor.org/books

Saylor.org
125

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?
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).

Saylor URL: http://www.saylor.org/books

Saylor.org
126

[2] Note the division of labor here: questions of law are for the judge, while questions of “fact” are for
the jury. Here, “foreseeability” is a fact question, while the judge retains authority over questions of law.
The division between questions of fact and questions of law is not an easy one, however.

Chapter 4
Constitutional Law and US Commerce
LEARNING OBJECTIVES

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

Saylor.org
127

contrary to the Constitution’s language. No knowledgeable citizen or businessperson can afford
to be ignorant of its basic provisions.

4.1 Basic Aspects of the US Constitution
LEARNING OBJECTIVES

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

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

Saylor URL: http://www.saylor.org/books

Saylor.org
128

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

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

Saylor URL: http://www.saylor.org/books

Saylor.org
129

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

Saylor URL: http://www.saylor.org/books

Saylor.org
130

Because the Supreme Court has this power of judicial review, there have been many arguments
about how it should be exercised and what kind of “philosophy” a Supreme Court justice should
have. President Richard Nixon often said that a Supreme Court justice should “strictly construe”
the Constitution and not add to its language. Finding law in the Constitution was “judicial
activism” rather than “judicial restraint.” The general philosophy behind the call for “strict
constructionist” justices is that legislatures make laws in accord with the wishes of the majority,
and so unelected judges should not make law according to their own views and values. Nixon
had in mind the 1960s Warren court, which “found” rights in the Constitution that were not
specifically mentioned—the right of privacy, for example. In later years, critics of the Rehnquist
court would charge that it “found” rights that were not specifically mentioned, such as the right
of states to be free from federal antidiscrimination laws. See, for example, Kimel v. Florida
Board of Regents, or the Citizens United v. Federal Election Commission case (Section 4.6.5),
which held that corporations are “persons” with “free speech rights” that include spending
unlimited amounts of money in campaign donations and political advocacy. [3]
Because Roe v. Wade has been so controversial, this chapter includes a seminal case on “the
right of privacy,” Griswold v. Connecticut, Section 4.6.1. Was the court was correct in
recognizing a “right of privacy” in Griswold? This may not seem like a “business case,” but
consider: the manufacture and distribution of birth control devices is a highly profitable (and
legal) business in every US state. Moreover, Griswold illustrates another important and muchdebated concept in US constitutional law: substantive due process (see Section 4.5.3 "Fifth
Amendment"). The problem of judicial review and its proper scope is brought into sharp focus
in the abortion controversy. Abortion became a lucrative service business after Roe v. Wade was
decided in 1973. That has gradually changed, with state laws that have limited rather than
overruledRoe v. Wade and with persistent antiabortion protests, killings of abortion doctors,
and efforts to publicize the human nature of the fetuses being aborted. The key here is to
understand that there is no explicit mention in the Constitution of any right of privacy. As
Justice Harry Blackmun argued in his majority opinion in Roe v. Wade,
The Constitution does not explicitly mention any right of privacy. In a line of
decisions, however, the Court has recognized that a right of personal privacy or a
Saylor URL: http://www.saylor.org/books

Saylor.org
131

guarantee of certain areas or zones of privacy, does exist under the
Constitution.…[T]hey also make it clear that the right has some extension to activities
relating to marriage…procreation…contraception…family relationships…and child
rearing and education.…The right of privacy…is broad enough to encompass a
woman’s decision whether or not to terminate her pregnancy.
In short, justices interpreting the Constitution wield quiet yet enormous power through judicial
review. In deciding that the right of privacy applied to a woman’s decision to abort in the first
trimester, the Supreme Court did not act on the basis of a popular mandate or clear and
unequivocal language in the Constitution, and it made illegal any state or federal legislative or
executive action contrary to its interpretation. Only a constitutional amendment or the court’s
repudiation of Roe v. Wade as a precedent could change that interpretation.

KEY TAKEAWAY

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

EXERCISES

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

Saylor URL: http://www.saylor.org/books

Saylor.org
132

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

Section 8

[Clause 1] The Congress shall have Power To lay and collect Taxes, Duties, Imposts
and Excises, to pay the Debts and provide for the common Defence and general
Welfare of the United States; but all Duties, Imposts and Excises shall be uniform
throughout the United States;
Saylor URL: http://www.saylor.org/books

Saylor.org
133

[Clause 2] To borrow Money on the credit of the United States;
[Clause 3] To regulate Commerce with foreign Nations, and among the
several States, and with the Indian Tribes;
[Clause 4] To establish a uniform Rule of Naturalization, and uniform Laws on the
subject of Bankruptcies throughout the United States;
[Clause 5] To coin Money, regulate the Value thereof, and of foreign Coin, and fix the
Standard of Weights and Measures;

Early Commerce Clause Cases
For many years, the Supreme Court was very strict in applying the commerce clause: Congress
could only use it to legislate aspects of the movement of goods from one state to another.
Anything else was deemed local rather than national. For example, InHammer v. Dagenhart,
decided in 1918, a 1916 federal statute had barred transportation in interstate commerce of
goods produced in mines or factories employing children under fourteen or employing children
fourteen and above for more than eight hours a day. A complaint was filed in the US District
Court for the Western District of North Carolina by a father in his own behalf and on behalf of
his two minor sons, one under the age of fourteen years and the other between fourteen and
sixteen years, who were employees in a cotton mill in Charlotte, North Carolina. The father’s
lawsuit asked the court to enjoin (block) the enforcement of the act of Congress intended to
prevent interstate commerce in the products of child labor.
The Supreme Court saw the issue as whether Congress had the power under the commerce
clause to control interstate shipment of goods made by children under the age of fourteen. The
court found that Congress did not. The court cited several cases that had considered what
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
Saylor URL: http://www.saylor.org/books

Saylor.org
134

interstate commerce: “If the facility of interstate transportation can be taken away from the
demoralization of lotteries, the debasement of obscene literature, the contagion of diseased
cattle or persons, the impurity of food and drugs, the like facility can be taken away from the
systematic enticement to, and the enslavement in prostitution and debauchery of women, and,
more insistently, of girls.” [2]
In each of those instances, the Supreme Court said, “[T]he use of interstate transportation was
necessary to the accomplishment of harmful results.” In other words, although the power over
interstate transportation was to regulate, that could only be accomplished by prohibiting the use
of the facilities of interstate commerce to effect the evil intended. But in Hammer v. Dagenhart,
that essential element was lacking. The law passed by Congress aimed to standardize among all
the states the ages at which children could be employed in mining and manufacturing, while the
goods themselves are harmless. Once the labor is done and the articles have left the factory, the
“labor of their production is over, and the mere fact that they were intended for interstate
commerce transportation does not make their production subject to federal control under the
commerce power.”
In short, the early use of the commerce clause was limited to the movement of physical goods
between states. Just because something might enter the channels of interstate commerce later
on does not make it a fit subject for national regulation. The production of articles intended for
interstate commerce is a matter of local regulation. The court therefore upheld the result from
the district and circuit court of appeals; the application of the federal law was enjoined. Goods
produced by children under the age of fourteen could be shipped anywhere in the United States
without violating the federal law.

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.

Saylor URL: http://www.saylor.org/books

Saylor.org
135

In NLRB v. Jones & Laughlin Steel Corporation, a union dispute with management at a large
steel-producing facility near Pittsburgh, Pennsylvania, became a court case. In this case, the
NLRB had charged the Jones & Laughlin Steel Corporation with discriminating against
employees who were union members. The company’s position was that the law authorizing the
NLRB was unconstitutional, exceeding Congress’s powers. The court held that the act was
narrowly constructed so as to regulate industrial activities that had the potential to restrict
interstate commerce. The earlier decisions under the commerce clause to the effect that labor
relations had only an indirect effect on commerce were effectively reversed. Since the ability of
employees to engage in collective bargaining (one activity protected by the act) is “an essential
condition of industrial peace,” the national government was justified in penalizing corporations
engaging in interstate commerce that “refuse to confer and negotiate” with their workers. This
was, however, a close decision, and the switch of one justice made this ruling possible. Without
this switch, the New Deal agenda would have been effectively derailed.

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

Saylor.org
136

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 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
Saylor URL: http://www.saylor.org/books

Saylor.org
137

dropped out of the university. Brzonkala then sued Morrison, Crawford, and Virginia Tech in
federal district court, alleging that Morrison’s and Crawford’s attack violated 42 USC Section
13981, part of the VAWA), which provides a federal civil remedy for the victims of gendermotivated violence. Morrison and Crawford moved to dismiss Brzonkala’s suit on the ground
that Section 13981’s civil remedy was unconstitutional. In dismissing the complaint, the district
court found that that Congress lacked authority to enact Section 13981 under either the
commerce clause or the Fourteenth Amendment, which Congress had explicitly identified as the
sources of federal authority for the VAWA. Ultimately, the court of appeals affirmed, as did the
Supreme Court.
The Supreme Court held that Congress lacked the authority to enact a statute under the
commerce clause or the Fourteenth Amendment because the statute did not regulate an activity
that substantially affected interstate commerce nor did it redress harm caused by the state. Chief
Justice William H. Rehnquist wrote for the court that “under our federal system that remedy
must be provided by the Commonwealth of Virginia, and not by the United States.” Dissenting,
Justice Stephen G. Breyer argued that the majority opinion “illustrates the difficulty of finding a
workable judicial Commerce Clause touchstone.” Justice David H. Souter, dissenting, noted that
VAWA contained a “mountain of data assembled by Congress…showing the effects of violence
against women on interstate commerce.”
The absence of a workable judicial commerce clause touchstone remains. In 1996, California
voters passed the Compassionate Use Act, legalizing marijuana for medical use. California’s law
conflicted with the federal Controlled Substances Act (CSA), which banned possession of
marijuana. After the Drug Enforcement Administration (DEA) seized doctor-prescribed
marijuana from a patient’s home, a group of medical marijuana users sued the DEA and US
Attorney General John Ashcroft in federal district court.
The medical marijuana users argued that the CSA—which Congress passed using its
constitutional power to regulate interstate commerce—exceeded Congress’s commerce clause
power. The district court ruled against the group, but the Ninth Circuit Court of Appeals
reversed and ruled the CSA unconstitutional because it applied to medical marijuana use solely
within one state. In doing so, the Ninth Circuit relied on U.S. v. Lopez (1995) and U.S. v.
Saylor URL: http://www.saylor.org/books

Saylor.org
138

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

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
Saylor URL: http://www.saylor.org/books

Saylor.org
139

only 40 percent of its patrons are travelers on I-80. Are the owners of the Holiday Restaurant
in violation of the Civil Rights Act of 1964? What would happen if the owners resisted
enforcement by claiming that Title II of the act (relating to “public accommodations” such as
hotels, motels, and restaurants) was unconstitutional?
2. If the Supreme Court were to go back to the days of Hammer v. Dagenhart and rule that only
goods and services involving interstate movement could be subject to federal law, what kinds
of federal programs might be lacking a sound basis in the commerce clause? “Obamacare”?
Medicare? Homeland security? Social Security? What other powers are granted to Congress
under the Constitution to legislate for the general good of society?

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

4.3 Dormant Commerce Clause

LEARNING OBJECTIVES

1. Understand that when Congress does not exercise its powers under the commerce clause,
the Supreme Court may still limit state legislation that discriminates against interstate
commerce or places an undue burden on interstate commerce.
2. Distinguish between “discrimination” dormant-commerce-clause cases and “undue burden”
dormant-commerce-clause cases.
Congress has the power to legislate under the commerce clause and often does legislate. For
example, Congress might say that trucks moving on interstate highways must not be more than
seventy feet in length. But if Congress does not exercise its powers and regulate in certain areas
(such as the size and length of trucks on interstate highways), states may make their own rules.
States may do so under the so-called historic police powers of states that were never yielded up
to the federal government.

Saylor URL: http://www.saylor.org/books

Saylor.org
140

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 all Michigan counties would effectively be
excluding waste from outside of Michigan, which is discriminatory.) [3]
Saylor URL: http://www.saylor.org/books

Saylor.org
141

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

Saylor URL: http://www.saylor.org/books

Saylor.org
142

groundwater contamination, noise pollution and foul odors, are exacerbated by the
significant increase in the use of our landfills from sources outside of Michigan.
I have teamed up with Senator Stabenow and Congressman Dingell to introduce
legislation that would strengthen our ability to stop shipments of waste from Canada.
We have protections contained in a 17 year-old international agreement between the
U.S. and Canada called the Agreement Concerning the Transboundary Movement of
Hazardous Waste. The U.S. and Canada entered into this agreement in 1986 to allow
the shipment of hazardous waste across the U.S./Canadian border for treatment,
storage or disposal. In 1992, the two countries decided to add municipal solid waste
to the agreement. To protect both countries, the agreement requires notification of
shipments to the importing country and it also provides that the importing country
may withdraw consent for shipments. Both reasons are evidence that these shipments
were intended to be limited. However, the agreement’s provisions have not been
enforced by the United States.
Canada could not export waste to Michigan without the 1986 agreement, but the U.S.
has not implemented the provisions that are designed to protect the people of
Michigan. Although those of us that introduced this legislation believe that the
Environmental Protection Agency has the authority to enforce this agreement, they
have not done so. Our bill would require the EPA [Environmental Protection Agency]
to enforce the agreement.
In order to protect the health and welfare of the citizens of Michigan and our
environment, we must consider the impact of the importation of trash on state and
local recycling efforts, landfill capacity, air emissions, road deterioration resulting
from increased vehicular traffic and public health and the environment.
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

Saylor URL: http://www.saylor.org/books

Saylor.org
143

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

EXERCISES

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

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

4.4 Preemption: The Supremacy Clause
LEARNING OBJECTIVES

Saylor URL: http://www.saylor.org/books

Saylor.org
144

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

Saylor URL: http://www.saylor.org/books

Saylor.org
145

because federal Clean Air Act emissions restrictions do not preempt more rigorous state
standards.
Large industries and companies actually prefer regulation at the national level. It is easier for a
large company or industry association to lobby in Washington, DC, than to lobby in fifty
different states. Accordingly, industry often asks Congress to put preemptive language into its
statutes. The tobacco industry is a case in point.
The cigarette warning legislation of the 1960s (where the federal government required warning
labels on cigarette packages) effectively preempted state negligence claims based on failure to
warn. When the family of a lifetime smoker who had died sued in New Jersey court, one cause of
action was the company’s failure to warn of the dangers of its product. The Supreme Court
reversed the jury’s award based on the federal preemption of failure to warn claims under state
law. [1]

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

Saylor.org
146

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

KEY TAKEAWAY

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

EXERCISES

1. For many years, the United States engaged in discussions with friendly nations as to the
reciprocal use of ports and harbors. These discussions led to various multilateral agreements
Saylor URL: http://www.saylor.org/books

Saylor.org
147

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

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

4.5 Business and the Bill of Rights

LEARNING OBJECTIVES

1. Understand and describe which articles in the Bill of Rights apply to business activities and
how they apply.
2. Explain the application of the Fourteenth Amendment—including the due process clause and
the equal protection clause—to various rights enumerated in the original Bill of Rights.
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
Saylor URL: http://www.saylor.org/books

Saylor.org
148

constitutionally correct for a court to assert personal jurisdiction over a nonresident. The states
cannot constitutionally award a judgment against a nonresident if doing so would offend
traditional notions of fair play and substantial justice. Even if the state’s long-arm statute would
seem to allow such a judgment, other states should not give it full faith and credit (see Article V
of the Constitution). In short, a state’s long-arm statute cannot confer personal jurisdiction that
the state cannot constitutionally claim.
The Bill of Rights (the first ten amendments to the Constitution) was originally meant to apply
to federal actions only. During the twentieth century, the court began to apply selected rights to
state action as well. So, for example, federal agents were prohibited from using evidence seized
in violation of the Fourth Amendment, but state agents were not, until Mapp v. Ohio (1960),
when the court applied the guarantees (rights) of the Fourth Amendment to state action as well.
In this and in similar cases, the Fourteenth Amendment’s due process clause was the basis for
the court’s action. The due process clause commanded that states provide due process in cases
affecting the life, liberty, or property of US citizens, and the court saw in this command certain
“fundamental guarantees” that states would have to observe. Over the years, most of the
important guarantees in the Bill of Rights came to apply to state as well as federal action. The
court refers to this process as selective incorporation.
Here are some very basic principles to remember:
1. The guarantees of the Bill of Rights apply only to state and federal government action. They do
not limit what a company or person in the private sector may do. For example, states may not
impose censorship on the media or limit free speech in a way that offends the First Amendment,
but your boss (in the private sector) may order you not to talk to the media.
2. In some cases, a private company may be regarded as participating in “state action.” For
example, a private defense contractor that gets 90 percent of its business from the federal
government has been held to be public for purposes of enforcing the constitutional right to free
speech (the company had a rule barring its employees from speaking out in public against its
corporate position). It has even been argued that public regulation of private activity is sufficient
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
Saylor URL: http://www.saylor.org/books

Saylor.org
149

power companies, regulated by the state, to give customers a hearing before cutting off
electricity for failure to pay the bill. [1]
3. States have rights, too. While “states rights” was a battle cry of Southern states before the Civil
War, the question of what balance to strike between state sovereignty and federal union has
never been simple. In Kimel v. Florida, for example, the Supreme Court found in the words of
the Eleventh Amendment a basis for declaring that states may not have to obey certain federal
statutes.

First Amendment
In part, the First Amendment states that “Congress shall make no law…abridging the freedom of
speech, or of the press.” The Founding Fathers believed that democracy would work best if
people (and the press) could talk or write freely, without governmental interference. But the
First Amendment was also not intended to be as absolute as it sounded. Oliver Wendell
Holmes’s famous dictum that the law does not permit you to shout “Fire!” in a crowded theater
has seldom been answered, “But why not?” And no one in 1789 thought that defamation laws
(torts for slander and libel) had been made unconstitutional. Moreover, because the apparent
purpose of the First Amendment was to make sure that the nation had a continuing, vigorous
debate over matters political, political speech has been given the highest level of protection over
such other forms of speech as (1) “commercial speech,” (2) speech that can and should be
limited by reasonable “time, place, and manner” restrictions, or (3) obscene speech.
Because of its higher level of protection, political speech can be false, malicious, mean-spirited,
or even a pack of lies. A public official in the United States must be prepared to withstand all
kinds of false accusations and cannot succeed in an action for defamation unless the defendant
has acted with “malice” and “reckless disregard” of the truth. Public figures, such as CEOs of the
largest US banks, must also be prepared to withstand accusations that are false. In any
defamation action, truth is a defense, but a defamation action brought by a public figure or
public official must prove that the defendant not only has his facts wrong but also lies to the
public in a malicious way with reckless disregard of the truth. Celebrities such as Lindsay Lohan
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
Saylor URL: http://www.saylor.org/books

Saylor.org
150

celebrities; it is possible to say many things that aren’t completely true and still have the
protection of the First Amendment.
Political speech is so highly protected that the court has recognized the right of people to
support political candidates through campaign contributions and thus promote the particular
viewpoints and speech of those candidates. Fearing the influence of money on politics, Congress
has from time to time placed limitations on corporate contributions to political campaigns. But
the Supreme Court has had mixed reactions over time. Initially, the court recognized the First
Amendment right of a corporation to donate money, subject to certain limits. [2] In another
case, Austin v. Michigan Chamber of Commerce (1990), the Michigan Campaign Finance Act
prohibited corporations from using treasury money for independent expenditures to support or
oppose candidates in elections for state offices. But a corporation could make such expenditures
if it set up an independent fund designated solely for political purposes. The law was passed on
the assumption that “the unique legal and economic characteristics of corporations necessitate
some regulation of their political expenditures to avoid corruption or the appearance of
corruption.”
The Michigan Chamber of Commerce wanted to support a candidate for Michigan’s House of
Representatives by using general funds to sponsor a newspaper advertisement and argued that
as a nonprofit organization, it was not really like a business firm. The court disagreed and
upheld the Michigan law. Justice Marshall found that the chamber was akin to a business group,
given its activities, linkages with community business leaders, and high percentage of members
(over 75 percent) that were business corporations. Furthermore, Justice Marshall found that the
statute was narrowly crafted and implemented to achieve the important goal of maintaining
integrity in the political process. But as you will see in Citizens United v. Federal Election
Commission(Section 4.6 "Cases"), Austin was overruled; corporations are recognized as
“persons” with First Amendment political speech rights that cannot be impaired by Congress or
the states without some compelling governmental interest with restrictions on those rights that
are “narrowly tailored.”

Fourth Amendment

Saylor URL: http://www.saylor.org/books

Saylor.org
151

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

Fifth Amendment

Saylor URL: http://www.saylor.org/books

Saylor.org
152

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

Saylor URL: http://www.saylor.org/books

Saylor.org
153

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

Saylor.org
154

common law, moral philosophy, and deeply rooted traditions of US legal history. The Supreme
Court has stressed that he word libertycannot be defined by a definitive list of rights; rather, it
must be viewed as a rational continuum of freedom through which every aspect of human
behavior is protected from arbitrary impositions and random restraints. In this regard, as the
Supreme Court has observed, the due process clause protects abstract liberty interests, including
the right to personal autonomy, bodily integrity, self-dignity, and self-determination.
These liberty interests often are grouped to form a general right to privacy, which was first
recognized in Griswold v. Connecticut (Section 4.6.1), where the Supreme Court struck down a
state statute forbidding married adults from using, possessing, or distributing contraceptives on
the ground that the law violated the sanctity of the marital relationship. According to Justice
Douglas’s plurality opinion, this penumbra of privacy, though not expressly mentioned in the
Bill of Rights, must be protected to establish a buffer zone or breathing space for those freedoms
that are constitutionally enumerated.
But substantive due process has seen fairly limited use since the 1930s. During the 1990s, the
Supreme Court was asked to recognize a general right to die under the doctrine of substantive
due process. Although the court stopped short of establishing such a far-reaching right, certain
patients may exercise a constitutional liberty to hasten their deaths under a narrow set of
circumstances. In Cruzan v. Missouri Department of Health, the Supreme Court ruled that the
due process clause guarantees the right of competent adults to make advanced directives for the
withdrawal of life-sustaining measures should they become incapacitated by a disability that
leaves them in a persistent vegetative state. [4] Once it has been established by clear and
convincing evidence that a mentally incompetent and persistently vegetative patient made such
a prior directive, a spouse, parent, or other appropriate guardian may seek to terminate any
form of artificial hydration or nutrition.

Fourteenth Amendment: Due Process and Equal Protection Guarantees
The Fourteenth Amendment (1868) requires that states treat citizens of other states with due
process. This can be either an issue of procedural due process (as in Section 3.9 "Cases", Burger
King v. Rudzewicz) or an issue of substantive due process. For substantive due process, consider
what happened in an Alabama court not too long ago. [5]
Saylor URL: http://www.saylor.org/books

Saylor.org
155

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

Saylor.org
156

outcome of any equal protection case can usually be predicted by knowing how the court is likely
to classify the case:
•

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

•

Intermediate scrutiny: gender. Government classifications are sometimes upheld.

•

Strict scrutiny: race, ethnicity, and fundamental rights. Classifications based on any of these are
almost never upheld.
Under minimal scrutiny for economic and social regulation, laws that regulate economic or
social issues are presumed valid and will be upheld if they are rationally related to legitimate
goals of government. So, for example, if the city of New Orleans limits the number of street
vendors to some rational number (more than one but fewer than the total number that could
possibly fit on the sidewalks), the local ordinance would not be overturned as a violation of
equal protection.
Under intermediate scrutiny, the city of New Orleans might limit the number of street vendors
who are men. For example, suppose that the city council decreed that all street vendors must be
women, thinking that would attract even more tourism. A classification like this, based on sex,
will have to meet a sterner test than a classification resulting from economic or social regulation.
A law like this would have to substantially relate to important government objectives.
Increasingly, courts have nullified government sex classifications as societal concern with
gender equality has grown. (See Shannon Faulkner’s case against The Citadel, an all-male state
school.)[7]
Suppose, however, that the city of New Orleans decided that no one of Middle Eastern heritage
could drive a taxicab or be a street vendor. That kind of classification would be examined with
strict scrutiny to see if there was any compelling justification for it. As noted, classifications such
as this one are almost never upheld. The law would be upheld only if it were necessary to
promote a compelling state interest. Very few laws that have a racial or ethnic classification meet
that test.
The strict scrutiny test will be applied to classifications involving racial and ethnic criteria as
well as classifications that interfere with a fundamental right. In Palmore v. Sidoti, the state
Saylor URL: http://www.saylor.org/books

Saylor.org
157

refused to award custody to the mother because her new spouse was racially different from the
child. [8]This practice was declared unconstitutional because the state had made a racial
classification; this was presumptively invalid, and the government could not show a compelling
need to enforce such a classification through its law. An example of government action
interfering with a fundamental right will also receive strict scrutiny. When New York State gave
an employment preference to veterans who had been state residents at the time of entering the
military, the court declared that veterans who were new to the state were less likely to get jobs
and that therefore the statute interfered with the right to travel, which was deemed a
fundamental right. [9]

KEY TAKEAWAY

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

EXERCISES

1. John Hanks works at ProLogis. The company decides to institute a drug-testing policy. John is
a good and longtime employee but enjoys smoking marijuana on the weekends. The drug
testing will involve urine samples and, semiannually, a hair sample. It is nearly certain that
the drug-testing protocol that ProLogis proposes will find that Hanks is a marijuana user. The
company has made it clear that it will have zero tolerance for any kind of nonprescribed
controlled substances. John and several fellow employees wish to go to court to challenge
the proposed testing as “an unreasonable search and seizure.” Can he possibly succeed?
2. Larry Reed, majority leader in the Senate, is attacked in his reelection campaign by a series of
ads sponsored by a corporation (Global Defense, Inc.) that does not like his voting record.
The corporation is upset that Reed would not write a special provision that would favor
Global Defense in a defense appropriations bill. The ads run constantly on television and
radio in the weeks immediately preceding election day and contain numerous falsehoods.
For example, in order to keep the government running financially, Reed found it necessary to
vote for a bill that included a last-minute rider that defunded a small government program
Saylor URL: http://www.saylor.org/books

Saylor.org
158

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

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

4.6 Cases
Griswold v. Connecticut
Griswold v. Connecticut
381 U.S. 479 (U.S. Supreme Court 1965)
A nineteenth-century Connecticut law made the use, possession, or distribution of birth control
devices illegal. The law also prohibited anyone from giving information about such devices.
The executive director and medical director of a planned parenthood association were found
guilty of giving out such information to a married couple that wished to delay having children
for a few years. The directors were fined $100 each.

Saylor URL: http://www.saylor.org/books

Saylor.org
159

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
Saylor URL: http://www.saylor.org/books

Saylor.org
160

precincts of marital bedrooms for telltale signs of the use of contraceptives? The very idea is
repulsive to the notions of privacy surrounding the marital relationship.
We deal with a right of privacy older than the Bill of Rights—older than our political parties,
older than our school system. Marriage is a coming together for better or for worse, hopefully
enduring, and intimate to the degree of being sacred. It is an association that promotes a way of
life, not causes; a harmony in living, not political faiths; a bilateral loyalty, not commercial or
social projects. Yet it is an association for as noble a purpose as any involved in our prior
decisions.
Mr. Justice Stewart, whom Mr. Justice Black joins, dissenting.
Since 1879 Connecticut has had on its books a law which forbids the use of contraceptives by
anyone. I think this is an uncommonly silly law. As a practical matter, the law is obviously
unenforceable, except in the oblique context of the present case. As a philosophical matter, I
believe the use of contraceptives in the relationship of marriage should be left to personal and
private choice, based upon each individual’s moral, ethical, and religious beliefs. As a matter of
social policy, I think professional counsel about methods of birth control should be available to
all, so that each individual’s choice can be meaningfully made. But we are not asked in this case
to say whether we think this law is unwise, or even asinine. We are asked to hold that it violates
the United States Constitution. And that I cannot do.
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
Saylor URL: http://www.saylor.org/books

Saylor.org
161

has been quartered in any house. There has been no search, and no seizure. Nobody has been
compelled to be a witness against himself.
The Court also quotes the Ninth Amendment, and my Brother Goldberg’s concurring opinion
relies heavily upon it. But to say that the Ninth Amendment has anything to do with this case is
to turn somersaults with history. The Ninth Amendment, like its companion the Tenth, which
this Court held “states but a truism that all is retained which has not been surrendered,” United
States v. Darby, 312 U.S. 100, 124, was framed by James Madison and adopted by the States
simply to make clear that the adoption of the Bill of Rights did not alter the plan that
the Federal Government was to be a government of express and limited powers, and that all
rights and powers not delegated to it were retained by the people and the individual States. Until
today no member of this Court has ever suggested that the Ninth Amendment meant anything
else, and the idea that a federal court could ever use the Ninth Amendment to annul a law
passed by the elected representatives of the people of the State of Connecticut would have
caused James Madison no little wonder.
What provision of the Constitution, then, does make this state law invalid? The Court says it is
the right of privacy “created by several fundamental constitutional guarantees.” With all
deference, I can find no such general right of privacy in the Bill of Rights, in any other part of the
Constitution, or in any case ever before decided by this Court.
At the oral argument in this case we were told that the Connecticut law does not “conform to
current community standards.” But it is not the function of this Court to decide cases on the
basis of community standards. We are here to decide cases “agreeably to the Constitution and
laws of the United States.” It is the essence of judicial duty to subordinate our own personal
views, our own ideas of what legislation is wise and what is not. If, as I should surely hope, the
law before us does not reflect the standards of the people of Connecticut, the people of
Connecticut can freely exercise their true Ninth and Tenth Amendment rights to persuade their
elected representatives to repeal it. That is the constitutional way to take this law off the books.

CASE QUESTIONS

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

Saylor URL: http://www.saylor.org/books

Saylor.org
162

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

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

Saylor URL: http://www.saylor.org/books

Saylor.org
163

extends federal regulation to production not intended in any part for commerce but wholly for
consumption on the farm.

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

I
Appellee Consolidated Freightways Corporation of Delaware (Consolidated) is one of the largest
common carriers in the country: it offers service in 48 States under a certificate of public
convenience and necessity issued by the Interstate Commerce Commission. Among other routes,
Consolidated carries commodities through Iowa on Interstate 80, the principal east-west route
linking New York, Chicago, and the west coast, and on Interstate 35, a major north-south route.
Consolidated mainly uses two kinds of trucks. One consists of a three-axle tractor pulling a 40foot two-axle trailer. This unit, commonly called a single, or “semi,” is 55 feet in length overall.
Such trucks have long been used on the Nation’s highways. Consolidated also uses a two-axle
tractor pulling a single-axle trailer which, in turn, pulls a single-axle dolly and a second singleaxle trailer. This combination, known as a double, or twin, is 65 feet long overall. Many trucking
companies, including Consolidated, increasingly prefer to use doubles to ship certain kinds of
commodities. Doubles have larger capacities, and the trailers can be detached and routed
separately if necessary. Consolidated would like to use 65-foot doubles on many of its trips
through Iowa.
The State of Iowa, however, by statute, restricts the length of vehicles that may use its highways.
Unlike all other States in the West and Midwest, Iowa generally prohibits the use of 65-foot
doubles within its borders.
…

Saylor URL: http://www.saylor.org/books

Saylor.org
164

Because of Iowa’s statutory scheme, Consolidated cannot use its 65-foot doubles to move
commodities through the State. Instead, the company must do one of four things: (i) use 55-foot
singles; (ii) use 60-foot doubles; (iii) detach the trailers of a 65-foot double and shuttle each
through the State separately; or (iv) divert 65-foot doubles around Iowa. Dissatisfied with these
options, Consolidated filed this suit in the District Court averring that Iowa’s statutory scheme
unconstitutionally burdens interstate commerce. Iowa defended the law as a reasonable safety
measure enacted pursuant to its police power. The State asserted that 65-foot doubles are more
dangerous than 55-foot singles and, in any event, that the law promotes safety and reduces road
wear within the State by diverting much truck traffic to other states.
In a 14-day trial, both sides adduced evidence on safety and on the burden on interstate
commerce imposed by Iowa’s law. On the question of safety, the District Court found that the
“evidence clearly establishes that the twin is as safe as the semi.” 475 F.Supp. 544, 549 (SD Iowa
1979). For that reason, “there is no valid safety reason for barring twins from Iowa’s highways
because of their configuration.…The evidence convincingly, if not overwhelmingly, establishes
that the 65-foot twin is as safe as, if not safer than, the 60-foot twin and the 55-foot semi.…”
“Twins and semis have different characteristics. Twins are more maneuverable, are less sensitive
to wind, and create less splash and spray. However, they are more likely than semis to jackknife
or upset. They can be backed only for a short distance. The negative characteristics are not such
that they render the twin less safe than semis overall. Semis are more stable, but are more likely
to ‘rear-end’ another vehicle.”
In light of these findings, the District Court applied the standard we enunciated inRaymond
Motor Transportation, Inc. v. Rice, 434 U.S. 429 (1978), and concluded that the state law
impermissibly burdened interstate commerce: “[T]he balance here must be struck in favor of the
federal interests. The total effect of the law as a safety measure in reducing accidents and
casualties is so slight and problematical that it does not outweigh the national interest in
keeping interstate commerce free from interferences that seriously impede it.”
The Court of Appeals for the Eighth Circuit affirmed. 612 F.2d 1064 (1979). It accepted the
District Court’s finding that 65-foot doubles were as safe as 55-foot singles. Id. at 1069. Thus,
the only apparent safety benefit to Iowa was that resulting from forcing large trucks to detour
Saylor URL: http://www.saylor.org/books

Saylor.org
165

around the State, thereby reducing overall truck traffic on Iowa’s highways. The Court of
Appeals noted that this was not a constitutionally permissible interest. It also commented that
the several statutory exemptions identified above, such as those applicable to border cities and
the shipment of livestock, suggested that the law, in effect, benefited Iowa residents at the
expense of interstate traffic. Id. at 1070-1071. The combination of these exemptions weakened
the presumption of validity normally accorded a state safety regulation. For these reasons, the
Court of Appeals agreed with the District Court that the Iowa statute unconstitutionally
burdened interstate commerce.
Iowa appealed, and we noted probable jurisdiction. 446 U.S. 950 (1980). We now affirm.

II
It is unnecessary to review in detail the evolution of the principles of Commerce Clause
adjudication. The Clause is both a “prolific ‘ of national power and an equally prolific source of
conflict with legislation of the 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.
Saylor URL: http://www.saylor.org/books

Saylor.org
166

For example, regulations that touch upon safety—especially highway safety—are those that “the
Court has been most reluctant to invalidate.” Raymond, supra at 434 U.S. 443 (and other cases
cited). Indeed, “if safety justifications are not illusory, the Court will not second-guess legislative
judgment about their importance in comparison with related burdens on interstate
commerce.”Raymond, supra at 434 U.S. at 449. Those who would challenge such bona fide
safety regulations must overcome a “strong presumption of validity.” Bibb v. Navajo Freight
Lines, Inc., 359 U.S. 520 at (1959).
But the incantation of a purpose to promote the public health or safety does not insulate a state
law from Commerce Clause attack. Regulations designed for that salutary purpose nevertheless
may further the purpose so marginally, and interfere with commerce so substantially, as to be
invalid under the Commerce Clause. In the Court’s recent unanimous decision in Raymond we
declined to “accept the State’s contention that the inquiry under the Commerce Clause is ended
without a weighing of the asserted safety purpose against the degree of interference with
interstate commerce.” This “weighing” by a court requires—and indeed the constitutionality of
the state regulation depends on—“a sensitive consideration of the weight and nature of the state
regulatory concern in light of the extent of the burden imposed on the course of interstate
commerce.” Id. at 434 U.S. at 441; accord, Pike v. Bruce Church, Inc., 397 U.S. 137 at 142
(1970); Bibb, supra, at 359 U.S. at 525-530.

III
Applying these general principles, we conclude that the Iowa truck length limitations
unconstitutionally burden interstate commerce.
In Raymond Motor Transportation, Inc. v. Rice, the Court held that a Wisconsin statute that
precluded the use of 65-foot doubles violated the Commerce Clause. This case
is Raymond revisited. Here, as in Raymond, the State failed to present any persuasive evidence
that 65-foot doubles are less safe than 55-foot singles. Moreover, Iowa’s law is now out of step
with the laws of all other Midwestern and Western States. Iowa thus substantially burdens the
interstate flow of goods by truck. In the absence of congressional action to set uniform
standards, some burdens associated with state safety regulations must be tolerated. But where,
as here, the State’s safety interest has been found to be illusory, and its regulations impair
Saylor URL: http://www.saylor.org/books

Saylor.org
167

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 “offtracking,” and to wind.
None of these findings is seriously disputed by Iowa. Indeed, the State points to only three ways
in which the 55-foot single is even arguably superior: singles take less time to be passed and to
clear intersections; they may back up for longer distances; and they are somewhat less likely to
jackknife.
The first two of these characteristics are of limited relevance on modern interstate highways. As
the District Court found, the negligible difference in the time required to pass, and to cross
intersections, is insignificant on 4-lane divided highways, because passing does not require
crossing into oncoming traffic lanes, Raymond, 434 U.S. at 444, and interstates have few, if any,
intersections. The concern over backing capability also is insignificant, because it seldom is
necessary to back up on an interstate. In any event, no evidence suggested any difference in
backing capability between the 60-foot doubles that Iowa permits and the 65-foot doubles that it
bans. Similarly, although doubles tend to jackknife somewhat more than singles, 65-foot
doubles actually are less likely to jackknife than 60-foot doubles.
Statistical studies supported the view that 65-foot doubles are at least as safe overall as 55-foot
singles and 60-foot doubles. One such study, which the District Court credited, reviewed
Consolidated’s comparative accident experience in 1978 with its own singles and doubles. Each
kind of truck was driven 56 million miles on identical routes. The singles were involved in 100
Saylor URL: http://www.saylor.org/books

Saylor.org
168

accidents resulting in 27 injuries and one fatality. The 65-foot doubles were involved in 106
accidents resulting in 17 injuries and one fatality. Iowa’s expert statistician admitted that this
study provided “moderately strong evidence” that singles have a higher injury rate than doubles.
Another study, prepared by the Iowa Department of Transportation at the request of the state
legislature, concluded that “[s]ixty-five foot twin trailer combinations have not been shown by
experiences in other states to be less safe than 60-foot twin trailer combinations orconventional
tractor-semitrailers.”
In sum, although Iowa introduced more evidence on the question of safety than did Wisconsin
in Raymond, the record as a whole was not more favorable to the State.

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

[IV. Omitted]
V
Saylor URL: http://www.saylor.org/books

Saylor.org
169

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?
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

Saylor URL: http://www.saylor.org/books

Saylor.org
170

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 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].
Saylor URL: http://www.saylor.org/books

Saylor.org
171

…
[North Carolina] maintains that [the] burdens on the interstate sale of Washington apples were
far outweighed by the local benefits flowing from what they contend was a valid exercise of
North Carolina’s [police powers]. Prior to the statute’s enactment,…apples from 13 different
States were shipped into North Carolina for sale. Seven of those States, including [Washington],
had their own grading systems which, while differing in their standards, used similar descriptive
labels (e.g., fancy, extra fancy, etc.). This multiplicity of inconsistent state grades [posed]
dangers of deception and confusion not only in the North Carolina market, but in the Nation as
a whole. The North Carolina statute, appellants claim, was enacted to eliminate this source of
deception and confusion. [Moreover], it is contended that North Carolina sought to accomplish
this goal of uniformity in an evenhanded manner as evidenced by the fact that its statute applies
to all apples sold in closed containers in the State without regard to their point of origin.
[As] the appellants properly point out, not every exercise of state authority imposing some
burden on the free flow of commerce is invalid, [especially] when the State acts to protect its
citizenry in matters pertaining to the sale of foodstuffs. By the same token, however, a finding
that state legislation furthers matters of legitimate local concern, even in the health and
consumer protection areas, does not end the inquiry. Rather, when such state legislation comes
into conflict with the Commerce Clause’s overriding requirement of a national “common
market,” we are confronted with the task of effecting an accommodation of the competing
national and local interests. We turn to that task.
As the District Court correctly found, the challenged statute has the practical effect of not only
burdening interstate sales of Washington apples, but also discriminating against them. This
discrimination takes various forms. The first, and most obvious, is the statute’s consequence of
raising the costs of doing business in the North Carolina market for Washington apple growers
and dealers, while leaving those of their North Carolina counterparts unaffected. [This]
disparate effect results from the fact that North Carolina apple producers, unlike their
Washington competitors, were not forced to alter their marketing practices in order to comply
with the statute. They were still free to market their wares under the USDA grade or none at all
as they had done prior to the statute’s enactment. Obviously, the increased costs imposed by the
Saylor URL: http://www.saylor.org/books

Saylor.org
172

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 the statute’s operation, Washington apples
which would otherwise qualify for and be sold under the superior Washington grades will now
have to be marketed under their inferior USDA counterparts. Such “downgrading” offers the
North Carolina apple industry the very sort of protection against competing out-of-state
products that the Commerce Clause was designed to prohibit. At worst, it will have the effect of
an embargo against those Washington apples in the superior grades as Washington dealers
withhold them from the North Carolina market. At best, it will deprive Washington sellers of the
market premium that such apples would otherwise command.
Despite the statute’s facial neutrality, the Commission suggests that its discriminatory impact on
interstate commerce was not an unintended by-product, and there are some indications in the
record to that effect. The most glaring is the response of the North Carolina Agriculture
Commissioner to the Commission’s request for an exemption following the statute’s passage in
which he indicated that before he could support such an exemption, he would “want to have the
sentiment from our apple producers since they were mainly responsible for this legislation
Saylor URL: http://www.saylor.org/books

Saylor.org
173

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 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.

Saylor URL: http://www.saylor.org/books

Saylor.org
174

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

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

Saylor.org
175

Website address. Citizens United desired to promote the video-on-demand offering by running
advertisements on broadcast and cable television.

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

C
Citizens United wanted to make Hillary available through video-on-demand within 30 days of
the 2008 primary elections. It feared, however, that both the film and the ads would be covered
by §441b’s ban on corporate-funded independent expenditures, thus subjecting the corporation
to civil and criminal penalties under §437g. In December 2007, Citizens United sought
declaratory and injunctive relief against the FEC. It argued that (1) §441b is unconstitutional as
applied to Hillary; and (2) BCRA’s disclaimer and disclosure requirements, BCRA §§201 and
311, are unconstitutional as applied to Hillary and to the three ads for the movie.
Saylor URL: http://www.saylor.org/books

Saylor.org
176

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

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

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

Saylor.org
177

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

Saylor.org
178

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

Saylor.org
179

attempts by Congress to seek to dispel either the appearance or the reality of these influences.
The remedies enacted by law, however, must comply with the First Amendment; and, it is our
law and our tradition that more speech, not less, is the governing rule. An outright ban on
corporate political speech during the critical preelection period is not a permissible remedy.
Here Congress has created categorical bans on speech that are asymmetrical to preventing quid
pro quocorruption.
Our precedent is to be respected unless the most convincing of reasons demonstrates that
adherence to it puts us on a course that is sure error. “Beyond workability, the relevant factors in
deciding whether to adhere to the principle of stare decisis include the antiquity of the
precedent, the reliance interests at stake, and of course whether the decision was well reasoned.”
[citing prior cases]
These considerations counsel in favor of rejecting Austin, which itself contravened this Court’s
earlier precedents in Buckley and Bellotti. “This Court has not hesitated to overrule decisions
offensive to the First Amendment.” WRTL, 551 U.S., at 500 (opinion of Scalia, J.). “[S]tare
decisis is a principle of policy and not a mechanical formula of adherence to the latest
decision.” Helvering v. Hallock, 309 U.S. 106 at 119 (1940).
Austin is undermined by experience since its announcement. Political speech is so ingrained in
our culture that speakers find ways to circumvent campaign finance laws. See, e.g., McConnell,
540 U.S., at 176–177 (“Given BCRA’s tighter restrictions on the raising and spending of soft
money, the incentives…to exploit [26 U.S.C. §527] organizations will only increase”). Our
Nation’s speech dynamic is changing, and informative voices should not have to circumvent
onerous restrictions to exercise their First Amendment rights. Speakers have become adept at
presenting citizens with sound bites, talking points, and scripted messages that dominate the
24-hour news cycle. Corporations, like individuals, do not have monolithic views. On certain
topics corporations may possess valuable expertise, leaving them the best equipped to point out
errors or fallacies in speech of all sorts, including the speech of candidates and elected officials.
Rapid changes in technology—and the creative dynamic inherent in the concept of free
expression—counsel against upholding a law that restricts political speech in certain media or by
certain speakers. Today, 30-second television ads may be the most effective way to convey a
Saylor URL: http://www.saylor.org/books

Saylor.org
180

political message. Soon, however, it may be that Internet sources, such as blogs and social
networking Web sites, will provide citizens with significant information about political
candidates and issues. Yet, §441b would seem to ban a blog post expressly advocating the
election or defeat of a candidate if that blog were created with corporate funds. The First
Amendment does not permit Congress to make these categorical distinctions based on the
corporate identity of the speaker and the content of the political speech.
Due consideration leads to this conclusion: Austin should be and now is overruled. We return to
the principle established in Buckley and Bellotti that the Government may not suppress political
speech on the basis of the speaker’s corporate identity. No sufficient governmental interest
justifies limits on the political speech of nonprofit or for-profit corporations.

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

Saylor URL: http://www.saylor.org/books

Saylor.org
181

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

CASE QUESTIONS

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

4.7 Summary and Exercises
Saylor URL: http://www.saylor.org/books

Saylor.org
182

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

EXERCISES

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

Saylor URL: http://www.saylor.org/books

Saylor.org
183

covering more than 30 percent of a store’s windows with signs. Salib sued,
claiming that the sign code violated his First Amendment rights. What was the
result, and why?
2. Jennifer is a freshman at her local public high school. Her sister, Jackie, attends a nearby
private high school. Neither school allows them to join its respective wrestling team; only
boys can wrestle at either school. Do either of them have a winning case based on the equal
protection clause of the Fourteenth Amendment?
3. The employees of the US Treasury Department that work the border crossing between the
United States and Mexico learned that they will be subject to routine drug testing. The
customs bureau, which is a division of the treasury department, announces this policy along
with its reasoning: since customs agents must routinely search for drugs coming into the
United States, it makes sense that border guards must themselves be completely drug-free.
Many border guards do not use drugs, have no intention of using drugs, and object to the
invasion of their privacy. What is the constitutional basis for their objection?
4. Happy Time Chevrolet employs Jim Bydalek as a salesman. Bydalek takes part in a Gay Pride
March in Los Angeles, is interviewed by a local news camera crew, and reports that he is gay
and proud of it. His employer is not, and he is fired. Does he have any constitutional causes
of action against his employer?
5. You begin work at the Happy-Go-Lucky Corporation on Halloween. On your second day at
work, you wear a political button on your coat, supporting your choice for US senator in the
upcoming election. Your boss, who is of a different political persuasion, looks at the button
and says, “Take that stupid button off or you’re fired.” Has your boss violated your
constitutional rights?
6. David Lucas paid $975,000 for two residential parcels on the Isle of Palms near Charleston,
South Carolina. His intention was to build houses on them. Two years later, the South
Carolina legislature passed a statute that prohibited building beachfront properties. The
purpose was to leave the dunes system in place to mitigate the effects of hurricanes and
strong storms. The South Carolina Coastal Commission created the rules and regulations with
substantial input from the community and from experts and with protection of the dune
Saylor URL: http://www.saylor.org/books

Saylor.org
184

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

SELF-TEST QUESTIONS

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

places an undue burden on interstate commerce

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

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

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

Saylor URL: http://www.saylor.org/books

Saylor.org
185

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

the supremacy clause

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

a violation of the Tenth Amendment

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

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

convicted.
b. The materials in Raleigh may be the basis for a criminal conviction.
c. The materials are protected under the First Amendment’s right of free speech.
Saylor URL: http://www.saylor.org/books

Saylor.org
186

d. The materials are protected under state law.
e. a and b

SELF-TEST ANSWERS

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

Chapter 5
Administrative Law
LEARNING OBJECTIVES

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

5.1 Administrative Agencies: Their Structure and Powers
LEARNING OBJECTIVES

Saylor URL: http://www.saylor.org/books

Saylor.org
187

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

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

Why Regulate the Economy at All?
The market often does not work properly, as economists often note. Monopolies, for example,
happen in the natural course of human events but are not always desirable. To fix this, wellconceived and objectively enforced competition law (what is called antitrust law in the United
States) is needed.
Negative externalities must be “fixed,” as well. For example, as we see in tort law (Chapter 7
"Introduction to Tort Law"), people and business organizations often do things that impose
costs (damages) on others, and the legal system will try—through the award of compensatory
damages—to make fair adjustments. In terms of the ideal conditions for a free market, think of
tort law as the legal system’s attempt to compensate for negative externalities: those costs
imposed on people who have not voluntarily consented to bear those costs.
Saylor URL: http://www.saylor.org/books

Saylor.org
188

In terms of freedoms to enter or leave the market, the US constitutional guarantees of equal
protection can prevent local, state, and federal governments from imposing discriminatory rules
for commerce that would keep minorities, women, and gay people from full participation in
business. For example, if the small town of Xenophobia, Colorado, passed a law that required all
business owners and their employees to be Christian, heterosexual, and married, the equal
protection clause (as well as numerous state and federal equal opportunity employment laws)
would empower plaintiffs to go to court and have the law struck down as unconstitutional.
Knowing that information is power, we will see many laws administered by regulatory agencies
that seek to level the playing field of economic competition by requiring disclosure of the most
pertinent information for consumers (consumer protection laws), investors (securities laws),
and citizens (e.g., the toxics release inventory laws in environmental law).

Ideal Conditions for a Free Market

1. There are many buyers and many sellers, and none of them has a substantial share of the
market.
2. All buyers and sellers in the market are free to enter the market or leave it.
3. All buyers and all sellers have full and perfect knowledge of what other buyers and sellers are up
to, including knowledge of prices, quantity, and quality of all goods being bought or sold.
4. The goods being sold in the market are similar enough to each other that participants do not
have strong preferences as to which seller or buyer they deal with.
5. The costs and benefits of making or using the goods that are exchanged in the market are borne
only by those who buy or sell those goods and not by third parties or people “external” to the
market transaction. (That is, there are no “externalities.”)
6. All buyers and sellers are utility maximizers; each participant in the market tries to get as much
as possible for as little as possible.
7. There are no parties, institutions, or governmental units regulating the price, quantity, or
quality of any of the goods being bought and sold in the market.
In short, some forms of legislation and regulation are needed to counter a tendency toward
consolidation of economic power (Chapter 23 "Antitrust Law") and discriminatory attitudes

Saylor URL: http://www.saylor.org/books

Saylor.org
189

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

Saylor.org
190

objectives are met by giving individuals statutory rights that can be used in bringing a complaint
(e.g., Title VII of the Civil Rights Act of 1964, for employment discrimination), and sometimes
they are met by creating agencies with the right to investigate and monitor and enforce statutory
law and regulations created to enforce such law (e.g., the Environmental Protection Agency, for
bringing a lawsuit against a polluting company).

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

Classification of Agencies
Independent agencies are different from federal executive departments and other executive
agencies by their structural and functional characteristics. Most executive departments have a
single director, administrator, or secretary appointed by the president of the United States.
Independent agencies almost always have a commission or board consisting of five to seven
members who share power over the agency. The president appoints the commissioners or board
subject to Senate confirmation, but they often serve with staggered terms and often for longer
terms than a usual four-year presidential term. They cannot be removed except for “good cause.”
Saylor URL: http://www.saylor.org/books

Saylor.org
191

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
Saylor URL: http://www.saylor.org/books

Saylor.org
192

society growing ever more complex, Congress does not know how to legislate with the kind of
detail that is necessary, nor would it have the time to approach all the sectors of society even if it
tried. Precisely because they are to do what general legislative bodies cannot do, agencies are
specialized bodies. Through years of experience in dealing with similar problems they
accumulate a body of knowledge that they can apply to accomplish their statutory duties.
All administrative agencies have two different sorts of personnel. The heads, whether a single
administrator or a collegial body of commissioners, are political appointees and serve for
relatively limited terms. Below them is a more or less permanent staff—the bureaucracy. Much
policy making occurs at the staff level, because these employees are in essential control of
gathering facts and presenting data and argument to the commissioners, who wield the ultimate
power of the agencies.

The Constitution and Agencies
Congress can establish an agency through legislation. When Congress gives powers to an agency,
the legislation is known as an enabling act. The concept that Congress can delegate power to an
agency is known as the delegation doctrine. Usually, the agency will have all three kinds of
power: executive, legislative, and judicial. (That is, the agency can set the rules that business
must comply with, can investigate and prosecute those businesses, and can hold administrative
hearings for violations of those rules. They are, in effect, rule maker, prosecutor, and judge.)
Because agencies have all three types of governmental powers, important constitutional
questions were asked when Congress first created them. The most important question was
whether Congress was giving away its legislative power. Was the separation of powers violated if
agencies had power to make rules that were equivalent to legislative statutes?
In 1935, in Schechter Poultry Corp. v. United States, the Supreme Court overturned the
National Industrial Recovery Act on the ground that the congressional delegation of power was
too broad. [1] Under the law, industry trade groups were granted the authority to devise a code of
fair competition for the entire industry, and these codes became law if approved by the
president. No administrative body was created to scrutinize the arguments for a particular code,
to develop evidence, or to test one version of a code against another. Thus it was
unconstitutional for the Congress to transfer all of its legislative powers to an agency. In later
Saylor URL: http://www.saylor.org/books

Saylor.org
193

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

KEY TAKEAWAY

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

EXERCISES

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

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

5.2 Controlling Administrative Agencies
LEARNING OBJECTIVES

1. Understand how the president controls administrative agencies.
2. Understand how Congress controls administrative agencies.
3. Understand how the courts can control administrative agencies.
During the course of the past seventy years, a substantial debate has been conducted, often in
shrill terms, about the legitimacy of administrative lawmaking. One criticism is that agencies are
“captured” by the industry they are directed to regulate. Another is that they overregulate,
Saylor URL: http://www.saylor.org/books

Saylor.org
194

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

Figure 5.1 Major Administrative Agencies of the United States

Saylor URL: http://www.saylor.org/books

Saylor.org
195

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

Executive Control
The president (or a governor, for state agencies) can exercise considerable control over agencies
that are part of his cabinet departments and that are not statutorily defined as independent.
Federal agencies, moreover, are subject to the fiscal scrutiny of the Office of Management and
Budget (OMB), subject to the direct control of the president. Agencies are not permitted to go
directly to Congress for increases in budget; these requests must be submitted through the
Saylor URL: http://www.saylor.org/books

Saylor.org
196

OMB, giving the president indirect leverage over the continuation of administrators’ programs
and policies.

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

KEY TAKEAWAY

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

EXERCISES

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

5.3 The Administrative Procedure Act
LEARNING OBJECTIVES

1. Understand why the Administrative Procedure Act was needed.
2. Understand how hearings are conducted under the act.
3. Understand how the act affects rulemaking by agencies.
Saylor URL: http://www.saylor.org/books

Saylor.org
197

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

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

Saylor.org
198

airplanes) can be made on the spot by skilled inspectors. Certain licenses can be administered
through tests without a hearing (a test for a driver’s license), and some decisions can be made by
election of those affected (labor union elections).

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

Saylor.org
199

multivolume paperback series containing all federal rules and regulations keyed to the fifty titles
of the US Code (the compilation of all federal statutes enacted by Congress and grouped
according to subject).

KEY TAKEAWAY

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

EXERCISES

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

5.4 Administrative Burdens on Business Operations
LEARNING OBJECTIVES

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

The Paperwork Burden
The administrative process is not frictionless. The interplay between government agency and
private enterprise can burden business operations in a number of ways. Several of these are
noted in this section.
Deciding whether and how to act are not decisions that government agencies reach out of the
blue. They rely heavily on information garnered from business itself. Dozens of federal agencies
require corporations to keep hundreds of types of records and to file numerous periodic reports.
The Commission on Federal Paperwork, established during the Ford administration to consider
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

Saylor URL: http://www.saylor.org/books

Saylor.org
200

enterprises spent $10 billion annually on paperwork alone. The paperwork involved in licensing
a single nuclear power plant, the commission said, costs upward of $15 million.
Not surprisingly, therefore, businesses have sought ways of avoiding requests for data. Since the
1940s, the Federal Trade Commission (FTC) has collected economic data on corporate
performance from individual companies for statistical purposes. As long as each company
engages in a single line of business, data are comparable. When the era of conglomerates began
in the 1970s, with widely divergent types of businesses brought together under the roof of a
single corporate parent, the data became useless for purposes of examining the competitive
behavior of different industries. So the FTC ordered dozens of large companies to break out their
economic information according to each line of business that they carried on. The companies
resisted, but the US Court of Appeals for the District of Columbia Circuit, where much of the
litigation over federal administrative action is decided, directed the companies to comply with
the commission’s order, holding that the Federal Trade Commission Act clearly permits the
agency to collect information for investigatory purposes. [1]
In 1980, responding to cries that businesses, individuals, and state and local governments were
being swamped by federal demands for paperwork, Congress enacted the Paperwork Reduction
Act. It gives power to the federal Office of Management and Budget (OMB) to develop uniform
policies for coordinating the gathering, storage, and transmission of all the millions of reports
flowing in each year to the scores of federal departments and agencies requesting information.
These reports include tax and Medicare forms, financial loan and job applications,
questionnaires of all sorts, compliance reports, and tax and business records. The OMB was
given the power also to determine whether new kinds of information are needed. In effect, any
agency that wants to collect new information from outside must obtain the OMB’s approval.

Inspections
No one likes surprise inspections. A section of the Occupational Safety and Health Act of 1970
empowers agents of the Occupational Safety and Health Administration (OSHA) to search work
areas for safety hazards and for violations of OSHA regulations. The act does not specify
whether inspectors are required to obtain search warrants, required under the Fourth
Amendment in criminal cases. For many years, the government insisted that surprise
Saylor URL: http://www.saylor.org/books

Saylor.org
201

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

Access to Business Information in Government Files
In 1966, Congress enacted the Freedom of Information Act (FOIA), opening up to the citizenry
many of the files of the government. (The act was amended in 1974 and again in 1976 to
overcome a tendency of many agencies to stall or refuse access to their files.) Under the FOIA,
any person has a legally enforceable right of access to all government documents, with nine
specific exceptions, such as classified military intelligence, medical files, and trade secrets and
commercial or financial information if “obtained from a person and privileged or confidential.”
Without the trade-secret and financial-information exemptions, business competitors could,
merely by requesting it, obtain highly sensitive competitive information sitting in government
files.
Saylor URL: http://www.saylor.org/books

Saylor.org
202

A federal agency is required under the FOIA to respond to a document request within ten days.
But in practice, months or even years may pass before the government actually responds to an
FOIA request. Requesters must also pay the cost of locating and copying the records. Moreover,
not all documents are available for public inspection. Along with the trade-secret and financialinformation exemptions, the FOIA specifically exempts the following:
•

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

•

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

•

records exempted from disclosure by another statute

•

interagency memos or decisions reflecting the deliberative process

•

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

•

information compiled for law enforcement purposes

•

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

KEY TAKEAWAY

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

Saylor URL: http://www.saylor.org/books

Saylor.org
203

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

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

5.5 The Scope of Judicial Review

LEARNING OBJECTIVES

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

Exhaustion of Administrative Remedies
Before you can complain to court about an agency’s action, you must first try to get the agency to
reconsider its action. Generally, you must have asked for a hearing at the hearing examiner
level, there must have been a decision reached that was unfavorable to you, and you must have
appealed the decision to the full board. The full board must rule against you, and only then will
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,
Saylor URL: http://www.saylor.org/books

Saylor.org
204

or if great harm would happen should the rule or regulation continue to apply. Also, if the
agency is not acting in good faith, the courts will hear an appeal without exhaustion.

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

not in accordance with the agency’s scope of authority

•

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

•

not in accordance with the substantial evidence test

•

unwarranted by the facts
Saylor URL: http://www.saylor.org/books

Saylor.org
205

•

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

Suing the Government
In the modern administrative state, the range of government activity is immense, and
administrative agencies frequently get in the way of business enterprise. Often, bureaucratic
involvement is wholly legitimate, compelled by law; sometimes, however, agencies or
government officials may overstep their bounds, in a fit of zeal or spite. What recourse does the
private individual or company have?
Mainly for historical reasons, it has always been more difficult to sue the government than to
sue private individuals or corporations. For one thing, the government has long had recourse to
the doctrine of sovereign immunity as a shield against lawsuits. Yet in 1976, Congress amended
the Administrative Procedure Act to waive any federal claim to sovereign immunity in cases of
injunctive or other nonmonetary relief. Earlier, in 1946, in the Federal Tort Claims Act,
Congress had waived sovereign immunity of the federal government for most tort claims for
money damages, although the act contains several exceptions for specific agencies (e.g., one
cannot sue for injuries resulting from fiscal operations of the Treasury Department or for
injuries stemming from activities of the military in wartime). The act also contains a major
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
Saylor URL: http://www.saylor.org/books

Saylor.org
206

against officials whose decision to ship explosive materials by public carrier leads to mass deaths
and injuries following an explosion en route. [2]
In recent years, the Supreme Court has been stripping away the traditional immunity enjoyed by
many government officials against personal suits. Some government employees—judges,
prosecutors, legislators, and the president, for example—have absolute immunity against suit for
official actions. But many public administrators and government employees have at best a
qualified immunity. Under a provision of the Civil Rights Act of 1871 (so-called Section 1983
actions), state officials can be sued in federal court for money damages whenever “under color of
any state law” they deprive anyone of his rights under the Constitution or federal law. In Bivens
v. Six Unknown Federal Narcotics Agents, the Supreme Court held that federal agents may be
sued for violating the plaintiff’s Fourth Amendment rights against an unlawful search of his
home. [3] Subsequent cases have followed this logic to permit suits for violations of other
constitutional provisions. This area of the law is in a state of flux, and it is likely to continue to
evolve.
Sometimes damage is done to an individual or business because the government has given out
erroneous information. For example, suppose that Charles, a bewildered, disabled navy
employee, is receiving a federal disability annuity. Under the regulations, he would lose his
pension if he took a job that paid him in each of two succeeding years more than 80 percent of
what he earned in his old navy job. A few years later, Congress changed the law, making him
ineligible if he earned more than 80 percent in anyone year. For many years, Charles earned
considerably less than the ceiling amount. But then one year he got the opportunity to make
some extra money. Not wishing to lose his pension, he called an employee relations specialist in
the US Navy and asked how much he could earn and still keep his pension. The specialist gave
him erroneous information over the telephone and then sent him an out-of-date form that said
Charles could safely take on the extra work. Unfortunately, as it turned out, Charles did exceed
the salary limit, and so the government cut off his pension during the time he earned too much.
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.
Saylor URL: http://www.saylor.org/books

Saylor.org
207

Unfortunately for Charles, he will lose his case. In Office of Personnel Management v.
Richmond, the Supreme Court reasoned that it would be unconstitutional to permit
recovery. [4] The appropriations clause of Article I says that federal money can be paid out only
through an appropriation made by law. The law prevented this particular payment to be made.
If the court were to make an exception, it would permit executive officials in effect to make
binding payments, even though unauthorized, simply by misrepresenting the facts. The harsh
reality, therefore, is that mistakes of the government are generally held against the individual,
not the government, unless the law specifically provides for recompense (as, for example, in the
Federal Tort Claims Act just discussed).

KEY TAKEAWAY

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

EXERCISES

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

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

5.6 Cases
Saylor URL: http://www.saylor.org/books

Saylor.org
208

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

Saylor.org
209

general warrant was a recurring point of contention in the Colonies immediately preceding the
Revolution. The particular offensiveness it engendered was acutely felt by the merchants and
businessmen whose premises and products were inspected for compliance with the several
parliamentary revenue measures that most irritated the colonists.…
***
This Court has already held that warrantless searches are generally unreasonable, and that this
rule applies to commercial premises as well as homes. In Camara v. Municipal Court, we held:
[E]xcept in certain carefully defined classes of cases, a search of private property
without proper consent is ‘unreasonable’ unless it has been authorized by a valid
search warrant.
On the same day, we also ruled: As we explained in Camara, a search of private
houses is presumptively unreasonable if conducted without a warrant. The
businessman, like the occupant of a residence, has a constitutional right to go about
his business free from unreasonable official entries upon his private commercial
property. The businessman, too, has that right placed in jeopardy if the decision to
enter and inspect for violation of regulatory laws can be made and enforced by the
inspector in the field without official authority evidenced by a warrant. These same
cases also held that the Fourth Amendment prohibition against unreasonable
searches protects against warrantless intrusions during civil as well as criminal
investigations. The reason is found in the “basic purpose of this Amendment…[which]
is to safeguard the privacy and security of individuals against arbitrary invasions by
governmental officials.” If the government intrudes on a person’s property, the
privacy interest suffers whether the government’s motivation is to investigate
violations of criminal laws or breaches of other statutory or regulatory standards.…
[A]n exception from the search warrant requirement has been recognized for “pervasively
regulated business[es],” United States v. Biswell, 406 U.S. 311, 316 (1972), and for “closely
regulated” industries “long subject to close supervision and inspection,” Colonnade Catering
Corp. v. United States, 397 U.S. 72, 74, 77 (1970). These cases are indeed exceptions, but they
represent responses to relatively unique circumstances. Certain industries have such a history of
Saylor URL: http://www.saylor.org/books

Saylor.org
210

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

Saylor.org
211

***
[The District Court judgment is affirmed.]

CASE QUESTIONS

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

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

Saylor URL: http://www.saylor.org/books

Saylor.org
212

Respondents, the Secretary of Labor and two labor organizations, counter that Congress
balanced the costs and benefits in the Act itself, and that the Act should therefore be construed
not to require OSHA to do so. They interpret the Act as mandating that OSHA enact the most
protective standard possible to eliminate a significant risk of material health impairment,
subject to the constraints of economic and technological feasibility.
The Court of Appeals held that the Act did not require OSHA to compare costs and benefits.
We granted certiorari, 449 U.S. 817 (1980), to resolve this important question, which was
presented but not decided in last Term’s Industrial Union Dept. v. American Petroleum
Institute, 448 U.S. 607 (1980), and to decide other issues related to the Cotton Dust Standard.
***
Not until the early 1960’s was byssinosis recognized in the United States as a distinct
occupational hazard associated with cotton mills. In 1966, the American Conference of
Governmental Industrial Hygienists (ACGIH), a private organization, recommended that
exposure to total cotton dust be limited to a “threshold limit value” of 1,000 micrograms per
cubic meter of air (1,000 g/m3.) averaged over an 8-hour workday. See 43 Fed. Reg. 27351, col. 1
(1978). The United States Government first regulated exposure to cotton dust in 1968, when the
Secretary of Labor, pursuant to the Walsh-Healey Act, 41 U.S.C. 35 (e), promulgated airborne
contaminant threshold limit values, applicable to public contractors, that included the 1,000
g/m3 limit for total cotton dust. 34 Fed. Reg. 7953 (1969). Following passage of the Act in 1970,
the 1,000 g/m3. standard was adopted as an “established Federal standard” under 6 (a) of the
Act, 84 Stat. 1593, 29 U.S.C. 655 (a), a provision designed to guarantee immediate protection of
workers for the period between enactment of the statute and promulgation of permanent
standards.
That same year, the Director of the National Institute for Occupational Safety and Health
(NIOSH), pursuant to the Act, 29 U.S.C. §§ 669(a)(3), 671 (d)(2), submitted to the Secretary of
Labor a recommendation for a cotton dust standard with a permissible exposure limit (PEL)
that “should be set at the lowest level feasible, but in no case at an environmental concentration
as high as 0.2 mg lint-free cotton dust/cu m,” or 200 g/m3. of lint-free respirable dust. Several
months later, OSHA published an Advance Notice of Proposed Rulemaking, 39 Fed.Reg. 44769
Saylor URL: http://www.saylor.org/books

Saylor.org
213

(1974), requesting comments from interested parties on the NIOSH recommendation and other
related matters. Soon thereafter, the Textile Worker’s Union of America, joined by the North
Carolina Public Interest Research Group, petitioned the Secretary, urging a more stringent PEL
of 100 g/m3.
On December 28, 1976, OSHA published a proposal to replace the existing federal standard on
cotton dust with a new permanent standard, pursuant to § 6(b)(5) of the Act, 29 U.S.C. §
655(b)(5). 41 Fed.Reg. 56498. The proposed standard contained a PEL of 200 g/m3 of vertical
elutriated lint-free respirable cotton dust for all segments of the cotton industry. Ibid. It also
suggested an implementation strategy for achieving the PEL that relied on respirators for the
short term and engineering controls for the long-term. OSHA invited interested parties to
submit written comments within a 90-day period.
***
The starting point of our analysis is the language of the statute itself. Section 6(b)(5) of the Act,
29 U.S.C. § 655(b)(5) (emphasis added), provides:
The Secretary, in promulgating standards dealing with toxic materials or harmful
physical agents under this subsection, shall set the standard which most adequately
assures, to the extent feasible, on the basis of the best available evidence, that no
employee will suffer material impairment of health or functional capacity even if such
employee has regular exposure to the hazard dealt with by such standard for the
period of his working life. Although their interpretations differ, all parties agree that
the phrase “to the extent feasible” contains the critical language in § 6(b)(5) for
purposes of these cases.
The plain meaning of the word “feasible” supports respondents’ interpretation of the statute.
According to Webster’s Third New International Dictionary of the English Language 831 (1976),
“feasible” means “capable of being done, executed, or effected.” In accord, the Oxford English
Dictionary 116 (1933) (“Capable of being done, accomplished or carried out”); Funk & Wagnalls
New “Standard” Dictionary of the English Language 903 (1957) (“That may be done, performed
or effected”). Thus, § 6(b)(5) directs the Secretary to issue the standard that “most adequately
assures…that no employee will suffer material impairment of health,” limited only by the extent
Saylor URL: http://www.saylor.org/books

Saylor.org
214

to which this is “capable of being done.” In effect then, as the Court of Appeals held, Congress
itself defined the basic relationship between costs and benefits, by placing the “benefit” of
worker health above all other considerations save those making attainment of this “benefit”
unachievable. Any standard based on a balancing of costs and benefits by the Secretary that
strikes a different balance than that struck by Congress would be inconsistent with the
command set forth in § 6(b)(5). Thus, cost-benefit analysis by OSHA is not required by the
statute because feasibility analysis is.
When Congress has intended that an agency engage in cost-benefit analysis, it has clearly
indicated such intent on the face of the statute. One early example is the Flood Control Act of
1936, 33 U.S.C. § 701:
[T]he Federal Government should improve or participate in the improvement of
navigable waters or their tributaries, including watersheds thereof, for flood control
purposes if the benefits to whomsoever they may accrue are in excess of the
estimated costs, and if the lives and social security of people are otherwise
adversely affected. (emphasis added)
A more recent example is the Outer Continental Shelf Lands Act Amendments of 1978,
providing that offshore drilling operations shall use the best available and safest technologies
which the Secretary determines to be economically feasible, wherever failure of equipment
would have a significant effect on safety, health, or the environment, except where the Secretary
determines that the incremental benefits are clearly insufficient to justify the incremental costs
of using such technologies.
These and other statutes demonstrate that Congress uses specific language when intending that
an agency engage in cost-benefit analysis. Certainly in light of its ordinary meaning, the word
“feasible” cannot be construed to articulate such congressional intent. We therefore reject the
argument that Congress required cost-benefit analysis in § 6(b)(5).

CASE QUESTIONS

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

Saylor URL: http://www.saylor.org/books

Saylor.org
215

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

5.7 Summary and Exercises
Summary

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

EXERCISES

1. The Equal Employment Opportunity Commission seeks data about the racial composition of
Terrific Textiles’ labor force. Terrific refuses on the grounds that inadvertent disclosure of the
numbers might cause certain “elements” to picket its factories. The EEOC takes Terrific to
court to get the data. What is the result?
2. In order to police the profession, the state legislature has just passed a law permitting the
State Plumbers’ Association the power to hold hearings to determine whether a particular
plumber has violated the plumbing code of ethics, written by the association. Sam, a
plumber, objects to the convening of a hearing when he is accused by Roger, a fellow
Saylor URL: http://www.saylor.org/books

Saylor.org
216

plumber, of acting unethically by soliciting business from Roger’s customers. Sam goes to
court, seeking to enjoin the association’s disciplinary committee from holding the hearing.
What is the result? How would you argue Sam’s case? The association’s case?
3. Assume that the new president of the United States was elected overwhelmingly by pledging
in his campaign to “do away with bureaucrats who interfere in your lives.” The day he takes
the oath of office he determines to carry out his pledge. Discuss which of the following
courses he may lawfully follow: (a) Fire all incumbent commissioners of federal agencies in
order to install new appointees. (b) Demand that all pending regulations being considered by
federal agencies be submitted to the White House for review and redrafting, if necessary. (c)
Interview potential nominees for agency positions to determine whether their regulatory
philosophy is consistent with his.
4. Dewey owned a mine in Wisconsin. He refused to allow Department of Labor agents into the
mine to conduct warrantless searches to determine whether previously found safety
violations had been corrected. The Federal Mine Safety and Health Amendments Act of 1977
authorizes four warrantless inspections per year. Is the provision for warrantless inspections
by this agency constitutional?[1]
5. In determining the licensing requirements for nuclear reactors, the Nuclear Regulatory
Commission (NRC) adopted a zero-release assumption: that the permanent storage of certain
nuclear waste would have no significant environmental impact and that potential storage
leakages should not be a factor discussed in the appropriate environmental impact
statement (EIS) required before permitting construction of a nuclear power plant. This
assumption is based on the NRC’s belief that technology would be developed to isolate the
wastes from the environment, and it was clear from the record that the NRC had “digested a
massive material and disclosed all substantial risks” and had considered that the zero-release
assumption was uncertain. There was a remote possibility of contamination by water leakage
into the storage facility. An environmental NGO sued, asserting that the NRC had violated the
regulations governing the EIS by arbitrarily and capriciously ignoring the potential
contamination. The court of appeals agreed, and the power plant appealed. Had the NRC
acted arbitrarily and capriciously? [2]
Saylor URL: http://www.saylor.org/books

Saylor.org
217

SELF-TEST QUESTIONS
1. Most federal administrative agencies are created by
a.

an executive order by the president

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

the executive branch of government

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

in the Congressional record

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

the Administrative Procedure Act

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

issue proposed rules

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

Saylor URL: http://www.saylor.org/books

Saylor.org
218

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

SELF-TEST ANSWERS

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

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

Saylor URL: http://www.saylor.org/books

Saylor.org
219

Chapter 6
Criminal Law

LEARNING OBJECTIVES
After reading this chapter, you should be able to do the following:
1. Explain how criminal law differs from civil law.
2. Categorize the various types of crimes and define the most serious felonies.
3. Discuss and question the criminal “intent” of a corporation.
4. Explain basic criminal procedure and the rights of criminal defendants.
At times, unethical behavior by businesspeople can be extreme enough that society will respond
by criminalizing certain kinds of activities. Ponzi schemes, arson, various kinds of fraud,
embezzlement, racketeering, foreign corrupt practices, tax evasion, and insider trading are just a
few. A corporation can face large fines, and corporate managers can face both fines and jail
sentences for violating criminal laws. This chapter aims to explain how criminal law differs from
civil law, to discuss various types of crimes, and to relate the basic principles of criminal
procedure.

6.1 The Nature of Criminal Law
Criminal law is the most ancient branch of the law. Many wise observers have tried to define and
explain it, but the explanations often include many complex and subtle distinctions. A
traditional criminal law course would include a lot of discussions on criminal intent, the nature
of criminal versus civil responsibility, and the constitutional rights accorded the accused. But in
this chapter, we will consider only the most basic aspects of intent, responsibility, and
constitutional rights.
Unlike civil actions, where plaintiffs seek compensation or other remedies for themselves,
crimes involve “the state” (the federal government, a state government, or some subunit of state
government). This is because crimes involve some “harm to society” and not just harm to certain
individuals. But “harm to society” is not always evident in the act itself. For example, two friends
of yours at a party argue, take the argument outside, and blows are struck; one has a bloody nose
and immediately goes home. The crimes of assault and battery have been committed, even
Saylor URL: http://www.saylor.org/books

Saylor.org
220

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 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!
Saylor URL: http://www.saylor.org/books

Saylor.org
221

The usual answer to this is that the phrase “ignorance of the law is no excuse” means that society
(through its elected representatives) gets to decide what is harmful to society, not you. Still, you
may ask, “Isn’t it my choice whether to take the risk of failing to wear a seat belt? Isn’t this a
victimless crime? Where is the harm to society?” A policymaker or social scientist may answer
that your injuries, statistically, are generally going to be far greater if you don’t wear one and
that your choice may actually impose costs on society. For example, you might not have enough
insurance, so that a public hospital will have to take care of your head injuries, injuries that
would likely have been avoided by your use of a seat belt.
But, as just noted, it is hard to know the meaning of some criminal laws. Teenagers hanging
around the sidewalks on Main Street were sometimes arrested for “loitering.” The constitutional
void-for-vagueness doctrine has led the courts to overturn statutes that are not clear. For
example, “vagrancy” was long held to be a crime, but US courts began some forty years ago to
overturn vagrancy and “suspicious person” statutes on the grounds that they are too vague for
people to know what they are being asked not to do.
This requirement that criminal statutes not be vague does not mean that the law always defines
crimes in ways that can be easily and clearly understood. Many statutes use terminology
developed by the common-law courts. For example, a California statute defines murder as “the
unlawful killing of a human being, with malice aforethought.” If no history backed up these
words, they would be unconstitutionally vague. But there is a rich history of judicial decisions
that provides meaning for much of the arcane language like “malice aforethought” strewn about
in the statute books.
Because a crime is an act that the legislature has defined as socially harmful, the parties involved
cannot agree among themselves to forget a particular incident, such as a barroom brawl, if the
authorities decide to prosecute. This is one of the critical distinctions between criminal and civil
law. An assault is both a crime and a tort. The person who was assaulted may choose to forgive
his assailant and not to sue him for damages. But he cannot stop the prosecutor from bringing
an indictment against the assailant. (However, because of crowded dockets, a victim that
declines to press charges may cause a busy prosecutor to choose to not to bring an indictment.)

Saylor URL: http://www.saylor.org/books

Saylor.org
222

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

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
Saylor URL: http://www.saylor.org/books

Saylor.org
223

Homicide
Homicide is the killing of one person by another. Not every killing is criminal. When the law
permits one person to kill another—for example, a soldier killing an enemy on the battlefield
during war, or a killing in self-defense—the death is considered the result of justifiable homicide.
An excusable homicide, by contrast, is one in which death results from an accident in which the
killer is not at fault.
All other homicides are criminal. The most severely punished form is murder, defined as
homicide committed with “malice aforethought.” This is a term with a very long history. Boiled
down to its essentials, it means that the defendant had the intent to kill. A killing need not be
premeditated for any long period of time; the premeditation might be quite sudden, as in a bar
fight that escalates in that moment when one of the fighters reaches for a knife with the intent to
kill.
Sometimes a homicide can be murder even if there is no intent to kill; an intent to inflict great
bodily harm can be murder if the result is the death of another person. A killing that takes place
while a felony (such as armed robbery) is being committed is also murder, whether or not the
killer intended any harm. This is the so-called felony murder rule. Examples are the accidental
discharge of a gun that kills an innocent bystander or the asphyxiation death of a fireman from
smoke resulting from a fire set by an arsonist. The felony murder rule is more significant than it
sounds, because it also applies to the accomplices of one who does the killing. Thus the driver of
a getaway car stationed a block away from the scene of the robbery can be convicted of murder if
a gun accidentally fires during the robbery and someone is killed. Manslaughter is an act of
killing that does not amount to murder. Voluntary manslaughter is an intentional killing, but
one carried out in the “sudden heat of passion” as the result of some provocation. An example is
a fight that gets out of hand. Involuntary manslaughter entails a lesser degree of willfulness; it
usually occurs when someone has taken a reckless action that results in death (e.g., a death
resulting from a traffic accident in which one driver recklessly runs a red light).

Assault and Battery
Ordinarily, we would say that a person who has struck another has “assaulted” him. Technically,
that is a battery—the unlawful application of force to another person. The force need not be
Saylor URL: http://www.saylor.org/books

Saylor.org
224

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

Offenses against Property
Theft: Larceny, Robbery, Embezzlement, False Pretenses
The concept of theft is familiar enough. Less familiar is the way the law has treated various
aspects of the act of stealing. Criminal law distinguishes among many different crimes that are
popularly known as theft. Many technical words have entered the language—burglary, larceny,
robbery—but are often used inaccurately. Brief definitions of the more common terms are
discussed here.
The basic crime of stealing personal property is larceny. By its old common-law definition, still
in use today, larceny is the wrongful “taking and carrying away of the personal property of
another with intent to steal the same.”

Saylor URL: http://www.saylor.org/books

Saylor.org
225

The separate elements of this offense have given rise to all kinds of difficult cases. Take the theft
of fruit, for example, with regard to the essential element of “personal property.” If a man
walking through an orchard plucks a peach from a tree and eats it, he is not guilty of larceny
because he has not taken away personal property (the peach is part of the land, being connected
to the tree). But if he picks up a peach lying on the ground, he is guilty of larceny. Or consider
the element of “taking” or “carrying away.” Sneaking into a movie theater without paying is not
an act of larceny (though in most states it is a criminal act). Taking electricity by tapping into the
power lines of an electric utility was something that baffled judges late in the nineteenth century
because it was not clear whether electricity is a “something” that can be taken. Modern statutes
have tended to make clear that electricity can be the object of larceny. Or consider the element
of an “intent to steal the same.” If you borrow your friend’s BMW without his permission in
order to go to the grocery store, intending to return it within a few minutes and then do return
it, you have not committed larceny. But if you meet another friend at the store who convinces
you to take a long joyride with the car and you return hours later, you may have committed
larceny.
A particular form of larceny is robbery, which is defined as larceny from a person by means of
violence or intimidation.
Larceny involves the taking of property from the possession of another. Suppose that a person
legitimately comes to possess the property of another and wrongfully appropriates it—for
example, an automobile mechanic entrusted with your car refuses to return it, or a bank teller
who is entitled to temporary possession of cash in his drawer takes it home with him. The
common law had trouble with such cases because the thief in these cases already had
possession; his crime was in assuming ownership. Today, such wrongful conversion, known
as embezzlement, has been made a statutory offense in all states.
Statutes against larceny and embezzlement did not cover all the gaps in the law. A conceptual
problem arises in the case of one who is tricked into giving up his title to property. In larceny
and embezzlement, the thief gains possession or ownership without any consent of the owner or
custodian of the property. Suppose, however, that an automobile dealer agrees to take his
customer’s present car as a trade-in. The customer says that he has full title to the car. In fact,
Saylor URL: http://www.saylor.org/books

Saylor.org
226

the customer is still paying off an installment loan and the finance company has an interest in
the old car. If the finance company repossesses the car, the customer—who got a new car at a
discount because of his false representation—cannot be said to have taken the new car by
larceny or embezzlement. Nevertheless, he tricked the dealer into selling, and the dealer will
have lost the value of the repossessed car. Obviously, the customer is guilty of a criminal act; the
statutes outlawing it refer to this trickery as the crime of false pretenses, defined as obtaining
ownership of the property of another by making untrue representations of fact with intent to
defraud.
A number of problems have arisen in the judicial interpretation of false-pretense statutes. One
concerns whether the taking is permanent or only temporary. The case ofState v. Mills (Section
6.7 "Cases") shows the subtle questions that can be presented and the dangers inherent in
committing “a little fraud.”
In the Mills case, the claim was that a mortgage instrument dealing with one parcel of land was
used instead for another. This is a false representation of fact. Suppose, by contrast, that a
person misrepresents his state of mind: “I will pay you back tomorrow,” he says, knowing full
well that he does not intend to. Can such a misrepresentation amount to false pretenses
punishable as a criminal offense? In most jurisdictions it cannot. A false-pretense violation
relates to a past event or existing fact, not to a statement of intention. If it were otherwise,
anyone failing to pay a debt might find himself facing criminal prosecution, and business would
be less prone to take risks.
The problem of proving intent is especially difficult when a person has availed himself of the
services of another without paying. A common example is someone leaving a restaurant without
paying for the meal. In most states, this is specifically defined in the statutes as theft of services.

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

Saylor URL: http://www.saylor.org/books

Saylor.org
227

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 permittee pays him. Under modern statutes,
the crime of extortion has been broadened to include the wrongful collection of money or
something else of value by anyone by means of a threat (short of a threat of immediate physical
violence, for such a threat would make the demand an act of robbery). This kind of extortion is
usually called blackmail. The blackmail threat commonly is to expose some fact of the victim’s
private life or to make a false accusation about him.

Offenses against Habitation and Other Offenses
Burglary

Saylor URL: http://www.saylor.org/books

Saylor.org
228

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.

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

Saylor URL: http://www.saylor.org/books

Saylor.org
229

from conviction for perjury. To support a charge of perjury, however, the false statement must
be “material,” meaning that the statement is relevant to whatever the court is trying to find out.

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

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

Violations of Antitrust Law
In Chapter 23 "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.
Saylor URL: http://www.saylor.org/books

Saylor.org
230

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]

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

Saylor.org
231

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

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

Sec. (a)(1)

10 years maximum (20 years second
offense)

Trespassing in a government computer

Sec. (a)(3)

1 year (5)

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).
Saylor URL: http://www.saylor.org/books

Saylor.org
232

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

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

6.3 The Nature of a Criminal Act

LEARNING OBJECTIVES

1. Understand how it is possible to commit a criminal act without actually doing anything that
you think might be criminal.
2. Analyze and explain the importance of intention in criminal law and criminal prosecutions.
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
Saylor URL: http://www.saylor.org/books

Saylor.org
233

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.
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,
Saylor URL: http://www.saylor.org/books

Saylor.org
234

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

Agency and Corporations
A person can be guilty of a crime if he acts through another. Again, the usual reason for
“imputing” the guilt of the actor to another is that both were engaged in a conspiracy. But
imputation of guilt is not limited to a conspiracy. The agent may be innocent even though he
participates. A corporate officer directs a junior employee to take a certain bag and deliver it to
the officer’s home. The employee reasonably believes that the officer is entitled to the bag.
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.
Saylor URL: http://www.saylor.org/books

Saylor.org
235

Can a corporation be guilty of a crime? For many types of crimes, the guilt of individual
employees may be imputed to the corporation. Thus the antitrust statutes explicitly state that
the corporation may be convicted and fined for violations by employees. This is so even though
the shareholders are the ones who ultimately must pay the price—and who may have had
nothing to do with the crime nor the power to stop it. The law of corporate criminal
responsibility has been changing in recent years. The tendency is to hold the corporation liable
under criminal law if the act has been directed by a responsible officer or group within the
corporation (the president or board of directors).

KEY TAKEAWAY

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

EXERCISES

1. Give an example of how someone can intend to commit a crime but fail to commit one.
2. Describe a situation where there is a conspiracy to commit a crime without the crime actually
taking place.
3. Create a scenario based on current events where a corporation could be found guilty of
committing a crime even though the CEO, the board of directors, and the shareholders have
not themselves done a criminal act.

6.4 Responsibility

LEARNING OBJECTIVES

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

In General

Saylor URL: http://www.saylor.org/books

Saylor.org
236

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 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.
Saylor URL: http://www.saylor.org/books

Saylor.org
237

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 may spank a child, within limits), and
defense of self, others, property, and habitation. Each of these excuses is a complex subject in
itself.
Saylor URL: http://www.saylor.org/books

Saylor.org
238

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

1. Describe the basic steps in pretrial criminal procedure that follow a government's
determination to arrest someone for an alleged criminal act.
2. Describe the basic elements of trial and posttrial criminal procedure.
The procedure for criminal prosecutions is complex. Procedures will vary from state to state. A
criminal case begins with an arrest if the defendant is caught in the act or fleeing from the scene;
if the defendant is not caught, a warrant for the defendant’s arrest will issue. The warrant is
issued by a judge or a magistrate upon receiving a complaint detailing the charge of a specific
crime against the accused. It is not enough for a police officer to go before a judge and say, “I’d
like you to arrest Bonnie because I think she’s just murdered Clyde.” She must supply enough
information to satisfy the magistrate that there is probable cause (reasonable grounds) to
Saylor URL: http://www.saylor.org/books

Saylor.org
239

believe that the accused committed the crime. The warrant will be issued to any officer or agency
that has power to arrest the accused with warrant in hand.
The accused will be brought before the magistrate for a preliminary hearing. The purpose of the
hearing is to determine whether there is sufficient reason to hold the accused for trial. If so, the
accused can be sent to jail or be permitted to make bail. Bail is a sum of money paid to the court
to secure the defendant’s attendance at trial. If he fails to appear, he forfeits the money.
Constitutionally, bail can be withheld only if there is reason to believe that the accused will flee
the jurisdiction.
Once the arrest is made, the case is in the hands of the prosecutor. In the fifty states,
prosecution is a function of the district attorney’s office. These offices are usually organized on a
county-by-county basis. In the federal system, criminal prosecution is handled by the office of
the US attorney, one of whom is appointed for every federal district.
Following the preliminary hearing, the prosecutor must either file an information (a document
stating the crime of which the person being held is accused) or ask thegrand jury for
an indictment. The grand jury consists of twenty-three people who sit to determine whether
there is sufficient evidence to warrant a prosecution. It does not sit to determine guilt or
innocence. The indictment is the grand jury’s formal declaration of charges on which the
accused will be tried. If indicted, the accused formally becomes a defendant.
The defendant will then be arraigned, that is, brought before a judge to answer the accusation in
the indictment. The defendant may plead guilty or not guilty. If he pleads not guilty, the case will
be tried before a jury (sometimes referred to as a petit jury). The jury cannot convict unless it
finds the defendant guilty beyond a reasonable doubt.
The defendant might have pleaded guilty to the offense or to a lesser charge (often referred to as
a “lesser included offense”—simple larceny, for example, is a lesser included offense of robbery
because the defendant may not have used violence but nevertheless stole from the victim). Such
a plea is usually arranged throughplea bargaining with the prosecution. In return for the plea,
the prosecutor promises to recommend to the judge that the sentence be limited. The judge
most often, but not always, goes along with the prosecutor’s recommendation.

Saylor URL: http://www.saylor.org/books

Saylor.org
240

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.

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
Saylor URL: http://www.saylor.org/books

Saylor.org
241

other driver expects to bring a civil action against Kumar for her injuries after Kumar’s
criminal case. What should Kumar plead in the criminal case—careless driving or driving
under the influence?

6.6 Constitutional Rights of the Accused
LEARNING OBJECTIVES

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

Search and Seizure
The rights of those accused of a crime are spelled out in four of the ten constitutional
amendments that make up the Bill of Rights (Amendments Four, Five, Six, and Eight). For the
most part, these amendments have been held to apply to both the federal and the state
governments. The Fourth Amendment says in part that “the right of the people to be secure in
their persons, houses, papers, and effects, against unreasonable searches and seizures, shall not
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
Saylor URL: http://www.saylor.org/books

Saylor.org
242

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

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

Saylor URL: http://www.saylor.org/books

Saylor.org
243

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

Cruel and Unusual Punishment
Punishment under the common law was frequently horrifying. Death was a common
punishment for relatively minor crimes. In many places throughout the world, punishments still
persist that seem cruel and unusual, such as the practice of stoning someone to death. The
guillotine, famously in use during and after the French Revolution, is no longer used, nor are
defendants put in stocks for public display and humiliation. In pre-Revolutionary America, an
unlucky defendant who found himself convicted could face brutal torture before death.
The Eighth Amendment banned these actions with the words that “cruel and unusual
punishments [shall not be] inflicted.” Virtually all such punishments either never were enacted
or have been eliminated from the statute books in the United States. Nevertheless, the Eighth
Amendment has become a source of controversy, first with the Supreme Court’s ruling in 1976
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

Saylor URL: http://www.saylor.org/books

Saylor.org
244

proceedings, and the Fourteenth Amendment requires that each state provide “due process” to
defendants.

KEY TAKEAWAY

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

EXERCISES

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

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

6.7 Cases
False Pretenses
State v. Mills
96 Ariz. 377, 396 P.2d 5 (Ariz. 1964)
LOCKWOOD, VICE CHIEF JUSTICE
Defendants appeal from a conviction on two counts of obtaining money by false pretenses in
violation of AR.S. §§ 13-661.A3. and 13-663.A1. The material facts, viewed “…in the light most
favorable to sustaining the conviction,” are as follows: Defendant William Mills was a builder
and owned approximately 150 homes in Tucson in December, 1960. Mills conducted his
business in his home. In 1960 defendant Winifred Mills, his wife, participated in the business
generally by answering the telephone, typing, and receiving clients who came to the office.
Saylor URL: http://www.saylor.org/books

Saylor.org
245

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 misconceive the elements of the crime of theft by false pretenses.
Stated in a different form, their argument is that although the complainant has parted with his
cash, a bank check, and a second mortgage, the defendants intend to repay the loan.
Defendants admit that the proposition of law which they assert is a novel one in this jurisdiction.
Respectable authority in other states persuades us that their contention is without merit. A
creditor has a right to determine for himself whether he wishes to be a secured or an unsecured
Saylor URL: http://www.saylor.org/books

Saylor.org
246

creditor. In the former case, he has a right to know about the security. If he extends credit in
reliance upon security which is falsely represented to be adequate, he has been defrauded even if
the debtor intends to repay the debt. His position is now that of an unsecured creditor. At the
very least, an unreasonable risk of loss has been forced upon him by reason of the deceit. This
risk which he did not intend to assume has been imposed upon him by the intentional act of the
debtor, and such action constitutes an intent to defraud.
***
The cases cited by defendants in support of their contention are distinguishable from the instant
case in that they involved theft by larceny. Since the crime of larceny is designed to protect a
person’s possessory interest in property whereas the crime of false pretenses protects one’s title
interest, the requirement of a permanent deprivation is appropriate to the former. Accordingly,
we hold that an intent to repay a loan obtained on the basis of a false representation of the
security for the loan is no defense.
***
Affirmed in part, reversed in part, and remanded for resentencing.

CASE QUESTIONS

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

White-Collar Crimes
United States v. Park
421 U.S. 658 (1975)
MR. CHIEF JUSTICE BURGER delivered the opinion of the Court.
We granted certiorari to consider whether the jury instructions in the prosecution of a corporate
officer under § 301 (k) of the Federal Food, Drug, and Cosmetic Act, 52 Stat. 1042, as amended,
21 U.S.C. § 331 (k), were appropriate under United States v. Dotterweich, 320 U.S. 277 (1943).

Saylor URL: http://www.saylor.org/books

Saylor.org
247

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 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
Saylor URL: http://www.saylor.org/books

Saylor.org
248

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 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.”
Saylor URL: http://www.saylor.org/books

Saylor.org
249

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 selfprotection. It observed that the Act is of “a now familiar type” which “dispenses with the
conventional requirement for criminal conduct-awareness of some wrongdoing: In the interest
of the larger good it puts the burden of acting at hazard upon a person otherwise innocent but
standing in responsible relation to a public danger. Central to the Court’s conclusion that
individuals other than proprietors are subject to the criminal provisions of the Act was the

Saylor URL: http://www.saylor.org/books

Saylor.org
250

reality that the only way in which a corporation can act is through the individuals, who act on its
behalf.
***
The Court recognized that, because the Act dispenses with the need to prove “consciousness of
wrongdoing,” it may result in hardship even as applied to those who share “responsibility in the
business process resulting in” a violation.…The rule that corporate employees who have “a
responsible share in the furtherance of the transaction which the statute outlaws” are subject to
the criminal provisions of the Act was not formulated in a vacuum. Cf. Morissette v. United
States, 342 U.S. 246, 258 (1952). Cases under the Federal Food and Drugs Act of 1906 reflected
the view both that knowledge or intent were not required to be proved in prosecutions under its
criminal provisions, and that responsible corporate agents could be subjected to the liability
thereby imposed.
***
The rationale of the interpretation given the Act in Dotterweich…has been confirmed in our
subsequent cases. Thus, the Court has reaffirmed the proposition that the public interest in the
purity of its food is so great as to warrant the imposition of the highest standard of care on
distributors.
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
Saylor URL: http://www.saylor.org/books

Saylor.org
251

alleged violations. Viewed as a whole, the charge did not permit the jury to find guilt solely on
the basis of respondent’s position in the corporation; rather, it fairly advised the jury that to find
guilt it must find respondent “had a responsible relation to the situation,” and “by virtue of his
position…had…authority and responsibility” to deal with the situation.
The situation referred to could only be “food…held in unsanitary conditions in a warehouse with
the result that it consisted, in part, of filth or…may have been contaminated with filth.”
Our conclusion that the Court of Appeals erred in its reading of the jury charge suggests as well
our disagreement with that court concerning the admissibility of evidence demonstrating that
respondent was advised by the FDA in 1970 of insanitary conditions in Acme’s Philadelphia
warehouse. We are satisfied that the Act imposes the highest standard of care and permits
conviction of responsible corporate officials who, in light of this standard of care, have the
power to prevent or correct violations of its provisions.
***
Reversed.

CASE QUESTIONS

1. Did Park have criminal intent to put adulterated food into commerce? If not, how can Park’s
conduct be criminalized?
2. To get a conviction, what does the prosecutor have to show, other than that Park was the
CEO of Acme and therefore responsible for what his company did or didn’t do?

6.8 Summary and Exercises
Summary

Criminal law is that branch of law governing offenses against society. Most criminal law requires
a specific intent to commit the prohibited act (although a very few economic acts, made criminal
by modern legislation, dispense with the requirement of intent). In this way, criminal law differs
from much of civil law—for example, from the tort of negligence, in which carelessness, rather
than intent, can result in liability.
Major crimes are known as felonies. Minor crimes are known as misdemeanors. Most people
have a general notion about familiar crimes, such as murder and theft. But conventional
knowledge does not suffice for understanding technical distinctions among related crimes, such
Saylor URL: http://www.saylor.org/books

Saylor.org
252

as larceny, robbery, and false pretenses. These distinctions can be important because an
individual can be found guilty not merely for committing one of the acts defined in the criminal
law but also for attempting or conspiring to commit such an act. It is usually easier to convict
someone of attempt or conspiracy than to convict for the main crime, and a person involved in a
conspiracy to commit a felony may find that very little is required to put him into serious
trouble.
Of major concern to the business executive is white-collar crime, which encompasses a host of
offenses, including bribery, embezzlement, fraud, restraints of trade, and computer crime.
Anyone accused of crime should know that they always have the right to consult with a lawyer
and should always do so.

EXERCISES

1. Bill is the chief executive of a small computer manufacturing company that desperately
needs funds to continue operating. One day a stranger comes to Bill to induce him to take
part in a cocaine smuggling deal that would net Bill millions of dollars. Unbeknownst to Bill,
the stranger is an undercover policeman. Bill tells the stranger to go away. The stranger
persists, and after five months of arguing and cajoling, the stranger wears down Bill’s will to
resist. Bill agrees to take delivery of the cocaine and hands over a down payment of $10,000
to the undercover agent, who promptly arrests him for conspiracy to violate the narcotics
laws. What defenses does Bill have?
2. You are the manager of a bookstore. A customer becomes irritated at having to stand in line
and begins to shout at the salesclerk for refusing to wait on him. You come out of your office
and ask the customer to calm down. He shouts at you. You tell him to leave. He refuses. So
you and the salesclerk pick him up and shove him bodily out the door. He calls the police to
have you arrested for assault. Should the police arrest you? Assuming that they do, how
would you defend yourself in court?
3. Marilyn is arrested for arson against a nuclear utility, a crime under both state and federal
law. She is convicted in state court and sentenced to five years in jail. Then the federal
government decides to prosecute her for the same offense. Does she have a double-jeopardy
defense against the federal prosecution?

Saylor URL: http://www.saylor.org/books

Saylor.org
253

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 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]
Saylor URL: http://www.saylor.org/books

Saylor.org
254

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

b. company computer time
c. the use of Data Systems’ Internet for personal business
d. any of the above

Saylor URL: http://www.saylor.org/books

Saylor.org
255

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).

Saylor URL: http://www.saylor.org/books

Saylor.org
256

Chapter 7
Introduction to Tort Law
LEARNING OBJECTIVES

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

7.1 Purpose of Tort Laws

LEARNING OBJECTIVES

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

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

Saylor URL: http://www.saylor.org/books

Saylor.org
257

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

Kinds of Torts
Saylor URL: http://www.saylor.org/books

Saylor.org
258

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.

Saylor URL: http://www.saylor.org/books

Saylor.org
259

Figure 7.1 Dimensions of Tort Liability

Dimensions of Tort: Fault
Tort principles can be viewed along different dimensions. One is the fault dimension. Like
criminal law, tort law requires a wrongful act by a defendant for the plaintiff to recover. Unlike
criminal law, however, there need not be a specific intent. Since tort law focuses on injury to the
plaintiff, it is less concerned than criminal law about the reasons for the defendant’s actions. An
innocent act or a relatively innocent one may still provide the basis for liability. Nevertheless,
tort law—except for strict liability—relies on standards of fault, or blameworthiness.
The most obvious standard is willful conduct. If the defendant (often called thetortfeasor—i.e.,
the one committing the tort) intentionally injures another, there is little argument about tort
liability. Thus all crimes resulting in injury to a person or property (murder, assault, arson, etc.)
are also torts, and the plaintiff may bring a separate lawsuit to recover damages for injuries to
his person, family, or property.

Saylor URL: http://www.saylor.org/books

Saylor.org
260

Most tort suits do not rely on intentional fault. They are based, rather, on negligent conduct that
in the circumstances is careless or poses unreasonable risks of causing damage. Most
automobile accident and medical malpractice suits are examples of negligence suits.
The fault dimension is a continuum. At one end is the deliberate desire to do injury. The middle
ground is occupied by careless conduct. At the other end is conduct that most would consider
entirely blameless, in the moral sense. The defendant may have observed all possible
precautions and yet still be held liable. This is calledstrict liability. An example is that incurred
by the manufacturer of a defective product that is placed on the market despite all possible
precautions, including quality-control inspection. In many states, if the product causes injury,
the manufacturer will be held liable.

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

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

Saylor.org
261

is consent: two boxers in the ring consent to being struck with fists (but not to being bitten on
the ear).

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

KEY TAKEAWAY

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

Saylor URL: http://www.saylor.org/books

Saylor.org
262

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

EXERCISES

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

7.2 Intentional Torts

LEARNING OBJECTIVES

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

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

Saylor.org
263

with an iron skillet and you didn’t see it coming, there is a battery but no assault. Likewise, if
Andrea passes out from drinking too much at the fraternity party and a stranger (Andre) kisses
her on the lips while she is passed out, she would not be aware of any threat of offensive contact
and would have no apprehension of any harm. Thus there has been no tort of assault, but she
could allege the tort of battery. (The question of what damages, if any, would be an interesting
argument.)
Under the doctrine of transferred intent, if Draco aims his wand at Harry but Harry ducks just
in time and the impact is felt by Hermione instead, English law (and American law) would
transfer Draco’s intent from the target to the actual victim of the act. Thus Hermione could sue
Draco for battery for any damages she had suffered.

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

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

Saylor.org
264

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

Trespass and Nuisance
Trespass is intentionally going on land that belongs to someone else or putting something on
someone else’s property and refusing to remove it. This part of tort law shows how strongly the
law values the rights of property owners. The right to enjoy your property without interference
from others is also found in common law of nuisance. There are limits to property owners’
rights, however. In Katko v. Briney, for example, the plaintiff was injured by a spring gun while
trespassing on the defendant’s property. [2] The defendant had set up No Trespassing signs after
ten years of trespassing and housebreaking events, with the loss of some household items.
Windows had been broken, and there was “messing up of the property in general.” The
defendants had boarded up the windows and doors in order to stop the intrusions and finally
had set up a shotgun trap in the north bedroom of the house. One defendant had cleaned and
oiled his 20-gauge shotgun and taken it to the old house where it was secured to an iron bed
with the barrel pointed at the bedroom door. “It was rigged with wire from the doorknob to the
gun’s trigger so would fire when the door was opened.” The angle of the shotgun was adjusted to

Saylor URL: http://www.saylor.org/books

Saylor.org
265

hit an intruder in the legs. The spring could not be seen from the outside, and no warning of its
presence was posted.
The plaintiff, Katko, had been hunting in the area for several years and considered the property
abandoned. He knew it had long been uninhabited. He and a friend had been to the house and
found several old bottles and fruit jars that they took and added to their collection of antiques.
When they made a second trip to the property, they entered by removing a board from a porch
window. When the plaintiff opened the north bedroom door, the shotgun went off and struck
him in the right leg above the ankle bone. Much of his leg was blown away. While Katko knew he
had no right to break and enter the house with intent to steal bottles and fruit jars, the court
held that a property owner could not protect an unoccupied boarded-up farmhouse by using a
spring gun capable of inflicting death or serious injury.
In Katko, there is an intentional tort. But what if someone trespassing is injured by the
negligence of the landowner? States have differing rules about trespass and negligence. In some
states, a trespasser is only protected against the gross negligence of the landowner. In other
states, trespassers may be owed the duty of due care on the part of the landowner. The burglar
who falls into a drained swimming pool, for example, may have a case against the homeowner
unless the courts or legislature of that state have made it clear that trespassers are owed the
limited duty to avoid gross negligence. Or a very small child may wander off his own property
and fall into a gravel pit on a nearby property and suffer death or serious injury; if the pit should
(in the exercise of due care) have been filled in or some barrier erected around it, then there was
negligence. But if the state law holds that the duty to trespassers is only to avoid gross
negligence, the child’s family would lose, unless the state law makes an exception for very young
trespassers. In general, guests, licensees, and invitees are owed a duty of due care; a trespasser
may not be owed such a duty, but states have different rules on this.

Intentional Interference with Contractual Relations
Tortious interference with a contract can be established by proving four elements:
1. There was a contract between the plaintiff and a third party.
2. The defendant knew of the contract.

Saylor URL: http://www.saylor.org/books

Saylor.org
266

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

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

Saylor URL: http://www.saylor.org/books

Saylor.org
267

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

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

Saylor URL: http://www.saylor.org/books

Saylor.org
268

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

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

Qualified Privilege
Absolute privileges pertain to those in the public sector. A narrower privilege exists for private
citizens. In general, a statement that would otherwise be actionable is held to be justified if made
in a reasonable manner and for a reasonable purpose. Thus you may warn a friend to beware of
dealing with a third person, and if you had reason to believe that what you said was true, you are
privileged to issue the warning, even though false. Likewise, an employee may warn an employer
Saylor URL: http://www.saylor.org/books

Saylor.org
269

about the conduct or character of a fellow or prospective employee, and a parent may complain
to a school board about the competence or conduct of a child’s teacher. There is a line to be
drawn, however, and a defendant with nothing but an idle interest in the matter (an “officious
intermeddler”) must take the risk that his information is wrong.
In 1964, the Supreme Court handed down its historic decision in New York Times v. Sullivan,
holding that under the First Amendment a libel judgment brought by a public official against a
newspaper cannot stand unless the plaintiff has shown “actual malice,” which in turn was
defined as “knowledge that [the statement] was false or with a reckless disregard of whether it
was false or not.” [4] In subsequent cases, the court extended the constitutional doctrine further,
applying it not merely to government officials but to public figures, people who voluntarily place
themselves in the public eye or who involuntarily find themselves the objects of public scrutiny.
Whether a private person is or is not a public figure is a difficult question that has so far eluded
rigorous definition and has been answered only from case to case. A CEO of a private
corporation ordinarily will be considered a private figure unless he puts himself in the public
eye—for example, by starring in the company’s television commercials.

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

Appropriation of Name or Likeness
The earliest privacy interest recognized by the courts was appropriation of name or likeness:
someone else placing your photograph on a billboard or cereal box as a model or using your
name as endorsing a product or in the product name. A New York statute makes it a
misdemeanor to use the name, portrait, or picture of any person for advertising purposes or for
the purposes of trade (business) without first obtaining written consent. The law also permits
Saylor URL: http://www.saylor.org/books

Saylor.org
270

the aggrieved person to sue and to recover damages for unauthorized profits and also to have
the court enjoin (judicially block) any further unauthorized use of the plaintiff’s name, likeness,
or image. This is particularly useful to celebrities.
Because the publishing and advertising industries are concentrated heavily in New York, the
statute plays an important part in advertising decisions made throughout the country. Deciding
what “commercial” or “trade” purposes are is not always easy. Thus a newsmagazine may use a
baseball player’s picture on its cover without first obtaining written permission, but a chocolate
manufacturer could not put the player’s picture on a candy wrapper without consent.

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

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

False Light
A final type of privacy invasion is that which paints a false picture in a publication. Though false,
it might not be libelous, since the publication need contain nothing injurious to reputation.
Indeed, the publication might even glorify the plaintiff, making him seem more heroic than he
actually is. Subject to the First Amendment requirement that the plaintiff must show intent or
Saylor URL: http://www.saylor.org/books

Saylor.org
271

extreme recklessness, statements that put a person in a false light, like a fictionalized biography,
are actionable.

KEY TAKEAWAY

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

EXERCISES

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

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

7.3 Negligence

LEARNING OBJECTIVES

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

Elements of Negligence
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
Saylor URL: http://www.saylor.org/books

Saylor.org
272

imposes a duty of care on all of us in our everyday lives. Accidents caused by negligence are
actionable.
Determining negligence is not always easy. If a driver runs a red light, we can say that he is
negligent because a driver must always be careful to ascertain whether the light is red and be
able to stop if it is. Suppose that the driver was carrying a badly injured person to a nearby
hospital and that after slowing down at an intersection, went through a red light, blowing his
horn, whereupon a driver to his right, seeing him, drove into the intersection anyway and
crashed into him. Must one always stop at a red light? Is proof that the light was red always
proof of negligence? Usually, but not always: negligence is an abstract concept that must always
be applied to concrete and often widely varying sets of circumstances. Whether someone was or
was not negligent is almost always a question of fact for a jury to decide. Rarely is it a legal
question that a judge can settle.
The tort of negligence has four elements: (1) a duty of due care that the defendant had, (2)
the breach of the duty of due care, (3) connection between cause and injury, and (4) actual
damage or loss. Even if a plaintiff can prove each of these aspects, the defendant may be able to
show that the law excuses the conduct that is the basis for the tort claim. We examine each of
these factors below.

Standard of Care
Not every unintentional act that causes injury is negligent. If you brake to a stop when you see a
child dart out in front of your car, and if the noise from your tires gives someone in a nearby
house a heart attack, you have not acted negligently toward the person in the house. The
purpose of the negligence standard is to protect others against the risk of injury that foreseeably
would ensue from unreasonably dangerous conduct.
Given the infinite variety of human circumstances and conduct, no general statement of a
reasonable standard of care is possible. Nevertheless, the law has tried to encapsulate it in the
form of the famous standard of “the reasonable man.” This fictitious person “of ordinary
prudence” is the model that juries are instructed to compare defendants with in assessing
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
Saylor URL: http://www.saylor.org/books

Saylor.org
273

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.
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
Saylor URL: http://www.saylor.org/books

Saylor.org
274

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 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
Saylor URL: http://www.saylor.org/books

Saylor.org
275

also be foreseeable, or not “too remote,” for the defendant’s act to create liability. This
is proximate cause: a cause that is not too remote or unforseeable.
Suppose that the person who was injured was not one whom a reasonable person could have
expected to be harmed. Such a situation was presented in one of the most famous US tort
cases, Palsgraf v. Long Island Railroad (Section 7.5 "Cases"), which was decided by Judge
Benjamin Cardozo. Although Judge Cardozo persuaded four of his seven brethren to side with
his position, the closeness of the case demonstrates the difficulty that unforeseeable
consequences and unforeseeable plaintiffs present.

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

Problems of Proof
The plaintiff in a tort suit, as in any other, has the burden of proving his allegations.
He must show that the defendant took the actions complained of as negligent, demonstrate the
circumstances that make the actions negligent, and prove the occurrence and extent of injury.
Factual issues are for the jury to resolve. Since it is frequently difficult to make out the requisite
proof, the law allows certain presumptions and rules of evidence that ease the plaintiff’s task, on
the ground that without them substantial injustice would be done. One important rule goes by
the Latin phraseres ipsa loquitur, meaning “the thing speaks for itself.” The best evidence is
Saylor URL: http://www.saylor.org/books

Saylor.org
276

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
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.
Saylor URL: http://www.saylor.org/books

Saylor.org
277

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

Assumption of Risk
Risk of injury pervades the modern world, and plaintiffs should not win a lawsuit simply
because they took a risk and lost. The law provides, therefore, that when a person knowingly
takes a risk, he or she must suffer the consequences.
The assumption of risk doctrine comes up in three ways. The plaintiff may have formally agreed
with the defendant before entering a risky situation that he will relieve the defendant of liability
should injury occur. (“You can borrow my car if you agree not to sue me if the brakes fail,
because they’re worn and I haven’t had a chance to replace them.”) Or the plaintiff may have
entered into a relationship with the defendant knowing that the defendant is not in a position to
protect him from known risks (the fan who is hit by a line drive in a ballpark). Or the plaintiff
may act in the face of a risky situation known in advance to have been created by the defendant’s
negligence (failure to leave, while there was an opportunity to do so, such as getting into an
automobile when the driver is known to be drunk).
The difficulty in many cases is to determine the dividing line between subjectivity and
objectivity. If the plaintiff had no actual knowledge of the risk, he cannot be held to have
assumed it. On the other hand, it is easy to claim that you did not appreciate the danger, and the
Saylor URL: http://www.saylor.org/books

Saylor.org
278

courts will apply an objective standard of community knowledge (a “but you should have
known” test) in many situations. When the plaintiff has no real alternative, however,
assumption of risk fails as a defense (e.g., a landlord who negligently fails to light the exit to the
street cannot claim that his tenants assumed the risk of using it).
At the turn of the century, courts applied assumption of risk in industrial cases to bar relief to
workers injured on the job. They were said to assume the risk of dangerous conditions or
equipment. This rule has been abolished by workers’ compensation statutes in most states.

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

Vicarious Liability
Liability for negligent acts does not always end with the one who was negligent. Under certain
circumstances, the liability is imputed to others. For example, an employer is responsible for the
negligence of his employees if they were acting in the scope of employment. This rule of
vicarious liability is often called respondeat superior, meaning that the higher authority must
respond to claims brought against one of its agents. Respondeat superior is not limited to the
employment relationship but extends to a number of other agency relationships as well.
Legislatures in many states have enacted laws that make people vicariously liable for acts of
certain people with whom they have a relationship, though not necessarily one of agency. It is
common, for example, for the owner of an automobile to be liable for the negligence of one to
whom the owner lends the car. So-called dram shop statutes place liability on bar and tavern
Saylor URL: http://www.saylor.org/books

Saylor.org
279

owners and others who serve too much alcohol to one who, in an intoxicated state, later causes
injury to others. In these situations, although the injurious act of the drinker stemmed from
negligence, the one whom the law holds vicariously liable (the bartender) is not himself
necessarily negligent—the law is holding him strictly liable, and to this concept we now turn.

KEY TAKEAWAY

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

EXERCISES

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

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

7.4 Strict Liability
Saylor URL: http://www.saylor.org/books

Saylor.org
280

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

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

Strict Liability for Products
Because of the importance of products liability, this text devotes an entire chapter to it (Chapter
20 "Products Liability"). Strict liability may also apply as a legal standard for products, even
those that are not ultrahazardous. In some national legal systems, strict liability is not available
as a cause of action to plaintiffs seeking to recover a judgment of products liability against a
manufacturer, wholesaler, distributor, or retailer. (Some states limit liability to the

Saylor URL: http://www.saylor.org/books

Saylor.org
281

manufacturer.) But it is available in the United States and initially was created by a California
Supreme Court decision in the 1962 case ofGreenman v. Yuba Power Products, Inc.
In Greenman, the plaintiff had used a home power saw and bench, the Shopsmith, designed and
manufactured by the defendant. He was experienced in using power tools and was injured while
using the approved lathe attachment to the Shopsmith to fashion a wooden chalice. The case
was decided on the premise that Greenman had done nothing wrong in using the machine but
that the machine had a defect that was “latent” (not easily discoverable by the consumer).
Rather than decide the case based on warranties, or requiring that Greenman prove how the
defendant had been negligent, Justice Traynor found for the plaintiff based on the overall social
utility of strict liability in cases of defective products. According to his decision, the purpose of
such liability is to ensure that the “cost of injuries resulting from defective products is borne by
the manufacturers…rather than by the injured persons who are powerless to protect
themselves.”
Today, the majority of US states recognize strict liability for defective products, although some
states limit strict liability actions to damages for personal injuries rather than property damage.
Injured plaintiffs have to prove the product caused the harm but do not have to prove exactly
how the manufacturer was careless. Purchasers of the product, as well as injured guests,
bystanders, and others with no direct relationship with the product, may sue for damages
caused by the product.
The Restatement of the Law of Torts, Section 402(a), was originally issued in 1964. It is a widely
accepted statement of the liabilities of sellers of goods for defective products. The Restatement
specifies six requirements, all of which must be met for a plaintiff to recover using strict liability
for a product that the plaintiff claims is defective:
1. The product must be in a defective condition when the defendant sells it.
2. The defendant must normally be engaged in the business of selling or otherwise distributing the
product.
3. The product must be unreasonably dangerous to the user or consumer because of its defective
condition.
4. The plaintiff must incur physical harm to self or to property by using or consuming the product.
Saylor URL: http://www.saylor.org/books

Saylor.org
282

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

Saylor.org
283

potential ill health effects of eating at McDonald’s, they cannot blame McDonald’s if they,
nonetheless, choose to satiate their appetite with a surfeit of supersized McDonald’s
products.” [1]

KEY TAKEAWAY

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

EXERCISES

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

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

7.5 Cases
Intentional Torts: False Imprisonment
Lester v. Albers Super Markets, Inc.
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
Saylor URL: http://www.saylor.org/books

Saylor.org
284

that she was humiliated. The jury awarded her $800. She also testified that no one laid a hand
on her or made a move to restrain her from leaving by any one of numerous exits.
***
MATTHEWS, JUDGE.
As we view the record, it raises the fundamental question of what is imprisonment. Before any
need for a determination of illegality arises there must be proof of imprisonment. In 35 Corpus
Juris Secundum (C.J.S.), False Imprisonment, § II, pages 512–13, it is said: “Submission to the
mere verbal direction of another, unaccompanied by force or by threats of any character, cannot
constitute a false imprisonment, and there is no false imprisonment where an employer
interviewing an employee declines to terminate the interview if no force or threat of force is used
and false imprisonment may not be predicated on a person’s unfounded belief that he was
restrained.”
Many cases are cited in support of the text.
***
In Fenn v. Kroger Grocery & Baking Co., Mo. Sup., 209 S.W. 885, 887, the court said:
A case was not made out for false arrest. The plaintiff said she was intercepted as she
started to leave the store; that Mr. Krause stood where she could not pass him in
going out. She does not say that he made any attempt to intercept her. She says he
escorted her back to the desk, that he asked her to let him see the change.
…She does not say that she went unwillingly…Evidence is wholly lacking to show that
she was detained by force or threats. It was probably a disagreeable experience, a
humiliating one to her, but she came out victorious and was allowed to go when she
desired with the assurance of Mr. 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
Saylor URL: http://www.saylor.org/books

Saylor.org
285

individual to detain one for an unreasonable time, or under unreasonable
circumstances, for the purpose of investigating a dispute over the payment of a bill
alleged to be owed by the person detained for cash services.
***
For these reasons, the judgment is reversed and final judgment entered for the defendantappellant.

CASE QUESTIONS

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

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

Saylor URL: http://www.saylor.org/books

Saylor.org
286

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

Saylor.org
287

Whitlock a duty of due care to remove the trampoline from the fraternity premises or to
supervise its use.…The case was remanded to the trial court with orders to reinstate the verdict
and damages as determined by the jury. The University then petitioned for certiorari review, and
we granted that petition.

II.
A negligence claim must fail if based on circumstances for which the law imposes no duty of care
upon the defendant for the benefit of the plaintiff. [Citations] Therefore, if Whitlock’s judgment
against the University is to be upheld, it must first be determined that the University owed a
duty of care to take reasonable measures to protect him against the injury that he sustained.
Whether a particular defendant owes a legal duty to a particular plaintiff is a question of law.
[Citations] “The court determines, as a matter of law, the existence and scope of the duty—that
is, whether the plaintiff’s interest that has been infringed by the conduct of the defendant is
entitled to legal protection.” [Citations] In Smith v. City & County of Denver, 726 P.2d 1125
(Colo. 1986), we set forth several factors to be considered in determining the existence of duty in
a particular case:
Whether the law should impose a duty requires consideration of many factors
including, for example, the risk involved, the foreseeability and likelihood of injury as
weighed against the social utility of the actor’s conduct, the magnitude of the burden
of guarding against injury or harm, and the consequences of placing the burden upon
the actor.
…A court’s conclusion that a duty does or does not exist is “an expression of the sum total of
those considerations of policy which lead the law to say that the plaintiff is [or is not] entitled to
protection.”
…
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]
Saylor URL: http://www.saylor.org/books

Saylor.org
288

and passive inaction or a failure to take steps to protect them from harm [nonfeasance].” W.
Keeton, § 56, at 373. Liability for nonfeasance was slow to receive recognition in the law. “The
reason for the distinction may be said to lie in the fact that by ‘misfeasance’ the defendant has
created a new risk of harm to the plaintiff, while by ‘nonfeasance’ he has at least made his
situation no worse, and has merely failed to benefit him by interfering in his
affairs.” Id. The Restatement (Second) of Torts § 314 (1965) summarizes the law on this point as
follows:
The fact that an actor realizes or should realize that action on his part is necessary for
another’s aid or protection does not of itself impose upon him a duty to take such
action.
Imposition of a duty in all such cases would simply not meet the test of fairness under
contemporary standards.
In nonfeasance cases the existence of a duty has been recognized only during the last century in
situations involving a limited group of special relationships between parties. Such special
relationships are predicated on “some definite relation between the parties, of such a character
that social policy justifies the imposition of a duty to act.” W. Keeton, § 56, at 374. Special
relationships that have been recognized by various courts for the purpose of imposition of a duty
of care include common carrier/passenger, innkeeper/guest, possessor of land/invited entrant,
employer/employee, parent/child, and hospital/patient. See Restatement (Second) of Torts §
314 A (1965); 3 Harper and James, § 18.6, at 722–23. The authors of theRestatement (Second)
of Torts § 314 A, comment b (1965), state that “the law appears…to be working slowly toward a
recognition of the duty to aid or protect in any relation of dependence or of mutual dependence.”
…

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
Saylor URL: http://www.saylor.org/books

Saylor.org
289

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 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.
Saylor URL: http://www.saylor.org/books

Saylor.org
290

Nothing in the University’s student handbook, which contains certain regulations concerning
student conduct, reflects an effort by the University to control the risk-taking decisions of its
students in their private recreation.…Indeed, fraternity and sorority self-governance with
minimal supervision appears to have been fostered by the University.
…
Aside from advising the Beta house on one occasion to put the trampoline up when not in use,
there is no evidence that the University officials attempted to assert control over trampoline use
by the fraternity members. We conclude from this record that the University’s very limited
actions concerning safety of student recreation did not give Whitlock or the other members of
campus fraternities or sororities any reason to depend upon the University for evaluation of the
safety of trampoline use.…Therefore, we conclude that the student-university relationship is not
a special relationship of the type giving rise to a duty of the University to take reasonable
measures to protect the members of fraternities and sororities from risks of engaging in extracurricular trampoline jumping.
The plaintiff asserts, however, that we should recognize a duty of the University to take
affirmative action to protect fraternity members because of the foreseeability of the injury, the
extent of the risks involved in trampoline use, the seriousness of potential injuries, and the
University’s superior knowledge concerning these matters. The argument in essence is that a
duty should spring from the University’s natural interest in the welfare and safety of its
students, its superior knowledge of the nature and degree of risk involved in trampoline use, and
its knowledge of the use of trampolines on the University campus. The evidence amply supports
a conclusion that trampoline use involves risks of serious injuries and that the potential for an
injury such as that experienced by Whitlock was foreseeable. It shows further that prior injuries
resulting from trampoline accidents had been reported to campus security and to the student
clinic, and that University administrators were aware of the number and severity of trampoline
injuries nationwide.
The record, however, also establishes through Whitlock’s own testimony that he was aware of
the risk of an accident and injury of the very nature that he experienced.…

Saylor URL: http://www.saylor.org/books

Saylor.org
291

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 the imposition of liability for nonfeasance would directly

Saylor URL: http://www.saylor.org/books

Saylor.org
292

contravene the competing social policy of fostering an educational environment of student
autonomy and independence.
We reverse the judgment of the court of appeals and return this case to that court with
directions to remand it to the trial court for dismissal of Whitlock’s complaint against the
University.

CASE QUESTIONS

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

Negligence: Proximate Cause
Palsgraf v. Long Island R.R.
248 N.Y. 339,162 N.E. 99 (N.Y. 1928)
CARDOZO, Chief Judge
Plaintiff was standing on a platform of defendant’s railroad after buying a ticket to go to
Rockaway Beach. A train stopped at the station, bound for another place. Two men ran forward
to catch it. One of the men reached the platform of the car without mishap, though the train was
already moving. The other man, carrying a package, jumped aboard the car, but seemed
unsteady as if about to fall. A guard on the car, who had held the door open, reached forward to
help him in, and another guard on the platform pushed him from behind. In this act, the
package was dislodged, and fell upon the rails. It was a package of small size, about fifteen
inches long, and was covered by a newspaper. In fact it contained fireworks, but there was
nothing in its appearance to give notice of its contents. The fireworks when they fell exploded.
The shock of· the explosion threw down some scales at the other end of the platform many feet
away. The scales struck the plaintiff, causing injuries for which she sues.
The conduct of the defendant’s guard, if a wrong in its relation to the holder of the package, was
not a wrong in its relation to the plaintiff, standing far away. Relatively to her it was not
negligence at all. Nothing in the situation gave notice that the falling package had in it the

Saylor URL: http://www.saylor.org/books

Saylor.org
293

potency of peril to persons thus removed. Negligence is not actionable unless it involves the
invasion of a legally protected interest, the violation of a right. “Proof of negligence in the air, so
to speak, will not do.…If no hazard was apparent to the eye of ordinary vigilance, an act innocent
and harmless, at least to outward seeming, with reference to her, did not take to itself the quality
of a tort because it happened to be a wrong, though apparently not one involving the risk of
bodily insecurity, with reference to someone else.…The plaintiff sues in her own right for a
wrong personal to her, and not as the vicarious beneficiary of a breach of duty to another.
A different conclusion will involve us, and swiftly too, in a maze of contradictions. A guard
stumbles over a package which has been left upon a platform.
It seems to be a bundle of newspapers. It turns out to be a can of dynamite. To the eye of
ordinary vigilance, the bundle is abandoned waste, which may be kicked or trod on with
impunity. Is a passenger at the other end of the platform protected by the law against the
unsuspected hazard concealed beneath the waste? If not, is the result to be any different, so far
as the distant passenger is concerned, when the guard stumbles over a valise which a truckman
or a porter has left upon the walk?…The orbit of the danger as disclosed to the eye of reasonable
vigilance would be the orbit of the duty. One who jostles one’s neighbor in a crowd does not
invade the rights of others standing at the outer fringe when the unintended contact casts a
bomb upon the ground. The wrongdoer as to them is the man who carries the bomb, not the one
who explodes it without suspicion of the danger. Life will have to be made over, and human
nature transformed, before prevision so extravagant can be accepted as the norm of conduct, the
customary standard to which behavior must conform.
The argument for the plaintiff is built upon the shifting meanings of such words as “wrong” and
“wrongful” and shares their instability. For what the plaintiff must show is a “wrong” to herself;
i.e., a violation of her own right, and not merely a “wrong” to someone else, nor conduct
“wrongful” because unsocial, but not a “wrong” to anyone. We are told that one who drives at
reckless speed through a crowded city street is guilty of a negligent act and therefore of a
wrongful one, irrespective of the consequences.
Negligent the act is, and wrongful in the sense that it is unsocial, but wrongful and unsocial in
relation to other travelers, only because the eye of vigilance perceives the risk of damage. If the
Saylor URL: http://www.saylor.org/books

Saylor.org
294

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
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

Saylor URL: http://www.saylor.org/books

Saylor.org
295

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

CASE QUESTIONS

1. Why would certain activities be deemed ultrahazardous or abnormally dangerous so that
strict liability is imposed?
2. If the activities are known to be abnormally dangerous, did Klein assume the risk?
3. Assume that the fireworks were negligently manufactured in China. Should Klein’s only
remedy be against the Chinese company, as Pyrodyne argues? Why or why not?

7.6 Summary and Exercises
Summary

The principles of tort law pervade modern society because they spell out the duties of care that
we owe each other in our private lives. Tort law has had a significant impact on business because

Saylor URL: http://www.saylor.org/books

Saylor.org
296

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 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

Saylor URL: http://www.saylor.org/books

Saylor.org
297

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
a.

malice

b. ill will
c. malice aforethought

Saylor URL: http://www.saylor.org/books

Saylor.org
298

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

trespass on the case

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

He is liable for an intentional tort.

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

only if Amanda is injured

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

SELF-TEST ANSWERS

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

Saylor URL: http://www.saylor.org/books

Saylor.org
299

Chapter 8
Introduction to Contract Law
LEARNING OBJECTIVES

After reading this chapter, you should understand the following:
1. Why and how contract law has developed
2. What a contract is
3. What topics will be discussed in the contracts chapter of this book
4. What the sources of contract law are
5. How contracts are classified (basic taxonomy)

8.1 General Perspectives on Contracts
LEARNING OBJECTIVES

1. Explain contract law’s cultural roots: how it has evolved as capitalism has evolved.
2. Understand that contracts serve essential economic purposes.
3. Define contract.
4. Understand the basic issues in contract law.

The Role of Contracts in Modern Society
Contract is probably the most familiar legal concept in our society because it is so central to the
essence of our political, economic, and social life. In common parlance, contract is used
interchangeably with agreement, bargain, undertaking, or deal. Whatever the word, the
concept it embodies is our notion of freedom to pursue our own lives together with others.
Contract is central because it is the means by which a free society orders what would otherwise
be a jostling, frenetic anarchy.
So commonplace is the concept of contract—and our freedom to make contracts with each
other—that it is difficult to imagine a time when contracts were rare, when people’s everyday
associations with one another were not freely determined. Yet in historical terms, it was not so
long ago that contracts were rare, entered into if at all by very few: that affairs should be ordered
based on mutual assent was mostly unknown. In primitive societies and in feudal Europe,
relationships among people were largely fixed; traditions spelled out duties that each person
Saylor URL: http://www.saylor.org/books

Saylor.org
300

owed to family, tribe, or manor. People were born into an ascribed position—a status (not unlike
the caste system still existing in India)—and social mobility was limited. Sir Henry Maine, a
nineteenth-century British historian, wrote that “the movement of the progressive societies
has…been a movement from status to contract.” [1] This movement was not accidental—it
developed with the emerging industrial order. From the fifteenth to the nineteenth century,
England evolved into a booming mercantile economy, with flourishing trade, growing cities, an
expanding monetary system, the commercialization of agriculture, and mushrooming
manufacturing. With this evolution, contract law was created of necessity.
Contract law did not develop according to a conscious plan, however. It was a response to
changing conditions, and the judges who created it frequently resisted, preferring the imagined
quieter pastoral life 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, and help create,
modern capitalism.
Modern capitalism, indeed, would not be possible without contract law. So it is that in planned
economies, like those of the former Soviet Union and precapitalistic China, the contract did not
determine the nature of an economic transaction. That transaction was first set forth by the
state’s planning authorities; only thereafter were the predetermined provisions set down in a
written contract. Modern capitalism has demanded new contract regimes in Russia and China;
the latter adopted its Revised Contract Law in 1999.
Contract law may be viewed economically as well as culturally. In An Economic Analysis of Law,
Judge Richard A. Posner (a former University of Chicago law professor) suggests that contract
law performs three significant economic functions. First, it helps maintain incentives for
individuals to exchange goods and services efficiently. Second, it reduces the costs of economic
transactions because its very existence means that the parties need not go to the trouble of
negotiating a variety of rules and terms already spelled out. Third, the law of contracts alerts the
parties to troubles that have arisen in the past, thus making it easier to plan the transactions
more intelligently and avoid potential pitfalls. [2]

The Definition of Contract

Saylor URL: http://www.saylor.org/books

Saylor.org
301

As usual in the law, the legal definition of contract is formalistic. The Restatement (Second) of
Contracts (Section 1) says, “A contract is a promise or a set of promises for the breach of which
the law gives a remedy, or the performance of which the law in some way recognizes as a duty.”
Similarly, the Uniform Commercial Code says, “‘Contract’ means the total legal obligation which
results from the parties’ agreement as affected by this Act and any other applicable rules of
law.” [3] As operational definitions, these two are circular; in effect, a contract is defined as an
agreement that the law will hold the parties to.
Most simply, a contract is a legally enforceable promise. This implies that not every promise or
agreement creates a binding contract; if every promise did, the simple definition set out in the
preceding sentence would read, “A contract is a promise.” But—again—a contract is not simply a
promise: it is a legally enforceable promise. The law takes into account the way in which
contracts are made, by whom they are made, and for what purposes they are made. For example,
in many states, a wager is unenforceable, even though both parties “shake” on the bet. We will
explore these issues in the chapters to come.

Overview of the Contracts Chapter
Although contract law has many wrinkles and nuances, it consists of four principal inquiries,
each of which will be taken up in subsequent chapters:
1. Did the parties create a valid contract? Four elements are necessary for a valid contract:
a.

Mutual assent (i.e., offer and acceptance), Chapter 9 "The Agreement"

b. Real assent (no duress, undue influence, misrepresentation, mistake, or incapacity), Chapter 10
"Real Assent"
c. Consideration, Chapter 11 "Consideration"
d. Legality, Chapter 12 "Legality"
What does the contract mean, and is it in the proper form to carry out this meaning?
Sometimes contracts need to be in writing (or evidenced by some writing), or they can’t be
enforced. Sometimes it isn’t clear what the contract means, and a court has to figure that out.
These problems are taken up in Chapter 13 "Form and Meaning".
Saylor URL: http://www.saylor.org/books

Saylor.org
302

Do persons other than the contracting parties have rights or duties under the contract?
Can the right to receive a benefit from the contract be assigned, and can the duties be delegated
so that a new person is responsible? Can persons not a party to the contract sue to enforce its
terms? These questions are addressed inChapter 14 "Third-Party Rights".
How do contractual duties terminate, and what remedies are available if a party has
breached the contract? These issues are taken up in Chapter 15 "Discharge of
Obligations" and Chapter 16 "Remedies".
Together, the answers to these four basic inquiries determine the rights and obligations of
contracting parties.

KEY TAKEAWAY

Contract law developed when the strictures of feudalism dissipated, when a person’s
position in society came to be determined by personal choice (by mutual agreement) and not
by status (by how a person was born). Capitalism and contract law have developed together,
because having choices in society means that people decide and agree to do things with and
to each other, and those agreements bind the parties; the agreements must be enforceable.

EXERCISES

1. Why is contract law necessary in a society where a person’s status is not predetermined by
birth?
2. Contract law serves some economic functions. What are they?

[1] Sir Henry Maine, Ancient Law (1869), 180–82.
[2] Richard A. Posner, Economic Analysis of Law (New York: Aspen, 1973).
[3] Uniform Commercial Code, Section 1-201(11).

8.2 Sources of Contract Law

LEARNING OBJECTIVES

1. Understand that contract law comes from two sources: judges (cases) and legislation.
2. Know what the Restatement of Contracts is.
3. Recognize the Convention on Contracts for the International Sale of Goods.

Saylor URL: http://www.saylor.org/books

Saylor.org
303

The most important sources of contract law are state case law and state statutes (though there
are also many federal statutes governing how contracts are made by and with the federal
government).

Case Law
Law made by judges is called case law. Because contract law was made up in the common-law
courtroom by individual judges as they applied rules to resolve disputes before them, it grew
over time to formidable proportions. By the early twentieth century, tens of thousands of
contract disputes had been submitted to the courts for resolution, and the published opinions, if
collected in one place, would have filled dozens of bookshelves. Clearly this mass of material was
too unwieldy for efficient use. A similar problem also had developed in the other leading
branches of the common law.
Disturbed by the profusion of cases and the resulting uncertainty of the law, a group of
prominent American judges, lawyers, and law teachers founded the American Law Institute
(ALI) in 1923 to attempt to clarify, simplify, and improve the law. One of the ALI’s first projects,
and ultimately one of its most successful, was the drafting of
theRestatement of the Law of Contracts, completed in 1932. A revision—the Restatement
(Second) of Contracts—was undertaken in 1964 and completed in 1979. Hereafter, references to
“the Restatement” pertain to the Restatement (Second) of Contracts.
The Restatements—others exist in the fields of torts, agency, conflicts of laws, judgments,
property, restitution, security, and trusts—are detailed analyses of the decided cases in each
field. These analyses are made with an eye to discerning the various principles that have
emerged from the courts, and to the maximum extent possible, the Restatements declare the law
as the courts have determined it to be. The Restatements, guided by a reporter (the director of
the project) and a staff of legal scholars, go through several so-called tentative drafts—
sometimes as many as fifteen or twenty—and are screened by various committees within the ALI
before they are eventually published as final documents.
The Restatement (Second) of Contracts won prompt respect in the courts and has been cited in
innumerable cases. The Restatements are not authoritative, in the sense that they are not actual
judicial precedents; but they are nevertheless weighty interpretive texts, and judges frequently
Saylor URL: http://www.saylor.org/books

Saylor.org
304

look to them for guidance. They are as close to “black letter” rules of law as exist anywhere in the
American common-law legal system.
Common law, case law (the terms are synonymous), governs contracts for the sale of real estate
and services. “Services” refer to acts or deeds (like plumbing, drafting documents, driving a car)
as opposed to the sale of property.

Statutory Law: The Uniform Commercial Code
Common-law contract principles govern contracts for real estate and services. Because of the
historical development of the English legal system, contracts for the sale of goods came to be
governed by a different body of legal rules. In its modern American manifestation, that body of
rules is an important statute: theUniform Commercial Code (UCC), especially Article 2, which
deals with the sale of goods.

History of the UCC
A bit of history is in order. Before the UCC was written, commercial law varied, sometimes
greatly, from state to state. This first proved a nuisance and then a serious impediment to
business as the American economy became nationwide during the twentieth century. Although
there had been some uniform laws concerned with commercial deals—including the Uniform
Sales Act, first published in 1906—few were widely adopted and none nationally. As a result, the
law governing sales of goods, negotiable instruments, warehouse receipts, securities, and other
matters crucial to doing business in an industrial market economy was a crazy quilt of untidy
provisions that did not mesh well from state to state.
The UCC is a model law developed by the ALI and the National Conference of Commissioners on
Uniform State Laws; it has been adopted in one form or another by the legislatures in all fifty
states, the District of Columbia, and the American territories. It is a “national” law not enacted
by Congress—it is not federal law but uniform state law.
Initial drafting of the UCC began in 1942 and was ten years in the making, involving the efforts
of hundreds of practicing lawyers, law teachers, and judges. A final draft, promulgated by the
ALI, was endorsed by the American Bar Association and published in 1951. Various revisions
followed in different states, threatening the uniformity of the UCC. The ALI responded by
creating a permanent editorial board to oversee future revisions. In one or another of its various
Saylor URL: http://www.saylor.org/books

Saylor.org
305

revisions, the UCC has been adopted in whole or in part in all American jurisdictions. The UCC
is now a basic law of relevance to every business and business lawyer in the United States, even
though it is not entirely uniform because different states have adopted it at various stages of its
evolution—an evolution that continues still.

Organization of the UCC
The UCC consists of nine major substantive articles; each deals with separate though related
subjects. The articles are as follows:
•

Article 1: General Provisions

•

Article 2: Sales

•

Article 2A: Leases

•

Article 3: Commercial Paper

•

Article 4: Bank Deposits and Collections

•

Article 4A: Funds Transfers

•

Article 5: Letters of Credit

•

Article 6: Bulk Transfers

•

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

•

Article 8: Investment Securities

•

Article 9: Secured Transactions
Article 2 deals only with the sale of goods, which the UCC defines as “all things…which are
movable at the time of identification to the contract for sale other than the money in which the
price is to be paid.” [1] The only contracts and agreements covered by Article 2 are those relating
to the present or future sale of goods.
Article 2 is divided in turn into six major parts: (1) Form, Formation, and Readjustment of
Contract; (2) General Obligation and Construction of Contract; (3) Title, Creditors, and Good
Faith Purchasers; (4) Performance; (5) Breach, Repudiation, and Excuse; and (6) Remedies.
These topics will be discussed in Chapter 17 "Introduction to Sales and Leases", Chapter 18
"Title and Risk of Loss", Chapter 19 "Performance and Remedies", Chapter 20 "Products
Liability", and Chapter 21 "Bailments and the Storage, Shipment, and Leasing of Goods".

Saylor URL: http://www.saylor.org/books

Saylor.org
306

Figure 8.1 Sources of Law

International Sales Law
The Convention on Contracts for the International Sale of Goods
A Convention on Contracts for the International Sale of Goods (CISG) was approved in 1980 at a
diplomatic conference in Vienna. (A convention is a preliminary agreement that serves as the
basis for a formal treaty.) The CISG has been adopted by more than forty countries, including
the United States.
The CISG is significant for three reasons. First, it is a uniform law governing the sale of goods—
in effect, an international Uniform Commercial Code. The major goal of the drafters was to
produce a uniform law acceptable to countries with different legal, social, and economic
systems. Second, although provisions in the CISG are generally consistent with the UCC, there
are significant differences. For instance, under the CISG, consideration (discussed in Chapter 11
"Consideration") is not required to form a contract, and there is no Statute of Frauds (a
requirement that certain contracts be evidenced by a writing). Third, the CISG represents the
first attempt by the US Senate to reform the private law of business through its treaty powers,
for the CISG preempts the UCC. The CISG is not mandatory: parties to an international contract
for the sale of goods may choose to have their agreement governed by different law, perhaps the
UCC, or perhaps, say, Japanese contract law. The CISG does not apply to contracts for the sale
of (1) ships or aircraft, (2) electricity, or (3) goods bought for personal, family, or household use,
Saylor URL: http://www.saylor.org/books

Saylor.org
307

nor does it apply (4) where the party furnishing the goods does so only incidentally to the labor
or services part of the contract.

KEY TAKEAWAY

Judges have made contract law over several centuries by deciding cases that create, extend,
or change the developing rules affecting contract formation, performance, and enforcement.
The rules from the cases have been abstracted and organized in the Restatements of
Contracts. To facilitate interstate commerce, contract law for many commercial
transactions—especially the sale of goods—not traditionally within the purview of judges has
been developed by legal scholars and presented for the states to adopt as the Uniform
Commercial Code. There is an analogous Convention on Contracts for the International Sale
of Goods, to which the United States is a party.

EXERCISES

1. How do judges make contract law?
2. What is the Restatement of the Law of Contracts, and why was it necessary?
3. Why was the Uniform Commercial Code developed, and by whom?
4. Who adopts the UCC as governing law?
5. What is the Convention on Contracts for the International Sale of Goods?

[1] Uniform Commercial Code, Section 2-105.

8.3 Basic Taxonomy of Contracts

LEARNING OBJECTIVES

1. Understand that contracts are classified according to the criteria of explicitness, mutuality,
enforceability, and degree of completion and that some noncontract promises are
nevertheless enforceable under the doctrine of promissory estoppel.
2. Keep your eyes (and ears) alert to the use of suffixes (word endings) in legal terminology that
express relationships between parties.
Some contracts are written, some oral; some are explicit, some not. Because contracts can be
formed, expressed, and enforced in a variety of ways, a taxonomy of contracts has developed
that is useful in grouping together like legal consequences. In general, contracts are classified
Saylor URL: http://www.saylor.org/books

Saylor.org
308

along four different dimensions: explicitness, mutuality, enforceability, and degree of
completion. Explicitness is the degree to which the agreement is manifest to those not party to
it. Mutuality takes into account whether promises are given by two parties or only one.
Enforceability is the degree to which a given contract is binding. Completion considers whether
the contract is yet to be performed or whether the obligations have been fully discharged by one
or both parties. We will examine each of these concepts in turn.

Explicitness
Express Contract
An express contract is one in which the terms are spelled out directly. The parties to an express
contract, whether it is written or oral, are conscious that they are making an enforceable
agreement. For example, an agreement to purchase your neighbor’s car for $5,500 and to take
title next Monday is an express contract.

Implied Contract (Implied in Fact)
An implied contract is one that is inferred from the actions of the parties. When parties have not
discussed terms, an implied contract exists if it is clear from the conduct of both parties that
they intended there be one. A delicatessen patron who asks for a turkey sandwich to go has
made a contract and is obligated to pay when the sandwich is made. By ordering the food, the
patron is implicitly agreeing to the price, whether posted or not.
The distinction between express and implied contracts has received a degree of notoriety in the
so-called palimony cases, in which one member of an unmarried couple seeks a division of
property after a long-standing live-together relationship has broken up. When a married couple
divorces, their legal marriage contract is dissolved, and financial rights and obligations are
spelled out in a huge body of domestic relations statutes and judicial decisions. No such laws
exist for unmarried couples. However, about one-third of the states recognize common-law
marriage, under which two people are deemed to be married if they live together with the intent
to be married, regardless of their failure to have obtained a license or gone through a ceremony.
Although there is no actual contract of marriage (no license), their behavior implies that the
parties intended to be treated as if they were married.

Quasi-Contract
Saylor URL: http://www.saylor.org/books

Saylor.org
309

A quasi-contract (implied in law) is—unlike both express and implied contracts, which embody
an actual agreement of the parties—an obligation said to be “imposed by law” in order to avoid
unjust enrichment of one person at the expense of another. A quasi-contract is not a contract at
all; it is a fiction that the courts created to prevent injustice. Suppose, for example, that the local
lumberyard mistakenly delivers a load of lumber to your house, where you are repairing your
deck. It was a neighbor on the next block who ordered the lumber, but you are happy to accept
the load for free; since you never talked to the lumberyard, you figure you need not pay the bill.
Although it is true there is no contract, the law implies a contract for the value of the material: of
course you will have to pay for what you got and took. The existence of this implied contract
does not depend on the intention of the parties.

Mutuality
Bilateral Contract
The typical contract is one in which the parties make mutual promises. Each is both promisor
and promisee; that is, each pledges to do something, and each is the recipient of such a pledge.
This type of contract is called a bilateral contract.

Unilateral Contract
Mutual promises are not necessary to constitute a contract. Unilateral contracts, in which one
party performs an act in exchange for the other party’s promise, are equally valid. An offer of a
reward—for catching a criminal or for returning a lost cat—is an example of a unilateral
contract: there is an offer on one side, and the other side accepts by taking the action requested.

Figure 8.2 Bilateral and Unilateral Contracts

Saylor URL: http://www.saylor.org/books

Saylor.org
310

Enforceability
Void
Not every agreement between two people is a binding contract. An agreement that is lacking one
of the legal elements of a contract is said to be a void contract—that is, not a contract at all. An
agreement that is illegal—for example, a promise to commit a crime in return for a money
payment—is void. Neither party to a void “contract” may enforce it.

Voidable
By contrast, a voidable contract is one that may become unenforceable by one party but can be
enforced by the other. For example, a minor (any person under eighteen, in most states) may
“avoid” a contract with an adult; the adult may not enforce the contract against the minor if the
minor refuses to carry out the bargain. But the adult has no choice if the minor wishes the
contract to be performed. (A contract may be voidable by both parties if both are minors.)
Ordinarily, the parties to a voidable contract are entitled to be restored to their original
condition. Suppose you agree to buy your seventeen-year-old neighbor’s car. He delivers it to
you in exchange for your agreement to pay him next week. He has the legal right to terminate
the deal and recover the car, in which case you will of course have no obligation to pay him. If
you have already paid him, he still may legally demand a return to the status quo ante (previous
state of affairs). You must return the car to him; he must return the cash to you.
A voidable contract remains a valid contract until it is voided. Thus a contract with a minor
remains in force unless the minor decides he or she does not wish to be bound by it. When the
Saylor URL: http://www.saylor.org/books

Saylor.org
311

minor reaches majority, he or she may “ratify” the contract—that is, agree to be bound by it—in
which case the contract will no longer be voidable and will thereafter be fully enforceable.

Unenforceable
An unenforceable contract is one that some rule of law bars a court from enforcing. For example,
Tom owes Pete money, but Pete has waited too long to collect it and the statute of limitations
has run out. The contract for repayment is unenforceable and Pete is out of luck, unless Tom
makes a new promise to pay or actually pays part of the debt. (However, if Pete is holding
collateral as security for the debt, he is entitled to keep it; not all rights are extinguished because
a contract is unenforceable.) A debt becomes unenforceable, too, when the debtor declares
bankruptcy.
A bit more on enforceability is in order. A promise or what seems to be a promise is usually
enforceable only if it is otherwise embedded in the elements necessary to make that promise a
contract. Those elements are mutual assent, real assent, consideration, capacity, and legality.
Sometimes, though, people say things that seem like promises, and on which another person
relies. In the early twentieth century, courts began, in some circumstances, to recognize that
insisting on the existence of the traditional elements of contract to determine whether a promise
is enforceable could work an injustice where there has been reliance. Thus developed the
equitable doctrine ofpromissory estoppel, which has become an important adjunct to contract
law. The Restatement (Section 90) puts it this way: “A promise which the promisor should
reasonably expect to induce action or forbearance on the party of the promisee or a third person
and which does induce such action or forbearance is binding if injustice can be avoided only by
enforcement of the promise. The remedy granted for breach may be limited as justice requires.”
To be “estopped” means to be prohibited from denying now the validity of a promise you made
before.
The doctrine has an interesting background. In 1937, High Trees House Ltd. (a British
corporation) leased a block of London apartments from Central London Properties. As World
War II approached, vacancy rates soared because people left the city. In 1940 the parties agreed
to reduce the rent rates by half, but no term was set for how long the reduction would last. By
mid-1945, as the war was ending, occupancy was again full, and Central London sued for the full
Saylor URL: http://www.saylor.org/books

Saylor.org
312

rental rates from June on. The English court, under Judge Alfred Thompson Denning (1899–
1999), had no difficulty finding that High Trees owed the full amount once full occupancy was
again achieved, but Judge Denning went on. In an aside (called a dicta—a statement “by the
way”—that is, not necessary as part of the decision), he mused about what would have happened
if in 1945 Central London had sued for the full-occupancy rate back to 1940. Technically, the
1940 amendment to the 1937 contract was not binding on Central London—it lacked
consideration—and Central London could have reached back to demand full-rate payment. But
Judge Denning said that High Trees would certainly have relied on Central London’s promise
that a reduced-rate rent would be acceptable, and that would have been enough to bind it, to
prevent it from acting inconsistently with the promise. He wrote, “The courts have not gone so
far as to give a cause of action in damages for the breach of such a promise, but they have
refused to allow the party making it to act inconsistently with it.” [1]
In the years since, though, courts have gone so far as to give a cause of action in damages for
various noncontract promises. Contract protects agreements; promissory estoppel protects
reliance, and that’s a significant difference. The law of contracts continues to evolve.

Degree of Completion
An agreement consisting of a set of promises is called an executory contract before any promises
are carried out. Most executory contracts are enforceable. If John makes an agreement to deliver
wheat to Humphrey and does so, the contract is called apartially executed contract: one side has
performed, the other has not. When John pays for the wheat, the contract is fully performed. A
contract that has been carried out fully by both parties is called an executed contract.

Terminology: Suffixes Expressing Relationships
Although not really part of the taxonomy of contracts (i.e., the orderly classification of the
subject), an aspect of contractual—indeed, legal—terminology should be highlighted
here. Suffixes (the end syllables of words) in the English language are used to express
relationships between parties in legal terminology. Here are examples:
•

Offeror. One who makes an offer.

•

Offeree. One to whom an offer is made.

•

Promisor. One who makes a promise.
Saylor URL: http://www.saylor.org/books

Saylor.org
313

•

Promisee. One to whom a promise is made.

•

Obligor. One who makes and has an obligation.

•

Obligee. One to whom an obligation is made.

•

Transferor. One who makes a transfer.

•

Transferee. One to whom a transfer is made.

KEY TAKEAWAY

Contracts are described and thus defined on the basis of four criteria: explicitness (express,
implied, or quasi-contracts), mutuality (bilateral or unilateral), enforceability (void, voidable,
unenforceable), and degree of completion (executory, partially executed, executed). Legal
terminology in English often describes relationships between parties by the use of suffixes, to
which the eye and ear must pay attention.

EXERCISES

1. Able writes to Baker: “I will mow your lawn for $20.” If Baker accepts, is this an express or
implied contract?
2. Able telephones Baker: “I will mow your lawn for $20.” Is this an express or implied contract?
3. What is the difference between a void contract and a voidable one?
4. Carr staples this poster to a utility pole: “$50 reward for the return of my dog, Argon.”
Describe this in contractual terms regarding explicitness, mutuality, enforceability, and
degree of completion.
5. Is a voidable contract always unenforceable?
6. Contractor bids on a highway construction job, incorporating Guardrail Company’s bid into its
overall bid to the state. Contractor cannot accept Guardrail’s offer until it gets the nod from
the state. Contractor gets the nod from the state, but before it can accept Guardrail’s offer,
the latter revokes it. Usually a person can revoke an offer any time before it is accepted. Can
Guardrail revoke its offer in this case?

[1] Central London Property Trust Ltd. v. High Trees House Ltd. (1947) KB 130.

8.4 Cases
Saylor URL: http://www.saylor.org/books

Saylor.org
314

Explicitness: Implied Contract
Roger’s Backhoe Service, Inc. v. Nichols
681 N.W.2d 647 (Iowa 2004)
Carter, J.
Defendant, Jeffrey S. Nichols, is a funeral director in Muscatine.…In early 1998 Nichols decided
to build a crematorium on the tract of land on which his funeral home was located. In working
with the Small Business Administration, he was required to provide drawings and specifications
and obtain estimates for the project. Nichols hired an architect who prepared plans and
submitted them to the City of Muscatine for approval. These plans provided that the surface
water from the parking lot would drain onto the adjacent street and alley and ultimately enter
city storm sewers. These plans were approved by the city.
Nichols contracted with Roger’s [Backhoe Service, Inc.] for the demolition of the foundation of a
building that had been razed to provide room for the crematorium and removal of the concrete
driveway and sidewalk adjacent to that foundation. Roger’s completed that work and was paid in
full.
After construction began, city officials came to the jobsite and informed Roger’s that the
proposed drainage of surface water onto the street and alley was unsatisfactory. The city
required that an effort be made to drain the surface water into a subterranean creek, which
served as part of the city’s storm sewer system. City officials indicated that this subterranean
sewer system was about fourteen feet below the surface of the ground.…Roger’s conveyed the
city’s mandate to Nichols when he visited the jobsite that same day.
It was Nichols’ testimony at trial that, upon receiving this information, he advised…Roger’s that
he was refusing permission to engage in the exploratory excavation that the city required.
Nevertheless, it appears without dispute that for the next three days Roger’s did engage in
digging down to the subterranean sewer system, which was located approximately twenty feet
below the surface. When the underground creek was located, city officials examined the brick
walls in which it was encased and determined that it was not feasible to penetrate those walls in
order to connect the surface water drainage with the underground creek. As a result of that

Saylor URL: http://www.saylor.org/books

Saylor.org
315

conclusion, the city reversed its position and once again gave permission to drain the surface
water onto the adjacent street and alley.
[T]he invoices at issue in this litigation relate to charges that Roger’s submitted to Nichols for
the three days of excavation necessary to locate the underground sewer system and the cost for
labor and materials necessary to refill the excavation with compactable materials and attain
compaction by means of a tamping process.…The district court found that the charges submitted
on the…invoices were fair and reasonable and that they had been performed for Nichols’ benefit
and with his tacit approval.…
The court of appeals…concluded that a necessary element in establishing an implied-in-fact
contract is that the services performed be beneficial to the alleged obligor. It concluded that
Roger’s had failed to show that its services benefited Nichols.…
In describing the elements of an action on an implied contract, the court of appeals stated in
[Citation], that the party seeking recovery must show:
(1) the services were carried out under such circumstances as to give the recipient
reason to understand:
(a) they were performed for him and not some other person, and
(b) they were not rendered gratuitously, but with the expectation of compensation
from the recipient; and
(2) the services were beneficial to the recipient.
In applying the italicized language in [Citation] to the present controversy, it was the conclusion
of the court of appeals that Roger’s’ services conferred no benefit on Nichols. We disagree. There
was substantial evidence in the record to support a finding that, unless and until an effort was
made to locate the subterranean sewer system, the city refused to allow the project to proceed.
Consequently, it was necessary to the successful completion of the project that the effort be
made. The fact that examination of the brick wall surrounding the underground creek indicated
that it was unfeasible to use that source of drainage does not alter the fact that the project was
stalemated until drainage into the underground creek was fully explored and rejected. The
district court properly concluded that Roger’s’ services conferred a benefit on Nichols.…
Decision of court of appeals vacated; district court judgment affirmed.
Saylor URL: http://www.saylor.org/books

Saylor.org
316

CASE QUESTIONS
1. What facts must be established by a plaintiff to show the existence of an implied contract?
2. What argument did Nichols make as to why there was no implied contract here?
3. How would the facts have to be changed to make an express contract?

Mutuality of Contract: Unilateral Contract
SouthTrust Bank v. Williams
775 So.2d 184 (Ala. 2000)
Cook, J.
SouthTrust Bank (“SouthTrust”) appeals from an order denying its motion to compel arbitration
of an action against it by checking-account customers Mark Williams and Bessie Daniels. We
reverse and remand.
Daniels and Williams began their relationship with SouthTrust in 1981 and 1995, respectively,
by executing checking-account “signature cards.” The signature card each customer signed
contained a “change-in-terms” clause. Specifically, when Daniels signed her signature card, she
“agree[d] to be subject to the Rules and Regulations as may now or hereafter be adopted by the
Bank.” (Emphasis added.)…[Later,] SouthTrust added paragraph 33 to the regulations:…
ARBITRATION OF DISPUTES. You and we agree that the transactions in your
account involve ‘commerce’ under the Federal Arbitration Act (‘FAA’). ANY
CONTROVERSY OR CLAIM BETWEEN YOU AND US…WILL BE SETTLED BY
BINDING ARBITRATION UNDER THE FAA.…
This action…challenges SouthTrust’s procedures for paying overdrafts, and alleges that
SouthTrust engages in a “uniform practice of paying the largest check(s) before paying multiple
smaller checks…[in order] to generate increased service charges for [SouthTrust] at the expense
of [its customers].”
SouthTrust filed a “motion to stay [the] lawsuit and to compel arbitration.” It based its motion
on paragraph 33 of the regulations. [T]he trial court…entered an order denying SouthTrust’s
motion to compel arbitration. SouthTrust appeals.…
Williams and Daniels contend that SouthTrust’s amendment to the regulations, adding
paragraph 33, was ineffective because, they say, they did not expressly assent to the

Saylor URL: http://www.saylor.org/books

Saylor.org
317

amendment. In other words, they object to submitting their claims to arbitration because, they
say, when they opened their accounts, neither the regulations nor any other relevant document
contained an arbitration provision. They argue that “mere failure to object to the addition of a
material term cannot be construed as an acceptance of it.”…They contend that SouthTrust could
not unilaterally insert an arbitration clause in the regulations and make it binding on depositors
like them.
SouthTrust, however, referring to its change-of-terms clause insists that it “notified” Daniels and
Williams of the amendment in January 1997 by enclosing in each customer’s “account
statement” a complete copy of the regulations, as amended. Although it is undisputed that
Daniels and Williams never affirmatively assented to these amended regulations, SouthTrust
contends that their assent was evidenced by their failure to close their accounts after they
received notice of the amendments.…Thus, the disposition of this case turns on the legal effect of
Williams and Daniels’s continued use of the accounts after the regulations were amended.
Williams and Daniels argue that “[i]n the context of contracts between merchants [under the
UCC], a written confirmation of an acceptance may modify the contractunless it adds
a material term, and arbitration clauses are material terms.”…
Williams and Daniels concede—as they must—…that Article 2 governs “transactions in goods,”
and, consequently, that it is not applicable to the transactions in this case. Nevertheless, they
argue:
It would be astonishing if a Court were to consider the addition of an arbitration
clause a material alteration to a contract between merchants, who by definition are
sophisticated in the trade to which the contract applies, butnot hold that the addition
of an arbitration clause is a material alteration pursuant to a change-of-terms clause
in a contract between one sophisticated party, a bank, and an entire class of less
sophisticated parties, its depositors.…
In response, SouthTrust states that “because of the ‘at-will’ nature of the relationship, banks by
necessity must contractually reserve the right to amend their deposit agreements from time to
time.” In so stating, SouthTrust has precisely identified the fundamental difference between the
transactions here and those transactions governed by [Article 2].
Saylor URL: http://www.saylor.org/books

Saylor.org
318

Contracts for the purchase and sale of goods are essentially bilateral and executory in nature.
See [Citation] “An agreement whereby one party promises to sell and the other promises to buy
a thing at a later time…is a bilateral promise of sale or contract to sell”.…“[A] unilateral contract
results from an exchange of a promise for an act; a bilateral contract results from an exchange of
promises.”…Thus, “in a unilateral contract, there is no bargaining process or exchange of
promises by parties as in a bilateral contract.” [Citation] “[O]nly one party makes an offer (or
promise) which invites performance by another, and performance constitutes both acceptance of
that offer and consideration.” Because “a ‘unilateral contract’ is one in which no promisor
receives promise as consideration for his promise,” only one party is bound.…The difference is
not one of semantics but of substance; it determines the rights and responsibilities of the
parties, including the time and the conditions under which a cause of action accrues for a breach
of the contract.
This case involves at-will, commercial relationships, based upon a series of unilateral
transactions. Thus, it is more analogous to cases involving insurance policies, such as
[Citations]. The common thread running through those cases was the amendment by one of the
parties to a business relationship of a document underlying that relationship—without the
express assent of the other party—to require the arbitration of disputes arising after the
amendment.…
The parties in [the cited cases], like Williams and Daniels in this case, took no action that could
be considered inconsistent with an assent to the arbitration provision. In each case, they
continued the business relationship after the interposition of the arbitration provision. In doing
so, they implicitly assented to the addition of the arbitration provision.…
Reversed and remanded.

CASE QUESTIONS

1. Why did the plaintiffs think they should not be bound by the arbitration clause?
2. The court said this case involved a unilateral contract. What makes it that, as opposed to a
bilateral contract?
3. What should the plaintiffs have done if they didn’t like the arbitration requirement?

Unilateral Contract and At-Will Employment
Saylor URL: http://www.saylor.org/books

Saylor.org
319

Woolley v. Hoffmann-La Roche, Inc.
491 A.2d 1257 (N.J. 1985)
Wilntz, C. J.
Plaintiff, Richard Woolley, was hired by defendant, Hoffmann-La Roche, Inc., in October 1969,
as an Engineering Section Head in defendant’s Central Engineering Department at Nutley.
There was no written employment contract between plaintiff and defendant. Plaintiff began
work in mid-November 1969. Sometime in December, plaintiff received and read the personnel
manual on which his claims are based.
[The company’s personnel manual had eight pages;] five of the eight pages are devoted to
“termination.” In addition to setting forth the purpose and policy of the termination section, it
defines “the types of termination” as “layoff,” “discharge due to performance,” “discharge,
disciplinary,” “retirement” and “resignation.” As one might expect, layoff is a termination caused
by lack of work, retirement a termination caused by age, resignation a termination on the
initiative of the employee, and discharge due to performance and discharge, disciplinary, are
both terminations for cause. There is no category set forth for discharge without cause. The
termination section includes “Guidelines for discharge due to performance,” consisting of a
fairly detailed procedure to be used before an employee may be fired for cause. Preceding these
definitions of the five categories of termination is a section on “Policy,” the first sentence of
which provides: “It is the policy of Hoffmann-La Roche to retain to the extent consistent with
company requirements, the services of all employees who perform their duties efficiently and
effectively.”
In 1976, plaintiff was promoted, and in January 1977 he was promoted again, this latter time to
Group Leader for the Civil Engineering, the Piping Design, the Plant Layout, and the Standards
and Systems Sections. In March 1978, plaintiff was directed to write a report to his supervisors
about piping problems in one of defendant’s buildings in Nutley. This report was written and
submitted to plaintiff’s immediate supervisor on April 5, 1978. On May 3, 1978, stating that the
General Manager of defendant’s Corporate Engineering Department had lost confidence in him,
plaintiff’s supervisors requested his resignation. Following this, by letter dated May 22, 1978,
plaintiff was formally asked for his resignation, to be effective July 15, 1978.
Saylor URL: http://www.saylor.org/books

Saylor.org
320

Plaintiff refused to resign. Two weeks later defendant again requested plaintiff’s resignation,
and told him he would be fired if he did not resign. Plaintiff again declined, and he was fired in
July.
Plaintiff filed a complaint alleging breach of contract.…The gist of plaintiff’s breach of contract
claim is that the express and implied promises in defendant’s employment manual created a
contract under which he could not be fired at will, but rather only for cause, and then only after
the procedures outlined in the manual were followed. Plaintiff contends that he was not
dismissed for good cause, and that his firing was a breach of contract.
Defendant’s motion for summary judgment was granted by the trial court, which held that the
employment manual was not contractually binding on defendant, thus allowing defendant to
terminate plaintiff’s employment at will. The Appellate Division affirmed. We granted
certification.
The employer’s contention here is that the distribution of the manual was simply an expression
of the company’s “philosophy” and therefore free of any possible contractual consequences. The
former employee claims it could reasonably be read as an explicit statement of company policies
intended to be followed by the company in the same manner as if they were expressed in an
agreement signed by both employer and employees.…
This Court has long recognized the capacity of the common law to develop and adapt to current
needs.…The interests of employees, employers, and the public lead to the conclusion that the
common law of New Jersey should limit the right of an employer to fire an employee at will.
In order for an offer in the form of a promise to become enforceable, it must be accepted.
Acceptance will depend on what the promisor bargained for: he may have bargained for a return
promise that, if given, would result in a bilateral contract, both promises becoming enforceable.
Or he may have bargained for some action or nonaction that, if given or withheld, would render
his promise enforceable as a unilateral contract. In most of the cases involving an employer’s
personnel policy manual, the document is prepared without any negotiations and is voluntarily
distributed to the workforce by the employer. It seeks no return promise from the employees. It
is reasonable to interpret it as seeking continued work from the employees, who, in most cases,
are free to quit since they are almost always employees at will, not simply in the sense that the
Saylor URL: http://www.saylor.org/books

Saylor.org
321

employer can fire them without cause, but in the sense that they can quit without breaching any
obligation. Thus analyzed, the manual is an offer that seeks the formation of a unilateral
contract—the employees’ bargained-for action needed to make the offer binding being their
continued work when they have no obligation to continue.
The unilateral contract analysis is perfectly adequate for that employee who was aware of the
manual and who continued to work intending that continuation to be the action in exchange for
the employer’s promise; it is even more helpful in support of that conclusion if, but for the
employer’s policy manual, the employee would have quit. See generally M. Petit, “Modern
Unilateral Contracts,” 63 Boston Univ. Law Rev. 551 (1983) (judicial use of unilateral contract
analysis in employment cases is widespread).
…All that this opinion requires of an employer is that it be fair. It would be unfair to allow an
employer to distribute a policy manual that makes the workforce believe that certain promises
have been made and then to allow the employer to renege on those promises. What is sought
here is basic honesty: if the employer, for whatever reason, does not want the manual to be
capable of being construed by the court as a binding contract, there are simple ways to attain
that goal. All that need be done is the inclusion in a very prominent position of an appropriate
statement that there is no promise of any kind by the employer contained in the manual; that
regardless of what the manual says or provides, the employer promises nothing and remains
free to change wages and all other working conditions without having to consult anyone and
without anyone’s agreement; and that the employer continues to have the absolute power to fire
anyone with or without good cause.
Reversed and remanded for trial.

CASE QUESTIONS

1. What did Woolley do to show his acceptance of the terms of employment offered to him?
2. In part of the case not included here, the court notes that Mr. Woolley died “before oral
arguments on this case.” How can there be any damages if the plaintiff has died? Who now
has any case to pursue?
3. The court here is changing the law of employment in New Jersey. It is making case law, and
the rule here articulated governs similar future cases in New Jersey. Why did the court make

Saylor URL: http://www.saylor.org/books

Saylor.org
322

this change? Why is it relevant that the court says it would be easy for an employer to avoid
this problem?

8.5 Summary and Exercises
Summary

Contract law developed as the status-centered organization of feudal society faded and people
began to make choices about how they might order their lives. In the capitalistic system, people
make choices about how to interact with others, and—necessarily—those choices expressed as
promises must be binding and enforceable.
The two fundamental sources of contract law are (1) the common law as developed in the state
courts and as summarized in the Restatement (Second) of Contracts and (2) the Uniform
Commercial Code for the sale of goods. In general, the UCC is more liberal than the common law
in upholding the existence of a contract.
Types of contracts can be distinguished by four criteria: (1) express and implied, including
quasi-contracts implied by law; (2) bilateral and unilateral; (3) enforceable and unenforceable;
and (4) completed (executed) and uncompleted (executory). To understand contract law, it is
necessary to master these distinctions and their nuances.

EXERCISES

1.
a. Mr. and Mrs. Smith, an elderly couple, had no relatives. When Mrs. Smith became
ill, the Smiths asked a friend, Henrietta, to help with various housekeeping chores,
including cleaning and cooking. Although the Smiths never promised to pay her,
Henrietta performed the chores for eighteen months. Henrietta now claims that
she is entitled to the reasonable value of the services performed. Is she correct?
Explain.
b. Assume instead that the Smiths asked Mrs. Smith’s sister, Caroline, who lived
nearby, to help with the housekeeping. After eighteen months, Caroline claims
she is entitled to the reasonable value of the services performed. Is she correct?
Explain.

Saylor URL: http://www.saylor.org/books

Saylor.org
323

A letter from Bridge Builders Inc. to the Allied Steel Company stated, “We offer to
purchase 10,000 tons of No. 4 steel pipe at today’s quoted price for delivery two months
from today. Your acceptance must be received in five days.” Does Bridge Builders intend to
create a bilateral or a unilateral contract? Why?
Roscoe’s barber persuaded him to try a new hair cream called Sansfree, which the barber
applied to Roscoe’s hair and scalp. The next morning Roscoe had a very unpleasant rash
along his hairline. Upon investigation he discovered that the rash was due to an improper
chemical compound in Sansfree. If Roscoe filed a breach of contract action against the
barber, would the case be governed by the Uniform Commercial Code or common law?
Explain.
Rachel entered into a contract to purchase a 2004 Dodge from Hanna, who lived in the
neighboring apartment. When a dispute arose over the terms of the contract, Hanna argued
that, because neither she nor Rachel was a merchant, the dispute should be decided under
general principles of common law. Rachel, on the other hand, argued that Hanna was legally
considered to be a merchant because she sold the car for profit and that, consequently, the
sale was governed by the Uniform Commercial Code. Who is correct? Explain.
Lee and Michelle decided to cohabit. When they set up house, Michelle gave up her
career, and Lee promised to share his earnings with her on a fifty-fifty basis. Several years
later they ended their relationship, and when Lee failed to turn over half of his earnings,
Michelle filed suit on the basis of Lee’s promise. What kind of contract would Michelle allege
that Lee had breached? Explain.
Harry and Wilma were divorced in 2008, and Harry was ordered in the divorce decree to
pay his ex-wife $10,000. In 2009 and 2010 Harry was hospitalized, incurring $3,000 in bills. He
and Wilma discussed the matter, and Wilma agreed to pay the bill with her own money, even
though Harry still owed her $5,000 from the divorce decree. When Harry died in late 2010,
Wilma made a claim against his estate for $8,000 (the $3,000 in medical bills and the $5,000
from the decree), but the estate was only willing to pay the $5,000 from the decree, claiming
she had paid the hospital bill voluntarily and had no contract for repayment. Is the estate
correct? Explain.
Saylor URL: http://www.saylor.org/books

Saylor.org
324

Louie, an adult, entered into a contract to sell a case of scotch whiskey to Leroy, a minor.
Is the contract void or voidable? Explain.
James Mann owned a manufacturing plant that assembled cell phones. A
CPA audit determined that several phones were missing. Theft by one or more of
the workers was suspected. Accordingly, under Mann’s instructions, the following
sign was placed in the employees’ cafeteria:
Reward. We are missing phones. I want all employees to watch for
thievery. A reward of $500 will be paid for information given by any
employee that leads to the apprehension of employee thieves.
—James Mann
Waldo, a plant employee, read the notice and immediately called Mann, stating,
“I accept your offer. I promise to watch other employees and provide you with the
requested information.” Has a contract been formed? Explain.
Almost every day Sally took a break at lunch and went to the International News Stand—a
magazine store—to browse the newspapers and magazines and chat with the owner,
Conrad. Often she bought a magazine. One day she went there, browsed a bit, and took a
magazine off the rack. Conrad was busy with three customers. Sally waved the magazine at
Conrad and left the store with it. What kind of a contract, if any, was created?
Joan called Devon Sand & Gravel and ordered two “boxes” (dump-truck loads) of gravel to
be spread on her rural driveway by the “shoot and run” method: the tailgate is partially
opened, the dump-truck bed is lifted, and the truck moves down the driveway spreading
gravel as it goes. The driver mistakenly graveled the driveway of Joan’s neighbor, Watson,
instead of Joan’s. Is Devon entitled to payment by Watson? Explain.

SELF-TEST QUESTIONS

1. An implied contract
a.

must be in writing

b. is one in which the terms are spelled out
c. is one inferred from the actions of the parties
d. is imposed by law to avoid an unjust result

Saylor URL: http://www.saylor.org/books

Saylor.org
325

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
An unenforceable contract is
a.

void, not a contract at all

b. one that a court will not enforce for either side because of a rule of law
c. unenforceable by one party but enforceable by the other
d. one that has been performed by one party but not the other
e. too indefinite to be valid
Betty Baker found a bicycle apparently abandoned near her house. She took
it home and spent $150 repairing and painting it, after which Carl appeared and
proved his ownership of it. Under what theory is Betty able to get reimbursed for
her expenditures?
a.

express contract

b. implied contract
c. apparent or quasi-contract
d. executory contract
e. none: she will not get reimbursed
Alice discusses with her neighbor Bob her plan to hire Woodsman to cut
three trees on her side of their property line, mentioning that she can get a good
deal because Woodsman is now between jobs. Bob says, “Oh, don’t do that. My
brother is going to cut some trees on my side, and he can do yours too for free.”
Alice agrees. But Bob’s brother is preoccupied and never does the job. Three

Saylor URL: http://www.saylor.org/books

Saylor.org
326

weeks later Alice discovers Woodsman’s rates have risen prohibitively. Under
what theory does Alice have a cause of action against Bob?
a.

express contract

b. promissory estoppel
c. quasi-contract
d. implied contract
e. none: she has no cause of action against Bob

SELF-TEST ANSWERS

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

Saylor URL: http://www.saylor.org/books

Saylor.org
327

Chapter 9
The Agreement

LEARNING OBJECTIVES

After reading this chapter, you should understand the following:
1. What a contract offer is, and what proposals are not offers
2. How an offer is communicated
3. How definite the offer needs to be
4. How long an offer is good for
5. How an offer is accepted, who can accept it, and when acceptance is effective
In this chapter, we begin the first of the four broad inquiries of contract law mentioned
in Chapter 8 "Introduction to Contract Law": Did the parties create a valid contract? The answer
is not always obvious; the range of factors that must be taken into account can be large, and
their relationships subtle. Since businesspeople frequently conduct contract negotiations
without the assistance of a lawyer, it is important to attend to the nuances in order to avoid legal
trouble at the outset. Whether a contract has been formed depends in turn on whether
1. the parties reached an agreement (the focus of this chapter);
2. consideration was present;
3. the agreement was legal; and
4. the parties entered into the contract of their own free will, with knowledge of the facts, and with
the capacity to make a contract.
Factors 2, 3, and 4 are the subjects of subsequent chapters.

9.1 The Agreement in General

LEARNING OBJECTIVES

1. Recognize that not all agreements or promises are contracts.
2. Understand that whether a contract exists is based on an objective analysis of the parties’
interaction, not on a subjective one.

The Significance of Agreement

Saylor URL: http://www.saylor.org/books

Saylor.org
328

The core of a legal contract is the agreement between the parties. This is not a necessary
ingredient; in Communist nations, contracts were (or are, in the few remaining Communist
countries) routinely negotiated between parties who had the terms imposed on them. But in the
West, and especially in the United States, agreement is of the essence. That is not merely a
matter of convenience; it is at the heart of our philosophical and psychological beliefs. As the
great student of contract law Samuel Williston put it, “It was a consequence of the emphasis laid
on the ego and the individual will that the formation of a contract should seem impossible
unless the wills of the parties concurred. Accordingly we find at the end of the eighteenth
century, and the beginning of the nineteenth century, the prevalent idea that there must be a
“meeting of the minds” (a new phrase) in order to form a contract.” [1]
Although agreements may take any form, including unspoken conduct between the parties, they
are usually structured in terms of an offer and an acceptance. [2] These two components will be
the focus of our discussion. Note, however, that not every agreement, in the broadest sense of
the word, need consist of an offer and an acceptance, and that it is entirely possible, therefore,
for two persons to reach agreement without forming a contract. For example, people may agree
that the weather is pleasant or that it would be preferable to go out for Chinese food rather than
to see a foreign film; in neither case has a contract been formed. One of the major functions of
the law of contracts is to sort out those agreements that are legally binding—those that are
contracts—from those that are not.

The Objective Test
In interpreting agreements, courts generally apply an objective standard (outwardly, as an
observer would interpret; not subjectively). The Restatement (Second) of Contracts
defines agreement as a “manifestation of mutual assent by two or more persons to one
another.” [3] The Uniform Commercial Code defines agreement as “the bargain of the parties in
fact as found in their language or by implication from other circumstances including course of
dealing or usage of trade or course of performance.”[4] The critical question is what the parties
said or did, not what they thought they said or did, or not what impression they thought they
were making.

Saylor URL: http://www.saylor.org/books

Saylor.org
329

The distinction between objective and subjective standards crops up occasionally when one
person claims he spoke in jest. The vice president of a company that manufactured
punchboards, used in gambling, testified to the Washington State Game Commission that he
would pay $100,000 to anyone who found a “crooked board.” Barnes, a bartender, who had
purchased two boards that were crooked some time before, brought one to the company office
and demanded payment. The company refused, claiming that the statement was made in jest
(the audience at the commission hearing had laughed when the offer was made). The court
disagreed, holding that it was reasonable to interpret the pledge of $100,000 as a means of
promoting punchboards:
[I]f the jest is not apparent and a reasonable hearer would believe that an offer was
being made, then the speaker risks the formation of a contract which was not
intended. It is the objective manifestations of the offeror that count and not secret,
unexpressed intentions. If a party’s words or acts, judged by a reasonable standard,
manifest an intention to agree in regard to the matter in question, that agreement is
established, and it is immaterial what may be the real but unexpressed state of the
party’s mind on the subject. [5]
Lucy v. Zehmer (Section 9.4.1 "Objective Intention" at the end of the chapter) illustrates that a
party’s real state of mind must be expressed to the other party, rather than in an aside to one’s
spouse.

KEY TAKEAWAY

Fundamentally, a contract is a legally binding “meeting of the minds” between the parties. It
is not the unexpressed intention in the minds of the parties that determines whether there
was “a meeting.” The test is objective: how would a reasonable person interpret the
interaction?

EXERCISES

1. For the purposes of determining whether a party had a contractual intention, why do courts
employ an objective rather than a subjective test?
2. What is the relationship between “the emphasis laid on the ego and the individual will” in
modern times (Williston) and the concept of the contractual agreement?

Saylor URL: http://www.saylor.org/books

Saylor.org
330

[1] Samuel Williston, “Freedom of Contract,” Cornell Law Quarterly 6 (1921), 365.
[2] Uniform Commercial Code, Section 2-204(1).
[3] Uniform Commercial Code, Section 3.
[4] Uniform Commercial Code, Section 1-201(3).
[5] Barnes v. Treece, 549 P.2d 1152 (Wash. App. 1976).

9.2 The Offer

LEARNING OBJECTIVES

1. Know the definition of offer.
2. Recognize that some proposals are not offers.
3. Understand the three essentials of an offer: intent, communication, and definiteness.
4. Know when an offer expires and can no longer be accepted.
Offer and acceptance may seem to be straightforward concepts, as they are when two people
meet face-to-face. But in a commercial society, the ways of making offers and accepting them are
nearly infinite. A retail store advertises its merchandise in the newspaper. A seller makes his
offer by mail or over the Internet. A telephone caller states that his offer will stand for ten days.
An offer leaves open a crucial term. An auctioneer seeks bids. An offeror gives the offeree a
choice. All these situations can raise tricky questions, as can corresponding situations involving
acceptances.

The Definition of Offer
The Restatement defines offer as “the manifestation of willingness to enter into a bargain, so
made as to justify another person in understanding that his assent to that bargain is invited and
will conclude it.” [1] Two key elements are implicit in that definition: the offer must be
communicated, and it must be definite. Before considering these requirements, we examine the
threshold question of whether an offer was intended. Let us look at proposals that may look like,
but are not, offers.

Proposals That Are Not Offers
Advertisements
Saylor URL: http://www.saylor.org/books

Saylor.org
331

Most advertisements, price quotations, and invitations to bid are not construed as offers. A
notice in the newspaper that a bicycle is on sale for $800 is normally intended only as an
invitation to the public to come to the store to make a purchase. Similarly, a statement that a
seller can “quote” a unit price to a prospective purchaser is not, by itself, of sufficient
definiteness to constitute an offer; quantity, time of delivery, and other important factors are
missing from such a statement. Frequently, in order to avoid construction of a statement about
price and quantity as an offer, a seller or buyer may say, “Make me an offer.” Such a statement
obviously suggests that no offer has yet been made. This principle usually applies to invitations
for bids (e.g., from contractors on a building project). Many forms used by sales representatives
as contracts indicate that by signing, the customer is making an offer to be accepted by the home
office and is not accepting an offer made by the sales representative.
Although advertisements, price quotations, and the like are generally not offers, the facts in each
case are important. Under the proper circumstances, an advertised statement can be construed
as an offer, as shown in the well-known Lefkowitz case (Section 9.4.2 "Advertisements as
Offers" at the end of the chapter), in which the offended customer acted as his own lawyer and
pursued an appeal to the Minnesota Supreme Court against a Minneapolis department store
that took back its advertised offer.
Despite the common-law rule that advertisements are normally to be considered invitations
rather than offers, legislation and government regulations may offer redress. For many years,
retail food stores have been subject to a rule, promulgated by the Federal Trade Commission
(FTC), that goods advertised as “specials” must be available and must be sold at the price
advertised. It is unlawful for a retail chain not to have an advertised item in each of its stores
and in sufficient quantity, unless the advertisement specifically states how much is stocked and
which branch stores do not carry it. Many states have enacted consumer protection statutes that
parallel the FTC rule.

Invitations to Bid
Invitations to bid are also not generally construed as offers. An auctioneer does not make offers
but solicits offers from the crowd: “May I have an offer?—$500? $450? $450! I have an offer for
$450. Do I hear $475? May I have an offer?”
Saylor URL: http://www.saylor.org/books

Saylor.org
332

Communication
A contract is an agreement in which each party assents to the terms of the other party. Without
mutual assent there cannot be a contract, and this implies that the assent each person gives
must be with reference to that of the other. If Toni places several alternative offers on the table,
only one of which can be accepted, and invites Sandy to choose, no contract is formed if Sandy
says merely, “I accept your terms.” Sandy must specify which offer she is assenting to.
From this general proposition, it follows that no contract can be legally binding unless an offer is
in fact communicated to the offeree. If you write an e-mail to a friend with an offer to sell your
car for a certain sum and then get distracted and forget to send it, no offer has been made. If
your friend coincidentally e-mails you the following day and says that she wants to buy your car
and names the same sum, no contract has been made. Her e-mail to you is not an acceptance,
since she did not know of your offer; it is, instead, an offer or an invitation to make an offer. Nor
would there have been a contract if you had sent your communication and the two e-mails
crossed in cyberspace. Both e-mails would be offers, and for a valid contract to be formed, it
would still be necessary for one of you to accept the other’s offer. An offer is not effective until it
is received by the offeree (and that’s also true of a revocation of the offer, and a rejection of the
offer by the offeree).
The requirement that an offer be communicated does not mean that every term must be
communicated. You call up your friend and offer to sell him your car. You tell him the price and
start to tell him that you will throw in the snow tires but will not pay for a new inspection, and
that you expect to keep the car another three weeks. Impatiently, he cuts you off and says,
“Never mind about all that; I’ll accept your offer on whatever terms you want.” You and he have
a contract.
These principles apply to unknown offers of reward. An offer of a reward constitutes a unilateral
contract that can be made binding only by performing the task for which the reward is offered.
Suppose that Bonnie posts on a tree a sign offering a reward for returning her missing dog. If
you saw the sign, found the dog, and returned it, you would have fulfilled the essentials of the
offer. But if you chanced upon the dog, read the tag around its neck, and returned it without ever

Saylor URL: http://www.saylor.org/books

Saylor.org
333

having been aware that a reward was offered, then you have not responded to the offer, even if
you acted in the hope that the owner would reward you. There is no contractual obligation.
In many states, a different result follows from an offer of a reward by a governmental entity.
Commonly, local ordinances provide that a standing reward of, say, $1,000 will be paid to
anyone providing information that leads to the arrest and conviction of arsonists. To collect the
reward, it is not necessary for a person who does furnish local authorities with such information
to know that a reward ordinance exists. In contract terms, the standing reward is viewed as a
means of setting a climate in which people will be encouraged to act in certain ways in the
expectation that they will earn unknown rewards. It is also possible to view the claim to a reward
as noncontractual; the right to receive it is guaranteed, instead, by the local ordinance.
Although a completed act called for by an unknown private offer does not give rise to a contract,
partial performance usually does. Suppose Apex Bakery posts a notice offering a one-week
bonus to all bakers who work at least six months in the kitchen. Charlene works two months
before discovering the notice on the bulletin board. Her original ignorance of the offer will not
defeat her claim to the bonus if she continues working, for the offer serves as an inducement to
complete the performance called for.

Definiteness
The common law reasonably requires that an offer spell out the essential proposed terms with
sufficient definiteness—certainty of terms that enables a court to order enforcement or measure
damages in the event of a breach. As it has often been put, “The law does not make contracts for
the parties; it merely enforces the duties which they have undertaken” (Simpson, 1965, p. 19).
Thus a supposed promise to sell “such coal as the promisor may wish to sell” is not an
enforceable term because the seller, the coal company, undertakes no duty to sell anything
unless it wishes to do so. Essential terms certainly include price and the work to be done. But
not every omission is fatal; for example, as long as a missing term can be fixed by referring to
some external standard—such as “no later than the first frost”—the offer is sufficiently definite.
In major business transactions involving extensive negotiations, the parties often sign a
preliminary “agreement in principle” before a detailed contract is drafted. These preliminary
agreements may be definite enough to create contract liability even though they lack many of the
Saylor URL: http://www.saylor.org/books

Saylor.org
334

terms found in a typical contract. For example, in a famous 1985 case, a Texas jury concluded
that an agreement made “in principle” between the Pennzoil Company and the Getty Oil
Company and not entirely finished was binding and that Texaco had unlawfully interfered with
their contract. As a result, Texaco was held liable for over $10 billion, which was settled for $3
billion after Texaco went into bankruptcy.
Offers that state alternatives are definitive if each alternative is definite. David offers Sheila the
opportunity to buy one of two automobiles at a fixed price, with delivery in two months and the
choice of vehicle left to David. Sheila accepts. The contract is valid. If one of the cars is destroyed
in the interval before delivery, David is obligated to deliver the other car. Sometimes, however,
what appears to be an offer in the alternative may be something else. Charles makes a deal to
sell his business to Bernie. As part of the bargain, Charles agrees not to compete with Bernie for
the next two years, and if he does, to pay $25,000. Whether this is an alternative contract
depends on the circumstances and intentions of the parties. If it is, then Charles is free to
compete as long as he pays Bernie $25,000. On the other hand, the intention might have been to
prevent Charles from competing in any event; hence a court could order payment of the
$25,000 as damages for a breach and still order Charles to refrain from competition until the
expiration of the two-year period.

The UCC Approach
The Uniform Commercial Code (UCC) is generally more liberal in its approach to definiteness
than is the common law—at least as the common law was interpreted in the heyday of classical
contract doctrine. Section 2-204(3) states the rule: “Even though one or more terms are left
open, a contract for sale does not fail for indefiniteness if the parties have intended to make a
contract and there is a reasonably certain basis for giving an appropriate remedy.”
The drafters of the UCC sought to give validity to as many contracts as possible and grounded
that validity on the intention of the parties rather than on formalistic requirements. As the
official comment to Section 2-204(3) notes, “If the parties intend to enter into a binding
agreement, this subsection recognizes that agreement as valid in law, despite missing terms, if
there is any reasonably certain basis for granting a remedy.…Commercial standards on the point

Saylor URL: http://www.saylor.org/books

Saylor.org
335

of ‘indefiniteness’ are intended to be applied.” Other sections of the UCC spell out rules for
filling in such open provisions as price, performance, and remedies. [2]
One of these sections, Section 2-306(1), provides that a contract term under which a buyer
agrees to purchase the seller’s entire output of goods (an “outputs contract”) or a seller agrees to
meet all the buyer’s requirements (a “requirements” or “needs” contract) means output or
requirements that occur in good faith. A party to such a contract cannot offer or demand a
quantity that is “unreasonably disproportionate” to a stated estimate or past quantities.

Duration of Offer
An offer need not be accepted on the spot. Because there are numerous ways of conveying an
offer and numerous contingencies that may be part of the offer’s subject matter, the offeror
might find it necessary to give the offeree considerable time to accept or reject the offer. By the
same token, an offer cannot remain open forever, so that once given, it never lapses and cannot
be terminated. The law recognizes seven ways by which the offer can expire (besides acceptance,
of course): revocation, rejection by the offeree, counteroffer, acceptance with counteroffer, lapse
of time, death or insanity of a person or destruction of an essential term, and illegality. We will
examine each of these in turn.

Revocation
People are free to make contracts and, in general, to revoke them.

Revocability
The general rule, both in common law and under the UCC, is that the offeror may revoke his or
her offer at any time before acceptance, even if the offer states that it will remain open for a
specified period of time. Neil offers Arlene his car for $5,000 and promises to keep the offer
open for ten days. Two days later, Neil calls Arlene to revoke the offer. The offer is terminated,
and Arlene’s acceptance thereafter, though within the ten days, is ineffective. But if Neil had sent
his revocation (the taking back of an offer before it is accepted) by mail, and if Arlene, before she
received it, had telephoned her acceptance, there would be a contract, since revocation is
effective only when the offeree actually receives it. There is an exception to this rule for offers
made to the public through newspaper or like advertisements. The offeror may revoke a public
offering by notifying the public by the same means used to communicate the offer. If no better
Saylor URL: http://www.saylor.org/books

Saylor.org
336

means of notification is reasonably available, the offer is terminated even if a particular offeree
had no actual notice.
Revocation may be communicated indirectly. If Arlene had learned from a friend that Neil had
sold his car to someone else during the ten-day period, she would have had sufficient notice. Any
attempt to accept Neil’s offer would have been futile.

Irrevocable Offers
Not every type of offer is revocable. One type of offer that cannot be revoked is
theoption contract (the promisor explicitly agrees for consideration to limit his right to revoke).
Arlene tells Neil that she cannot make up her mind in ten days but that she will pay him $25 to
hold the offer open for thirty days. Neil agrees. Arlene has an option to buy the car for $5,000; if
Neil should sell it to someone else during the thirty days, he will have breached the contract with
Arlene. Note that the transactions involving Neil and Arlene consist of two different contracts.
One is the promise of a thirty-day option for the promise of $25. It is this contract that makes
the option binding and is independent of the original offer to sell the car for $5,000. The offer
can be accepted and made part of an independent contract during the option period.
Partial performance of a unilateral contract creates an option. Although the option is not stated
explicitly, it is recognized by law in the interests of justice. Otherwise, an offeror could induce
the offeree to go to expense and trouble without ever being liable to fulfill his or her part of the
bargain. Before the offeree begins to carry out the contract, the offeror is free to revoke the offer.
But once performance begins, the law implies an option, allowing the offeree to complete
performance according to the terms of the offer. If, after a reasonable time, the offeree does not
fulfill the terms of the offer, then it may be revoked.

Revocability under the UCC
The UCC changes the common-law rule for offers by merchants. Under Section 2-205,
a firm offer (a written and signed promise by a merchant to hold an offer to buy or sell goods for
some period of time) is irrevocable. That is, an option is created, but no consideration is
required. The offer must remain open for the time period stated or, if no time period is given, for
a reasonable period of time, which may not exceed three months.

Irrevocability by Law
Saylor URL: http://www.saylor.org/books

Saylor.org
337

By law, certain types of offers may not be revoked (statutory irrevocability), despite the absence
of language to that effect in the offer itself. One major category of such offers is that of the
contractor submitting a bid to a public agency. The general rule is that once the period of
bidding opens, a bidder on a public contract may not withdraw his or her bid unless the
contracting authority consents. The contractor who purports to withdraw is awarded the
contract based on the original bid and may be sued for damages for nonperformance.

Rejection by the Offeree
Rejection (a manifestation of refusal to agree to the terms of an offer) of the offer is effective
when the offeror receives it. A subsequent change of mind by the offeree cannot revive the offer.
Donna calls Chuck to reject Chuck’s offer to sell his lawn mower. Chuck is then free to sell it to
someone else. If Donna changes her mind and calls Chuck back to accept after all, there still is
no contract, even if Chuck has made no further effort to sell the lawn mower. Having rejected
the original offer, Donna, by her second call, is not accepting but making an offer to buy.
Suppose Donna had written Chuck to reject, but on changing her mind, decided to call to accept
before the rejection letter arrived. In that case, the offer would have been accepted.

Counteroffer
A counteroffer, a response that varies the terms of an offer, is a rejection. Jones offers Smith a
small parcel of land for $10,000 and says the offer will remain open for one month. Smith
responds ten days later, saying he will pay $5,000. Jones’s original offer has thereby been
rejected. If Jones now declines Smith’s counteroffer, may Smith bind Jones to his original offer
by agreeing to pay the full $10,000? He may not, because once an original offer is rejected, all
the terms lapse. However, an inquiry by Smith as to whether Jones would consider taking less is
not a counteroffer and would not terminate the offer.

Acceptance with Counteroffer
This is not really an acceptance at all but is a counteroffer: an acceptance that changes the terms
of the offer is a counteroffer and terminates the offer. The common law imposes
a mirror image rule: the acceptance must match the offer in all its particulars or the offer is
rejected. However, if an acceptance that requests a change or an addition to the offer does not
require the offeror’s assent, then the acceptance is valid. The broker at Friendly Real Estate
Saylor URL: http://www.saylor.org/books

Saylor.org
338

offers you a house for $320,000. You accept but include in your acceptance “the vacant lot next
door.” Your acceptance is a counteroffer, which serves to terminate the original offer. If, instead,
you had said, “It’s a deal, but I’d prefer it with the vacant lot next door,” then there is a contract
because you are not demanding that the broker abide by your request. If you had said, “It’s a
deal, and I’d also like the vacant lot next door,” you have a contract, because the request for the
lot is a separate offer, not a counteroffer rejecting the original proposal.

The UCC and Counteroffers
The UCC is more liberal than the common law in allowing contracts to be formed despite
counteroffers and in incorporating the counteroffers into the contracts. This UCC provision is
necessary because the use of routine forms for contracts is very common, and if the rule were
otherwise, much valuable time would be wasted by drafting clauses tailored to the precise
wording of the routine printed forms. A buyer and a seller send out documents accompanying or
incorporating their offers and acceptances, and the provisions in each document rarely
correspond precisely. Indeed, it is often the case that one side’s form contains terms favorable to
it but inconsistent with terms on the other side’s form. Section 2-207 of the UCC attempts to
resolve this “battle of the forms” by providing that additional terms or conditions in an
acceptance operate as such unless the acceptance is conditioned on the offeror’s consent to the
new or different terms. The new terms are construed as offers but are automatically
incorporated in any contract between merchants for the sale of goods unless “(a) the offer
expressly limits acceptance to the terms of the offer; (b) [the terms] materially alter it; or (c)
notification of objection to them has already been given or is given within a reasonable time
after notice of them is received.”
An example of terms that become part of the contract without being expressly agreed to are
clauses providing for interest payments on overdue bills. Examples of terms that would
materially alter the contract and hence need express approval are clauses that negate the
standard warranties that sellers give buyers on their merchandise.
Frequently, parties use contract provisions to prevent the automatic introduction of new terms.
A typical seller’s provision is as follows:
Amendments
Saylor URL: http://www.saylor.org/books

Saylor.org
339

Any modification of this document by the Buyer, and all additional or different terms
included in Buyer’s purchase order or any other document responding to this offer,
are hereby objected to. BY ORDERING THE GOODS HERE FOR SHIPMENT, BUYER
AGREES TO ALL THE TERMS AND CONDITIONS CONTAINED ON BOTH SIDES OF
THIS DOCUMENT.
Section 2-207 of the UCC, liberalizing the mirror image rule, is pervasive, covering all sorts of
contracts, from those between industrial manufacturers to those between friends.

Lapse of Time
Offers are not open-ended; they lapse after some period of time. An offer may contain its own
specific time limitation—for example, “until close of business today.”
In the absence of an expressly stated time limit, the common-law rule is that the offer expires at
the end of a “reasonable” time. Such a period is a factual question in each case and depends on
the particular circumstances, including the nature of the service or property being contracted
for, the manner in which the offer is made, and the means by which the acceptance is expected
to be made. Whenever the contract involves a speculative transaction—the sale of securities or
land, for instance—the time period will depend on the nature of the security and the risk
involved. In general, the greater the risk to the seller, the shorter the period of time. Karen offers
to sell Gary a block of oil stocks that are fluctuating rapidly hour by hour. Gary receives the offer
an hour before the market closes; he accepts by fax two hours after the market has opened the
next morning and after learning that the stock has jumped up significantly. The time period has
lapsed if Gary was accepting a fixed price that Karen set, but it may still be open if the price is
market price at time of delivery. (Under Section 41 of the Restatement, an offer made by mail is
“seasonably accepted if an acceptance is mailed at any time before midnight on the day on which
the offer is received.”)
For unilateral contracts, both the common law and the UCC require the offeree to notify the
offeror that he has begun to perform the terms of the contract. Without notification, the offeror
may, after a reasonable time, treat the offer as having lapsed.

Death or Insanity of the Offeror

Saylor URL: http://www.saylor.org/books

Saylor.org
340

The death or insanity of the offeror prior to acceptance terminates the offer; the offer is said to
die with the offeror. (Notice, however, that the death of a party to a contractdoes not necessarily
terminate the contract: the estate of a deceased person may be liable on a contract made by the
person before death.)

Destruction of Subject Matter Essential to the Offer
Destruction of something essential to the contract also terminates the offer. You offer to sell
your car, but the car is destroyed in an accident before your offer is accepted; the offer is
terminated.

Postoffer Illegality
A statute making unlawful the object of the contract will terminate the offer if the statute takes
effect after the offer was made. Thus an offer to sell a quantity of herbal weight-loss supplements
will terminate if the Food and Drug Administration outlaws the sale of such supplements.

KEY TAKEAWAY

An offer is a manifestation of willingness to enter into a contract, effective when received. It
must be communicated to the offeree, be made intentionally (according to an objective
standard), and be definite enough to determine a remedy in case of breach. An offer
terminates in one of seven ways: revocation before acceptance (except for option contracts,
firm offers under the UCC, statutory irrevocability, and unilateral offers where an offeree has
commenced performance); rejection; counteroffer; acceptance with counteroffer; lapse of
time (as stipulated or after a reasonable time); death or insanity of the offeror before
acceptance or destruction of subject matter essential to the offer; and postoffer illegality.

EXERCISES

1. Why is it said an offer is a “manifestation” of willingness to enter into a contract? How could
willingness be “manifested”?
2. Which kind of standard is used to determine whether a person has made an offer—
subjective or objective?
3. If Sandra posts a written notice offering “to the kitchen staff at Coldwater Bay (Alaska)
transportation to Seattle at the end of the fishing season,” and if David, one of the
maintenance workers, says to her, “I accept your offer of transportation to Seattle,” is there
a contract?
Saylor URL: http://www.saylor.org/books

Saylor.org
341

4. What are the seven ways an offer can terminate?

[1] Restatement (Second) of Contracts, Section 24.
[2] Chiefly, Uniform Commercial Code, Sections 2-305 through 2-310.

9.3 The Acceptance

LEARNING OBJECTIVES

1. Define acceptance.
2. Understand who may accept an offer.
3. Know when the acceptance is effective.
4. Recognize when silence is acceptance.

General Definition of Acceptance
To result in a legally binding contract, an offer must be accepted by the offeree. Just as the law
helps define and shape an offer and its duration, so the law governs the nature and manner
of acceptance. The Restatement defines acceptance of an offer as “a manifestation of assent to
the terms thereof made by the offeree in a manner invited or required by the offer.” [1]The assent
may be either by the making of a mutual promise or by performance or partial performance. If
there is doubt about whether the offer requests a return promise or a return act, the
Restatement, Section 32, provides that the offeree may accept with either a promise or
performance. The Uniform Commercial Code (UCC) also adopts this view; under Section 2206(1)(a), “an offer to make a contract shall be construed as inviting acceptance in any manner
and by any medium reasonable in the circumstances” unless the offer unambiguously requires a
certain mode of acceptance.

Who May Accept?
The identity of the offeree is usually clear, even if the name is unknown. The person to whom a
promise is made is ordinarily the person whom the offeror contemplates will make a return
promise or perform the act requested. But this is not invariably so. A promise can be made to
one person who is not expected to do anything in return. The consideration necessary to weld
Saylor URL: http://www.saylor.org/books

Saylor.org
342

the offer and acceptance into a legal contract can be given by a third party. Under the common
law, whoever is invited to furnish consideration to the offeror is the offeree, and only an offeree
may accept an offer. A common example is sale to a minor. George promises to sell his
automobile to Bartley, age seventeen, if Bartley’s father will promise to pay $3,500 to George.
Bartley is the promisee (the person to whom the promise is made) but not the offeree; Bartley
cannot legally accept George’s offer. Only Bartley’s father, who is called on to pay for the car, can
accept, by making the promise requested. And notice what might seem obvious: apromise to
perform as requested in the offer is itself a binding acceptance.

When Is Acceptance Effective?
As noted previously, an offer, a revocation of the offer, and a rejection of the offer are not
effective until received. The same rule does not always apply to the acceptance.

Instantaneous Communication
Of course, in many instances the moment of acceptance is not in question: in face-to-face deals
or transactions negotiated by telephone, the parties extend an offer and accept it
instantaneously during the course of the conversation. But problems can arise in contracts
negotiated through correspondence.

Stipulations as to Acceptance
One common situation arises when the offeror stipulates the mode of acceptance (e.g., return
mail, fax, or carrier pigeon). If the offeree uses the stipulated mode, then the acceptance is
deemed effective when sent. Even though the offeror has no knowledge of the acceptance at that
moment, the contract has been formed. Moreover, according to the Restatement, Section 60, if
the offeror says that the offer can be accepted only by the specified mode, that mode must be
used. (It is said that “the offeror is the master of the offer.”)
If the offeror specifies no particular mode, then acceptance is effective when transmitted, as long
as the offeree uses a reasonable method of acceptance. It is implied that the offeree can use the
same means used by the offeror or a means of communication customary to the industry.

The “Mailbox Rule”

Saylor URL: http://www.saylor.org/books

Saylor.org
343

The use of the postal service is customary, so acceptances are considered effective when mailed,
regardless of the method used to transmit the offer. Indeed, the so-calledmailbox rule has a
lineage tracing back more than one hundred years to the English courts. [2]
The mailbox rule may seem to create particular difficulties for people in business, since the
acceptance is effective even though the offeror is unaware of the acceptance, and even if the
letter is lost and never arrives. But the solution is the same as the rationale for the rule. In
contracts negotiated through correspondence, there will always be a burden on one of the
parties. If the rule were that the acceptance is not effective until received by the offeror, then the
offeree would be on tenterhooks, rather than the other way around, as is the case with the
present rule. As between the two, it seems fairer to place the burden on the offeror, since he or
she alone has the power to fix the moment of effectiveness. All the offeror need do is specify in
the offer that acceptance is not effective until received.
In all other cases—that is, when the offeror fails to specify the mode of acceptance and the
offeree uses a mode that is not reasonable—acceptance is deemed effective only when received.

Acceptance “Outruns” Rejection
When the offeree sends a rejection first and then later transmits a superseding acceptance, the
“effective when received” rule also applies. Suppose a seller offers a buyer two cords of firewood
and says the offer will remain open for a week. On the third day, the buyer writes the seller,
rejecting the offer. The following evening, the buyer rethinks his firewood needs, and on the
morning of the fifth day, he sends an e-mail accepting the seller’s terms. The previously mailed
letter arrives the following day. Since the letter had not yet been received, the offer had not been
rejected. For there to be a valid contract, the e-mailed acceptance must arrive before the mailed
rejection. If the e-mail were hung up in cyberspace, although through no fault of the buyer, so
that the letter arrived first, the seller would be correct in assuming the offer was terminated—
even if the e-mail arrived a minute later. In short, where “the acceptance outruns the rejection”
the acceptance is effective. See Figure 9.1.

Saylor URL: http://www.saylor.org/books

Saylor.org
344

Figure 9.1

When Is Communication Effective?

Electronic Communications
Electronic communications have, of course, become increasingly common. Many contracts are
negotiated by e-mail, accepted and “signed” electronically. Generally speaking, this does not
change the rules. TheUniform Electronic Transactions Act (UETA) was promulgated (i.e.,
disseminated for states to adopt) in 1999. It is one of a number of uniform acts, like the Uniform
Commercial Code. As of June 2010, forty-seven states and the US Virgin Islands had adopted
the statute. The introduction to the act provides that “the purpose of the UETA is to remove
barriers to electronic commerce by validating and effectuating electronic records and
signatures.” [3] In general, the UETA provides the following:
a.

A record or signature may not be denied legal effect or enforceability solely because it is

in electronic form.
b. A contract may not be denied legal effect or enforceability solely because an electronic record
was used in its formation.
c. If a law requires a record to be in writing, an electronic record satisfies the law.
d. If a law requires a signature, an electronic signature satisfies the law.
The UETA, though, doesn’t address all the problems with electronic contracting. Clicking on a
computer screen may constitute a valid acceptance of a contractual offer, but only if the offer is
clearly communicated. In Specht v. Netscape Communications Corp., customers who had
Saylor URL: http://www.saylor.org/books

Saylor.org
345

downloaded a free online computer program complained that it effectively invaded their privacy
by inserting into their machines “cookies”; they wanted to sue, but the defendant said they were
bound to arbitration. [4] They had clicked on the Download button, but hidden below it were the
licensing terms, including the arbitration clause. The federal court of appeals held that there was
no valid acceptance. The court said, “We agree with the district court that a reasonably prudent
Internet user in circumstances such as these would not have known or learned of the existence
of the license terms before responding to defendants’ invitation to download the free software,
and that defendants therefore did not provide reasonable notice of the license terms. In
consequence, the plaintiffs’ bare act of downloading the software did not unambiguously
manifest assent to the arbitration provision contained in the license terms.”
If a faxed document is sent but for some reason not received or not noticed, the emerging law is
that the mailbox rule does not apply. A court would examine the circumstances with care to
determine the reason for the nonreceipt or for the offeror’s failure to notice its receipt. A person
has to have fair notice that his or her offer has been accepted, and modern communication
makes the old-fashioned mailbox rule—that acceptance is effective upon dispatch—
problematic. [5]

Silence as Acceptance
General Rule: Silence Is Not Acceptance
Ordinarily, for there to be a contract, the offeree must make some positive manifestation of
assent to the offeror’s terms. The offeror cannot usually word his offer in such a way that the
offeree’s failure to respond can be construed as an acceptance.

Exceptions
The Restatement, Section 69, gives three situations, however, in which silence can operate as an
acceptance. The first occurs when the offeree avails himself of services proffered by the offeror,
even though he could have rejected them and had reason to know that the offeror offered them
expecting compensation. The second situation occurs when the offer states that the offeree may
accept without responding and the offeree, remaining silent, intends to accept. The third
situation is that of previous dealings, in which only if the offeree intends not to accept is it
reasonable to expect him to say so.
Saylor URL: http://www.saylor.org/books

Saylor.org
346

As an example of the first type of acceptance by silence, assume that a carpenter happens by
your house and sees a collapsing porch. He spots you in the front yard and points out the
deterioration. “I’m a professional carpenter,” he says, “and between jobs. I can fix that porch for
you. Somebody ought to.” You say nothing. He goes to work. There is an implied contract, with
the work to be done for the carpenter’s usual fee.
To illustrate the second situation, suppose that a friend has left her car in your garage. The
friend sends you a letter in which she offers you the car for $4,000 and adds, “If I don’t hear
from you, I will assume that you have accepted my offer.” If you make no reply, with the
intention of accepting the offer, a contract has been formed.
The third situation is illustrated by Section 9.4.3 "Silence as Acceptance", a well-known decision
made by Justice Oliver Wendell Holmes Jr. when he was sitting on the Supreme Court of
Massachusetts.

KEY TAKEAWAY

Without an acceptance of an offer, no contract exists, and once an acceptance is made, a
contract is formed. If the offeror stipulates how the offer should be accepted, so be it. If
there is no stipulation, any reasonable means of communication is good. Offers and
revocations are usually effective upon receipt, while an acceptance is effective on dispatch.
The advent of electronic contracting has caused some modification of the rules: courts are
likely to investigate the facts surrounding the exchange of offer and acceptance more
carefully than previously. But the nuances arising because of the mailbox rule and
acceptance by silence still require close attention to the facts.

EXERCISES

1. Rudy puts this poster, with a photo of his dog, on utility poles around his neighborhood: “$50
reward for the return of my lost dog.” Carlene doesn’t see the poster, but she finds the dog
and, after looking at the tag on its collar, returns the dog to Rudy. As she leaves his house,
her eye falls on one of the posters, but Rudy declines to pay her anything. Why is Rudy
correct that Carlene has no legal right to the reward?
2. How has the UCC changed the common law’s mirror image rule, and why?
3. When is an offer generally said to be effective? A rejection of an offer? A counteroffer?
4. How have modern electronic communications affected the law of offer and acceptance?
Saylor URL: http://www.saylor.org/books

Saylor.org
347

5. When is silence considered an acceptance?

[1] Restatement (Second) of Contracts, Section 24.
[2] Adams v. Lindsell, 1 Barnewall & Alderson 681 (K.B. 1818).
[3] The National Conference of Commissioners on Uniform State Laws, Uniform Electronic Transactions
Act (1999) (Denver: National Conference of Commissioners on Uniform State Laws, 1999), accessed
March 29, 2011,http://www.law.upenn.edu/bll/archives/ulc/fnact99/1990s/ueta99.pdf.
[4] Specht v. Netscape Communications Corp., 306 F.3d 17 (2d Cir. 2002).
[5] See, for example, Clow Water Systems Co. v. National Labor Relations Board, 92 F.3d 441 (6th Cir.
1996).

9.4 Cases
Objective Intention
Lucy v. Zehmer
84 S.E.2d 516 (Va. 1954)
Buchanan, J.
This suit was instituted by W. O. Lucy and J. C. Lucy, complainants, against A. H. Zehmer and
Ida S. Zehmer, his wife, defendants, to have specific performance of a contract by which it was
alleged the Zehmers had sold to W. O. Lucy a tract of land owned by A. H. Zehmer in Dinwiddie
county containing 471.6 acres, more or less, known as the Ferguson farm, for $50,000. J. C.
Lucy, the other complainant, is a brother of W. O. Lucy, to whom W. O. Lucy transferred a half
interest in his alleged purchase.
The instrument sought to be enforced was written by A. H. Zehmer on December 20, 1952, in
these words: “We hereby agree to sell to W. O. Lucy the Ferguson farm complete for
$50,000.00, title satisfactory to buyer,” and signed by the defendants, A. H. Zehmer and Ida S.
Zehmer.

Saylor URL: http://www.saylor.org/books

Saylor.org
348

The answer of A. H. Zehmer admitted that at the time mentioned W. O. Lucy offered him
$50,000 cash for the farm, but that he, Zehmer, considered that the offer was made in jest; that
so thinking, and both he and Lucy having had several drinks, he wrote out “the memorandum”
quoted above and induced his wife to sign it; that he did not deliver the memorandum to Lucy,
but that Lucy picked it up, read it, put it in his pocket, attempted to offer Zehmer $5 to bind the
bargain, which Zehmer refused to accept, and realizing for the first time that Lucy was serious,
Zehmer assured him that he had no intention of selling the farm and that the whole matter was
a joke. Lucy left the premises insisting that he had purchased the farm.…
In his testimony Zehmer claimed that he “was high as a Georgia pine,” and that the transaction
“was just a bunch of two doggoned drunks bluffing to see who could talk the biggest and say the
most.” That claim is inconsistent with his attempt to testify in great detail as to what was said
and what was done.…
If it be assumed, contrary to what we think the evidence shows, that Zehmer was jesting about
selling his farm to Lucy and that the transaction was intended by him to be a joke, nevertheless
the evidence shows that Lucy did not so understand it but considered it to be a serious business
transaction and the contract to be binding on the Zehmers as well as on himself. The very next
day he arranged with his brother to put up half the money and take a half interest in the land.
The day after that he employed an attorney to examine the title. The next night, Tuesday, he was
back at Zehmer’s place and there Zehmer told him for the first time, Lucy said, that he wasn’t
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.”
Saylor URL: http://www.saylor.org/books

Saylor.org
349

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.
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.
Saylor URL: http://www.saylor.org/books

Saylor.org
350

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

Advertisements as Offers
Lefkowitz v. Great Minneapolis Surplus Store
86 N.W.2d 689 (Minn. 1957)
Murphy, Justice.
This is an appeal from an order of the Municipal Court of Minneapolis denying the motion of the
defendant for amended findings of fact, or, in the alternative, for a new trial. The order for
judgment awarded the plaintiff the sum of $138.50 as damages for breach of contract.
This case grows out of the alleged refusal of the defendant to sell to the plaintiff a certain fur
piece which it had offered for sale in a newspaper advertisement. It appears from the record that
on April 6, 1956, the defendant published the following advertisement in a Minneapolis
newspaper:
Saturday 9 A.M. Sharp
3 Brand New Fur Coats Worth to $100.00
First Come
First Served
$1 Each
[The $100 coat would be worth about $800 in 2010 dollars.] On April 13, the defendant again
published an advertisement in the same newspaper as follows:

Saylor URL: http://www.saylor.org/books

Saylor.org
351

Saturday 9 A.M.
2 Brand New Pastel Mink 3-Skin Scarfs
Selling for. $89.50
Out they go Saturday. Each…$1.00
1 Black Lapin Stole Beautiful, worth $139.50…$1.00
First Come First Served
The record supports the findings of the court that on each of the Saturdays following the
publication of the above-described ads the plaintiff was the first to present himself at the
appropriate counter in the defendant’s store and on each occasion demanded the coat and the
stole so advertised and indicated his readiness to pay the sale price of $1. On both occasions, the
defendant refused to sell the merchandise to the plaintiff, stating on the first occasion that by a
“house rule” the offer was intended for women only and sales would not be made to men, and on
the second visit that plaintiff knew defendant’s house rules.
The trial court properly disallowed plaintiff’s claim for the value of the fur coats since the value
of these articles was speculative and uncertain. The only evidence of value was the
advertisement itself to the effect that the coats were “Worth to $100.00,” how much less being
speculative especially in view of the price for which they were offered for sale. With reference to
the offer of the defendant on April 13, 1956, to sell the “1 Black Lapin Stole * * * worth $139.50 *
* *” the trial court held that the value of this article was established and granted judgment in
favor of the plaintiff for that amount less the $1 quoted purchase price.
1. The defendant contends that a newspaper advertisement offering items of merchandise for sale
at a named price is a “unilateral offer” which may be withdrawn without notice. He relies upon
authorities which hold that, where an advertiser publishes in a newspaper that he has a certain
quantity or quality of goods which he wants to dispose of at certain prices and on certain terms,
such advertisements are not offers which become contracts as soon as any person to whose
notice they may come signifies his acceptance by notifying the other that he will take a certain
quantity of them. Such advertisements have been construed as an invitation for an offer of sale
on the terms stated, which offer, when received, may be accepted or rejected and which

Saylor URL: http://www.saylor.org/books

Saylor.org
352

therefore does not become a contract of sale until accepted by the seller; and until a contract has
been so made, the seller may modify or revoke such prices or terms. [Citations]
…On the facts before us we are concerned with whether the advertisement constituted an offer,
and, if so, whether the plaintiff’s conduct constituted an acceptance.
There are numerous authorities which hold that a particular advertisement in a newspaper or
circular letter relating to a sale of articles may be construed by the court as constituting an offer,
acceptance of which would complete a contract. [Citations]
The test of whether a binding obligation may originate in advertisements addressed to the
general public is “whether the facts show that some performance was promised in positive terms
in return for something requested.” 1 Williston, Contracts (Rev. ed.) s 27.
The authorities above cited emphasize that, where the offer is clear, definite, and explicit, and
leaves nothing open for negotiation, it constitutes an offer, acceptance of which will complete
the contract.…
Whether in any individual instance a newspaper advertisement is an offer rather than an
invitation to make an offer depends on the legal intention of the parties and the surrounding
circumstances. [Citations] We are of the view on the facts before us that the offer by the
defendant of the sale of the Lapin fur was clear, definite, and explicit, and left nothing open for
negotiation. The plaintiff having successfully managed to be the first one to appear at the seller’s
place of business to be served, as requested by the advertisement, and having offered the stated
purchase price of the article, he was entitled to performance on the part of the defendant. We
think the trial court was correct in holding that there was in the conduct of the parties a
sufficient mutuality of obligation to constitute a contract of sale.
2. The defendant contends that the offer was modified by a “house rule” to the effect that only
women were qualified to receive the bargains advertised. The advertisement contained no such
restriction. This objection may be disposed of briefly by stating that, while an advertiser has the
right at any time before acceptance to modify his offer, he does not have the right, after
acceptance, to impose new or arbitrary conditions not contained in the published offer.
[Citations]
Affirmed.
Saylor URL: http://www.saylor.org/books

Saylor.org
353

CASE QUESTIONS
1. If the normal rule is that display advertisements in newspapers and the like are not offers,
but rather invitations to make an offer, why was this different? Why did the court hold that
this was an offer?
2. What is the rationale for the rule that a display ad is usually not an offer?
3. If a newspaper display advertisement reads, “This offer is good for two weeks,” is it still only
an invitation to make an offer, or is it an offer?
4. Is a listing by a private seller for the sale of a trailer on Craigslist or in the weekly classified
advertisements an offer or an invitation to make an offer?

Silence as Acceptance
Hobbs v.Massasoit Whip Co.
33 N.E. 495 (Mass. 1893)
Holmes, J.
This is an action for the price of eel skins sent by the plaintiff to the defendant, and kept by the
defendant some months, until they were destroyed. It must be taken that the plaintiff received
no notice that the defendant declined to accept the skins. The case comes before us on
exceptions to an instruction to the jury that, whether there was any prior contract or not, if skins
are sent to the defendant, and it sees fit, whether it has agreed to take them or not, to lie back,
and to say nothing, having reason to suppose that the man who has sent them believes that it is
taking them, since it says nothing about it, then, if it fails to notify, the jury would be warranted
in finding for the plaintiff.
Standing alone, and unexplained, this proposition might seem to imply that one stranger may
impose a duty upon another, and make him a purchaser, in spite of himself, by sending goods to
him, unless he will take the trouble, and bear the expense, of notifying the sender that he will
not buy. The case was argued for the defendant on that interpretation. But, in view of the
evidence, we do not understand that to have been the meaning of the judge and we do not think
that the jury can have understood that to have been his meaning. The plaintiff was not a
stranger to the defendant, even if there was no contract between them. He had sent eel skins in
the same way four or five times before, and they had been accepted and paid for. On the

Saylor URL: http://www.saylor.org/books

Saylor.org
354

defendant’s testimony, it was fair to assume that if it had admitted the eel skins to be over 22
inches in length, and fit for its business, as the plaintiff testified and the jury found that they
were, it would have accepted them; that this was understood by the plaintiff; and, indeed, that
there was a standing offer to him for such skins.
In such a condition of things, the plaintiff was warranted in sending the defendant skins
conforming to the requirements, and even if the offer was not such that the contract was made
as soon as skins corresponding to its terms were sent, sending them did impose on the
defendant a duty to act about them; and silence on its part, coupled with a retention of the skins
for an unreasonable time, might be found by the jury to warrant the plaintiff in assuming that
they were accepted, and thus to amount to an acceptance. [Citations] The proposition stands on
the general principle that conduct which imports acceptance or assent is acceptance or assent, in
the view of the law, whatever may have been the actual state of mind of the party—a principle
sometimes lost sight of in the cases. [Citations]
Exceptions overruled.

CASE QUESTIONS

1. What is an eel, and why would anybody make a whip out of its skin?
2. Why did the court here deny the defendant’s assertion that it never accepted the plaintiff’s
offer?
3. If it reasonably seems that silence is acceptance, does it make any difference what the
offeree really intended?

9.5 Summary and Exercises
Summary

Whether a legally valid contract was formed depends on a number of factors, including whether
the parties reached agreement, whether consideration was present, and whether the agreement
was legal. Agreement may seem like an intuitive concept, but intuition is not a sufficient guide to
the existence of agreement in legal terms. The most common way of examining an agreement for
legal sufficiency is by determining whether a valid offer and acceptance were made.
An offer is a manifestation of willingness to enter into a bargain such that it would be reasonable
for another individual to conclude that assent to the offer would complete the bargain. Offers
Saylor URL: http://www.saylor.org/books

Saylor.org
355

must be communicated and must be definite; that is, they must spell out terms to which the
offeree can assent.
An important aspect of the offer is its duration. An offer can expire in any one of several ways:
(1) rejection, (2) counteroffer, (3) acceptance with counteroffer, (4) lapse of time, (5) death or
insanity of the offeror or destruction of an essential term, (6) illegality, and (7) revocation. No
understanding of agreement is complete without a mastery of these conditions.
To constitute an agreement, an offer must be accepted.
The offeree must manifest his assent to the terms of the offer in a manner invited or required by
the offer. Complications arise when an offer is accepted indirectly through correspondence.
Although offers and revocations of offers are not effective until received, an acceptance is
deemed accepted when sent if the offeree accepts in the manner specified by the offeror. But the
nuances that arise because of the mailbox rule and acceptance by silence require close attention
to the circumstances of each agreement.

EXERCISES

1. Sarah’s student apartment was unfurnished. She perused Doug’s List, an online classified ad
service (for nonmerchants), and saw this advertisement: “Moving. For sale: a very nice brown
leather couch, almost new, $600.” There was an accompanying photo and contact
information. Sarah e-mailed the contact, saying she wanted to buy the couch. Does Sarah
have a contract with the seller? Explain.
2. Seller called Buyer on the telephone and offered to sell his used stereo. Buyer agreed to buy
it without asking the price. The next day Buyer changed her mind and attempted to back out
of the agreement. Do the parties have a contract? Explain.
3. On August 1, Ernie wrote to Elsie offering to sell Elsie his car for $7,600, and he promised to
hold the offer open for ten days. On August 4 Ernie changed his mind; he sent Elsie a letter
revoking the offer. On August 5 Elsie e-mailed Ernie, accepting the offer. Ernie’s letter of
revocation arrived on August 6. Is there a contract? Explain.
4. On August 1 Grover visited a local electronics shop to purchase a new television. He saw one
he liked but wasn’t sure if he could afford the $750. The store owner agreed to write up and
sign an offer stating that it would be held open for ten days, which he did. On August 2 the

Saylor URL: http://www.saylor.org/books

Saylor.org
356

owner changed his mind and sent Grover an e-mail revoking the offer, which Grover received
immediately. On August 3 Grover sent a reply e-mail accepting the original offer. Is there a
contract? Explain.
5. Acme Corporation sent the following letter, here set out in its entirety:
January 2, 2012
Acme Corporation
We hereby offer you 100 Acme golden widgets, size 6. This offer will be
good for 10 days.
[Signed] Roberta Acme
Owner, Acme Corporation
Is this offer irrevocable for the time stated? Explain.
6. On November 26, Joe wrote to Kate offering to purchase a farm that she owned. Upon
receiving the letter on November 28, Kate immediately sent Joe a letter of acceptance.
However, shortly after mailing the letter, Kate had second thoughts and called Joe to advise
him that she was rejecting his offer. The call was made before Joe received the letter of
acceptance. Has a contract been formed? Why?
7. On a busy day just before April 15, Albert Accountant received a call from a local car dealer.
The dealer said, “Hi, Mr. Accountant. Now, while you have income from doing clients’ taxes, I
have an excellent offer for you. You can buy a new Buick Century automobile completely
loaded for $36,000. Al, I know you’re busy. If I don’t hear from you by the end of the day, I’ll
assume you want the car.” Albert, distracted, did not respond immediately, and the dealer
hung up. Then followed an exhausting day of working with anxiety-ridden tax clients. Albert
forgot about the conversation. Two days later a statement arrived from the dealer, with
instructions on how Albert should pick up the car at the dealership. Is there a contract?
Explain.
8. Mr. and Mrs. Mitchell, the owners of a small secondhand store, attended an auction where
they bought a used safe for $50. The safe, part of the Sumstad estate, had a locked
compartment inside, a fact the auctioneer mentioned. After they bought the safe, the
Mitchells had a locksmith open the interior compartment; it contained $32,000 in cash. The
Saylor URL: http://www.saylor.org/books

Saylor.org
357

locksmith called the police, who impounded the safe, and a lawsuit ensued between the
Mitchells and the Sumstad estate to determine the ownership of the cash. Who should get it,
and why?
9. Ivan Mestrovic, an internationally renowned artist, and his wife lived for years in a house in
Indiana. Ivan died in 1982. His widow remained in the house for some years; upon her death
the contents of the house were willed to her children. When the Wilkens bought the house
from the estate, it was very cluttered. A bank representative (the executor of the estate)
said, “You can clean it yourself and keep whatever items you want, or we—as executor of
Mrs. Mestrovic’s estate—will hire a rubbish removal service to dispose of it.” The Wilkens
opted to clean it up themselves, and amid the mess, behind sofas and in odd closets, were six
apparently valuable paintings by Mestrovic. The estate claimed them; the Wilkens claimed
them. Who gets the paintings, and why?
10. David Kidd’s dog bit Mikaila Sherrod. On June 14, 2010, the Kidds offered to settle for
$32,000. On July 12 the Sherrods sued the Kidds. On July 20 the Kidds bumped their offer up
to $34,000. The suit was subject to mandatory arbitration, which proceeded on April 28,
2011. On May 5 the arbitrator awarded the Sherrods $25,000. On May 9 the Sherrods wrote
to the Kidds and purported to accept their last offer of $34,000, made the year before. The
Sherrods’ attorney moved to enforce that purported $34,000 “settlement agreement.” The
court concluded that the offer was properly accepted because it had not been withdrawn
and entered judgment against the Kidds for $34,000. The Kidds appealed. What result should
obtain on appeal, and why? [1]

SELF-TEST QUESTIONS

1. In interpreting agreements for the purpose of establishing whether a valid contract
exists, courts generally apply
a.

subjective standards

b. objective standards
c. either a subjective or an objective standard
d. none of the above
A valid offer must be

Saylor URL: http://www.saylor.org/books

Saylor.org
358

a.

written

b. written and intended
c. communicated by letter
d. communicated and definite
An offer
a.

must specify time, place, and manner of acceptance

b. must be accepted immediately to be valid
c. need not be accepted immediately
d. can only be accepted by the same means it was made
An offer generally
a.

is rejected by a counteroffer

b. can be revoked if the offeror changes his or her mind
c. can lapse after a reasonable period of time
d. involves all of the above
An acceptance is generally considered effective
a.

when a letter is received by the offeror

b. when a letter is mailed
c. when the offeree is silent
d. only when the acceptance is transmitted in writing

SELF-TEST ANSWERS

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

[1] Sherrod ex rel. Cantone v. Kidd, 155 P.3d 976 (Wash. Ct. App., 2007).

Saylor URL: http://www.saylor.org/books

Saylor.org
359

Chapter 10
Real Assent

LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1. Contracts require “a meeting of the minds” between competent parties, and if there is no
such “meeting,” the agreement is usually voidable.
2. Parties must enter the contract voluntarily, without duress or undue influence.
3. Misrepresentation or fraud, when proven, vitiates a contract.
4. A mistake may make a contract voidable.
5. Parties to a contract must have capacity—that is, not labor under infancy, intoxication, or
insanity.
We turn to the second of the four requirements for a valid contract. In addition to manifestation
of assent, a party’s assent must be real; he or she must consent to the contract freely, with
adequate knowledge, and must have capacity. The requirement of real assent raises the
following major questions:
1. Did the parties enter into the contract of their own free will, or was one forced to agree under
duress or undue influence?
2. Did the parties enter into the contract with full knowledge of the facts, or was one or both led to
the agreement through fraud or mistake?
3. Did both parties have the capacity to make a contract?

10.1 Duress and Undue Influence

LEARNING OBJECTIVES

1. Recognize that if a person makes an agreement under duress (being forced to enter a
contract against his or her will), the agreement is void.
2. Understand what undue influence is and what the typical circumstances are when it arises to
make a contract voidable.
Saylor URL: http://www.saylor.org/books

Saylor.org
360

Duress
When a person is forced to do something against his or her will, that person is said to have been
the victim of duress—compulsion. There are two types of duress: physical duress and duress by
improper threat. A contract induced by physical violence is void.

Physical Duress
If a person is forced into entering a contract on threat of physical bodily harm, he or she is the
victim of physical duress. It is defined by the Restatement (Second) of Contracts in Section 174:
“If conduct that appears to be a manifestation of assent by a party who does not intend to engage
in that conduct is physically compelled by duress, the conduct is not effective as a manifestation
of assent.”
Comment (a) to Section 174 provides in part, “This Section involves an application of that
principle to those relatively rare situations in which actual physical force has been used to
compel a party to appear to assent to a contract.…The essence of this type of duress is that a
party is compelled by physical force to do an act that he has no intention of doing. He is, it is
sometimes said, ‘a mere mechanical instrument.’ The result is that there is no contract at all, or
a ‘void contract’ as distinguished from a voidable one” (emphasis added).
The Restatement is undoubtedly correct that there are “relatively rare situations in which actual
physical force” is used to compel assent to a contract. Extortion is a crime.

Duress by Threat
The second kind of duress is duress by threat; it is more common than physical duress. Here the
perpetrator threatens the victim, who feels there is no reasonable alternative but to assent to the
contract. It renders the contract voidable. This rule contains a number of elements.
First, the threat must be improper. Second, there must be no reasonable alternative. If, for
example, a supplier threatens to hold up shipment of necessary goods unless the buyer agrees to
pay more than the contract price, this would not be duress if the buyer could purchase identical
supplies from someone else. Third, the test for inducement is subjective. It does not matter that
the person threatened is unusually timid or that a reasonable person would not have felt
threatened. The question is whether the threat in fact induced assent by the victim. Such facts as
the victim’s belief that the threatener had the ability to carry out the threat and the length of
Saylor URL: http://www.saylor.org/books

Saylor.org
361

time between the threat and assent are relevant in determining whether the threat did prompt
the assent.
There are many types of improper threats that might induce a party to enter into a contract:
threats to commit a crime or a tort (e.g., bodily harm or taking of property), to instigate criminal
prosecution, to instigate civil proceedings when a threat is made in bad faith, to breach a “duty
of good faith and fair dealing under a contract with the recipient,” or to disclose embarrassing
details about a person’s private life.
Jack buys a car from a local used-car salesman, Mr. Olson, and the next day realizes he bought a
lemon. He threatens to break windows in Olson’s showroom if Olson does not buy the car back
for $2,150, the purchase price. Mr. Olson agrees. The agreement is voidable, even though the
underlying deal is fair, if Olson feels he has no reasonable alternative and is frightened into
agreeing. Suppose Jack knows that Olson has been tampering with his cars’ odometers, a federal
offense, and threatens to have Olson prosecuted if he will not repurchase the car. Even though
Olson may be guilty, this threat makes the repurchase contract voidable, because it is a misuse
for personal ends of a power (to go to the police) given each of us for other purposes. If these
threats failed, suppose Jack then tells Olson, “I’m going to haul you into court and sue your
pants off.” If Jack means he will sue for his purchase price, this is not an improper threat,
because everyone has the right to use the courts to gain what they think is rightfully theirs. But if
Jack meant that he would fabricate damages done him by a (falsely) claimed odometer
manipulation, that would be an improper threat. Although Olson could defend against the suit,
his reputation would suffer in the meantime from his being accused of odometer tampering.
A threat to breach a contract that induces the victim to sign a new contract could be improper.
Suppose that as part of the original purchase price, Olson agrees to make all necessary repairs
and replace all failed parts for the first ninety days. At the end of one month, the transmission
dies, and Jack demands a replacement. Olson refuses to repair the car unless Jack signs a
contract agreeing to buy his next car from Olson. Whether this threat is improper depends on
whether Jack has a reasonable alternative; if a replacement transmission is readily available and
Jack has the funds to pay for it, he might have an alternative in suing Olson in small claims
court for the cost. But if Jack needs the car immediately and he is impecunious, then the threat
Saylor URL: http://www.saylor.org/books

Saylor.org
362

would be improper and the contract voidable. A threat to breach a contract is not necessarily
improper, however. It depends on whether the new contract is fair and equitable because of
unanticipated circumstances. If, for example, Olson discovers that he must purchase a
replacement transmission at three times the anticipated cost, his threat to hold up work unless
Jack agrees to pay for it might be reasonable.

Undue Influence
The Restatement of Contracts (Second) characterizes undue influence as “unfair
persuasion.” [1] It is a milder form of duress than physical harm or threats. The unfairness does
not lie in any misrepresentation; rather, it occurs when the victim is under the domination of the
persuader or is one who, in view of the relationship between them, is warranted in believing that
the persuader will act in a manner detrimental to the victim’s welfare if the victim fails to assent.
It is the improper use of trust or power to deprive a person of free will and substitute instead
another’s objective. Usually the fact pattern involves the victim being isolated from receiving
advice except from the persuader. Falling within this rule are situations where, for example, a
child takes advantage of an infirm parent, a doctor takes advantage of an ill patient, or a lawyer
takes advantage of an unknowledgeable client. If there has been undue influence, the contract is
voidable by the party who has been unfairly persuaded. Whether the relationship is one of
domination and the persuasion is unfair is a factual question. The answer hinges on a host of
variables, including “the unfairness of the resulting bargain, the unavailability of independent
advice, and the susceptibility of the person persuaded.” [2] See Section 10.5.1 "Undue
Influence", Hodge v. Shea.

KEY TAKEAWAY

A contract induced by physical duress—threat of bodily harm—is void; a contract induced by
improper threats—another type of duress—is voidable. Voidable also are contracts induced
by undue influence, where a weak will is overborne by a stronger one.

EXERCISES

1. What are the two types of duress?
2. What are the elements necessary to support a claim of undue influence?

Saylor URL: http://www.saylor.org/books

Saylor.org
363

[1] Restatement (Second) of Contracts, Section 177.
[2] Restatement (Second) of Contracts, Section 177(b).

10.2 Misrepresentation

LEARNING OBJECTIVES

1. Understand the two types of misrepresentation: fraudulent and nonfraudulent.
2. Distinguish between fraudulent misrepresentation in the execution and fraudulent
misrepresentation in the inducement.
3. Know the elements necessary to prove fraudulent and nonfraudulent misrepresentation.
4. Recognize the remedies for misrepresentation.

General Description
The two types of misrepresentation are fraudulent and nonfraudulent. Within the former are
fraud in the execution and fraud in the inducement. Within the latter are negligent
misrepresentation and innocent misrepresentation.
Misrepresentation is a statement of fact that is not consistent with the truth. If
misrepresentation is intentional, it is fraudulent misrepresentation; if it is not intentional, it is
nonfraudulent misrepresentation, which can be either negligent or innocent.
In further taxonomy, courts distinguish between fraud in the execution and fraud in the
inducement. Fraud in the execution is defined by the Restatement as follows: “If a
misrepresentation as to the character or essential terms of a proposed contract induces conduct
that appears to be a manifestation of assent by one who neither knows nor has reasonable
opportunity to know of the character or essential terms of the proposed contract, his conduct is
not effective as a manifestation of assent.” [1] For example, Alphonse and Gaston decide to sign a
written contract incorporating terms to which they have agreed. It is properly drawn up, and
Gaston reads it and approves it. Before he can sign it, however, Alphonse shrewdly substitutes a
different version to which Gaston has not agreed. Gaston signs the substitute version. There is
no contract. There has been fraud in the execution.
Fraud in the inducement is more common. It involves some misrepresentation about the subject
of the contract that induces assent. Alphonse tells Gaston that the car Gaston is buying from
Saylor URL: http://www.saylor.org/books

Saylor.org
364

Alphonse has just been overhauled—which pleases Gaston—but it has not been. This renders the
contract voidable.

Fraudulent Misrepresentation
Necessary to proving fraudulent misrepresentation (usually just “fraud,” though technically
“fraud” is the crime and “fraudulent misrepresentation” is the civil wrong) is a misstatement of
fact that is intentionally made and justifiably relied upon.

Misstatement of Fact
Again, generally, any statement not in accord with the facts (a fact is something amenable to
testing as true) is a misrepresentation. Falsity does not depend on intent. A typist’s unnoticed
error in a letter (inadvertently omitting the word “not,” for example, or transposing numbers)
can amount to a misrepresentation on which the recipient may rely (it is not fraudulent
misrepresentation). A half-truth can amount to a misrepresentation, as, for example, when the
seller of a hotel says that the income is from both permanent and transient guests but fails to
disclose that the bulk of the income is from single-night stopovers by seamen using the hotel as
a brothel. [2]

Concealment
Another type of misrepresentation is concealment. It is an act that is equivalent to a statement
that the facts are to the contrary and that serves to prevent the other party from learning the
true statement of affairs; it is hiding the truth. A common example is painting over defects in a
building—by concealing the defects, the owner is misrepresenting the condition of the property.
The act of concealment need not be direct; it may consist of sidetracking the other party from
gaining necessary knowledge by, for example, convincing a third person who has knowledge of
the defect not to speak. Concealment is always a misrepresentation.

Nondisclosure
A more passive type of concealment is nondisclosure. Although generally the law imposes no
obligation on anyone to speak out, nondisclosure of a fact can operate as a misrepresentation
under certain circumstances. This occurs, for example, whenever the other party has erroneous
information, or, as Reed v. King (Section 10.5.2 "Misrepresentation by Concealment") shows,
where the nondisclosure amounts to a failure to act in good faith, or where the party who
Saylor URL: http://www.saylor.org/books

Saylor.org
365

conceals knows or should know that the other side cannot, with reasonable diligence, discover
the truth.
In a remarkable 1991 case out of New York, a New York City stockbroker bought an old house
upstate (basically anyplace north of New York City) in the village of Nyack, north of New York
City, and then wanted out of the deal when he discovered—the defendant seller had not told
him—that it was “haunted.” The court summarized the facts: “Plaintiff, to his horror, discovered
that the house he had recently contracted to purchase was widely reputed to be possessed by
poltergeists [ghosts], reportedly seen by defendant seller and members of her family on
numerous occasions over the last nine years. Plaintiff promptly commenced this action seeking
rescission of the contract of sale. Supreme Court reluctantly dismissed the complaint, holding
that plaintiff has no remedy at law in this jurisdiction.”
The high court of New York ruled he could rescind the contract because the house was “haunted
as a matter of law”: the defendant had promoted it as such on village tours and in Reader’s
Digest. She had concealed it, and no reasonable buyer’s inspection would have revealed the
“fact.” The dissent basically hooted, saying, “The existence of a poltergeist is no more binding
upon the defendants than it is upon this court.” [3]

Statement Made False by Subsequent Events
If a statement of fact is made false by later events, it must be disclosed as false. For example, in
idle chatter one day, Alphonse tells Gaston that he owns thirty acres of land. In fact, Alphonse
owns only twenty-seven, but he decided to exaggerate a little. He meant no harm by it, since the
conversation had no import. A year later, Gaston offers to buy the “thirty acres” from Alphonse,
who does not correct the impression that Gaston has. The failure to speak is a nondisclosure—
presumably intentional, in this situation—that would allow Gaston to rescind a contract induced
by his belief that he was purchasing thirty acres.

Statements of Opinion
An opinion, of course, is not a fact; neither is sales puffery. For example, the statements “In my
opinion this apple is very tasty” and “These apples are the best in the county” are not facts; they
are not expected to be taken as true. Reliance on opinion is hazardous and generally not
considered justifiable.
Saylor URL: http://www.saylor.org/books

Saylor.org
366

If Jack asks what condition the car is in that he wishes to buy, Mr. Olson’s response of “Great!”
is not ordinarily a misrepresentation. As the Restatement puts it: “The propensity of sellers and
buyers to exaggerate the advantages to the other party of the bargains they promise is well
recognized, and to some extent their assertions must be discounted.” [4] Vague statements of
quality, such as that a product is “good,” ought to suggest nothing other than that such is the
personal judgment of the opinion holder.
Despite this general rule, there are certain exceptions that justify reliance on opinions and
effectively make them into facts. Merely because someone is less astute than the one with whom
she is bargaining does not give rise to a claim of justifiable reliance on an unwarranted opinion.
But if the person is inexperienced and susceptible or gullible to blandishments, the contract can
be voided, as illustrated in Vokes v. Arthur Murray, Inc. in Section 10.5.3 "Misrepresentation by
Assertions of Opinion".

Misstatement of Law
Incorrect assertions of law usually do not give rise to any relief, but sometimes they do. An
assertion that “the city has repealed the sales tax” or that a court has cleared title to a parcel of
land is a statement of fact; if such assertions are false, they are governed by the same rules that
govern misrepresentations of fact generally. An assertion of the legal consequences of a given set
of facts is generally an opinion on which the recipient relies at his or her peril, especially if both
parties know or assume the same facts. Thus, if there is a lien on a house, the seller’s statement
that “the courts will throw it out, you won’t be bothered by it” is an opinion. A statement that
“you can build a five-unit apartment on this property” is not actionable because, at common law,
people are supposed to know what the local and state laws are, and nobody should rely on a
layperson’s statement about the law. However, if the statement of law is made by a lawyer or real
estate broker, or some other person on whom a layperson may justifiably rely, then it may be
taken as a fact and, if untrue, as the basis for a claim of misrepresentation. (Assertions about
foreign laws are generally held to be statements of fact, not opinion.)

Assertions of Intention
Usually, assertions of intention are not considered facts. The law allows considerable leeway in
the honesty of assertions of intention. The Restatement talks in terms of “a misrepresentation of
Saylor URL: http://www.saylor.org/books

Saylor.org
367

intention…consistent with reasonable standards of fair dealing.”[5] The right to misstate
intentions is useful chiefly in the acquisition of land; the cases permit buyers to misrepresent the
purpose of the acquisition so as not to arouse the suspicion of the seller that the land is worth
considerably more than his asking price. To be a misrepresentation that will permit rescission,
an assertion of intention must be false at the time made; that is, the person asserting an
intention must not then have intended it. That later he or she does not carry out the stated
intention is not proof that there was no intention at the time asserted. Moreover, to render a
contract voidable, the false assertion of intention must be harmful in some way to other interests
of the recipient. Thus, in the common example, the buyer of land tells the seller that he intends
to build a residence on the lot, but he actually intends to put up a factory and has lied because he
knows that otherwise the seller will not part with it because her own home is on an adjacent lot.
The contract is voidable by the seller. So a developer says, as regards the picturesque old barn on
the property, “I’ll sure try to save it,” but after he buys the land he realizes it would be very
expensive (and in the way), so he does not try to save it. No misrepresentation.

Intentionally Made Misrepresentation
The second element necessary to prove fraud is that the misrepresentation was intentionally
made. A misrepresentation is intentionally made “if the maker intends his assertion to induce a
party to manifest his assent and the maker (a) knows or believes that the assertion is not in
accord with the facts, or (b) does not have the confidence that he states or implies in the truth of
the assertion, or (c) knows that he does not have the basis that he states or implies for the
assertion.” [6]
The question of intent often has practical consequences in terms of the remedy available to the
plaintiff. If the misrepresentation is fraudulent, the plaintiff may, as an alternative to avoiding
the contract, recover damages. Some of this is discussed inSection 10.2.4 "Remedies" and more
fully in Chapter 16 "Remedies", where we see that some states would force the plaintiff to elect
one of these two remedies, whereas other states would allow the plaintiff to pursue both
remedies (although only one type of recovery would eventually be allowed). If the
misrepresentation is not intentional, then the common law allowed the plaintiff only the remedy
of rescission. But the Uniform Commercial Code (UCC), Section 2-721, allows both remedies in
Saylor URL: http://www.saylor.org/books

Saylor.org
368

contracts for the sale of goods, whether the misrepresentation is fraudulent or not, and does not
require election of remedies.

Reliance
The final element necessary to prove fraud is reliance by the victim. He or she must show that
the misrepresentation induced assent—that is, he or she relied on it. The reliance need not be
solely on the false assertion; the defendant cannot win the case by demonstrating that the
plaintiff would have assented to the contract even without the misrepresentation. It is sufficient
to avoid the contract if the plaintiff weighed the assertion as one of the important factors leading
him to make the contract, and he believed it to be true. The person who asserts reliance to avoid
a contract must have acted in good faith and reasonably in relying on the false assertion. Thus if
the victim failed to read documents given him that truly stated the facts, he cannot later
complain that he relied on a contrary statement, as, for example, when the purchaser of a car
dealership was told the inventory consisted of new cars, but the supporting papers, receipt of
which he acknowledged, clearly stated how many miles each car had been driven. If Mr. Olson
tells Jack that the car Jack is interested in is “a recognized classic,” and if Jack doesn’t care a
whit about that but buys the car because he likes its tail fins, he will have no case against Mr.
Olson when he finds out the car is not a classic: it didn’t matter to him, and he didn’t rely on it.
Ordinarily, the person relying on a statement need not verify it independently. However, if
verification is relatively easy, or if the statement is one that concerns matters peculiarly within
the person’s purview, he or she may not be held to have justifiably relied on the other party’s
false assertion. Moreover, usually the rule of reliance applies to statements about past events or
existing facts, not about the occurrence of events in the future.

Nonfraudulent Misrepresentation
Nonfraudulent misrepresentation may also be grounds for some relief. There are two types:
negligent misrepresentation and innocent misrepresentation.

Negligent Misrepresentation
Where representation is caused by carelessness, it is negligent misrepresentation. To prove it, a
plaintiff must show a negligent misstatement of fact that is material and justifiably relied upon.

Negligent
Saylor URL: http://www.saylor.org/books

Saylor.org
369

As an element of misrepresentation, “negligent” here means the party who makes the
representation was careless. A potential buyer of rural real estate asks the broker if the
neighborhood is quiet. The broker assures her it is. In fact, the neighbors down the road have a
whole kennel of hunting hounds that bark a lot. The broker didn’t know that; she just assumed
the neighborhood was quiet. That is negligence: failure to use appropriate care.

Misstatement of Fact
Whether a thing is a fact may be subject to the same general analysis used in discussing
fraudulent misrepresentation. (A person could negligently conceal a fact, or negligently give an
opinion, as in legal malpractice.)

Materiality
A material misrepresentation is one that “would be likely to induce a reasonable person to
manifest his assent” or that “the maker knows…would be likely to induce the recipient to do
so.” [7] An honestly mistaken statement that the house for sale was built in 1922 rather than 1923
would not be the basis for avoiding the contract because it is not material unless the seller knew
that the buyer had sentimental or other reasons for purchasing a house built in 1922.
We did not mention materiality as an element of fraud; if the misrepresentation is fraudulent,
the victim can avoid the contract, no matter the significance of the misrepresentation. So
although materiality is not technically required for fraudulent misrepresentation, it is usually a
crucial factor in determining whether the plaintiff did rely. Obviously, the more immaterial the
false assertion, the less likely it is that the victim relied on it to his detriment. This is especially
the case when the defendant knows that he does not have the basis that he states for an
assertion but believes that the particular point is unimportant and therefore immaterial. And of
course it is usually not worth the plaintiff’s while to sue over an immaterial fraudulent
misrepresentation. Consequently, for practical purposes, materiality is an important
consideration in most cases. Reed v. King (Section 10.5.2 "Misrepresentation by Concealment")
discusses materiality (as well as nondisclosure).

Justifiable Reliance
The issues here for negligent misrepresentation are the same as those set out for fraudulent
misrepresentation.
Saylor URL: http://www.saylor.org/books

Saylor.org
370

Negligent misrepresentation implies culpability and is usually treated the same as fraudulent
misrepresentation; if the representation is not fraudulent, however, it cannot be the basis for
rescission unless it is also material.

Innocent Misrepresentation
The elements necessary to prove innocent misrepresentation are, reasonably enough, based on
what we’ve looked at so far, as follows: an innocent misstatement of fact that is material and
justifiably relied upon.
It is not necessary here to go over the elements in detail. The issues are the same as previously
discussed, except now the misrepresentation is innocent. The plaintiffs purchased the
defendants’ eighteen-acre parcel on the defendants’ representation that the land came with
certain water rights for irrigation, which they believed was true. It was not true. The plaintiffs
were entitled to rescission on the basis of innocent misrepresentation. [8]

Remedies
Remedies will be taken up in Chapter 16 "Remedies", but it is worth noting the difference
between remedies for fraudulent misrepresentation and remedies for nonfraudulent
misrepresentation.
Fraudulent misrepresentation has traditionally given the victim the right to rescind the contract
promptly (return the parties to the before-contract status) or affirm it and bring an action for
damages caused by the fraud, but not both. [9] The UCC (Section 2-721) has rejected the “election
of remedies” doctrine; it allows cumulative damages, such that the victim can both return the
goods and sue for damages. And this is the modern trend for fraudulent misrepresentation:
victims may first seek damages, and if that does not make them whole, they may seek
rescission. [10] In egregious cases of fraud where the defendant has undertaken a pattern of such
deceit, the rare civil remedy of punitive damages may be awarded against the defendant.
One further note: the burden of proof for fraudulent misrepresentation is that it must be proved
not just “by a preponderance of the evidence,” as in the typical civil case, but rather “by clear,
cogent, and convincing evidence”; the fact finder must believe the claim of fraud is very probably
true. [11]

Saylor URL: http://www.saylor.org/books

KEY TAKEAWAY
Saylor.org
371

Misrepresentation may be of two types: fraudulent (in the execution or in the inducement)
and nonfraudulent (negligent or innocent). Each type has different elements that must be
proved, but in general there must be a misstatement of fact by some means that is
intentionally made (for fraud), material (for nonfraudulent), and justifiably relied upon.

EXERCISES

1. Distinguish between fraudulent misrepresentation and nonfraudulent misrepresentation,
between fraud in the execution and fraud in the inducement, and between negligent and
innocent misrepresentation.
2. List the elements that must be shown to prove the four different types of misrepresentation
noted in Exercise 1.
3. What is the difference between the traditional common-law approach to remedies for fraud
and the UCC’s approach?

[1] Restatement (Second) of Contracts, Section 163.
[2] Ikeda v. Curtis, 261 P.2d 684 (Wash. 1951).
[3] Stambovsky v. Ackley, 169 A.D.2d 254 (N.Y. 1991).
[4] Restatement (Second) of Contracts, Section 168(d).
[5] Restatement (Second) of Contracts, Section 171(1).
[6] Restatement (Second) of Contracts, Section 162(1).
[7] Restatement (Second) of Contracts, Section 162(2).
[8] Lesher v. Strid, 996 P.2d 988 (Or. Ct. App. 2000).
[9] Merritt v. Craig, 753 A.2d 2 (Md. Ct. App. 2000).
[10] Ehrman v. Mann, 979 So.2d 1011 (Fla. Ct. App. 2008).
[11] Kirkham v. Smith, 23 P.3d 10 (Wash. Ct. App. 2001).

10.3 Mistake

LEARNING OBJECTIVES

1. Recognize under what circumstances a person may be relieved of a unilateral mistake.
Saylor URL: http://www.saylor.org/books

Saylor.org
372

2. Recognize when a mutual mistake will be grounds for relief, and the types of mutual
mistakes.
In discussing fraud, we have considered the ways in which trickery by the other party makes a
contract void or voidable. We now examine the ways in which the parties might “trick”
themselves by making assumptions that lead them mistakenly to believe that they have agreed
to something they have not. A mistake is “a belief about a fact that is not in accord with the
truth.” [1]

Mistake by One Party
Unilateral Mistake
Where one party makes a mistake, it is a unilateral mistake. The rule: ordinarily, a contract is
not voidable because one party has made a mistake about the subject matter (e.g., the truck is
not powerful enough to haul the trailer; the dress doesn’t fit).

Exceptions
If one side knows or should know that the other has made a mistake, he or she may not take
advantage of it. A person who makes the mistake of not reading a written document will usually
get no relief, nor will relief be afforded to one whose mistake is caused by negligence (a
contractor forgets to add in the cost of insulation) unless the negligent party would suffer
unconscionable hardship if the mistake were not corrected. Courts will allow the correction of
drafting errors in a contract (“reformation”) in order to make the contract reflect the parties’
intention. [2]

Mutual Mistake
In the case of mutual mistake—both parties are wrong about the subject of the contract—relief
may be granted.
The Restatement sets out three requirements for successfully arguing mutual mistake.[3] The
party seeking to avoid the contract must prove that
1. the mistake relates to a “basic assumption on which the contract was made,”
2. the mistake has a material effect on the agreed exchange of performances,
3. the party seeking relief does not bear the risk of the mistake.

Saylor URL: http://www.saylor.org/books

Saylor.org
373

Basic assumption is probably clear enough. In the famous “cow case,” the defendant sold the
plaintiff a cow—Rose of Abalone—believed by both to be barren and thus of less value than a
fertile cow (a promising young dairy cow in 2010 might sell for $1,800).[4] Just before the
plaintiff was to take Rose from the defendant’s barn, the defendant discovered she was “large
with calf”; he refused to go on with the contract. The court held this was a mutual mistake of
fact—“a barren cow is substantially a different creature than a breeding one”—and ruled for the
defendant. That she was infertile was “a basic assumption,” but—for example—that hay would
be readily available to feed her inexpensively was not, and had hay been expensive, that would
not have vitiated the contract.

Material Effect on the Agreed-to Exchange of Performance
“Material effect on the agreed-to exchange of performance” means that because of the mutual
mistake, there is a significant difference between the value the parties thought they were
exchanging compared with what they would exchange if the contract were performed, given the
standing facts. Again, in the cow case, had the seller been required to go through with the deal,
he would have given up a great deal more than he anticipated, and the buyer would have
received an unagreed-to windfall.

Party Seeking Relief Does Not Bear the Risk of the Mistake
Assume a weekend browser sees a painting sitting on the floor of an antique shop. The owner
says, “That old thing? You can have it for $100.” The browser takes it home, dusts it off, and
hangs it on the wall. A year later a visitor, an expert in art history, recognizes the hanging as a
famous lost El Greco worth $1 million. The story is headlined; the antique dealer is chagrined
and claims the contract for sale should be voided because both parties mistakenly thought they
were dickering over an “old, worthless” painting. The contract is valid. The owner is said to bear
the risk of mistake because he contracted with conscious awareness of his ignorance: he knew he
didn’t know what the painting’s possible value might be, but he didn’t feel it worthwhile to have
it appraised. He gambled it wasn’t worth much, and lost.

KEY TAKEAWAY

A mistake may be unilateral, in which case no relief will be granted unless the other side
knows of the mistake and takes advantage of it. A mistake may be mutual, in which case

Saylor URL: http://www.saylor.org/books

Saylor.org
374

relief may be granted if it is about a basic assumption on which the contract was made, if the
mistake has a material effect on the agreed-to exchange, and if the person adversely affected
did not bear the risk of the mistake.

EXERCISES

1. Why is relief usually not granted for unilateral mistakes? When is relief granted for them?
2. If there is a mutual mistake, what does the party seeking relief have to show to avoid the
contract?

[1] Restatement (Second) of Contracts, Section 151.
[2] Sikora v. Vanderploeg, 212 S.W.3d 277 (Tenn. Ct. App. 2006).
[3] Restatement (Second) of Contracts, Section 152.
[4] Sherwood v. Walker, 33 N.W. 919 (1887).

10.4 Capacity

LEARNING OBJECTIVES

1. Understand that infants may avoid their contracts, with limitations.
2. Understand that insane or intoxicated people may avoid their contracts, with limitations.
3. Understand the extent to which contracts made by mentally ill persons are voidable, void, or
effectively enforceable.
4. Recognize that contracts made by intoxicated persons may be voidable.
A contract is a meeting of minds. If someone lacks mental capacity to understand what he is
assenting to—or that he is assenting to anything—it is unreasonable to hold him to the
consequences of his act. At common law there are various classes of people who are presumed to
lack the requisite capacity. These include infants (minors), the mentally ill, and the intoxicated.

Minors (or “Infants”)
The General Rule
The general rule is this: minors (or more legalistically “infants”) are in most states persons
younger than seventeen years old; they can avoid their contracts, up to and within a reasonable
Saylor URL: http://www.saylor.org/books

Saylor.org
375

time after reaching majority, subject to some exceptions and limitations. The rationale here is
that infants do not stand on an equal footing with adults, and it is unfair to require them to
abide by contracts made when they have immature judgment.
The words minor and infant are mostly synonymous, but not exactly, necessarily. In a state
where the legal age to drink alcohol is twenty-one, a twenty-year-old would be a minor, but not
an infant, because infancy is under eighteen. A seventeen-year-old may avoid contracts
(usually), but an eighteen-year-old, while legally bound to his contracts, cannot legally drink
alcohol. Strictly speaking, the better term for one who may avoid his contracts is infant, even
though, of course, in normal speaking we think of an infant as a baby.
The age of majority (when a person is no longer an infant or a minor) was lowered in all states
except Mississippi during the 1970s (to correspond to the Twenty-Sixth Amendment, ratified in
1971, guaranteeing the right to vote at eighteen) from twenty-one to either eighteen or nineteen.
Legal rights for those under twenty-one remain ambiguous, however. Although eighteen-yearolds may assent to binding contracts, not all creditors and landlords believe it, and they may
require parents to cosign. For those under twenty-one, there are also legal impediments to
holding certain kinds of jobs, signing certain kinds of contracts, marrying, leaving home, and
drinking alcohol. There is as yet no uniform set of rules.
The exact day on which the disability of minority vanishes also varies. The old common-law rule
put it on the day before the twenty-first birthday. Many states have changed this rule so that
majority commences on the day of the eighteenth birthday.
An infant’s contract is voidable, not void. An infant wishing to avoid the contract need do
nothing positive to disaffirm. The defense of infancy to a lawsuit is sufficient; although the adult
cannot enforce the contract, the infant can (which is why it is said to be voidable, not void).

Exceptions and Complications
There are exceptions and complications here. We call out six of them.

Necessities
First, as an exception to the general rule, infants are generally liable for the reasonable cost of
necessities (for the reason that denying them the right to contract for necessities would harm
them, not protect them). At common law, a necessity was defined as food, medicine, clothing, or
Saylor URL: http://www.saylor.org/books

Saylor.org
376

shelter. In recent years, however, the courts have expanded the concept, so that in many states
today, necessities include property and services that will enable the infant to earn a living and to
provide for those dependent on him. If the contract is executory, the infant can simply disaffirm.
If the contract has been executed, however, the infant must face more onerous consequences.
Although he will not be required to perform under the contract, he will be liable under a theory
of “quasi-contract” for the reasonable value of the necessity. In Gastonia Personnel Corp. v.
Rogers, an emancipated infant, nineteen years old (before the age of minority was reduced),
needed employment; he contracted with a personnel company to find him a job, for which it
would charge him a fee. [1] The company did find him a job, and when he attempted to disaffirm
his liability for payment on the grounds of infancy, the North Carolina court ruled against him,
holding that the concepts of necessities “should be enlarged to include such…services as are
reasonable and necessary to enable the infant to earn the money required to provide the
necessities of life for himself” and his dependents.

Nonvoidable Contracts
Second, state statutes variously prohibit disaffirmation for such contracts as insurance,
education or medical care, bonding agreements, stocks, or bank accounts. In addition, an infant
will lose her power to avoid the contract if the rights of third parties intervene. Roberta, an
infant, sells a car to Oswald; Oswald, in turn, shortly thereafter sells it to Byers, who knows
nothing of Roberta. May Roberta—still an infant—recover it from Byers? No: the rights of the
third party have intervened. To allow the infant seller recovery in this situation would
undermine faith in commercial transactions.

Misrepresentation of Age
A third exception involves misrepresentation of age. Certainly, that the adult reasonably
believed the infant was an adult is of no consequence in a contract suit. In many states, an infant
may misrepresent his age and disaffirm in accordance with the general rule. But it depends. If
an infant affirmatively lies about his age, the trend is to deny disaffirmation. A Michigan statute,
for instance, prohibits an infant from disaffirming if he has signed a “separate instrument
containing only the statement of age, date of signing and the signature.” And some states estop
him from claiming to be an infant even if he less expressly falsely represented himself as an
Saylor URL: http://www.saylor.org/books

Saylor.org
377

adult. Estoppel is a refusal by the courts on equitable grounds to allow a person to escape
liability on an otherwise valid defense; unless the infant can return the consideration, the
contract will be enforced. It is a question of fact how far a nonexpress (an implied)
misrepresentation will be allowed to go before it is considered so clearly misleading as to range
into the prohibited area. Some states hold the infant liable for damages for the tort of
misrepresentation, but others do not. As William Prosser, the noted torts scholar, said of cases
paying no attention to an infant’s lying about his age, “The effect of the decisions refusing to
recognize tort liability for misrepresentation is to create a privileged class of liars who are a great
trouble to the business world.” [2]

Ratification
Fourth, when the infant becomes an adult, she has two choices: she may ratify the contract or
disaffirm it. She may ratify explicitly; no further consideration is necessary. She may also do so
by implication—for instance, by continuing to make payments or retaining goods for an
unreasonable period of time. If the child has not disaffirmed the contract while still an infant,
she may do so within a reasonable time after reaching majority; what is a “reasonable time”
depends on the circumstances.

Duty to Return Consideration Received
Fifth, in most cases of disavowal, the infant’s only obligation is to return the goods (if he still has
them) or repay the consideration (unless it has been dissipated); he does not have to account for
what he wasted, consumed, or damaged during the contract. But since the age of majority has
been lowered to eighteen or nineteen, when most young people have graduated from high
school, some courts require, if appropriate to avoid injustice to the adult, that the infant account
for what he got. (In Dodson v. Shrader, the supreme court of Tennessee held that an infant
would—if the contract was fair—have to pay for the pickup truck he bought and wrecked.) [3]

Tort Connected with a Contract
Sixth, the general rule is that infants are liable for their torts (e.g., assault, trespass, nuisance,
negligence) unless the tort suit is only an indirect method of enforcing a contract. Henry, age
seventeen, holds himself out to be a competent mechanic. He is paid $500 to overhaul Baker’s
engine, but he does a careless job and the engine is seriously damaged. He offers to return the
Saylor URL: http://www.saylor.org/books

Saylor.org
378

$500 but disaffirms any further contractual liability. Can Baker sue him for his negligence, a
tort? No, because such a suit would be to enforce the contract.

Persons Who Are Mentally Ill or Intoxicated
Mentally Ill Persons
The general rule is that a contract made by person who is mentally ill is voidable by the person
when she regains her sanity, or, as appropriate, by a guardian. If, though, a guardian has been
legally appointed for a person who is mentally ill, any contract made by the mentally ill person is
void, but may nevertheless be ratified by the ward (the incompetent person who is under a
guardianship) upon regaining sanity or by the guardian. [4]
However, if the contract was for a necessity, the other party may have a valid claim against the
estate of the one who is mentally ill in order to prevent unjust enrichment. In other cases,
whether a court will enforce a contract made with a person who is mentally ill depends on the
circumstances. Only if the mental illness impairs the competence of the person in the particular
transaction can the contract be avoided; the test is whether the person understood the nature of
the business at hand. Upon avoidance, the mentally ill person must return any property in her
possession. And if the contract was fair and the other party had no knowledge of the mental
illness, the court has the power to order other relief.

Intoxicated Persons
If a person is so drunk that he has no awareness of his acts, and if the other person knows this,
there is no contract. The intoxicated person is obligated to refund the consideration to the other
party unless he dissipated it during his drunkenness. If the other person is unaware of his
intoxicated state, however, an offer or acceptance of fair terms manifesting assent is binding.
If a person is only partially inebriated and has some understanding of his actions, “avoidance
depends on a showing that the other party induced the drunkenness or that the consideration
was inadequate or that the transaction departed from the normal pattern of similar
transactions; if the particular transaction is one which a reasonably competent person might
have made, it cannot be avoided even though entirely executory.” [5] A person who was
intoxicated at the time he made the contract may nevertheless subsequently ratify it. Thus where
Mervin Hyland, several times involuntarily committed for alcoholism, executed a promissory
Saylor URL: http://www.saylor.org/books

Saylor.org
379

note in an alcoholic stupor but later, while sober, paid the interest on the past-due note, he was
denied the defense of intoxication; the court said he had ratified his contract. [6] In any event,
intoxicated is a disfavored defense on public policy grounds.

KEY TAKEAWAY

Infants may generally disaffirm their contracts up to majority and within a reasonable time
afterward, but the rule is subject to some exceptions and complications: necessities,
contracts made nonvoidable by statute, misrepresentation of age, extent of duty to return
consideration, ratification, and a tort connected with the contract are among these
exceptions.
Contracts made by insane or intoxicated people are voidable when the person regains
competency. A contract made by a person under guardianship is void, but the estate will be
liable for necessities. A contract made while insane or intoxicated may be ratified.

EXERCISES

1. Ivar, an infant, bought a used car—not a necessity—for $9,500. Seller took advantage of
Ivar’s infancy: the car was really worth only $5,500. Can Ivar keep the car but disclaim liability
for the $4,000 difference?
2. If Ivar bought the car and it was a necessity, could he disclaim liability for the $4,000?
3. Alice Ace found her adult son’s Christmas stocking; Mrs. Ace herself had made it fifty years
before. It was considerably deteriorated. Isabel, sixteen, handy with knitting, agreed to reknit
it for $100, which Mrs. Ace paid in advance. Isabel, regrettably, lost the stocking. She
returned the $100 to Mrs. Ace, who was very upset. May Mrs. Ace now sue Isabel for the loss
of the stocking (conversion) and emotional distress?
4. Why is voluntary intoxication a disfavored defense?

[1] Gastonia Personnel Corp. v. Rogers, 172 S.E.2d 19 (N.C. 1970).
[2] William L. Prosser, Handbook of the Law of Torts, 4th ed. (St. Paul, MN: West, 1971), 999.
[3] Dodson v. Shrader, 824 S.W.2d 545 (Tenn. 1992).
[4] Restatement (Second) of Contracts, Section 13.
Saylor URL: http://www.saylor.org/books

Saylor.org
380

[5] Restatement (Second) of Contracts, Section 16(b).
[6] First State Bank of Sinai v. Hyland, 399 N.W.2d 894 (S.D. 1987).

10.5 Cases
Undue Influence
Hodge v. Shea
168 S.E.2d 82 (S.C. 1969)
Brailsford, J.
In this equitable action the circuit court decreed specific performance of a contract for the sale
of land, and the defendant has appealed. The plaintiff is a physician, and the contract was
prepared and executed in his medical office on August 19, 1965. The defendant had been
plaintiff’s patient for a number of years. On the contract date, he was seventy-five years of age,
was an inebriate of long standing, and was afflicted by grievous chronic illnesses, including
arteriosclerosis, cirrhosis of the liver, neuritises, arthritis of the spine and hip and varicose veins
of the legs. These afflictions and others required constant medication and frequent medical
attention, and rendered him infirm of body and mind, although not to the point of incompetency
to contract.
During the period immediately before and after August 19, 1965, George A. Shea, the defendant,
was suffering a great deal of pain in his back and hip and was having difficulty in voiding. He
was attended professionally by the plaintiff, Dr. Joseph Hodge, either at the Shea home, at the
doctor’s office or in the hospital at least once each day from August 9 through August 26, 1965,
except for August 17. The contract was signed during the morning of August 19. One of Dr.
Hodge’s frequent house calls was made on the afternoon of that day, and Mr. Shea was admitted
to the hospital on August 21, where he remained until August 25.
Mr. Shea was separated from his wife and lived alone. He was dependent upon Dr. Hodge for
house calls, which were needed from time to time. His relationship with his physician, who
sometimes visited him as a friend and occasionally performed non-professional services for him,
was closer than ordinarily arises from that of patient and physician.…

Saylor URL: http://www.saylor.org/books

Saylor.org
381

“Where a physician regularly treats a chronically ill person over a period of two years, a
confidential relationship is established, raising a presumption that financial dealings between
them are fraudulent.” [Citation]
A 125 acre tract of land near Mr. Shea’s home, adjacent to land which was being developed as
residential property, was one of his most valuable and readily salable assets. In 1962, the
developer of this contiguous land had expressed to Mr. Shea an interest in it at $1000.00 per
acre. A firm offer of this amount was made in November, 1964, and was refused by Mr. Shea on
the advice of his son-in-law that the property was worth at least $1500.00 per acre. Negotiations
between the developer and Mr. Ransdell commenced at that time and were in progress when
Mr. Shea, at the instance of Dr. Hodge and without consulting Mr. Ransdell or anyone else,
signed the contract of August 19, 1965. Under this contract Dr. Hodge claims the right to
purchase twenty choice acres of the 125 acre tract for a consideration calculated by the circuit
court to be the equivalent of $361.72 per acre. The market value of the land on the contract date
has been fixed by an unappealed finding of the master at $1200.00 per acre.…
The consideration was expressed in the contract between Dr. Hodge and Mr. Shea as follows:
The purchase price being (Cadillac Coupe DeVille 6600) & $4000.00 Dollars, on the
following terms: Dr. Joseph Hodge to give to Mr. George Shea a new $6600 coupe
DeVille Cadillac which is to be registered in name of Mr. George A. Shea at absolutely
no cost to him. In return, Mr. Shea will give to Dr. Joe Hodge his 1964 Cadillac coupe
DeVille and shall transfer title of this vehicle to Dr. Hodge. Further, Dr. Joseph Hodge
will pay to Mr. George A. Shea the balance of $4000.00 for the 20 acres of land
described above subject to survey, title check, less taxes on purchase of vehicle.
Dr. Hodge was fully aware of Mr. Shea’s financial troubles, the liens on his property and his sonin-law’s efforts in his behalf. He was also aware of his patient’s predilection for new Cadillacs.
Although he was not obligated to do so until the property was cleared of liens, which was not
accomplished until the following June, Dr. Hodge hastened to purchase a 1965 Cadillac Coupe
DeVille and delivered it to Mr. Shea on the day after his discharge from the hospital on August
25, 1965. If he acted in haste in an effort to fortify what he must have realized was a dubious
contract, he has so far succeeded.…
Saylor URL: http://www.saylor.org/books

Saylor.org
382

The case at hand is attended by gross inadequacy of consideration, serious impairment of the
grantor’s mentality from age, intemperance and disease, and a confidential relationship between
the grantee and grantor. Has the strong presumption of vitiating unfairness arising from this
combination of circumstances been overcome by the evidence? We must conclude that it has
not. The record is devoid of any evidence suggesting a reason, compatible with fairness, for Mr.
Shea’s assent to so disadvantageous a bargain. Disadvantageous not only because of the gross
disparity between consideration and value, but because of the possibility that the sale would
impede the important negotiations in which Mr. Ransdell was engaged. Unless his memory
failed him, Mr. Shea knew that his son-in-law expected to sell the 125 acre tract for about
$1500.00 per acre as an important step toward raising sufficient funds to satisfy the tax and
judgment liens against the Shea property. These circumstances furnish strong evidence that Mr.
Shea’s assent to the contract, without so much as notice to Mr. Ransdell, was not the product of
a deliberate Exercise of an informed judgment.…
Finally, on this phase of the case, it would be naive not to recognize that the 1965 Cadillac was
used to entice a highly susceptible old man into a hard trade. Mr. Shea was fatuously fond of
new Cadillacs, but was apparently incapable of taking care of one. His own 1964 model (he had
also had a 1963 model) had been badly abused. According to Dr. Hodge, it ‘smelled like a toilet. *
* * had several fenders bumped, bullet holes in the top and the car was just filthy * * *. It was a
rather foul car.’…Knowing the condition of Mr. Shea’s car, his financial predicament and the
activities of his son-in-law in his behalf, Dr. Hodge used the new automobile as a means of
influencing Mr. Shea to agree to sell. The means was calculated to becloud Mr. Shea’s judgment,
and, under the circumstances, its use was unfair.…
Reversed and remanded.

CASE QUESTIONS

1. Why is it relevant that Mr. Shea was separated from his wife and lived alone?
2. Why is it relevant that it was his doctor who convinced him to sell the real estate?
3. Why did the doctor offer the old man a Cadillac as part of the deal?
4. Generally speaking, if you agree to sell your real estate for less than its real value, that’s just
a unilateral mistake and the courts will grant no relief. What’s different here?

Saylor URL: http://www.saylor.org/books

Saylor.org
383

Misrepresentation by Concealment
Reed v. King
193 Cal. Rptr. 130 (Calif. Ct. App. 1983)
Blease, J.
In the sale of a house, must the seller disclose it was the site of a multiple murder? Dorris Reed
purchased a house from Robert King. Neither King nor his real estate agents (the other named
defendants) told Reed that a woman and her four children were murdered there ten years
earlier. However, it seems “truth will come to light; murder cannot be hid long.” (Shakespeare,
Merchant of Venice, Act II, Scene II.) Reed learned of the gruesome episode from a neighbor
after the sale. She sues seeking rescission and damages. King and the real estate agent
defendants successfully demurred to her first amended complaint for failure to state a cause of
action. Reed appeals the ensuing judgment of dismissal. We will reverse the judgment.

Facts
We take all issuable facts pled in Reed’s complaint as true. King and his real estate agent knew
about the murders and knew the event materially affected the market value of the house when
they listed it for sale. They represented to Reed the premises were in good condition and fit for
an “elderly lady” living alone. They did not disclose the fact of the murders. At some point King
asked a neighbor not to inform Reed of that event. Nonetheless, after Reed moved in neighbors
informed her no one was interested in purchasing the house because of the stigma. Reed paid
$76,000, but the house is only worth $65,000 because of its past.…

Discussion
Does Reed’s pleading state a cause of action? Concealed within this question is the nettlesome
problem of the duty of disclosure of blemishes on real property which are not physical defects or
legal impairments to use.
Numerous cases have found non-disclosure of physical defects and legal impediments to use of
real property are material. [Citation] However, to our knowledge, no prior real estate sale case
has faced an issue of non-disclosure of the kind presented here. Should this variety of ill-repute
be required to be disclosed? Is this a circumstance where “non-disclosure of the fact amounts to

Saylor URL: http://www.saylor.org/books

Saylor.org
384

a failure to act in good faith and in accordance with reasonable standards of fair dealing [?]”
(Rest.2d Contracts, § 161, subd. (b).)
The paramount argument against an affirmative conclusion is it permits the camel’s nose of
unrestrained irrationality admission to the tent. If such an “irrational” consideration is
permitted as a basis of rescission the stability of all conveyances will be seriously undermined.
Any fact that might disquiet the enjoyment of some segment of the buying public may be seized
upon by a disgruntled purchaser to void a bargain. In our view, keeping this genie in the bottle is
not as difficult a task as these arguments assume. We do not view a decision allowing Reed to
survive a demurrer in these unusual circumstances as endorsing the materiality of facts
predicating peripheral, insubstantial, or fancied harms.
The murder of innocents is highly unusual in its potential for so disturbing buyers they may be
unable to reside in a home where it has occurred. This fact may foreseeably deprive a buyer of
the intended use of the purchase. Murder is not such a common occurrence that buyers should
be charged with anticipating and discovering this disquieting possibility. Accordingly, the fact is
not one for which a duty of inquiry and discovery can sensibly be imposed upon the buyer.
Reed alleges the fact of the murders has a quantifiable effect on the market value of the
premises. We cannot say this allegation is inherently wrong and, in the pleading posture of the
case, we assume it to be true. If information known or accessible only to the seller has a
significant and measureable effect on market value and, as is alleged here, the seller is aware of
this effect, we see no principled basis for making the duty to disclose turn upon the character of
the information. Physical usefulness is not and never has been the sole criterion of valuation.
Stamp collections and gold speculation would be insane activities if utilitarian considerations
were the sole measure of value.
Reputation and history can have a significant effect on the value of realty. “George Washington
slept here” is worth something, however physically inconsequential that consideration may be.
Ill-repute or “bad will” conversely may depress the value of property. Failure to disclose such a
negative fact where it will have a forseeably depressing effect on income expected to be
generated by a business is tortuous. [Citation] Some cases have held that unreasonable fears of

Saylor URL: http://www.saylor.org/books

Saylor.org
385

the potential buying public that a gas or oil pipeline may rupture may depress the market value
of land and entitle the owner to incremental compensation in eminent domain.
Whether Reed will be able to prove her allegation the decade-old multiple murder has a
significant effect on market value we cannot determine. If she is able to do so by competent
evidence she is entitled to a favorable ruling on the issues of materiality and duty to disclose.
Her demonstration of objective tangible harm would still the concern that permitting her to go
forward will open the floodgates to rescission on subjective and idiosyncratic grounds.…
The judgment is reversed.

CASE QUESTIONS

1. Why is it relevant that the plaintiff was “an elderly lady living alone”?
2. How did Mrs. Reed find out about the gruesome fact here?
3. Why did the defendants conceal the facts?
4. What is the concern about opening “floodgates to rescission on subjective and idiosyncratic
grounds”?
5. Why did George Washington sleep in so many places during the Revolutionary War?
6. Did Mrs. Reed get to rescind her contract and get out of the house as a result of this case?

Misrepresentation by Assertions of Opinion
Vokes v. Arthur Murray, Inc.
212 S.2d. 906 (Fla. 1968)
Pierce, J.
This is an appeal by Audrey E. Vokes, plaintiff below, from a final order dismissing with
prejudice, for failure to state a cause of action, her fourth amended complaint, hereinafter
referred to as plaintiff’s complaint.
Defendant Arthur Murray, Inc., a corporation, authorizes the operation throughout the nation of
dancing schools under the name of “Arthur Murray School of Dancing” through local franchised
operators, one of whom was defendant J. P. Davenport whose dancing establishment was in
Clearwater.
Plaintiff Mrs. Audrey E. Vokes, a widow of 51 years and without family, had a yen to be “an
accomplished dancer” with the hopes of finding “new interest in life.” So, on February 10, 1961, a

Saylor URL: http://www.saylor.org/books

Saylor.org
386

dubious fate, with the assist of a motivated acquaintance, procured her to attend a “dance party”
at Davenport’s “School of Dancing” where she whiled away the pleasant hours, sometimes in a
private room, absorbing his accomplished sales technique, during which her grace and poise
were elaborated upon and her rosy future as “an excellent dancer” was painted for her in vivid
and glowing colors. As an incident to this interlude, he sold her eight 1/2-hour dance lessons to
be utilized within one calendar month therefrom, for the sum of $14.50 cash in hand paid,
obviously a baited “come-on.”
Thus she embarked upon an almost endless pursuit of the terpsichorean art during which, over a
period of less than sixteen months, she was sold fourteen “dance courses” totaling in the
aggregate 2302 hours of dancing lessons for a total cash outlay of $31,090.45 [about $220,000
in 2010 dollars] all at Davenport’s dance emporium. All of these fourteen courses were
evidenced by execution of a written “Enrollment Agreement-Arthur Murray’s School of
Dancing” with the addendum in heavy black print, “No one will be informed that you are taking
dancing lessons. Your relations with us are held in strict confidence”, setting forth the number of
“dancing lessons” and the “lessons in rhythm sessions” currently sold to her from time to time,
and always of course accompanied by payment of cash of the realm.
These dance lesson contracts and the monetary consideration therefore of over $31,000 were
procured from her by means and methods of Davenport and his associates which went beyond
the unsavory, yet legally permissible, perimeter of “sales puffing” and intruded well into the
forbidden area of undue influence, the suggestion of falsehood, the suppression of truth, and the
free Exercise of rational judgment, if what plaintiff alleged in her complaint was true. From the
time of her first contact with the dancing school in February, 1961, she was influenced
unwittingly by a constant and continuous barrage of flattery, false praise, excessive
compliments, and panegyric encomiums, to such extent that it would be not only inequitable,
but unconscionable, for a Court exercising inherent chancery power to allow such contracts to
stand.
She was incessantly subjected to overreaching blandishment and cajolery. She was assured she
had “grace and poise”; that she was “rapidly improving and developing in her dancing skill”; that
the additional lessons would “make her a beautiful dancer, capable of dancing with the most
Saylor URL: http://www.saylor.org/books

Saylor.org
387

accomplished dancers”; that she was “rapidly progressing in the development of her dancing
skill and gracefulness”, etc., etc. She was given “dance aptitude tests” for the ostensible purpose
of “determining” the number of remaining hours of instructions needed by her from time to
time.
At one point she was sold 545 additional hours of dancing lessons to be entitled to an award of
the “Bronze Medal” signifying that she had reached “the Bronze Standard”, a supposed
designation of dance achievement by students of Arthur Murray, Inc.…At another point, while
she still had over 1,000 unused hours of instruction she was induced to buy 151 additional hours
at a cost of $2,049.00 to be eligible for a “Student Trip to Trinidad”, at her own expense as she
later learned.…
Finally, sandwiched in between other lesser sales promotions, she was influenced to buy an
additional 481 hours of instruction at a cost of $6,523.81 in order to “be classified as a Gold Bar
Member, the ultimate achievement of the dancing studio.”
All the foregoing sales promotions, illustrative of the entire fourteen separate contracts, were
procured by defendant Davenport and Arthur Murray, Inc., by false representations to her that
she was improving in her dancing ability, that she had excellent potential, that she was
responding to instructions in dancing grace, and that they were developing her into a beautiful
dancer, whereas in truth and in fact she did not develop in her dancing ability, she had no
“dance aptitude,” and in fact had difficulty in “hearing that musical beat.” The complaint alleged
that such representations to her “were in fact false and known by the defendant to be false and
contrary to the plaintiff’s true ability, the truth of plaintiff’s ability being fully known to the
defendants, but withheld from the plaintiff for the sole and specific intent to deceive and
defraud the plaintiff and to induce her in the purchasing of additional hours of dance lessons.” It
was averred that the lessons were sold to her “in total disregard to the true physical, rhythm,
and mental ability of the plaintiff.” In other words, while she first exulted that she was entering
the “spring of her life”, she finally was awakened to the fact there was “spring” neither in her life
nor in her feet.
The complaint prayed that the Court decree the dance contracts to be null and void and to be
cancelled, that an accounting be had, and judgment entered against, the defendants “for that
Saylor URL: http://www.saylor.org/books

Saylor.org
388

portion of the $31,090.45 not charged against specific hours of instruction given to the
plaintiff.” The Court held the complaint not to state a cause of action and dismissed it with
prejudice. We disagree and reverse.
It is true that “generally a misrepresentation, to be actionable, must be one of fact rather than of
opinion.” [Citations] But this rule has significant qualifications, applicable here. It does not
apply where there is a fiduciary relationship between the parties, or where there has been some
artifice or trick employed by the representor, or where the parties do not in general deal at
“arm’s length” as we understand the phrase, or where the representee does not have equal
opportunity to become apprised of the truth or falsity of the fact represented. [Citation] As
stated by Judge Allen of this Court in [Citation]:
“* * * A statement of a party having * * * superior knowledge may be regarded as a statement of
fact although it would be considered as opinion if the parties were dealing on equal terms.”…
In [Citation] it was said that “* * * what is plainly injurious to good faith ought to be considered
as a fraud sufficient to impeach a contract.”… [Reversed.]

CASE QUESTIONS

1. What was the motivation of the “motivated acquaintance” in this case?
2. Why is it relevant that Mrs. Vokes was a “widow of 51 years and without family”?
3. How did the defendant J. P. Davenport entice her into spending a lot of money on dance
lessons?
4. What was the defendants’ defense as to why they should not be liable for misrepresentation,
and why was that defense not good?
5. Would you say the court here is rather condescending to Mrs. Vokes, all things considered?

Mutual Mistake
Konic International Corporation v. Spokane Computer Services, Inc.,
708 P.2d 932 (Idaho 1985)
The magistrate found the following facts. David Young, an employee of Spokane Computer, was
instructed by his employer to investigate the possibility of purchasing a surge protector, a device
which protects computers from damaging surges of electrical current. Young’s investigation
turned up several units priced from $50 to $200, none of which, however, were appropriate for

Saylor URL: http://www.saylor.org/books

Saylor.org
389

his employer’s needs. Young then contacted Konic. After discussing Spokane Computer’s needs
with a Konic engineer, Young was referred to one of Konic’s salesmen. Later, after deciding on a
certain unit, Young inquired as to the price of the selected item. The salesman responded, “fiftysix twenty.” The salesman meant $5,620. Young in turn thought $56.20.
The salesman for Konic asked about Young’s authority to order the equipment and was told that
Young would have to get approval from one of his superiors. Young in turn prepared a purchase
order for $56.20 and had it approved by the appropriate authority. Young telephoned the order
and purchase order number to Konic who then shipped the equipment to Spokane Computer.
However, because of internal processing procedures of both parties the discrepancy in prices
was not discovered immediately. Spokane Computer received the surge protector and installed it
in its office. The receipt and installation of the equipment occurred while the president of
Spokane Computer was on vacation. Although the president’s father, who was also chairman of
the board of Spokane Computer, knew of the installation, he only inquired as to what the item
was and who had ordered it. The president came back from vacation the day after the surge
protector had been installed and placed in operation and was told of the purchase. He
immediately ordered that power to the equipment be turned off because he realized that the
equipment contained parts which alone were worth more than $56 in value. Although the
president then told Young to verify the price of the surge protector, Young failed to do so. Two
weeks later, when Spokane Computer was processing its purchase order and Konic’s invoice, the
discrepancy between the amount on the invoice and the amount on the purchase order was
discovered. The president of Spokane Computer then contacted Konic, told Konic that Young
had no authority to order such equipment, that Spokane Computer did not want the equipment,
and that Konic should remove it. Konic responded that Spokane Computer now owned the
equipment and if the equipment was not paid for, Konic would sue for the price. Spokane
Computer refused to pay and this litigation ensued.
Basically what is involved here is a failure of communication between the parties. A similar
failure to communicate arose over 100 years ago in the celebrated case ofRaffles v. Wichelhaus,
[Citation] which has become better known as the case of the good ship “Peerless.” In Peerless,
the parties agreed on a sale of cotton which was to be delivered from Bombay by the ship
Saylor URL: http://www.saylor.org/books

Saylor.org
390

“Peerless.” In fact, there were two ships named “Peerless” and each party, in agreeing to the sale,
was referring to a different ship. Because the sailing time of the two ships was materially
different, neither party was willing to agree to shipment by the “other” Peerless. The court ruled
that, because each party had a different ship in mind at the time of the contract, there was in fact
no binding contract. The Peerless rule later was incorporated into section 71 of the Restatement
of Contracts and has now evolved into section 20 of Restatement (Second) of Contracts (1981).
Section 20 states in part:
(1) There is no manifestation of mutual assent to an exchange if the parties attach
materially different meanings to their manifestations and
(a) neither knows or has reason to know the meaning attached by the other.
Comment (c) to Section 20 further explains that “even though the parties manifest mutual
assent to the same words of agreement, there may be no contract because of a material
difference of understanding as to the terms of the exchange.” Another authority, Williston,
discussing situations where a mistake will prevent formation of a contract, agrees that “where a
phrase of contract…is reasonably capable of different interpretations…there is no contract.”
[Citation]
In the present case, both parties attributed different meanings to the same term, “fifty-six
twenty.” Thus, there was no meeting of the minds of the parties. With a hundred fold difference
in the two prices, obviously price was a material term. Because the “fifty-six twenty” designation
was a material term expressed in an ambiguous form to which two meanings were obviously
applied, we conclude that no contract between the parties was ever formed. Accordingly, we do
not reach the issue of whether Young had authority to order the equipment.
[Affirmed.]

CASE QUESTIONS

1. Why is it reasonable to say that no contract was made in this case?
2. A discrepancy in price of one hundred times is, of course, enormous. How could such an
egregious mistake have occurred by both parties? In terms of running a sensible business,
how could this kind of mistake be avoided before it resulted in expensive litigation?

10.6 Summary and Exercises
Saylor URL: http://www.saylor.org/books

Saylor.org
391

Summary
No agreement is enforceable if the parties did not enter into it (1) of their own free will, (2) with
adequate knowledge of the terms, and (3) with the mental capacity to appreciate the
relationship.
Contracts coerced through duress will void a contract if actually induced through physical harm
and will make the contract voidable if entered under the compulsion of many types of threats.
The threat must be improper and leave no reasonable alternative, but the test is subjective—that
is, what did the person threatened actually fear, not what a more reasonable person might have
feared.
Misrepresentations may render an agreement void or voidable. Among the factors to be
considered are whether the misrepresentation was deliberate and material; whether the
promisee relied on the misrepresentation in good faith; whether the representation was of fact,
opinion, or intention; and whether the parties had a special relationship.
Similarly, mistaken beliefs, not induced by misrepresentations, may suffice to avoid the bargain.
Some mistakes on one side only make a contract voidable. More often, mutual mistakes of facts
will show that there was no meeting of the minds.
Those who lack capacity are often entitled to avoid contract liability. Although it is possible to
state the general rule, many exceptions exist—for example, in contracts for necessities, infants
will be liable for the reasonable value of the goods purchased.

EXERCISES

1. Eulrich, an auto body mechanic who had never operated a business, entered into a Snap-On
Tools franchise agreement. For $22,000 invested from his savings and the promise of another
$22,000 from the sale of inventory, he was provided a truck full of tools. His job was to drive
around his territory and sell them. The agreement allowed termination by either party; if
Eulrich terminated, he was entitled to resell to Snap-On any new tools he had remaining.
When he complained that his territory was not profitable, his supervisors told him to work it
harder, that anybody could make money with Snap-On’s marketing system. (In fact, the
evidence was the system made money for the supervisors and little for dealers; dealers
quickly failed and were replaced by new recruits.) Within several months Eulrich was out of

Saylor URL: http://www.saylor.org/books

Saylor.org
392

money and desperate. He tried to “check in” his truck to get money to pay his household bills
and uninsured medical bills for his wife; the supervisors put him off for weeks. On the checkin day, the exhausted Eulrich’s supervisors berated him for being a bad businessman, told
him no check would be forthcoming until all the returned inventory was sold, and presented
him with a number of papers to sign, including a “Termination Agreement” whereby he
agreed to waive any claims against Snap-On; he was not aware that was what he had signed.
He sued to rescind the contract and for damages. The defendants held up the waiver as a
defense. Under what theory might Eulrich recover? [1]
2. Chauncey, a college student, worked part-time in a restaurant. After he had worked for
several months, the owner of the restaurant discovered that Chauncey had stolen $2,000
from the cash register. The owner called Chauncey’s parents and told them that if they did
not sign a note for $2,000, he would initiate criminal proceedings against Chauncey. The
parents signed and delivered the note to the owner but later refused to pay. May the owner
collect on the note? Why?
3. A restaurant advertised a steak dinner that included a “juicy, great-tasting steak, a fresh crisp
salad, and a warm roll.” After reading the ad, Clarence visited the restaurant and ordered the
steak dinner. The steak was dry, the lettuce in the salad was old and limp with brown edges,
and the roll was partly frozen. May Clarence recover from the restaurant on the basis of
misrepresentation? Why?
4. Bert purchased Ernie’s car. Before selling the car, Ernie had stated to Bert, “This car runs well
and is reliable. Last week I drove the car all the way from Seattle to San Francisco to visit my
mother and back again to Seattle.” In fact, Ernie was not telling the truth: he had driven the
car to San Francisco to visit his paramour, not his mother. Upon discovery of the truth, may
Bert avoid the contract? Why?
5. Randolph enrolled in a business law class and purchased a new business law textbook from
the local bookstore. He dropped the class during the first week and sold the book to his
friend Scott. Before making the sale, Randolph told Scott that he had purchased the book
new and had owned it for one week. Unknown to either Randolph or Scott, the book was in
fact a used one. Scott later discovered some underlining in the middle of the book and
Saylor URL: http://www.saylor.org/books

Saylor.org
393

attempted to avoid the contract. Randolph refused to refund the purchase price, claiming
that he had not intentionally deceived his friend. May Scott avoid the contract? Why?
6. Langstraat was seventeen when he purchased a motorcycle. When applying for insurance, he
signed a “Notice of Rejection,” declining to purchase uninsured motorist coverage. He was
involved in an accident with an uninsured motorist and sought to disaffirm his rejection of
the uninsured motorist coverage on the basis of infancy. May he do so?
7. Waters was attracted to Midwest Supply by its advertisements for doing federal income
taxes. The ads stated “guaranteed accurate tax preparation.” Waters inquired about
amending past returns to obtain refunds. Midwest induced him to apply for and receive
improper refunds. When Waters was audited, he was required to pay more taxes, and the
IRS put tax liens on his wages and bank accounts. In fact, Midwest hired people with no
knowledge about taxes at all; if a customer inquired about employees’ qualifications,
Midwest’s manual told the employees to say, “Midwest has been preparing taxes for twenty
years.” The manual also instructed office managers never to refer to any employee as a
“specialist” or “tax expert,” but never to correct any news reporters or commentators if they
referred to employees as such. What cause of action has Waters, and for what remedies?
8. Mutschler Grain Company (later Jamestown Farmers Elevator) agreed to sell
General Mills 30,000 bushels of barley at $1.22 per bushel. A dispute arose:
Mutschler said that transportation was to be by truck but that General Mills never
ordered any trucks to pick up the grain; General Mills said the grain was to be
shipped by rail (railcars were in short supply). Nine months later, after Mutschler
had delivered only about one-tenth the contracted amount, the price of barley
was over $3.00 per bushel. Mutschler defaulted on, and then repudiated, the
contract. Fred Mutschler then received this telephone call from General Mills:
“We’re General Mills, and if you don’t deliver this grain to us, why we’ll have a
battery of lawyers in there tomorrow morning to visit you, and then we are going
to the North Dakota Public Service (Commission); we’re going to the Minneapolis
Grain Exchange and we’re going to the people in Montana and there will be no
more Mutschler Grain Company. We’re going to take your license.”
Saylor URL: http://www.saylor.org/books

Saylor.org
394

Mutchsler then shipped 22,000 bushels of barley at the $1.22 rate and sued
General Mills for the difference between that price and the market price of over
$3.00. Summary judgment issued for General Mills. Upon what basis might
Mutschler Grain appeal?
9. Duke decided to sell his car. The car’s muffler had a large hole in it, and as a result, the car
made a loud noise. Before showing the car to potential buyers, Duke patched the hole with
muffler tape to quiet it. Perry bought the car after test-driving it. He later discovered the
faulty muffler and sought to avoid the contract, claiming fraud. Duke argued that he had not
committed fraud because Perry had not asked about the muffler and Duke had made no
representation of fact concerning it. Is Duke correct? Decide and explain.
10. At the end of the term at college, Jose, talking in the library with his friend Leanne, said, “I’ll
sell you my business law notes for $25.” Leanne agreed and paid him the money. Jose then
realized he’d made a mistake in that he had offered his notes when he meant to offer his
book. Leanne didn’t want the book; she had a book. She wanted the notes. Would Leanne
have a cause of action against Jose if he refused to deliver the notes? Decide and explain.

SELF-TEST QUESTIONS

1. Misrepresentation that does not go to the core of a contract is
a.

fraud in the execution

b. fraud in the inducement
c. undue influence
d. an example of mistake
In order for a misrepresentation to make a contract voidable,
a.

it must have been intentional

b. the party seeking to void must have relied on the misrepresentation
c. it must always be material
d. none of the above is required
A mistake by one party will not invalidate a contract unless
a.

the other party knew of the mistake

b. the party making the mistake did not read the contract closely

Saylor URL: http://www.saylor.org/books

Saylor.org
395

c. the parties to the contract had never done business before
d. the party is mistaken about the law
Upon reaching the age of majority, a person who entered into a contract to
purchase goods while a minor may
a.

ratify the contract and keep the goods without paying for them

b. disaffirm the contract and keep the goods without paying for them
c. avoid paying for the goods by keeping them without ratifying or disaffirming the
contract
d. none of these
Seller does not disclose to Buyer that the foundation of a house is infested
with termites. Upon purchasing the house and remodeling part of the basement,
Buyer discovers the termites. Has Buyer a cause of action against Seller?
a.

yes

b. no

SELF-TEST ANSWERS

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

[1] Eulrich v. Snap-On Tools Corp., 853 P.2d 1350 (Or. Ct. App. 1993).

Saylor URL: http://www.saylor.org/books

Saylor.org
396

Chapter 11
Consideration

LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1. What “consideration” is in contract law, what it is not, and what purposes it serves
2. How the sufficiency of consideration is determined
3. In what common situations an understanding of consideration is important
4. What promises are enforceable without consideration

11.1 General Perspectives on Consideration
LEARNING OBJECTIVES

1. Understand what “consideration” is in contract law.
2. Recognize what purposes the doctrine serves.
3. Understand how the law determines whether consideration exists.
4. Know the elements of consideration.

The Purpose of Consideration
This chapter continues our inquiry into whether the parties created a valid contract. InChapter 9
"The Agreement", we saw that the first requisite of a valid contract is an agreement: offer and
acceptance. In this chapter, we assume that agreement has been reached and concentrate on one
of its crucial aspects: the existence of consideration. Which of the following, if any, is a contract?
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 twenty-five dollars. Lou accepts.
3. Betty offers to give Lou the book if Lou promises to pick it up at Betty’s house. Lou agrees.
In American law, only the second situation is a binding contract, because only that contract
contains consideration, a set of mutual promises in which each party agrees to give up
something to the benefit of the other. This chapter will explore the meaning and rationale of that
statement.
Saylor URL: http://www.saylor.org/books

Saylor.org
397

The question of what constitutes a binding contract has been answered differently throughout
history and in other cultures. For example, under Roman law, a contract without consideration
was binding if certain formal requirements were met. And in the Anglo-American tradition, the
presence of a seal—the wax impression affixed to a document—was once sufficient to make a
contract binding without any other consideration. The seal is no longer a substitute for
consideration, although in some states it creates a presumption of consideration; in forty-nine
states, the Uniform Commercial Code (UCC) has abolished the seal on contracts for the sale of
goods. (Louisiana has not adopted UCC Article 2.)
Whatever its original historical purposes, and however apparently arcane, the doctrine of
consideration serves some still-useful purposes. It provides objective evidence for asserting that
a contract exists; it distinguishes between enforceable and unenforceable bargains; and it is a
check against rash, unconsidered action, against thoughtless promise making. [1]

A Definition of Consideration
Consideration is said to exist when the promisor receives some benefit for his promise and the
promisee gives up something in return; it is the bargained-for price you pay for what you get.
That may seem simple enough. But as with much in the law, the complicating situations are
never very far away. The “something” that is promised or delivered cannot be just anything, such
as a feeling of pride, warmth, amusement, or friendship; it must be something known as
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.
The detriment to one side is usually a legal benefit to the other, but the detriment to the
promisee need not confer a tangible benefit on the promisor; the promisee can agree to forego
something without that something being given to the promisor. Whether consideration is legally
sufficient has nothing to do with whether it is morally or economically adequate to make the
bargain a fair one. Moreover, legal consideration need not even be certain; it can be a promise
contingent on an event that may never happen. Consideration is a legal concept, and it centers
on the giving up of a legal right or benefit.
Consideration has two elements. The first, as just outlined, is whether the promisee has incurred
a legal detriment—given up something, paid some “price,” though it may be, for example, the
Saylor URL: http://www.saylor.org/books

Saylor.org
398

promise to do something, like paint a house. (Some courts—although a minority—take the view
that a bargained-for legal benefit to the promisor is sufficient consideration.) The second
element is whether the legal detriment was bargained for: did the promisor specifically intend
the act, forbearance, or promise in return for his promise? Applying this two-pronged test to the
three examples given at the outset of the chapter, we can easily see why only in the second is
there legally sufficient consideration. In the first, Lou incurred no legal detriment; he made no
pledge to act or to forbear from acting, nor did he in fact act or forbear from acting. In the third
example, what might appear to be such a promise is not really so. Betty made a promise on a
condition that Lou comes to her house; the intent clearly is to make a gift.

KEY TAKEAWAY

Consideration is—with some exceptions—a required element of a contract. It is the
bargained-for giving up of something of legal value for something in return. It serves the
purposes of making formal the intention to contract and reducing rash promise making.

EXERCISES

1. Alice promises to give her neighbor a blueberry bush; the neighbor says, “Thank you!”
Subsequently, Alice changes her mind. Is she bound by her promise?
2. Why, notwithstanding its relative antiquity, does consideration still serve some useful
purposes?
3. Identify the exchange of consideration in this example: A to B, “I will pay you $800 if you
paint my garage.” B to A, “Okay, I’ll paint your garage for $800.”

[1] Lon L. Fuller, “Consideration and Form,” Columbia Law Review 41 (1941): 799.

11.2 Legal Sufficiency

LEARNING OBJECTIVES

1. Know in general what “legal sufficiency” means when examining consideration.
2. Recognize how the concept operates in such common situations as threat of litigation, and
accord and satisfaction.
3. Understand why illusory promises are unenforceable, and how courts deal with needs,
outputs, and exclusive dealings contracts.
Saylor URL: http://www.saylor.org/books

Saylor.org
399

The Concept of Legal Sufficiency
As suggested in Section 11.1 "General Perspectives on Consideration", what is required in
contract is the exchange of a legal detriment and a legal benefit; if that happens, the
consideration is said to have legal sufficiency.

Actual versus Legal Detriment
Suppose Phil offers George $500 if George will quit smoking for one year. Is Phil’s promise
binding? Because George is presumably benefiting by making and sticking to the agreement—
surely his health will improve if he gives up smoking—how can his act be considered a legal
detriment? The answer is that there is forbearance on George’s part: George is legally entitled to
smoke, and by contracting not to, he suffers a loss of his legal right to do so. This is a legal
detriment; consideration does not require an actual detriment.

Adequacy of Consideration
Scrooge offers to buy Caspar’s motorcycle, worth $700, for $10 and a shiny new fountain pen
(worth $5). Caspar agrees. Is this agreement supported by adequate consideration? Yes, because
both have agreed to give up something that is theirs: Scrooge, the cash and the pen; Caspar, the
motorcycle. Courts are not generally concerned with the economic adequacy of the
consideration but instead with whether it is present. As Judge Richard A. Posner puts it, “To ask
whether there is consideration is simply to inquire whether the situation is one of exchange and
a bargain has been struck. To go further and ask whether the consideration is adequate would
require the court to do what…it is less well equipped to do than the parties—decide whether the
price (and other essential terms) specified in the contract are reasonable.” [1] In short, “courts do
not inquire into the adequacy of consideration.”
Of course, normally, parties to contracts will not make such a one-sided deal as Scrooge and
Caspar’s. But there is a common class of contracts in which nominal consideration—usually one
dollar—is recited in printed forms. Usually these are option contracts, in which “in consideration
of one dollar in hand paid and receipt of which is hereby acknowledged” one party agrees to hold
open the right of the other to make a purchase on agreed terms. The courts will enforce these
contracts if the dollar is intended “to support a short-time option proposing an exchange on fair
terms.” [2] If, however, the option is for an unreasonably long period of time and the underlying
Saylor URL: http://www.saylor.org/books

Saylor.org
400

bargain is unfair (the Restatement gives as an example a ten-year option permitting the
optionee to take phosphate rock from a widow’s land at a per-ton payment of only one-fourth
the prevailing rate), then the courts are unlikely to hold that the nominal consideration makes
the option irrevocable.
Because the consideration on such option contracts is nominal, its recital in the written
instrument is usually a mere formality, and it is frequently never paid; in effect, the recital of
nominal consideration is false. Nevertheless, the courts will enforce the contract—precisely
because the recital has become a formality and nobody objects to the charade. Moreover, it
would be easy enough to upset an option based on nominal consideration by falsifying oral
testimony that the dollar was never paid or received. In a contest between oral testimonies
where the incentive to lie is strong and there is a written document clearly incorporating the
parties’ agreement, the courts prefer the latter. However, as Section 11.4.1 "Consideration for an
Option", Board of Control of Eastern Michigan University v. Burgess, demonstrates, the state
courts are not uniform on this point, and it is a safe practice always to deliver the consideration,
no matter how nominal.

Applications of the Legal Sufficiency Doctrine
This section discusses several common circumstances where the issue of whether the
consideration proffered (offered up) is adequate.

Threat of Litigation: Covenant Not to Sue
Because every person has the legal right to file suit if he or she feels aggrieved, a promise to
refrain from going to court is sufficient consideration to support a promise of payment or
performance. In Dedeaux v. Young, Dedeaux purchased property and promised to make certain
payments to Young, the broker. [3] But Dedeaux thereafter failed to make these payments, and
Young threatened suit; had he filed papers in court, the transfer of title could have been blocked.
To keep Young from suing, Dedeaux promised to pay a 5 percent commission if Young would
stay out of court. Dedeaux later resisted paying on the ground that he had never made such a
promise and that even if he had, it did not amount to a contract because there was no
consideration from Young. The court disagreed, holding that the evidence supported Young’s
contention that Dedeaux had indeed made such a promise and upholding Young’s claim for the
Saylor URL: http://www.saylor.org/books

Saylor.org
401

commission because “a request to forbear to exercise a legal right has been generally accepted as
sufficient consideration to support a contract.” If Young had had no grounds to sue—for
example, if he had threatened to sue a stranger, or if it could be shown that Dedeaux had no
obligation to him originally—then there would have been no consideration because Young would
not have been giving up a legal right. A promise to forebear suing in return for settlement of a
dispute is called a covenant not to sue(covenant is another word for agreement).

Accord and Satisfaction Generally
Frequently, the parties to a contract will dispute the meaning of its terms and conditions,
especially the amount of money actually due. When the dispute is genuine (and not the
unjustified attempt of one party to avoid paying a sum clearly due), it can be settled by the
parties’ agreement on a fixed sum as the amount due. This second agreement, which substitutes
for the disputed first agreement, is called an accord, and when the payment or other term is
discharged, the completed second contract is known as an accord and satisfaction. A suit
brought for an alleged breach of the original contract could be defended by citing the later
accord and satisfaction.
An accord is a contract and must therefore be supported by consideration. Suppose Jan owes
Andy $7,000, due November 1. On November 1, Jan pays only $3,500 in exchange for Andy’s
promise to release Jan from the remainder of the debt. Has Andy (the promisor) made a binding
promise? He has not, because there is no consideration for the accord. Jan has incurred no
detriment; she has received something (release of the obligation to pay the remaining $3,500),
but she has given up nothing. But if Jan and Andy had agreed that Jan would pay the $3,500 on
October 25, then there would be consideration; Jan would have incurred a legal detriment by
obligating herself to make a payment earlier than the original contract required her to. If Jan
had paid the $3,500 on November 11 and had given Andy something else agreed to—a pen, a keg
of beer, a peppercorn—the required detriment would also be present.
Let’s take a look at some examples of the accord and satisfaction principle. The dispute that
gives rise to the parties’ agreement to settle by an accord and satisfaction may come up in
several typical ways: where there is an unliquidated debt; a disputed debt; an “in-full-payment
check” for less than what the creditor claims is due; unforeseen difficulties that give rise to a
Saylor URL: http://www.saylor.org/books

Saylor.org
402

contract modification, or a novation; or a composition among creditors. But no obligation ever
arises—and no real legal dispute can arise—where a person promises a benefit if someone will do
that which he has a preexisting obligation to, or where a person promises a benefit to someone
not to do that which the promisee is already disallowed from doing, or where one makes an
illusory promise.

Settling an Unliquidated Debt
An unliquidated debt is one that is uncertain in amount. Such debts frequently occur when
people consult professionals in whose offices precise fees are rarely discussed, or where one
party agrees, expressly or by implication, to pay the customary or reasonable fees of the other
without fixing the exact amount. It is certain that a debt is owed, but it is not certain how much.
(A liquidated debt, on the other hand, is one that is fixed in amount, certain. A debt can be
liquidated by being written down in unambiguous terms—“IOU $100”—or by being
mathematically ascertainable—$1 per pound of ice ordered and 60 pounds delivered; hence the
liquidated debt is $60.)
Here is how the matter plays out: Assume a patient goes to the hospital for a gallbladder
operation. The cost of the operation has not been discussed beforehand in detail, although the
cost in the metropolitan area is normally around $8,000. After the operation, the patient and
the surgeon agree on a bill of $6,000. The patient pays the bill; a month later the surgeon sues
for another $2,000. Who wins? The patient: he has forgone his right to challenge the
reasonableness of the fee by agreeing to a fixed amount payable at a certain time. The agreement
liquidating the debt is an accord and is enforceable. If, however, the patient and the surgeon had
agreed on an $8,000 fee before the operation, and if the patient arbitrarily refused to pay this
liquidated debt unless the surgeon agreed to cut her fee in half, then the surgeon would be
entitled to recover the other half in a lawsuit, because the patient would have given no
consideration—given up nothing, “suffered no detriment”—for the surgeon’s subsequent
agreement to cut the fee.

Settling a Disputed Debt
A disputed debt arises where the parties did agree on (liquidated) the price or fee but
subsequently get into a dispute about its fairness, and then settle. When this dispute is settled,
Saylor URL: http://www.saylor.org/books

Saylor.org
403

the parties have given consideration to an agreement to accept a fixed sum as payment for the
amount due. Assume that in the gallbladder case the patient agrees in advance to pay $8,000.
Eight months after the operation and as a result of nausea and vomiting spells, the patient
undergoes a second operation; the surgeons discover a surgical sponge embedded in the
patient’s intestine. The patient refuses to pay the full sum of the original surgeon’s bill; they
settle on $6,000, which the patient pays. This is a binding agreement because subsequent facts
arose to make legitimate the patient’s quarrel over his obligation to pay the full bill. As long as
the dispute is based in fact and is not trumped up, as long as the promisee is acting in good faith,
then consideration is present when a disputed debt is settled.

The “In-Full-Payment” Check Situation
To discharge his liquidated debt for $8,000 to the surgeon, the patient sends a check for $6,000
marked “payment in full.” The surgeon cashes it. There is no dispute. May the surgeon sue for
the remaining $2,000? This may appear to be an accord: by cashing the check, the surgeon
seems to be agreeing with the patient to accept the $6,000 in full payment. But consideration is
lacking. Because the surgeon is owed more than the face amount of the check, she causes the
patient no legal detriment by accepting the check. If the rule were otherwise, debtors could
easily tempt hard-pressed creditors to accept less than the amount owed by presenting
immediate cash. The key to the enforceability of a “payment in full” legend is the character of the
debt. If unliquidated, or if there is a dispute, then “payment in full” can serve as accord and
satisfaction when written on a check that is accepted for payment by a creditor. But if the debt is
liquidated and undisputed, there is no consideration when the check is for a lesser amount.
(However, it is arguable that if the check is considered to be an agreement modifying a sales
contract, no consideration is necessary under Uniform Commercial Code (UCC) Section 2-209.)

Unforeseen Difficulties
An unforeseen difficulty arising after a contract is made may be resolved by an accord and
satisfaction, too. Difficulties that no one could foresee can sometimes serve as catalyst for a
further promise that may appear to be without consideration but that the courts will enforce
nevertheless. Suppose Peter contracts to build Jerry a house for $390,000. While excavating,
Peter unexpectedly discovers quicksand, the removal of which will cost an additional $10,000.
Saylor URL: http://www.saylor.org/books

Saylor.org
404

To ensure that Peter does not delay, Jerry promises to pay Peter $10,000 more than originally
agreed. But when the house is completed, Jerry reneges on his promise. Is Jerry liable? Logically
perhaps not: Peter has incurred no legal detriment in exchange for the $10,000; he had already
contracted to build the house. But most courts would allow Peter to recover on the theory that
the original contract was terminated, or modified, either by mutual agreement or by an implied
condition that the original contract would be discharged if unforeseen difficulties developed. In
short, the courts will enforce the parties’ own mutual recognition that the unforeseen conditions
had made the old contract unfair. The parties either have modified their original contract (which
requires consideration at common law) or have given up their original contract and made a new
one (called anovation).
It is a question of fact whether the new circumstance is new and difficult enough to make a
preexisting obligation into an unforeseen difficulty. Obviously, if Peter encounters only a small
pocket of quicksand—say two gallons’ worth—he would have to deal with it as part of his
already-agreed-to job. If he encounters as much quicksand as would fill an Olympic-sized
swimming pool, that’s clearly unforeseen, and he should get extra to deal with it. Someplace
between the two quantities of quicksand there is enough of the stuff so that Peter’s duty to
remove it is outside the original agreement and new consideration would be needed in exchange
for its removal.

Creditors’ Composition
A creditors’ composition may give rise to debt settlement by an accord and satisfaction. It is an
agreement whereby two or more creditors of a debtor consent to the debtor’s paying them pro
rata shares of the debt due in full satisfaction of their claims. A composition agreement can be
critically important to a business in trouble; through it, the business might manage to stave off
bankruptcy. Even though the share accepted is less than the full amount due and is payable after
the due date so that consideration appears to be lacking, courts routinely enforce these
agreements. The promise of each creditor to accept a lesser share than that owed in return for
getting something is taken as consideration to support the promises of the others. A debtor has
$3,000 on hand. He owes $3,000 each to A, B, and C. A, B, and C agree to accept $1,000 each
and discharge the debtor. Each creditor has given up $2,000 but in return has at least received
Saylor URL: http://www.saylor.org/books

Saylor.org
405

something, the $1,000. Without the composition, one might have received the entire amount
owed her, but the others would have received nothing.

Preexisting Duty
Not amenable to settlement by an accord and satisfaction is the situation where a party has
a preexisting duty and he or she is offered a benefit to discharge it. When the only
consideration offered the promisor is an act or promise to act to carry out a preexisting duty,
there is no valid contract. As Denney v. Reppert (Section 11.4.2 "Consideration: Preexisting
Obligation") makes clear, the promisee suffers no legal detriment in promising to undertake that
which he is already obligated to do. Where a person is promised a benefit not to do that which
he is already disallowed from doing, there is no consideration. David is sixteen years old; his
uncle promises him $50 if he will refrain from smoking. The promise is not enforceable: legally,
David already must refrain from smoking, so he has promised to give up nothing to which he
had a legal right. As noted previously, the difficulty arises where it is unclear whether a person
has a preexisting obligation or whether such unforeseen difficulties have arisen as to warrant the
recognition that the parties have modified the contract or entered into a novation. What if Peter
insists on additional payment for him to remove one wheelbarrow full of quicksand from the
excavation? Surely that’s not enough “unforeseen difficulty.” How much quicksand is enough?

Illusory Promises
Not every promise is a pledge to do something. Sometimes it is an illusory promise, where the
terms of the contract really bind the promisor to give up nothing, to suffer no detriment. For
example, Lydia offers to pay Juliette $10 for mowing Lydia’s lawn. Juliette promises to mow the
lawn if she feels like it. May Juliette enforce the contract? No, because Juliette has incurred no
legal detriment; her promise is illusory, since by doing nothing she still falls within the literal
wording of her promise. The doctrine that such bargains are unenforceable is sometimes
referred to as the rule of mutuality of obligation: if one party to a contract has not made a
binding obligation, neither is the other party bound. Thus if A contracts to hire B for a year at
$6,000 a month, reserving the right to dismiss B at any time (an “option to cancel” clause), and
B agrees to work for a year, A has not really promised anything; A is not bound to the
agreement, and neither is B.
Saylor URL: http://www.saylor.org/books

Saylor.org
406

The illusory promise presents a special problem in agreements for exclusive dealing, outputs,
and needs contracts.

Exclusive Dealing Agreement
In an exclusive dealing agreement, one party (the franchisor) promises to deal solely with the
other party (the franchisee)—for example, a franchisor-designer agrees to sell all of her specially
designed clothes to a particular department store (the franchisee). In return, the store promises
to pay a certain percentage of the sales price to the designer. On closer inspection, it may appear
that the store’s promise is illusory: it pays the designer only if it manages to sell dresses, but it
may sell none. The franchisor-designer may therefore attempt to back out of the deal by arguing
that because the franchisee is not obligated to do anything, there was no consideration for her
promise to deal exclusively with the store.
Courts, however, have upheld exclusive dealing contracts on the theory that the franchisee has
an obligation to use reasonable efforts to promote and sell the product or services. This
obligation may be spelled out in the contract or implied by its terms. In the classic statement of
this concept, Judge Benjamin N. Cardozo, then on the New York Court of Appeals, in upholding
such a contract, declared:
It is true that [the franchisee] does not promise in so many words that he will use
reasonable efforts to place the defendant’s endorsements and market her designs. We
think, however, that such a promise is fairly to be implied. The law has outgrown its
primitive stage of formalism when the precise word was the sovereign talisman, and
every slip was fatal. It takes a broader view today. A promise may be lacking, and yet
the whole writing may be “instinct with an obligation,” imperfectly expressed.…His
promise to pay the defendant one-half of the profits and revenues resulting from the
exclusive agency and to render accounts monthly was a promise to use reasonable
efforts to bring profits and revenues into existence. [4]
The UCC follows the same rule. In the absence of language specifically delineating the seller’s or
buyer’s duties, an exclusive dealing contract under Section 2-306(2) imposes “an obligation by
the seller to use best efforts to supply the goods and by the buyer to use best efforts to promote
their sale.”
Saylor URL: http://www.saylor.org/books

Saylor.org
407

Outputs Contracts and Needs Contracts
A similar issue arises with outputs contracts and needs contracts. In anoutputs contract, the
seller—say a coal company—agrees to sell its entire yearly output of coal to an electric utility.
Has it really agreed to produce and sell any coal at all? What if the coal-mine owner decides to
shut down production to take a year’s vacation—is that a violation of the agreement? Yes. The
law imposes upon the seller here a duty to produce and sell a reasonable amount. Similarly, if
the electric utility contracted to buy all its requirements of coal from the coal company—
aneeds contract—could it decide to stop operation entirely and take no coal? No, it is required to
take a reasonable amount.

KEY TAKEAWAY

Courts do not inquire into the adequacy of consideration, but (with some exceptions) do
require the promisor to incur a legal detriment (the surrender of any legal right he or she
possesses—to give up something) in order to receive the bargained-for benefit. The
surrender of the right to sue is a legal detriment, and the issue arises in analyzing various
kinds of dispute settlement agreements (accord and satisfaction): the obligation to pay the
full amount claimed by a creditor on a liquidated debt, an unliquidated debt, and a disputed
debt. Where unforeseen difficulties arise, an obligor will be entitled to additional
compensation (consideration) to resolve them either because the contract is modified or
because the parties have entered into a novation, but no additional consideration is owing to
one who performs a preexisting obligation or forbears from performing that which he or she
is under a legal duty not to perform. If a promisor gives an illusory promise, he or she gives
no consideration and no contract is formed; but exclusive dealing agreements, needs
contracts, and outputs contracts are not treated as illusory.

EXERCISES

1. What is meant by “legally sufficient” consideration?
2. Why do courts usually not “inquire into the adequacy of consideration”?
3. How can it be said there is consideration in the following instances: (a) settlement of an
unliquidated debt? (b) settlement of a disputed debt? (c) a person agreeing to do more than
originally contracted for because of unforeseen difficulties? (d) a creditor agreeing with other
creditors for each of them to accept less than they are owed from the debtor?
Saylor URL: http://www.saylor.org/books

Saylor.org
408

4. Why is there no consideration where a person demands extra compensation for that which
she is already obligated to do, or for forbearing to do that which she already is forbidden
from doing?
5. What is the difference between a contract modification and a novation?
6. How do courts resolve the problem that a needs or outputs contract apparently imposes no
detriment—no requirement to pass any consideration to the other side—on the promisor?

[1] Richard A. Posner, Economic Analysis of Law (New York: Aspen, 1973), 46.
[2] Restatement (Second) of Contracts, Section 87(b).
[3] Dedeaux v. Young, 170 So.2d 561 (1965).
[4] Otis F. Wood v. Lucy, Lady Duff-Gordon, 118 N.E. 214 (1917).

11.3 Promises Enforceable without Consideration
LEARNING OBJECTIVE

1. Understand the exceptions to the requirement of consideration.
For a variety of policy reasons, courts will enforce certain types of promises even though
consideration may be absent. Some of these are governed by the Uniform Commercial Code
(UCC); others are part of the established common law.

Promises Enforceable without Consideration at Common Law
Past Consideration
Ordinarily, past consideration is not sufficient to support a promise. By past consideration, the
courts mean an act that could have served as consideration if it had been bargained for at the
time but that was not the subject of a bargain. For example, Mrs. Ace’s dog Fluffy escapes from
her mistress’s condo at dusk. Robert finds Fluffy, sees Mrs. Ace, who is herself out looking for
her pet, and gives Fluffy to her. She says, “Oh, thank you for finding my dear dog. Come by my
place tomorrow morning and I’ll give you fifty dollars as a reward.” The next day Robert stops by
Mrs. Ace’s condo, but she says, “Well, I don’t know. Fluffy soiled the carpet again last night. I
think maybe a twenty-dollar reward would be plenty.” Robert cannot collect the fifty dollars.
Even though Mrs. Ace might have a moral obligation to pay him and honor her promise, there
Saylor URL: http://www.saylor.org/books

Saylor.org
409

was no consideration for it. Robert incurred no legal detriment; his contribution—finding the
dog—was paid out before her promise, and his past consideration is invalid to support a
contract. There was no bargained-for exchange.
However, a valid consideration, given in the past to support a promise, can be the basis for
another, later contract under certain circumstances. These occur when a person’s duty to act for
one reason or another has become no longer binding. If the person then makes a new promise
based on the unfulfilled past duty, the new promise is binding without further consideration.
Three types of cases follow.

Promise Revived after Statute of Limitations Has Passed
A statute of limitations is a law requiring a lawsuit to be filed within a specified period of years.
For example, in many states a contract claim must be sued on within six years; if the plaintiff
waits longer than that, the claim will be dismissed, regardless of its merits. When the time
period set forth in the statute of limitations has lapsed, the statute is said to have “run.” If a
debtor renews a promise to pay or acknowledges a debt after the running of a statute of
limitations, then under the common law the promise is binding, although there is no
consideration in the usual sense. In many states, this promise or acknowledgment must be in
writing and signed by the debtor. Also, in many states, the courts will imply a promise or
acknowledgment if the debtor makes a partial payment after the statute has run.

Voidable Duties
Some promises that might otherwise serve as consideration are voidable by the promisor, for a
variety of reasons, including infancy, fraud, duress, or mistake. But a voidable contract does not
automatically become void, and if the promisor has not avoided the contract but instead
thereafter renews his promise, it is binding. For example, Mr. Melvin sells his bicycle to Seth,
age thirteen. Seth promises to pay Mr. Melvin one hundred dollars. Seth may repudiate the
contract, but he does not. When he turns eighteen, he renews his promise to pay the one
hundred dollars. This promise is binding. (However, a promise made up to the time he turned
eighteen would not be binding, since he would still have been a minor.)

Promissory Estoppel

Saylor URL: http://www.saylor.org/books

Saylor.org
410

We examined the meaning of this forbidding phrase in Chapter 8 "Introduction to Contract
Law" (recall the English High Trees case). It represents another type of promise that the courts
will enforce without consideration. Simply stated,promissory estoppel means that the courts will
stop the promisor from claiming that there was no consideration. The doctrine of promissory
estoppel is invoked in the interests of justice when three conditions are met: (1) the promise is
one that the promisor should reasonably expect to induce the promisee to take action or forbear
from taking action of a definite and substantial character; (2) the action or forbearance is taken;
and (3) injustice can be avoided only by enforcing the promise. (The complete phraseology is
“promissory estoppel with detrimental reliance.”)
Timko served on the board of trustees of a school. He recommended that the school purchase a
building for a substantial sum of money, and to induce the trustees to vote for the purchase, he
promised to help with the purchase and to pay at the end of five years the purchase price less the
down payment. At the end of four years, Timko died. The school sued his estate, which defended
on the ground that there was no consideration for the promise. Timko was promised or given
nothing in return, and the purchase of the building was of no direct benefit to him (which would
have made the promise enforceable as a unilateral contract). The court ruled that under the
three-pronged promissory estoppel test, Timko’s estate was liable. [1]
Cases involving pledges of charitable contributions have long been troublesome to courts.
Recognizing the necessity to charitable institutions of such pledges, the courts have also been
mindful that a mere pledge of money to the general funds of a hospital, university, or similar
institution does not usually induce substantial action but is, rather, simply a promise without
consideration. When the pledge does prompt a charitable institution to act, promissory estoppel
is available as a remedy. In about one-quarter of the states, another doctrine is available for
cases involving simple pledges: the “mutual promises” theory, whereby the pledges of many
individuals are taken as consideration for each other and are binding against each promisor.
This theory was not available to the plaintiff in Timko because his was the only promise.

Moral Obligation
The Restatement allows, under some circumstances, the enforcement of past-consideration
contracts. It provides as follows in Section 86, “Promise for Benefit Received”:
Saylor URL: http://www.saylor.org/books

Saylor.org
411

A promise made in recognition of a benefit previously received by the promisor from
the promisee is binding to the extent necessary to prevent injustice.
A promise is not binding under Subsection (1)
if the promisee conferred the benefit as a gift or for other reasons the promisor has
not been unjustly enriched; or
to the extent that its value is disproportionate to the benefit.

Promises Enforceable without Consideration by Statute
We have touched on several common-law exceptions to the consideration requirement. Some
also are provided by statute.

Under the UCC
The UCC permits one party to discharge, without consideration, a claim or right arising out of an
alleged breach of contract by the other party. This is accomplished by delivering to the other
party a signed written waiver or renunciation. [2] This provision applies to any contract governed
by the UCC and is not limited to the sales provisions of Article 2.
The UCC also permits a party to discharge the other side without consideration when there is no
breach, and it permits parties to modify their Article 2 contract without consideration. [3] The
official comments to the UCC section add the following: “However, modifications made
thereunder must meet the test of good faith imposed by this Act. The effective use of bad faith to
escape performance on the original contract terms is barred, and the extortion of a
“modification” without legitimate commercial reason is ineffective as a violation of the duty of
good faith.”
Seller agrees to deliver a ton of coal within seven days. Buyer needs the coal sooner and asks
Seller to deliver within four days. Seller agrees. This promise is binding even though Seller
received no additional consideration beyond the purchase price for the additional duty agreed to
(the duty to get the coal to Buyer sooner than originally agreed). The UCC allows a
merchant’s firm offer, signed, in writing, to bind the merchant to keep the offer to buy or sell
open without consideration. [4] This is the UCC’s equivalent of a common-law option, which, as
you recall, does require consideration.

Saylor URL: http://www.saylor.org/books

Saylor.org
412

Section 1-207 of the UCC allows a party a reservation of rights while performing a contract. This
section raises a difficult question when a debtor issues an in-full-payment check in payment of a
disputed debt. As noted earlier in this chapter, because under the common law the creditor’s
acceptance of an in-full-payment check in payment of a disputed debt constitutes an accord and
satisfaction, the creditor cannot collect an amount beyond the check. But what if the creditor, in
cashing the check, reserves the right (under Section 1-207) to sue for an amount beyond what
the debtor is offering? The courts are split on the issue: regarding the sale of goods governed by
the UCC, some courts allow the creditor to sue for the unpaid debt notwithstanding the check
being marked “paid in full,” and others do not.

Bankruptcy
Bankruptcy is, of course, federal statutory law. The rule here regarding a promise to pay after
the obligation is discharged is similar to that governing statutes of limitations. Traditionally, a
promise to repay debts after a bankruptcy court has discharged them makes the debtor liable
once again. This traditional rule gives rise to potential abuse; after undergoing the rigors of
bankruptcy, a debtor could be badgered by creditors intoreaffirmation, putting him in a worse
position than before, since he must wait six years before being allowed to avail himself of
bankruptcy again.
The federal Bankruptcy Act includes certain procedural protections to ensure that the debtor
knowingly enters into a reaffirmation of his debt. Among its provisions, the law requires the
debtor to have reaffirmed the debt before the debtor is discharged in bankruptcy; he then has
sixty days to rescind his reaffirmation. If the bankrupt party is an individual, the law also
requires that a court hearing be held at which the consequences of his reaffirmation must be
explained, and reaffirmation of certain consumer debts is subject to court approval if the debtor
is not represented by an attorney.

International Contracts
Contracts governed by the Convention on Contracts for the International Sale of Goods (as
mentioned in Chapter 8 "Introduction to Contract Law") do not require consideration to be
binding.

Saylor URL: http://www.saylor.org/books

KEY TAKEAWAY
Saylor.org
413

There are some exceptions to the consideration requirement. At common law, past
consideration doesn’t count, but no consideration is necessary in these cases: where a
promise barred by the statute of limitations is revived, where a voidable duty is reaffirmed,
where there has been detrimental reliance on a promise (i.e., promissory estoppel), or where
a court simply finds the promisor has a moral obligation to keep the promise.
Under statutory law, the UCC has several exceptions to the consideration requirement. No
consideration is needed to revive a debt discharged in bankruptcy, and none is called for
under the Convention on Contracts for the International Sale of Goods.

EXERCISES

1. Melba began work for Acme Company in 1975 as a filing clerk. Thirty years later she had risen
to be comptroller. At a thirty-year celebration party, her boss, Mr. Holder, said, “Melba, I
hope you work here for a long time, and you can retire at any time, but if you decide to
retire, on account of your years of good service, the company will pay you a monthly pension
of $2,000.” Melba continued to work for another two years, then retired. The company paid
the pension for three years and then, in an economic downturn, stopped. When Melba sued,
the company claimed it was not obligated to her because the pension was of past
consideration. What will be the result?
2. What theories are used to enforce charitable subscriptions?
3. What are the elements necessary for the application of the doctrine of promissory estoppel?
4. Under what circumstances does the Restatement employ moral obligation as a basis for
enforcing an otherwise unenforceable contract?
5. Promises unenforceable because barred by bankruptcy or by the running of the statute of
limitations can be revived without further consideration. What do the two circumstances
have in common?
6. Under the UCC, when is no consideration required where it would be in equivalent situations
at common law?

[1] Estate of Timko v. Oral Roberts Evangelistic Assn., 215 N.W.2d 750 (Mich. App. 1974).
[2] Uniform Commercial Code, Section 1-107.
Saylor URL: http://www.saylor.org/books

Saylor.org
414

[3] Uniform Commercial Code, Sections 2-209(4) and 2-209(1).
[4] Uniform Commercial Code, Section 2-205.

11.4 Cases
Consideration for an Option
Board of Control of Eastern Michigan University v. Burgess
206 N.W.2d 256 (Mich. 1973)
Burns, J.
On February 15, 1966, defendant signed a document which purported to grant to plaintiff a 60day option to purchase defendant’s home. That document, which was drafted by plaintiff’s
agent, acknowledged receipt by defendant of “One and no/100 ($1.00) Dollar and other valuable
consideration.” Plaintiff concedes that neither the one dollar nor any other consideration was
ever paid or even tendered to defendant. On April 14, 1966, plaintiff delivered to defendant
written notice of its intention to exercise the option. On the closing date defendant rejected
plaintiff’s tender of the purchase price. Thereupon, plaintiff commenced this action for specific
performance.
At trial defendant claimed that the purported option was void for want of consideration, that any
underlying offer by defendant had been revoked prior to acceptance by plaintiff, and that the
agreed purchase price was the product of fraud and mutual mistake. The trial judge concluded
that no fraud was involved, and that any mutual mistake was not material. He also held that
defendant’s acknowledgment of receipt of consideration bars any subsequent contention to the
contrary. Accordingly, the trial judge entered judgment for plaintiff.
Options for the purchase of land, if based on valid consideration, are contracts which may be
specifically enforced. [Citations] Conversely, that which purports to be an option, but which is
not based on valid consideration, is not a contract and will not be enforced. [Citations] One
dollar is valid consideration for an option to purchase land, provided the dollar is paid or at least
tendered. [Citations] In the instant case defendant received no consideration for the purported
option of February 15, 1966.

Saylor URL: http://www.saylor.org/books

Saylor.org
415

A written acknowledgment of receipt of consideration merely creates a rebuttable presumption
that consideration has, in fact, passed. Neither the parol evidence rule nor the doctrine of
estoppel bars the presentation of evidence to contradict any such acknowledgment. [Citation]
It is our opinion that the document signed by defendant on February 15, 1966, is not an
enforceable option, and that defendant is not barred from so asserting.
The trial court premised its holding to the contrary on Lawrence v. McCalmont…(1844). That
case is significantly distinguishable from the instant case. Mr. Justice Story held that ‘(t)he
guarantor acknowledged the receipt of one dollar, and is now estopped to deny it.’ However, in
reliance upon the guaranty substantial credit had been extended to the guarantor’s sons. The
guarantor had received everything she bargained for, save one dollar. In the instant case
defendant claims that she never received any of the consideration promised her.
That which purports to be an option for the purchase of land, but which is not based on valid
consideration, is a simple offer to sell the same land. [Citation] An option is a contract collateral
to an offer to sell whereby the offer is made irrevocable for a specified period. [Citation]
Ordinarily, an offer is revocable at the will of the offeror. Accordingly, a failure of consideration
affects only the collateral contract to keep the offer open, not the underlying offer.
A simple offer may be revoked for any reason or for no reason by the offeror at any time prior to
its acceptance by the offeree. [Citation] Thus, the question in this case becomes, ‘Did defendant
effectively revoke her offer to sell before plaintiff accepted that offer?’…
Defendant testified that within hours of signing the purported option she telephoned plaintiff’s
agent and informed him that she would not abide by the option unless the purchase price was
increased. Defendant also testified that when plaintiff’s agent delivered to her on April 14, 1966,
plaintiff’s notice of its intention to exercise the purported option, she told him that ‘the option
was off’.
Plaintiff’s agent testified that defendant did not communicate to him any dissatisfaction until
sometime in July, 1966.
If defendant is telling the truth, she effectively revoked her offer several weeks before plaintiff
accepted that offer, and no contract of sale was created. If plaintiff’s agent is telling the truth,
defendant’s offer was still open when plaintiff accepted that offer, and an enforceable contract
Saylor URL: http://www.saylor.org/books

Saylor.org
416

was created. The trial judge thought it unnecessary to resolve this particular dispute. In light of
our holding the dispute must be resolved.
An appellate court cannot assess the credibility of witnesses. We have neither seen nor heard
them testify. [Citation] Accordingly, we remand this case to the trial court for additional findings
of fact based on the record already before the court.…
Reversed and remanded for proceedings consistent with this opinion. Costs to defendant.

CASE QUESTIONS

1. Why did the lower court decide the option given by the defendant was valid?
2. Why did the appeals court find the option invalid?
3. The case was remanded. On retrial, how could the plaintiff (the university) still win?
4. It was not disputed that the defendant signed the purported option. Is it right that she should
get out of it merely because she didn’t really get the $1.00?

Consideration: Preexisting Obligation
Denney v. Reppert
432 S.W.2d 647 (Ky. 1968)
R. L. Myre, Sr., Special Commissioner.
The sole question presented in this case is which of several claimants is entitled to an award for
information leading to the apprehension and conviction of certain bank robbers.…
On June 12th or 13th, 1963, three armed men entered the First State Bank, Eubank, Kentucky,
and with a display of arms and threats robbed the bank of over $30,000 [about $208,000 in
2010 dollars]. Later in the day they were apprehended by State Policemen Garret Godby,
Johnny Simms and Tilford Reppert, 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

Saylor URL: http://www.saylor.org/books

Saylor.org
417

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 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.
Saylor URL: http://www.saylor.org/books

Saylor.org
418

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?

Consideration: Required for Contract Modification
Gross v. Diehl Specialties International, Inc.
776 S.W.2d 879 (Missouri Ct. App. 1989)
Smith, J.
Plaintiff appeals from a jury verdict and resultant judgment for defendant in a breach of
employment contract case.…

Saylor URL: http://www.saylor.org/books

Saylor.org
419

Plaintiff was employed under a fifteen year employment contract originally executed in 1977
between plaintiff and defendant. Defendant, at that time called Dairy Specialties, Inc., was a
company in the business of formulating ingredients to produce non-dairy products for use by
customers allergic to cow’s milk. Plaintiff successfully formulated [Vitamite]…for that usage.
Thereafter, on August 24, 1977, plaintiff and defendant corporation entered into an employment
contract employing plaintiff as general manager of defendant for fifteen years. Compensation
was established at $14,400 annually plus cost of living increases. In addition, when 10% of
defendant’s gross profits exceeded the annual salary, plaintiff would receive an additional
amount of compensation equal to the difference between his compensation and 10% of the gross
profits for such year. On top of that plaintiff was to receive a royalty for the use of each of his
inventions and formulae of 1% of the selling price of all of the products produced by defendant
using one or more of plaintiff’s inventions or formulae during the term of the agreement. That
amount was increased to 2% of the selling price following the term of the agreement. The
contract further provided that during the term of the agreement the inventions and formulae
would be owned equally by plaintiff and defendant and that following the term of the agreement
the ownership would revert to plaintiff. During the term of the agreement defendant had
exclusive rights to use of the inventions and formulae and after the term of agreement a nonexclusive right of use.
At the time of the execution of the contract, sales had risen from virtually nothing in 1976 to
$750,000 annually from sales of Vitamite and a chocolate flavored product formulated by
plaintiff called Chocolite. [Dairy’s owner] was in declining health and in 1982 desired to sell his
company. At that time yearly sales were $7,500,000. [Owner] sold the company to the Diehl
family enterprises for 3 million dollars.
Prior to sale Diehl insisted that a new contract between plaintiff and defendant be executed or
Diehl would substantially reduce the amount to be paid for [the company]. A new contract was
executed August 24, 1982. It reduced the expressed term of the contract to 10 years, which
provided the same expiration date as the prior contract. It maintained the same base salary of
$14,400 effective September 1982, thereby eliminating any cost of living increases incurred
since the original contract. The 10% of gross profit provision remained the same. The new
Saylor URL: http://www.saylor.org/books

Saylor.org
420

contract provided that plaintiff’s inventions and formula were exclusively owned by defendant
during the term of the contract and after its termination. The 1% royalty during the term of the
agreement remained the same, but no royalties were provided for after the term of the
agreement. No other changes were made in the agreement. Plaintiff received no compensation
for executing the new contract. He was not a party to the sale of the company by [Owner] and
received nothing tangible from that sale.
After the sale plaintiff was given the title and responsibilities of president of defendant with
additional duties but no additional compensation. In 1983 and 1984 the business of the
company declined severely and in October 1984, plaintiff’s employment with defendant was
terminated by defendant. This suit followed.…
We turn now to the court’s holding that the 1982 agreement was the operative contract. Plaintiff
contends this holding is erroneous because there existed no consideration for the 1982
agreement. We agree. A modification of a contract constitutes the making of a new contract and
such new contract must be supported by consideration. [Citation] Where a contract has not been
fully performed at the time of the new agreement, the substitution of a new provision, resulting
in a modification of the obligations on bothsides, for a provision in the old contract still
unperformed is sufficient consideration for the new contract. While consideration may consist of
either a detriment to the promisee or a benefit to the promisor, a promise to carry out an already
existing contractual duty does not constitute consideration. [Citation]
Under the 1982 contract defendant assumed no detriment it did not already have. The term of
the contract expired on the same date under both contracts. Defendant undertook no greater
obligations than it already had. Plaintiff on the other hand received less than he had under the
original contract. His base pay was reduced back to its amount in 1977 despite the provision in
the 1977 contract for cost of living adjustments. He lost his equal ownership in his formulae
during the term of the agreement and his exclusive ownership after the termination of the
agreement. He lost all royalties after termination of the agreement and the right to use and
license the formulae subject to defendant’s right to non-exclusive use upon payment of royalties.
In exchange for nothing, defendant acquired exclusive ownership of the formulae during and
after the agreement, eliminated royalties after the agreement terminated, turned its nonSaylor URL: http://www.saylor.org/books

Saylor.org
421

exclusive use after termination into exclusive use and control, and achieved a reduction in
plaintiff’s base salary. Defendant did no more than promise to carry out an already existing
contractual duty. There was no consideration for the 1982 agreement.
Defendant asserts that consideration flowed to plaintiff because the purchase of defendant by
the Diehls might not have occurred without the agreement and the purchase provided plaintiff
with continued employment and a financially viable employer. There is no evidence to support
this contention. Plaintiff had continued employment with the same employer under the 1977
agreement. Nothing in the 1982 agreement provided for any additional financial protection to
plaintiff. The essence of defendant’s position is that [the owner] received more from his sale of
the company because of the new agreement than he would have without it. We have difficulty
converting [the owner’s] windfall into a benefit to plaintiff.
[Remanded to determine how much plaintiff should receive.]

CASE QUESTIONS

1. Why did the court determine that Plaintiff’s postemployment benefits should revert to those
in his original contract instead being limited to those in the modified contract?
2. What argument did Defendant make as to why the terms of the modified contract should be
valid?

11.5 Summary and Exercises
Summary

Most agreements—including contract modification at common law (but not under the Uniform
Commercial Code [UCC])—are not binding contracts in the absence of what the law terms
“consideration.” Consideration is usually defined as a “legal detriment”—an act, forbearance, or
a promise. The act can be the payment of money, the delivery of a service, or the transfer of title
to property. Consideration is a legal concept in that it centers on the giving up of a legal right or
benefit.
An understanding of consideration is important in many commonplace situations, including
those in which (1) a debtor and a creditor enter into an accord that is later disputed, (2) a duty is
preexisting, (3) a promise is illusory, and (4) creditors agree to a composition.

Saylor URL: http://www.saylor.org/books

Saylor.org
422

Some promises are enforceable without consideration. These include certain promises under the
UCC and other circumstances, including (1) contracts barred by the statute of limitations, (2)
promises by a bankrupt to repay debts, and (3) situations in which justice will be served by
invoking the doctrine of promissory estoppel. Determining whether an agreement should be
upheld despite the lack of consideration, technically defined, calls for a diligent assessment of
the factual circumstances.

EXERCISES

1. Hornbuckle purchased equipment from Continental Gin (CG) for $6,300. However, after
some of the equipment proved defective, Hornbuckle sent CG a check for $4,000 marked “by
endorsement this check is accepted in full payment,” and CG endorsed and deposited the
check. May CG force Hornbuckle to pay the remaining $2,300? Why?
2. Joseph Hoffman alleged that Red Owl Stores promised him that it would build a store
building in Chilton, Wisconsin, and stock it with merchandise for Hoffman to operate in
return for Hoffman’s investment of $18,000. The size, cost, design, and layout of the store
building was not discussed, nor were the terms of the lease as to rent, maintenance, and
purchase options. Nevertheless, in reliance on Red Owl’s promise, the Hoffmans sold their
bakery and grocery store business, purchased the building site in Chilton, and rented a
residence there for the family. The deal was never consummated: a dispute arose, Red Owl
did not build the store, and it denied liability to Hoffman on the basis that its promise to him
was too indefinite with respect to all details for a contract to have resulted. Is Hoffman
entitled to some relief? On what theory?
3. Raquel contracted to deliver one hundred widgets to Sam on December 15, for which he
would pay $4,000. On November 25, Sam called her and asked if she could deliver the
widgets on December 5. Raquel said she could, and she promised delivery on that day. Is her
promise binding? Why?
4. Richard promised to have Darlene’s deck awning constructed by July 10. On June 20, Darlene
called him and asked if he could get the job done by July 3, in time for Independence Day.
Richard said he could, but he failed to do so, and Darlene had to rent two canopies at some

Saylor URL: http://www.saylor.org/books

Saylor.org
423

expense. Darlene claims that because Richard breached his promise, he is liable for the cost
of awning rental. Is she correct—was his promise binding? Why?
5. Seller agreed to deliver gasoline to Buyer at $3.15 per gallon over a period of one year. By
the sixth month, gasoline had increased in price over a dollar a gallon. Although Seller had
gasoline available for sale, he told Buyer the price would have to increase by that much or he
would be unable to deliver. Buyer agreed to the increase, but when billed, refused to pay the
additional amount. Is Buyer bound by the promise? Explain.
6. Montbanks’s son, Charles, was seeking an account executive position with Dobbs, Smith &
Fogarty, Inc., a large brokerage firm. Charles was independent and wished no interference by
his well-known father. The firm, after several weeks’ deliberation, decided to hire Charles.
They made him an offer on April 12, 2010, and Charles accepted. Montbanks, unaware that
his son had been hired and concerned that he might not be, mailed a letter to Dobbs on April
13 in which he promised to give the brokerage firm $150,000 in commission business if the
firm would hire his son. The letter was received by Dobbs, and the firm wishes to enforce it
against Montbanks. May Dobbs enforce the promise? Why?
7. In 1869, William E. Story promised his nephew, William E. Story II (then sixteen years old),
$5,000 (about $120,000 in today’s money) if “Willie” would abstain from drinking alcohol,
smoking, swearing, and playing cards or billiards for money until the nephew reached
twenty-one years of age. All of these were legally permissible activities for the teenager at
that time in New York State. Willie accepted his uncle’s promise and did refrain from the
prohibited acts until he turned twenty-one. When the young man asked for the money, his
uncle wrote to him that he would honor the promise but would rather wait until Willie was
older before delivering the money, interest added on. Willie agreed. Subsequently, Willie
assigned the right to receive the money to one Hamer (Willie wanted the money sooner),
and Story I died without making any payment. The estate, administered by Franklin Sidway,
refused to pay, asserting there was no binding contract due to lack of consideration: the boy
suffered no “detriment,” and the uncle got no benefit. The trial court agreed with the estate,
and the plaintiff appealed. Should the court on appeal affirm or reverse? Explain.

Saylor URL: http://www.saylor.org/books

Saylor.org
424

8. Harold Pearsall and Joe Alexander were friends for over twenty-five years. About twice a
week, they bought what they called a package: a half-pint of vodka, orange juice, two cups,
and two lottery tickets. They went to Alexander’s house to watch TV, drink screwdrivers, and
scratch the lottery tickets. The two had been sharing tickets and screwdrivers since the
Washington, DC, lottery began. On the evening in issue, Pearsall bought the package and
asked Alexander, “Are you in on it?” Alexander said yes. Pearsall asked for his half of the
purchase price, but Alexander had no money. A few hours later, Alexander, having come by
some funds of his own, bought another package. He handed one ticket to Pearsall, and they
both scratched the tickets; Alexander’s was a $20,000 winner. When Pearsall asked for his
share, Alexander refused to give him anything. Are the necessary elements of offer,
acceptance, and consideration present here so as to support Pearsall’s assertion the parties
had a contract?
9. Defendant, Lee Taylor, had assaulted his wife, who took refuge in the house of Plaintiff,
Harrington. The next day, Taylor gained access to the house and began another assault upon
his wife. Mrs. Taylor knocked him down with an axe and was on the point of cutting his head
open or decapitating him while he was lying on the floor when Plaintiff intervened and
caught the axe as it was descending. The blow intended for Defendant fell upon Harrington’s
hand, mutilating it badly, but saving Defendant’s life. Subsequently, Defendant orally
promised to pay Plaintiff her damages but, after paying a small sum, failed to pay anything
more. Is Harrington entitled to enforce Taylor’s entire promise?
10. White Sands Forest Products (Defendant) purchased logging equipment from Clark
Corporation (Plaintiff) under an installment contract that gave Plaintiff the right to repossess
and resell the equipment if Defendant defaulted on the contract. Defendant did default and
agreed to deliver the equipment to Plaintiff if Plaintiff would then discharge Defendant from
further obligation. Plaintiff accepted delivery and resold the equipment, but the sale left a
deficiency (there was still money owing by Defendant). Plaintiff then sued for the deficiency,
and Defendant set up as a defense the accord and satisfaction. Is the defense good?

SELF-TEST QUESTIONS

1. Consideration

Saylor URL: http://www.saylor.org/books

Saylor.org
425

a.

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

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

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

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

one is not able to pay

b. not yet paid
c. of uncertain amount
d. that is unenforceable debt
The rule that if one party to a contract has not made a binding obligation,
the other party is not bound is called
a.

revocation

b. mutuality of obligation
c. accord and satisfaction
d. estoppel
Examples of promises enforceable without consideration include
a.

an agreement modifying a sales contract

b. a promise to pay a debt after the statute of limitations has run
c. a debtor’s promise to repay a debt that has been discharged in bankruptcy
d. all of the above

SELF-TEST ANSWERS

1. c
2. b

Saylor URL: http://www.saylor.org/books

Saylor.org
426

3. c
4. b
5. d

Saylor URL: http://www.saylor.org/books

Saylor.org
427

Chapter 12
Legality

LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1. The types of contracts (bargains) that are deemed illegal
2. How courts deal with disputes concerning illegal contracts
3. Under what circumstances courts will enforce otherwise illegal contracts

12.1 General Perspectives on Illegality
LEARNING OBJECTIVES

1. Understand why courts refuse to enforce illegal agreements.
2. Recognize the rationale behind exceptions to the rule.
We have discussed the requirements of mutual assent, real assent, and consideration. We now
turn to the fourth of the five requirements for a valid contract: the legality of the underlying
bargain. The basic rule is that courts will not enforce an illegal bargain. (The term illegal
bargain is better than illegal contract because a contract is by definition a legal agreement, but
the latter terminology prevails in common usage.) Why should this be? Why should the courts
refuse to honor contracts made privately by people who presumably know what they are doing—
for example, a wager on the World Series or a championship fight? Two reasons are usually
given. One is that refusal to enforce helps discourage unlawful behavior; the other is that
honoring such contracts would demean the judiciary. Are these reasons valid? Yes and no, in the
opinion of one contracts scholar:
[D]enying relief to parties who have engaged in an illegal transaction…helps to
effectuate the public policy involved by discouraging the conduct that is disapproved.
Mere denial of contractual and quasi-contractual remedy [however] rarely has a
substantial effect in discouraging illegal conduct. A man who is hired to perform a
murder is not in the least deterred by the fact that the courts are not open to him to
collect his fee. Such a man has other methods of enforcement, and they are in fact
more effective than legal process. The same is true in varying degrees where less
Saylor URL: http://www.saylor.org/books

Saylor.org
428

heinous forms of illegal conduct are involved. Even in the matter of usury it was
found that mere denial of enforcement was of little value in the effort to eliminate the
loan shark. And restraints of trade were not curbed to an appreciable extent until
contracts in restraint of trade were made criminal.
In most instances, then, the protection of the good name of the judicial institution
must provide the principal reason for the denial of a remedy to one who has
trafficked in the forbidden. This is, moreover, a very good reason. The first duty of an
institution is to preserve itself, and if the courts to any appreciable extent busied
themselves with “justice among thieves,” the community…would be shocked and the
courts would be brought into disrepute.[1]
Strictly enforced, the rule prohibiting courts from ordering the parties to honor illegal contracts
is harsh. It means that a promisee who has already performed under the contract can neither
obtain performance of the act for which he bargained nor recover the money he paid or the value
of the performance he made. The court will simply leave the parties where it finds them,
meaning that one of the parties will have received an uncompensated benefit.
Not surprisingly, the severity of the rule against enforcement has led courts to seek ways to
moderate its impact, chiefly by modifying it according to the principle ofrestitution. In general,
restitution requires that one who has conferred a benefit or suffered a loss should not unfairly be
denied compensation.
Pursuing this notion, the courts have created several exceptions to the general rule. Thus a party
who is excusably ignorant that his promise violates public policy and a party who is not equally
in the wrong may recover. Likewise, when a party “would otherwise suffer a forfeiture that is
disproportionate in relation to the contravention of public policy involved,” restitution will be
allowed. [2] Other exceptions exist when the party seeking restitution withdraws from the
transaction contemplated in the contract before the illegal purpose has been carried out and
when “allowing the claim would put an end to a continuing situation that is contrary to the
public interest.” [3] An example of the latter situation occurs when two bettors place money in the
hands of a stakeholder. If the wager is unlawful, the loser of the bet has the right to recover his
money from the stakeholder before it is paid out to the winner.
Saylor URL: http://www.saylor.org/books

Saylor.org
429

Though by and large courts enforce contracts without considering the worth or merits of the
bargain they incorporate, freedom of contract can conflict with other public policies. Tensions
arise between the desire to let people pursue their own ends and the belief that certain kinds of
conduct should not be encouraged. Thus a patient may agree to be treated by an herbalist, but
state laws prohibit medical care except by licensed physicians. Law and public policies against
usury, gambling, obstructing justice, bribery, corrupt influence, perjury, restraint of trade,
impairment of domestic relations, and fraud all significantly affect the authority and willingness
of courts to enforce contracts.
In this chapter, we will consider two types of illegality: (1) that which results from a bargain that
violates a statute and (2) that which the courts deem contrary to public policy, even though not
expressly set forth in statutes.

KEY TAKEAWAY

Courts refuse to enforce illegal bargains notwithstanding the basic concept of freedom to
contract because they do not wish to reward illegal behavior or sully themselves with
adjudication of that which is forbidden to undertake. However, fairness sometimes compels
courts to make exceptions.

EXERCISES

1. Why is illegal contract a contradiction in terms?
2. Why do courts refuse to enforce contracts (or bargains) made by competent adults if the
contracts harm no third party but are illegal?

[1] Harold C. Havighurst, review of Corbin on Contracts, by Arthur L. Corbin, Yale Law Journal61 (1952):
1143, 1144–45.
[2] Restatement (Second) of Contracts, Section 197(b).
[3] Restatement (Second) of Contracts, Section 197(b).

12.2 Agreements in Violation of Statute
LEARNING OBJECTIVES

1. Understand that various types of bargains may be made illegal by statute, including
gambling, some service-for-fee agreements involving unlicensed practitioners, and usury.
Saylor URL: http://www.saylor.org/books

Saylor.org
430

2. Recognize that while gambling contracts are often illegal, some agreements that might
appear to involve gambling are not.

Overview
Any bargain that violates the criminal law—including statutes that govern extortion, robbery,
embezzlement, forgery, some gambling, licensing, and consumer credit transactions—is illegal.
Thus determining whether contracts are lawful may seem to be an easy enough task. Clearly,
whenever the statute itself explicitly forbids the making of the contract or the performance
agreed upon, the bargain (such as a contract to sell drugs) is unlawful. But when the statute does
not expressly prohibit the making of the contract, courts examine a number of factors, as
discussed in Section 12.5.1 "Extension of Statutory Illegality Based on Public Policy" involving
the apparently innocent sale of a jewelry manufacturing firm whose real business was making
marijuana-smoking paraphernalia.

Types of Bargains Made Illegal by Statute
Gambling Contracts
All states have regulations affecting gambling (wagering) contracts because gambling tends to be
an antiutilitarian activity most attractive to those who can least afford it, because gambling
tends to reinforce fatalistic mind-sets fundamentally incompatible with capitalism and
democracy, because gambling can be addictive, and because gambling inevitably attracts
criminal elements lured by readily available money. With the spread of antitax enthusiasms over
the last thirty-some years, however, some kinds of gambling have been legalized and regulated,
including state-sponsored lotteries. Gambling is betting on an outcome of an event over which
the bettors have no control where the purpose is to play with the risk.
But because the outcome is contingent on events that lie outside the power of the parties to
control does not transform a bargain into a wager. For example, if a gardener agrees to care for
the grounds of a septuagenarian for life in return for an advance payment of $10,000, the
uncertainty of the date of the landowner’s death does not make the deal a wager. The parties
have struck a bargain that accurately assesses, to the satisfaction of each, the risks of the
contingency in question. Likewise, the fact that an agreement is phrased in the form of a wager
does not make it one. Thus a father says to his daughter, “I’ll bet you can’t get an A in organic
Saylor URL: http://www.saylor.org/books

Saylor.org
431

chemistry. If you do, I’ll give you $50.” This is a unilateral contract, the consideration to the
father being the daughter’s achieving a good grade, a matter over which she has complete
control.
Despite the general rule against enforcing wagers, there are exceptions, most statutory but some
rooted in the common law. The common law permits the sale or purchase of securities: Sally
invests $6,000 in stock in Acme Company, hoping the stock will increase in value, though she
has no control over the firm’s management. It is not called gambling; it is considered
respectable risk taking in the capitalist system, or “entrepreneurialism.” (It really is gambling,
though, similar to horse-race gambling.) But because there are speculative elements to some
agreements, they are subject to state and federal regulation.
Insurance contracts are also speculative, but unless one party has no insurable interest (a
concern for the person or thing insured) in the insured, the contract is not a wager. Thus if you
took out a life insurance contract on the life of someone whose name you picked out of the
phone book, the agreement would be void because you and the insurance company would have
been gambling on a contingent event. (You bet that the person would die within the term of the
policy, the insurance company that she would not.) If, however, you insure your spouse, your
business partner, or your home, the contingency does not make the policy a wagering agreement
because you will have suffered a direct loss should it occur, and the agreement, while
compensating for a possible loss, does not create a new risk just for the “game.”

Sunday Contracts
At common law, contracts entered into on Sundays, as well as other commercial activities, were
valid and enforceable. But a separate, religious tradition that traces to the Second
Commandment frowned on work performed on “the Lord’s Day.” In 1781 a New Haven city
ordinance banning Sunday work was printed on blue paper, and since that time such laws have
been known as blue laws. The first statewide blue law was enacted in the United States in 1788;
it prohibited travel, work, sports and amusements, and the carrying on of any business or
occupation on Sundays. The only exceptions in most states throughout most of the nineteenth
century were mutual promises to marry and contracts of necessity or charity. As the Puritan
fervor wore off, and citizens were, more and more, importuned to consider themselves
Saylor URL: http://www.saylor.org/books

Saylor.org
432

“consumers” in a capitalistic economic system, the laws have faded in importance and are
mostly repealed, moribund, or unenforced. Washington State, up until 2008, completely
prohibited hard alcohol sales on Sunday, and all liquor stores were closed, but subsequently the
state—desperate for tax revenue—relaxed the prohibition.

Usury
A usury statute is one that sets the maximum allowable interest that may be charged on a
loan; usury is charging illegal interest rates. Formerly, such statutes were a matter of real
importance because the penalty levied on the lender—ranging from forfeiture of the interest, or
of both the principal and the interest, or of some part of the principal—was significant. But
usury laws, like Sunday contract laws, have been relaxed to accommodate an ever-more-frenzied
consumer society. There are a number of transactions to which the laws do not apply, varying by
state: small consumer loans, pawn shop loans, payday loans, and corporate loans. In Marquette
v. First Omaha Service Corp., the Supreme Court ruled that a national bank could charge the
highest interest rate allowed in its home state to customers living anywhere in the United States,
including states with restrictive interest caps. [1] Thus it was that in 1980 Citibank moved its
credit card headquarters from cosmopolitan New York City to the somewhat less cosmopolitan
Sioux Falls, South Dakota. South Dakota had recently abolished its usury laws, and so, as far as
credit-card interest rates, the sky was the limit. That appealed to Citibank and a number of other
financial institutions, and to the state: it became a major player in the US financial industry,
garnering many jobs. [2]

Licensing Statutes
To practice most professions and carry on the trade of an increasing number of occupations,
states require that providers of services possess licenses—hairdressers, doctors, plumbers, real
estate brokers, and egg inspectors are among those on a long list. As sometimes happens,
though, a person may contract for the services of one who is unlicensed either because he is
unqualified and carrying on his business without a license or because for technical reasons (e.g.,
forgetting to mail in the license renewal application) he does not possess a license at the
moment. Robin calls Paul, a plumber, to install the pipes for her new kitchen. Paul, who has no

Saylor URL: http://www.saylor.org/books

Saylor.org
433

license, puts in all the pipes and asks to be paid. Having discovered that Paul is unlicensed,
Robin refuses to pay. May Paul collect?
To answer the question, a three-step analysis is necessary. First, is a license required? Some
occupations may be performed without a license (e.g., lawn mowing). Others may be performed
with or without certain credentials, the difference lying in what the professional may tell the
public. (For instance, an accountant need not be a certified public accountant to carry on most
accounting functions.) Let us assume that the state requires everyone who does any sort of
plumbing for pay to have a valid license.
The second step is to determine whether the licensing statute explicitly bars recovery by
someone who has performed work while unlicensed. Some do; many others contain no specific
provision on the point. Statutes that do bar recovery must of course govern the courts when they
are presented with the question.
If the statute is silent, courts must, in the third step of the analysis, distinguish between
“regulatory” and “revenue” licenses. A regulatory license is intended to protect the public health,
safety, and welfare. To obtain these licenses, the practitioner of the art must generally
demonstrate his or her abilities by taking some sort of examination, like the bar exam for
lawyers or the medical boards for doctors. A plumber’s or electrician’s licensing requirement
might fall into this category. A revenue license generally requires no such examination and is
imposed for the sake of raising revenue and to ensure that practitioners register their address so
they can be found if a disgruntled client wants to serve them legal papers for a lawsuit. Some
revenue licenses, in addition to requiring registration, require practitioners to demonstrate that
they have insurance. A license to deliver milk, open to anyone who applies and pays the fee,
would be an example of a revenue license. (In some states, plumbing licenses are for revenue
purposes only.)
Generally speaking, failure to hold a regulatory license bars recovery, but the absence of a
revenue or registration license does not—the person may obtain the license and then move to
recover. See Section 12.5.2 "Unlicensed Practitioner Cannot Collect Fee" for an example of a
situation in which the state statute demands practitioners be licensed.

KEY TAKEAWAY

Saylor URL: http://www.saylor.org/books

Saylor.org
434

Gambling, interest rates, and Sunday contracts are among the types of contracts that have,
variously, been subject to legislative illegality. Laws may require certain persons to have
licenses in order to practice a trade or profession. Whether an unlicensed person is barred
from recovering a fee for service depends on the language of the statute and the purpose of
the requirement: if it is a mere revenue-raising or registration statute, recovery will often be
allowed. If the practitioner is required to prove competency, no recovery is possible for an
unlicensed person.

EXERCISES

1. List the typical kinds of contracts made illegal by statute.
2. Why are some practitioners completely prohibited from collecting a fee for service if they
don’t have a license, and others allowed to collect the fee after they get the license?
3. If no competency test is required, why do some statutes require the practitioner to be
licensed?

[1] Marquette v. First Omaha Service Corp., 439 US 299 (1978).
[2] See Thomas M. Reardon, “T. M. Reardon’s first-hand account of Citibank’s move to South
Dakota,” NorthWestern Financial Review, September 15, 2004, accessed March 1,
2011,http://www.highbeam.com/doc/1P3-708279811.html. Mr. Reardon was a member of the South
Dakota Bankers’ Association.

12.3 Bargains Made Illegal by Common Law
LEARNING OBJECTIVE

1. Understand what contracts or bargains have been declared illegal by courts.

Overview
Public policy is expressed by courts as well as legislatures. In determining whether to enforce a
contract where there is no legislative dictate, courts must ordinarily balance the interests at
stake. To strike the proper balance, courts must weigh the parties’ expectations, the forfeitures
that would result from denial of enforcement, and the public interest favoring enforcement
against these factors: the strength of the policy, whether denying enforcement will further the
Saylor URL: http://www.saylor.org/books

Saylor.org
435

policy, the seriousness and deliberateness of the violation, and how direct the connection is
between the misconduct and the contractual term to be enforced. [1]

Types of Bargains Made Illegal by Common Law
Common-Law Restraint of Trade
One of the oldest public policies evolved by courts is the common-law prohibition against
restraint of trade. From the early days of industrialism, the courts took a dim view of ostensible
competitors who agreed among themselves to fix prices or not to sell in each other’s territories.
Since 1890, with the enactment of the Sherman Act, the law of restraint of trade has been
absorbed by federal and state antitrust statutes. But the common-law prohibition still exists.
Though today it is concerned almost exclusively with promises not to compete in sales of
businesses and employment contracts, it can arise in other settings. For example, George’s
promise to Arthur never to sell the parcel of land that Arthur is selling to him is void because it
unreasonably restrains trade in the land.
The general rule is one of reason: not every restraint of trade is unlawful; only unreasonable
ones are. As the Restatement puts it, “Every promise that relates to business dealings or to a
professional or other gainful occupation operates as a restraint in the sense that it restricts the
promisor’s future activity. Such a promise is not, however, unenforceable, unless the restraint
that it imposes is unreasonably detrimental to the smooth operation of a freely competitive
private economy.” [2] An agreement that restrains trade will be construed as unreasonable unless
it is ancillary to a legitimate business interest and is no greater than necessary to protect the
legitimate interest. Restraint-of-trade cases usually arise in two settings: (1) the sale of a
business and an attendant agreement not to compete with the purchasers and (2) an employee’s
agreement not to compete with the employer should the employee leave for any reason.

Sale of a Business
A first common area where a restraint-of-trade issue may arise is with the sale of a business.
Regina sells her lingerie store to Victoria and promises not to establish a competing store in
town for one year. Since Victoria is purchasing Regina’s goodwill (the fact that customers are
used to shopping at her store), as well as her building and inventory, there is clearly a property
interest to be protected. And the geographical limitation (“in town”) is reasonable if that is
Saylor URL: http://www.saylor.org/books

Saylor.org
436

where the store does business. But if Regina had agreed not to engage in any business in town,
or to wait ten years before opening up a new store, or not to open up a new store anywhere
within one hundred miles of town, she could avoid the noncompetition terms of the contract
because the restraint in each case (nature, duration, and geographic area of restraint) would
have been broader than necessary to protect Victoria’s interest. Whether the courts will uphold
an agreement not to compete depends on all the circumstances of the particular case, as the
Connecticut barber in Section 12.5.3 "Unconscionability" discovered.

Employment Noncompete Agreements
A second common restraint-of-trade issue arises with regard tononcompete agreements in
employment contracts. As a condition of employment by the research division of a market
research firm, Bruce, a product analyst, is required to sign an agreement in which he promises,
for a period of one year after leaving the company, not to “engage, directly or indirectly, in any
business competing with the company and located within fifty miles of the company’s main
offices.” The principal reason recited in the agreement for this covenant not to compete is that
by virtue of the employment, Bruce will come to learn a variety of internal secrets, including
client lists, trade or business secrets, reports, confidential business discussions, ongoing
research, publications, computer programs, and related papers. Is this agreement a lawful
restraint of trade?
Here both the property interest of the employer and the extent of the restraint are issues.
Certainly an employer has an important competitive interest in seeing that company
information not walk out the door with former employees. Nevertheless, a promise by an
employee not to compete with his or her former employer is scrutinized carefully by the courts,
and an injunction (an order directing a person to stop doing what he or she should not do) will
be issued cautiously, partly because the prospective employee is usually confronted with
a contract of adhesion (take it or leave it) and is in a weak bargaining position compared to the
employer, and partly because an injunction might cause the employee’s unemployment. Many
courts are not enthusiastic about employment noncompete agreements. The California Business
and Professions Code provides that “every contract by which anyone is restrained from engaging
in a lawful profession, trade, or business of any kind is to that extent void.” [3] As a result of the
Saylor URL: http://www.saylor.org/books

Saylor.org
437

statute, and to promote entrepreneurial robustness, California courts typically interpret the
statute broadly and refuse to enforce noncompete agreements. Other states are less stingy, and
employers have attempted to avoid the strictures of no-enforcement state rulings by providing
that their employment contracts will be interpreted according to the law of a state where
noncompetes are favorably viewed.
If a covenant not to compete is ruled unlawful, the courts can pursue one of three courses by way
of remedy. A court can refuse to enforce the entire covenant, freeing the employee to compete
thenceforth. The court could delete from the agreement only that part that is unreasonable and
enforce the remainder (the “blue pencil” rule). In some states, the courts have moved away from
this rule and have actually taken to rewriting the objectionable clause themselves. Since the
parties intended that there be some form of restriction on competition, a reasonable
modification would achieve a more just result. [4]

Unconscionable Contracts
Courts may refuse to enforce unconscionable contracts, those that are very one-sided, unfair, the
product of unequal bargaining power, or oppressive; a court may find the contract divisible and
enforce only the parts that are not unconscionable.
The common-law rule is reflected in Section 208 of the Restatement: “If a contract or term
thereof is unconscionable at the time the contract is made a court may refuse to enforce the
contract, or may enforce the remainder of the contract without the unconscionable term, or may
so limit the application of any unconscionable term as to avoid any unconscionable result.”
And the Uniform Commercial Code (UCC) (again, of course, a statute, not common law)
provides a similar rule in Section 2-302(1): “If the court as a matter of law finds the contract or
any clause of the contract to have been unconscionable at the time it was made the court may
refuse to enforce the contract, or it may enforce the remainder of the contract without the
unconscionable clause, or it may so limit the application of any unconscionable clause as to
avoid any unconscionable result.”
Unconscionable is not defined in the Restatement or the UCC, but cases have given gloss to the
meaning, as in Section 12.5.3 "Unconscionability", Williams v. Walker-Thomas Furniture Co., a
well-known early interpretation of the section by the DC Court of Appeals.
Saylor URL: http://www.saylor.org/books

Saylor.org
438

Unconscionability may arise procedurally or substantively. A term is procedurally
unconscionable if it is imposed upon the “weaker” party because of fine or inconspicuous print,
unexpected placement in the contract, lack of opportunity to read the term, lack of education or
sophistication that precludes understanding, or lack of equality of bargaining power.
Substantive unconscionability arises where the affected terms are oppressive and harsh, where
the term deprives a party of any real remedy for breach. Most often—but not always—courts find
unconscionable contracts in the context of consumer transactions rather than commercial
transactions. In the latter case, the assumption is that the parties tend to be sophisticated
businesspeople able to look out for their own contract interests.

Exculpatory Clauses
The courts have long held that public policy disfavors attempts to contract out of tort
liability. Exculpatory clauses that exempt one party from tort liability to the other for harm
caused intentionally or recklessly are unenforceable without exception. A contract provision that
exempts a party from tort liability for negligence is unenforceable under two general
circumstances: (1) when it “exempts an employer from liability to an employee for injury in the
course of his employment” or (2) when it exempts one charged with a duty of public service and
who is receiving compensation from liability to one to whom the duty is owed. [5] Contract terms
with offensive exculpatory clauses may be considered somewhat akin to unconscionability.
Put shortly, exculpatory clauses are OK if they are reasonable. Put not so shortly, exculpatory
clauses will generally be held valid if (1) the agreement does not involve a business generally
thought suitable for public regulation (a twenty-kilometer bicycle race, for example, is probably
not one thought generally suitable for public regulation, whereas a bus line is); (2) the party
seeking exculpation is not performing a business of great importance to the public or of practical
necessity for some members of the public; (3) the party does not purport to be performing the
service to just anybody who comes along (unlike the bus line); (4) the parties are dealing at
arms’ length, able to bargain about the contract; (5) the person or property of the purchaser is
not placed under control of the seller, subject to his or his agent’s carelessness; or (6) the clause
is conspicuous and clear. [6]

Obstructing the Administration of Justice or Violating a Public Duty
Saylor URL: http://www.saylor.org/books

Saylor.org
439

It is well established under common law that contracts that would interfere with the
administration of justice or that call upon a public official to violate a public duty are void and
unenforceable. Examples of such contracts are numerous: to conceal or compound a crime, to
pay for the testimony of a witness in court contingent on the court’s ruling, to suppress evidence
by paying a witness to leave the state, or to destroy documents. Thus, in an unedifying case in
Arkansas, a gambler sued a circuit court judge to recover $1,675 allegedly paid to the judge as
protection money, and the Arkansas Supreme Court affirmed the dismissal of the suit, holding,
“The law will not aid either party to the alleged illegal and void contract…‘but will leave them
where it finds them, if they have been equally cognizant of the illegality.’” [7] Also in this category
are bribes, agreements to obstruct or delay justice (jury tampering, abuse of the legal process),
and the like.

Family Relations
Another broad area in which public policy intrudes on private contractual arrangements is that
of undertakings between couples, either prior to or during marriage. Marriage is quintessentially
a relationship defined by law, and individuals have limited ability to change its scope through
legally enforceable contracts. Moreover, marriage is an institution that public policy favors, and
agreements that unreasonably restrain marriage are void. Thus a father’s promise to pay his
twenty-one-year-old daughter $100,000 if she refrains from marrying for ten years would be
unenforceable. However, a promise in a postnuptial (after marriage) agreementthat if the
husband predeceases the wife, he will provide his wife with a fixed income for as long as she
remains unmarried is valid because the offer of support is related to the need. (Upon
remarriage, the need would presumably be less pressing.) Property settlements before, during,
or upon the breakup of a marriage are generally enforceable, since property is not considered to
be an essential incident of marriage. But agreements in the form of property arrangements that
tend to be detrimental to marriage are void—for example, a prenuptial (premarital) contract in
which the wife-to-be agrees on demand of the husband-to-be to leave the marriage and
renounce any claims upon the husband-to-be at any time in the future in return for which he
will pay her $100,000. Separation agreements are not considered detrimental to marriage as
long as they are entered after or in contemplation of immediate separation; but a separation
Saylor URL: http://www.saylor.org/books

Saylor.org
440

agreement must be “fair” under the circumstances, and judges may review them upon challenge.
Similarly, child custody agreements are not left to the whim of the parents but must be
consistent with the best interest of the child, and the courts retain the power to examine this
question.
The types of contracts or bargains that might be found illegal are innumerable, limited only by
the ingenuity of those who seek to overreach.

KEY TAKEAWAY

Courts will not enforce contracts that are, broadly speaking, contrary to public policy. These
include some noncompete agreements, exculpatory clauses, unconscionable bargains,
contracts to obstruct the public process or justice, and contracts interfering with family
relations.

EXERCISES

1. Why are employment noncompete agreements viewed less favorably than sale-of-business
noncompete agreements?
2. Can a person by contract exculpate herself from liability for gross negligence? For ordinary
negligence?
3. A parking lot agreement says the parking lot is “not responsible for loss of contents or
damage to the vehicle.” Is that acceptable? Explain.
4. A valet parking lot agreement—where the car owner gives the keys to the attendant who
parks the car—has the same language as that for the lot in Exercise 3. Is that acceptable?
Explain.

[1] Restatement (Second) of Contracts, Section 178.
[2] Restatement (Second) of Contracts, Section 186(a).
[3] California Business and Professions Code, Section 16600.
[4] Raimondo v. Van Vlerah, 325 N.E.2d 544 (Ohio 1975).
[5] Restatement (Second) of Contracts, Section 195.
[6] Henrioulle v. Marin Ventures, Inc., 573 P.2d 465 (Calif. 1978).
[7] Womack v. Maner, 301 S.W.2d 438 (Ark. 1957).

Saylor URL: http://www.saylor.org/books

Saylor.org
441

12.4 Effect of Illegality and Exceptions
LEARNING OBJECTIVES

1. Recognize that courts will not enforce illegal bargains.
2. Know that there are exceptions to that rule.

Effect of Illegality
The general rule is this: courts will not enforce illegal bargains. The parties are left where the
court found them, and no relief is granted: it’s a hands-off policy. The illegal agreement is void,
and that a wrongdoer has benefited to the other’s detriment does not matter.
For example, suppose a specialty contractor, statutorily required to have a license, constructs a
waterslide for Plaintiff, when the contractor knew or should have known he was unlicensed.
Plaintiff discovers the impropriety and refuses to pay the contractor $80,000 remaining on the
deal. The contractor will not get paid. [1] In another example, a man held himself out to be an
architect in a jurisdiction requiring that architects pass a test to be licensed. He was paid
$80,000 to design a house costing $900,000. The project was late and over budget, and the
building violated relevant easement building-code rules. The unlicensed architect was not
allowed to keep his fee.[2]

Exceptions
As always in the law, there are exceptions. Of relevance here are situations where a court might
permit one party to recover: party withdrawing before performance, party protected by statute,
party not equally at fault, excusable ignorance, and partial illegality.

Party Withdrawing before Performance
Samantha and Carlene agree to bet on a soccer game and deliver their money to the stakeholder.
Subsequently, but before the payout, Carlene decides she wants out; she can get her money from
the stakeholder. Ralph hires Jacob for $5,000 to arrange a bribe of a juror. Ralph has a change
of heart; he can get his money from Jacob.

Party Protected by Statute
An airline pilot, forbidden by federal law from working overtime, nevertheless does so; she
would be entitled to payment for the overtime worked. Securities laws forbid the sale or
Saylor URL: http://www.saylor.org/books

Saylor.org
442

purchase of unregistered offerings—such a contract is illegal; the statute allows the purchaser
rescission (return of the money paid). An attorney (apparently unwittingly) charged his client
beyond what the statute allowed for procuring for the client a government pension; the
pensioner could get the excess from the attorney.

Party Not Equally at Fault
One party induces another to make an illegal contract by undue influence, fraud, or duress; the
victim can recover the consideration conveyed to the miscreant if possible.

Excusable Ignorance
A woman agrees to marry a man not knowing that he is already married; bigamy is illegal, the
marriage is void, and she may sue him for damages. A laborer is hired to move sealed crates,
which contain marijuana; it is illegal to ship, sell, or use marijuana, but the laborer is allowed
payment for his services.

Partial Illegality
A six-page employment contract contains two paragraphs of an illegal noncompete agreement.
The illegal part is thrown out, but the legal parts are enforceable.

KEY TAKEAWAY

There are a number of exceptions to the general rule that courts give no relief to either party
to an illegal contract. The rule may be relaxed in cases where justice would be better served
than by following the stricture of hands off.

EXERCISES

1. When, in general, will a court allow a party relief from an illegal contract (or bargain)?
2. A and B engage in a game of high-stakes poker under circumstances making the game illegal
in the jurisdiction. A owes B $5,000 when A loses. When A does not pay, B sues. Does B get
the money? What if A had paid B the $5,000 and then sued to get it back?

[1] Pacific Custom Pools, Inc. v. Turner Construction, 94 Cal. Rptr. 2d 756 (Calif. 2000).
[2] Ransburg v. Haase, 586 N.E. 2d 1295 (Ill. Ct. App. 1992).

12.5 Cases
Saylor URL: http://www.saylor.org/books

Saylor.org
443

Extension of Statutory Illegality Based on Public Policy
Bovard v. American Horse Enterprises
247 Cal. Rptr. 340 (Calif. 1988)
[Bovard sued Ralph and American Horse Enterprises (a corporation) to recover on
promissory notes that were signed when Ralph purchased the corporation, ostensibly
a jewelry-making business. The trial court dismissed Bovard’s complaint.]
Puglia, J.
The court found that the corporation predominantly produced paraphernalia used to smoke
marijuana [roach clips and bongs] and was not engaged significantly in jewelry production, and
that Bovard had recovered the corporate machinery through self-help [i.e., he had repossessed
it]. The parties do not challenge these findings. The court acknowledged that the manufacture of
drug paraphernalia was not itself illegal in 1978 when Bovard and Ralph contracted for the sale
of American Horse Enterprises, Inc. However, the court concluded a public policy against the
manufacture of drug paraphernalia was implicit in the statute making the possession, use and
transfer of marijuana unlawful. The trial court held the consideration for the contract was
contrary to the policy of express law, and the contract was therefore illegal and void. Finally, the
court found the parties were in pari delicto [equally at fault] and thus with respect to their
contractual dispute should be left as the court found them.
The trial court concluded the consideration for the contract was contrary to the policy of the law
as expressed in the statute prohibiting the possession, use and transfer of marijuana. Whether a
contract is contrary to public policy is a question of law to be determined from the
circumstances of the particular case. Here, the critical facts are not in dispute. Whenever a court
becomes aware that a contract is illegal, it has a duty to refrain from entertaining an action to
enforce the contract. Furthermore the court will not permit the parties to maintain an action to
settle or compromise a claim based on an illegal contract.…
[There are several] factors to consider in analyzing whether a contract violates public policy:
“Before labeling a contract as being contrary to public policy, courts must carefully inquire into
the nature of the conduct, the extent of public harm which may be involved, and the moral

Saylor URL: http://www.saylor.org/books

Saylor.org
444

quality of the conduct of the parties in light of the prevailing standards of the community
[Citations]”
These factors are more comprehensively set out in the Restatement Second of Contracts section
178:
(1) A promise or other term of an agreement is unenforceable on grounds of public
policy if legislation provides that it is unenforceable or the interest in its enforcement
is clearly outweighed in the circumstances by a public policy against the enforcement
of such terms.
(2) In weighing the interest in the enforcement of a term, account is taken of
(a) the parties’ justified expectations,
(b) any forfeiture that would result if enforcement were denied, and
(c) any special public interest in the enforcement of the particular term.
(3) In weighing a public policy against enforcement of a term, account is taken of
(a) the strength of that policy as manifested by legislation or judicial decisions,
(b) the likelihood that a refusal to enforce the term will further that policy,
(c) the seriousness of any misconduct involved and the extent to which it was
deliberate, and
(d) the directness of the connection between that misconduct and the term.
Applying the Restatement test to the present circumstances, we conclude the interest in
enforcing this contract is very tenuous. Neither party was reasonably justified in expecting the
government would not eventually act to geld American Horse Enterprises, a business harnessed
to the production of paraphernalia used to facilitate the use of an illegal drug. Moreover,
although voidance of the contract imposed a forfeiture on Bovard, he did recover the corporate
machinery, the only assets of the business which could be used for lawful purposes, i.e., to
manufacture jewelry. Thus, the forfeiture was significantly mitigated if not negligible. Finally,
there is no special public interest in the enforcement of this contract, only the general interest in
preventing a party to a contract from avoiding a debt.
On the other hand, the Restatement factors favoring a public policy against enforcement of this
contract are very strong. As we have explained, the public policy against manufacturing
Saylor URL: http://www.saylor.org/books

Saylor.org
445

paraphernalia to facilitate the use of marijuana is strongly implied in the statutory prohibition
against the possession, use, etc., of marijuana, a prohibition which dates back at least to
1929.…Obviously, refusal to enforce the instant contract will further that public policy not only
in the present circumstances but by serving notice on manufacturers of drug paraphernalia that
they may not resort to the judicial system to protect or advance their business interests.
Moreover, it is immaterial that the business conducted by American Horse Enterprises was not
expressly prohibited by law when Bovard and Ralph made their agreement since both parties
knew that the corporation’s products would be used primarily for purposes which were expressly
illegal. We conclude the trial court correctly declared the contract contrary to the policy of
express law and therefore illegal and void.

CASE QUESTIONS

1. Why did the court think it was significant that Bovard had repossessed the jewelry-making
equipment?
2. What did Bovard want in this case?
3. If it was not illegal to make bongs and roach clips, why did the court determine that this
contract should not be enforced?

Unlicensed Practitioner Cannot Collect Fee
Venturi & Company v. Pacific Malibu Development Corp.
172 Cal.App.4th 1417 (Calif. Ct. App. 2009)
Rubin, J.
In June 2003, plaintiff Venturi & Company LLC and defendant Pacific Malibu Development
Corp. entered into a contract involving development of a high-end resort on undeveloped
property on the Bahamian island of Little Exuma. Under the contract, plaintiff agreed to serve as
a financial advisor and find financing for the Little Exuma project.…[P]laintiff was entitled to
some payment under the contract even if plaintiff did not secure financing for the project [called
a success fee].
After signing the contract, plaintiff contacted more than 60 potential sources of financing for the
project.…[I]n the end, defendants did not receive financing from any source that plaintiff had
identified.

Saylor URL: http://www.saylor.org/books

Saylor.org
446

Defendants terminated the contract in January 2005. Two months earlier, however, defendants
had signed a [financing agreement] with the Talisker Group. Plaintiff was not involved in
defendants’ negotiations with the Talisker Group.…Nevertheless, plaintiff claimed the contract’s
provision for a success fee entitled plaintiff to compensation following the [agreement]. When
defendants refused to pay plaintiff’s fee, plaintiff sued defendants for the fee and for the
reasonable value of plaintiff’s services.
Defendants moved for summary judgment. They argued plaintiff had provided the services of a
real estate broker by soliciting financing for the Little Exuma project yet did not have a broker’s
license. Thus, defendants asserted…the Business and Professions Code barred plaintiff from
receiving any compensation as an unlicensed broker.…Plaintiff opposed summary judgment. It
argued that one of its managing principals, Jane Venturi, had a real estate sales license and was
employed by a real estate broker (whom plaintiff did not identify) when defendants had signed
their term sheet with the Talisker Group, the document that triggered plaintiff’s right to a fee.
The court entered summary judgment for defendants. The court found plaintiff had acted as a
real estate broker when working on the Little Exuma project. The court pointed, however, to
plaintiff’s lack of evidence that Jane Venturi’s unnamed broker had employed or authorized her
to work on the project.…[Summary judgment was issued in favor of defendants, denying
plaintiff any recovery.] This appeal followed.
The court correctly ruled plaintiff could not receive compensation for providing real estate
broker services to defendants because plaintiff was not a licensed broker. (Section 11136
[broker’s license required to collect compensation for broker services].) But decisions such
as Lindenstadt [Citation] establish that the court erred in denying plaintiff compensation to the
extent plaintiff’s services were not those of a real estate broker. In Lindenstadt, the parties
entered into 25 to 30 written agreements in which the plaintiff promised to help the defendant
find businesses for possible acquisition. After the plaintiff found a number of such businesses,
the defendant refused to compensate the plaintiff. The defendant cited the plaintiff’s
performance of broker’s services without a license as justifying its refusal to pay. On appeal, the
appellate court rejected the defendant’s sweeping contention that the plaintiff’s unlicensed
services forsome business opportunities meant the plaintiff could not receive compensation
Saylor URL: http://www.saylor.org/books

Saylor.org
447

for anybusiness opportunity. Rather, the appellate court directed the trial court to examine
individually each business opportunity to determine whether the plaintiff acted as an unlicensed
broker for that transaction or instead provided only services for which it did not need a broker’s
license.
Likewise here, the contract called for plaintiff to provide a range of services, some apparently
requiring a broker’s license, others seemingly not. Moreover, and more to the point, plaintiff
denied having been involved in arranging, let alone negotiating, defendants’ placement of
Securities with the Talisker Group for which plaintiff claimed a “success fee” under the
contract’s provision awarding it a fee even if it had no role in procuring the financing. Thus,
triable issues existed involving the extent to which plaintiff provided either unlicensed broker
services or, alternatively, non-broker services for which it did not need a license. (Accord:
[Citation] [severability allowed partial enforcement of personal manager employment contract
when license required for some, but not all, services rendered under the contract].)
[T]he contract here…envisioned plaintiff directing its efforts toward many potential sources of
financing. As to some of those sources, plaintiff may have crossed the line into performing
broker services. But for other sources, plaintiff may have provided only financial and marketing
advice for which it did not need a broker’s license. (See, e.g. [Citation] [statute barring
unlicensed contractor from receiving fees for some services did not prohibit recovery for work
not within scope of licensing statute].) And finally, as to the Talisker Group, plaintiff may have
provided even less assistance than financial and marketing advice, given that plaintiff denied
involvement with the group. Whether plaintiff crossed the line into providing broker services is
thus a triable issue of fact that we cannot resolve on summary judgment.
…Plaintiff…did not have a broker’s license, and therefore was not entitled to compensation for
broker’s services. Plaintiff contends it was properly licensed because one of its managers, Jane
Venturi, obtained a real estate sales license in February 2004. Thus, she, and plaintiff claims by
extension itself, were licensed when defendants purportedly breached the contract by refusing to
pay plaintiff months later for the Talisker Group placement. Jane Venturi’s sales license was not,
however, sufficient; only a licensed broker may provide broker services. A sales license does not
permit its holder to represent another unless the salesperson acts under a broker’s authority.
Saylor URL: http://www.saylor.org/books

Saylor.org
448

The judgment for defendants is vacated, and the trial court is directed to enter a new order
denying defendants’ motion for summary judgment.…

CASE QUESTIONS

1. Why did the plaintiff think it should be entitled to full recovery under the contract, including
for services rendered as a real estate broker? Why did the court deny that?
2. Even if the plaintiff were not a real estate broker, why would that mean it could not recover
for real estate services provided to the defendant?
3. The appeals court remanded the case; what did it suggest the plaintiff should recover on
retrial?

Unconscionability
Williams v. Walker-Thomas Furniture Co.
350 F.2d 445 (D.C. Ct. App. 1965)
Wright, J.
Appellee, Walker-Thomas Furniture Company, operates a retail furniture store in the District of
Columbia. During the period from 1957 to 1962 each appellant in these cases purchased a
number of household items from Walker-Thomas, for which payment was to be made in
installments. The terms of each purchase were contained in a printed form contract which set
forth the value of the purchased item and purported to lease the item to appellant for a
stipulated monthly rent payment. The contract then provided, in substance, that title would
remain in Walker-Thomas until the total of all the monthly payments made equaled the stated
value of the item, at which time appellants could take title. In the event of a default in the
payment of any monthly installment, Walker-Thomas could repossess the item.
The contract further provided that ‘the amount of each periodical installment payment to be
made by (purchaser) to the Company under this present lease shall be inclusive of and not in
addition to the amount of each installment payment to be made by (purchaser) under such prior
leases, bills or accounts; and all payments now and hereafter made by (purchaser) shall be
credited pro rata on all outstanding leases, bills and accounts due the Company by (purchaser)
at the time each such payment is made.’ The effect of this rather obscure provision was to keep a
balance due on every item purchased until the balance due on all items, whenever purchased,

Saylor URL: http://www.saylor.org/books

Saylor.org
449

was liquidated. As a result, the debt incurred at the time of purchase of each item was secured by
the right to repossess all the items previously purchased by the same purchaser, and each new
item purchased automatically became subject to a security interest arising out of the previous
dealings.
On May 12, 1962, appellant Thorne purchased an item described as a daveno, three tables, and
two lamps, having total stated value of $391.11 [about $2,800 in 2011 dollars]. Shortly
thereafter, he defaulted on his monthly payments and appellee sought to replevy [repossess] all
the items purchased since the first transaction in 1958. Similarly, on April 17, 1962, appellant
Williams bought a stereo set of stated value of $514.95 [about $3,600 in 2011 dollars]. She too
defaulted shortly thereafter, and appellee sought to replevy all the items purchased since
December, 1957. The Court of General Sessions granted judgment for appellee. The District of
Columbia Court of Appeals affirmed, and we granted appellants’ motion for leave to appeal to
this court.
Appellants’ principal contention, rejected by both the trial and the appellate courts below, is that
these contracts, or at least some of them, are unconscionable and, hence, not enforceable. [In its
opinion the lower court said:]
The record reveals that prior to the last purchase appellant had reduced the balance
in her account to $164. The last purchase, a stereo set, raised the balance due to $678.
Significantly, at the time of this and the preceding purchases, appellee was aware of
appellant’s financial position. The reverse side of the stereo contract listed the name
of appellant’s social worker and her $218 monthly stipend from the government.
Nevertheless, with full knowledge that appellant had to feed, clothe and support both
herself and seven children on this amount, appellee sold her a $514 stereo set.
We cannot condemn too strongly appellee’s conduct. It raises serious questions of
sharp practice and irresponsible business dealings. A review of the legislation in the
District of Columbia affecting retail sales and the pertinent decisions of the highest
court in this jurisdiction disclose, however, no ground upon which this court can
declare the contracts in question contrary to public policy. We note that were the
Maryland Retail Installment Sales Act…or its equivalent, in force in the District of
Saylor URL: http://www.saylor.org/books

Saylor.org
450

Columbia, we could grant appellant appropriate relief. We think Congress should
consider corrective legislation to protect the public from such exploitive contracts as
were utilized in the case at bar.
We do not agree that the court lacked the power to refuse enforcement to contracts found to be
unconscionable. In other jurisdictions, it has been held as a matter of common law that
unconscionable contracts are not enforceable. While no decision of this court so holding has
been found, the notion that an unconscionable bargain should not be given full enforcement is
by no means novel.…
Since we have never adopted or rejected such a rule, the question here presented is actually one
of first impression.…[W]e hold that where the element of unconscionability is present at the
time a contract is made, the contract should not be enforced.
Unconscionability has generally been recognized to include an absence of meaningful choice on
the part of one of the parties together with contract terms which are unreasonably favorable to
the other party. Whether a meaningful choice is present in a particular case can only be
determined by consideration of all the circumstances surrounding the transaction. In many
cases the meaningfulness of the choice is negated by a gross inequality of bargaining power. The
manner in which the contract was entered is also relevant to this consideration. Did each party
to the contract, considering his obvious education or lack of it, have a reasonable opportunity to
understand the terms of the contract, or were the important terms hidden in a maze of fine print
and minimized by deceptive sales practices? Ordinarily, one who signs an agreement without
full knowledge of its terms might be held to assume the risk that he has entered a one-sided
bargain. But when a party of little bargaining power, and hence little real choice, signs a
commercially unreasonable contract with little or no knowledge of its terms, it is hardly likely
that his consent, or even an objective manifestation of his consent, was ever given to all the
terms. In such a case the usual rule that the terms of the agreement are not to be questioned
should be abandoned and the court should consider whether the terms of the contract are so
unfair that enforcement should be withheld.…
In determining reasonableness or fairness, the primary concern must be with the terms of the
contract considered in light of the circumstances existing when the contract was made. The test
Saylor URL: http://www.saylor.org/books

Saylor.org
451

is not simple, nor can it be mechanically applied. The terms are to be considered ‘in the light of
the general commercial background and the commercial needs of the particular trade or case.’
Corbin suggests the test as being whether the terms are ‘so extreme as to appear unconscionable
according to the mores and business practices of the time and place.’ We think this formulation
correctly states the test to be applied in those cases where no meaningful choice was exercised
upon entering the contract. So ordered.
Danaher, J. (dissenting):
[The lower] court…made no finding that there had actually been sharp practice. Rather the
appellant seems to have known precisely where she stood.
There are many aspects of public policy here involved. What is a luxury to some may seem an
outright necessity to others. Is public oversight to be required of the expenditures of relief
funds? A washing machine, e.g., in the hands of a relief client might become a fruitful source of
income. Many relief clients may well need credit, and certain business establishments will take
long chances on the sale of items, expecting their pricing policies will afford a degree of
protection commensurate with the risk. Perhaps a remedy when necessary will be found within
the provisions of the D.C. “Loan Shark” law, [Citation].
I mention such matters only to emphasize the desirability of a cautious approach to any such
problem, particularly since the law for so long has allowed parties such great latitude in making
their own contracts. I dare say there must annually be thousands upon thousands of installment
credit transactions in this jurisdiction, and one can only speculate as to the effect the decision in
these cases will have.

CASE QUESTIONS

1. Did the court here say that cross-collateral contracts are necessarily unconscionable?
2. Why is it relevant that the plaintiff had seven children and was on welfare?
3. Why did the defendant have a cross-collateral clause in the contract? What would happen if
no such clauses were allowed?
4. What are the elements of unconscionability that the court articulates?

12.6 Summary and Exercises
Summary

Saylor URL: http://www.saylor.org/books

Saylor.org
452

In general, illegal contracts are unenforceable. The courts must grapple with two types of
illegalities: (1) statutory violations and (2) violations of public policy not expressly declared
unlawful by statute. The former include gambling contracts, contracts with unlicensed
professionals, and Sunday contracts.
Contracts that violate public policy include many types of covenants not to compete. No general
rule for determining their legality can be given, except to say that the more rigid their
restrictions against working or competing, the less likely they will withstand judicial scrutiny.
Other types of agreements that may violate public policy and hence are unenforceable include
provisions that waive tort liability and contracts that interfere with family relationships.
The exceptions to the rule that illegal agreements will not be enforced and that courts leave the
parties where they are generally involve situations where the hands-off approach would lead to
an unfair result: where the parties are not equally at fault, where one is excusably ignorant or
withdraws before performance, or where one is protected by a statute. A court may sometimes
divide a contract, enforcing the legal part and not the illegal part.

EXERCISES

1. Henrioulle was an unemployed widower with two children who received public assistance
from the Marin County (California) Department of Social Services. There was a shortage of
housing for low-income residents in Marin County. He entered into a lease agreement on a
printed form by which the landlord disclaimed any liability for any injury sustained by the
tenants anywhere on the property. Henrioulle fractured his wrist when he tripped on a rock
on the common stairs in the apartment building. The landlord had been having a hard time
keeping the area clean. Is the disclaimer valid? Explain.
2. Albert Bennett, an amateur cyclist, entered a bicycle race sponsored by the United
States Cycling Federation. He signed a release exculpating the federation for
liability: “I further understand that serious accidents occasionally occur during
bicycle racing and that participants in bicycle racing occasionally sustain mortal or
serious personal injuries, and/or property damage, as a consequence thereof.
Knowing the risks of bicycle racing, nevertheless I hereby agree to assume those
risks and to release and hold harmless all the persons or entities mentioned above

Saylor URL: http://www.saylor.org/books

Saylor.org
453

who (through negligence or carelessness) might otherwise be liable to me (or my
heirs or assigns) for damages.”
During the race, Bennett was hit by an automobile that had been allowed on the
otherwise blocked-off street by agents of the defendant. Bennett sued; the trial
court dismissed the case on summary judgment. Bennett appealed. What was the
decision on appeal?
3. Ramses owned an industrial supply business. He contracted to sell the business to
Tut. Clause VI of their Agreement of Sale provided as follows: “In further
consideration for the purchase, Ramses agrees that he shall not compete, either
directly or indirectly, in the same business as is conducted by the corporation in
its established territory.”
Two months after the sale, Ramses opened a competing business across the
street from the business now owned by Tut, who brought suit, asking the court to
close Ramses’s business on the basis of Clause VI. What should the court decide?
Why?
4. After taking a business law class at State U, Elke entered into a contract to sell her business
law book to a classmate, Matthew, for $45. As part of the same contract, she agreed to
prepare a will for Matthew’s mother for an additional $110. Elke prepared the will and sent
the book to Matthew, but he refused to pay her. Is she entitled to any payment? Explain.
5. Elmo, a door-to-door salesman, entered into a contract to sell the Wilson family $320 worth
of household products on credit. The Wilsons later learned that Elmo had failed to purchase
a city license to make door-to-door sales and refused to pay him. May Elmo collect from the
Wilsons? Why?
6. Gardner purchased from Singer a sewing machine ($700) and three vacuums (about $250
each), one after the other, on Singer’s “1 to 36 month plan.” Gardner defaulted after paying
a total of $400 on account, and Singer sued to repossess all the purchases. Gardner defended
by claiming the purchase plan was unconscionable and pointed to the Williams case (Section
12.5.3 "Unconscionability") as controlling law (that cross-collateral contracts are

Saylor URL: http://www.saylor.org/books

Saylor.org
454

unconscionable). The trial court ruled for Gardner; Singer appealed. What was the result on
appeal?
7. Blubaugh leased a large farm combine from John Deere Leasing by signing an agreement
printed on very lightweight paper. The back side of the form was “written in such fine, light
print as to be nearly illegible.…The court was required to use a magnifying glass.” And the
wording was “unreasonably complex,” but it contained terms much in John Deere’s favor.
When Blubaugh defaulted, John Deere repossessed the combine, sold it for more than he
had paid, and sued him for additional sums in accordance with the default clauses on the
back side of the lease. Blubaugh defended by asserting the clauses were unconscionable. Is
this a case of procedural, substantive, or no unconscionability? Decide.
8. Sara Hohe, a fifteen-year-old junior at Mission Bay High School in San Diego, was injured
during a campus hypnotism show sponsored by the PTSA as a fund-raiser for the senior class.
Hypnotism shows had been held annually since 1980, and Sara had seen the previous year’s
show. She was selected at random from a group of many volunteers. Her participation in the
“Magic of the Mind Show” was conditioned on signing two release forms. Hohe’s father
signed a form entitled “Mission Bay High School PTSA Presents Dr. Karl Santo.” Hohe and her
father both signed a form titled “Karl Santo Hypnotist,” releasing Santo and the school
district from all liability. During the course of the show, while apparently hypnotized, Hohe
slid from her chair and also fell to the floor about six times and was injured. She, through her
father, then sued the school district. The Hohes claimed the release was contrary to public
policy; the trial court dismissed the suit on summary judgment. Was the release contrary to
public policy? Decide.
9. In 1963 the Southern Railway Company was disturbed by an order issued by the Interstate
Commerce Commission, a federal agency, which would adversely affect the firm’s profit by
some $13 million [about $90 million in 2011 dollars]. Southern hired a lawyer, Robert
Troutman, who was a friend of President John F. Kennedy, to lobby the president that the
latter might convince the attorney general, Robert Kennedy, to back Southern’s position in a
lawsuit against the ICC. It worked; Southern won. Southern then refused to pay Troutman’s
bill in the amount of $200,000 [about $14 million in 2011 dollars] and moved for summary
Saylor URL: http://www.saylor.org/books

Saylor.org
455

judgment dismissing Troutman’s claim, asserting—among other things—that contracts
whereby one person is hired to use his influence with a public official are illegal bargains.
Should summary judgment issue? Decide.
10. Buyer, representing himself to be experienced in timber negotiations, contracted to buy the
timber on Seller’s land. The first $11,500 would go to Buyer, the next $2,000 would go to
Seller, and the rest would be divided fifty-fifty after costs of removal of the timber. Buyer
said the timber would be worth $18,000–$20,000. When Seller discovered the timber was in
fact worth more than $50,000, he sued, claiming the contract was unconscionable. How
should the court rule?

SELF-TEST QUESTIONS

1. Gambling contracts are
a.

always unenforceable

b. enforceable if written
c. in effect enforceable in certain situations involving the sale of securities
d. always enforceable when made with insurance companies
In State X, plumbers must purchase a license but do not have to pass an
examination. This is an example of
a.

a regulatory license

b. a revenue license
c. both a and b
d. neither a nor b
A contract to pay a lobbyist to influence a public official is generally illegal.
a.

true

b. false
Exculpatory clauses are sometimes enforceable when they relieve someone
from liability for
a.

an intentional act

b. recklessness
c. negligence

Saylor URL: http://www.saylor.org/books

Saylor.org
456

d. all of the above
An employee’s promise not to compete with the employer after leaving the
company
a.

is never enforceable because it restrains trade

b. is always enforceable if in writing
c. is always enforceable
d. is enforceable if related to the employer’s property interests

SELF-TEST ANSWERS

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

Saylor URL: http://www.saylor.org/books

Saylor.org
457

Chapter 13
Form and Meaning
LEARNING OBJECTIVES

After reading this chapter, you should understand the following:
1. What kinds of contracts must be evidenced by some writing under the Statute of Frauds,
what the exceptions to the requirements are, and what satisfies a writing requirement
2. What effect prior or contemporaneous “side” agreements have on a written contract
3. How a contract is to be interpreted if its meaning is disputed
In four chapters, we have focused on the question of whether the parties created a valid contract
and have examined the requirements of (1) agreement (offer and acceptance), (2) real consent
(free will, knowledge, and capacity), (3) consideration, and (4) legality. Assuming that these
requirements have been met, we now turn to the form and meaning of the contract itself. Does
the contract have to be in a written form, and—if there is a dispute—what does the contract
mean?

13.1 The Statute of Frauds

LEARNING OBJECTIVES

1. Know which contracts are required to be evidenced by some writing to be enforceable.
2. Understand the exceptions to that requirement.
3. Recognize what the writing requirement means.
4. Understand the effect of noncompliance with the Statute of Frauds.

Overview of the Statute of Frauds
The general rule is this: a contract need not be in writing to be enforceable. An oral agreement to
pay a high-fashion model $2 million to pose for photographs is as binding as if the language of
the deal were printed on vellum and signed in the presence of twenty bishops. For three
centuries, however, a large exception grew up around the Statute of Frauds, first enacted in
England in 1677 under the formal name “An Act for the Prevention of Frauds and Perjuries.”
The Statute of Frauds requires that some contracts be evidenced by a writing, signed by the
party to be bound. The English statute’s two sections dealing with contracts read as follows:
Saylor URL: http://www.saylor.org/books

Saylor.org
458

[Sect. 4]…no action shall be brought
1. whereby to charge any executor or administrator upon any special promise, to
answer damages out of his own estate;
2. or whereby to charge the defendant upon any special promise to answer for the debt,
default or miscarriages of another person;
3. or to charge any person upon any agreement made upon consideration of marriage;
4. or upon any contract or sale of lands, tenements or hereditaments, or any interest in
or concerning them;
5. or upon any agreement that is not to be performed within the space of one year from
the making thereof;
unless the agreement upon which such action shall be brought, or some memorandum
or note thereof, shall be in writing, and signed by the party to be charged therewith,
or some other person thereunto by him lawfully authorized.
[Sect. 17]…no contract for the sale of any goods, wares and merchandizes, for the
price of ten pounds sterling or upwards, shall be allowed to be good, except the buyer
shall accept part of the goods so sold, and actually receive the same, or give
something in earnest to bind the bargain or in part of payment, or that some note or
memorandum in writing of the said bargain be made and signed by the parties to be
charged by such contract, or their agents thereunto lawfully authorized.
As may be evident from the title of the act and its language, the general purpose of the law is to
provide evidence, in areas of some complexity and importance, that a contract was actually
made. To a lesser degree, the law serves to caution those about to enter a contract and “to create
a climate in which parties often regard their agreements as tentative until there is a signed
writing.” [1] Notice, of course, that this is a statute; it is a legislative intrusion into the common
law of contracts. The name of the act is somewhat unfortunate: insofar as it deals with fraud at
all, it does not deal with fraud as we normally think of it. It tries to avoid the fraud that occurs
when one person attempts to impose on another a contract that never was agreed to.
The Statute of Frauds has been enacted in form similar to the seventeenth-century act in every
state but Maryland and New Mexico, where judicial decisions have given it legal effect, and
Saylor URL: http://www.saylor.org/books

Saylor.org
459

Louisiana. With minor exceptions in Minnesota, Wisconsin, North Carolina, and Pennsylvania,
the laws all embrace the same categories of contracts that are required to be in writing. Early in
the twentieth century, Section 17 was replaced by a section of the Uniform Sales Act, and this in
turn has now been replaced by provisions in the Uniform Commercial Code (UCC).

Figure 13.1 Contracts Required to Be in Writing

However ancient, the Statute of Frauds is alive and well in the United States. Today it is used as
a technical defense in many contract actions, often with unfair results: it can be used by a person
to wriggle out of an otherwise perfectly fine oral contract (it is said then to be used “as a sword
instead of a shield”). Consequently, courts interpret the law strictly and over the years have
enunciated a host of exceptions—making what appears to be simple quite complex. Indeed, after
more than half a century of serious scholarly criticism, the British Parliament repealed most of
the statute in 1954. As early as 1885, a British judge noted that “in the vast majority of cases [the
statute’s] operation is simply to enable a man to break a promise with impunity because he did
not write it down with sufficient formality.” A proponent of the repeal said on the floor of the
House of Commons that “future students of law will, I hope, have their labours lightened by the

Saylor URL: http://www.saylor.org/books

Saylor.org
460

passage of this measure.” In the United States, students have no such reprieve from the Statute
of Frauds, to which we now turn for examination.

Types of Contracts Required in Writing and the Exceptions
Promises to Pay the Debt of Another
The rule: a promise to pay the debt of another person must be evidenced by some writing if it
is a “collateral promise of suretyship (or ‘guaranty’).” A collateral promise is one secondary or
ancillary to some other promise. A surety or guarantor(the terms are essentially synonymous) is
one who promises to perform upon the default of another. Consider this:
A and B agree to pay C.
Here, both A and B are making a direct promise to pay C. Although A is listed first, both are
promising to pay C. Now consider this:
B agrees to pay C if A does not.
Here it is clear that there must be another agreement somewhere for A to pay C, but that is not
contained in this promise. Rather, B is making an agreement with C that iscollateral—on the
side—to the promise A is making to C. Sometimes the other agreement somewhere for A to pay
C is actually in the same document as B’s promise to pay C if A does not. That does not make B’s
promise a direct promise as opposed to a collateral one.
Suppose Lydia wishes to purchase on credit a coat at Miss Juliette’s Fine Furs. Juliette thinks
Lydia’s creditworthiness is somewhat shaky. So Lydia’s friend Jessica promises Miss Juliette’s
that if the store will extend Lydia credit, Jessica will pay whatever balance is due should Lydia
default. Jessica is a surety for Lydia, and the agreement is subject to the Statute of Frauds; an
oral promise will not be enforceable. [2] Suppose Jessica very much wants Lydia to have the coat,
so she calls the store and says, “Send Lydia the fur, and I will pay for it.” This agreement does
not create a suretyship, because Jessica is primarily liable: she is making a direct promise to pay.
To fall within the Statute of Frauds, the surety must back the debt of another person to a thirdparty promisee (also known as the obligee of the principal debtor). The “debt,” incidentally,
need not be a money obligation; it can be any contractual duty. If Lydia had promised to work as
a cashier on Saturdays at Miss Juliette’s in return for the coat, Jessica could become surety to

Saylor URL: http://www.saylor.org/books

Saylor.org
461

that obligation by agreeing to work in Lydia’s place if she failed to show up. Such a promise
would need to be in writing to be enforceable.
The exception: the main purpose doctrine. The main purpose doctrine is a major exception to
the surety provision of the Statute of Frauds. It holds that if the promisor’s principal reason for
acting as surety is to secure her own economic advantage, then the agreement is not bound by
the Statute of Frauds writing requirement. Suppose, in the previous example, that Jessica is
really the one who wants the fur coat but cannot, for reasons of prudence, let it be known that
she has bought one. So she proposes that Lydia “buy” it for her and that she will guarantee
Lydia’s payments. Since the main purpose of Jessica’s promise is to advance her own interests,
an oral agreement is binding. Normally, the main purpose rule comes into play when the surety
desires a financial advantage to herself that cannot occur unless she provides some security. For
example, the board chairman of a small company, who also owns all the voting stock, might
guarantee a printer that if his company defaulted in paying the bill for desperately needed
catalogs, he would personally pay the bill. If his main purpose in giving the guarantee was to get
the catalogues printed in order to stave off bankruptcy, and thus to preserve his own interest in
the company, he would be bound by an oral agreement. [3] The same principle can be used to
bind other creditors to oral agreements, as the bank discovered in Section 13.4.1 "The Statute of
Frauds’ Main Purpose Doctrine" (Wilson Floors).

Agreements of Executor or Administrator
The rule: the promise by an executor or administrator of an estate to answer personally for the
debt or other duty of the deceased is analogous to the surety provision—it must be evidenced by
some writing if it is to be enforced over an objection by the would-be obligor. For an agreement
to be covered by the statute, there must have been an obligation before the decedent’s death.
Thus if the executor arranges for a funeral and guarantees payment should the estate fail to pay
the fee, an oral contract is binding, because there was no preexisting obligation. If, however, the
decedent has made his own arrangements and signed a note obligating his estate to pay, the
executor’s promise to guarantee payment would be binding only if written.

Saylor URL: http://www.saylor.org/books

Saylor.org
462

The exception: the main purpose exception to the surety provision applies to this section of
the Statute of Frauds as well as to the “promises to pay the debts of another” section, noted
earlier.

The Marriage Provision
The rule: if any part of the marriage or the promise to marry consists also of a promise to
exchange some consideration, the Statute of Frauds requires that part to be evidenced by some
writing. [4] Mutual promises to marry are not within the rule. John and Sally exchange promises
to marry; the promise would not be unenforceable for failure to be evidenced by some writing.
(Of course courts are very unlikely to force anybody to keep a promise to marry; the point is, the
Statute of Frauds doesn’t apply). But if Sally understands John to say, “If you marry me, I will
deed to you my property in the Catskill Mountains,” the part about the property would need to
be evidenced by some writing to be enforced over John’s denial. The Statute of Frauds governs
such promises regardless of who makes them. Suppose John’s father had said, “If you marry
Sally and settle down, I will give you $1 million,” and John agrees and marries Sally. The father’s
promise is not enforceable unless written, if he denies it.
Sometimes couples—especially rich people like movie stars—execute written property settlement
agreements to satisfy the statute, stipulating how their assets will be treated upon marriage or
upon divorce or death. If done before marriage, they are
calledprenuptial (premarital) agreements; if after
marriage,postnuptial (after marriage) agreements (“prenupts” and “postnupts” in lawyer lingo).
The exception: there is no “named” exception here, but courts are free to make equitable
adjustments of property of the marriage to avoid an injustice.
The factors to be considered in the division of the marital estate are set forth at
[Citation], which states, inter alia [among other things], that the court shall finally
and equitably apportion the property of the parties, however and whenever acquired.
The statute vests wide discretion in the district court. [Citation]. The court is free to
adopt any reasonable valuation of marital property which is supported by the
record. [5]

Contracts Affecting an Interest in Real Estate
Saylor URL: http://www.saylor.org/books

Saylor.org
463

The rule: almost all contracts involving an interest in real estate are subject to the Statute of
Frauds. “An interest in land” is a broad description, including the sale, mortgaging, and leasing
of real property (including homes and buildings); profits from the land; the creation of
easements; and the establishment of other interests through restrictive covenants and
agreements concerning use. Short-term leases, usually for a term of one year or less, are exempt
from the provision.
The exception: the part performance doctrine. The name here is a misnomer, because it is a
doctrine of reliance, and the acts taken in reliance on the contract are not necessarily partial
performances under it. As in all such cases, the rationale is that it is unjust not to give the
promisee specific performance if he or she acted in reasonable reliance on the contract and the
promisor has continued to manifest assent to its terms. An oral contract to sell land is not
binding simply because the buyer has paid the purchase price; payment is not by itself reliance,
and if the seller refuses to transfer title, the buyer may recover the purchase price. However, if
the buyer has taken possession and made improvements on the property, courts will usually say
the case is out of the statute, and the party claiming an oral contract can attempt to prove the
existence of the oral contract.

The One-Year Rule
The rule: any agreement that cannot be performed within one year from its making must be
evidenced by some writing to be enforceable. The purpose of this part is perhaps more obvious
than most of the statute’s provisions: memories fade regarding the terms of oral contracts made
long ago; people die; disputes are not uncommon. Notice the critical time frame is not how long
it will take to perform the contract, but how long from the time it is made until performance is
complete. If a contract is made on January 1 for a house to be constructed starting on June 1 and
to be completed on February 1 of the next year, the performance will be completed in eight
months from the time it was begun, but thirteen months from the time the contract was made. It
falls within the statute.
The exception: the possibility test. The statute’s one-year rule has been universally interpreted
to mean a contract that is impossible to be fully performed within one year; if there is even the
slightest chance of carrying out the agreement completely within the year, an oral contract is
Saylor URL: http://www.saylor.org/books

Saylor.org
464

enforceable. Thus an oral agreement to pay a sum of money on a date thirteen months hence is
within the statute and not enforceable, but one calling for payment “within thirteen months”
would be enforceable, since it is possible under the latter contract to pay in less than a year.
Because in many cases strict application of the statute would dictate harsh results, the courts
often strain for an interpretation that finds it possible to perform the agreement within the year.
Courts will even hold that because any person may die within the year, a contract without a fixed
term may be fully performed in under a year and does not, therefore, fall within the statute.

Under the UCC
The rule: contracts for the sale of goods in an amount greater than $500 must be evidenced by
some writing to be enforceable. Section 2-201 of the UCC requires all contracts for the sale of
goods for the price of $500 or more to be in writing, but oral agreements for the sale of goods
valued at less than $500 are fully enforceable without exception.

Other Writing Requirements
In addition to these requirements, the UCC provides that agreements for the sale of securities
(e.g., most stocks and bonds) usually need to be evidenced by a writing, and agreements for
property not included in the sales or securities articles of the UCC that exceed $5,000 in value
need to be so evidenced. [6] Included here would be intangible property such as rights to royalties
and to mortgage payments, and other rights created by contract. And in many states, other
statutes require a writing for several different kinds of contracts. These include agreements to
pay commissions to real estate brokers, to make a will, to pay debts already discharged in
bankruptcy, to arbitrate rather than litigate, to make loans, and to make installment contracts.

Exceptions under the UCC
There are four exceptions to the UCC’s Statute of Frauds requirement that are relevant here.

The Ten-Day-Reply Doctrine
This provides that, as between merchants, if an oral agreement is reached and one party sends
the other a written statement confirming it, the other party has ten days to object in writing or
the agreement is enforceable. [7]

“Specially Manufactured Goods”

Saylor URL: http://www.saylor.org/books

Saylor.org
465

This exception provides that a seller who has manufactured goods to the buyer’s specifications
or who has made “either a substantial beginning of their manufacture or commitments for their
procurement” will not be stuck if the buyer repudiates, assuming that the goods are unsuitable
for sale to others. [8]

The “Admission” Exception
This exception arises—reasonably enough—when the party against whom enforcement is sought
admits in testimony or legal papers that a contract was in fact made. [9]However, the admission
will not permit enforcement of all claimed terms of the contract; enforcement is limited to the
quantity of goods admitted.

The “Payment or Delivery and Acceptance” Exception
The UCC provides that an oral contract for goods in excess of $500 will be upheld if payment
has already been made and accepted, or if the goods have been received and accepted. [10]

Sufficiency of the Required Writing
At Common Law
We have been careful not to say “the contract needs to be in writing.” We have said, “a
contractual intention must be evidenced by some writing, signed by the party to be bound.” A
signed contract is not required. What is required in most states, following the wording of the
original statute, is that there be at least some memorandum or note concerning the agreement—
a logical consequence of the statute’s purpose to evidence the making of the contract. The words
need not appear in a formal document; they are sufficient in any form in a will, or on a check or
receipt, or in longhand on the back of an envelope—so long as the document is signed by the
party to be charged (i.e., the party being sued on the contract).
Although the writing need not contain every term, it must recite the subject matter of the
contract. It need not do so, however, in terms comprehensible to those who were not party to the
negotiations; it is enough if it is understandable in context. A written agreement to buy a parcel
of land is usually sufficiently definitive if it refers to the parcel in such a way that it could be
mistaken for no other—for example, “seller’s land in Tuscaloosa,” assuming that the seller
owned only one parcel there. Beyond the subject matter, the essential terms of promises to be
performed must be written out; all details need not be. If an essential term is missing, it cannot
Saylor URL: http://www.saylor.org/books

Saylor.org
466

be enforced, unless it can be inferred or imposed by rule of law. A written contract for the sale of
land containing every term but the time for payment, which the parties orally agreed would be
upon delivery of the deed, is sufficient. (A contract that omitted the selling price would not be.)
The parties must be named in the writing in a manner sufficient to identify them. Their whole
names need not be given if initials or some other reference makes it inescapable that the writing
does concern the actual parties. Reference to the agent of a party identifies the party. Possession
of the writing may even be sufficient: if a seller gives a memorandum of an oral agreement for
the sale of his land, stating all the terms, to the buyer, the latter may seek specific performance
even though the writing omits to name or describe him or his agent. [11]
In a few states, consideration for the promise must be stated in writing, even if the consideration
has already been given. Consequently, written contracts frequently contain such language as “for
value received.” But in most states, failure to refer to consideration already given is unnecessary:
“the prevailing view is that error or omission in the recital of past events does not affect the
sufficiency of a memorandum.”[12] The situation is different, however, when the consideration is
a return promise yet to be performed. Usually the return promise is an essential term of the
agreement, and failure to state it will vitiate the writing.

Under the UCC
In contracts for the sale of goods, the writing must be signed by the party to be charged, and the
parties must be sufficiently identified. [13] But consideration, including the selling price, need not
be set forth for the memorandum to meet the requirements of the UCC (“a writing is not
insufficient because it omits or incorrectly states a term agreed upon”), though obviously it
makes sense to do so whenever possible. By contrast, UCC Sections 1-206 and 3-319 concerning
intangible personal property and investment securities require “a defined or stated price.”

Electronic Communications
One of the primary purposes of the Electronic Signatures in Global and National Commerce Act,
S. 761, popularly referred to as ESign, is to repeal state law requirements for written instruments
as they apply to electronic agreements and to make almost anything reasonably indicative of a
signature good enough electronically. [14] It provides the following:

Saylor URL: http://www.saylor.org/books

Saylor.org
467

Notwithstanding any statute, regulation, or other rule of law [other than subsequent
parts of this same statute], with respect to any transactions in or affecting interstate
or foreign commerce—
1. a signature, contract, or other record relating to such transaction may not be denied
legal effect, validity or enforceability solely because it is in electronic form; and
2. a contract relating to such transaction may not be denied legal effect, validity or
enforceability solely because an electronic signature or electronic record was used in
its formation.…
The term “transaction” means an action or set of actions relating to the conduct of a
business, consumer or commercial affairs between two or more persons, including
any of the following types of conduct—
1. the sale, lease, exchange, or other disposition of [personal property and intangibles]
2. the sale, lease, exchange or other disposition of any interest in real property, or any
combination thereof.
The term “electronic signature” means an electronic sound, symbol, or process,
attached to or logically associated with a contract or other record and executed or
adopted by a person with the intent to sign the record.

Effect of Noncompliance and Exceptions; Oral Rescission
The basic rule is that contracts governed by the Statute of Frauds are unenforceable if they are
not sufficiently written down. If the agreement contains several promises, the unenforceability
of one will generally render the others unenforceable also.
The Statute of Frauds can work injustices. In addition to the exceptions already noted, there are
some general exceptions.

Full Performance
First, certainly, if the contract has been performed fully by both sides, its unenforceability under
the statute is moot. Having fulfilled its function (neither side having repudiated the contract),
the agreement cannot be rescinded on the ground that it should have been, but was not, reduced
to writing.

Detrimental Reliance
Saylor URL: http://www.saylor.org/books

Saylor.org
468

Second, some relief may be granted to one who has relied on an oral contract to her detriment
(similar to the part performance doctrine mentioned already). For a partially performed
contract unenforceable under the Statute of Frauds, restitution may be available. Suppose
George agrees orally to landscape Arthur’s fifteen acres, in return for which George is to receive
title to one acre at the far end of the lot. George is not entitled to the acre if Arthur defaults, but
he may recover for the reasonable value of the services he has performed up to the time of
repudiation. Somewhat related, if one side has reasonably and foreseeably relied upon a promise
in such a way that injustice can only be avoided by enforcing it, some courts will use promissory
estoppel to preclude the necessity of a writing, but the connection between the alleged oral
contract and the detrimental reliance must be convincing.

Oral Rescission
Third, most contracts required to be in writing may be rescinded orally. The new agreement is
treated in effect as a modification of the old one, and since a complete rescission will not usually
trigger any action the statute requires to be in writing, the rescission becomes effective in the
absence of any signed memorandum.
Some agreements, however, may not be rescinded orally. Those that by their terms preclude oral
rescission are an obvious class. Under the UCC, certain agreements for the sale of goods may not
be orally rescinded, depending on the circumstances. For instance, if title has already passed to
the buyer under a written agreement that satisfies the statute, the contract can be rescinded only
by a writing. Contracts for the sale of land are another class of agreements that generally may
not be orally rescinded. If title has already been transferred, or if there has been a material
change of position in reliance on the contract, oral agreements to rescind are unenforceable. But
a contract that remains wholly executory, even though enforceable because in writing, may be
rescinded orally in most states.

Contract Modification
Fourth, contracts governed by the Statute of Frauds may be modified orally if the resulting
contract, taken as a whole, falls outside the statute. The same rule applies under the
UCC. [15] Thus a written contract for the sale of a new bicycle worth $1,200 may be orally

Saylor URL: http://www.saylor.org/books

Saylor.org
469

modified by substituting the sale of a used bicycle worth $450, but not by substituting the sale of
a used bike worth $600. The modified contract effectively rescinds the original contract.

KEY TAKEAWAY

The Statute of Frauds, an ancient legislative intrusion into common-law contracts, requires
that certain contracts be evidenced by some writing, signed by the party to be bound, to be
enforceable. Among those affected by the statute are contracts for an interest in real estate,
contracts that by their terms cannot be performed within one year, contracts whereby one
person agrees to pay the debt of another, contracts involving the exchange of consideration
upon promise to marry (except mutual promises to marry), and, under the UCC, contracts in
an amount greater than $500. For each contract affected by the statute, there are various
exceptions intended to prevent the statute from being used to avoid oral contracts when it is
very likely such were in fact made.
The writing need not be a contract; anything in writing, signed by the person to be bound,
showing adequate contractual intention will take the matter out of the statute and allow a
party to attempt to show the existence of the oral contract.
There may be relief under restitution or promissory estoppel. Contracts affected by the
statute can usually be orally rescinded. Any contract can be modified or rescinded; if the new
oral contract as modified does not fall within the statute, the statute does not apply.

EXERCISES

1. What is the purpose of the Statute of Frauds?
2. What common-law contracts are affected by it, and what are the exceptions?
3. How does the UCC deal with the Statute of Frauds?
4. How is the requirement of the statute satisfied?
5. Contracts can always be modified. How does the Statute of Frauds play with contract
modification?

[1] Restatement (Second) of Contracts, Chapter 5, statutory note.

Saylor URL: http://www.saylor.org/books

Saylor.org
470

[2] Of course, if Jessica really did orally promise Miss Juliette’s to pay in case Lydia didn’t, it would be
bad faith to lie about it. The proper course for Jessica is not to say, “Ha, ha, I promised, but it was only
oral, so I’m not bound.” Jessica should say, “I raise the Statute of Frauds as a defense.”
[3] Stuart Studio, Inc. v. National School of Heavy Equipment, Inc., 214 S.E.2d 192 (N.C. 1975).
[4] Restatement (Second) of Contracts, Section 125.
[5] In re Marriage of Rada, 402, 869 P.2d 254 (Mont. 1994).
[6] Uniform Commercial Code, Sections 8-319 and 1-206.
[7] Uniform Commercial Code, Section 2-201(2).
[8] Uniform Commercial Code, Section 2-201(3)(a).
[9] Uniform Commercial Code, Section 2-201(3)(b).
[10] Uniform Commercial Code, Section 2-20l(3)(c).
[11] Restatement (Second) of Contracts, Section 207(f).
[12] Restatement (Second) of Contracts, Section 207(h).
[13] Uniform Commercial Code, Section 2-210(1).
[14] Electronic Signatures in Global and National Commerce Act, 15 U.S.C. § 96, 106th Congress (2000).
[15] Uniform Commercial Code, Section 2-209(3).

13.2 The Parol Evidence Rule

LEARNING OBJECTIVES

1. Understand the purpose and operation of the parol evidence rule, including when it applies
and when it does not.
2. Know how the Uniform Commercial Code (UCC) deals with evidence to show a contract’s
meaning.

The Purpose of the Rule
Unlike Minerva sprung forth whole from the brow of Zeus in Greek mythology, contracts do not
appear at a stroke memorialized on paper. Almost invariably, negotiations of some sort precede
the concluding of a deal. People write letters, talk by telephone, meet face-to-face, send e-mails,
and exchange thoughts and views about what they want and how they will reciprocate. They may
even lie and cajole in duplicitous ways, making promises they know they cannot or will not keep
Saylor URL: http://www.saylor.org/books

Saylor.org
471

in order not to kill the contract talks. In the course of these discussions, they may reach tentative
agreements, some of which will ultimately be reflected in the final contract, some of which will
be discarded along the way, and some of which perhaps will not be included in the final
agreement but will nevertheless not be contradicted by it. Whether any weight should be given
to these prior agreements is a problem that frequently arises.

Parol Evidence at Common-Law
The Rule
The rule at common law is this: a written contract intended to be the parties’ complete
understanding discharges all prior or contemporaneous promises, statements, or agreements
that add to, vary, or conflict with it.
The parol evidence rule (parol means oral; it is related to parliament and parly—talking) is a
substantive rule of law that operates to bar the introduction of evidence intended to show that
the parties had agreed to something different from what they finally arrived at and wrote down.
It applies to prior written as well as oral discussions that don’t make it into the final written
agreement. Though its many apparent exceptions make the rule seem difficult to apply, its
purposes are simple: to give freedom to the parties to negotiate without fear of being held to the
consequences of asserting preliminary positions, and to give finality to the contract.
The rule applies to all written contracts, whether or not the Statute of Frauds requires them to
be in writing. The Statute of Frauds gets to whether there was a contract at all; the parol
evidence rule says, granted there was a written contract, does it express the parties’
understanding? But the rule is concerned only with events that transpired before the contract in
dispute was signed. It has no bearing on agreements reached subsequently that may alter the
terms of an existing contract.

The Exemptions and Exceptions
Despite its apparent stringency, the parol evidence rule does not negate all prior agreements or
statements, nor preclude their use as evidence. A number of situations fall outside the scope of
the rule and hence are not technically exceptions to it, so they are better phrased as exemptions
(something not within the scope of a rule).

Not an Integrated Contract
Saylor URL: http://www.saylor.org/books

Saylor.org
472

If the parties never intended the written contract to be their full understanding—if they intended
it to be partly oral—then the rule does not apply. If the document is fully integrated, no extrinsic
evidence will be permitted to modify the terms of the agreement, even if the modification is in
addition to the existing terms, rather than a contradiction of them. If the contract is partially
integrated, prior consistent additional terms may be shown. It is the duty of the party who wants
to exclude the parol evidence to show the contract was intended to be integrated. That is not
always an easy task. To prevent a party later from introducing extrinsic evidence to show that
there were prior agreements, the contract itself can recite that there were none. Here, for
example, is the final clause in the National Basketball Association Uniform Player Contract:
“This agreement contains the entire agreement between the parties and there are no oral or
written inducements, promises or agreements except as contained herein.” Such a clause is
known as a merger clause.

Void or Voidable Contracts
Parol evidence is admissible to show the existence of grounds that would cause the contract to
be void. Such grounds include illegality, fraud, duress, mistake, and lack of consideration. And
parol evidence is allowed to show evidence of lack of contractual capacity. Evidence of infancy,
incompetency, and so on would not change the terms of the contract at all but would show it was
voidable or void.

Contracts Subject to a Condition Precedent
When the parties orally agree that a written contract is contingent on the occurrence of an event
or some other condition (a condition precedent), the contract is not integrated and the oral
agreement may be introduced. The classic case is that of an inventor who sells in a written
contract an interest in his invention. Orally, the inventor and the buyer agree that the contract is
to take effect only if the buyer’s engineer approves the invention. (The contract was signed in
advance of approval so that the parties would not need to meet again.) The engineer did not
approve it, and in a suit for performance, the court permitted the evidence of the oral agreement
because it showed “that in fact there never was any agreement at all.” [1] Note that the oral
condition does not contradict a term of the written contract; it negates it. The parol evidence

Saylor URL: http://www.saylor.org/books

Saylor.org
473

rule will not permit evidence of an oral agreement that is inconsistent with a written term, for as
to that term the contract is integrated.

Untrue Recital or Errors
The parol evidence rule does not prevent a showing that a fact stated in a contract is untrue. The
rule deals with prior agreements; it cannot serve to choke off inquiry into the facts. Thus the
parol evidence rule will not bar a showing that one of the parties is a minor, even if the contract
recites that each party is over eighteen. Nor will it prevent a showing that a figure in the contract
had a typographical error—for example, a recital that the rate charged will be the plumber’s
“usual rate of $3 per hour” when both parties understood that the usual rate was in fact $30 per
hour. A court would allowreformation (correction) of such errors.

Ambiguity
To enforce a contract, its terms must be understood, so parol evidence would be allowed, but a
claim of ambiguity cannot be used to alter, vary, or change the contract’s meaning.

Postcontract Modification
Ordinarily, an additional consistent oral term may be shown only if the contract was partially
integrated. The parol evidence rule bars evidence of such a term if the contract was fully
integrated. However, when there is additional consideration for the term orally agreed, it lies
outside the scope of the integrated contract and may be introduced. In effect, the law treats each
separate consideration as creating a new contract; the integrated written document does not
undercut the separate oral agreement, as long as they are consistent. Buyer purchases Seller’s
business on a contract; as part of the agreement, Seller agrees to stay on for three weeks to help
Buyer “learn the ropes.” Buyer realizes she is not yet prepared to go on her own. She and Seller
then agree that Seller will stay on as a salaried employee for five more weeks. Buyer cannot use
the parol evidence rule to preclude evidence of the new agreement: it is a postcontract
modification supported by new consideration. Similarly, parties could choose to rescind a
previously made contract, and the parol evidence rule would not bar evidence of that.

The UCC Approach
Under Section 2-202 of the UCC, a course of dealing, a usage of trade, or a course of
performance can be introduced as evidence to explain or supplement any written contract for
Saylor URL: http://www.saylor.org/books

Saylor.org
474

the sale of goods. A course of dealing is defined as “a sequence of previous conduct between the
parties to a particular transaction which is fairly to be regarded as establishing a common basis
of understanding for interpreting their expressions and other conduct.” A usage of trade is “any
practice or method of dealing having such regularity of observance in a place, vocation or trade
as to justify an expectation that it will be observed with respect to the transaction in question.”
Acourse of performance is the conduct of a party in response to a contract that calls for repeated
action (e.g., a purchase agreement for a factory’s monthly output, or an undertaking to wash a
neighbor’s car weekly).

KEY TAKEAWAY

The parol evidence rule is intended to preserve “the four corners” of the contract: it
generally prohibits the introduction of contemporaneous oral or written elements of
negotiation that did not get included in the written contract, subject to a number of
exemptions.
The UCC allows evidence of course of dealing, course of performance, or usage of trade to
give meaning to the contract.

EXERCISES

1. What is the purpose of the parol evidence rule?
2. How does it operate to crystallize the intention of the contracting parties?
3. To what kinds of contract issues does the rule not apply?
4. What “help” does the UCC give to fleshing out the parties’ contractual understanding?

[1] Pym v. Campbell, 119 Eng. Rep. 903 (Q.B. 1856).

13.3 Interpretation of Agreements: Practicalities versus
Legalities
LEARNING OBJECTIVES

1. Understand the purpose of contractual interpretation.
2. Know the tools courts use to interpret contracts.
Saylor URL: http://www.saylor.org/books

Saylor.org
475

3. Recognize that in everyday life, businesspeople tolerate oral contracts or poorly written
ones, but a writing remains useful.

The General Problem and the Purpose of Contractual Interpretation
The General Problem
As any reader knows, the meaning of words depends in part on context and in part on the skill
and care of the writer. As Justice Oliver Wendell Holmes Jr. once succinctly noted, “A word is
not a crystal, transparent and unchanged; it is the skin of a living thought and may vary greatly
in color and content according to the circumstances and the time in which it is used.” [1] Words
and phrases can be ambiguous, either when they stand alone or when they take on a different
coloration from words and phrases near them. A writer can be careless and contradict himself
without intending to; people often read hurriedly and easily miss errors that a more deliberate
perusal might catch. Interpretation difficulties can arise for any of a number of reasons: a form
contract might contain language that is inconsistent with provisions specifically annexed; the
parties might use jargon that is unclear; they might forget to incorporate a necessary term;
assumptions about prior usage or performance, unknown to outsiders like judges, might color
their understanding of the words they do use. Because ambiguities do arise, courts are
frequently called on to give content to the words on paper.

The Basic Rule of Interpretation
Courts attempt to give meaning to the parties’ understanding when they wrote the contract.
The intention of the parties governs, and if their purpose in making the contract is known or can
be ascertained from all the circumstances, it will be given great weight in determining the
meaning of an obscure, murky, or ambiguous provision or a pattern of conduct. A father tells the
college bookstore that in consideration of its supplying his daughter, a freshman, with books for
the coming year, he will guarantee payment of up to $350. His daughter purchases books
totaling $400 the first semester, and he pays the bill. Midway through the second semester, the
bookstore presents him with a bill for an additional $100, and he pays that. At the end of the
year, he refuses to pay a third bill for $150. A court could construe his conduct as indicating a
purpose to ensure that his daughter had whatever books she needed, regardless of cost, and
interpret the contract to hold him liable for the final bill.
Saylor URL: http://www.saylor.org/books

Saylor.org
476

Tools of Interpretation
The policy of uncovering purpose has led to a number of tools of judicial interpretation:
•

More specific terms or conduct are given more weight than general terms or unremarkable
conduct. Thus a clause that is separately negotiated and added to a contract will be counted as
more significant than a standard term in a form contract.

•

A writing is interpreted as a whole, without undue attention to one clause.

•

Common words and terms are given common meaning; technical terms are given their technical
meaning.

•

In the range of language and conduct that helps in interpretation, the courts prefer the following
items in the order listed: express terms, course of performance, course of dealing, and usage of
trade.

•

If an amount is given in words and figures that differ, the words control.

•

Writing controls over typing; typing controls over printed forms.

•

Ambiguities are construed against the party that wrote the contract.
In this chapter, we have considered a set of generally technical legal rules that spell out the
consequences of contracts that are wholly or partially oral or that, if written, are ambiguous or
do not contain every term agreed upon. These rules fall within three general headings: the
Statute of Frauds, the parol evidence rule, and the rules of interpretation. Obviously, the more
attention paid to the contract before it is formally agreed to, the fewer the unforeseen
consequences. In general, the conclusion is inescapable that a written contract will avoid a host
of problems. Writing down an agreement is not always sensible or practical, but it can probably
be done more often than it is. Writing almost fifty years ago—and it is still true—a law professor
studying business practices noted the following:
Businessmen often prefer to rely on “a man’s word” in a brief letter, a handshake or
“common honesty and decency”—even when the transaction involves exposure to
serious risks. Seven lawyers from law firms with business practices were interviewed.
Five thought that businessmen often entered contracts with only a minimal degree of
advanced planning. They complained that businessmen desire to “keep it simple and
avoid red tape” even where large amounts of money and significant risks are
Saylor URL: http://www.saylor.org/books

Saylor.org
477

involved.…Another said that businessmen when bargaining often talk only in
pleasant generalities, think they have a contract, but fail to reach agreement on any
of the hard, unpleasant questions until forced to do so by a lawyer. [2]
Written contracts do not, to be sure, guarantee escape from disputes and litigation. Sometimes
ambiguities are not seen; sometimes they are necessary if the parties are to reach an agreement
at all. Rather than back out of the deal, it may be worth the risk to one or both parties
deliberately to go along with an ambiguous provision and hope that it never arises to be tested in
a dispute that winds up in court.
Nevertheless, it is generally true that a written contract has at least three benefits over oral ones,
even those that by law are not required to be in writing. (1) The written contract usually avoids
ambiguity. (2) It can serve both as a communications device and as a device for the allocation of
power, especially within large companies. By alerting various divisions to its formal
requirements, the contract requires the sales, design, quality-control, and financial departments
to work together. By setting forth requirements that the company must meet, it can place the
power to take certain actions in the hands of one division or another. (3) Finally, should a
dispute later arise, the written contract can immeasurably add to proof both of the fact that a
contract was agreed to and of what its terms were.

KEY TAKEAWAY

It is not uncommon for the meaning of a contract to be less than entirely clear. When called
upon to interpret the meaning of a contract, courts try to give it the meaning the parties
intended when they made it. Various tools of interpretation are used.
Businesspeople usually do not like to seem overbearing; they do not wish to appear
untrusting; they often dislike unpleasantries. Therefore it is not uncommon for even big deals
to be sealed with a handshake. But it’s a trade-off, because a written contract has obvious
benefits, too.

EXERCISES

1. Why do courts fairly frequently have to interpret the meaning of contracts?
2. What is the purpose of contractual interpretation?
3. What tools do the courts use in interpreting contracts?

Saylor URL: http://www.saylor.org/books

Saylor.org
478

4. What is the social “cost” of insisting upon a written contract in a business setting? What are
the benefits of the contract?

[1] Towne v. Eisner, 245 US 418, 425 (1917).
[2] Stewart Macaulay, “Non-contractual Relations in Business: A Preliminary Study,” American
Sociological Review 28, no. 1 (1963): 58–59.

13.4 Cases
The Statute of Frauds’ Main Purpose Doctrine
Wilson Floors Co. v. Sciota Park, Ltd., and Unit, Inc.
377 N.E.2d 514 (1978)
Sweeny, J.
In December of 1971, Wilson Floors Company (hereinafter “Wilson”) entered into a contract
with Unit, Inc. (hereinafter “Unit”), a Texas corporation to furnish and install flooring materials
for “The Cliffs” project, a development consisting of new apartments and an office building to be
located in Columbus, Ohio. Unit…was the general manager for the project. The Pittsburgh
National Bank (hereinafter the bank), as the construction lender for the project, held mortgages
on The Cliffs property security for construction loans which the bank had made to Unit.
As the work progressed on the project Unit fell behind in making payments to Wilson for its
completed work in the spring of 1973. At that time, the project was approximately two-thirds
completed, the first mortgage money of seven million dollars having been fully dispersed by the
bank to Unit. Appellant [Wilson] thereupon stopped work in May of 1973 and informed Unit
that it would not continue until payments were forthcoming. On May 15, 1973, the bank
conducted a meeting with the subcontractors in The Cliffs project, including Wilson.
At the meeting, the bank sought to determine whether it would be beneficial at that stage of the
project to lend more money to Unit, foreclose on the mortgage and hire a new contractor to
complete the work, or do nothing. Subcontractors were requested to furnish the bank an
Saylor URL: http://www.saylor.org/books

Saylor.org
479

itemized account of what Unit owed them, and a cost estimate of future services necessary to
complete their job contracts. Having reviewed the alternatives, the bank determined that it
would be in its best interest to provide additional financing for the project. The bank reasoned
that to foreclose on the mortgage and hire a new contractor at this stage of construction would
result in higher costs.
There is conflicting testimony in regard to whether the bank made assurances to Wilson at this
meeting that it would be paid for all work to be rendered on the project. However, after the May
meeting, Wilson, along with the other subcontractors, did return to work.
Payments from Unit again were not forthcoming, resulting in a second work stoppage. The bank
then arranged another meeting to be conducted on June 28, 1973.
At this second meeting, there is conflicting testimony concerning the import of the statements
made by the bank representative to the subcontractors. The bank representative who spoke at
the meeting testified at trial that he had merely advised the subcontractors that adequate funds
would be available to complete the job. However, two representatives of Wilson, also in
attendance at the meeting, testified that the bank representative had assured Wilson that if it
returned to work, it would be paid.
After the meeting, Wilson returned to work and continued to submit its progress billings to Unit
for payment. Upon completion of its portion of The Cliffs project, Wilson submitted its final
invoice of $15,584.50 to Unit. This amount was adjusted downward to $15,443.06 upon
agreement of Unit and Wilson. However, Wilson was not paid this amount.
As a result of nonpayment, Wilson filed suit…against Unit and the bank to recover the
$15,443.06 [about $60,700 in 2010 dollars]. On September 26, 1975, Wilson and Unit
stipulated that judgment for the sum of $15,365.84, plus interest, be entered against Unit. When
Unit failed to satisfy the judgment, appellant proceeded with its action against the bank. [The
trial court decided in favor of Wilson, but the intermediate appellate court reversed the trial
court decision.]…[The Ohio statute of frauds provides]:
No action shall be brought whereby to charge the defendant, upon a special promise,
to answer for the debt, default, or miscarriage of another person…unless the

Saylor URL: http://www.saylor.org/books

Saylor.org
480

agreement…or some memorandum thereof, is in writing and signed by the party to
be charged.…
In paragraph one of Crawford v. Edison [an 1887 Ohio case], however, this court stated:
When the leading object of the promisor is, not to answer for another, but to subserve
some pecuniary or business purpose of his own, involving a benefit to himself…his
promise is not within the statute of frauds, although it may be in form a promise to
pay the debt of another and its performance may incidentally have the effect of
extinguishing that liability.…
So long as the promisor undertakes to pay the subcontractor whatever his services are worth
irrespective of what he may owe the general contractor and so long as the main purpose of the
promisor is to further his own business or pecuniary interest, the promise is enforceable.…
The facts in the instant case reflect that the bank made its guarantee to Wilson to subserve its
own business interest of reducing costs to complete the project. Clearly, the bank induced
Wilson to remain on the job and rely on its credit for future payments. To apply the statute of
frauds and hold that the bank had no contractual duty to Wilson despite its oral guarantees
would not prevent the wrong which the statute’s enactment was to prevent, but would in reality
effectuate a wrong.
Therefore, this court affirms the finding of the Court of Common Pleas that the verbal
agreement made by the bank is enforceable by Wilson, and reverses the judgment of the Court of
Appeals.

CASE QUESTIONS

1. The exception to the Statute of Frauds in issue here is the main purpose doctrine. How does
this doctrine relate to the concept of promissory estoppel?
2. What was the main purpose behind the bank’s purported promise?

The Statute of Frauds’ One-Year Rule
Iacono v. Lyons
16 S.W.3d 92 (Texas Ct. App. 2000)
O’Connor, J.

Saylor URL: http://www.saylor.org/books

Saylor.org
481

Mary Iacono, the plaintiff below and appellant here, appeals from a take-nothing summary
judgment rendered in favor of Carolyn Lyons, the defendant below and appellee here. We
reverse and remand.
The plaintiff [Iacono] and defendant [Lyons] had been friends for almost 35 years. In late 1996,
the defendant invited the plaintiff to join her on a trip to Las Vegas, Nevada. There is no dispute
that the defendant paid all the expenses for the trip, including providing money for gambling.
The plaintiff contended she was invited to Las Vegas by the defendant because the defendant
thought the plaintiff was lucky. Sometime before the trip, the plaintiff had a dream about
winning on a Las Vegas slot machine. The plaintiff’s dream convinced her to go to Las Vegas,
and she accepted the defendant’s offer to split “50-50” any gambling winnings.
In February 1997, the plaintiff and defendant went to Las Vegas. They started playing the slot
machines at Caesar’s Palace. The plaintiff contends that, after losing $47, the defendant wanted
to leave to see a show. The plaintiff begged the defendant to stay, and the defendant agreed on
the condition that she (the defendant) put the coins into the machines because doing so took the
plaintiff too long. (The plaintiff, who suffers from advanced rheumatoid arthritis, was in a
wheelchair.) The plaintiff agreed, and took the defendant to a dollar slot machine that looked
like the machine in her dream. The machine did not pay on the first try. The plaintiff then said,
“Just one more time,” and the defendant looked at the plaintiff and said, “This one’s for you,
Puddin.”
The slot machine paid $1,908,064. The defendant refused to share the winnings with the
plaintiff, and denied they had an agreement to split any winnings. The defendant told Caesar’s
Palace she was the sole winner and to pay her all the winnings.
The plaintiff sued the defendant for breach of contract. The defendant moved for summary
judgment on the grounds that any oral agreement was unenforceable under the statute of frauds
or was voidable for lack of consideration. The trial court rendered summary judgment in favor of
the defendant.…
[Regarding the “consideration” argument:] The defendant asserted the agreement, if any, was
voidable because there was no consideration. The defendant contended the plaintiff’s only
contribution was the plaintiff’s dream of success in Las Vegas and her “luck.” The plaintiff
Saylor URL: http://www.saylor.org/books

Saylor.org
482

asserted the defendant bargained with her to go to Las Vegas in return for intangibles that the
defendant thought the plaintiff offered (good luck and the realization of the dream). The
plaintiff said she gave up her right to remain in Houston in return for the agreement to split any
winnings. The plaintiff also asserted the agreement was an exchange of promises.
…The plaintiff alleged she promised to share one-half of her winnings with the defendant in
exchange for the defendant’s promise to share one-half of her winnings with the plaintiff. These
promises, if made, represent the respective benefits and detriments, or the bargained for
exchange, necessary to satisfy the consideration requirement. See [Citation] (when no other
consideration is shown, mutual obligations by the parties to the agreement will furnish sufficient
consideration to constitute a binding contract).…[Regarding the Statute of Frauds argument:]
The defendant asserted the agreement, if any, was unenforceable under the statute of frauds
because it could not be performed within one year. There is no dispute that the winnings were to
be paid over a period of 20 years.…
[The statute] does not apply if the contract, from its terms, could possibly be performed within a
year—however improbable performance within one year may be. [Citations] [It bars] only oral
contracts that cannot be completed within one year. [Citation] (If the agreement, either by its
terms or by the nature of the required acts, cannot be performed within one year, it falls within
the statute of frauds and must be in writing).
To determine the applicability of the statute of frauds with indefinite contracts, this Court may
use any reasonably clear method of ascertaining the intended length of performance. [Citation]
The method is used to determine the parties’ intentions at the time of contracting. The fact that
the entire performance within one year is not required, or expected, will not bring an agreement
within the statute. See [Citations].
Assuming without deciding that the parties agreed to share their gambling winnings, such an
agreement possibly could have been performed within one year. For example, if the plaintiff and
defendant had won $200, they probably would have received all the money in one pay-out and
could have split the winnings immediately. Therefore, the defendant was not entitled to
summary judgment based on her affirmative defense of the statute of frauds.
We reverse the trial court’s judgment and remand for further proceedings.
Saylor URL: http://www.saylor.org/books

Saylor.org
483

CASE QUESTIONS
1. The defendant contended there was no consideration to support her alleged promise to split
the winnings fifty-fifty. What consideration did the court find here?
2. The defendant contended that the Statute of Frauds’ one-year rule prohibited the plaintiff
from attempting to prove the existence of the alleged oral contract to split the winnings.
What reasoning did the court give here as to why the statute did not apply?
3. After this case, the court remanded the matter to the lower court. What has to happen there
before plaintiff gets her money?

The Parol Evidence Rule: Postcontract Modification
Hampden Real Estate, Inc. v. Metropolitan Management Group, Inc.
142 Fed. Appx. 600 (Fed. Ct. App. Pa. 2005)
Cowen, J.
[The court has jurisdiction based on diversity of citizenship.]
Hampden Real Estate sold Metropolitan Management a residential property pursuant to an
Agreement of Sale (the “Sale Agreement”). The Sale Agreement provided that the property
would be sold for $3.7 million, that Metropolitan would assume Hampden’s mortgage on the
building, and that Hampden would receive a credit in the amount of $120,549.78—the amount
being held in escrow pursuant to the mortgage (the “Escrow Account Credit”).
Between the execution of the Sale Agreement and the closing, the parties negotiated certain
adjustments to the purchase price to compensate for required repairs. During these
negotiations, the parties reviewed a draft and final Settlement Statement (the “Settlement
Statement”), prepared by the closing agent, which did not list the Escrow Account Credit among
the various debits and credits. A few weeks after the closing, Hampden demanded payment of
the Escrow Account Credit.
Following Metropolitan’s refusal to pay the Escrow Account Credit, Hampden filed a complaint
claiming breach of contract, unjust enrichment, and conversion. Metropolitan brought
counterclaims for breach of contract, unjust enrichment, and fraudulent or negligent
misrepresentation. Hampden brought a partial motion for summary judgment as to the breach

Saylor URL: http://www.saylor.org/books

Saylor.org
484

of contract claim, which was granted and its unjust enrichment and conversion claims were
dismissed as moot.…
The District Court correctly determined that the threshold issue is the role of the Settlement
Statement, “based on both the intent of the parties and the custom and usage of the document.”
However, the Court refused to consider extrinsic or parol evidence to determine the intent of the
parties, reasoning that the parol evidence rule precluded such consideration absent ambiguity in
the written contract. We find that the District Court misapplied the rule. The parol evidence rule
seeks to preserve the integrity of written agreements by precluding the introduction of
contemporaneous or prior declarations to alter the meaning of written agreements. [Citation]
The rule does not apply, however, where a party seeks to introduce evidence of subsequent oral
modifications. See [Citation:] a “written agreement may be modified by a subsequent written or
oral agreement and this modification may be shown by writings or by words or by conduct or by
all three. In such a situation the parol evidence rule is inapplicable.” Here, the parol evidence
rule does not preclude testimony regarding the parties’ intention to alter the final purchase price
by executing a Settlement Statement, after the execution of the Sale Agreement, which omitted
the Escrow Account Credit.
The cases cited by Hampden are not to the contrary as each involved the admissibility of prior
negotiations to demonstrate misrepresentations made in the inducement of the contract. As
example, the court in [Citation], held that “[i]f a party contends that a writing is not an accurate
expression of the agreement between the parties, and that certain provisions were omitted
therefrom, the parol evidence rule does not apply.” (Permitting the introduction of parol
evidence to establish that the contract omitted provisions which appellees represented would be
included in the writing).…
The District Court further held that the integration clause contained in the written contract
supports the conclusion that the Settlement Statement, which mentioned neither the Escrow
Account Credit nor that it was amending the Sale Agreement, is not a modification of the Sale
Agreement. The Court explained that the outcome might be different if the Settlement
Statement mentioned “the escrow credit but provided different details, but as the [Settlement
Statement] in this case simply ignored the escrow credit, and both parties agree that there were
Saylor URL: http://www.saylor.org/books

Saylor.org
485

no oral discussions regarding the escrow credit, the [Settlement Statement] cannot be said to
modify the escrow credit provision in the Agreement of Sale.” We disagree.
It is well-settled law in Pennsylvania that a “written contract which is not for the sale of goods
may be modified orally, even when the contract provides that modifications may only be made
in writing.” [Citition] “The modification may be accomplished either by words or conduct,”
[Citation] demonstrating that the parties intended to waive the requirement that amendments
be made in writing. [Citation] An oral modification of a written contract must be proven by
“clear, precise and convincing evidence.” [Citation] Viewing the evidence in the light most
favorable to Metropolitan, we find that the District Court erred in concluding that there was
insufficient evidence in the record to raise a genuine issue of material fact as to whether the
parties intended to orally modify the Sale Agreement. Metropolitan introduced a Settlement
Statement which omitted the Escrow Account Credit, while listing all other debits and credits
and submitted an affidavit from its President who “reviewed the Draft Settlement Statement and
understood that the Escrow Account Credit had been omitted as part of the ongoing negotiations
between the parties concerning the amount of the credit to which Metropolitan was entitled”
due to the poor condition of the property.
Accordingly, the District Court erred in granting summary judgment in favor of Hampden. At a
minimum, there was a triable issue of fact concerning whether the Settlement Statement was
intended to modify the prior written Sale Agreement and serve as the final and binding
manifestation of the purchase price. Specifically, whether the parties intended to exclude the
Escrow Account Credit from the purchase price as part of the negotiations to address
Hampden’s failure to maintain the property.
[Reversed and remanded.]

CASE QUESTIONS

1. The contract had an integration clause. Why didn’t that bar admission of the subsequent oral
modification to the contract?
2. What rule of law was the plaintiff relying on in support of its contention that the original
agreement should stand?

Saylor URL: http://www.saylor.org/books

Saylor.org
486

3. What rule of law was the defendant relying on in support of its contention that the original
agreement had been modified?
4. According to the defendant, how had the original agreement been modified, and why?

13.5 Summary and Exercises
Summary

In an economic system mostly governed by contract, parties may not only make the kinds of
deals they wish but may make them in any form they wish—with some significant exceptions.
The most significant issue of form in contract law is whether the contract must be written or
may be oral and still be enforceable. The question can be answered by paying close attention to
the Statute of Frauds and court decisions interpreting it. In general, as we have seen, the
following types of contracts must be in writing: interests in real property, promises to pay the
debt of another, certain agreements of executors and administrators, performances that cannot
be completed within one year, sale of goods for $500 or more, and sale of securities. There are
exceptions to all these rules.
Another significant rule that permeates contract law is the parol evidence rule: prior statements,
agreements, or promises, whether oral or written, made during the negotiation process are often
discharged by a subsequent written agreement. No matter what you were promised before you
signed on the dotted line, you are stuck if you sign an integrated agreement without the promise.
Again, of course, exceptions lie in wait for the unwary: Is the agreement only partially
integrated? Are there grounds to invalidate the entire agreement? Is the contract subject to an
oral condition? Is a fact recited in the contract untrue?
Contracts are not always clear and straightforward. Often they are murky and ambiguous.
Interpreting them when the parties disagree is for the courts. To aid them in the task, the courts
over the years have developed a series of guidelines such as these: Does the agreement have a
plain meaning on its face? If there is an ambiguity, against whom should it be construed? Are
there usages of trade or courses of dealing or performance that would help explain the terms?

EXERCISES

1. Plaintiff’s and Defendant’s cars crashed. Plaintiff hired an attorney, who negotiated with
Defendant’s insurance adjuster. Plaintiff’s attorney claimed he and the adjuster reached an
Saylor URL: http://www.saylor.org/books

Saylor.org
487

oral settlement, but the insurance company refused to honor it and filed for summary
judgment, raising the Statute of Frauds’ suretyship provision as a defense: a promise by one
person (the insurance company here) to pay the debts of another (the insured) must be
evidenced by some writing, and there was no writing. Is the defense good? Explain.
2. Plaintiff Irma Kozlowski cohabited with Defendant Thaddeus Kozlowski for fifteen years
without marriage. She repeatedly asked him specifically about her financial situation should
he predecease her, and he assured her—she said—that he would arrange to provide for her
for the rest of her life. She had provided the necessary household services and emotional
support to permit him to successfully pursue his business career; she had performed
housekeeping, cleaning, and shopping services and had run the household and raised the
children, her own as well as his. When they separated and she was “literally forced out of the
house,” she was sixty-three years old and had no means or wherewithal for survival. When
she sued, he raised the Statute of Frauds’ one-year rule as a defense. Is the defense good? [1]
3. Carlson purchased a parcel of real estate that was landlocked. Carlson called his neighbor,
Peterson, and asked if he could use an abandoned drive on Peterson’s property to travel to
his (Carlson’s) property from the highway. Peterson said, “Sure, anytime.” Later the two
became engaged in a dispute, and Peterson blocked the drive. May Carlson enforce
Peterson’s promise that he could use the drive “anytime”? Why?
4. Silverman, who was elderly and somewhat disabled, lived alone on a farm. Silverman called
Burch and said, “Burch, if you will move in with me and help me take care of the farm, it will
be yours when I die.” Burch did as Silverman requested and on Silverman’s death two years
later, claimed the farm on the basis of their oral agreement, but the estate resisted. Is Burch
entitled to the farm? Why?
5. On February 12, Sally was hired to manage a company for a period of one year. She reported
for work on February 26 but was fired two weeks later. She sued the owner of the company
for breach of their one-year oral contract. May she recover? Why?
6. Baker entered into an oral contract to sell her car to Clyde for $8,600. She delivered the car
to Clyde; Clyde inspected it, found no problems, kept it for three days, but then refused to
pay and now wants to return the car. Is the contract enforceable? Why?
Saylor URL: http://www.saylor.org/books

Saylor.org
488

7. Wayne, a building contractor, built a new house and offered it for sale. A young couple
accepted the offer, and the parties entered into an oral agreement covering all the terms of
sale. The couple later tried to back out of the agreement. Wayne filed suit, and during the
trial, the couple admitted making the contract. Is the contract enforceable? Why?
8. Plaintiff leased commercial space from Defendant for a florist shop. After the lease was
signed, Plaintiff learned that the county code allowed only one freestanding sign on the
property, and one was already up, advertising Defendant’s business. Plaintiff claimed
Defendant breached the lease by not providing them space for a sign; Defendant pointed to
the lease, paragraph 16 of which provided that “Tenant shall not erect or install any
sign…without written consent of the Landlord.” But Plaintiff claimed Defendant said during
negotiations he could have a sign, evidence Defendant objected to based on the parol
evidence rule. Defendant admitted that during negotiations he told Plaintiff that despite
paragraph 16, he could have a sign (but not freestanding); that despite language in the lease
requiring renovation plans to be in writing, they did not have to be. Defendant also testified
that the written form lease he used was not drafted specifically for this property, and that
although the lease required attachments of exhibits, there were no attachments. Is Plaintiff
barred by the parol evidence rule from showing that Defendant said he could have a
freestanding sign?
9. On March 1, 2010, Milton talked to Harriet and, as Harriet claimed, said, “I will hire you as
sales manager for one year at a salary of $57,000. You start next Monday, March 8.” Harriet
agreed. Four months later Milton discharged Harriet and she sued, claiming breach of
employment contract. Is the alleged contract enforceable?
10. Al Booth’s Inc. sued Boyd-Scarp (a contractor) and James Rathmann for nonpayment
following delivery of various appliances to Rathmann’s new home being built by Boyd-Scarp.
Booth’s was aware that Boyd-Scarp was having financial problems and allegedly contacted
Rathmann prior to delivery, asking him to guarantee payment. Evidence was adduced that
Rathmann orally promised to pay in the event the builder did not and that the goods were
then delivered. Rathmann denied any such promise, raising the Statute of Frauds, and Al
Booth’s sued. Will Al Booth’s prevail?
Saylor URL: http://www.saylor.org/books

Saylor.org
489

SELF-TEST QUESTIONS
1. As a general rule
a.

contracts do not have to be in writing to be enforceable

b. contracts that can be performed in one year must be in writing
c. all oral contracts are unenforceable
d. a suretyship agreement need not be in writing to be enforceable
An exception to the UCC Statute of Frauds provision is
a.

the one-year rule

b. the reply doctrine
c. executor agreements
d. all of the above
Rules that require certain contracts to be in writing are found in
a.

state statutory law

b. the UCC
c. the Statute of Frauds
d. all of the above
The parol evidence rule
a.

applies only when contracts must be in writing

b. does not apply to real estate contracts
c. states that a written contract discharges all prior or contemporaneous promises
that add to, vary, or conflict with it
d. is designed to hold parties to promises they made during negotiations
A merger clause
a.

is required when goods are sold for $500 or more

b. is used when two parcels of real estate are sold in the same contract
c. invalidates a contract for the sale of securities
d. evidences an intention that the written contract is the parties’ full understanding

SELF-TEST ANSWERS

1. a
2. b
Saylor URL: http://www.saylor.org/books

Saylor.org
490

3. d
4. c
5. d

[1] Kozlowski v. Kozlowski, 395 A.2d 913 (N.J. 1978).

Saylor URL: http://www.saylor.org/books

Saylor.org
491

Chapter 14
Third-Party Rights
LEARNING OBJECTIVES

After reading this chapter, you should understand the following:
1. How an assignment of contract rights is made and how it operates
2. What a delegation of duties is and how it operates
3. Under what circumstances a person not a party to a contract can enforce it
To this point, we have focused on the rights and duties of the two parties to the contract. In this
chapter, we turn our attention to contracts in which outsiders acquire rights or duties or both.
Three types of outsiders merit examination:
1. Assignees (outsiders who acquire rights after the contract is made)
2. Delegatees (outsiders who acquire duties after the contract is made)
3. Third-party beneficiaries (outsiders who acquire rights when the original contract is made)

14.1 Assignment of Contract Rights

LEARNING OBJECTIVES

1. Understand what an assignment is and how it is made.
2. Recognize the effect of the assignment.
3. Know when assignments are not allowed.
4. Understand the concept of assignor’s warranties.

The Concept of a Contract Assignment
Contracts create rights and duties. By an assignment, an obligee (one who has the right to
receive a contract benefit) transfers a right to receive a contract benefit owed by the obligor (the
one who has a duty to perform) to a third person (assignee); the obligee then becomes
an assignor (one who makes an assignment).
The Restatement (Second) of Contracts defines an assignment of a right as “a manifestation of
the assignor’s intention to transfer it by virtue of which the assignor’s right to performance by
the obligor is extinguished in whole or in part and the assignee acquires the right to such

Saylor URL: http://www.saylor.org/books

Saylor.org
492

performance.” [1] The one who makes the assignment is both an obligee and a transferor. The
assignee acquires the right to receive the contractual obligations of the promisor, who is referred
to as the obligor (see Figure 14.1 "Assignment of Rights"). The assignor may assign any right
unless (1) doing so would materially change the obligation of the obligor, materially burden him,
increase his risk, or otherwise diminish the value to him of the original contract; (2) statute or
public policy forbids the assignment; or (3) the contract itself precludes assignment. The
common law of contracts and Articles 2 and 9 of the Uniform Commercial Code (UCC) govern
assignments. Assignments are an important part of business financing, such as factoring.
A factor is one who purchases the right to receive income from another.

Figure 14.1 Assignment of Rights

Method of Assignment
Manifesting Assent
To effect an assignment, the assignor must make known his intention to transfer the rights to
the third person. The assignor’s intention must be that the assignment is effective without need
of any further action or any further manifestation of intention to make the assignment. In other
words, the assignor must intend and understand himself to be making the assignment then and
there; he is not promising to make the assignment sometime in the future.
Saylor URL: http://www.saylor.org/books

Saylor.org
493

Under the UCC, any assignments of rights in excess of $5,000 must be in writing, but otherwise,
assignments can be oral and consideration is not required: the assignor could assign the right to
the assignee for nothing (not likely in commercial transactions, of course). Mrs. Franklin has the
right to receive $750 a month from the sale of a house she formerly owned; she assigns the right
to receive the money to her son Jason, as a gift. The assignment is good, though such a
gratuitous assignment is usually revocable, which is not the case where consideration has been
paid for an assignment.

Acceptance and Revocation
For the assignment to become effective, the assignee must manifest his acceptance under most
circumstances. This is done automatically when, as is usually the case, the assignee has given
consideration for the assignment (i.e., there is a contract between the assignor and the assignee
in which the assignment is the assignor’s consideration), and then the assignment is not
revocable without the assignee’s consent. Problems of acceptance normally arise only when the
assignor intends the assignment as a gift. Then, for the assignment to be irrevocable, either the
assignee must manifest his acceptance or the assignor must notify the assignee in writing of the
assignment.

Notice
Notice to the obligor is not required, but an obligor who renders performance to the assignor
without notice of the assignment (that performance of the contract is to be rendered now to the
assignee) is discharged. Obviously, the assignor cannot then keep the consideration he has
received; he owes it to the assignee. But if notice is given to the obligor and she performs to the
assignor anyway, the assignee can recover from either the obligor or the assignee, so the obligor
could have to perform twice, as in Exercise 2 at the chapter’s end, Aldana v. Colonial Palms
Plaza. Of course, an obligor who receives notice of the assignment from the assignee will want to
be sure the assignment has really occurred. After all, anybody could waltz up to the obligor and
say, “I’m the assignee of your contract with the bank. From now on, pay me the $500 a month,
not the bank.” The obligor is entitled to verification of the assignment.

Effect of Assignment
General Rule
Saylor URL: http://www.saylor.org/books

Saylor.org
494

An assignment of rights effectively makes the assignee stand in the shoes of the assignor. He
gains all the rights against the obligor that the assignor had, but no more. An obligor who could
avoid the assignor’s attempt to enforce the rights could avoid a similar attempt by the assignee.
Likewise, under UCC Section 9-318(1), the assignee of an account is subject to all terms of the
contract between the debtor and the creditor-assignor. Suppose Dealer sells a car to Buyer on a
contract where Buyer is to pay $300 per month and the car is warranted for 50,000 miles. If the
car goes on the fritz before then and Dealer won’t fix it, Buyer could fix it for, say, $250 and
deduct that $250 from the amount owed Dealer on the next installment (called a setoff). Now, if
Dealer assigns the contract to Assignee, Assignee stands in Dealer’s shoes, and Buyer could
likewise deduct the $250 from payment to Assignee.

Exceptions
The “shoe rule” does not apply to two types of assignments. First, it is inapplicable to the sale of
a negotiable instrument to a holder in due course. Second, the rule may be waived: under the
UCC and at common law, the obligor may agree in the original contract not to raise defenses
against the assignee that could have been raised against the assignor. [2] While
a waiver of defenses makes the assignment more marketable from the assignee’s point of view, it
is a situation fraught with peril to an obligor, who may sign a contract without understanding
the full import of the waiver. Under the waiver rule, for example, a farmer who buys a tractor on
credit and discovers later that it does not work would still be required to pay a credit company
that purchased the contract; his defense that the merchandise was shoddy would be unavailing
(he would, as used to be said, be “having to pay on a dead horse”).
For that reason, there are various rules that limit both the holder in due course and the waiver
rule. Certain defenses, the so-called real defenses (infancy, duress, and fraud in the execution,
among others), may always be asserted. Also, the waiver clause in the contract must have been
presented in good faith, and if the assignee has actual notice of a defense that the buyer or lessee
could raise, then the waiver is ineffective. Moreover, in consumer transactions, the UCC’s rule is
subject to state laws that protect consumers (people buying things used primarily for personal,
family, or household purposes), and many states, by statute or court decision, have made
waivers of defenses ineffective in such consumer transactions. Federal Trade Commission
Saylor URL: http://www.saylor.org/books

Saylor.org
495

regulations also affect the ability of many sellers to pass on rights to assignees free of defenses
that buyers could raise against them. Because of these various limitations on the holder in due
course and on waivers, the “shoe rule” will not govern in consumer transactions and, if there are
real defenses or the assignee does not act in good faith, in business transactions as well.

When Assignments Are Not Allowed
The general rule—as previously noted—is that most contract rights are assignable. But there are
exceptions. Five of them are noted here.

Material Change in Duties of the Obligor
When an assignment has the effect of materially changing the duties that the obligor must
perform, it is ineffective. Changing the party to whom the obligor must make a payment is not a
material change of duty that will defeat an assignment, since that, of course, is the purpose
behind most assignments. Nor will a minor change in the duties the obligor must perform defeat
the assignment.
Several residents in the town of Centerville sign up on an annual basis with the
Centerville Times to receive their morning paper. A customer who is moving out of town may
assign his right to receive the paper to someone else within the delivery route. As long as the
assignee pays for the paper, the assignment is effective; the only relationship the obligor has to
the assignee is a routine delivery in exchange for payment. Obligors can consent in the original
contract, however, to a subsequent assignment of duties. Here is a clause from the World Team
Tennis League contract: “It is mutually agreed that the Club shall have the right to sell, assign,
trade and transfer this contract to another Club in the League, and the Player agrees to accept
and be bound by such sale, exchange, assignment or transfer and to faithfully perform and carry
out his or her obligations under this contract as if it had been entered into by the Player and
such other Club.” Consent is not necessary when the contract does not involve a personal
relationship.

Assignment of Personal Rights
When it matters to the obligor who receives the benefit of his duty to perform under the
contract, then the receipt of the benefit is a personal right that cannot be assigned. For example,
a student seeking to earn pocket money during the school year signs up to do research work for
Saylor URL: http://www.saylor.org/books

Saylor.org
496

a professor she admires and with whom she is friendly. The professor assigns the contract to one
of his colleagues with whom the student does not get along. The assignment is ineffective
because it matters to the student (the obligor) who the person of the assignee is. An insurance
company provides auto insurance covering Mohammed Kareem, a sixty-five-year-old man who
drives very carefully. Kareem cannot assign the contract to his seventeen-year-old grandson
because it matters to the insurance company who the person of its insured is. Tenants usually
cannot assign (sublet) their tenancies without the landlord’s permission because it matters to
the landlord who the person of their tenant is. Section 14.4.1 "Nonassignable Rights", Nassau
Hotel Co. v. Barnett & Barse Corp., is an example of the nonassignability of a personal right.

Assignment Forbidden by Statute or Public Policy
Various federal and state laws prohibit or regulate some contract assignment. The assignment of
future wages is regulated by state and federal law to protect people from improvidently denying
themselves future income because of immediate present financial difficulties. And even in the
absence of statute, public policy might prohibit some assignments.

Contracts That Prohibit Assignment
Assignability of contract rights is useful, and prohibitions against it are not generally favored.
Many contracts contain general language that prohibits assignment of rights or of “the contract.”
Both the Restatement and UCC Section 2-210(3) declare that in the absence of any contrary
circumstances, a provision in the agreement that prohibits assigning “the contract” bars “only
the delegation to the assignee of the assignor’s performance.” [3] In other words, unless the
contract specifically prohibits assignment of any of its terms, a party is free to assign anything
except his or her own duties.
Even if a contractual provision explicitly prohibits it, a right to damages for breach of the whole
contract is assignable under UCC Section 2-210(2) in contracts for goods. Likewise, UCC Section
9-318(4) invalidates any contract provision that prohibits assigning sums already due or to
become due. Indeed, in some states, at common law, a clause specifically prohibiting assignment
will fail. For example, the buyer and the seller agree to the sale of land and to a provision barring
assignment of the rights under the contract. The buyer pays the full price, but the seller refuses
to convey. The buyer then assigns to her friend the right to obtain title to the land from the
Saylor URL: http://www.saylor.org/books

Saylor.org
497

seller. The latter’s objection that the contract precludes such an assignment will fall on deaf ears
in some states; the assignment is effective, and the friend may sue for the title.

Future Contracts
The law distinguishes between assigning future rights under an existing contract and assigning
rights that will arise from a future contract. Rights contingent on a future event can be assigned
in exactly the same manner as existing rights, as long as the contingent rights are already
incorporated in a contract. Ben has a long-standing deal with his neighbor, Mrs. Robinson, to
keep the latter’s walk clear of snow at twenty dollars a snowfall. Ben is saving his money for a
new printer, but when he is eighty dollars shy of the purchase price, he becomes impatient and
cajoles a friend into loaning him the balance. In return, Ben assigns his friend the earnings from
the next four snowfalls. The assignment is effective. However, a right that will arise from a
future contract cannot be the subject of a present assignment.

Partial Assignments
An assignor may assign part of a contractual right, but only if the obligor can perform that part
of his contractual obligation separately from the remainder of his obligation. Assignment of part
of a payment due is always enforceable. However, if the obligor objects, neither the assignor nor
the assignee may sue him unless both are party to the suit. Mrs. Robinson owes Ben one
hundred dollars. Ben assigns fifty dollars of that sum to his friend. Mrs. Robinson is perplexed
by this assignment and refuses to pay until the situation is explained to her satisfaction. The
friend brings suit against Mrs. Robinson. The court cannot hear the case unless Ben is also a
party to the suit. This ensures all parties to the dispute are present at once and avoids multiple
lawsuits.

Successive Assignments
It may happen that an assignor assigns the same interest twice (see Figure 14.2 "Successive
Assignments"). With certain exceptions, the first assignee takes precedence over any subsequent
assignee. One obvious exception is when the first assignment is ineffective or revocable. A
subsequent assignment has the effect of revoking a prior assignment that is ineffective or
revocable. Another exception: if in good faith the subsequent assignee gives consideration for
the assignment and has no knowledge of the prior assignment, he takes precedence whenever he
Saylor URL: http://www.saylor.org/books

Saylor.org
498

obtains payment from, performance from, or a judgment against the obligor, or whenever he
receives some tangible evidence from the assignor that the right has been assigned (e.g., a bank
deposit book or an insurance policy).
Some states follow the different English rule: the first assignee to give notice to the obligor has
priority, regardless of the order in which the assignments were made. Furthermore, if the
assignment falls within the filing requirements of UCC Article 9, the first assignee to file will
prevail.

Figure 14.2 Successive Assignments

Assignor’s Warranties
An assignor has legal responsibilities in making assignments. He cannot blithely assign the same
interests pell-mell and escape liability. Unless the contract explicitly states to the contrary, a
person who assigns a right for value makes certainassignor’s warranties to the assignee: that he
will not upset the assignment, that he has the right to make it, and that there are no defenses
that will defeat it. However, the assignor does not guarantee payment; assignment does not by
itself amount to a warranty that the obligor is solvent or will perform as agreed in the original
contract. Mrs. Robinson owes Ben fifty dollars. Ben assigns this sum to his friend. Before the
friend collects, Ben releases Mrs. Robinson from her obligation. The friend may sue Ben for the
fifty dollars. Or again, if Ben represents to his friend that Mrs. Robinson owes him (Ben) fifty
dollars and assigns his friend that amount, but in fact Mrs. Robinson does not owe Ben that
Saylor URL: http://www.saylor.org/books

Saylor.org
499

much, then Ben has breached his assignor’s warranty. The assignor’s warranties may be express
or implied.

KEY TAKEAWAY

Generally, it is OK for an obligee to assign the right to receive contractual performance from
the obligor to a third party. The effect of the assignment is to make the assignee stand in the
shoes of the assignor, taking all the latter’s rights and all the defenses against
nonperformance that the obligor might raise against the assignor. But the obligor may agree
in advance to waive defenses against the assignee, unless such waiver is prohibited by law.
There are some exceptions to the rule that contract rights are assignable. Some, such as
personal rights, are not circumstances where the obligor’s duties would materially change,
cases where assignability is forbidden by statute or public policy, or, with some limits, cases
where the contract itself prohibits assignment. Partial assignments and successive
assignments can happen, and rules govern the resolution of problems arising from them.
When the assignor makes the assignment, that person makes certain warranties, express or
implied, to the assignee, basically to the effect that the assignment is good and the assignor
knows of no reason why the assignee will not get performance from the obligor.

EXERCISES

1. If Able makes a valid assignment to Baker of his contract to receive monthly rental payments
from Tenant, how is Baker’s right different from what Able’s was?
2. Able made a valid assignment to Baker of his contract to receive monthly purchase payments
from Carr, who bought an automobile from Able. The car had a 180-day warranty, but the car
malfunctioned within that time. Able had quit the auto business entirely. May Carr withhold
payments from Baker to offset the cost of needed repairs?
3. Assume in the case in Exercise 2 that Baker knew Able was selling defective cars just before
his (Able’s) withdrawal from the auto business. How, if at all, does that change Baker’s
rights?
4. Why are leases generally not assignable? Why are insurance contracts not assignable?

Saylor URL: http://www.saylor.org/books

Saylor.org
500

[1] Restatement (Second) of Contracts, Section 317(1).
[2] Uniform Commercial Code, Section 9-206.
[3] Restatement (Second) of Contracts, Section 322.

14.2 Delegation of Duties

LEARNING OBJECTIVES

1. Know what a delegation of duty is.
2. Recognize how liability remains on the delegator following a delegation.
3. Understand what duties may not be delegated.

Basic Rules Regarding Delegation
General Rule
To this point, we have been considering the assignment of the assignor’s rights (usually, though
not solely, to money payments). But in every contract, a right connotes a corresponding duty,
and these may be delegated. A delegation is the transfer to a third party of the duty to perform
under a contract. The one who delegates is thedelegator. Because most obligees are also
obligors, most assignments of rights will simultaneously carry with them the delegation of
duties. Unless public policy or the contract itself bars the delegation, it is legally enforceable.
In most states, at common law, duties must be expressly delegated. Under Uniform Commercial
Code (UCC) Section 2-210(4) and in a minority of states at common law (as illustrated
in Section 14.4.2 "Assignment Includes Delegation", Rose v. Vulcan Materials Co.), an
assignment of “the contract” or of “all my rights under the contract” is not only an assignment of
rights but also a delegation of duties to be performed; by accepting the assignment,
the delegatee (one to whom the delegation is made) implies a promise to perform the duties.
(See Figure 14.3 "Delegation of Duties")

Saylor URL: http://www.saylor.org/books

Saylor.org
501

Figure 14.3 Delegation of Duties

Effect on Obligor
An obligor who delegates a duty (and becomes a delegator) does not thereby escape liability for
performing the duty himself. The obligee of the duty may continue to look to the obligor for
performance unless the original contract specifically provides for substitution by delegation.
This is a big difference between assignment of contract rights and delegation of contract duties:
in the former, the assignor is discharged (absent breach of assignor’s warranties); in the latter,
the delegator remains liable. The obligee (again, the one to whom the duty to perform flows)
may also, in many cases, look to the delegatee, because the obligee becomes an intended
beneficiary of the contract between the obligor and the delegatee, as discussed in Section 14.3
"Third-Party Beneficiaries". Of course, the obligee may subsequently agree to accept the
delegatee and discharge the obligor from any further responsibility for performing the duty. A
contract among three persons having this effect is called a novation; it is a new contract. Fred
sells his house to Lisa, who assumes his mortgage. Fred, in other words, has delegated the duty
to pay the bank to Lisa. If Lisa defaults, Fred continues to be liable to the bank, unless in the
Saylor URL: http://www.saylor.org/books

Saylor.org
502

original mortgage agreement a provision specifically permitted any purchaser to be substituted
without recourse to Fred, or unless the bank subsequently accepts Lisa and discharges Fred.

Nondelegable Duties
Personal Services
Personal services are not delegable. If the contract is such that the promisee expects the obligor
personally to perform the duty, the obligor may not delegate it. Suppose the Catskill Civic Opera
Association hires a famous singer to sing in its production ofCarmen and the singer delegates
the job to her understudy. The delegation is ineffective, and performance by the understudy
does not absolve the famous singer of liability for breach.
Many duties may be delegated, however. Indeed, if they could not be delegated, much of the
world’s work would not get done. If you hire a construction company and an architect to design
and build your house to certain specifications, the contractor may in turn hire individual
craftspeople—plumbers, electricians, and the like—to do these specialized jobs, and as long as
they are performed to specification, the contract terms will have been met. If you hired an
architecture firm, though, you might not be contracting for the specific services of a particular
individual in that firm.

Public Policy
Public policy may prohibit certain kinds of delegations. A public official, for example, may not
delegate the duties of her office to private citizens, although various statutes generally permit
the delegation of duties to her assistants and subordinates.

Delegations Barred by Contract
As we have already noted, the contract itself may bar assignment. The law generally disfavors
restricting the right to assign a benefit, but it will uphold a contract provision that prohibits
delegation of a duty. Thus, as we have seen, UCC Section 2-210(3) states that in a contract for
sale of goods, a provision against assigning “the contract” is to be construed only as a
prohibition against delegating the duties.

KEY TAKEAWAY

Saylor URL: http://www.saylor.org/books

Saylor.org
503

The duty to perform a contractual obligation may usually be delegated to a third party. Such
delegation, however, does not discharge the delegator, who remains liable on the contract
absent a novation.
Some duties may not be delegated: personal services cannot be, and public policy or the
contract itself may bar delegation.

EXERCISES

1. What is the difference between an assignment and a delegation?
2. Under what circumstances is the delegator discharged from liability on the contract?

14.3 Third-Party Beneficiaries

LEARNING OBJECTIVES

1. Know what a third-party beneficiary is, and what the types of such beneficiaries are.
2. Recognize the rights obtained by third-party beneficiaries.
3. Understand when the public might be a third-party beneficiary of government contracts.
The fundamental issue with third-party beneficiaries gets to this: can a person who is not a party
to a contract sue to enforce its terms?

The General Rule
The general rule is this: persons not a party to a contract cannot enforce its terms; they are said
to lack privity, a private, face-to-face relationship with the contracting parties. But if the persons
are intended to benefit from the performance of a contract between others, then they can
enforce it: they are intended beneficiaries.

Two Types of Third-Party Beneficiaries
In the vocabulary of the Restatement, a third person whom the parties to the contract intend to
benefit is an intended beneficiary—that is, one who is entitled under the law of contracts to
assert a right arising from a contract to which he or she is not a party. There are two types of
intended beneficiaries.

Creditor Beneficiary
A creditor beneficiary is one to whom the promisor agrees to pay a debt of the promisee. For
example, a father is bound by law to support his child. If the child’s uncle (the promisor)
contracts with the father (the promisee) to furnish support for the child, the child is a creditor
Saylor URL: http://www.saylor.org/books

Saylor.org
504

beneficiary and could sue the uncle. Or again, suppose Customer pays Ace Dealer for a new car,
and Ace delegates the duty of delivery to Beta Dealer. Ace is now a debtor: he owes Customer
something: a car. Customer is a creditor; she is owed something: a car. When Beta performs
under his delegated contract with Ace, Beta is discharging the debt Ace owes to Customer.
Customer is a creditor beneficiary of Dealers’ contract and could sue either one for nondelivery.
She could sue Ace because she made a contract with him, and she could sue Beta because—
again—she was intended to benefit from the performance of Dealers’ agreement.

Donee Beneficiary
The second type of intended beneficiary is a donee beneficiary. When the promisee is not
indebted to the third person but intends for him or her to have the benefit of the promisor’s
performance, the third person is a donee beneficiary (and the promise is sometimes called a gift
promise). For example, an insurance company (the promisor) promises to its policyholder (the
promisee), in return for a premium, to pay $100,000 to his wife on his death; this makes the
wife a donee beneficiary (see Figure 14.1 "Assignment of Rights"). The wife could sue to enforce
the contract although she was not a party to it. Or if Able makes a contract with Woodsman for
the latter to cut the trees in Able’s backyard as a Christmas gift to Able’s uphill Neighbor (so that
Neighbor will have a view), Neighbor could sue Woodsman for breach of the contract.
If a person is not an intended beneficiary—not a creditor or donee beneficiary—then he or she is
said to be only an incidental beneficiary, and that person has no rights. So if Able makes the
contract with Woodsman not to benefit Neighbor but for Able’s own benefit, the fact that the
tree removal would benefit Neighbor does not make Neighbor an intended beneficiary.
The beneficiary’s rights are always limited by the terms of the contract. A failure by the promisee
to perform his part of the bargain will terminate the beneficiary’s rights if the promisee’s lapse
terminates his own rights, absent language in the contract to the contrary. If Able makes the
contract as a gift to Neighbor but doesn’t make the required down payment to Woodsman,
Neighbor’s claim fails. In a suit by the beneficiary, the promisor may avail himself of any defense
he could have asserted against the promisee. Woodsman may defend himself against Neighbor’s
claim that Woodsman did not do the whole job by showing that Able didn’t make full payment
for the work.
Saylor URL: http://www.saylor.org/books

Saylor.org
505

Modification of the Beneficiary’s Rights
Conferring rights on an intended beneficiary is relatively simple. Whether his rights can be
modified or extinguished by subsequent agreement of the promisor and promisee is a more
troublesome issue. The general rule is that the beneficiary’s rights may be altered as long as
there has been no vesting of rights (the rights have not taken effect). The time at which the
beneficiary’s rights vest differs among jurisdictions: some say immediately, some say when the
beneficiary assents to the receipt of the contract right, some say the beneficiary’s rights don’t
vest until she has detrimentally relied on the right. The Restatement says that unless the
contract provides that its terms cannot be changed without the beneficiary’s consent, the parties
may change or rescind the benefit unless the beneficiary has sued on the promise, has
detrimentally relied, or has assented to the promise at the request of one of the parties. [1] Some
contracts provide that the benefit never vests; for example, standard insurance policies today
reserve to the insured the right to substitute beneficiaries, to borrow against the policy, to assign
it, and to surrender it for cash.

Government Contracts
The general rule is that members of the public are only incidental beneficiaries of contracts
made by the government with a contractor to do public works. It is not illogical to see a contract
between the government and a company pledged to perform a service on behalf of the public as
one creating rights in particular members of the public, but the consequences of such a view
could be extremely costly because everyone has some interest in public works and government
services.
A restaurant chain, hearing that the county was planning to build a bridge that would reroute
commuter traffic, might decide to open a restaurant on one side of the bridge; if it let contracts
for construction only to discover that the bridge was to be delayed or canceled, could it sue the
county’s contractor? In general, the answer is that it cannot. A promisor under contract to the
government is not liable for the consequential damages to a member of the public arising from
its failure to perform (or from a faulty performance) unless the agreement specifically calls for
such liability or unless the promisee (the government) would itself be liable and a suit directly
against the promisor would be consistent with the contract terms and public policy. When the
Saylor URL: http://www.saylor.org/books

Saylor.org
506

government retains control over litigation or settlement of claims, or when it is easy for the
public to insure itself against loss, or when the number and amount of claims would be
excessive, the courts are less likely to declare individuals to be intended beneficiaries. But the
service to be provided can be so tailored to the needs of particular persons that it makes sense to
view them as intended beneficiaries—in the case, for example, of a service station licensed to
perform emergency road repairs, as in Section 14.4.3 "Third party Beneficiaries and Foreseeable
Damages", Kornblut v. Chevron Oil Co.

KEY TAKEAWAY

Generally, a person who is not a party to a contract cannot sue to enforce its terms. The
exception is if the person is an intended beneficiary, either a creditor beneficiary or a donee
beneficiary. Such third parties can enforce the contract made by others but only get such
rights as the contract provides, and beneficiaries are subject to defenses that could be made
against their benefactor.
The general rule is that members of the public are not intended beneficiaries of contracts
made by the government, but only incidental beneficiaries.

EXERCISES

1. What are the two types of intended beneficiaries?
2. Smith contracted to deliver a truck on behalf of Truck Sales to Byers, who had purchased it
from Truck Sales. Smith was entitled to payment by Byers for the delivery. The truck was
defective. May Byers withhold payment from Smith to offset the repair costs?
3. Why is the public not usually considered an intended beneficiary of contracts made by the
government?

[1] Restatement (Second) of Contracts, Section 311.

14.4 Cases
Nonassignable Rights
Nassau Hotel Co. v. Barnett & Barse Corporation
Saylor URL: http://www.saylor.org/books

Saylor.org
507

147 N.Y.S. 283 (1914)
McLaughlin, J.
Plaintiff owns a hotel at Long Beach, L. I., and on the 21st of November, 1912, it entered into a
written agreement with the individual defendants Barnett and Barse to conduct the same for a
period of years.…Shortly after this agreement was signed, Barnett and Barse organized the
Barnett & Barse Corporation with a capital stock of $10,000, and then assigned the agreement
to it. Immediately following the assignment, the corporation went into possession and assumed
to carry out its terms. The plaintiff thereupon brought this action to cancel the agreement and to
recover possession of the hotel and furniture therein, on the ground that the agreement was not
assignable. [Summary judgment in favor of the plaintiff, defendant corporation appeals.]
The only question presented is whether the agreement was assignable. It provided, according to
the allegations of the complaint, that the plaintiff leased the property to Barnett and Barse with
all its equipment and furniture for a period of three years, with a privilege of five successive
renewals of three years each. It expressly provided:
‘That said lessees…become responsible for the operation of the said hotel and for the upkeep and
maintenance thereof and of all its furniture and equipment in accordance with the terms of this
agreement and the said lessees shall have the exclusive possession, control and management
thereof. * * * The said lessees hereby covenant and agree that they will operate the said hotel at
all times in a first-class business-like manner, keep the same open for at least six (6) months of
each year, * * *’ and ‘in lieu of rental the lessor and lessees hereby covenant and agree that the
gross receipts of such operation shall be, as received, divided between the parties hereto as
follows: (a) Nineteen per cent. (19%) to the lessor. * * * In the event of the failure of the lessees
well and truly to perform the covenants and agreements herein contained,’ they should be liable
in the sum of $50,000 as liquidated damages. That ‘in consideration and upon condition that
the said lessees shall well and faithfully perform all the covenants and agreements by them to be
performed without evasion or delay the said lessor for itself and its successors, covenants and
agrees that the said lessees, their legal representatives and assigns may at all times during said
term and the renewals thereof peaceably have and enjoy the said demised premises.’ And that

Saylor URL: http://www.saylor.org/books

Saylor.org
508

‘this agreement shall inure to the benefit of and bind the respective parties hereto, their personal
representatives, successors and assigns.’
The complaint further alleges that the agreement was entered into by plaintiff in reliance upon
the financial responsibility of Barnett and Barse, their personal character, and especially the
experience of Barnett in conducting hotels; that, though he at first held a controlling interest in
the Barnett & Barse Corporation, he has since sold all his stock to the defendant Barse, and has
no interest in the corporation and no longer devotes any time or attention to the management or
operation of the hotel.
…[C]learly…the agreement in question was personal to Barnett and Barse and could not be
assigned by them without the plaintiff’s consent. By its terms the plaintiff not only entrusted
them with the care and management of the hotel and its furnishings—valued, according to the
allegations of the complaint, at more than $1,000,000—but agreed to accept as rental or
compensation a percentage of the gross receipts. Obviously, the receipts depended to a large
extent upon the management, and the care of the property upon the personal character and
responsibility of the persons in possession. When the whole agreement is read, it is apparent
that the plaintiff relied, in making it, upon the personal covenants of Barnett and Barse. They
were financially responsible. As already said, Barnett had had a long and successful experience
in managing hotels, which was undoubtedly an inducing cause for plaintiff’s making the
agreement in question and for personally obligating them to carry out its terms.
It is suggested that because there is a clause in the agreement to the effect that it should ‘inure to
the benefit of and bind the respective parties hereto, their personal representatives and assigns,’
that Barnett and Barse had a right to assign it to the corporation. But the intention of the parties
is to be gathered, not from one clause, but from the entire instrument [Citation] and when it is
thus read it clearly appears that Barnett and Barse were to personally carry out the terms of the
agreement and did not have a right to assign it. This follows from the language used, which
shows that a personal trust or confidence was reposed by the plaintiff in Barnett and Barse when
the agreement was made.

Saylor URL: http://www.saylor.org/books

Saylor.org
509

In [Citation] it was said: “Rights arising out of contract cannot be transferred if they…involve a
relation of personal confidence such that the party whose agreement conferred those rights must
have intended them to be exercised only by him in whom he actually confided.”
This rule was applied in [Citation] the court holding that the plaintiff—the assignee—was not
only technically, but substantially, a different entity from its predecessor, and that the defendant
was not obliged to entrust its money collected on the sale of the presses to the responsibility of
an entirely different corporation from that with which it had contracted, and that the contract
could not be assigned to the plaintiff without the assent of the other party to it.
The reason which underlies the basis of the rule is that a party has the right to the benefit
contemplated from the character, credit, and substance of him with whom he contracts, and in
such case he is not bound to recognize…an assignment of the contract.
The order appealed from, therefore, is affirmed.

CASE QUESTIONS

1. The corporation created to operate the hotel was apparently owned and operated by the
same two men the plaintiff leased the hotel to in the first place. What objection would the
plaintiff have to the corporate entity—actually, of course, a legal fiction—owning and
operating the hotel?
2. The defendants pointed to the clause about the contract inuring to the benefit of the parties
“and assigns.” So the defendants assigned the contract. How could that not be allowed by
the contract’s own terms?
3. What is the controlling rule of law upon which the outcome here depends?

Assignment Includes Delegation
Rose v. Vulcan Materials Co.
194 S.E.2d 521 (N.C. 1973)
Huskins, J.
…Plaintiff [Rose], after leasing his quarry to J. E. Dooley and Son, Inc., promised not to engage
in the rock-crushing business within an eight-mile radius of [the city of] Elkin for a period of ten
years. In return for this promise, J. E. Dooley and Son, Inc., promised, among other things, to

Saylor URL: http://www.saylor.org/books

Saylor.org
510

furnish plaintiff stone f.o.b. the quarry site at Cycle, North Carolina, at stipulated prices for ten
years.…
By a contract effective 23 April 1960, Vulcan Materials Company, a corporation…, purchased the
stone quarry operations and the assets and obligations of J. E. Dooley and Son, Inc.…[Vulcan
sent Rose a letter, part of which read:]
Mr. Dooley brought to us this morning the contracts between you and his companies,
copies of which are attached. This is to advise that Vulcan Materials Company
assumes all phases of these contracts and intends to carry out the conditions of these
contracts as they are stated.
In early 1961 Vulcan notified plaintiff that it would no longer sell stone to him at the prices set
out in [the agreement between Rose and Dooley] and would thereafter charge plaintiff the same
prices charged all of its other customers for stone. Commencing 11 May 1961, Vulcan raised
stone prices to the plaintiff to a level in excess of the prices specified in [the Rose-Dooley
agreement].
At the time Vulcan increased the prices of stone to amounts in excess of those specified in [the
Rose-Dooley contract], plaintiff was engaged in his ready-mix cement business, using large
quantities of stone, and had no other practical source of supply. Advising Vulcan that he
intended to sue for breach of contract, he continued to purchase stone from Vulcan under
protest.…
The total of these amounts over and above the prices specified in [the Rose-Dooley contract] is
$25,231.57, [about $152,000 in 2010 dollars] and plaintiff seeks to recover said amount in this
action.
The [Rose-Dooley] agreement was an executory bilateral contract under which plaintiff’s
promise not to compete for ten years gained him a ten-year option to buy stone at specified
prices. In most states, the assignee of an executory bilateral contract is not liable to anyone for
the nonperformance of the assignor’s duties thereunder unless he expressly promises his
assignor or the other contracting party to perform, or ‘assume,’ such duties.…These states refuse
to imply a promise to perform the duties, but if the assignee expressly promises his assignor to
perform, he is liable to the other contracting party on a third-party beneficiary theory. And, if
Saylor URL: http://www.saylor.org/books

Saylor.org
511

the assignee makes such a promise directly to the other contracting party upon a consideration,
of course he is liable to him thereon. [Citation]
A minority of states holds that the assignee of an executory bilateral contract under a general
assignment becomes not only assignee of the rights of the assignor but also delegatee of his
duties; and that, absent a showing of contrary intent, the assignee impliedly promises the
assignor that he will perform the duties so delegated. This rule is expressed in Restatement,
Contracts, s 164 (1932) as follows:
(1) Where a party under a bilateral contract which is at the time wholly or partially
executory on both sides purports to assign the whole contract, his action is
interpreted, in the absence of circumstances showing a contrary intention, as an
assignment of the assignor’s rights under the contract and a delegation of the
performance of the assignor’s duties.
(2) Acceptance by the assignee of such an assignment is interpreted, in the absence of
circumstances showing a contrary intention, as both an assent to become an assignee
of the assignor’s rights and as a promise to the assignor to assume the
performance of the assignor’s duties.’ (emphasis added)
We…adopt the Restatement rule and expressly hold that the assignee under a general
assignment of an executory bilateral contract, in the absence of circumstances showing a
contrary intention, becomes the delegatee of his assignor’s duties and impliedly promises his
assignor that he will perform such duties.
The rule we adopt and reaffirm here is regarded as the more reasonable view by legal scholars
and textwriters. Professor Grismore says:
It is submitted that the acceptance of an assignment in this form does presumptively
import a tacit promise on the part of the assignee to assume the burdens of the
contract, and that this presumption should prevail in the absence of the clear showing
of a contrary intention. The presumption seems reasonable in view of the evident
expectation of the parties. The assignment on its face indicates an intent to do more
than simply to transfer the benefits assured by the contract. It purports to transfer
the contract as a whole, and since the contract is made up of both benefits and
Saylor URL: http://www.saylor.org/books

Saylor.org
512

burdens both must be intended to be included.…Grismore, Is the Assignee of a
Contract Liable for the Nonperformance of Delegated Duties? 18 Mich.L.Rev. 284
(1920).
In addition, with respect to transactions governed by the Uniform Commercial Code, an
assignment of a contract in general terms is a delegation of performance of the duties of the
assignor, and its acceptance by the assignee constitutes a promise by him to perform those
duties. Our holding in this case maintains a desirable uniformity in the field of contract liability.
We further hold that the other party to the original contract may sue the assignee as a thirdparty beneficiary of his promise of performance which he impliedly makes to his assignor, under
the rule above laid down, by accepting the general assignment. Younce v. Lumber Co., [Citation]
(1908), holds that where the assignee makes an express promise of performance to his assignor,
the other contracting party may sue him for breach thereof. We see no reason why the same
result should not obtain where the assignee breaches his promise of performance implied under
the rule of Restatement s 164. ‘That the assignee is liable at the suit of the third party where he
expressly assumes and promises to perform delegated duties has already been decided in a few
cases (citing Younce). If an express promise will support such an action it is difficult to see why a
tacit promise should not have the same effect.’ Grismore, supra. Parenthetically, we note that
such is the rule under the Uniform Commercial Code, [2-210].
We now apply the foregoing principles to the case at hand. The contract of 23 April 1960,
between defendant and J. E. Dooley and Son, Inc., under which, as stipulated by the parties, ‘the
defendant purchased the assets and obligations of J. E. Dooley and Son, Inc.,’ was a general
assignment of all the assets and obligations of J. E. Dooley and Son, Inc., including those under
[the Rose-Dooley contract]. When defendant accepted such assignment it thereby became
delegatee of its assignor’s duties under it and impliedly promised to perform such duties.
When defendant later failed to perform such duties by refusing to continue sales of stone to
plaintiff at the prices specified in [the Rose-Dooley contract], it breached its implied promise of
performance and plaintiff was entitled to bring suit thereon as a third-party beneficiary.

Saylor URL: http://www.saylor.org/books

Saylor.org
513

The decision…is reversed with directions that the case be certified to the Superior Court of
Forsyth County for reinstatement of the judgment of the trial court in accordance with this
opinion.

CASE QUESTIONS

1. Why did Rose need the crushed rock from the quarry he originally leased to Dooley?
2. What argument did Vulcan make as to why it should not be liable to sell crushed rock to Rose
at the price set out in the Rose-Dooley contract?
3. What rule did the court here announce in deciding that Vulcan was required to sell rock at
the price set out in the Rose-Dooley contract? That is, what is the controlling rule of law in
this case?

Third party Beneficiaries and Foreseeable Damages
Kornblut v. Chevron Oil Co.
62 A.D.2d 831 (N.Y. 1978)
Hopkins, J.
The plaintiff-respondent has recovered a judgment after a jury trial in the sum of $519,855.98
[about $1.9 million in 2010 dollars] including interest, costs and disbursements, against
Chevron Oil Company (Chevron) and Lawrence Ettinger, Inc. (Ettinger) (hereafter collectively
referred to as defendants) for damages arising from the death and injuries suffered by Fred
Kornblut, her husband. The case went to the jury on the theory that the decedent was the thirdparty beneficiary of a contract between Chevron and the New York State Thruway Authority and
a contract between Chevron and Ettinger.
On the afternoon of an extremely warm day in early August, 1970 the decedent was driving
northward on the New York State Thruway. Near Sloatsburg, New York, at about 3:00 p.m., his
automobile sustained a flat tire. At the time the decedent was accompanied by his wife and 12year-old son. The decedent waited for assistance in the 92 degree temperature.
After about an hour a State Trooper, finding the disabled car, stopped and talked to the
decedent. The trooper radioed Ettinger, which had the exclusive right to render service on the
Thruway under an assignment of a contract between Chevron and the Thruway Authority.

Saylor URL: http://www.saylor.org/books

Saylor.org
514

Thereafter, other State Troopers reported the disabled car and the decedent was told in each
instance that he would receive assistance within 20 minutes.
Having not received any assistance by 6:00 p.m., the decedent attempted to change the tire
himself. He finally succeeded, although he experienced difficulty and complained of chest pains
to the point that his wife and son were compelled to lift the flat tire into the trunk of the
automobile. The decedent drove the car to the next service area, where he was taken by
ambulance to a hospital; his condition was later diagnosed as a myocardial infarction. He died
28 days later.
Plaintiff sued, inter alia, Chevron and Ettinger alleging in her complaint causes of action
sounding in negligence and breach of contract. We need not consider the issue of negligence,
since the Trial Judge instructed the jury only on the theory of breach of contract, and the
plaintiff has recovered damages for wrongful death and the pain and suffering only on that
theory.
We must look, then, to the terms of the contract sought to be enforced. Chevron agreed to
provide “rapid and efficient roadside automotive service on a 24-hour basis from each gasoline
service station facility for the areas…when informed by the authority or its police personnel of a
disabled vehicle on the Thruway”. Chevron’s vehicles are required “to be used and operated in
such a manner as will produce adequate service to the public, as determined in the authority’s
sole judgment and discretion”. Chevron specifically covenanted that it would have “sufficient
roadside automotive service vehicles, equipment and personnel to provide roadside automotive
service to disabled vehicles within a maximum of thirty (30) minutes from the time a call is
assigned to a service vehicle, subject to unavoidable delays due to extremely adverse weather
conditions or traffic conditions.”…
In interpreting the contract, we must bear in mind the circumstances under which the parties
bargained. The New York Thruway is a limited access toll highway, designed to move traffic at
the highest legal speed, with the north and south lanes separated by green strips. Any disabled
vehicle on the road impeding the flow of traffic may be a hazard and inconvenience to the other
users. The income realized from tolls is generated from the expectation of the user that he will
be able to travel swiftly and smoothly along the Thruway. Consequently, it is in the interest of
Saylor URL: http://www.saylor.org/books

Saylor.org
515

the authority that disabled vehicles will be repaired or removed quickly to the end that any
hazard and inconvenience will be minimized. Moreover, the design and purpose of the highway
make difficult, if not impossible, the summoning of aid from garages not located on the
Thruway. The movement of a large number of vehicles at high speed creates a risk to the
operator of a vehicle who attempts to make his own repairs, as well as to the other users. These
considerations clearly prompted the making of contracts with service organizations which would
be located at points near in distance and time on the Thruway for the relief of distressed
vehicles.
Thus, it is obvious that, although the authority had an interest in making provision for roadside
calls through a contract, there was also a personal interest of the user served by the contract.
Indeed, the contract provisions regulating the charges for calls and commanding refunds be paid
directly to the user for overcharges, evince a protection and benefit extended to the user only.
Hence, in the event of an overcharge, the user would be enabled to sue on the contract to obtain
a recovery.…Here the contract contemplates an individual benefit for the breach running to the
user.…
By choosing the theory of recovery based on contract, it became incumbent on the plaintiff to
show that the injury was one which the defendants had reason to foresee as a probable result of
the breach, under the ancient doctrine of Hadley v Baxendale [Citation], and the cases following
it…in distinction to the requirement of proximate cause in tort actions.…
The death of the decedent on account of his exertion in the unusual heat of the midsummer day
in changing the tire cannot be said to have been within the contemplation of the contracting
parties as a reasonably foreseeable result of the failure of Chevron or its assignee to comply with
the contract.…
The case comes down to this, then, in our view: though the decedent was the intended
beneficiary to sue under certain provisions of the contract—such as the rate specified for services
to be rendered—he was not the intended beneficiary to sue for consequential damages arising
from personal injury because of a failure to render service promptly. Under these circumstances,
the judgment must be reversed and the complaint dismissed, without costs or disbursements.

Saylor URL: http://www.saylor.org/books

Saylor.org
516

[Martuscello, J., concurred in the result but opined that the travelling public was not an
intended beneficiary of the contract.]

CASE QUESTIONS

1. Chevron made two arguments as to why it should not be liable for Mr. Kornblut’s death.
What were they?
2. Obviously, when Chevron made the contract with the New York State Thruway Authority, it
did not know Mr. Kornblut was going to be using the highway. How could he, then, be an
intended beneficiary of the contract?
3. Why was Chevron not found liable for Mr. Kornblut’s death when, clearly, had it performed
the contract properly, he would not have died?

14.5 Summary and Exercises
Summary

The general rule that the promisee may assign any right has some exceptions—for example,
when the promisor’s obligation would be materially changed. Of course the contract itself may
prohibit assignment, and sometimes statutes preclude it. Knowing how to make the assignment
effective and what the consequences of the assignment are on others is worth mastering. When,
for example, does the assignee not stand in the assignor’s shoes? When may a future right be
assigned?
Duties, as well as rights, may be transferred to third parties. Most rights (promises) contained in
contracts have corresponding duties (also expressed as promises). Often when an entire contract
is assigned, the duties go with it; the transferee is known, with respect to the duties, as the
delegatee. The transferor himself does not necessarily escape the duty, however. Moreover,
some duties are nondelegable, such as personal promises and those that public policy require to
be carried out by a particular official. Without the ability to assign rights and duties, much of the
modern economy would grind to a halt.
The parties to a contract are not necessarily the only people who acquire rights or duties under
it. One major category of persons acquiring rights is third-party beneficiaries. Only intended
beneficiaries acquire rights under the contract, and these are of two types: creditor and donee
beneficiaries. The rules for determining whether rights have been conferred are rather
Saylor URL: http://www.saylor.org/books

Saylor.org
517

straightforward; determining whether rights can subsequently be modified or extinguished is
more troublesome. Generally, as long as the contract does not prohibit change and as long as the
beneficiary has not relied on the promise, the change may be made.

EXERCISES

1. The Dayton Country Club offered its members various social activities. Some members were
entitled, for additional payment, to use the golf course, a coveted amenity. Golfing
memberships could not be transferred except upon death or divorce, and there was a long
waiting list in this special category; if a person at the top of the list declined, the next in line
was eligible. Golfing membership rules were drawn up by a membership committee.
Magness and Redman were golfing members. They declared bankruptcy, and the bankruptcy
trustee sought, in order to increase the value of their debtors’ estates, to assume and sell the
golfing memberships to members on the waiting list, other club members, or the general
public, provided the persons joined the club. The club asserted that under relevant state law,
it was “excused from rendering performance to an entity other than the debtor”—that is, it
could not be forced to accept strangers as members. Can these memberships be assigned?
2. Tenant leased premises in Landlord’s shopping center, agreeing in the lease “not to assign,
mortgage, pledge, or encumber this lease in whole or in part.” Under the lease, Tenant was
entitled to a construction allowance of up to $11,000 after Tenant made improvements for
its uses. Prior to the completion of the improvements, Tenant assigned its right to receive the
first $8,000 of the construction allowance to Assignee, who, in turn, provided Tenant $8,000
to finance the construction. Assignee notified Landlord of the assignment, but when the
construction was complete, Landlord paid Tenant anyway; when Assignee complained,
Landlord pointed to the nonassignment clause. Assignee sued Landlord. Who wins? [1]
3. Marian contracted to sell her restaurant to Billings for $400,000. The contract provided that
Billings would pay $100,000 and sign a note for the remainder. Billings sold the restaurant to
Alice, who agreed to assume responsibility for the balance due on the note held by Marian.
But Alice had difficulties and declared bankruptcy. Is Billings still liable on the note to
Marian?

Saylor URL: http://www.saylor.org/books

Saylor.org
518

4. Yellow Cab contracted with the Birmingham Board of Education to transport
physically handicapped students. The contract provided, “Yellow Cab will
transport the physically handicapped students of the School System…and furnish
all necessary vehicles and personnel and will perform all maintenance and make
all repairs to the equipment to keep it in a safe and efficient operating condition
at all times.”
Yellow Cab subcontracted with Metro Limousine to provide transportation in
connection with its contract with the board. Thereafter, Metro purchased two
buses from Yellow Cab to use in transporting the students. DuPont, a Metro
employee, was injured when the brakes on the bus that he was driving failed,
causing the bus to collide with a tree. DuPont sued Yellow Cab, alleging that under
its contract with the board, Yellow Cab had a nondelegable duty to properly
maintain the bus so as to keep it in a safe operating condition; that that duty
flowed to him as an intended third-party beneficiary of the contract; and that
Yellow Cab had breached the contract by failing to properly maintain the bus.
Who wins? [2]
5. Joan hired Groom to attend to her herd of four horses at her summer place in the high
desert. The job was too much for Groom, so he told Tony that he (Groom) would pay Tony,
who claimed expertise in caring for horses, to take over the job. Tony neglected the horses in
hot weather, and one of them needed veterinarian care for dehydration. Is Groom liable?
6. Rensselaer Water Company contracted with the city to provide water for business, domestic,
and fire-hydrant purposes. While the contract was in effect, a building caught on fire; the fire
spread to Plaintiff’s (Moch Co.’s) warehouse, destroying it and its contents. The company
knew of the fire but was unable to supply adequate water pressure to put it out. Is the owner
of the warehouse able to maintain a claim against the company for the loss?
7. Rusty told Alice that he’d do the necessary overhaul on her classic car for $5,000 during the
month of May, and that when the job was done, she should send the money to his son, Jim,
as a graduation present. He confirmed the agreement in writing and sent a copy to Jim.
Subsequently, Rusty changed his mind. What right has Jim?
Saylor URL: http://www.saylor.org/books

Saylor.org
519

8. Fox Brothers agreed to convey to Clayton Canfield Lot 23 together with a one-year option to
purchase Lot 24 in a subdivision known as Fox Estates. The agreement contained no
prohibitions, restrictions, or limitations against assignments. Canfield paid the $20,000 and
took title to Lot 23 and the option to Lot 24. Canfield thereafter assigned his option rights in
Lot 24 to the Scotts. When the Scotts wanted to exercise the option, Fox Brothers refused to
convey the property to them. The Scotts then brought suit for specific performance. Who
wins?
9. Rollins sold Byers, a businessperson, a flatbed truck on a contract; Rollins assigned the
contract to Frost, and informed Byers of the assignment. Rollins knew the truck had
problems, which he did not reveal to Byers. When the truck needed $3,200 worth of repairs
and Rollins couldn’t be found, Byers wanted to deduct that amount from payments owed to
Frost, but Frost insisted he had a right to payment. Upon investigation, Byers discovered that
four other people in the state had experienced similar situations with Rollins and with Frost
as Rollins’s assignee. What recourse has Byers?
10. Merchants and resort owners in the San Juan Islands in Washington State stocked extra
supplies, some perishable, in anticipation of the flood of tourists over Labor Day. They
suffered inconvenience and monetary damage due to the union’s Labor Day strike of the
state ferry system, in violation of its collective bargaining agreement with the state and of a
temporary restraining order. The owners sued the union for damages for lost profits,
attorney fees, and costs, claiming the union should be liable for intentional interference with
contractual relations (the owners’ relations with their would-be customers). Do the owners
have a cause of action?

SELF-TEST QUESTIONS

1. A creditor beneficiary is
a.

the same as a donee beneficiary

b. a third-party beneficiary
c. an incidental beneficiary
d. none of the above
Assignments are not allowed

Saylor URL: http://www.saylor.org/books

Saylor.org
520

a.

for rights that will arise from a future contract

b. when they will materially change the duties that the obligor must perform
c. where they are forbidden by public policy
d. for any of the above
When an assignor assigns the same interest twice,
a.

the subsequent assignee generally takes precedence

b. the first assignee generally takes precedence
c. the first assignee always takes precedence
d. the assignment violates public policy
Factoring
a.

is an example of delegation of duties

b. involves using an account receivable as collateral for a loan
c. involves the purchase of a right to receive income from another
d. is all of the above
Personal promises
a.

are always delegable

b. are generally not delegable
c. are delegable if not prohibited by public policy
d. are delegable if not barred by the contract

SELF-TEST ANSWERS

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

[1] Aldana v. Colonial Palms Plaza, Inc., 591 So.2d 953 (Fla. Ct. App., 1991).
[2] DuPont v. Yellow Cab Co. of Birmingham, Inc., 565 So.2d 190 (Ala. 1990).
Saylor URL: http://www.saylor.org/books

Saylor.org
521

Saylor URL: http://www.saylor.org/books

Saylor.org
522

Chapter 15
Discharge of Obligations
LEARNING OBJECTIVES

After reading this chapter, you should understand the following:
1. What is meant by discharge of contract obligations
2. How contract obligations are discharged

15.1 Discharge of Contract Duties

LEARNING OBJECTIVES

1. Understand how performance, partial performance, or no performance may discharge
contractual obligations.
2. Recognize what rights accrue to the nonbreaching party when the other side announces,
before the time for performance, that performance will not be forthcoming—anticipatory
breach.
3. Understand the concept of the right to adequate assurances, and the consequences if no
such assurances are forthcoming.
A person is liable to perform agreed-to contract duties until or unless he or she is discharged. If
the person fails to perform without being discharged, liability for damages arises. Here we deal
with the second-to-the-last of the four broad themes of contract law: how contract duties are
discharged.

Discharge by Performance (or Nonperformance) of the Duty
A contract can be discharged by complete performance or material nonperformance of the
contractual duty. Note, in passing, that the modern trend at common law (and explicit under the
Uniform Commercial Code [UCC], Section 1-203) is that the parties have a good-faith duty to
perform to each other. There is in every contract “an implied covenant of good faith” (honesty in
fact in the transaction) that the parties will deal fairly, keep their promises, and not frustrate the
other party’s reasonable expectations of what was given and what received.

Full Performance

Saylor URL: http://www.saylor.org/books

Saylor.org
523

Full performance of the contractual obligation discharges the duty. If Ralph does a fine job of
plumbing Betty’s new bathroom, she pays him. Both are discharged.

Nonperformance, Material Breach
If Ralph doesn’t do any work at all on Betty’s bathroom, or almost none, then Betty owes him
nothing. She—the nonbreaching party—is discharged, and Ralph is liable for breach of contract.
Under UCC Section 2-106(4), a party that ends a contract breached by the other party is said to
have effected a cancellation. The cancelling party retains the right to seek a remedy for breach of
the whole contract or any unperformed obligation. The UCC distinguishes cancellation
from termination, which occurs when either party exercises a lawful right to end the contract
other than for breach. When a contract is terminated, all executory duties are discharged on
both sides, but if there has been a partial breach, the right to seek a remedy survives. [1]

Substantial Performance
Logically, anything less than full performance, even a slight deviation from what is owed, is
sufficient to prevent the duty from being discharged and can amount to a breach of contract. So
if Ralph does all the plumbing for Betty’s new bathroom excepthook up the toilet feed, he has
not really “plumbed the new bathroom.” He has only plumbed part of it. At classic common law,
that was it: either you did the thing you promised completely or you had materially breached.
But under modern theories, an ameliorative doctrine has developed,
called substantial performance: if one side has substantially, but not completely, performed, so
that the other side has received a benefit, the nonbreaching party owes something for the value
received. The Restatement (Second) of Contracts puts it this way: [2]

Substantial Performance.

In an important category of disputes over failure of performance, one party asserts
the right to payment on the ground that he has completed his performance, while the
other party refuses to pay on the ground that there is an uncured material failure of
performance.…In such cases it is common to state the issue…in terms of whether there
has been substantial performance.…If there has been substantial although not full
performance, the building contractor has a claim for the unpaid balance and the
owner has a claim only for damages. If there has not been substantial performance,
Saylor URL: http://www.saylor.org/books

Saylor.org
524

the building contractor has no claim for the unpaid balance, although he may have a
claim in restitution.
The contest here is between the one who claims discharge by the other’s material breach and the
one who asserts there has been substantial performance. What constitutes substantial
performance is a question of fact, as illustrated in Section 15.2.1 "Substantial Performance;
Conditions Precedent", TA Operating Corp. v. Solar Applications Engineering, Inc. The
doctrine has no applicability where the breaching party willfully failed to follow the contract, as
where a plumber substitutes a different faucet for the one ordered; installation of the incorrect
faucet is a breach, even if it is of equal or greater value than the one ordered.
Under the UCC, there is no such thing as substantial performance. Section 2-601 requires that
the goods delivered according to the contract be the exact things ordered—that there be
a perfect tender (unless the parties agree otherwise).

Anticipatory Breach and Demand for Reasonable Assurances
When a promisor announces before the time his performance is due that he will not perform, he
is said to have committed an anticipatory breach (or repudiation). Of course a person cannot fail
to perform a duty before performance is due, but the law allows the promisee to treat the
situation as a material breach that gives rise to a claim for damages and discharges the obligee
from performing duties required of him under the contract. The common-law rule was first
recognized in the well-known 1853 British case Hochster v. De La Tour. In April, De La Tour
hired Hochster as his courier, the job to commence in June. In May, De La Tour changed his
mind and told Hochster not to bother to report for duty. Before June, Hochster secured an
appointment as courier to Lord Ashburton, but that job was not to begin until July. Also in May,
Hochster sued De La Tour, who argued that he should not have to pay Hochster because
Hochster had not stood ready and willing to begin work in June, having already agreed to work
for Lord Ashburton. The court ruled for the plaintiff Hochster:
[I]t is surely much more rational, and more for the benefit of both parties, that, after
the renunciation of the agreement by the defendant, the plaintiff should be at liberty
to consider himself absolved from any future performance of it, retaining his right to
sue for any damage he has suffered from the breach of it. Thus, instead of remaining
Saylor URL: http://www.saylor.org/books

Saylor.org
525

idle and laying out money in preparations which must be useless, he is at liberty to
seek service under another employer, which would go in mitigation of the damages to
which he would otherwise be entitled for a breach of the contract. It seems strange
that the defendant, after renouncing the contract, and absolutely declaring that he
will never act under it, should be permitted to object that faith is given to his
assertion, and that an opportunity is not left to him of changing his mind. [3]
Another type of anticipatory breach consists of any voluntary act by a party that destroys, or
seriously impairs, that party’s ability to perform the promise made to the other side. If a seller of
land, having agreed to sell a lot to one person at a date certain, sells it instead to a third party
before that time, there is an anticipatory breach. If Carpenter announces in May that instead of
building Owner’s deck in July, as agreed, he is going on a trip to Europe, there is an anticipatory
breach. In the first instance, there would be no point to showing up at the lawyer’s office when
the date arrives to await the deed, so the law gives a right to sue when the land is sold to the
other person. In the second instance, there would be no point to waiting until July, when indeed
Carpenter does not do the job, so the law gives the right to sue when the future nonperformance
is announced.
These same general rules prevail for contracts for the sale of goods under UCC Section 2-610.
Related to the concept of anticipatory breach is the idea that the obligee has a right to demand
reasonable assurances from the obligor that contractual duties will be performed. If the obligee
makes such a demand for reasonable assurances and no adequate assurances are forthcoming,
the obligee may assume that the obligor will commit an anticipatory breach, and consider it so.
That is, after making the contract, the obligee may come upon the disquieting news that the
obligor’s ability to perform is shaky. A change in financial condition occurs, an unknown
claimant to rights in land appears, a labor strike arises, or any of a number of situations may
crop up that will interfere with the carrying out of contractual duties. Under such circumstances,
the obligee has the right to a demand for reasonable assurance that the obligor will perform as
contractually obligated. The general reason for such a rule is given in UCC Section 2-609(1),
which states that a contract “imposes an obligation on each party that the other’s expectation of
receiving due performance will not be impaired.” Moreover, an obligee would be foolish not to
Saylor URL: http://www.saylor.org/books

Saylor.org
526

make alternative arrangements, if possible, when it becomes obvious that his original obligor
will be unable to perform. The obligee must have reasonable grounds to believe that the obligor
will breach. The fear must be that of a failure of performance that would amount to a total
breach; a minor defect that can be cured and that at most would give rise to an offset in price for
damages will not generally support a demand for assurances.
Under UCC Section 2-609(1), the demand must be in writing, but at common law the demand
may be oral if it is reasonable in view of the circumstances. If the obligor fails within a
reasonable time to give adequate assurance, the obligee may treat the failure to do so as an
anticipatory repudiation, or she may wait to see if the obligor might change his mind and
perform.

KEY TAKEAWAY

Contracts can be discharged by performance: complete performance discharges both sides;
material breach discharges the breaching party, who has a right to claim damages;
substantial performance obligates the promisee to pay something for the benefit conferred
but is a breach. A party may demand reasonable assurances of performance, which, if not
forthcoming, may be treated as an anticipatory breach (or repudiation).

EXERCISES

1. What types of performance discharge a contractual obligation?
2. Under the UCC, what is the difference between cancellation and termination of a contract?
3. What is an anticipatory breach, and under what circumstances can a party claim it?

Discharge by Conditions

LEARNING OBJECTIVES

1. Understand the concept of conditions in a contract.
2. Recognize that conditions can be classified on the basis of how they are created, their effect
on the duty to perform, the essentialness of timely performance, or performance to
someone’s satisfaction.
Usually contracts consist of an exchange of promises—a pledge or commitment by each party
that somebody will or will not do something. Andy’s promise to cut Anne’s lawn “over the
weekend” in return for Anne’s promise to pay twenty-five dollars is a commitment to have the
lawn mowed by Sunday night or Monday morning. Andy’s promise “not to tell anyone what I
Saylor URL: http://www.saylor.org/books

Saylor.org
527

saw you doing Saturday night” in return for Anne’s promise to pay one hundred dollars is a
commitment that an event (the revealing of a secret) will not occur. These promises are known
as independent or absolute or unconditional, because their performance does not depend on any
outside event. Such promises, if contractually binding, create a present duty to perform (or a
duty to perform at the time stated).
However, it is common that the obligation to perform a contract is conditioned (or conditional).
A condition is an event the happening or nonhappening of which gives rise to a duty to perform
(or discharges a duty to perform). Conditions may be express or implied; they may also be
precedent, concurrent, subsequent, or to the satisfaction of a party.

Conditions Classified Based on How They Are Created
Express conditions are stated in words in the contract, orally or written. Andy promises to mow
Anne’s lawn “provided it doesn’t rain.” “Provided it doesn’t rain” is an express condition. If rain
comes, there is no duty to cut the lawn, and Andy’s failure to do so is not a breach of promise.
Express conditions are usually introduced by language such as “provided that,” “if,” “when,”
“assuming that,” “as soon as,” “after,” and the like. Implied conditions are unexpressed but
understood to be part of the contract. If Mr. Olson guarantees Jack’s used car for ninety days, it
is implied that his obligation to fix any defects doesn’t arise until Jack lets him know the car is
defective. If Ralph is hired to plumb Betty’s new bathroom, it is implied that Betty’s duty to pay
is conditioned on Ralph’s completion of the job.

Conditions Classified Based on Their Effect on Duty to Perform
A condition precedent is a term in a contract (express or implied) that requires performance
only in the event something else happens first. Jack will buy a car from Mr. Olson if Jack gets
financing. “If Jack gets financing” is a condition precedent. Aconcurrent condition arises when
the duty to perform the contract is simultaneous: the promise of a landowner to transfer title to
the purchaser and the purchaser to tender payment to the seller. The duty of each to perform is
conditioned on the performance by the other. (As a practical matter, of course, somebody has to
make the first move, proffering deed or tendering the check.) A condition that terminates an
already existing duty of performance is known as a condition subsequent. Ralph agrees to do
preventive plumbing maintenance on Deborah Dairy’s milking equipment for as long as David
Saylor URL: http://www.saylor.org/books

Saylor.org
528

Dairy, Deb’s husband, is stationed overseas. When David returns, Ralph’s obligation to do the
maintenance (and Deb’s duty to pay him) terminates.

Condition of Timeliness
If, as often occurs, it does not matter a great deal whether a contract is performed exactly on
time, failure to do so is not a material breach, and the promisee has to accept the performance
and deduct any losses caused by the delay. If, though, it makes a difference to the promisee
whether the promisor acts on time, then it is said that “time is of the essence.” Time as a
condition can be made explicit in a clause reciting that time is of the essence. If there is no
express clause, the courts will read it in when the purpose of the contract was clearly to provide
for performance at or by a certain time, and the promisee will gain little from late performance.
But even express clauses are subject to a rule of reason, and if the promisor would suffer greatly
by enforcement of the clause (and the promisee would suffer only slightly or not at all from a
refusal to invoke it), the courts will generally excuse the untimely performance, as long as it was
completed within a reasonable time. A builder’s failure to finish a house by July 1 will not
discharge the buyer’s obligation to pay if the house is finished a week or even a month later,
although the builder will be liable to the buyer for expenses incurred because of the lateness
(storage charges for furniture, costs for housing during the interim, extra travel, and the like).

Condition That a Party Must Be Satisfied
“You must be satisfied or your money back” is a common advertisement. A party to a contract
can require that he need not pay or otherwise carry out his undertaking unless satisfied by the
obligor’s performance, or unless a third party is satisfied by the performance.
Parties may contract to perform to one side’s personal satisfaction. Andy tells Anne, a
prospective client, that he will cut her hair better than her regular hairdresser, and that if she is
not satisfied, she need not pay him. Andy cuts her hair, but Anne frowns and says, “I don’t like
it.” Assume that Andy’s work is excellent. Whether Anne must pay depends on the standard for
judging to be employed—a standard of objective or subjective satisfaction. The objective
standard is that which would satisfy the reasonable purchaser. Most courts apply this standard
when the contract involves the performance of a mechanical job or the sale of a machine whose
performance is capable of objective measurement. So even if the obligee requires performance to
Saylor URL: http://www.saylor.org/books

Saylor.org
529

his “personal satisfaction,” the courts will hold that the obligor has performed if the service
performed or the goods produced are in fact satisfactory. By contrast, if the goods or services
contracted for involve personal judgment and taste, the duty to pay will be discharged if the
obligee states personal (subjective) dissatisfaction. No reason at all need be given, but it must be
for a good-faith reason, not just to escape payment.
The duty to make a contract payment may be conditioned on the satisfaction of a third party.
Building contracts frequently make the purchaser’s duty to pay conditional on the builder’s
receipt of an architect’s certificate of compliance with all contractual terms; road construction
contracts often require that the work be done “to the satisfaction of the County Engineer.” These
conditions can be onerous. The builder has already erected the structure and cannot “return”
what he has done. Nevertheless, because the purchaser wants assurance that the building
(obviously a major purchase) or road meets his specifications, the courts will hold the contractor
to the condition unless it is impossible to provide a certificate (e.g., architect may have died) or
the architect has acted in bad faith, or the purchaser has somehow prevented the certificate from
issuing. The third party’s refusal to issue a certificate needs to be reasonable.

KEY TAKEAWAY

Parties may, expressly or implicitly, condition the requirement for contractual performance
on the happening or nonhappening of an event, or on timeliness. They may condition
performance on satisfaction to one of the parties to the contract or to the satisfaction of a
third party; in any event, dissatisfaction must be in good faith.

EXERCISES

1. What is “conditioned” by a condition in a contract?
2. What conditions are based on how they are made?
3. What conditions are based on their effect on the duty of performance?
4. What typical situations involve performance to a party’s satisfaction?

Discharge by Agreement of the Parties

LEARNING OBJECTIVE

1. Recognize that there are various ways the parties may agree between themselves to
terminate mutual obligations under the contract.

Saylor URL: http://www.saylor.org/books

Saylor.org
530

Parties are free to agree to almost any contract they want, and they are free to agree to end the
contract whenever they want. There are several ways this is done.

Mutual Rescission
The parties may agree to give up the duties to perform, called mutual rescission. This may be by
a formal written release saying the obligor is discharged upon delivery of the writing or upon
occurrence of a condition. Or an obligation may be discharged by a contract not to sue about it.
The Restatement terms this an agreement of rescission. [4] An agreement to rescind will be given
effect even though partial performance has been made or one or both parties have a claim for
partial breach. The agreement need not be in writing or even expressed in words. By their
actions, such as failure to take steps to perform or enforce, the parties may signal their mutual
intent to rescind. Andy starts to mow Anne’s lawn as they agreed. He begins the job, but it is
unbearably hot. She sees how uncomfortable he is and readily agrees with him when he says,
“Why don’t we just forget the whole thing?” Andy’s duty to finish mowing is discharged, as is
Anne’s duty to pay Andy, either for the whole job or for the part he has done.
Business executives live by contracts, but they do not necessarily die by them. A sociologist who
studied business behavior under contract discovered a generation ago—and it is still valid—that
in the great majority of cases in which one party wishes to “cancel an order,” the other party
permits it without renegotiation, even though the cancellation amounts to a repudiation of a
contract. As one lawyer was quoted as saying,
Often business[people] do not feel they have “a contract”—rather they have an
“order.” They speak of “cancelling the order” rather than “breaching our contract.”
When I began practice I referred to order cancellations as breaches of contract, but
my clients objected since they do not think of cancellation as wrong. Most clients, in
heavy industry at least, believe that there is a right to cancel as part of the buyerseller relationship. There is a widespread attitude that one can back out of any deal
within some very vague limits. Lawyers are often surprised by this attitude. [5]
This attitude is understandable. People who depend for their economic survival on continuing
relationships will be loath to react to every change in plans with a lawsuit. The legal
consequences of most of these cancellations are an agreement of rescission. Under UCC Section
Saylor URL: http://www.saylor.org/books

Saylor.org
531

2-720, the use of a word like “cancellation” or “rescission” does not by itself amount to a
renunciation of the right to sue for breach of a provision that occurred before the rescission. If
the parties mean to discharge each other fully from all duties owed, they must say so explicitly.
Actions continue to speak more loudly than words, however, and in law, so can inactions. Legal
rights under contracts may be lost by both parties if they fail to act; by abandoning their claims,
they can affect rescission.

Waiver
A second means of discharge is by waiver, whereby a party voluntarily gives up a right she has
under a contract but doesn’t give up the entire right to performance by the other side. Tenant is
supposed to pay rent on the first of the month, but because his employer pays on the tenth,
Tenant pays Landlady on that day. If Landlady accepts the late payment without objection, she
has waived her right to insist on payment by the first of the month, unless the lease provides
that no waiver occurs from the acceptance of any late payments. See Section 15.2.2 "Waiver of
Contract Rights; Nonwaiver Provisions",Minor v. Chase Auto Finance Corporation. A “waiver”
is permission to deviate from the contract; a “release” means to let go of the whole thing.

Substituted Agreement
Discharge by substituted agreement is a third way of mutual rescission. The parties may enter
into a novation, either a new contract or one whereby a new person is substituted for the original
obligor, and the latter is discharged. If Mr. Olson is obligated to deliver a car to Jack, Jack and
Mr. Olson may agree that Dewey Dealer should deliver the car to Jack instead of Mr. Olson; the
latter is discharged by this novation. A substituted agreement may also simply replace the
original one between the original parties.

Accord and Satisfaction
Discharge by accord and satisfaction is a fourth way of mutual rescission. Here the parties to a
contract (usually a disputed one) agree to substitute some performance different from what was
originally agreed, and once this new agreement is executed, the original contract (as well as the
more recent accord) is satisfied. But before then, the original agreement is only suspended: if
the obligor does not satisfy the accord, the other side can sue on the original obligation or on the
accord.
Saylor URL: http://www.saylor.org/books

Saylor.org
532

KEY TAKEAWAY
Parties to a contract may agree to give it up. This may be by mutual rescission, release,
waiver, novation, substituted agreement, or accord and satisfaction.

EXERCISES

1. How does mutual rescission discharge a common-law contract without apparent new
consideration?
2. What is the difference between a substituted agreement and a novation?
3. What happens if the parties negotiate an accord and satisfaction and one side fails to
perform it?
4. If an obligee accepts performance from the obligor that deviates from the contract, under
what circumstances can the obligee nevertheless insist on strict compliance in the future?

Discharge When Performance Becomes Impossible or Very Difficult
LEARNING OBJECTIVE

1. Recognize that there are several circumstances when performance of the contract becomes
variously impossible, very difficult, or useless, and that these may give rise to discharge.
There are at least five circumstances in which parties may be discharged from contractual
obligations because performance is impossible, difficult, or useless.

Overview
Every contract contains some element of risk: the buyer may run out of money before he can
pay; the seller may run out of goods before he can deliver; the cost of raw materials may
skyrocket, throwing off the manufacturer’s fine financial calculations. Should the obligor’s luck
run out, he is stuck with the consequences—or, in the legal phrase, his liability is strict: he must
either perform or risk paying damages for breach of contract, even if his failure is due to events
beyond his control. Of course, an obligor can always limit his liability through the contract itself.
Instead of obligating himself to deliver one million units, he can restrict his obligation to “one
million units or factory output, whichever is less.” Instead of guaranteeing to finish a job by a
certain date, he can agree to use his “best efforts” to do so. Similarly, damages in the event of
breach can be limited. A party can even include a clause canceling the contract in the event of an
untoward happening. But if these provisions are absent, the obligor is generally held to the
terms of his bargain.
Saylor URL: http://www.saylor.org/books

Saylor.org
533

Exceptions include the concepts of impossibility, impracticability, and frustration of purpose.

Impossibility
If performance is impossible, the duty is discharged. The categories here are death or incapacity
of a personal services contractor, destruction of a thing necessary for performance, and
performance prohibited by government order.

Death or Incapacity of a Personal Services Contractor
If Buyer makes a contract to purchase a car and dies before delivery, Buyer’s estate could be held
liable; it is not impossible (for the estate) to perform. The estate of a painter hired to do a
portrait cannot be sued for damages because the painter died before she could complete the
work.

Destruction or Deterioration of a Thing Necessary for Performance
When a specific object is necessary for the obligor’s performance, its destruction or deterioration
making its use impracticable (or its failure to come into existence) discharges the obligor’s duty.
Diane’s Dyers contracts to buy the annual wool output of the Sheepish Ranch, but the sheep die
of an epidemic disease before they can be shorn. Since the specific thing for which the contract
was made has been destroyed, Sheepish is discharged from its duty to supply Diane’s with wool,
and Diane’s has no claim against the Ranch. However, if the contract had called for a quantity of
wool, without specifying that it was to be from Sheepish’s flock, the duty would not be
discharged; since wool is available on the open market, Sheepish could buy that and resell it to
Diane’s.

Performance Prohibited by Government Regulation or Order
When a government promulgates a rule after a contract is made, and the rule either bars
performance or will make it impracticable, the obligor’s duty is discharged. An obligor is not
required to break the law and risk the consequences. Financier Bank contracts to sell World
Mortgage Company certain collateralized loan instruments. The federal government, in a bank
reform measure, prohibits such sales. The contract is discharged. If the Supreme Court later
declared the prohibition unconstitutional, World Mortgage’s duty to buy (or Financier Bank’s to
sell) would not revive.

Impracticability
Saylor URL: http://www.saylor.org/books

Saylor.org
534

Less entirely undoable than impossibility, but still grounds for discharge, are common-law
impracticability and its relative, commercial impracticability.

Common-Law Impracticability
Impracticability is said to exist when there is a radical departure from the circumstances that the
parties reasonably contemplated would exist at the time they entered into the contract; on such
facts, the courts might grant relief. They will do so when extraordinary circumstances (often
called “acts of God” or “force majeure”) make it unjust to hold a party liable for performance.
Although the justification for judicial relief could be found in an implied condition in all
contracts that extraordinary events shall not occur, the Restatement eschews so obvious a
bootstrap logic and adopts the language of UCC Section 2-615(a), which states that the crux of
the analysis is whether the nonoccurrence of the extraordinary circumstance was “a basic
assumption on which the contract was made.” [6] If it was—if, that is, the parties assumed that
the circumstance would not occur—then the duty is discharged if the circumstance later does
occur.
In one well-known case, Autry v. Republic Productions, the famous cowboy movie star Gene
Autry had a contract to perform to the defendant. He was drafted into the army in 1942; it was
temporarily, at least, impossible for him to perform his movie contractual obligations incurred
prior to his service. When he was discharged in 1945, he sued to be relieved of the prewar
obligations. The court took notice that there had been a long interruption in Autry’s career and
of “the great decrease in the purchasing power of the dollar”—postwar inflation—and
determined that to require him to perform under the old contract’s terms would work a
“substantial hardship” on him. A world war is an extraordinary circumstance. The temporary
impossibility had transformed into impracticability. [7]
Impracticability refers to the performance, not to the party doing it. Only if the performance is
impracticable is the obligor discharged. The distinction is between “the thing cannot be done”
and “I cannot do it.” The former refers to that which isobjectively impracticable, and the latter to
that which is subjectively impracticable. That a duty is subjectively impracticable does not
excuse it if the circumstances that made the duty difficult are not extraordinary. A buyer is liable
for the purchase price of a house, and his inability to raise the money does not excuse him or
Saylor URL: http://www.saylor.org/books

Saylor.org
535

allow him to escape from a suit for damages when the seller tenders the deed. [8] If Andy
promises to transport Anne to the football stadium for ten dollars, he cannot wriggle out of his
agreement because someone smashed into his car (rendering it inoperable) a half hour before he
was due to pick her up. He could rent a car or take her in a taxi, even though that will cost
considerably more than the sum she agreed to pay him. But if the agreement was that he would
transport her in his car, then the circumstances make his performance objectively
impracticable—the equivalent of impossible—and he is excused.

Commercial Impracticability
This common-law concept of impracticability has been adopted by the UCC. [9] When
performance cannot be undertaken except with extreme difficulty or at highly unreasonable
expense, it might be excused on the theory ofcommercial impracticability. However,
“impracticable” (the action is impossible) is not the same as “impractical” (the action would
yield an insufficient return or would have little practical value). The courts allow a considerable
degree of fluctuation in market prices, inflation, weather, and other economic and natural
conditions before holding that an extraordinary circumstance has occurred. A manufacturer that
based its selling price on last year’s costs for raw materials could not avoid its contracts by
claiming that inflation within the historical range had made it difficult or unprofitable to meet
its commitments. Examples of circumstances that could excuse might be severe limitations of
supply due to war, embargo, or a natural disaster. Thus a shipowner who contracted with a
purchaser to carry goods to a foreign port would be excused if an earthquake destroyed the
harbor or if war broke out and the military authorities threatened to sink all vessels that entered
the harbor. But if the shipowner had planned to steam through a canal that is subsequently
closed when a hostile government seizes it, his duty is not discharged if another route is
available, even if the route is longer and consequently more expensive.

Frustration of Purpose
If the parties made a basic assumption, express or implied, that certain circumstances would not
arise, but they do arise, then a party is discharged from performing his duties if his principal
purpose in making the contract has been “substantially frustrated.” This is not a rule of objective
impossibility. It operates even though the parties easily might be able to carry out their
Saylor URL: http://www.saylor.org/books

Saylor.org
536

contractual duties. The frustration of purpose doctrine comes into play when circumstances
make the value of one party’s performance virtually worthless to the other. This rule does not
permit one party to escape a contract simply because he will make less money than he had
planned or because one potential benefit of the contract has disappeared. The purpose that is
frustrated must be the core of the contract, known and understood by both parties, and the level
of frustration must be severe; that is, the value of the contract to the party seeking to be
discharged must be destroyed or nearly destroyed.
The classic illustration of frustration of purpose is the litigation that gave birth to the rule: the
so-called coronation cases. In 1901, when King Edward VII was due to be crowned following the
death of Queen Victoria, a parade route was announced for the coronation. Scores of people
rented rooms in buildings that lined the streets of the route to watch the grand spectacle. But the
king fell ill, and the procession was canceled. Many expectant viewers failed to pay, and the
building owners took them to court; many lessees who had paid took the owners to court to seek
refunds. The court declared that the lessees were not liable because the purpose of the contract
had been frustrated by the king’s illness.
Supervening government regulations (though here different from illegality), floods that destroy
buildings in which an event was to take place, and business failures may all contribute to
frustration of purpose. But there can be no general rule: the circumstances of each case are
determinative. Suppose, for example, that a manufacturer agrees to supply a crucial circuit
board to a computer maker who intends to sell his machine and software to the government for
use in the international space station’s ventilation systems. After the contract is made but before
the circuit boards are delivered, the government decides to scrap that particular space station
module. The computer manufacturer writes the circuit board maker, canceling the contract.
Whether the manufacturer is discharged depends on the commercial prospects for the computer
and the circuit board. If the circuit board can be used only in the particular computer, and it in
turn is only of use on the space station, the duty to take the boards is discharged. But if the
computer can be sold elsewhere, or the circuit boards can be used in other computers that the
manufacturer makes, it is liable for breach of contract, since its principal purpose—selling
computers—is not frustrated.
Saylor URL: http://www.saylor.org/books

Saylor.org
537

As before, the parties can provide in the contract that the duty is absolute and that no
supervening event shall give rise to discharge by reason of frustration of purpose.

KEY TAKEAWAY

The obligations to perform under a contract cannot be dismissed lightly, but a person’s duty
to perform a contract duty may be discharged if it becomes impossible or very difficult to do
it. This includes impossibility, common-law impracticability, commercial impracticability
under the UCC, and frustration of purpose.

EXERCISES

1. If it is possible to perform a contract, why might a party be excused because of frustration of
purpose?
2. What is the difference between impractical and impracticable?
3. How would supervening government regulation be different from supervening illegality?

Other Methods of Discharge

LEARNING OBJECTIVES

1. Recognize when alteration, power of avoidance, the statute of limitations, and bankruptcy
discharge parties from contracts.
2. In addition to performance (or lack of it), agreement of the parties, the happening or
nonhappening of conditions, and variations on the theme of impossibility, there are several
other ways contract duties may be discharged.

Cancellation, Destruction, or Surrender
An obligee may unilaterally discharge the obligor’s duty toward him by canceling, destroying, or
surrendering the written document embodying the contract or other evidence of the duty. No
consideration is necessary; in effect, the obligee is making a gift of the right that he possesses.
No particular method of cancellation, destruction, or surrender is necessary, as long as the
obligee manifests his intent that the effect of his act is to discharge the duty. The entire
document can be handed over to the obligor with the words, “Here, you don’t owe me anything.”
The obligee can tear the paper into pieces and tell the obligor that he has done so because he
does not want anything more. Or he can mutilate the signatures or cross out the writing.

Power of Avoidance

Saylor URL: http://www.saylor.org/books

Saylor.org
538

A contractual duty can be discharged if the obligor can avoid the contract. As discussed
in Chapter 10 "Real Assent", a contract is either void or can be avoided if one of the parties
lacked capacity (infancy, insanity); if there has been duress, undue influence, misrepresentation,
or mistake; or the contract is determined to be unconscionable. Where a party has
a power of avoidance and exercises it, that party is discharged from further obligation.

Statute of Limitations
When an obligor has breached a contract, the obligee has the right to sue in court for a remedy.
But that right does not last forever. Every state has statutes of limitations that establish time
periods within which the suit must be brought (different time periods are spelled out for
different types of legal wrongs: contract breach, various types of torts, and so on). The time
period for contract actions under most statutes of limitations ranges between two and six years.
The UCC has a four-year statute of limitations.[10] The period begins to run from the day on
which the suit could have been filed in court—for example, from the moment of contract breach.
An obligee who waits until after the statute has run—that is, does not seek legal relief within the
period prescribed by the statute of limitations—is barred from going to court thereafter (unless
she is under some incapacity like infancy), but the obligor is not thereby discharged. The effect is
simply that the obligee has no legal remedy. If the parties have a continuing relationship, the
obligee might be able to recoup—for example, by applying a payment for another debt to the one
barred by the statute, or by offsetting a debt the obligee owes to the obligor.

Bankruptcy
Under the federal bankruptcy laws certain obligations are discharged once a court declares a
debtor to be bankrupt. The law spells out the particular types of debts that are canceled upon
bankruptcy.

KEY TAKEAWAY

Contract duties may be discharged by cancellation, destruction, or surrender of the written
contract; by the running of the statute of limitations; or by bankruptcy.

[1] Uniform Commercial Code, Section 2-106(3).
[2] Restatement (Second) of Contracts, Section 237(d).
Saylor URL: http://www.saylor.org/books

Saylor.org
539

[3] Hochster v. De La Tour, 2 Ellis & Blackburn 678 (Q.B. 1853).
[4] Restatement (Second) of Contracts, Section 283.
[5] Stewart Macaulay, “Non-contractual Relations in Business: A Preliminary Study,” American
Sociological Review 28, no. 1 (1963): 55, 61.
[6] Restatement (Second) of Contracts, Section 261.
[7] Autry v. Republic Productions, 180 P.2d 144 (Calif. 1947).
[8] Christy v. Pilkinton, 273 S.W.2d 533 (Ark. 1954).
[9] Uniform Commercial Code, Section 2-615.
[10] Uniform Commercial Code, Section 2-725.

15.2 Cases
Substantial Performance; Conditions Precedent
TA Operating Corp. v. Solar Applications Engineering, Inc.
191 S.W.3d 173 (Tex. Ct. App. 2005)
TA Operating Corporation, a truck stop travel center company, contracted with Solar
Applications Engineering, Inc. to construct a prototype multi-use truck stop in San Antonio for a
fixed price of $3,543,233.…
[When the project was near] completion, TA sent Solar a “punch list” of items that needed to be
finished to complete the building. Solar disputed several items on the list and delivered a
response to TA listing the items Solar would correct.…Solar began work on the punch list items
and filed a lien affidavit [a property that carries a lien can be forced into sale by the creditor in
order to collect what is owed] against the project on October 2, 2000 in the amount of
$472,392.77. TA understood the lien affidavit to be a request for final payment.
On October 18, 2000, TA sent notice to Solar that Solar was in default for not completing the
punch list items, and for failing to keep the project free of liens. TA stated in the letter that Solar
was not entitled to final payment until it completed the remainder of the punch list items and
provided documentation that liens filed against the project had been paid.…Solar acknowledged
at least two items on the punch list had not been completed, and submitted a final application
for payment in the amount of $472,148,77.…TA refused to make final payment, however,
Saylor URL: http://www.saylor.org/books

Saylor.org
540

contending that Solar had not complied with section 14.07 of the contract, which expressly made
submission of a [lien-release] affidavit a condition precedent to final payment:…
The final Application for Payment shall be accompanied by:…complete and legally
effective releases or waivers…of all lien rights arising out of or liens filed in
connection with the work.
Although Solar did not comply with this condition precedent to final payment, Solar sued TA for
breach of contract under the theory of substantial performance.…TA [asserts that] the doctrine
of substantial performance does not excuse Solar’s failure to comply with an express condition
precedent to final payment.…
The first issue we must resolve is whether the doctrine of substantial performance excuses the
breach of an express condition precedent to final payment that is unrelated to completion of the
building. TA acknowledges that Solar substantially performed its work on the project, but
contends its duty to pay was not triggered until Solar pleaded or proved it provided TA with
documentation of complete and legally effective releases or waivers of all liens filed against the
project.…TA contends that when the parties have expressly conditioned final payment on
submission of [a liens-release] affidavit, the owner’s duty to pay is not triggered until the
contractor pleads or proves it complied with the condition precedent.
Solar contends that although it did not submit [a liens-release] affidavit in accordance with the
contract, it may still recover under the contract pursuant to the substantial performance
doctrine. Solar argues that to hold otherwise would bring back the common law tradition that
the only way for a contractor to recover under a contract is full, literal performance of the
contract’s terms.…
While the common law did at one time require strict compliance with the terms of a contract,
this rule has been modified for building or construction contracts by the doctrine of substantial
performance. “Substantial performance” was defined by the Texas [court] in [Citation]:
To constitute substantial compliance the contractor must have in good faith intended
to comply with the contract, and shall have substantially done so in the sense that the
defects are not pervasive, do not constitute a deviation from the general plan
contemplated for the work, and are not so essential that the object of the parties in
Saylor URL: http://www.saylor.org/books

Saylor.org
541

making the contract and its purpose cannot without difficulty, be accomplished by
remedying them. Such performance permits only such omissions or deviation from
the contract as are inadvertent and unintentional, are not due to bad faith, do not
impair the structure as a whole, and are remediable without doing material damage
to other parts of the building in tearing down and reconstructing.
…The doctrine of substantial performance recognizes that the contractor has not completed
construction, and therefore is in breach of the contract. Under the doctrine, however, the owner
cannot use the contractor’s failure to complete the work as an excuse for non-payment. “By
reason of this rule a contractor who has in good faith substantially performed a building
contract is permitted to sue under the contract, substantial performance being regarded as full
performance, so far as a condition precedent to a right to recover thereunder is concerned.”
[Citation]…
Solar argues that by agreeing substantial performance occurred, TA acknowledged that Solar
was in “full compliance” with the contract and any express conditions to final payment did not
have to be met. [Citation]: “[a] finding that a contract has been substantially completed is the
legal equivalent of full compliance, less any offsets for remediable defects.” Solar argues that TA
may not expressly provide for substantial performance in its contract and also insist on strict
compliance with the conditions precedent to final payment. We disagree. While the substantial
performance doctrine permits contractors to sue under the contract, it does not ordinarily
excuse the non-occurrence of an express condition precedent:
The general acceptance of the doctrine of substantial performance does not mean that
the parties may not expressly contract for literal performance of the contract
terms.…Stated otherwise, if the terms of an agreement make full or strict
performance an express condition precedent to recovery, then substantial
performance will not be sufficient to enable recovery under the contract.
15 Williston on Contracts § 44.53 (4th Ed.2000) (citing Restatement (Second) of Contracts, §
237, cmt. d (1981)).…
TA, seeking protection from double liability and title problems, expressly conditioned final
payment on Solar’s submission of a [liens-release] affidavit. Solar did not dispute that it was
Saylor URL: http://www.saylor.org/books

Saylor.org
542

contractually obligated to submit the affidavit as a condition precedent to final payment, and it
was undisputed at trial that $246,627.82 in liens had been filed against the project. Though the
doctrine of substantial performance permitted Solar to sue under the contract, Solar did not
plead or prove that it complied with the express condition precedent to final payment. Had Solar
done so, it would have been proper to award Solar the contract balance minus the cost of
remediable defects. While we recognize the harsh results occasioned from Solar’s failure to
perform this express condition precedent, we recognize that parties are free to contract as they
choose and may protect themselves from liability by requesting literal performance of their
conditions for final payment.…
[T]he trial court erred in awarding Solar the contract balance [as] damages, and we render
judgment that Solar take nothing on its breach of contract claim.

CASE QUESTIONS

1. Why did Solar believe it was entitled to the contract balance here?
2. Why did the court determine that Solar should not have been awarded the contract damages
that it claimed, even though it substantially complied?
3. How has the common law changed in regard to demanding strict compliance with a contract?

Waiver of Contract Rights; Nonwaiver Provisions
Minor v. Chase Auto Finance Corporation
—S.W.3d——, 2010 WL 2006401 (Ark. 2010)
Sheffield, J.
We have been asked to determine whether non-waiver and no-unwritten-modifications clauses
in a [contract] preclude a creditor from waiving future strict compliance with the agreement by
accepting late payments.…
Appellant Mose Minor (Minor) entered into a Simple Interest Motor Vehicle Contract and
Security Agreement with Appellee Chase Auto Finance Corporation (Chase) to finance the
purchase of a 2003 Toyota Tundra. By the terms of the agreement, Minor was to make sixty-six
payments of $456.99 on the fourteenth of each month.…The agreement also included the
following relevant provisions:

Saylor URL: http://www.saylor.org/books

Saylor.org
543

G. Default: If you…default in the performance of any promise you make in this
contract or any other contract you have with us, including, but not limited to, failing
to make any payments when due, or become insolvent, or file any proceeding under
the U.S. Bankruptcy Code,…we may at our option and without notice or demand (1)
declare all unpaid sums immediately due and payable subject to any right of
reinstatement as required by law (2) file suit against you for all unpaid sums (3) take
immediate possession of the vehicle (4) exercise any other legal or equitable
remedy.…Our remedies are cumulative and taking of any action shall not be a waiver
or prohibit us from pursuing any other remedy. You agree that upon your default we
shall be entitled to recover from you our reasonable collection costs, including, but
not limited to, any attorney’s fee. In addition, if we repossess the vehicle, you grant to
us and our agents permission to enter upon any premises where the vehicle is located.
Any repossession will be performed peacefully.…
J. Other Agreements of Buyer:…(2) You agree that if we accept moneys in sums less
than those due or make extensions of due dates of payments under this contract,
doing so will not be a waiver of any later right to enforce the contract terms as
written.…(12) All of the agreements between us and you are set forth in this contract
and no modification of this contract shall be valid unless it is made in writing and
signed by you and us.…
K. Delay in Enforcement: We can delay or waive enforcement of any of our rights
under this contract without losing them.
Minor’s first payment was late, as were several subsequent payments. At times he failed to make
any payment for months. Chase charged a late fee for each late payment, and sent several letters
requesting payment and offering to assist Minor with his account. Chase also warned Minor that
continued failure to make payments would result in Chase exercising its legal options available
under the agreement, including repossession of the vehicle.…At one point, Minor fell so far
behind in his payments that Chase was on the verge of repossessing the vehicle. However…the
parties agreed to a two-month extension of the agreement.…The extension agreement indicated
that all other terms and conditions of the original contract would remain the same.
Saylor URL: http://www.saylor.org/books

Saylor.org
544

On November 2, 2004, Minor filed for Chapter 7 "Introduction to Tort Law" bankruptcy [after
which] Chase sent Minor a letter acknowledging that Minor’s debt to Chase had been discharged
in bankruptcy. The letter further stated that Chase still had a valid lien on the vehicle, and if
Minor wished to keep the vehicle, he would have to continue to make payments to Chase.
Otherwise, Chase would repossess the vehicle.…
On September 28, 2006, a repossession agent…arrived at Minor’s home some time in the
afternoon to repossess the vehicle.…[Notwithstanding Minor’s insistence that the agent stop]
the agent removed Minor’s possessions from the vehicle and towed it away. Chase sold the
vehicle. The amount of the purchase price was reflected on Minor’s account.…
On January 7, 2008, Minor filed a complaint against Chase [alleging] that, during the course of
the contract, the parties had altered the provisions of the contract regarding Chase’s right to
repossess the vehicle and Chase had waived the right to strictly enforce the repossession clause.
Minor further claimed that the repossession agent committed trespass and repossessed the
vehicle forcibly, without Minor’s permission, and through trickery and deceit, in violation of
[state law]. Also, Minor asserted that he was not in default on his payments, pursuant to the
repayment schedule, at the time Chase authorized repossession. Therefore, according to Minor,
Chase committed conversion, and breached the Arkansas Deceptive Trade Practices Act
[Citation], and enhanced by Arkansas Code Annotated section 4-88-202, because Minor is an
elderly person. Minor sought compensatory and punitive damages.…
After hearing these arguments, the circuit court ruled that Minor had presented no evidence that
the conduct of Chase or the repossession agent constituted grounds for punitive damages; that
by the express terms of the contract Chase’s acceptance of late payments did not effect a waiver
of its rights in the future; that at the time of repossession, Minor was behind in his payments
and in breach of the contract; that Chase had the right under the contract to repossess the
vehicle and did not commit conversion; and that there was no evidence to support a claim that
Chase had violated the Arkansas Deceptive Trade Practices Act.…
[W]e affirm our previous decisions that when a contract does not contain a non-waiver and a
no-unwritten-modification provision and the creditor has established a course of dealing in
accepting late payments from the debtor, the creditor waives its right to insist on strict
Saylor URL: http://www.saylor.org/books

Saylor.org
545

compliance with the contract and must give notice to the debtor that it will no longer accept late
payments before it can declare default of the debt. However, we announce today that, if a
contract includes non-waiver and no-unwritten-modification clauses, the creditor, in accepting
late payments, does not waive its right under the contract to declare default of the debt, and
need not give notice that it will enforce that right in the event of future late payments.…
In arriving at this conclusion, we adhere to the principle that “a [contract] is effective according
to its terms between the parties.”…We have long held that non-waiver clauses are legal and
valid. See [Citations] Also, [the Arkansas UCC 2-209(2)] declares that no-unwrittenmodification provisions are binding.
We acknowledge that there is a difference of opinion amongst the courts in other jurisdictions
over the effect of non-waiver and no-unwritten-modification clauses.…
We concur with the Supreme Court of Indiana’s decision in [Citation], that a rule providing that
non-waiver clauses could themselves be waived by the acceptance of late payments is “illogical,
since the very conduct which the [non-waiver] clause is designed to permit[,] acceptance of late
payment[,] is turned around to constitute waiver of the clause permitting the conduct.” We also
agree that the approach of jurisdictions that require creditors who have accepted late payments
in the past to notify debtors that they expect strict compliance in the future, despite the
existence of a non-waiver provision in the contract, is not “sound.” Such a rule, we recognize,
“begs the question of validity of the non-waiver clause.” Finally, our holding is in line with the
Indiana Supreme Court’s ruling that it would enforce the provisions of the contract, since the
parties had agreed to them, and that it would not require the creditor to give notice, because the
non-waiver clause placed the [creditor] in the same position as one who had never accepted a
late payment. [Citations]…
Certified question answered; remanded to court of appeals.

CASE QUESTIONS

1. What is a nonwaiver clause?
2. Why did Mose think his late payments were not grounds for repossession of his truck?
3. Why would a creditor accept late payments instead of immediately repossessing the
collateral?

Saylor URL: http://www.saylor.org/books

Saylor.org
546

4. Why did Mose lose?

Impossibility as a Defense
Parker v. Arthur Murray, Inc.
295 N.E.2d 487 (Ill. Ct. App. 1973)
Stamos, J.
The operative facts are not in dispute. In November, 1959 plaintiff went to the Arthur Murray
Studio in Oak Park to redeem a certificate entitling him to three free dancing lessons. At that
time he was a 37 year-old college-educated bachelor who lived alone in a one-room attic
apartment in Berwyn, Illinois. During the free lessons the instructor told plaintiff he had
‘exceptional potential to be a fine and accomplished dancer’ and generally encouraged further
participation. Plaintiff thereupon signed a contract for 75 hours of lessons at a cost of $1000. At
the bottom of the contract were the bold-type words, ‘NON-CANCELABLE, NEGOTIABLE
CONTRACT.’ This initial encounter set the pattern for the future relationship between the
parties. Plaintiff attended lessons regularly. He was praised and encouraged regularly by the
instructors, despite his lack of progress. Contract extensions and new contracts for additional
instructional hours were executed. Each written extension contained the bold-type words,
‘NON-CANCELABLE CONTRACT,’ and each written contract contained the bold-type words,
‘NON-CANCELABLE NEGOTIABLE CONTRACT.’ Some of the agreements also contained the
bold-type statement, ‘I UNDERSTAND THAT NO REFUNDS WILL BE MADE UNDER THE
TERMS OF THIS CONTRACT.’
On September 24, 1961 plaintiff was severely injured in an automobile collision, rendering him
incapable of continuing his dancing lessons. At that time he had contracted for a total of 2734
hours of lessons, for which he had paid $24,812.80 [about $176,000 in 2010 dollars]. Despite
written demand defendants refused to return any of the money, and this suit in equity ensued.
At the close of plaintiff’s case the trial judge dismissed the fraud count (Count II), describing the
instructors’ sales techniques as merely ‘a matter of pumping salesmanship.’ At the close of all
the evidence a decree was entered under Count I in favor of plaintiff for all prepaid sums, plus
interest, but minus stipulated sums attributable to completed lessons.

Saylor URL: http://www.saylor.org/books

Saylor.org
547

Plaintiff was granted rescission on the ground of impossibility of performance. The applicable
legal doctrine is expressed in the Restatement of Contracts, s 459, as follows:
A duty that requires for its performance action that can be rendered only by the
promisor or some other particular person is discharged by his death or by such illness
as makes the necessary action by him impossible or seriously injurious to his health,
unless the contract indicates a contrary intention or there is contributing fault on the
part of the person subject to the duty.…
Defendants do not deny that the doctrine of impossibility of performance is generally applicable
to the case at bar. Rather they assert that certain contract provisions bring this case within the
Restatement’s limitation that the doctrine is inapplicable if ‘the contract indicates a contrary
intention.’ It is contended that such bold type phrases as ‘NON-CANCELABLE CONTRACT,’
‘NON-CANCELABLE NEGOTIABLE CONTRACT’ and ‘I UNDERSTAND THAT NO REFUNDS
WILL BE MADE UNDER THE TERMS OF THIS CONTRACT’ manifested the parties’ mutual
intent to waive their respective rights to invoke the doctrine of impossibility. This is a
construction which we find unacceptable. Courts engage in the construction and interpretation
of contracts with the sole aim of determining the intention of the parties. We need rely on no
construction aids to conclude that plaintiff never contemplated that by signing a contract with
such terms as ‘NON-CANCELABLE’ and ‘NO REFUNDS’ he was waiving a remedy expressly
recognized by Illinois courts. Were we also to refer to established tenets of contractual
construction, this conclusion would be equally compelled. An ambiguous contract will be
construed most strongly against the party who drafted it. [Citation] Exceptions or reservations
in a contract will, in case of doubt or ambiguity, be construed least favorably to the party
claiming the benefit of the exceptions or reservations. Although neither party to a contract
should be relieved from performance on the ground that good business judgment was lacking, a
court will not place upon language a ridiculous construction. We conclude that plaintiff did not
waive his right to assert the doctrine of impossibility.
Plaintiff’s Count II, which alleged fraud and sought punitive damages, was dismissed by the trial
judge at the close of plaintiff’s case. It is contended on appeal that representations to plaintiff
that he had ‘exceptional potential to be a fine and accomplished dancer,’ that he had ‘exceptional
Saylor URL: http://www.saylor.org/books

Saylor.org
548

potential’ and that he was a ‘natural born dancer’ and a ‘terrific dancer’ fraudulently induced
plaintiff to enter into the contracts for dance lessons.
Generally, a mere expression of opinion will not support an action for fraud. [Citation] In
addition, misrepresentations, in order to constitute actionable fraud, must pertain to present or
pre-existing facts, rather than to future or contingent events, expectations or probabilities.
[Citation] Whether particular language constitutes speculation, opinion or averment of fact
depends upon all the attending facts and circumstances of the case. [Citation] Mindful of these
rules, and after carefully considering the representations made to plaintiff, and taking into
account the business relationship of the parties as well as the educational background of
plaintiff, we conclude that the instructors’ representations did not constitute fraud. The trial
court correctly dismissed Count II. We affirm.
Affirmed.

CASE QUESTIONS

1. Why is it relevant that the plaintiff was “a bachelor who lived alone in a one-room attic
apartment”?
2. The contract here contained a “no cancellation” clause; how did the court construe the
contract to allow cancellation?
3. Plaintiff lost on his claim of fraud (unlike Mrs. Vokes in the similar case in Chapter 10 "Real
Assent" against another franchisee of Arthur Murray, Inc.). What defense was successful?
4. What is the controlling rule of law here?

15.3 Summary and Exercises
Summary

The law of contracts has various rules to determine whether obligations have been discharged.
Of course, if both parties have fully performed the contract, duties will have terminated. But
many duties are subject to conditions, including conditions precedent and subsequent,
conditions requiring approval of the promisee or someone else, and clauses that recite time to be
of the essence.
A contract obligation may be discharged if the promisor has not received the benefit of the
promisee’s obligation. In some cases, failure to carry out the duty completely will discharge the
Saylor URL: http://www.saylor.org/books

Saylor.org
549

corresponding obligation (material breach); in other cases, the substantial performance doctrine
will require the other party to act.
A contract may have terminated because one of the parties tells the other in advance that he will
not carry out his obligations; this is called anticipatory breach. The right to adequate assurance
allows one party to determine whether the contract will be breached by the other party.
There are other events, too, that may excuse performance: impracticability (including the UCC
rules governing impracticability in contracts for the sale of goods), death or incapacity of the
obligor, destruction of the thing necessary for the performance, government prohibition,
frustration of purpose, and power of avoidance.
Finally, note that not all obligations are created by contract, and the law has rules to deal with
discharge of duties in general. Thus, in the appropriate cases, the obligee may cancel or
surrender a written contract, may enter into an accord, may agree to rescind the agreement, or
may release the obligor. Or the obligor may show a material alteration in the contract, may
become bankrupt, or may plead the statute of limitations—that is, plead that the obligee waited
too long to sue. Or the parties may, by word or deed, mutually abandon the agreement. In all
these ways, duties may be discharged.

EXERCISES

1. Theresa hired Contractor to construct a large office building. Theresa’s duty to pay
Contractor was conditioned on receipt of a statement from her architect that the building
complied with the terms of the contract. Contractor completed the building but used the
wrong color fixtures in the bathrooms. The architect refused to approve the work, but under
state law, Contractor was considered to have substantially performed the contract. Is he
entitled to payment, less damages for the improper fixtures? Explain.
2. In early 1987, Larry McLanahan submitted a claim to Farmers Insurance for theft of his 1985
Lamborghini while it was on consignment for sale in the Los Angeles area. The car had
sustained extensive damage, which McLanahan had his mechanic document. The insurance
policy contained this language: “Allow us to inspect and appraise the damaged vehicle before
its repair or disposal.” But after considerable delay by Farmers, McLanahan sold the car to a
cash buyer without notifying Farmers. He then sued Farmers for its refusal to pay for

Saylor URL: http://www.saylor.org/books

Saylor.org
550

damages to his car. Upon what legal theory did Farmers get a summary judgment in its
favor?
3. Plaintiff sold a tavern to Defendants. Several months later, Defendants began to experience
severe problems with the septic tank system. They informed Plaintiff of the problem and
demanded the return of their purchase money. Plaintiff refused. Defendants took no formal
action against Plaintiff at that time, and they continued to operate the tavern and make their
monthly payments under the contract. Some months later, Defendants met with state
officials from the Departments of Environmental Quality, Health, and Liquor Control
Commission. The officials warned Defendants that because of the health hazards posed by
the septic tank problems, Defendants’ licenses might not be renewed. As a result,
Defendants decided to close the tavern and attempt to reopen when the septic tank was
repaired. Defendants advertised a going-out-of-business sale. The purpose of the sale was to
deplete the tavern’s inventory before closing. Plaintiff learned about the sale and discovered
that Defendants had removed certain personal property from the tavern. He sued the
Defendants, claiming, among other things, that they had anticipatorily breached their
contract with him, though he was receiving payments on time. Did the Defendants’ actions
amount to an anticipatory breach? [1]
4. Julius, a manufacturer of neckties, contracted to supply neckties to a wholesaler. When
Julius’s factory burned, he failed to supply any, and the wholesaler sued. Is Julius excused
from performance by impossibility?
5. The Plaintiff (a development corporation) contracted to buy Defendant’s property for $1.8
million. A term in the contract read: “The sale…shall be closed at the office of Community
Title Company on May 16th at 10:00 am.…Time is of the essence in this contract.” Defendant
appeared at the office at 10:00 a.m. on the day designated, but the Plaintiff’s agent was not
there. Defendant waited for twenty minutes, then left. Plaintiff’s agent arrived at 10:30 a.m.
and announced that he would not have funds for payment until 1:30 p.m., but Defendant
refused to return; she had already made other arrangements to finance her purchase of
other real estate. Plaintiff sued Defendant for specific performance. Who wins, and why?

Saylor URL: http://www.saylor.org/books

Saylor.org
551

6. A contract between the Koles and Parker-Yale provided for completion of the Koles’s
condominium unit within 180 days. It also authorized the Koles to make written changes in
the plans and specifications. Construction was not completed within the 180-day period, and
the Koles, prior to completion, sent a letter to Parker-Yale rescinding the contract. Were the
Koles within their rights to rescind the contract?
7. Plaintiff contracted to buy Defendant’s commercial property for $1,265,000. Under the terms
of the agreement, Defendant paid $126,000 as an earnest-money deposit, which would be
retained by Plaintiff as liquidated damages if Defendant failed to close by the deadline.
Tragically, Defendant’s husband died four days before the closing deadline, and she was not
able to close by the deadline. She was relying on her husband’s business to assist her in
obtaining the necessary financing to complete the purchase, and after his death, she was not
able to obtain it. Plaintiff sued for the $126,000; Defendant argued that the purpose of the
contract was frustrated due to the untimely death of her husband. Is this a good argument?
8. Buyer contracted to buy Seller’s house for $290,000; the contract included a representation
by Buyer “that he has sufficient cash available to complete this purchase.” Buyer was a
physician who practiced with his uncle. He had received assurances from his uncle of a loan
of $200,000 in order to finance the purchase. Shortly after the contract was executed, the
uncle was examined by a cardiologist, who found his coronary arteries to be dangerously
clogged. As a result, the uncle immediately had triple bypass surgery. After the operation, he
told Buyer that his economic future was now uncertain and that therefore it was impossible
for him to finance the house purchase. Meanwhile, Seller, who did not know of Buyer’s
problem, committed herself to buy a house in another state and accepted employment there
as well. Buyer was unable to close; Seller sued. Buyer raised as a defense impossibility or
impracticability of performance. Is the defense good?
9. Pursuant to a contract for the repair and renovation of a swimming pool owned by
Defendant (City of Fort Lauderdale), Plaintiff commenced the work, which included
resurfacing the inside of the pool, and had progressed almost to completion. Overnight,
vandals damaged the work Plaintiff had done inside the pool, requiring that part of the work
be redone. Plaintiff proceeded to redo the work and billed Defendant, who paid the contract
Saylor URL: http://www.saylor.org/books

Saylor.org
552

price but refused to pay for the additional work required to repair the damage. Did the
damage constitute destruction of subject matter discharging Plaintiff from his obligation to
complete the job without getting paid extra?
10. Apache Plaza (the landlord) leased space to Midwest Savings to construct a bank building in
Apache’s shopping mall, based on a prototype approved by Apache. Midwest constructed
the building and used it for twelve years until it was destroyed by a tornado. Midwest
submitted plans for a new building to Apache, but Apache rejected the plans because the
new building was larger and had less glass than the old building or the prototype. Midwest
built it anyway. Its architect claimed that certain changes in the structure of the new building
were required by new regulations and building codes, but he admitted that a building of the
stipulated size could have been constructed in compliance with the applicable codes. Apache
claimed $210,000 in damages over the term of the lease because the new building consumed
more square feet of mall space and required more parking. Midwest claimed it had
substantially complied with the lease requirements. Is this a good defense? [2]

SELF-TEST QUESTIONS

1. A condition precedent
a.

is a condition that terminates a duty

b. is always within the control of one of the parties
c. is an event giving rise to performance
d. is a condition that follows performance
If Al and Betty have an executory contract, and if Betty tells Al that she will
not be fulfilling her side of the bargain,
a.

Al must wait until the date of performance to see if Betty in fact performs

b. Al can sue immediately for full contract damages
c. Al can never sue because the contract was executory when Betty notified him of
nonperformance
d. none of the above
Jack contracts with Anne to drive her to the airport Wednesday afternoon
in his specially designed stretch limousine. On Wednesday morning Jack’s

Saylor URL: http://www.saylor.org/books

Saylor.org
553

limousine is hit by a drunken driver, and Jack is unable to drive Anne. This is an
example of
a.

impossibility of performance

b. frustration of purpose
c. discharge by merger
d. none of the above
Jack is ready and willing to drive Anne to the airport. But Anne’s flight is
cancelled, and she refuses to pay. This is an example of
a.

impracticability of performance

b. frustration of purpose
c. discharge of merger
d. none of the above
Rescission is
a.

the discharge of one party to a contract through substitution of a third

person
b. an agreement to settle for substitute performance
c. a mutual agreement between parties to a contract to discharge each other’s
contractual duties
d. none of the above

SELF-TEST ANSWERS

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

[1] Crum v. Grant, 692 P.2d 147 (Or. App., 1984).
[2] Apache Plaza, Ltd. v. Midwest Sav. Ass’n, 456 N.W.2d 729 (Minn. App. 1990).

Saylor URL: http://www.saylor.org/books

Saylor.org
554

Chapter 16
Remedies

LEARNING OBJECTIVES
After reading this chapter, you should understand the following:
1. The basic theory of contract remedies, and why courts don’t just order the promisor to
perform as promised
2. The interests that are protected by contract remedies
3. The types of legal remedies
4. The types of equitable remedies
5. The limitations on remedies
We come at last to the question of remedies. A valid agreement has been made, the promisor’s
duties have not been discharged; he or she has breached the contract. When one party has failed
to perform, what are the rights of the parties? Or when the contract has been avoided because of
incapacity or misrepresentation and the like, what are the rights of the parties after
disaffirmance? These questions form the focus of this chapter. Remedies for breach of contracts
for the sale of goods will be considered separately, inChapter 18 "Title and Risk of Loss".

16.1 Theory of Contract Remedies

LEARNING OBJECTIVES

1. Understand the basic purpose of remedies.
2. Recognize that there are two general categories of remedies: legal and equitable.
3. See that courts do not simply order obligors to keep their promise but instead allow them to
breach and the nonbreaching party to have remedies for that breach.

Purpose of Remedies
The fundamental purpose of remedies in noncriminal cases is not to punish the breaching party
but—if possible—to put the nonbreaching party in the position he or she would have been in had
there been no breach. Or, as is said, the purpose is to make the nonbreaching party whole.
There are two general categories of remedies—legal and equitable. In the category of legal
remedies are damages. Damages are money paid by one party to another; there are several types
of damages. In the category of equitable remedies are these three:specific performance, which
Saylor URL: http://www.saylor.org/books

Saylor.org
555

means a person is ordered to deliver a unique thing (land or a unique personal property, such as
a painting or an antique car);injunction, a judicial order directing a person to stop doing what he
or she should not do (such as competing with a former employer in violation of a noncompete
agreement); and restitution, which means putting the parties back into the position they were in
before the contract was made.

Parties Have the Power—but Not the Right—to Breach
In view of the importance given to the intention of the parties in forming and interpreting
contracts, it may seem surprising that the remedy for every breach is not a judicial order that the
obligor carry out his or her undertakings. But it is not. Of course, some duties cannot be
performed after a breach, because time and circumstances will have altered their purpose and
rendered many worthless. Still, there are numerous occasions on which it would be theoretically
possible for courts to order the parties to carry out their contracts, yet the courts will not do it.
In 1897, Justice Oliver Wendell Holmes Jr. declared in a famous line that “the duty to keep a
contract at common law means a prediction that you must pay damages if you do not keep it.”
By that, he meant simply that the common law looks more toward compensating the promisee
for his or her loss than toward compelling the promisor to perform. Indeed, the law of remedies
often provides the parties with an incentive to break the contract. In short, the promisor has a
choice: perform or pay.
The logic of this position is clear in many typical cases. The computer manufacturer orders
specially designed circuit boards, then discovers before the circuits are made that a competitor
has built a better machine and destroyed his market. The manufacturer cancels the order. It
would make little economic sense for the circuit board maker to fabricate the boards if they
could not be used elsewhere. A damage remedy to compensate the maker for out-of-pocket loss
or lost profits is sensible; a judicial decree forcing the computer manufacturer to pay for and
take delivery of the boards would be wasteful.
In general and if possible, the fundamental purpose of contract remedies is to put the
nonbreaching party in the position it would have been in had there been no breach.

KEY TAKEAWAY

Saylor URL: http://www.saylor.org/books

Saylor.org
556

Remedies are intended to make the nonbreaching party whole. The two categories of
remedies for breach of contract are legal and equitable. In the legal category are damages; in
the equitable category are specific performance, injunctions, and restitution. The law does
not force a party to perform; he or she always has the power (though not the right) to
breach, and may do so if it is economically more advantageous to breach and suffer the
consequence than to perform. Remedies, though, are not (usually) intended to punish the
breaching party.

EXERCISES

1. Remedies are not supposed to punish the breaching party, generally. In what circumstances
might punishment be a remedy, and what is that called?
2. What is the difference between legal and equitable remedies?
3. Why shouldn’t people be forced to perform as they contracted, instead of giving them the
power to breach and then be required to pay damages?

16.2 Promisee’s Interests Protected by Contract
LEARNING OBJECTIVE

1. Understand that the nonbreaching party to a contract has certain expectations that contract
remedies seek to fulfill to make the nonbreaching party whole.
Contract remedies serve to protect three different interests: an expectation interest, a reliance
interest, and a restitution interest. A promisee will have one of these and may have two or all
three.
An expectation interest is the benefit for which the promisee bargained, and the remedy is to put
him in a position as good as that which he would have been in had the contract been performed.
A reliance interest is the loss suffered by relying on the contract and taking actions consistent
with the expectation that the other party will abide by it; the remedy is reimbursement that
restores the promisee to his position before the contract was made. A restitution interest is that
which restores to the promisee any benefit he conferred on the promisor. These interests do not
dictate the outcome according to a rigid formula; circumstances and the nature of the contract,
as usual, will play a large role. But in general, specific performance is a remedy that addresses

Saylor URL: http://www.saylor.org/books

Saylor.org
557

the expectation interest, monetary damages address all three interests, and, not surprisingly,
restitution addresses the restitution interest.
Consider some simple examples. A landowner repudiates an executory contract with a builder to
construct a garage on her property for $100,000. The builder had anticipated a $10,000 profit
(the garage would have cost him $90,000 to build). What can he expect to recover in a lawsuit
against the owner? The court will not order the garage to be built; such an order would be
wasteful, since the owner no longer wants it and may not be able to pay for it. Instead, the court
will look to the builder’s three possible interests. Since the builder has not yet started his work,
he has given the owner nothing, and therefore has no restitution interest. Nor has he any
reliance interest, since we are assuming that he has not paid out any money for supplies, hired a
work crew, or advanced money to subcontractors. But he anticipated a profit, and so he has an
expectation interest of $10,000.
Now suppose that the builder had dug out the foundation and poured concrete, at a cost of
$15,000. His expectation interest has become $25,000 (the difference between $100,000 and
$75,000, the money he will save by not having to finish the job). His reliance interest is
$15,000, because this is the amount he has already spent. He may also have a restitution
interest, depending on how much the foundation of the house is worth to the owner. (The value
could be more or less than the sum of money actually expended to produce the foundation; for
example, the builder might have had to pay his subcontractors for a greater share of the job than
they had completed, and those sums therefore would not be reflected in the worth of the
foundation.)
Normally, the promisee will choose which of the three interests to pursue. As is to be expected,
the choice hinges on the circumstances of the case, his feelings, and the amount at stake.

KEY TAKEAWAY

A nonbreaching party might have one or more interests that the law seeks to realize:
expectation, reliance, and restitution.

EXERCISES

1. What is the expectation interest? The reliance interest? The restitution interest?
2. How are these concepts useful in understanding contract remedies?

Saylor URL: http://www.saylor.org/books

Saylor.org
558

16.3 Legal Remedies: Damages

LEARNING OBJECTIVES

1. Understand what is meant when it is said that damages are a legal remedy (as opposed to an
equitable remedy).
2. Understand the names and purposes of the six types of remedies.
3. Know when liquidated damages will be allowed.
4. Recognize the circumstances that might allow punitive damages.

Overview
The promisee, whom we will hereafter refer to as the nonbreaching party, has the right to
damages (a money award), if that is required to make her whole, whenever the other party has
breached the contract, unless, of course, the contract itself or other circumstances suspend or
discharge that right. Damages refers to money paid by one side to the other; it is a legal
remedy. For historical and political reasons in the development of the English legal system, the
courts of law were originally only able to grant monetary relief. If a petitioner wanted something
other than money, recourse to a separate system of equity was required. The courtrooms and
proceedings for each were separate. That actual separation is long gone, but the distinction is
still recognized; a judge may be said to be “sitting in law” or “sitting in equity,” or a case may
involve requests for both money and some action. We take up the legal remedies of damages
first.

Types of Damages
There are six different types of damages: compensatory, incidental, consequential, nominal,
liquidated, and (sometimes) punitive.

Compensatory Damages
Damages paid to directly compensate the nonbreaching party for the value of what was not done
or performed are compensatory damages. Sometimes calculating that value of the promisor’s
performance is easy—for example, when the nonbreaching party has ascertainable costs and
profits, as in the case of the builder who would have earned $10,000 profit on a $100,000
house. When the performance is a service, a useful measure of loss is what it would cost to
substitute performance by someone else. But the calculation is frequently difficult, especially
Saylor URL: http://www.saylor.org/books

Saylor.org
559

when the performance is a service that is not easily duplicated. If Rembrandt breached a
contract to paint your portrait, the loss could not be measured simply by inquiring how much
Van Gogh would charge to do the same thing. Nevertheless, in theory, whatever net value would
ultimately have been conferred on the nonbreaching party is the proper measure of
compensatory damages. An author whose publisher breaches its contract to publish the book
and who cannot find another publisher is entitled to lost royalties (if ascertainable) plus the
value that would have accrued from her enhanced reputation.
Since the nonbreaching party usually has obligations under the contract also, a breach by the
other party discharges his duty to perform and may result in savings. Or he may have made
substitute arrangements and realized at least a partial profit on the substitution. Or, as in the
case of the builder, he may have purchased goods intended for the job that can be used
elsewhere. In all these situations, the losses he has avoided—savings, profits, or value of goods—
are subtracted from the losses incurred to arrive at the net damages. The nonbreaching party
may recover his actual losses, not more. Suppose an employer breaches a contract with a
prospective employee who was to begin work for a year at a salary of $35,000. The employee
quickly finds other, similar work at a salary of $30,000. Aside from whatever he might have had
to spend searching for the job (incidental damages), his compensatory damages are limited to
$5,000, the difference between what he would have earned and what he is earning.
Lost volume can be a troublesome problem in calculating damages. This problem arises when
the nonbreaching party, a supplier of goods or services, enters a second contract when the buyer
repudiates. The question is whether the second contract is a substituted performance or an
additional one. If it is substituted, damages may be little or nothing; if additional, the entire
expectation interest may be recovered. An automobile dealer contracts to sell a car in his
inventory. Shortly before the deal is closed, the buyer calls up and repudiates the contract. The
dealer then sells the car to someone else. If the dealer can show that he could have sold an
identical car to the second purchaser regardless of what the first purchaser did, then the second
sale stands on its own and cannot be used to offset the net profit recoverable from the first
purchaser. The factual inquiry in lost volume cases is whether the nonbreaching party would
have engaged in the second transaction if the breach had never occurred.
Saylor URL: http://www.saylor.org/books

Saylor.org
560

Incidental Damages
In addition to compensatory damages, the nonbreaching party may recoverincidental damages.
Incidental loss includes expenditures that the nonbreaching party incurs in attempting to
minimize the loss that flows from the breach. To arrange for substitute goods or services, the
nonbreaching party might have to pay a premium or special fees to locate another supplier or
source of work.

Consequential Damages
A consequential loss is addressed with consequential damages. These are damages incurred by
the nonbreaching party without action on his part because of the breach. For example, if Ralph
does a poor job of plumbing Betty’s bathroom and the toilet leaks, damaging the floor, the
downstairs ceiling, and the downstairs rug, Ralph would owe for those loses in consequential
damages. Or, again, lost sales stemming from a failure to fix a manufacturer’s machine in time
or physical and property injury due to a defective machine sold by the promisor would be
addressed with consequential damages. Note, however, that one obvious, and often large,
expenditure occasioned by a breach—namely, legal expenses in bringing a lawsuit to remedy the
particular breach—is not an element of damages, unless the contract explicitly states that it is,
and cannot be charged to the defendant. There is one situation, however, in which legal costs
can be added to damages: when the breach causes the nonbreaching party to be involved in a
lawsuit with someone else. Consequential damages will not be allowed if those damages are not
foreseeable. This issue is taken up in /6059 - mayer_1.0-ch16_s05.

Nominal Damages

In the situation where there has been a breach but the nonbreaching party has really suffered no
loss or cannot prove what his loss is, he is entitled to nominal damages. Ricardo contracts to buy
a new car from a dealer; the dealer breaches the contract. Ricardo finds and buys the same car
from another dealer at the same price that the first one was to sell it for. Ricardo has suffered
nominal damages: five dollars, perhaps.

Liquidated Damages
Precisely because damages are sometimes difficult to assess, the parties themselves may specify
how much should be paid in the event of a breach. Courts will enforce
Saylor URL: http://www.saylor.org/books

Saylor.org
561

aliquidated damages provision as long as the actual amount of damages is difficult to ascertain
(in which case proof of it is simply made at trial) and the sum is reasonable in light of the
expected or actual harm. If the liquidated sum is unreasonably large, the excess is termed a
penalty and is said to be against public policy and unenforceable. /6059 - mayer_1.0ch16_s06_s02,Watson v. Ingram, illustrates liquidated damages.

Punitive Damages

Punitive damages are those awarded for the purpose of punishing a defendant in a civil action,
in which criminal sanctions are of course unavailable. They are proper in cases in which the
defendant has acted willfully and maliciously and are thought to deter others from acting
similarly. Since the purpose of contract law is compensation, not punishment, punitive damages
have not traditionally been awarded, with one exception—when the breach of contract is also a
tort for which punitive damages may be recovered. Punitive damages are permitted in the law of
torts (in all but four states) when the behavior is malicious or willful (reckless conduct causing
physical harm, deliberate defamation of one’s character, a knowingly unlawful taking of
someone’s property), and some kinds of contract breach are also tortious. For example, when a
creditor holding collateral as security under a contract for a loan sells the collateral to a goodfaith purchaser for value even though the debtor was not in default, he has breached the contract
and committed the tort of conversion; punitive damages may be awarded, assuming the
behavior was willful and not merely mistaken.
Punitive damages are not fixed by law. The judge or jury may award at its discretion whatever
sum is believed necessary to redress the wrong or deter like conduct in the future. This means
that a richer person may be slapped with much heavier punitive damages than a poorer one in
the appropriate case. But the judge in all cases may remit (reduce) some or all of a punitive
damage award if he or she considers it excessive.

KEY TAKEAWAY

As the purpose of contract remedies is, in general, to make the nonbreaching party whole,
the law allows several types of damages (money paid) to reflect the losses suffered by the
nonbreaching party. Compensatory damages compensate for the special loss suffered;
consequential damages compensate for the foreseeable consequences of the breach;

Saylor URL: http://www.saylor.org/books

Saylor.org
562

incidental damages compensate for the costs of keeping any more damages from occurring;
nominal damages are awarded if the actual amount cannot be shown or there are no actual
damages; liquidated damages are agreed to in advance where the actual amount is difficult
to ascertain, and they are allowed if not a penalty; and punitive damages may sometimes be
allowed if the breaching party’s behavior is an egregious tort, an outrage.

EXERCISES

1. What is the difference between a legal remedy and an equitable remedy?
2. What types of remedies are there, and what purpose does each serve?
3. What must be shown if liquidated damages are to be allowed?
4. Under what circumstances may punitive damages be allowed?

16.4 Equitable Remedies

LEARNING OBJECTIVES

1. Know when equitable (as opposed to legal) remedies will be allowed.
2. Understand the different types of equitable remedies: specific performance, injunction, and
restitution.

Overview
Really the only explanation for the differences between law and equity is to be found in the
history and politics of England dating to the twelfth century, but in practical terms, the
distinctions are notable. First, juries are not used in equitable cases. Second, equity relies less on
precedent and more on the sense that justice should be served. Third, and of most significance,
where what is sought by the nonbreaching party is not money—that is, where there is no
adequate legal remedy—equity may afford relief. In equity a person may get a judge to order the
breaching party to deliver some actual property, or to stop doing something that he should not
do, or to return the consideration the nonbreaching party gave so as to return the parties to the
precontract status (specific performance, injunction, and restitution, respectively).

Types of Remedies in Equity
There are three types of equitable remedies: specific performance, injunction, and restitution.

Specific Performance

Saylor URL: http://www.saylor.org/books

Saylor.org
563

Specific performance is a judicial order to the promisor that he undertake the performance
to which he obligated himself in a contract. Specific performance is an alternative remedy to
damages and may be issued at the discretion of the court, subject to a number of exceptions.
Emily signs a contract to sell Charlotte a gold samovar, a Russian antique of great sentimental
value because it once belonged to Charlotte’s mother. Emily then repudiates the contract while
still executory. A court may properly grant Charlotte an order of specific performance against
Emily.
Once students understand the basic idea of specific performance, they often want to pounce
upon it as the solution to almost any breach of contract. It seems reasonable that the
nonbreaching party could ask a court to simply require the promisor to do what she promised
she would. But specific performance is a very limited remedy: it is onlyavailable for breach of
contract to sell a unique item, that is, a unique item of personal property (the samovar), or a
parcel of real estate (all real estate is unique). But if the item is not unique, so that the
nonbreaching party can go out and buy another one, then the legal remedy of money damages
will solve the problem. And specific performance will never be used to force a person to perform
services against his will, which would be involuntary servitude. A person may be forced to stop
doing that which he should not do (injunction), but not forced to do what he will not do.

Injunction
An injunction is the second type of equitable remedy available in contract (it is also available
in tort). It is a court order directing a person to stop doing that which she should not do. For
example, if an employer has a valid noncompete contract with an employee, and the employee,
in breach of that contract, nevertheless undertakes to compete with his former employer, a court
may enjoin (issue an order of injunction), directing the former employee to stop such
competition. A promise by a person not to do something—in this example, not to compete—is
called a negative covenant (a covenant is a promise in a contract, itself a contract). Or if Seller
promises to give Buyer the right of first refusal on a parcel of real estate or a unique work of art,
but Seller, in breach of a written promise, offers the thing to a third party, a court may enjoin
Seller from selling it to the third party. If a person violates an injunction, he may be held in
contempt of court and put in jail for a while. Madison Square Garden v. Carnera
Saylor URL: http://www.saylor.org/books

Saylor.org
564

Corporation, /6059 - mayer_1.0-ch16_s06_s03, is a classic case involving injunctions for breach of
contract.

Restitution
The third type of equitable relief is restitution. Restitution is a remedy applicable to several
different types of cases: those in which the contract was avoided because of incapacity or
misrepresentation, those in which the other party breached, and those in which the party
seeking restitution breached. As the word implies, restitution is a restoring to one party of what
he gave to the other. Therefore, only to the extent that the injured party conferred a benefit on
the other party may the injured party be awarded restitution. The point is, a person who
breaches a contract should not suffer a punishment, and the nonbreaching party should not be
unjustly enriched.

Total Nonperformance by Breaching Party
The nonbreaching party is always entitled to restitution in the event of total breach by
nonperformance or repudiation, unless both parties have performed all duties except for
payment by the other party of a definite sum of money for the injured party’s
performance. [1] Calhoun, a contractor, agrees to build $3,000 worth of fences for only $2,000
and completes the construction. Arlene, the landowner, refuses to pay. Calhoun’s only right is to
get the $2,000; he does not have a restitution right to $2,500, the market price of his services
(or $3,000, the amount by which her property increased in value); he is entitled, instead, only to
$2,000, his contract price. Had Arlene repudiated prior to completion, however, Calhoun would
then have been entitled to restitution based either on the market price of the work or on the
amount by which he enhanced her property. If the one party breaches, the nonbreaching party is
generally entitled to restitution of property that can be returned. Arlene gives Calhoun a
valuable Ming vase in return for his promise to construct the fences. Upon Calhoun’s breach,
Arlene is entitled to specific restitution of the vase.
Measuring restitution interest can be problematic. The courts have considerable discretion to
award either what it would have cost to hire someone else to do the work that the nonbreaching
party performed (generally, the market price of the service) or the value that was added to the
property of the party in breach by virtue of the claimant’s performance. Calhoun, the contractor,
Saylor URL: http://www.saylor.org/books

Saylor.org
565

agrees to construct ten fences around Arlene’s acreage at the market price of $25,000. After
erecting three, Calhoun has performed services that would cost $7,500, market value. Assume
that he has increased the value of Arlene’s grounds by $8,000. If Arlene repudiated, there are
two measures of Calhoun’s restitution interest: $8,000, the value by which the property was
enhanced, or $7,500, the amount it would have cost Arlene to hire someone else to do the work.
Which measure to use depends on who repudiated the contract and for what reason. In some
cases, the enhancement of property or wealth measurement could lead to an award vastly
exceeding the market price for the service. In such cases, the smaller measure is used. For a
doctor performing lifesaving operations on a patient, restitution would recover only the market
value of the doctor’s services—not the monetary value of the patient’s life.

Part Performance and Then Breach
A party who has substantially performed and then breached is entitled to restitution of a benefit
conferred on the injured party, if the injured party has refused (even though justifiably) to
complete his own performance owing to the other’s breach. Since the party in breach is liable to
the injured party for damages for loss, this rule comes into play only when the benefit conferred
is greater than the amount the nonbreaching party has lost. Arlene agrees to sell her property to
Calhoun for $120,000, and Calhoun makes a partial payment of $30,000. He then repudiates.
Arlene turns around and sells the property to a third party for $110,000. Calhoun—the
breaching party—can get his money back, less the damages Arlene suffered as a result of his
breach. He gets $30,000 minus the $10,000 loss Arlene incurred. He gets $20,000 in
restitution. Otherwise Arlene would be enriched by Calhoun’s breach: she’d get $140,000 in
total for real estate worth $120,000. But if he gets $20,000 of his $30,000 back, she receives
$110,000 from the third party and $10,000 from Calhoun, so she gets $120,000 total (plus, we
hope, incidental damages, at least).

Restitution in Other Cases
Upon repudiation of an oral contract governed by the Statute of Frauds, the nonbreaching party
is not entitled to her expectation interest, but she may recover in restitution unless the purpose
of the statute would be frustrated. When one party avoids a contract owing to lack of capacity,
mistake, misrepresentation, duress, or the like, she is entitled to restitution for benefit conferred
Saylor URL: http://www.saylor.org/books

Saylor.org
566

on the other party. Restitution is also available if a contract duty is discharged or never arises
because (1) performance was impracticable, (2) the purpose of the contract was frustrated, (3) a
condition did not occur, or (4) a beneficiary disclaimed his benefit.

KEY TAKEAWAY

Equitable remedies for breach of contract are available when legal remedies won’t make the
nonbreaching party whole. The equitable remedies are specific performance (an order
directing a person to deliver to the buyer the unique thing the seller contracted to sell),
injunction (an order directing a person to stop doing that which he should not do), and
restitution (the return by one party of the benefit conferred on him when the contract is not
performed, to the extent necessary to avoid imposing a penalty on the breaching party).

EXERCISES

1. Buyer contracts to buy a 1941 four-door Cadillac convertible from Seller for $75,000. Seller,
having found a Third Party who will pay $85,000 for the car, refuses to sell to Buyer. What is
Buyer’s remedy?
2. Assume Third Party had paid the $85,000 and Seller was ordered to sell to Buyer. What is
Third Party’s remedy?
3. Professor Smith contracts to teach business law at State University for the academic year.
After the first term is over, she quits. Can State University get an order of specific
performance or an injunction requiring Professor Smith to return for the second term?
4. Now suppose that the reason Professor Smith quit work at State University is because she
got a better job at Central University, fifteen miles away. Can State University get an
injunction prohibiting her from teaching at Central University?

[1] Restatement (Second) of Contracts, Section 373.

16.5 Limitations on Contract Remedies
LEARNING OBJECTIVES

Saylor URL: http://www.saylor.org/books

Saylor.org
567

1. Understand that there are various rules that limit recovery for the nonbreaching party in a
contract case.
2. Know how these concepts serve to limit contract remedies: foreseeability, mitigation of
damages, certainty of damages, loss of power of avoidance, election of remedies, and
agreement of the parties.

Overview
We have observed that the purpose of remedies in contract law is, where possible, to put the
nonbreaching party in as good a position as he would have been in had there been no breach.
There are, however, several limitations or restrictions affecting when a person can claim
remedies, in both law (damages) and equity. Of course the contract itself may—if not
unconscionable—limit remedies. Beyond that, the nonbreaching party must be able to articulate
with some degree of certainty what her damages are; the damages must be foreseeable; the
nonbreaching party must have made a reasonable effort to mitigate the damages; she must
sometime elect to go with one remedy and forgo another; she cannot seek to avoid a contract if
she has lost the power to do so. We turn to these points.

Foreseeability
If the damages that flow from a breach of contract lack foreseeability, they will not be
recoverable. Failures to act, like acts themselves, have consequences. As the old fable has it, “For
want of a nail, the kingdom was lost.” To put a nonbreaching party in the position he would have
been in had the contract been carried out could mean, in some cases, providing compensation
for a long chain of events. In many cases, that would be unjust, because a person who does not
anticipate a particular event when making a contract will not normally take steps to protect
himself (either through limiting language in the contract or through insurance). The law is not
so rigid; a loss is not compensable to the nonbreaching party unless the breaching party, at the
time the contract was made, understood the loss was foreseeable as a probable result of his
breach.
Of course, the loss of the contractual benefit in the event of breach is always foreseeable. A
company that signs an employment contract with a prospective employee knows full well that if
it breaches, the employee will have a legitimate claim to lost salary. But it might have no reason
Saylor URL: http://www.saylor.org/books

Saylor.org
568

to know that the employee’s holding the job for a certain length of time was a condition of his
grandfather’s gift of $1 million.
The leading case, perhaps the most studied case, in all the common law is Hadley v. Baxendale,
decided in England in 1854. Joseph and Jonah Hadley were proprietors of a flour mill in
Gloucester. In May 1853, the shaft of the milling engine broke, stopping all milling. An employee
went to Pickford and Company, a common carrier, and asked that the shaft be sent as quickly as
possible to a Greenwich foundry that would use the shaft as a model to construct a new one. The
carrier’s agent promised delivery within two days. But through an error, the shaft was shipped
by canal rather than by rail and did not arrive in Greenwich for seven days. The Hadleys sued
Joseph Baxendale, managing director of Pickford, for the profits they lost because of the delay.
In ordering a new trial, the Court of Exchequer ruled that Baxendale was not liable because he
had had no notice that the mill was stopped:
Where two parties have made a contract which one of them has broken, the damages
which the other party ought to receive in respect of such breach of contract should be
such as may fairly and reasonably be considered either arising naturally, i.e.,
according to the usual course of things, from such breach of contract itself, or such as
may reasonably be supposed to have been in the contemplation of both parties, at the
time they made the contract, as the probable result of the breach of it. [1]
Thus when the party in breach has not known and has had no reason to know that the contract
entailed a special risk of loss, the burden must fall on the nonbreaching party. As we have seen,
damages attributable to losses that flow from events that do not occur in the ordinary course of
events are known as consequential or special damages. The exact amount of a loss need not be
foreseeable; it is the nature of the event that distinguishes between claims for ordinary or
consequential damages. A repair shop agrees to fix a machine that it knows is intended to be
resold. Because it delays, the sale is lost. The repair shop, knowing why timeliness of
performance was important, is liable for the lost profit, as long as it was reasonable. It would not
be liable for an extraordinary profit that the seller could have made because of circumstances
peculiar to the particular sale unless they were disclosed.

Saylor URL: http://www.saylor.org/books

Saylor.org
569

The special circumstances need not be recited in the contract. It is enough for the party in
breach to have actual knowledge of the loss that would occur through his breach. Moreover, the
parol evidence rule (/6059 - mayer_1.0-ch13) does not bar introduction of evidence bearing on the

party’s knowledge before the contract was signed. So the lesson to a promisee is that the reason
for the terms he bargains for should be explained to the promisor—although too much
explanation could kill a contract. A messenger who is paid five dollars to deliver a letter across
town is not likely to undertake the mission if he is told in advance that his failure for any reason
to deliver the letter will cost the sender $1 million, liability to be placed on the messenger.
Actual knowledge is not the only criterion, because the standard of foreseeability is objective,
not subjective. That means that if the party had reason to know—if a reasonable person would
have understood—that a particular loss was probable should he breach, then he is liable for
damages. What one has reason to know obviously depends on the circumstances of the case, the
parties’ prior dealings, and industry custom. A supplier selling to a middleman should know that
the commodity will be resold and that delay or default may reduce profits, whereas delay in sale
to an end user might not. If it was foreseeable that the breach might cause the nonbreaching
party to be sued, the other party is liable for legal fees and a resulting judgment or the cost of a
settlement.
Even though the breaching party may have knowledge, the courts will not always award full
consequential damages. In the interests of fairness, they may impose limitations if such an
award would be manifestly unfair. Such cases usually crop up when the parties have dealt
informally and there is a considerable disproportion between the loss caused and the benefit the
nonbreaching party had agreed to confer on the party who breached. The messenger may know
that a huge sum of money rides on his prompt delivery of a letter across town, but unless he
explicitly contracted to bear liability for failure to deliver, it is unlikely that the courts would
force him to ante up $1 million when his fee for the service was only five dollars.
EBWS, LLC v. Britly Corp., /6059 - mayer_1.0-ch16_s06_s01, is a case that represents a modern

application of the rule of Hadley v. Baxendale on the issue of foreseeability of consequential
damages.

Mitigation of Damages
Saylor URL: http://www.saylor.org/books

Saylor.org
570

Contract law encourages the nonbreaching party to avoid loss wherever possible; this is
called mitigation of damages. The concept is a limitation on damages in law. So there can be no
recovery if the nonbreaching party had an opportunity to avoid or limit losses and failed to take
advantage of it. Such an opportunity exists as long as it does not impose, in the Restatement’s
words, an “undue risk, burden or humiliation.” [2] The effort to mitigate need not be successful.
As long as the nonbreaching party makes a reasonable, good-faith attempt to mitigate his losses,
damages are recoverable.
Mitigation crops up in many circumstances. Thus a nonbreaching party who continues to
perform after notice that the promisor has breached or will breach may not recover for expenses
incurred in continuing to perform. And losses from the use of defective goods delivered in
breach of contract are not compensable if the nonbreaching party knew before use that they
were defective. Often the nonbreaching party can make substitute arrangements—find a new job
or a new employee, buy substitute goods or sell them to another buyer—and his failure to do so
will limit the amount of damages he will recover from the party who breaches. Under the general
rule, failure to mitigate when possible permits the promisor to deduct from damages the amount
of the loss that the nonbreaching party could have avoided. When there is a readily ascertainable
market price for goods, damages are equal to the difference between the contract price and the
market price.
A substitute transaction is not just any possible arrangement; it must be suitable under the
circumstances. Factors to be considered include the similarity, time, and place of performance,
and whether the difference between the contracted-for and substitute performances can be
measured and compensated. A prospective employee who cannot find substitute work within
her field need not mitigate by taking a job in a wholly different one. An advertising salesperson
whose employment is repudiated need not mitigate by taking a job as a taxi driver. When the
only difference between the original and the substitute performances is price, the nonbreaching
party must mitigate, even if the substitute performer is the original promisor.
The nonbreaching party must mitigate in timely fashion, but each case is different. If it is clear
that the promisor has unconditionally repudiated before performance is due, the nonbreaching

Saylor URL: http://www.saylor.org/books

Saylor.org
571

party must begin to mitigate as soon as practicable and should not wait until the day
performance is due to look for an alternative.
As long as the nonbreaching party makes a reasonable effort to mitigate, the success of that
effort is not an issue in assessing damages. If a film producer’s original cameraman breaches the
contract, and if the producer had diligently searched for a substitute cameraman, who cost $150
extra per week and it later came to light that the producer could have hired a cameraman for
$100, the company is entitled nevertheless to damages based on the higher figure. Shirley
MacLaine v. Twentieth Century-Fox Corporation, /6059 - mayer_1.0-ch16_s06_s04, is a well-known
case involving mitigation of damages.

Certainty of Damages
A party can recover only that amount of damage in law which can be proved with reasonable
certainty. Especially troublesome in this regard are lost profits and loss of goodwill. Alf is
convinced that next spring the American public will be receptive to polka-dotted belts with his
name monogrammed in front. He arranges for a garment factory to produce 300,000 such belts,
but the factory, which takes a large deposit from him in advance, misplaces the order and does
not produce the belts in time for the selling season. When Alf discovers the failure, he cannot
raise more money to go elsewhere, and his project fails. He cannot recover damages for lost
profits because the number is entirely speculative; no one can prove how much he would have
made, if anything. He can, instead, seek restitution of the monies advanced. If he had rented a
warehouse to store the belts, he would also be able to recover his reliance interest.
Proof of lost profits is not always difficult: a seller can generally demonstrate the profit he would
have made on the sale to the buyer who has breached. The problem is more difficult, as Alf’s
case demonstrates, when it is the seller who has breached. A buyer who contracts for but does
not receive raw materials, supplies, and inventory cannot show definitively how much he would
have netted from the use he planned to make of them. But he is permitted to prove how much
money he has made in the past under similar circumstances, and he may proffer financial and
market data, surveys, and expert testimony to support his claim. When proof of profits is

Saylor URL: http://www.saylor.org/books

Saylor.org
572

difficult or impossible, the courts may grant a nonmonetary award, such as specific
performance.

Loss of Power of Avoidance
You will recall that there are several circumstances when a person may avoid a contract: duress,
undue influence, misrepresentation (fraudulent, negligent, or innocent), or mistake. But a party
may lose the right to avoid, and thus the right to any remedy, in several ways.

Delay
If a party is the victim of fraud, she must act promptly to rescind at common law, or she will lose
the right and her remedy will be limited to damages in tort. (This is discussed a bit more in /6059
- mayer_1.0-ch16_s05_s07.)

Affirmation

An infant who waits too long to disaffirm (again, delay) will have ratified the contract, as will
one who—notwithstanding being the victim of duress, undue influence, mistake, or any other
grounds for avoidance—continues to operate under the contract with full knowledge of his right
to avoid. Of course the disability that gave rise to the power of avoidance must have passed
before affirmation works.

Rights of Third Parties
The intervening rights of third parties may terminate the power to avoid. For example, Michelle,
a minor, sells her watch to Betty Buyer. Up to and within a reasonable time after reaching
majority, Michelle could avoid—disaffirm—the contract. But if, before that time, Betty sells the
watch to a third party, Michelle cannot get it back from the third party. Similarly, Salvador Seller
sells his car to Bill Buyer, who pays for it with a bad check. If the check bounces, Salvador can
rescind the deal—Bill’s consideration (the money represented by the check) has failed: Salvador
could return the check and get his car back. But if, before the check from Bill bounces, Bill in
turn sells the car to Pat Purchaser, Salvador cannot avoid the contract. Pat gets to keep the car.
There are some exceptions to this rule.

Agreement of the Parties Limiting Remedies
Certainly it is the general rule that parties are free to enter into any kind of a contract they want,
so long as it is not illegal or unconscionable. The inclusion into the contract of a liquidated
Saylor URL: http://www.saylor.org/books

Saylor.org
573

damages clause—mentioned previously—is one means by which the parties may make an
agreement affecting damages. But beyond that, as we saw in /6059 - mayer_1.0-ch12, it is very

common for one side to limit its liability, or for one side to agree that it will pursue only limited
remedies against the other in case of breach. Such agree-to limitations on the availability of
remedies are generally OK provided they are conspicuous, bargained-for, and not
unconscionable. In consumer transactions, courts are more likely to find a contracted-for
limitation of remedies unconscionable than in commercial transactions, and under the Uniform
Commercial Code (UCC) there are further restrictions on contractual remedy limitations.
For example, Juan buys ten bags of concrete to make a counter and stand for his expensive new
barbecue. The bags have this wording in big print: “Attention. Our sole liability in case this
product is defective will be to provide you with a like quantity of nondefective material. We will
not be liable for any other damages, direct or indirect, express or implied.” That’s fine. If the
concrete is defective, the concrete top breaks, and Juan’s new barbecue is damaged, he will get
nothing but some new bags of good concrete. He could have shopped around to find somebody
who would deliver concrete with no limitation on liability. As it is, his remedies are limited by
the agreement he entered into.

Election of Remedies
At Common Law
Another limitation on remedies—at common law—is the concept ofelection of remedies. The
nature of a loss resulting from a contract breach may be such as to entitle one party to a choice
among two or more means to redress the grievance, where the choices are mutually exclusive.
At classic common law, a person who was defrauded had an election of remedies: she could,
immediately upon discovering the fraud, rescind, or she could retain the item (real estate or
personal property) and attempt to remedy the fraudulently defective performance by suing for
damages, but not both. Buyer purchases real estate from Seller for $300,000 and shortly
discovers that Seller fraudulently misrepresented the availability of water. Buyer spends
$60,000 trying to drill wells. Finally he gives up and sues Seller for fraud, seeking $360,000.
Traditionally at common law, he would not get it. He should have rescinded upon discovery of
the fraud. Now he can only get $60,000 in damages in tort. [3] The purpose of the election of
Saylor URL: http://www.saylor.org/books

Saylor.org
574

remedies doctrine is to prevent the victim of fraud from getting a double recovery, but it has
come under increasing criticism. Here is one court’s observation: “A host of commentators
support elimination of the election of remedies doctrine. A common theme is that the doctrine
substitutes labels and formalism for inquiry into whether double recovery results in fact. The
rigid doctrine goes to the other extreme, actually resulting in the under compensation of fraud
victims and the protection of undeserving wrongdoers.” [4]

Under the UCC
The doctrine of election of remedy has been rejected by the UCC, which means that the remedies
are cumulative in nature. According to Section 2-703(1): “Whether the pursuit of one remedy
bars another depends entirely on the facts of the individual case.” UCC, Section 2-721, provides
that neither demand for rescission of the contract in the case of misrepresentation or fraud, nor
the return or rejection of goods, bars a claim for damages or any other remedy permitted under
the UCC for nonfraudulent breach (we will examine remedies for breach of sales contracts
in /6059 - mayer_1.0-ch18).

Tort versus Contract

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

Saylor URL: http://www.saylor.org/books

Saylor.org
575

4. Insurance coverage. Most policies do not cover intentional torts, so a contract theory that avoids
the element of willfulness would provide the plaintiff with a surer chance of recovering money
damages.

Legal versus Extralegal Remedies
A party entitled to a legal remedy is not required to pursue it. Lawsuits are disruptive not merely
to the individuals involved in the particular dispute but also to the ongoing relationships that
may have grown up around the parties, especially if they are corporations or other business
enterprises. Buyers must usually continue to rely on their suppliers, and sellers on their buyers.
Not surprisingly, therefore, many businesspeople refuse to file suits even though they could,
preferring to settle their disputes privately or even to ignore claims that they might easily press.
Indeed, the decision whether or not to sue is not one for the lawyer but for the client, who must
analyze a number of pros and cons, many of them not legal ones at all.

KEY TAKEAWAY

There are several limitations on the right of an aggrieved party to get contract remedies for a
breach besides any limitations fairly agreed to by the parties. The damages suffered by the
nonbreaching party must be reasonably foreseeable. The nonbreaching party must make a
reasonable effort to mitigate damages, or the amount awarded will be reduced by the
damages that could have been avoided. The party seeking damages must be able to explain
within reason how much loss he has suffered as a result of the breach. If he cannot articulate
with any degree of certainty—if the damages are really speculative—he will be entitled to
nominal damages and that’s all. There are circumstances in which a party who could have got
out of a contractual obligation—avoided it—loses the power to do so, and her remedy of
avoidance is lost. Not infrequently, a person will enter into a contract for services or goods
that contains a limitation on her right to damages in case the other side breaches. That’s all
right unless the limitation is unconscionable. Sometimes parties are required to make an
election of remedies: to choose among two or more possible bases of recovery. If the
remedies are really mutually exclusive and one is chosen, the aggrieved party loses the right
to pursue the others. And of course a person is always free not to pursue any remedy at all

Saylor URL: http://www.saylor.org/books

Saylor.org
576

for breach of contract; that may be strategically or economically smart in some
circumstances.

EXERCISES

1. When one party to a contract breaches, what duty, if any, is then imposed on the other
party?
2. A chef who has never owned her own restaurant sues a contractor who failed to finish
building the chef’s first restaurant on time. She presents evidence of the profits made by
similar restaurants that have been in business for some time. Is this good evidence of the
damages she has suffered by the delay? To what damages is she entitled?
3. Rebecca, seventeen years and ten months old, buys a party dress for $300. She wears it to
the junior prom but determines it doesn’t look good on her. She puts it in her closet and
forgets about it until six months later, when she decides to return it to the store. Is she now
entitled to the remedy of rescission?
4. What is the difference between rescission and restitution?
5. Why are parties sometimes required to make an election of remedies?

[1] Hadley v. Baxendale (1854), 9 Ex. 341, 354, 156 Eng.Rep. 145, 151.
[2] Restatement (Second) of Contracts, Section 350.
[3] Merritt v. Craig, 746 A.2d 923 (Md. 2000).
[4] Head & Seemann, Inc. v. Gregg, 311 N.W.2d 667 (Wis. App. 1981).

16.6 Cases
Consequential Damages
EBWS, LLC v. Britly Corp.
928 A.2d 497 (Vt. 2007)
Reiber, C.J.
The Ransom family owns Rock Bottom Farm in Strafford, Vermont, where Earl Ransom owns a
dairy herd and operates an organic dairy farm. In 2000, the Ransoms decided to build a
Saylor URL: http://www.saylor.org/books

Saylor.org
577

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 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
Saylor URL: http://www.saylor.org/books

Saylor.org
578

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.…

Saylor URL: http://www.saylor.org/books

Saylor.org
579

In addition, the actual costs of the wages and milk are uncertain.…[T]he the milk and wages
here are future expenses, for which no legal obligation was assumed by EBWS, and which are
separate from the terms of the parties’ contract. We note that at the time of the construction
contract EBWS had not yet begun to operate as a creamery and had no history of buying milk or
paying employees. See [Citation] (explaining that profits for a new business are uncertain and
speculative and not recoverable). Thus, both the cost of the milk and the number and amount of
wages of future employees that EBWS might pay in the event of a plant closure for repairs are
uncertain.
Award for consequential damages is reversed.…

CASE QUESTIONS

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

Liquidated Damages
Watson v. Ingram
881 P.2d 247 (Wash. 1994)
Johnson, J.
…In the summer of 1990, Wayne Watson offered to buy James Ingram’s Bellingham home for
$355,000, with a $15,000 [about $24,000 in 2010 dollars] earnest money deposit.…
Under the agreement, the entire amount of the purchase price was due in cash on or before
December 3, 1990.…The agreement required Watson to pay a $15,000 earnest money deposit
into escrow at Kelstrup Realty, and provided that “[i]n the event of default by Buyer, earnest

Saylor URL: http://www.saylor.org/books

Saylor.org
580

money shall be forfeited to Seller as liquidated damages, unless Seller elects to seek actual
damages or specific performance. Lastly, the agreement contained a provision entitled
“BUYER’S REPRESENTATIONS,” which stated, “Buyer represents that buyer has sufficient
funds available to close this sale in accordance with this agreement, and is not relying on any
contingent source of funds unless otherwise set forth in this agreement”.…
On November 10, 1990, Watson sent a written proposal to Ingram seeking to modify the original
agreement. The proposed modification would have allowed Watson to defer paying $54,000 of
the $355,000 sale price for between 6 and 12 months after the scheduled December closing date.
In exchange, Ingram would receive a second lien position on certain real estate Watson owned.
According to Ingram, the November 10 proposal was the first time he realized Watson did not
have financing readily available for the purchase of the house. Ingram notified Watson on
November 12, 1990, that he would not agree to modify the original agreement and intended to
strictly enforce its terms. Ingram was involved in a child custody suit in California and wanted to
move to that state as soon as possible.…[Further efforts by Ingram to sell to third parties and by
Watson to get an extension from Ingram failed.]
In September 1991, Ingram finally sold the house to a third party for $355,000, the same price
that Watson had agreed to pay in December 1990.
Ingram and Watson each sought to recover Watson’s $15,000 earnest money held in escrow. On
December 4, 1990, Ingram wrote to Kelstrup Realty, indicating he was entitled to the $15,000
earnest money in escrow because Watson had defaulted. In January 1991, Watson filed this
action to recover the earnest money, alleging it amounted to a penalty and Ingram had suffered
no actual damages.…
The trial court found the earnest money “was clearly intended by both parties to be nonrefundable” if Watson defaulted and determined $15,000 was “a reasonable forecast by [Ingram
and Watson] of damages that would be incurred by [Ingram] if [Watson] failed to complete the
purchase”. The court entered judgment in favor of Ingram for the amount of the earnest money
plus interest. The court also awarded Ingram his attorney fees pursuant to the parties’
agreement. The Court of Appeals, Division One, affirmed. Watson now appeals to this court.

Saylor URL: http://www.saylor.org/books

Saylor.org
581

This case presents a single issue for review: whether the parties’ contract provision requiring
Watson to forfeit a $15,000 nonrefundable earnest money deposit is enforceable as liquidated
damages. Liquidated damages clauses are favored in Washington, and courts will uphold them if
the sums involved do not amount to a penalty or are otherwise unlawful. [Citation] To
determine whether liquidated damages clauses are enforceable, Washington courts have applied
a 2-part test from the Restatement of Contracts.…Liquidated damages clauses are upheld if the
following two factors are satisfied:
First, the amount fixed must be a reasonable forecast of just compensation for the
harm that is caused by the breach. Second, the harm must be such that it is incapable
or very difficult of ascertainment.
The question before this court is whether this test is to be applied as of the time of contract
formation (prospectively) or as of the time of trial (retrospectively). We have previously held, the
“[r]easonableness of the forecast will be judged as of the time the contract was entered”.
[Citations]
In contrast, a prior Division One opinion relied upon by Petitioner held the reasonableness of
the estimate of damages and the difficulty of ascertainment of harm should be measured as of
the time of trial, and earnest money agreements should not be enforceable as liquidated
damages if the nonbreaching party does not suffer actual damage. [Citations]
We…adopt the date of contract formation as the proper timeframe for evaluating the
Restatement test. The prospective approach concentrates on whether the liquidated sum
represents a reasonable prediction of the harm to the seller if the buyer breaches the agreement,
and ignores actual damages except as evidence of the reasonableness of the estimate of potential
damage.
We believe this approach better fulfills the underlying purposes of liquidated damages clauses
and gives greater weight to the parties’ expectations. Liquidated damages permit parties to
allocate business and litigation risks. Even if the estimates of damages are not exact, parties can
allocate and quantify those risks and can negotiate adjustments to the contract price in light of
the allocated risks. Under the prospective approach, courts will enforce the parties’ allocation of
risk so long as the forecasts appear reasonable when made. [Citations]
Saylor URL: http://www.saylor.org/books

Saylor.org
582

In addition to permitting parties to allocate risks, liquidated damages provisions lend certainty
to the parties’ agreements and permit parties to resolve disputes efficiently in the event of a
breach. Rather than litigating the amount of actual damages, the nonbreaching party must only
establish the reasonableness of the agreement. The prospective approach permits parties to rely
on their stipulated amounts without having to precisely establish damages at trial. In contrast, if
the reasonableness of the amount is judged retrospectively, against the damage actually
suffered, the “parties must fully litigate (at great expense and delay) that which they sought not
to litigate.” [Citation].
Petitioner argues the prospective approach treats buyers unfairly because it permits sellers to
retain earnest money deposits even when the seller suffers no actual damage, and this violates
the principle that contract damages should be compensatory only. He further contends that by
evaluating parties’ liquidated damages agreements against actual damages established at trial,
courts can most effectively determine whether such agreements were reasonable and fair.
We disagree. As this court has previously explained, “[w]e are loath to interfere with the rights
of parties to contract as they please between themselves [Citations] It is not the role of the court
to enforce contracts so as to produce the most equitable result. The parties themselves know
best what motivations and considerations influenced their bargaining, and, while, “[t]he bargain
may be an unfortunate one for the delinquent party,…it is not the duty of courts of common law
to relieve parties from the consequences of their own improvidence…” [Citations]
The retrospective approach fails to give proper weight to the parties’ negotiations. At the time of
contract formation, unpredictable market fluctuations and variations in possible breaches make
it nearly impossible for contracting parties to predict “precisely or within a narrow range the
amount of damages that would flow from breach.” [Citations]. However, against this backdrop
of uncertainty, the negotiated liquidated damages sum represents the parties’ best estimate of
the value of the breach and permits the parties to allocate and incorporate these risks in their
negotiations. Under the prospective approach, a court will uphold the parties’ agreed upon
liquidated sum so long as the amount represents a reasonable attempt to compensate the
nonbreaching party. On the other hand, if the reasonableness of a liquidated damages provision
is evaluated under a retrospective approach, the parties cannot confidently rely on their
Saylor URL: http://www.saylor.org/books

Saylor.org
583

agreement because the liquidated sum will not be enforced if, at trial, it is not a close
approximation of the damage suffered or if no actual damages are proved.…
Having adopted the date of contract formation as the proper timeframe for evaluating the
Restatement test, the Restatement’s second requirement loses independent significance. The
central inquiry is whether the specified liquidated damages were reasonable at the time of
contract formation.…
We also agree with the Court of Appeals that in the context of real estate agreements, a
requirement that damages be difficult to prove at trial would undermine the very purposes of
the liquidated damage provision: “certainty, assurance that the contract will be performed, and
avoidance of litigation”. [Citation] It would “encourage litigation in virtually every case in which
the sale did not close, regardless of whether the earnest money deposit was a reasonable
estimate of the seller’s damages.” [Citation]
In sum, so long as the agreed upon earnest money agreement, viewed prospectively, is a
reasonable prediction of potential damage suffered by the seller, the agreement should be
enforced “without regard to the retrospective calculation of actual damages or the ease with
which they may be proved”. The prospective difficulty of estimating potential damage is a factor
to be used in assessing the reasonableness of the earnest money agreement…
The decision of the Court of Appeals is affirmed.

CASE QUESTIONS

1. What does the court here mean when it says that liquidated damages clauses allow the
parties to “allocate and incorporate the risks [of the transaction] in their negotiations”?
2. Why is it relevant that the plaintiff Ingram was engaged in a child-custody dispute and
wanted to move to California as soon as possible?
3. What, in plain language, is the issue here?
4. How does the court’s resolution of the issue seem to the court the better analysis?
5. Why did the plaintiff get to keep the $15,000 when he really suffered no damages?
6. Express the controlling rule of law out of this case.

Injunctions and Negative Covenants
Madison Square Garden Corporation v. Carnera

Saylor URL: http://www.saylor.org/books

Saylor.org
584

52 F.2d 47 (2d Cir. Ct. App. 1931)
Chase, J.
On January 13, 1931, the plaintiff and defendant by their duly authorized agents entered into the
following agreement in writing:
1. Carnera agrees that he will render services as a boxer in his next contest (which
contest, hereinafter called the ‘First Contest.’…
9. Carnera shall not, pending the holding of the First Contest, render services as a
boxer in any major boxing contest, without the written permission of the Garden in
each case had and obtained. A major contest is understood to be one with Sharkey,
Baer, Campolo, Godfrey, or like grade heavyweights, or heavyweights who shall have
beaten any of the above subsequent to the date hereof. If in any boxing contest
engaged in by Carnera prior to the holding of the First Contest, he shall lose the same,
the Garden shall at its option, to be exercised by a two weeks’ notice to Carnera in
writing, be without further liability under the terms of this agreement to Carnera.
Carnera shall not render services during the continuance of the option referred to in
paragraph 8 hereof for any person, firm or corporation other than the Garden.
Carnera shall, however, at all times be permitted to engage in sparring exhibitions in
which no decision is rendered and in which the heavy weight championship title is not
at stake, and in which Carnera boxes not more than four rounds with any one
opponent.’…
Thereafter the defendant, without the permission of the plaintiff, written or otherwise, made a
contract to engage in a boxing contest with the Sharkey mentioned in paragraph 9 of the
agreement above quoted, and by the terms thereof the contest was to take place before the first
contest mentioned in the defendant’s contract with the plaintiff was to be held.
The plaintiff then brought this suit to restrain the defendant from carrying out his contract to
box Sharkey, and obtained the preliminary injunction order, from which this appeal was taken.
Jurisdiction is based on diversity of citizenship and the required amount is involved.
The District Court has found on affidavits which adequately show it that the defendant’s services
are unique and extraordinary. A negative covenant in a contract for such personal services is
Saylor URL: http://www.saylor.org/books

Saylor.org
585

enforceable by injunction where the damages for a breach are incapable of ascertainment.
[Citations]
The defendant points to what is claimed to be lack of consideration for his negative promise, in
that the contract is inequitable and contains no agreement to employ him. It is true that there is
no promise in so many words to employ the defendant to box in a contest with Stribling or
Schmeling, but the agreement read as a whole binds the plaintiff to do just that, provided either
Stribling or Schmeling becomes the contestant as the result of the match between them and can
be induced to box the defendant. The defendant has agreed to ‘render services as a boxer’ for the
plaintiff exclusively, and the plaintiff has agreed to pay him a definite percentage of the gate
receipts as his compensation for so doing. The promise to employ the defendant to enable him
to earn the compensation agreed upon is implied to the same force and effect as though
expressly stated. [Citations] The fact that the plaintiff’s implied promise is conditioned, with
respect to the contest with the winner of the Stribling-Schmeling match, upon the consent of
that performer, does not show any failure of consideration for the defendant’s promise,
[Citation].
As we have seen, the contract is valid and enforceable. It contains a restrictive covenant which
may be given effect. Whether a preliminary injunction shall be issued under such circumstances
rests in the sound discretion of the court. [Citation] The District Court, in its discretion, did
issue the preliminary injunction.…
Order affirmed.

CASE QUESTIONS

1. Why did the plaintiff not want the defendant to engage in any boxing matches until and
except the ones arranged by the plaintiff?
2. What assertion did the defendant make as to why his promise was not enforceable? Why
wasn’t that argument accepted by the court?
3. If the defendant had refused to engage in a boxing match arranged by the plaintiff, would a
court force him to do what he had promised?

Limitation on Damages: Mitigation of Damages
Shirley MacLaine Parker v. Twentieth Century-Fox Film Corporation

Saylor URL: http://www.saylor.org/books

Saylor.org
586

474 P.2d 689 (Cal. 1970)
Burke, Justice.
Defendant Twentieth Century-Fox Film Corporation appeals from a summary judgment
granting to plaintiff the recovery of agreed compensation under a written contract for her
services as an actress in a motion picture. As will appear, we have concluded that the trial court
correctly ruled in plaintiff’s favor and that the judgment should be affirmed.
Plaintiff is well known as an actress.…Under the contract, dated August 6, 1965, plaintiff was to
play the female lead in defendant’s contemplated production of a motion picture entitled
“Bloomer Girl.” The contract provided that defendant would pay plaintiff a minimum
“guaranteed compensation” of $53,571.42 per week for 14 weeks commencing May 23, 1966, for
a total of $750,000 [about $5,048,000 in 2010 dollars]. Prior to May 1966 defendant decided
not to produce the picture and by a letter dated April 4, 1966, it notified plaintiff of that decision
and that it would not “comply with our obligations to you under” the written contract.
By the same letter and with the professed purpose “to avoid any damage to you,” defendant
instead offered to employ plaintiff as the leading actress in another film tentatively entitled “Big
Country, Big Man” (hereinafter, “Big Country”). The compensation offered was identical, as
were 31 of the 34 numbered provisions or articles of the original contract. Unlike “Bloomer
Girl,” however, which was to have been a musical production, “Big Country” was a dramatic
“western type” movie. “Bloomer Girl” was to have been filmed in California; “Big Country” was
to be produced in Australia. Also, certain terms in the proffered contract varied from those of
the original. Plaintiff was given one week within which to accept; she did not and the offer
lapsed. Plaintiff then commenced this action seeking recovery of the agreed guaranteed
compensation.
The complaint sets forth two causes of action. The first is for money due under the contract; the
second, based upon the same allegations as the first, is for damages resulting from defendant’s
breach of contract. Defendant in its answer admits the existence and validity of the contract,
that plaintiff complied with all the conditions, covenants and promises and stood ready to
complete the performance, and that defendant breached and “anticipatorily repudiated” the
contract. It denies, however, that any money is due to plaintiff either under the contract or as a
Saylor URL: http://www.saylor.org/books

Saylor.org
587

result of its breach, and pleads as an affirmative defense to both causes of action plaintiff’s
allegedly deliberate failure to mitigate damages, asserting that she unreasonably refused to
accept its offer of the leading role in “Big Country.”
Plaintiff moved for summary judgment…[T]he motion was granted…for $750,000 plus
interest…in plaintiff’s favor. This appeal by defendant followed.…
The general rule is that the measure of recovery by a wrongfully discharged employee is the
amount of salary agreed upon for the period of service, less the amount which the employer
affirmatively proves the employee has earned or with reasonable effort might have earned from
other employment. [Citation] However, before projected earnings from other employment
opportunities not sought or accepted by the discharged employee can be applied in mitigation,
the employer must show that the other employment was comparable, or substantially similar, to
that of which the employee has been deprived; the employee’s rejection of or failure to seek
other available employment of a different or inferior kind may not be resorted to in order to
mitigate damages. [Citations]
In the present case defendant has raised no issue of reasonableness of efforts by plaintiff to
obtain other employment; the sole issue is whether plaintiff’s refusal of defendant’s substitute
offer of “Big Country” may be used in mitigation. Nor, if the “Big Country” offer was of
employment different or inferior when compared with the original “Bloomer Girl” employment,
is there an issue as to whether or not plaintiff acted reasonably in refusing the substitute offer.
Despite defendant’s arguments to the contrary, no case cited or which our research has
discovered holds or suggests that reasonableness is an element of a wrongfully discharged
employee’s option to reject, or fail to seek, different or inferior employment lest the possible
earnings therefrom be charged against him in mitigation of damages.
Applying the foregoing rules to the record in the present case, with all intendments in favor of
the party opposing the summary judgment motion—here, defendant—it is clear that the trial
court correctly ruled that plaintiff’s failure to accept defendant’s tendered substitute
employment could not be applied in mitigation of damages because the offer of the “Big
Country” lead was of employment both different and inferior, and that no factual dispute was
presented on that issue. The mere circumstance that “Bloomer Girl” was to be a musical review
Saylor URL: http://www.saylor.org/books

Saylor.org
588

calling upon plaintiff’s talents as a dancer as well as an actress, and was to be produced in the
City of Los Angeles, whereas “Big Country” was a straight dramatic role in a “Western Type”
story taking place in an opal mine in Australia, demonstrates the difference in kind between the
two employments; the female lead as a dramatic actress in a western style motion picture can by
no stretch of imagination be considered the equivalent of or substantially similar to the lead in a
song-and-dance production.
Additionally, the substitute “Big Country” offer proposed to eliminate or impair the director and
screenplay approvals accorded to plaintiff under the original “Bloomer Girl” contract, and thus
constituted an offer of inferior employment. No expertise or judicial notice is required in order
to hold that the deprivation or infringement of an employee’s rights held under an original
employment contract converts the available “other employment” relied upon by the employer to
mitigate damages, into inferior employment which the employee need not seek or accept.
[Citation]
In view of the determination that defendant failed to present any facts showing the existence of
a factual issue with respect to its sole defense—plaintiff’s rejection of its substitute employment
offer in mitigation of damages—we need not consider plaintiff’s further contention that for
various reasons, including the provisions of the original contract set forth in footnote 1, Ante,
plaintiff was excused from attempting to mitigate damages.
The judgment is affirmed.

CASE QUESTIONS

1. Why did Ms. MacLaine refuse to accept the employment opportunity offered by the
defendant?
2. Why did the defendant think it should not be liable for any damages as a result of its
admitted breach of the original contract?
3. Who has the burden of proof on mitigation issues—who has to show that no mitigation
occurred?
4. Express the controlling rule of law out of this case.

16.7 Summary and Exercises
Summary

Saylor URL: http://www.saylor.org/books

Saylor.org
589

Contract remedies serve to protect three different interests: an expectation interest (the benefit
bargained for), a reliance interest (loss suffered by relying on the contract), and a restitution
interest (benefit conferred on the promisor). In broad terms, specific performance addresses the
expectation interest, monetary damages address all three, and restitution addresses the
restitution interest.
The two general categories of remedies are legal and equitable. In the former category are
compensatory, consequential, incidental, nominal, liquated, and (rarely) punitive damages. In
the latter category—if legal remedies are inadequate—are specific performance, injunction, and
restitution.
There are some limitations or restrictions on the availability of damages: they must pass the
tests of foreseeability and certainty. They must be reasonably mitigated, if possible. And
liquidated damages must be reasonable—not a penalty. In some situations, a person can lose the
remedy of rescission—the power to avoid a contract—when the rights of third parties intervene.
In some cases a person is required to make an election of remedies: to choose one remedy
among several, and when the one is chosen, the others are not available any more.

EXERCISES

1. Owner of an auto repair shop hires Contractor to remodel his shop but does not mention
that two days after the scheduled completion date, Owner is to receive five small US Army
personnel carrier trucks for service, with a three-week deadline to finish the job and turn the
trucks over to the army. The contract between Owner and the army has a liquidated
damages clause calling for $300 a day for every day trucks are not operable after the
deadline. Contractor is five days late in finishing the remodel. Can Owner claim the $1,500 as
damages against Contractor as a consequence of the latter’s tardy completion of the
contract? Explain.
2. Inventor devised an electronic billiard table that looked like a regular billiard table, but when
balls dropped into the pocket, various electronic lights and scorekeeping devices activated.
Inventor contracted with Contractor to manufacture ten prototypes and paid him $50,000 in
advance, on a total owing of $100,000 ($10,000 for each completed table). After the tables
were built to accommodate electronic fittings, Inventor repudiated the contract. Contractor

Saylor URL: http://www.saylor.org/books

Saylor.org
590

broke the ten tables up, salvaged $1,000 of wood for other billiard tables, and used the rest
for firewood. The ten intact tables, without electronics, could have been sold for $500 each
($5,000 total). Contractor then sued Inventor for the profit Contractor would have made had
Inventor not breached. To what, if anything, is Contractor entitled by way of damages and
why?
3. Calvin, a promising young basketball and baseball player, signed a multiyear contract with a
professional basketball team after graduating from college. After playing basketball for one
year, he decided he would rather play baseball and breached his contract with the basketball
team. What remedy could the team seek?
4. Theresa leased a one-bedroom apartment from Landlady for one year at $500 per month.
After three months, she vacated the apartment. A family of five wanted to rent the
apartment, but Landlady refused. Three months later—six months into what would have
been Theresa’s term—Landlady managed to rent the apartment to Tenant for $400 per
month. How much does Theresa owe, and why?
5. Plaintiff, a grocery store, contracted with Defendant, a burglar alarm company, for
Defendant to send guards to Plaintiff's premises and to notify the local police if
the alarm was activated. The contract had this language: “It is agreed that the
Contractor is not an insurer, that the payments here are based solely on the value
of the service in the maintenance of the system described, that it is impracticable
and extremely difficult to fix the actual damages, if any, which may proximately
result from a failure to perform its services, and in case of failure to perform such
services and a resulting loss, its liability shall be limited to $500 as liquidated
damages, and not as a penalty, and this liability shall be exclusive.”
A burglary took place and the alarm was activated, but Defendant failed to
respond promptly. The burglars left with $330,000. Is the liquidated damages
clause—the limitation on Plaintiff’s right to recover—valid?
6. The decedent, father of the infant Plaintiff, was killed in a train accident. Testimony showed
he was a good and reliable man. Through a representative, the decedent’s surviving child,
age five, recovered judgment against the railroad (Defendant). Defendant objected to expert
Saylor URL: http://www.saylor.org/books

Saylor.org
591

testimony that inflation would probably continue at a minimum annual rate of 5 percent for
the next thirteen years (until the boy attained his majority), which was used to calculate the
loss in support money caused by the father’s death. The calculations, Defendant said, were
unreasonably speculative and uncertain, and damages must be proven with reasonable
certainty. Is the testimony valid?
7. Plaintiff produced and directed a movie for Defendant, but contrary to their agreement,
Plaintiff was not given screen credit in the edited film (his name was not shown). The film
was screened successfully for nearly four years. Plaintiff then sued (1) for damages for loss of
valuable publicity or advertising because his screen credits were omitted for the years and (2)
for an injunction against future injuries. The jury awarded Plaintiff $25,000 on the first count.
On the second count, the court held Plaintiff should be able to “modify the prints in his
personal possession to include his credits.” But Plaintiff appealed, claiming that Defendant
still had many unmodified prints in its possession and that showing those films would cause
future damages. What remedy is available to Plaintiff? [1]
8. In 1929 Kerr Steamship Company, Inc. (Plaintiff), delivered to Defendant, the Radio
Corporation of America (RCA), a fairly long telegram—in code—to be transmitted to Manila,
Philippine Islands, with instructions about loading one of Kerr’s ships. By mistake, the
telegraph was mislaid and not delivered. As a result of the failure to transmit it, the cargo
was not loaded and the freight was lost in an amount of $6,675.29 [about $84,000 in 2010
dollars], profit that would have been earned if the message had been carried. Plaintiff said
that because the telegram was long and because the sender was a ship company, RCA
personnel should have known it was important information dealing with shipping and
therefore RCA should be liable for the consequential damages flowing from the failure to
send it. Is RCA liable?
9. Defendant offered to buy a house from Plaintiff. She represented, verbally and in writing,
that she had $15,000 to $20,000 of equity in another house and would pay this amount to
Plaintiff after selling it. She knew, however, that she had no such equity. Relying on these
intentionally fraudulent representations, Plaintiff accepted Defendant’s offer to buy, and the
parties entered into a land contract. After taking occupancy, Defendant failed to make any of
Saylor URL: http://www.saylor.org/books

Saylor.org
592

the contract payments. Plaintiff’s investigation then revealed the fraud. Based on the fraud,
Plaintiff sought rescission, ejectment, and recovery for five months of lost use of the
property and out-of-pocket expenses. Defendant claimed that under the election of remedies
doctrine, Plaintiff seller could not both rescind the contract and get damages for its breach.
How should the court rule?
10. Buyers contracted to purchase a house being constructed by Contractor. The contract
contained this clause: “Contractor shall pay to the owners or deduct from the total contract
price $100.00 per day as liquidated damages for each day after said date that the
construction is not completed and accepted by the Owners and Owners shall not arbitrarily
withhold acceptance.” Testimony established the rental value of the home at $400–$415 per
month. Is the clause enforceable?

SELF-TEST QUESTIONS

1. Contract remedies protect
a.

a restitution interest

b. a reliance interest
c. an expectation interest
d. all of the above
A restitution interest is
a.

the benefit for which the promisee bargained

b. the loss suffered by relying on the contract
c. that which restores any benefit one party conferred on the other
d. none of the above
When breach of contract caused no monetary loss, the plaintiff is entitled
to
a.

special damages

b. nominal damages
c. consequential damages
d. no damages

Saylor URL: http://www.saylor.org/books

Saylor.org
593

Damages attributable to losses that flow from events that do not occur in
the ordinary course of events are
a.

incidental damages

b. liquidated damages
c. consequential damages
d. punitive damages
Restitution is available
a.

when the contract was avoided because of incapacity

b. when the other party breached
c. when the party seeking restitution breached
d. all of the above

SELF-TEST ANSWERS

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

[1] Tamarind Lithography Workshop v. Sanders, 193 Cal. Rptr. 409 (Calif. Ct. App., 1983).

Saylor URL: http://www.saylor.org/books

Saylor.org
594

Chapter 17
Introduction to Sales and Leases
LEARNING OBJECTIVES

After reading this chapter, you should understand the following:
1. Why the law of commercial transactions is separate from the common law
2. What is meant by “commercial transactions” and how the Uniform Commercial Code (UCC)
deals with them in general
3. The scope of Article 2, Article 2A, and the Convention on Contracts for the International Sale
of Goods
4. What obligations similar to the common law’s are imposed on parties to a UCC contract, and
what obligations different from the common law’s are imposed
5. The difference between a consumer lease and a finance lease

17.1 Commercial Transactions: the Uniform Commercial
Code
LEARNING OBJECTIVES

1. Understand why there is a separate body of law governing commercial transactions.
2. Be aware of the scope of the Uniform Commercial Code.
3. Have a sense of this text’s presentation of the law of commercial transactions.

History of the UCC
In Chapter 8 "Introduction to Contract Law" we introduced the Uniform Commercial Code. As
we noted, the UCC has become a national law, adopted in every state—although Louisiana has
not enacted Article 2, and differences in the law exist from state to state. Of all the uniform laws
related to commercial transactions, the UCC is by far the most successful, and its history goes
back to feudal times.
In a mostly agricultural, self-sufficient society there is little need for trade, and almost all law
deals with things related to land (real estate): its sale, lease, and devising (transmission of
ownership by inheritance); services performed on the land; and damages to the land or to things
related to it or to its productive capacity (torts). Such trade as existed in England before the late
Saylor URL: http://www.saylor.org/books

Saylor.org
595

fourteenth century was dominated by foreigners. But after the pandemic of the Black Death in
1348–49 (when something like 30 percent to 40 percent of the English population died), the
self-sufficient feudal manors began to break down. There was a shortage of labor. People could
move off the manors to find better work, and no longer tied immediately to the old estates, they
migrated to towns. Urban centers—cities—began to develop. Urbanization inevitably reached
the point where citizens’ needs could not be met locally. Enterprising people recognized that
some places had a surplus of a product and that other places were in need of that surplus and
had a surplus of their own to exchange for it. So then, by necessity, people developed the means
to transport the surpluses. Enter ships, roads, some medium of exchange, standardized weights
and measures, accountants, lawyers, and rules governing merchandising. And enter merchants.
The power of merchants was expressed through franchises obtained from the
government which entitled merchants to create their own rules of law and to enforce
these rules through their own courts. Franchises to hold fairs [retail exchanges] were
temporary; but the franchises of the staple cities, empowered to deal in certain basic
commodities [and to have mercantile courts], were permanent.…Many trading towns
had their own adaptations of commercial law.… The seventeenth century movement
toward national governments resulted in a decline of separate mercantile franchises
and their courts. The staple towns…had outlived their usefulness. When the law
merchant became incorporated into a national system of laws enforced by national
courts of general jurisdiction, the local codes were finally extinguished. But national
systems of law necessarily depended upon the older codes for their stock of ideas and
on the changing customs of merchants for new developments. [1]
When the American colonies declared independence from Britain, they continued to use British
law, including the laws related to commercial transactions. By the early twentieth century, the
states had inconsistent rules, making interstate commerce difficult and problematic. Several
uniform laws affecting commercial transactions were floated in the late nineteenth century, but
few were widely adopted. In 1942, the American Law Institute (ALI) [2] hired staff to begin work
on a rationalized, simplified, and harmonized national body of modern commercial law. The

Saylor URL: http://www.saylor.org/books

Saylor.org
596

ALI’s first draft of the UCC was completed in 1951.The UCC was adopted by Pennsylvania two
years later, and other states followed in the 1950s and 1960s.
In the 1980s and 1990s, the leasing of personal property became a significant factor in
commercial transactions, and although the UCC had some sections that were applicable to
leases, the law regarding the sale of goods was inadequate to address leases. Article 2A
governing the leasing of goods was approved by the ALI in 1987. It essentially repeats Article 2
but applies to leases instead of sales. In 2001, amendments to Article 1—which applies to the
entire UCC—were proposed and subsequently have been adopted by over half the states. No
state has yet adopted the modernizing amendments to Article 2 and 2A that the ALI proposed in
2003.
That’s the short history of why the body of commercial transaction law is separate from the
common law.

Scope of the UCC and This Text’s Presentation of the UCC
The UCC embraces the law 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 lease or 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)

•

Leases (Article 2A)

•

Commercial Paper (Article 3)

•

Bank Deposits and Collections (Article 4)

•

Funds Transfers (Article 4A)

•

Letters of Credit (Article 5)

•

Bulk Transfers (Article 6)

•

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

•

Investment Securities (Article 8)
Saylor URL: http://www.saylor.org/books

Saylor.org
597

•

Secured Transactions; Sales of Accounts and Chattel Paper (Article 9)
Although the UCC comprehensively covers commercial transactions, it does not deal with every
aspect of commercial law. Among the subjects not covered are the sale of real property,
mortgages, insurance contracts, suretyship transactions (unless the surety is party to a
negotiable instrument), and bankruptcy. Moreover, common-law principles of contract law that
were examined in previous chapters continue to apply to many transactions covered in a
particular way by the UCC. These principles include capacity to contract, misrepresentation,
coercion, and mistake. Many federal laws supersede the UCC; these include the Bills of Lading
Act, the Consumer Credit Protection Act, the warranty provisions of the Magnuson-Moss Act,
and other regulatory statutes.
We follow the general outlines of the UCC in this chapter and in Chapter 18 "Title and Risk of
Loss" and Chapter 19 "Performance and Remedies". In this chapter, we cover the law governing
sales (Article 2) and make some reference to leases (Article 2A), though space constraints
preclude an exhaustive analysis of leases. The use of documents of title to ship and store goods is
closely related to sales, and so we cover documents of title (Article 7) as well as the law of
bailments in Chapter 21 "Bailments and the Storage, Shipment, and Leasing of Goods".
We now turn our attention to the sale—the first facet, and the cornerstone, of the commercial
transaction.

KEY TAKEAWAY

In the development of the English legal system, commercial transactions were originally of
such little importance that the rules governing them were left to the merchants themselves.
They had their own courts and adopted their own rules based on their customary usage. By
the 1700s, the separate courts had been absorbed into the English common law, but the
distinct rules applicable to commercial transactions remained and have carried over to the
modern UCC. The UCC treats commercial transactions in phases, and this text basically traces
those phases.

EXERCISES

1. Why were medieval merchants compelled to develop their own rules about commercial
transactions?
2. Why was the UCC developed, and when was the period of its initial adoption by states?
Saylor URL: http://www.saylor.org/books

Saylor.org
598

[1] Frederick G. Kempin Jr., Historical Introduction to Anglo-American Law (Eagan, MN: West, 1973),
217–18, 219–20, 221.
[2] American Law Insitute, “ALI Overview,” accessed March 1,
2011,http://www.ali.org/index.cfm?fuseaction=about.overview.

17.2 Introduction to Sales and Lease Law, and the
Convention on Contracts for the International Sale of
Goods
LEARNING OBJECTIVES

1. Understand that the law of sales not only incorporates many aspects of common-law
contract but also addresses some distinct issues that do not occur in contracts for the sale of
real estate or services.
2. Understand the scope of Article 2 and the definitions of sale and goods.
3. Learn how courts deal with hybrid situations: mixtures of the sale of goods and of real estate,
mixtures of goods and services.
4. Recognize the scope of Article 2A and the definitions of lease, consumer lease, and finance
lease.
5. Learn about the Convention on Contracts for the International Sale of Goods and why it is
relevant to our discussion of Article 2.

Scope of Articles 2 and 2A and Definitions
In dealing with any statute, it is of course very important to understand the statute’s scope or
coverage.
Article 2 does not govern all commercial transactions, only sales. It does not cover all sales, only
the sale of goods. Article 2A governs leases, but only of personal property (goods), not real
estate. The Convention on Contracts for the International Sale of Goods (CISG)—kind of an
international Article 2—“applies to contracts of sale of goods between parties whose places of
business are in different States [i.e., countries]” (CISG, Article 1). So we need to consider the
definitions of sale, goods, and lease.
Saylor URL: http://www.saylor.org/books

Saylor.org
599

Definition of Sale
A sale “consists in the passing of title from the seller to the buyer for a price.” [1]
Sales are distinguished from gifts, bailments, leases, and secured transactions. Article 2 sales
should be distinguished from gifts, bailments, leases, and secured transactions. A gift is the
transfer of title without consideration, and a “contract” for a gift of goods is unenforceable under
the Uniform Commercial Code (UCC) or otherwise (with some exceptions). A bailment is the
transfer of possession but not title or use; parking your car in a commercial garage often creates
a bailment with the garage owner. A lease (see the formal definition later in this chapter) is a
fixed-term arrangement for possession and use of something—computer equipment, for
example—and does not transfer title. In a secured transaction, the owner-debtor gives a security
interest in collateral to a creditor that allows the creditor to repossess the collateral if the owner
defaults.

Definition of Goods
Even if the transaction is considered a sale, the question still remains whether the contract
concerns the sale of goods. Article 2 applies only to goods; sales of real estate and services are
governed by non-UCC law. Section 2-105(1) of the UCC defines goodsas “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.” Money can be considered goods subject to Article 2 if it is the object of the
contract—for example, foreign currency.
In certain cases, the courts have difficulty applying this definition because the item in question
can also be viewed as realty or service. Most borderline cases raise one of two general questions:
1. Is the contract for the sale of the real estate, or is it for the sale of goods?
2. Is the contract for the sale of goods, or is it for services?

Real Estate versus Goods
The dilemma is this: A landowner enters into a contract to sell crops, timber, minerals, oil, or
gas. If the items have already been detached from the land—for example, timber has been cut
and the seller agrees to sell logs—they are goods, and the UCC governs the sale. But what if, at
the time the contract is made, the items are still part of the land? Is a contract for the sale of
uncut timber governed by the UCC or by real estate law?
Saylor URL: http://www.saylor.org/books

Saylor.org
600

The UCC governs under either of two circumstances: (1) if the contract calls for the seller to
sever the items or (2) if the contract calls for the buyer to sever the items and if the goods can be
severed without material harm to the real estate. [2] The second provision specifically includes
growing crops and timber. By contrast, the law of real property governs if the buyer’s severance
of the items will materially harm the real estate; for example, the removal of minerals, oil, gas,
and structures by the buyer will cause the law of real property to govern. (See /6059 - mayer_1.0ch17_s02_s01_s02_s01_f01.)

Figure 17.1 Governing Law

Goods versus Services
Distinguishing goods from services is the other major difficulty that arises in determining the
nature of the object of a sales contract. The problem: how can goods and services be separated in
contracts calling for the seller to deliver a combination of goods and services? That issue is
examined in /6059 - mayer_1.0-ch17_s05_s01(Pittsley v. Houser), where the court applied the

common “predominant factor” (also sometimes “predominate purpose” or “predominant
thrust”) test—that is, it asked whether the transaction was predominantly a contract for goods or
for services. However, the results of this analysis are not always consistent. Compare Epstein v.
Giannattasio, in which the court held that no sale of goods had been made because the plaintiff
received a treatment in which the cosmetics were only incidentally used, with Newmark v.
Gimble’s, Inc., 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.” [3] The New Jersey court rejected the defendant’s argument that
Saylor URL: http://www.saylor.org/books

Saylor.org
601

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-versus-services issue out of the courts’
hands and resolved the issue through legislation. Food sold in restaurants is a sale of goods,
whether it is to be consumed on or off the premises. Blood transfusions (really the sale of blood)
in hospitals have been legislatively declared a service, not a sale of goods, in more than forty
states, thus relieving the suppliers and hospitals of an onerous burden for liability from selling
blood tainted with the undetectable hepatitis virus.

Definition of Lease
Section 2A-103(j) of the UCC defines a lease as “a transfer of the right to possession and use of
goods for a term in return for consideration.” The lessor is the one who transfers the right to
possession to the lessee. If Alice rents a party canopy from Equipment Supply, Equipment
Supply is the lessor and Alice is the lessee.

Two Types of Leases
The UCC recognizes two kinds of leases: consumer leases and finance leases. Aconsumer lease is
used when a lessor leases goods to “an individual…primarily for personal, family, or household
purposes,” where total lease payments are less than $25,000. [4] The UCC grants some special
protections to consumer lessees. Afinance lease is used when a lessor “acquires the goods or the
right to [them]” and leases them to the lessee. [5] The person from whom the lessor acquires the
goods is a supplier, and the lessor is simply financing the deal. Jack wants to lease a boom lift
(personnel aerial lift, also known as a cherry picker) for a commercial roof renovation. First
Bank agrees to buy (or itself lease) the machine from Equipment Supply and in turn lease it to
Jack. First Bank is the lessor, Jack is the lessee, and Equipment Supply is the supplier.

International Sales of Goods
The UCC is, of course, American law, adopted by the states of the United States. The reason it
has been adopted is because of the inconvenience of doing interstate business when each state
had a different law for the sale of goods. The same problem presents itself in international
transactions. As a result, the United Nations Commission on International Trade Law developed
an international equivalent of the UCC, the Convention on Contracts for the International Sale
Saylor URL: http://www.saylor.org/books

Saylor.org
602

of Goods (CISG), first mentioned in/6059 - mayer_1.0-ch08. It was promulgated in Vienna in 1980.
As of July 2010, the convention (a type of treaty) has been adopted by seventy-six countries,

including the United States and all its major trading partners except the United Kingdom. One
commentator opined on why the United Kingdom is an odd country out: it is “perhaps because
of pride in its longstanding common law legal imperialism or in its long-treasured feeling of the
superiority of English law to anything else that could even challenge it.” [6]
The CISG is interesting for two reasons. First, assuming globalization continues, the CISG will
become increasingly important around the world as the law governing international sale
contracts. Its preamble states, “The adoption of uniform rules which govern contracts for the
international sale of goods and take into account the different social, economic and legal
systems [will] contribute to the removal of legal barriers in international trade and promote the
development of international trade.” Second, it is interesting to compare the legal culture
informing the common law to that informing the CISG, which is not of the English common-law
tradition. Throughout our discussion of Article 2, we will make reference to the CISG, the
complete text of which is available online. [7] References to the CISG are in bold.
As to the CISG’s scope, CISG Article 1 provides that it “applies to contracts of sale
of goods between parties whose places of business are in different States [i.e.,
countries]; it “governs only the formation of the contract of sale and the rights and
obligations of the seller and the buyer arising from such a contract,” and has
nothing to do “with the validity of the contract or of any of its provisions or of any
usage” (Article 4). It excludes sales (a) of goods bought for personal, family or
household use, unless the seller, at any time before or at the conclusion of the
contract, neither knew nor ought to have known that the goods were bought for
any such use; (b) by auction; (c) on execution or otherwise by authority of law; (d)
of stocks, shares, investment securities, negotiable instruments or money; (e) of
ships, vessels, hovercraft or aircraft; (f) of electricity (Article 2).
Parties are free to exclude the application of the Convention or, with a limited
exception, vary the effect of any of its provisions (Article 6).

KEY TAKEAWAY

Saylor URL: http://www.saylor.org/books

Saylor.org
603

Article 2 of the UCC deals with the sale of goods. Sale and goods have defined meanings.
Article 2A of the UCC deals with the leasing of goods. Lease has a defined meaning, and the
UCC recognizes two types of leases: consumer leases and finance leases. Similar in purpose
to the UCC of the United States is the Convention on Contracts for the International Sale of
Goods, which has been widely adopted around the world.

EXERCISES

1. Why is there a separate body of statutory law governing contracts for the sale of goods as
opposed to the common law, which governs contracts affecting real estate and services?
2. What is a consumer lease? A finance lease?
3. What is the Convention on Contracts for the International Sale of Goods?

[1] Uniform Commercial Code, Section 2-106.
[2] Uniform Commercial Code, Section 2-107.
[3] Epstein v. Giannattasio 197 A.2d 342 (Conn. 1963); Newmark v. Gimble’s, Inc., 258 A.2d 697 (N.J.
1969).
[4] Uniform Commercial Code, Section 2A-103(e).
[5] Uniform Commercial Code, Section 2A-103(g).
[6] A. F. M. Maniruzzaman, quoted by Albert H. Kritzer, Pace Law School Institute of International
Commercial Law, CISG: Table of Contracting States, accessed March 1,
2011,http://www.cisg.law.pace.edu/cisg/countries/cntries.html.
[7] Pace Law School, “United Nations Convention on Contracts for the International Sale of Goods (1980)
[CISG]” CISG Database, accessed March 1, 2011,http://www.cisg.law.pace.edu/cisg/text/treaty.html.

17.3 Sales Law Compared with Common-Law Contracts
and the CISG
LEARNING OBJECTIVE

1. Recognize the differences and similarities among the Uniform Commercial Code
(UCC), common-law contracts, and the CISG as related to the following contract
issues:
Saylor URL: http://www.saylor.org/books

Saylor.org
604

o

Offer and acceptance

o

Revocability

o

Consideration

o

The requirement of a writing and contractual interpretation (form and meaning)

Sales law deals with the sale of goods. Sales law is a special type of contract law, but the common
law informs much of Article 2 of the UCC—with some differences, however. Some of the
similarities and differences were discussed in previous chapters that covered common-law
contracts, but a review here is appropriate, and we can refer briefly to the CISG’s treatment of
similar issues.

Mutual Assent: Offer and Acceptance
Definiteness of the Offer
The common law requires more definiteness than the UCC. Under the UCC, a contractual
obligation may arise even if the agreement has open terms. Under Section 2-204(3), such an
agreement for sale is not voidable for indefiniteness, as in the common law, if the parties have
intended to make a contract and the court can find a reasonably certain basis for giving an
appropriate remedy. Perhaps the most important example is the open price term.
The open price term is covered in detail in Section 2-305. At common law, a contract that fails to
specify price or a means of accurately ascertaining price will almost always fail. This is not so
under the UCC provision regarding open price terms. If the contract says nothing about price, or
if it permits the parties to agree on price but they fail to agree, or if it delegates the power to fix
price to a third person who fails to do so, then Section 2-305(1) “plugs” the open term and
decrees that the price to be awarded is a “reasonable price at the time for delivery.” When one
party is permitted to fix the price, Section 2-305(2) requires that it be fixed in good faith.
However, if the parties intendnot to be bound unless the price is first fixed or agreed on, and it is
not fixed or agreed on, then no contract results. [1]
Another illustration of the open term is in regard to particulars of performance. Section 2-311(1)
provides that a contract for sale of goods is not invalid just because it leaves to one of the parties
the power to specify a particular means of performing. However, “any such specification must be

Saylor URL: http://www.saylor.org/books

Saylor.org
605

made in good faith and within limits set by commercial reasonableness.” (Performance will be
covered in greater detail in /6059 - mayer_1.0-ch18.)

The CISG (Article 14) provides the following: “A proposal for concluding a contract
addressed to one or more specific persons constitutes an offer if it is sufficiently
definite and indicates the intention of the offeror to be bound in case of
acceptance. A proposal is sufficiently definite if it indicates the goods and
expressly or implicitly fixes or makes provision for determining the quantity and
the price.”

Acceptance Varying from Offer: Battle of the Forms
The concepts of offer and acceptance are basic to any agreement, but the UCC makes a change
from the common law in its treatment of an acceptance that varies from the offer (this was
discussed in /6059 - mayer_1.0-ch08). At common law, where the “mirror image rule” reigns, if the
acceptance differs from the offer, no contract results. If that were the rule for sales contracts,
with the pervasive use of form contracts—where each side’s form tends to favor that side—it
would be very problematic.
Section 2-207 of the UCC attempts to resolve this “battle of the forms” by providing that
additional terms or conditions in an acceptance operate as such unless the acceptance is
conditioned on the offeror’s consent to the new or different terms. The new terms are construed
as offers but are automatically incorporated in any contract between merchants for the sale of
goods unless “(a) the offer expressly limits acceptance to the terms of the offer; (b) [the terms]
materially alter it; or (c) notification of objection to them has already been given or is given
within a reasonable time after notice of them is received.” In any case, Section 2-207 goes on like
this: “Conduct by both parties which recognizes the existence of a contract is sufficient to
establish a contract for sale although the writings of the parties do not otherwise establish a
contract. In such case the terms of the particular contract consist of those terms on which the
writings of the parties agree, together with any supplementary terms incorporated under any
other provisions of this Act.” [2]

Saylor URL: http://www.saylor.org/books

Saylor.org
606

As to international contracts, the CISG says this about an acceptance that
varies from the offer (Article 19), and it’s pretty much the same as the
UCC:
(1) A reply to an offer which purports to be an acceptance but contains
additions, limitations or other modifications is a rejection of the offer and
constitutes a counter-offer.
(2) However, a reply to an offer which purports to be an acceptance but
contains additional or different terms which do not materially alter the
terms of the offer constitutes an acceptance, unless the offeror, without
undue delay, objects orally to the discrepancy or dispatches a notice to
that effect. If he does not so object, the terms of the contract are the terms
of the offer with the modifications contained in the acceptance.
(3) Additional or different terms relating, among other things, to the
price, payment, quality and quantity of the goods, place and time of
delivery, extent of one party’s liability to the other or the settlement of
disputes are considered to alter the terms of the offer materially.

Revocation of Offer
Under both common law and the UCC, an offer can be revoked at any time prior to acceptance
unless the offeror has given the offeree an option (supported by consideration); under the UCC,
an offer can be revoked at any time prior to acceptance unless a merchant gives a “firm offer”
(for which no consideration is needed). The CISG (Article 17) provides that an offer is revocable
before it is accepted unless, however, “it indicates…that it is irrevocable” or if the offeree
reasonably relied on its irrevocability.

Reality of Consent
There is no particular difference between the common law and the UCC on issues of duress,
misrepresentation, undue influence, or mistake. As for international sales contracts, the CISG
provides (Article 4(a)) that it “governs only the formation of the contract of sale and the rights
and obligations of the seller and the buyer arising from such a contract and is not concerned
with the validity of the contract or of any of its provisions.”
Saylor URL: http://www.saylor.org/books

Saylor.org
607

Consideration
The UCC
The UCC requires no consideration for modification of a sales contract made in good faith; at
common law, consideration is required to modify a contract. [3] The UCC requires no
consideration if one party wants to forgive another’s breach by written waiver or renunciation
signed and delivered by the aggrieved party; under common law, consideration is required to
discharge a breaching party. [4] The UCC requires no consideration for a “firm offer”—a writing
signed by a merchant promising to hold an offer open for some period of time; at common law
an option requires consideration. (Note, however, the person can give an option under either
common law or the code.)
Under the CISG (Article 29), “A contract may be modified or terminated by the
mere agreement of the parties.” No consideration is needed.

Form and Meaning
Requirement of a Writing
The common law has a Statute of Frauds, and so does the UCC. It requires a writing to enforce a
contract for the sale of goods worth $500 or more, with some exceptions, as discussed in /6059 mayer_1.0-ch13.

[5]

The CISG provides (Article 11), “A contract of sale need not be concluded in or
evidenced by writing and is not subject to any other requirement as to form. It may
be proved by any means, including witnesses.” But Article 29 provides, “A contract
in writing which contains a provision requiring any modification or termination
by agreement to be in writing may not be otherwise modified or terminated by
agreement.”

Parol Evidence
Section 2-202 of the UCC provides pretty much the same as the common law: if the parties have
a writing intended to be their final agreement, it “may not be contradicted by evidence of any
prior agreement or of a contemporaneous oral agreement.” However, it may be explained by
“course of dealing or usage of trade or by course of performance” and “by evidence of consistent
additional terms.”
Saylor URL: http://www.saylor.org/books

Saylor.org
608

The CISG provides (Article 8) the following: “In determining the intent of a party or the
understanding a reasonable person would have had, due consideration is to be given to all
relevant circumstances of the case including the negotiations, any practices which the parties
have established between themselves, usages and any subsequent conduct of the parties.”

KEY TAKEAWAY

The UCC modernizes and simplifies some common-law strictures. Under the UCC, the mirror
image rule is abolished: an acceptance may sometimes differ from the offer, and the UCC can
“plug” open terms in many cases. No consideration is required under the UCC to modify or
terminate a contract or for a merchant’s “firm offer,” which makes the offer irrevocable
according to its terms. The UCC has a Statute of Frauds analogous to the common law, and its
parol evidence rule is similar as well. The CISG compares fairly closely to the UCC.

EXERCISES

1. Why does the UCC change the common-law mirror image rule, and how?
2. What is meant by “open terms,” and how does the UCC handle them?
3. The requirement for consideration is relaxed under the UCC compared with common law. In
what circumstances is no consideration necessary under the UCC?
4. On issues so far discussed, is the CISG more aligned with the common law or with the UCC?
Explain your answer.

[1] Uniform Commercial Code, Section 2-305(4).
[2] This section of the UCC is one of the most confusing and fiercely litigated sections; Professor Grant
Gilmore once called it a “miserable, bungled, patched-up job” and “arguably the greatest statutory mess
of all time.” Mark E. Roszkowski, “Symposium on Revised Article 2 of the Uniform Commercial Code—
Section-by-Section Analysis,” SMU Law Review 54 (Spring 2001): 927, 932, quoting Professor Grant
Gilmore to Professor Robert Summers, Cornell University School of Law, September 10, 1980,
in Teaching Materials on Commercial and Consumer Law, ed. Richard E. Speidel, Robert S Summers, and
James J White, 3rd ed. (St. Paul, MN: West. 1981), pp. 54–55. In 2003 the UCC revisioners presented an
amendment to this section in an attempt to fix Section 2-207, but no state has adopted this section’s

Saylor URL: http://www.saylor.org/books

Saylor.org
609

revision. See Commercial Law, “UCC Legislative Update,” March 2, 2010, accessed March 1,
2011,http://ucclaw.blogspot.com/2010/03/ucc-legislative-update.html.
[3] Uniform Commercial Code, Section 2-209(1).
[4] Uniform Commercial Code, Section 1–107.
[5] Proposed amendments by UCC revisioners presented in 2003 would have raised the amount of
money—to take into account inflation since the mid-fifties—to $5,000, but no state has yet adopted this
amendment; Uniform Commercial Code, Section 2-201.

17.4 General Obligations under UCC Article 2
LEARNING OBJECTIVES

1. Know that the Uniform Commercial Code (UCC) imposes a general obligation to act in good
faith and that it makes unconscionable contracts or parts of a contract unenforceable.
2. Recognize that though the UCC applies to all sales contracts, merchants have special
obligations.
3. See that the UCC is the “default position”—that within limits, parties are free to put anything
they want to in their contract.
Article 2 of the UCC of course has rules governing the obligations of parties specifically as to the
offer, acceptance, performance of sales contracts, and so on. But it also imposes some general
obligations on the parties. Two are called out here: one deals with unfair contract terms, and the
second with obligations imposed on merchants.

Obligation of Good-Faith Dealings in General
Under the UCC
Section 1-203 of the UCC provides, “Every contract or duty within this Act imposes an obligation
of good faith in its performance or enforcement.” Good faith is defined at Section 2-103(j) as
“honesty in fact and the observance of reasonable commercial standards of fair dealing.” This is
pretty much the same as what is held by common law, which “imposes a duty of good faith and
fair dealing upon the parties in performing and enforcing the contract.” [1]
The UCC’s good faith in “performance or enforcement” of the contract is one thing, but what if
the terms of the contract itself are unfair? Under Section 2-302(1), the courts may tinker with a
Saylor URL: http://www.saylor.org/books

Saylor.org
610

contract if they determine that it is particularly unfair. The provision reads as follows: “If the
court as a matter of law finds the contract or any clause of the contract to have been
unconscionable at the time it was made the court may refuse to enforce the contract, or it may
enforce the remainder of the contract without the unconscionable clause, or it may so limit the
application of any unconscionable clause as to avoid any unconscionable result.”
The court thus has considerable flexibility. It may refuse to enforce the entire contract, strike a
particular clause or set of clauses, or limit the application of a particular clause or set of clauses.
And what does “unconscionable” mean? The UCC provides little guidance on this crucial
question. According to Section 2-302(1), the test is “whether, in the light of the general
commercial background and the commercial needs of the particular trade or case, the clauses
involved are so one-sided as to be unconscionable under the circumstances existing at the time
of the making of the contract.…The principle is one of the prevention of oppression and unfair
surprise and not of disturbance of allocation of risks because of superior bargaining power.”
The definition is somewhat circular. For the most part, judges have had to develop the concept
with little help from the statutory language. Unconscionability is much like US Supreme Court
Justice Potter Stewart’s famous statement about obscenity: “I can’t define it, but I know it when
I see it.” In the leading case, Williams v. Walker-Thomas Furniture Co. (Section 12.5.3
"Unconscionability", set out in Chapter 12 "Legality"), Judge J. Skelly Wright attempted to
develop a framework for analysis. He refined the meaning of unconscionability by focusing on
“absence of meaningful choice” (often referred to as procedural unconscionability) and on terms
that are “unreasonably favorable” (commonly referred to as substantive unconscionability). An
example of procedural unconscionability is the salesperson who says, “Don’t worry about all that
little type on the back of this form.” Substantive unconscionability is the harsh term—the
provision that permits the “taking of a pound of flesh” if the contract is not honored.
Despite its fuzziness, the concept of unconscionability has had a dramatic impact on American
law. In many cases, in fact, the traditional notion of caveat emptor (Latin for “buyer beware”)
has changed to caveat venditor (“let the seller beware”). So important is this provision that
courts in recent years have applied the doctrine in cases not involving the sale of goods.

Saylor URL: http://www.saylor.org/books

Saylor.org
611

Under the CISG, Article 7: “Regard is to be had…to the observance of good faith in
international trade.”

Obligations Owed by Merchants
“Merchant” Sellers
Although the UCC applies to all sales of goods (even when you sell your used car to your
neighbor), merchants often have special obligations or are governed by special rules.

As between Merchants
The UCC assumes that merchants should be held to particular standards because they are more
experienced and have or should have special knowledge. Rules applicable to professionals ought
not apply to the casual or inexperienced buyer or seller. For example, we noted previously that
the UCC relaxes the mirror image rule and provides that as “between merchants” additional
terms in an acceptance become part of the contract, and we have discussed the “ten-day-reply
doctrine” that says that, again “as between merchants,” a writing signed and sent to the other
binds the recipient as an exception to the Statute of Frauds. [2] There are other sections of the
UCC applicable “as between merchants,” too.
Article 1 of the CISG abolishes any distinction between merchants and
nonmerchants: “Neither the nationality of the parties nor the civil or commercial
character of the parties or of the contract is to be taken into consideration in
determining the application of this Convention.”

Merchant to Nonmerchant
In addition to duties imposed between merchants, the UCC imposes certain duties on a
merchant when she sells to a nonmerchant. A merchant who sells her merchandise makes an
important implied warranty of merchantability. That is, she promises that goods sold will be fit
for the purpose for which such goods are normally intended. A nonmerchant makes no such
promise, nor does a merchant who is not selling merchandise—for example, a supermarket
selling a display case is not a “merchant” in display cases.
In Sheeskin v. Giant Foods, Inc., the problem of whether a merchant made an implied warranty
of merchantability was nicely presented. Mr. Seigel, the plaintiff, was carrying a six-pack carton
of Coca-Cola from a display bin to his shopping cart when one or more of the bottles exploded.
Saylor URL: http://www.saylor.org/books

Saylor.org
612

He lost his footing and was injured. When he sued the supermarket and the bottler for breach of
the implied warranty of fitness, the defendants denied there had been a sale: he never paid for
the soda pop, thus no sale by a merchant and thus no warranty. The court said that Mr. Seigel’s
act of reaching for the soda to put it in his cart was a “reasonable manner of acceptance”
(quoting UCC, Section 2-206(1)). [3]

Who Is a Merchant?
Section 2-104(1) of the UCC defines a merchant as one “who deals in goods of the kind or
otherwise by his occupation holds himself out as having knowledge or skill peculiar to the
practices or goods involved in the transaction.” A phrase that recurs throughout Article 2—
“between merchants”—refers to any transaction in which both parties are chargeable with the
knowledge or skill of merchants. [4] Not every businessperson is a merchant with respect to every
possible transaction. But a person or institution normally not considered a merchant can be one
under Article 2 if he employs an agent or broker who holds himself out as having such
knowledge or skill. (Thus a university with a purchasing office can be a merchant with respect to
transactions handled by that department.)
Determining whether a particular person operating a business is a merchant under Article 2-104
is a common problem for the courts. Goldkist, Inc. v. Brownlee, Section 17.5.2 "“Merchants”
under the UCC", shows that making the determination is difficult and contentious, with
significant public policy implications.

Obligations May Be Determined by Parties
Under the UCC
Under the UCC, the parties to a contract are free to put into their contract pretty much anything
they want. Article 1-102 states that “the effect of provisions of this Act may be varied by
agreement…except that the obligations of good faith, diligence, reasonableness and care
prescribed by this Act may not be disclaimed by agreement but the parties may by agreement
determine the standards by which the performance of such obligations is to be measure if such
standards are not manifestly unreasonable.” Thus the UCC is the “default” position: if the
parties want the contract to operate in a specific way, they can provide for that. If they don’t put
anything in their agreement about some aspect of their contract’s operation, the UCC applies.
Saylor URL: http://www.saylor.org/books

Saylor.org
613

For example, if they do not state where “delivery” will occur, the UCC provides that term.
(Section 2-308 says it would be at the “seller’s place of business or if he has none, his
residence.”)
Article 6 of the CISG similarly gives the parties freedom to contract. It provides,
“The parties may exclude the application of this Convention or…vary the effect of
any of its provisions.”

KEY TAKEAWAY

The UCC imposes some general obligations on parties to a sales contract. They must act in
good faith, and unconscionable contracts or terms thereof will not be enforced. The UCC
applies to any sale of goods, but sometimes special obligations are imposed on merchants.
While the UCC imposes various general (and more specific) obligations on the parties, they
are free, within limits, to make up their own contract terms and obligations; if they do not,
the UCC applies. The CISG tends to follow the basic thrust of the UCC.

EXERCISES

1. What does the UCC say about the standard duty parties to a contract owe each other?
2. Why are merchants treated specially by the UCC in some circumstances?
3. Give an example of a merchant-to-merchant duty imposed by the UCC and of a merchant-tononmerchant duty.
4. What does it mean to say the UCC is the “default” contract term?

[1] Restatement (Second) of Contracts, Section 205.
[2] Uniform Commercial Code, Sections 2-205 and 2A–205.
[3] Sheeskin v. Giant Food, Inc., 318 A.2d 874 (Md. Ct. App. 1974).
[4] Uniform Commercial Code, Section 2-104(3).

17.5 Cases
Mixed Goods and Services Contracts: The “Predominant Factor” Test
Pittsley v. Houser
875 P.2d 232 (Idaho App. 1994)
Saylor URL: http://www.saylor.org/books

Saylor.org
614

Swanstrom, J.
In September of 1988, Jane Pittsley contracted with Hilton Contract Carpet Co. (Hilton) for the
installation of carpet in her home. The total contract price was $4,402 [about $7,900 in 2010
dollars]. Hilton paid the installers $700 to put the carpet in Pittsley’s home. Following
installation, Pittsley complained to Hilton that some seams were visible, that gaps appeared,
that the carpet did not lay flat in all areas, and that it failed to reach the wall in certain locations.
Although Hilton made various attempts to fix the installation, by attempting to stretch the
carpet and other methods, Pittsley was not satisfied with the work. Eventually, Pittsley refused
any further efforts to fix the carpet. Pittsley initially paid Hilton $3,500 on the contract, but
refused to pay the remaining balance of $902.
Pittsley later filed suit, seeking rescission of the contract, return of the $3,500 and incidental
damages. Hilton answered and counterclaimed for the balance remaining on the contract. The
matter was heard by a magistrate sitting without a jury. The magistrate found that there were
defects in the installation and that the carpet had been installed in an unworkmanlike manner.
The magistrate also found that there was a lack of evidence on damages. The trial was continued
to allow the parties to procure evidence on the amount of damages incurred by Pittsley.
Following this continuance, Pittsley did not introduce any further evidence of damages, though
witnesses for Hilton estimated repair costs at $250.
Although Pittsley had asked for rescission of the contract and a refund of her money, the
magistrate determined that rescission, as an equitable remedy, was only available when one
party committed a breach so material that it destroyed the entire purpose of the contract.
Because the only estimate of damages was for $250, the magistrate ruled rescission would not
be a proper remedy. Instead, the magistrate awarded Pittsley $250 damages plus $150 she
expended in moving furniture prior to Hilton’s attempt to repair the carpet. On the
counterclaim, the magistrate awarded Hilton the $902 remaining on the contract. Additionally,
both parties had requested attorney fees in the action. The magistrate determined that both
parties had prevailed and therefore awarded both parties their attorney fees.
Following this decision, Pittsley appealed to the district court, claiming that the transaction
involved was governed by the Idaho Uniform Commercial Code (UCC), [Citation]. Pittsley
Saylor URL: http://www.saylor.org/books

Saylor.org
615

argued that if the UCC had been properly applied, a different result would have been reached.
The district court agreed with Pittsley’s argument, reversing and remanding the case to the
magistrate to make additional findings of fact and to apply the UCC to the transaction.…
Hilton now appeals the decision of the district court. Hilton claims that Pittsley failed to allege
or argue the UCC in either her pleadings or at trial. Even if application of the UCC was properly
raised, Hilton argues that there were no defects in the goods that were the subject of the
transaction, only in the installation, making application of the UCC inappropriate.…
The single question upon which this appeal depends is whether the UCC is applicable to the
subject transaction. If the underlying transaction involved the sale of “goods,” then the UCC
would apply. If the transaction did not involve goods, but rather was for services, then
application of the UCC would be erroneous.
Idaho Code § 28–2-105(1) defines “goods” as “all things (including specially manufactured
goods) which are movable at the time of identification to the contract for sale.…” Although there
is little dispute that carpets are “goods,” the transaction in this case also involved installation, a
service. Such hybrid transactions, involving both goods and services, raise difficult questions
about the applicability of the UCC. Two lines of authority have emerged to deal with such
situations.
The first line of authority, and the majority position, utilizes the “predominant factor” test. The
Ninth Circuit, applying the Idaho Uniform Commercial Code to the subject transaction, restated
the predominant factor test as:
The test for inclusion or exclusion is not whether they are mixed, but, granting that
they are mixed, whether their predominant factor, their thrust, their purpose,
reasonably stated, is the rendition of service, with goods incidentally involved (e.g.,
contract with artist for painting) or is a transaction of sale, with labor incidentally
involved (e.g., installation of a water heater in a bathroom).
[Citations]. This test essentially involves consideration of the contract in its entirety, applying
the UCC to the entire contract or not at all.
The second line of authority, which Hilton urges us to adopt, allows the contract to be severed
into different parts, applying the UCC to the goods involved in the contract, but not to the nonSaylor URL: http://www.saylor.org/books

Saylor.org
616

goods involved, including services as well as other non-goods assets and property. Thus, an
action focusing on defects or problems with the goods themselves would be covered by the UCC,
while a suit based on the service provided or some other non-goods aspect would not be covered
by the UCC.…
We believe the predominant factor test is the more prudent rule. Severing contracts into various
parts, attempting to label each as goods or non-goods and applying different law to each
separate part clearly contravenes the UCC’s declared purpose “to simplify, clarify and modernize
the law governing commercial transactions.” I.C. § 28–1–102(2)(a). As the Supreme Court of
Tennessee suggested in [Citation], such a rule would, in many contexts, present “difficult and in
some instances insurmountable problems of proof in segregating assets and determining their
respective values at the time of the original contract and at the time of resale, in order to apply
two different measures of damages.”
Applying the predominant factor test to the case before us, we conclude that the UCC was
applicable to the subject transaction. The record indicates that the contract between the parties
called for “175 yds Masterpiece # 2122-Installed” for a price of $4319.50. There was an
additional charge for removing the existing carpet. The record indicates that Hilton paid the
installers $700 for the work done in laying Pittsley’s carpet. It appears that Pittsley entered into
this contract for the purpose of obtaining carpet of a certain quality and color. It does not appear
that the installation, either who would provide it or the nature of the work, was a factor in
inducing Pittsley to choose Hilton as the carpet supplier. On these facts, we conclude that the
sale of the carpet was the predominant factor in the contract, with the installation being merely
incidental to the purchase. Therefore, in failing to consider the UCC, the magistrate did not
apply the correct legal principles to the facts as found. We must therefore vacate the judgment
and remand for further findings of fact and application of the UCC to the subject transaction.

CASE QUESTIONS

1. You may recall in /6059 - mayer_1.0-ch15the discussion of the “substantial performance”

doctrine. It says that if a common-law contract is not completely, but still “substantially,”
performed, the nonbreaching party still owes something on the contract. And it was noted
there that under the UCC, there is no such doctrine. Instead, the “perfect tender” rule

Saylor URL: http://www.saylor.org/books

Saylor.org
617

applies: the goods delivered by the seller must be exactly right. Does the distinction between
the substantial performance doctrine and the perfect tender rule shed light on what
difference applying the common law or the UCC would make in this case?
2. If Pittsley won on remand, what would she get?
3. In discussing the predominant factor test, the court here quotes from the Ninth Circuit,
a federal court of appeals. What is a federal court doing making rules for a state court?

“Merchants” under the UCC
Goldkist, Inc. v. Brownlee
355 S.E.2d 773 (Ga. App. 1987)
Beasley, J.
The question is whether the two defendant farmers, who as a partnership both grew and sold
their crops, were established by the undisputed facts as not being “merchants” as a matter of
law, according to the definition in [Georgia UCC 2-104(1)].…
Appellees admit that their crops are “goods” as defined in [2-105]. The record establishes the
following facts. The partnership had been operating the row crop farming business for 14 years,
producing peanuts, soybeans, corn, milo, and wheat on 1,350 acres, and selling the crops.
It is also established without dispute that Barney Brownlee, whose deposition was taken, was
familiar with the marketing procedure of “booking” crops, which sometimes occurred over the
phone between the farmer and the buyer, rather than in person, and a written contract would be
signed later. He periodically called plaintiff’s agent to check the price, which fluctuated. If the
price met his approval, he sold soybeans. At this time the partnership still had some of its 1982
crop in storage, and the price was rising slowly. Mr. Brownlee received a written confirmation in
the mail concerning a sale of soybeans and did not contact plaintiff to contest it but simply did
nothing. In addition to the agricultural business, Brownlee operated a gasoline service station.…
In dispute are the facts with respect to whether or not an oral contract was made between
Barney Brownlee for the partnership and agent Harrell for the buyer in a July 22 telephone
conversation. The plaintiff’s evidence was that it occurred and that it was discussed soon
thereafter with Brownlee at the service station on two different occasions, when he
Saylor URL: http://www.saylor.org/books

Saylor.org
618

acknowledged it, albeit reluctantly, because the market price of soybeans had risen. Mr.
Brownlee denies booking the soybeans and denies the nature of the conversations at his service
station with Harrell and the buyer’s manager.…
Whether or not the farmers in this case are “merchants” as a matter of law, which is not before
us, the evidence does not demand a conclusion that they are outside of that category which is
excepted from the requirement of a signed writing to bind a buyer and seller of goods.…To allow
a farmer who deals in crops of the kind at issue, or who otherwise comes within the definition of
“merchant” in [UCC] 2-104(1), to renege on a confirmed oral booking for the sale of crops,
would result in a fraud on the buyer. The farmer could abide by the booking if the price
thereafter declined but reject it if the price rose; the buyer, on the other hand, would be forced to
sell the crop following the booking at its peril, or wait until the farmer decides whether to honor
the booking or not.
Defendants’ narrow construction of “merchant” would, given the booking procedure used for the
sale of farm products, thus guarantee to the farmers the best of both possible worlds (fulfill
booking if price goes down after booking and reject it if price improves) and to the buyers the
worst of both possible worlds. On the other hand, construing “merchants” in [UCC] 2-104(1) as
not excluding as a matter of law farmers such as the ones in this case, protects them equally as
well as the buyer. If the market price declines after the booking, they are assured of the higher
booking price; the buyer cannot renege, as [UCC]2-201(2) would apply.
In giving this construction to the statute, we are persuaded by [Citation], supra, and the analyses
provided in the following cases from other states: [Citations]. By the same token, we reject the
narrow construction given in other states’ cases: [Citations]. We believe this is the proper
construction to give the two statutes, [UCC 2-104(1) and 2-201(2)], as taken together they are
thus further branches stemming from the centuries-old simple legal idea pacta servanda sunt—
agreements are to be kept. So construed, they evince the legislative intent to enforce the
accepted practices of the marketplace among those who frequent it.
Judgment reversed. [Four justices concurred with Justice Beasley].
Benham, J., dissenting.

Saylor URL: http://www.saylor.org/books

Saylor.org
619

Because I cannot agree with the majority’s conclusion that appellees are merchants, I must
respectfully dissent.
…The validity of [plaintiff’s] argument, that sending a confirmation within a reasonable time
makes enforceable a contract even though the statute of frauds has not been satisfied, rests upon
a showing that the contract was “[b]etween merchants.” “Between merchants” is statutorily
defined in the Uniform Commercial Code as meaning “any transaction with respect to which
both parties are chargeable with the knowledge or skill of merchants” [2-104(3)]. “‘Merchant’
means a person [1] who deals in goods of the kind or [2] otherwise by his occupation holds
himself out as having knowledge or skill peculiar to the practices or goods involved in the
transaction or [3] to whom such knowledge or skill may be attributed by his employment of an
agent or broker or other intermediary who by his occupation holds himself out as having such
knowledge or skill” [Citation]. Whether [plaintiff] is a merchant is not questioned here; the
question is whether, under the facts in the record, [defendant]/farmers are merchants.…
The Official Comment to § 2-104 of the U.C.C. (codified in Georgia)…states: “This Article
assumes that transactions between professionals in a given field require special and clear rules
which may not apply to a casual or inexperienced seller or buyer…This section lays the
foundation of this policy by defining those who are to be regarded as professionals or
‘merchants’ and by stating when a transaction is deemed to be ‘between merchants.’ The term
‘merchant’ as defined here roots in the ‘law merchant’ concept of a professional in business.” As
noted by the Supreme Court of Kansas in [Citation] (1976): “The concept of professionalism is
heavy in determining who is a merchant under the statute. The writers of the official UCC
comment virtually equate professionals with merchants—the casual or inexperienced buyer or
seller is not to be held to the standard set for the professional in business. The defined term
‘between merchants,’ used in the exception proviso to the statute of frauds, contemplates the
knowledge and skill of professionals on each side of the transaction.” The Supreme Court of
Iowa [concurs in cases cited]. Where, as here, the undisputed evidence is that the farmer’s sole
experience in the marketplace consists of selling the crops he has grown, the courts of several of
our sister states have concluded that the farmer is not a merchant. [Citations]. Just because
appellee Barney Brownlee kept “conversant with the current price of [soybeans] and planned to
Saylor URL: http://www.saylor.org/books

Saylor.org
620

market it to his advantage does not necessarily make him a ‘merchant.’ It is but natural for
anyone who desires to sell anything he owns to negotiate and get the best price obtainable. If
this would make one a ‘merchant,’ then practically anyone who sold anything would be deemed
a merchant, hence would be an exception under the statute[,] and the need for a contract in
writing could be eliminated in most any kind of a sale.” [Citation].
It is also my opinion that the record does not reflect that appellees “dealt” in soybeans, or that
through their occupation, they held themselves out as having knowledge or skill peculiar to the
practices or goods involved in the transaction. See [UCC] 2-104(1). “[A]lthough a farmer may
well possess special knowledge or skill with respect to the production of a crop, the term
‘merchant,’ as used in the Uniform Commercial Code, contemplates special knowledge and skill
associated with the marketplace. As to the area of farm crops, this special skill or knowledge
means, for instance, special skill or knowledge associated with the operation of the commodities
market. It is inconceivable that the drafters of the Uniform Commercial Code intended to place
the average farmer, who merely grows his yearly crop and sells it to the local elevator, etc., on
equal footing with the professional commodities dealer whose sole business is the buying and
selling of farm commodities” [Citations]. If one who buys or sells something on an annual basis
is a merchant, then the annual purchaser of a new automobile is a merchant who need not sign a
contract for the purchase in order for the contract to be enforceable.…
If these farmers are not merchants, a contract signed by both parties is necessary for
enforcement. If the farmer signs a contract, he is liable for breach of contract if he fails to live up
to its terms. If he does not sign the contract, he cannot seek enforcement of the terms of the
purchaser’s offer to buy.…
Because I find no evidence in the record that appellees meet the statutory qualifications as
merchants, I would affirm the decision of the trial court. I am authorized to state that [three
other justices] join in this dissent.

CASE QUESTIONS

1. How is the UCC’s ten-day-reply doctrine in issue here?
2. Five justices thought the farmers here should be classified as “merchants,” and four of them
thought otherwise. What argument did the majority have against calling the farmers

Saylor URL: http://www.saylor.org/books

Saylor.org
621

“merchants”? What argument did the dissent have as to why they should not be called
merchants?
3. Each side marshaled persuasive precedent from other jurisdictions to support its contention.
As a matter of public policy, is one argument better than another?
4. What does the court mean when it says the defendants are not excluded from the definition
of merchants “as a matter of law”?

Unconscionability in Finance Lease Contracts
Info. Leasing Corp. v. GDR Investments, Inc.
787 N.E.2d 652 (Ohio App. 2003)
Gorman, J.
The plaintiff-appellant, Information Leasing Corporation (“ILC”), appeals from the order of the
trial court rendering judgment in favor of the defendants-appellees…GDR Investments, Inc.
[defendant Arora’s corporation], Pinnacle Exxon, and Avtar S. Arora, in an action to recover
$15,877.37 on a five-year commercial lease of an Automated Teller Machine (“ATM”).…
This is one of many cases involving ILC that have been recently before this court. ILC is an Ohio
corporation wholly owned by the Provident Bank. ILC is in the business of leasing ATMs
through a third party, or vendor. In all of these cases, the vendor has been…Credit Card Center
(“CCC”). CCC was in the business of finding lessees for the machines and then providing the
services necessary to operate them, offering the lessees attractive commissions. Essentially, CCC
would find a customer, usually a small business interested in having an ATM available on its
premises, arrange for its customer to sign a lease with ILC, and then agree to service the
machine, keeping it stocked with cash and paying the customer a certain monthly commission.
Usually, as in the case of [defendants], the owner of the business was required to sign as a
personal guarantor of the lease. The twist in this story is that CCC soon went bankrupt, leaving
its customers stuck with ATMs under the terms of leases with ILC but with no service provider.
Rather than seeking to find another company to service the ATMs, many of CCC’s former
customers, like [defendants], simply decided that they no longer wanted the ATMs and were no

Saylor URL: http://www.saylor.org/books

Saylor.org
622

longer going to make lease payments to ILC. The terms of each lease, however, prohibited
cancellation. The pertinent section read,
LEASE NON-CANCELABLE AND NO WARRANTY. THIS LEASE CANNOT BE
CANCELED BY YOU FOR ANY REASON, INCLUDING EQUIPMENT FAILURE, LOSS
OR DAMAGE. YOU MAY NOT REVOKE ACCEPTANCE OF THE EQUIPMENT. YOU,
NOT WE, SELECTED THE EQUIPMENT AND THE VENDOR. WE ARE NOT
RESPONSIBLE FOR EQUIPMENT FAILURE OR THE VENDOR’S ACTS. YOU ARE
LEASING THE EQUIPMENT ‘AS IS’, [sic] AND WE DISCLAIM ALL WARRANTIES,
EXPRESS OR IMPLIED. WE ARE NOT RESPONSIBLE FOR SERVICE OR REPAIRS.
Either out of a sense of fair play or a further desire to make enforcement of the lease ironclad,
ILC put a notice on the top of the lease that stated,
NOTICE: THIS IS A NON-CANCELABLE, BINDING CONTRACT. THIS CONTRACT
WAS WRITTEN IN PLAIN LANGUAGE FOR YOUR BENEFIT. IT CONTAINS
IMPORTANT TERMS AND CONDITIONS AND HAS LEGAL AND FINANCIAL
CONSEQUENCES TO YOU. PLEASE READ IT CAREFULLY; FEEL FREE TO ASK
QUESTIONS BEFORE SIGNING BY CALLING THE LEASING COMPANY AT 1-513421-9191.
Arora, the owner of [defendant corporation], was a resident alien with degrees in commerce and
economics from the University of Delhi, India. Arora wished to have an ATM on the premises of
his Exxon station in the hope of increasing business. He made the mistake of arranging
acquisition of the ATM through CCC. According to his testimony, a representative of CCC
showed up at the station one day and gave him “formality papers” to sign before the ATM could
be delivered. Arora stated that he was busy with other customers when the CCC representative
asked him to sign the papers. He testified that when he informed the CCC representative that he
needed time to read the documents before signing them, he was told not to worry and…that the
papers did not need his attention and that his signature was a mere formality. Arora signed the
ILC lease, having never read it.
Within days, CCC went into bankruptcy. Arora found himself with an ATM that he no longer
wanted.…According to his testimony, he tried unsuccessfully to contact ILC to take back the
Saylor URL: http://www.saylor.org/books

Saylor.org
623

ATM. Soon Arora suffered a mild heart attack, the gas station went out of business, and the
ATM, which had been in place for approximately eighteen days, was left sitting in the garage, no
longer in use until ILC came and removed it several months later.
Unfortunately for Arora, the lease also had an acceleration clause that read,
DEFAULT. If you fail to pay us or perform as agreed, we will have the right to (i)
terminate this lease, (ii) sue you for all past due payment AND ALL FUTURE
PAYMENTS UNDER THIS LEASE, plus the Residual Value we have placed on the
equipment and other charges you owe us, (iii) repossess the equipment at your
expense and (iv) exercise any other right or remedy which may be available under
applicable law or proceed by court act.
The trial court listened to the evidence in this case, which was awkwardly presented due in large
part to Arora’s decision to act as his own trial counsel. Obviously impressed with Arora’s honesty
and sympathetic to his situation, the trial court found that Arora owed ILC nothing. In so ruling,
the court stated that ILC “ha[d] not complied with any of its contractual obligations and that
[Arora] appropriately canceled any obligations by him, if there really were any.” The court also
found that ILC, “if they did have a contract, failed to mitigate any damages by timely picking up
the machine after [Arora] gave them notice to pick up the machine.”…
ILC contends, and we do not disagree, that the lease in question satisfied the definition of a
“finance lease” under [UCC 2A-407]. A finance lease is considerably different from an ordinary
lease in that it adds a third party, the equipment supplier or manufacturer (in this case, the now
defunct CCC). As noted by White and Summers, “In effect, the finance lessee * * * is relying
upon the manufacturer * * * to provide the promised goods and stand by its promises and
warranties; the [lessee] does not look to the [lessor] for these. The [lessor] is only a finance
lessor and deals largely in paper, rather than goods.” [Citation].
One notorious feature of a finance lease is its typically noncancelable nature, which is
specifically authorized by statute [UCC 2A-407]. [UCC 2A-407(1)] provides in the case of a
finance lease that is not a consumer lease, “[T]he lessee’s promises under the lease contract
become irrevocable and independent upon the lessee’s acceptance of the goods.” The same
statutory section also makes clear that the finance lease is “not subject to cancellation,
Saylor URL: http://www.saylor.org/books

Saylor.org
624

termination, modification, repudiation, excuse, or substitution without the consent of the party
to whom it runs.” [Citation]
Because of their noncancelable nature, finance leases enjoy somewhat of a reputation. The titles
of law review articles written about them reveal more than a little cynicism regarding their
fairness: [Citations].
…As described by Professors White and Summers, “The parties can draft a lease agreement that
carefully excludes warranty and promissory liability of the finance lessor to the lessee, and that
sets out what is known in the trade as a ‘hell or high water clause,’ namely, a clause that requires
the lessee to continue to make rent payments to the finance lessor even though the [equipment]
is unsuitable, defective, or destroyed.”…“The lessor’s responsibility is merely to provide the
money, not to instruct the lessee like a wayward child concerning a suitable purchase * * *.
Absent contrary agreement, even if [, for example, a finance-leased] Boeing 747 explodes into
small pieces in flight and is completely uninsured, lessee’s obligation to pay continues.”
…Some people complain about being stuck with the bill; Arora’s complaint was that he was stuck
with the ATM.…
To begin the proper legal analysis, we note first that this was not a “consumer lease” expressly
excepted from [UCC 2A-407]. A “consumer lease” is defined in [UCC 2A-103(e)] as one in which
the lessee is “an individual and who takes under the lease primarily for a personal, family, or
household purpose.” This would definitely not apply here, where the ATM was placed on the
business premises of the Exxon station, and where the lessee was [Arora’s corporation] and not
Arora individually. (Arora was liable individually as the personal guarantor of [his corporation]’s
obligations under the lease.)…
Certain defenses do remain, however. First, the UCC expressly allows for the application of the
doctrine of unconscionability to finance leases, both consumer and commercial. [Citation]
authorizes the trial court to find “any clause of a lease contract to have been unconscionable at
the time it was made * * *.” If it so finds, the court is given the power to “refuse to enforce the
lease contract, * * * enforce the remainder of the lease contract without the unconscionable
clause, or * * * limit the application of the unconscionable clause as to avoid any unconscionable
result.” [Citation]
Saylor URL: http://www.saylor.org/books

Saylor.org
625

In this case, the trial court made no findings as to whether the finance lease was unconscionable.
The primary purpose of the doctrine of unconscionability is to prevent oppression and unfair
surprise. [Citation] “Oppression” refers to substantive unconscionability and arises from overly
burdensome or punitive terms of a contract, whereas “unfair surprise” refers to procedural
unconscionability and is implicated in the formation of a contract, when one of the parties is
either overborne by a lack of equal bargaining power or otherwise unfairly or unjustly drawn
into a contract. [Citation]
It should be pointed that, although harsh, many characteristics of a finance lease are not
inherently unconscionable and, as we have discussed, are specifically authorized by statute.
Simply because a finance lease has a “hell or high water clause” does not make it
unconscionable. As noted, a finance lease is a separate animal—it is supposed to secure minimal
risk to the lessor. At least one court has rejected the argument that an acceleration clause in a
commercial finance lease is punitive and unconscionable in the context of parties of relatively
equal bargaining power. See [Citation]
At the heart of Arora’s defense in this case was his claim that he was misled into signing the
finance lease by the CCC representative and was unfairly surprised to find himself the unwitting
signatory of an oppressive lease. This is clearly an argument that implicated procedural
unconscionability. His claim of being an unwitting signatory, however, must be carefully
balanced against the law in Ohio that places upon a person a duty to read any contract before
signing it, a duty that is not excused simply because a person willingly gives into the
encouragement to “just go ahead and sign.” See [Citation]
Moreover, we note that courts have also recognized that the lessor may give, through word or
conduct, the lessee consent to cancel an otherwise noncancelable lease. [UCC 2A-40792)(b)]
makes a finance lease “not subject to cancellation, termination, modification, repudiation,
excuse, or substitution without the consent of the party to whom it runs.” (Emphasis supplied.)
As noted by the court in Colonial Court[Citation], the UCC does not say anything with respect to
the form or content of the consent. The Colonial Pacific court concluded, therefore, “that the
consent may be oral and may be established by conduct that reasonably manifests an intent. * *
* Any manifestations that the obligation of the lessee will not be enforced independently of the
Saylor URL: http://www.saylor.org/books

Saylor.org
626

obligation that runs to the consenting party is sufficient.” The question whether consent has
been given to a cancellation is a question of fact for the trier of fact.
We raise this point because the evidence indicates that there was some communication between
Arora and ILC before ILC retrieved the ATM. It is unclear whether ILC removed the ATM at
Arora’s request, or whether the company was forcibly repossessing the equipment pursuant to
the default provision of the lease. In view of the murkiness of the testimony, it is unclear when
the ATM was taken back and when the final lease payment was made. One interesting question
that arises from ILC’s retrieval of the ATM, not addressed in the record, is what ILC did with the
equipment afterward. Did ILC warehouse the equipment for the next four and one-half years
(conduct that would appear unprofitable and therefore unlikely) or did the company then turn
around and lease the ATM to someone else? If there was another lease, was ILC actually seeking
a double recovery on the ATM’s rental value? In this regard, we note that the trial court ruled
that ILC had failed to mitigate its damages, a finding that is not supported by the current record,
but may well prove to be true upon further trial of the matter.
In sum, this is a case that requires a much more elaborate presentation of evidence by the
parties, and much more detailed findings of fact and conclusions of law than those actually
made by the trial court. We sustain ILC’s assignment of error upon the basis that the trial court
did not apply the correct legal analysis, and that the evidence of record did not mandate a
judgment in Arora’s favor. Because of the number of outstanding issues and unresolved factual
questions, we reverse the trial court’s judgment and remand this case for a new trial consistent
with the law set forth in this opinion.
Judgment reversed and cause remanded.

CASE QUESTIONS

1. Why would a finance lease have such an iron-clad, “hell or high water” noncancellation
clause as is apparently common and demonstrated here?
2. On what basis did the lower court rule in the defendant’s favor?
3. What is an acceleration clause?
4. What was Mr. Arora’s main defense? What concern did the court have with it?

Saylor URL: http://www.saylor.org/books

Saylor.org
627

5. The appeals court helpfully suggested several arguments the defendant might make on
remand to be relieved of his contract obligations. What were they?

17.6 Summary and Exercises
Summary

Sales law is a special type of contract law, governed by Article 2 of the Uniform Commercial
Code (UCC), adopted in every state but Louisiana. Article 2 governs the sale of goods only,
defined as things movable at the time of identification to the contract for sale. Article 2A, a more
recent offering, deals with the leasing of goods, including finance leases and consumer leases.
The Convention on Contracts for the International Sale of Goods (CISG) is an international
equivalent of Article 2.
Difficult questions sometimes arise when the subject of the contract is a hybrid of goods and real
estate or goods and services. If the seller is called on to sever crops, timber, or minerals from the
land, or the buyer is required to sever and can do so without material harm to the land, then the
items are goods subject to Article 2. When the goods are “sold” incidental to a service, the
“predominant factor” test is used, but with inconsistent results. For two categories of goods,
legislation specifically answers the question: foodstuffs served by a restaurant are goods; blood
supplied for transfusions is not.
Although they are kin, in some areas Article 2 differs from the common law. As regards mutual
assent, the UCC abolishes the mirror image rule; it allows for more indefiniteness and open
terms. The UCC does away with some requirements for consideration. It sometimes imposes
special obligations on merchants (though defining a merchant is problematic), those who deal in
goods of the kind, or who by their occupations hold themselves out as experts in the use of the
goods as between other merchants and in selling to nonmerchants. Article 2 gives courts greater
leeway than under the common law to modify contracts at the request of a party, if a clause is
found to have been unconscionable at the time made.

EXERCISES

1. Ben owns fifty acres of timberland. He enters into a contract with Bunyan under which
Bunyan is to cut and remove the timber from Ben’s land. Bunyan enters into a contract to sell

Saylor URL: http://www.saylor.org/books

Saylor.org
628

the logs to Log Cabin, Inc., a homebuilder. Are these two contracts governed by the UCC?
Why?
2. Clarence agreed to sell his farm to Jud in exchange for five antique cars owned by Jud. Is this
contract governed by the UCC? Why?
3. Professor Byte enters into a contract to purchase a laptop computer from Ultra-Intelligence
Inc. He also enters into a contract with a graduate student, who is to write programs that will
be run on the computer. Are these two contracts governed by the UCC? Why?
4. Pat had a skin problem and went to Dr. Pore, a dermatologist, for treatment. Dr. Pore applied
a salve obtained from a pharmaceutical supplier, which made the problem worse. Is Dr. Pore
liable under Article 2 of the UCC? Why?
5. Zanae visited the Bonita Burrito restaurant and became seriously ill after eating tainted food.
She was rushed to a local hospital, where she was given a blood transfusion. Zanae
developed hepatitis as a result of the transfusion. When she sued the restaurant and the
hospital, claiming remedies under the UCC, both defended the suit by arguing that they were
providing services, not goods. Are they correct? Why?
6. Bill, the owner of Bill’s Used Books, decided to go out of business. He sold two of his
bookcases to Ned. Ned later discovered that the bookcases were defective and sued Bill on
the theory that, as a merchant, he warranted that the bookcases were of fair, average
quality. Will Ned prevail on this theory? Why?
7. Rufus visited a supermarket to purchase groceries. As he moved past a display of soda pop
and perhaps lightly brushed it, a bottle exploded. Rufus sustained injury and sued the
supermarket, claiming breach of warranty under the UCC. Will Rufus win? Why?
8. Carpet Mart bought carpet from Collins & Aikman (Defendant) represented to be
100 percent polyester fiber. When Carpet Mart discovered in fact the carpet
purchased was composed of cheaper, inferior fiber, it sued for compensatory and
punitive damages. Defendant moved for a stay pending arbitration, pointing to
the language of its acceptance form: “The acceptance of your order is subject to
all the terms and conditions on the face and reverse side hereof, including
arbitration, all of which are accepted by buyer; it supersedes buyer’s order form.”
Saylor URL: http://www.saylor.org/books

Saylor.org
629

The small print on the reverse side of the form provided, among other things, that
all claims arising out of the contract would be submitted to arbitration in New
York City. The lower court held that Carpet Mart was not bound by the arbitration
agreement appearing on the back of Collins & Aikman’s acknowledgment form,
and Defendant appealed. How should the appeals court rule?
9. Plaintiff shipped to Defendant—Pizza Pride Inc. of Jamestown, North Carolina—an order of
mozzarella cheese totaling $11,000. That same day, Plaintiff mailed Defendant an invoice for
the order, based on Plaintiff’s understanding that an oral contract existed between the
parties whereby Defendant had agreed to pay for the cheese. Defendant was engaged in the
real estate business at this time and had earlier been approached by Pizza Pride Inc. to
discuss that company’s real estate investment potential. Defendant denied ever
guaranteeing payment for the cheese and raised the UCC’s Statute of Frauds, Section 2-201,
as an affirmative defense. The Plaintiff contended that because Defendant was in the
business of buying and selling real estate, she possessed knowledge or skill peculiar to the
practices involved in the transaction here. After hearing the evidence, the court concluded as
a matter of law that Defendant did agree to pay for the cheese and was liable to Plaintiff in
the amount of $11,000. Defendant appealed. How should the appeals court rule?
10. Seller offered to sell to Buyer goods at an agreed price “to be shipped to Buyer by UPS.”
Buyer accepted on a form that included this term: “goods to be shipped FedEx, Buyer to pay
freight.” Seller then determined not to carry on with the contract as the price of the goods
had increased, and Seller asserted that because the acceptance was different from the offer,
there was no contract. Is this correct?

SELF-TEST QUESTIONS

1. Among subjects the UCC does not cover are
a.

letters of credit

b. service contracts
c. sale of goods
d. bank collections
When a contract is unconscionable, a court may

Saylor URL: http://www.saylor.org/books

Saylor.org
630

a.

refuse to enforce the contract

b. strike the unconscionable clause
c. limit the application of the unconscionable clause
d. take any of the above approaches
Under the UCC, the definition of merchant is limited to
a.

manufacturers

b. retailers
c. wholesalers
d. none of the above
For the purpose of sales law, goods
a.

always include items sold incidental to a service

b. include things movable at the time of identification to the contract
c. include blood supplied for transfusions
d. include all of the above
Article 2 differs from the common law of contracts
a.

in no substantial way

b. by disallowing parties to create agreements with open terms
c. by obligating courts to respect all terms of the contract
d. by imposing special obligations on merchants

SELF-TEST ANSWERS

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

Saylor URL: http://www.saylor.org/books

Saylor.org
631

Chapter 18
Title and Risk of Loss
LEARNING OBJECTIVES

After reading this chapter, you should understand the following:
1. Why title is important and at what point in the contracting relationship the buyer acquires
title
2. Why risk of loss is important, when risk of loss passes to the buyer, and when the buyer
acquires an insurable interest
3. Under what circumstances the buyer can obtain title when a nonowner sells the goods
Parties to a sales contract will usually agree on the obvious details of a sales transaction—the
nature of goods, the price, and the delivery time, as discussed in the next chapter. But there are
two other issues of importance lurking in the background of every sale:
1. When does the title pass to the buyer? This question arises more in cases involving third parties,
such as creditors and tax collectors. For instance, a creditor of the seller will not be allowed to
take possession of goods in the seller’s warehouse if the title has already passed to the buyer.
2. If goods are damaged or destroyed, who must bear the loss? The answer has obvious financial
significance to both parties. If the seller must bear the loss, then in most cases he must pay
damages or send the buyer another shipment of goods. A buyer who bears the loss must pay for
the goods even though they are unusable. In the absence of a prior agreement, loss can trigger
litigation between the parties.

18.1 Transfer of Title

LEARNING OBJECTIVES

1. Understand why it is important to know who has title in a sales transaction.
2. Be able to explain when title shifts.
3. Understand when a person who has no title can nevertheless pass good title on to a buyer.

Why It Is Important When Title Shifts

Saylor URL: http://www.saylor.org/books

Saylor.org
632

There are three reasons why it is important when title shifts from seller to buyer—that is, when
the buyer gets title.

It Affects Whether a Sale Has Occurred
First, a sale cannot occur without a shift in title. You will recall that a sale is defined by the
Uniform Commercial Code (UCC) as a “transfer of title from seller to buyer for a price.” Thus if
there is no shift of title, there is no sale. And there are several consequences to there being no
sale, one of which is—concerning a merchant-seller—that no implied warranty of
merchantability arises. (Again, as discussed in the previous chapter, an implied warranty
provides that when a merchant-seller sells goods, the goods are suitable for the ordinary
purpose for which such goods are used.) In a lease, of course, title remains with the lessor.

Creditors’ Rights
Second, title is important because it determines whether creditors may take the goods. If
Creditor has a right to seize Debtor’s goods to satisfy a judgment or because the parties have a
security agreement (giving Creditor the right to repossess Debtor’s goods), obviously it won’t do
at all for Creditor to seize goods when Debtor doesn’t have title to them—they are somebody
else’s goods, and seizing them would be conversion, a tort (the civil equivalent of a theft
offense).

Insurable Interest
Third, title is related to who has an insurable interest. A buyer cannot legally obtain
insurance unless he has an insurable interest in the goods. Without an insurable interest, the
insurance contract would be an illegal gambling contract. For example, if you attempt to take
out insurance on a ship with which you have no connection, hoping to recover a large sum if it
sinks, the courts will construe the contract as a wager you have made with the insurance
company that the ship is not seaworthy, and they will refuse to enforce it if the ship should sink
and you try to collect. Thus this question arises: under the UCC, at what point does the buyer
acquire an insurable interest in the goods? Certainly a person has insurable interest if she has
title, but the UCC allows a person to have insurable interest with less than full title. The
argument here is often between two insurance companies, each denying that its insured had
insurable interest as to make it liable.
Saylor URL: http://www.saylor.org/books

Saylor.org
633

Goods Identified to the Contract
The Identification Issue
The UCC at Section 2-401 provides that “title to goods cannot pass under a contract for sale
prior to their identification to the contract.” (In a lease, of course, title to the leased goods does
not pass at all, only the right to possession and use for some time in return for consideration. [1])
So identification to the contract has to happen before title can
shift. Identification to the contract here means that the seller in one way or another picks the
goods to be sold out of the mass of inventory so that they can be delivered or held for the buyer.
Article 67 of the CISG says the same thing: “[T]he risk does not pass to the buyer
until the goods are clearly identified to the contract, whether by markings on the
goods, by shipping documents, by notice given to the buyer or otherwise.”
When are goods “identified”? There are two possibilities as to when identification happens.

Parties May Agree
Section 2-501(1) of the UCC says “identification can be made at any time and in any manner
explicated agreed to by the parties.”

UCC Default Position
If the parties do not agree on when identification happens, the UCC default kicks in. Section 2501(1) of the UCC says identification occurs
a.

when the contract is made if it is for the sale of goods already existing and identified;

b. if the contract is for the sale of future goods other than those described in paragraph c., when
goods are shipped, marked, or otherwise identified by the seller as goods to which the contract
refers;
c. when crops are planted or otherwise become growing crops or the young are conceived if the
contract is for the sale of unborn young to be born within twelve months after contract or for the
sale of corps to be harvested within twelve months or the next normal harvest seasons after
contracting, whichever is longer.
Thus if Very Fast Food Inc.’s purchasing agent looks at a new type of industrial sponge on Delta
Sponge Makers’ store shelf for restaurant supplies, points to it, and says, “I’ll take it,”
identification happens then, when the contract is made. But if the purchasing agent wants to
Saylor URL: http://www.saylor.org/books

Saylor.org
634

purchase sponges for her fast-food restaurants, sees a sample on the shelf, and says, “I want a
gross of those”—they come in boxes of one hundred each—identification won’t happen until one
or the other of them chooses the gross of boxes of sponges out of the warehouse inventory.

When Title Shifts
Parties May Agree
Assuming identification is done, when does title shift? The law begins with the premise that the
agreement of the parties governs. Section 2-401(1) of the UCC says that, in general, “title to
goods passes from the seller to the buyer in any manner and on any conditions explicitly agreed
on by the parties.” Many companies specify in their written agreements at what moment the title
will pass; here, for example, is a clause that appears in sales contracts of Dow Chemical
Company: “Title and risk of loss in all goods sold hereunder shall pass to Buyer upon Seller’s
delivery to carrier at shipping point.” Thus Dow retains title to its goods only until it takes them
to the carrier for transportation to the buyer.
Because the UCC’s default position (further discussed later in this chapter) is that title shifts
when the seller has completed delivery obligations, and because the parties may agree on
delivery terms, they also may, by choosing those terms, effectively agree when title shifts (again,
they also can agree using any other language they want). So it is appropriate to examine some
delivery terms at this juncture. There are three possibilities: shipment contracts, destination
contracts, and contracts where the goods are not to be moved.

Shipment Contracts
In a shipment contract, the seller’s obligation is to send the goods to the buyer, but not to a
particular destination. The typical choices are set out in the UCC at Section 2-319:
•

F.O.B. [place of shipment] (the place from which the goods are to be shipped goes in the
brackets, as in “F.O.B. Seattle”). F.O.B. means “free on board”; the seller’s obligation, according
to Section 2-504 of the UCC, is to put the goods into the possession of a carrier and make a
reasonable contract for their transportation, to deliver any necessary documents so the buyer
can take possession, and promptly notify the buyer of the shipment.

•

F.A.S. [named port] (the name of the seaport from which the ship is carrying the goods goes in
the brackets, as in “F.A.S. Long Beach”). F.A.S means “free alongside ship”; the seller’s
Saylor URL: http://www.saylor.org/books

Saylor.org
635

obligation is to at his “expense and risk deliver the goods alongside the vessel in the manner
usual in that port” and to provide the buyer with pickup instructions. [2]
•

C.I.F. and C. & F. These are actually not abbreviations for delivery terms, but rather they
describe who pays insurance and freight. “C.I.F” means “cost, insurance, and freight”—if this
term is used, it means that the contract price “includes in a lump sum the cost of the goods and
the insurance and freight to the named destination.” [3] “C. & F.” means that “the price so
includes cost and freight to the named destination.” [4]

Destination Contracts
In a destination contract, the seller’s obligation is to see to it that the goods actually arrive at the
destination. Here again, the parties may employ the use of abbreviations that indicate the
seller’s duties. See the following from the UCC, Section 2-319:
•

F.O.B. [destination] means the seller’s obligation is to “at his own expense and risk transport the
goods to that place and there tender delivery of them” with appropriate pickup instructions to
the buyer.

•

Ex-ship “is the reverse of the F.A.S. term.” [5] It means “from the carrying vessel”—the seller’s
obligation is to make sure the freight bills are paid and that “the goods leave the ship’s tackle or
are otherwise properly unloaded.”

•

No arrival, no sale means the “seller must properly ship conforming goods and if they arrive by
any means he must tender them on arrival but he assumes no obligation that the goods will
arrive unless he has caused the non-arrival.” [6] If the goods don’t arrive, or if they are damaged
or deteriorated through no fault of the seller, the buyer can either treat the contract as avoided,
or pay a reduced amount for the damaged goods, with no further recourse against the seller. [7]

Goods Not to Be Moved
It is not uncommon for contracting parties to sell and buy goods stored in a grain elevator or
warehouse without physical movement of the goods. There are two possibilities:
1. Goods with documents of title. A first possibility is that the ownership of the goods is manifested
by a document of title—“bill of lading, dock warrant, dock receipt, warehouse receipt or order for
the delivery of goods, and also any other document which in the regular course of business or
financing is treated as adequately evidencing that the person in possession of it is entitled to
Saylor URL: http://www.saylor.org/books

Saylor.org
636

receive, hold and dispose of the document and the goods it covers.” [8] In that case, the UCC,
Section 2-401(3)(a), says that title passes “at the time when and the place where” the documents
are delivered to the buyer.
2. Goods without documents of title. If there is no physical transfer of the goods and no documents
to exchange, then UCC, Section 2-401(3)(b), provides that “title passes at the time and place of
contracting.”
Here are examples showing how these concepts work.
Suppose the contract calls for Delta Sponge Makers to “ship the entire lot of industrial grade
Sponge No. 2 by truck or rail” and that is all that the contract says about shipment. That’s a
“shipment contract,” and the UCC, Section 2-401(2)(a), says that title passes to Very Fast Foods
at the “time and place of shipment.” At the moment that Delta turns over the 144 cartons of
1,000 sponges each to a trucker—perhaps Easy Rider Trucking comes to pick them up at Delta’s
own factory—title has passed to Very Fast Foods.
Suppose the contract calls for Delta to “deliver the sponges on June 10 at the Maple Street
warehouse of Very Fast Foods Inc.” This is a destination contract, and the seller “completes his
performance with respect to the physical delivery of the goods” when it pulls up to the door of
the warehouse and tenders the cartons. [9] “Tender” means that the party—here Delta Sponge
Makers—is ready, able, and willing to perform and has notified its obligor of its readiness. When
the driver of the delivery truck knocks on the warehouse door, announces that the gross of
industrial grade Sponge No. 2 is ready for unloading, and asks where the warehouse foreman
wants it, Delta has tendered delivery, and title passes to Very Fast Foods.
Suppose Very Fast Foods fears that the price of industrial sponges is about to soar; it wishes to
acquire a large quantity long before it can use them all or even store them all. Delta does not
store all of its sponges in its own plant, keeping some of them instead at Central Warehousing.
Central is a bailee, one who has rightful possession but not title. (A parking garage often is a
bailee of its customers’ cars; so is a carrier carrying a customer’s goods.) Now assume that
Central has issued a warehouse receipt (a document of title that provides proof of ownership of
goods stored in a warehouse) to Delta and that Delta’s contract with Very Fast Foods calls for
Delta to deliver “document of title at the office of First Bank” on a particular day. When the
Saylor URL: http://www.saylor.org/books

Saylor.org
637

goods are not to be physically moved, that title passes to Very Fast Foods “at the time when and
the place where” Delta delivers the document.
Suppose the contract did not specify physical transfer or exchange of documents for the
purchase price. Instead, it said, “Seller agrees to sell all sponges stored on the north wall of its
Orange Street warehouse, namely, the gross of industrial Sponge No. 2, in cartons marked
B300–B444, to Buyer for a total purchase price of $14,000, payable in twelve equal monthly
installments, beginning on the first of the month beginning after the signing of this agreement.”
Then title passes at the time and place of contracting—that is, when Delta Sponge Makers and
Very Fast Foods sign the contract.
So, as always under the UCC, the parties may agree on the terms they want when title shifts.
They can do that directly by just saying when—as in the Dow Chemical example—or they can
indirectly agree when title shifts by stipulating delivery terms: shipment, destination, goods not
to be moved. If they don’t stipulate, the UCC default kicks in.

UCC Default Provision
If the parties do not stipulate by any means when title shifts, Section 2-401(2) of the UCC
provides that “title passes to the buyer at the time and place at which seller completes his
performance with reference to the physical delivery of the goods.” And if the parties have no
term in their contract about delivery, the UCC’s default delivery term controls. It says “the place
for delivery is the seller’s place of business or if he has none his residence,” and delivery is
accomplished at the place when the seller “put[s] and hold[s] conforming goods at the buyer’s
disposition and give[s] the buyer any notification reasonably necessary to enable him to take
delivery.” [10]

KEY TAKEAWAY

Title is important for three reasons: it determines whether a sale has occurred, it determines
rights of creditors, and it affects who has an insurable interest. Parties may explicitly agree
when title shifts, or they may agree indirectly by settling on delivery terms (because absent
explicit agreement, delivery controls title passage). Delivery terms to choose from include
shipment contracts, destination contracts, and delivery without the goods being moved (with
or without documents of title). If nothing is said about when title shifts, and the parties have

Saylor URL: http://www.saylor.org/books

Saylor.org
638

not indirectly agreed by choosing a delivery term, then title shifts when delivery obligations
under the contract are complete, and if there are no delivery terms, delivery happens when
the seller makes the goods available at seller’s place of business (or if seller has no place of
business, goods will be made available at seller’s residence)—that’s when title shifts.

EXERCISES

1. Why does it matter who has title?
2. If the parties do not otherwise agree, when does title shift from seller to buyer?
3. Why does the question of delivery terms arise in examining when title shifts?
4. When does title shift for goods stored in a warehouse that are not to be moved?

[1] Uniform Commercial Code, Section 2A-103(1)(j).
[2] Uniform Commercial Code, Section 2-319(2).
[3] Uniform Commercial Code, Section 2-320.
[4] Uniform Commercial Code, Section 2-320.
[5] Uniform Commercial Code, Section 2-322.
[6] Uniform Commercial Code, Section 2-324.
[7] Uniform Commercial Code, Section 2-613.
[8] Uniform Commercial Code, Section 1-201(15).
[9] Uniform Commercial Code, Section 2-401(2)(b).
[10] Uniform Commercial Code, Sections 2-308 and 2-503.

18.2 Title from Nonowners

LEARNING OBJECTIVE

1. Understand when and why a nonowner can nevertheless pass title on to a purchaser.

The Problem of Title from Nonowners
We have examined when title transfers from buyer to seller, and here the assumption is, of
course, that seller had good title in the first place. But what title does a purchaser acquire when
the seller has no title or has at best only a voidable title? This question has often been difficult
Saylor URL: http://www.saylor.org/books

Saylor.org
639

for courts to resolve. It typically involves a type of eternal triangle with a three-step sequence of
events, as follows (see Figure 18.1 "Sales by Nonowners"): (1) The nonowner obtains possession,
for example, by loan or theft; (2) the nonowner sells the goods to an innocent purchaser for
cash; and (3) the nonowner then takes the money and disappears, goes into bankruptcy, or ends
up in jail. The result is that two innocent parties battle over the goods, the owner usually
claiming that the purchaser is guilty of conversion (i.e., the unlawful assumption of ownership of
property belonging to another) and claiming damages or the right to recover the goods.

Figure 18.1 Sales by Nonowners

Saylor URL: http://www.saylor.org/books

Saylor.org
640

The Response to the Problem of Title from Nonowners
The Basic Rule
To resolve this dilemma, we begin with a basic policy of jurisprudence: a person cannot transfer
better title than he or she had. (The Uniform Commercial Code [UCC] notes this policy in
Sections 2-403, 2A-304, and 2A-305.) This policy would apply in a sale-of-goods case in which
the nonowner had a void title or no title at all. For example, if a nonowner stole the goods from
the owner and then sold them to an innocent purchaser, the owner would be entitled to the
goods or to damages. Because the thief had no title, he had no title to transfer to the purchaser.
Saylor URL: http://www.saylor.org/books

Saylor.org
641

A person cannot get good title to goods from a thief, nor does a person have to retain physical
possession of her goods at all times to retain their ownership—people are expected to leave their
cars with a mechanic for repair or to leave their clothing with a dry cleaner.
If thieves could pass on good title to stolen goods, there would be a hugely increased traffic in
stolen property; that would be unacceptable. In such a case, the owner can get her property back
from whomever the thief sold it to in an action called replevin (an action to recover personal
property unlawfully taken). On the other hand, when a buyer in good faith buys goods from an
apparently reputable seller, she reasonably expects to get good title, and that expectation cannot
be dashed with impunity without faith in the market being undermined. Therefore, as between
two innocent parties, sometimes the original owner does lose, on the theory that (1) that person
is better able to avoid the problem than the downstream buyer, who had absolutely no control
over the situation, and (2) faith in commercial transactions would be undermined by allowing
original owners to claw back their property under all circumstances.
So the basic legal policy that a person cannot pass on better title than he had is subject to a
number of exceptions. Likewise, the law governing the sale of goods contains exceptions to the
basic legal policy. These usually fall within one of two categories: sellers with voidable title and
entrustment.

The Exceptions
As noted, there are exceptions to the law governing the sale of goods.

Sellers with a Voidable Title
Under the UCC, a person with a voidable title has the power to transfer title to a good-faith
purchaser for value (see Figure 18.2 "Voidable Title"). The UCC defines good faithas “honesty in
fact in the conduct or transaction concerned.” [1] A “purchaser” is not restricted to one who pays
cash; any taking that creates an interest in property, whether by mortgage, pledge, lien, or even
gift, is a purchase for purposes of the UCC. And “value” is not limited to cash or goods; a person
gives value if he gives any consideration sufficient to support a simple contract, including a
binding commitment to extend credit and security for a preexisting claim. Recall from Chapter 9
"The Agreement" that a “voidable” title is one that, for policy reasons, the courts will cancel on
application of one who is aggrieved. These reasons include fraud, undue influence, mistake, and
Saylor URL: http://www.saylor.org/books

Saylor.org
642

lack of capacity to contract. When a person has a voidable title, title can be taken away from her,
but if it is not, she can transfer better title than she has to a good-faith purchaser for value.
(See Section 18.4.2 "Defrauding Buyer Sells to Good-Faith Purchaser for Value" at the end of
this chapter.)
Rita, sixteen years old, sells a video game to her neighbor Annie, who plans to give the game to
her nephew. Since Rita is a minor, she could rescind the contract; that is, the title that Annie
gets is voidable: it is subject to be avoided by Rita’s rescission. But Rita does not rescind. Then
Annie discovers that her nephew already has that video game, so she sells it instead to an office
colleague, Donald. He has had no notice that Annie bought the game from a minor and has only
a voidable title. He pays cash. Should Rita—the minor—subsequently decide she wants the game
back, it would be too late: Annie has transferred good title to Donald even though Annie’s title
was voidable.

Figure 18.2 Voidable Title

Suppose Rita was an adult and Annie paid her with a check that later bounced, but Annie sold
the game to Donald before the check bounced. Does Donald still have good title? The UCC says
he does, and it identifies three other situations in which the good-faith purchaser is protected:
Saylor URL: http://www.saylor.org/books

Saylor.org
643

(1) when the original transferor was deceived about the identity of the purchaser to whom he
sold the goods, who then transfers to a good-faith purchaser; (2) when the original transferor
was supposed to but did not receive cash from the intermediate purchaser; and (3) when “the
delivery was procured through fraud punishable as larcenous under the criminal law.” [2]
This last situation may be illustrated as follows: Dimension LLC leased a Volkswagen to DK Inc.
The agreement specified that DK could use the Volkswagen solely for business and commercial
purposes and could not sell it. Six months later, the owner of DK, Darrell Kempf, representing
that the Volkswagen was part of DK’s used-car inventory, sold it to Edward Seabold. Kempf
embezzled the proceeds from the sale of the car and disappeared. When DK defaulted on its
payments for the Volkswagen, Dimension attempted to repossess it. Dimension discovered that
Kempf had executed a release of interest on the car’s title by forging the signature of
Dimension’s manager. The Washington Court of Appeals, applying the UCC, held that Mr.
Seabold should keep the car. The car was not stolen from Dimension; instead, by leasing the
vehicle to DK, Dimension transferred possession of the car to DK voluntarily, and because
Seabold was a good-faith purchaser, he won. [3]

Entrustment
A merchant who deals in particular goods has the power to transfer all rights of one who
entrusts to him goods of the kind to a “buyer in the ordinary course of business” (see Figure 18.3
"Entrustment"). [4] The UCC defines such a buyer as a person who buys goods in an ordinary
transaction from a person in the business of selling that type of goods, as long as the buyer
purchases in “good faith and without knowledge that the sale to him is in violation of the
ownership rights or security interest of a third party in the goods.” [5] Bess takes a pearl necklace,
a family heirloom, to Wellborn’s Jewelers for cleaning; as the entrustor, she has entrusted the
necklace to an entrustee. The owner of Wellborn’s—perhaps by mistake—sells it to Clara, a
buyer, in the ordinary course of business. Bess cannot take the necklace back from Clara,
although she has a cause of action against Wellborn’s for conversion. As between the two
innocent parties, Bess and Clara (owner and purchaser), the latter prevails. Notice that the UCC
only says that the entrustee can pass whatever title the entrustor had to a good-faith purchaser,
not necessarily good title. If Bess’s cleaning woman borrowed the necklace, soiled it, and took it
Saylor URL: http://www.saylor.org/books

Saylor.org
644

to Wellborn’s, which then sold it to Clara, Bess could get it back because the cleaning woman
had no title to transfer to the entrustee, Wellborn’s.

Figure 18.3 Entrustment

Entrustment is based on the general principle of estoppel: “A rightful owner may be estopped by
his own acts from asserting his title. If he has invested another with the usual evidence of title,
or an apparent authority to dispose of it, he will not be allowed to make claim against an
innocent purchaser dealing on the faith of such apparent ownership.” [6]

KEY TAKEAWAY

The general rule—for obvious reasons—is that nobody can pass on better title to goods than
he or she has: a thief cannot pass on good title to stolen goods to anybody. But in balancing
that policy against the reasonable expectations of good-faith buyers that they will get title,
the UCC has made some exceptions. A person with voidable title can pass on good title to a
good-faith purchaser, and a merchant who has been entrusted with goods can pass on title
of the entrustor to a good-faith purchaser.

EXERCISES

1. Why is it the universal rule that good title to goods cannot be had from a thief?

Saylor URL: http://www.saylor.org/books

Saylor.org
645

2. What is the “voidable title” exception to the universal rule? Why is the exception made?
3. What is the “entrusting” exception to the general rule?

[1] Uniform Commercial Code, Section 1-201(19).
[2] Uniform Commercial Code, Sections 2-403(1), 2-403(1), 2A-304, and 2A-305.
[3] Dimension Funding, L.L.C. v. D.K. Associates, Inc., 191 P.3d 923 (Wash. App. 2008).
[4] Uniform Commercial Code, Sections 2-403(2), 2A-304(2), and 2A-305(2).
[5] Uniform Commercial Code, Section 1-201(9).
[6] Zendman v. Harry Winston, Inc., 111 N.E. 2d 871 (N.Y. 1953).

18.3 Risk of Loss

LEARNING OBJECTIVES

1. Understand why who has the risk of loss is important.
2. Know how parties may agree on when the risk of loss shifts.
3. Know when the risk of loss shifts if there is no breach, and if there is a breach.
4. Recognize what “insurable interest” is, why it is important, and how it attaches.

Why Risk of Loss Is Important
“Risk of loss” means who has to pay—who bears the risk—if the goods are lost or
destroyed without the fault of either party. It is obvious why this issue is important: Buyer
contracts to purchase a new car for $35,000. While the car is in transit to Buyer, it is destroyed
in a landslide. Who takes the $35,000 hit?
The CISG, Article 66, provides as follows: “Loss of or damage to the goods after the
risk has passed to the buyer does not discharge him from his obligation to pay the
price, unless the loss or damage is due to an act or omission of the seller.”

When Risk of Loss Passes
The Parties May Agree

Saylor URL: http://www.saylor.org/books

Saylor.org
646

Just as title passes in accordance with the parties’ agreement, so too can the parties fix the risk
of loss on one or the other. They may even devise a formula to divide the risk between
themselves. [1]
Common terms by which parties set out their delivery obligations that then affect when title
shifts (F.O.B., F.A.S., ex-ship, and so on) were discussed earlier in this chapter. Similarly, parties
may use common terms to set out which party has the risk of loss; these situation arise with trial
sales. That is, sometimes the seller will permit the buyer to return the goods even though the
seller had conformed to the contract. When the goods are intended primarily for the buyer’s use,
the transaction is said to be “sale on approval.” When they are intended primarily for resale, the
transaction is said to be “sale or return.” When the “buyer” is really only a sales agent for the
“seller,” it is a consignment sale.

Sale on Approval
Under a sale-on-approval contract, risk of loss (and title) remains with the seller until the buyer
accepts, and the buyer’s trial use of the goods does not in itself constitute acceptance. If the
buyer decides to return the goods, the seller bears the risk and expense of return, but a
merchant buyer must follow any reasonable instructions from the seller. Very Fast Foods asks
Delta for some sample sponges to test on approval; Delta sends a box of one hundred sponges.
Very Fast plans to try them for a week, but before that, through no fault of Very Fast, the
sponges are destroyed in a fire. Delta bears the loss. [2]

Sale or Return
The buyer might take the goods with the expectation of reselling them—as would a women’s
wear shop buy new spring fashions, expecting to sell them. But if the shop doesn’t sell them
before summer wear is in vogue, it could arrange with the seller to return them for credit. In
contrast to sale-on-approval contracts, sale-or-return contracts have risk of loss (and title too)
passing to the buyer, and the buyer bears the risk and expense of returning the goods.
Occasionally the question arises whether the buyer’s other creditors may claim the goods when
the sales contract lets the buyer retain some rights to return the goods. The answer seems
straightforward: in a sale-on-approval contract, where title remains with the seller until
acceptance, the buyer does not own the goods—hence they cannot be seized by his creditors—
Saylor URL: http://www.saylor.org/books

Saylor.org
647

unless he accepts them, whereas they are the buyer’s goods (subject to his right to return them)
in a sale-or-return contract and may be taken by creditors if they are in his possession.

Consignment Sales
In a consignment situation, the seller is a bailee and an agent for the owner who sells the goods
for the owner and takes a commission. Under the Uniform Commercial Code (UCC), this is
considered a sale or return, thus the consignee (at whose place the goods are displayed for sale
to customers) is considered a buyer and has the risk of loss and title. [3] The consignee’s creditors
can take the goods; that is, unless the parties comply “with an applicable law providing for a
consignor’s interest or the like to be evidenced by a sign, or where it is established that the
person conducting the business is generally known by his creditors to be substantially engaged
in selling the goods of others” (or complies with secured transactions requirements under
Article 9, discussed in a later chapter). [4]

The UCC Default Position
If the parties fail to specify how the risk of loss is to be allocated or apportioned, the UCC again
supplies the answers. A generally applicable rule, though not explicitly stated, is that risk of loss
passes when the seller has completed obligations under the contract. Notice this is not the same
as when title passes: title passes when seller has completed delivery obligations under the
contract, risk of loss passes when allobligations are completed. (Thus a buyer could get good
title to nonconforming goods, which might be better for the buyer than not getting title to them:
if the seller goes bankrupt, at least the buyer has something of value.)

Risk of Loss in Absence of a Breach
If the goods are conforming, then risk of loss would indeed pass when delivery obligations are
complete, just as with title. And the analysis here would be the same as we looked at in
examining shift of title.
A shipment contract. The contract requires Delta to ship the sponges by carrier but does not
require it to deliver them to a particular destination. In this situation, risk of loss passes to Very
Fast Foods when the goods are delivered to the carrier.
The CISG—pretty much like the UCC—provides as follows (Article 67):

Saylor URL: http://www.saylor.org/books

Saylor.org
648

If the contract of sale involves carriage of the goods and the seller is not
bound to hand them over at a particular place, the risk passes to the
buyer when the goods are handed over to the first carrier for
transmission to the buyer in accordance with the contract of sale. If the
seller is bound to hand the goods over to a carrier at a particular place,
the risk does not pass to the buyer until the goods are handed over to the
carrier at that place.
A destination contract. If the destination contract agreement calls for Delta to deliver the
sponges by carrier to a particular location, Very Fast Foods assumes the risk of loss only when
Delta’s carrier tenders them at the specified place.
The CISG provides for basically the same thing (Article 69): “If the contract is for
something other than shipment, the risk passes to the buyer when he takes over
the goods or, if he does not do so in due time, from the time when the goods are
placed at his disposal and he commits a breach of contract by failing to take
delivery.”
Goods not to be moved. If Delta sells sponges that are stored at Central Warehousing to Very
Fast Foods, and the sponges are not to be moved, Section 2-509(2) of the UCC sets forth three
possibilities for transfer of the risk of loss:
1. The buyer receives a negotiable document of title covering the goods. A document of title is
negotiable if by its terms goods are to be delivered to the bearer of the document or to the order
of a named person.
2. The bailee acknowledges the buyer’s right to take possession of the goods. Delta signs the
contract for the sale of sponges and calls Central to inform it that a buyer has purchased 144
cartons and to ask it to set aside all cartons on the north wall for that purpose. Central does so,
sending notice to Very Fast Foods that the goods are available. Very Fast Foods assumes risk of
loss upon receipt of the notice.
3. When the seller gives the buyer a nonnegotiable document of title or a written direction to the
bailee to deliver the goods and the buyer has had a reasonable time to present the document or
direction.
Saylor URL: http://www.saylor.org/books

Saylor.org
649

All other cases. In any case that does not fit within the rules just described, the risk of loss
passes to the buyer only when the buyer actually receives the goods. Cases that come within this
section generally involve a buyer who is taking physical delivery from the seller’s premises. A
merchant who sells on those terms can be expected to insure his interest in any goods that
remain under his control. The buyer is unlikely to insure goods not in his possession.
The Ramos case (Section 18.4.3 "Risk of Loss, Seller a Merchant" in this chapter) demonstrates
how this risk-of-loss provision applies when a customer pays for merchandise but never actually
receives his purchase because of a mishap.

Risk of Loss Where Breach Occurs
The general rule for risk of loss was set out as this: risk of loss shifts when seller has completed
obligations under the contract. We said if the goods are conforming, the only obligation left is
delivery, so then risk of loss would shift upon delivery. But if the goods are nonconforming, then
the rule would say the risk doesn’t shift. And that’s correct, though it’s subject to one wrinkle
having to do with insurance. Let’s examine the two possible circumstances: breach by seller and
breach by buyer.
First, suppose the seller breaches the contract by proffering nonconforming goods, and the
buyer rejects them—never takes them at all. Then the goods are lost or damaged. Under Section
2-510(1) of the UCC, the loss falls on seller and remains there until seller cures the breach or
until buyer accepts despite the breach. Suppose Delta is obligated to deliver a gross of industrial
No. 2 sponges; instead it tenders only one hundred cartons or delivers a gross of industrial No. 3
sponges. The risk of loss falls on Delta because Delta has not completed its obligation under the
contract and Very Fast Foods doesn’t have possession of the goods. Or suppose Delta has
breached the contract by tendering to Very Fast Foods a defective document of title. Delta cures
the defect and gives the new document of title to Very Fast Foods, but before it does so the
sponges are stolen. Delta is responsible for the loss.
Now suppose that a seller breaches the contract by proffering nonconforming goods and that the
buyer, not having discovered the nonconformity, accepts them—the nonconforming goods are in
the buyer’s hands. The buyer has a right to revoke acceptance, but before the defective goods are
returned to the seller, they are destroyed while in the buyer’s possession. The seller breached,
Saylor URL: http://www.saylor.org/books

Saylor.org
650

but here’s the wrinkle: the UCC says that the seller bears the loss only to the extent of any
deficiency in the buyer’s insurance coverage. [5] Very Fast Foods had taken delivery of the
sponges and only a few days later discovered that the sponges did not conform to the contract.
Very Fast has the right to revoke and announces its intention to do so. A day later its warehouse
burns down and the sponges are destroyed. It then discovers that its insurance was not adequate
to cover all the sponges. Who stands the loss? The seller does, again, to the extent of any
deficiency in the buyer’s insurance coverage.
Second, what if the buyer breaches the contract? Here’s the scenario: Suppose Very Fast Foods
calls two days before the sponges identified to the contract are to be delivered by Delta and says,
“Don’t bother; we no longer have a need for them.” Subsequently, while the lawyers are arguing,
Delta’s warehouse burns down and the sponges are destroyed. Under the rules, risk of loss does
not pass to the buyer until the seller has delivered, which has not occurred in this case.
Nevertheless, responsibility for the loss here has passed to Very Fast Foods, to the extent that
the seller’s insurance does not cover it. Section 2-510(3) of the UCC permits the seller to treat
the risk of loss as resting on the buyer for a “commercially reasonable time” when the buyer
repudiates the contract before risk of loss has passed to him. This transfer of the risk can take
place only when the goods are identified to the contract. The theory is that if the buyer had taken
the goods as per the contract, the goods would not have been in the warehouse and thus would
not have been burned up.

Insurable Interest
Why It Matters
We noted at the start of this chapter that who has title is important for several reasons, one of
which is because it affects who has an insurable interest. (You can’t take out insurance in
something you have no interest in: if you have no title, you may not have an insurable interest.)
And it was noted that the rules on risk of loss are affected by insurance. (The theory is that a
businessperson is likely to have insurance, which is a cost of business, and if she has insurance
and also has possession of goods—even nonconforming ones—it is reasonable to charge her
insurance with loss of the goods; thus she will have cause to take care of them in her possession,
else her insurance rates increase.) So in commercial transactions insurance is important, and
Saylor URL: http://www.saylor.org/books

Saylor.org
651

when goods are lost or destroyed, the frequent argument is between the buyer’s and the seller’s
insurance companies, neither of which wants to be responsible. They want to deny that their
insured had an insurable interest. Thus it becomes important who has an insurable interest.

Insurable Interest of the Buyer
It is not necessary for the buyer to go all the way to having title in order for him to have an
insurable interest. The buyer obtains a “special property and insurable interest in goods by
identification of existing goods as goods to which the contract refers.” [6] We already discussed
how “identification” of the goods can occur. The parties can do it by branding, marking, tagging,
or segregating them—and they can do it at any time. We also set out the rules for when goods
will be considered identified to the contract under the UCC if the parties don’t do it themselves
(Section 18.1.2 "Goods Identified to the Contract").

Insurable Interest of the Seller
As long as the seller retains title to or any security interest in the goods, he has an insurable
interest.

Other Rights of the Buyer
The buyer’s “special property” interest that arises upon identification of goods gives the buyer
rights other than that to insure the goods. For example, under Section 2-502 of the UCC, the
buyer who has paid for unshipped goods may take them from a seller who becomes insolvent
within ten days after receipt of the whole payment or the first installment payment. Similarly, a
buyer who has not yet taken delivery may sue a third party who has in some manner damaged
the property.

KEY TAKEAWAY

Knowing who has the risk of loss in a contract for the sale of goods is important for obvious
reasons: it is not uncommon for goods to be lost or stolen between the time they leave the
seller’s possession and before the buyer gets them. The parties are certainly free to agree on
when the risk of loss shifts; if they do not, the UCC says it shifts when the seller has
completed obligations under the contract. Thus if there is no breach, the risk of loss shifts
upon delivery. If there is a breach, the UCC places the risk of loss on the breaching party, with
this caveat: where the nonbreaching party is in control of the goods, the UCC places the risk

Saylor URL: http://www.saylor.org/books

Saylor.org
652

of loss on that party to the extent of her insurance coverage. So if there is a breach by the
seller (delivery of nonconforming goods), the risk of loss never shifts except if the buyer has
taken possession of the nonconforming goods; in that case, the buyer does have the risk of
loss insofar as her insurance covers the loss. If the buyer breaches by repudiating before the
risk of loss passes to him (by the goods’ delivery), the UCC permits the seller to treat the risk
of loss as resting on the buyer for a commercially reasonable time as to goods identified to
the contract.
Insurable interest becomes important when goods suffer a casualty loss because—among
other reasons—often neither the seller’s nor the buyer’s insurance company
wants its insured to have an interest in the goods: each side denies it. The seller retains an
insurable interest if he has title to or any security interest in the goods, and the buyer obtains
an insurable interest by identification of existing goods as goods to which the contract refers.
A person has an insurable interest in any property owned or in the person’s possession.

EXERCISES

1. Which is more important in determining who has the risk of loss, the agreement of the
parties or the UCC’s default provisions?
2. When does the risk of loss shift to the buyer if the parties have no agreement on the issue?
3. Why does the UCC impose the risk of loss to the extent of his insurance on a nonbreaching
party if that party has control of the goods?
4. Why can a person not take out insurance for goods in which the person has no interest? How
does a seller retain an insurable interest? When does the buyer get an insurable interest?

[1] Uniform Commercial Code, Section 2-303.
[2] Uniform Commercial Code, Section 2-327(1)(a).
[3] Uniform Commercial Code, Section 2-326(3).
[4] Uniform Commerical Code, Section 2-326.
[5] Uniform Commercial Code, Section 2-510(2).
[6] Uniform Commercial Code, Section 2-501(1).
Saylor URL: http://www.saylor.org/books

Saylor.org
653

18.4 Cases
Transfer of Title: Destination Contracts
Sam and Mac, Inc. v. Treat
783 N.E.2d 760 (Ind. App. 2003)
Anthony L. Gruda and Sharon R. Gruda (the “Grudas”) owned and operated Gruda Enterprises,
Inc. (Gruda Enterprises), which in turn operated The Kitchen Works, a kitchen supply business.
On March 5, 1998, Gruda Enterprises contracted to sell a set of kitchen cabinets to Sam and
Mac, Inc. [SMI], a commercial construction and contracting corporation. Gruda Enterprises was
also to deliver and install the cabinets. Because it did not have the cabinets in stock, Gruda
Enterprises ordered them from a manufacturer. On March 14, 1998, nine days after placing the
order, SMI pre-paid Gruda Enterprises for the cabinet order.
On May 14, 1998, prior to delivery and installation of the cabinets, the Grudas ceased operation
of Gruda Enterprises and filed for personal bankruptcy. Gruda Enterprises did not file for
bankruptcy and was not dissolved. Instead, the Grudas’ stock in Gruda Enterprises became part
of their bankruptcy estate.…When no cabinets were delivered or installed, and the Grudas
ceased operation of Gruda Enterprises, SMI asked Treat, who was the landlord of Gruda
Enterprises, to open the business premises and permit SMI to remove cabinets from the
property. Treat declined, stating that he feared he would incur liability to Gruda Enterprises if
he started giving away its inventory. Treat and other secured creditors sued Gruda Enterprises,
which owed them money. [Summary judgment was for Treat, SMI appeals.]
SMI contends that there was a completed sale between SMI, as the buyer, and Gruda
Enterprises, as the seller. Specifically, SMI maintains that title to the cabinets under [UCC] 2401(3)(b) passed to SMI when the contract for sale was [made].…Therefore, SMI argues that the
trial court improperly granted summary judgment in favor of Treat because [SMI] held title and,
thus, a possessory interest in the cabinets.…
[T]he contract is governed by the…Indiana Uniform Commercial Code (UCC). 2-401 establishes
the point in time at which title passes from seller to buyer. Specifically, 2-401(2) provides, in

Saylor URL: http://www.saylor.org/books

Saylor.org
654

pertinent part, that unless explicitly agreed, title passes to the buyer at the time and place at
which the seller completes his performance with respect to the physical delivery of goods.…
Moreover, the record indicates that SMI and Gruda Enterprises did not have an explicit
agreement to pass title at any other time, or at any time prior to actual delivery of the cabinets.
SMI argues that title passed to it under 2-401(3)(b) [“where delivery is to be made without
moving the goods,…if the goods are at the time of contacting already identified and no
documents are to be delivered, title passes at the time and place of contacting.”].…However, the
record reflects that SMI admitted that the terms of the contract required Gruda Enterprises to
not only order the cabinets, but to deliver and install them at the location specified by SMI, i.e.
the house that SMI was building. 2-403(3) applies to purchases of goods where delivery is to be
made without moving the goods. SMI argues that since the cabinets were identified at the time
of contracting and no documents needed delivery, title passed at the time and place of
contracting.…
[T]itle to goods cannot pass under a contract for sale prior to their identification in the
contract. See 2-401(1). This does not mean that title passes when the goods are identified. It only
means that identification is merely the earliest possible opportunity for title to
pass.…[I]dentification does not, in and of itself, confer either ownership or possessory rights in
the goods. [UCC] 2-401(2)(b) states that “[i]f the contract requires delivery at destination, title
passes on tender there.” In the present case, tender did not occur when Gruda Enterprises called
SMI to notify it that the cabinets were in and ready to be delivered and installed. SMI requested
that the cabinets remain at the warehouse until the house it was building was ready for the
cabinets to be installed.…[W]e find that SMI and Gruda Enterprises agreed to a destination
point, i.e. the house that SMI was building. Accordingly, we find that 2-401(2)(b) is also
applicable. The title to the cabinets did not pass to SMI because the cabinets were not delivered
and installed at the agreed upon destination. Therefore, we conclude that SMI does not have a
possessory interest in the cabinets.
Based on the foregoing, we conclude that the trial court properly granted summary judgment in
favor of Treat.…Affirmed.

Saylor URL: http://www.saylor.org/books

CASE QUESTIONS
Saylor.org
655

1. One argument made by the plaintiff was that because the plaintiff had paid for the goods and
they had been identified to the contract, title passed to the plaintiff. Why did the court
disagree with this contention?
2. When would title to the cabinets have shifted to the plaintiff?
3. This is footnote 2 (it was not included in the parts of the case set out above): “We
note that Treat owned Kitchen Wholesalers, Inc., from approximately 1987 to
approximately June 20, 1996. On or about June 20, 1996, Kitchen Wholesalers,
Inc. sold its assets, inventory, equipment, and business to Gruda Enterprises. The
Grudas executed an Agreement for Sale of Assets, Lease, and Security Agreement,
as well as a Promissory Note in which they agreed to pay $45,000 for the assets,
inventory, equipment, and business, and to pay monthly rent of $1,500 for the
premises where the business was located, and secured their obligations with
inventory, equipment, and proceeds therefrom, of the business which they were
purchasing. Treat filed and perfected a security interest in the accounts
receivable, inventory, and equipment of The Kitchen Works on August 28, 1998.
The Grudas currently owe Treat $61,794.99.”
This means that when the Grudas failed to pay Treat, he had a right to repossess
all assets belonging to them, including the cabinets—Treat was a creditor of the
Grudas. SMI, of course, contended it had title to the cabinets. Based on the
court’s analysis, who is going to get the cabinets?

Defrauding Buyer Sells to Good-Faith Purchaser for Value
Marlow v. Conley
787 N.E.2d 490, (Ind. App. 2003)
Donald E. Marlow appeals the trial court’s judgment in favor of Robert L. Medley and Linda L.
Medley (collectively, the “Medleys”) on Marlow’s complaint for replevin. Marlow raises [this
issue],…whether the Medleys obtained good title to a truck pursuant to Indiana UCC 2-403(1).
We affirm.
The relevant facts follow. On May 21, 2000, Robert Medley attended a car show in Indianapolis.
Henderson Conley attended the same car show and was trying to sell a 1932 Ford Truck
Saylor URL: http://www.saylor.org/books

Saylor.org
656

(“Truck”). Conley told Robert that he operated a “buy here, pay here car lot,” and Robert saw
that the Truck had a dealer license plate. Robert purchased the Truck for $7,500.00 as a gift for
Linda. Conley gave Robert the Truck’s certificate of title, which listed the owner as Donald
Marlow. When Robert questioned Conley about the owner of the Truck, Conley responded that
Marlow had signed the title as part of a deal Conley had made with him. After purchasing the
Truck, Robert applied to the Bureau of Motor Vehicles for a certificate of title in Linda’s name.
On December 18, 2000, Marlow filed a complaint against Conley and the Medleys.…At the
bench trial, Marlow testified that he had met Conley at a car show in Indianapolis on May 19,
2000, and Conley had told him that Conley owed a “car lot” on the west side of Indianapolis.
Marlow also testified that Conley came to his house that night, but he “didn’t let him in.” Rather,
Marlow testified that Conley “[came] over [his] fence…a big high fence.” According to Marlow,
Conley asked him to invest in Conley’s business that night. Marlow gave Conley $500.00.
Marlow testified that Conley came back the next day and Marlow gave him an additional
$4,000.00. Marlow then testified that Conley stole the certificate of title for the Truck from
Marlow’s house and stole the Truck from his garage. According to Marlow, he told Conley later
in the day to bring his Truck back and Conley told him that it had caught on fire. Marlow
testified that he then called the police. However, in the May 30, 2000 police report, which was
admitted into evidence at trial, the police officer noted the following:
The deal was [Conley] gets $4500.00, plus an orange ′32 Ford truck. In return,
[Marlow] would get a ′94 Ford flatbed dump truck and an ′89 Ford Bronco.
[Marlow] stated that he has not received the vehicles and that [Conley] keeps
delaying getting the vehicles for him. [Conley] gave [Marlow] several titles of vehicles
which are believed to be junk. [Conley] told [Marlow] that he has a car lot at 16th and
Lafayette Road.
[The trial court determined that Marlow bought the truck from Conley, paying Conley $4500
plus a Ford flatbed truck and Ford Bronco.]
…
The issue is whether the Medleys obtained good title to the Truck pursuant to Indiana UCC 2403(1) [voidable title passed on to good-faith purchaser]. We first note that UCC 2-401(2)
Saylor URL: http://www.saylor.org/books

Saylor.org
657

provides that “[u]nless otherwise explicitly agreed, title passes to the buyer at the time and place
at which the seller completes his performance with reference to the physical delivery of the
goods.…” Further, 2-403(1) provides as follows: “A purchaser of goods acquires all title which
his transferor had or had power to transfer.…A person with voidable title has power to transfer a
good title to a good faith purchaser for value. When goods have been delivered under a
transaction of purchase, the purchaser has such power even though:…(d) the delivery was
procured through fraud punishable as theft under the criminal law.”
Thus, Conley, as purchaser of the goods, acquired all title to the Truck that Marlow, as
transferor, had or had power to transfer. Additionally, even if Conley had “voidable title,” he had
the power to transfer good title to the Medleys if they were “good faith purchasers for value.”
Consequently, we must determine whether Conley had voidable title and, if so, whether the
Medleys were good faith purchasers for value.

A. Voidable Title
We first determine whether Conley had voidable title to the Truck.…[T]he UCC does not define
“voidable title.” However, we have held that Indiana’s UCC 2-403 is consistent with Indiana’s
common law, which provided that “legal title passes to a defrauding buyer. This title is not void;
it is voidable, which means that when title gets into the hands of a bona fide purchaser for value
then he will prevail over the defrauded seller.” [Citation] Thus, a “defrauding buyer” obtains
voidable title. However, a thief obtains void title. See, e.g., [Citation] holding that a renter who
stole a motor home had void title, not voidable title, and could not convey good title).…
Here, Marlow argues that Conley stole the Truck and forged his name on the certificate of title.
However, the trial court was presented with conflicting evidence regarding whether Conley stole
the Truck and the certificate of title or whether Conley and Marlow had a business deal and
Conley failed to comply with the agreement. The trial court found that:
Evidence presented concerning [Marlow’s] complaint to the Indianapolis Police
Department on May 30, 2000 casts doubt on the credibility of [Marlow’s] trial
testimony as the report states the truck and title were obtained by Conley in exchange
for a 1994 Ford Flatbed Dump Truck and a 1989 Ford Bronco plus the payment of

Saylor URL: http://www.saylor.org/books

Saylor.org
658

$4500.00 by [Marlow]. Apparently, [Marlow] was complaining to the police
concerning Conley’s failure to deliver the two Ford vehicles.
…The trial court did not find Marlow’s testimony regarding the theft of the Truck and the
certificate of title to be credible.…[B]ased upon the trial court’s findings of fact, we must assume
that the police report accurately describes the circumstances under which Conley obtained
possession of the Truck and its signed certificate of title. Consequently, we assume that Marlow
gave Conley $4,500.00 and the Truck in exchange for two other vehicles. Although Conley gave
Marlow the certificates of title for the two vehicles, he never delivered the vehicles.
Conley’s title is voidable if “the delivery was procured through fraud punishable as theft under
the criminal law” under 2-403(1)(d).…Assuming that Conley knew that he would not deliver the
two vehicles to Marlow, the delivery of the Truck to Conley was procured through fraud
punishable as theft. Consequently, Marlow was defrauded, and Conley obtained voidable title to
the Truck.…

B. Good Faith Purchasers for Value
Having determined that Conley obtained voidable title to the Truck, we must now determine
whether the Medleys were good faith purchasers for value. Marlow does not dispute that the
Medleys were purchasers for value. Rather, Marlow questions their “good faith” because they
purchased the Truck from someone other than the person listed on the Truck’s certificate of
title. [UCC 1-201919] defines good faith as “honesty in fact in the conduct or transaction
concerned.” Marlow argues that Robert did not purchase the Truck in good faith because,
although Robert purchased the vehicle from Conley, he was aware that the certificate of title was
signed by Marlow.
…Here, the sole evidence presented by Marlow regarding the Medleys’ lack of good faith is the
fact that the certificate of title provided by Conley was signed by Marlow. Robert testified that he
thought Conley was a licensed dealer and operated a “buy here, pay here” car lot. The Truck had
a dealer license plate. Robert questioned Conley about the certificate of title. Conley explained
that Marlow had signed the title as part of a deal Conley had made with him. Robert also
testified that he had previously purchased vehicles at car shows and had previously purchased a
vehicle from a dealer where the certificate of title had the previous owner’s name on it.…
Saylor URL: http://www.saylor.org/books

Saylor.org
659

The Medleys’ failure to demand a certificate of title complying with [the Indiana licensing
statute] does not affect their status as good faith purchasers in this case.…The statute does not
void transactions that violate the statute. [Citations] Although the failure to comply with [the
licensing statute] may, combined with other suspicious circumstances, raise questions about a
purchaser’s good faith, we find no such circumstances here. Consequently, the Medleys were
good faith purchasers for value.…
Lastly, Marlow also argues that the Medleys violated [licensing statutes] by providing false
information to the Bureau of Motor Vehicles because the Medleys allegedly listed the seller of
the Truck as Marlow rather than Conley. We noted above that legal title to a vehicle is governed
by the sales provisions of the UCC rather than the Indiana Certificate of Title Act. Thus,
although false statements to the Bureau of Motor Vehicles under Ind.Code § 9-18-2-2 could
result in prosecution for perjury, such false statements do not affect legal title to the vehicle.
In summary, we conclude that, as a defrauding buyer, Conley possessed voidable title and
transferred good title to the Medleys as good faith purchasers for value.…Thus, legal title to the
Truck passed to the Medleys at the time Conley delivered the Truck to them. See UCC 2-401(2)
(“[T]itle passes to the buyer at the time and place at which the seller completes his performance
with reference to the physical delivery of the goods.…”). This result is consistent with the policy
behind 2-403.
Section 2-403 was intended to determine the priorities between the two innocent parties: (1) the
original owner who parts with his goods through fraudulent conduct of another and (2) an
innocent third party who gives value for the goods to the perpetrator of the fraud without
knowledge of the fraud. By favoring the innocent third party, the Uniform Commercial Code
endeavors to promote the flow of commerce by placing the burden of ascertaining and
preventing fraudulent transactions on the one in the best position to prevent them, the original
seller. The policy behind the UCC is to favor the Medleys because, as between the Medleys and
Marlow, Marlow was in the best position to prevent the fraudulent transaction.
For the foregoing reasons, we affirm the trial court’s judgment for the Medleys. Affirmed.

CASE QUESTIONS

1. The court determined Marlow was defrauded by Conley. How did Conley defraud Marlow?

Saylor URL: http://www.saylor.org/books

Saylor.org
660

2. What is the rationale, here expressed, for the UCC’s provision that a defrauding purchaser
(Conley) can pass on title to a good-faith purchaser for value?
3. Why did Marlow think the Medleys should not be considered good-faith purchasers?
4. Why would the UCC prevail over the state’s certificate of title act?

Risk of Loss, Seller a Merchant
Ramos v. Wheel Sports Center
409 N.Y.S.2d 505 (N.Y. Civ. Ct. 1978)
Mercorella, J.
In this non-jury action plaintiff/purchaser is seeking to recover from defendant/vendor the sum
of $893 [about $3,200 in 2010 dollars] representing the payment made by plaintiff for a
motorcycle.
The parties entered into a sales contract wherein defendant agreed to deliver a motorcycle to
plaintiff by June 30, 1978, for the agreed price of $893. The motorcycle was subsequently stolen
by looters during the infamous power blackout of July 11, 1977.
It is uncontroverted that plaintiff paid for the motorcycle in full; was given the papers necessary
for registration and insurance and did in fact register the cycle and secure liability insurance
prior to the loss although license plates were never affixed to the vehicle. It is also conceded that
the loss occurred without any negligence on defendant’s part.
Plaintiff testified that defendant’s salesman was informed that plaintiff was leaving on vacation
and plaintiff would come for the cycle when he returned. He further testified that he never saw
or rode the vehicle. From the evidence adduced at trial it is apparent that plaintiff never
exercised dominion or control over the vehicle.
Defendant’s president testified that he had no knowledge of what transpired between his
salesman and plaintiff nor why the cycle was not taken prior to its loss.
The sole issue presented to the Court is which party, under the facts disclosed, bears the risk of
loss?
It is the opinion of this Court that defendant must bear the risk of loss under the provisions of
Section 2-509(3) of the Uniform Commercial Code.

Saylor URL: http://www.saylor.org/books

Saylor.org
661

This section provides that “…the risk of loss passes to the buyer on his receipt of the goods if the
seller is a merchant.…” Section 2-103(1)(c) states that receipt of goods means taking physical
possession of them. [Authors’ note: UCC revisions have changed the rule so that risk of loss
passes to the buyer on his receipt of the goodsirrespective of whether the seller is a merchant or
not. It is still 2-509(3), however.]
The provision tends more strongly to hold risk of loss on the seller than did the former Uniform
Sales Act. Whether the contract involves delivery at the seller’s place of business or at the situs
of the goods, a merchant seller cannot transfer risk of loss and it remains on him until actual
receipt by the buyer, even though full payment has been made and the buyer notified that the
goods are at his disposal. The underlying theory is that a merchant who is to make physical
delivery at his own place continues meanwhile to control the goods and can be expected to
insure his interest in them.
The Court is also of the opinion that no bailee/bailor relationship, constructive or otherwise,
existed between the parties.
Accordingly, let judgment be entered in favor of plaintiff for the sum of $893, together with
interest, costs and disbursements.

CASE QUESTIONS

1. What caused the loss here, through no fault of either party?
2. What is the rationale for holding the merchant-seller liable in this circumstance?
3. Suppose instead that Ramos had purchased the motorcycle at a garage sale from an
acquaintance and the same loss occurred. Who would bear the risk then?

18.5 Summary and Exercises
Summary

Two significant questions lurk in the background of any sale: (1) when does title pass? and (2)
who must bear the risk of loss if the goods are destroyed or damaged through no fault of either
party?
In general, title passes when the buyer and the seller agree that it passes. If the buyer and the
seller fail to specify the time at which title passes, Article 2 lays down four rules: (1) under a
shipment contract, title passes when the seller places the goods with the carrier; (2) under a
Saylor URL: http://www.saylor.org/books

Saylor.org
662

destination contract, title passes when the goods are tendered at the place of delivery; (3) under
a contract calling for delivery of documents of title, title passes when the seller tenders
documents of title, even if the goods are not physically moved; and (4) when no physical delivery
or exchange of documents is called for, title passes when the contract is signed.
The buyer and the seller may also specify who must bear the risk of loss. But if they do not,
Article 2 sets out these four rules: (1) when the seller must ship by carrier but not to any
particular destination, risk passes to the buyer when the seller delivers the goods to the carrier;
(2) when the goods must be transported to a particular destination, risk passes when the carrier
tenders them at that destination; (3) if the goods are held by a bailee who has issued a
negotiable document of title, risk passes when the buyer receives the document; (4) in other
cases, risk of loss turns on whether the seller is a merchant. If he is a merchant, risk passes when
the buyer receives the goods; if he is not a merchant, risk passes when the seller tenders the
goods. These rules are modified when either of the parties breaches the contract. In general,
unless the breach is cured, the risk of uninsured losses lies on the party who breached.
Either party may insure the goods if it has an insurable interest in them. The buyer has an
insurable interest in goods identified to the contract—for example, by marking them in some
manner. The seller has an insurable interest as long as he retains title or a security interest.
In fixing passage of title and risk of loss, the parties often use shorthand terminology whose
meaning must be mastered to make sense of the contract. These terms include F.O.B.; F.A.S.;
ex-ship; C.I.F.; C.F.; no arrival, no sale; sale on approval; and sale or return. Use of these terms
in a contract can have a significant effect on title and risk of loss.
Sometimes goods are sold by nonowners. A person with voidable title has the power to transfer
title to a good-faith purchaser for value. A merchant who deals in particular goods has the power
to transfer all rights of one who entrusts to him goods of the kind. And a rightful owner may be
estopped by his own acts from asserting title against an innocent purchaser.

EXERCISES

1. Betty from Baltimore contracts to purchase one hundred purple llama figurines from Sam of
Syracuse. Sam is to send the goods by carrier and is not required to deliver them to Betty’s

Saylor URL: http://www.saylor.org/books

Saylor.org
663

Boutique, their destination. He ships them by train, which unfortunately crashes in Delaware.
All the figurines are destroyed. Whose loss is it? Why?
2. In Exercise 1, assume that the train did not crash but that Sam’s creditors attempted to seize
the goods before their arrival. May the creditors do so? Why?
3. Hattie’s Head Shop signed a written agreement with the Tangerine Computer Company to
supply a Marilyn, a supercomputer with bubble memory, to total up its orders and pay its
foreign agents. The contract provided that the computer was to be specially built and that
Tangerine would deliver it by carrier to Hattie’s ready to install no later than June 1.
Tangerine engineers worked feverishly to comply with the contract terms. On May 25, the
computer stood gleaming in Tangerine’s shipping department. That night, before the trucks
could depart, a tornado struck the factory and destroyed the computer intended for Hattie’s.
Whose loss is it? Why?
4. In Exercise 3, assume that the tornado did not strike but that Tangerine’s creditors
attempted to seize the computer. May they? Why?
5. On February 18, Clancy, who was in debt, took his stereo to Lucy’s repair shop. Because Lucy
and Clancy were old friends, Lucy didn’t give him a receipt. On February 19, hounded by
creditors, Clancy sold the stereo on credit to Grover, who was to pick it up on February 21 at
Lucy’s, pay Lucy the repair bill, and pay the balance of the purchase price to Clancy. Who is
entitled to the radio if, on February 20, Clancy’s creditor appears with the sheriff to seize the
stereo from Lucy? Why?
6. Assume in Exercise 5 that, instead of the attempted seizure of the stereo by the creditor,
Lucy’s shop and the stereo are destroyed by fire on February 20. Must Grover still pay Clancy
for the stereo? Why?
7. Cleo’s Close-Outs, a wholesaler of discounted merchandise, offered Randy’s Retailers a
chance to buy all the contents of a shipment of bathtub toys just received. Cleo estimated
that she had between five hundred and six hundred rubber ducks and wrote on October 21
offering them to Randy for only one dollar each if Randy would pick them up at Cleo’s. Randy
received the letter in the mail the next day and mailed his acceptance immediately. In the
wee hours of the following morning, October 23, a fire consumed Cleo’s warehouse, melting
Saylor URL: http://www.saylor.org/books

Saylor.org
664

the ducks into an uneven soup. Assuming that Cleo was a merchant, who bears the loss?
Why?
8. Plaintiff, a manufacturer of men’s clothing in Los Angeles, contracted to sell a variety of
clothing items to Defendant, Harrison’s clothing store in Westport, Connecticut, “F.O.B. Los
Angeles.” Plaintiff delivered the goods to Trucking Company and received a bill of lading.
When the goods arrived at Defendant’s store about two weeks later, Mrs. Harrison,
Defendant’s wife, who was in charge of the store at the time, requested the truck driver to
deliver the goods inside the door of the shop. The driver refused and ultimately drove away.
The goods were lost. Defendant refused to pay for the goods and raised as a defense that
“the Plaintiff refused to deliver the merchandise into the Defendant’s place of business.”
Who wins and why? [1]
9. Jackson owned a number of guns and asked his friend Willard, who ran a country store, if
Willard would let Jackson display the guns in the store for sale on consignment. Willard
would get some compensation for his trouble. Willard agreed. Subsequently Willard’s
creditors seized assets of the store, including the guns. Jackson protested that they were his
guns, not Willard’s, and that the latter’s creditors should keep their hands off them. Given no
other facts, who wins?
10. Plaintiff advertised his car for sale. Roberts stopped by to look at it. He took it for a short test
drive, returned to Plaintiff’s house, and said, “I like it, but my wife needs to look at it before I
buy it. I’ll be back in less than half an hour.” Roberts took the car and never returned. Plaintiff
called the police, who later found the car in a neighboring state. Defendant had bought it
from Roberts, who had presented him with forged registration papers. Plaintiff then sued
Defendant to get the car back. Who wins?

SELF-TEST QUESTIONS

1. In a sale-on-approval contract
a.

the goods are intended primarily for the buyer’s use

b. the goods are intended primarily for resale
c. the risk of loss is on the buyer
d. the buyer obtains title upon receipt of the goods

Saylor URL: http://www.saylor.org/books

Saylor.org
665

As a general rule
a.

goods cannot be sold by persons with voidable title

b. a rightful owner cannot be estopped from asserting title against an innocent
purchaser
c. a merchant cannot transfer the rights of a person who entrusts goods to him
d. a person with voidable title has the power to transfer title to a good-faith
purchaser for value
In general, title passes
a.

to a buyer when the contract is signed

b. when the buyer and the seller agree that it passes
c. to a buyer when the seller receives payment for goods
d. under none of the above conditions
When a destination contract does not specify when title is to pass, it passes
a.

when the goods are shipped

b. when the contract is signed
c. when the buyer pays for the goods
d. when the seller tenders delivery
In a C.I.F. contract
a.

the seller must obtain insurance

b. the buyer must obtain insurance
c. the seller has fewer duties than with a C.F. contract
d. title passes to the buyer when the seller tenders delivery

SELF-TEST ANSWERS

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

Saylor URL: http://www.saylor.org/books

Saylor.org
666

[1] Ninth Street East, Ltd. v. Harrison, 259 A.2d 772 (Conn. 1968).

Saylor URL: http://www.saylor.org/books

Saylor.org
667

Chapter 19
Performance and Remedies
LEARNING OBJECTIVES

After reading this chapter, you should understand the following:
1. What performance is expected of the seller in a sales contract
2. What performance is expected of the buyer in a sales contract
3. What rights and duties the buyer has if there is a nonconforming delivery
4. How, in general, the UCC approaches remedies
5. What the seller’s remedies are for breach by the buyer
6. What the buyer’s remedies are for breach by the seller
7. What excuses the UCC provides for nonperformance
In Part II, we examined contract performance and remedies under common law. In this chapter,
we examine performance and remedies under Article 2, the law of sales, of the Uniform
Commercial Code (UCC). In the next chapter, we cover special remedies for those damaged or
injured by defective products.
The parties often set out in their contracts the details of performance. These include price terms
and terms of delivery—where the goods are to be delivered, when, and how. If the parties fail to
list these terms, the rules studied in this chapter will determine the parties’ obligations: the
parties may agree; if they do not, the UCC rules kick in as the default. In any event, the parties
have an obligation to act in good faith.

19.1 Performance by the Seller

LEARNING OBJECTIVE

1. Understand what is meant when it is said the seller has a duty to “make a timely delivery of
conforming goods.”

The Seller’s Duty in General
The general duty of the seller is this: to make a timely delivery of conforming goods. [1]

Saylor URL: http://www.saylor.org/books

Saylor.org
668

The CISG, Article 30, says, “The seller must deliver the goods, hand over any
documents relating to them and transfer the property in the goods, as required by
the contract and this Convention.”

Analysis of the Seller’s Duty
Timing
By agreement or stipulation, the parties may fix the time when delivery is to be made by
including statements in contracts such as “Delivery is due on or before July 8” or “The first of 12
installments is due on or before July 8.” Both statements are clear.
If the parties do not stipulate in their contract when delivery is to occur, the UCC fills the gap.
Section 2-309 of the UCC says, “The time for shipment or any other action under a contract if
not provided for in this Article or agreed upon shall be a reasonable time.” And what is a
“reasonable time” is addressed by comment 1 to this section:
It thus turns on the criteria as to “reasonable time” and on good faith and commercial
standards set forth in Sections 1-202, 1-203 and 2-103. It…depends on what
constitutes acceptable commercial conduct in view of the nature, purposes and
circumstances of the action to be taken.
The CISG (Article 33) provides as follows:
The seller must deliver the goods
(a) if a date is fixed by or determinable from the contract, on that date;
(b) if a period of time is fixed by or determinable from the contract, at any
time within that period unless circumstances indicate that the buyer is to
choose a date; or
(c) in any other case, within a reasonable time after the conclusion of the
contract.

Delivery
The parties may agree as to how delivery shall be accomplished; if they do not, the UCC fills the
gap.
The CISG (Article 31) says this:

Saylor URL: http://www.saylor.org/books

Saylor.org
669

If the seller is not bound to deliver the goods at any other particular
place, his obligation to deliver consists
(a) if the contract of sale involves carriage of the goods—in handing the
goods over to the first carrier for transmission to the buyer;
(b) if, in cases not within the preceding subparagraph…in placing the
goods at the buyer’s disposal at that place [where the goods are];
(c) in other cases—in placing the goods at the buyer’s disposal at the
place where the seller had his place of business at the time of the
conclusion of the contract.

By Agreement
The parties may use any language they want to agree on delivery terms.

If There Is No Agreement
If the parties do not stipulate delivery terms or if their agreement is incomplete or merely
formulaic, the UCC describes the seller’s obligations or gives meaning to the formulaic language.
(Because form contracts are prevalent, formulaic language is customary.) You recall the
discussion in /6059 - mayer_1.0-ch18about when title shifts: we said title shifts when the seller has
completed delivery obligations under the contract, and we ran through how those obligations
are usually expressed. A quick review here is appropriate.
The contract may be either a shipment contract, a destination contract, or a contract where
the goods are not to be moved (being held by a bailee). In any case, unless otherwise agreed, the
delivery must be at a reasonable time and the tender (the offer to make delivery) must be kept
open for a reasonable time; the buyer must furnish facilities “reasonably suited to the receipt of
the goods.” [2]
In a shipment contract, the seller has four duties: (1) to deliver the goods to a carrier; (2) to
deliver the goods with a reasonable contract for their transportation; (3) to deliver them with
proper documentation for the buyer; and (4) to promptly notify the buyer of the shipment (UCC,
Section 2-504). The contract may set out the seller’s duties using customary abbreviations, and
the UCC interprets those: “F.O.B [insert place where goods are to be shipped from]” means “free
on board”—the seller must see to it that the goods are loaded on the vehicle of conveyance at the
Saylor URL: http://www.saylor.org/books

Saylor.org
670

place of shipment. “F.A.S. [port of shipment inserted here]” means the seller must see to it that
the goods are placed along the ship on the dock ready to be loaded (Section 2-319). Price terms
include “C.I.F.,” which means the sale price includes the cost of the goods, insurance, and freight
charges, and “C. & F.,” which means the sales price includes the cost of the goods at a cheaper
unit price and freight but not insurance. [3] If it is clear from the contract that the seller is
supposed to ship the goods (i.e., the buyer is not going to the seller’s place to get them) but not
clear whether it is a shipment or a destination contract, the UCC presumes it is a shipment
contract. [4]
If it is a destination contract, the seller has two duties: to get the goods to the destination at the
buyer’s disposal and to provide appropriate documents of delivery. [5]The contract language
could be “F.O.B. [place of destination inserted here],” which obligates the seller to deliver to that
specific location; “ex-ship,” which obligates the seller to unload the goods from the vehicle of
transportation at the agreed location (e.g., load the goods onto the dock); or it could be “no
arrival, no sale,” where the seller is not liable for failure of the goods to arrive, unless she caused
it. [6]
If the goods are in the possession of a bailee and are not to be moved—and the parties don’t
stipulate otherwise—the UCC, Section 2-503 says delivery is accomplished when the seller gives
the buyer a negotiable document of title, or if none, when the bailee acknowledges the buyer’s
right to take the goods.
If nothing at all is said about delivery, the place for delivery is the seller’s place of business or his
residence if he has no place of business. [7]

Conforming Goods
As always, the parties may put into the contract whatever they want about the goods as
delivered. If they don’t, the UCC fills the gaps.

By Agreement
The parties may agree on what “conforming goods” means. An order will specify “large grade A
eggs,” and that means something in the trade. Or an order might specify “20 gross 100-count
boxes No. 8 × 3/8 × 32 Phillips flathead machine screws.” That is a screw with a designated
diameter, length, number of threads per inch, and with a unique, cruciform head insert to take a
Saylor URL: http://www.saylor.org/books

Saylor.org
671

particular kind of driver. The buyer might, for example, agree to purchase “seconds,” which are
goods with some flaw, such as clothes with seams not sewed quite straight or foodstuffs past
their pull date. The parties may also agree in the contract what happens if nonconforming goods
are delivered, as we’ll see later in this chapter.

If There Is No Agreement
If nothing is said in the contract about what quality of goods conform to the contract, then the
UCC default rule kicks in. The seller is to make a perfect tender: what is delivered must in every
respect conform to the contract. [8] And if what is delivered doesn’t conform to the contract, the
buyer is not obligated to accept the goods.
The CISG has no perfect tender rule. Article 46 provides this:
If the goods do not conform with the contract, the buyer may require
delivery of substitute goods only if the lack of conformity constitutes a
fundamental breach of contract and a request for substitute goods is
made either in conjunction with notice given under article 39 or within a
reasonable time thereafter. If the goods do not conform with the contract,
the buyer may require the seller to remedy the lack of conformity by
repair, unless this is unreasonable having regard to all the
circumstances. A request for repair must be made either in conjunction
with notice given under article 39 or within a reasonable time thereafter.

Installment Contracts
Unless otherwise agreed, all goods should be delivered at one time, and no payment is due until
tender. But where circumstances permit either party to make or demand delivery in lots, Section
2-307 of the UCC permits the seller to demand payment for each lot if it is feasible to apportion
the price. What if the contract calls for delivery in installment, and one installment is defective—
is that a material breach of the whole contract? No. Section 2-612 of the UCC says this:
(2) The buyer may reject any installment which is non-conforming if the nonconformity substantially impairs the value of that installment and cannot be cured or
if the non-conformity is a defect in the required documents; but if the non-conformity

Saylor URL: http://www.saylor.org/books

Saylor.org
672

does not fall within subsection (3) and the seller gives adequate assurance of its cure
the buyer must accept that installment.
(3) Whenever non-conformity or default with respect to one or more installments
substantially impairs the value of the whole contract there is a breach of the whole.

Cure for Improper Delivery
Failure to make a perfect tender, unless otherwise agreed, is a material breach of the sales
contract. However, before the defaulting seller is in complete default, she has a right to cure.
Here’s what the UCC says in Section 2-508:
(1) Where any tender or delivery by the seller is rejected because non-conforming and
the time for performance has not yet expired, the seller may seasonably notify the
buyer of his intention to cure and may then within the contract time make a
conforming delivery.
(2) Where the buyer rejects a non-conforming tender which the seller had reasonable
grounds to believe would be acceptable with or without money allowance the seller
may if he seasonably notifies the buyer have a further reasonable time to substitute a
conforming tender.
Buyer orders Santa Claus candles deliverable November 5; on October 25 the goods are
delivered, but they’re not right: they’re Christmas angel candles instead. But the seller still has
eleven days to cure, and the buyer must allow that. Buyer places an order exactly the same as the
first order, and the order arrives on November 5 in the original manufacturer’s packaging, but
they’re not right. “Well,” says the seller, “I thought they’d be OK right out of the package. I’ll get
the correct ones to you right away.” And the buyer would have a duty to allow that, if “right
away” is a “further reasonable time.”
Article 48 of the CISG says this:
The seller may, even after the date for delivery, remedy at his own
expense any failure to perform his obligations, if he can do so without
unreasonable delay and without causing the buyer unreasonable
inconvenience or uncertainty of reimbursement by the seller of expenses
advanced by the buyer. However, the buyer retains any right to claim
Saylor URL: http://www.saylor.org/books

Saylor.org
673

damages as provided for in this Convention. If the seller requests the
buyer to make known whether he will accept performance and the buyer
does not comply with the request within a reasonable time, the seller may
perform within the time indicated in his request. The buyer may not,
during that period of time, resort to any remedy which is inconsistent
with performance by the seller.
So, again, the seller’s duty is to make a timely delivery of conforming goods. Let’s take a look
now at the buyer’s duties.

KEY TAKEAWAY

The seller’s obligation under the UCC is to make a timely delivery of conforming goods. For
each element of the duty—timely, delivery, conforming goods—the parties may agree in
their contract. If they do not, the UCC fills in default rules.

EXERCISES

1. If the parties do not specify a time for delivery, what is the UCC’s default position?
2. What are the seller’s obligations in an F.O.B. shipment contract? In an F.O.B. destination
contract?
3. Compare the UCC’s perfect tender rule to the common-law substantial performance
doctrine.

[1] Uniform Commercial Code, Sections 2-301and 2-309.
[2] Uniform Commercial Code, Section 2-503.
[3] Uniform Commercial Code, Section 2-320.
[4] Uniform Commercial Code, Section 2-503(5).
[5] Uniform Commercial Code, Section 2-503.
[6] Uniform Commercial Code, Sections 2-319, 2-322, and 2-324.
[7] Uniform Commercial Code, Section 2-308.
[8] Uniform Commercial Code, Section 2-601.

Saylor URL: http://www.saylor.org/books

Saylor.org
674

19.2 Performance by Buyer

LEARNING OBJECTIVES

1. Understand what the general duties of the buyer are.
2. Recognize what rights the buyer has if the seller tenders a nonconforming delivery.

General Duties of Buyer
The general duty of the buyer is this: inspection, acceptance, and payment. [1] But the buyer’s
duty does not arise unless the seller tenders delivery.

Inspection
Under Sections 2-513(1) and (2) of the Uniform Commercial Code (UCC), the buyer has a
qualified right to inspect goods. That means the buyer must be given the chance to look over the
goods to determine whether they conform to the contract. If they do not, he may properly reject
the goods and refuse to pay. The right to inspect is subject to three exceptions:
1. The buyer waives the right. If the parties agree that payment must be made before inspection,
then the buyer must pay (unless the nonconformity is obvious without inspection). Payment
under these circumstances does not constitute acceptance, and the buyer does not lose the right
to inspect and reject later.
2. The delivery is to be made C.O.D. (cash on delivery).
3. Payment is to be made against documents of title.
If the buyer fails to inspect, or fails to discover a defect that an inspection would have revealed,
he cannot later revoke his acceptance, subject to some exceptions.

Acceptance
Acceptance is clear enough: it means the buyer takes the goods. But the buyer’s options on
improper delivery need to be examined, because that’s often a problem area.
The buyer may accept goods by words, silence, or action. Section 2-606(1) of the UCC defines
acceptance as occurring in any one of three circumstances:
1. Words. The buyer, after a reasonable opportunity to inspect, tells the seller either that the
goods conform or that he will keep them despite any nonconformity.
2. Silence. The buyer fails to reject, after a reasonable opportunity to inspect.

Saylor URL: http://www.saylor.org/books

Saylor.org
675

3. Action. The buyer does anything that is inconsistent with the seller’s ownership, such as using
the goods (with some exceptions) or selling the goods to someone else.
Once the buyer accepts, she is obligated to pay at the contract rate and loses the right to reject
the goods. [2] She is stuck, subject to some exceptions.

Payment
The parties may specify in their contract what payment means and when it is to be made. If they
don’t, the UCC controls the transaction. [3]

A Buyer’s Right on Nonconforming Delivery
Obviously if the delivery is defective, the disappointed buyer does not have to accept the goods:
the buyer may (a) reject the whole, (b) accept the whole, or (c) accept any commercial unit and
reject the rest (2-601, 2A-509), or (d)—in two situations—revoke an acceptance already made.

Rejection and a Buyer’s Duties after Rejection
Under UCC, Section 2-601(a), rejection is allowed if the seller fails to make a perfect tender. The
rejection must be made within a reasonable time after delivery or tender. Once it is made, the
buyer may not act as the owner of the goods. If he has taken possession of the goods before he
rejects them, he must hold them with reasonable care to permit the seller to remove them. If the
buyer is a merchant, then the buyer has a special duty to follow reasonable instructions from the
seller for disposing of the rejected goods; if no instructions are forthcoming and the goods are
perishable, then he must try to sell the goods for the seller’s account and is entitled to a
commission for his efforts. Whether or not he is a merchant, a buyer may store the goods, reship
them to the seller, or resell them—and charge the seller for his services—if the seller fails to send
instructions on the goods’ disposition. Such storage, reshipping, and reselling are not
acceptance or conversion by the buyer.

Acceptance of a Nonconforming Delivery
The buyer need not reject a nonconforming delivery. She may accept it with or without
allowance for the nonconformity.

Acceptance of Part of a Nonconforming Delivery
The buyer may accept any commercial unit and reject the rest if she wants to.
Acommercial unit means “such a unit of goods as by commercial usage is a single whole for
Saylor URL: http://www.saylor.org/books

Saylor.org
676

purposes of sale and division of which materially impairs its character or value on the market or
in use. A commercial unit may be a single article (as a machine), a set of articles (as a suite of
furniture or an assortment of sizes), a quantity (as a bale, gross, or carload), or any other unit
treated in use or in the relevant market as a single whole.” [4]

Installment Sales
A contract for an installment sale complicates the answer to the question, “What right does the
buyer have to accept or reject when the seller fails to deliver properly?”
(Aninstallment contract is one calling for delivery of goods in separate lots with separate
acceptance for each delivery.) The general answer is found in the UCC at Section 2-612, which
permits the buyer to reject any nonconforming installment if the nonconformity cannot be cured
if it substantially impairs the value of that particular installment. However, the seller may avoid
rejection by giving the buyer adequate assurances that he will cure the defect, unless the
particular defect substantially impairs the value of the whole contract.
Suppose the Corner Gas Station contracts to buy 12,000 gallons of regular gasoline from
Gasoline Seller, deliverable in twelve monthly installments of 1,000 gallons on the first of each
month, with a set price payable three days after delivery. In the third month, Seller is short and
can deliver only 500 gallons immediately and will not have the second 500 gallons until
midmonth. May Corner Gas reject this tender? The answer depends on the circumstances. The
nonconformity clearly cannot be cured, since the contract calls for the full 1,000 on a particular
day. But the failure to make full delivery does not necessarily impair the value of that
installment; for example, Corner Gas may know that it will not use up the 500 gallons until
midmonth. However, if the failure will leave Corner Gas short before midmonth and unable to
buy from another supplier unless it agrees to take a full 1,000 (more than it could hold at once if
it also took Seller’s 500 gallons), then Corner Gas is entitled to reject Seller’s tender.
Is Corner Gas entitled to reject the entire contract on the grounds that the failure to deliver
impairs the value of the contract as a whole? Again, the answer depends on whether the
impairment was substantial. Suppose other suppliers are willing to sell only if Corner Gas agrees
to buy for a year. If Corner Gas needed the extra gasoline right away, the contract would have
been breached as whole, and Corner Gas would be justified in rejecting all further attempted
Saylor URL: http://www.saylor.org/books

Saylor.org
677

tenders of delivery from Seller. Likewise, if the spot price of gasoline were rising so that monthto-month purchases from other suppliers might cost it more than the original agreed price with
Seller, Corner Gas would be justified in rejecting further deliveries from Seller and fixing its
costs with a supply contract from someone else. Of course, Corner Gas would have a claim
against Seller for the difference between the original contract price and what it had to pay
another supplier in a rising market (as you’ll see later in this chapter).

Revocation
A revocation of acceptance means that although the buyer has accepted and exercised ownership
of the goods, he can return the goods and get his money back. There are two circumstances in
which the buyer can revoke an acceptance if the nonconformity “substantially impairs its value
to him”: [5]
a.

if the buyer reasonably thought the nonconformity would be cured and it is not within a

reasonable time; or
b. if the acceptance was due to a latent defect that could not reasonably have been discovered
before acceptance.
Consider two examples illustrated in the next paragraph. The first deals with point a (buyer
thought nonconformity would be cured and it was not within a reasonable time), and the second
gets to point b (latent defect).
In August 1983, the Borsages purchased a furnished mobile home on the salesperson’s assertion
that it was “the Cadillac of mobile homes.” But when they moved in, the Borsages discovered
defects: water leaks, loose moldings, a warped dishwasher door, a warped bathroom door, holes
in walls, defective heating and cooling systems, cabinets with chips and holes, furniture that fell
apart, mold and mildew in some rooms, a closet that leaked rainwater, and defective doors and
windows. They had not seen these defects at the time of purchase because they looked at the
mobile home at night and there were no lights on in it. The Borsages immediately complained.
Repairmen came by but left, only promising to return again. Others did an inadequate repair job
by cutting a hole in the bottom of the home and taping up the hole with masking tape that soon
failed, causing the underside of the home to pooch out. Yet more repairmen came by but made
things worse by inadvertently poking a hole in the septic line and failing to fix it, resulting in a
Saylor URL: http://www.saylor.org/books

Saylor.org
678

permanent stench. More repairmen came by, but they simply left a new dishwasher door and
countertop at the home, saying they didn’t have time to make the repairs. In June 1984, the
Borsages provided the seller a long list of uncorrected problems; in October they stopped
making payments. Nothing happened. In March 1986—thirty-one months after buying the
mobile home—they told the seller to pick up the mobile home: they revoked their acceptance
and sued for the purchase price. The defendant seller argued that the Borsages’ failure to move
out of the house for so long constituted acceptance. But they were repeatedly assured the
problems would be fixed, and moreover they had no place else to live, and no property to put
another mobile home on if they abandoned the one they had. The court had no problem
validating the Borsages’ revocation of acceptance, under the section noted earlier, if they ever
had accepted it. The seller might have a right to some rental value, though. [6]
In April 1976, Clarence Miller ordered a new 1976 Dodge Royal Monaco station wagon from
plaintiff Colonial Dodge. The car included a heavy-duty trailer package with wide tires. The
evening of the day the Millers picked up the new car, Mrs. Miller noticed that there was no spare
tire. The following morning, the defendant notified the plaintiff that he insisted on a spare tire,
but when he was told there were no spare tires available (because of a labor strike), Mr. Miller
told the plaintiff’s salesman that he would stop payment on the check he’d given them and that
the car could be picked up in front of his house. He parked it there, where it remained until the
temporary registration sticker expired and it was towed by the police to an impound yard.
Plaintiff sued for the purchase price, asserting that the missing spare tire did not “substantially
impair the value of the goods to the buyer.” On appeal to the Michigan Supreme Court, the
plaintiff lost. “In this case the defendant’s concern with safety is evidenced by the fact that he
ordered the special package which included spare tires. The defendant’s occupation demanded
that he travel extensively, sometimes in excess of 150 miles per day on Detroit freeways, often in
the early morning hours.…He was afraid of a tire going flat…at 3 a.m. Without a spare, he would
be helpless until morning business hours. The dangers attendant upon a stranded motorist are
common knowledge, and Mr. Miller’s fears are not unreasonable.” The court observed that
although he had accepted the car before he discovered the nonconformity, that did not preclude
revocation: the spare was under a fastened panel, concealed from view. [7]
Saylor URL: http://www.saylor.org/books

Saylor.org
679

KEY TAKEAWAY
The duty of the buyer in a sales contract is to inspect, accept, and pay. Failure to discover a
defect that an inspection would have revealed is a waiver of right to complain. Normally the
goods are conforming and the buyer accepts them, but upon discovery of a defect the buyer
may reject the whole nonconforming delivery, part of it (the buyer has some duties if she has
possession of the rejected goods), or in some cases reject one installment of an installment
sale or, if one defective installment is serious enough to vitiate the whole contract, the buyer
may consider the contract terminated. If goods have been accepted because the seller
promised to fix defects or because the defects were latent, then the buyer may revoke the
acceptance where the nonconformity substantially impairs the value of the contract to the
buyer.

EXERCISES

1. If a buyer takes possession of goods and shortly thereafter discovers they are
nonconforming, what duty does the nonmerchant buyer have with respect to the goods?
What duty does the merchant buyer have with respect to the goods?
2. What is the difference between rejection and revocation?
3. Under what circumstances will a defective installment allow the buyer to reject that
installment? Under what circumstances would a defective installment allow the buyer to
terminate the contract?

[1] Uniform Commercial Code, Sections 2-301 and 2-513.
[2] Uniform Commercial Code, Section 2-607.
[3] Uniform Commercial Code, Sections 2-511 and 2-512.
[4] Uniform Commercial Code, Sections 2-105 and 2A103(1).
[5] Uniform Commercial Code, Section 2-608.
[6] North River Homes, Inc., v. Borsage, Mississippi (1992).
[7] Colonial Dodge v. Miller, 362 N.W.2d 704 (Mich. 1984).

Saylor URL: http://www.saylor.org/books

Saylor.org
680

19.3 Remedies

LEARNING OBJECTIVES

1. Understand what purpose remedies serve under the UCC.
2. Be able to see when the parties’ agreements as to limited remedies fail under the UCC.
3. Recognize what the seller’s remedies are.
4. Recognize what the buyer’s remedies are.

Remedies in General
General Policy
The general policy of the Uniform Commercial Code (UCC) is to put the aggrieved party in a
good position as if the other party had fully performed—as if there had been a timely delivery of
conforming goods. The UCC provisions are to be read liberally to achieve that result if possible.
Thus the seller has a number of potential remedies when the buyer breaches, and likewise the
buyer has a number of remedies when the seller breaches.
The CISG provides, at Article 74:
Damages for breach of contract by one party consist of a sum equal to the
loss, including loss of profit, suffered by the other party as a consequence
of the breach. Such damages may not exceed the loss which the party in
breach foresaw or ought to have foreseen at the time of the conclusion of
the contract, in the light of the facts and matters of which he then knew or
ought to have known, as a possible consequence of the breach of contract.

Specifying Remedies
We have emphasized how the UCC allows people to make almost any contract they want (as long
as it’s not unconscionable). Just as the parties may specify details of performance in the
contract, so they may provide for and limit remedies in the event of breach. [1] The following
would be a typical limitation of remedy: “Seller’s sole obligation in the event goods are deemed
defective by the seller is to replace a like quantity of nondefective goods.” A remedy is optional
unless it is expressly agreed that it is the exclusive remedy. [2]
But the parties are not free to eliminate all remedies. As the UCC comment to this provision puts
it, “If the parties intend to conclude a contract for sale within this Article they must accept the
Saylor URL: http://www.saylor.org/books

Saylor.org
681

legal consequence that there be at least a fair quantum of remedy for breach of the obligations or
duties outlined in the contract.” In particular, the UCC lists three exemptions from the general
rule that the parties are free to make their contract up any way they want as regards remedies:
1. When the circumstances cause the agreed-to remedy to fail or be ineffective, the default UCC
remedy regime works instead. [3]
2. Consequential damages may be limited or excluded unless the limitation or exclusion is
unconscionable. Limitation of consequential damages for injury to the person in the case of
consumer goods is prima facie unconscionable, but limitation of damages where the loss is
commercial is not. [4]
3. The parties may agree to liquidated damages: “Damages for breach by either party may be
liquidated in the agreement but only at an amount which is reasonable in the light of the
anticipated or actual harm caused by the breach, the difficulties of proof of loss, and the
inconvenience or nonfeasibility of otherwise obtaining an adequate remedy. A term fixing
unreasonably large liquidated damages is void as a penalty.” [5] The Code’s equivalent position
on leases is interestingly slightly different. UCC 2A-504(1) says damages may be liquidated “but
only at an amount or by a formula that is reasonable in light of the then anticipated harm
caused” by the breach. It leaves out anything about difficulties of proof or inconvenience of
obtaining another adequate remedy.

Statute of Limitations
The UCC statute of limitations for breach of any sales contract is four years. The parties may
“reduce the period of limitation to not less than one year but may not extend it.” [6]Article 2A506(1) is similar, but omits the prohibition against extending the limitation. Article 2-725(2)
goes on: “A cause of action accrues when the breach occurs, regardless of the aggrieved party’s
lack of knowledge of the breach. A breach of warranty occurs when tender of delivery is made,
except that where a warranty explicitly extends to future performance of the goods and
discovery of the breach must await the time of such performance the cause of action accrues
when the breach is or should have been discovered.”
Article 2A-506(2) is similar to 2-725(2).

Seller’s Remedies
Saylor URL: http://www.saylor.org/books

Saylor.org
682

Article 2 in General
Article 2-703 of the UCC lists the four things the buyer can do by way of default, and it lists—
here slightly paraphrased—the seller’s remedies (2A-523(1) is similar for leases):
Where the buyer wrongfully rejects or revokes acceptance of goods or fails to make a
payment due on or before delivery or repudiates with respect to a part or the whole,
then with respect to any goods directly affected and, if the breach is of the whole
contract, then also with respect to the whole undelivered balance, the aggrieved seller
may:
(1) withhold delivery of such goods;
(2) stop delivery by any bailee;
(3) identify to the contract conforming goods not already identified;
(4) reclaim the goods on the buyer’s insolvency;
(5) resell and recover damages;
(6) recover damages for non-acceptance or repudiation;
(7) or in a proper case recover the price;
(8) cancel.
Items (1)–(4) address the seller’s rights to deal with the goods; items (5)–(7) deal with the
seller’s rights as regards the price, and item (8) deals with the continued existence of the
contract.
The CISG’s take is similar. Article 61 and following state,
If the buyer fails to perform any of his obligations under the contract or
this Convention, the seller may:…(a) require the buyer to pay the price.
(b) Fix an additional period of time of reasonable length for performance
by the buyer of his obligations; unless the seller has received notice from
the buyer that he will not perform within the period so fixed, the seller
may not, during that period, resort to any remedy for breach of contract.
(c) Declare the contract avoided if the failure by the buyer to perform any
of his obligations under the contract or this Convention amounts to a
fundamental breach of contract or if the buyer does not, within the
Saylor URL: http://www.saylor.org/books

Saylor.org
683

additional period of time fixed by the seller [above], perform his
obligation to pay the price or take delivery of the goods, or if he declares
that he will not do so within the period so fixed. (d) The seller also has the
right to damages.
To illustrate the UCC’s remedy provision, in this and the following section, we assume these
facts: Howard, of Los Angeles, enters into a contract to sell and ship one hundred prints of a
Pieter Bruegel painting, plus the original, to Bunker in Dallas. Twenty-five prints have already
been delivered to Bunker, another twenty-five are en route (having been shipped by common
carrier), another twenty-five are finished but haven’t yet been shipped, and the final twenty-five
are still in production. The original is hanging on the wall in Howard’s living room. We will take
up the seller’s remedies if the buyer breaches and if the buyer is insolvent.

Remedies on Breach
Bunker, the buyer, breaches the contract. He sends Howard an e-mail stating that he won’t buy
and will reject the goods if delivery is attempted. Howard has the following cumulative
remedies; election is not required.

Withhold Further Delivery
Howard may refuse to send the third batch of twenty-five prints that are awaiting shipment.

Stop Delivery
Howard may also stop the shipment. If Bunker is insolvent, and Howard discovers it, Howard
would be permitted to stop any shipment in the possession of a carrier or bailee. If Bunker is not
insolvent, the UCC permits Howard to stop delivery only of carload, truckload, planeload, or
larger shipment. The reason for limiting the right to bulk shipments in the case of noninsolvency
is that stopping delivery burdens the carrier and requiring a truck, say, to stop and the driver to
find a small part of the contents could pose a sizeable burden.

Identify to the Contract Goods in Possession
Howard could “identify to the contract” the twenty-five prints in his possession. Section 2704(1) of the UCC permits the seller to denote conforming goods that were not originally
specified as the exact objects of the contract, if they are under his control or in his possession at
the time of the breach. Assume that Howard had five hundred prints of the Bruegel painting.
Saylor URL: http://www.saylor.org/books

Saylor.org
684

The contract did not state which one hundred of those prints he was obligated to sell, but once
Bunker breached, Howard could declare that those particular prints were the ones contemplated
by the contract. He has this right whether or not the identified goods could be resold. Moreover,
Howard may complete production of the twenty-five unfinished prints and identify them to the
contract, too, if in his “reasonable commercial judgment” he could better avoid loss—for
example, by reselling them. If continued production would be expensive and the chances of
resale slight, the seller should cease manufacture and resell for scrap or salvage value.

Resell
Howard could resell the seventy-five prints still in his possession as well as the original. As long
as he proceeds in good faith and in a commercially reasonable manner, per Section 2-706(2) and
Section 2A-527(3), he is entitled to recover the difference between the resale price and the
contract price, plus incidental damages (but less any expenses saved, like shipping expenses).
“Incidental damages” include any reasonable charges or expenses incurred because, for
example, delivery had to be stopped, new transportation arranged, storage provided for, and
resale commissions agreed on.
The seller may resell the goods in virtually any way he desires as long as he acts reasonably. He
may resell them through a public or private sale. If the resale is public—at auction—only
identified goods can be sold, unless there is a market for a public sale of futures in the goods (as
there is in agricultural commodities, for example). In a public resale, the seller must give the
buyer notice unless the goods are perishable or threaten to decline in value speedily. The goods
must be available for inspection before the resale, and the buyer must be allowed to bid or buy.
The seller may sell the goods item by item or as a unit. Although the goods must relate to the
contract, it is not necessary for any or all of them to have exited or to have been identified at the
time of breach.
The seller does not owe the buyer anything if resale or re-lease results in a profit for the buyer. [7]

Recover Damages
The seller may recover damages equal to the difference between the market price (measured at
the time and place for tender of delivery) and the unpaid contract price, plus incidental
damages, but less any expenses saved because of the buyer’s breach. Suppose Howard’s contract
Saylor URL: http://www.saylor.org/books

Saylor.org
685

price was $100 per print plus $10,000 for the original and that the market price on the day
Howard was to deliver the seventy-five prints was $75 (plus $8,000 for the original). Suppose
too that the shipping costs (including insurance) that Howard saved when Bunker repudiated
were $2,000 and that to resell them Howard would have to spend another $750. His damages,
then, would be calculated as follows: original contract price ($17,500) less market price
($13,625) = $3,875 less $2,000 in saved expenses = $1,875 plus $750 in additional expenses =
$2,625 net damages recoverable by Howard, the seller.
The CISG puts it similarly in Article 75: “If the contract is avoided and if, in a
reasonable manner and within a reasonable time after avoidance, the buyer has
bought goods in replacement or the seller has resold the goods, the party claiming
damages may recover the difference between the contract price and the price in
the substitute transaction as well as any further damages recoverable.”
If the formula would not put the seller in as good a position as performance under the contract,
then the measure of damages is lost profits—that is, the profit that Howard would have made
had Bunker taken the original painting and prints at the contract price (again, deducting
expenses saved and adding additional expenses incurred, as well as giving credit for proceeds of
any resale). [8] This provision becomes especially important for so-called lost volume sellers.
Howard may be able to sell the remaining seventy-five prints easily and at the same price that
Bunker had agreed to pay. Then why isn’t Howard whole? The reason is that the second buyer
was not a substitutebuyer but an additional one; that is, Howard would have made that sale
even if Bunker had not reneged on the contract. So Howard is still short a sale and is out a profit
that he would have made had Bunker honored the contract.

Recover the Price
Howard—the seller—could recover from Bunker for the price of the twenty-five prints that
Bunker holds. Or suppose they had agreed to a shipment contract, so that the risk of loss passed
to Bunker when Howard placed the other prints with the trucker and that the truck crashed en
route and the cargo destroyed. Howard could recover the price. Or suppose there were no
market for the remaining seventy-five prints and the original. Howard could identify these
prints to the contract and recover the contract price. If Howard did resell some prints, the
Saylor URL: http://www.saylor.org/books

Saylor.org
686

proceeds of the sale would have to be credited to Bunker’s account and deducted from any
judgment. Unless sold, the prints must be held for Bunker and given to him upon his payment of
the judgment.

Cancel the Contract
When Bunker repudiated, Howard could declare the contract cancelled. This would also apply if
a buyer fails to make a payment due on or before delivery. Cancellation entitles the
nonbreaching party to any remedies for the breach of the whole contract or for any unperformed
balance. That is what happens when Howard recovers damages, lost profits, or the price. [9]
Again, the CISG is similar. Article 64 provides that the seller may declare the
contract avoided “if the failure by the buyer to perform any of his obligations
under the contract or this Convention amounts to a fundamental breach of
contract; or if the buyer does not, within the additional period of time fixed by the
seller perform his obligation to pay the price or take delivery of the goods, or if he
declares that he will not do so within the period so fixed.”
Note again that these UCC remedies are cumulative. That is, Howard could withhold future
delivery and stop delivery en route, and identify to the contract goods in his
possession, and resell, and recover damages, and cancel.

Remedies on Insolvency
The remedies apply when the buyer breaches the contract. In addition to those remedies, the
seller has remedies when he learns that the buyer is insolvent, even if the buyer has not
breached. Insolvency results, for example, when the buyer has “ceased to pay his debts in the
ordinary course of business,” or the buyer “cannot pay his debts as they become due.” [10]
Upon learning of Bunker’s insolvency, Howard could refuse to deliver the remaining prints,
unless Bunker pays cash not only for the remaining prints but for those already delivered. If
Howard learned of Bunker’s insolvency within ten days of delivering the first twenty-five prints,
he could make a demand to reclaim them. If within three months prior to delivery, Bunker had
falsely represented that he was solvent, the ten-day limitation would not cut off Howard’s right
to reclaim. If he does seek to reclaim, Howard will lose the right to any other remedy with
respect to those particular items. However, Howard cannot reclaim goods already purchased
Saylor URL: http://www.saylor.org/books

Saylor.org
687

from Bunker by a customer in the ordinary course of business. The customer does not risk losing
her print purchased several weeks before Bunker has become insolvent. [11]
In the lease situation, of course, the goods belong to the lessor—the lessor has title to them—so
the lessor can repossess them if the lessee defaults. [12]

Buyer’s Remedies
In this section, let us assume that Howard, rather than Bunker, breaches, and all other
circumstances are the same. That is, Howard had delivered twenty-five prints, twenty-five more
were en route, the original painting hung in Howard’s living room, another twenty-five prints
were in Howard’s factory, and the final twenty-five prints were in production.

In General
The buyer can do the following three things by way of defaulting: repudiate the contract, fail to
deliver the goods, or deliver or tender nonconforming goods. Section 2-711 of the UCC provides
the following remedies for the buyer:
Where the seller fails to make delivery or repudiates, or the buyer rightfully rejects or
justifiably revokes, then with respect to any goods involved, and with respect to the
whole if the breach goes to the whole contract, the buyer may
(1) cancel the contract, and
(2) recover as much of the price as has been paid; and
(3) “cover” and get damages; and
(4) recover damages for nondelivery.
Where the seller fails to deliver or repudiates, the buyer may also:
(5) if the goods have been identified recover them; or
(6) in a proper case obtain specific performance or
(7) replevy the goods.
On rightful rejection or justifiable revocation of acceptance, a buyer:
(8) has a security interest in goods in his possession or control for any payments
made on their price and any expenses reasonably incurred in their inspection, receipt,
transportation, care and custody and may hold such goods and resell them in like
manner as an aggrieved seller.
Saylor URL: http://www.saylor.org/books

Saylor.org
688

If the buyer has accepted non-conforming goods and notified seller of the nonconformity, buyer can
(9) recover damages for the breach; [13]
and in addition the buyer may
(10) recover incidental damages and
(11) recover consequential damages. [14]
Thus the buyer’s remedies can be divided into two general categories: (1) remedies for goods
that the buyer does not receive or accept, when he has justifiably revoked acceptance or when
the seller repudiates, and (2) remedies for goods accepted.
The CISG provides similar remedies at Articles 45–51:
If the seller fails to perform any of his obligations under the contract,
buyer may (1) declare the contract avoided if the seller’s breach is
fundamental; or (2) require performance by the seller of his obligations
unless the buyer has resorted to a remedy which is inconsistent with this
requirement; (3) require delivery of substitute goods if the nonconformity constitutes a fundamental breach of contract; (4) may require
the seller to remedy the lack of conformity by repair, unless this is
unreasonable having regard to all the circumstances; (5) may fix an
additional period of time of reasonable length for performance by the
seller of his obligations and unless the buyer has received notice from the
seller that he will not perform within the period so fixed, the buyer may
not, during that period, resort to any remedy for breach of contract; (6)
in case of non-conforming delivery, reduce the price in the same
proportion as the value that the goods actually delivered had at the time
of the delivery bears to the value that conforming goods would have had
at that time.

Goods Not Received
The UCC sets out buyer’s remedies if goods are not received or if they are rightfully rejected or
acceptance is rightfully revoked.
Saylor URL: http://www.saylor.org/books

Saylor.org
689

Cancel
If the buyer has not yet received or accepted the goods (or has justifiably rejected or revoked
acceptance because of their nonconformity), he may cancel the contract and—after giving notice
of his cancellation—he is excused from further performance. [15]

Recover the Price
Whether or not the buyer cancels, he is entitled to recover the price paid above the value of what
was accepted.

Cover
In the example case, Bunker—the buyer—may “cover” and have damages: he may make a goodfaith, reasonable purchase of substitute goods. He may then recover damages from the seller for
the difference between the cost of cover and the contract price. This is the buyer’s equivalent of
the seller’s right to resell. Thus Bunker could try to purchase seventy-five additional prints of the
Bruegel from some other manufacturer. But his failure or inability to do so does not bar him
from any other remedy open to him.

Sue for Damages for Nondelivery
Bunker could sue for damages for nondelivery. Under Section 2-713 of the UCC, the measure of
damages is the difference between the market price at the time when the buyer learned of the
breach and the contract price (plus incidental damages, less expenses saved). Suppose Bunker
could have bought seventy-five prints for $125 on the day Howard called to say he would not be
sending the rest of the order. Bunker would be entitled to $1,875—the market price ($9,375) less
the contract price ($7,500). This remedy is available even if he did not in fact purchase the
substitute prints. Suppose that at the time of breach, the original painting was worth $15,000
(Howard having just sold it to someone else at that price). Bunker would be entitled to an
additional $5,000, which would be the difference between his contract price and the market
price.
For leases, the UCC, Section 2A-519(1), provides the following: “the measure of damages for
non-delivery or repudiation by the lessor or for rejection or revocation of acceptance by the
lessee is the present value, as of the date of the default, of the then market rent minus the
present value as of the same date of the original rent, computed for the remaining lease term of
Saylor URL: http://www.saylor.org/books

Saylor.org
690

the original lease agreement, together with incidental and consequential damages, less expenses
saved in consequence of the lessor’s default.”

Recover the Goods
If the goods are unique—as in the case of the original Bruegel—Bunker is entitled to specific
performance—that is, recovery of the painting. This section is designed to give the buyer rights
comparable to the seller’s right to the price and modifies the old common-law requirement that
courts will not order specific performance except for unique goods. It permits specific
performance “in other proper circumstances,” and these might include particular goods
contemplated under output or requirements contracts or those peculiarly available from one
market source. [16]
Even if the goods are not unique, the buyer is entitled to replevy them if they are identified to
the contract and after good-faith effort he cannot recover them. Replevinis the name of an
ancient common-law action for recovering goods that have been unlawfully taken; in effect it is
not different from specific performance, and the UCC makes no particular distinction between
them in Section 2-716. Section 2A-521 holds the same for leases. In our case, Bunker could
replevy the twenty-five prints identified and held by Howard.
Bunker also has the right to recover the goods should it turn out that Howard is insolvent.
Under UCC, Section 2-502, if Howard were to become insolvent within ten days of the day on
which Bunker pays the first installment of the price due, Bunker would be entitled to recover the
original and the prints, as long as he tendered any unpaid portion of the price.
For security interest in goods rightfully rejected, if the buyer rightly rejects nonconforming
goods or revokes acceptance, he is entitled to a security interest in any goods in his possession.
In other words, Bunker need not return the twenty-five prints he has already received unless
Howard reimburses him for any payments made and for any expenses reasonably incurred in
their inspection, receipt, transportation, care, and custody. If Howard refuses to reimburse him,
Bunker may resell the goods and take from the proceeds the amount to which he is entitled. [17]

Goods Accepted
The buyer does not have to reject nonconforming goods. She may accept them anyway or may
effectively accept them because the time for revocation has expired. In such a case, the buyer is
Saylor URL: http://www.saylor.org/books

Saylor.org
691

entitled to remedies as long as she notifies the seller of the breach within a reasonable
time. [18] In our example, Bunker can receive three types of damages, all of which are outlined
here.

Compensatory Damages
Bunker may recover damages for any losses that in the ordinary course of events stem from the
seller’s breach. Suppose Howard had used inferior paper that was difficult to detect, and within
several weeks of acceptance the prints deteriorated. Bunker is entitled to be reimbursed for the
price he paid.

Consequential Damages
Bunker is also entitled to consequential damages. [19] These are losses resulting from general or
particular requirements of the buyer’s needs, which the seller had reason to know and which the
buyer could not reasonably prevent by cover or otherwise. Suppose Bunker is about to make a
deal to resell the twenty-five prints that he has accepted, only to discover that Howard used
inferior ink that faded quickly. Howard knew that Bunker was in the business of retailing prints
and therefore he knew or should have known that one requirement of the goods was that they be
printed in long-lasting ink. Because Bunker will lose the resale, he is entitled to the profits he
would have made. (If Howard had not wished to take the risk of paying for consequential
damages, he could have negotiated a provision limiting or excluding this remedy.) The buyer has
the burden or proving consequential damages, but the UCC does not require mathematical
precision. Suppose customers come to Bunker’s gallery and sneer at the faded colors. If he can
show that he would have sold the prints were it not for the fading ink (perhaps by showing that
he had sold Bruegels in the past), he would be entitled to recover a reasonable estimate of his
lost profits.
In De La Hoya v. Slim’s Gun Shop the plaintiff purchased a handgun from the defendant, a
properly licensed dealer. While the plaintiff was using it for target shooting, he was questioned
by a police officer, who traced the serial number of the weapon and determined that—unknown
to either the plaintiff or the defendant—it had been stolen. The plaintiff was arrested for
possession of stolen property and incurred, in 2010 dollars, $3,000 in attorney fees to extricate
himself from the criminal charges. He sued the defendant for breach of the implied warranty of
Saylor URL: http://www.saylor.org/books

Saylor.org
692

title and was awarded the amount of the attorney fees as consequential damages. On appeal the
California court held it foreseeable that the plaintiff would get arrested for possessing a stolen
gun, and “once the foreseeability of the arrest is established, a natural and usual consequence is
that the [plaintiff] would incur attorney’s fee.” [20] Compare with In re Stem in the exercises later
in this chapter.

Incidental Damages
Section 2-715 of the UCC allows incidental damages, which are “damages resulting from the
seller’s breach including expenses reasonably incurred in inspection, receipt, transportation and
care and custody of goods rightfully rejected, any commercially reasonable charges, expenses or
commissions in connection with effecting cover and any other reasonable expense incident to
the delay or other breach.” Section 2A-520(1) of the UCC is similar for leases.

KEY TAKEAWAY

Parties to a contract for the sale of goods may specify what the remedies will be in case of
breach. They may limit or exclude remedies, but the UCC insists that there be some
remedies; if the parties agree to liquidated damages, the amount set cannot be a penalty.
If the parties do not agree to different remedies for the seller in case the buyer defaults, the
UCC sets out remedies. As to the seller’s obligation, he may cancel the contract. As to the
goods, he may withhold or stop delivery, identify conforming goods to the contract, or
reclaim goods upon the buyer’s insolvency. As to money, he may resell and recover damages
or lost profits and recover the price. Unless they are inconsistent, these remedies are
cumulative. The point of the range of remedies is, as much as possible, to put the
nonbreaching seller in the position she would have been in had there been no breach. The
aggrieved lessor is entitled to similar remedies as the seller.
The UCC also provides a full panoply of remedies available to a buyer if the seller fails to
deliver goods or if the buyer rightfully rejects them or revokes her acceptance. As to the
buyer’s obligations, she may cancel the contract. As to the goods, she may claim a security
interest in those rightfully rejected, recover goods identified if the seller is insolvent, or
replevy or seek specific performance to get goods wrongfully withheld. As to money, she may
recover payments made or cover and recover damages for nondelivery. If the buyer accepts

Saylor URL: http://www.saylor.org/books

Saylor.org
693

nonconforming goods, she is entitled to damages for breach of warranty. These remedies are
cumulative, so the aggrieved buyer may pursue any of them, unless the remedies are
mutually exclusive. The Article on leases provides basically the same remedies for the
aggrieved lessee (UCC 2A 520–523).

EXERCISES

1. What are the four things a breaching seller could do to cause the buyer grief, commercially
speaking?
2. If the buyer breaches, what rights does the seller have in regard to the goods?
3. In regard to the money owed to her?
4. In regard to the continued existence of the contract?
5. What are the four things a breaching buyer could do to cause the seller grief, commercially
speaking?
6. If the seller breaches, what rights does the buyer have in regard to the goods?
7. In regard to the money owed to him?
8. In regard to the continued existence of the contract?

[1] Uniform Commercial Code, Sections 2-719(1) and 2A-503(1).
[2] Uniform Commercial Code, Sections 2-719(1)(b) and 2A-503(2).
[3] Uniform Commercial Code, Sections 2-719(2) and 2A-503(2).
[4] Uniform Commercial Code, Sections 2-719(3) and 2A-503(2).
[5] Uniform Commercial Code, Section 2-718.
[6] Uniform Commercial Code, Section 2-725.
[7] Uniform Commercial Code, Sections 2-706 and 2A-527.
[8] Uniform Commercial Code, Section 2-708(2); Section 2A-528(2) is similar.
[9] Uniform Commercial Code, Sections 2-703(f) and 2A-524(1)(a).
[10] Uniform Commercial Code, Section 1-201(23).
[11] Uniform Commercial Code, Section 2-702 (3).
[12] Uniform Commercial Code, Section 2A-525(2).
Saylor URL: http://www.saylor.org/books

Saylor.org
694

[13] Uniform Commercial Code, Section 2-714.
[14] Uniform Commercial Code, Section 2-715.
[15] Uniform Commercial Code, Sections 2-711(1), 2-106, 2A-508(1)(a), and 2A-505(1).
[16] Uniform Commercial Code, Sections 2-716(1) and 2A-521(1).
[17] Uniform Commercial Code, Sections 2-711(3), 2-706, 2A-508(5), and 2A-527(5).
[18] Uniform Commercial Code, Sections 2-714(1) and 2A-519(3).
[19] Uniform Commercial Code, Sections 2-714(3), 2-715, and 2A-519(3).
[20] De La Hoya v. Slim’s Gun Shop, 146 Cal. Rptr. 68 (Super. 1978).

19.4 Excuses for Nonperformance

LEARNING OBJECTIVES

1. Recognize how parties are discharged if the goods are destroyed.
2. Determine what defenses are valid when it becomes very difficult or impossible to perform.
3. Understand the UCC’s position on the right to adequate assurances and anticipatory
repudiation.
In contracts for the sale of goods, as in common law, things can go wrong. What then?

Casualty to Identified Goods
As always, the parties may agree what happens if the goods are destroyed before delivery. The
default is Sections 2-613 and 2A-221(a) of the Uniform Commercial Code (UCC). The UCC says
that “where the contract requires for its performance goods identified when the contract is
made, and the goods suffer casualty without fault of either party before the risk of loss passes to
the buyer,…then (a) if the loss is total the contract is avoided; and (b) if the loss is partial the
buyer may nevertheless accept them with due allowance for the goods’ defects.” Thus if Howard
ships the original Bruegel to Bunker but the painting is destroyed, through no fault of either
party, before delivery occurs, the parties are discharged. If the frame is damaged, Bunker could,
if he wants, take the painting anyway, but at a discount.

The UCC’s Take on Issues Affecting “Impossibility”
Although this matter was touched on in Chapter 15 "Discharge of Obligations", it is appropriate
to mention briefly again the UCC’s treatment of variations on the theme of “impossibility.”
Saylor URL: http://www.saylor.org/books

Saylor.org
695

Impracticability
Sections 2-614(1) and 2A-404(1) of the UCC require reasonable substitution for berthing,
loading, and unloading facilities that become unavailable. They also require reasonable
substitution for transportation and delivery systems that become “commercially impracticable”;
if a practical alternative exists, “performance must be tendered and accepted.” If Howard agreed
to send the prints by rail, but a critical railroad bridge is unusable and no trains can run,
delivery by truck would be required.
Section 2-615 of the UCC says that the failure to deliver goods is not a breach of the seller’s duty
“if performance as agreed has become impracticable by the occurrence of a contingency the nonoccurrence of which was a basic assumption on which the contract was made or by compliance
in good faith with any applicable foreign or domestic government regulation or order whether or
not it later proves to be invalid.” Section 2A-405(b) of the UCC is similar for leases.
The CISG provides something similar at Article 79: “A party is not liable for a
failure to perform any of his obligations if he proves that the failure was due to an
impediment beyond his control and that he could not reasonably be expected to
have taken the impediment into account at the time of the conclusion of the
contract or to have avoided or overcome it or its consequences.”

Right to Adequate Assurances of Performance
Section 2-609, Comment 1, of the UCC observes that “the essential purpose of a contract…is
actual performance [but] a continuing sense of reliance and security that the promised
performance will be forthcoming when due is an important feature of the bargain.” Thus the
UCC says that if one party has “reasonable grounds for insecurity arise…either party may in
writing demand adequate assurance and until he receives such assurance may if commercially
reasonable suspend [his own] performance[.]”
The CISG has a similar take at Article 71: “A party may suspend the performance of
his obligations if, after the conclusion of the contract, it becomes apparent that the
other party will not perform a substantial part of his obligations. A party
suspending performance, whether before or after dispatch of the goods, must
immediately give notice of the suspension to the other party and must continue
Saylor URL: http://www.saylor.org/books

Saylor.org
696

with performance if the other party provides adequate assurance of his
performance.”

Anticipatory Repudiation
Obviously if a person repudiates the contract it’s clear she will not perform, but what if she
repudiates before time for performance is due? Does the other side have to wait until
nonperformance actually happens, or can he sue in anticipation of the other’s default? Sections
2-610 and 2A-402 of the UCC say the aggrieved party can do either: wait for performance or
“resort to any remedy for breach.” Under the UCC, Sections 2-611 and 2A-403, the one who has
anticipatorily repudiated can “retract his repudiation unless the aggrieved party has since the
repudiation cancelled or materially changed his position[.]”
Suppose that Howard has cause to suspect that if he does deliver the goods, Bunker won’t pay.
Howard may write to Bunker and demand—not request—assurances of adequate performance.
If such assurances are not adequately forthcoming, Howard may assume that Bunker has
repudiated the contract and have remedies.
Article 72 of the CISG is pretty much the same: “If prior to the date for
performance of the contract it is clear that one of the parties will commit a
fundamental breach of contract, the other party may declare the contract
avoided.”

KEY TAKEAWAY

If, through no fault of either party, the goods are destroyed before the risk of loss has passed
from the seller to the buyer, the parties are both discharged. If the expected means of
performance is impossible, but an alternative is available, the alternative must be utilized. If
performance becomes impracticable because of an unexpected contingency, failure to
deliver the goods is excused. But a party who has concerns whether the other side will
perform is entitled to adequate assurances of performance; if they are not forthcoming, the
worried party may suspend performance. Where a party repudiates a contract before
performance is due, the other side may sue immediately (anticipatory repudiation) or may
wait until the time performance comes due and then sue.

EXERCISES

Saylor URL: http://www.saylor.org/books

Saylor.org
697

1. Suppose Plaintiff sues Defendant for breach of contract, and Defendant successfully raises an
excuse for nonperformance. What liability does Defendant have now?
2. The contract read that the goods would be “shipped F.O.B. Seattle, by Burlington Northern
Rail to the buyer in Vancouver, B.C.” Due to heavy rain and mudslides, the rail line between
Seattle and points north was impassable. Buyer insists Seller is obligated to send the goods
by motor truck; Seller insists her performance has become impossible or at least that
shipment must await the rail-line clearance. Who is correct? Explain.
3. Buyer manufactured ceramic insulators and ordered the dies into which the liquid ceramic
would be poured for hardening and finishing from Seller, to be delivered April 15. The first
test batch of a dozen dies arrived on February 15; these dies were defective. Buyer wrote
inquiring whether the defects could be remedied in time for the final delivery. Seller
responded, “We are working to address the problems here.” Buyer again inquired; Seller
responded, “As I said, we are working on the problems.” Buyer fretted that the deadline—
two months in the future—would not be met. What remedy, if any, does Buyer have now?

19.5 Cases
Limitations of Remedy Results in No Remedy
Hartzell v. Justus Co., Inc.
693 F.2d 770 (8th Cir. S.D. 1982)
Arnold, J.
This is a diversity case arising out of the purchase by Dr. Allan Hartzell of Sioux Falls, South
Dakota, of a log home construction kit manufactured by the defendant Justus Homes. Dr.
Hartzell purchased the package in 1977 for $38,622 [about $135,000 in 2010 dollars] from Del
Carter, who was Justus Homes’ dealer for the Sioux Falls area. He also hired Carter’s
construction company, Natural Wood Homes, to build the house. Hartzell, who testified that the
home eventually cost about $150,000, was dissatisfied with the house in many respects. His
chief complaints were that knotholes in the walls and ceiling leaked rain profusely, and that the
home was not weather tight because flashings were not included in the roofing materials and
because the timbers were not kiln-dried and therefore shrank. He also complained that an
Saylor URL: http://www.saylor.org/books

Saylor.org
698

undersized support beam, which eventually cracked, was included in the package. This latter
defect was alleged to have resulted in cracks in the floor and inside doors that would not close.
Hartzell further alleged that these structural defects were only partially remediable, and that the
fair market value of the house was reduced even after all practicable repairs had been made.
Alleging breach of implied and express warranties and negligence, he sought damages for this
loss in value and for the cost of repairs. After a two-day trial, the jury returned a plaintiff’s
verdict for $34,794.67.
Justus Homes contends the District Court erred in failing to instruct the jury on a limitation-ofremedies clause contained in its contract with the plaintiff. The defendants rely on Clause 10c of
the contract, which says Justus will repair or replace defective materials, and Clause 10d,
which states that this limited repair or replacement clause is the exclusive remedy available
against Justus [emphasis added]. These agreements, Justus asserts, are valid under the
Uniform Commercial Code 2-719(1). Section 2-719(1) states:
(1) Subject to the provisions of subsections (2) and (3) of this section and of § 57A-2718 on liquidation and limitation of damages,
(a) The agreement may provide for remedies in addition to or in substitution for those
provided in this chapter and may limit or alter the measure of damages recoverable
under this chapter, as by limiting the buyer’s remedies to return of the goods and
repayment of the price or to repair and replacement of nonconforming goods or
parts; and
(b) Resort to a remedy as provided is optional unless the remedy is expressly agreed
to be exclusive, in which case it is the sole remedy.
Subsection (1) of section 2-719 is qualified by subsection (2): “Where circumstances cause an
exclusive or limited remedy to fail of its essential purpose, remedy may be had as provided in
this title.”…
The jury’s verdict for the plaintiff in an amount almost exactly equal to the plaintiff’s evidence of
cost of repairs plus diminution in market value means it must have found that the structural
defects were not entirely remediable. Such a finding necessarily means that the limited warranty
failed of its essential purpose.
Saylor URL: http://www.saylor.org/books

Saylor.org
699

Two of our recent cases support this conclusion. In Soo Line R.R. v. Fruehauf Corp., 547 F.2d
1365 (8th Cir.1977), the defendant claimed, relying on a limitation-of-remedies clause similar to
the one involved here, that the plaintiff’s damages should be limited to the reasonable cost of
repairing the railroad cars that plaintiff had bought from defendant. The jury verdict included,
among other things, an award for the difference between the value of the cars as actually
manufactured, and what they would have been worth if they had measured up to the defendant’s
representations. This Court affirmed the verdict for the larger amount. We held, construing the
Minnesota U.C.C., which is identical to § 2-719 as adopted in South Dakota, that the limitationof-remedies clause was ineffective because the remedy as thus limited failed of its essential
purpose. The defendant, though called upon to make the necessary repairs, had refused to do so,
and the repairs as performed by the plaintiff itself “did not fully restore the cars to totally
acceptable operating conditions.”
Here, Justus Homes attempted to help with the necessary repairs, which is more than Fruehauf
did in the Soo Line case, but after the repairs had been completed the house was still, according
to the jury verdict, not what Justus had promised it would be. The purpose of a remedy is to give
to a buyer what the seller promised him—that is, a house that did not leak. If repairs alone do
not achieve that end, then to limit the buyer’s remedy to repair would cause that remedy to fail
of its essential purpose.…
An analogous case is Select Pork, Inc. v. Babcock Swine, Inc. [Citation], applying § 2-719 as
adopted in Iowa. The defendant had promised to deliver to plaintiff certain extraordinary pigs
known as Midwestern Gilts and Meatline Boars. Instead, only ordinary pigs were delivered.
Plaintiff sued for breach of warranty, and defendant claimed that its damages, if any, should be
limited to a return of the purchase price by an express clause to that effect in the contract. The
District Court held that the clause was unenforceable because it was unconscionable, see § 2719(3), and because it failed of its essential purpose. We affirmed,…“Having failed to deliver the
highly-touted special pigs, defendants may not now assert a favorable clause to limit their
liability.” So here, where the house sold was found by the jury to fall short of the seller’s
promises, and where repairs could not make it right, defendant’s liability cannot be limited to
the cost of repairs. If the repairs had been adequate to restore the house to its promised
Saylor URL: http://www.saylor.org/books

Saylor.org
700

condition, and if Dr. Hartzell had claimed additional consequential damages, for example, water
damage to a rug from the leaky roof, the limitation-of-remedies clause would have been
effective. But that is not this case.
There was no double recovery here: the verdict was not for cost of repair plus the entire decrease
in market value, but rather for cost of repair plus the decrease in market value that still existed
after all the repairs had been completed.
[T]he evidence in the record all demonstrate[s] that the repair or replacement clause was a
failure under the circumstances of this case. Some of the house’s many problems simply could
not be remedied by repair or replacement. The clause having failed of its essential purpose, that
is, effective enjoyment of implied and express warranties, the plaintiff was entitled, under UCC §
2-719(2), to any of the buyer’s remedies provided by the Code. Among these remedies are
consequential damages as provided in §§ 2-714 and 2-715(2).…
The judgment is affirmed.

CASE QUESTIONS

1. What did the seller here limit itself to do in case of defects? What was the limitation of
remedy?
2. Did Justus Homes disclaim implied and expressed warranties with its contract language
regarding limitation of remedies?
3. Was the essential purpose of the limitation of remedy to protect the party benefiting from
it—here, the seller of the log home kit—or was the essential purpose of the limitation of
remedy, as the court said, “effective enjoyment of implied and expressed warranties”?
4. In a part of the opinion excised, the court wrote, “A finding of unconscionability is, as a
matter of logic, simply unnecessary in cases where § 2-719(2) applies.” Would it be easier
simply to say that the limitation of liability here was unconscionable?

Cure for Improper Delivery
Wilson v. Scampoli
228 A.2d 848 (D.C. App. 1967)
Myers, J.

Saylor URL: http://www.saylor.org/books

Saylor.org
701

This is an appeal from an order of the trial court granting rescission of a sales contract for a
color television set and directing the return of the purchase price plus interest and costs.
Appellee [Mrs. Kolley’s father] purchased the set in question on November 4, 1965, paying the
total purchase price in cash. The transaction was evidenced by a sales ticket showing the price
paid and guaranteeing ninety days’ free service and replacement of any defective tube and parts
for a period of one year. Two days after purchase the set was delivered and uncrated, the
antennae adjusted and the set plugged into an electrical outlet to “cook out.” When the set was
turned on however, it did not function properly, the picture having a reddish tinge. Appellant’s
delivery man advised the buyer’s daughter, Mrs. Kolley, that it was not his duty to tune in or
adjust the color but that a service representative would shortly call at her house for that purpose.
After the departure of the delivery men, Mrs. Kolley unplugged the set and did not use it.
On November 8, 1965, a service representative arrived, and after spending an hour in an effort
to eliminate the red cast from the picture advised Mrs. Kolley that he would have to remove the
chassis from the cabinet and take it to the shop as he could not determine the cause of the
difficulty from his examination at the house. He also made a written memorandum of his service
call, noting that the television ‘\”Needs Shop Work (Red Screen).” Mrs. Kolley refused to allow
the chassis to be removed, asserting she did not want a ‘repaired’ set but another ‘brand new’
set. Later she demanded the return of the purchase price, although retaining the set. Appellant
refused to refund the purchase price, but renewed his offer to adjust, repair, or, if the set could
not be made to function properly, to replace it. Ultimately, appellee instituted this suit against
appellant seeking a refund of the purchase price. After a trial, the court ruled that “under the
facts and circumstances the complaint is justified. Under the equity powers of the Court I will
order the parties put back in their original status, let the $675 [about $4500 in 2010 dollars] be
returned, and the set returned to the defendant.”
Appellant does not contest the jurisdiction of the trial court to order rescission in a proper case,
but contends the trial judge erred in holding that rescission here was appropriate. He argues
that he was always willing to comply with the terms of the sale either by correcting the
malfunction by minor repairs or, in the event the set could not be made thereby properly

Saylor URL: http://www.saylor.org/books

Saylor.org
702

operative, by replacement; that as he was denied the opportunity to try to correct the difficulty,
he did not breach the contract of sale or any warranty thereunder, expressed or implied.
[The District of Columbia UCC 2-508] provides:
(1) Where any tender or delivery by the seller is rejected because non-conforming and
the time for performance has not yet expired, the seller may seasonably notify the
buyer of his intention to cure and may then within the contract time make a
conforming delivery.
(2) Where the buyer rejects a nonconforming tender which the seller had reasonable
grounds to believe would be acceptable with or without money allowance the seller
may if he seasonably notifies the buyer have a further reasonable time to substitute a
conforming tender.
…
Removal of a television chassis for a short period of time in order to determine the cause of color
malfunction and ascertain the extent of adjustment or correction needed to effect full
operational efficiency presents no great inconvenience to the buyer. In the instant case,
appellant’s expert witness testified that this was not infrequently necessary with new televisions.
Should the set be defective in workmanship or parts, the loss would be upon the manufacturer
who warranted it free from mechanical defect. Here the adamant refusal of Mrs. Kolley, acting
on behalf of appellee, to allow inspection essential to the determination of the cause of the
excessive red tinge to the picture defeated any effort by the seller to provide timely repair or
even replacement of the set if the difficulty could not be corrected. The cause of the defect might
have been minor and easily adjusted or it may have been substantial and required replacement
by another new set—but the seller was never given an adequate opportunity to make a
determination.
We do not hold that appellant has no liability to appellee, but as he was denied access and a
reasonable opportunity to repair, appellee has not shown a breach of warranty entitling him
either to a brand new set or to rescission. We therefore reverse the judgment of the trial court
granting rescission and directing the return of the purchase price of the set.
Reversed.
Saylor URL: http://www.saylor.org/books

Saylor.org
703

CASE QUESTIONS
1. Why did the seller “have reasonable grounds to believe [the television] would be
acceptable”?
2. What did Mrs. Kolley want?
3. Does this case require a buyer to accept patchwork goods or substantially repaired articles in
lieu of flawless merchandise?

Seller’s Remedies When Buyer Defaults
Santos v. DeBellis
901 N.Y.S.2d 457 (N.Y. Sup.App. 2010)
Molia, J.
On March 1, 2008 and March 11, 2008, plaintiff made payments to defendant of $3,000 each, in
connection with the purchase of a mobile home located in Fort Pierce, Florida. Thereafter, on
March 13, 2008, plaintiff and defendant signed an agreement which had been prepared by
defendant. The agreement described the subject property by its location, recorded the fact that
plaintiff had paid defendant deposits totaling $6,000, set forth a closing date of March 25,
2008, and specified that “the remaining $27,000.00” was payable at closing to defendant by a
guaranteed financial instrument. Plaintiff never paid the outstanding balance and brought this
action to recover the $6,000 deposit she paid to defendant. Following a nonjury trial, judgment
was awarded in favor of defendant dismissing the complaint.
Because the sale of a mobile home constitutes a contract for the sale of goods rather than of real
property [Citations], the parties’ agreement was governed by the Uniform Commercial Code.
The agreement, which was made after plaintiff had made the two $3,000 “deposit” payments,
constituted a memorandum in confirmation of an oral agreement and, even though it omitted
some terms, was sufficient to satisfy the statute of frauds [Citations].
Section 2-718 of the Uniform Commercial Code specifies that in the absence of a contractual
provision with respect to the liquidation or limitation of damages and the return of deposits,
(2) Where the seller justifiably withholds delivery of goods because of the buyer’s
breach, the buyer is entitled to restitution of any amount by which the sum of his
payments exceeds…

Saylor URL: http://www.saylor.org/books

Saylor.org
704

(b) [in the absence of contractually fixed terms] twenty per cent of the value of the
total performance for which the buyer is obligated under the contract or $500,
whichever is smaller.
(3) The buyer’s right to restitution under subsection (2) is subject to offset to the extent
that the seller establishes
(a) a right to recover damages under the provisions of this Article other than
subsection (1), and
(b) the amount or value of any benefits received by the buyer directly or indirectly by
reason of the contract.
Here, notwithstanding the fact that plaintiff, as buyer, had breached the contract, defendant
failed to demonstrate any damages resulting therefrom; nor did defendant establish that
plaintiff had received any benefits directly or indirectly by reason of the parties’ agreement
(see UCC 2-718[3]). Therefore, pursuant to UCC 2-718(2), plaintiff was entitled to the return of
all but $500 of her deposit.
The order of the District Court dismissing the complaint is accordingly reversed, and judgment
is awarded to plaintiff in the principal sum of $5,500.

CASE QUESTIONS

1. If the plaintiff had been a dealer in mobile homes and the unit here had been part of his
inventory, he would be entitled to claim lost profits on the sale of one unit. Here, apparently,
the plaintiff seller was a private party. Why was he not entitled to any damages greater than
$500?
2. New York adopted the UCC in 1964. Five hundred dollars in 1964 would be worth about
$3,500 in 2010. Why isn’t the change in the dollar’s value recognized here?

Buyer’s Remedies When Seller Breaches
[Note: this case is slightly edited by the authors.]
Furlong v. Alpha Chi Omega Sorority
657 N.E.2d 866 (Ohio Mun. 1993)
Bachman, J.

Saylor URL: http://www.saylor.org/books

Saylor.org
705

In late September through mid-October 1992, plaintiff Johnathan James Furlong (“Furlong”)
contacted defendant Alpha Chi Omega Sorority (“AXO”), by phoning the chairperson of its
social committee, Emily Lieberman (“Emily”), between a dozen and a dozen and a half times.
Ultimately (about the first week in October), Furlong received Emily’s order for one hundred
sixty-eight imprinted sweaters at $21.50 each (plus one free sweater) for delivery on Friday,
October 23, 1992, so as to arrive in time for AXO’s Midnight Masquerade III on the evening of
Saturday, October 24, 1992.
The price was to be $3,612, [about $5600 in 2010 dollars] payable as follows: $2,000 down
payment when the contract was made, and $1,612 balance when the sweaters were delivered.
An oral contract for the sale of goods (the imprinted sweaters) was made between Furlong and
AXO, at a definite price and with specified dates for payment and for delivery.
At some point in those phone calls with Furlong, Emily said that the sweaters were to be custom
designed with the following specified design: namely, with three colors (hunter green letters on
top of maroon letters outlined in navy blue, and hunter green masks). Furlong promised to have
them so imprinted (by a third party whom he would select).…Thereafter, he delivered to Emily
an Ohio Wesleyan sweater with maroon letters to show her the maroon color.…Additionally, he
faxed to Emily a two-page description of the sweaters, which not only included the designs for
the fronts and the backs of the sweaters, but also included arrows showing where each of the
three colors would go (hunter green letters on top of maroon letters outlined in navy blue, and
hunter green masks).
Furlong and Emily created an express warranty by each of the above three statutory means:
namely, by affirmation of fact (his initial phone calls); by sample (the maroon sweater) by
description (the fax).This express warranty became part of the contract. Each of the three
methods of showing the express warranty was not in conflict with the other two methods, and
thus they are consistent and cumulative, and constitute the warranty. [2-317]
The design was a “dickered” aspect of the individual bargain and went clearly to the essence of
that. Thus, the express warranty was that the sweaters would be in accordance with the above
design (including types of colors for the letters and the mask, and the number of colors for the
same). Further, the express warranty became part of the contract.
Saylor URL: http://www.saylor.org/books

Saylor.org
706

On October 13, 1992, AXO mailed Furlong a $2,000 check for the down payment; he deposited
it in his bank account on October 16, 1992. Thereafter, as discussed below, Furlong had the
sweaters imprinted (on Thursday, October 22) and delivered to AXO (on Friday, October 23).
Upon receipt of the delivery, AXO gave a check to Furlong’s agent in the amount of $1,612 for
the balance of the purchase price. However, later on that day, AXO inspected the sweaters,
discovered the design changes (mentioned below), caused AXO’s bank to stop payment on the
check, and stated AXO’s objections in a phone call with Furlong. AXO has never paid Furlong
that balance on the purchase price.
Furlong’s obligation as the seller was to transfer and deliver the goods in accordance with the
contract. AXO’s obligation was to accept and pay in accordance with that contract. [2-301] We
will now discuss whether it legally did so.
Furlong was a jobber for Argento Bros., Inc. (“Argento”) and had Argento print the sweaters. In
doing so, Furlong worked with Argento’s artists. Early in the morning of Thursday (October 22,
1992), the artist(s) began to prepare the art work and recommended changes to the design.
Furlong authorized the artist(s) to change the design without the knowledge or consent of AXO.
Argento spent about eight hours printing the sweaters all day Thursday. Furlong did not phone
AXO about the changes until the next day, Friday (October 23), after the sweaters were printed
with those changes. Here are the five design changes that he made:
•

The first change was to delete the agreed-upon outline for the letters (namely, the navy blue
outline).

•

The second change was to reduce the agreed-upon number of colors for the fronts and the backs
(from three colors per side to two colors per side).

•

The third change was to alter one of the agreed-upon colors (from maroon to red).

•

The fourth change was to alter the agreed-upon scheme of colors for the letters on the fronts
and the backs (namely, both sides were to have the same two colors of maroon and hunter
green; whereas in fact the backs had neither of those colors, and instead had a navy blue color
for the letters).

•

The fifth change was to alter the agreed-upon color of the masks (from hunter green to
maroon—actually red).
Saylor URL: http://www.saylor.org/books

Saylor.org
707

The court specifically finds that the color was red (actually, scarlet) and was not maroon (like
the maroon-colored letters on the Ohio Wesleyan sweater).
The sweaters did not conform to the contract (specifically, the express warranty in the contract).
Thus (in the words of the statute), the sweaters did “fail in any respect to conform to the
contract.” Actually, the sweaters failed in at least five respects. [2-601] Further, not only did they
“fail in any respect,” they failed in a substantial respect. In either event, they were a
nonconforming tender of goods. [2-601]
On Friday morning (October 23), Furlong picked up the five to six boxes of sweaters from
Argento and had a friend deliver them from Columbus to Bowling Green. The boxes arrived at
the AXO house around midday. Sometime thereafter on the same day, Emily inspected one of
them and screamed her dismay upon discovering that the sweaters were not what AXO had
ordered.
The court rejects Furlong’s assertion that he did all that he could do under the circumstances.
The obvious answer is that he did not do enough. He should have gotten AXO’s prior consent to
the changes. He could have done this by providing for more lead time-between the time that
Argento prepared the art work and the time that it printed the sweaters. Instead, he had both
done at the same time (Thursday morning).
Finally, and alternatively, plaintiff should have entered into a contract that gave him discretion
to make design changes without AXO’s consent. We must remember that “these sweaters,” as
Furlong himself admits (and describes), were to be “custom-designed” for AXO. Thus, they were
to be printed according to AXO’s specifications, and not according to Furlong’s discretion.
Next, Furlong asserts that AXO—after learning of the changes—should have agreed to his offer
of compromise: namely, that he would reduce the unit price of the sweaters in exchange for
AXO’s keeping them and paying the reduced price. Also, Furlong asserts that AXO should have
communicated his compromise offer to AXO’s members and pledges. In both respects, the court
disagrees: Although the law allowed AXO to do so, it did not require AXO to do. Instead, AXO
did exactly what the law allowed: AXO rejected the nconforming goods in whole.
About 4:00 p.m. on the same day that the sweaters arrived at the AXO house (Friday, October
23), Amy—as the AXO president—phoned Furlong. She said that the sweaters were not what
Saylor URL: http://www.saylor.org/books

Saylor.org
708

AXO had ordered. She stated the specifics as to why the sweaters were not as ordered. She
offered to return the sweaters to him, but he said “No.” AXO still has possession or custody of
the boxes of sweaters.
[The UCC] provides: “Rejection of goods must be within a reasonable time after their delivery *
* *. It is ineffective unless the buyer seasonably notifies the seller.” [2-602] AXO did what this
statute requires.
That statute further provides: “[I]f the buyer has before rejection taken physical possession of
goods * * *, he is under a duty after rejection to hold them with reasonable care at the seller’s
disposition for a time sufficient to permit the seller to remove them[.]” [2-602(2)(b)] AXO has
done this, too. From the above, it is seen that AXO legally rejected the sweaters on the same day
that AXO received physical possession of them.
The court disagrees with Furlong’s assertion that AXO accepted the sweaters. He is confusing a
layman’s understanding of the term accept (“to receive a thing [with a consenting mind]),”
Webster’s Collegiate Dictionary (5 Ed.1947), at 6, with the statutory meaning of the term. The
mere fact that AXO took physical possession of the sweaters does not, by itself, mean that AXO
legally “accepted” them.
In regard to…seller’s remedies, Furlong has no legal remedies because AXO did not breach the
contract. Thus, he is not entitled to an award for the $1,612 balance that he claims is due on the
contract price.
As concluded above, AXO rightfully rejected the sweaters, after having paid part of the purchase
price: namely, $2,000. AXO is entitled to cancel the contract and to recover the partial payment
of the purchase price. [2-606]
Also, as concluded above, AXO still has rightful possession or control of the sweaters. AXO has a
security interest in the sweaters in its possession or control for the part payment made on the
purchase price—but when reimbursed for that part payment AXO must return the sweaters to
Furlong.
The court will prepare, file, and serve a judgment entry as follows: dismissing with prejudice
Furlong’s claim against all defendants; dismissing with prejudice Emily Lieberman’s and Amy

Saylor URL: http://www.saylor.org/books

Saylor.org
709

Altomondo’s counterclaims against Furlong; granting AXO’s counterclaim (for $2,000, plus ten
percent per annum postjudgment interest and costs).
Further, that entry will order AXO’s attorney (Mr. Reddin) to retain possession of the sweaters
either until further court order or until AXO’s judgment is satisfied in full (whereupon he shall
surrender the sweaters to Furlong if Furlong picks them up within thirty days thereafter, or, if
Furlong does not, he may then dispose of them as abandoned property without any liability).
Judgment accordingly.

CASE QUESTIONS

1. Surely the plaintiff could not have thought that the radically altered design would be
acceptable for the young women’s masquerade ball. On what basis did he think he would be
entitled to the full payment contracted for?
2. Whether Amy Altomondo knew it or not, she did what the UCC says a buyer should do when
nonconforming goods are delivered. What are those steps?
3. What does it mean that AXO has a security interest in the sweaters? Security for what?

19.6 Summary and Exercises
Summary

As with most of the Uniform Commercial Code (UCC), the parties may specify the terms of their
performance. Only if they fail to do so does Article 2 (and 2A) provide the terms for them. The
seller’s duty is to make a timely delivery of conforming goods. In the absence of agreement, the
time for delivery is a reasonable one, and the place of delivery is the seller’s place of business. All
goods must be tendered in a single delivery, unless circumstances permit either party the right
to make or demand delivery in lots.
If the seller ships nonconforming goods but has time to meet his contractual obligations or if he
reasonably believed the goods would be suitable, he may notify the buyer of his intention to
cure, and if he does so in a timely manner the buyer must pay.
The buyer’s general obligation is to inspect, accept, and pay. If an inspection reveals that the
goods are nonconforming, the buyer may reject them; if he has accepted because defects were
latent or because he received assurances that the defects would be cured, and they are not, the
buyer may revoke his acceptance. He then has some duties concerning the goods in his
Saylor URL: http://www.saylor.org/books

Saylor.org
710

possession. The buyer must pay for any conforming goods; payment may be in any manner
consistent with current business customs. Payment is due at the time and place at which the
buyer will ultimately receive the goods.
The general policy of the UCC is to put an aggrieved party in as good a position as she would
have been had the other party fully performed. The parties may specify or limit certain
remedies, but they may not eliminate all remedies for a breach. However, if circumstances make
an agreed-on remedy inadequate, then the UCC’s other remedies apply; parties may not
unconscionably limit consequential damages; they may agree to liquidated damages, but not to
unreasonable penalties.
In general, the seller may pursue the following remedies: withhold further delivery, stop
delivery, identify to the contract goods in her possession, resell the goods, recover damages or
the price, or cancel the contract. In addition, when it becomes apparent that the buyer is
insolvent, the seller may, within certain time periods, refuse to deliver the remaining goods or
reclaim goods already delivered.
The buyer, in general, has remedies. For goods not yet received, she may cancel the contract;
recover the price paid; cover the goods and recover damages for the difference in price; or
recover the specific goods if they are unique or in “other proper circumstances.” For goods
received and accepted, the buyer may recover ordinary damages for losses that stem from the
breach and consequential damages if the seller knew of the buyer’s particular needs and the
buyer could not reasonably cover.
The UCC provides some excuses for nonperformance: casualty of the goods, through no fault of
either party; the nonhappening of presupposed conditions that were a basic assumption of the
contract; substituted performance if the agreed-on methods of performance become
impracticable; right to adequate assurances of performance when reasonable grounds for
insecurity of performance arise; anticipatory repudiation and resort to any remedy, before time
for performance is due, is allowed if either party indicates an unwillingness to perform.

EXERCISES

1. Anne contracted to sell one hundred cans of yellow tennis balls to Chris, with a
delivery to be made by June 15.

Saylor URL: http://www.saylor.org/books

Saylor.org
711

a.

On June 8, Anne delivered one hundred cans of white tennis balls, which

were rejected by Chris. What course of action would you recommend for Anne,
and why?
b. Assume Ann had delivered the one hundred cans of white balls on June 15; these
were rejected by Chris. Under what circumstances might Anne be allowed
additional time to perform the contract?
c. If the contract did not specify delivery, when must Anne deliver the tennis balls?

a. When Anne delivers the tennis balls, does Chris have a right to inspect them? If
Chris accepts the white tennis balls, may the acceptance be revoked?
b. Assume Chris decided she could use twenty-five cans of the white balls. Could she
accept twenty-five cans and reject the rest?
c. Suppose Anne delivered white tennis balls because a fire at her warehouse
destroyed her entire stock of yellow balls. Does the fire discharge Anne’s
contractual duties?
d. If Chris rejected the white tennis balls and Anne refused to deliver yellow ones,
may Chris recover damages? If so, how would they be calculated?
In 1961, Dorothy and John Wilson purchased a painting from Hammer
Galleries titled Femme Debout. It cost $11,000 (about $78,000 in 2010 dollars)
and came with this promise: “The authenticity of this picture is guaranteed.” In
1984, an expert deemed the painting a fake. The district court held that the
Wilsons’ suit for breach of warranty, filed in February 1987—twenty-one years
after its purchase—was barred by the UCC’s four-year statute of limitations. The
Wilsons argued, however, that the Code’s exception to the four-year rule
applied: [1] “A breach of warranty occurs when tender of delivery is made, except
where a warranty explicitly extends to future performance and discovery must
await the time of such performance the cause of action accrues when the breach
is or should have been discovered.”

Saylor URL: http://www.saylor.org/books

Saylor.org
712

They said the painting “performed” by being an authentic Vuillard—a French
artist—and that the warranty of authenticity not only guaranteed the present
“being” of the painting but also extended, as required by 2-725(2), to the future
existence as a Vuillard. Therefore, they contended, explicit words warranting
future performance would be superfluous: a warranty that promises authenticity
“now and at all times in the future” would be redundant. How should the court
rule?
Speedi Lubrication Centers Inc. and Atlas Match Corp. entered into a
contract that provided for Speedi to buy 400,000 advertising matchbooks from
Atlas, to be paid for within thirty days of delivery of each shipment. Orders for
such matches required artwork, artists’ commissions, and printing plates. Atlas
sent twenty-two cases of matches to Speedi with an invoice showing $2,100
owed. Almost ninety days later, Speedi sent Atlas a check for $1,000, received the
same day Atlas sent Speedi a letter declaring Speedi to be in material breach of
the contract. A second check for $1,100 was later received; it bounced but was
later replaced by a cashier’s check. The contract provided that an untimely
payment was a breach, and it included these provisions related to liquidated
damages:
Atlas shall have the right to recover from Purchaser the price of all
matchbooks and packaging delivered and/or identified to this
agreement at the time of Purchaser’s breach hereof and shall be
additionally entitled to recover fifty percent (50%) of the contract price
of matchbooks and/or packaging ordered hereby, but not delivered or
identified to this Agreement at the time of Purchaser’s breach.
Purchaser agrees that the percentage as specified hereinabove…will be
reasonable and just compensation for such breach, and Purchaser
hereby promises to pay such sum as liquidated damages, not as penalty
in the event of any such breach.

Saylor URL: http://www.saylor.org/books

Saylor.org
713

On appeal, Speedi complained that the liquidated damages clause was a penalty.
Is the matter settled by the contract saying the liquidated damages are
reasonable? On what criteria would a court determine whether liquidated
damages are reasonable?
Mrs. Kaiden made a $5,000 deposit on the purchase of new 1973 Rolls-Royce automobile.
Lee Oldsmobile, the seller, confirmed the request by transmitting a regular order form, which
Mrs. Kaiden signed and returned. The price was $29,500.00 [about $150,000 in 2010 dollars].
Some of the correspondence and a notation on Mrs. Kaiden’s check indicated that delivery
was expected in November. The order form, however, specified no delivery date. Further, it
contained a disclaimer of liability for delay in delivery beyond the dealer’s control, and it
provided that the dealer had the right, upon failure of the purchaser to accept delivery, to
retain as liquidated damages any cash deposit made. On November 21, 1973, Mrs. Kaiden
notified Lee by telephone that she had purchased another Rolls-Royce elsewhere. She told
the salesman to cancel her order. On November 29, Lee Oldsmobile notified Mrs. Kaiden that
the car was ready for delivery. She refused delivery and demanded the return of her deposit.
The dealer refused. In January 1974, the dealer—without notice to the Kaidens—sold the
Rolls-Royce to another purchaser for $26,495. Mrs. Kaiden sued Lee Oldsmobile for the
$5,000 deposit. The dealer carefully itemized its losses on the Kaiden deal—$5080.07. On
what basis did the court dismiss the liquidated damages clause? What is the consequence of
the dealer’s failure to give notice of the private sale under UCC, Section 2-706(3)?
Hemming saw an advertisement for a Cadillac convertible once owned by the famous
early rock ’n’ roll singer Elvis Presley. He contracted to buy it from Whitney for $350,000 and
sent Whitney $10,000 as a deposit. But, after some delay, Whitney returned the $10,000 and
informed Hemming that the car had been sold to another purchaser. What remedy does
Hemming have?
Murrey manufactured and sold pool tables. He was approached by Madsen, who had an
idea for a kind of electronic pool table that would light up and make sounds like a pinball
machine. Madsen made a $70,000 deposit on an order for one hundred tables but then
encountered difficulties and notified Murrey that he would be unable to accept delivery of
Saylor URL: http://www.saylor.org/books

Saylor.org
714

the tables. Murrey broke the tables up, salvaging materials worth about $15,000 and using
the rest for firewood. The evidence was that the tables, if completed by Murrey, could have
been sold for $45,000 as regular pool tables. Madsen gets his deposit back less expenses
incurred by Murrey. But what principle affects Murrey’s measure of damages, his right to
claim expenses incurred?
In January 1992, Joseph Perna bought an eleven-year-old Oldsmobile at a New York City
police auction sale for $1,800 plus towing fees. It had been impounded by the police for
nonpayment of parking tickets. The bill of sale from the police to Perna contained this
language: “subject to the terms and conditions of any and all chattel mortgages, rental
agreements, liens, conditional bills of sale, and encumbrances that may be on the motor
vehicle of the [its original owner].” About a year later Perna sold the car to a coworker, Elio
Marino, for $1,200. Marino repaired and improved the car by replacing the radiator, a gasket,
and door locks. Ten months after his father bought the car, Marino’s son was stopped by
police and arrested for driving a stolen vehicle; Mario paid $600 to a lawyer to get that
matter resolved, and he never got the car back from the police. Is Perna liable to Marino for
the value of the car? Is Perna liable for the consequential damages—the attorney’s fees? The
relevant UCC sections are 2-312(2) and 2-714.
William Stem bought a used BMW from Gary Braden for $6,600 on Braden’s assertion that
as far as he knew the car had not been wrecked and it was in good condition. Less than a
week later Stem discovered a disconnected plug; when connected the oil-sensor warning
light glowed. Mechanics informed Stem that the car was made up of the front end of a 1979
BMW and the rear end of a 1975 BMW, and the front half had 100,000 more miles on it than
Stem thought. Six weeks after he purchased the car, Stem wrote Braden a letter that he
refused the car and intended to rescind the sale. Braden did not accept return of the car or
refund the money, and Braden continued to drive it for seven months and nearly 9,000 miles
before suing. He had no other car and needed to transport his child. These issues were
before the Alabama Supreme Court, construing UCC, Section 2-608: did Stem’s use of the car,
notwithstanding his letter of rescission, constitute such use of it as to be an acceptance? And
if not, does Stem owe Braden anything for its use?
Saylor URL: http://www.saylor.org/books

Saylor.org
715

Donnelly ordered a leather motorcycle jacket from Leathers Inc. The jacket was specially
designed according to Donnelly’s instructions: it had a unique collar, various chromed studs
throughout, and buckles, and he required an unusually large size. The coat cost $6,000.
Donnelly paid $1,200 as a deposit, but after production was nearly complete, he telephoned
Leathers Inc. and repudiated the contract. What should Leathers do now?

SELF-TEST QUESTIONS

1. In the absence of agreement, the place of delivery is
a.

the buyer’s place of business

b. the seller’s place of business
c. either the buyer’s place of business or the buyer’s residence
d. any of the above
The UCC’s statute of limitations is
a.

two years

b. three years
c. four years
d. none of the above
Under the UCC, if the buyer breaches, the seller can
a.

withhold further delivery

b. resell the goods still in the seller’s possession
c. recover damages
d. do all of the above
If the seller breaches, the buyer can generally
a.

recover the goods, even when the goods have not been identified to the

contract and the seller is not insolvent
b. purchase substitute goods and recover their cost
c. purchase substitute goods and recover the difference between their cost and the
contract price
d. recover punitive damages
Following a seller’s breach, the buyer can recover the price paid

Saylor URL: http://www.saylor.org/books

Saylor.org
716

a.

if the buyer cancels the contract

b. only for goods the buyer has accepted
c. for all the goods the buyer was to have received, whether or not they were
accepted
d. under none of the above conditions

SELF-TEST ANSWERS

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

[1] Uniform Commercial Code, Section 2-725(2).

Chapter 20
Products Liability
LEARNING OBJECTIVES

After reading this chapter, you should understand the following:
1. How products-liability law allocates the costs of a consumer society
2. How warranty theory works in products liability, and what its limitations are
3. How negligence theory works, and what its problems are
4. How strict liability theory works, and what its limitations are
5. What efforts are made to reform products-liability law, and why

20.1 Introduction: Why Products-Liability Law Is
Important
LEARNING OBJECTIVES
Saylor URL: http://www.saylor.org/books

Saylor.org
717

1. Understand why products-liability law underwent a revolution in the twentieth century.
2. Recognize that courts play a vital role in policing the free enterprise system by adjudicating
how the true costs of modern consumer culture are allocated.
3. Know the names of the modern causes of action for products-liability cases.
In previous chapters, we discussed remedies generally. In this chapter, we focus specifically on
remedies available when a defective product causes personal injury or other damages. Products
liability describes a type of claim, not a separate theory of liability. Products liability has strong
emotional overtones—ranging from the prolitigation position of consumer advocates to the
conservative perspective of the manufacturers.

History of Products-Liability Law
The theory of caveat emptor—let the buyer beware—that pretty much governed consumer law
from the early eighteenth century until the early twentieth century made some sense. A horsedrawn buggy is a fairly simple device: its workings are apparent; a person of average experience
in the 1870s would know whether it was constructed well and made of the proper woods. Most
foodstuffs 150 years ago were grown at home and “put up” in the home kitchen or bought in bulk
from a local grocer, subject to inspection and sampling; people made home remedies for coughs
and colds and made many of their own clothes. Houses and furnishings were built of wood,
stone, glass, and plaster—familiar substances. Entertainment was a book or a piano. The state of
technology was such that the things consumed were, for the most part, comprehensible and—
very important—mostly locally made, which meant that the consumer who suffered damages
from a defective product could confront the product’s maker directly. Local reputation is a
powerful influence on behavior.
The free enterprise system confers great benefits, and no one can deny that: materialistically,
compare the image sketched in the previous paragraph with circumstances today. But those
benefits come with a cost, and the fundamental political issue always is who has to pay. Consider
the following famous passage from Upton Sinclair’s great novel The Jungle. It appeared in 1906.
He wrote it to inspire labor reform; to his dismay, the public outrage focused instead on
consumer protection reform. Here is his description of the sausage-making process in a big
Chicago meatpacking plant:
Saylor URL: http://www.saylor.org/books

Saylor.org
718

There was never the least attention paid to what was cut up for sausage; there would
come all the way back from Europe old sausage that had been rejected, and that was
moldy and white—it would be dosed with borax and glycerin, and dumped into the
hoppers, and made over again for home consumption. There would be meat that had
tumbled out on the floor, in the dirt and sawdust, where the workers had tramped
and spit uncounted billions of consumption germs. There would be meat stored in
great piles in rooms; and the water from leaky roofs would drip over it, and
thousands of rats would race about on it. It was too dark in these storage places to
see well, but a man could run his hand over these piles of meat and sweep off handfuls
of the dried dung of rats. These rats were nuisances, and the packers would put
poisoned bread out for them; they would die, and then rats, bread, and meat would
go into the hoppers together. This is no fairy story and no joke; the meat would be
shoveled into carts, and the man who did the shoveling would not trouble to lift out a
rat even when he saw one—there were things that went into the sausage in
comparison with which a poisoned rat was a tidbit. There was no place for the men to
wash their hands before they ate their dinner, and so they made a practice of washing
them in the water that was to be ladled into the sausage. There were the butt-ends of
smoked meat, and the scraps of corned beef, and all the odds and ends of the waste of
the plants, that would be dumped into old barrels in the cellar and left there.
Under the system of rigid economy which the packers enforced, there were some jobs
that it only paid to do once in a long time, and among these was the cleaning out of
the waste barrels. Every spring they did it; and in the barrels would be dirt and rust
and old nails and stale water—and cartload after cartload of it would be taken up
and dumped into the hoppers with fresh meat, and sent out to the public’s breakfast.
Some of it they would make into “smoked” sausage—but as the smoking took time,
and was therefore expensive, they would call upon their chemistry department, and
preserve it with borax and color it with gelatin to make it brown. All of their sausage
came out of the same bowl, but when they came to wrap it they would stamp some of
it “special,” and for this they would charge two cents more a pound. [1]
Saylor URL: http://www.saylor.org/books

Saylor.org
719

It became clear from Sinclair’s exposé that associated with the marvels of then-modern
meatpacking and distribution methods was food poisoning: a true cost became apparent. When
the true cost of some money-making enterprise (e.g., cigarettes) becomes inescapably apparent,
there are two possibilities. First, the legislature can in some way mandate that the manufacturer
itself pay the cost; with the meatpacking plants, that would be the imposition of sanitary foodprocessing standards. Typically, Congress creates an administrative agency and gives the agency
some marching orders, and then the agency crafts regulations dictating as many industry-wide
reform measures as are politically possible. Second, the people who incur damages from the
product (1) suffer and die or (2) access the machinery of the legal system and sue the
manufacturer. If plaintiffs win enough lawsuits, the manufacturer’s insurance company raises
rates, forcing reform (as with high-powered muscle cars in the 1970s); the business goes
bankrupt; or the legislature is pressured to act, either for the consumer or for the manufacturer.
If the industry has enough clout to blunt—by various means—a robust proconsumer legislative
response so that government regulation is too lax to prevent harm, recourse is had through the
legal system. Thus for all the talk about the need for tort reform (discussed later in this chapter),
the courts play a vital role in policing the free enterprise system by adjudicating how the true
costs of modern consumer culture are allocated.
Obviously the situation has improved enormously in a century, but one does not have to look
very far to find terrible problems today. Consider the following, which occurred in 2009–10:
•

In the United States, Toyota recalled 412,000 passenger cars, mostly the Avalon model, for
steering problems that reportedly led to three accidents.

•

Portable baby recliners that are supposed to help fussy babies sleep better were recalled after the
death of an infant: the Consumer Product Safety Commission announced the recall of 30,000
Nap Nanny recliners made by Baby Matters of Berwyn, Pennsylvania.

•

More than 70,000 children and teens go to the emergency room each year for injuries and
complications from medical devices. Contact lenses are the leading culprit, the first detailed
national estimate suggests.

Saylor URL: http://www.saylor.org/books

Saylor.org
720

•

Smith and Noble recalled 1.3 million Roman shades and roller shades after a child was nearly
strangled: the Consumer Product Safety Commission says a five-year-old boy in Tacoma,
Washington, was entangled in the cord of a roller shade in May 2009. [2]

•

The Consumer Product Safety Commission reported that 4,521 people were killed in the United
States in consumer-product-related incidences in 2009, and millions of people visited hospital
emergency rooms from consumer-product-related injuries.[3]

•

Reports about the possibility that cell-phone use causes brain cancer continue to be hotly
debated. Critics suggest that the studies minimizing the risk were paid for by cell-phone
manufacturers. [4]
Products liability can also be a life-or-death matter from the manufacturer’s perspective. In
2009, Bloomberg BusinessWeek reported that the costs of product safety for manufacturing
firms can be enormous: “Peanut Corp., based in Lynchberg, Va., has been driven into
bankruptcy since health officials linked tainted peanuts to more than 600 illnesses and nine
deaths. Mattel said the first of several toy recalls it announced in 2007 cut its quarterly
operating income by $30 million. Earlier this decade, Ford Motor spent roughly $3 billion
replacing 10.6 million potentially defective Firestone tires.” [5] Businesses complain, with good
reason, about the expenses associated with products-liability problems.

Current State of the Law
Although the debate has been heated and at times simplistic, the problem of products liability is
complex and most of us regard it with a high degree of ambivalence. We are all consumers, after
all, who profit greatly from living in an industrial society. In this chapter, we examine the legal
theories that underlie products-liability cases that developed rapidly in the twentieth century to
address the problems of product-caused damages and injuries in an industrial society.
In the typical products-liability case, three legal theories are asserted—a contract theory and two
tort theories. The contract theory is warranty, governed by the UCC, and the two tort theories
are negligence and strict products liability, governed by the common law. See /6059 - mayer_1.0ch20_s01_s02_f01.

Saylor URL: http://www.saylor.org/books

Saylor.org
721

Figure 20.1 Major Products Liability Theories

KEY TAKEAWAY
As products became increasingly sophisticated and potentially dangerous in the twentieth
century, and as the separation between production and consumption widened, products
liability became a very important issue for both consumers and manufacturers. Millions of
people every year are adversely affected by defective products, and manufacturers and
sellers pay huge amounts for products-liability insurance and damages. The law has
responded with causes of action that provide a means for recovery for products-liability
damages.

EXERCISES

1. How does the separation of production from consumption affect products-liability issues?
2. What other changes in production and consumption have caused the need for the
development of products-liability law?
3. How can it be said that courts adjudicate the allocation of the costs of a consumer-oriented
economy?

[1] Upton Sinclair, The Jungle (New York: Signet Classic, 1963), 136.
[2] FindLaw, AP reports.
[3] US Consumer Product Safety Commission, 2009 Report to the President and the Congress, accessed
March 1, 2011, http://www.cpsc.gov/cpscpub/pubs/reports/2009rpt.pdf.
Saylor URL: http://www.saylor.org/books

Saylor.org
722

[4] Matt Hamblen, “New Study Warns of Cell Phone Dangers,” Computerworld US, August 9, 2009,
accessed March 1, 2011, http://news.techworld.com/personal-tech/3200539/new-study-warns-of-cellphone-dangers.
[5] Michael Orey, “Taking on Toy Safety,” BusinessWeek, March 6, 2009, accessed March 1,
2011, http://www.businessweek.com/managing/content/mar2009/ca2009036_271002.htm.

20.2 Warranties

LEARNING OBJECTIVES

1. Recognize a UCC express warranty and how it is created.
2. Understand what is meant under the UCC by implied warranties, and know the main types of
implied warranties: merchantability, fitness for a particular purpose, and title.
3. Know that there are other warranties: against infringement and as may arise from usage of
the trade.
4. See that there are difficulties with warranty theory as a cause of action for products liability;
a federal law has addressed some of these.
The UCC governs express warranties and various implied warranties, and for many years it was
the only statutory control on the use and meanings of warranties. In 1975, after years of debate,
Congress passed and President Gerald Ford signed into law the Magnuson-Moss Act, which
imposes certain requirements on manufacturers and others who warrant their goods. We will
examine both the UCC and the Magnuson-Moss Act.

Types of Warranties
Express Warranties
An express warranty is created whenever the seller affirms that the product will perform in a
certain manner. Formal words such as “warrant” or “guarantee” are not necessary. A seller may
create an express warranty as part of the basis for the bargain of sale by means of (1) an
affirmation of a fact or promise relating to the goods, (2) a description of the goods, or (3) a
sample or model. Any of these will create an express warranty that the goods will conform to the
fact, promise, description, sample, or model. Thus a seller who states that “the use of rustproof
linings in the cans would prevent discoloration and adulteration of the Perform solution” has
Saylor URL: http://www.saylor.org/books

Saylor.org
723

given an express warranty, whether he realized it or not. [1] Claims of breach of express warranty
are, at base, claims of misrepresentation.
But the courts will not hold a manufacturer to every statement that could conceivably be
interpreted to be an express warranty. Manufacturers and sellers constantly “puff” their
products, and the law is content to let them inhabit that gray area without having to make good
on every claim. UCC 2-313(2) says that “an affirmation merely of the value of the goods or a
statement purporting to be merely the seller’s opinion or commendation of the goods does not
create a warranty.” Facts do.
It is not always easy, however, to determine the line between an express warranty and a piece of
puffery. A salesperson who says that a strawberry huller is “great” has probably puffed, not
warranted, when it turns out that strawberries run through the huller look like victims of a
massacre. But consider the classic cases of the defective used car and the faulty bull. In the
former, the salesperson said the car was in “A-1 shape” and “mechanically perfect.” In the latter,
the seller said not only that the bull calf would “put the buyer on the map” but that “his father
was the greatest living dairy bull.” The car, carrying the buyer’s seven-month-old child, broke
down while the buyer was en route to visit her husband in the army during World War II. The
court said that the salesperson had made an express warranty. [2] The bull calf turned out to be
sterile, putting the farmer on the judicial rather than the dairy map. The court said the seller’s
spiel was trade talk, not a warranty that the bull would impregnate cows. [3]
Is there any qualitative difference between these decisions, other than the quarter century that
separates them and the different courts that rendered them? Perhaps the most that can be said
is that the more specific and measurable the statement’s standards, the more likely it is that a
court will hold the seller to a warranty, and that a written statement is easier to construe as a
warranty than an oral one. It is also possible that courts look, if only subliminally, at how
reasonable the buyer was in relying on the statement, although this ought not to be a strict test.
A buyer may be unreasonable in expecting a car to get 100 miles to the gallon, but if that is what
the seller promised, that ought to be an enforceable warranty.
The CISG (Article 35) provides, “The seller must deliver goods which are of the
quantity, quality and description required by the contract and which are contained
Saylor URL: http://www.saylor.org/books

Saylor.org
724

or packaged in the manner required by the contract. [And the] goods must possess
the qualities of goods which the seller has held out to the buyer as a sample or
model.”

Implied Warranties
Express warranties are those over which the parties dickered—or could have. Express warranties
go to the essence of the bargain. An implied warranty, by contrast, is one that circumstances
alone, not specific language, compel reading into the sale. In short, an implied warranty is one
created by law, acting from an impulse of common sense.

Implied Warranty of Merchantability
Section 2-314 of the UCC lays down the fundamental rule that goods carry
animplied warranty of merchantability if sold by a merchant-seller. What is merchantability?
Section 2-314(2) of the UCC says that merchantable goods are those that conform at least to the
following six characteristics:
1. Pass without objection in the trade under the contract description
2. In the case of fungible goods, are of fair average quality within the description
3. Are fit for the ordinary purposes for which such goods are used
4. Run, within the variations permitted by the agreement, of even kind, quality, and quantity
within each unit and among all units involved
5. Are adequately contained, packaged, and labeled as the agreement may require
6. Conform to the promise or affirmations of fact made on the container or label if any
For the purposes of Section 2-314(2)(c) of the UCC, selling and serving food or drink for
consumption on or off the premises is a sale subject to the implied warranty of
merchantability—the food must be “fit for the ordinary purposes” to which it is put. The problem
is common: you bite into a cherry pit in the cherry-vanilla ice cream, or you choke on the clam
shells in the chowder. Is such food fit for the ordinary purposes to which it is put? There are two
schools of thought. One asks whether the food was natural as prepared. This view adopts the
seller’s perspective. The other asks what the consumer’s reasonable expectation was.

Saylor URL: http://www.saylor.org/books

Saylor.org
725

The first test is sometimes said to be the “natural-foreign” test. If the substance in the soup is
natural to the substance—as bones are to fish—then the food is fit for consumption. The second
test, relying on reasonable expectations, tends to be the more commonly used test.
The Convention provides (Article 35) that “unless otherwise agreed, the goods sold
are fit for the purposes for which goods of the same description would ordinarily
be used.”

Fitness for a Particular Purpose
Section 2-315 of the UCC creates another implied warranty. Whenever a seller, at the time she
contracts to make a sale, knows or has reason to know that the buyer is relying on the seller’s
skill or judgment to select a product that is suitable for the particular purpose the buyer has in
mind for the goods to be sold, there is an implied warranty that the goods are fit for that
purpose. For example, you go to a hardware store and tell the salesclerk that you need a paint
that will dry overnight because you are painting your front door and a rainstorm is predicted for
the next day. The clerk gives you a slow-drying oil-based paint that takes two days to dry. The
store has breached animplied warranty of fitness for particular purpose.
Note the distinction between “particular” and “ordinary” purposes. Paint is made to color and
when dry to protect a surface. That is its ordinary purpose, and had you said only that you
wished to buy paint, no implied warranty of fitness would have been breached. It is only because
you had a particular purpose in mind that the implied warranty arose. Suppose you had found a
can of paint in a general store and told the same tale, but the proprietor had said, “I don’t know
enough about that paint to tell you anything beyond what’s on the label; help yourself.” Not
every seller has the requisite degree of skill and knowledge about every product he sells to give
rise to an implied warranty. Ultimately, each case turns on its particular circumstances: “The
Convention provides (Article 35): [The goods must be] fit for any particular
purpose expressly or impliedly made known to the seller at the time of the
conclusion of the contract, except where the circumstances show that the buyer
did not rely, or that it was unreasonable for him to rely, on the seller’s skill and
judgment.”

Other Warranties
Saylor URL: http://www.saylor.org/books

Saylor.org
726

Article 2 contains other warranty provisions, though these are not related specifically to
products liability. Thus, under UCC, Section 2-312, unless explicitly excluded, the seller
warrants he is conveying good title that is rightfully his and that the goods are transferred free of
any security interest or other lien or encumbrance. In some cases (e.g., a police auction of
bicycles picked up around campus and never claimed), the buyer should know that the seller
does not claim title in himself, nor that title will necessarily be good against a third party, and so
subsection (2) excludes warranties in these circumstances. But the circumstances must be so
obvious that no reasonable person would suppose otherwise.
In Menzel v. List, an art gallery sold a painting by Marc Chagall that it purchased in Paris. [4] The
painting had been stolen by the Germans when the original owner was forced to flee Belgium in
the 1930s. Now in the United States, the original owner discovered that a new owner had the
painting and successfully sued for its return. The customer then sued the gallery, claiming that it
had breached the implied warranty of title when it sold the painting. The court agreed and
awarded damages equal to the appreciated value of the painting. A good-faith purchaser who
must surrender stolen goods to their true owner has a claim for breach of the implied warranty
of title against the person from whom he bought the goods.
A second implied warranty, related to title, is that the merchant-seller warrants the goods
are free of any rightful claim by a third person that the seller has infringed his rights (e.g., that
a gallery has not infringed a copyright by selling a reproduction). This provision only applies to a
seller who regularly deals in goods of the kind in question. If you find an old print in your
grandmother’s attic, you do not warrant when you sell it to a neighbor that it is free of any valid
infringement claims.
A third implied warranty in this context involves the course of dealing or usage of trade. Section
2-314(3) of the UCC says that unless modified or excluded implied warranties may arise from a
course of dealing or usage of trade. If a certain way of doing business is understood, it is not
necessary for the seller to state explicitly that he will abide by the custom; it will be implied. A
typical example is the obligation of a dog dealer to provide pedigree papers to prove the dog’s
lineage conforms to the contract.

Problems with Warranty Theory
Saylor URL: http://www.saylor.org/books

Saylor.org
727

In General
It may seem that a person asserting a claim for breach of warranty will have a good chance of
success under an express warranty or implied warranty theory of merchantability or fitness for a
particular purpose. In practice, though, claimants are in many cases denied recovery. Here are
four general problems:
•

The claimant must prove that there was a sale.

•

The sale was of goods rather than real estate or services.

•

The action must be brought within the four-year statute of limitations under Article 2-725, when
the tender of delivery is made, not when the plaintiff discovers the defect.

•

Under UCC, Section 2-607(3)(a) and Section 2A-516(3)(a), which covers leases, the claimant
who fails to give notice of breach within a reasonable time of having accepted the goods will see
the suit dismissed, and few consumers know enough to do so, except when making a complaint
about a purchase of spoiled milk or about paint that wouldn’t dry.
In addition to these general problems, the claimant faces additional difficulties stemming
directly from warranty theory, which we take up later in this chapter.

Exclusion or Modification of Warranties
The UCC permits sellers to exclude or disclaim warranties in whole or in part. That’s reasonable,
given that the discussion here is about contract, and parties are free to make such contracts as
they see fit. But a number of difficulties can arise.

Exclusion of Express Warranties
The simplest way for the seller to exclude express warranties is not to give them. To be sure,
Section 2-316(1) of the UCC forbids courts from giving operation to words in fine print that
negate or limit express warranties if doing so would unreasonably conflict with express
warranties stated in the main body of the contract—as, for example, would a blanket statement
that “this contract excludes all warranties express or implied.” The purpose of the UCC provision
is to prevent customers from being surprised by unbargained-for language.

Exclusion of Implied Warranties in General
Implied warranties can be excluded easily enough also, by describing the product with language
such as “as is” or “with all faults.” Nor is exclusion simply a function of what the seller says. The
Saylor URL: http://www.saylor.org/books

Saylor.org
728

buyer who has either examined or refused to examine the goods before entering into the
contract may not assert an implied warranty concerning defects an inspection would have
revealed.
The Convention provides a similar rule regarding a buyer’s rights when he has
failed to inspect the goods (Article 35): “The seller is not liable…for any lack of
conformity of the goods if at the time of the conclusion of the contract the buyer
knew or could not have been unaware of such lack of conformity.”

Implied Warranty of Merchantability
Section 2-316(2) of the UCC permits the seller to disclaim or modify the implied warranty of
merchantability, as long as the statement actually mentions “merchantability” and, if it is
written, is “conspicuous.” Note that the disclaimer need not be in writing, and—again—all
implied warranties can be excluded as noted.

Implied Warranty of Fitness
Section 2-316(2) of the UCC permits the seller also to disclaim or modify an implied warranty of
fitness. This disclaimer or modification must be in writing, however, and must be conspicuous.
It need not mention fitness explicitly; general language will do. The following sentence, for
example, is sufficient to exclude all implied warranties of fitness: “There are no warranties that
extend beyond the description on the face of this contract.”
Here is a standard disclaimer clause found in a Dow Chemical Company agreement: “Seller
warrants that the goods supplied here shall conform to the description stated on the front side
hereof, that it will convey good title, and that such goods shall be delivered free from any lawful
security interest, lien, or encumbrance. SELLER MAKES NO WARRANTY OF
MERCHANTABILITY OR FITNESS FOR A PARTICULAR USE. NOR IS THERE ANY OTHER
EXPRESS OR IMPLIED WARRANTY.”

Conflict between Express and Implied Warranties
Express and implied warranties and their exclusion or limitation can often conflict. Section 2317 of the UCC provides certain rules for deciding which should prevail. In general, all
warranties are to be construed as consistent with each other and as cumulative. When that
assumption is unreasonable, the parties’ intention governs the interpretation, according to the
Saylor URL: http://www.saylor.org/books

Saylor.org
729

following rules: (a) exact or technical specifications displace an inconsistent sample or model or
general language of description; (b) a sample from an existing bulk displaces inconsistent
general language of description; (c) express warranties displace inconsistent implied warranties
other than an implied warranty of fitness for a particular purpose. Any inconsistency among
warranties must always be resolved in favor of the implied warranty of fitness for a particular
purpose. This doesn’t mean that warranty cannot be limited or excluded altogether. The parties
may do so. But in cases of doubt whether it or some other language applies, the implied
warranty of fitness will have a superior claim.

The Magnuson-Moss Act and Phantom Warranties
After years of debate over extending federal law to regulate warranties, Congress enacted the
Magnuson-Moss Federal Trade Commission Warranty Improvement Act (more commonly
referred to as the Magnuson-Moss Act) and President Ford signed it in 1975. The act was
designed to clear up confusing and misleading warranties, where—as Senator Magnuson put it
in introducing the bill—“purchasers of consumer products discover that their warranty may
cover a 25-cent part but not the $100 labor charge or that there is full coverage on a piano so
long as it is shipped at the purchaser’s expense to the factory.…There is a growing need to
generate consumer understanding by clearly and conspicuously disclosing the terms and
conditions of the warranty and by telling the consumer what to do if his guaranteed product
becomes defective or malfunctions.” The Magnuson-Moss Act only applies to consumer
products (for household and domestic uses); commercial purchasers are presumed to be
knowledgeable enough not to need these protections, to be able to hire lawyers, and to be able to
include the cost of product failures into the prices they charge.
The act has several provisions to meet these consumer concerns; it regulates the content of
warranties and the means of disclosing those contents. The act gives the Federal Trade
Commission (FTC) the authority to promulgate detailed regulations to interpret and enforce it.
Under FTC regulations, any written warranty for a product costing a consumer more than ten
dollars must disclose in a single document and in readily understandable language the following
nine items of information:

Saylor URL: http://www.saylor.org/books

Saylor.org
730

1. The identity of the persons covered by the warranty, whether it is limited to the original
purchaser or fewer than all who might come to own it during the warranty period.
2. A clear description of the products, parts, characteristics, components, or properties covered,
and where necessary for clarity, a description of what is excluded.
3. A statement of what the warrantor will do if the product fails to conform to the warranty,
including items or services the warranty will pay for and, if necessary for clarity, what it will not
pay for.
4. A statement of when the warranty period starts and when it expires.
5. A step-by-step explanation of what the consumer must do to realize on the warranty, including
the names and addresses of those to whom the product must be brought.
6. Instructions on how the consumer can be availed of any informal dispute resolution mechanism
established by the warranty.
7. Any limitations on the duration of implied warranties—since some states do not permit such
limitations, the warranty must contain a statement that any limitations may not apply to the
particular consumer.
8. Any limitations or exclusions on relief, such as consequential damages—as above, the warranty
must explain that some states do not allow such limitations.
9. The following statement: “This warranty gives you specific legal rights, and you may also have
other rights which vary from state to state.”
In addition to these requirements, the act requires that the warranty be labeled either a full or
limited warranty. A full warranty means (1) the defective product or part will be fixed or
replaced for free, including removal and reinstallation; (2) it will be fixed within a reasonable
time; (3) the consumer need not do anything unreasonable (like shipping the piano to the
factory) to get warranty service; (4) the warranty is good for anyone who owns the product
during the period of the warranty; (5) the consumer gets money back or a new product if the
item cannot be fixed within a reasonable number of attempts. But the full warranty may not
cover the whole product: it may cover only the hard drive in the computer, for example; it must
state what parts are included and excluded. A limited warranty is less inclusive. It may cover
only parts, not labor; it may require the consumer to bring the product to the store for service; it
Saylor URL: http://www.saylor.org/books

Saylor.org
731

may impose a handling charge; it may cover only the first purchaser. Both full and limited
warranties may exclude consequential damages.
Disclosure of the warranty provisions prior to sale is required by FTC regulations; this can be
done in a number of ways. The text of the warranty can be attached to the product or placed in
close conjunction to it. It can be maintained in a binder kept in each department or otherwise
easily accessible to the consumer. Either the binders must be in plain sight or signs must be
posted to call the prospective buyer’s attention to them. A notice containing the text of the
warranty can be posted, or the warranty itself can be printed on the product’s package or
container.
Phantom warranties are addressed by the Magnuson-Moss Act. As we have seen, the UCC
permits the seller to disclaim implied warranties. This authority often led sellers to give what
were called phantom warranties—that is, the express warranty contained disclaimers of implied
warranties, thus leaving the consumer with fewer rights than if no express warranty had been
given at all. In the words of the legislative report of the act, “The bold print giveth, and the fine
print taketh away.” The act abolished these phantom warranties by providing that if the seller
gives a written warranty, whether express or implied, he cannot disclaim or modify implied
warranties. However, a seller who gives a limited warranty can limit implied warranties to the
duration of the limited warranty, if the duration is reasonable.
A seller’s ability to disclaim implied warranties is also limited by state law in two ways. First, by
amendment to the UCC or by separate legislation, some states prohibit disclaimers whenever
consumer products are sold. [5] Second, the UCC at 2-302 provides that unconscionable
contracts or clauses will not be enforced. UCC 2-719(3) provides that limitation of damages for
personal injury in the sale of “consumer goods is prima facie unconscionable, but limitation of
damages where the loss is commercial is not.” (Unconscionability was discussed in Chapter 12
"Legality".)
A first problem with warranty theory, then, is that it’s possible to disclaim or limit the warranty.
The worst abuses of manipulative and tricky warranties are eliminated by the Magnuson-Moss
Act, but there are several other reasons that warranty theory is not the panacea for claimants
who have suffered damages or injuries as a result of defective products.
Saylor URL: http://www.saylor.org/books

Saylor.org
732

Privity
A second problem with warranty law (after exclusion and modification of warranties) is that
of privity. Privity is the legal term for the direct connection between the seller and buyer, the two
contracting parties. For decades, the doctrine of privity has held that one person can sue another
only if they are in privity. That worked well in the days when most commerce was local and the
connection between seller and buyer was immediate. But in a modern industrial (or
postindustrial) economy, the product is transported through a much larger distribution system,
as depicted in Figure 20.2 "Chain of Distribution". Two questions arise: (1) Is the manufacturer
or wholesaler (as opposed to the retailer) liable to the buyer under warranty theory? and (2) May
the buyer’s family or friends assert warranty rights?

Figure 20.2 Chain of Distribution

Saylor URL: http://www.saylor.org/books

Saylor.org
733

Horizontal Privity
Suppose Carl Consumer buys a new lamp for his family’s living room. The lamp is defective: Carl
gets a serious electrical shock when he turns it on. Certainly Carl would be covered by the
implied warranty of merchantability: he’s in direct privity with the seller. But what if Carl’s
spouse Carlene is injured? She didn’t buy the lamp; is she covered? Or suppose Carl’s friend
David, visiting for an afternoon, gets zapped. Is David covered? This gets to horizontal privity,
noncontracting parties who suffer damages from defective goods, such as nonbuyer users,
consumers, and bystanders. Horizontal privity determines to whose benefit the warranty
“flows”—who can sue for its breach. In one of its rare instances of nonuniformity, the UCC does
not dictate the result. It gives the states three choices, labeled in Section 2-318 as Alternatives A,
B, and C.
Alternative A says that a seller’s warranty extends “to any natural person who is in the family or
household of his buyer or who is a guest in his home” provided (1) it is reasonable to expect the
person suffering damages to use, consume, or be affected by the goods and (2) the warranty
extends only to damages for personal injury.
Alternative B “extends to any natural person who may reasonably be expected to use, consume,
or be affected by the goods, and who is injured in person by breach of the warranty.” It is less
restrictive than the first alternative: it extends protection to people beyond those in the buyer’s
home. For example, what if Carl took the lamp to a neighbor’s house to illuminate a poker table:
under Alternative B, anybody at the neighbor’s house who suffered injury would be covered by
the warranty. But this alternative does not extend protection to organizations; “natural person”
means a human being.
Alternative C is the same as B except that it applies not only to any “natural person” but “to any
person who is injured by breach of the warranty.” This is the most far-reaching alternative
because it provides redress for damage to property as well as for personalinjury, and it extends
protection to corporations and other institutional buyers.
One may incidentally note that having three different alternatives for when third-party
nonpurchasers can sue a seller or manufacturer for breach of warranty gives rise to unintended
consequences. First, different outcomes are produced among jurisdictions, including variations
Saylor URL: http://www.saylor.org/books

Saylor.org
734

in the common law. Second, the great purpose of the Uniform Commercial Code in promoting
national uniformity is undermined. Third, battles over choice of law—where to file the lawsuit—
are generated.
UCC, Section 2A-216, provides basically the same alternatives as applicable to the leasing of
goods.

Vertical Privity
The traditional rule was that remote selling parties were not liable: lack of privity was a defense
by the manufacturer or wholesaler to a suit by a buyer with whom these entities did not
themselves contract. The buyer could recover damages from the retailer but not from the
original manufacturer, who after all made the product and who might be much more financially
able to honor the warranty. The UCC takes no position here, but over the last fifty years the
judicial trend has been to abolish this vertical privityrequirement. (See Figure 20.2 "Chain of
Distribution"; the entities in the distribution chain are those in vertical privity to the buyer.) It
began in 1958, when the Michigan Supreme Court overturned the old theory in an opinion
written by Justice John D. Voelker (who also wrote the novel Anatomy of a Murder, under the
pen name Robert Traver). [6]

Contributory Negligence, Comparative Negligence, and Assumption of Risk
After disclaimers and privity issues are resolved, other possible impediments facing the plaintiff
in a products-liability warranty case are issues of assumption of the risk, contributory
negligence, and comparative negligence (discussed in Chapter 7 "Introduction to Tort Law" on
torts).
Courts uniformly hold that assumption of risk is a defense for sellers against a claim of breach of
warranty, while there is a split of authority over whether comparative and contributory
negligence are defenses. However, the courts’ use of this terminology is often conflicting and
confusing. The ultimate question is really one of causation: was the seller’s breach of the
warranty the cause of the plaintiff’s damages?
The UCC is not markedly helpful in clearing away the confusion caused by years of discussion of
assumption of risk and contributory negligence. Section 2-715(2)(b) of the UCC says that among
the forms of consequential damage for which recovery can be sought is “injury to person or
Saylor URL: http://www.saylor.org/books

Saylor.org
735

property proximately resulting from any breach of warranty” (emphasis added). But
“proximately” is a troublesome word. Indeed, ultimately it is a circular word: it means nothing
more than that the defendant must have been a direct enough cause of the damages that the
courts will impose liability. Comment 5 to this section says, “Where the injury involved follows
the use of goods without discovery of the defect causing the damage, the question of ‘proximate’
turns on whether it was reasonable for the buyer to use the goods without such inspection as
would have revealed the defects. If it was not reasonable for him to do so, or if he did in fact
discover the defect prior to his use, the injury would not proximately result from the breach of
warranty.”
Obviously if a sky diver buys a parachute and then discovers a few holes in it, his family would
not likely prevail in court when they sued to recover for his death because the parachute failed to
function after he jumped at 5,000 feet. But the general notion that it must have been reasonable
for a buyer to use goods without inspection can make a warranty case difficult to prove.

KEY TAKEAWAY

A first basis of recovery in products-liability theory is breach of warranty. There are two types
of warranties: express and implied. Under the implied category are three major subtypes: the
implied warranty of merchantability (only given by merchants), the implied warranty of
fitness for a particular purpose, and the implied warranty of title. There are a number of
problems with the use of warranty theory: there must have been a sale of the goods; the
plaintiff must bring the action within the statute of limitations; and the plaintiff must notify
the seller within a reasonable time. The seller may—within the constraints of the MagnusonMoss Act—limit or exclude express warranties or limit or exclude implied warranties. Privity,
or lack of it, between buyer and seller has been significantly eroded as a limitation in
warranty theory, but lack of privity may still affect the plaintiff’s recovery; the plaintiff’s
assumption of the risk in using defective goods may preclude recovery.

EXERCISES

1. What are the two main types of warranties and the important subtypes?
2. Who can make each type of warranty?
3. What general problems does a plaintiff have in bringing a products-liability warranty case?

Saylor URL: http://www.saylor.org/books

Saylor.org
736

4. What problems are presented concerning exclusion or manipulative express warranties, and
how does the Magnuson-Moss Act address them?
5. How are implied warranties excluded?
6. What is the problem of lack of privity, and how does modern law deal with it?

[1] Rhodes Pharmacal Co. v. Continental Can Co., 219 N.E.2d 726 (Ill. 1976).
[2] Wat Henry Pontiac Co. v. Bradley, 210 P.2d 348 (Okla. 1949).
[3] Frederickson v. Hackney, 198 N.W. 806 (Minn. 1924).
[4] Menzel v. List, 246 N.E.2d 742 (N.Y. 1969).
[5] A number of states have special laws that limit the use of the UCC implied warranty disclaimer rules
in consumer sales. Some of these appear in amendments to the UCC and others are in separate statutes.
The broadest approach is that of the nine states that prohibit the disclaimer of implied warranties in
consumer sales (Massachusetts, Connecticut, Maine, Vermont, Maryland, the District of Columbia, West
Virginia, Kansas, Mississippi, and, with respect to personal injuries only, Alabama). There is a difference
in these states whether the rules apply to manufacturers as well as retailers.
[6] Spence v. Three Rivers Builders & Masonry Supply, Inc., 90 N.W.2d 873 (Mich. 1958).

20.3 Negligence

LEARNING OBJECTIVES

1. Recognize how the tort theory of negligence may be of use in products-liability suits.
2. Understand why negligence is often not a satisfactory cause of action in such suits: proof of it
may be difficult, and there are powerful defenses to claims of negligence.
Negligence is the second theory raised in the typical products-liability case. It is a tort theory (as
compared to breach of warranty, which is of course a contract theory), and it does have this
advantage over warranty theory: privity is never relevant. A pedestrian is struck in an
intersection by a car whose brakes were defectively manufactured. Under no circumstances
would breach of warranty be a useful cause of action for the pedestrian—there is no privity at all.
Negligence is considered in detail in the Chapter 7 "Introduction to Tort Law" on torts; it
basically means lack of due care.

Typical Negligence Claims: Design Defects and Inadequate Warnings
Saylor URL: http://www.saylor.org/books

Saylor.org
737

Negligence theory in products liability is most useful in two types of cases: defective design and
defective warnings.

Design Defects
Manufacturers can be, and often are, held liable for injuries caused by products that were
defectively designed. The question is whether the designer used reasonable care in designing a
product reasonably safe for its foreseeable use. The concern over reasonableness and standards
of care are elements of negligence theory.
Defective-design cases can pose severe problems for manufacturing and safety engineers. More
safety means more cost. Designs altered to improve safety may impair functionality and make
the product less desirable to consumers. At what point safety comes into reasonable balance
with performance, cost, and desirability (see Figure 20.3 "The Reasonable Design Balance") is
impossible to forecast accurately, though some factors can be taken into account. For example, if
other manufacturers are marketing comparable products whose design are intrinsically safer,
the less-safe products are likely to lose a test of reasonableness in court.

Figure 20.3 The Reasonable Design Balance

Warning Defects
We noted that a product may be defective if the manufacturer failed to warn the user of potential
dangers. Whether a warning should have been affixed is often a question of what is reasonably
foreseeable, and the failure to affix a warning will be treated as negligence. The manufacturer of
a weed killer with poisonous ingredients is certainly acting negligently when it fails to warn the
consumer that the contents are potentially lethal.

Saylor URL: http://www.saylor.org/books

Saylor.org
738

The law governing the necessity to warn and the adequacy of warnings is complex. What is
reasonable turns on the degree to which a product is likely to be misused and, as the
disturbing Laaperi case (Section 20.6.3 "Failure to Warn") illustrates, whether the hazard is
obvious.

Problems with Negligence Theory
Negligence is an ancient cause of action and, as was discussed in the torts chapter, it carries with
it a number of well-developed defenses. Two categories may be mentioned: common-law
defenses and preemption.

Common-Law Defenses against Negligence
Among the problems confronting a plaintiff with a claim of negligence in products-liability suits
(again, these concepts are discussed in the torts chapter) are the following:
•

Proving negligence at all: just because a product is defective does not necessarily prove the
manufacturer breached a duty of care.

•

Proximate cause: even if there was some negligence, the plaintiff must prove her damages
flowed proximately from that negligence.

•

Contributory and comparative negligence: the plaintiff’s own actions contributed to the
damages.

•

Subsequent alteration of the product: generally the manufacturer will not be liable if the product
has been changed.

•

Misuse or abuse of the product: using a lawn mower to trim a hedge or taking too much of a
drug are examples.

•

Assumption of the risk: knowingly using the product in a risky way.

Preemption
Preemption (or “pre-emption”) is illustrated by this problem: suppose there is a federal
standard concerning the product, and the defendant manufacturer meets it, but the standard is
not really very protective. (It is not uncommon, of course, for federal standard makers of all
types to be significantly influenced by lobbyists for the industries being regulated by the
standards.) Is it enough for the manufacturer to point to its satisfaction of the standard so that
such satisfaction preempts (takes over) any common-law negligence claim? “We built the
Saylor URL: http://www.saylor.org/books

Saylor.org
739

machine to federal standards: we can’t be liable. Our compliance with the federal safety
standard is an affirmative defense.”
Preemption is typically raised as a defense in suits about (1) cigarettes, (2) FDA-approved
medical devices, (3) motor-boat propellers, (4) pesticides, and (5) motor vehicles. This is a
complex area of law. Questions inevitably arise as to whether there was federal preemption,
express or implied. Sometimes courts find preemption and the consumer loses; sometimes the
courts don’t find preemption and the case goes forward. According to one lawyer who works in
this field, there has been “increasing pressure on both the regulatory and congressional fronts to
preempt state laws.” That is, the usual defendants (manufacturers) push Congress and the
regulatory agencies to state explicitly in the law that the federal standards preempt and defeat
state law. [1]

KEY TAKEAWAY

Negligence is a second possible cause of action for products-liability claimants. A main
advantage is that no issues of privity are relevant, but there are often problems of proof;
there are a number of robust common-law defenses, and federal preemption is a recurring
concern for plaintiffs’ lawyers.

EXERCISES

1. What two types of products-liability cases are most often brought under negligence?
2. How could it be said that merely because a person suffers injury as the result of a defective
product, proof of negligence is not necessarily made?
3. What is “preemption” and how is it used as a sword to defeat products-liability plaintiffs?

[1] C. Richard Newsome and Andrew F. Knopf, “Federal Preemption: Products Lawyers Beware,” Florida
Justice Association Journal, July 27, 2007, accessed March 1,
2011,http://www.newsomelaw.com/resources/articles/federal-preemption-products-lawyers-beware.

20.4 Strict Liability in Tort

LEARNING OBJECTIVES

1. Know what “strict products liability” means and how it differs from the other two productsliability theories.
Saylor URL: http://www.saylor.org/books

Saylor.org
740

2. Understand the basic requirements to prove strict products liability.
3. See what obstacles to recovery remain with this doctrine.
The warranties grounded in the Uniform Commercial Code (UCC) are often ineffective in
assuring recovery for a plaintiff’s injuries. The notice requirements and the ability of a seller to
disclaim the warranties remain bothersome problems, as does the privity requirement in those
states that continue to adhere to it.
Negligence as a products-liability theory obviates any privity problems, but negligence comes
with a number of familiar defenses and with the problems of preemption.
To overcome the obstacles, judges have gone beyond the commercial statutes and the ancient
concepts of negligence. They have fashioned a tort theory of products liability based on the
principle of strict products liability. One court expressed the rationale for the development
of the concept as follows: “The rule of strict liability for defective products is an example of
necessary paternalism judicially shifting risk of loss by application of tort doctrine because [the
UCC] scheme fails to adequately cover the situation. Judicial paternalism is to loss shifting what
garlic is to a stew—sometimes necessary to give full flavor to statutory law, always distinctly
noticeable in its result, overwhelmingly counterproductive if excessive, and never an end in
itself.” [1]Paternalism or not, strict liability has become a very important legal theory in productsliability cases.

Strict Liability Defined
The formulation of strict liability that most courts use is Section 402A of the Restatement of
Torts (Second), set out here in full:
(1) One who sells any product in a defective condition unreasonably dangerous to the
user or consumer or to his property is subject to liability for physical harm thereby
caused to the ultimate user or consumer, or to his property, if
(a) the seller is engaged in the business of selling such a product, and
(b) it is expected to and does reach the user or consumer without substantial change
in the condition in which it is sold.
(2) This rule applies even though

Saylor URL: http://www.saylor.org/books

Saylor.org
741

(a) the seller has exercised all possible care in the preparation and sale of his product,
and
(b) the user or consumer has not bought the product from or entered into any
contractual relation with the seller.
Section 402A of the Restatement avoids the warranty booby traps. It states a rule of law not
governed by the UCC, so limitations and exclusions in warranties will not apply to a suit based
on the Restatement theory. And the consumer is under no obligation to give notice to the seller
within a reasonable time of any injuries. Privity is not a requirement; the language of the
Restatement says it applies to “the user or consumer,” but courts have readily found that
bystanders in various situations are entitled to bring actions under Restatement, Section 402A.
The formulation of strict liability, though, is limited to physical harm. Many courts have held
that a person who suffers economic loss must resort to warranty law.
Strict liability avoids some negligence traps, too. No proof of negligence is required. SeeFigure
20.4 "Major Difference between Warranty and Strict Liability".

Figure 20.4 Major Difference between Warranty and Strict Liability

Section 402A Elements
Product in a Defective Condition
Sales of goods but not sales of services are covered under the Restatement, Section 402A.
Furthermore, the plaintiff will not prevail if the product was safe for normal handling and
consumption when sold. A glass soda bottle that is properly capped is not in a defective
condition merely because it can be broken if the consumer should happen to drop it, making the
Saylor URL: http://www.saylor.org/books

Saylor.org
742

jagged glass dangerous. Chocolate candy bars are not defective merely because you can become
ill by eating too many of them at once. On the other hand, a seller would be liable for a product
defectively packaged, so that it could explode or deteriorate and change its chemical
composition. A product can also be in a defective condition if there is danger that could come
from an anticipated wrongful use, such as a drug that is safe only when taken in limited doses.
Under those circumstances, failure to place an adequate dosage warning on the container makes
the product defective.
The plaintiff bears the burden of proving that the product is in a defective condition, and this
burden can be difficult to meet. Many products are the result of complex feats of engineering.
Expert witnesses are necessary to prove that the products were defectively manufactured, and
these are not always easy to come by. This difficulty of proof is one reason why many cases raise
the failure to warn as the dispositive issue, since in the right case that issue is far easier to prove.
The Anderson case (detailed in the exercises at the end of this chapter) demonstrates that the
plaintiff cannot prevail under strict liability merely because he was injured. It is not the fact of
injury that is dispositive but the defective condition of the product.

Unreasonably Dangerous
The product must be not merely dangerous but unreasonably dangerous. Most products have
characteristics that make them dangerous in certain circumstances. As the Restatement
commentators note, “Good whiskey is not unreasonably dangerous merely because it will make
some people drunk, and is especially dangerous to alcoholics; but bad whiskey, containing a
dangerous amount of fuel oil, is unreasonably dangerous.…Good butter is not unreasonably
dangerous merely because, if such be the case, it deposits cholesterol in the arteries and leads to
heart attacks; but bad butter, contaminated with poisonous fish oil, is unreasonably
dangerous.” [2] Under Section 402A, “the article sold must be dangerous to an extent beyond that
which would be contemplated by the ordinary consumer who purchases it, with the ordinary
knowledge common to the community as to its characteristics. ”
Even high risks of danger are not necessarily unreasonable. Some products are unavoidably
unsafe; rabies vaccines, for example, can cause dreadful side effects. But the disease itself,
almost always fatal, is worse. A product is unavoidably unsafe when it cannot be made safe for
Saylor URL: http://www.saylor.org/books

Saylor.org
743

its intended purpose given the present state of human knowledge. Because important benefits
may flow from the product’s use, its producer or seller ought not to be held liable for its danger.
However, the failure to warn a potential user of possible hazards can make a product defective
under Restatement, Section 402A, whether unreasonably dangerous or even unavoidably
unsafe. The dairy farmer need not warn those with common allergies to eggs, because it will be
presumed that the person with an allergic reaction to common foodstuffs will be aware of them.
But when the product contains an ingredient that could cause toxic effects in a substantial
number of people and its danger is not widely known (or if known, is not an ingredient that
would commonly be supposed to be in the product), the lack of a warning could make the
product unreasonably dangerous within the meaning of Restatement, Section 402A. Many of the
suits brought by asbestos workers charged exactly this point; “The utility of an insulation
product containing asbestos may outweigh the known or foreseeable risk to the insulation
workers and thus justify its marketing. The product could still be unreasonably dangerous,
however, if unaccompanied by adequate warnings. An insulation worker, no less than any other
product user, has a right to decide whether to expose himself to the risk.” [3] This rule of law
came to haunt the Manville Corporation: it was so burdened with lawsuits, brought and likely to
be brought for its sale of asbestos—a known carcinogen—that it declared Chapter 11 bankruptcy
in 1982 and shucked its liability. [4]

Engaged in the Business of Selling
Restatement, Section 402A(1)(a), limits liability to sellers “engaged in the business of selling
such a product.” The rule is intended to apply to people and entities engaged in business, not to
casual one-time sellers. The business need not be solely in the defective product; a movie theater
that sells popcorn with a razor blade inside is no less liable than a grocery store that does so. But
strict liability under this rule does not attach to a private individual who sells his own
automobile. In this sense, Restatement, Section 402A, is analogous to the UCC’s limitation of
the warranty of merchantability to the merchant.
The requirement that the defendant be in the business of selling gets to the rationale for the
whole concept of strict products liability: businesses should shoulder the cost of injuries because
they are in the best position to spread the risk and distribute the expense among the public. This
Saylor URL: http://www.saylor.org/books

Saylor.org
744

same policy has been the rationale for holding bailors and lessors liable for defective equipment
just as if they had been sellers. [5]

Reaches the User without Change in Condition
Restatement, Section 402A(1)(b), limits strict liability to those defective products that are
expected to and do reach the user or consumer without substantial change in the condition in
which the products are sold. A product that is safe when delivered cannot subject the seller to
liability if it is subsequently mishandled or changed. The seller, however, must anticipate in
appropriate cases that the product will be stored; faulty packaging or sterilization may be the
grounds for liability if the product deteriorates before being used.

Liability Despite Exercise of All Due Care
Strict liability applies under the Restatement rule even though “the seller has exercised all
possible care in the preparation and sale of his product.” This is the crux of “strict liability” and
distinguishes it from the conventional theory of negligence. It does not matter how reasonably
the seller acted or how exemplary is a manufacturer’s quality control system—what matters is
whether the product was defective and the user injured as a result. Suppose an automated bottle
factory manufactures 1,000 bottles per hour under exacting standards, with a rigorous and
costly quality-control program designed to weed out any bottles showing even an infinitesimal
amount of stress. The plant is “state of the art,” and its computerized quality-control operation
is the best in the world. It regularly detects the one out of every 10,000 bottles that analysis has
shown will be defective. Despite this intense effort, it proves impossible to weed out every
defective bottle; one out of one million, say, will still escape detection. Assume that a bottle,
filled with soda, finds its way into a consumer’s home, explodes when handled, sends glass
shards into his eye, and blinds him. Under negligence, the bottler has no liability; under strict
liability, the bottler will be liable to the consumer.

Liability without Contractual Relation
Under Restatement, Section 402A(2)(b), strict liability applies even though the user has not
purchased the product from the seller nor has the user entered into any contractual relation with
the seller. In short, privity is abolished and the injured user may use the theory of strict liability
against manufacturers and wholesalers as well as retailers. Here, however, the courts have
Saylor URL: http://www.saylor.org/books

Saylor.org
745

varied in their approaches; the trend has been to allow bystanders recovery. The Restatement
explicitly leaves open the question of the bystander’s right to recover under strict liability.

Problems with Strict Liability
Strict liability is liability without proof of negligence and without privity. It would seem that
strict liability is the “holy grail” of products-liability lawyers: the complete answer. Well, no, it’s
not the holy grail. It is certainly true that 402A abolishes the contractual problems of warranty.
Restatement, Section 402A, Comment m, says,
The rule stated in this Section is not governed by the provisions of the Uniform
Commercial Code, as to warranties; and it is not affected by limitations on the scope
and content of warranties, or by limitation to “buyer” and “seller” in those statutes.
Nor is the consumer required to give notice to the seller of his injury within a
reasonable time after it occurs, as provided by the Uniform Act. The consumer’s cause
of action does not depend upon the validity of his contract with the person from
whom he acquires the product, and it is not affected by any disclaimer or other
agreement, whether it be between the seller and his immediate buyer, or attached to
and accompanying the product into the consumer’s hands. In short, “warranty” must
be given a new and different meaning if it is used in connection with this Section. It is
much simpler to regard the liability here stated as merely one of strict liability in tort.
Inherent in the Restatement’s language is the obvious point that if the product has been altered,
losses caused by injury are not the manufacturer’s liability. Beyond that there are still some
limitations to strict liability.

Disclaimers
Comment m specifically says the cause of action under Restatement, Section 402A, is not
affected by disclaimer. But in nonconsumer cases, courts have allowed clear and specific
disclaimers. In 1969, the Ninth Circuit observed: “In Kaiser Steel Corp. the [California Supreme
Court] court upheld the dismissal of a strict liability action when the parties, dealing from
positions of relatively equal economic strength, contracted in a commercial setting to limit the
defendant’s liability. The court went on to hold that in this situation the strict liability cause of
action does not apply at all. In reaching this conclusion, the court in Kaiser reasoned that strict
Saylor URL: http://www.saylor.org/books

Saylor.org
746

liability ‘is designed to encompass situations in which the principles of sales warranties serve
their purpose “fitfully at best.”’ [Citation]” It concluded that in such commercial settings the
UCC principles work well and “to apply the tort doctrines of products liability will displace the
statutory law rather than bring out its full flavor.” [6]

Plaintiff’s Conduct
Conduct by the plaintiff herself may defeat recovery in two circumstances.

Assumption of Risk
Courts have allowed the defense of assumption of the risk in strict products-liability cases. A
plaintiff assumes the risk of injury, thus establishing defense to claim of strict products liability,
when he is aware the product is defective, knows the defect makes the product unreasonably
dangerous, has reasonable opportunity to elect whether to expose himself to the danger, and
nevertheless proceeds to make use of the product. The rule makes sense.

Misuse or Abuse of the Product
Where the plaintiff does not know a use of the product is dangerous but nevertheless uses for an
incorrect purpose, a defense arises, but only if such misuse was not foreseeable. If it was, the
manufacturer should warn against that misuse. In Eastman v. Stanley Works, a carpenter used
a framing hammer to drive masonry nails; the claw of the hammer broke off, striking him in the
eye. [7] He sued. The court held that while a defense does exist “where the product is used in a
capacity which is unforeseeable by the manufacturer and completely incompatible with the
product’s design…misuse of a product suggests a use which was unanticipated or unexpected by
the product manufacturer, or unforeseeable and unanticipated [but] it was not the case that
reasonable minds could only conclude that appellee misused the [hammer]. Though the
plaintiff’s use of the hammer might have been unreasonable, unreasonable use is not a defense
to a strict product-liability action or to a negligence action.”

Limited Remedy
The Restatement says recovery under strict liability is limited to “physical harm thereby caused
to the ultimate user or consumer, or to his property,” but not other losses and not economic
losses. In Atlas Air v. General Electric, a New York court held that the “economic loss rule” (no
recovery for economic losses) barred strict products-liability and negligence claims by the
Saylor URL: http://www.saylor.org/books

Saylor.org
747

purchaser of a used airplane against the airplane engine manufacturer for damage to the plane
caused by an emergency landing necessitated by engine failure, where the purchaser merely
alleged economic losses with respect to the plane itself, and not damages for personal injury
(recovery for damage to the engine was allowed). [8]
But there are exceptions. In Duffin v. Idaho Crop Imp. Ass’n, the court recognized that a party
generally owes no duty to exercise due care to avoid purely economic loss, but if there is a
“special relationship” between the parties such that it would be equitable to impose such a duty,
the duty will be imposed. [9] “In other words, there is an extremely limited group of cases where
the law of negligence extends its protections to a party’s economic interest.”

The Third Restatement
The law develops. What seemed fitting in 1964 when the Restatement (Second) announced the
state of the common-law rules for strict liability in Section 402A seemed, by 1997, not to be
tracking common law entirely closely. The American Law Institute came out with the
Restatement (Third) in that year. The Restatement changes some things. Most notably it
abolishes the “unreasonably dangerous” test and substitutes a “risk-utility test.” That is, a
product is not defective unless its riskiness outweighs its utility. More important, the
Restatement (Third), Section 2, now requires the plaintiff to provide a reasonable alternative
design to the product in question. In advancing a reasonable alternative design, the plaintiff is
not required to offer a prototype product. The plaintiff must only show that the proposed
alternative design exists and is superior to the product in question. The Restatement (Third)
also makes it more difficult for plaintiffs to sue drug companies successfully. One legal scholar
commented as follows on the Restatement (Third):
The provisions of the Third Restatement, if implemented by the courts, will establish a
degree of fairness in the products liability arena. If courts adopt the Third
Restatement’s elimination of the “consumer expectations test,” this change alone will
strip juries of the ability to render decisions based on potentially subjective,
capricious and unscientific opinions that a particular product design is unduly
dangerous based on its performance in a single incident. More important, plaintiffs
will be required to propose a reasonable alternative design to the product in question.
Saylor URL: http://www.saylor.org/books

Saylor.org
748

Such a requirement will force plaintiffs to prove that a better product design exists
other than in the unproven and untested domain of their experts’ imaginations. [10]
Of course some people put more faith in juries than is evident here. The new Restatement has
been adopted by a few jurisdictions and some cases the adopting jurisdictions incorporate some
of its ideas, but courts appear reluctant to abandon familiar precedent.

KEY TAKEAWAY

Because the doctrines of breach of warranty and negligence did not provide adequate relief
to those suffering damages or injuries in products-liability cases, beginning in the 1960s
courts developed a new tort theory: strict products liability, restated in the Second
Restatement, section 402A. Basically the doctrine says that if goods sold are unreasonably
dangerous or defective, the merchant-seller will be liable for the immediate property loss
and personal injuries caused thereby. But there remain obstacles to recovery even under this
expanded concept of liability: disclaimers of liability have not completely been dismissed, the
plaintiff’s conduct or changes to the goods may limit recovery, and—with some exceptions—
the remedies available are limited to personal injury (and damage to the goods themselves);
economic loss is not recoverable. Almost forty years of experience with the Second
Restatement’s section on strict liability has seen changes in the law, and the Third
Restatement introduces those, but it has not been widely accepted yet.

EXERCISES

1. What was perceived to be inadequate about warranty and negligence theories that
necessitated the development of strict liability?
2. Briefly describe the doctrine.
3. What defects in goods render their sellers strictly liable?
4. Who counts as a liable seller?
5. What obstacles does a plaintiff have to overcome here, and what limitations are there to
recovery?

[1] Kaiser Steel Corp. v. Westinghouse Electric Corp., 127 Cal. Rptr. 838 (Cal. 1976).
[2] Restatement (Second) of Contracts, Section 402A(i).

Saylor URL: http://www.saylor.org/books

Saylor.org
749

[3] Borel v. Fibreboard Paper Products Corp., 493 F.Zd 1076 (5th Cir. 1973).
[4] In re Johns-Manville Corp., 36 R.R. 727 (So. Dist. N.Y. 1984).
[5] Martin v. Ryder Rental, Inc., 353 A.2d 581 (Del. 1976).
[6] Idaho Power Co. v. Westinghouse Electric Corp., 596 F.2d 924, 9CA (1979).
[7] Eastman v. Stanley Works, 907 N.E.2d 768 (Ohio App. 2009).
[8] Atlas Air v. General Electric, 16 A.D.3d 444 (N.Y.A.D. 2005).
[9] Duffin v. Idaho Crop Imp. Ass’n, 895 P.2d 1195 (Idaho 1995).
[10] Quinlivan Wexler LLP, “The 3rd Restatement of Torts—Shaping the Future of Products Liability
Law,” June 1, 1999, accessed March 1, 2011,http://library.findlaw.com/1999/Jun/1/127691.html.

20.5 Tort Reform

LEARNING OBJECTIVES

1. See why tort reform is advocated, why it is opposed, and what interests take each side.
2. Understand some of the significant state reforms in the last two decades.
3. Know what federal reforms have been instituted.

The Cry for Reform
In 1988, The Conference Board published a study that resulted from a survey of more than 500
chief executive officers from large and small companies regarding the effects of products liability
on their firms. The study concluded that US companies are less competitive in international
business because of these effects and that products-liability laws must be reformed. The reform
effort has been under way ever since, with varying degrees of alarms and finger-pointing as to
who is to blame for the “tort crisis,” if there even is one. Business and professional groups beat
the drums for tort reform as a means to guarantee “fairness” in the courts as well as spur US
economic competitiveness in a global marketplace, while plaintiffs’ attorneys and consumer
advocates claim that businesses simply want to externalize costs by denying recovery to victims
of greed and carelessness.
Each side vilifies the other in very unseemly language: probusiness advocates call consumeroriented states “judicial hell-holes” and complain of “well-orchestrated campaign[s] by tort
lawyer lobbyists and allies to undo years of tort reform at the state level,” [1] while pro-plaintiff
Saylor URL: http://www.saylor.org/books

Saylor.org
750

interests claim that there is “scant evidence” of any tort abuse. [2] It would be more amusing if it
were not so shrill and partisan. Perhaps the most one can say with any certainty is that peoples’
perception of reality is highly colored by their self-interest. In any event, there have been
reforms (or, as the detractors say, “deforms”).

State Reforms
Prodded by astute lobbying by manufacturing and other business trade associations, state
legislatures responded to the cries of manufacturers about the hardships that the judicial
transformation of the products-liability lawsuit ostensibly worked on them. Most state
legislatures have enacted at least one of some three dozen “reform” proposal pressed on them
over the last two decades. Some of these measures do little more than affirm and clarify case
law. Among the most that have passed in several states are outlined in the next sections.

Statutes of Repose
Perhaps nothing so frightens the manufacturer as the occasional reports of cases involving
products that were fifty or sixty years old or more at the time they injured the plaintiff. Many
states have addressed this problem by enacting the so-calledstatute of repose. This statute
establishes a time period, generally ranging from six to twelve years; the manufacturer is not
liable for injuries caused by the product after this time has passed.

State-of-the-Art Defense
Several states have enacted laws that prevent advances in technology from being held against
the manufacturer. The fear is that a plaintiff will convince a jury a product was defective because
it did not use technology that was later available. Manufacturers have often failed to adopt new
advances in technology for fear that the change will be held against them in a products-liability
suit. These new statutes declare that a manufacturer has a valid defense if it would have been
technologically impossible to have used the new and safer technology at the time the product
was manufactured.

Failure to Warn
Since it is often easier to prove that an injury resulted because the manufacturer failed to warn
against a certain use than it is to prove an injury was caused by a defective design,
manufacturers are subjected to a considerable degree of hindsight. Some of the state statutes
Saylor URL: http://www.saylor.org/books

Saylor.org
751

limit the degree to which the failure to warn can be used to connect the product and the injury.
For example, the manufacturer has a valid defense if it would have been impossible to foresee
that the consumer might misuse the product in a certain way.

Comparative Fault for Consumer Misuse
Contributory negligence is generally not a defense in a strict liability action, while assumption of
risk is. In states that have enacted so-called comparative fault statutes, the user’s damages are
pegged to the percentage of responsibility for the injury that the defendant bears. Thus if the
consumer’s misuse of the product is assessed as having been 20 percent responsible for the
accident (or for the extent of the injuries), the consumer is entitled to only 80 percent of
damages, the amount for which the defendant manufacturer is responsible.

Criminal Penalties
Not all state reform is favorable to manufacturers. Under the California Corporate Criminal
Liability Act, which took effect twenty years ago, companies and managers must notify a state
regulatory agency if they know that a product they are selling in California has a safety defect,
and the same rule applies under certain federal standards, as Toyota executives were informed
by their lawyers following alarms about sudden acceleration in some Toyota automobiles.
Failure to provide notice may result in corporate and individual criminal liability.

Federal Reform
Piecemeal reform of products-liability law in each state has contributed to the basic lack of
uniformity from state to state, giving it a crazy-quilt effect. In the nineteenth century, this might
have made little difference, but today most manufacturers sell in the national market and are
subjected to the varying requirements of the law in every state. For years there has been talk in
and out of Congress of enacting a federal products-liability law that would include reforms
adopted in many states, as discussed earlier. So far, these efforts have been without much
success.
Congressional tort legislation is not the only possible federal action to cope with productsrelated injuries. In 1972, Congress created the Consumer Product Safety Commission (CPSC)
and gave the commission broad power to act to prevent unsafe consumer products. The CPSC
can issue mandatory safety standards governing design, construction, contents, performance,
Saylor URL: http://www.saylor.org/books

Saylor.org
752

packaging, and labeling of more than 10,000 consumer products. It can recall unsafe products,
recover costs on behalf of injured consumers, prosecute those who violate standards, and
require manufacturers to issue warnings on hazardous products. It also regulates four federal
laws previously administered by other departments: the Flammable Fabrics Act, the Hazardous
Substances Act, the Poison Prevention Packaging Act, and the Refrigerator Safety Act. In its
early years, the CPSC issued standards for bicycles, power mowers, television sets, architectural
glass, extension cords, book matches, pool slides, and space heaters. But the list of products is
long, and the CPSC’s record is mixed: it has come under fire for being short on regulation and
for taking too long to promulgate the relatively few safety standards it has issued in a decade.

KEY TAKEAWAY

Business advocates claim the American tort system—products-liability law included—is
broken and corrupted by grasping plaintiffs’ lawyers; plaintiffs’ lawyers say businesses are
greedy and careless and need to be smacked into recognition of its responsibilities to be
more careful. The debate rages on, decade after decade. But there have been some reforms
at the state level, and at the federal level the Consumer Product Safety Act sets out
standards for safe products and requires recalls for defective ones. It is regularly castigated
for (1) being officious and meddling or (2) being too timid.

EXERCISES

1. Why is it so difficult to determine if there really is a “tort crisis” in the United States?
2. What reforms have been made to state tort law?
3. What federal legislation affects consumer safety?

[1] American Tort Reform Association website, accessed March 1, 2011, http://www.atra.org.
[2] http://www.shragerlaw.com/html/legal_rights.html.

20.6 Cases
Implied Warranty of Merchantability and the Requirement of a “Sale”
Sheeskin v. Giant Food, Inc.
318 A.2d 874 (Md. App. 1974)
Saylor URL: http://www.saylor.org/books

Saylor.org
753

Davidson, J.
Every Friday for over two years Nathan Seigel, age 73, shopped with his wife at a Giant Food
Store. This complex products liability case is before us because on one of these Fridays, 23
October 1970, Mr. Seigel was carrying a six-pack carton of Coca-Cola from a display bin at the
Giant to a shopping cart when one or more of the bottles exploded. Mr. Seigel lost his footing,
fell to the floor and was injured.
In the Circuit Court for Montgomery County, Mr. Seigel sued both the Giant Food, Inc., and the
Washington Coca-Cola Bottling Company, Inc., for damages resulting from their alleged
negligence and breach of an implied warranty. At the conclusion of the trial Judge Walter H.
Moorman directed a verdict in favor of each defendant.…
In an action based on breach of warranty it is necessary for the plaintiff to show the existence of
the warranty, the fact that the warranty was broken and that the breach of warranty was the
proximate cause of the loss sustained. [UCC] 2-314.…The retailer, Giant Food, Inc., contends
that appellant failed to prove that an implied warranty existed between himself and the retailer
because he failed to prove that there was a sale by the retailer to him or a contract of sale
between the two. The retailer maintains that there was no sale or contract of sale because at the
time the bottles exploded Mr. Seigel had not yet paid for them. We do not agree.
[UCC] 2-314(1) states in pertinent part:
Unless excluded or modified, a warranty that the goods shall be merchantable is
implied in a contract for their sale if the seller is a merchant with respect to goods
of that kind. [1] (emphasis added)
Thus, in order for the implied warranties of 2-314 to be applicable there must be a “contract for
sale.” In Maryland it has been recognized that neither a completed ‘sale’ nor a fully executed
contract for sale is required. It is enough that there be in existence an executory contract for
sale.…
Here, the plaintiff has the burden of showing the existence of the warranty by establishing that
at the time the bottles exploded there was a contract for their sale existing between himself and
the Giant. [Citation] Mr. Titus, the manager of the Giant, testified that the retailer is a “selfservice” store in which “the only way a customer can buy anything is to select it himself and take
Saylor URL: http://www.saylor.org/books

Saylor.org
754

it to the checkout counter.” He stated that there are occasions when a customer may select an
item in the store and then change his mind and put the item back. There was no evidence to
show that the retailer ever refused to sell an item to a customer once it had been selected by him
or that the retailer did not consider himself bound to sell an item to the customer after the item
had been selected. Finally, Mr. Titus said that an employee of Giant placed the six-pack of CocaCola selected by Mr. Seigel on the shelf with the purchase price already stamped upon it. Mr.
Seigel testified that he picked up the six-pack with the intent to purchase it.
We think that there is sufficient evidence to show that the retailer’s act of placing the bottles
upon the shelf with the price stamped upon the six-pack in which they were contained
manifested an intent to offer them for sale, the terms of the offer being that it would pass title to
the goods when Mr. Seigel presented them at the check-out counter and paid the stated price in
cash. We also think that the evidence is sufficient to show that Mr. Seigel’s act of taking physical
possession of the goods with the intent to purchase them manifested an intent to accept the offer
and a promise to take them to the checkout counter and pay for them there.
[UCC] 2-206 provides in pertinent part:
(1) Unless otherwise unambiguously indicated by the language or circumstances
(a) An offer to make a contract shall be construed as inviting acceptance in any
manner and by any medium reasonable in the circumstances.…
The Official Comment 1 to this section states:
Any reasonable manner of acceptance is intended to be regarded as available unless
the offeror has made quite clear that it will not be acceptable.
In our view the manner by which acceptance was to be accomplished in the transaction herein
involved was not indicated by either language or circumstances. The seller did not make it clear
that acceptance could not be accomplished by a promise rather than an act. Thus it is equally
reasonable under the terms of this specific offer that acceptance could be accomplished in any of
three ways: 1) by the act of delivering the goods to the check-out counter and paying for them; 2)
by the promise to pay for the goods as evidenced by their physical delivery to the check-out
counter; and 3) by the promise to deliver the goods to the check-out counter and to pay for them
there as evidenced by taking physical possession of the goods by their removal from the shelf.
Saylor URL: http://www.saylor.org/books

Saylor.org
755

The fact that customers, having once selected goods with the intent to purchase them, are
permitted by the seller to return them to the shelves does not preclude the possibility that a
selection of the goods, as evidenced by taking physical possession of them, could constitute a
reasonable mode of acceptance. Section 2-106(3) provides:
“Termination” occurs when either party pursuant to a power created by agreement
or law puts an end to the contract otherwise then for its breach. On “termination” all
obligations which are still executory on both sides are discharged but any right based
on prior breach or performance survives.
Here the evidence that the retailer permits the customer to “change his mind” indicates only an
agreement between the parties to permit the consumer to end his contract with the retailer
irrespective of a breach of the agreement by the retailer. It does not indicate that an agreement
does not exist prior to the exercise of this option by the consumer.…
Here Mr. Seigel testified that all of the circumstances surrounding his selection of the bottles
were normal; that the carton in which the bottles came was not defective; that in lifting the
carton from the shelf and moving it toward his basket the bottles neither touched nor were
touched by anything other than his hand; that they exploded almost instantaneously after he
removed them from the shelf; and that as a result of the explosion he fell injuring himself. It is
obvious that Coca-Cola bottles which would break under normal handling are not fit for the
ordinary use for which they were intended and that the relinquishment of physical control of
such a defective bottle to a consumer constitutes a breach of warranty. Thus the evidence was
sufficient to show that when the bottles left the retailer’s control they did not conform to the
representations of the warranty of merchantability, and that this breach of the warranty was the
cause of the loss sustained.…
[Judgment in favor of Giant Foods is reversed and the case remanded for a new trial. Judgment
in favor of the bottler is affirmed because the plaintiff failed to prove that the bottles were
defective when they were delivered to the retailer.]

CASE QUESTIONS

1. What warranty did the plaintiff complain was breached here?

Saylor URL: http://www.saylor.org/books

Saylor.org
756

2. By displaying the soda pop, the store made an offer to its customers. How did the court say
such offers might be accepted?
3. Why did the court get into the discussion about “termination” of the contract?
4. What is the controlling rule of law applied in this case?

Strict Liability and Bystanders
Embs v. Pepsi-Cola Bottling Co. of Lexington, Kentucky, Inc.
528 S.W.2d 703 (Ky. 1975)
Jukowsky, J.
On the afternoon of July 25, 1970 plaintiff-appellant entered the self-service retail store
operated by the defendant-appellee, Stamper’s Cash Market, Inc., for the purpose of “buying soft
drinks for the kids.” She went to an upright soft drink cooler, removed five bottles and placed
them in a carton. Unnoticed by her, a carton of Seven-Up was sitting on the floor at the edge of
the produce counter about one foot from where she was standing. As she turned away from the
cooler she heard an explosion that sounded “like a shotgun.” When she looked down she saw a
gash in her leg, pop on her leg, green pieces of a bottle on the floor and the Seven-Up carton in
the midst of the debris. She did not kick or otherwise come into contact with the carton of
Seven-Up prior to the explosion. Her son, who was with her, recognized the green pieces of glass
as part of a Seven-Up bottle.
She was immediately taken to the hospital by Mrs. Stamper, a managing agent of the store. Mrs.
Stamper told her that a Seven-Up bottle had exploded and that several bottles had exploded that
week. Before leaving the store Mrs. Stamper instructed one of her children to clean up the mess.
Apparently, all of the physical evidence went out with the trash. The location of the Seven-Up
carton immediately before the explosion was not a place where such items were ordinarily
kept.…
When she rested her case, the defendants-appellees moved for a directed verdict in their favor.
The trial court granted the motion on the grounds that the doctrine of strict product liability in
tort does not extend beyond users and consumers and that the evidence was insufficient to
permit an inference by a reasonably prudent man that the bottle was defective or if it was, when
it became so.
Saylor URL: http://www.saylor.org/books

Saylor.org
757

In [Citation] we adopted the view of strict product liability in tort expressed in Section 402 A of
the American Law Institute’s Restatement of Torts 2d.

402 A. Special Liability of Seller of Product for Physical Harm to
User or Consumer
(1) One who sells any product in a defective condition unreasonably dangerous to the
user or to his property is subject to liability for physical harm thereby caused to the
ultimate user or consumer, or to his property, if
(a) the seller is engaged in the business of selling such a product, and
(b) it is expected to and does reach the user or consumer without substantial change
in the condition in which it was sold.
(2) The rule stated in Subsection (1) applies although
(a) the seller has exercised all possible care in the preparation and sale of his product,
and
(b) the user or consumer has not bought the product from or entered into any
contractual relation with the seller.

Comment f on that section makes it abundantly clear that this rule applies to any person
engaged in the business of supplying products for use or consumption, including any
manufacturer of such a product and any wholesale or retail dealer or distributor.
Comment c points out that on whatever theory, the justification for the rule has been said to be
that the seller, by marketing his product for use and consumption, has undertaken and assumed
a special responsibility toward any member of the consuming public who may be injured by it;
that the public has the right to and does expect that reputable sellers will stand behind their
goods; that public policy demands that the burden of accidental injuries caused by products
intended for consumption be placed upon those who market them, and be treated as a cost of
production against which liability insurance can be obtained; and that the consumer of such
products is entitled to the maximum of protection at the hands of someone, and the proper
persons to afford it are those who market the products.
The caveat to the section provides that the Institute expresses no opinion as to whether the rule
may not apply to harm to persons other than users or consumers. Comment on caveat o states
Saylor URL: http://www.saylor.org/books

Saylor.org
758

the Institute expresses neither approval nor disapproval of expansion of the rule to permit
recovery by casual bystanders and others who may come in contact with the product, and admits
there may be no essential reason why such plaintiffs should not be brought within the scope of
protection afforded, other than they do not have the same reasons for expecting such protection
as the consumer who buys a marketed product, and that the social pressure which has been
largely responsible for the development of the rule has been a consumer’s pressure, and there is
not the same demand for the protection of casual strangers.…
The caveat articulates the essential point: Once strict liability is accepted, bystander recovery is
fait accompli.
Our expressed public policy will be furthered if we minimize the risk of personal injury and
property damage by charging the costs of injuries against the manufacturer who can procure
liability insurance and distribute its expense among the public as a cost of doing business; and
since the risk of harm from defective products exists for mere bystanders and passersby as well
as for the purchaser or user, there is no substantial reason for protecting one class of persons
and not the other. The same policy requires us to maximize protection for the injured third party
and promote the public interest in discouraging the marketing of products having defects that
are a menace to the public by imposing strict liability upon retailers and wholesalers in the
distributive chain responsible for marketing the defective product which injures the bystander.
The imposition of strict liability places no unreasonable burden upon sellers because they can
adjust the cost of insurance protection among themselves in the course of their continuing
business relationship.
We must not shirk from extending the rule to the manufacturer for fear that the retailer or
middleman will be impaled on the sword of liability without regard to fault. Their liability was
already established under Section 402 A of the Restatement of Torts 2d. As a matter of public
policy the retailer or middleman as well as the manufacturer should be liable since the loss for
injuries resulting from defective products should be placed on those members of the marketing
chain best able to pay the loss, who can then distribute such risk among themselves by means of
insurance and indemnity agreements. [Citation]…

Saylor URL: http://www.saylor.org/books

Saylor.org
759

The result which we reach does not give the bystander a “free ride.” When products and
consumers are considered in the aggregate, bystanders, as a class, purchase most of the same
products to which they are exposed as bystanders. Thus, as a class, they indirectly subsidize the
liability of the manufacturer, middleman and retailer and in this sense do pay for the insurance
policy tied to the product.…
For the sake of clarity we restate the extension of the rule. The protections of Section 402 A of
the Restatement of Torts 2d extend to bystanders whose injury from the defective product is
reasonably foreseeable.…
The judgment is reversed and the cause is remanded to the Clark Circuit Court for further
proceedings consistent herewith.
Stephenson, J. (dissenting):
I respectfully dissent from the majority opinion to the extent that it subjects the seller to
liability. Every rule of law in my mind should have a rational basis. I see none here.
Liability of the seller to the user, or consumer, is based upon warranty. Restatement, Second,
Torts s 403A. To extend this liability to injuries suffered by a bystander is to depart from any
reasonable basis and impose liability by judicial fiat upon an otherwise innocent defendant. I do
not believe that the expression in the majority opinion which justifies this rule for the reason
that the seller may procure liability insurance protection is a valid legal basis for imposing
liability without fault. I respectfully dissent.

CASE QUESTIONS

1. Why didn’t the plaintiff here use warranty as a theory of recovery, as Mr. Seigel did in the
previous case?
2. The court offers a rationale for the doctrine of strict products liability. What is it?
3. Restatement, Section 402A, by its terms extends protection “to the ultimate user or
consumer,” but Mrs. Embs [plaintiff-appellant] was not that. What rationale did the court
give for expanding the protection here?
4. Among the entities in the vertical distribution chain—manufacturer, wholesaler, retailer—
who is liable under this doctrine?
5. What argument did Judge Stephenson have in dissent? Is it a good one?

Saylor URL: http://www.saylor.org/books

Saylor.org
760

6. What is the controlling rule of law developed in this case?

Failure to Warn
Laaperi v. Sears, Roebuck & Co., Inc.
787 F.2d 726 C.A.1 (Mass. 1986)
Campbell, J.
In March 1976, plaintiff Albin Laaperi purchased a smoke detector from Sears. The detector,
manufactured by the Pittway Corporation, was designed to be powered by AC (electrical)
current. Laaperi installed the detector himself in one of the two upstairs bedrooms in his home.
Early in the morning of December 27, 1976, a fire broke out in the Laaperi home. The three boys
in one of the upstairs bedrooms were killed in the blaze. Laaperi’s 13-year-old daughter Janet,
who was sleeping in the other upstairs bedroom, received burns over 12 percent of her body and
was hospitalized for three weeks.
The uncontroverted testimony at trial was that the smoke detector did not sound an alarm on
the night of the fire. The cause of the fire was later found to be a short circuit in an electrical
cord that was located in a cedar closet in the boys’ bedroom. The Laaperi home had two separate
electrical circuits in the upstairs bedrooms: one which provided electricity to the outlets and one
which powered the lighting fixtures. The smoke detector had been connected to the outlet
circuit, which was the circuit that shorted and cut off. Because the circuit was shorted, the ACoperated smoke detector received no power on the night of the fire. Therefore, although the
detector itself was in no sense defective (indeed, after the fire the charred detector was tested
and found to be operable), no alarm sounded.
Laaperi brought this diversity action against defendants Sears and Pittway, asserting negligent
design, negligent manufacture, breach of warranty, and negligent failure to warn of inherent
dangers. The parties agreed that the applicable law is that of Massachusetts. Before the claims
went to the jury, verdicts were directed in favor of defendants on all theories of liability other
than failure to warn.…
Laaperi’s claim under the failure to warn theory was that he was unaware of the danger that the
very short circuit which might ignite a fire in his home could, at the same time, incapacitate the
smoke detector. He contended that had he been warned of this danger, he would have purchased
Saylor URL: http://www.saylor.org/books

Saylor.org
761

a battery-powered smoke detector as a back-up or taken some other precaution, such as wiring
the detector to a circuit of its own, in order better to protect his family in the event of an
electrical fire.
The jury returned verdicts in favor of Laaperi in all four actions on the failure to warn claim. The
jury assessed damages in the amount of $350,000 [$1,050,000, or about $3,400,000 in 2010
dollars] each of the three actions brought on behalf of the deceased sons, and $750,000 [about
$2,500,000 in 2010 dollars] in the action brought on behalf of Janet Laaperi. The defendants’
motions for directed verdict and judgment notwithstanding the verdict were denied, and
defendants appealed.
Defendants ask us to declare that the risk that an electrical fire could incapacitate an ACpowered smoke detector is so obvious that the average consumer would not benefit from a
warning. This is not a trivial argument; in earlier—some might say sounder—days, we might
have accepted it.… Our sense of the current state of the tort law in Massachusetts and most
other jurisdictions, however, leads us to conclude that, today, the matter before us poses a jury
question; that “obviousness” in a situation such as this would be treated by the Massachusetts
courts as presenting a question of fact, not of law. To be sure, it would be obvious to anyone that
an electrical outage would cause this smoke detector to fail. But the average purchaser might not
comprehend the specific danger that a fire-causing electrical problem can simultaneously knock
out the circuit into which a smoke detector is wired, causing the detector to fail at the very
moment it is needed. Thus, while the failure of a detector to function as the result of an electrical
malfunction due, say, to a broken power line or a neighborhood power outage would, we think,
be obvious as a matter of law, the failure that occurred here, being associated with the very
risk—fire—for which the device was purchased, was not, or so a jury could find.…
Finally, defendants contend that the award of $750,000 [$2.5 million in 2010 dollars] in
damages to Janet Laaperi was excessive, and should have been overturned by the district
court.…
Janet Laaperi testified that on the night of the fire, she woke up and smelled smoke. She woke
her friend who was sleeping in her room, and they climbed out to the icy roof of the house. Her
father grabbed her from the roof and took her down a ladder. She was taken to the hospital.
Saylor URL: http://www.saylor.org/books

Saylor.org
762

Although she was in “mild distress,” she was found to be “alert, awake, [and] cooperative.” Her
chest was clear. She was diagnosed as having first and second degree burns of her right calf,
both buttocks and heels, and her left lower back, or approximately 12 percent of her total body
area. She also suffered from a burn of her tracheobronchial mucosa (i.e., the lining of her
airway) due to smoke inhalation, and multiple superficial lacerations on her right hand.
The jury undoubtedly, and understandably, felt a great deal of sympathy for a young girl who, at
the age of 13, lost three brothers in a tragic fire. But by law the jury was only permitted to
compensate her for those damages associated with her own injuries. Her injuries included fright
and pain at the time of and after the fire, a three-week hospital stay, some minor discomfort for
several weeks after discharge, and a permanent scar on her lower back. Plaintiff has pointed to
no cases, and we have discovered none, in which such a large verdict was sustained for such
relatively minor injuries, involving no continuing disability.
The judgments in favor of Albin Laaperi in his capacity as administrator of the estates of his
three sons are affirmed. In the action on behalf of Janet Laaperi, the verdict of the jury is set
aside, the judgment of the district court vacated, and the cause remanded to that court for a new
trial limited to the issue of damages.

CASE QUESTIONS

1. The “C.A. 1” under the title of the case means it is a US Court of Appeals case from the First
Circuit in Massachusetts. Why is this case in federal court?
2. Why does the court talk about its “sense of the current state of tort law in Massachusetts”
and how this case “would be treated by the Massachusetts courts,” as if it were not in the
state at all but somehow outside?
3. What rule of law is in play here as to the defendants’ liability?
4. This is a tragic case—three boys died in a house fire. Speaking dispassionately—if not
heartlessly—though, did the fire actually cost Mr. Laaperi, or did he lose $3.4 million (in 2010
dollars) as the result of his sons’ deaths? Does it make sense that he should become a
millionaire as a result? Who ends up paying this amount? (The lawyers’ fees probably took
about half.)

Saylor URL: http://www.saylor.org/books

Saylor.org
763

5. Is it likely that smoke-alarm manufactures and sellers changed the instructions as a result of
this case?

[1] Uniform Commercial Code, Section 2-316.

20.7 Summary and Exercises
Summary

Products liability describes a type of claim—for injury caused by a defective product—and not a
separate theory of liability. In the typical case, three legal doctrines may be asserted: (1)
warranty, (2) negligence, and (3) strict liability.
If a seller asserts that a product will perform in a certain manner or has certain characteristics,
he has given an express warranty, and he will be held liable for damages if the warranty is
breached—that is, if the goods do not live up to the warranty. Not every conceivable claim is an
express warranty; the courts permit a certain degree of “puffing.”
An implied warranty is one created by law. Goods sold by a merchant-seller carry an implied
warranty of merchantability, meaning that they must possess certain characteristics, such as
being of average quality for the type described and being fit for the ordinary purposes for which
they are intended.
An implied warranty of fitness for a particular purpose is created whenever a seller knows or has
reason to know that the buyer is relying on the seller’s knowledge and skill to select a product for
the buyer’s particular purposes.
Under UCC Article 2, the seller also warrants that he is conveying good title and that the goods
are free of any rightful claim by a third person.
UCC Article 2 permits sellers to exclude or disclaim warranties in whole or in part. Thus a seller
may exclude express warranties. He may also disclaim many implied warranties—for example,
by noting that the sale is “as is.” The Magnuson-Moss Act sets out certain types of information
that must be included in any written warranty. The act requires the manufacturer or seller to
label the warranty as either “full” or “limited” depending on what types of defects are covered

Saylor URL: http://www.saylor.org/books

Saylor.org
764

and what the customer must do to obtain repair or replacement. The act also abolishes
“phantom warranties.”
Privity once stood as a bar to recovery in suits brought by those one or more steps removed in
the distribution chain from the party who breached a warranty. But the nearly universal trend in
the state courts has been to abolish privity as a defense.
Because various impediments stand in the way of warranty suits, courts have adopted a tort
theory of strict liability, under which a seller is liable for injuries resulting from the sale of any
product in a defective condition if it is unreasonably dangerous to the user or consumer. Typical
issues in strict liability cases are these: Is the defendant a seller engaged in the business of
selling? Was the product sold in a defective condition? Was it unreasonably dangerous, either on
its face or because of a failure to warn? Did the product reach the consumer in an unchanged
condition? Strict liability applies regardless of how careful the seller was and regardless of his
lack of contractual relation with the consumer or user.
Manufacturers can also be held liable for negligence—most often for faulty design of products
and inadequate warnings about the hazards of using the product.
The products-liability revolution prompted many state legislatures to enact certain laws limiting
to some degree the manufacturer’s responsibility for defective products. These laws include
statutes of repose and provide a number of other defenses.

EXERCISES

1. Ralph’s Hardware updated its accounting system and agreed to purchase a computer system
from a manufacturer, Bits and Bytes (BB). During contract negotiations, BB’s sales
representative promised that the system was “A-1” and “perfect.” However, the written
contract, which the parties later signed, disclaimed all warranties, express and implied. After
installation the computer produced only random numbers and letters, rather than the
desired accounting information. Is BB liable for breaching an express warranty? Why?
2. Kate owned a small grocery store. One day John went to the store and purchased a can of
chip dip that was, unknown to Kate or John, adulterated. John became seriously ill after
eating the dip and sued Kate for damages on the grounds that she breached an implied
warranty of merchantability. Is Kate liable? Why?

Saylor URL: http://www.saylor.org/books

Saylor.org
765

3. Carrie visited a neighborhood store to purchase some ham, which a salesperson cut by
machine in the store. The next day she made a ham sandwich. In eating the sandwich, Carrie
bit into a piece of cartilage in the ham. As a result, Carrie lost a tooth, had to undergo root
canal treatments, and must now wear a full-coverage crown to replace the tooth. Is the store
liable for the damage? Why?
4. Clarence, a business executive, decided to hold a garage sale. At the sale, his neighbor Betty
mentioned to Clarence that she was the catcher on her city-league baseball team and was
having trouble catching knuckleball pitches, which required a special catcher’s mitt. Clarence
pulled an old mitt from a pile of items that were on sale and said, “Here, try this.” Betty
purchased the mitt but discovered during her next game that it didn’t work. Has Clarence
breached an express or implied warranty? Why?
5. Sarah purchased several elegant picture frames to hang in her dorm room. She also
purchased a package of self-sticking hangers. Late one evening, while Sarah was studying
business law in the library, the hangers came loose and her frames came crashing to the
floor. After Sarah returned to her room and discovered the rubble, she examined the box in
which the hangers were packaged and found the following language: “There are no
warranties except for the description on this package and specifically there is NO IMPLIED
WARRANTY OF MERCHANTABILITY.” Assuming the hangers are not of fair, average, ordinary
quality, would the hanger company be liable for breaching an implied warranty of
merchantability? Why?
6. A thirteen-year-old boy received a Golfing Gizmo—a device for training novice golfers—as a
gift from his mother. The label on the shipping carton and the cover of the instruction
booklet urged players to “drive the ball with full power” and further stated: “COMPLETELY
SAFE BALL WILL NOT HIT PLAYER.” But while using the device, the boy was hit in the eye by
the ball. Should lack of privity be a defense to the manufacturer? The manufacturer argued
that the Gizmo was a “completely safe” training device only when the ball is hit squarely,
and—the defendant argued—plaintiffs could not reasonably expect the Gizmo to be
“completely safe” under all circumstances, particularly those in which the player hits beneath
the ball. What legal argument is this, and is it valid?
Saylor URL: http://www.saylor.org/books

Saylor.org
766

7. A bank repossessed a boat and sold it to Donald. During the negotiations with Donald,
Donald stated that he wanted to use the boat for charter service in Florida. The bank officers
handling the sale made no representations concerning the boat during negotiations. Donald
later discovered that the boat was defective and sued the bank for breach of warranty. Is the
bank liable? Why?
8. Tom Anderson, the produce manager at the Thriftway Market in Pasco, Washington,
removed a box of bananas from the top of a stack of produce. When he reached for a lug of
radishes that had been under the bananas, a six-inch spider—Heteropoda venatoria,
commonly called a banana spider—leaped from some wet burlap onto his left hand and bit
him. Nine months later he died of heart failure. His wife brought an action against Associated
Grocers, parent company of Thriftway Market, on theories of (1) strict products liability
under Restatement, Section 402(a); (2) breach of the implied warranty of merchantability;
and (3) negligence. The trial court ruled against the plaintiff on all three theories. Was that a
correct ruling? Explain.
9. A broken water pipe flooded a switchboard at RCA’s office. The flood tripped the
switchboard circuit breakers and deactivated the air-conditioning system. Three employees
were assigned to fix it: an electrical technician with twelve years on-the-job training, a
licensed electrician, and an electrical engineer with twenty years of experience who had
studied power engineering in college. They switched on one of the circuit breakers, although
the engineer said he knew that one was supposed to test the operation of a wet switchboard
before putting it back into use. There was a “snap” and everyone ran from the room up the
stairs and a “big ball of fire” came after them up the stairs. The plaintiffs argued that the
manufacturer of the circuit breaker had been negligent in failing to give RCA adequate
warnings about the circuit breakers. How should the court rule, and on what theory should it
rule?
10. Plaintiff’s business was to convert vans to RVs, and for this purpose it had used a 3M
adhesive to laminate carpeting to the van walls. This adhesive, however, failed to hold the
fabric in place in hot weather, so Plaintiff approached Northern Adhesive Co., a manufacturer
of adhesives, to find a better one. Plaintiff told Northern why it wanted the adhesive, and
Saylor URL: http://www.saylor.org/books

Saylor.org
767

Northern—Defendant—sent several samples to Plaintiff to experiment with. Northern told
Plaintiff that one of the adhesives, Adhesive 7448, was “a match” for the 3M product that
previously failed. Plaintiff tested the samples in a cool plant and determined that Adhesive
7448 was better than the 3M product. Defendant had said nothing except that “what they
would ship would be like the sample. It would be the same chemistry.” Plaintiff used the
adhesive during the fall and winter; by spring complaints of delamination came in: Adhesive
7448 failed just as the 3M product had. Over 500 vans had to be repaired. How should the
court rule on Plaintiff’s claims of breach of (1) express warranty, (2) implied warranty of
merchantability, and (3) implied warranty of fitness for a particular purpose?

SELF-TEST QUESTIONS

1. In a products-liability case
a.

only tort theories are typically asserted

b. both tort and contract theories are typically asserted
c. strict liability is asserted only when negligence is not asserted
d. breach of warranty is not asserted along with strict liability
An implied warranty of merchantability
a.

is created by an express warranty

b. is created by law
c. is impossible for a seller to disclaim
d. can be disclaimed by a seller only if the disclaimer is in writing
A possible defense to breach of warranty is
a.

lack of privity

b. absence of an express warranty
c. disclaimer of implied warranties
d. all of the above
Under the strict liability rule in Restatement, Section 402A, the seller is
liable for all injuries resulting from a product
a.

even though all possible care has been exercised

b. regardless of the lack of a contract with the user

Saylor URL: http://www.saylor.org/books

Saylor.org
768

c. in both of the above situations
d. in none of the above situations
An individual selling her car could be liable
a.

for breaching the implied warranty of merchantability

b. under the strict liability theory
c. for breaching the implied warranty of fitness
d. under two of the above

SELF-TEST ANSWERS

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

Saylor URL: http://www.saylor.org/books

Saylor.org
769

Chapter 21
Bailments and the Storage, Shipment, and Leasing
of Goods
LEARNING OBJECTIVES

After reading this chapter, you should understand the following:
1. What the elements of a bailment are
2. What the bailee’s liability is
3. What the bailor’s liability is
4. What other rights and duties—compensation, bailee’s liens, casualty to goods—arise
5. What special types of bailments are recognized: innkeepers, warehousing
6. What rules govern the shipment of goods
7. How commodity paper is negotiated and transferred

21.1 Introduction to Bailment Law

LEARNING OBJECTIVES

1. Understand what a bailment is, and why the law of bailment is important.
2. Recognize how bailments compare with sales.
3. Point out the elements required to create a bailment.
Finally, we turn to the legal relationships that buyers and sellers have with warehousers and
carriers—the parties responsible for physically transferring goods from seller to buyer. This
topic introduces a new branch of law—that of bailments; we’ll examine it before turning directly
to warehousers and carriers.

Overview of Bailments
A bailment is the relationship established when someone entrusts his property temporarily to
someone else without intending to give up title. Although bailment has often been said to arise
only through a contract, the modern definition does not require that there be an agreement. One
widely quoted definition holds that a bailment is “the rightful possession of goods by one who is
not the owner. It is the element of lawful possession, however created, and the duty to account

Saylor URL: http://www.saylor.org/books

Saylor.org
770

for the thing as the property of another, that creates the bailment, regardless of whether such
possession is based upon contract in the ordinary sense or not.” [1]
The word bailment derives from a Latin verb, bajulare, meaning “to bear a burden,” and then
from French, bailler, which means “to deliver” (i.e., into the hands or possession of someone).
The one who bails out a boat, filling a bucket and emptying it overboard, is a water-bearer. The
one who bails someone out of jail takes on the burden of ensuring that the one sprung appears
in court to stand trial; he also takes on the risk of loss of bond money if the jailed party does not
appear in court. The one who is abailee takes on the burden of being responsible to return the
goods to their owner.
The law of bailments is important to virtually everyone in modern society: anyone who has ever
delivered a car to a parking lot attendant, checked a coat in a restaurant, deposited property in a
safe-deposit box, rented tools, or taken items clothes or appliance in to a shop for repair. In
commercial transactions, bailment law governs the responsibilities of warehousers and the
carriers, such as UPS and FedEx, that are critical links in the movement of goods from
manufacturer to the consumer. Bailment law is an admixture of common law (property and
tort), state statutory law (in the Uniform Commercial Code; UCC), federal statutory law, and—
for international issues—treaty. [2]

Bailments Compared with Sales
Bailment versus Sales
In a sale, the buyer acquires title and must pay for the goods. In a bailment, the bailee acquires
possession and must return the identical object. In most cases the distinction is clear, but
difficult borderline cases can arise. Consider the sad case of the leased cows: Carpenter v.
Griffen (N.Y. 1841). Carpenter leased a farm for five years to Spencer. The lease included thirty
cows. At the end of the term, Spencer was to give Carpenter, the owner, “cows of equal age and
quality.” Unfortunately, Spencer fell into hard times and had to borrow money from one Griffin.
When the time came to pay the debt, Spencer had no money, so Griffin went to court to levy
against the cows (i.e., he sought a court order giving him the cows in lieu of the money owed).
Needless to say, this threatened transfer of the cows upset Carpenter, who went to court to stop
Griffin from taking the cows. The question was whether Spencer was a bailee, in which case the
Saylor URL: http://www.saylor.org/books

Saylor.org
771

cows would still belong to Carpenter (and Griffin could not levy against them), or a purchaser, in
which case Spencer would own the cows and Griffin could levy against them. The court ruled
that title had passed to Spencer—the cows were his. Why? The court reasoned that Spencer was
not obligated to return the identical cows to Carpenter, hence Spencer was not a
bailee. [3] Section 2-304(1) of the UCC confirms this position, declaring that whenever the price
of a sale is payable in goods, each party is a seller of the goods that he is to transfer.
Note the implications that flow from calling this transaction a sale. Creditors of the purchaser
can seize the goods. The risk of loss is on the purchaser. The seller cannot recover the goods (to
make up for the buyer’s failure to pay him) or sell them to a third party.

Fungible Goods
Fungible goods (goods that are identical, like grain in a silo) present an especially troublesome
problem. In many instances the goods of several owners are mingled, and the identical items are
not intended to be returned. For example, the operator of a grain elevator agrees to return an
equal quantity of like-quality grain but not the actual kernels deposited there. Following the rule
in Carpenter’s cow case, this might seem to be a sale, but it is not. Under the UCC, Section 2207, the depositors of fungible goods are “tenants in common” of the goods; in other words, the
goods are owned by all. This distinction between a sale and a bailment is important. When there
is a loss through natural causes—for example, if the grain elevator burns—the depositors must
share the loss on a pro rata basis (meaning that no single depositor is entitled to take all his
grain out; if 20 percent of the grain was destroyed, then each depositor can take out no more
than 80 percent of what he deposited).

Elements of a Bailment
As noted, bailment is defined as “the rightful possession of goods by one who is not the owner.”
For the most part, this definition is clear (and note that it does not dictate that a bailment be
created by contract). Bailment law applies to the delivery of goods—that is, to the delivery
personal property. Personal property is usually defined as anything that can be owned other
than real estate. As we have just seen in comparing bailments to sales, the definition implies a
duty to return the identical goods when the bailment ends.

Saylor URL: http://www.saylor.org/books

Saylor.org
772

But one word in the definition is both critical and troublesome: possession. Possession requires
both a physical and a mental element. We examine these in turn.

Possession: Physical Control
In most cases, physical control is proven easily enough. A car delivered to a parking garage is
obviously within the physical control of the garage. But in some instances, physical control is
difficult to conceptualize. For example, you can rent a safe-deposit box in a bank to store
valuable papers, stock certificates, jewelry, and the like. The box is usually housed in the bank’s
vault. To gain access, you sign a register and insert your key after a bank employee inserts the
bank’s key. You may then inspect, add to, or remove contents of the box in the privacy of a small
room maintained in the vault for the purpose. Because the bank cannot gain access to the box
without your key and does not know what is in the box, it might be said to have no physical
control. Nevertheless, the rental of a safe-deposit box is a bailment. In so holding, a New York
court pointed out that if the bank was not in possession of the box renter’s property “it is
difficult to know who was. Certainly [the renter] was not, because she could not obtain access to
the property without the consent and active participation of the defendant. She could not go into
her safe unless the defendant used its key first, and then allowed her to open the box with her
own key; thus absolutely controlling [her] access to that which she had deposited within the
safe. The vault was the [company’s] and was in its custody, and its contents were under the same
conditions.” [4] Statutes in some states, however, provide that the relationship is not a bailment
but that of a landlord and tenant, and many of these statutes limit the bank’s liability for losses.

Possession: Intent to Possess
In addition to physical control, the bailee must have had an intent to possess the goods; that is,
to exercise control over them. This mental condition is difficult to prove; it almost always turns
on the specific circumstances and, as a fact question, is left to the jury to determine. To illustrate
the difficulty, suppose that one crisp fall day, Mimi goes to Sally Jane’s Boutique to try on a
jacket. The sales clerk hands Mimi a jacket and watches while Mimi takes off her coat and places
it on a nearby table. A few minutes later, when Mimi is finished inspecting herself in the mirror,
she goes to retrieve her coat, only to discover it is missing. Who is responsible for the loss? The
answer depends on whether the store is a bailee. In some sense the boutique had physical
Saylor URL: http://www.saylor.org/books

Saylor.org
773

control, but did it intend to exercise that control? In a leading case, the court held that it did,
even though no one said anything about guarding the coat, because a store invites its patrons to
come in. Implicit in the act of trying on a garment is the removal of the garment being worn.
When the customer places it in a logical place, with the knowledge of and without objection from
the salesperson, the store must exercise some care in its safekeeping. [5]
Now suppose that when Mimi walked in, the salesperson told her to look around, to try on some
clothes, and to put her coat on the table. When the salesperson was finished with her present
customer, she said, she would be glad to help Mimi. So Mimi tried on a jacket and minutes later
discovered her coat gone. Is this a bailment? Many courts, including the New York courts, would
say no. The difference? The salesperson was helping another customer. Therefore, Mimi had a
better opportunity to watch over her own coat and knew that the salesperson would not be
looking out for it. This is a subtle distinction, but it has been sufficient in many cases to change
the ruling. [6]
Questions of intent and control frequently arise in parking lot cases. As someone once said, “The
key to the problem is the key itself.” The key is symbolic of possession and intent to possess. If
you give the attendant your key, you are a bailor and he (or the company he works for) is the
bailee. If you do not give him the key, no bailment arises. Many parking lot cases do not fall
neatly within this rule, however. Especially common are cases involving self-service airport
parking lots. The customer drives through a gate, takes a ticket dispensed by a machine, parks
his car, locks it, and takes his key. When he leaves, he retrieves the car himself and pays at an
exit gate. As a general rule, no bailment is created under these circumstances. The lot operator
does not accept the vehicle nor intend to watch over it as bailee. In effect, the operator is simply
renting out space. [7] But a slight change of facts can alter this legal conclusion. Suppose, for
instance, that the lot had an attendant at the single point of entrance and exit, that the attendant
jotted down the license number on the ticket, one portion of which he retained, and that the car
owner must surrender the ticket when leaving or prove that he owns the car. These facts have
been held to add up to an intention to exercise custody and control over the cars in the lot, and
hence to have created a bailment. [8]

Saylor URL: http://www.saylor.org/books

Saylor.org
774

For a bailment to exist, the bailee must know or have reason to know that the property exists.
When property is hidden within the main object entrusted to the bailee, lack of notice can defeat
the bailment in the hidden property. For instance, a parking lot is not responsible for the
disappearance of valuable golf clubs stored in the trunk of a car, nor is a dance hall cloak room
responsible for the disappearance of a fur wrap inside a coat, if they did not know of their
existence. [9] This result is usually justified by observing that when a person is unaware that
goods exist or does not know their value, it is inequitable to hold him responsible for their loss
since he cannot take steps to prevent it. This rule has been criticized: trunks are meant to hold
things, and if the car was within the garage’s control, surely its contents were too. Some courts
soften the impact of the rule by holding that a bailee is responsible for goods that he might
reasonably expect to be present, like gloves in a coat checked at a restaurant or ordinary baggage
in a car checked at a hotel.

KEY TAKEAWAY

A bailment arises when one person (a bailee) rightfully holds property belonging to another
(a bailor). The law of bailments addresses the critical links in the movement of goods from
the manufacturer to the end user in a consumer society: to the storage and transportation of
goods. Bailments only apply to personal property; a bailment requires that the bailor deliver
physical control of the goods to the bailee, who has an intention to possess the goods and a
duty to return them.

EXERCISES

1. Dennis takes his Mercedes to have the GPS system repaired. In the trunk of his car is a
briefcase containing $5,000 in cash. Is the cash bailed goods?
2. Marilyn wraps up ten family-heirloom crystal goblets, packages them carefully in a cardboard
box, and drops the box off at the local UPS store. Are the goblets bailed goods?
3. Bob agrees to help his friend Roger build a deck at Roger’s house. Bob leaves some of his
tools—without Bob’s noticing—around the corner of the garage at the foot of a
rhododendron bush. The tools are partly hidden. Are they bailed goods?

[1] Zuppa v. Hertz, 268 A.2d 364 (N.J. 1970).

Saylor URL: http://www.saylor.org/books

Saylor.org
775

[2] Here is a link to a history of bailment law: Globusz Publishing, “Lecture v. the Bailee at Common
Law,” accessed March 1, 2011,http://www.globusz.com/ebooks/CommonLaw/00000015.htm.
[3] Carpenter v. Spencer & Griffin, 37 Am. Dec. 396 (N.Y. 1841).
[4] Lockwood v. Manhattan Storage & Warehouse Co., 50 N.Y.S. 974 (N.Y. 1898).
[5] Bunnell v. Stern, 25 N.E. 910 (N.Y. 1890).
[6] Wamser v. Browning, King & Co., 79 N.E. 861 (N.Y. 1907).
[7] Wall v. Airport Parking Co. of Chicago, 244 N.E.2d 190 (Ill. 1969).
[8] Continental Insurance Co. v. Meyers Bros. Operations, Inc., 288 N.Y.S.2d 756 (Civ. Ct. N.Y. 1968).
[9] Samples v. Geary, 292 S.W. 1066 (Mo. App. 1927).

21.2 Liability of the Parties to a Bailment
LEARNING OBJECTIVES

1. Understand how the bailee’s liability arises and operates.
2. Recognize the cases in which the bailee can disclaim liability, and what limits are put on such
disclaimers.
3. Understand what duty and liability the bailor has.
4. Know other rights and duties that arise in a bailment.
5. Understand the extent to which innkeepers—hotel and motels—are liable for their guests’
property.

Liability of the Bailee
Duty of Care
The basic rule is that the bailee is expected to return to its owner the bailed goods when the
bailee’s time for possession of them is over, and he is presumed liable if the goods are not
returned. But that a bailee has accepted delivery of goods does not mean that he is responsible
for their safekeeping no matter what. The law of bailments does not apply a standard of absolute
liability: the bailee is not an insurer of the goods’ safety; her liability depends on the
circumstances.

The Ordinary Care Rule

Saylor URL: http://www.saylor.org/books

Saylor.org
776

Some courts say that the bailee’s liability is the straightforward standard of “ordinary care under
the circumstances.” The question becomes whether the bailee exercised such care. If she did, she
is not liable for the loss.

The Benefit-of-the-Bargain Rule
Most courts use a complex (some say annoying) tripartite division of responsibility. If the
bailment is for the sole benefit of the owner (the bailor), the bailee is answerable only for gross
neglect or fraud: the duty of care is slight. For example, imagine that your car breaks down on a
dark night and you beg a passing motorist to tow it to a gas station; or you ask your neighbor if
you can store your utility trailer in her garage.
On the other hand, if the goods are entrusted to the bailee for his sole benefit, then he owes the
bailor extraordinary care. For example, imagine that your neighbor asks you to let him borrow
your car to go to the grocery store downtown because his car is in the shop; or a friend asks if
she can borrow your party canopy.
If the bailment is for the mutual benefit of bailee and bailor, then the ordinary negligence
standard of care will govern. For example, imagine you park your car in a commercial parking
lot, or you take your suit jacket to a dry cleaner (see /6059 - mayer_1.0-ch21_s02_s01_s01_s02_f01).
Figure 21.1 Duty of Care

One problem with using the majority approach is the inherent ambiguity in the standards of
care. What constitutes “gross” negligence as opposed to “ordinary” negligence? The degree-ofcare approach is further complicated by the tendency of the courts to take into account the value
of the goods; the lesser the value of the goods, the lesser the obligation of the bailee to watch out
for them. To some degree, this approach makes sense, because it obviously behooves a person
Saylor URL: http://www.saylor.org/books

Saylor.org
777

guarding diamonds to take greater precautions against theft than one holding three paperback
books. But the value of the goods ought not to be the whole story: some goods obviously have
great value to the owner, regardless of any lack of intrinsic value.
Another problem in using the majority approach to the standard of care is determining whether
or not a benefit has been conferred on the bailee when the bailor did not expressly agree to pay
compensation. For example, a bank gives its customers free access to safe-deposit boxes. Is the
bank a “gratuitous bailee” that owes its bailor only a slight degree of care, or has it made the
boxes available as a commercial matter to hold onto its customers? Some courts cling to one
theory, some to the other, suggesting the difficulty with the tripartite division of the standard of
care. However, in many cases, whatever the formal theory, the courts look to the actual benefits
to be derived. Thus when a customer comes to an automobile showroom and leaves her car in
the lot while she test-drives the new car, most courts would hold that two bailments for mutual
benefit have been created: (1) the bailment to hold the old car in the lot, with the customer as
the bailor; and (2) the bailment to try out the new car, with the customer as the bailee.

Burden of Proof
In a bailment case, the plaintiff bailor has the burden of proving that a loss was caused by the
defendant bailee’s failure to exercise due care. However, the bailor establishes a prima facie (“at
first sight”—on first appearance, but subject to further investigation) case by showing that he
delivered the goods into the bailee’s hands and that the bailee did not return them or returned
them damaged. At that point, a presumption of negligence arises, and to avoid liability the
defendant must rebut that presumption by showing affirmatively that he was not negligent. The
reason for this rule is that the bailee usually has a much better opportunity to explain why the
goods were not returned or were returned damaged. To put this burden on the bailor might
make it impossible for him to win a meritorious case.

Liability of the Bailor
As might be expected, most bailment cases involve the legal liability of bailees. However, a body
of law on the liability of bailors has emerged.

Negligence of Bailor

Saylor URL: http://www.saylor.org/books

Saylor.org
778

A bailor may be held liable for negligence. If the bailor receives a benefit from the bailment, then
he has a duty to inform the bailee of known defects and to make a reasonable inspection for
other defects. Suppose the Tranquil Chemical Manufacturing Company produces an insecticide
that it wants the Plattsville Chemical Storage Company to keep in tanks until it is sold. One of
the batches is defectively acidic and oozes out of the tanks. This acidity could have been
discovered through a routine inspection, but Tranquil neglects to inspect the batch. The tanks
leak and the chemical builds up on the floor until it explodes. Since Tranquil, the bailor, received
a benefit from the storage, it had a duty to warn Plattsville, and its failure to do so makes it liable
for all damages caused by the explosion.
If the bailor does not receive any benefit, however, then his only duty is to inform the bailee of
known defects. Your neighbor asks to borrow your car. You have a duty to tell her that the
brakes are weak, but you do not need to inspect the car beforehand for unknown defects.

Other Types of Liability
The theory of products liability discussed in /6059 - mayer_1.0-ch20extends to bailors. Both

warranty and strict liability theories apply. The rationale for extending liability in the absence of
sale is that in modern commerce, damage can be done equally by sellers or lessors of equipment.
A rented car can inflict substantial injury no less than a purchased one.
In several states, when an automobile owner (bailor) lends a vehicle to a friend (bailee) who
causes an accident, the owner is liable to third persons injured in the accident.

Disclaimers of Liability
Bailee’s Disclaimer
Bailees frequently attempt to disclaim their liability for loss or damage. But courts often refuse
to honor the disclaimers, usually looking to one of two justifications for invalidating them.

Lack of Notice
The disclaimer must be brought to the attention of the bailor and must be unambiguous. Thus
posted notices and receipts disclaiming or limiting liability must set forth clearly and legibly the
legal effects intended. Most American courts follow the rule that the defendant bailee must show
that the bailor in fact knew about the disclaimer. Language printed on the back side of a receipt
will not do.
Saylor URL: http://www.saylor.org/books

Saylor.org
779

Public Policy Exception
Even if the bailor reads the disclaimer, some courts will nevertheless hold the bailee liable on
public policy grounds, especially when the bailee is a “business bailee,” such as a warehouse or
carrier. Indeed, to the extent that a business bailee attempts to totally disclaim liability, he will
probably fail in every American jurisdiction. But the Restatement (Second) of Contracts, Section
195(2)(b), does not go quite this far for most nonbusiness bailees. They may disclaim liability as
long as the disclaimer is read and does not relieve the bailee from wanton carelessness.

Bailor’s Disclaimer
Bailors most frequently attempt to disclaim liability in rental situations. For example,
in Zimmer v. Mitchell and Ness, the plaintiff went to the defendant’s rental shop at the
Camelback ski area to rent skis, boots, and poles. [1] He signed a rental agreement before
accepting the ski equipment. He was a lessee and a bailee. Later, while descending the
beginners’ slope, he fell. The bindings on his skis did not release, thereby causing him to sustain
numerous injuries. The plaintiff sued the defendant and Camelback Ski Corporation, alleging
negligence, violation of Section 402A of the Restatement (Second) of Torts, and breach of
warranty. The defendant filed an answer and claimed that the plaintiff signed a rental
agreement that fully released the defendant from liability. In his reply, the plaintiff admitted
signing the agreement but generally denied that it released the defendant from liability. The
defendant won on summary judgment.
On appeal, the Pennsylvania Supreme Court held for the defendant and set out the law: “The
test for determining the validity of exculpatory clauses, admittedly not favored in the law, is set
out in [Citation]. The contract must not contravene any policy of the law. It must be a contract
between individuals relating to their private affairs. Each party must be a free bargaining agent,
not simply one drawn into an adhesion contract, with no recourse but to reject the entire
transaction.…We must construe the agreement strictly and against the party asserting it [and],
the agreement must spell out the intent of the parties with the utmost particularity.” The court
here was satisfied with the disclaimer.

Other Rights and Duties
Compensation
Saylor URL: http://www.saylor.org/books

Saylor.org
780

If the bailor hires the bailee to perform services for the bailed property, then the bailee is
entitled to compensation. Remember, however, that not every bailment is necessarily for
compensation. The difficult question is whether the bailee is entitled to compensation when
nothing explicit has been said about incidental expenses he has incurred to care for the bailed
property—as, for example, if he were to repair a piece of machinery to keep it running. No firm
rule can be given. Perhaps the best generalization that can be made is that, in the absence of an
express agreement, ordinary repairs fall to the bailee to pay, but extraordinary repairs are the
bailor’s responsibility. An express agreement between the parties detailing the responsibilities
would solve the problem, of course.

Bailee’s Lien
Lien is from the French, originally meaning “line,” “string,” or “tie.” In law a lien is the hold that
someone has over the property of another. It is akin, in effect, to a security interest. A common
type is the mechanic’s lien (“mechanic” here means one who works with his hands). For
example, a carpenter builds a room on your house and you fail to pay him; he can secure a lien
on your house, meaning that he has a property interest in the house and can start foreclosure
proceedings if you still fail to pay. Similarly, a bailee is said to have a lien on the bailed property
in his possession and need not redeliver it to the bailor until he has been paid. Try to take your
car out of a parking lot without paying and see what happens. The attendant’s refusal to give you
the car is entirely lawful under a common-law rule now more than a century and a half old. As
the rule is usually stated, the common law confers the lien on the bailee if he has added value to
the property through his labor, skill, or materials. But that statement of the rule is somewhat
deceptive, since the person who has simply housed the goods is entitled to a lien, as is a person
who has altered or repaired the goods without measurably adding value to them. Perhaps a
better way of stating the rule is this: a lien is created when the bailee performs some special
benefit to the goods (e.g., preserving them or repairing them).
Many states have enacted statutes governing various types of liens. In many instances, these
have broadened the bailee’s common-law rights. This book discusses two types of liens in great
detail: the liens of warehousemen and those of common carriers. Recall that a lease creates a

Saylor URL: http://www.saylor.org/books

Saylor.org
781

type of bailment: the lessor is the bailor and the lessee is the bailee. This book references the
UCC’s take on leasing in its discussion of the sale of goods. [2]

Rights When Goods Are Taken or Damaged by a Third Party
The general rule is that the bailee can recover damages in full if the bailed property is damaged
or taken by a third party, but he must account in turn to the bailor. A delivery service is carrying
parcels—bailed goods entrusted to the trucker for delivery—when the truck is struck from
behind and blows up. The carrier may sue the third person who caused the accident and recover
for the total loss, including the value of the packages. The bailor may also recover for damages to
the parcels, but not if the bailee has already recovered a judgment. Suppose the bailee has sued
and lost. Does the bailor have a right to sue independently on the same grounds? Ordinarily, the
principle of res judicata would prevent a second suit, but if the bailor did not know of and
cooperate in the bailee’s suit, he probably has the right to proceed on his own suit.

Innkeepers’ Liability
The liability of an innkeeper—a type of bailor—is thought to have derived from the warlike
conditions that prevailed in medieval England, where brigands and bandits roamed the
countryside and the innkeeper himself might not have been above stealing from his guests. The
innkeeper’s liability extended not merely to loss of goods through negligence. His was an
insurer’s liability, extending to any loss, no matter how occasioned, and even to losses that
occurred in the guest’s room, a place where the guest had the primary right of possession. The
only exception was for losses due to the guest’s own negligence.
Most states have enacted statutes providing exceptions to this extraordinarily broad commonlaw duty. Typically, the statutes exempt the hotel keeper from insurer’s liability if the hotelier
furnishes a safe in which the guests can leave their jewels, money, and other valuables and if a
notice is posted a notice advising the guests of the safe’s availability. The hotelier might face
liability for valuables lost or stolen from the safe but not from the rooms.

KEY TAKEAWAY

If the bailee fails to redeliver the goods to the bailor, a presumption of negligence arises, but
the bailee can rebut the presumption by showing that she exercised appropriate care. What
is “appropriate care” depends on the test used in the jurisdiction: some courts use the

Saylor URL: http://www.saylor.org/books

Saylor.org
782

“ordinary care under the circumstances,” and some determine how much care the bailee
should have exercised based on the extent to which she was benefited from the transaction
compared to the bailor. The bailor can be liable too for negligently delivering goods likely to
cause damage to the bailee. In either case reasonable disclaimers of liability are allowed. If
the bailed goods need repair while in the bailee’s possession, the usual rule is that ordinary
repairs are the bailee’s responsibility, extraordinary ones the bailor’s. Bailees are entitled to
liens to enforce payment owing to them. In common law, innkeepers were insurers of their
guests’ property, but hotels and motels today are governed mostly by statute: they are to
provide a safe for their guests’ valuables and are not liable for losses from the room.

EXERCISES

1. What is the “ordinary care under the circumstances” test for a bailee’s liability when the
bailed goods are not returned?
2. What is the tripartite test?
3. What liability does a bailor have for delivering defective goods to a bailee?
4. Under what circumstances are disclaimers of liability by the bailee or bailor acceptable?
5. Jason takes his Ford Mustang to a repair shop but fails to pay for the repairs. On what theory
can the shop keep and eventually sell the car to secure payment?

[1] Zimmer v. Mitchell and Ness, 385 A.2d 437 (Penn. 1978).
[2] Uniform Commercial Code, Section 2A.

21.3 The Storage and Shipping of Goods
LEARNING OBJECTIVES

1. Understand a warehouser’s liability for losing goods, what types of losses a warehouser is
liable for, and what rights the warehouser has concerning the goods.
2. Know the duties, liabilities, and exceptions to liability a carrier of freight has, and what rights
the carrier has.
3. Understand the liability that is imposed on entities whose business it is to carry passengers.

Storage of Goods
Saylor URL: http://www.saylor.org/books

Saylor.org
783

Warehousing has been called the “second oldest profession,” stemming from the biblical story of
Joseph, who stored grain during the seven good years against the famine of the seven bad years.
Whatever its origins, warehousing is today a big business, taking in billions of dollars to
stockpile foods and other goods. As noted previously, the source of law governing warehousing
is Article 7 of the UCC, but noncode law also can apply. Section 7-103 of the Uniform
Commercial Code (UCC) specifically provides that any federal statute or treaty and any state
regulation or tariff supersedes the provisions of Article 7. A federal example is the United States
Warehouse Act, which governs receipts for stored agricultural products. Here we take up, after
some definitions, the warehouser’s liabilities and rights. A warehouser is a special type of bailee.

Definitions
A warehouser is defined in UCC, Section 7-102(h), as “a person engaged in the business of
storing goods for hire,” and under Section 1-201(45) awarehouse receipt is any receipt issued by
a warehouser. The warehouse receipt is an important document because it can be used to
transfer title to the goods, even while they remain in storage: it is worth money. No form is
prescribed for the warehouse receipt, but unless it lists in its terms the following nine items, the
warehouser is liable to anyone who is injured by the omission of any of them:
1. Location of the warehouse
2. Date receipt was issued
3. Consecutive number of the receipt
4. Statement whether the goods will be delivered to bearer, to a specified person, or “to a specified
person or his order”
5. The rate of storage and handling charges
6. Description of the goods or the packages containing them
7. Signature of the warehouser, which his or her authorized agent may make
8. The warehouser’s ownership of the goods, if he or she has a sole or part ownership in them
9. The amount (if known, otherwise the fact) of advances made and liabilities incurred for which
the warehouser claims a lien or security interest

General Duty of Care

Saylor URL: http://www.saylor.org/books

Saylor.org
784

The warehouser’s general duty of care is embodied in the tort standard for measuring
negligence: he is liable for any losses or injury to the goods caused by his failure to exercise
“such care in regard to them as a reasonably careful man would exercise under like
circumstances.” [1] However, subsection 4 declares that this section does not repeal or dilute any
other state statute that imposes a higher responsibility on a warehouser. Nor does the section
invalidate contractual limitations otherwise permissible under Article 7. The warehouser’s duty
of care under this section is considerably weaker than the carrier’s duty. Determining when a
warehouser becomes a carrier, if the warehouser is to act as shipper, can become an important
issue.

Limitation of Liability
The warehouser may limit the amount of damages she will pay by so stating in the warehouse
receipt, but she must strictly observe that section’s requirements, under which the limitation
must be stated “per article or item, or value per unit of weight.” [2]Moreover, the warehouser
cannot force the bailor to accept this limitation: the bailor may demand in writing increased
liability, in which event the warehouser may charge more for the storage. If the warehouser
converts the goods to her own UCC, the limitation of liability does not apply.

Specific Types of Liability and Duties
Several problems recur in warehousing, and the law addresses them.

Nonreceipt or Misdescription
Under UCC Section 7-203, a warehouser is responsible for goods listed in a warehouse receipt
that were not in fact delivered to the warehouse (or were misdescribed) and must pay damages
to a good-faith purchaser of or party to a document of title. To avoid this liability, the issuer
must conspicuously note on the document that he does not know whether the goods were
delivered or are correctly described. One simple way is to mark on the receipt that “contents,
condition, and quality are unknown.”

Delivery to the Wrong Party
The bailee is obligated to deliver the goods to any person with documents that entitle him to
possession, as long as the claimant pays any outstanding liens and surrenders the document so
that it can be marked “cancelled” (or can be partially cancelled in the case of partial delivery).
Saylor URL: http://www.saylor.org/books

Saylor.org
785

The bailee can avoid liability for no delivery by showing that he delivered the goods to someone
with a claim to possession superior to that of the claimant, that the goods were lost or destroyed
through no fault of the bailee, or that certain other lawful excuses apply. [3] Suppose a thief
deposits goods he has stolen with a warehouse. Discovering the theft, the warehouser turns the
goods over to the rightful owner. A day later the thief arrives with a receipt and demands
delivery. Because the rightful owner had the superior claim, the warehouser is not liable in
damages to the thief.
Now suppose you are moving and have placed your goods with a local storage company. A few
weeks later, you accidentally drop your wallet, which contains the receipt for the goods and all
your identification. A thief picks up the wallet and immediately heads for the warehouse,
pretending to be you. Having no suspicion that anything is amiss—it’s a large place and no one
can be expected to remember what you look like—the warehouse releases the goods to the thief.
This time you are probably out of luck. Section 7-404 says that “a bailee who in good faith
including observance of reasonable commercial standards has received goods and
delivered…them according to the terms of the document of title…is not liable.” This rule is true
even though the person to whom he made delivery had no authority to receive them, as in the
case of the thief. However, if the warehouser had a suspicion and failed to take precautions, then
he might be liable to the true owner.

Duty to Keep Goods Separate
Except for fungible goods, like grain, the warehouse must keep separate goods covered by each
warehouse receipt. The purpose of this rule, which may be negated by explicit language in the
receipt, is to permit the bailor to identify and take delivery of his goods at any time.

Rights of the Warehouser
The warehouser has certain rights concerning the bailed goods.

Termination
A warehouser is not obligated to store goods indefinitely. Many warehouse receipts will specify
the period of storage. At the termination of the period, the warehouser may notify the bailor to
pay and to recover her goods. If no period is fixed in the receipt or other document of title, the
warehouser may give notice to pay and remove within no less than thirty days. The bailor’s
Saylor URL: http://www.saylor.org/books

Saylor.org
786

failure to pay and remove permits the warehouser to sell the goods for her fee. Suppose the
goods begin to deteriorate. Sections 7-207(2) and 7-207(3) of the UCC permit the warehouser to
sell the goods early if necessary to recover the full amount of her lien or if the goods present a
hazard. But if the rightful owner demands delivery before such a sale, the warehouser is
obligated to do so.

Liens
Section 7-209(1) of the UCC provides that a warehouser has a lien on goods covered by a
warehouse receipt to recover the following charges and expenses: charges for storage or
transportation, insurance, labor, and expenses necessary to preserve the goods. The lien is not
discharged if the bailor transfers his property interest in the goods by negotiating a warehouse
receipt to a purchaser in good faith, although the warehouser is limited then to an amount or a
rate fixed in the receipt or to a reasonable amount or rate if none was stated. The lien attaches
automatically and need not be spelled out in the warehouse receipt.
The warehouser may enforce the lien by selling the goods at a public or private sale, as long as
she does so in a commercially reasonable manner, as defined in Section 7-210. All parties known
to be claiming an interest in the goods must be notified of the sale and told the amount due, the
nature of the sale, and its time and place. Any person who in good faith purchases the goods
takes them free of any claim by the bailor, even if the warehouser failed to comply with the
requirements of Section 7-210. However, her failure to comply subjects her to damages, and if
she has willfully violated the provisions of this section she is liable to the bailor for conversion.

Shipment of Goods
Introduction and Terminology
The shipment of goods throughout the United States and abroad is a very big business, and
many specialized companies have been established to undertake it, including railways, air cargo
operations, trucking companies, and ocean carriers. Article 7 of the UCC applies to carriage of
goods as it does to warehousing, but federal law is more important. The Federal Bill of Lading
Act (FBLA) covers bills of lading issued by common carriers for transportation of goods in
interstate or foreign commerce (i.e., from one state to another; in federal territory; or to foreign
countries). The Carmack Amendment was enacted in 1906 as an amendment to the Interstate
Saylor URL: http://www.saylor.org/books

Saylor.org
787

Commerce Act of 1887, and it is now part of the Interstate Commerce Commission Termination
Act of 1995; it covers liability of interstate carriers for loss, destruction, and damage to goods.
The shipper is the entity hiring the one who transports the goods: if you send your sister crystal
goblets for her birthday, you are the shipper.
Two terms are particularly important in discussing shipment of goods. One is common carrier;
the common carrier is “one who undertakes for hire or reward to transport the goods of such as
chooses to employ him, from place to place.” [4] This definition contains three elements: (1) the
carrier must hold itself out for all in common for hire—the business is not restricted to
particular customers but is open to all who apply for its services; (2) it must charge for his
services—it is for hire; (3) the service in question must be carriage. Included within this
tripartite definition are numerous types of carriers: household moving companies, taxicabs,
towing companies, and even oil and gas pipelines. Note that to be a common carrier it is not
necessary to be in the business of carrying every type of good to every possible point; common
carriers may limit the types of goods or the places to which they will transport them.
A bill of lading is any document that evidences “the receipt of goods for shipment issued by a
person engaged in the business of transporting or forwarding goods.” [5]This is a comprehensive
definition and includes documents used by contract carriers—that is, carriers who are not
common carriers. An example of a bill of lading is depicted in Figure 21.2 "A Bill of Lading
Form".

Saylor URL: http://www.saylor.org/books

Saylor.org
788

Figure 21.2 A Bill of Lading Form

Saylor URL: http://www.saylor.org/books

Saylor.org
789

Duties and Liabilities
Saylor URL: http://www.saylor.org/books

Saylor.org
790

The transportation of goods has been an important part of all evolved economic systems for a
long time, and certainly it is critical to the development and operation of any capitalistic system.
The law regarding it is well developed.

Absolute Liability
Damage, destruction, and loss are major hazards of transportation for which the carrier will be
liable. Who will assert the claim against the carrier depends on who bears the risk of loss. The
rules governing risk of loss (examined in Chapter 18 "Title and Risk of Loss") determine whether
the buyer or seller will be the plaintiff. But whoever is the plaintiff, the common carrier
defendant faces absolute liability. With five exceptions explored two paragraphs on, the
common carrier is an insurer of goods, and regardless of the cause of damage or loss—that is,
whether or not the carrier was negligent—it must make the owner whole. This ancient commonlaw rule is codified in state law, in the federal Carmack Amendment, and in the UCC, Section 7309(1), all of which hold the common carrier to absolute liability to the extent that the common
law of the state had previously done so.
Absolute liability was imposed in the early cases because the judges believed such a rule was
necessary to prevent carriers from conspiring with thieves. Since it is difficult for the owner, who
was not on the scene, to prove exactly what happened, the judges reasoned that putting the
burden of loss on the carrier would prompt him to take extraordinary precautions against loss
(and would certainly preclude him from colluding with thieves). Note that the rules in this
section govern only common carriers; contract carriers that do not hold themselves out for
transport for hire are liable as ordinary bailees.

Exceptions to Absolute Liability
In general, the burden or proof rests on the carrier in favor of the shipper. The shipper (or
consignee of the shipper) can make out a prima facie case by showing that it delivered the goods
to the carrier in good condition and that the goods either did not arrive or arrived damaged in a
specified amount. Thereafter the carrier has the burden of proving that it was not negligent and
that the loss or damage was caused by one of the five following recognized exceptions to the rule
of absolute liability.

Act of God
Saylor URL: http://www.saylor.org/books

Saylor.org
791

No one has ever succeeded in defining precisely what constitutes an act of God, but the courts
seem generally agreed that it encompasses acts that are of sudden and extraordinary natural, as
opposed to human, origin. Examples of acts of God are earthquakes, hurricanes, and fires
caused by lightning against which the carrier could not have protected itself. Rapid River
Carriers contracts to transport a refrigerated cargo of beef down the Mississippi River on the
SS Rapid. When the ship is en route, it is hit by a tornado and sinks. This is an act of God. But a
contributing act of negligence by a carrier overcomes the act of God exception. If it could be
shown that the captain was negligent to set sail when the weather warned of imminent tornados,
the carrier might be liable.

Act of Public Enemy
This is a narrow exception that applies only to acts committed by pirates at high sea or by the
armed forces of enemies of the state to which the carrier owes allegiance. American ships at sea
that are sunk during wartime by enemy torpedoes would not be liable for losses to the owners of
cargo. Moreover, public enemies do not include lawless mobs or criminals listed on the FBI’s
Ten Most Wanted list, even if federal troops are required, as in the Pullman Strike of 1894, to
put down the violence. After the Pullman Strike, carriers were held liable for property destroyed
by violent strikers.

Act of Public Authority
When a public authority—a sheriff or federal marshal, for example—through lawful process
seizes goods in the carrier’s possession, the carrier is excused from liability. Imagine that federal
agents board the SS Rapid in New Orleans and, as she is about to sail, show the captain a search
warrant and seize several boxes of cargo marked “beef” that turn out to hold cocaine. The owner
or consignee of this illegal cargo will not prevail in a suit against the carrier to recover damages.
Likewise, if the rightful owner of the goods obtains a lawful court order permitting him to attach
them, the carrier is obligated to permit the goods to be taken. It is not the carrier’s responsibility
to contest a judicial writ or to face the consequences of resisting a court order. The courts
generally agree that the carrier must notify the owner whenever goods are seized.

Act of Shipper

Saylor URL: http://www.saylor.org/books

Saylor.org
792

When goods are lost or damaged because of the shipper’s negligence, the shipper is liable, not
the carrier. The usual situation under this exception arises from defective packing. The shipper
who packs the goods defectively is responsible for breakage unless the defect is apparent and the
carrier accepts the goods anyway. For example, if you ship your sister crystal goblets packed
loosely in the box, they will inevitably be broken when driven in trucks along the highways. The
trucker who knowingly accepts boxes in this condition is liable for the damage. Likewise, the
carrier’s negligence will overcome the exception and make him absolutely liable. A paper
supplier ships several bales of fine stationery in thin cardboard boxes susceptible to moisture.
Knowing their content, SS Rapid accepts the bales and exposes them to the elements on the
upper deck. A rainstorm curdles the stationery. The carrier is liable.

Inherent Nature of the Goods
The fifth exception to the rule of absolute liability is rooted in the nature of the goods
themselves. If they are inherently subject to deterioration or their inherent characteristics are
such that they might be destroyed, then the loss must lie on the owner. Common examples are
chemicals that can explode spontaneously and perishable fruits and vegetables. Of course, the
carrier is responsible for seeing that foodstuffs are properly stored and cared for, but if they
deteriorate naturally and not through the carrier’s negligence, he is not liable.

Which Carrier Is Liable?
The transportation system is complex, and few goods travel from portal to portal under the care
of one carrier only. In the nineteenth century, the shipper whose goods were lost had a difficult
time recovering their value. Initial carriers blamed the loss on subsequent carriers, and even if
the shipper could determine which carrier actually had possession of the goods when the
damage or loss occurred, diverse state laws made proof burdensome. The Carmack Amendment
ended the considerable confusion by placing the burden on the initial carrier; connecting
carriers are deemed agents of the initial carrier. So the plaintiff, whether seller or buyer, need
sue only the initial carrier, no matter where the loss occurred. Likewise, Section 7-302 of the
UCC fastens liability on an initial carrier for damages or loss caused by connecting carriers.

When Does Carrier Liability Begin and End?

Saylor URL: http://www.saylor.org/books

Saylor.org
793

When a carrier’s liability begins and ends is an important issue because the same company can
act both to store the goods and to carry them. The carrier’s liability is more stringent than the
warehouser’s. So the question is, when does a warehouser become a carrier and vice versa?
The basic test for the beginning of carrier liability is whether the shipper must take further
action or give further instructions to the carrier before its duty to transport arises. Suppose that
Cotton Picking Associates delivers fifty bales of cotton to Rapid River Carriers for transport on
the SS Rapid. The SS Rapid is not due back to port for two more days, so Rapid River Carrier
stores the cotton in its warehouse, and on the following day the warehouse is struck by lightning
and burns to the ground. Is Rapid River Carriers liable in its capacity as a carrier or warehouse?
Since nothing was left for the owner to do, and Rapid River was storing the cotton for its own
convenience awaiting the ship’s arrival, it was acting as a carrier and is liable for the loss. Now
suppose that when Cotton Picking Associates delivered the fifty bales it said that another fifty
bales would be coming in a week and the entire lot was to be shipped together. Rapid River
stores the first fifty bales and lightning strikes. Since more remained for Cotton Picking to do
before Rapid River was obligated to ship, the carrier was acting in its warehousing capacity and
is not liable.
The carrier’s absolute liability ends when it has delivered the goods to the consignee’s residence
or place of business, unless the agreement states otherwise (as it often does). By custom, certain
carriers—notably rail carriers and carriers by water—are not required to deliver the goods to the
consignee (since rail lines and oceans do not take the carrier to the consignee’s door). Instead,
consignees must take delivery at the dock or some other place mutually agreed on or established
by custom.
When the carrier must make personal delivery to the consignee, carrier liability continues until
the carrier has made reasonable efforts to deliver. An express trucking company cannot call on a
corporate customer on Sunday or late at night, for instance. If reasonable efforts to deliver fail, it
may store the goods in its own warehouse, in which case its liability reverts to that of a
warehouser.
If personal delivery is not required (e.g., as in shipment by rail), the states use different
approaches for determining when the carrier’s liability terminates. The most popular intrastate
Saylor URL: http://www.saylor.org/books

Saylor.org
794

approach provides that the carrier continues to be absolutely responsible for the goods until the
consignee has been notified of their arrival and has had a reasonable opportunity to take
possession of them.
Interstate shipments are governed by the Carmack Amendment, which generally provides that
liability will be determined by language in the bill of lading. The typical bill of lading (or “BOL”
and “B/L”) provides that if the consignee does not take the goods within a stated period of time
after receiving notice of their arrival, the carrier will be liable as warehouser only.

Disclaimers
The apparently draconian liability of the carrier—as an insurer of the goods—is in practice easily
minimized. Under neither federal nor state law may the carrier disclaim its absolute liability, but
at least as to commercial transactions it may limit the damages payable under certain
circumstances. Both the Carmack Amendment and Section 7-309 of the UCC permit the carrier
to set alternate tariffs, one costing the shipper more and paying full value, the other costing less
and limited to a dollar per pound or some other rate less than full value. The shipper must have
a choice; the carrier may not impose a lesser tariff unilaterally on the shipper, and the loss must
not be occasioned by the carrier’s own negligence.

Specific Types of Liability
The rules just discussed relate to the general liability of the carrier for damages to the goods.
There are two specific types of liability worth noting.

Nonreceipt or Misdescription
Under the UCC, Section 7-301(1), the owner of the goods (e.g., a consignee) described in a bill of
lading may recover damages from the issuer of the bill (the carrier) if the issuer did not actually
receive the goods from the shipper, if the goods were misdescribed, or if the bill was misdated.
The issuer may avoid liability by reciting in the bill of lading that she does not know whether the
goods were received or if they conform to the description; the issuer may avoid liability also by
marking the goods with such words as “contents or condition of contents unknown.” Even this
qualifying language may be ineffective. For instance, a common carrier may not hide behind
language indicating that the description was given by the shipper; the carrier must actually
count the packages of goods or ascertain the kind and quantity of bulk freight. Just because the
Saylor URL: http://www.saylor.org/books

Saylor.org
795

carrier is liable to the consignee for errors in description does not mean that the shipper is free
from blame. Section 7-301(5) requires the shipper to indemnify the carrier if the shipper has
inaccurately described the goods in any way (including marks, labels, number, kind, quantity,
condition, and weight).

Delivery to the Wrong Party
The rule just discussed for warehouser applies to carriers under both state and federal law:
carriers are absolutely liable for delivering the goods to the wrong party. In the classic case
of Southern Express Co. v. C. L. Ruth & Son, a clever imposter posed as the representative of a
reputable firm and tricked the carrier into delivering a diamond ring.[6] The court held the
carrier liable, even though the carrier was not negligent and there was no collusion. The UCC
contains certain exceptions; under Section 7-303(1), the carrier is immune from liability if the
holder, the consignor, or (under certain circumstances) the consignee gives instructions to
deliver the goods to someone other than a person named in the bill of lading.

Carrier’s Right to Lien and Enforcement of Lien
Just as the warehouser can have a lien, so too can the carrier. The lien can cover charges for
storage, transportation, and preservation of goods. When someone has purchased a negotiable
bill of lading, the lien is limited to charges stated in the bill, allowed under applicable tariffs, or,
if none are stated, to a reasonable charge. A carrier who voluntarily delivers or unjustifiably
refuses to deliver the goods loses its lien. The carrier has rights paralleling those of the
warehouser to enforce the lien.

Passengers
In addition to shipping goods, common carriers also transport passengers and their baggage.
The carrier owes passengers a high degree of care; in 1880 the Supreme Court described the
standard as “the utmost caution characteristic of very careful prudent men.” [7] This duty implies
liability for a host of injuries, including mental distress occasioned by insults (“lunatic,”
“whore,” “cheap, common scalawag”) and by profane or indecent language. In Werndli v.
Greyhound, [8] Mrs. Werndli deboarded the bus at her destination at 2:30 a.m.; finding the bus
station closed, she walked some distance to find a bathroom. While doing so, she became the
victim of an assault. The court held Greyhound liable: it should have known the station was
Saylor URL: http://www.saylor.org/books

Saylor.org
796

closed at 2:30 a.m. and that it was located in a area that became dangerous after hours. The case
illustrates the degree to which a carrier is responsible for its passengers’ safety and comfort.
The baggage carrier is liable as an insurer unless the baggage is not in fact delivered to the
carrier. A passenger who retains control over his hand luggage by taking it with him to his seat
has not delivered the baggage to the carrier, and hence the carrier has no absolute liability for its
loss or destruction. The carrier remains liable for negligence, however. When the passenger does
deliver his luggage to the carrier, the question often arises whether the property so delivered is
“baggage.” If it is not, the carrier does not have an insurer’s liability toward it. Thus a person
who transports household goods in a suitcase would not have given the carrier “baggage,” as that
term is usually defined (i.e., something transported for the passenger’s personal use or
convenience). At most, the carrier would be responsible for the goods as a gratuitous bailee.

KEY TAKEAWAY

The storage of goods is a special type of bailment. People who store goods can retrieve them
or transfer ownership of them by transferring possession of the warehouse receipt: whoever
has rightful possession of the receipt can take the goods, and the warehouser is liable for
misdelivery or for mixing up goods. The warehouser has a right to a lien to secure his fee,
enforceable by selling the goods in a commercially reasonable way. The shipping of goods is
of course an important business. Common carriers (those firms that hire out their trucks,
airplanes, ships, or trains to carry cargo) are strictly liable to ensure the proper arrival of the
goods to their destination, with five exceptions (act of God, public enemy, public authority,
shipper; inherent nature of the goods); the first carrier to receive them is liable—others who
subsequently carry are that carrier’s agents. The carrier may also store goods: if it does so for
its own convenience it is liable as a carrier; if it does so for the shipper’s convenience, it is
liable as a warehouser. As with warehousers, the carrier is liable for misdelivery and is
entitled to a lien to enforce payment. Carriers also carry people, and the standard of care
they owe to passengers is very high. Carrying passengers’ baggage, the carrier is liable as an
insurer—it is strictly liable.

EXERCISES

1. How are warehousers any different from the more generic bailees?
2. How do the duties and liabilities of warehousers differ from those of carriers?
Saylor URL: http://www.saylor.org/books

Saylor.org
797

3. What rights do warehousers and carriers have to ensure their payment?
4. May a carrier limit its liability for losses not its fault?

[1] Uniform Commercial Code, Section 7-204(1).
[2] Uniform Commercial Code, Section 7-204(2).
[3] Uniform Commercial Code, Section 7-403(1).
[4] Ace High Dresses v. J. C. Trucking Co., 191 A. 536 (Conn. 1937).
[5] Uniform Commercial Code, Section 1-206(6).
[6] Southern Express Co. v. C. L. Ruth & Son, 59 So. 538 (Ala. Ct. App. 1912).
[7] Pennsylvania Co. v. Roy, 102 US 451 (1880).
[8] Werndli v. Greyhound Corp., 365 So.2d 177 (Fla. Ct. App., 1978)

21.4 Negotiation and Transfer of Documents of Title (or
Commodity Paper)
LEARNING OBJECTIVES

1. Understand how commodity paper operates in the sale of goods.
2. Recognize when the transferee of a properly negotiated document of title gets better rights
than her transferor had and the exceptions to this principle.

Overview of Negotiability
We have discussed in several places the concept of a document of title (also
calledcommodity paper). That is a written description, identification, or declaration of goods
authorizing the holder—usually a bailee—to receive, hold, and dispose of the document and the
goods it covers. Examples of documents of title are warehouse receipts, bills of lading, and
delivery orders. The document of title, properly negotiated (delivered), gives its holder
ownership of the goods it represents. It is much easier to pass around a piece of paper
representing the ownership interest in goods than it is to pass around the goods themselves.
It is a basic feature of our legal system that a person cannot transfer more rights to property
than he owns. It would follow here that no holder of a document of title has greater rights in the
goods than the holder’s transferor—the one from whom she got the document (and thus the
Saylor URL: http://www.saylor.org/books

Saylor.org
798

goods). But there are certain exceptions to this rule; for example, Chapter 17 "Introduction to
Sales and Leases" discusses the power of a merchant in certain circumstances to transfer title to
goods, even though the merchant himself did not have title to them. To conclude this chapter,
we discuss the rule as it applies to documents of title, sometimes known as commodity paper.

The Elements and Effect of Negotiation
If a document of title is “negotiable” and is “duly negotiated,” the purchaser can obtain rights
greater than those of the storer or shipper. In the following discussion, we refer only to the
Uniform Commercial Code (UCC), although federal law also distinguishes between negotiable
and nonnegotiable documents of title (some of the technical details in the federal law may differ,
but these are beyond the scope of this book).

Negotiable Defined
Any document of title, including a warehouse receipt and a bill of lading, is negotiable or
becomes negotiable if by its terms the goods are to be delivered “to bearer or to the order of” a
named person. [1] All other documents of title are nonnegotiable. Suppose a bill of lading says
that the goods are consigned to Tom Thumb but that they may not be delivered unless Tom
signs a written order that they be delivered. Under Section 7-104(2), that is not a negotiable
document of title. A negotiable document of title must bear words such as “Deliver to the bearer”
or “deliver to the order of Tom Thumb.” These are the “magic words” that create a negotiable
document.

Duly Negotiated
To transfer title effectively through negotiation of the document of title, it must be “duly
negotiated.” In general terms, under Section 7-501 of the UCC, a negotiable document of title
is duly negotiated when the person named in it indorses (signs it over—literally “on the back of”)
and delivers it to a holder who purchases it in good faith and for value, without any notice that
someone else might have a claim against the goods, assuming the transaction is in the regular
course of business or financing. Note that last part: assuming the transaction is in the regular
course of business. If you gave your roommate a negotiable document of title in payment for a
car you bought from her, your roommate would have something of value, but it would not have
been duly negotiated. Paper made out “to bearer” (bearer paper) is negotiated by delivery alone;
Saylor URL: http://www.saylor.org/books

Saylor.org
799

no indorsement is needed. A holder is anyone who possesses a document of title that is drawn to
his order, indorsed to him, or made out “to bearer.”

Effect
As a general rule, if these requirements are not met, the transferee acquires only those rights
that the transferor had and nothing more. And if a nonnegotiable document is sold, the buyer’s
rights may be defeated. For example, a creditor of the transferor might be entitled to treat the
sale as void.
Under Section 7-502 of the UCC, however, if the document is duly negotiated, then the holder
acquires (1) title to the document, (2) title to the goods, (3) certain rights to the goods delivered
to the bailee after the document itself was issued, and (4) the right to have the issuer of the
document of title hold the goods or deliver the goods free of any defense or claim by the issuer.
To contrast the difference between sale of goods and negotiation of the document of title,
consider the plight of Lucy, the owner of presidential campaign pins and other political
memorabilia. Lucy plans to hold them for ten years and then sell them for many times their
present value. She does not have the room in her cramped apartment to keep them, so she crates
them up and takes them to a friend for safekeeping. The friend gives her a receipt that says
simply: “Received from Lucy, five cartons; to be stored for ten years at $25 per year.” Although a
document of title, the receipt is not negotiable. Two years later, a browser happens on Lucy’s
crates, discovers their contents, and offers the friend $1,000 for them. Figuring Lucy will forget
all about them, the friend sells them. As it happens, Lucy comes by a week later to check on her
memorabilia, discovers what her former friend has done, and sues the browser for their return.
Lucy would prevail. Now suppose instead that the friend, who has authority from Lucy to store
the goods, takes the cartons to the Trusty Storage Company, receives a negotiable warehouse
receipt (“deliver to bearer five cartons”), and then negotiates the receipt. This time Lucy would
be out of luck. The bona fide purchaser from her friend would cut off Lucy’s right to recover the
goods, even though the friend never had good title to them.
A major purpose of the concept is to allow banks and other creditors to loan money with the
right to the goods as represented on the paper as collateral. They can, in effect, accept the paper
as collateral without fear that third parties will make some claim on the goods.
Saylor URL: http://www.saylor.org/books

Saylor.org
800

But even if the requirements of negotiability are met, the document of title still will confer no
rights in certain cases. For example, when a thief forges the indorsement of the owner, who held
negotiable warehouse receipts, the bona fide purchaser from the thief does not obtain good title.
Only if the receipts were in bearer form would the purchaser prevail in a suit by the owner.
Likewise, if the owner brought his goods to a repair shop that warehoused them without any
authority and then sold the negotiable receipts received for them, the owner would prevail over
the subsequent purchaser.
Another instance in which an apparent negotiation of a document of title will not give the bona
fide purchaser superior rights occurs when a term in the document is altered without
authorization. But if blanks are filled in without authority, the rule states different consequences
for bills of lading and warehouse receipts. Under Section 7-306 of the UCC, any unauthorized
filling in of a blank in a bill of lading leaves the bill enforceable only as it was originally.
However, under Section 7-208, an unauthorized filling in of a blank in a warehouse receipt
permits the good-faith purchaser with no notice that authority was lacking to treat the insertion
as authorized, thus giving him good title. This section makes it dangerous for a warehouser to
issue a receipt with blanks in it, because he will be liable for any losses to the owner if a goodfaith purchaser takes the goods.
Finally, note that a purchaser of a document of title who is unable to get his hands on the
goods—perhaps the document was forged—might have a breach of warranty action against the
seller of the document. Under Section 7-507 of the UCC, a person who negotiates a document of
title warrants to his immediate purchaser that the document is genuine, that he has no
knowledge of any facts that would impair its validity, and that the negotiation is rightful and
effective. Thus the purchaser of a forged warehouse receipt would not be entitled to recover the
goods but could sue his transferor for breach of the warranty.

KEY TAKEAWAY

It is a lot easier to move pieces of paper around than goods in warehouses. Therefore
commercial paper, or commodity paper, was invented: the paper represents the goods, and
the paper is transferred from one person to another by negotiation. The holder signs on the
back of the paper and indicates who its next holder should be (or foolishly leaves that blank);

Saylor URL: http://www.saylor.org/books

Saylor.org
801

that person then has rights to the goods and, indeed, better rights. On due negotiation the
transferee does not merely stand in the transferor’s shoes: the transferee takes free of
defects and defenses that could have been available against the transferor. For a document
of title to be a negotiable one, it must indicate that the intention of it is that it should be
passed on through commerce, with the words “to bearer” or “to the order of [somebody],”
and it must be duly negotiated: signed off on by its previous holder (or without any signature
needed if it was bearer paper).

EXERCISES

1. “George Baker deposited five cardboard boxes in my barn’s loft, and he can pick them up
when he wants.” Is this statement a negotiable document of title?
2. “George Baker deposited five cardboard boxes in my barn’s loft, and he or anybody to his
order can pick them up.” Is this statement a negotiable document of title?
3. Why is the concept of being a holder of duly negotiated documents of title important?

[1] Uniform Commercial Code, Section 7-104(1)(a).

21.5 Cases
Bailments and Disclaimers of Bailee’s Liability
Carr v. Hoosier Photo Supplies, Inc.
441 N.E.2d 450 (Ind. 1982)
Givan, J.
Litigation in this cause began with the filing of a complaint in Marion Municipal Court by John
R. Carr, Jr. (hereinafter “Carr”), seeking damages in the amount of $10,000 from defendants
Hoosier Photo Supplies, Inc. (hereinafter “Hoosier”) and Eastman Kodak Company (hereinafter
“Kodak”). Carr was the beneficiary of a judgment in the amount of $1,013.60. Both sides
appealed. The Court of Appeals affirmed the trial court in its entirety.
The facts were established by stipulation agreement between the parties and thus are not in
dispute. In the late spring or early summer of 1970, Carr purchased some Kodak film from a
retailer not a party to this action, including four rolls of Kodak Ektachrome-X 135 slide film that
Saylor URL: http://www.saylor.org/books

Saylor.org
802

are the subject matter of this dispute. During the month of August, 1970, Carr and his family
vacationed in Europe. Using his own camera Carr took a great many photographs of the sites
they saw, using among others the four rolls of film referred to earlier. Upon their return to the
United States, Carr took a total of eighteen [18] rolls of exposed film to Hoosier to be developed.
Only fourteen [14] of the rolls were returned to Carr after processing. All efforts to find the
missing rolls or the pictures developed from them were unsuccessful. Litigation commenced
when the parties were unable to negotiate a settlement.
The film Carr purchased, manufactured by Kodak, is distributed in boxes on which there is
printed the following legend:

READ THIS NOTICE
This film will be replaced if defective in manufacture, labeling, or packaging, or if
damaged or lost by us or any subsidiary company even though by negligence or other
fault. Except for such replacement, the sale, processing, or other handling of this film
for any purpose is without other warranty of liability.

In the stipulation of facts it was agreed though Carr never read this notice on the packages of
film he bought, he knew there was printed on such packages “a limitation of liability similar or
identical to the Eastman Kodak limitation of liability.” The source of Carr’s knowledge was
agreed to be his years of experience as an attorney and as an amateur photographer.
When Carr took all eighteen [18] rolls of exposed film to Hoosier for processing, he was given a
receipt for each roll. Each receipt contained the following language printed on the back side:
Although film price does not include processing by Kodak, the return of any film or
print to us for processing or any other purpose, will constitute an agreement by you
that if any such film or print is damaged or lost by us or any subsidiary company,
even though by negligence or other fault, it will be replaced with an equivalent
amount of Kodak film and processing and, except for such replacement, the handling
of such film or prints by us for any purpose is without other warranty or liability.
Again, it was agreed though Carr did not read this notice he was aware Hoosier “[gave] to their
customers at the time of accepting film for processing, receipts on which there are printed

Saylor URL: http://www.saylor.org/books

Saylor.org
803

limitations of liability similar or identical to the limitation of liability printed on each receipt
received by Carr from Hoosier Photo.”
It was stipulated upon receipt of the eighteen [18] rolls of exposed film only fourteen [14] were
returned to Hoosier by Kodak after processing. Finally, it was stipulated the four rolls of film
were lost by either Hoosier or Kodak.…
That either Kodak or Hoosier breached the bailment contract, by negligently losing the four rolls
of film, was established in the stipulated agreement of facts. Therefore, the next issue raised is
whether either or both, Hoosier or Kodak, may limit their liability as reflected on the film
packages and receipts.…
[A] prerequisite to finding a limitation of liability clause in a contract unconscionable and
therefore void is a showing of disparity in bargaining power in favor of the party whose liability
is thus limited.…In the case at bar the stipulated facts foreclose a finding of disparate bargaining
power between the parties or lack of knowledge or understanding of the liability clause by Carr.
The facts show Carr is an experienced attorney who practices in the field of business law. He is
hardly in a position comparable to that of the plaintiff in Weaver, supra. Moreover, it was
stipulated he was aware of the limitation of liability on both the film packages and the receipts.
We believe these crucial facts belie a finding of disparate bargaining power working to Carr’s
disadvantage.
Contrary to Carr’s assertions, he was not in a “take it or leave it position” in that he had no
choice but to accept the limitation of liability terms of the contract. As cross-appellants Hoosier
and Kodak correctly point out, Carr and other photographers like him do have some choice in
the matter of film processing. They can, for one, undertake to develop their film themselves.
They can also go to independent film laboratories not a part of the Kodak Company. We do not
see the availability of processing as limited to Kodak.…
We hold the limitation of liability clauses operating in favor of Hoosier and Kodak were assented
to by Carr; they were not unconscionable or void. Carr is, therefore, bound by such terms and is
limited in his remedy to recovery of the cost of four boxes of unexposed Kodak Ektachrome-X
135 slide film.

Saylor URL: http://www.saylor.org/books

Saylor.org
804

The Court of Appeals’ opinion in this case is hereby vacated. The cause is remanded to the trial
court with instructions to enter a judgment in favor of appellant, John R. Carr, Jr., in the
amount of $13.60, plus interest. Each party is to bear its own costs.
Hunter and Pivarnik, JJ., concur. Prentice, J., concurs in result without opinion.
DeBruler, J., dissenting.
…As a general rule the law does not permit professional bailees to escape or diminish liability for
their own negligence by posting signs or handing out receipts. [Citations] The statements on the
film box and claim check used by Kodak and Hoosier Photo are in all respects like the printed
forms of similar import which commonly appear on packages, signs, chits, tickets, tokens and
receipts with which we are all bombarded daily. No one does, or can reasonably be expected, to
take the time to carefully read the front, back, and sides of such things. We all know their gist
anyway.
The distinguished trial judge below characterizes these statements before us as “mere notices”
and concludes that plaintiff below did not “assent” to them so as to render them a binding part
of the bailment contract. Implicit here is the recognition of the exception to the general rule
regarding such notices, namely, that they may attain the dignity of a special contract limiting
liability where the bailor overtly assents to their terms. [Citations] To assent to provisions of this
sort requires more than simply placing the goods into the hands of the bailee and taking back a
receipt or claim check. Such acts are as probative of ignorance as they are of knowledge.
However, according to the agreed statement of facts, plaintiff Carr “knew” by past experience
that the claim checks carried the limitation of liability statements, but he did not read them and
was unaware of the specific language in them. There is nothing in this agreed statement that
Carr recalled this knowledge to present consciousness at the time of these transactions.
Obviously we all know many things which we do not recall or remember at any given time. The
assent required by law is more than this; it is, I believe, to perform an act of understanding.
There is no evidence of that here.
The evidence presented tending to support the award of damages included an actual
uncontroverted amount of $13.60 thereby precluding mere nominal damages. There was further
evidence that 150 exposures were lost. The actual award of $1,014.60 amounted to between
Saylor URL: http://www.saylor.org/books

Saylor.org
805

$6.00 and $7.00 per picture. Carr provided evidence that the pictures were of exceptional value
to him, having been taken in a once-in-a-lifetime European trip costing $6000 [about $33,000
in 2110 dollars], including visits arranged there before hand with relatives. The award was fair
and just compensation for the loss of value to the owner and does not include sentimental or
fanciful value.
The trial court judgment should be affirmed.

CASE QUESTIONS

1. Four out of eighteen rolls of film were not returned to the bailor, Mr. Carr. The court here
affirmed a judgment for about $6 per lost image. How could an image taken by an amateur
photographer be worth $6 a piece?
2. The European trip cost him $6,000 in 1970; he asked for $10,000 (about $55,000 in 2010
dollars). Upon what basis could such damages be arrived? What did he apparently want?
3. What argument did the plaintiff make as to why the limitation of liability should not be
enforced? What response did the court have to that?
4. Would it have made a difference if the plaintiff were not himself a business attorney? Why or
why not?
5. Why did the dissent think the court of appeals’ decision to award the plaintiff $1,000 was
correct and the majority’s opinion incorrect?

Bailed Goods of Sentimental Value
Mieske v. Bartell Drug Co.
593 P.2d 1308 (Wash. 1979)
Brachtenbach, J.
This case determines the measure of damages for personal property, developed movie film,
which is destroyed, and which cannot be replaced or reproduced. It also decides the legal effect
of a clause which purports to limit the responsibility of a film processor to replacement of film.…
The facts are that over a period of years the plaintiffs had taken movie films of their family
activities. The films started with the plaintiffs’ wedding and honeymoon and continued through
vacations in Mexico, Hawaii and other places, Christmas gatherings, birthdays, Little League

Saylor URL: http://www.saylor.org/books

Saylor.org
806

participation by their son, family pets, building of their home and irreplaceable pictures of
members of their family, such as the husband’s brother, who are now deceased.
Plaintiffs had 32 50-foot reels of such developed film which they wanted spliced together into
four reels for convenience of viewing. Plaintiff wife visited defendant Bartell’s camera
department, with which she had dealt as a customer for at least 10 years. She was told that such
service could be performed.
The films were put in the order which plaintiffs desired them to be spliced and so marked. They
were then placed in four separate paper bags which in turn were placed in one large bag and
delivered to the manager of Bartell. The plaintiff wife explained the desired service and the
manner in which the films were assembled in the various bags. The manager placed a film
processing packet on the bag and gave plaintiff wife a receipt which contained this language:
“We assume no responsibility beyond retail cost of film unless otherwise agreed to in writing.”
There was no discussion about the language on the receipt. Rather, plaintiff wife told the
manager, “Don’t lose these. They are my life.”
Bartell sent the film package to defendant GAF Corporation, which intended to send them to
another processing lab for splicing. Plaintiffs assumed that Bartell did this service and were
unaware of the involvement of two other firms.
The bag of films arrived at the processing lab of GAF. The manager of the GAF lab described the
service ordered and the packaging as very unusual. Yet it is undisputed that the film was in the
GAF lab at the end of one day and gone the next morning. The manager immediately searched
the garbage disposal dumpster which already had been emptied. The best guess is that the
plaintiffs’ film went from GAF’s lab to the garbage dumpster to a truck to a barge to an upSound landfill where it may yet repose.
After several inquiries to Bartell, plaintiff wife was advised to call GAF. Not surprisingly, after
being advised of the complete absence and apparent fatality of plaintiffs’ films, this lawsuit
ensued.…
Two main issues are raised: (1) the measure of damages and (2) the effect of the exclusionary
clause appearing on the film receipt.

Saylor URL: http://www.saylor.org/books

Saylor.org
807

On damages, the defendants assign error to (a) the court’s damages instruction and (b) the
court’s failure to give their proposed damages instruction.
The standard of recovery for destruction of personal property was summarized in [McCurdy].
We recognized in McCurdy that (1) personal property which is destroyed may have a market
value, in which case that market value is the measure of damages; (2) if destroyed property has
no market value but can be replaced or reproduced, then the measure is the cost of replacement
or reproduction; (3) if the destroyed property has no market value and cannot be replaced or
reproduced, then the value to the owner is to be the proper measure of damages. However, while
not stated in McCurdy, we have held that in the third McCurdy situation, damages are not
recoverable for the sentimental value which the owner places on the property. [Citations]
The defendants argue that plaintiffs’ property comes within the second rule of McCurdy, i.e., the
film could be replaced and that their liability is limited to the cost of replacement film. Their
position is not well taken. Defendants’ proposal would award the plaintiffs the cost of acquiring
film without pictures imposed thereon. That is not what plaintiffs lost. Plaintiffs lost not merely
film able to capture images by exposure but rather film upon which was recorded a multitude of
frames depicting many significant events in their lives. Awarding plaintiffs the funds to purchase
32 rolls of blank film is hardly a replacement of the 32 rolls of images which they had recorded
over the years. Therefore the third rule of McCurdy is the appropriate measure of damages, i.e.,
the property has no market value and cannot be replaced or reproduced.
The law, in those circumstances, decrees that the measure of damages is to be determined by the
value to the owner, often referred to as the intrinsic value of the property. Restatement of Torts
s. 911 (1939).
Necessarily the measure of damages in these circumstances is the most imprecise of the three
categories. Yet difficulty of assessment is not cause to deny damages to a plaintiff whose
property has no market value and cannot be replaced or reproduced. [Citations]
The fact that damages are difficult to ascertain and measure does not diminish the loss to the
person whose property has been destroyed. Indeed, the very statement of the rule suggests the
opposite. If one’s destroyed property has a market value, presumably its equivalent is available
on the market and the owner can acquire that equivalent property. However, if the owner cannot
Saylor URL: http://www.saylor.org/books

Saylor.org
808

acquire the property in the market or by replacement or reproduction, then he simply cannot be
made whole.
The problem is to establish the value to the owner. Market and replacement values are relatively
ascertainable by appropriate proof. Recognizing that value to the owner encompasses a
subjective element, the rule has been established that compensation for sentimental or fanciful
values will not be allowed. [Citations] That restriction was placed upon the jury in this case by
the court’s damages instruction.…
Under these rules, the court’s damages instruction was correct. In essence it allowed recovery
for the actual or intrinsic value to the plaintiffs but denied recovery for any unusual sentimental
value of the film to the plaintiffs or a fanciful price which plaintiffs, for their own special
reasons, might place thereon.…
The next issue is to determine the legal effect of the exclusionary clause which was on the film
receipt given plaintiff wife by Bartell. As noted above, it read: “We assume no responsibility
beyond retail cost of film unless otherwise agreed to in writing.”
Is the exclusionary clause valid? Defendants rely upon 2-719(3), a section of the Uniform
Commercial Code, which authorizes a limitation or exclusion of consequential damages unless
the limitation is unconscionable.
Plaintiffs, on the other hand, argue that the Uniform Commercial Code is not applicable to this
transaction.…It is now clearly established that the reach of Article 2 goes considerably beyond
the confines of that type transaction which the Code itself defines to be a “sale”; namely, the
passing of title from a party called the seller to one denominated a buyer for a price. Chief
opportunity for this expansion is found in Section 2-102, which states that the article applies to
“transactions in goods.” “Article 2 sections are finding their way into more and more decisions
involving transactions which are not sales, but which are used as substitutes for a sale or which
to a court appear to have attributes to which sales principles or at least some of them seem
appropriate for application.…Most important of these is the application of the Article’s warranty
provisions to leases, bailments, or construction contracts. Of growing importance is the
tendency of courts to find the Section on unconscionability, Section 2-302, appropriate to
nonsales deals.”
Saylor URL: http://www.saylor.org/books

Saylor.org
809

Application of the Uniform Commercial Code to this transaction leads to defendants’ next two
contentions. First, they urge that the code’s recognition of course of dealings and trade usage
validates the exclusionary clause. Second, defendants assign error to the grounds upon which
the court found the clause to be unconscionable and therefore invalid.
Defendants contend that it is the uniform trade practice of film processors to impose an
exclusionary clause similar to that contained in Bartell’s film receipt. However, the existence of a
trade usage is to be established as a fact [Citation]. It was proved as a usage among film
processors, but not as between commercial film processors and their retail
customers.…Consequently, defendants’ reliance on trade usage to uphold the exclusionary
clause is not well founded.
As to course of dealings, the record is clear that Mrs. Mieske and the Bartell manager never
discussed the exclusionary clause. Mrs. Mieske had never read it, she viewed the numbered slip
as merely a receipt. The manager was not “too clear on what it said.” There was no showing what
was the language on any other receipt given in prior dealings between the parties. In summary,
defendants’ proof fell short of that required by the express language of 1-205(3). Defendants
contend we should apply a course of dealing standard as a matter of law, but cite no authority
for such proposition. We decline the invitation.
Defendants next assert that the trial court held the exclusionary clause to be unconscionable
without considering the rules laid down in Schroeder v. Fageol Motors, Inc., 544 P.2d 20
(1975). In Schroeder, we recognized that the term unconscionable is not defined in the Uniform
Commercial Code. We acknowledge that the code mandates the court to determine
unconscionability as a matter of law, 2-302(1). Schroeder held that numerous factors enter into
a determination of unconscionability. No one element is controlling. The court must examine all
the circumstances surrounding the transaction, including conspicuousness of the clause, prior
course of dealings between the parties, negotiations about the clause, the commercial setting
and usage of the trade. Not each element will be applicable factually to every transaction.…
The real question is whether the court considered the necessary elements of Schroeder. A review
of the record convinces us that it did. The court had the facts, the Schroeder case was argued,

Saylor URL: http://www.saylor.org/books

Saylor.org
810

the criteria set forth therein were discussed by defendants’ counsel both on objections and on
exceptions. There was no error. Judgment affirmed.

CASE QUESTIONS

1. This case presents pretty much the same fact situation as the previous one, but it comes out
the other way. Why? What’s the difference?
2. The court said there could be “recovery for the actual or intrinsic value to the plaintiffs but
[not for] for any unusual sentimental value of the film to the plaintiffs or a fanciful price
which plaintiffs, for their own special reasons, might place thereon.” What actual value does
a role of film have if not sentimental value, and if the court were not concerned about the
sentimental value, why did it mention all the irreplaceable memories recorded on the film—
what difference would it make what was on the film if it had an ascertainable “actual value”?
3. Determining that this bailment was governed by the UCC opened up three lines of argument
for the defendant. What were they?
4. Why did the court here say the disclaimer was unconscionable?

Liability of Carrier; Limitations on Liability
Calvin Klein Ltd. v. Trylon Trucking Corp.
892 F.2d 191C.A.2 (N.Y. 1989)
Miner, J.
Defendant-appellant Trylon Trucking Corp. (“Trylon”) appeals from a judgment…in favor of
plaintiff-appellee Calvin Klein Ltd. (“Calvin Klein”) for the full value of a lost shipment of
clothing. The appeal presents a novel issue under New York law: whether a limitation of liability
agreement between a shipper and a carrier is enforceable when the shipment is lost as a result of
the carrier’s gross negligence.
The district court held that the parties’ customary limitation of liability agreement did not
extend to the shipment at issue, due to the absence of assent and consideration. The court
observed that, had there been such an agreement, the liability of the carrier for its gross
negligence would be limited. For the reasons that follow, we reverse the judgment of the district
court, find that the parties agreed to the limitation of liability, and determine that the agreement
limits Trylon’s liability for its gross negligence.…

Saylor URL: http://www.saylor.org/books

Saylor.org
811

Trylon is a New Jersey trucking firm which engaged in the business of transporting goods from
New York City’s airports for delivery to its customers’ facilities. Calvin Klein, a New York
clothing company, had used the services of Trylon for at least three years, involving hundreds of
shipments, prior to the lost shipment at issue. In past deliveries Calvin Klein, through its
customs broker, would contact Trylon to pick up the shipment from the airport for delivery to
Calvin Klein’s facility. After completing the carriage, Trylon would forward to Calvin Klein an
invoice, which contained a limitation of liability provision as follows:
In consideration of the rate charged, the shipper agrees that the carrier shall not be
liable for more than $50.00 on any shipment accepted for delivery to one consignee
unless a greater value is declared, in writing, upon receipt at time of shipment and
charge for such greater value paid, or agreed to be paid, by the shipper.
A shipment of 2,833 blouses from Hong Kong arrived at John F. Kennedy International Airport
for Calvin Klein on March 27, 1986. Calvin Klein arranged for Trylon to pick up the shipment
and deliver it to Calvin Klein’s New Jersey warehouse. On April 2, Trylon dispatched its driver,
Jamahl Jefferson, to pick up this shipment. Jefferson signed a receipt for the shipment from
Calvin Klein’s broker. By April 2, the parties discovered that Jefferson had stolen Trylon’s truck
and its shipment. The shipment never was recovered. Calvin Klein sent a claim letter to Trylon
for the full value of the lost blouses. In the absence of any response by Trylon, Calvin Klein filed
this action…to recover $150,000, allegedly the value of the lost shipment.…
In their stipulation in lieu of a jury trial, the parties agreed that Trylon is liable to Calvin Klein
for the loss of the shipment and that Trylon was grossly negligent in the hiring and supervision
of Jefferson. They also agreed that “[t]he terms and conditions of [Trylon]’s carriage [were] that
liability for loss or damage to cargo is limited to $50 in accordance with the legend on Trylon’s
invoice forms.” Calvin Klein conceded that it was aware of this limitation of liability, and that it
did not declare a value on the blouses at the time of shipment.
The parties left at issue whether the limitation of liability clause was valid and enforceable.
Calvin Klein argued in the district court, as it does here, that the limitation clause was not
enforceable for two reasons: no agreement existed between Calvin Klein and Trylon as to the

Saylor URL: http://www.saylor.org/books

Saylor.org
812

limitation of liability; and, if such an agreement existed, public policy would prevent its
enforcement because of Trylon’s gross negligence.
The district court applied New York law, finding that the carriage was exempt from the
Interstate Commerce Commission’s jurisdiction, being entirely within the New York City
commercial zone.…
A common carrier…under New York law is strictly liable for the loss of goods in its custody.
“Where the loss is not due to the excepted causes [that is, act of God or public enemy, inherent
nature of goods, or shipper’s fault], it is immaterial whether the carrier was negligent or not.…”
[Citations] Even in the case of loss from theft by third parties, liability may be imposed up on a
negligent common carrier. [Citation]
A shipper and a common carrier may contract to limit the carrier’s liability in cases of loss to an
amount agreed to by the parties [Citations], so long as the language of the limitation is clear, the
shipper is aware of the terms of the limitation, and the shipper can change the terms by
indicating the true value of the goods being shipped. [Citations]…(similar scheme under
Interstate Commerce Act). Such a limitation agreement is generally valid and enforceable
despite carrier negligence. The limitation of liability provision involved here clearly provides
that, at the time of delivery, the shipper may increase the limitation by written notice of the
value of the goods to be delivered and by payment of a commensurately higher fee.
The parties stipulated to the fact that the $50 limitation of liability was a term and condition of
carriage and that Calvin Klein was aware of that limitation. This stipulated fact removes the first
issue, namely whether an agreement existed as to a liability limitation between the parties, from
this case. Calvin Klein’s argument that it never previously acknowledged this limitation by
accepting only $50 in settlement of a larger loss does not alter this explicit stipulation. “[A]
stipulation of fact that is fairly entered into is controlling on the parties and the court is bound
to enforce it.” [Citations] Neither party here has argued that the stipulation was unfairly entered
into.…
The remaining issue concerns the enforceability of the limitation clause in light of Trylon’s
conceded gross negligence. The district court considered that, assuming an agreement between

Saylor URL: http://www.saylor.org/books

Saylor.org
813

the parties as to Trylon’s liability, Trylon’s gross negligence would not avoid the enforcement of
a limitation clause.
The district court found that New York law, as opposed to federal interstate commerce law,
applies in this case. The parties do not seriously contest this choice of law. With the choice thus
unchallenged, we must apply both established New York law as well as our belief of how the New
York Court of Appeals would rule if this case were before it.…
Although the New York Court of Appeals has addressed a limitation of liability provision in the
context of a contract between an airline and a passenger, [Citation] (refusing to enforce
unilateral limitation provision for death of passenger due to defendant’s negligence), that court
has never been called upon to enforce a limitation provision in the case of a grossly negligent
common carrier of goods. The various departments of the Appellate Division of the New York
State Supreme Court have addressed whether gross negligence bars enforcement of limitations
of liability in the context of contracts for the installation, maintenance and monitoring of
burglar alarm systems and are divided on the issue. Compare [Citation] (enforcing limitation
despite gross negligence) and [Citation] (even if gross negligence were established, plaintiff’s
recovery would be limited by limitation clause) with [Citation] (limitation clause cannot limit
liability for gross negligence) and [Citation] (finding “no significant distinction” between
complete exculpation and limitation “to a nominal sum,” therefore limitation is ineffective). The
First Department distinguished between exculpatory provisions and limitation provisions,
indicating that the latter would be effective even if the former are unenforceable due to the
contracting party’s gross negligence. [Citations].…The other departments which have considered
the question applied the holding of [Citation], that “[a]greements which purport to exempt a
party from liability for willful or grossly negligent acts are contrary to public policy and are
void.”…
Absent a rule of decision formulated by the New York Court of Appeals, we are not bound by the
opinions issued by the state’s lower courts.…
In the absence of direct New York authority, we must make our best estimate as to how New
York’s highest court would rule in this case. In making that determination, we are free to
consider all the resources the highest court of the state could use, including decisions reached in
Saylor URL: http://www.saylor.org/books

Saylor.org
814

other jurisdictions.…We believe that the New York Court of Appeals would not differentiate
between gross negligence and ordinary negligence in recognizing the validity of the limitation of
liability in this case.
Since carriers are strictly liable for loss of shipments in their custody and are insurers of these
goods, the degree of carrier negligence is immaterial. [Citation] The common carrier must
exercise reasonable care in relation to the shipment in its custody. U.C.C. § 7-309(1). Carriers
can contract with their shipping customers on the amount of liability each party will bear for the
loss of a shipment, regardless of the degree of carrier negligence. See U.C.C. § 7-309(2)
(allowing limitation of liability for losses from any cause save carrier conversion). Unlike the
parachute school student, see [Citation], or the merchant acquiring a burglar alarm, the shipper
can calculate the specific amount of its potential damages in advance, declare the value of the
shipment based on that calculation, and pay a commensurately higher rate to carry the goods, in
effect buying additional insurance from the common carrier.
In this case, Calvin Klein and Trylon were business entities with an on-going commercial
relationship involving numerous carriages of Calvin Klein’s goods by Trylon. Where such
entities deal with each other in a commercial setting, and no special relationship exists between
the parties, clear limitations between them will be enforced. [Citation]. Here, each carriage was
under the same terms and conditions as the last, including a limitation of Trylon’s liability. See
[Citation] (court enforced limitation on shipper who possessed over five years of the carrier’s
manifests which included the $50 limitation). This is not a case in which the shipper was dealing
with the common carrier for the first time or contracting under new or changed terms. Calvin
Klein was aware of the terms and was free to adjust the limitation upon a written declaration of
the value of a given shipment, but failed to do so with the shipment at issue here. Since Calvin
Klein failed to adjust the limitation, the limitation applies here, and no public policy that
dictates otherwise can be identified.
Calvin Klein now argues that the limitation is so low as to be void.…This amount is immaterial
because Calvin Klein had the opportunity to negotiate the amount of coverage by declaring the
value of the shipment.…Commercial entities can easily negotiate the degree of risk each party
will bear and which party will bear the cost of insurance. That this dispute actually involves who
Saylor URL: http://www.saylor.org/books

Saylor.org
815

will bear the cost of insurance is illustrated by the fact that this case has been litigated not by the
principal parties, but by their insurers. Calvin Klein could have increased Trylon’s coverage by
declaring the value of its shipment, but did not do so. Calvin Klein had the opportunity to
declare a higher value and we find all of its arguments relating to the unreasonableness of the
limitation to be without merit.
We reverse and remand to the district court with instructions to enter judgment against
defendant in the sum of $50.

CASE QUESTIONS

1. Why is the federal court here trying to figure out what the New York high court would do if it
had this case in front of it?
2. Did the federal court find direct New York State law to apply?
3. What is the legal issue here?
4. What argument did Calvin Klein make as to why the $50 limitation should not be valid?
5. The common-law rule was that carriers were strictly liable. Why didn’t the court apply that
rule?
6. Would this case have come out differently if the shipper (a) were an unsophisticated in
matters of relevant business or (b) if it had never done business with Trylon before?

21.6 Summary and Exercises
Summary

Ownership and sale of goods are not the only important legal relationships involving goods. In a
modern economy, possession of goods is often temporarily surrendered without surrendering
title. This creates a bailment, which is defined as the lawful possession of goods by one who is
not the owner.
To create a bailment, the goods must be in the possession of the bailee. Possession requires
physical control and intent. Whether the owner or someone else must bear a loss often hinges on
whether the other person is or is not a bailee.
The bailee’s liability for loss depends on the circumstances. Some courts use a straightforward
standard of ordinary care. Others use a tripartite test, depending on whether the bailment was
for the benefit of the owner (the standard then is gross negligence), for the bailee (extraordinary
Saylor URL: http://www.saylor.org/books

Saylor.org
816

care), or for both (ordinary care). Bailees may disclaim liability unless they have failed to give
adequate notice or unless public policy prohibits disclaimers. A bailee who converts the property
will be held liable as an insurer.
A bailor may have liability toward the bailee—for example, for negligent failure to warn of
hazards in the bailed property and for strict liability if the injury was caused by a dangerous
object in a defective condition.
Special bailments arise in the cases of innkeepers (who have an insurer’s liability toward their
guests, although many state statutes provide exceptions to this general rule), warehouses,
carriers, and leases.
A warehouser is defined as a person engaged in the business of storing goods for hire. The
general standard of care is the same as that of ordinary negligence. Many states have statutes
imposing a higher standard.
A common carrier—one who holds himself out to all for hire to transport goods—has an
insurer’s liability toward the goods in his possession, with five exceptions: act of God, act of
public enemy, act of public authority, negligence of shipper, and inherent nature of the goods.
Because many carriers are involved in most commercial shipments of goods, the law places
liability on the initial carrier. The carrier’s liability begins once the shipper has given all
instructions and taken all action required of it. The carrier’s absolute liability ends when it has
delivered the goods to the consignee’s place of business or residence (unless the agreement
states otherwise) or, if no delivery is required, when the consignee has been notified of the
arrival of the goods and has had a reasonable opportunity to take possession.
Commodity paper—any document of title—may be negotiated; that is, through proper
indorsements on the paper, title may be transferred without physically touching the goods. A
duly negotiated document gives the holder title to the document and to the goods, certain rights
to the goods delivered to the bailee after the document was issued, and the right to take
possession free of any defense or claim by the issuer of the document of title. Certain rules limit
the seemingly absolute right of the holder to take title better than that held by the transferor.

EXERCISES

Saylor URL: http://www.saylor.org/books

Saylor.org
817

1. Joe Andrews delivered his quarter horse I’ll Call Ya (worth about $319,000 in 2010 dollars) to
Harold Stone for boarding and stabling. Later he asked Stone if Stone could arrange for the
horse’s transportation some distance, and Stone engaged the services of the Allen brothers
for that purpose. Andrews did not know the Allens, but Stone had previously done business
with them. On the highway the trailer with I’ll Call Ya in it became disengaged from the
Allens’ truck and rolled over. The mare, severely injured, “apparently lingered for several
hours on the side of the road before she died without veterinary treatment.” The evidence
was that the Allens had properly secured the horse’s head at the front of the trailer and used
all other equipment that a reasonably prudent person would use to secure and haul the
horse; that the ball was the proper size and in good condition; that the ball was used without
incident to haul other trailers after the accident; that Ronny Allen was driving at a safe speed
and in a safe manner immediately before the accident; that after the accident the sleeve of
the trailer hitch was still in the secured position; and that they made a reasonable effort to
obtain veterinary treatment for the animal after the accident. The court determined this was
a mutual-benefit bailment. Are the Allens liable? [1]
2. Fisher Corporation, a manufacturer of electronic equipment, delivered VCRs to Consolidated
Freightways’ warehouse in California for shipment to World Radio Inc., an electronics retailer
in Council Bluffs, Iowa. World Radio rejected the shipments as duplicative, and they were
returned to Consolidated’s terminal in Sarpy County, Nebraska, pending Fisher’s instructions.
The VCRs were loaded onto a trailer; the doors of the trailer were sealed but not padlocked,
and the trailer was parked at the south end of the terminal. Padlocks were not used on any
trailers so as not to call attention to a trailer containing expensive cargo. The doors of the
trailer faced away from the terminal toward a cyclone fence that encircled the yard. Two
weeks later, on Sunday, July 15, a supervisor checked the grounds and found nothing amiss.
On Tuesday, July 17, Consolidated’s employees discovered a 3 × 5 foot hole had been cut in
the fence near the trailer, and half the VCRs were gone; they were never recovered.
Consolidated received Fisher’s return authorization after the theft occurred. If Consolidated
is considered a carrier, it would be strictly liable for the loss; if it is considered a bailee, it is
not liable unless negligent. Which is it?
Saylor URL: http://www.saylor.org/books

Saylor.org
818

3. Plaintiff purchased a Greyhound bus ticket in St. Petersburg, Florida, for a trip to Fort
Meyers. The bus left at 11:30 p.m. and arrived at 4:15 a.m. When Plaintiff got off the bus, she
noticed that the station and restrooms were darkened, closed, and locked. She left the
terminal to cross at a lighted service station to use the bathroom. As she walked away from
the terminal, she was attacked by an unknown person and injured. The terminal was located
in a high-crime area of Fort Meyers. Is Greyhound liable?
4. Mrs. Carter, Plaintiff, took her fur coat to Reichlin Furriers for cleaning, glazing, and storage
until the next winter season. She was given a printed receipt form on the front of which
Furrier’s employee had written “$100” as the coat’s value, though Mrs. Carter did not discuss
its value with the employee, did not know that such a value had been noted, and didn’t read
the receipt. A space for the customer’s signature on the front of the receipt was blank; below
this in prominent type was this notice: “see reverse side for terms and conditions.” On the
back was a statement that this was a storage contract and the customer would be bound by
the terms unless contrary notice was given within ten days. There were fifteen conditions,
one of which was the following: “Storage charges are based upon valuation herein declared
by the depositor and amount recoverable for loss or damage shall not exceed…the
depositor’s valuation appearing in this receipt.” Six months later, when Mrs. Carter sought to
retrieve her coat, she was informed by Furrier that it was lost. Carter sued Furrier for $450
(about $2,200 in 2010 dollars); Furrier claimed its liability was limited to $100. Who wins and
why?
5. Michael Capezzaro (Plaintiff) reported to the police that he had been robbed of $30,000 (in
2010 dollars) at gunpoint by a woman. The next day police arrested a woman with $9,800 in
her possession. Plaintiff identified her as the woman who had robbed him, and the money
was impounded as evidence. Two years later the case against her was dismissed because she
was determined to have been insane when she committed the crime, and the money in the
police property room was released to her. Plaintiff then sued the police department, which
claimed it was “obligated to return the money to [the woman] as bailor.” Who wins and
why?

Saylor URL: http://www.saylor.org/books

Saylor.org
819

6. Harley Hightower delivered his Cadillac to Auto Auction, where it was damaged. Auto Auction
defended itself against Hightower’s claim that it was a negligent bailee by asserting (1) that
he had not met the required burden of proof that a proximate cause of the injury was Auto
Auction’s negligence because it introduced evidence that negligence of a third party was a
proximate cause of the damage to his car and (2) that it was entitled to judgment in the
absence of evidence of specific acts of negligence of the bailee. There was evidence that a
Mrs. Tune drove her automobile onto the lot to sell it and parked it where she was directed
to; that the automobiles on said lot for sale were ordinarily lined up and numbered by Auto
Auction; that Plaintiff’s Cadillac was not so parked by the auction company but was parked so
that if Mrs. Tune’s automobile continued forward it would strike Hightower’s Cadillac
broadside; that when Mrs. Tune stopped her Buick and alighted, her car rolled down the
incline on the lot toward Hightower’s car; that she attempted to stop her car but it knocked
her down and continued rolling toward appellee’s Cadillac and, finally, struck and damaged
it. Who wins and why?
7. Several student radicals led by Richard Doctor, ranked number three on the FBI’s Ten Most
Wanted list, destroyed a shipment of military cargo en route from Colorado to a military
shipping facility in Washington State. Should the carrier be liable for the loss?
8. Everlena Mitchell contracted in writing with All American Van & Storage to transport and
store her household goods and furnishings, and she was to pay all charges incurred on a
monthly basis. As security she granted All American a warehouser’s lien giving it the right to
sell the property if the charges remained unpaid for three months and if, in the opinion of
the company, such action would be necessary to protect accrued charges. Everlena fell eight
months in arrears and on October 20 she received notice that the amount owed was to be
paid by October 31, 1975. The notice also stated that if payment was not made, her goods
and furnishings would be sold on November 7, 1975. Everlena had a pending claim with the
Social Security Administration, and advised All American that she would be receiving a
substantial sum of money soon from the Social Services Administration; this was confirmed
by two government agents. However, All American would not postpone the sale. Everlena’s
property was sold on November 7, 1975, for $925.50. Near the end of November 1975,
Saylor URL: http://www.saylor.org/books

Saylor.org
820

Everlena received approximately $5,500 (about $22,000 in 2010 dollars) from the United
States as a disability payment under the Social Security Act, and she sued All American for
improperly selling her goods. The trial court ruled for All American on summary judgment.
What result should Everlena obtain on appeal?
9. Roland delivered a shipment of desks to Security Warehousers and received from Security a
negotiable receipt. Peter broke into Roland’s office, stole the document, and forged Roland’s
signature as an indorsement, making Peter himself the holder. Peter then indorsed the
document over to Billings, who knew nothing of the theft. Does Billings get good title to the
desks?
10. Baker’s Transfer & Storage Company, Defendant, hauled household goods and personal
effects by trucks “anywhere for hire.” Its trucks did not travel on regular routes or between
established terminals; it hauled household goods and personal effects on private contracts
with the owners as and when the opportunity presented itself. Baker contracted to haul the
Klein family’s household goods from Bakersfield, California, to Hollywood. En route the goods
were destroyed by fire without Baker’s negligence. Baker’s contract provided it would
redeliver the property “damage by the elements excepted.” If Baker were a common carrier,
its liability would be statutorily limited to less than the amount ordered by the trial court; if it
were a private carrier, its liability would be either based on ordinary negligence or as the
parties’ contract provided. Working with both points, what result obtains here?

SELF-TEST QUESTIONS

1. In a bailment, the bailee
a.

must return similar goods

b. must return identical goods
c. acquires title to the goods
d. must pay for the goods
In a bailment for the benefit of a bailee, the bailee’s duty of care is
a.

slight

b. extraordinary
c. ordinary

Saylor URL: http://www.saylor.org/books

Saylor.org
821

A disclaimer of liability by a bailee is
a.

never allowed

b. sometimes allowed
c. always allowed
d. unheard of in business
A bailor may be held liable to the bailee on
a.

a negligence theory

b. a warranty theory
c. a strict liability theory
d. all of the above
The highest duty of care is imposed on which of the following?
a.

a common carrier

b. a lessee
c. a warehouser
d. an innkeeper

SELF-TEST ANSWERS

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

[1] Andrews v. Allen, 724 S.W.2d 893 (Tex. Ct. App., 1987).

Chapter 22
Intellectual Property
LEARNING OBJECTIVES

After reading this chapter, you should understand the following:
1. The principal kinds of intellectual property
Saylor URL: http://www.saylor.org/books

Saylor.org
822

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.

22.1 Patents

LEARNING OBJECTIVES

1. Explain why Congress would grant exclusive monopolies (patents) for certain periods of time.

Saylor URL: http://www.saylor.org/books

Saylor.org
823

2. Describe what kinds of things may be patentable and what kinds of things may not be
patentable.
3. Explain the procedures for obtaining a patent, and how patent rights may be an issue where
the invention is created by an employee.
4. Understand who can sue for patent infringement, on what basis, and with what potential
remedies.

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

Patentability
What May Be Patented
The patent law says that “any new and useful process, machine, manufacture, or composition of
matter, or any new and useful improvement thereof” may be patented.[1] A process is a “process,
art or method, and includes a new use of a known process, machine, manufacture, composition
of matter, or material.” [2] A process for making rolled steel, for example, qualifies as a
patentable process under the statute. Amachine is a particular apparatus for achieving a certain
result or carrying out a distinct process—lathes, printing presses, motors, and the cotton gin are
all examples of the hundreds of thousands of machines that have received US patents since the
first Patent Act in 1790. A manufacture is an article or a product, such as a television, an
automobile, a telephone, or a lightbulb. A composition of matter is a new arrangement of
elements so that the resulting compound, such as a metal alloy, is not found in nature.
In Commissioner of Patents v. Chakrabarty, [3] the Supreme Court said that even living
organisms—in particular, a new “genetically engineered” bacterium that could “eat” oil spills—
Saylor URL: http://www.saylor.org/books

Saylor.org
824

could be patented. The Chakrabarty decision has spawned innovation: a variety of small
biotechnology firms have attracted venture capitalists and other investors.
According to the PTO, gene sequences are patentable subject matter, provided they are isolated
from their natural state and processed in a way that separates them from other molecules
naturally occurring with them. Gene patenting, always controversial, generated new controversy
when the PTO issued a patent to Human Genome Sciences, Inc. for a gene found to serve as a
platform from which the AIDS virus can infect cells of the body. Critics faulted the PTO for
allowing “ownership” of a naturally occurring human gene and for issuing patents without
requiring a showing of the gene’s utility. New guidelines from the PTO followed in 2000; these
focused on requiring the applicant to make a strong showing on the utility aspect of patentability
and somewhat diminished the rush of biotech patent requests.
There are still other categories of patentable subjects. An improvement is an alteration of a
process, machine, manufacture, or composition of matter that satisfies one of the tests for
patentability given later in this section. New, original ornamental designs for articles of
manufacture are patentable (e.g., the shape of a lamp); works of art are not patentable but are
protected under the copyright law. New varieties of cultivated or hybridized plants are also
patentable, as are genetically modified strains of soybean, corn, or other crops.

What May Not Be Patented
Many things can be patented, but not (1) the laws of nature, (2) natural phenomena, and (3)
abstract ideas, including algorithms (step-by-step formulas for accomplishing a specific task).
One frequently asked question is whether patents can be issued for computer software. The PTO
was reluctant to do so at first, based on the notion that computer programs were not “novel”—
the software program either incorporated automation of manual processes or used
mathematical equations (which were not patentable). But in 1998, the Supreme Court held
in Diamond v. Diehr [4] that patents could be obtained for a process that incorporated a
computer program if the process itself was patentable.
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
Saylor URL: http://www.saylor.org/books

Saylor.org
825

through a series of mathematical calculations that would help manage mutual funds. State
Street sued to challenge that patent. Signature argued that its model and process was protected,
and the court of appeals upheld it as a “practical application of a mathematical, algorithm,
formula, or calculation,” because it produces a “useful, concrete and tangible result.” Since State
Street, many other firms have applied for business process patents. For example, Amazon.com
obtained a business process patent for its “one-click” ordering system, a method of processing
credit-card orders securely. (But see Amazon.com v. Barnesandnoble.com, [6] in which the court
of appeals rejected Amazon’s challenge to Barnesandnoble.com using its Express Land one-click
ordering system.)

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

Procedures for Obtaining a Patent
In general, the United States (unlike many other countries) grants a patent right to the first
person to invent a product or process rather than to the first person to file for a patent on that
product or process. As a practical matter, however, someone who invents a product or process
but does not file immediately 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
Saylor URL: http://www.saylor.org/books

Saylor.org
826

date would forfeit the rights granted to an inventor who had published details of the invention
or offered it for sale. But until the year has passed, the PTO may not issue a patent to X if Y has
described the invention in a printed publication here or abroad or the invention has been in
public use or on sale in this country.
An inventor cannot obtain a patent automatically; obtaining a patent is an expensive and timeconsuming process, and the inventor will need the services of a patent attorney, a highly
specialized practitioner. The attorney will help develop the requiredspecification, a description
of the invention that gives enough detail so that one skilled in the art will be able to make and
use the invention. After receiving an application, a PTO examiner will search the records and
accept or reject the claim. Usually, the attorney will negotiate with the examiner and will rewrite
and refine the application until it is accepted. A rejection may be appealed, first to the PTO’s
Board of Appeals and then, if that fails, to the federal district court in the District of Columbia or
to the US Court of Appeals for the Federal Circuit, the successor court to the old US Court of
Customs and Patent Appeals.
Once a patent application has been filed, the inventor or a company to which she has assigned
the invention may put the words “patent pending” on the invention. These words have no legal
effect. Anyone is free to make the invention as long as the patent has not yet been issued. But
they do put others on notice that a patent has been applied for. Once the patent has been
granted, infringers may be sued even if the infringed has made the product and offered it for sale
before the patent was granted.
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.
Saylor URL: http://www.saylor.org/books

Saylor.org
827

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

Infringement and Invalidity Suits
Suits for patent infringement can arise in three ways: (1) the patent holder may seek damages
and an injunction against the infringer in federal court, requesting damages for royalties and
lost profits as well; (2) even before being sued, the accused party may take the patent holder to
court under the federal Declaratory Judgment Act, seeking a court declaration that the patent is
invalid; (3) the patent holder may sue a licensee for royalties claimed to be due, and the licensee
may counterclaim that the patent is invalid. Such a suit, if begun in state court, may be removed
to federal court.
In a federal patent infringement lawsuit, the court may grant the winning party reimbursement
for attorneys’ fees and costs. If the infringement is adjudged to be intentional, the court can
triple the amount of damages awarded. Prior to 2006, courts were typically granting permanent
injunctions to prevent future infringement. CitingeBay, Inc. v. Merc Exchange, LLC, [7] the
Supreme Court ruled that patent holders are not automatically entitled to a permanent
injunction against infringement during the life of the patent. Courts have the discretion to
determine whether justice requires a permanent injunction, and they may conclude that the
public interest and equitable principles may be better satisfied with compensatory damages
only.
Saylor URL: http://www.saylor.org/books

Saylor.org
828

Proving infringement can be a difficult task. Many companies employ engineers to “design
around” a patent product—that is, to seek ways to alter the product to such an extent that the
substitute product no longer consists of enough of the elements of the invention safeguarded by
the patent. However, infringing products, processes, or machines need not be identical; as the
Supreme Court said in Sanitary Refrigerator Co. v. Winers, [8] “one device is an infringement of
another…if two devices do the same work in substantially the same way, and accomplish
substantially the same result…even though they differ in name, form, or shape.” This is known
as thedoctrine of equivalents. In an infringement suit, the court must choose between these two
extremes: legitimate “design around” and infringement through some equivalent product.
An infringement suit can often be dangerous because the defendant will almost always assert in
its answer that the patent is invalid. The plaintiff patent holder thus runs the risk that his entire
patent will be taken away from him if the court agrees. In ruling on validity, the court may
consider all the tests, such as prior art and obviousness, discussed in Section 22.1.2
"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 23
"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

Saylor URL: http://www.saylor.org/books

Saylor.org
829

may grant a patent to an applicant. The patent, which allows a limited-time monopoly, is for
twenty years. The categories of patentable things include processes, machines,
manufactures, compositions of matter, and improvements. Ideas, mental processes,
naturally occurring substances, methods of doing business, printed matter, and scientific
principles cannot be patented. Patent holders may sue for infringement and royalties from
an infringer user.

EXERCISES

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

[1] 35 United States Code, Section 101.
[2] 35 United States Code, Section 101.
[3] Commissioner of Patents v. Chakrabarty, 444 U.S. 1028 (1980).
[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).

22.2 Trade Secrets

LEARNING OBJECTIVES

Saylor URL: http://www.saylor.org/books

Saylor.org
830

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

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

Saylor.org
831

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

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

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

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
Saylor URL: http://www.saylor.org/books

Saylor.org
832

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

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
Saylor URL: http://www.saylor.org/books

Saylor.org
833

395 and 396 of the Restatement (Second) of Agency suggest that it is an actionable breach of
duty to disclose to third persons information given confidentially during the course of the
agency. However, every person is held to have a right to earn a living. If the rule were strictly
applied, a highly skilled person who went to another company might be barred from using his
knowledge and skills. The courts do not prohibit people from using elsewhere the general
knowledge and skills they developed on the job. Only specific trade secrets are protected.
To get around this difficulty, some companies require their employees to sign agreements not to
compete. But unless the agreements are limited in scope and duration to protect a company
against only specific misuse of trade secrets, they are unenforceable.

KEY TAKEAWAY

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

EXERCISES

1. Wu Dang, based in Hong Kong, hacks into the Hewlett-Packard database and “steals” plans
and specifications for HP’s latest products. The HP server is located in the United States. He
sells this information to a Chinese company in Shanghai. Has he violated the US Economic
Espionage Act?
2. What are the advantages of keeping a formula as a trade secret rather than getting patent
protection?

[1] Economic Espionage Act, 18 United States Code, Section 1831(a) (1996)
[2] Economic Espionage Act, 18 United States Code, Section 1832 (1996).
Saylor URL: http://www.saylor.org/books

Saylor.org
834

[3] Economic Espionage Act, 18 United States Code, Section 1834 (1996).

22.3 Copyright

LEARNING OBJECTIVES

3. Describe and explain copyrights, how to obtain one, and how they differ from trademarks.
4. 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
Saylor URL: http://www.saylor.org/books

Saylor.org
835

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

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

Fair Use
One major exception to the exclusivity of copyrights is the fair use doctrine. Section 107 of the
Copyright Act provides as follows:
Fair use of a copyrighted work, including such use by reproduction in copies or
phonorecords or by any other means specified by section 106 of the copyright, for
purposes such as criticism, comment, news reporting, teaching (including multiple
copies for classroom use), scholarship, or research, is not an infringement of
copyright. In determining whether the use made of a work in any particular case is a
fair use, the factors to be considered shall include–
(1) the purpose and character of the use, including whether such use is of a
commercial nature or is for nonprofit educational purposes;
(2) the nature of the copyrighted work;

Saylor URL: http://www.saylor.org/books

Saylor.org
836

(3) the amount and substantiality of the portion used in relation to the copyrighted
work as a whole; and
(4) the effect of the use upon the potential market for or value of the copyrighted
work. [1]
These are broad guidelines. Accordingly, any copying could be infringement, and fair use could
become a question of fact on a case-by-case basis. In determining fair use, however, courts have
often considered the fourth factor (effect of the use upon the potential market for the
copyrighted work) to be the most important.
Clear examples of fair use would be when book reviewers or writers quote passages from
copyrighted books. Without fair use, most writing would be useless because it could not readily
be discussed. But the doctrine of fair use grew more troublesome with the advent of plain-paper
copiers and is now even more troublesome with electronic versions of copyrighted materials that
are easily copied and distributed. The 1976 act took note of the new copier technology, listing
“teaching (including multiple copies for classroom use)” as one application of fair use. The
Copyright Office follows guidelines specifying just how far the copying may go—for example,
multiple copies of certain works may be made for classroom use, but copies may not be used to
substitute for copyrighted anthologies.

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

Copyrightability Standards
To be subject to copyright, the writing must be “fixed” in some “tangible medium of expression.”
A novelist who composes a chapter of her next book in her mind and tells it to a friend before
putting it on paper could not stop the friend from rushing home, writing it down, and selling it
(at least the federal copyright law would offer no protection; some states might independently
offer a legal remedy, however).
Saylor URL: http://www.saylor.org/books

Saylor.org
837

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.
Section 102 of the Copyright Act excludes copyright protection for any “idea, procedure, process,
system, method of operation, concept, principle, or discovery, regardless of the form in which it
is described, explained, illustrated, or embodied.” [3]
Einstein copyrighted books and monographs he wrote on the theory of relativity, but he could
not copyright the famous formula E = mc2, nor could he prevent others from writing about the
theory. But he could protect the particular way in which his ideas were expressed. In general,
facts widely known by the public are not copyrightable, and mathematical calculations are not
copyrightable. Compilations of facts may be copyrightable, if the way that they are coordinated
or arranged results in a work that shows some originality. For example, compiled information
about yachts listed for sale may qualify for copyright protection. [4]
One of the most troublesome recent questions concerning expression versus ideas is whether a
computer program may be copyrighted. After some years of uncertainty, the courts have
accepted the copyrightability of computer programs. [5] Now the courts are wrestling with the
Saylor URL: http://www.saylor.org/books

Saylor.org
838

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 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
Saylor URL: http://www.saylor.org/books

Saylor.org
839

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 legal battle on copyright and had to cease doing business. By providing the
means by which individuals could copy music that had been purchased, major record labels
were losing substantial profits. Grokster, a privately owned software company based in the West
Indies, provided peer-to-peer file sharing from 2001 to 2005 until the US Supreme Court’s
decision in MGM Studios, Inc. v. Grokster, Ltd. [9]
For computers with the Microsoft operating system, the Court disallowed the peer-to-peer file
sharing, even though Grokster claimed it did not violate any copyright laws because no files
passed through its computers. (Grokster had assigned certain user computers as “root
supernodes” that acted as music hubs for the company and was not directly involved in
controlling any specific music-file downloads.)

Saylor URL: http://www.saylor.org/books

Saylor.org
840

Grokster had argued, based on Sony v. Universal Studios, [10] that the sale of its copying
equipment (like the Betamax videocassette recorders at issue in that case) did not constitute
contributory infringement “if the product is widely used for legitimate, unobjectionable
purposes.” Plaintiffs successfully argued that the Sony safe-harbor concept requires proof that
the noninfringing use is the primary use in terms of the product’s utility.
The Digital Millennium Copyright Act (DMCA), passed into law in 1998, implements two 1996
treaties of the World Intellectual Property Organization. It criminalizes production and sale of
devices or services intended to get around protective measures that control access to
copyrighted works. In addition, the DMCA heightens the penalties for copyright infringement on
the Internet. The DMCA amended Title 17 of the United States Code to extend the reach of
copyright, while limiting the liability of the providers of online services for copyright
infringement by their users.

KEY TAKEAWAY

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

EXERCISES

•

Explain how a list could be copyrightable.

•

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?

•

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

Saylor URL: http://www.saylor.org/books

Saylor.org
841

the New York Times’s permission? Does it matter that he uses the word Times in his
proposed title?
•

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).

22.4 Trademarks

LEARNING OBJECTIVES

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

Definitions of Trademarks
Saylor URL: http://www.saylor.org/books

Saylor.org
842

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

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

Limitations on Marks
Although trademarks abound, the law limits the subjects that may fall into one of the defined
categories. Not every word or shape or symbol will be protected in an infringement action. To
qualify for protection, a trademark must be used to identify and distinguish. The courts employ
a four-part test: (1) Is the mark so arbitrary and fanciful that it merits the widest protection? (2)
Is it “suggestive” enough to warrant protection without proof of secondary meaning? (3) Is it
“descriptive,” warranting protection if secondary meaning is proved? (4) Is the mark generic and
thus unprotectable?

Saylor URL: http://www.saylor.org/books

Saylor.org
843

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 living person
Saylor URL: http://www.saylor.org/books

Saylor.org
844

without consent, or of a deceased US president during the lifetime of his widow; and immoral,
deceptive, or scandalous matter (in an earlier era, the phrase “Bubby Trap” for brassieres was
denied registration).

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

Acquiring Trademark Rights
For the first time in more than forty years, Congress, in 1988, changed the way in which
trademarks can be secured. Under the Lanham Act, the fundamental means of obtaining a
trademark was through use. The manufacturer or distributor actually must have placed the
mark on its product—or on related displays, labels, shipping containers, advertisements, and the
like—and then have begun selling the product. If the product was sold in interstate commerce,
the trademark was entitled to protection under the Lanham Act (or if not, to protection under
the common law of the state in which the product was sold).
Under the Trademark Law Revision Act of 1988, which went into effect in 1989, trademarks can
be obtained in advance by registering with the PTO an intention to use the mark within six
months (the applicant can gain extensions of up to thirty more months to put the mark into
use). Once obtained, the trademark will be protected for ten years (before the 1988 revision, a
Saylor URL: http://www.saylor.org/books

Saylor.org
845

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.

KEY TAKEAWAY

Saylor URL: http://www.saylor.org/books

Saylor.org
846

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 highend automobile. Can Lexus succeed in getting Mead Data Central to stop using “Lexis” as a
mark?

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

22.5 Cases
Fair Use in Copyright
Elvis Presley Enterprises et al. v. Passport Video et al.
349 F.3d 622 (9th Circuit Court of Appeals, 2003)
TALLMAN, CIRCUIT JUDGE:
Plaintiffs are a group of companies and individuals holding copyrights in various materials
relating to Elvis Presley. For example, plaintiff SOFA Entertainment, Inc., is the registered
owner of several Elvis appearances on The Ed Sullivan Show. Plaintiff Promenade Trust owns
the copyright to two television specials featuring Elvis: The Elvis 1968 Comeback
Saylor URL: http://www.saylor.org/books

Saylor.org
847

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 Elvisdescribes itself as an all-encompassing, indepth look at the life and career of a man whose popularity is unrivaled in the history of show
business and who continues to attract millions of new fans each year.…
The Definitive Elvis uses Plaintiffs’ copyrighted materials in a variety of ways. With the video
footage, the documentary often uses shots of Elvis appearing on television while a narrator or
interviewee talks over the film. These clips range from only a few seconds in length to portions
running as long as 30 seconds. In some instances, the clips are the subject of audio commentary,
while in other instances they would more properly be characterized as video “filler” because the
commentator is discussing a subject different from or more general than Elvis’ performance on a
particular television show. But also significant is the frequency with which the copyrighted video
footage is used. The Definitive Elvis employs these clips, in many instances, repeatedly. In total,
at least 5% to 10% of The Definitive Elvis uses Plaintiffs’ copyrighted materials.
Use of the video footage, however, is not limited to brief clips.…Thirty-five percent of his
appearances on The Ed Sullivan Show is replayed, as well as three minutes from The 1968
Comeback Special.
***
Plaintiffs sued Passport for copyright infringement.…Passport, however, asserts that its use of
the copyrighted materials was “fair use” under 17 U.S.C. § 107. Plaintiffs moved for a
preliminary injunction, which was granted by the district court after a hearing. The district court
found that Passport’s use of Plaintiffs’ copyrighted materials was likely not fair use. The court
enjoined Passport from selling or distributing The Definitive Elvis. Passport timely appeals.
***

Saylor URL: http://www.saylor.org/books

Saylor.org
848

We first address the purpose and character of Passport’s use of Plaintiffs’ copyrighted materials.
Although not controlling, the fact that a new use is commercial as opposed to non-profit weighs
against a finding of fair use. Harper & Row Publishers, Inc. v. Nation Enters., 471 U.S. 539, 562,
85 L. Ed. 2d 588, 105 S.Ct. 2218 (1985). And the degree to which the new user exploits the
copyright for commercial gain—as opposed to incidental use as part of a commercial
enterprise—affects the weight we afford commercial nature as a factor. More importantly for the
first fair-use factor, however, is the “transformative” nature of the new work. Specifically, we ask
“whether the new work…merely supersedes the objects of the original creation, or instead adds
something new, with a further purpose or different character, altering the first with new
expression, meaning, or message.…” The more transformative a new work, the less significant
other inquiries, such as commercialism, become.
***
The district court below found that the purpose and character of The Definitive Elviswill likely
weigh against a finding of fair use. We cannot say, based on this record, that the district court
abused its discretion.
First, Passport’s use, while a biography, is clearly commercial in nature. But more significantly,
Passport seeks to profit directly from the copyrights it uses without a license. One of the most
salient selling points on the box of The Definitive Elvis is that “Every Film and Television
Appearance is represented.” Passport is not advertising a scholarly critique or historical
analysis, but instead seeks to profit at least in part from the inherent entertainment value of
Elvis’ appearances on such shows as The Steve Allen Show, The Ed Sullivan Show, and The 1968
Comeback Special. Passport’s claim that this is scholarly research containing biographical
comments on the life of Elvis is not dispositive of the fair use inquiry.
Second, Passport’s use of Plaintiffs’ copyrights is not consistently transformative. True,
Passport’s use of many of the television clips is transformative because the clips play for only a
few seconds and are used for reference purposes while a narrator talks over them or
interviewees explain their context in Elvis’ career. But voice-overs do not necessarily transform a
work.…

Saylor URL: http://www.saylor.org/books

Saylor.org
849

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 infringingwork.” Harper & Row,
471 U.S. at 565 (emphasis in original). But if the amount used is substantial with respect to the
infringing work, it is evidence of the value of the copy-righted work.
Passport’s use of clips from television appearances, although in most cases of short duration,
were repeated numerous times throughout the tapes. While using a small number of clips to
reference an event for biographical purposes seems fair, using a clip over and over will likely no
longer serve a biographical purpose. Additionally, some of the clips were not short in length.
Passport’s use of Elvis’ appearance on The Steve Allen Show plays for over a minute and many
more clips play for more than just a few seconds.
Additionally, although the clips are relatively short when compared to the entire shows that are
copyrighted, they are in many instances the heart of the work. What makes these copyrighted
works valuable is Elvis’ appearance on the shows, in many cases singing the most familiar
passages of his most popular songs. Plaintiffs are in the business of licensing these copyrights.
Taking key portions extracts the most valuable part of Plaintiffs’ copyrighted works. With
respect to the photographs, the entire picture is often used. The music, admittedly, is usually
played only for a few seconds.
***
The last, and “undoubtedly the single most important” of all the factors, is the effect the use will
have on the potential market for and value of the copyrighted works. Harper & Row, 471 U.S. at
566. We must “consider not only the extent of market harm caused by the particular actions of
Saylor URL: http://www.saylor.org/books

Saylor.org
850

the alleged infringer, but also whether unrestricted and widespread conduct of the sort engaged
in by the defendant…would result in a substantially adverse impact on the potential market for
the original.” Campbell, 510 U.S. at 590. The more transformative the new work, the less likely
the new work’s use of copyrighted materials will affect the market for the materials. Finally, if
the purpose of the new work is commercial in nature, “the likelihood [of market harm] may be
presumed.” A&M Records, 239 F.3d at 1016 (quoting Sony, 464 U.S. at 451).
The district court found that Passport’s use of Plaintiffs’ copyrighted materials likely does affect
the market for those materials. This conclusion was not clearly erroneous.
First, Passport’s use is commercial in nature, and thus we can assume market harm. Second,
Passport has expressly advertised that The Definitive 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?

Saylor URL: http://www.saylor.org/books

Saylor.org
851

3. What is the significance of the discussion on “transformative” aspects of the defendant’s
product?

Trademark Infringement and Dilution
Playboy Enterprises v. Welles
279 F.3d 796 (9th Circuit Court of Appeals, 2001)
T. G. NELSON, Circuit Judge:
Terri Welles was on the cover of Playboy in 1981 and was chosen to be the Playboy Playmate of
the Year for 1981. Her use of the title “Playboy Playmate of the Year 1981,” and her use of other
trademarked terms on her website are at issue in this suit. During the relevant time period,
Welles’ website offered information about and free photos of Welles, advertised photos for sale,
advertised memberships in her photo club, and promoted her services as a spokesperson. A
biographical section described Welles’ selection as Playmate of the Year in 1981 and her years
modeling for PEI. The site included a disclaimer that read as follows: “This site is neither
endorsed, nor sponsored, nor affiliated with Playboy Enterprises, Inc. PLAYBOY tm PLAYMATE
OF THE YEAR tm AND PLAYMATE OF THE MONTH tm are registered trademarks of Playboy
Enterprises, Inc.”
Wells used (1) the terms “Playboy ”and “Playmate” in the metatags of the website; (2) the phrase
“Playmate of the Year 1981” on the masthead of the website; (3) the phrases “Playboy Playmate
of the Year 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

Saylor URL: http://www.saylor.org/books

Saylor.org
852

sponsorship or endorsement by PEI. Instead, they serve to identify Welles as a past PEI
“Playmate of the Year.”
We articulated the test for a permissible, nominative use in New Kids On The Block v. New
America Publishing, Inc. The band, New Kids On The Block, claimed trademark infringement
arising from the use of their trademarked name by several newspapers. The newspapers had
conducted polls asking which member of the band New Kids On The Block was the best and
most popular. The papers’ use of the trademarked term did not fall within the traditional fair use
doctrine. Unlike a traditional fair use scenario, the defendant newspaper was using the
trademarked term to describe not its own product, but the plaintiff’s. Thus, the factors used to
evaluate fair use were inapplicable. The use was nonetheless permissible, we concluded, based
on its nominative nature.
We adopted the following test for nominative use:
First, the product or service in question must be one not readily identifiable without
use of the trademark; second, only so much of the mark or marks may be used as is
reasonably necessary to identify the product or service; and third, the user must do
nothing that would, in conjunction with the mark, suggest sponsorship or
endorsement by the trademark holder.
We group the uses of PEI’s trademarked terms into three for the purpose of applying the test for
nominative use.
1. Headlines and banner advertisements.
...
The district court properly identified Welles’ situation as one which must… be excepted. No
descriptive substitute exists for PEI’s trademarks in this context.…Just as the newspapers
in New Kids could only identify the band clearly by using its trademarked name, so can Welles
only identify herself clearly by using PEI’s trademarked title.
The second part of the nominative use test requires that “only so much of the mark or marks
may be used as is reasonably necessary to identify the product or service[.]” New Kids provided
the following examples to explain this element: “[A] soft drink competitor would be entitled to
compare its product to Coca-Cola or Coke, but would not be entitled to use Coca-Cola’s
Saylor URL: http://www.saylor.org/books

Saylor.org
853

distinctive lettering.” Similarly, in a past case, an auto shop was allowed to use the trademarked
term “Volkswagen” on a sign describing the cars it repaired, in part because the shop “did not
use Volkswagen’s distinctive lettering style or color scheme, nor did he display the encircled
‘VW’ emblem.” Welles’ banner advertisements and headlines satisfy this element because they
use only the trademarked words, not the font or symbols associated with the trademarks.
The third element requires that the user do “nothing that would, in conjunction with the mark,
suggest sponsorship or endorsement by the trademark holder.” As to this element, we conclude
that aside from the wallpaper, which we address separately, Welles does nothing in conjunction
with her use of the marks to suggest sponsorship or endorsement by PEI. The marks are clearly
used to describe the title she received from PEI in 1981, a title that helps describe who she is. It
would be unreasonable to assume that the Chicago Bulls sponsored a website of Michael
Jordan’s simply because his name appeared with the appellation “former Chicago Bull.”
Similarly, in this case, it would be unreasonable to assume that PEI currently sponsors or
endorses someone who describes herself as a “Playboy Playmate of the Year in 1981.” The
designation of the year, in our case, serves the same function as the “former” in our example. It
shows that any sponsorship or endorsement occurred in the past.
For the foregoing reasons, we conclude that Welles’ use of PEI’s marks in her headlines and
banner advertisements is a nominative use excepted from the law of trademark infringement.
2. Metatags
Welles includes the terms “playboy” and “playmate” in her metatags. Metatags describe the
contents of a website using keywords. Some search engines search metatags to identify websites
relevant to a search. Thus, when an internet searcher enters “playboy” or “playmate” into a
search engine that uses metatags, the results will include Welles’ site. Because Welles’ metatags
do not repeat the terms extensively, her site will not be at the top of the list of search results.
Applying the three-factor test for nominative use, we conclude that the use of the trademarked
terms in Welles’ metatags is nominative.
As we discussed above with regard to the headlines and banner advertisements, Welles has no
practical way of describing herself without using trademarked terms. In the context of metatags,

Saylor URL: http://www.saylor.org/books

Saylor.org
854

we conclude that she has no practical way of identifying the content of her website without
referring to PEI’s trademarks.
...
Precluding their use would have the unwanted effect of hindering the free flow of information on
the internet, something which is certainly not a goal of trademark law. Accordingly, the use of
trademarked terms in the metatags meets the first part of the test for nominative use.…We
conclude that the metatags satisfy the second and third elements of the test as well. The
metatags use only so much of the marks as reasonably necessary and nothing is done in
conjunction with them to suggest sponsorship or endorsement by the trademark holder. We
note that our decision might differ if the metatags listed the trademarked term so repeatedly
that Welles’ site would regularly appear above PEI’s in searches for one of the trademarked
terms.
3. Wallpaper/watermark.
The background, or wallpaper, of Welles’ site consists of the repeated abbreviation “PMOY ’81,”
which stands for “Playmate of the Year 1981.” Welles’ name or likeness does not appear before
or after “PMOY ’81.” The pattern created by the repeated abbreviation appears as the
background of the various pages of the website. Accepting, for the purposes of this appeal, that
the abbreviation “PMOY” is indeed entitled to protection, we conclude that the repeated, stylized
use of this abbreviation fails the nominative use test.
The repeated depiction of “PMOY ‘81” is not necessary to describe Welles. “Playboy Playmate of
the Year 1981” is quite adequate. Moreover, the term does not even appear to describe Welles—
her name or likeness do not appear before or after each “PMOY ’81.” Because the use of the
abbreviation fails the first prong of the nominative use test, we need not apply the next two
prongs of the test.
Because the defense of nominative use fails here, and we have already determined that the
doctrine of fair use does not apply, we remand to the district court. The court must determine
whether trademark law protects the abbreviation “PMOY,” as used in the wallpaper.
B. Trademark Dilution [At this point, the court considers and rejects PEI’s claim for trademark
dilution.]
Saylor URL: http://www.saylor.org/books

Saylor.org
855

Conclusion
For the foregoing reasons, we affirm the district court’s grant of summary judgment as to PEI’s
claims for trademark infringement and trademark dilution, with the sole exception of the use of
the abbreviation “PMOY.” We reverse as to the abbreviation and remand for consideration of
whether it merits protection under either an infringement or a dilution theory.

CASE QUESTIONS

1. Do you agree with the court’s decision that there is no dilution here?
2. If PMOY is not a registered trademark, why does the court discuss it?
3. What does “nominative use” mean in the context of this case?
4. In business terms, why would PEI even think that it was losing money, or could lose money,
based on Welles’s use of its identifying marks?

22.6 Summary and Exercises
Summary

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

EXERCISES

1. Samuel Morse filed claims in the US Patent Office for his invention of the telegraph and also
for the “use of the motive power of the electric or galvanic current…however developed, for

Saylor URL: http://www.saylor.org/books

Saylor.org
856

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

SELF-TEST QUESTIONS

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

Saylor URL: http://www.saylor.org/books

Saylor.org
857

a.

a synthesized molecule

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

a closely guarded trade secret not released to the public

b. a patent granted by the US Patent and Trademark Office
c. a copyright registered in the US Copyright Office
d. a federal trademark registered under the Lanham Act
A sculptor casts a marble statue of a three-winged bird. To protect against
copying, the sculptor can obtain which of the following?
a.

a patent

b. a trademark
c. a copyright
d. none of the above
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

Saylor URL: http://www.saylor.org/books

SELF-TEST ANSWERS
Saylor.org
858

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

Chapter 23
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 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.

Saylor URL: http://www.saylor.org/books

Saylor.org
859

23.1 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 /6059 - mayer_1.0-ch49, 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 23.1 An Antitrust Schematic

Saylor URL: http://www.saylor.org/books

Saylor.org
860

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.

Saylor URL: http://www.saylor.org/books

Saylor.org
861

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 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
Saylor URL: http://www.saylor.org/books

Saylor.org
862

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 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
Saylor URL: http://www.saylor.org/books

Saylor.org
863

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.
What does “restraint of trade” mean? The Sherman Act’s drafters based the act on a commonlaw 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 anactual adverse impact on competition,
Saylor URL: http://www.saylor.org/books

Saylor.org
864

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.
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 /6059 - mayer_1.0-ch49.

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, thirtySaylor URL: http://www.saylor.org/books

Saylor.org
865

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 /6059 -

mayer_1.0-ch05. 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 are directly involved in antitrust 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

Saylor URL: http://www.saylor.org/books

Saylor.org
866

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 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

Saylor URL: http://www.saylor.org/books

Saylor.org
867

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 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
Saylor URL: http://www.saylor.org/books

Saylor.org
868

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 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
Saylor URL: http://www.saylor.org/books

Saylor.org
869

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”
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 very essence.” [9] 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 Oilitself 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
Saylor URL: http://www.saylor.org/books

Saylor.org
870

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 Oilopinion, 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.
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 violations 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. Price-fixing is an example. Price-fixing is said to
Saylor URL: http://www.saylor.org/books

Saylor.org
871

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 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).
Saylor URL: http://www.saylor.org/books

Saylor.org
872

[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).

23.2 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, 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

Saylor URL: http://www.saylor.org/books

Saylor.org
873

Price-fixing agreements are per se violations of Section 1 of the Sherman Act. The per se rule was
announced explicitly in United States v. Trenton Potteries. [1] In that case, twenty individuals
and twenty-three 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 amaximum 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
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
Saylor URL: http://www.saylor.org/books

Saylor.org
874

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
afterAmerican 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.

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’
Saylor URL: http://www.saylor.org/books

Saylor.org
875

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, Section 23.8.1 "Horizontal
Restraints of Trade", 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.

Nonprice 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 v. Sealy, the defendant company licensed manufacturers to use the Sealy
trademark on beds and mattresses and restricted the territories in which the manufacturers
could sell. [6] 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
Saylor URL: http://www.saylor.org/books

Saylor.org
876

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 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
Saylor URL: http://www.saylor.org/books

Saylor.org
877

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 uncontradicted fact that within blocks
of Klor’s, hundreds of household appliance retailers stood ready to sell the public 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
Saylor URL: http://www.saylor.org/books

Saylor.org
878

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.
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).
Saylor URL: http://www.saylor.org/books

Saylor.org
879

[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).

23.3 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 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
ofresale 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
Saylor URL: http://www.saylor.org/books

Saylor.org
880

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 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.
Saylor URL: http://www.saylor.org/books

Saylor.org
881

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 anticompetitive conduct.” The Khan case is at the end of this chapter, in Section 23.8.2 "Vertical
Maximum Price Fixing and the Rule of Reason".

Exclusive Dealing and Tying
We move now to a nonprice 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 anexclusive 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 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)
Saylor URL: http://www.saylor.org/books

Saylor.org
882

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 franchisee that can carry cooking ingredients bought
only from the franchisor (Chapter 24 "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:
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
Saylor URL: http://www.saylor.org/books

Saylor.org
883

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 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 themselves whenever
a party has sufficient economic power with respect to the tying product
Saylor URL: http://www.saylor.org/books

Saylor.org
884

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. (See United States v.
Microsoft.[6])

Nonprice Vertical Restraints: Allocating Territory and Customers
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
Saylor URL: http://www.saylor.org/books

Saylor.org
885

affected. The key here is distinguishing intrabrand competition from interbrand 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 interbrand competition.
Intrabrand 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, intrabrand competition is lowered, but interbrand competition remains
strong.
Notice that it is unlikely that the six remaining retailers will raise their prices substantially, since
there is still strong interbrand competition. If the retailer only deals in Samsung electronics, it is
unlikely to raise prices that much, given the strength of interbrand 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
interbrand 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 class of customers. Samsung may reduce its outlets in Iowa from four to
Saylor URL: http://www.saylor.org/books

Saylor.org
886

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 “interbrand competition.” Thus the rule of reason will apply to vertical allocation
of customers and territory.

Nonprice 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

Saylor URL: http://www.saylor.org/books

Saylor.org
887

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).

23.4 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.
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 RobinsonPatman 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
Saylor URL: http://www.saylor.org/books

Saylor.org
888

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 RobinsonPatman 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.

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

Saylor URL: http://www.saylor.org/books

Saylor.org
889

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 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
Saylor URL: http://www.saylor.org/books

Saylor.org
890

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 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

Saylor URL: http://www.saylor.org/books

Saylor.org
891

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 has 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 23.2 "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 23.2 Primary-Line Injury

Saylor URL: http://www.saylor.org/books

Saylor.org
892

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 that 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 Pushers’s business begins to slack off. This is secondaryline injury at the buyer’s level. Jobbers and Pushers are in direct competition, and by impairing
Pushers’s ability to compete, the requisite injury has been committed. This situation is
illustrated inFigure 23.3 "Secondary-Line Injury".
Saylor URL: http://www.saylor.org/books

Saylor.org
893

Figure 23.3 Secondary-Line Injury

Variations on this secondary-line injury are possible. Assume Ace Brothers sells directly to Fast
Widgets, a retail shop, and also to Jobbers. Jobbers sells to retail shops that compete with Fast
Widgets and also directly to consumers. The situation is illustrated in Figure 23.4 "Variation on
Secondary-Line Injury").

Figure 23.4 Variation on Secondary-Line Injury

Saylor URL: http://www.saylor.org/books

Saylor.org
894

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 competitors could buy it from their
wholesalers. See Figure 23.5 "Variation: Morton Salt Co." for a schematic illustration. In this

Saylor URL: http://www.saylor.org/books

Saylor.org
895

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 23.5 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 23.6 "Variation: Boron-Fast Schematic" shows the Boron-Fast schematic.
Saylor URL: http://www.saylor.org/books

Saylor.org
896

Figure 23.6 Variation: Boron-Fast Schematic

Third-Line Injury
Second-line injury to buyers does not exhaust the possibilities. Robinson-Patman also
[cell cut: 2183541 characters, first 2000000 kept]